UMB Financial 10-K 2005
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended: December 31, 2004
For the transition period from to
Commission file number: 0-4887
UMB FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code): (816) 860-7000
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
As of June 30, 2004, the aggregate market value of common stock outstanding held by nonaffiliates of the registrant was approximately $876,307,949 based on the NASDAQ closing price of that date.
Indicate the number of shares outstanding of the registrants classes of common stock, as of the latest practicable date.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Companys definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders, to be held on April 26, 2005, are incorporated by reference into in Part III of this Form 10K.
ITEM 1. BUSINESS
UMB Financial Corporation (the Company) was organized in 1967 under Missouri law for the purpose of becoming a bank holding company registered under the Bank Holding Company Act of 1956. In 2001, the Company elected to become a financial holding company under the Gramm-Leach-Bliley Act of 1999. The Company owns all of the outstanding stock of four commercial banks, a reinsurance company, a community development corporation, a consulting company, mutual fund servicing company and eleven other subsidiaries.
The four commercial banks are engaged in general commercial banking business entirely in domestic markets. Two of the banks are in Missouri, and two banks are in Kansas and Colorado. The principal affiliate bank, UMB Bank, n.a., whose charter is in Missouri, also has locations in Illinois, Kansas, Nebraska and Oklahoma. Another affiliate bank, UMB Bank, Colorado, opened a loan production office in Phoenix, Arizona during 2004. The banks offer a full range of banking services to commercial, retail, government and correspondent bank customers. In addition to standard banking functions, the principal affiliate bank, UMB Bank, n.a., provides international banking services, investment and cash management services, data processing services for correspondent banks and a full range of trust activities for individuals, estates, business corporations, governmental bodies and public authorities. The table below sets forth the names and locations of the Companys affiliate banks, as well as their respective total assets, total loans, deposits and shareholders equity as of December 31, 2004.
SELECTED FINANCIAL DATA OF AFFILIATE BANKS (in thousands)
Other subsidiaries of the Company are Kansas City Realty Company, Kansas City Financial Corporation, UMB Redevelopment Corporation and Warsaw Financial Corporation. United Missouri Insurance Company, an
Arizona corporation, is a reinsurance company that reinsures credit life and disability insurance originated by affiliate banks. UMB Community Development Corporation provides low-cost mortgage loans to low- to moderate-income families for acquiring or rehabilitating owner-occupied housing in Missouri, Kansas, Illinois, Nebraska, Oklahoma and Colorado. UMB Consulting Services, Inc. offers regulatory and compliance assistance to regional banks. UMB Fund Services, Inc. (formerly known as Sunstone Financial Group Inc.), located in Milwaukee, Wisconsin, is a nationally recognized mutual fund service provider to nearly 40 fund groups representing approximately 140 funds.
Effective August 1, 2004, UMB U.S.A., n.a. was merged into the principal affiliate bank, UMB Bank, n.a. UMB, U.S.A., n.a. was a credit card bank located in Nebraska. The credit card operations were moved to Missouri. Effective December 4, 2004, UMB Bank Omaha, n.a. was merged into the principal affiliate bank, UMB Bank, n.a. The branches of UMB Bank Omaha, n.a. continue to operate as branches of UMB Bank, n.a.
On a full-time equivalent basis at December 31, 2004, the Company and its subsidiaries employed 3,573 persons.
Competition. The Company faces intense competition from hundreds of financial service providers in the markets served. The Company competes with other financial service providers including banks, savings and loan associations, finance companies, mutual funds, mortgage banking companies and credit unions. Customers for banking services and other financial services offered by the Company are generally influenced by convenience, quality of service, personal contacts, price of services and availability of products.
Monetary Policy and Economic Conditions. The operations of the Companys affiliate banks are affected by general economic conditions, as well as the monetary policy of the Board of Governors of the Federal Reserve System (the Federal Reserve Board), which affects the supply of money available to commercial banks. Monetary policy measures by the Federal Reserve Board are affected through open market operations in U.S. government securities, changes in the discount rate on bank borrowings and changes in reserve requirements.
Supervision and Regulation. As a bank holding company and a financial holding company, the Company (and its subsidiaries) are subject to extensive regulation and are affected by numerous federal and state laws and regulations.
Supervision. The Company is subject to regulation and examination by the Federal Reserve Board (FRB) and the Federal Reserve Bank of Kansas City. Its four subsidiary banks are subject to regulation and examination by the Office of the Comptroller of the Currency (OCC). UMB Scout Insurance Services, Inc. is regulated by state agencies in the states in which it operates. The FRB possesses cease and desist powers over bank holding companies if their actions represent unsafe or unsound practices or violations of law. In addition, the FRB is empowered to impose civil money penalties for violations of banking statutes and regulations. Regulation by the FRB is intended to protect depositors of the Companys banks, not the Companys shareholders. The Company is subject to a number of restrictions and requirements imposed by the Sarbanes-Oxley Act of 2002 relating to loans to directors or executive officers of the Corporation and its subsidiaries, the preparation and certification of the Companys consolidated financial statements, the duties of the Companys audit committee, relations with and functions performed by the Companys independent auditors, and various accounting and corporate governance matters. The Companys brokerage affiliate, UMB Scout Brokerage Services, Inc., is regulated by the Securities and Exchange Commission (SEC), the National Association of Securities Dealers, Inc., and the Missouri Division of Securities; it is also subject to certain regulations of the various states in which it transacts business. It is subject to regulations covering all aspects of the securities business, including sales methods, trade practices among broker/dealers, capital structure of securities firms, uses and safekeeping of customers funds and securities, recordkeeping, and the conduct of directors, officers and employees. The SEC and the self-regulatory organizations to whom it has delegated certain regulatory authority, may conduct administrative proceedings that can result in censure, fines, suspension or expulsion of a broker/dealer, its directors, officers and employees. The principal purposes of regulation of securities broker/dealers is the protection of customers and the securities market, rather than the protection of stockholders of broker/dealers.
Limitation on Acquisitions and Activities. The Company is subject to the Bank Holding Company Act of 1956 as amended (BHCA), which requires the Company to obtain the prior approval of the Federal Reserve Board to (i) acquire substantially all the assets of any bank, (ii) acquire more than 5% of any class of voting stock of a bank or bank holding company which is not already majority owned, or (iii) merge or consolidate with another bank holding company. The BHCA also imposes significant limitations on the scope and type of activities in which the Company and its subsidiaries may engage. The activities of bank holding companies are generally limited to the business of banking, managing or controlling banks, and other activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In addition, under the Gramm-Leach-Bliley Act of 1999 (GLB Ac)t, a bank holding company, all of whose controlled depository institutions are well-capitalized and well-managed (as defined in federal banking regulations) and which obtains satisfactory Community Reinvestment Act ratings, may declare itself to be a financial holding company and engage in a broader range of activities.
A financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or incidental or complementary to activities that are financial in nature. Financial in nature activities include:
A financial holding company that desires to engage in activities that are financial in nature or incidental to a financial activity but not previously authorized by the FRB, must obtain approval from the FRB before engaging in such activity. Also, a financial holding company may seek FRB approval to engage in an activity that is complementary to a financial activity, if it shows that the activity does not pose a substantial risk to the safety and soundness of insured depository institutions or the financial system. Under the GLB Act, subsidiaries of financial holding companies engaged in non-bank activities are supervised and regulated by the federal and state agencies which normally supervise and regulate such functions outside of the financial holding company context.
A financial holding company may acquire a company (other than a bank holding company, bank or savings association) engaged in activities that are financial in nature or incidental to activities that are financial in nature without prior approval from the FRB. Prior FRB approval is required, however, before the financial holding company may acquire control of more than 5% of the voting shares or substantially all of the assets of a bank holding company, bank or savings association. In addition, under the FRBs merchant banking regulations, a financial holding company is authorized to invest in companies that engage in activities that are not financial in nature, as long as the financial holding company makes its investment with the intention of limiting the duration of the investment, does not manage the company on a day-to-day basis, and the company does not cross market its products or services with any of the financial holding companys controlled depository institutions. If any subsidiary bank of a financial holding company receives a rating under the Community Reinvestment Act of less than satisfactory, then the financial holding company is limited with respect to its engaging in new activities or acquiring other companies, until the rating is raised to at least satisfactory.
Interstate Banking and Branching. Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Riegle-Neal Act), a bank holding company is permitted to acquire the stock or substantially all of the assets of banks located in any state regardless of whether such transaction is prohibited under the laws of any state. The FRB will not approve an interstate acquisition if as a result of the acquisition the bank holding company would control more than 10% of the total amount of insured deposits in the United States or would
control more than 30% of the insured deposits in the home state of the acquired bank. The 30%-of-insured-deposits state limit does not apply if the acquisition is the initial entry into a state by a bank holding company, or if the home state waives such limit. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states. Under the Riegle-Neal Act, individual states may restrict interstate acquisitions in two ways. A state may prohibit an out-of-state bank holding company from acquiring a bank located in the state unless the target bank has been in existence for a specified minimum period of time (not to exceed five years). A state may also establish limits on the total amount of insured deposits within the state which are controlled by a single bank holding company, provided that such deposit limit does not discriminate against out-of-state bank holding companies As a result of the Riegle-Neal Act, the Company has many more opportunities for expansion and has potentially greater competition in its market area from nationwide or regional banks.
Other Regulatory Restrictions & Requirements. A bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit, with limited exceptions. There are also various legal restrictions on the extent to which a bank holding company and certain of its non-bank subsidiaries can borrow or otherwise obtain credit from its bank subsidiaries. The Company and its subsidiaries are also subject to certain restrictions on issuance, underwriting and distribution of securities. FRB policy requires a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. Under this source of strength doctrine, a bank holding company is expected to stand ready to use its available resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity, and to maintain resources and the capacity to raise capital that it can commit to its subsidiary banks. Furthermore, the FRB has the right to order a bank holding company to terminate any activity that the FRB believes is a serious risk to the financial safety, soundness or stability of any subsidiary bank. Also, under cross-guaranty provisions of the Federal Deposit Insurance Act (the FDIA ), bank subsidiaries of a bank holding company are liable for any loss incurred by the FDIC insurance fund, in connection with the failure of any other bank subsidiary of the bank holding company.
The Companys bank subsidiaries are subject to a number of laws regulating depository institutions, including the Federal Deposit Insurance Corporation Improvement Act of 1991, which expanded the regulatory and enforcement powers of the federal bank regulatory agencies. Such laws require that such agencies prescribe standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, fees and benefits, and mandated annual examinations of banks by their primary regulators. The Companys bank subsidiaries are also subject to a number of consumer protection laws and regulations of general applicability, as well as the USA Patriot Act, which is designed to identify, prevent and deter international money laundering and terrorist financing.
The rate of interest a bank may charge on certain classes of loan is limited by law. At certain times in the past, such limitations have resulted in reductions of net interest margins on certain classes of loans. Federal laws also impose additional restrictions on the lending activities of banks, including the amount that can be loaned to one borrower or related group.
All four of the commercial banks owned by the Company are national banks and are subject to supervision and examination by the Office of the Comptroller of the Currency (OCC). In addition, the national banks are subject to examination by The Federal Reserve System. All such banks are members of, and subject to examination by, the Federal Deposit Insurance Corporation (FDIC).
Payment of dividends by the Companys affiliate banks to the Company is subject to various regulatory restrictions. For national banks, the OCC must approve the declaration of any dividends generally in excess of the sum of net income for that year and retained net income for the preceding two years. At December 31, 2004, approximately $11,335,000 of the equity of the Companys banks was available for distribution as dividends to the Company without prior regulatory approval or without reducing the capital of the respective banks below prudent levels.
Each of the Companys subsidiary banks are subject to the Community Reinvestment Act (the CRA ) and implementing regulations. CRA regulations establish the framework and criteria by which the bank regulatory agencies assess an institutions record of helping to meet the credit needs of its community, including low- and-moderate-income neighborhoods. CRA ratings are taken into account by regulators in reviewing certain applications made by the Company and its bank subsidiaries.
Regulatory Capital Requirements Applicable to the Company. The FRB has promulgated capital adequacy guidelines for use in its examination and supervision of bank holding companies. If a bank holding companys capital falls below minimum required levels, then the bank holding company must implement a plan to increase its capital, and its ability to pay dividends and make acquisitions of new bank subsidiaries may be restricted or prohibited. The FRBs capital adequacy guidelines provide for the following types of capital:
Tier 1 capital, also referred to as core capital, calculated as:
Tier 2 capital, also referred to as supplementary capital, calculated as:
The maximum amount of supplementary capital that qualifies as Tier 2 capital is limited to 100% of Tier 1 capital.
Total capital, calculated as:
The Company is required to maintain minimum amounts of capital to various categories of assets, as defined by the banking regulators. At December 31, 2004, the Company was required to have minimum Tier 1 capital, Total capital, and leverage, ratios of 4.00%, 8.00%, and 4.00% respectively. The Companys actual ratios at that date were 18.2%, 19.2%, and 11%, respectively.
Regulatory Capital Requirements Applicable to the Companys Subsidiary Banks. In addition to the minimum capital requirements of the FRB applicable to the Company, there are separate minimum capital requirements applicable to its subsidiary national banks
Federal banking laws classify an insured financial institution in one of the following five categories, depending upon the amount of its regulatory capital:
Federal banking laws require the federal regulatory agencies to take prompt corrective action against undercapitalized financial institutions. The Companys banks must be well-capitalized and well-managed in order for the Company to remain a financial holding company. To be well-capitalized, a bank must maintain a total Tier 1 leverage ratio of 5% or greater, a Tier 1 risk-based capital ratio of 6% or greater and a total risk-based capital ratio of 10% or greater. The capital ratios and classifications of each of the Companys four banks as of December 31, 2005, are set forth below:
The Company is required to maintain minimum balances with the FRB for each of its subsidiary banks. These balances are calculated from reports filed with the respective FRB for each affiliate. At December 31, 2004, the Company held $58,861,000 at the respective FRB.
Deposit Insurance and Assessments. The deposits of each of the Companys four subsidiary banks are insured by an insurance fund administered by the FDIC, in general up to a maximum of $100,000 per insured deposit. Under federal banking regulations, insured banks are required to pay semi-annual assessments to the FDIC for deposit insurance. The FDICs risk-based assessment system requires members to pay varying assessment rates depending upon the level of the institutions capital and the degree of supervisory concern over the institution. The FDICs assessment rates range from zero cents to 27 cents per $100 of insured deposits. The FDIC has authority to increase the annual assessment rate and there is no cap on the annual assessment rate which the FDIC may impose.
Limitations on Transactions with Affiliates. The Company and its non-bank subsidiaries are affiliates within the meaning of Sections 23A and 23B of the Federal Reserve Act. The amount of loans or extensions of credit which a bank may make to non-bank affiliates, or to third parties secured by securities or obligations of the non-bank affiliates, are substantially limited by the Federal Reserve Act and the FDIA. Such acts further restrict the range of permissible transactions between a bank and an affiliated company. A bank and subsidiaries of a bank may engage in certain transactions, including loans and purchases of assets, with an affiliated company only if the terms and conditions of the transaction, including credit standards, are substantially the same as, or at least as favorable to the bank as, those prevailing at the time for comparable transactions with non-affiliated companies or, in the absence of comparable transactions, on terms and conditions that would be offered to non-affiliated companies.
Other Banking Activities. The investments and activities of the Companys subsidiary banks are also subject to regulation by federal banking agencies, regarding investments in subsidiaries, investments for their own account (including limitations in investments in junk bonds and equity securities), loans to officers, directors and their affiliates, security requirements, anti-tying limitations, anti-money laundering, financial privacy and customer identity verification requirements, truth-in-lending, the types of interest bearing deposit accounts which it can offer, trust department operations, brokered deposits, audit requirements, issuance of securities, branching and mergers and acquisitions.
Fiscal & Monetary Policies. The Companys business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. It is particularly affected by the policies of the FRB, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the FRB are: conducting open market operations in United States government securities; changing the discount rates of borrowings of depository institutions; imposing or changing reserve requirements against depository institutions deposits; and imposing or changing reserve requirements against certain borrowings by banks and their affiliates. These methods are used in varying degrees and combinations to directly effect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. The policies of the FRB have a material effect on the Companys business, results of operations and financial condition.
Future Legislation. Various legislation, including proposals to change substantially the financial institution regulatory system, is from time to time introduced in Congress. This legislation may change banking statutes and the Companys (and its subsidiaries) operating environment in substantial and unpredictable ways. If enacted, this legislation could increase or decrease the cost of doing business, limit or expand permissible activities, or affect the competitive balance among banks, savings associations, credit unions and other financial institutions. The Company cannot predict whether any of this potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, could have on the business, results of operations or financial condition of the Company or its subsidiaries.
The references in the foregoing discussion to various aspects of statutes and regulations are merely summaries which do not purport to be complete and which are qualified in their entirety by reference to the actual statutes and regulations.
Segment Information. Financial information regarding segments is included in Note 12 to the Consolidated Financial Statements provided in Item 8, pages 55 through 58 of this report.
Statistical Disclosure. The information required by Guide 3, Statistical Disclosure by Bank Holding Companies, has been included in Items 6, 7, and 7A, pages 13 through 41 of this report.
Executive Officers of the Registrants. The following are the executive officers of the Company, each of whom is elected annually, and there are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was elected as an officer.
A discussion of recent acquisitions is included in Note 15 to the Consolidated Financial Statements provided in Item 8 on page 65 of this report.
The Company makes available free of charge on its website at www.umb.com/investor, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports, as soon as reasonably practicable after it electronically files or furnishes such material with or to the SEC.
ITEM 2. PROPERTIES
The Companys headquarters building, the UMB Bank Building, is located at 1010 Grand Boulevard in downtown Kansas City, Missouri, and was opened in July 1986. Of the total 250,000 square feet, the offices of the parent company and customer service functions of UMB Bank, n.a. comprise 175,000 square feet. The remaining 75,000 square feet are available for lease to third parties. The Companys principal accounting firm is a lessee of a portion of the space. The Company is currently looking for a lessee to fill the remaining space.
UMB Fund Services, Inc., a subsidiary of the Company, leases 72,135 square feet in Milwaukee, Wisconsin, at which its fund services operations are headquartered.
The banking facilities of UMB Bank, n.a. at 928 Grand Boulevard and 906 Grand Boulevard principally house the banks support functions. The 928 Grand Boulevard location is connected to the headquarters building by an enclosed pedestrian walkway. The 928 Grand Boulevard finished a major rehabilitation during 2004. UMB Bank, n.a. also leases 40,000 square feet of space in the Equitable Building, in the heart of the downtown commercial sector of St. Louis. A full service banking center, operations and administrative offices are housed at this location.
At December 31, 2004, the Companys affiliate banks operated a total of four main banking houses and 148 detached facilities, the majority of which are owned by the affiliate banks or a non-bank subsidiary of the Company and leased to the respective bank. The Company constructed an 180,000 square foot operations center in downtown Kansas City, Missouri. The Company moved its operational and item processing functions, as well as management information systems, to this building in the second quarter of 1999.
Additional information with respect to premises and equipment is presented in Note 1 and 8 to the Consolidated Financial Statements in Item 8, pages 47 and 55 of this report.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to the shareholders for a vote during the fourth quarter ended December 31, 2004.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Companys stock is traded on the NASDAQ National Market System under the symbol UMBF. As of February 28, 2005, the Company had 1,958 shareholders. Company stock information for each full quarter period within the two most recent fiscal years is set forth in the table below.
Information concerning restrictions on the ability of the Registrant to pay dividends and the Registrants subsidiaries to transfer funds to the Registrant is contained in Item 1, page 6 and Note 10 to the Consolidated Financial Statements provided in Item 8, pages 52 and 53 of this report. Information concerning securities the Company issued under equity compensation plans is contained in Item 12, page 78 of this report.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
The following table provides information about share repurchase activity by the Company during the quarter ended December 31, 2004:
ISSUER PURCHASE OF EQUITY SECURITIES
On April 29, 2004 the Company announced a plan to purchase up to one million shares of common stock. This plan will terminate on April 29, 2005. The Company has not made any repurchases other than through this
plan. All share purchases under this share repurchase plan are within the scope of Rule 10b-18 promulgated under the Securities Exchange Act of 1934. Rule 10b-18 provides a safe harbor for purchases in a given day if the Company satisfies the manner, timing, price and volume conditions of the rule when purchasing its own common shares.
ITEM 6. SELECTED FINANCIAL DATA
For a discussion of factors that may materially affect the comparability of the information below, please see Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, pages 14 through 35, of this report.
FIVE-YEAR FINANCIAL SUMMARY
(in thousands except per share data)
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
MANAGEMENTS DISCUSSION AND ANALYSIS
The following presents managements discussion and analysis of the Companys consolidated financial condition, changes in condition, and results of operations. This review highlights the major factors affecting results of operations and any significant changes in financial conditions for the three-year period ended December 31, 2004. It should be read in conjunction with the accompanying Consolidated Financial Statements and other financial statistics appearing elsewhere in the report.
The discussion contains forward-looking statements of expected future developments. We wish to ensure such statements are accompanied by meaningful cautionary statements pursuant to safe harbor established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements may refer to projections of future financial performance and financial items, plans and objectives of future operations, and other matters. The use of variations of words such as expects, estimates, anticipates, believes, and similar expressions are intended to identify such forward-looking statements. These forward-looking statements reflect managements expectations and are based on currently available data; however, actual future results are subject to future events and uncertainties, which could materially affect actual performance and cause future results to differ materially from those referred to in the forward-looking statements. Such future events and uncertainties include, but are not limited to, changes in: loan demand, the ability of customers to repay loans, consumer saving habits, employee costs, pricing, interest rates, competition, legal or regulatory requirements or restrictions, U.S. or international economic or political conditions such as inflation or fluctuation in interest rates or in the values of securities traded in the equity markets. Any forward-looking statements should be read in conjunction with information about risks and uncertainties set forth in this report. Forward-looking statements speak only as of the date they are made, and the Company does not intend to review or revise any particular forward-looking statement in light of events that occur thereafter or to reflect the occurrence of unanticipated events.
The Company has experienced nearly three years of suppressed earnings largely driven by the following factors: the sustained low interest rate environment, the overall health of the equity markets and increased competition within its market. However, as discussed later, the fourth quarter of 2004 has begun to reflect improvements in these factors.
The sustained low interest rate environment adversely impacts the net interest income as the Companys balance sheet is structured to be both very short in duration and liquid. Management believes that liquidity and capital are necessary given the types of products and services the Company offers, particularly as it relates to treasury and cash management products and services. Thus, the Company does not anticipate that the structure of its balance sheet will change substantially in the near future. The Companys liquidity and capital position is designed to provide assurances that the cash needs of the Company can be met. This position adversely impacts the Companys net interest income in a declining rate environment. However, in an increasing rate environment, this position should, over time, benefit the Company. Management believes that we will be entering into a period of rising interest rates given the overall expansion of the economy. Item 7a, Quantitative and Qualitative Disclosures about Market Risk discusses in detail the impact of rising and declining rates on net interest income.
Net interest income is a main source of revenue for the Company. Net interest income is negatively impacted by smaller spreads between the yield on earning assets and the interest-free sources of funds. As the yield on loans and investments have declined, interest-free sources of funds could not, by definition, be lowered to match the decrease in yield on earning assets. In addition, a competitive deposit- pricing environment prevented the lowering of rates on interest bearing deposits to match the decrease in yields on earning assets. During the second half of 2004, interest rates began to rise but the repricing of funds occurred faster than the repricing of rates on loans and investments. Table 2 appearing in the Results of OperationsNet Interest
Income section of the Managements Discussion and Analysis shows the impact of the declining rate environment and also shows the declining benefits derived from the Companys interest free source of funds.
Management continues to focus on diversifying its revenue sources so that the net income of the Company is less susceptible to changes in interest rates. Management has also focused on reducing expenses that are not necessary to the delivery of products and services to the Companys customer base.
As some of the Companys fee-based business is the direct result of the market value of its customers investments, the overall health of the equity markets plays an important role in the recognition of fee income, particularly in the trust, mutual fund servicing and investment management areas of the Company. As the overall equity markets improve, the basis on which certain fee income is calculated is expected to grow.
The Company is also facing increased competition from other banks in its markets as well as other competitors such as non-bank financial institutions, brokers, insurance companies and investment advisory firms. The Company faces intense competition for retail customers and competes nationally with respect to its asset management business. This increased competition continues to have the impact of compressing margins and income from the Companys fee based businesses.
To counteract this competitive pressure, the Companys goal is to differentiate itself from its large super-regional and national competitors through superior service, attention to detail, customer knowledge and responsiveness. Management believes that the Companys size should allow it to meet this goal and at the same time offer the wide range of products most customers need. The Company has experienced growth in markets outside of the Kansas City metropolitan area and is developing its customer base in those outlying regions. In particular, the Company will be focusing on the St. Louis and Colorado markets. The Company believes that there is demand in these markets for bank services delivered with a customer-centric focus.
The Company recorded consolidated net income of $42.8 million for the year ended December 31, 2004. This represents a 27.2% decrease over 2003. Net income for 2003 increased 3% compared to 2002. Earnings per share for the year ended December 31, 2004, were $1.98 per share compared to $2.70 in 2003 and $2.59 in 2002. Earnings per share for 2004 decreased 26.7% over 2003 per share earnings, which had increased 4.2% over 2002.
The Federal Reserve Board has reduced the interest rate 550 basis points (5.50%) since 2001. In the second half of 2004, the Federal Reserve Board increased interest rates five times aggregating 125 basis points (1.25%). This overall reduction in rates caused repricing pressures on loans and securities and thus contributed significantly to a decrease in interest income for 2002, 2003 and into 2004. Although this decrease in interest income was partially offset by a decrease in interest expense, the Companys net interest income declined to $180.1 million in 2004 compared to $194.1 million in 2003 and $218.0 million in 2002. With the five rate increases in the second half of 2004, the Company is beginning to see a turn around in its yield on earning assets as these rate increases are beginning to have a positive impact. To illustrate: the Companys yield on earning assets reached a low in the first quarter of 2004 at 3.62% and increased to 3.87% during the fourth quarter of 2004. The Company anticipates that its yields will continue to slowly improve if rates gradually rise or remain stable.
The Company had a decrease of 7.6% in noninterest income in 2004 as compared to 2003 and a 5.8% increase in 2003 compared to 2002. This decrease of $18.7 million in 2004 is due to two factors: In 2003, the Company sold its merchant discount operation, which processes credit and debit card activity for commercial and retail merchants, and realized a one-time gain of $8.25 million. Decreases in trading, trust and investment banking income and service charges on deposit accounts in 2004 contributed to an absolute decrease in noninterest income for 2004 compared to 2003. Trust income was down in 2004 primarily because of the sale of the employee benefit accounts in 2003. Except for its receipt later in 2005 of the final payment on the sale of such accounts, no significant income or expenses are expected in the future with respect to employee benefit accounts.
Noninterest expense declined in 2004 by 0.5% compared to 2003 and decreased in 2003 by 2.6% compared to 2002. The $1.8 million decrease in 2004 compared to 2003 was primarily due to lower salaries and employee benefit costs as fully realized from the sale of its employee benefits business as well as other personnel related efficiencies. This decrease in salaries and benefits was partially offset by increases in occupancy (largely due to the refurbishment of the headquarters building in Kansas City and the construction of new branches) equipment, legal and consulting and processing fees (linked to the Companys upgrading of its core operating systems); and marketing expenses (the Companys creation of its branding strategy as well as product support). The decrease in 2003 compared to 2002 was primarily due to lower salaries and employee benefit related costs.
Results of Operations
Net Interest Income
Net interest income is a significant source of the Companys earnings and represents the amount by which interest income on earning assets exceeds the interest expense paid on liabilities. The volume of interest earning assets and the related funding sources, the overall mix of these assets and liabilities and the rates paid on each, affects net interest income. Table 1 summarizes the change in net interest income resulting from changes in volume and rates for 2004, 2003 and 2002. Table 1 also shows the impact of the declining rate environment on net interest income over the last three years.
Net interest margin is calculated as net interest income on a fully tax equivalent basis (FTE) as a percentage of average earning assets. A critical component of net interest income and related net interest margin is the percentage of earning assets funded by interest free funding sources. Table 2 analyzes net interest rate margin for the three years ended December 31, 2004, 2003 and 2002. Table 2 also shows the decline in the benefit of interest free funds as a result of the declining interest rate environment over the last three years. Net interest income, average balance sheet amounts and the corresponding yields earned and rates paid for the years 2000 through 2004 are presented in a table following the footnotes to the Consolidated Financial Statements. Net interest income is presented on a tax-equivalent basis to adjust for the tax-exempt status of earnings from certain loans and investments, which are primarily obligations of state and local governments.
RATE-VOLUME ANALYSIS (in thousands)
This analysis attributes changes in net interest income either to changes in average balances or to changes in average rates for earning assets and interest-bearing liabilities. The change in net interest income is due jointly to both volume and rate and has been allocated to volume and rate in proportion to the relationship of the absolute dollar amount of the change in each. All rates are presented on a tax-equivalent basis and give effect to the disallowance of interest expense, for federal income tax purposes, related to certain tax-free assets. The loan average balances and rates include nonaccrual loans.
ANALYSIS OF NET INTEREST MARGIN (in thousands)
The Company experienced lower net interest income of $14.0 million for the year 2004 compared to 2003 and $24.0 million for the year 2003 compared to 2002. As illustrated in Table 1, the 2004 and 2003 declines were primarily driven by lower rates. These decreases in net interest income have occurred due to several factors, primarily a reduction in demand for loans due to the soft economy; a reduction in mutual fund and trust related money market balances largely driven by both economic factors and a residual lack of public confidence impacting the overall securities industry; and an earning asset portfolio that, by design, is very short in duration and has been negatively impacted by the overall decline in interest rates over the past three years. As discussed below, management believes these factors will gradually improve.
Management believes that the overall outlook in its net interest income is positive. Outstanding loans have increased from $2.72 billion at the end of 2003 to $2.87 billion at the end of 2004. As the economy continues to strengthen, this will spur higher demand for commercial and consumer loans. Loan-related earning assets tend to have a higher spread than those earned in the Companys investment portfolio, as, by design, its investment portfolio is very short in duration and liquid in its composition of assets. In addition, as evidenced by the rate increases in 2004, most economists believe that the Federal Reserve Board will slowly apply the brake to the economy by increasing rates in 2005. Given the term of the Companys earning assets, a rising rate environment has historically had a positive impact on the Companys net interest income and management expects that this will occur in the future, especially once rates stabilize. Finally, management is continuing a strategic initiative that it launched in the early part of 2004 to focus additional efforts on marketing, product enhancements and streamlining the approval process for its consumer loan product suite. These efforts are expected to result in increased volumes of new applications and booked loans.
Provision and Allowance for Loan Losses
The allowance for loan losses (ALL) represents managements judgment of the probable losses inherent in the Companys loan portfolio. The provision for loan losses is the amount necessary to adjust its ALL to the level considered appropriate by management. The adequacy of the ALL is reviewed quarterly, considering such items as historical loss trends, a review of individual loans, current economic conditions, loan growth and characteristics, industry or segment concentration and other factors. Bank regulatory agencies require that the adequacy of the ALL be maintained on a bank-by-bank basis for each of the Companys subsidiaries. Furthermore, a Joint Interagency Advisory was issued on March 1, 2004, by the federal banking, thrift and credit union regulators providing clarification on the guidance on the accounting for loan and lease losses. Management estimates its probable losses in accordance with this guidance.
In 2004, the Company partially decentralized its loan approval process by increasing the lending authority limits for its regions. However, the Company maintained its centralized credit administration function, which
provides information on affiliate bank risk levels, delinquencies, an internal ranking system and overall credit exposure. In addition, larger loan requests are still centrally reviewed to ensure the consistent application of the loan policy and standards.
Management of the Company decreased the ALL from 1.60% of total loans as of December 31, 2003 to 1.49% of total loans as of December 31, 2004. This decrease was due to both a decrease in nonperforming loans in 2004 and sustained low charge-offs in 2003 and 2004. In 2003 the ALL was increased from 1.40% of total loans as of December 31, 2002 to 1.60% of total loans as of December 31, 2003. This increase was due to an increase in nonperforming loans in 2003.
As shown in Table 3, the ALL has been allocated to various loan portfolio segments. The Company manages the ALL against the risk in the entire loan portfolio and therefore, the allocation of the ALL to a particular loan segment may change in the future. In the opinion of management, the ALL is appropriate based on the inherent losses in the loan portfolio at December 31, 2004. Although no assurance can be given, management of the Company believes the present ALL is adequate considering the Companys loss experience, delinquency trends and current economic conditions, and does not anticipate material increases in the ALL or in the level of provisions to the ALL, in the near future. Future economic conditions and borrowers ability to meet their obligations, however, are uncertainties which could affect the Companys ALL and/or need to change its current level of provision.
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES (in thousands)
This table presents an allocation of the allowance for loan losses by loan categories. The breakdown is based on a number of qualitative factors; therefore, the amounts presented are not necessarily indicative of actual future charge-offs in any particular category.
The Company recorded a provision for loan losses of $5.4 million in 2004, compared with $12.0 million during 2003 and $16.7 million during 2002. The decrease in the loan provision in 2004 was primarily due to sustained low charge-offs in 2004. Net charge-offs were $6.1 million in 2004 and $5.8 million in 2003 compared with $15.0 million in 2002. The decrease in the loan provision in 2003 was primarily due to a $9.2 million decrease in net loan charge-offs, $8.7 million of the decrease is related to a decrease in commercial loans net charge offs.
Table 4 presents a five-year summary of the Companys ALL. Also, please see Credit Risk under Risk Management on pages 39 and 40 in this report for information relating to nonaccrual, past due, restructured loans, and other credit risk matters.
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES (in thousands)
A key objective of the Company is the growth of noninterest income to enhance profitability, as fee-based services are non-credit related, provide steady income and are not directly affected by fluctuations in interest rates. Fee-based services provide the opportunity to offer multiple products and services to customers and, therefore, more closely align the customer with the Company. The Companys ongoing focus is to develop and offer multiple products and services to its customers, the quality of which will differentiate it from the competition. Fee-based services that have been emphasized include trust and securities processing, securities trading/brokerage and cash management. Management believes that it can offer these products and services both efficiently and profitably as most of these are driven off of common platforms and support structures.
To further leverage these common platforms and support structures, management has developed a strategic initiative centered around developing HSA (Health Savings Account) healthcare initiatives where the Company provides the payment mechanisms to support these HSAs which the Company foresees as having an impact on the health care industry similar to that which 401(k)s have had on mutual funds. To date, the Company has entered into agreements with certain major healthcare providers. Management believes that, along with institutional asset management and mutual fund servicing, HSAs have the potential to be a significant new noninterest income growth engine for the Company.
SUMMARY OF NONINTEREST INCOME (in thousands)
Noninterest income (summarized in table 5) decreased 7.6% in 2004 compared to an increase of 5.8% in 2003. The decrease in 2004 was primarily a result of a decrease in trading and investment banking, the sale of the merchant discount operation in December 2003 which was recorded in 2003 as a one-time noninterest income item, and a decline in 2004 trust income due to the one-time sale of the employee benefit accounts in 2003. As the sale of the employee benefit accounts enabled the Company to avoid significant capital expenditures, management believes that this sale will not have a significant impact on future earnings. Simultaneous with the sale of the merchant discount operation, a marketing agreement was executed whereby the Company receives a share of future merchant discount income. Therefore, management believes that this sale will not have a significant impact on future earnings. The growth in noninterest income in 2003 was driven primarily by the sale of the merchant discount business in December 2003 and an increase in trading and investment banking income and an increase in service charges on deposit accounts.
Trust and securities processing consists of fees earned on personal and corporate trust accounts, custody of securities services, trust investments and money management services and servicing of mutual fund assets. These fees decreased in 2004 compared to 2003 primarily because of the sale of the Companys employee benefits business. Fees from mutual fund servicing increased slightly during 2004. Although increased regulatory compliance costs have slowed the formation of new funds who represent potential customers of the Company, there has been a growth of alternative investment products whose business is a target of the Companys sales efforts. Also, the Company has been able to obtain business from existing mutual funds. The Company expects this trend to continue, although it is uncertain as to the level or volume of new business it may be able to obtain or the extent that the traditional mutual fund business may change. Mergers and liquidations of equity funds appear to be slowing, but increased costs and receding margins will likely force further consolidation. The decline in 2003 compared to 2002 was partially due to the decline in equity and financial markets as trust fees are derived from the market value of the assets in the trust. In addition, due to the overall market decline in mutual fund volumes, fees relating to the custody of the securities and the servicing of mutual fund assets were negatively impacted. Management believes that the overall quality and performance of both its investment management and Scout Funds will attract both increased and new investable dollars to it assets under management. The Company also introduced a wrap product that will allow its brokerage operations to sell its Scout Funds to retail clients. Finally, the Company has put a special emphasis on selling the Scout Funds through our institutional channels by the establishment of a dedicated sales force. Through the end of 2004, this dedicated sales force has increased the net inflows into the Companys Scout Funds (primarily its Worldwide and Small Cap Funds) by approximately $200 Million. Although any forecast of future growth of such funds is uncertain, it is believed the continued efforts of the sales force will positively affect such future growth.
Trading and investment banking consists mostly of fees earned from the sale of bonds to the Companys correspondent bank and non-financial institution client base. Fees from such activity decreased $2.9 million in
2004 compared to 2003 and as compared to an increase of $2.9 million in 2003 compared to 2002. The 2004 decrease was mainly market driven as customers changed their positions of mortgaged backed securities, in 2003, due to the heavy refinancing of real estate loans. This returned to more normal trading levels in 2004. Management intends to focus its sales efforts on increasing our correspondent bank client base in 2005 which is expected to have a positive affect on trading and investment banking income.
Service charges on deposit accounts increased $2.8 million in 2004 compared to 2003 and $4.6 million in 2003 compared to 2002. The increase in 2004 was primarily related to an increase in overdraft and return item charges due to pricing increases and new overdraft decision and collection procedures. These increased consumer overdraft and return item fees are expected to increase 2005 deposit service charge income; however, some of this increase will be offset by reduced consumer service charge income with the introduction of new free checking products. Commercial deposit service charge income growth slowed due to a rapid increase in earnings credits during the second half of 2004. With the possibility of more increases to the earnings credit rates in 2005, growth in commercial service charge income could be challenged. Management believes the shift of customer payments from paper to electronic will continue at a rapid pace. The cash management service providers that weather this environment will be those who kept pace with the technological changes and the changing nature of the payments cycle. Management is expending 27% of its discretionary capital expenditure budget in 2005 to upgrade its product capabilities. In addition, more targeted commission and incentive plans have been put in place to help foster more concerted sales efforts to both attract new and retain current clients. Although the Company has focused significant resources into maintaining its cash management income levels, the external challenges facing the Company make the impact of these changes on its income uncertain.
Bankcard fees were flat in 2004 compared to 2003 and increased $1.8 million in 2003 compared to 2002. Merchant product revenue decreased $1.5 million due to the sale of the merchant bankcard portfolio in December 2003. Income from commercial credit and debit card programs grew rapidly in both 2003 and 2004. Continued growth in the commercial segments and rapid transfer from offline to online debit card activity in the consumer segment is anticipated. With the Companys launch of HSAs, management is expecting an increase in bankcard income within the HSA segment in 2005.
Other income decreased $4.8 million in 2004 compared to 2003 and increased $8.5 million in 2003 compared to 2002. The decrease in 2004 was largely due to the one-time sale of the merchant discount operation for an $8.25 million gain in 2003 partially offset by income recognized on the one-time sale of the employee benefit accounts in 2004.
Noninterest expense in 2004 decreased $1.8 million compared to 2003 primarily due to lower salary and benefits costs partially offset by increases in occupancy, equipment, marketing and business development, processing fees and related legal and consulting expenses. Noninterest expense decreased $9.3 million in 2003 compared to 2002 due to lower equipment expenses and lower salary expenses. The decrease in salary and benefits is primarily attributed to the reduction of employee benefit staff. As discussed below, noninterest expense will increase in 2005 primarily due to salary and benefit expense increases.
SUMMARY OF NONINTEREST EXPENSE (in thousands)
Salaries and employee benefits declined $7.0 million in 2004 compared to 2003 and decreased $6.6 million in 2003 compared to 2002. The decrease in salary and benefits in 2004 were primarily the result of the savings achieved through the reduction of staffing levels due to the sale of the Companys employee benefit business. This was a continuation of the 2003 and 2002 decrease in staffing levels. To illustrate, the Companys full time equivalent employees dropped from 4,027 at year-end 2002 to 3,807 at year-end 2003 to 3,587 in 2004. Management anticipates salary and benefit expenses to go up in 2005 as a result of a new short-term incentive plan and the adoption of new accounting rules for equity-based compensation related to the Companys incentive stock option and long-term incentive plans. A voluntary separation plan was rolled out in January 2005. Although an overall reduction in staff is anticipated as a result of this plan, the full savings associated with this plan will not be realized during 2005. The overall impact on salary expense will be dependent on the number of individuals accepting the offer.
Net occupancy expense increased $1.4 million or 5.7% in 2004 over 2003 due largely to the amortization of costs associated with the refurbishment of a building in the Companys downtown Kansas City campus, as well as the construction of new branches. Occupancy remained flat in 2003 compared to 2002. Additionally, rental income from our office buildings decreased significantly during 2004. Whether this decrease will continue into future years depends upon the Companys ability to fully lease its vacant space, and the timing and conditions of any such leases are currently unknown. Equipment costs increased $0.8 million in 2004 compared to 2003 and decreased $1.7 million in 2003 compared to 2002. The 2004 increase was primarily due to a $1.4 million increase in software costs from upgrades to core systems during 2004 offset by a decrease in equipment depreciation. The decrease in 2003 was a result of lower depreciation and equipment maintenance costs. Management expects these expenses to continue to increase in 2005 due to the ongoing upgrading of our core systems.
Marketing and business development increased $1.8 million or 13% over 2003 due to brand positioning and product enhancement and support costs as well as increased emphasis on business development. Marketing expenses decreased by $1.3 million in 2003 over 2002. Management anticipates that marketing costs will decrease in 2005 due to a shift in television and other media advertising to more local community sponsorships.
Processing fees increased $1.0 million in 2004 compared to 2003 and increased $0.9 million in 2003 compared to 2002. This increase was primarily the result of an increase in distribution fees for the Scout Funds as a result of increased flows into the funds and an increase in the distribution fee rate. The increase in 2002 was due to an increase in Federal Reserve Bank processing charges because of the decreased earnings credit on balances and increased volumes of activity.
Legal and consulting fees were up $1.5 million in 2004 over 2003 and were up $1.5 million in 2003 over 2002. The increases were largely due to consulting costs associated with the upgrades to core systems in 2004
and 2003. As most core systems upgrades have occurred, management expects such consulting fees to decrease in 2005. The 2004 increase was also attributable to increased legal costs associated with the Scout Funds and with professional fees associated with the Sarbanes-Oxley Act of 2002 compliance. Management expects the legal and professional fees to remain flat or slightly decrease in the future.
Other expense remained flat in 2004 compared to 2003 and decreased from 2002 to 2003.
Income tax expense totaled $8.9 million in 2004, compared to $17.1 million in 2003, and compared to $15.4 million in 2002. These expense levels equate to effective rates of 17.2%, 22.5% and 21.2% for 2004, 2003, and 2002 respectively. The primary reason for the difference between the Companys effective tax rate and the statutory tax rate is the effect of non-taxable income from municipal securities and state and federal tax credits realized. The amount of municipal interest income received has not decreased proportionately to the decrease in the Companys pretax income, causing an overall reduction in the effective tax rate for each of the three years. The decline in the effective tax rate between 2004 and 2003 resulted mainly from a net $3.7 million reduction in federal and state tax expense as a result of federal and state historic rehabilitation tax credits received on the on-going renovation of a downtown Kansas City office building. The net effect of the sale of state historic rehabilitation tax credits was approximately $1.85 million. The effective income tax rate for 2003 and 2002 includes a reduction in the tax reserve resulting from a reassessment of ongoing risks associated with tax matters. Management believes that the effective tax rate will increase in 2005 as a result of a decrease in the overall impact of municipal interest income.
Strategic Lines of Business
The Companys operations are strategically aligned into six major lines of business: Commercial Banking and Lending, Corporate Services, Banking Services, Consumer Services, Asset Management, and Investment Services Group. The lines of business in 2003 were Commercial Banking, Retail Banking, Trust and Wealth Management, and Investments Services Group. This change was made by management to better reflect the current organizational structure. This resulted in breaking Commercial Banking into three separate sectors: Commercial Banking and Lending, Corporate Services, and Banking Services. This breakout was done to better reflect how the Company markets its products and services as well as adding more granularity to better identify the primary drivers of our profitability. In addition, the Company merged consumer oriented business lines into the Retail Banking Business Segment and created Consumer Services. Finally, to reflect our desire to focus on both Personal and Institutional lines of business, the Trust and Wealth Management Business Segment has been renamed Asset Management. Under Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information, the prior year information has been reclassified to conform to the 2004 reporting structure. The lines of business are differentiated by both the customers and the products and services offered. Note 12 to the Consolidated Financial Statements describes how these segments are identified and presents financial results of the lines of business for the years ended December 31, 2004, 2003 and 2002. The Treasury and Other Adjustments category includes items not directly associated with the other lines of business.
Commercial Banking and Lendings pre-tax net income increased $7.9 million, or 57.8 percent, to $21.4 million in 2004, compared to a decrease of $0.6 million, or 4.2 percent to $13.6 million in 2003. For 2004, the increase in net income was driven primarily by an increase in net interest margin of $4.8 million or 10.8 percent over 2003. This increase in margin was largely fueled by lower cost of funding $5 million or 14.8%, which was partially offset by lower average loans of $39.9 million, or 2.2%. The cost of funding outstanding loans dropped from 2.15% to 1.91% largely driven by the Companys overall lower funding costs resulting from the drop in interest rates over the past few years. Loans outstanding have dropped due to a slow economy in most of the Companys footprint, increased competition and current clients and prospects having excess liquidity (resulting
in their not drawing down on lines or increasing existing lines). A lower provision for loan losses, due to a reduction in non-performing loans, also contributed to the improvement in net income. Net interest income declined in 2003 due to the sustained low interest rate environment and the corresponding impact on repricing of earning assets. An increase in interest rates, as expected by most economists, would have the most significant impact on this business segment, causing net interest income to rise. Management also believes that an anticipated improving economy would spur an increase in both loan commitments and outstandings that would generate increased net interest income. Loan authority increases have been made in 2004 and will continually be reviewed for further increases in 2005, which management believes should motivate and empower associates to make decisions locally and improve the turnaround time for clients. In addition, a new bonus program is being rolled out in 2005 to reward associates for acquiring profitable business. Management anticipates that the amounts to be paid under this program will not be material. Although the intent of the plan is to increase loan volume, the effectiveness of such plan is unknown.
Corporate Services pre-tax net income decreased $11.1 million to $23.1 million compared to an increase of $1.9 million or 5.8 percent to $34.2 million in 2003. For 2004, the decrease is largely due to lower net interest income of $10.1 million. The decline in margin is due to lower yields on deposit balances partially offset by an increase in average deposit balances of 2% or $33.5 million. Yields dropped from 1.85% in 2003 to 1.41% in 2004. Noninterest income remained relatively flat from 2003 to 2004, but increased by $7.8 million or 14.6% from 2002 to 2003. Challenges for this line of business arise from competitive pressures, as well as the technological challenges due to the movement from paper to electronic processing. Management believes interest rates will continue to increase in 2005, thus putting pressure on deposit service charge income which is impacted by earnings credits. New products are being developed to keep the Company in step with the clients changing needs. In addition to the new products, the new business development incentive program that has been rolled out for 2005 is expected to fuel an increase in customer acquisitions and sales to existing clients. Management believes Corporate Trust will expand its market share in regions where the Company has a physical presence outside of Kansas and Missouri due to an enhanced marketing emphasis. The Company has focused significant resources into maintaining its cash management income despite the external challenges facing the company from the shift in customer payments from paper to electronic form. The impact on income from these changes is uncertain.
Banking Services pre-tax net income was $8.5 million in 2004, a decrease of $2.8 million from 2003. The 2003 net income increased by $1.4 million from 2002. For 2004, the decrease is primarily attributable to a decrease in noninterest income of $1.8 million. This was primarily driven by lower demand from brokerage income related to the sale of mortgage-backed agencies to correspondent banks. The 2003 noninterest income increased from 2002 due to increased demand of agency products. Banking Services also saw a decline in net-interest margin of $0.6 million in 2004 due to a shift in the deposit mix from noninterest bearing deposits to interest bearing repurchase agreements. If this trend continues, future increases in interest rates would have an adverse affect on interest margin. Management believes that reorganizing the Banking Services group around delivering 12 major UMB product sets through its community bank relationships should improve income within this segment.
Consumer Services pre-tax net income decreased $4.0 million to a net loss of $9.9 million, compared to a decrease of $9.2 million from 2002 to 2003. Consumer Services is a source of funding for other activities within the Company. Due to the competitive nature of deposit pricing within the Companys markets, the Companys affiliates and subsidiaries increased deposit rates at a higher pace than its increases in earning asset yields during 2004. The 2004 decrease is primarily attributable to a decrease in net interest income before provision of $8.8 million or 10.4% from 2003. Net interest income is lower because of a $67.3 million decrease, or 2% drop in average retail branch deposits from 2003 to 2004, combined with a higher rate of interest paid on deposits during 2004. The majority of the decline in deposits was from time deposits. Growth was experienced in interest checking, savings and regular checking accounts during 2004. The decrease in net interest income was partially offset by lower provision for loan loss expense due to sustained lower charge-offs, as well as an increase in noninterest income. Noninterest income increased during 2004 primarily as a result of higher deposit service
charge income due to new overdraft decision and collection procedures. This was partially offset by a decrease in ATM interchange income due to overall reduced volume. Management believes that Consumer Services will improve net interest margin in 2005 by growing noninterest bearing deposits with the introduction of a free-checking product and redesigning in a deposit product set. Further, variable-rate consumer loan products such as home equity lines of credit will be a focus in this rising interest rate environment. Management believes that noninterest expense will increase in 2005 as a result of planned new branch openings and expansions and will evaluate operational efficiencies and branch realignment to offset such expenses.
Asset Managements pre-tax net income was $5.9 million, which is a decrease of $1.0 million or 14.2% from 2003. This is compared to a $2.1 million increase in income from 2002 to 2003. The $3.1 million increase in noninterest income from 2003 to 2004 was offset by a $4.0 million increase in noninterest expense. Noninterest income increased as a result of increased inflows into the Scout Funds, in particular the UMB Scout WorldWide and UMB Scout Small Cap Funds which grew by over $200 million and $100 million, respectively. Noninterest expense also increased related to increases in distribution, accounting and administration fees from the funds. Another significant expense in 2004 was the related to the amortization of a new trust system placed in service in February 2004. Management believes that 2005 income will increase as it continues to focus its marketing efforts on increasing the inflows into the Scout Funds. Total assets under management for the UMB Scout Funds are over $2.4 billion as of December 31, 2004.
Investment Services Groups net income decreased $2.4 million or 26.5 percent to $6.5 million in 2004, compared to a decrease of 13.3% to $8.9 million in 2003 from 2002. For 2004, the decrease is due to a decline in net interest income and an increase in noninterest expense. Net interest income declined due to a reduction of deposits from mutual fund clients. The noninterest expense increased by $1.1 million in 2004 over 2003 primarily because of increased personnel costs and credits received in 2003. For 2003, decreased revenues related to a sluggish mutual fund industry had the greatest impact on earnings. Management believes that income from new customers added in 2004 are expected to result in increased revenues in 2005, subject to the overall uncertainties within the mutual fund industry and the overall health of the equity markets.
The net loss for the Treasury and Other Adjustments category was $12.8 million for 2004, compared to a net loss of $10.1 million for 2003. The net loss for all years includes unallocated income tax expense for the consolidated Company. The smaller loss in 2003 was due primarily to the gain on the one-time sale of the merchant discount processing activity that appears as noninterest income in 2003. This is partially offset by income from the one-time sale of the employee benefits accounts during 2004 and decreased income tax expense as a result of federal and state rehabilitation tax credits.
Balance Sheet Analysis
Loans represent the Companys largest source of interest income. Loan balances increased by $147 million in 2004 due to managements effort to focus on new commercial and consumer loan relationships, as well as the overall improvement in the economy. Management plans to continue to focus on growing our consumer and middle market business as these market niches represent our best opportunity to cross-sell fee-related services, such as cash management. Additionally, management has implemented a new incentive plan for loan officers, as well as increased the loan authority for the regional presidents.
Included in Table 7 is a five-year breakdown of loans by type. During the first quarter of 2003 the Company reviewed the classifications of loans to ensure that loans were properly recorded on the loan system, which resulted in the reclassification of $92 million in loans from the commercial category to the commercial real estate category. Business-related loans continue to represent the largest segment of the Companys loan portfolio, comprising approximately 60% of total loans. The Company targets customers that will utilize multiple banking services and products.
ANALYSIS OF LOANS BY TYPE (in thousands)
As a percentage of total loans, commercial real estate which includes real estate construction loans now comprise 17.4% of total loans, compared to 15.9% at the end of 2003. Generally, these loans are made for working capital or expansion purposes and are primarily secured by real estate with a maximum loan-to-value of 80%. Many of these properties are owner-occupied and have other collateral or guarantees as security.
Bankcard loans have increased slightly as a percentage of total loans. The increase in 2004 was due primarily to increased promotional activity, for which the continued impact of such activities is unknown. A significant portion of the decrease in volume of bankcard loans in 2003 and 2002 was caused by a reduction in the private label portion of the portfolio. This type of loan is generally less profitable than traditional bankcard loans and is likely to continue to decrease in volume.
Other consumer installment loans have decreased as a percentage of loans. Future loan volumes may be affected by the competitive environment including financing terms from auto makers, the overall economy and consumer debt levels. The effects of such factors are uncertain.
Real estate residential loans have increased as a percentage of loans. The increase was due to the success of a low rate home equity line promotion and product enhancements.
Nonaccrual, past due and restructured loans are discussed under Credit Risk within the Quantitative and Qualitative Disclosure about Market Risk in Item 7A on pages 39 and 40 of this report.
The Companys security portfolio provides liquidity as a result of the composition and average life of the underlying securities. This liquidity can be used to fund loan growth or to offset the outflow of traditional funding sources. In addition to providing a potential source of liquidity, the security portfolio can be used as a tool to manage interest rate sensitivity. The Companys goal in the management of its securities portfolio is to maximize return within the Companys parameters of liquidity goals, interest rate risk and credit risk. The Company maintains very high liquidity levels while investing in only high-grade securities. The security portfolio generates the Companys second largest component of interest income.
Securities available for sale and securities held to maturity comprised 54.1% of earning assets as of December 31, 2004, compared to 55.1% at year-end 2003. Securities totaled $3.8 billion at December 31, 2004, compared to $3.7 billion at year-end 2003. Loan demand is expected to be the primary factor impacting changes in the level of security holdings.
Securities available for sale comprised 95.3% of the Companys securities portfolio at December 31, 2004 compared to 91.5% at year-end 2003. In order to improve the yields of the securities portfolio the Company has altered the mix of the portfolio from U.S. Treasury Notes to Mortgage-Backed Securities of U.S. Agencies and State and Political Subdivisions. Securities available for sale had a net unrealized loss of $16.7 million at year-end, compared to a gain of $5.1 million the preceding year. These amounts are reflected, on an after-tax basis, in the Companys other comprehensive income in shareholders equity, net of tax, as an unrealized loss of $10.6 million at year-end 2004, compared to a gain of $3.2 million for 2003.
The securities portfolio achieved an average yield on a tax-equivalent basis of 2.9% for 2004, compared to 3.1% in 2003 and 3.7% in 2002. The yield on the portfolio decreased by 21 basis points in 2003 as a result of low, sustained short-term interest rates. A significant portion of the investment portfolio must be reinvested each year as a result of its liquidity. The average life of the securities portfolio was 15.3 months at December 31, 2004 compared to 16.8 months at year-end 2003. Management has adopted a portfolio modification plan designed to improve noninterest margin which it intends to implement over the course of the next two years. This plan calls for a modest extension of 6-12 months, to the portfolio average life. Implementation of this plan is subject to market conditions including sufficient supply of securities with acceptable risk/reward characteristics. The effectiveness of this plan is uncertain as it is dependent on future market conditions including interest rate changes. Included in Tables 8 and 9 are analyses of the cost, fair value and average yield (tax equivalent basis) of securities available for sale and securities held to maturity.
The securities portfolio contains securities that have unrealized losses and are not deemed to be other-than-temporarily impaired (see the table of these securities in Footnote 4 on page 53 of this document). There are U.S. Treasury obligations, federal agency mortgage backed securities, and municipal securities that have had unrealized losses for greater than 12 months. These unrealized losses are a result of interest rate volatility in the markets and not related to the credit quality of the investments. The Company had the ability and intent to hold these investments until a recovery of fair value is achieved, which may be maturity. Therefore, management does not consider these securities to be other-than-temporarily impaired at December 31, 2004.
SECURITIES AVAILABLE FOR SALE (in thousands)
SECURITIES HELD TO MATURITY (in thousands)
Other Earning Assets
Federal funds transactions essentially are overnight loans between financial institutions, which allow for either the daily investment of excess funds or the daily borrowing of another institutions funds in order to meet short-term liquidity needs. The net purchased position at year-end 2004 was $105.9 million compared to a net sold position of $12.0 million at year-end 2003.
The Investment Banking Division of the Companys principal affiliate bank buys and sells federal funds as agent for non-affiliated banks. Because the transactions are pursuant to agency arrangements, these transactions do not appear on the balance sheet and averaged $568.5 million in 2004 and $827.9 million in 2003.
At December 31, 2004, the Company held securities bought under agreements to resell of $293.6 million compared to $264.7 million at year-end 2003. The Company used these instruments as short-term secured investments, in lieu of selling federal funds, or to acquire securities required for a repurchase agreement. These investments averaged $253.9 million in 2004 and $113.1 million in 2003.
The Investment Banking Division also maintains an active securities trading inventory. The average holdings in the securities trading inventory in 2004 were $68.0 million, compared to $49.4 million in 2003, and was recorded at market value.
Deposits and Borrowed Funds
Deposits represent the Companys primary funding source for its asset base. In addition to the core deposits garnered by the Companys retail branch structure, the Company continues to focus on its cash management services, as well as its trust and mutual fund servicing lines of business in order to attract and retain additional core deposits. Deposits totaled $5.4 billion at December 31, 2004 and $5.6 billion at year-end 2003. Deposits averaged $5.0 billion in 2004 and $5.3 billion in 2003. The Company continually strives to expand, improve and promote its cash management services in order to attract and retain commercial funding customers. It is one of the Companys core competencies given both its scale and competitive product mix.
Noninterest bearing demand deposits average $1.9 billion and $1.8 billion during 2004 and 2003, respectively. These deposits represented 37.5% of average deposits in 2004, compared to 33.9% in 2003. The Companys large commercial customer base provides a significant source of noninterest bearing deposits. Many of these commercial accounts do not earn interest, however, they receive an earnings credit to offset the cost of other services provided by the Company.
MATURITIES OF TIME DEPOSITS OF $100,000 OR MORE (in thousands)
ANALYSIS OF AVERAGE DEPOSITS (in thousands)
Securities sold under agreements to repurchase totaled $1.4 billion at December 31, 2004, and $1.2 billion at year-end 2003. This liability averaged $975.1 million in 2004 and $914.7 million in 2003. Repurchase agreements are transactions involving the exchange of investment funds by the customer for securities by the Company, under an agreement to repurchase the same or similar issues at an agreed-upon price and date. The Company enters into these transactions with its downstream correspondent banks, commercial customers, and various trust, mutual fund and local government relationships.
SHORT-TERM DEBT (in thousands)
The Company has eleven fixed-rate advances from the Federal Home Loan Bank at rates of 3.80% to 7.61%. These advances, collateralized by Company securities, are used to offset interest rate risk of longer term fixed rate loans.
Capital and Liquidity
The Company places a significant emphasis on the maintenance of a strong capital position, which promotes investor confidence, provides access to funding sources under favorable terms, and enhances the Companys ability to capitalize on business growth and acquisition opportunities. The Company is not aware of any trend, demands, commitments, events or uncertainties that would materially change its capital position or affect its liquidity in the foreseeable future. Nor does the Company anticipate any materially increased levels of capital expenditures in the near term. Capital is managed for each subsidiary based upon its respective risks and growth opportunities as well as regulatory requirements.
Total shareholders equity was $819.2 million at December 31, 2004 compared to $811.9 million one year earlier. During each year, management has the opportunity to repurchase shares of the Companys stock if it concludes that the applicable price is then such that purchases, would enhance overall shareholder value. During 2004 and 2003, the Company acquired 87,364 and 301,293 shares, respectively, of its common stock.
Risk-based capital guidelines established by regulatory agencies establish minimum capital standards based on the level of risk associated with a financial institutions assets. A financial institutions total capital is required to equal at least 8% of risk-weighted assets. At least half of that 8% must consist of Tier 1 core capital, and the remainder may be Tier 2 supplementary capital. The risk-based capital guidelines indicate the specific risk weightings by type of asset. Certain off-balance-sheet items (such as standby letters of credit and binding loan commitments) are multiplied by credit conversion factors to translate them into balance sheet equivalents before assigning them specific risk weightings. Due to the Companys high level of core capital and substantial portion of earning assets invested in government securities, the Tier 1 capital ratio of 18.19% and total capital ratio of 19.20% substantially exceed the regulatory minimums.
For further discussion of capital and liquidity, see the Liquidity Risk section of Item 7A, Quantitative and Qualitative Disclosures about Market Risk on pages 40 and 41 of this report.
RISK-BASED CAPITAL (in thousands)
This table computes risk-based capital in accordance with current regulatory guidelines. These guidelines as of December 31, 2004, excluded net unrealized gains or losses on securities available for sale from the computation of regulatory capital and the related risk-based capital ratios.
For further discussion of regulatory capital requirements, see note 10, Regulatory Requirements with the Notes to Consolidated Financial Statements under Item 8 on pages 56 and 57.
Off-balance Sheet Arrangements
The Companys main off-balance sheet arrangements are loan commitments, commercial and standby letters of credit, futures contracts and forward exchange contracts, which have maturity dates rather than payment due dates. Please see note 14, Commitments, Contingencies and Guarantees in the Notes to Consolidated Financial Statements under Item 8 on pages 64 and 65 for detailed information on these arrangements.
OFF-BALANCE SHEET ARRANGEMENTS (in thousands)
The table below details the contractual obligations for the Company as of December 31, 2004. The Company has no capital leases or long-term purchase obligations.
Critical Accounting Policies and Estimates
Managements Discussion and Analysis of financial condition and results of operations discusses the Companys Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to customers and suppliers, allowance for loan losses, bad debts, investments, financing operations, long-lived assets, taxes, other contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which have formed the basis for making such judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from the recorded estimates under different assumptions or conditions.
Management believes that the Companys critical accounting policies are those relating to: allowance for loan losses; goodwill and other intangibles; impairment of long-lived assets; revenue recognition; and, accounting for stock-based compensation.
The allowance for loan losses represents managements judgment of the losses inherent in the Companys loan portfolio. The adequacy is reviewed quarterly, considering such items as historical trends, a review of individual loans, current economic conditions, loan growth and characteristics. The allowance for loan losses are maintained on a bank-by-bank basis, however, the Company uses a centralized credit administration function, which provides information on affiliate bank risk levels, delinquencies, and internal ranking systems.
Goodwill is tested periodically for impairment. The Company has performed three impairment tests of goodwill since inception of the new standard. As a result of those tests, the Company has not recorded an impairment charge. The Company is amortizing other intangibles over their estimated useful life of 10 years.
Long-lived assets including goodwill, other intangible assets and premises and equipment, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset or a group of assets may not be recoverable. Goodwill and other intangibles were addressed above. The impairment review for long-lived assets other than goodwill includes a comparison of future cash flows expected to be generated by the asset or group of assets to their current carrying value. If the carrying value of the asset or group of assets exceeds expected cash flows (undiscounted and with interest charges), an impairment loss is recognized to the extent the carrying value exceeds its fair value.
Revenue recognition is the recording of interest on loans and securities and is recognized based on rate multiplied by the principal amount outstanding. Interest accrual is discontinued when, in the opinion of management, the likelihood of collection becomes doubtful. Annual bankcard fees are recognized on a straight-line basis over the period that cardholders may use the card. Other noninterest income is recognized as services are performed or revenue-generating transactions are executed.
Stock-based compensation is recognized using the intrinsic value method for disclosure purposes. Pursuant to the requirements of FAS 123 proforma net income and earnings per share are disclosed in Note 1 to the Consolidated Financial Statements and discloses the impact on earnings as if the fair value method had been applied. Please see the discussion on FAS123(R) issued December, 2004, under Note 2, New Accounting Pronouncements in the Notes to the Consolidated Financial Statements under Item 8 on pages 48 and 49.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is a broad term for the risk of economic loss due to adverse changes in the fair value of a financial instrument. These changes may be the result of various factors, including interest rates, foreign exchange prices, commodity prices or equity prices. Financial instruments that are subject to market risk can be classified either as held for trading or held for purposes other than trading.
The Company is subject to market risk primarily through the effect of changes in interest rates of its assets held for purposes other than trading. The following discussion of interest risk, however, combines instruments held for trading and instruments held for purposes other than trading because the instruments held for trading represent such a small portion of the Companys portfolio that the interest rate risk associated with them is immaterial.
Interest Rate Risk
In the banking industry, a major risk exposure is changing interest rates. To minimize the effect of interest rate changes to net interest income and exposure levels to economic losses, the Company manages its exposure to
changes in interest rates through asset and liability management within guidelines established by its Funds Management Committee (FMC) and approved by the Companys Board of Directors. The FMC has the responsibility for approving and ensuring compliance with asset/liability management policies, including interest rate exposure. The Company uses the following methods (simulation tools) for measuring and analyzing consolidated interest rate risk: Market Value of Equity Modeling (Net Portfolio Value), Net Interest Income Simulation Analysis, and Repricing Mismatch Analysis. The Company does not use hedges or swaps to manage interest rate risk except for the use of futures contracts to offset interest rate risk on specific securities held in its trading portfolio.
Market Value of Equity (Net Portfolio Value) Modeling
The Company uses the Net Portfolio Value to measure and manage interest rate sensitivity. The Net Portfolio Value measures the degree to which the market values of the Companys assets and liabilities will change given a change in interest rates. This model is designed to represent, as of the respective date selected, the increase or decrease in the market value of assets and liabilities that would result from a hypothetical change in interest rates on such date. The Company uses a hypothetical rate change (rate shock) of 100 basis points and 200 basis points, up or down. To perform these calculations, the Company uses the current loan, investment and deposit portfolios. The Company then makes certain cash flow assumptions regarding non-maturity deposits based on historical analysis, and managements outlook. The Company also analyzes loan prepayments and other market risks from industry estimates of prepayments and other market changes. Given the low level of current interest rates, the down 200 basis point scenario could not be completed as of December 31, 2003. Table 15 sets forth, for December 31, 2004 and 2003, the increase or decrease (as applicable) in Net Portfolio Value, that would be caused by the following hypothetical immediate changes in interest rates on such date: an immediate increase of 200 basis points; an immediate increase of 100 basis points; an immediate decrease of 200 basis points; and, an immediate decrease of 100 basis points. Table 15 includes both instruments entered into for trading purposes, and the instruments entered into for other than trading purposes, since the former represents such a small portion of the Companys portfolio that any difference in the interest rate risk associated with it (as compared with the risk associated with instruments entered into for other than trading purposes) is immaterial.
Net portfolio value as of December 31, 2004 is higher than December 31, 2003 at both the 100 and 200 basis points increases. This is due primarily to a modeling change in which longer-term non-maturity deposit cash flows are now being discounted with a longer-term wholesale funding replacement versus in the past where they were discounted with a short-term wholesale funding replacement rate. The Company is indicated to benefit from rate increases because a majority of its earnings assets are shorter in duration that its deposits have been repriced. Also, the Company had higher loans at December 31, 2004 than December 31, 2003. The indicated benefit from rising rate on NPV may not necessarily translate into improved earnings over the near-term.
MARKET RISK (in thousands)
Net Interest Income Modeling
Another tool used to measure interest rate risk and the effect of interest rate changes on net interest income and net interest margin is Net Interest Income Simulation Analysis. This analysis incorporates substantially all of
the Companys assets and liabilities together with forecasted changes in the balance sheet and assumptions that reflect the current interest rate environment. Through these simulations management estimates the impact on net interest income of a 200 basis point upward or downward gradual change of market interest rates over a one year period. Assumptions are made to project rates for new loans and deposits based on historical analysis, management outlook and repricing strategies. Asset prepayments and other market risks are developed from industry estimates of prepayment speeds and other market changes. Since the results of these simulations can be significantly influenced by assumptions utilized, management evaluates the sensitivity of the simulation results to changes in assumptions. Due to the low level of interest rates, the scenarios that simulate a 100 basis point and a 200 basis point decrease could not be completed as of December 31, 2003. Table 16 shows the net interest income increase or decrease over the next twelve months as of December 31, 2004 and 2003. Both years show that if rates rise 100 or 200 basis points, net interest income will increase.
MARKET RISK (in thousands)
Repricing Mismatch Analysis
The Company also evaluates its interest rate sensitivity position in an attempt to maintain a balance between the amount of interest-bearing assets and interest-bearing liabilities which are expected to mature or reprice at any point in time. While a traditional repricing mismatch analysis (gap analysis) provides a snapshot of interest rate risk, it does not take into consideration that assets and liabilities with similar repricing characteristics may not in fact reprice at the same time or the same degree. Also, it does not necessarily predict the impact of changes in general levels of interest rates on net interest income.
Management attempts to structure the balance sheet to provide for the repricing of approximately equal amounts of assets and liabilities within specific time intervals. Table 17 is a static gap analysis, which presents the Companys assets and liabilities, based on their repricing or maturity characteristics. This analysis shows that the Company is in a positive gap position because assets maturing or repricing exceed liabilities.
INTEREST RATE SENSITIVITY ANALYSIS (in millions)
MATURITIES AND SENSITIVITIES TO CHANGES IN INTEREST RATES (in thousands)
The Companys subsidiary UMB Bank, n.a. carries taxable governmental securities in a trading account that is maintained according to a Board-approved policy and relevant procedures. The policy limits the amount and type of securities that can be carried in the trading account as well as requiring that any limits under applicable law and regulations also be complied with, and mandates the use of a value at risk methodology to manage price volatility risks within financial parameters. The risk associated with the carrying of trading securities is offset by the sale of exchange traded financial futures contracts, with both the trading account and futures contracts marked to market daily.
This account had a balance of $60.2 million as of December 31, 2004 compared to $60.8 million as of December 31, 2003.
The Manager of the Investment Banking Division of UMB Bank, n.a. presents documentation of the methodology used in determining value at risk at least annually to the Board for approval in compliance with OCC Banking Circular 277, Risk Management of Financial Derivatives, and other banking laws and regulations. The aggregate value at risk is reviewed quarterly. The aggregate value at risk in the trading account was negligible as of December 31, 2004 and 2003.
Other Market Risk
The Company does not have material commodity price risks or derivative risks.
Credit risk represents the risk that a customer or counterparty may not perform in accordance with contractual terms. Credit risk is inherent in the financial services business and results from extending credit to customers. The Company utilizes a centralized credit administration function, which provides information on affiliate bank risk levels, delinquencies, an internal ranking system and overall credit exposure. In addition, loan requests are centrally reviewed to insure the consistent application of the loan policy and standards. In addition, the Company has an internal loan review staff that operates independently of the affiliate banks. This review team performs periodic examinations of each banks loans for credit quality, documentation and loan administration. The respective regulatory authority of each affiliate bank also reviews loan portfolios.
Another means of ensuring loan quality is diversification of the portfolio. By keeping its loan portfolio diversified, the Company has avoided problems associated with undue concentrations of loans within particular industries. Commercial real estate loans comprise only 16.4% of total loans, with no history of significant losses. The Company has no significant exposure to highly leveraged transactions and has no foreign credits in its loan portfolio.
The allowance for loan losses, (ALL) is discussed on pages 19 and 20. Also, please see Table 4 for a five-year analysis of the ALL. The adequacy of the ALL is reviewed quarterly, considering such items as historical loss trends, a review of individual loans, current economic conditions, loan growth and characteristics, industry or segment concentration and other factors. A primary indicator of credit quality and risk management is the level of nonperforming loans. Nonperforming loans include both nonaccrual loans and restructured loans. The Companys nonperforming loans decreased $3.0 million at December 31, 2004, compared to an increase of $2.1 million a year earlier. The major portion of nonperforming loans is due to three commercial loan customers. The Companys nonperforming loans have not exceeded 0.50% of total loans in any of the last five years. While the Company plans to increase its loan portfolio, management does not intend to compromise the Companys high credit standards as it grows its loan portfolio. The impact of future loan growth on the allowance for loan losses is uncertain as it is dependent on many factors including asset quality and changes in the overall economy.
The Company has no other real estate owned as of December 31, 2004, compared to $78,000 at December 31, 2003. Loans past due more than 90 days totaled $3.0 million at December 31, 2004 compared to $3.1 million at December 31, 2003.
A loan is generally placed on nonaccrual status when payments are past due 90 days or more and/or when management has considerable doubt about the borrowers ability to repay on the terms originally contracted. The accrual of interest is discontinued and recorded thereafter only when actually received in cash.
Certain loans are restructured to provide a reduction or deferral of interest or principal due to deterioration in the financial condition of the respective borrowers. In 2002, there was no reduction or deferral of interest due. The Company had no restructured loans at December 31, 2004, compared to $365,000 at December 31, 2003.
LOAN QUALITY (in thousands)