Community Bank System 10-K 2012
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Securities registered pursuant to Section 12(g) of the Act: None
TABLE OF CONTENTS
This Annual Report on Form 10-K contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements by their nature address matters that involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set forth herein under the caption “Forward-Looking Statements.”
Item 1. Business
Community Bank System, Inc. ("the Company") was incorporated on April 15, 1983, under the Delaware General Corporation Law. Its principal office is located at 5790 Widewaters Parkway, DeWitt, New York 13214. The Company is a single bank holding company which wholly-owns five subsidiaries: Community Bank, N.A. (“the Bank” or “CBNA”), Benefit Plans Administrative Services, Inc. (“BPAS”), CFSI Closeout Corp. (“CFSICC”), First of Jermyn Realty Company, Inc. (“FJRC”) and Town & Country Agency LLC (“T&C”). BPAS owns three subsidiaries, Benefit Plans Administrative Services LLC (“BPA”), a provider of defined contribution plan administration services; Harbridge Consulting Group LLC (“Harbridge”), a provider of actuarial and benefit consulting services; and Hand Benefits & Trust Company (“HB&T”), a provider of Collective Investment Fund administration and institutional trust services. CFSICC, FJRC and T&C are inactive companies. The Company also wholly-owns two unconsolidated subsidiary business trusts formed for the purpose of issuing mandatorily-redeemable preferred securities which are considered Tier I capital under regulatory capital adequacy guidelines.
The Bank’s business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial, and municipal customers. The Bank operates 168 customer facilities throughout 35 counties of Upstate New York, where it operates as Community Bank, N.A. and five counties of Northeastern Pennsylvania, where it is known as First Liberty Bank & Trust, offering a range of commercial and retail banking services. The Bank owns the following subsidiaries: Community Investment Services, Inc. (“CISI”), CBNA Treasury Management Corporation (“TMC”), CBNA Preferred Funding Corporation (“PFC”), Nottingham Advisors, Inc. (“Nottingham”), First Liberty Service Corp. (“FLSC”), Brilie Corporation (“Brilie”), CBNA Insurance Agency, Inc. (“CBNA Insurance”) and Western Catskill Realty, LLC (“WCR”). CISI provides broker-dealer and investment advisory services. TMC provides cash management, investment, and treasury services to the Bank. PFC primarily acts as an investor in residential real estate loans. Nottingham provides asset management services to individuals, corporate pension and profit sharing plans, and foundations. FLSC provides banking-related services to the Pennsylvania branches of the Bank. Brilie and WCR are inactive companies. CBNA Insurance is a full-service insurance agency offering primarily property and casualty products.
The Company maintains websites at communitybankna.com and firstlibertybank.com. Annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports, are available on the Company’s website free of charge as soon as reasonably practicable after such reports or amendments are electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). The information posted on the website is not incorporated into or a part of this filing. Copies of all documents filed with the SEC can also be obtained by visiting the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, by calling the SEC at 1-800-SEC-0330 or by accessing the SEC’s website at http://www.sec.gov.
On January 19, 2012, the Bank, the wholly-owned banking subsidiary of the Company, entered into an Assignment, Purchase and Assumption Agreement (the “HSBC Branch Agreement”) and a Purchase and Assumption Agreement (the “First Niagara Branch Agreement”) (collectively, the “Agreements”) with First Niagara Bank, N.A. (“First Niagara”). Under the Agreements, the Bank will acquire 19 branches in Central, Northern, and Western New York consisting of three branches purchased directly from First Niagara and 16 branches which are currently owned by HSBC Bank USA, National Association (“HSBC”). First Niagara is assigning its rights to the HSBC branches in connection with its pending acquisition of HSBC’s Upstate New York banking franchise. Upon its completion, the branch acquisitions will strengthen and extend the Company’s Upstate New York presence. Under the terms of the Agreements, Community Bank will acquire approximately $218 million in loans and $955 million in deposits at a blended deposit premium of 3.22%. The branch acquisitions are expected to close during the third quarter of 2012 subject to regulatory review and approval and customary closing conditions. The Company expects to incur certain one-time, transaction-related costs in 2012.
The Company completed a public stock offering in late January 2012. The offering raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company intends to use the net proceeds from this offering to support the HSBC and First Niagara branch acquisitions.
Acquisition History (2007-2011)
CAI Benefits, Inc.
On November 30, 2011, BPAS acquired, in an all-cash transaction, certain assets and liabilities of CAI, a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction is expected to add approximately $4 million of revenue to this business line in 2012.
The Wilber Corporation Acquisition
On April 8, 2011, the Company acquired The Wilber Corporation, parent company of Wilber National Bank, and its 22 branch-banking centers in the Central, Greater Capital District and Catskill regions of New York for $103 million of stock and cash. The Company acquired approximately $462 million in loans, $297 million of investment securities and $772 million in deposits.
Citizens Branches Acquisition
On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. (“Citizens”) in an all-cash transaction. The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 13%. In support of the transaction, the Company issued approximately $50 million of equity capital in the form of common stock in October 2008.
Alliance Benefit Group MidAtlantic
On July 7, 2008, BPAS acquired the Philadelphia division of Alliance Benefit Group MidAtlantic (“ABG”) from BenefitStreet, Inc. in an all-cash transaction. ABG was a provider of retirement plan consulting, daily valuation administration, actuarial, and ancillary support services.
TLNB Financial Corporation
On June 1, 2007, the Company acquired TLNB Financial Corporation, parent company of Tupper Lake National Bank (“TLNB”), in an all-cash transaction valued at approximately $17.8 million. Based in Tupper Lake, New York, TLNB operated five branches in the northeastern New York State cities of Tupper Lake, Plattsburgh and Saranac Lake, as well as an insurance subsidiary, TLNB Insurance Agency, Inc.
Hand Benefits & Trust, Company
On May 18, 2007, BPAS acquired HB&T in an all-cash transaction. HB&T was a Houston, Texas based provider of employee benefit plan administration and trust services.
The Bank is a community bank committed to the philosophy of serving the financial needs of customers in local communities. The Bank's branches are generally located in smaller towns and cities within its geographic market areas of Upstate New York and Northeastern Pennsylvania. The Company believes that the local character of its business, knowledge of the customers and their needs, and its comprehensive retail and business products, together with responsive decision-making at the branch and regional levels, enable the Bank to compete effectively in its geographic market. The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank of New York ("FHLB"), and its deposits are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to applicable limits.
The banking and financial services industry is highly competitive in the New York and Pennsylvania markets. The Company competes actively for loans, deposits and customers with other national and state banks, thrift institutions, credit unions, retail brokerage firms, mortgage bankers, finance companies, insurance companies, and other regulated and unregulated providers of financial services. In order to compete with other financial service providers, the Company stresses the community nature of its operations and the development of profitable customer relationships across all lines of business.
The table below summarizes the Bank’s deposits and market share by the forty counties of New York and Pennsylvania in which it has customer facilities. Market share is based on deposits of all commercial banks, credit unions, savings and loan associations, and savings banks.
(1) Deposit market share data as of June 30, 2011 the most recent information available. Source: SNL Financial LLC
As of December 31, 2011, the Company employed 1,784 full-time employees, 144 part-time employees and 102 temporary employees. None of the Company's employees are represented by a collective bargaining agreement. The Company offers a variety of employment benefits and considers its relationship with its employees to be good.
Supervision and Regulation
The Company and its subsidiaries are subject to the laws and regulations of the federal government and the states in which they conduct business. The Company, as a bank holding company, is subject to extensive regulation, supervision and examination by the Board of Governors of the Federal Reserve System (“FRB”) as its primary federal regulator. The Bank is a nationally-chartered bank and is subject to extensive regulation, supervision and examination by the Office of the Comptroller of the Currency (“OCC”) as its primary federal regulator. The Bank is also subject to the regulations and supervision of the FRB and the Federal Deposit Insurance Corporation (“FDIC”).
The Company is subject to the jurisdiction of the Securities and Exchange Commission (“SEC”) and is subject to disclosure and regulatory requirement under the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. Nottingham Advisors, Inc., Community Investment Services, Inc. and Hand Securities, Inc. are subject to the jurisdiction of the SEC, the New York Stock Exchange, the Financial Industry Regulatory Authority (“FINRA”) and state securities regulators, among others.
Set forth below is a description of the material information governing the laws and regulations applicable to the Company:
Federal Bank Holding Company Regulation
The Company is registered under, and is subject to, the Bank Holding Company Act of 1956, as amended. This Act limits the type of companies that the Company may acquire or organize and the activities in which it or they may engage. In general, the Company and the Bank are prohibited from engaging in or acquiring direct or indirect control of any corporation engaged in non-banking activities unless such activities are so closely related to banking as to be a proper incident thereto. In addition, the Company must obtain the prior approval of the FRB to acquire control of any bank; to acquire, with certain exceptions, more than five percent of the outstanding voting stock of any other corporation; or to merge or consolidate with another bank holding company. As a result of such laws and regulation, the Company is restricted as to the types of business activities it may conduct and the Bank is subject to limitations on, among others, the types of loans and the amounts of loans it may make to any one borrower. The Financial Modernization Act of 1999 created, among other things, the “financial holding company”, a new entity which may engage in a broader range of activities that are “financial in nature”, including insurance underwriting, securities underwriting and merchant banking. Bank holding companies which are well capitalized and well managed under regulatory standards may convert to financial holding companies relatively easily through a notice filing with the FRB, which acts as the “umbrella regulator” for such entities. The Company may seek to become a financial holding company in the future.
Federal Reserve System Regulation
The Company, as a bank holding company, is subject to regulatory capital requirements and is required by the FRB to, among other things, maintain cash reserves against its deposits. The Bank is under similar capital requirements administered by the OCC. FRB policy has historically required a bank holding company to act as a source of financial and managerial strength to its subsidiary banks. The Dodd-Frank Act (as defined below) codifies this policy as a statutory requirement. After exhausting other sources of funds, the Company may seek borrowings from the FRB for such purposes. Bank holding companies registered with the FRB are, among other things, restricted from making direct investments in real estate. Both the Company and the Bank are subject to extensive supervision and regulation, which focus on, among other things, the protection of depositors’ funds.
The FRB also regulates the national supply of bank credit in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits, and affect the interest rates charged on loans or paid for deposits.
Fluctuations in interest rates, which may result from government fiscal policies and the monetary policies of the FRB, have a strong impact on the income derived from loans and securities, and interest paid on deposits and borrowings. While the Company and the Bank strive to model various interest rate changes and adjust their strategies for such changes, the level of earnings can be materially affected by economic circumstances beyond their control.
The Company and the Bank are subject to minimum capital requirements established by the FRB, the OCC and the FDIC. For information on these capital requirements and the Company’s and the Bank’s capital ratios see “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital” and Note P to the Financial Statements.
Office of Comptroller of the Currency Regulation
The Bank is supervised and regularly examined by the OCC. The various laws and regulations administered by the OCC affect corporate practices such as payment of dividends, incurring debt, and acquisition of financial institutions and other companies. It also affects business practices, such as payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices. The OCC generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be undercapitalized. Undercapitalized institutions are subject to growth limitations and are required to submit a capital restoration plan to the OCC. The Bank is well capitalized under regulatory standards administered by the OCC.
Insurance of Deposit Accounts
The Bank is a member of the Deposit Insurance Fund (“DIF”), which is administered by the FDIC. On July 22, 2010, the FDIC amended its insurance regulations to insure deposit accounts up to a maximum of $250,000 (previously $100,000) for each separately insured depositor. Additionally, on November 9, 2010, the FDIC issued a final rule implementing Section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“the Dodd-Frank Act”) which provides certain noninterest-bearing transaction accounts with unlimited insurance coverage, regardless of the dollar amount, through December 31, 2012.
The FDIC imposes an assessment against all depository institutions for deposit insurance. This assessment is based on the risk category of the institution and, prior to 2009, ranged from five to 43 basis points of the institution’s deposits. On December 22, 2008, as a result of decreases in the reserve ratio of the DIF, the FDIC published a final rule raising the current deposit insurance assessment rates uniformly for all institutions by seven basis points for the first quarter of 2009. On May 22, 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009, payable on September 30, 2009. The Company’s special assessment amounted to $2.5 million.
In the fourth quarter of 2009, the FDIC adopted a rule that required insured depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012, on December 30, 2009. For purposes of calculating the amount to prepay, the FDIC required that institutions use their total base assessment rate in effect on September 30, 2009 and increase that assessment base quarterly at a 5 percent annual growth rate through the end of 2012. The FDIC also increased annual assessment rates uniformly by three basis points beginning in 2011. The Company’s prepayment for 2010, 2011 and 2012 amounted to $21.4 million.
Effective April 1, 2011, the FDIC changed the basis for premium payments from a percentage of average deposits to a percentage of average consolidated Bank assets less average tangible capital, resulting in lower 2011 premiums for the Company.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). This law results in significant changes to the banking industry. The provisions that have received the most public attention have been those that apply to larger financial institutions; however, the Dodd-Frank Act does contain numerous other provisions that will affect all banks and bank holding companies and impacts how the Company and the Bank handle their operations. The Dodd-Frank Act requires various federal agencies, including those that regulate the Company and the Bank, to promulgate new rules and regulations and to conduct various studies and reports for Congress. The federal agencies are in the process of promulgating these rules and regulations and have been given significant discretion in drafting such rules and regulations. Several of the provisions of the Dodd-Frank Act may have the consequence of increasing the Bank’s expenses, decreasing its revenues, and changing the activities in which it chooses to engage. The specific impact of the Dodd-Frank Act on the Company's current activities or new financial activities the Company may consider in the future, the Company's financial performance, and the markets in which the Company operates depends on the manner in which the relevant agencies develop and implement the required rules and regulations and the reaction of market participants to these regulatory developments.
The Dodd-Frank Act includes provisions that, among other things:
Consumer Protection Laws
In connection with its lending activities, the Bank is subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy. These laws include the Equal Credit Opportunity Act, the Gramm-Leach-Bliley Act (“GLB Act”), the Fair Credit Reporting Act (“FCRA”), the Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”), Electronic Funds Transfer Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, the Dodd-Frank Act, the Real Estate Settlement Procedures Act, and various state law counterparts.
The Dodd-Frank Act creates the CFPB with broad powers to supervise and enforce consumer protection laws, including laws that apply to banks in order to prohibit unfair, deceptive or abusive practices. The CFPB has examination authority over all banks and savings institutions with more than $10 billion in assets. The Dodd-Frank Act weakens the federal preemption rules that have been applicable to national banks and gives attorney generals for the states certain powers to enforce federal consumer protection laws.
In addition, the GLB Act requires all financial institutions to adopt privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties and establishes procedures and practices to protect customer data from unauthorized access. In addition, the FCRA, as amended by the FACT Act, includes provisions affecting the Company, the Bank, and their affiliates, including provisions concerning obtaining consumer reports, furnishing information to consumer reporting agencies, maintaining a program to prevent identity theft, sharing of certain information among affiliated companies, and other provisions. The FACT Act requires persons subject to FCRA to notify their customers if they report negative information about them to a credit bureau or if they are granted credit on terms less favorable than those generally available. The FRB and the Federal Trade Commission have extensive rulemaking authority under the FACT Act, and the Company and the Bank are subject to the rules that have been created under the FACT Act, including rules regarding limitations on affiliate marketing and implementation of programs to identify, detect and mitigate certain identity theft red flags. The Bank is also subject to data security standards and data breach notice requirements issued by the OCC and other regulatory agencies. The Bank has created policies and procedures to comply with these consumer protection requirements.
USA Patriot Act
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (“USA Patriot Act”) imposes obligations on U.S. financial institutions, including banks and broker-dealer subsidiaries, to implement policies, procedures and controls which are reasonably designed to detect and report instances of money laundering and the financing of terrorism. In addition, provisions of the USA Patriot Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions. The USA Patriot Act also encourages information-sharing among financial institutions, regulators, and law enforcement authorities by providing an exemption from the privacy provisions of the GLB Act for financial institutions that comply with the provision of the Act. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal, financial and reputational consequences for the institution. The Company has approved policies and procedures that are designed to comply with the USA Patriot Act.
Office of Foreign Assets Control Regulation
The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others administrated by the Treasury’s Office of Foreign Assets Control (“OFAC”). The OFAC administered sanctions can take many different forms depending upon the country; however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal, financial, and reputational consequences.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”) implemented a broad range of corporate governance, accounting and reporting reforms for companies that have securities registered under the Securities Exchange Act of 1934 as amended. In particular, the Sarbanes-Oxley Act established, among other things: (i) new requirements for audit and other key Board of Directors committees involving independence, expertise levels, and specified responsibilities; (ii) additional responsibilities regarding the oversight of financial statements by the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) the creation of an independent accounting oversight board for the accounting industry; (iv) new standards for auditors and the regulation of audits, including independence provisions which restrict non-audit services that accountants may provide to their audit clients; (v) increased disclosure and reporting obligations for the reporting company and its directors and executive officers including accelerated reporting of company stock transactions; (vi) a prohibition of personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulator requirements; and (vii) a range of new and increased civil and criminal penalties for fraud and other violation of the securities laws.
The Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act of 2008 (“EESA”) provides the U.S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. The EESA authorizes the U.S. Treasury to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. The Company did not originate or invest in sub-prime assets and, therefore, does not expect to participate in the sale of any of our assets into these programs. One of the provisions resulting from the legislation is the Troubled Asset Relief Program Capital Purchase Program (“TARP Capital Purchase Program”), which provides direct equity investment in perpetual preferred stock by the U.S. Treasury Department in qualified financial institutions. The program is voluntary and requires an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions, and declaration of dividends. The Company chose not to participate in the TARP Capital Purchase Program.
Electronic Fund Transfer Act
Effective July 1, 2010, a new federal banking rule under the Electronic Fund Transfer Act prohibits financial institutions from charging consumers fees for paying overdrafts on automated teller machines and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. The new rule does not govern overdraft fees on the payment of checks and regular electronic bill payments. The adoption of this regulation lowered fee income in the fourth quarter of 2010 and all of 2011.
Community Reinvestment Act of 1977
Under the Community Reinvestment Act of 1977 (“CRA”), the Bank is required to help meet the credit needs of its communities, including low- and moderate-income neighborhoods. Although the Bank must follow the requirements of CRA, it does not limit the Bank’s discretion to develop products and services that are suitable for a particular community or establish lending requirements or programs. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibits discrimination in lending practices. The Bank’s failure to comply with the provisions of the CRA could, at a minimum, result in regulatory restrictions on its activities and the activities of the Company. The Bank’s failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions against it by its regulators as well as other federal regulatory agencies and the Department of Justice. The Bank’s latest CRA rating was Satisfactory.
The Bank Secrecy Act
The Bank Secrecy Act (“BSA”) requires all financial institutions, including banks and securities broker-dealers, to, among other things, establish a risk-based system of internal controls reasonably designed to prevent money laundering and the financing of terrorism. The BSA includes a variety of recordkeeping and reporting requirements (such as cash and suspicious activity reporting), as well as due diligence/know-your-customer documentation requirements. The Company has established an anti-money laundering program and taken other appropriate measures in order to comply with BSA requirements.
Item 1A. Risk Factors
There are risks inherent in the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Adverse experience with these could have a material impact on the Company’s financial condition and results of operations.
Changes in interest rates affect our profitability, assets and liabilities.
The Company’s income and cash flow depends to a great extent on the difference between the interest earned on loans and investment securities, and the interest paid on deposits and borrowings. Interest rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the FRB. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect (1) our ability to originate loans and obtain deposits, which could reduce the amount of fee income generated, (2) the fair value of our financial assets and liabilities and (3) the average duration of our mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income could be adversely affected, which in turn could negatively affect our earnings. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposit and other borrowings. Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the financial condition and results of operations.
Current levels of market volatility are unprecedented.
From December 2007 through June 2009, the U.S. economy was in recession. Although 2010 and 2011 have experienced modest improvements, the capital, credit and financial markets have experienced significant volatility and disruption during the last five years. These conditions have had significant adverse effects on our national and local economies, including declining real estate values, a widespread tightening of the availability of credit, illiquidity in certain securities markets, increasing loan delinquencies, historically unfavorable consumer confidence and spending, and a slow recovery of manufacturing and service business activity. Management does not expect these difficult market conditions to improve meaningfully over the short term, and a continuation of these conditions could exacerbate their adverse effects:
The Company operates in a highly regulated environment and may be adversely affected by changes in laws and regulations.
The Company and its subsidiaries are subject to extensive state and federal regulation, supervision and legislation that govern nearly every aspect of its operations. The Company, as a bank holding company is subject to regulation by the FRB and its banking subsidiary is subject to regulation by the OCC. These regulations affect deposit and lending practices, capital levels and structure, investment practices, dividend policy and growth. In addition, the non-bank subsidiaries are engaged in providing investment management and insurance brokerage service, which industries are also heavily regulated on both a state and federal level. Such regulators govern the activities in which the Company and its subsidiaries may engage. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of a bank, the classification of assets by a bank and the adequacy of a bank’s allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, could have a material impact on the Company and its operations. Changes to the regulatory laws governing these businesses could affect the Company’s ability to deliver or expand its services and adversely impact its operations and financial condition.
In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law. The Dodd-Frank Act is sweeping legislation intended to overhaul regulation of the financial services industry. Its goals are to establish a new council of “systemic risk” regulators, create a new consumer protection division within the Federal Reserve, empower the Federal Reserve to supervise the largest, most complex financial companies, allow the government to seize and liquidate failing financial companies, and give regulators new powers to oversee the derivatives market. The provisions of the Dodd-Frank Act are so extensive that full implementation may require several years, and an assessment of its full effect on the Company is not possible at this time.
The Dodd-Frank Act also established the Consumer Financial Protection Bureau (CFPB) and authorizes it to supervise certain consumer financial services companies and large depository institutions and their affiliates for consumer protection purposes. Subject to the provisions of the Act, the CFPB has responsibility to implement, examine for compliance with, and enforce “Federal consumer financial law.” As a depository institution, the Company will be subject to examinations by the CFPB, which will focus on the Company’s ability to detect, prevent, and correct practices that present a significant risk of violating the law and causing consumer harm.
Dodd-Frank provided that debit card interchange fees must be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. This provision is known as the Durbin Amendment. In June 2011, the Federal Reserve Board adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction if the issuer implements certain fraud-prevention standards. While the restrictions on interchange fees do not apply to banks that, together with their affiliates, have assets of less than $10 billion, the rule could affect the competitiveness of debit cards issued by smaller banks.
Compliance with new laws and regulations will likely result in additional costs and/or decreases in revenue, which could adversely impact the Company’s results of operations, financial condition or liquidity.
The Company may be subject to more stringent capital requirements.
As discussed above, the Dodd-Frank Act would require the federal banking agencies to establish stricter risk-based capital requirements and leverage limits to apply to banks and bank holding companies. Under the legislation, the federal banking agencies would be required to develop capital requirements that address systemically-risky activities. The capital rules must address, at a minimum, risks arising from significant volumes of activity in derivatives, securities products, financial guarantees, securities borrowing and lending and repurchase agreements; concentrations in assets for which reported values are based on models; and concentrations in market share for any activity that would substantially disrupt financial markets if the institutions were forced to unexpectedly cease the activity. These requirements, and any other new regulations, could adversely affect the Company’s ability to pay dividends, or could require it to reduce business levels or to raise capital, including in ways that may adversely affect its results of operations or financial condition.
Regional economic factors may have an adverse impact on the Company’s business.
The Company’s main markets are located in the states of New York and Pennsylvania. Most of the Company’s customers are individuals and small and medium-sized businesses which are dependent upon the regional economy. Accordingly, the local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. A prolonged economic downturn in these markets could negatively impact the Company.
The Company faces strong competition from other banks and financial institutions, which can negatively impact its business.
The Company conducts its banking operations in a number of competitive local markets. In those markets, it competes against commercial banks, savings banks, savings and loans associations, credit unions, mortgage banks, brokerage firms, and other financial institutions. Many of these entities are larger organizations with significantly greater financial, management and other resources than the Company has, and they offer the same or similar banking or financial services that it offers in its markets. Moreover, new and existing competitors may expand their business in or into the Company’s markets. Increased competition in its markets may result in a reduction in loans, deposits and other sources of its revenues. Ultimately, the Company may not be able to compete successfully against current and future competitors.
The allowance for loan loss may be insufficient.
The Company’s business depends on the creditworthiness of its customers. The Company periodically reviews the allowance for loan losses for adequacy considering economic conditions and trends, collateral values and credit quality indicators, including past charge-off experience and levels of past due loans and nonperforming assets. If the Company’s assumptions prove to be incorrect, the Company’s allowance for loan losses may not be sufficient to cover losses inherent in the Company’s loan portfolio, resulting in additions to the allowance. Material additions to the allowance would materially decrease its net income. It is possible that over time the allowance for loan losses will be inadequate to cover credit losses in the portfolio because of unanticipated adverse changes in the economy, market conditions or events adversely affecting specific customers, industries or markets.
FDIC deposit insurance premiums have increased and may increase further in the future.
The Company is generally unable to control the amount of premiums that it is required to pay for FDIC insurance. In November 2009, the FDIC adopted a rule requiring banks to prepay their quarterly risk-based assessment for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. In 2010, the FDIC increased the general assessment rate as compared to prior periods. Effective April 1, 2011, the FDIC changed the basis for premium payments from a percentage of average deposits to a percentage of average consolidated Bank assets less average tangible capital, resulting in lower 2011 premiums for the Company. However, if there are additional bank or financial institution failures, the Company may be required to pay higher FDIC premiums than the current levels. These announced increases and any future increases or required prepayments of FDIC insurance premiums may adversely impact the Company’s earnings.
Changes in the equity markets could materially affect the level of assets under management and the demand for other fee-based services.
Economic downturns could affect the volume of income from and demand for fee-based services. Revenue from the wealth management and benefit plan administration businesses depends in large part on the level of assets under management and administration. Market volatility that leads customers to liquidate investment, as well as lower asset values, can reduce our level of assets under management and administration and thereby decrease our investment management and administration revenues.
Mortgage banking income may experience significant volatility.
Mortgage banking income is highly influenced by the level and direction of mortgage interest rates, and real estate and refinancing activity. In lower interest rate environments, the demand for mortgage loans and refinancing activity will tend to increase. This has the effect of increasing fee income, but could adversely impact the estimated fair value of our mortgage servicing rights as the rate of loan prepayments increase. In higher interest rate environments, the demand for mortgage loans and refinancing activity will generally be lower. This has the effect of decreasing fee income opportunities.
The Company depends on dividends from its banking subsidiary for cash revenues, but those dividends are subject to restrictions.
The ability of the company to satisfy its obligations and pay cash dividends to its shareholders is primarily dependent on the earnings of and dividends from the subsidiary bank. However, payment of dividends by the bank subsidiary is limited by dividend restrictions and capital requirements imposed by bank regulations. The ability to pay dividends is also subject to the continued payment of interest that the Company owes on its subordinated junior debentures. As of December 31, 2011, the Company had $102 million of subordinated junior debentures outstanding. The Company has the right to defer payment of interest on the subordinated junior debentures for a period not exceeding 20 quarters, although the Company has not done so to date. If the Company defers interest payments on the subordinated junior debentures, it will be prohibited, subject to certain exceptions, from paying cash dividends on the common stock until all deferred interest has been paid and interest payments on the subordinated junior debentures resumes.
The risks presented by acquisitions could adversely affect the Company’s financial condition and result of operations.
The business strategy of the Company includes growth through acquisition. The Company has announced that it has entered into a definitive agreement to acquire 19 branch-banking centers from First Niagara and HSBC. The acquisition is expected to close during the third quarter of 2012. This acquisition and any other future acquisitions will be accompanied by the risks commonly encountered in acquisitions. These risks include among other things: the difficulty of integrating operations and personnel, the potential disruption of our ongoing business, the inability of our management to maximize our financial and strategic position, the inability to maintain uniform standards, controls, procedures and policies, and the impairment of relationships with employees and customers as a result of changes in ownership and management. Further, the asset quality or other financial characteristics of a company may deteriorate after the acquisition agreement is signed or after the acquisition closes.
The Company may be required to record impairment charges related to goodwill, other intangible assets and the investment portfolio.
The Company may be required to record impairment charges in respect to goodwill, other intangible assets and the investment portfolio. Numerous factors, including lack of liquidity for resale of certain investment securities, absence of reliable pricing information for investment securities, adverse changes in the business climate, adverse actions by regulators, unanticipated changes in the competitive environment or a decision to change the operations or dispose of an operating unit could have a negative effect on the investment portfolio, goodwill or other intangible assets in future periods.
During 2010 rating agencies imposed a number of downgrades and credit watches on certain securities in the Company’s investment securities portfolio, which contributed to the decline in fair value of such securities. During 2011 additional securities were downgraded, none of which resulted in an impairment charge to the Company. These downgrades were primarily the result of Standard & Poor’s downgrade of the U.S. government from AAA to AA+. However, any additional downgrades and credit watches may contribute to further declines in the fair value of these securities. In addition, the measurement of the fair value of these securities involves significant judgment due to the complexity of the factors contributing to the measurement. Market volatility makes measurement of the fair value even more difficult and subjective. To the extent that any portion of the unrealized losses in the investment portfolio is determined to be other than temporary, and the loss is related to credit factors, the Company could be required to recognize a charge to earnings in the quarter during which such determination is made.
The Company’s financial statements are based in part on assumptions and estimates which, if incorrect, could cause unexpected losses in the future.
Pursuant to accounting principles generally accepted in the United States, the Company is required to use certain assumptions and estimates in preparing its financial statements, including in determining credit loss reserves, mortgage repurchase liability and reserves related to litigations, among other items. Certain of the Company’s financial instruments, including available-for-sale securities and certain loans, among other items, require a determination of their fair value in order to prepare the Company’s financial statements. Where quoted market prices are not available, the Company may make fair value determinations based on internally developed models or other means which ultimately rely to some degree on management judgment. Some of these and other assets and liabilities may have no direct observable price levels, making their valuation particularly subjective, as they are based on significant estimation and judgment. In addition, sudden illiquidity in markets or declines in prices of certain loans and securities may make it more difficult to value certain balance sheet items, which may lead to the possibility that such valuations will be subject to further change or adjustment. If assumptions or estimates underlying the Company’s financial statements are incorrect, it may experience material losses.
The Company’s information systems may experience an interruption or security breach.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s online banking system, its general ledger, and its deposit and loan servicing and origination systems. Furthermore, if personal, confidential or proprietary information of customers or clients in the Company’s possession were to be mishandled or misused, the Company could suffer significant regulatory consequences, reputational damage and financial loss. Such mishandling or misuse could include circumstances where, for example, such information was erroneously provided to parties who are not permitted to have the information, either by fault of the Company’s systems, employees, or counterparties, or where such information was intercepted or otherwise inappropriately taken by third parties. The Company has policies and procedures designed to prevent or limit the effect of the possible failure, interruption or security breach of its information systems; however, any such failure, interruption or security breach could adversely affect the Company’s business and results of operations by requiring it to expend significant resources to correct the defect, as well as exposing the Company to civil litigation, regulatory fines or penalties or losses not covered by insurance.
The Company may be adversely affected by the soundness of other financial institutions.
The Company owns common stock of Federal Home Loan Bank of New York (“FHLBNY”) in order to qualify for membership in the FHLB system, which enables it to borrow funds under the FHLBNY advance program. The carrying value of the Company’s FHLBNY common stock was $37.3 million as of December 31, 2011. There are 12 branches of the FHLB, including New York. Several branches have warned that they have either breached risk-based capital requirement or that they are close to breaching those requirements. To conserve capital, some FHLB branches have suspended dividends, cut dividend payments, and have not redeemed excess FHLB stock that members hold. The FHLBNY has stated that they expect to be able to continue to pay dividends, redeem excess capital stock, and provide competitively priced advances currently and in the future. Although most of the severe problems in the FHLB system have been at the other FHLB branches, nonetheless, the 12 FHLB branches are jointly liable for the consolidated obligations of the FHLB system. To the extent that one FHLB branch cannot meet its obligations to pay its share of the system’s debt, other FHLB branches can be called upon to make any required payments. Any such adverse effects on the FHLBNY could adversely affect the value of the Company’s investment in its common stock and negatively impact the Company’s results of operations.
The Company continually encounters technological change and may have to continue to invest in technological improvements.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands as well as to create additional efficiencies in the Company’s operations. During the third quarter of 2010, the Company converted its core loan, deposit and financial reporting information technology platform from an outsourced, third-party provided system to an in-house, integrated solution. Although the Company expects to benefit from the enhanced functionality and process efficiencies of the new system, the conversion has created certain processing difficulties and continues to include the risk of integrating newly acquired banks and branches into the existing platform.
Trading activity in the Company’s common stock could result in material price fluctuations.
The market price of the Company’s common stock may fluctuate significantly in response to a number of other factors including, but not limited to:
The Company’s ability to attract and retain qualified employees is critical to the success of its business, and failure to do so may have a materially adverse affect on the Company’s performance.
The Company’s employees are its most important resource, and in many areas of the financial services industry, competition for qualified personnel is intense. The imposition on the Company or its employees of certain existing and proposed restrictions or taxes on executive compensation may adversely affect the Company’s ability to attract and retain qualified senior management and employees. If the Company is unable to continue to retain and attract qualified employees, the Company’s performance, including its competitive position, could have a materially adverse affect.
Item 1B. Unresolved Staff Comments
Item 2. Properties
The Company’s primary headquarters are located at 5790 Widewaters Parkway, Dewitt, New York, which is leased. In addition, the Company has 194 properties located in the counties identified in the table on page 5, of which 122 are owned and 72 are under lease arrangements. In total, the Company operates 168 full-service branches, 14 are other customer service facilities for our financial service subsidiaries and 12 are utilized for back office operations. Some properties contain tenant leases or subleases.
Real property and related banking facilities owned by the Company at December 31, 2011 had a net book value of $60.3 million and none of the properties were subject to any material encumbrances. For the year ended December 31, 2011, rental fees of $4.2 million were paid on facilities leased by the Company for its operations. The Company believes that its facilities are suitable and adequate for the Company’s current operations.
Item 3. Legal Proceedings
The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate liability, if any, arising out of litigation pending against the Company or its subsidiaries will have a material effect on the Company’s consolidated financial position or results of operations.
Item 4. Mine Safety Disclosures
The executive officers of the Company and the Bank who are elected by the Board of Directors are as follows:
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The Company’s common stock has been trading on the New York Stock Exchange under the symbol “CBU” since December 31, 1997. Prior to that, the common stock traded over-the-counter on the NASDAQ National Market under the symbol “CBSI” beginning on September 16, 1986. There were 36,986,409 shares of common stock outstanding on December 31, 2011, held by approximately 3,716 registered shareholders of record. The following table sets forth the high and low prices for the common stock, and the cash dividends declared with respect thereto, for the periods indicated. The prices do not include retail mark-ups, mark-downs or commissions.
The Company has historically paid regular quarterly cash dividends on its common stock, and declared a cash dividend of $0.26 per share for the first quarter of 2012. The Board of Directors of the Company presently intends to continue the payment of regular quarterly cash dividends on the common stock, as well as to make payment of regularly scheduled dividends on the trust preferred stock when due, subject to the Company's need for those funds. However, because substantially all of the funds available for the payment of dividends by the Company are derived from the subsidiary Bank, future dividends will depend upon the earnings of the Bank, its financial condition, its need for funds and applicable governmental policies and regulations.
The Company completed a public stock offering in late January 2012. The offering raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company intends to use the net proceeds from this offering to support the HSBC and First Niagara branch acquisitions.
The following graph compares cumulative total shareholders returns on the Company’s common stock over the last five fiscal years to the S&P 600 Commercial Banks Index, the NASDAQ Bank Index, the S&P 500 Index, and the KBW Regional Banking Index. Total return values were calculated as of December 31 of each indicated year assuming a $100 investment on December 31, 2006 and reinvestment of dividends.
The following table provides information as of December 31, 2011 with respect to shares of common stock that may be issued under the Company’s existing equity compensation plans.
(1) The number of securities includes unvested restricted stock issued of 269,641.
On July 22, 2009, the Company announced an authorization to repurchase up to 1,000,000 of its outstanding shares in open market transactions or privately negotiated transactions in accordance with securities laws and regulations through December 31, 2011. Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities. The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion. There were no treasury stock purchases in 2011 or 2010. At its December 2011 meeting, the Board approved extending the stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to 1,500,000 shares through December 31, 2012.
Item 6. Selected Financial Data
The following table sets forth selected consolidated historical financial data of the Company as of and for each of the years in the five-year period ended December 31, 2011. The historical information set forth under the captions “Income Statement Data” and “Balance Sheet Data” is derived from the audited financial statements while the information under the captions “Capital and Related Ratios”, “Selected Performance Ratios” and “Asset Quality Ratios” for all periods is unaudited. All financial information in this table should be read in conjunction with the information contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with the Consolidated Financial Statements and the related notes thereto included elsewhere in this Annual Report on Form 10-K.
SELECTED CONSOLIDATED FINANCIAL INFORMATION
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) primarily reviews the financial condition and results of operations of the Company for the past two years, although in some circumstances a period longer than two years is covered in order to comply with Securities and Exchange Commission disclosure requirements or to more fully explain long-term trends. The following discussion and analysis should be read in conjunction with the Selected Consolidated Financial Information on page 19 and the Company’s Consolidated Financial Statements and related notes that appear on pages 49 through 88. All references in the discussion to the financial condition and results of operations are to the consolidated position and results of the Company and its subsidiaries taken as a whole.
Unless otherwise noted, all earnings per share (“EPS”) figures disclosed in the MD&A refer to diluted EPS; interest income, net interest income and net interest margin are presented on a fully tax-equivalent (“FTE”) basis. The term “this year” and equivalent terms refer to results in calendar year 2011, “last year” and equivalent terms refer to calendar year 2010, and all references to income statement results correspond to full-year activity unless otherwise noted.
This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of Community Bank System, Inc. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements are set herein under the caption “Forward-Looking Statements” on page 46.
Critical Accounting Policies
As a result of the complex and dynamic nature of the Company’s business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles (“GAAP”), but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting the Company’s financial performance. It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from these estimates. Management believes that the critical accounting estimates include:
For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment.
A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies”, starting on page 54.
The Company’s business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers.
The Company’s core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build profitable loan and deposit volume using both organic and acquisition strategies, (iii) increase the non-interest income component of total revenue through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and to improve efficiencies.
Significant factors management reviews to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, noninterest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services units, performance of specific product lines, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share changes, peer comparisons, and the performance of acquisition and integration activities.
On April 8, 2011 the Company acquired Wilber, the parent company of Wilber National Bank, for $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company’s common stock. Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District and Catskills regions of Upstate New York. The acquisition added approximately $462 million of loans, $297 million of investment securities and $772 million of deposits.
On November 30, 2011, the Company, through its BPAS subsidiary, acquired certain assets and liabilities of CAI, a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business, including daily valuation plan and collective investment fund administration. The transaction is expected to add approximately $4 million of revenue to this business line in 2012.
The Company reported net income for the year ended December 31, 2011 of $73.1 million or 16% above 2010’s reported net income of $63.3 million. Earnings per share of $2.01 for the full year 2011 were $0.12 or 6.3% above the prior year level. The increase was due to higher revenue from both increased net interest income, as a result of earning asset growth, a higher net interest margin, and non-interest income. Also contributing to higher net income was a lower provision for loan losses. These were partially offset by higher operating expenses and a higher effective income tax rate due to a higher proportional level of fully taxable income. The 2011 results included $4.8 million or $0.09 per share of acquisition expenses related to the Company’s merger with Wilber in early April 2011, as compared to $1.4 million or $0.03 per share of acquisition expenses in 2010.
Asset quality remained favorable in 2011, with lower loan net charge-offs and a lower provision for loan losses. Year-end non-performing loan ratios and loan delinquency ratios increased, but remained much better than peer company averages. The Company experienced year-over-year growth in interest-earning assets, reflective of the Wilber acquisition which added approximately $462 million of loans and $297 million of investments in the second quarter of 2011. Average deposits increased in 2011 as compared to 2010, reflective of the Wilber acquisition and organic growth in core deposits, offset by a reduction in time deposit balances. Average external borrowings were down slightly from 2010.
On January 19, 2012, the Bank, entered into the HSBC Branch Agreement and the First Niagara Branch Agreement with First Niagara. Under the Agreements, the Bank will acquire 19 branches in Central, Northern, and Western New York consisting of three branches purchased directly from First Niagara and 16 branches which are currently owned by HSBC. First Niagara is assigning its rights to the HSBC branches in connection with its pending acquisition of HSBC’s Upstate New York banking franchise. The branch acquisitions will strengthen and extend the Company’s Upstate New York presence. Under the terms of the Agreements, the Bank will acquire approximately $218 million in loans and $955 million in deposits at a blended deposit premium of 3.22%. The branch acquisitions are expected to close during the third quarter of 2012 subject to regulatory review and approval and customary closing conditions. The Company expects to incur certain one-time, transaction-related costs in 2012.
The Company completed public stock offering in late January 2012. The offering raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9. The Company intends to use the net proceeds from this offering to support the HSBC and First Niagara branch acquisitions.
Net Income and Profitability
Net income for 2011 was $73.1 million, an increase of $9.8 million, or 16%, from 2010’s earnings of $63.3 million. Earnings per share for 2011 were $2.01, up 6.3% from 2010’s earnings per share of $1.89. The 2011 results included $4.8 million, or $0.09 per share, of acquisition expenses related principally to the Company’s acquisition of Wilber, which was completed in the second quarter of 2011. The 2010 results included $1.4 million, or $0.03 per share of acquisition expenses, principally related to the Wilber acquisition.
Net income for 2010 was $63.3 million, up $21.9 million, or 53% from 2009’s earnings of $41.4 million. Earnings per share for 2010 were $1.89, up 50% from 2009’s earnings per share. The 2010 results included $1.4 million, or $0.03 per share of acquisition expenses principally related to the Wilber acquisition. The 2009 results included a $3.1 million or $0.07 per share non-cash charge for impairment of goodwill associated with the Company’s wealth management business as well as a $1.4 million or $0.03 per share special charge related to the planned early termination of its core banking system services contract in 2010. Additionally, during 2009, FDIC insurance costs increased $6.9 million or $0.16 per share as compared to 2008 and included a $2.5 million one-time special assessment charge.
Table 1: Condensed Income Statements
The primary factors explaining 2011 earnings performance are discussed in detail in the remaining sections of this document and are summarized as follows:
Selected Profitability and Other Measures
Return on average assets, return on average equity, dividend payout and equity to asset ratios for the years indicated are as follows:
Table 2: Selected Ratios
As displayed in Table 2 above, the returns on average assets increased in 2011 as compared to both 2010 and 2009 and the return on equity was down slightly from 2010 and up significantly from 2009. The increase in comparison to both years was a result of net income growing at a faster pace than average assets due to increasing net interest margins, non-interest income growth, lower provision for loan losses and operating expense containment. The return on equity declined in 2011 despite strong earnings growth because of the equity issued in conjunction with the Wilber acquisition, build up of capital through earnings retention and a substantial increase in the equity components of the investment market value adjustment due mostly to a decrease in medium to long-term interest rates.
The dividend payout ratio for 2011 increased slightly from 2010 as dividends declared increased 15.7% primarily as a result of a 6.4% increase in the dividends declared per share as well as the additional 3.4 million shares issued in conjunction with the Wilber acquisition in the second quarter of 2011, while net income increased a slightly smaller 15.5% from 2010. The dividend payout ratio for 2010 was below 2009 primarily due to the significant increase in net income partially offset by a smaller increase in the dividend declared. In 2010 net income increased 53% while dividends declared increased 8.2% as a result of a 6.8% increase in the dividend per share and a 1.6% increase in the number of shares outstanding.
Net Interest Income
Net interest income is the amount that interest and fees on earning assets (loans and investments) exceeds the cost of funds, which consists primarily of interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.
As disclosed in Table 3, net interest income (with nontaxable income converted to a fully tax-equivalent basis) totaled $225.1 million in 2011, up $28.2 million, or 14%, from the prior year. A $656.4 million increase in average interest-earning assets and a three-basis point increase in the net interest margin more than offset a $510.5 million increase in average interest-bearing liabilities. As reflected in Table 4, the volume changes increased net interest income by approximately $26.7 million, while the higher net interest margin had a $1.5 million favorable impact.
The net interest margin increased three basis points from 4.04% in 2010 to 4.07% in 2011. This increase was primarily attributable to a 29-basis point decrease in interest-bearing liability yields having a greater impact than a 22-basis point decrease in the earning-asset yields. The yield on loans decreased five basis points in 2011, due to new volume coming on at lower yields in the current low-rate environment than the loans maturing or being prepaid and variable and adjustable rate loans repricing downward. The yield on investments, including cash equivalents, decreased from 4.70% in 2010 to 4.27% in 2011, with the yield decline being muted by the effective deployment of cash into higher yielding securities. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2010 and 2011 in response to market conditions.
The net interest margin in 2010 was 4.04%, compared to 3.80% in 2009. This 24-basis point increase was primarily attributable to a 43-basis point decrease in interest-bearing liability yields having a greater impact than a 13-basis point decrease in earning-asset yields. The decreased cost of funds was reflective of deposit rate reductions throughout 2009 and 2010. Additionally, the proportion of customer deposits in higher cost time deposits declined 7.1 percentage points during 2010, while the percentage of deposits in non-interest bearing and lower cost checking and money market accounts increased throughout 2009 and 2010. The yield on loans decreased 15 basis points in 2010, mostly as a result of the low interest rate environment. The yield on investments, including cash equivalents, decreased from 4.73% in 2009 to 4.70% in 2010, with the yield decline being muted by the effective deployment of cash into higher yielding securities during 2010.
As shown in Table 3, total interest income increased by $23.2 million, or 8.8%, in 2011 from 2010. Table 4 indicates that higher average earning assets contributed a positive $34.4 million variance, offset by lower yields with a negative impact of $11.2 million. Average loans increased a total of $280.3 million in 2011, primarily as result of the Wilber acquisition and organic growth in the consumer mortgage and consumer indirect portfolios. Loan interest income and fees increased $14.7 million in 2011 as compared to 2010, attributable to the higher average loan balances, partially offset by a five-basis point decrease in loan yields. Investment interest income, including cash equivalents, on an FTE basis of $92.7 million in 2011 was $8.4 million or 10.0% higher than the prior year as a result of a larger portfolio, partially offset by a 43-basis point decrease in the investment yield. Average investments, including cash equivalents, for 2011 were $376.1 million higher than 2010, reflective of the acquired Wilber portfolio and deployment of excess funding supplied by organic deposit growth.
Total interest income decreased by $1.0 million, or 0.4% in 2010 from 2009’s level. Table 4 indicates that higher average earning assets contributed a positive $5.3 million variance offset by lower yields with a negative impact of $6.3 million. Average loans declined a total of $29.8 million in 2010, adversely impacted by economic and demand conditions. Loan interest income and fees declined $6.4 million in 2010 as compared to 2009, attributable to a 15-basis point decrease in loan yields and the lower average loan balances. Investment interest income, including cash equivalents, on an FTE basis in 2010 of $84.3 million was $5.4 million or 6.8% higher than the prior year as a result of a larger portfolio, partially offset by a three-basis point decrease in the investment yield. Average investments for 2010 were $287.7 million higher than 2009, while overnight invested cash equivalents declined $161.0 million from 2009 reflective of the deployment during the first quarter of 2010 of a portion of the Company’s excess liquidity into intermediate-term U.S. Treasury securities.
The earning-asset yield declined 22 basis points to 5.19% in 2011 from 5.41% in 2010 because of the previously mentioned decrease in loan and investment yields. The change in the earning-asset yield is primarily a result of variable and adjustable-rate loans repricing downward and lower rates on new loan volume and investment purchases due to the decline in interest rates to levels below those prevalent in prior years, as well as the Company’s increased holding of lower-yielding cash instruments, as it maintained a liquid position in anticipation of improved investment opportunities in future periods. The earning-asset yield declined 13 basis points from 2009 to 5.51% in 2010 because of the previously mentioned decreases in loan and investment yields, partially offset by the higher interest rates earned on the redeployment of cash equivalents into U.S. Treasury Securities.
Total average funding (deposits and borrowings) in 2011 increased $607.4 million or 12.7%. Deposits increased $613.6 million, $559.7 million attributable to the Wilber acquisition and a $53.9 million increase in organic deposits. Consistent with the Company’s funding mix objective, organic average core deposit balances increased $207.1 million, while time deposits declined $153.2 million on an organic basis year-over-year. Average external borrowings decreased $6.2 million in 2011 as compared to the prior year. In 2010 total average funding increased $85.6 million or 1.8%. Deposits increased $105.5 million due to organic growth. Consistent with the Company’s funding mix objective, average core deposit balances increased $400.1 million, while time deposits were managed downward $294.6 million over the year. Average external borrowings decreased $19.8 million in 2010 as compared to the prior year.
The cost of funding, including the impact of non-interest checking deposits, decreased 25 basis points during 2011 to 1.14% as compared to 1.39% for 2010. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2010 and 2011 in response to market conditions. Additionally, the Company focused on expanding core account relationships while time deposit balances were allowed to decline. The cost of funding decreased 38 basis points during 2010 to 1.39% as compared to 1.77% for 2009. Interest rates on deposit accounts were lowered throughout 2010, with decreases in all product offerings. Additionally, the proportion of customer deposits in higher cost time deposits in 2010 declined 7.1 percentage points in comparison to the prior year, while the percentage of deposits in non-interest bearing and lower cost checking accounts increased.
Total interest expense decreased by $5.0 million to $61.6 million in 2011. As shown in Table 4, lower interest rates on deposits and external borrowings resulted in $12.8 million of this decrease, while higher deposit balances, partially offset by the lower external borrowings balance, accounted for an increase of $7.7 million in interest expense. Interest expense as a percentage of earning assets decreased by 26 basis points to 1.11%. The rate on interest-bearing deposits decreased 25 basis points to 0.70%, due largely to reductions of time deposit and money market rates throughout 2011 and the previously discussed balance decline of higher rate time deposits. The rate on external borrowings decreased four basis points to 4.25% in 2011. Total interest expense decreased by $16.7 million to $66.6 million in 2010 as compared to 2009. Lower interest rates on interest-bearing liabilities accounted for $17.6 million of this decrease, while the higher interest-bearing liability balances accounted for an increase of $0.9 million in interest expense. In 2010, the rate on interest-bearing deposits decreased 50 basis points to 0.95% and the rate on external borrowings decreased eight basis points to 4.29%.
The following table sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the years ended December 31, 2011, 2010 and 2009. Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.8% in 2011 and 38.5% in 2010 and 2009. Average balances are computed by totaling the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include nonaccrual loans and loans held for sale.
As discussed above, the change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.
Table 4: Rate/Volume
The Company’s sources of noninterest income are of three primary types: 1) general banking services related to loans, deposits and other core customer activities typically provided through the branch network and electronic banking channels (performed by CBNA and First Liberty Bank and Trust); 2) employee benefit trust, administration, actuarial and consulting services (performed by BPAS); and 3) wealth management services, comprised of trust services (performed by the personal trust units within CBNA), investment and insurance products and services (performed by CISI and CBNA Insurance), and asset management (performed by Nottingham). Additionally, the Company has periodic transactions, most often net gains (losses) from the sale of investment securities and prepayment of debt instruments.
Table 5: Noninterest Income
As displayed in Table 5, noninterest income, excluding security gains and losses and debt extinguishments costs, of $89.3 million for 2011 increased by $0.5 million, largely as a result of increased debit card related income, growth in revenue from the Company’s financial services businesses and incremental revenue produced by the acquired Wilber trust operations, partially offset by lower banking fees due to reduced utilization of certain services by the Bank’s customers as well as lower mortgage banking income. Total noninterest income, excluding security gains and losses and debt extinguishments costs, increased by 6.3% to $88.8 million in 2010 as compared to 2009 largely as a result of increased debit card related income and increased revenue from the Company’s financial services businesses.
Noninterest income as a percent of operating income (FTE basis) was 28.4% in 2011, down 2.7 percentage points from the prior year and down 3.2 percentage points from 2009. The current year decrease was due to a 14.3% increase in net interest income, primarily the result of the Wilber acquisition, while noninterest income increased at a much smaller rate of 0.6% as discussed below. The decrease from 2009 to 2010 was primarily driven by an 8.7% increase in net interest income being larger than the 6.3 % increase in noninterest income. The reduction of the ratio in both years was influenced by expansion of the net interest margin.
The largest portion of the Company’s recurring noninterest income is the wide variety of fees earned from general banking services, which was $47.0 million in 2011, down $2.4 million or 4.8% from the prior year. A large part of the decline was due to lower overdraft and deposit fees reflective of lower service utilization due to economic conditions and regulatory and policy changes. Effective July 1, 2010, Regulation E (a Federal Reserve Board Regulation) prohibited financial institutions from charging consumers fees for paying overdrafts on ATM and debit card transactions, unless the customer consents. The majority of the Company’s customers have consented to protecting their accounts from electronic transaction rejection. Additionally, mortgage banking revenue declined $2.0 million. Partially offsetting these declines was $3.1 million of income growth from electronic banking fees due in large part to a concerted effort to increase the penetration and utilization of consumer debit cards.
In 2011, mortgage banking revenue declined $2.0 million from the income generated in 2010, which had been down only slightly from the record level of 2009, reflective of the decision to hold a majority of secondary market eligible mortgages in portfolio in the latter half of 2011. Residential mortgage banking income consists of realized gains or losses from the sale of residential mortgage loans and the origination of mortgage loan servicing rights, unrealized gains and losses on residential mortgage loans held for sale and related commitments, mortgage loan servicing fees and other mortgage loan-related fee income. Included in mortgage banking income is a net impairment charge of $0.1 million in 2011 for the fair value of the mortgage servicing rights due primarily to an increase in the expected prepayment speed of the Company’s sold loan portfolio with servicing retained. Residential mortgage loans sold to investors, primarily Fannie Mae, totaled $43.1 million in 2011 as compared to $119.0 million and $177.8 million during 2010 and 2009, respectively. Residential mortgage loans held for sale and recorded at fair value at December 31, 2011 totaled $0.5 million. The continuation of the level of mortgage noninterest income produced in 2011 will be dependent on market conditions and the trend in long-term interest rates.
Fees from general banking services were $49.3 million in 2010, up $2.2 million or 4.7% from 2009. A large portion of the income growth was attributable to electronic banking fees (principally card-related), up $2.7 million or 31%, and overdraft fees, up $0.7 million, or 3.0%. Mortgage banking revenue remained strong during 2010, but was down $0.2 million from the record secondary market income generated in 2009.
As disclosed in Table 5, noninterest income from financial services (including revenues from benefit trust, administration, consulting and actuarial fees and wealth management services) rose $2.8 million, or 7.2%, in 2011 to $42.3 million. Financial services revenue now comprises 47% of total noninterest income, excluding net gains (losses) on the sale of investment securities and debt extinguishments. BPAS generated revenue growth of $2.0 million, or 6.7%, for the 2011 year, driven by a combination of new client generation, expanded service offerings, increased asset-based revenue and one month of revenue from its CAI acquisition. BPAS offers their clients daily valuation, actuarial and employee benefit consulting services on a national basis from offices in New Jersey, New York, Pennsylvania and Texas. BPAS revenue of $29.6 million in 2010 was $1.8 million higher than 2009’s results, driven by a combination of new client generation, expanded service offerings and increased asset-based revenue.
On November 30, 2011, BPAS acquired, in an all-cash transactions, certain assets and liabilities of CAI, a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business including daily valuation plan and collective investment fund administration. The transaction is expected to add an incremental $4 million of revenue to this business line in 2012.
Wealth management services revenue increased $0.9 million or 8.9% in 2011. Personal trust revenues increased $1.6 million, principally due to incremental revenue produced by the acquired Wilber trust operations. Nottingham revenue increased $0.2 million and CBNA Insurance revenue increased $0.3 million. These increases were partially offset by $1.2 million decrease in revenue at CISI due to lower production levels for broker advisory services. The improved revenue generation of the wealth management services was reflective of the Wilber acquisition, favorable market valuation comparisons and generally improving demand characteristics. Wealth management services revenue in 2010 increased $1.2 million or 13.9% as compared to 2009. CISI revenue increased $0.9 million from 2009, Nottingham revenue increased $0.2 million and personal trust revenues increased $0.1 million, while revenue generated at CBNA Insurance remained consistent with the prior year.
Assets under management and administration increased $1.0 billion during 2011 from $6.7 billion at year-end 2010. Market-driven gains in equity-based assets were augmented by the addition of new client assets. BPA, in particular, was successful at growing its asset base, as demonstrated by the approximately $0.5 billion increase in its assets under administration during 2011. Additionally, the acquired Wilber trust operation added $0.4 billion of assets under management in the second quarter of 2011. Assets under management and administration at the Company’s financial services businesses increased $1.1 billion during 2010 to $6.7 billion, compared to $5.6 billion at the end of 2009.
As shown in Table 6, operating expenses increased $13.5 million, or 7.6%, in 2011 to $190.4 million, primarily due to the acquisition of Wilber in April 2011, partially offset by lower FDIC premiums and lower amortization of intangibles. Operating expenses in 2010 were $9.3 million or 5.0% lower than 2009 primarily due to several expense reduction initiatives, lower FDIC premiums, lower amortization of intangibles and no goodwill impairment charge in 2010 as compared to 2009. Operating expenses for 2011 as a percent of average assets were 2.93%, down 18 basis points from 3.11% in 2010. The improvement in this ratio was due to effective cost controls on operating expenses combined with an increase in average assets from the Wilber acquisition. This ratio was down 15 basis points in 2010 as compared to 2009 as a result of decreased operating expenses combined with higher average assets.
The efficiency ratio, a performance measurement tool widely used by banks, is defined by the Company as operating expenses (excluding acquisition expenses and contract termination charges, goodwill impairment and intangible amortization) divided by operating income (fully tax-equivalent net interest income plus noninterest income, excluding net securities and debt gains and losses). Lower ratios are often correlated to higher operating efficiency. The efficiency ratio for 2011 was 1.8 percentage points lower than the 59.4% ratio for 2010 due to a 6.8% decrease in operating expenses, as defined above, combined with a 14.3% increase in net interest income and a 0.6% increase in noninterest income. In 2010 the efficiency ratio declined 6.1 percentage points due to a 2.2% decrease in operating expenses, as defined above, combined with an 8.7% increase in net interest income and a 6.3% increase in noninterest income (excluding net securities gains and debt extinguishments costs). The significant increase in FDIC premiums with no corresponding income generation was the primary reason for the elevated efficiency ratio for 2009. In addition, the efficiency ratios for both periods were adversely affected by the growing proportion of financial services activities, which due to the differing nature of their business and income statement structure have comparatively higher efficiency ratios.
Table 6: Noninterest Expenses
Salaries and employee benefits increased $10.9 million or 11.9% in 2011, primarily due to the addition of approximately 200 employees as a result of the Wilber acquisition, as well as the impact of annual merit increases. Total salaries and employee benefits decreased in 2010, however, salaries expense increased $2.8 million or 3.8%, primarily due to increased levels of incentive compensation. This increase was offset by a $4.1 million or 22% decrease in employee benefit costs primarily due to modifications made to the Company’s defined benefit pension plan and its post-retirement medical programs, partially offset by a higher contribution to the Company’s 401(k) Employee Stock Ownership Plan (“401(k) Plan”). Total full-time equivalent staff at the end of 2011 was 1,831, compared to 1,624 at December 31, 2010 and 1,595 at the end of 2009.
Medical expenses increased $0.9 million or 12.4% in 2011 due primarily to the additional employees added from the Wilber acquisition. Medical expenses decreased $0.2 million in 2010, or 2.8%, primarily due to favorable experience in the Company’s self-insured medical plans. This year’s qualified and nonqualified retirement plan expense was consistent with 2010. Qualified pension plan expense decreased approximately $0.3 million due primarily to higher returns on plan assets partially offset by a lower discount rate. The 401(k) Plan expense increased approximately $0.2 million due to additional participants as a result of the Wilber acquisition. Qualified and nonqualified pension expense decreased $4.2 million in 2010. The defined benefit pension plan was modified in the fourth quarter of 2009 to a new plan design, which combines service credits in the Company’s Cash Balance Plan with additional contributions to be made to the 401(k) Plan. In the fourth quarter of 2009, the Company terminated its post-retirement medical program for certain current and all future employees. Additionally, effective January 1, 2010, the Company increased its discretionary matching contribution to the 401(k) Plan for employee participants who contribute 6% of eligible compensation from a maximum of 3.5% to 4.5%. The three assumptions that have the largest impact on the calculation of annual pension expense are the discount rate utilized, the rate applied to future compensation increases and the expected rate of return on plan assets. See Note K to the financial statements for further information about the pension plan.
Total non-personnel noninterest expenses, excluding one-time acquisition expenses and contract termination charges decreased $0.9 million or 1.0% in 2011. Excluding expenses related to the retail branches acquired from Wilber, non-personnel noninterest expenses as defined above declined $6.2 million or 7.3%. As displayed in Table 6, this was largely caused by lower FDIC insurance premiums (down $1.9 million in total and down $2.3 million excluding acquired Wilber branches), amortization of intangible assets (down $1.6 million in total and down $2.2 million excluding acquired Wilber branches), data processing and communications (down $0.2 million in total and down $1.1 million excluding acquired Wilber branches), occupancy & equipment (up $1.6 million in total and down $0.1 million excluding acquired Wilber branches), partially offset by higher business development and marketing costs (up $0.7 million in total and up $0.4 million excluding the acquired Wilber branches), higher legal and professional fees (up $0.4 million in total and up $0.2 million excluding the acquired Wilber branches). Amortization of intangibles decreased in 2011, a result of accelerated amortization methodologies employed and the core deposit intangible from a 2001 acquisition became fully amortized in 2010. The lower data processing and communications costs are a result of the conversion of the Company’s core banking system in the second half of 2010.
The Company continually evaluates all aspects of its operating expense structure and is diligent about identifying opportunities to improve operating efficiencies. Over the last two years, the Company has consolidated certain of its branch offices. This realignment will reduce market overlap and further strengthen its branch network, and reflects management’s focus on achieving long-term performance improvements through proactive, strategic decision making.
The FDIC imposes an assessment against all depository institutions for deposit insurance. This assessment is based on the risk category of the institution and, prior to 2009, ranged from five to 43 basis points of the institution’s deposits. On December 22, 2008, as a result of decreases in the reserve ratio of the DIF, the FDIC published a final rule raising the current deposit insurance assessment rates uniformly for all institutions by seven basis points for the first quarter of 2009. On May 22, 2009, the FDIC adopted a final rule imposing a five basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009, payable on September 30, 2009. The Company’s special assessment amounted to $2.5 million in June 2009. No additional special assessments were levied during 2010 and 2011. Effective in April 1, 2011, the FDIC changed the calculation of the assessment to be based upon a percentage of average consolidated Bank assets less average tangible capital as opposed to a percentage of average deposits which has been used in the past. The result for Company was a savings of approximately $2 million a year in deposit insurance assessments.
Total non-personnel operating expenses, excluding acquisition expenses, contract termination charges, and goodwill impairment, decreased $4.6 million or 5.2% in 2010. As displayed in Table 6, this was largely caused by lower FDIC insurance premiums (down $2.8 million), amortization of intangible assets (down $2.2 million), business development and marketing (down $0.8 million), foreclosed property expenses (down $0.7 million), occupancy and equipment expense (down $0.3 million), partially offset by higher legal and professional (up $0.3 million), office supplies and postage (up $0.2 million), and miscellaneous other costs (up $1.5 million). Amortization of intangibles decreased $2.2 million in 2010, a result of no new acquisitions, accelerated amortization methodologies employed and the core deposit intangible from a 2001 acquisition became fully amortized.
Acquisition expenses and contract termination charges totaled $4.8 million in 2011, primarily associated with the Wilber acquisition which closed in April 2011, up $3.5 million from the costs incurred for acquisition and contract termination charges in the prior year. Acquisition expenses and contract termination charges totaled $1.4 million in 2010, a decrease of $0.3 million from 2009, and were comprised of $0.9 million of acquisition expenses related to the Wilber acquisition and $0.5 million of contract termination fees related to the core banking system conversion in the third quarter of 2010. Acquisition expenses and contract termination charges totaled $1.6 million in 2009 and were comprised of a $1.4 million charge related to the planned early termination of its core banking system services contract in 2010 as well as $0.2 million of acquisition expenses related to the Citizens transaction in late 2008. In 2009, the Company recorded a $3.1 million non-cash goodwill impairment charge in its wealth management businesses, a result of equity market valuation declines, changes in customer asset mixes and pricing compression related to the competitive environment.
The Company estimates its income tax expense based on the amount it expects to owe the respective tax authorities, plus the impact of deferred tax items. Taxes are discussed in more detail in Note I of the Consolidated Financial Statements beginning on page 71. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Company’s tax position. If the final resolution of taxes payable differs from its estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.
The effective tax rate for 2011 increased 2.7 percentage points to 29.4%, principally a result of a higher proportion of income being generated from fully taxable sources. The effective tax rate for 2010 increased 4.8 percentage points from 2009’s level to 26.7%, reflecting the higher level of income from fully taxable sources. The effective tax rate for 2009 was 21.9%, reflecting a higher proportional mix of non-taxable revenue sources and the impact of a $3.1 million goodwill impairment charge.
Shareholders’ equity ended 2011 at $774.6 million, up $167.3 million, or 28%, from one year earlier. This increase reflects $82.6 million from common stock, net income of $73.1 million, a $38.5 million increase in other comprehensive income, $5.6 million from the issuance of shares through employee stock plans, and $3.5 million from stock-based compensation. These increases were partially offset by common stock dividends declared of $36.0 million. The change in other comprehensive income was comprised of a $47.1 million increase in the market value adjustment (“MVA”, represents the after-tax, unrealized change in value of available-for-sale securities in the Company’s investment portfolio), a $10.6 million charge based on the funded status of the Company’s employee retirement plans and a $2.0 million increase in the fair value of interest rate swaps designated as a cash flow hedge. Excluding accumulated other comprehensive income in both 2011 and 2010, capital rose by $128.8 million, or 21%. Shares outstanding increased by 3.7 million during the year comprised of 3.35 million shares added through common stock issued from treasury shares in the Wilber acquisition in the second quarter and 314,000 added through employee stock plans.
Shareholders’ equity ended 2010 at $607.3 million, up $41.6 million, or 7.3%, from one year earlier. This increase reflects net income of $63.3 million, $6.4 million from the issuance of shares through employee stock plans, and $3.5 million from stock-based compensation. These increases were partially offset by common stock dividends declared of $31.2 million and a $0.6 million decrease in other comprehensive income. The change in other comprehensive income was comprised of a $1.7 million decrease in the MVA and a $1.1 million increase in the fair value of interest rate swaps designated as a cash flow hedge. Excluding accumulated other comprehensive income in both 2010 and 2009, capital rose by $42.1 million, or 7.3%. Shares outstanding increased by 519,000 during the year as a result of issuances made through employee stock plans.
The Company’s ratio of Tier 1 capital to assets (or tier 1 leverage ratio), the basic measure for which regulators have established a 5% minimum for an institution to be considered “well-capitalized,” increased 15 basis points to end the year at 8.38%. This was the result of a 19.8% increase in Tier 1 capital primarily from net income generation and the stock offered in the Wilber acquisition, being greater than the 17.6% year-over-year increase in fourth quarter average net assets (excludes investment market value adjustment, intangible assets net of related deferred tax liabilities and disallowed mortgage service rights) due mostly to the Wilber acquisition. The tangible equity to tangible assets ratio was 7.12% at the end of 2011 versus 6.14% one year earlier. The increase was due to common shareholders’ equity growing at a greater pace than tangible assets. The Company manages organic and acquired growth in a manner that enables it to continue to build upon its strong capital base, and maintain the Company’s ability to take advantage of future strategic growth opportunities.
Cash dividends declared on common stock in 2011 of $36.0 million represented an increase of 15.7% over the prior year. This growth was a result of the 3.4 million shares issued in conjunction with the Wilber acquisition in the second quarter of 2011, as well as dividends per share of $1.00 for 2011 increasing from $0.94 in 2010, a result of quarterly dividends per share being raised from $0.24 to $0.26 (+8.3%) in the third quarter of 2011 and from $0.22 to $0.24 in the third quarter of 2010. The dividend payout ratio for this year was 49.3% compared to 49.2% in 2010, and 69.5% in 2009. The payout ratio remained stable in 2011 because dividends paid increased 15.7% while net income increased 15.5%. The payout ratio declined significantly in 2010 because dividends paid increased 8.1% while net income increased 53%. In 2009, the dividends paid increased 9.6% in part due to the public issuance of 2.5 million common shares in October 2008 to support the Citizens acquisition while net income declined 9.8%.
The Company completed a public stock offering in late January 2012. The offering raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company intends to use the net proceeds from this offering to support the HSBC and First Niagara branch acquisitions.
Liquidity risk is a measure of the Company’s ability to raise cash when needed at a reasonable cost and minimize any loss. The Bank maintains appropriate liquidity levels in both normal operating environments as well as stressed environments. The Company must be capable of meeting all obligations to its customers at any time and, therefore, the active management of its liquidity position remains an important management role. The Bank has appointed the Asset Liability Committee to manage liquidity risk using policy guidelines and limits on indicators of potential liquidity risk. The indicators are monitored using a scorecard with three risk level limits. These risk indicators measure core liquidity and funding needs, capital at risk and change in available funding sources. The risk indicators are monitored using such statistics as the core basic surplus ratio, unencumbered securities to average assets, free loan collateral to average assets, loans to deposits, deposits to total funding and borrowings to total funding ratios.
Given the uncertain nature of our customers' demands as well as the Company's desire to take advantage of earnings enhancement opportunities, the Company must have available adequate sources of on and off-balance sheet funds that can be acquired in time of need. Accordingly, in addition to the liquidity provided by balance sheet cash flows, liquidity must be supplemented with additional sources such as credit lines from correspondent banks, borrowings from the Federal Home Loan Bank of New York (“FHLB”) and the Federal Reserve Bank of New York. Other funding alternatives may also be appropriate from time to time, including wholesale and retail repurchase agreements, large certificates of deposit and the brokered CD market. The primary source of non-deposit funds are FHLB advances, of which $728 million are outstanding.
The Bank’s primary sources of liquidity are its liquid assets, as well as unencumbered securities that can be used to collateralize additional funding. At December 31, 2011, the Bank had $325 million of cash and cash equivalents of which $203 million are interest earning deposits held at the Federal Reserve. The Bank also had $424 million in unused FHLB borrowing capacity based on the Company’s year-end collateral levels. Additionally, the Company has $1.2 billion of unencumbered securities that could be pledged at the FHLB or Federal Reserve to obtain additional funding. There is $65 million available in unsecured lines of credit with other correspondent banks.
The Company’s primary approach to measuring short-term liquidity is known as the Basic Surplus/Deficit model. It is used to calculate liquidity over two time periods: first, the amount of cash that could be made available within 30 days (calculated as liquid assets less short-term liabilities as a percentage of average assets); and second, a projection of subsequent cash availability over an additional 60 days. As of December 31, 2011, this ratio was 20.5% for both time periods, excluding the Company's capacity to borrow additional funds from the FHLB and other sources. There is a sufficient amount of liquidity given the Company’s internal policy requirement of 7.5%.
A sources and uses statement is used by the Company to measure intermediate liquidity risk over the next twelve months. As of December 31, 2011, there is ample liquidity available throughout 2012 to cover projected cash outflows. In addition, stress tests on the cash flows are performed in various scenarios ranging from high probability events with a low impact on the liquidity position to low probability events with high impact on the liquidity position. The results of the stress tests as of December 31, 2011 indicate the Bank has sufficient sources of funds for 2012 in all stressed scenarios.
To measure longer-term liquidity, a baseline projection of loan and deposit growth for five years is made to reflect how liquidity levels could change over time. This five-year measure reflects ample liquidity for loan and other asset growth over the next five years.
Though remote, the possibility of a funding crisis exists at all financial institutions. Accordingly, management has addressed this issue by formulating a Liquidity Contingency Plan, which has been reviewed and approved by both the Board of Directors and the Company’s Asset Liability Management Committee. The plan addresses the actions that the Company would take in response to both a short-term and long-term funding crisis.
A short-term funding crisis would most likely result from a shock to the financial system, either internal or external, which disrupts orderly short-term funding operations. Such a crisis should be temporary in nature and would not involve a change in credit ratings. A long-term funding crisis would most likely be the result of drastic credit deterioration at the Company. Management believes that both potential circumstances have been fully addressed through detailed action plans and the establishment of trigger points for monitoring such events.
The changes in intangible assets by reporting segment for the year ended December 31, 2011 are summarized as follows:
Table 7: Intangible Assets
Intangible assets at the end of 2011 totaled $360.6 million, an increase of $48.9 million from the prior year-end due to $53.3 million of additional intangible assets arising from the acquisitions of Wilber and CAI, offset by $4.4 million of amortization during the year. Intangible assets consist of goodwill, the value of core deposits and customer relationships that arise from acquisitions. Goodwill represents the excess cost of an acquisition over the fair value of the net assets acquired. Goodwill at December 31, 2011 totaled $345 million, comprised of $335 million related to banking acquisitions and $10 million arising from the acquisition of financial services businesses. Goodwill is subjected to periodic impairment analysis to determine whether the carrying value of the acquired net assets exceeds their fair value, which would necessitate a write-down of the goodwill. The Company completed its goodwill impairment analyses during the first quarters of 2011 and 2010 and no adjustments were necessary on the subsidiary bank or financial services businesses. The impairment analysis was based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires the selection of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific performance and risk indicators. Management believes that there is a low probability of future impairment with regard to the goodwill associated with its whole-bank, branch and financial services businesses acquisitions.
Core deposit intangibles represent the value of non-time deposits acquired in excess of funding that could have been obtained in the capital markets. Core deposit intangibles are amortized on either an accelerated or straight-line basis over periods ranging from seven to twenty years. The recognition of customer relationship intangibles arose due to the acquisitions of the trust department of Wilber, CAI, ABG, HB&T, Harbridge and the insurance agency of Tupper Lake National Bank. These assets were determined based on a methodology that calculates the present value of the projected future net income derived from the acquired customer base. These assets are being amortized on an accelerated basis over periods ranging from seven to twelve years.
The Company’s loans outstanding, by type, as of December 31 are as follows:
Table 8: Loans Outstanding
As disclosed in Table 8 above, gross loans outstanding of $3.5 billion as of year-end 2011 increased $444.7 million or 15% compared to December 31, 2010, primarily as a result of the Wilber acquisition in April 2011. Excluding loans acquired from Wilber, loans increased $49.1 million or 1.6%. The low interest rate environment and business development efforts contributed to strong organic consumer mortgage and consumer installment indirect lending activity during 2011. Excluding loans acquired from Wilber, the business lending and consumer installment direct portfolios declined as compared to year-end 2010. The home equity portfolio, excluding loans acquired from Wilber also decreased due primarily to pay downs associated with the high level of mortgage refinancing being conducted in the low interest rate environment, as well as the continued deleveraging activities being undertaken by consumers in the current economic environment.
The compounded annual growth rate (“CAGR”) for the Company’s total loan portfolio between 2007 and 2011 was 5.3% comprised of approximately 0.9% organic growth, with the remainder coming from acquisitions. The greatest overall expansion occurred in the business lending and consumer mortgage segments, which grew at a 6.0% and 5.2% CAGR (including the impact of acquisitions), respectively, over that time frame. The business lending growth was driven by acquisitions over the time period, while the consumer mortgage growth was driven by robust mortgage refinancing volumes over the last five years, as well as the acquisition of consumer-oriented banks and branches. The consumer installment segment grew at a compounded annual growth rate of 4.9% from 2007 to 2011. Consumer installment loans consist of personal loans originated both in the branch network and in automobile, marine and recreational vehicle dealerships. The home equity lending segment grew at a compounded annual growth rate of 2.6% from 2007 to 2011, including acquisitions.
The weighting of the components of the Company’s loan portfolio enables it to be highly diversified. Approximately 65% of loans outstanding at the end of 2011 were made to consumers borrowing on an installment, line of credit or residential mortgage loan basis. The business lending portfolio is also broadly diversified by industry type as demonstrated by the following distributions at year-end 2011: commercial real estate (31%), restaurant & lodging (10%), healthcare (9%), general services (9%), agriculture (6%), retail trade (6%), manufacturing (7%), construction (5%), motor vehicle and parts dealers (4%), and wholesale trade (4%). A variety of other industries with less than a 2% share of the total portfolio comprise the remaining 9%.
The consumer mortgage portion of the Company’s loan portfolio is comprised of fixed (98%) and adjustable rate (2%) residential lending and includes no exposure to subprime, Alt-A, or other higher-risk mortgage products. Consumer mortgages increased $157.3 million or 15% in 2011. Excluding mortgage loans acquired from Wilber, mortgage lending increased $78.4 million or 7.4%. During the year ended December 31, 2011, the Company originated and sold an additional $43.1 million of longer-term, fixed-rate residential mortgages, principally to Fannie Mae. Consumer mortgage volume has been strong over the last few years due to historically low long-term interest rates and comparatively stable real estate valuations in the Company’s primary markets. The Company’s solid performance during a tumultuous period in the overall industry is a reflection of the high quality profile of its portfolio and its ability to successfully meet customer needs at a time when some national mortgage lenders have restricted their lending activities in many of the Company’s markets. Interest rates and expected duration continue to be the most significant factors in determining whether the Company chooses to retain versus sell and service portions of its new mortgage generation.
The combined total of general-purpose business lending, including agricultural-related and dealer floor plans, as well as mortgages on commercial property, is characterized as the Company’s business lending activity. The business lending portfolio increased $203.2 million or 20% in 2011. Excluding loans acquired from Wilber, net business lending balances declined $53.4 million from one year ago. Customer demand in this segment has remained soft primarily due to general economic conditions. In addition, in 2011 the Company experienced higher levels of unscheduled payoffs in this portfolio, as well as generally lower line utilization characteristics. The Company maintains its commitment to generating growth in its business portfolio in a manner that adheres to its twin goals of maintaining strong asset quality and producing profitable margins. The Company has continued to invest in additional personnel, technology, and business development resources to further strengthen its capabilities in this important product category.
The following table shows the maturities and type of interest rates for business and construction loans as of December 31, 2011:
Table 9: Maturity Distribution of Business and Construction Loans (1)
Consumer installment loans, both those originated directly (such as personal installment loans and lines of credit), and indirectly (originated predominantly in automobile, marine and recreational vehicle dealerships), increased $65.0 million or 10.1% from one year ago. Excluding the impact of consumer installment loans acquired from Wilber, the consumer installment indirect lending portfolio had organic growth of $41.4 million or 8.4%, while the consumer installment direct lending portfolio declined $6.1 million or 4.1%, after a year of somewhat softer demand due to consumers spending less and conducting deleveraging activities. The volume of new and used vehicles sales to upper tier credit profile customers in the Company’s primary markets has improved in recent periods. The Company is focused on maintaining the solid profitability produced by its in-market and contiguous market indirect portfolio, while continuing to pursue its disciplined, long-term approach to expanding its dealer network. A by-product of the still historically low new vehicle sales rates has been an improvement in used car valuations, where the majority of the Company’s installment lending is concentrated. It is expected that continued improvement in the automotive market will create the opportunity for the Company to produce indirect loan growth that is consistent with its longer-term historical experience.
Home equity loans increased $19.2 million or 6.3% from one year ago. Excluding the home equity loans acquired from Wilber, the home equity portfolio decreased $11.2 million or 3.7% from one year ago, in part due to home equity loans being paid off or down as part of the high level of mortgage refinancing activity that occurred throughout 2011 in the low rate environment. In addition, home equity utilization has been adversely impacted by the heightened level of consumer deleveraging activity that is occurring in response to the continued longer-term weakened economic conditions.
The following table presents information concerning nonperforming assets as of December 31:
Table 10: Nonperforming Assets
The Company places a loan on nonaccrual status when the loan becomes ninety days past due, or sooner if management concludes collection of interest is doubtful, except when, in the opinion of management, it is well-collateralized and in the process of collection. As shown in Table 10 above, nonperforming loans, defined as nonaccruing loans, accruing loans 90 days or more past due and restructured loans ended 2011 at $29.4 million, up approximately $10.9 million from one year earlier. The ratio of nonperforming loans to total loans increased 24 basis points from the prior year. Excluding nonperforming acquired loans, the ratio of nonperforming loans to total loans was 0.67%, an increase of six basis points from the prior year. The increase is primarily attributable to two large commercial relationships, one of which was acquired from Wilber, moving to non-accrual status during the fourth quarter of 2011. The ratio of nonperforming assets (which includes other real estate owned, or “OREO”, in addition to nonperforming loans) to total loans plus OREO increased to 0.92% at year-end 2011, up 24 basis points from one year earlier. The Company’s success at keeping these ratios at favorable levels despite weak economic conditions was the result of continued focus on maintaining strict underwriting standards, early problem recognition, and effective collection and recovery efforts. At year-end 2011, the Company was managing 28 OREO properties with a value of $2.7 million, as compared to 22 OREO properties with a value of $2.0 million a year earlier. Only one property has a carrying value in excess of $275,000. Despite the increase in OREO balances, the current level still reflects the low level of foreclosure activity in the Company’s markets and its specific portfolio in comparison to national markets.
Approximately 65% of the nonperforming loans at December 31, 2011 are related to the business lending portfolio, which is comprised of business loans broadly diversified by industry type. The increase in nonperforming loans in the business lending portfolio is primarily related to two large relationships, one of which was acquired in the Wilber acquisition and became impaired subsequent to acquisition. With the economic downturn, certain businesses’ financial performance and position have deteriorated, and consequently the level of nonperforming loans remains higher than historical levels. Approximately 30% of nonperforming loans at December 31, 2011 are related to the consumer mortgage portfolio. Collateral values of residential properties within the Company’s market area did not experience the significant declines in values that other parts of the country have encountered. However, the continued soft economic conditions and high unemployment levels have adversely impacted consumers and businesses alike and have resulted in higher nonperforming levels. The remaining five percent of nonperforming loans relate to consumer installment and home equity loans. The allowance for loan losses to nonperforming loans ratio, a general measure of coverage adequacy, was 144% at the end of 2011 compared to 230% at year-end 2010 and 222% at December 31, 2009, reflective of the higher level of nonperforming loans. Excluding acquired loans, the ratio of allowance for legacy loans to nonperforming legacy loans was 204% at the end of 2011, compared to 230% at year-end 2010 and 222% at December 31, 2009.
Members of senior management, special asset officers, and lenders review all delinquent and nonaccrual loans and OREO regularly, in order to identify deteriorating situations, monitor known problem credits and discuss any needed changes to collection efforts, if warranted. Based on the group’s consensus, a relationship may be assigned a special assets officer or other senior lending officer to review the loan, meet with the borrowers, assess the collateral and recommend an action plan. This plan could include foreclosure, restructuring the loans, issuing demand letters, or other actions. The Company’s larger criticized credits are also reviewed on at least a quarterly basis by senior credit administration, special assets and commercial lending management to monitor their status and discuss relationship management plans. Commercial lending management reviews the entire criticized loan portfolio on a monthly basis.
Total delinquencies, defined as loans 30 days or more past due or in nonaccrual status, finished the current year at 1.99% of total loans outstanding, versus 1.91% at the end of 2010. As of year-end 2011, total delinquency ratios for commercial loans, consumer installment loans, real estate mortgages and home equity loans were 2.21%, 1.67%, 2.12% and 1.34%, respectively. These measures were 1.56%, 2.03%, 2.24% and 1.71%, respectively, as of December 31, 2010. Delinquency levels, particularly in the 30 to 89 days category, tend to be somewhat volatile due to their measurement at a point in time, and therefore management believes that it is useful to evaluate this ratio over a longer period. The average quarter-end delinquency ratio for total loans in 2011 was 1.63%, as compared to an average of 1.61% in 2010 and 1.45% in 2009, reflective of the underlying economic conditions and the typical delayed impact they have on loan performance characteristics.
The changes in the allowance for loan losses for the last five years are as follows:
Table 11: Allowance for Loan Losses Activity
As displayed in Table 11 above, total net charge-offs in 2011 were $5.0 million, down $1.6 million from the prior year due to lower charge-offs in the business lending and consumer installment portfolios, partially offset by higher levels of charge-offs in the consumer mortgage and home equity portfolios. Net charge-offs in 2010 were $0.9 million lower than 2009’s level, due to lower levels of net charge-offs in the consumer installment portfolios, partially offset by somewhat higher levels of charge-offs in the other lending portfolios.
Due to the significant increases in average loan balances over time due to acquisition and organic growth, management believes that net charge-offs as a percent of average loans (“net charge-off ratio”) offers a more meaningful representation of asset quality trends. The net charge-off ratio for 2011 was down six basis points from 2010 and was nine basis points lower than 2009. Gross charge-offs as a percentage of average loans was 0.29% in 2011 as compared to 0.35% in 2010 and 0.36% in 2009. Continued strong recovery efforts were evidenced by recoveries of $4.7 million in 2011, representing 46% of average gross charge-offs for the latest two years, compared to 38% in 2010 and 37% in 2009.
Business loan net charge-offs decreased in 2011, totaling $2.3 million or 0.19% of average business loans outstanding versus $3.2 million or 0.31% in 2010, reflective of the Company’s disciplined risk management and underwriting standards. Consumer installment loan net charge-offs decreased to $1.9 million this year from $2.7 million in 2010, with a net charge-off ratio of 0.27% in 2011 and 0.41% in 2010. Higher used automobile valuations benefited consumer installment recovery efforts, which increased to 66% of current year gross charge-offs, compared to 55% in 2010. Consumer mortgage net charge-offs increased in 2011, and the net charge-off ratio increased one basis point to 0.06%. Home equity net charges offs were consistent at $0.2 million in 2011 and 2010.
Management continually evaluates the credit quality of the Company’s loan portfolio and conducts a formal review of the allowance for loan losses adequacy on a quarterly basis. The two primary components of the loan review process that are used to determine proper allowance levels are specific and general loan loss allocations. Measurement of specific loan loss allocations is typically based on expected future cash flows, collateral values and other factors that may impact the borrower’s ability to pay. Impaired loans greater than $0.5 million are evaluated for specific loan loss allocations. Consumer mortgages, consumer installment and home equity loans are considered smaller balance homogeneous loans and are evaluated collectively. The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts according to the contractual terms of the loan agreement or the loan is delinquent 90 days or more.
The second component of the allowance establishment process, general loan loss allocations, is composed of two calculations that are computed on the five main loan segments: business lending, consumer direct, consumer indirect, consumer mortgage and home equity. The first calculation determines an allowance level based on the latest 36 months of historical net charge-off data for each loan category (commercial loans exclude balances with specific loan loss allocations). The second calculation is qualitative and takes into consideration eight qualitative environmental factors: levels and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedure, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry condition; and effects of changes in credit concentrations. The allowance levels computed from the specific and general loan loss allocation methods are combined with unallocated allowances, if any, to derive the required allowance for loan losses to be reflected on the Consolidated Statement of Condition. As it has in prior periods, the Company strives to refine and enhance its loss evaluation and estimation processes continually. In 2009, the Company developed and utilized more granular historical loss factors on a portfolio-specific basis, as well as enhanced its use of both Company-specific and macro-economic qualitative factors. These enhancements did not result in a significant change to the determined reserve levels.
The loan loss provision is calculated by subtracting the previous period allowance for loan losses, net of the interim period net charge-offs, from the current required allowance level. This provision is then recorded in the income statement for that period. Members of senior management and the Audit Committee of the Board of Directors review the adequacy of the allowance for loan losses quarterly. Management is committed to continually improving the credit assessment and risk management capabilities of the Company and has dedicated the resources necessary to ensure advancement in this critical area of operations.
Acquired loans are recorded at acquisition date at their acquisition date fair values, and therefore, are excluded from the calculation of loans loss reserves as of the acquisition date. To the extent there is a decrease in the present value of cash from the acquired impaired loans after the date of acquisition, the Company records a provision for potential losses. During the year ended December 31, 2011, the Company established an allowance for loan losses for acquired impaired loans of $0.4 million for estimated additional losses on certain acquired impaired loans.
For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for these loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment. The Company did not record a provision for loan losses on acquired non-impaired loans in the year ended December 31, 2011.
The allowance for loan losses decreased to $42.2 million at year-end 2011 from $42.5 million at the end of 2010. The $0.3 million decrease was primarily due to relatively stable asset quality metrics and only modest growth in legacy loan balances. The ratio of the allowance for loan losses to total loans decreased 18 basis points to 1.22% for year-end 2011 as compared to 1.40% for 2010 and 1.35% for 2009. The ratio of allowance for loan losses to total legacy loans decreased four basis points to 1.36% for 2011 as compared to 2010, but was one basis point higher than the ratio at December 31, 2009. Management believes the year-end 2011 allowance for loan losses to be adequate in light of the probable losses inherent in the Company’s loan portfolio.
The loan loss provision for legacy loans of $4.3 million in 2011 decreased by $2.9 million as a result of management’s assessment of the probable losses in the loan portfolio, as discussed above. The loan loss provision as a percentage of average loans was 0.14% in 2011 as compared to 0.23% in 2010 and 0.32% in 2009. The loan loss provision was 94% of net charge-offs this year versus 109% in 2010 and 131% in 2009, reflective of the assessed risk in the portfolio.
The following table sets forth the allocation of the allowance for loan losses by loan category as of the dates indicated, as well as the percentage of loans in each category to total loans. This allocation is based on management’s assessment, as of a given point in time, of the risk characteristics of each of the component parts of the total loan portfolio and is subject to changes when the risk factors of each component part change. The allocation is not indicative of either the specific amounts of the loan categories in which future charge-offs may be taken, nor should it be taken as an indicator of future loss trends. The allocation of the allowance to each category does not restrict the use of the allowance to absorb losses in any category.
Table 12: Allowance for Loan Losses by Loan Type