Community Bank Shares of Indiana 10-K 2012
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
x Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the Fiscal Year Ended December 31, 2011
¨ Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ____________ to _________
Commission File No. 0-25766
Community Bank Shares of Indiana, Inc.
(Exact Name of Registrant as Specified in its Charter)
101 West Spring Street, New Albany, Indiana 47150
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (812) 944-2224
Securities Registered Pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act:
Indicate by checkmark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES ¨NO x
Indicate by checkmark if the Registrant is not required to file requests pursuant to Section 13 or 15(d) of the Act. YES ¨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 twelve months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such requirements for the past 90 days. YES x NO ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulations S-T during the preceding 12 months. YES x NO ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer x Smaller reporting company ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ¨ NO x
As of June 30, 2011, the aggregate market value of the Registrant’s common stock held by non-affiliates of the Registrant was $28,437,126 based on the closing sale price as reported on the National Association of Securities Dealers Automated Quotation System National Market System. Shares of common stock held by each officer, director, and holder of 10% or more of the outstanding common stock of the Registrant have been excluded from this calculation in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
As of March 23, 2012, there were issued and outstanding 3,358,479 shares of the Registrant's Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s definitive Proxy Statement for its Annual Meeting of Stockholders to be held on May 15, 2012 are incorporated by reference into Items 10, 11, 12, 13 and 14 of Part III.
Item 1. Business
Community Bank Shares of Indiana, Inc. (the “Company”) is a bank holding company headquartered in New Albany, Indiana. The Company’s wholly-owned banking subsidiaries are Your Community Bank (“YCB”) and The Scott County State Bank (“SCSB”)(YCB and SCSB are at times collectively referred to as the “Banks”). The Banks are state-chartered commercial banks headquartered in New Albany, Indiana and Scottsburg, Indiana, respectively, and are both regulated by the Indiana Department of Financial Institutions. YCB is also regulated by the Federal Deposit Insurance Corporation (“FDIC”) and (with respect to its Kentucky branches) the Kentucky Department of Financial Institutions while SCSB is also regulated by the Federal Reserve.
YCB has three wholly-owned subsidiaries to manage its investment portfolio. CBSI Holdings, Inc. and CBSI Investments, Inc. are Nevada corporations which jointly own CBSI Investment Portfolio Management, LLC, a Nevada limited liability corporation which holds and manages investment securities previously owned by the Bank.
In June 2004 and June 2006, the Company completed placements of floating rate subordinated debentures through two trusts formed by the Company, Community Bank Shares (IN) Statutory Trust I and Trust II (“Trusts”). Because the Trusts are not consolidated with the Company, the Company’s financial statements reflect the subordinated debt issued by the Company to the Trusts.
The Company had total assets of $797.4 million, total deposits of $581.4 million, and stockholders' equity of $79.5 million as of December 31, 2011. The Company's principal executive office is located at 101 West Spring Street, New Albany, Indiana 47150, and the telephone number at that address is (812) 944-2224.
The Company's current business strategy is to operate well-capitalized, profitable and independent community banks that have a significant presence in their primary market areas. The Company’s growth strategy is focused on expansion through organic growth within its market areas. The Company offers business and personal banking services through a full range of deposit products that include non-interest and interest-bearing checking accounts, ATM’s, debit cards, savings accounts, money market accounts, certificates of deposit and individual retirement accounts. The Company’s loan products include: secured and unsecured business loans of various terms to local businesses and professional organizations; consumer loans including home equity lines of credit, automobile and recreational vehicles, construction, and loans secured by deposit accounts; and residential real estate loans. In addition, the Company also offers non-deposit investment products such as stocks, bonds, mutual funds, and annuities to customers within its banking market areas through a strategic alliance with Axiom Financial Strategies Group of Wells Fargo Advisors.
Internal Growth. Management believes the optimum way to grow the Company is by attracting new loan and deposit customers within its existing markets through its extensive product offerings and attentive customer service. Management believes the Company’s customers seek a banking relationship with a service-oriented community banking institution and feels the Company’s banking centers have an atmosphere which facilitates personalized service and a broad range of product offerings to meet customers’ needs. However, the Company will consider acquisition opportunities that help advance its strategic objectives.
Branch Expansion. Management continues to consider opportunities for branch expansion and is focusing its current efforts within existing markets. Management considers a variety of criteria when evaluating potential branching opportunities. These include: the market location of the potential branch and demographics of the surrounding communities; the investment required and opportunity costs; staffing needs; and other criteria management deems of particular importance.
Commercial Business Loans. The Company originates non-real estate related business loans to local businesses and professional organizations. This type of commercial loan has been offered at both variable rates and fixed rates and can be unsecured or secured by general business assets such as equipment, accounts receivable or inventory. Such loans generally have shorter terms and higher interest rates than commercial real estate loans. These commercial business loans involve a higher level of credit risk because of the type and nature of the collateral.
Commercial Real Estate Loans. The Company's commercial real estate loans are secured by improved property such as offices, small business facilities, apartment buildings, nursing homes, warehouses and other non-residential buildings, most of which are located in the Company's primary market area and some of which are to be used or occupied by the borrowers. Commercial real estate loans have been offered at adjustable interest rates and at fixed rates, typically with balloon provisions at the end of the term financing. The Company continues to offer commercial real estate loans, commercial real estate construction and development loans and land loans. Loans secured by commercial real estate generally involve a greater degree of risk than residential mortgage loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentrations of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multifamily and commercial real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired. The Company has sought to increase its origination of multi-family residential or commercial real estate loans over the last few years while attempting to decrease its exposure to development and land loans and has attempted to protect itself against the increased credit risk associated with these loans through its underwriting standards and ongoing monitoring processes.
Residential Real Estate Loans. The Company originates one-to-four family, owner-occupied, residential mortgage loans secured by property located in the Company's market area. While the Company currently sells a portion of its residential real estate loans into the secondary market, the Company does originate and retain a significant amount of these loans in its own portfolio. The majority of the Company's residential mortgage loans consist of loans secured by owner-occupied, single family residences. The Company currently offers residential mortgage loans for terms up to thirty years, with adjustable (“ARM”) or fixed interest rates. Origination of fixed-rate mortgage loans versus ARM loans is monitored continuously and is affected significantly by the level of market interest rates, customer preference, and loan products offered by the Company's competitors. Therefore, even if management's strategy is to emphasize ARM loans, market conditions may be such that there is greater demand for fixed-rate mortgage loans and/or fixed rate mortgage loans with balloon payment features.
The Company's fixed and adjustable rate residential mortgage loans are amortized on a monthly basis with principal and interest due each month. Residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms because borrowers may refinance or prepay loans at their option.
The primary purpose of offering ARM loans is to make the Company's loan portfolio more interest rate sensitive. ARM loans, however, can carry increased credit risk because during a period of rising interest rates the risk of default on ARM loans may increase due to increases in borrowers’ monthly payments.
After the initial fixed rate period, the Company's ARM loans generally adjust annually with interest rate adjustment limitations of two percentage points per year and six percentage points over the life of the loan. The Company also makes ARM loans with interest rates that adjust every one, three or five years. Under the Company's current practice, after the initial fixed rate period the interest rate on ARM loans adjusts to the applicable index plus a spread. The Company's policy is to qualify borrowers for one-year ARM loans based on the initial interest rate plus the maximum annual rate increase.
The Company has used different indices for its ARM loans such as the National Average Median Cost of Funds, the Sixth District Net Cost of Funds Monthly Index, the National Average Contract Rate for Previously Occupied Homes, the average three year Treasury Bill Rate, and the Eleventh District Cost of Funds. Consequently, the adjustments in the Company's portfolio of ARM loans tend not to reflect any one particular change in any specific interest rate index, but general interest rate trends overall.
Secondary market regulations limit the amount that a bank may lend based on the appraised value of real estate. Such regulations permit a maximum loan-to-value ratio of 95% percent for residential property and from 65-90% for all other real estate related loans.
The Company occasionally makes real estate loans with loan-to-value ratios in excess of 80%. For the loans sold into the secondary market, individual investor requirements pertaining to private mortgage insurance apply. For the mortgage real estate loans retained by the Company with loan-to-value ratios of 80-90%, the Company may require the first 20% of the loan to be covered by private mortgage insurance. For the mortgage real estate loans retained by the Company with loan-to-value ratios of 90-95%, the Company may require private mortgage insurance to cover the first 25-30% of the loan amount. The Company requires fire and casualty insurance, as well as title insurance or an opinion of counsel regarding good title, on all properties securing real estate loans made by the Company.
Construction Loans. The Company originates loans to finance the construction of owner-occupied residential property. The Company makes construction loans to private individuals for the purpose of constructing a personal residence or to local real estate builders and developers. Construction loans generally are made with either adjustable or fixed-rate terms, typically up to 12 months. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are structured to be converted to permanent loans at the end of the construction period or to be terminated upon receipt of permanent financing from another financial institution.
Consumer Loans. The principal types of consumer loans offered by the Company are home equity lines of credit, auto loans, home improvement loans, and loans secured by deposit accounts. Home equity lines of credit are predominately made at rates which adjust periodically and are indexed to the prime rate and generally have rate floors. Some consumer loans are offered on a fixed-rate basis depending upon the borrower's preference. The Company's home equity lines of credit are generally secured by the borrower's principal residence and a personal guarantee.
The underwriting standards employed by the Company for consumer loans include a determination of the applicant's credit history and an assessment of the prospective borrower’s ability to meet existing obligations and payments on the proposed loan. The stability of the applicant's monthly income may be determined by verification of gross monthly income from primary employment and from any verifiable secondary income. The underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount.
Mortgage-Banking Operations. The Company originates qualified government guaranteed loans and conventional secondary market loans which are sold with the servicing released. This arrangement provides necessary liquidity to the Company while providing additional loan products to the Company’s customers.
Loan Solicitation and Processing. Loans are originated through a number of sources including loan sales staff, real estate broker referrals, existing customers, borrowers, builders, attorneys and walk-in customers. Processing procedures are affected by the type of loan requested and whether the loan will be funded by the Company or sold into the secondary market.
Mortgage loans that are sold into the secondary market are submitted, when possible, for Automated Underwriting, which allows for faster approval and an expedited closing. The Company’s responsibility on these loans is the fulfillment of the loan purchaser's requirements. These loans require credit reports, appraisals, and income verification before they are approved or disapproved. Private mortgage insurance is generally required on loans with a ratio of loan to appraised value of greater than eighty percent. Property insurance and flood certifications are required on all real estate loans.
Installment loan documentation varies by the type of collateral offered to secure the loan. In general, an application and credit report is required before a loan is submitted for underwriting. The underwriter determines the necessity of any additional documentation, such as income verification or appraisal of collateral. An authorized loan officer approves or declines the loan after review of all applicable loan documentation collected during the underwriting process.
Commercial loans are underwritten by the commercial loan officer who makes the initial contact with the customer applying for credit. The underwriting of these loans is reviewed after the fact by the Risk Management area for compliance with the Company's general underwriting standards. A loan exceeding the authority of the underwriting loan officer requires the approval of other officers of the Banks based upon individual lending authorities, the Directors’ Loan Committee, or the Board of Directors of the Banks, depending on the loan amount.
Loan Commitments. The Company issues loan origination commitments to qualified borrowers primarily for the construction and purchase of residential real estate and commercial real estate. Such commitments are made with specified terms and conditions for periods of thirty days for commercial real estate loans and sixty days for residential real estate loans.
As of December 31, 2011, the Company employed 201 employees, 189 full-time and 12 part-time. None of these employees are represented by a collective bargaining group. Neither the Company nor any subsidiary has ever experienced a work stoppage.
Competition and Market Area Served
The banking business is highly competitive, and as such the Company competes not only with other commercial banks, but also with savings and loan associations, trust companies and credit unions for deposits and loans, as well as stock brokerage firms, insurance companies, and other entities providing one or more of the services and products offered by the Company. In addition to competition, the Company's business and operating results are affected by the general economic conditions prevalent in its market.
The Company’s primary market areas consist of Floyd, Clark, and Scott counties in Southern Indiana and Jefferson and Nelson counties in Kentucky. These are four (excluding Scott County) of the thirteen counties comprising the Louisville, Kentucky Standard Metropolitan Statistical Area, which has a population in excess of 1.2 million. The aggregate population of Floyd, Clark, and Scott counties is approximately 204,000 while the populations of Jefferson and Nelson Counties are approximately 714,000 and 43,000, respectively. The Company's headquarters are located in New Albany, Indiana, a city of 37,000 located approximately three miles from the center of Louisville.
Nature of Company’s Business
The business of the Company is not seasonal. The Company’s business does not depend upon a single customer, or a few customers, the loss of any one or more of which would have a material adverse effect on the Company. No material portion of the Company’s business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of any governmental entity.
Regulation and Supervision
As a bank holding company, the Company is regulated under the Bank Holding Company Act of 1956, as amended (the "Act"). The Act limits the business of bank holding companies to banking, managing or controlling banks and other subsidiaries authorized under the Act, performing certain servicing activities for subsidiaries and engaging in such other activities as the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) may determine to be closely related to banking. The Company is registered with and is subject to regulation by the Federal Reserve Board. Among other things, applicable statutes and regulations require the Company to file an annual report and such additional information as the Federal Reserve Board may require pursuant to the Act and the regulations which implement the Act. The Federal Reserve Board also conducts examinations of the Company.
The Act provides that a bank holding company must obtain the prior approval of the Federal Reserve Board to acquire more than five percent of the voting stock or substantially all the assets of any bank or bank holding company. The Act also provides that, with certain exceptions, a bank holding company may not (i) engage in any activities other than those of banking or managing or controlling banks and other authorized subsidiaries, or (ii) own or control more than five percent of the voting shares of any company that is not a bank, including any foreign company. A bank holding company is permitted, however, to acquire shares of any company, the activities of which the Federal Reserve Board has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company may also acquire shares of a company which furnishes or performs services for a bank holding company and acquire shares of the kinds and in the amounts eligible for investment by national banking associations. In addition, the Federal Reserve Act restricts the Bank’s extension of credit to the Company.
The Dodd-Frank Wall Street Reform and Consumer Protection Act financial reform legislation (“Dodd-Frank”), which became law on July 21, 2010, significantly revised and expanded the rulemaking, supervisory and enforcement authority of federal bank regulators. Dodd-Frank impacts many aspects of the financial industry and, in many cases, will impact larger and smaller financial institutions and community banks differently over time. Dodd-Frank includes, among other provisions, the following:
Many of the requirements of Dodd-Frank will be implemented over time and most will be subject to regulations to be implemented or which will not become fully effective for several years.
On November 12, 1999, Congress enacted the Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act permits bank holding companies to qualify as "financial holding companies" that may engage in a broad range of financial activities, including underwriting, dealing in and making a market in securities, insurance underwriting and agency activities and merchant banking. The Federal Reserve Board is authorized to expand the list of permissible financial activities. The Gramm-Leach-Bliley Act also authorizes banks to engage through financial subsidiaries in nearly all of the activities permitted for financial holding companies. The Company has not elected the status of financial holding company and at this time has no plans for these investments or broader financial activities.
As state-chartered commercial banks, the Company’s subsidiary banks are subject to examination, supervision and extensive regulation by the Federal Deposit Insurance Corporation (“FDIC”), the Indiana Department of Financial Institutions (“DFI”), with respect to YCB and its branch offices located in Kentucky, the Kentucky Department of Financial institutions (“KDFI), and by the Federal Reserve with respect to SCSB. The Banks are members of and own stock in the Federal Home Loan Bank (“FHLB”) of Indianapolis and Cincinnati. The FHLB institutions located in Indianapolis and Cincinnati are two of the twelve regional banks in the FHLB system. The Banks are also subject to regulation by the Federal Reserve Board, which governs reserves to be maintained against deposits and regulates certain other matters. The extensive system of banking laws and regulations to which the Banks are subject is intended primarily for the protection of the Company’s customers and depositors, and not its shareholders.
The FDIC, Federal Reserve, and DFI/KOFI regularly examine the Banks and prepare reports for the consideration of the Banks’ Board of Directors on any deficiencies that they may find in the Banks’ operations. The relationship of the Banks with their depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in such matters as the form and content of the Banks’ mortgage documents and communication of loan and deposit rates to both existing and prospective customers.
The investment and lending authority of a state-chartered bank is prescribed by state and federal laws and regulations, and such banks are prohibited from engaging in any activities not permitted by such laws and regulations. These laws and regulations generally are applicable to all state chartered banks. The Banks may not lend to a single or related group of borrowers on an unsecured basis an amount in excess of the greater of $500,000 or fifteen percent of the Banks unimpaired capital and surplus on a disaggregated basis. An additional amount may be lent, equal to ten percent of unimpaired capital and surplus, if such loan is secured by readily marketable collateral, which is defined to include certain securities, but generally does not include real estate.
Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than ten percent stockholder of a bank, and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the institution's loans to one borrower limit (15% of the Bank’s unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board of directors approval for certain loans. In addition, the aggregate amount of extensions of credit to all insiders cannot exceed the institution's unimpaired capital and surplus. At December 31, 2011 the Banks were in compliance with the above restrictions.
Safety and Soundness. The Federal Deposit Insurance Act (“FDIA”), as amended by the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) and the Riegle Community Development and Regulatory Improvement Act of 1994, requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to the internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest-rate-risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits and such other operational and managerial standards as the agencies may deem appropriate. The federal bank regulatory agencies adopted, effective August 9, 1995, a set of guidelines prescribing safety and soundness standards pursuant to FDICIA, as amended. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines.
The FDIC generally is authorized to take enforcement action against a financial institution that fails to meet its capital requirements; such action may include restrictions on operations and banking activities, the imposition of a capital directive, a cease and desist order, civil money penalties or harsher measures such as the appointment of a receiver or conservator or a forced merger into another institution. In addition, under current regulatory policy, an institution that fails to meet its capital requirements is prohibited from paying any dividends. Except under certain circumstances, further disclosure of final enforcement action by the FDIC is required.
Prompt Corrective Action. Under Section 38 of the FDIA, as amended by the FDICIA, each federal banking agency was required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies, including the FDIC, adopted substantially similar regulations to implement Section 38 of the FDIA, effective as of December 19, 1992. Under the regulations, an institution is deemed to be (i) "well-capitalized" if it has total risk-based capital of 10.0% or more, a Tier 1 risk-based capital ratio of 6.0% or more, a Tier 1 leverage capital ratio of 5.0% or more and is not subject to any order or final capital directive to meet and maintain a specific capital level for any capital measure, (ii) "adequately-capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well-capitalized," (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a Tier II average capital ratio that is less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Section 38 of the FDIA and the regulations promulgated thereunder also specify circumstances under which a federal banking agency may reclassify a well-capitalized institution as adequately-capitalized and may require an adequately-capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At December 31, 2011, the Company and the Banks were deemed well-capitalized for purposes of the above regulations. As discussed above, Dodd-Frank may result in more stringent capital requirements in the future.
Federal Home Loan Bank System. The Banks are members of the FHLB of Indianapolis. The FHLB of Indianapolis is one of the 12 regional FHLB's that lend money to its members to finance housing and economic development. With the enactment of the Housing and Economic Recovery Act on July 30, 2008, the Federal Housing Finance Agency (“FHFA”) was created to oversee the secondary mortgage market. The Act empowered the FHFA with the powers to oversee and regulate Fannie Mae, Freddie Mac, and the FHLBs.
As members of the FHLB system, the Banks are required to purchase and maintain stock in the FHLB in an amount equal to the greater of one percent of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year, or 1/20 (or such greater fraction as established by the FHLB) of outstanding FHLB advances. At December 31, 2011, $5.5 million of FHLB stock was outstanding for the Banks, which were in compliance with this requirement. In past years, the Banks have received dividends on its FHLB stock.
Insurance of Accounts. The FDIC is an independent federal agency that insures deposits, up to prescribed statutory limits, of federally insured banks and savings institutions and safeguards the safety and soundness of the banking and savings industries. The FDIC insures our customer deposits through the Deposit Insurance Fund (the “DIF”) up to prescribed limits for each depositor. Pursuant to Dodd-Frank, the maximum deposit insurance amount has been permanently increased to $250,000 and all non-interest-bearing transaction accounts are insured through December 31, 2012. The amount of FDIC assessments paid by each DIF member institution is based on its relative risk of default as measured by regulatory capital ratios and other supervisory factors. Due to the greatly increased number of bank failures and losses incurred by DIF, as well as the recent extraordinary programs in which the FDIC has been involved to support the banking industry generally, the FDIC’s DIF was substantially depleted and the FDIC has incurred substantially increased operating costs. In November, 2009, the FDIC adopted a requirement for institutions to prepay in 2009 their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011, and 2012. The Banks prepaid their assessments based on the calculations of the projected assessments at that time.
As required by Dodd-Frank, the FDIC adopted a new DIF restoration plan which became effective on January 1, 2011. Among other things, the plan: (1) raises the minimum designated reserve ratio, which the FDIC is required to set each year, to 1.35 percent (from the former minimum of 1.15 percent) and removes the upper limit on the designated reserve ratio (which was formerly capped at 1.5 percent) and consequently on the size of the fund; (2) requires that the fund reserve ratio reach 1.35 percent by 2020; (3) requires that, in setting assessments, the FDIC "offset the effect of (requiring that the reserve ratio reach 1.35 percent by September 30, 2020 rather than 1.15 percent by the end of 2016) on insured depository institutions with total consolidated assets of less than $10,000,000,000; (4) eliminates the requirement that the FDIC provide dividends from the fund when the reserve ratio is between 1.35 percent and 1.5 percent; and (5) continues the FDIC’s authority to declare dividends when the reserve ratio at the end of a calendar year is at least 1.5 percent, but grants the FDIC sole discretion in determining whether to suspend or limit the declaration or payment of dividends. The FDI Act continues to require that the FDIC’s Board of Directors consider the appropriate level for the designated reserve ratio annually and, if changing the designated reserve ratio, engage in notice-and-comment rulemaking before the beginning of the calendar year. The FDIC has set a long-term goal of getting its reserve ratio up to 2% of insured deposits by 2027.
On February 7,
2011, the FDIC approved a final rule, as mandated by Dodd-Frank, changing the deposit insurance assessment system from one that
is based on total domestic deposits to one that is based on average consolidated total assets minus average tangible equity.
In addition, the final rule creates a scorecard-based assessment system for larger banks (those with more than $10 billion
in assets). Larger insured depository institutions will likely pay higher assessments to the DIF than under the old system. The
FDIC suspended dividends indefinitely; however, in lieu of dividends, and pursuant to its authority to set risk-based assessments,
the FDIC adopted progressively lower assessment rate schedules that will take effect when the reserve ratio exceeds 1.15 percent,
2 percent, and 2.5 percent. Additionally, the final rule included a new adjustment for depository institution debt whereby an institution
pays an additional premium equal to 50 basis points on every dollar of long-term, unsecured debt held as an asset that was
issued by another insured depository institution (excluding debt guaranteed under the TLGP)
The Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain reserves against their transaction accounts and non-personal time deposits. Banks are authorized to borrow from the Federal Reserve Bank "discount window," but Federal Reserve Board regulations require banks to exhaust other reasonable alternative sources of funds, including FHLB advances, before borrowing from the Federal Reserve Bank.
SCSB is required to purchase and maintain stock in the Federal Reserve. At December 31, 2011, SCSB had $453,000 of Federal Reserve stock outstanding, which was in compliance with requirements. In past years, SCSB has received dividends on its Federal Reserve stock.
Federal Taxation. For federal income tax purposes, the Company and its subsidiaries file a consolidated federal income tax return on a calendar year basis. Consolidated returns have the effect of eliminating intercompany distributions, including dividends, from the computation of consolidated taxable income for the taxable year in which the distributions occur.
The Company and its subsidiaries are subject to the rules of federal income taxation generally applicable to corporations under the Internal Revenue Code of 1986, as amended (the "Code").
Indiana Taxation. The Company is subject to an income tax imposed by the State of Indiana. The tax is imposed at the rate of 8.5 percent of the Company's adjusted gross income. In computing adjusted gross income, no deductions are allowed for municipal interest and U.S. Government interest. In 2000, the Indiana financial institution tax law was amended to treat resident financial institutions the same as nonresident financial institutions by providing for apportionment of Indiana income based on receipts in Indiana. This revision allowed for the exclusion of receipts from out of state sources and federal government and agency obligations.
Currently, income from YCB’s subsidiaries CBSI Holdings, Inc., CBSI Investments, Inc. and CBSI Investment Portfolio Management, LLC is not subject to the Indiana income tax.
Kentucky Taxation. The Company is subject to a franchise tax imposed by the Commonwealth of Kentucky on its operations in Kentucky. The tax is imposed at a rate of 1.1% on taxable net capital, which equals capital stock paid in, surplus, undivided profits and capital reserves, and accumulated other comprehensive income or loss, less an amount equal to the same percentage of the total as the book value of United States obligations and Kentucky obligations bears to the book value of the total assets of the financial institution. A financial institution whose business activity is taxable within and without Kentucky must apportion its net capital based on the three factor apportionment formula of receipts, property and payroll unless the Kentucky Revenue Cabinet has granted written permission to use another method.
Participation in the Capital Purchase Program. Throughout 2008, the United States Federal Government launched a series of financial initiatives aimed at stabilizing the economy. The United States Department of the Treasury (“Treasury”) launched one of its largest initiatives, the Capital Purchase Program (“CPP”), under the Emergency Economic Stabilization Act (“EESA”) in October 2008. The CPP is a voluntary program which offered qualifying banks and bank holding companies the opportunity to sell preferred securities and warrant to the Treasury. The same terms generally applied to all public company participants in the plan. By providing capital to financial institutions through the CPP, Treasury aimed to enhance market confidence in the entire banking system by stabilizing the financial markets, thereby increasing the capacity of these institutions to lend to U.S. businesses and consumers and to support the U.S. economy under the difficult financial market conditions. On May 29, 2009, we entered into a letter agreement with the Treasury under the CPP by which we sold to the Treasury our preferred securities and warrant. In 2011, the Company repurchased its preferred shares and warrant issued in connection with its participation in CPP in connection with our participation in the Treasury’s Small Business Lending Fund. For a description of the transaction, see Note 12 to the Consolidated Financial Statements.
Participation in the Small Business Lending Fund. The Small Business Lending Fund (“SBLF”) is a dedicated investment fund that encourages lending to small businesses by providing capital to qualified community banks with assets of less than $10 billion. Enacted into law as part of the Small Business Jobs Act of 2010, under the SBLF Treasury makes a capital investment into community banks the dividend payment on which is adjusted depending on the growth in the bank’s qualifying small business lending. On September 15, 2011, as part of the SBLF program, the Company sold $28.0 million of Non-Cumulative Perpetual Preferred Stock, Series B (the “SBLF Preferred Stock”), to the Secretary of the Treasury (the “Secretary”), and used the proceeds from the sale of the SBLF Preferred Stock to redeem the 19,468 shares of the Company’s Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “CPP Preferred Stock”), issued in 2009 to the Treasury under the CPP, plus the accrued and unpaid dividends owed on the CPP Preferred Stock. As a result of its redemption of the CPP Preferred Stock, the Company is no longer subject to the limits on executive compensation and other restrictions stipulated under CPP. The Company will be subject to all terms, conditions and other requirements for participation in SBLF for as long as any SBLF Preferred Stock remains outstanding.
Available Information. The Company files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission (“SEC”) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The public may read and copy any material the Company files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549 and may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC on its website at www.sec.gov. The Company makes available through its website, www.yourcommunitybank.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K.
Item 1A. Risk Factors
There are a number of factors, including those specified below, that may adversely affect our business, financial results or stock price. Additional risks that we currently do not know about or currently view as immaterial may also impair our business or adversely impact our financial results or stock price.
As used in this Item 1A of the Form 10-K, the terms “we”, “us” and “our” refer to Community Bank Shares of Indiana, Inc., an Indiana corporation and its subsidiaries (unless the context clearly implies otherwise).
Industry Risk Factors
Economic Conditions. Our earnings are affected by the general economic conditions in the United States, and to a lesser extent, general international economic conditions. Economic conditions in the United States and abroad deteriorated significantly in the latter part of 2008 which continued into 2009, 2010 and 2011. Business activity across a wide range of industries and regions in the United States was greatly reduced. Although economic conditions have improved, certain sectors, such as real estate, remain weak and unemployment remains high. Many businesses are still in serious difficulty due to reduced consumer spending and continued liquidity challenges in the credit markets. Many financial institutions and institutional investors have tightened the availability of credit to borrowers and other financial institutions, which, in turn, results in more loan defaults and decreased business activity. While we have seen some signs of improvement, we do not expect significant improvement in the economy in the near future.
Enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the promulgation of regulations thereunder could significantly increase our compliance and operating costs or otherwise have a material and adverse effect on the Company’s financial position, results of operations, or cash flows. Recent government efforts to strengthen the U.S. financial system have resulted in the imposition of additional regulatory requirements, including expansive financial services regulatory reform legislation. Dodd-Frank sets out sweeping regulatory changes. Changes imposed by Dodd-Frank include, among others: (i) new requirements on banking, derivative and investment activities, including modified capital requirements, the repeal of the prohibition on the payment of interest on business demand accounts, and debit card interchange fee requirements; (ii) corporate governance and executive compensation requirements; (iii) enhanced financial institution safety and soundness regulations, including increases in assessment fees and deposit insurance coverage; and (iv) the establishment of new regulatory bodies, such as the Bureau of Consumer Financial Protection. Many of the requirements of Dodd-Frank will be implemented over time and most will be subject to regulations to be implemented or which will not become fully effective for several years.
Current and future legal and regulatory requirements, restrictions and regulations, including those imposed under Dodd-Frank, may adversely impact our profitability and may have a material and adverse effect on our business, financial condition, and results of operations. These requirements, restrictions and regulations may require us to invest significant management attention and resources to evaluate and make any changes required by the legislation and accompanying rules and may make it more difficult for us to attract and retain qualified executive officers and employees. See previous discussion under “Regulation and Supervision” for more information on Dodd-Frank.
Changes in the laws, regulations and policies governing financial services companies could alter our business environment and adversely affect our operations. The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part our cost of funds for lending and investing and the return that can be earned on those loans and investments, both of which affect our net interest margin. Federal Reserve Board policies can also materially affect the value of financial instruments that we hold, such as debt securities.
We, along with our subsidiaries, are heavily regulated at the federal and state levels. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Congress and state legislatures and federal and state agencies continually review banking laws, regulations and policies for possible changes. Changes in statutes, regulations or policies could affect us in substantial and unpredictable ways, including limiting the types of financial services and products that we offer and/or increasing the ability of non-banks to offer competing financial services and products. We cannot predict whether any of this potential legislation will be enacted, and if enacted, the effect that it or any regulations would have on our financial condition or results of operations.
The financial services industry is highly competitive, and competitive pressures could intensify and adversely affect our financial results. We operate in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. We compete with other commercial banks, savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions and investment companies. In addition, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Many of our competitors have fewer regulatory constraints and some have lower cost structures. Also, the potential need to adapt to industry changes in information technology systems, on which we and the financial services industry are highly dependent, could present operational issues and require capital spending.
Changes in consumer use of banks and changes in consumer spending and saving habits could adversely affect our financial results. Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This “disintermediation” could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.
Risks associated with unpredictable economic and political conditions may be amplified as a result of our limited market area. Commercial banks and other financial institutions are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, value of the dollar, recession, unemployment, high interest rates, short money supply, scarce natural resources, international disorders, terrorism and other factors beyond our control may adversely affect profitability. In addition, almost all of our primary business area is located in Southern Indiana and Jefferson County, Kentucky. A significant downturn in this regional economy may result in, among other things, deterioration in our credit quality or a reduced demand for credit and may harm the financial stability of our customers. Due to the regional market area, these negative conditions may have a more noticeable effect on us than would be experienced by an institution with a larger, more diverse market area.
Changes in the domestic interest rate environment could reduce our net interest income. Interest rate volatility could significantly harm our business. Our results of operations are affected by the monetary and fiscal policies of the federal government and the regulatory policies of governmental authorities. A significant component of earnings is net interest income, which is the difference between the income from interest-earning assets, such as loans, and the expense of interest-bearing liabilities, such as deposits. A change in market interest rates could adversely affect earnings if market interest rates change such that the interest we pay on deposits and borrowings increases faster than the interest we collect on loans and investments. Consequently, along with other financial institutions generally, we are sensitive to interest rate fluctuations.
Company Risk Factors
Our allowance for loan losses may not be adequate to cover actual losses. Like all financial institutions, we maintain an allowance for loan losses to provide for probable incurred losses due to loan defaults, non-performance, and other qualitative factors. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the loan portfolio, loan portfolio performance, fair value of collateral securing the loans, current economic conditions and geographic concentrations within the portfolio. Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect its financial results.
We may suffer losses in our loan portfolio despite our underwriting practices. Our results of operations are significantly affected by the ability of borrowers to repay their loans. Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is historically small, but if nonpayment levels are greater than anticipated, our earnings and overall financial condition, as well as the value of our common stock, could be adversely affected. No assurance can be given that our underwriting practices or monitoring procedures and policies will reduce certain lending risks. Loan losses can cause insolvency and failure of a financial institution and, in such an event, our stockholders could lose their entire investment. In addition, future provisions for loan losses could materially and adversely affect profitability. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.
Our loan portfolio is predominantly secured by real estate and thus we have a higher degree of risk from a downturn in our real estate markets. A further downturn in our real estate markets could hurt our business because many of our loans are secured by real estate. Real estate values and real estate markets are generally affected by changes in national, regional or local economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax laws and other governmental statutes, regulations and policies and acts of nature. Substantially all of our real estate collateral is located in Southern Indiana, Scottsburg, Indiana, and Louisville and Bardstown, Kentucky. If real estate values, including values of land held for development, continue to decline, the value of real estate collateral securing our loans could be significantly reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans. Commercial real estate loans typically involve large balances to single borrowers or group of related borrowers. Since payments on these loans are often dependent on the successful operation or management of the properties, as well as the business and financial condition of the borrower, repayment of such loans may be subject to adverse conditions in the real estate market, adverse economic conditions or changes in applicable government regulations.
Additional risks associated with our construction loan portfolio include failure of contractors to complete construction on a timely basis or at all, market deterioration during construction, cost overruns and failure to sell or lease the security underlying the construction loans so as to generate the cash flow anticipated by our borrower. Continued declines in real estate values, coupled with the current economic downturn and an associated increase in unemployment, may result in higher than expected loan delinquencies or problem assets, a decline in demand for our products and services, or a lack of growth or decrease in deposits, which may cause us to incur losses, adversely affect our capital or hurt our business.
We may incur losses in our investments portfolio. Our investment portfolio is comprised of state and municipal securities, residential mortgage-backed agencies issued by U.S. Government sponsored entities securities, trust preferred securities, and mutual funds. We must evaluate these securities for other-than-temporary impairment loss (“OTTI”) on a periodic basis. In 2009 and 2010, we recognized an OTTI charge on five of our six trust preferred securities holdings. Our remaining trust preferred securities, including those for which we recognized an OTTI charge, still exhibit signs of weakness which may necessitate an OTTI charge in the future should the financial condition of the underling issuers in the pools deteriorate further. Also, given the current economic environment we may need to record an OTTI charges in our other investments the future should the issuers of those securities experience financial difficulties. Any future OTTI charges could significantly impact our earnings.
Maintaining or increasing our market share may depend on lowering prices and market acceptance of new products and services. Our success depends, in part, on our ability to adapt our products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. Lower prices can reduce our net interest margin and revenues from our fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require us to make substantial expenditures to modify or adapt our existing products and services. Also, these and other capital investments in our businesses may not produce expected growth in earnings anticipated at the time of the expenditure. We might not be successful in introducing new products and services, achieving market acceptance of its products and services, or developing and maintaining loyal customers.
Because the nature of the financial services business involves a high volume of transactions, we face significant operational risks. Operational risk is the risk of loss resulting from our operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, we could suffer financial loss, face regulatory action and suffer damage to its reputation.
Acquisitions and the addition of branch facilities may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties. We regularly explore opportunities to establish branch facilities and acquire other banks or financial institutions. New or acquired branch facilities and other facilities may not be profitable. We may not be able to correctly identify profitable locations for new branches. The costs to start up new branch facilities or to acquire existing branches, and the additional costs to operate these facilities, may increase our noninterest expense and decrease earnings in the short term. It may be difficult to adequately and profitably manage growth through the establishment of these branches. In addition, we can provide no assurance that these branch sites will successfully attract enough deposits to offset the expenses of operating these branch sites. Any new or acquired branches will be subject to regulatory approval, and there can be no assurance that we will succeed in securing such approvals.
We cannot predict the number, size or timing of acquisitions. Difficulty in integrating an acquired business or company may cause us not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition (run-off), loss of key employees, disruption of our business or the business of the acquired company, or otherwise adversely affect our ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. Also, the negative effect of any divestitures required by regulatory authorities in acquisitions or business combinations may be greater than expected.
Our business could suffer if we fail to attract and retain skilled people. Our success depends, in large part, on our ability to attract and retain key people. Competition can be intense for the best people in most activities in which we engage. We may not be able to hire the best people or to keep them.
Significant legal actions could subject us to substantial uninsured liabilities. We are from time to time subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. To protect us from the cost of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage may not cover all claims against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our results of operations and financial condition.
We are exposed to risk of environmental liability when we take title to properties. In the course of our business, we may foreclose on and take title to real estate. As a result, we could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to 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 investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be 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 financial condition and results of operations could be adversely affected.
There is a limited trading market for our stock and you may not be able to resell your shares at or above the price you paid for them. The price of the common stock purchased may decrease significantly. Although our common stock is quoted on the Nasdaq Capital Market under the symbol "CBIN", trading activity in the stock historically has been sporadic. A public trading market having the desired characteristics of liquidity and order depends on the presence in the market of willing buyers and sellers at any given time. The presence of willing buyers and sellers depends on the individual decisions of investors and general economic conditions, all of which are beyond our control.
Liquidity risk could impair our ability to fund operations and jeopardize our financial condition. Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a material adverse effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities could be impaired by factors that affect us specifically or the financial services industry in general. Factors that could detrimentally impact our access to liquidity sources include a decrease in the level of our business activity due to a market downturn or adverse regulatory action against us. Our ability to acquire deposits or borrow could also be impaired by factors that are not specific to us, such as a severe disruption of the financial markets or negative views and expectations about the prospects for the financial services industry as a whole.
Our status as a holding company makes us dependent on dividends from our subsidiaries to meet our obligations. We are a bank holding company and conduct almost all of our operations through YCB and SCSB. We do not have any significant assets other than cash and the stock of YCB and SCSB. Accordingly, we depend on dividends from our subsidiaries to meet our obligations and obtain revenue. Our right to participate in any distribution of earnings or assets of our subsidiaries is subject to the prior claims of creditors of such subsidiaries. Under federal and state law, our bank subsidiaries are limited in the amount of dividends they may pay to us without prior regulatory approval. The Banks must maintain sufficient capital and liquidity and be in compliance with other general regulatory restrictions. Bank regulators have the authority to prohibit the subsidiary banks from paying dividends if the bank regulators determine the payment would be an unsafe and unsound banking practice. As of December 31, 2011, our subsidiaries had the ability to pay us dividends of $11.9 million without prior regulatory approval.
The FDIC’s restoration plan and the related increased assessment rate could affect our earnings. As a result of a series of financial institution failures and other market developments, the deposit insurance fund, or DIF, of the FDIC has been significantly depleted and reduced the ratio of reserves to insured deposits. In response to the recent economic conditions and the enactment of the Dodd-Frank Act, the FDIC has increased the deposit insurance assessment rates and thus raised deposit premiums for insured depository institutions. If these increases are insufficient for the DIF to meet its funding requirements, further special assessments or increases in deposit insurance premiums may be required which we may be required to pay. We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures or if the FDIC otherwise determines, we may be required to pay even higher FDIC premiums than the recently increased levels. Any future additional assessments, increases or required prepayments in FDIC insurance premiums may materially adversely affect our results of operations and could have a materially adverse effect on the value or market for our common stock.
Our results of operations and financial condition may be negatively affected if we are unable to meet a debt covenant and, correspondingly, unable to obtain a waiver regarding the debt covenant from the lender. From time to time we may obtain financing from other lenders. The loan documents reflecting the financing often require us to meet various debt covenants. If we are unable to meet one or more of our debt covenants, then we will typically attempt to obtain a waiver from the lender. If the lender does not agree to a waiver, then we will be in default under our borrowing obligation. This default could affect our ability to fund various strategies that we may have implemented resulting in a negative impact in our results of operations and financial condition.
Our business may be adversely affected by internet fraud. The Company is inherently exposed to many types of operational risk, including those caused by the use of computer, internet and telecommunications systems. These risks may manifest themselves in the form of fraud by employees, by customers, other outside entities targeting us and/or our customers that use our internet banking, electronic banking or some other form of our telecommunications systems. Given the growing level of use of electronic, internet-based, and networked systems to conduct business directly or indirectly with our clients, certain fraud losses may not be avoidable regardless of the preventative and detection systems in place.
We may experience interruptions or breaches in our information system security. We rely heavily on communications and information systems to conduct our business. Any failure or interruption of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure or interruption of these information systems, there can be no assurance that any such failures or interruptions will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures or interruptions of these information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
A failure in or breach, including cyber attacks, of our operational or security systems, or those of our third party vendors and other service providers, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a financial institution, we are susceptible to fraudulent activity that may be committed against us or our clients and that may result in financial losses to us or our clients, privacy breaches against our clients, or damage to our reputation. Such fraudulent activity may take many forms, including check fraud, electronic fraud, wire fraud, phishing, and other dishonest acts. In recent periods, there has been a rise in electronic fraudulent activity within the financial services industry, especially in the commercial banking sector, due to cyber criminals targeting commercial bank accounts. Consistent with industry trends, we have also experienced an increase in attempted electronic fraudulent activity in recent periods.
In addition, our operations rely on the secure processing, storage and transmission of confidential and other information on our computer systems and networks. Although we take numerous protective measures to maintain the confidentiality, integrity and availability of our and our clients’ information across all geographic and product lines, and endeavor to modify these protective measures as circumstances warrant, the nature of the threats continues to evolve. As a result, our computer systems, software and networks and those of our customers may be vulnerable to unauthorized access, loss or destruction of data (including confidential client information), account takeovers, unavailability of service, computer viruses or other malicious code, cyber attacks and other events that could have an adverse security impact and result in significant losses by us and/or our customers. Despite the defensive measures we take to manage our internal technological and operational infrastructure, these threats may originate externally from third parties, such as foreign governments, organized crime and other hackers, and outsource or infrastructure-support providers and application developers, or the threats may originate from within our organization. Given the increasingly high volume of our transactions, certain errors may be repeated or compounded before they can be discovered and rectified.
We also face the risk of operational disruption, failure, termination or capacity constraints of any of the third parties that facilitate our business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an attack on, or breach of, our operational systems, data or infrastructure. In addition, as interconnectivity with our clients grows, we increasingly face the risk of operational failure with respect to our clients’ systems.
Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, there can be no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats, the outsourcing of some of our business operations, and the continued uncertain global economic environment. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities.
We maintain an insurance policy which we believe provides sufficient coverage at a manageable expense for an institution of our size and scope with similar technological systems. However, we cannot assure that this policy will afford coverage for all possible losses or would be sufficient to cover all financial losses, damages, penalties, including lost revenues, should we experience any one or more of our or a third party’s systems failing or experiencing attack.
Our ability to pay dividends is subject to certain limitations and restrictions, and there is no guarantee that we will be able to continue paying the same level of dividends in the future that we paid in 2011 or that we will be able to pay future dividends at all. Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital. The ability of Your Community Bank and The Scott County Bank to pay dividends to us is limited by its obligations to maintain sufficient capital and liquidity and by other general restrictions on dividends that are applicable to these banks, including state regulatory requirements. The FDIC and other bank regulators have proposed guidelines and seek greater liquidity, and have been discussing increasing capital requirements. If these regulatory requirements are not met, our subsidiary banks will not be able to pay dividends to us, and we may be unable to pay dividends on our common stock.
In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) in light of our earnings, capital adequacy and financial condition. As a general matter, the Federal Reserve indicates that the board of directors of a bank holding company (including a financial holding company) should eliminate, defer or significantly reduce the dividends if:
On September 15, 2011, we issued shares of perpetual senior preferred stock to the Treasury as part of the Small Business Lending Fund. We are prohibited from continuing to pay dividends on our common stock unless we have fully paid all required dividends on the senior preferred stock. Although we expect to be able to pay all required dividends on the senior preferred stock, there is no guarantee that we will be able to do so.
If the Company is unable to redeem its Series B Preferred Stock after an initial four-and-one-half year period, the cost of this capital will increase substantially. If the Company is unable to redeem its Series B Preferred Stock prior to June 15, 2016, the cost of this capital to us will increase from approximately $1.1 million annually (dividend rate for the fourth quarter of 2011, or 4.1% per annum of the Series B preferred stock liquidation value) to $2.5 million annually (9.0% per annum of the Series B preferred stock liquidation value). This increase in the annual dividend rate on the Series B preferred stock would have a material negative effect on the earnings the Company can retain for growth and to pay dividends on its common stock.
Item 1B. Unresolved Staff Comments
The Company has received no written communication from the staff of the SEC regarding its periodic or current reporting under the Exchange Act.
Item 2. Properties
The Company conducts its business through its corporate headquarters located in New Albany, Indiana. YCB operates a main office and eleven branch offices in Clark and Floyd Counties, Indiana, and five branch offices in Jefferson and Nelson Counties, Kentucky. SCSB operates a main office and three branch offices in Scott County, Indiana. The following table sets forth certain information concerning the main offices and each branch office at December 31, 2011. The Company’s aggregate net book value of premises and equipment was $13.8 million at December 31, 2011.
Item 3. Legal Proceedings
There are various claims and law suits in which the Company or its subsidiaries are periodically involved, such as claims to enforce liens, foreclosure or condemnation proceedings on properties in which the Banks hold mortgages or security interests, claims involving the making and servicing of real property loans and other issues incident to the Banks’ business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits. Further, we maintain liability insurance to cover some, but not all, of the potential liabilities normally incident to the ordinary course of our businesses as well as other insurance coverage customary in our business, with coverage limits as we deem prudent.
Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities
The Company’s common stock is traded on the Nasdaq Capital Market under the symbol “CBIN”. The quarterly range of low and high trade prices per share of the Company’s common stock for the periods indicated as reported on the Nasdaq Capital Market, as well as the per share dividend paid in each such quarter by the Company on its common stock is shown below.
As of March 23, 2012 there were 824 holders of the Company’s common stock.
The Company intends to continue its historical practice of paying quarterly cash dividends although there is no assurance that such dividends will continue to be paid in the future. The payment of dividends in the future is dependent on future income, financial position, capital requirements, the discretion and judgment of the Board of Directors, and other considerations. In addition, the payment of dividends is subject to the regulatory restrictions described in Note 13 to the Company's consolidated financial statements.
Securities Authorized for Issuance under Equity Compensation Plans
The following table sets forth certain information regarding Company compensation plans under which equity securities of the Company are authorized for issuance.
(1) Of the shares reflected, 163,195 shares are available to be awarded under the Company’s Stock Award Plan and 267,525 shares are available to be awarded under the Company’s Performance Units Plan.
The following performance graph and included data shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed soliciting material or subject to Regulation 14A of the Exchange Act or incorporated by reference in any filing under the Exchange Act or the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.
The graph compares the performance of Community Bank Shares of Indiana, Inc. common stock to the Russell 2000 index and the SNL Bank $500 MM - $1 B Bank index for the Company’s last five fiscal years. The graph assumes the value of the investment in Company common stock and in each index was $100 at December 31, 2006 and that all dividends were reinvested.
Item 6. Selected Financial Data
The following table sets forth the Company’s selected historical consolidated financial information from 2007 through 2011. This information should be read in conjunction with the Consolidated Financial Statements and the related Notes. Factors affecting the comparability of certain indicated periods are discussed in "Management’s Discussion And Analysis Of Financial Condition And Results Of Operations." For analytical purposes, net interest margin is adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt assets, such as state and municipal securities. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
* Number is not meaningful
Item 7. Management’s Discussion And Analysis Of Financial Condition And Results of Operations
This section presents an analysis of the consolidated financial condition of the Company and its wholly-owned subsidiaries, the Banks, at December 31, 2011 and 2010, and the consolidated results of operations for each of the years in the three year period ended December 31, 2011. The information contained in this section should be read in conjunction with the consolidated financial statements, notes to consolidated financial statements and other financial data presented elsewhere in this annual report on Form 10-K.
The Company conducts its primary business through the Banks, which are community-oriented financial institutions offering a variety of financial services to its local communities. The Banks are engaged primarily in the business of attracting deposits from the general public and using such funds for the origination of: 1) commercial business and real estate loans and 2) secured consumer loans such as home equity lines of credit, automobile loans, and recreational vehicle loans. Additionally, the Banks originate and sell into the secondary market mortgage loans for the purchase of single-family homes in Floyd, Clark, and Scott counties, Indiana, and Jefferson and Nelson counties, Kentucky, including surrounding communities. The Banks invest excess liquidity balances in mortgage-backed, U.S. agency, state and municipal and corporate securities.
The operating results of the Company depend primarily upon the Banks’ net interest income, which is the difference between interest earned on interest-earning assets and interest incurred on interest-bearing liabilities. Interest-earning assets principally consist of loans, taxable and tax-exempt securities, and FHLB stock. Interest-bearing liabilities principally include deposits, retail repurchase agreements, federal funds purchased, advances from the FHLB Indianapolis, and subordinated debentures. The earnings of the Banks are also affected by 1) provision for loan losses, 2) non-interest income (including mortgage banking income, net gains on sales of securities, deposit account service charges and commission-based income on non-deposit investment products), 3) non-interest expenses (including compensation and benefits, occupancy, equipment, data processing expenses, marketing and advertising, legal and professional fees, FDIC insurance premiums, net foreclosed and repossessed asset expense, and other expenses, such as postage, printing, and telephone expenses), and 4) income tax expense.
Forward Looking Information
Statements contained within this report that are not statements of historical fact constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. When used in this discussion the words "anticipate," "project," "expect," "believe," and similar expressions are intended to identify forward-looking statements. The Company cautions that these forward-looking statements are subject to numerous assumptions, risks and uncertainties, all of which may change over time. Actual results could differ materially from forward-looking statements.
In addition to factors disclosed by the Company elsewhere in this annual report on Form 10-K, the following factors, among others, could cause actual results to differ materially from such forward-looking statements: 1) adverse changes in economic conditions affecting the banking industry in general and, more specifically, the market areas in which the Company and its subsidiary Banks operate, 2) adverse changes in the legislative and regulatory environment affecting the Company and its subsidiary Banks, 3) increased competition from other financial and non-financial institutions, 4) the impact of technological advances on the banking industry, and 5) other risks detailed at times in the Company’s filings with the Securities and Exchange Commission (see Item 1A of this annual report on Form 10-K for more risk factors). The Company does not assume an obligation to update or revise any forward-looking statements subsequent to the date on which they are made.
Application of Critical Accounting Policies
The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles and follow general practices within the financial services industry. The most significant accounting policies followed by the Company are presented in Note 1 to the Consolidated Financial Statements. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, fair value of investment securities and deferred tax assets to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
Allowance for Loan Losses
The allowance for loan losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated fair value of collateral securing the loans, estimated losses on loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses, and a discussion of the factors driving changes in the amount of the allowance for loan losses is included under "Asset Quality" below.
Loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, amounts of allowances are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Company. Included in the review of individual loans are those that are impaired. The Company evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Historical loss rates are applied to other loans not subject to allowance allocations. These historical loss rates may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in the nature and volume of loans (delinquencies, charge-offs and nonaccrual loans), changes in mix, asset quality trends, risk management and loan administration, changes in internal lending policies and credit standards, and examination results from bank regulatory agencies and the Company's internal credit examiners.
The Company has not substantively changed any aspect to its overall approach in the determination of the allowance for loan losses. There have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance.
Based on the procedures discussed above, management is of the opinion that the allowance of $10.2 million was adequate to address probable incurred credit losses associated with the loan portfolio at December 31, 2011.
Fair Value of Trust Preferred Securities
The Company had six trust preferred securities in its investment portfolio as of December 31, 2011 with a combined amortized cost of $4.1 million and a fair value of $937,000 as of the same date. Beginning in 2008, the market for these types of securities effectively froze as market participants were unwilling to conduct transactions unless forced to do so. As a result, the fair value of these securities began deteriorating significantly in 2008 and remained depressed through 2011. In 2009 and 2010, the Company recorded aggregate other-than-temporary impairment (“OTTI”) charges to earnings of $1.5 million related to five of the six securities in its portfolio due to continued weakening of the underlying issuers. Management evaluates these investments for OTTI by estimating the anticipated discounted cash flows from each security. The determination of the anticipated cash flows and the discount rate are both significant estimates requiring management’s judgment. Also, the estimated fair value of these securities is more difficult to determine due to the current market volatility and illiquidity. The valuation model to determine fair value utilizes discounted cash flow models with significant unobservable inputs. In management’s estimation, the valuation method provided a more relevant and accurate representation of the fair value of these securities as of December 31, 2011.
Carrying Value of Foreclosed and Repossessed Assets
Foreclosed and repossessed assets are acquired through or instead of loan foreclosure and are initially measured at fair value less estimated costs to sell. The Company obtains appraisals to determine the initial fair value and then makes any adjustments deemed necessary based on prevailing market conditions and length the asset remains in the Company’s inventory. Determining the carrying value requires significant management judgment as foreclosed and repossessed assets are typically acquired in distressed situations which may materially impact the valuation compared to similar assets in non-distressed sales transactions. Also, if foreclosed and repossessed assets are not sold in a timely manner, they can deteriorate in value significantly as there may be volatility in the market. At December 31, 2011, the Company had foreclosed and repossessed assets of $5.1 million which, in management’s estimation, were reported at the appropriate carrying value.
Deferred Tax Assets
The Company has a net deferred tax asset of approximately $2.2 million. The Company evaluates this asset on a quarterly basis. To the extent the Company believes it is more likely than not that it will not be utilized, the Company will establish a valuation allowance to reduce its carrying amount to the amount it expects to be realized. At December 31, 2011, a valuation allowance of $2.1 million has been established against the outstanding deferred tax asset due to incurred net operating losses for state income taxes. The net operating loss is partially due to YCB’s Nevada subsidiaries that hold and manage YCB’s investments and for the results of 2009 including elevated provision for loan losses. There is uncertainty the Company will be able to utilize this benefit, thus a valuation allowance has been established against the state net operating loss. Note 11 to the Consolidated Financial Statements describes the net deferred tax asset. The Company was profitable in 2010 and 2011 and has a positive earnings outlook for 2012. The net loss for 2009 was primarily attributable to a goodwill and other intangible asset impairment of $16.2 million and an elevated provision for loan losses of $15.9 million which were not repeated in 2010 and 2011 and are not expected to be repeated in 2012. As of December 31, 2011, the Company has $865,000 of remaining other intangible assets subject to impairment and has an allowance for loan losses to total loans ratio of 2.05% which management believes is sufficient to cover probable incurred losses as of that date. The estimate of the realizable amount of this asset is a critical accounting policy.
The Company had net income available to common shareholders of $6.0 million for the year ended December 31, 2011 compared to $5.9 million for 2010. The increase in earnings in 2011 was attributable to increases in net interest income of $559,000 and non-interest income of $1.1 million. Earnings per basic and diluted common shares increased to $1.82 and $1.79 for the year ended December 31, 2011 compared to basic and diluted earnings per common share of $1.80 and $1.77 in 2010. The Company’s book value per common share increased to $15.47 per share at December 31, 2011 from $13.36 at December 31, 2010.
The following table summarizes selected financial information regarding the Company's financial performance:
Table 1 – Summary
The Company’s total assets decreased to $797.4 million at December 31, 2011 from $801.5 million at December 31, 2010 primarily due to decreases in net loans of $12.5 million and securities available for sale of $5.4 million, offset by increases in cash and due from financial institutions and interest-bearing deposits in other financial institutions of $3.5 million and $6.5 million, respectively. Total deposits decreased by $37.5 million to $581.4 million at December 31, 2011 while non-interest deposits increased by $12.9 million from 2010. Other borrowings and FHLB advances increased by $1.5 million and $5.0 million, respectively, to $50.9 million and $55.0 million as of December 31, 2011. Total shareholders’ equity increased by $16.3 million to $79.5 million at December 31, 2011 as the Company achieved net income available to common shareholders of $6.0 million, a net increase of $7.8 million from the repurchase of preferred shares issued under the Treasury’s Capital Purchase Program (including the associated warrant) and shares issued under the Treasury’s Small Business Lending Fund, and declared and paid dividends on common shares of $1.3 million.
Results of Operations
Net Interest Income
The Company’s principal revenue source is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities, and the interest expense on the liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is impacted by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.
For the year ended December 31, 2011, net interest income increased to $28.3 million from $27.7 million in 2010 while the net interest margin on a taxable equivalent basis increased to 4.07% in 2011 as compared to 3.90% in 2010. The increase in net interest income and margin from 2010 to 2011 was achieved mostly through a decrease in the Company’s cost of interest bearing liabilities of 32 basis points, primarily time deposits and FHLB advances. The decrease in the cost of interest bearing liabilities was partially offset by a decrease in the yield on interest earning assets of 12 basis points which was mostly attributable to the decline in the yield on the Company’s loan portfolio during 2011. Also, the Company’s average non-interest bearing deposits decreased during 2011 to $119.9 million from $135.8 million in 2010 which also offset the decline in the cost of interest bearing liabilities.
Average interest earning assets decreased from $739.8 million for 2010 to $726.6 million in 2011, mostly due to decreases in average loans and interest-bearing deposits in other financial institutions while the yield decreased from 5.01% in 2010 to 4.89% in 2011. The Company’s yield on loans declined to 5.46% on an average balance of $505.1 million for 2011. The decrease in the average balance was due to net loan payments of $4.7 million and charge-offs during 2011 of $5.6 million while the reduction in yield was attributable to new loans and renewals being originated at lower rates due to the current rate environment and competition from other lending institutions. The markets in which the Company operates are extremely competitive for qualified loan customers which has resulted in downward pressure on the loan portfolio yield. Also impacting the yield on loans are non-accrual loans of $15.8 million and troubled debt restructurings of $24.2 million, which are at below market rates for the associated risk, as of December 31, 2011. The average balance of taxable securities has increased to $139.7 million for 2011 while the yield as declined to 2.81% from 2010 as the Company sold a significant portion of the portfolio during 2011 which, along with proceeds from maturities and prepayments, were reinvested at lower yields. The Company’s average balance in tax-exempt securities increased to $58.3 million in 2011 from $47.1 million in 2010 while the yield on a fully taxable equivalent basis declined to 6.48% from 6.74% over the respective periods. The decrease in the yield on tax-exempt securities was due to additional purchases of municipal securities during 2011.
Average interest bearing liabilities decreased to $591.7 million for 2011 as compared to $614.5 million in 2010 with average costs of 1.01% and 1.33%, respectively. The decrease in average balance and cost in 2011 was mostly attributable to a decline in time deposits. Due to the Company’s liquidity position, management was able to lower its offering rates on deposits. As a result, the average balance and cost of time deposits decreased to $208.6 million and 1.31% for 2011 from $242.9 million and 1.76% in 2010. Also contributing to the decrease in cost of funds, were lower average balances and average cost of FHLB advances which declined to $45.6 million and 2.03% in 2011. During 2011, the Company was able to renew maturing advances at lower rates which resulted in interest expense on FHLB advances declining by $527,000.
In 2010, net interest income increased to $27.7 million from $23.9 million for 2009 while the net interest margin on a taxable equivalent basis increased to 3.90% for 2010 from 3.19% in 2009. The increase in net interest income and net interest margin in 2010 was due to a decrease in the cost of interest bearing liabilities of 97 basis points while the yield on interest earnings assets decreased by 15 basis points. The Company’s cost of interest bearing liabilities decreased for most categories of interest bearing liabilities, primarily time deposits and FHLB advances, but increased slightly for other borrowings. Also contributing to the increase in net interest income for 2010 was an increase in average non-interest bearing deposits to $135.8 million from $110.1 million. The Company’s non-interest deposits at December 31, 2010 were $115.0 million, which was lower than the average for the year due to the loss of a significant customer account late in the fourth quarter of 2010.
Average interest earning assets decreased to $739.8 million for the year ended December 31, 2010 from $775.9 million for 2009 while the average yield decreased to 5.01% in 2010 from 5.16% in 2009. Most of the decrease in average interest earning assets was due to a reduction in average loans to $524.0 million in 2010 from $588.0 million in 2009. The decrease was due to net loan repayments and charge-offs during 2010 as loan demand from qualified borrowers remained soft. The yield on loans increased for 2010 to 5.66% from 5.56% as the Company was able to reduce its loans on non-accrual from $22.7 million in 2009 to $15.3 million in 2010. Also factoring into the increase in loan yields was management’s efforts to add rate floors to existing and new credit relationships where the loan was indexed to a variable rate. The Company’s yield on loans remains under pressure as higher-yielding fixed rate loans mature or refinance into a historically low rate environment. In addition, the Company continues to face heavy competition from other financial institutions in its market for new customers which has also put downward pressure on loan yields. Due to the net repayments of loans coupled with soft loan demand and the increase in deposits, the Company’s on balance-sheet liquidity remained elevated during the year. As a result, the Company used incoming cash flows to reduce FHLB advances and withstand a decrease in other borrowings due to reduction in offering rates (see discussion in following paragraph) and increase its investment in securities available for sale. The average balance of taxable securities increased to $120.4 million with a yield of 3.31% for 2010 from $104.5 million and 4.42% in 2009. The decrease in yield was attributable to sales and maturities in the portfolio for gains during the year replaced with purchases of lower-yielding securities. The average balance of tax-exempt securities increased to $47.1 million with a fully taxable equivalent yield of 6.74% from $34.8 million and 6.64% in 2009. The increase in yield on a fully taxable equivalent basis was due to minimal maturities in the portfolio and purchases of securities with higher yields than the portfolio.
Average interest bearing liabilities decreased to $614.5 million in 2010 from $667.1 million in 2009 due mostly to a decrease in the average FHLB advances and average time deposits. During 2010, the Company repaid $18.5 million, net, of FHLB advances, $10.5 million of which were prepayments of putable advances. The Company incurred prepayment penalties of $335,000 on repayment of the putable advances. As a result of these repayments, the Company’s interest expense paid on FHLB advances decreased by $2.8 million during 2010 while the average cost decreased by 232 bps to 2.66%. Beginning in 2009 and finishing in the first quarter of 2010, the Company prepaid a total of $67.0 million of putable advances which had a weighted average cost of 6.03%. These advances had a significant impact on the Company’s net interest income in 2009 and 2008 and a limited effect on net interest income 2010. The weighted average cost of the putable advances was significantly higher than most all alternative funding sources. The cost of time deposits decreased to 1.76% in 2010 from 2.98% in 2009 which contributed further to the overall reduction in the cost of funds. In 2010, the Company was able to reprice maturing time deposits and lower its offering rates for new time deposit accounts due to its strong liquidity position.
Table 2 provides detailed information as to average balances, interest income/expense, and rates by major balance sheet category for 2009 through 2011.
Table 2 - Average Balance Sheets and Rates for Years Ended 2011, 2010 and 2009
For analytical purposes, net interest margin and net interest spread are adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt assets, such as state and municipal securities. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
(1) The amount of direct loan origination cost included in interest on loans was $658, $591, and $726 for the years ended December 31, 2011, 2010, and 2009, respectively.
(2) Includes loans held for sale and non-accruing loans in the average loan amounts outstanding.
Table 3 illustrates the extent to which changes in interest rates on a fully taxable equivalent basis and changes in the volume of interest-earning assets and interest-bearing liabilities affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. A tax rate of 34% was used in adjusting interest on tax-exempt assets to a fully taxable equivalent (“FTE”) basis.
Table 3 - Volume/Rate Variance Analysis
Non-interest income was $8.5 million for 2011, $7.4 million for 2010, and $6.3 million for 2009. For the year ended December 31, 2011, non-interest income increased by 14.4% as compared to 2010 due primarily to increases in net gains on sales of available for sale securities of $748,000 and the non-recurrence of other-than-temporary impairment loss of $360,000 in 2010, offset by a decrease in mortgage banking income of $95,000. In 2010, non-interest income increased by 17.2%, due to increases in net gain on sales of available for sale securities of $371,000, commission income of $77,000, interchange income of $68,000 and a reduction in other-than-temporary impairment losses of $740,000, offset by decreases in gain on sale of loans of $197,000.
Table 4 provides a breakdown of the Company’s non-interest income during the past three years.
Table 4 - Analysis of Non-interest Income
Service charges on deposit accounts decreased slightly for the year ended December 31, 2011 to $3.4 million. On July 1, 2010 regulatory changes required customers to opt in or affirmatively consent to overdraft services and provides them with an ongoing right to revoke consent. Also, we must provide customers who do not opt in with the same account terms, conditions and features, including price, as provided to customers who do opt in. As a result, fee income from non-sufficient funds (“NSF fees”) decreased by $242,000. To offset the reduction in NSF fees, the Company implemented several new fees for deposit accounts during the year including, but not limited to: paper statement fees, dormant account fee, and minimum balance fees. As a result of the new fees, other service charge income on deposit accounts (excluding NSF fees) increased by $204,000. The Company is still reviewing its fee structure and may introduce new fees in 2012. Service charges on deposit accounts decreased slightly by $20,000 to $3.4 million for the year ended December 31, 2010. Of the $3.4 million of service charge income recognized in 2010, approximately $2.5 million was earned from non-sufficient funds and overdraft fees charged to customers. As a result of the aforementioned regulatory change, non-sufficient funds and overdraft fees decreased by $165,000 from 2009 to 2010. The decrease in non-sufficient funds and overdraft fees in 2010 was partially offset by an increase in service fees on deposit accounts of approximately $100,000.
In 2011, the Company received net proceeds of $107.4 million on sales of available for sale securities for net gains of $2.5 million compared to proceeds of $117.8 million and net gains of $1.8 million in 2010. The proceeds from sales were reinvested in the security portfolio. Management continues to selectively sell securities when the proceeds can be reinvested in similar securities with equivalent yields, usually with longer maturities.
Mortgage banking income decreased by $95,000 to $270,000 for the year ended December 31, 2011 compared to $365,000 in 2010. In 2011, the Company originated $15.3 million of loans for sale into the secondary market as compared to $20.2 million in 2010. In 2010, mortgage banking income increased by $51,000 to $365,000 compared to $314,000 in 2009. In 2010, the Company originated $20.2 million of loans for sale into the secondary market as compared to $21.2 million in 2009.
Earnings on company owned life insurance decreased to $686,000 for the year ended December 31, 2011 from $720,000 for the equivalent period in 2010. The income decreased in 2011 due to a decrease in the crediting rate by the companies that issued the policies. During 2010, earnings on company owned life insurance decreased slightly to $720,000 compared to $745,000 in 2009 as the crediting rate remained relatively consistent with 2009.
The Company recorded a net other-than-temporary impairment (“OTTI”) charge in earnings of $360,000 for the year ended December 31, 2010 compared to a charge of $1.1 million in 2009. In 2010 and 2009, the Company recorded OTTI charges on five of its six pooled trust preferred securities (“CDO”), which consisted of bank issuers (the one CDO for which the Company did not record an OTTI charge is comprised of insurance companies). The Company did not record an OTTI charge during 2011. Beginning in 2008 and continuing into 2011 we noted a continuing decline in the fair value of our CDO portfolio due to market illiquidity and a lack of transactions involving these types of securities. Additionally, as the economic downturn continued, we noted further deterioration in the financial condition of the underlying issuers, particularly those pools with issuer banks. Also, we noted an increase in the number of issuers deferring and defaulting on the underlying notes in the CDO’s consistent with the increase in bank closures. Our analysis to determine OTTI is based on estimating the expected cash flows to be received from the underlying issuers and determining the present value of cash flows expected to us utilizing an appropriate discount rate (see footnote 2 to the Consolidated Financial Statements for further discussion). At December 31, 2011, the fair value of our CDO’s has yet to recover. Although an appropriate amount of OTTI has been recorded in 2009 and 2010, further deterioration in the issuers in the CDO’s could lead to future OTTI charges should they be significant.
Commission income from investment products offered to customers through our alliance with Wells Fargo Advisors increased $77,000 for the year ended December 31, 2010 to $130,000 from the year prior. During 2009, the Company transitioned its relationship from Smith Barney to Wells Fargo, as a result, there was a period during 2009 for which the Company did not recognize commission income.
Interchange income increased to $907,000 in 2010 from $839,000 in 2009. The Company has focused on increasing interchange income through various initiatives including offering incentives to current and new customers. In addition, the Company has added new deposit accounts during 2010 which also factored into the increase in interchange income.
Non-interest expense increased to $22.9 million for the twelve months ended December 31, 2011 from $22.5 million for the same period in 2010. The increase was attributable mostly to salaries and employee benefits, but also occupancy, legal and professional, and foreclosed and repossessed assets expense, offset by decreases in equipment, marketing and advertising, FDIC insurance premiums, prepayment penalties on extinguishment of debt, and other expenses. Non-interest expense decreased to $22.5 million for the year ended December 31, 2010 from $41.2 million in 2009. Most categories of non-interest expense declined from the previous year including: salaries and employee benefits, occupancy, equipment, marketing and advertising, legal and professional service fees, FDIC insurance premiums, goodwill and other intangible asset impairment, prepayment penalties on extinguishment of debt, foreclosed and repossessed assets, net, and other expense. Generally, the reductions were achieved through expense reduction initiatives implemented in the second and third quarters of 2009 which were continued into 2010.
Table 5 provides a breakdown of the Company’s non-interest expense for the past three years.
Table 5 - Analysis of Non-interest Expense
Salaries and employee benefits increased to $11.6 million for the year ended December 31, 2011 from $10.5 million in 2010 while the number of full time equivalent employees (“FTE”) decreased to 196 at the end of 2011 from 199 at December 31, 2010. The average expense per FTE increased to $59,000 for 2011 from $53,000 in 2010 which was due to increases in base salaries to employees, bonus and incentive pay, stock based compensation, and unemployment assessments. Due to the Company’s performance in 2011, expense associated with net income increased which included the bonus and incentive pay and certain stock based compensation plans. Unemployment insurance assessments rose during the year due to staff reductions in 2009 which increased the Company’s claims history. In 2010, salaries and benefits decreased to $10.5 million compared to $11.2 million in 2009 while the number of FTE was 199 at the end of each year or $53,000 expense per FTE in 2010 versus $56,000 in 2009. The reduction in expense was primarily achieved due to reductions in staff in the middle of 2009 which lowered the Company’s base compensation from $9.6 million in 2009 to $8.7 million in 2010. Also contributing to the decrease in salaries and employee benefits was a reduction in the employer portion of insurance benefits of $124,000 from the aforementioned reduction in FTEs and new health insurance plan options offered to employees which had lower premiums and a decrease of $77,000 in expenditures for education and other employee benefits. These decreases were partially offset by an increase in stock award and bonus/incentive expense of $474,000 from 2009 to 2010. Due to the Company’s performance in 2009, all stock and bonuses with performance conditions tied to earnings were not met, therefore, expense was not recognized in 2009 related to these plans. In 2010, the Company achieved at least the minimum threshold for most of the plans and recorded the appropriate expense as determined by the Company’s compensation committee and performance conditions.
Occupancy increased from $2.1 million for 2010 to $2.3 million in 2011 due to higher expense for property tax on owned branch locations. During 2011, the Company increased its accrual for property taxes for its Scott County locations. In 2012, the Company anticipates a reduction in property taxes due to the successful challenge of the assessed value of YCB’s main office location with the local government authority. Occupancy expense decreased by $364,000 to $2.1 million in 2010 from $2.4 million in 2009 due to reductions in property taxes, utilities, and depreciation expense. During 2010, the Company closed one of its branch locations in the Jefferson County Kentucky market which lowered utilities and other related costs of operating the branch. In addition, the Company completed depreciating certain leasehold improvements during 2010 which resulted in a significant decrease in expense.
Equipment expense decreased to $1.1 million for 2011 from $1.2 million in 2010 as the result of a decrease in depreciation expense for furniture and fixtures and computer equipment. The Company has been focused on efficient use of its capital expenditures throughout 2010 and 2011 which has allowed us to reduce our expenditures in certain areas and/or use older equipment for longer periods. Equipment expense was $1.2 million for the year ended December 31, 2010, a reduction of $204,000 from $1.4 million in 2009 due to reductions in depreciation expense of $99,000 and maintenance and repairs expenditures of $57,000. As previously noted, the Company implemented several cost reduction initiatives during 2009, one of which was a limitation on purchases of equipment and software. Because equipment and software have short depreciable lives, typically between 3 to 7 years, lower capital expenditures have an immediate impact on the Company’s depreciation expense.
Data processing expense was $2.5 million in 2011 and 2010 as increases in expenditures for core data processing were fully offset by a decrease in expenditures for software maintenance. In 2010 data processing expense remained consistent with 2009 at $2.5 million as reductions in expenditures in communication lines and hardware maintenance were offset by an increase in expense for the Company’s third party core data processor. The increase in core data processor expense was due to the outsourcing of proof operations during 2010 which management estimates will be offset by reductions in hardware maintenance and personnel costs.
Marketing and advertising expense was $219,000 for 2011, down from $241,000 in 2010 as the Company decreased its spending on print and billboard advertising and increased expenditures on sponsorships. Marketing and advertising expense decreased to $241,000 for 2010 from $362,000 in 2009. The reduction was achieved by decreases in the expenditures for newspaper advertising and promotional items.
Legal and professional service fees increased to $1.6 million in 2011 from $1.4 million in 2010. The increase was due to expense associated with collection of past due credits in 2011 as the Company’s level of non-performing loans and classified loan credits remained consistent with 2010. Legal and professional service fees decreased to $1.4 million for the twelve months ended December 31, 2010 as compared to $1.6 million for the equivalent period in 2009. The decrease in was attributable to reductions in legal fees incurred to resolve past due loans of $96,000 and other legal fees of $150,000. The Company continues to have elevated levels of non-performing assets which will necessitate higher legal fees then we have historically incurred to collect and dispose of any foreclosed assets.
FDIC insurance premiums decreased to $743,000 in 2011 from $1.4 million in 2010. The decrease is attributable to a lower assessment rate for each of the Company’s subsidiary banks as the result of improved financial results in 2010. Also, in the second quarter of 2011, the FDIC changed the assessment base the premiums were calculated from the amount of deposits to average assets less average Tier 1 capital which further reduced the Company’s premiums. FDIC insurance premiums were $1.4 million in 2010, a decrease of $315,000 from $1.7 million in 2009 due primarily to a special assessment by the FDIC in 2009 of $370,000 which was not repeated in 2010.
During the twelve months ended December 31, 2011, 2010 and 2009 the Company incurred $0, $335,000 and $838,000 in prepayment penalties on extinguishment of debt for the prepayment of $0, $10.5 million and $56.5 million of FHLB advances, respectively. In total, the Company prepaid $67.0 million in putable advances that carried a weighted average cost of 6.03% which was significantly higher compared to the Company’s other cost of funds. Management determined the penalties incurred for prepaying the advances would be more than offset by a reduction in interest expense over the remaining scheduled maturities for each advance. The prepaid advances were not replaced with other borrowings, therefore, the penalties were entirely expensed in 2010 and 2009.
Foreclosed and repossessed assets expense, net, increased to $735,000 for 2011 as compared to $548,000 in 2010 due primarily to net losses realized on sales in 2011 of $140,000 versus net gains on sales of $11,000 in 2010. It is anticipated expenditures for foreclosed and repossessed assets will remain elevated in 2012. Foreclosed and repossessed assets expense, net was $548,000 for the twelve months ended December 31, 2010 from $665,000 in 2009 due primarily to realized net gains on sales of $12,000 in 2010 as compared to net losses of $(107,000) in 2009. Management was successful in reducing the balance of foreclosed and repossessed assets to $3.6 million as of December 31, 2010 from $5.2 million at end of 2009.
Other expenses decreased to $2.1 million in 2011 from $2.3 million in 2010. The decrease in 2011 was attributable to lower expenditures on postage as the result of fees implemented for paper statements to customers, which increased enrollment for electronic statements. Also contributing to the decline was a reduction in printing expenditures in 2011 as the Company focused on reducing printing by using dual monitors and issuing tablets to members of management.
Income Tax Expense (Benefit)
Income tax expense for 2011 increased to $2.1 million as compared to $1.8 million in 2010 while the Company’s effective tax rate increased to 22.0% from 20.9% over the respective periods. The increase in provision for taxes was directly attributable to an increase in income before taxes of $667,000 from 2010 to 2011. Additionally, the effective tax rate and provision was impacted by the end of the Company’s participation in the New Markets Tax Credit program at the end of 2010 which provided tax credits of $180,000 annually. Income tax expense was $1.8 million for the twelve months in 2010 compared to an income tax benefit of $(4.9) million for the equivalent period in 2009. The change was the result of the large increase in the Company’s pre-tax earnings from 2009.
The Company’s loan portfolio decreased to $500.0 million as of December 31, 2011 from $513.1 million at December 31, 2010. All categories of loans declined from the previous year with the largest decrease occurring in the Company’s construction and consumer loan portfolios. The decreases were due to loan charge-offs during the year of $5.6 million and as well as soft loan demand which resulted in net loan repayments during the year of $4.7 million. The Company’s loan portfolio mix remained relatively consistent with 2010.
Commercial loans, which consist of loans to business customers secured by business assets such as accounts receivable, inventory, and equipment, decreased to $100.9 million as of December 31, 2011 from $103.3 million at December 31, 2010. The decrease in the commercial portfolio was mostly due to charge-offs during 2011 of $2.8 million as new originations were offset by repayments. Commercial loans have certain inherent risks which require loan officers to carefully monitor the borrower’s financial condition and receive periodic updates on the aging and balance of accounts receivable and inventory, if secured by these types of assets. Should the Company be forced to pursue foreclosure, there can often be significant erosion in the value of the collateral securing these types of loans. The value of equipment securing commercial borrowings generally tends to depreciate in value rapidly and/or may be industry specific with a limited market for resale. Accounts receivable are most likely have significant past due issues if the borrower is having financial difficulty and also may be worth a fraction of the balance while inventory may be stale.
Construction loans decreased from $48.9 million at December 31, 2010 to $44.7 million as of December 31, 2011. The decline in construction loans was attributable to charge-offs totaling $1.1 million for 2011 as compared to $4.1 million in 2010. Also, there is very soft demand for construction loans in the Company’s market area for qualified borrowers which further contributed to the decline. Construction loans consist of both individual and business borrowings for the development and construction of 1-4 family residences and subdivisions. Beginning in 2008, the Company has experienced a high rate of delinquency and charge-offs in this portfolio, mostly to developers of multiple properties, as the market for new homes in our market area slowed. The repayment of commercial construction loans is dependent on the resale to third parties in a timely fashion. Should there be a significant delay in selling the finished properties or a downturn in the market, the developer may not receive cash sufficient to service their borrowings. In addition, if the Company forecloses on a partially or fully developed property, there can be significant erosion in value as the improvements may have deteriorated resulting in losses to the Company. Management has continued to work with our construction borrowers who are having difficulty to minimize our loss exposure and prevent foreclosure including restructuring where appropriate.
Commercial real estate loans decreased by $1.2 million to $170.7 million at December 31, 2011 from $171.9 million as of December 31, 2010. Given the sluggish economic conditions, loan demand for new commercial real estate loans has been minimal with most new loans during the year coming from refinancing of existing debt with other financial institutions. Also, we have had strong competition from other financial institutions in our market for new commercial real estate loans to qualified customers and, in some cases, we have declined to match offering rates that we believed were not commensurate with the associated risk.
Residential real estate loans were $175.9 million as of December 31, 2011 as compared to $177.4 million at December 31, 2010, a decrease of $1.5 million. Residential loans included borrowings secured by first and second liens on 1-4 family residential properties, including home equity lines of credit. The decrease in the portfolio was mostly due to soft loan demand as home sales in the Company’s market have been depressed resulting in fewer new loan originations.
At the end of 2011, the Company was servicing $6.0 million in mortgage loans for other investors compared to $8.0 million in 2010. Loans serviced for others consist of loans the Company has sold to the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation with servicing rights retained by the Company.
The Company’s lending activities remain primarily concentrated within its existing markets, and are principally comprised of loans secured by single-family residential housing developments, owner occupied manufacturing and retail facilities, general business assets, and single-family residential real estate. The Company emphasizes the acquisition of deposit relationships from new and existing commercial business and real estate loan clients.
Table 6 provides a breakdown of the Company’s loans by type during the past five years.
Table 6 - Loans by Type
Table 7 illustrates the Company’s fixed rate maturities and repricing frequency for the loan portfolio.
Table 7 - Selected Loan Distribution
Allowance and Provision for Loan Losses
Federal regulations require insured institutions to classify their assets on a regular basis. The regulations provide for three categories of classified loans: substandard, doubtful and loss. The regulations also contain a special mention and a specific allowance category. Special mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving management’s close attention. Assets classified as substandard or doubtful require the institution to establish general allowances for loan losses. If an asset or portion thereof is classified as loss, the insured institution must either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge off such amount.
The Company maintains the allowance for loan losses at a level that is sufficient to absorb probable credit losses incurred in its loan portfolio. The allowance is determined based on the application of loss estimates to graded loans by categories. Management determines the level of the allowance for loan losses based on its evaluation of the collectability of the loan portfolio, including the composition of the portfolio, historical loan loss experience, specific impaired loans, and general economic conditions. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated future cash flows. The allowance for loan losses is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs of specific loans, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited directly to the provision for loan losses. As of December 31, 2011, the Company’s allowance for loan losses totaled $10.2 million, a decrease of $630,000 from December 31, 2010 which lowered the allowance for loan losses to total loans ratio to 2.05% from 2.11% for the same periods, respectively. The Company’s net charge-offs totaled $5.0 million in 2011, down from $8.2 million for the 2010 fiscal year as all loan categories continued to experience higher than historical losses. Of the $5.6 million in charge-offs in 2011, $2.8 million were commercial loans as compared to $843,000 of commercial charge-offs in 2010. The increase in commercial charge-offs was mostly due to the write-off of one large credit, totaling $1.5 million. The remaining $500,000 after the charge-off was placed on non-accrual and was classified as “doubtful” as of 12/31/11. Beginning in late 2007 the Company has experienced an elevated level of non-performing loans coupled with a significant decline in the collateral values securing certain types of loans in its portfolio, specifically construction real estate. The Company’s loan portfolio has had increases in past due loans, impaired loans, and classified loans beginning in 2007 through 2011 which has led to an increase in charge-offs for those credits management has determined to be uncollectible. Management has allocated amounts for probable incurred losses in the Company’s loan portfolio based on the best estimate available as of December 31, 2011.
Provisions for loan losses are charged against earnings to bring the total allowance for loan losses to a level considered adequate by management based on historical experience, the volume and type of lending conducted by the Company, the status of past due principal and interest payments, general economic conditions, and inherent credit risk related to the collectability of the Company’s loan portfolio. The provision for loan losses increased to $4.4 million for the twelve months ended December 31, 2011 from $3.8 million for the same period in 2010, or $557,000 and 14.5%. The provision for loan losses in 2011 was attributable to the continued elevated level of non-performing and classified loans. During 2011, the volume of new identified problem credits increased as compared to 2010 which resulted in higher non-performing loans of $15.8 million at December 31, 2011 as compared to $15.0 million at December 31, 2010. Over the same period, classified loans increased to $69.5 million, which included TDRs of $24.0 million, as compared to $64.4 million at December 31, 2010, which included TDRs of $12.2 million (see Footnote 3 to the Company’s Consolidated Financial Statements for further information on classified loans and TDRs). The impact of new identified credits continues to be at a level that required a significant provision for loan losses during the year. The Company’s local economy continues to be weak and which has started to impact some of the stronger borrowers who have been able to service their debt previously. Also, loans that have previously been classified have either become more severely past due and have accordingly been downgraded during the year which has resulted in more provision for loan losses as well. As of December 31, 2011, the Company had a total of $15.1 million in loans classified as doubtful and $26.1 million classified as substandard. Of the total balance of substandard and doubtful loans, $11.4 million were construction loans while $21.4 million were commercial real estate loans. Beginning in 2008, the Company has had significant collection issues in its construction portfolio which has led to aggregate charge-offs of $11.7 million of the total $28.4 million total charge-offs for the four year period ended December 31, 2011 despite representing only approximately 10% of the Company entire loan portfolio over the same period. In addition, $21.2 million of the $44.7 million construction loans outstanding as of December 31, 2011, were classified with an allocated allowance for loan losses of $1.1 million as of the same date. In an effort to properly identify and resolve problem credits in the construction portfolio, management has undertaken several initiatives including loan reviews of unclassified construction credits and weekly meetings with loan officers. While management believes all construction loans have been properly classified as of December 31, 2011 with the appropriate allocation of allowance for loan losses, there can be no assurance that provision for loan losses in the future will decrease for this portfolio segment.
Statements made in this section regarding the adequacy of the allowance for loan losses are forward-looking statements that may or may not be accurate due to the impossibility of predicting future events. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may differ from actual results.
Table 8 provides the Company’s loan charge-off and recovery activity during the past five years.
Table 8 - Summary of Loan Loss Experience
The following table depicts management’s allocation of the allowance for loan losses by loan type during the last five years. Allowance funding and allocation is based on management’s assessment of economic conditions, past loss experience, loan volume, past-due history and other factors. Since these factors and management's assumptions are subject to change, the allocation is not necessarily indicative of future loan portfolio performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that may be charged off. Loan losses are charged against the allowance when a loss has been confirmed by management.
Table 9 - Management's Allocation of the Allowance for Loan Losses
Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest. When loans are placed on non-accrual status, all unpaid accrued interest is reversed. These loans remain on non-accrual status until the loan becomes current or the loan is deemed uncollectible and is charged off. The Company defines impaired loans to be those loans that management has determined it is probable, based on current information and events, the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans individually classified as impaired increased to $40.3 million at December 31, 2011 from $26.2 million at December 31, 2010. Impaired loans at December 31, 2011 and 2010 included $24.2 million and $10.4 million, respectively, of troubled debt restructurings (“TDR’s”), which included two large unrelated commercial real estate credit relationships totaling $16.8 million at the end of 2011. For further information on non-performing loans and their impact on the Company’s earnings, see discussion above under “Allowance and Provision for Loan Losses”.
Total non-performing loans increased from $15.0 million at December 31, 2010 to $15.8 million at December 31, 2011 with total non-performing assets increasing to $20.8 million from $18.6 million as of the same dates, respectively. Non-performing assets also include foreclosed real estate and other repossessed assets that have been acquired through foreclosure or acceptance of a deed in lieu of foreclosure. Foreclosed real estate and repossessed assets are carried at fair value less estimated selling costs, and are actively marketed for sale.
Table 10 provides the Company’s non-performing loan experience during the past five years.
Table 10 - Non-Performing Assets
(1) Impaired loans on non-accrual status are included in loans. See Note 3 to the Consolidated Financial Statements for additional discussion on impaired loans.
Table 11 sets forth the breakdown of the Company’s securities portfolio for the past five years.
Table 11 - Securities Portfolio
Table 12 sets forth the breakdown of the Company’s investment securities available for sale by type and maturity as of December 31, 2011. For analytical purposes, the weighted average yield on state and municipal securities is adjusted to a taxable equivalent adjustment basis to recognize the income tax savings on tax-exempt securities. A tax rate of 34% was used in adjusting interest on tax-exempt securities to a fully taxable equivalent (“FTE”) basis.
Table 12 - Investment Securities Available for Sale
Securities available for sale decreased from $204.2 million at December 31, 2010 to $198.7 million at December 31, 2011. The decrease in available for sale securities was due primarily to maturities, prepayments, and calls of $24.5 million and sales of $107.4 million, offset by purchases of $116.1 million during 2011. The current strategy for the securities portfolio is to maintain an intermediate average life that remains relatively stable in a changing interest rate environment, thus minimizing exposure to sustained increases in interest rates. The investment portfolio primarily consists of mortgage-backed securities, securities issued by the United States government and its agencies, securities issued by states and municipalities, and trust preferred securities. Mortgage-backed securities consist primarily of obligations insured or guaranteed by Federal Home Loan Mortgage Corporation, Federal National Mortgage Association, or Government National Mortgage Association.
A significant portion of the Company’s unrealized losses at December 31, 2011 were related to six trust preferred securities comprised of debt of banks and insurance companies. The decrease in the fair value of these securities is due primarily to the lack of transactions and the credit risk for these types of securities as market participants are currently unwilling to conduct transactions unless forced to do so. Also, the Company recorded an other-than-temporary impairment charge through earnings on three of the six securities in 2010. See footnote 2 to the Company’s consolidated financial statements for further discussion of the fair value of these securities and management’s evaluation of other-than-temporary impairment.
The Company attracts deposits from the market areas it serves by offering a wide range of deposit accounts with a variety of rate structures and terms. The Company uses interest rate risk simulations to assist management in monitoring the Company’s deposit pricing, and periodically may offer special rates on certificates of deposits and money market accounts to maintain sufficient liquidity levels. The Company relies primarily on its retail and commercial sales staff and current customer relationships to attract and retain deposits. Market interest rates and competitive pressures can significantly affect the Company’s ability to attract and retain deposits. The Company’s strategic plan includes continuing to grow non-interest bearing accounts which contribute to higher levels of non-interest income and net interest margin.
Total deposits decreased by $37.5 million to $581.4 million at December 31, 2011 due to decreases in interest bearing deposits of $50.3 million, partially offset by an increase in non-interest bearing deposits of $12.9 million. The decrease in total and interest bearing deposits was mostly attributable to a decrease of $40.0 million in certificates of deposits (including individual retirement accounts of $43.4 million) and money market accounts of $15.0 million. In 2011, management continued its focus on repricing maturing certificates of deposits and the current offering rates for other interest bearing deposit accounts given the current rate environment. Because the Company continued to have soft loan demand and excess liquidity, management was able to reprice deposits rates at or below rates offered in its markets. As a result of the reduction in rates, the Company saw a decrease in its money market and certificate of deposit accounts. The Company’s non-interest bearing deposits increased in 2011 due to an emphasis on growing these types of accounts such as allocating a significant portion of incentive based compensation for business service and retail employees on growth of non-interest deposits.
Table 13 provides a profile of the Company’s deposits during the past five years.
Table 13 – Deposits
Table 14 – Average Deposits
The Company’s other borrowings consist of repurchase agreements, line of credit with another financial institution, federal funds purchased, which represent overnight liabilities to non-affiliated financial institutions, and a structured repurchase agreement. While repurchase agreements are effectively deposit equivalents, these arrangements consist of securities that are sold to commercial customers under agreements to repurchase. Other borrowings increased to $50.9 million at December 31, 2011 from $49.4 million at December 31, 2010 as an increase in repurchase agreements of $3.5 million was offset partially be a decrease of $1.7 million in the line of credit with another financial institution.
Federal Home Loan Bank Advances
FHLB advances increased to $55.0 million at December 31, 2011 from $50.0 million at December 31, 2010. At the beginning of 2009, the Company had a total of $67.0 million of putable FHLB advances which carried a weighted average rate of 6.03%. The Company elected to prepay the advances through the exercise of the put option by the FHLB, and incurred penalties of $335,000 and $838,000 in 2010 and 2009. Management elected to prepay the putable advances in 2009 and early 2010 due to the impact these advances had on the Company’s net interest margin. Prior to prepaying each advance, management determined that the penalty incurred would be fully offset by increases in net interest income through the remaining scheduled maturity of each advance. The Company does not anticipate that it will enter into putable advances for the foreseeable future, but instead may use fixed or variable rate advances to fund balance sheet growth as needed. Prepaying the advances resulted in an average cost of funds of 2.03% for 2011 as compared to 2.66% in 2010 and 4.98% in 2009.
Liquidity levels are adjusted in order to meet funding needs for deposit outflows, repayment of borrowings, and loan commitments and to meet asset/liability objectives. The Bank’s primary sources of funds are deposits; repayment of loans and mortgage-backed securities; Federal Home Loan Bank advances; maturities of investment securities and other short-term investments; and income from operations. While scheduled loan and mortgage-backed security repayments are a relatively predictable source of funds, deposit flows and loan and mortgage-backed security prepayments are greatly influenced by general interest rates, economic conditions and competition. Liquidity management is both a daily and long term function of business management. If the Banks require funds beyond those generated internally, then as of December 31, 2011 the Banks had $55.0 million in additional capacity under its borrowing agreements with the FHLB based on the Banks’ current FHLB stock holdings and approximately $34.0 million in federal funds purchased with other financial institutions. The holding company’s primary source of liquidity is dividends from its subsidiaries, YCB and SCSB which are limited by banking regulations. Currently, YCB can declare and pay dividends of $9.5 million while SCSB can declare dividends of $2.4 million without prior regulatory approval. The holding company had $2.9 million in a correspondent account as of December 31, 2011. The Company anticipates it will have sufficient funds available to meet current loan commitments and other credit commitments.
Total capital of the Company increased to $79.5 million at December 31, 2011 from $63.2 million as of December 31, 2010, an increase of $16.3 million or 25.8%. The increase in capital was primarily due to the repurchase of preferred shares issued under the CPP program and issuance of shares under the SBLF program which resulted in a net increase, including the repurchase of the warrant issued in connection with the transaction, of $7.8 million (see footnote 12 to the Company’s Consolidated Financial Statements for further information on the transaction and terms of the SBLF preferred shares). Also contributing to the increases in shareholders’ equity was net income available to common shareholders of $6.0 million offset by dividends on common shares of $1.3 million. We are prohibited from continuing to pay dividends on our common stock unless we have fully paid all required dividends on the senior preferred stock.
The Company has been repurchasing shares of its common stock since May 21, 1999. A net total of 536,453 shares at an aggregate cost of $9.3 million have been repurchased since that time under both the current and prior repurchase plans. The Company's Board of Directors authorized a share repurchase plan in June 2007 under which a maximum of $5.0 million of the Company's common stock could be purchased. Through December 31, 2011, a total of $1.6 million had been expended to purchase 85,098 shares under this plan. The Company’s ability to repurchase shares is restricted should we not pay dividends on preferred shares issued under the SBLF program.
Regulatory agencies measure capital adequacy within a framework that makes capital requirements, in part, dependent on the risk inherent in the balance sheets of individual financial institutions. The Company and the Banks continue to exceed the regulatory requirements for Tier I, Tier I leverage and total risk-based capital ratios (see Note 13 to the Consolidated Financial Statements).
Off Balance Sheet Arrangements
The Company uses off balance sheet financial instruments, such as commitments to make loans, credit lines and letters of credit to meet customer financing needs. These agreements provide credit or support the credit of others and usually have expiration dates but may expire without being used. In addition to credit risk, the Company also has liquidity risk associated with these commitments as funding for these obligations could be required immediately. The contractual amount of these financial instruments with off balance sheet risk was as follows at December 31, 2011:
Aggregate Contractual Obligations
Time deposits represent certificates of deposit held by the Company.
FHLB advances represent the amounts that are due the FHLB and consist of $50.0 million in fixed rate advances.
Subordinated debentures represent the scheduled maturities of subordinated debentures issued to trusts formed by the Company in connection with the issuance of trust preferred securities.
Line of credit represents borrowings on the Company’s revolving line of credit with another bank.
Note payable represents amounts due for the participation in construction of a low income housing development project and are payable on demand.
Defined benefit plan represent expected benefit payments to be paid to participants.
Lease commitments represent the total minimum lease payments under noncancelable operating leases, before considering renewal options that generally are present.
Item 7A. Quantitative And Qualitative Disclosures About Market Risk
Asset/liability management is the process of balance sheet control designed to ensure safety and soundness and to maintain liquidity and regulatory capital standards while maintaining acceptable net interest income. Interest rate risk is the exposure to adverse changes in net interest income as a result of market fluctuations in interest rates. Management continually monitors interest rate and liquidity risk so that it can implement appropriate funding, investment, and other balance sheet strategies. Management considers market interest rate risk to be one of the Company’s most significant ongoing business risk considerations.
The Company currently contracts with an independent third party consulting firm to measure its interest rate risk position. The consulting firm utilizes an earnings simulation model to analyze net interest income sensitivity. Current balance sheet amounts, current yields and costs, corresponding maturity and repricing amounts and rates, other relevant information, and certain assumptions made by management are combined with gradual movements in interest rates of 200 basis points up and 200 basis points down within the model to estimate their combined effects on net interest income over a one-year horizon. In 2008, the Federal Open Market Committee lowered its target for the federal funds rate to 0-25 bps. A majority of our loans are indexed to prime, therefore, the Company has excluded an evaluation of the effect on net interest income assuming a decrease in interest rates as further reductions in the prime rate are extremely unlikely. Interest rate movements are spread equally over the forecast period of one year. The Company feels that using gradual interest rate movements within the model is more representative of future rate changes than instantaneous interest rate shocks. The Company does not project growth in amounts for any balance sheet category when constructing the model because of the belief that projected growth can mask current interest rate risk imbalances over the projected horizon. The Company believes that the changes made to its interest rate risk measurement process have improved the accuracy of results of the process. Consequently, the Company believes that it has better information on which to base asset and liability allocation decisions going forward.
Assumptions based on the historical behavior of the Company’s deposit rates and balances in relation to changes in interest rates are incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. The Company continually monitors and updates the assumptions as new information becomes available. Actual results will differ from the model's simulated results due to timing, magnitude and frequency of interest rate changes, and actual variations from the managerial assumptions utilized under the model, as well as changes in market conditions and the application and timing of various management strategies.
The base scenario represents projected net interest income over a one year forecast horizon exclusive of interest rate changes to the simulation model. Given a gradual 200 basis point increase in the projected yield curve used in the simulation model (“Up 200 Scenario”), it is estimated that as of December 31, 2011 the Company’s net interest income would decrease by an estimated $55,000, over the one year forecast horizon. As of December 31, 2010, in the Up 200 Scenario the Company estimated that net interest income would decrease 1.31%, or $398,000, over a one year forecast horizon ending December 31, 2011
The projected results are within the Company’s asset/liability management policy limits, which states that the negative impact to net interest income should not exceed 7% in a 200 basis point decrease or increase in the projected yield curve over a one year forecast horizon. The forecast results are heavily dependent on the assumptions regarding changes in deposit rates; the Company can minimize the reduction in net interest income in a period of rising interest rates to the extent that it can curtail raising deposit rates during this period. The Company continues to explore transactions and strategies to both increase its net interest income and minimize its interest rate risk.
The interest sensitivity profile of the Company at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities as well as their relative repricing schedules. Such profile is also influenced by market interest rates, deposit growth, loan growth, and other factors.
The following tables, which are representative only and are not precise measurements of the effect of changing interest rates on the Company’s net interest income in the future, illustrate the Company’s estimated one year net interest income sensitivity profile based on the above referenced asset/liability model as of December 31, 2011 and 2010, respectively:
Interest Rate Sensitivity For 2011
Interest Rate Sensitivity For 2010
COMMUNITY BANK SHARES OF INDIANA, INC.
New Albany, Indiana
December 31, 2011, 2010, and 2009
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Community Bank Shares of Indiana, Inc.
New Albany, Indiana
We have audited the accompanying consolidated balance sheets of Community Bank Shares of Indiana, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Community Bank Shares of Indiana, Inc. as of December 31, 2011 and 2010, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2011 in conformity with U.S. generally accepted accounting principles.
March 29, 2012
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31
(In thousands, except per share amounts)
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31
(In thousands, except per share amounts)
See accompanying notes.
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31
(In thousands except per share data)
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31
(In thousands except per share data)
COMMUNITY BANK SHARES OF INDIANA, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31
(In thousands except per share data)