UMB Financial 10-K 2006
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended: December 31, 2005
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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non- accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of June 30, 2005, the aggregate market value of common stock outstanding held by nonaffiliates of the registrant was approximately $849,535,488 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 25, 2006, are incorporated by reference into in Part III of this Form 10K.
ITEM 1. BUSINESS
UMB Financial Corporation (the Company) was organized as a corporation 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 five commercial banks, a brokerage company, a reinsurance company, a community development corporation, a consulting company, a mutual fund servicing company and fifteen other subsidiaries.
The five commercial banks are engaged in general commercial banking business entirely in domestic markets. Two of the banks are in Missouri, one bank in Kansas, one bank in Colorado, and one bank in Arizona. The principal subsidiary bank, UMB Bank, n.a., whose principal office is in Missouri, also has branches in Illinois, Kansas, Nebraska and Oklahoma. 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 subsidiary 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, 2005.
SELECTED FINANCIAL DATA OF AFFILIATE BANKS (in thousands)
UMB Fund Services, Inc. (formerly known as Sunstone Financial Group Inc.), located in Milwaukee, Wisconsin, is a mutual fund service provider to nearly 40 fund groups representing approximately 140 funds and alternative investment companies.
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 loans to qualified small businesses in low to moderate income areas in Missouri, Kansas, Illinois, Nebraska, Oklahoma and Colorado. UMB Consulting Services, Inc. offers regulatory and compliance assistance to regional banks.
On a full-time equivalent basis at December 31, 2005, the Company and its subsidiaries employed 3,433 persons.
Segment Information. Financial information regarding the Companys six segments is included in Note 12 to the Consolidated Financial Statements provided in Item 8, pages 67 through 70 of this report.
Competition. The Company faces intense competition from hundreds of financial service providers in the markets served. The Company competes with other traditional and non-traditional 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 of location, quality of service, personal contact, 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 interest rates and 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 five 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
internal controls over financial reporting, disclosure controls and procedures, 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 which 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 purpose 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 Act), 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.
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 (FDIA), bank subsidiaries of a bank holding company are liable for any loss incurred by the Federal Deposit Insurance Corporation (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. These 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 Bank Secrecy Act and 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 five 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, 2005, approximately $14,186,000 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, 2005, 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 16.14%, 16.99%, and 10.96%, 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 five 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, and no interest is paid by the FRB on such balances. These balances are calculated from reports filed with the respective FRB for each affiliate. At December 31, 2005, the Company held $30,020,000 at the FRB.
Deposit Insurance and Assessments. The deposits of each of the Companys five 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, types of interest bearing deposit accounts offered, 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 affect 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.
Statistical Disclosure. The information required by Guide 3, Statistical Disclosure by Bank Holding Companies, has been included in Items 6, 7, and 7A, pages 15 through 46 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 72 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 1A. RISK FACTORS
Our business routinely encounters and addresses risks. Some of such risks may give rise to occurrences that cause our future results to be materially different than we presently anticipate. In the following paragraphs, we describe our present view of certain important strategic risks, although the risks below are not the only risks we face. If any of such risks actually occur, our business, results of operations, financial condition and prospects could be affected materially and adversely. These risk factors should be read in conjunction with our managements discussion and analysis, beginning on page 16 hereof, and our consolidated financial statements, beginning on page 47 hereof.
General economic conditions, such as economic downturns or recessions, could materially impair our customers ability to repay loans, harm our operating results and reduce our volume of new loans. Our profitability depends significantly on economic conditions. Economic downturns or recessions, either nationally, internationally or in the states within our footprint, could materially reduce our operating results. An economic downturn could negatively impact demand for our loan and deposit products, the demand for insurance and brokerage products, the number of customers who cannot pay interest or principal on their loans and the demand for our other fee-based services. The fee revenue of our asset management segments including income from our Scout Investment Advisors and UMB Fund Services, Inc. subsidiaries, are largely dependent on both inflows to, and the fair value of, assets invested in the UMB Scout Funds and the fund clients to whom we provide services. General economic conditions can affect investor sentiment and confidence in the overall securities markets which could adversely affect asset values, net flows to these funds and other assets under management. Our bankcard revenues are dependent on transaction volumes from consumer and corporate spending to generate interchange fees. An economic downturn could negatively affect the amount of such fee income. Our banking services group is affected by corporate and consumer demand for debt securities which can be adversely affected by changes in general economic conditions. To the extent loan charge-offs exceed our estimates, an increase to the amount of expense provided related to the allowance for loans would reduce income. See Quantitative and Qualitative Disclosures About Market RiskCredit Risk in Part II, Item 7A for a discussion of how we monitor and manage credit risk.
Changes in interest rates could affect our results of operations. A significant portion of our net income is based on the difference between interest earned on earning assets (such as loans and investments) and interest paid on deposits and borrowings. These rates are sensitive to many factors that are beyond our control, such as general economic conditions, policies of various governmental and regulatory agencies, such as the Federal
Reserve Bank. Changes in interest rates greatly affect the amount of income earned and the amount of interest paid. Changes in interest rates also affect loan demand, the prepayment speed of loans, the purchase and sale of investment bonds and the generation and retention of customer deposits. A rapid increase in interest rates could result in interest expense increasing faster than interest income because of differences in maturities of assets and liabilities. See Quantitative and Qualitative Disclosures About Market RiskInterest Rate Risk in Part II, Item 7A for a discussion of how we monitor and manage interest rate risk.
We are exposed to operational risk. Operational risk could adversely affect our profitability. Operational risk includes reputation risk, legal and compliance risk, risk of fraud or theft by employees or outsiders and transaction processing and system errors. We rely on the ability of our employees and systems to properly process a high number of transactions involving large sums of money. In the event of a breakdown in internal control systems, inappropriate access and improper operation of systems or improper employee actions, we could suffer financial loss, face regulatory action or incur damage to our reputation. See Quantitative and Qualitative Disclosures About Market RiskOperational Risk in Part II, Item 7A for a discussion of how we monitor and manage operational risk.
We face strong competition from other financial services firms, which could lead to pricing pressures that could materially adversely affect our revenue and profitability. In addition to the challenge of competing against local, regional and national banks in attracting and retaining customers, our competitors also include brokers, mortgage bankers, mutual fund sponsors, securities dealers, investment advisors and specialty finance and insurance companies. The financial services industry is intensely competitive, and we expect it to remain so. We compete on the basis of several factors, including transaction execution, products and services, innovation, reputation and price. We may experience pricing pressures as a result of these factors and as some of our competitors seek to increase market share by reducing prices on products and services or increasing rates paid on deposits.
The shift from paper-based to electronic-based payment business may be difficult and negatively affect earnings. In todays payment environment, checks continue to be the payment of choice; however, checks as a percent of the total payment volume are declining and the payment volume is shifting to electronic alternatives. Check products are serviced regionally due to the physical constraints of the paper document; however, electronic documents are not bound by the same constraints, thus opening the geographic markets to all providers of electronic services. To address this shift, new systems are being developed and marketed which involve significant software and hardware costs. It is anticipated that we will encounter new competition, and any competitor that attracts the payments business of our existing customers will compete strongly for the remainder of such customers banking business.
We are subject to extensive regulation in the jurisdictions in which we conduct our businesses. We are subject to extensive state and federal regulation, supervision and legislation that govern most aspects of our operations. Laws and regulations, and in particular banking, securities and tax laws, may change from time to time. Such changes may negatively impact our future results of operations and may also have an impact on our ability to achieve our strategic objectives. Actions by regulatory agencies could cause us to devote significant time and resources to compliance and could lead to penalties and withdrawal of certain products or services offered in the market.
Liquidity is essential to our businesses and we rely on the securities market and other external sources to finance a significant portion of our operations. Liquidity affects our ability to meet our financial commitments. Our liquidity could be substantially negatively affected by an inability to increase deposits or obtain additional funds through borrowing. Factors that we cannot control, such as disruption of the financial markets or negative views about the general financial services industry could impair our ability to raise funding. If we are unable to raise funding using the methods described above, we would likely need to sell assets, such as our investment and trading portfolios, to meet maturing liabilities. We may be unable to sell some of our assets on a timely basis, or we may have to sell assets at a discount from market value, either of which could adversely
affect our results of operations. Our liquidity and funding policies have been designed to ensure that we maintain sufficient liquid financial resources to continue to conduct our business for an extended period in a stressed liquidity environment. If our liquidity and funding policies are not adequate, we may be unable to access sufficient financing to service our financial obligations when they come due, which could have a material adverse franchise or business impact. See Quantitative and Qualitative Disclosures About Market RiskLiquidity Risk in Part II, Item 7A for a discussion of how we monitor and manage liquidity risk.
Inability to hire or retain qualified employees could adversely affect our performance. Our people are our most important resource and competition for qualified employees is intense. Employee compensation is our greatest expense. We rely on key personnel to manage and operate our business, including major revenue generating functions such as our loan and deposit portfolios. The loss of key staff may adversely affect our ability to maintain and manage these portfolios effectively, which could negatively affect our results of operations. If compensation costs required to attract and retain employees become unreasonably expensive, our performance, including our competitive position, could be materially adversely affected.
Changes in accounting standards could impact reported earnings. The accounting standard setting bodies, including the Financial Accounting Standards Board and other regulatory bodies periodically change the financial accounting and reporting standards affecting the preparation of our consolidated financial statements. These changes are not within our control and could materially impact our consolidated financial statements.
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 250,000 square feet, 183,000 square feet is occupied by offices of the parent company, UMB Financial Corporation, as well as some customer service functions. The remaining 67,000 square feet of space is either leased or available for lease to third parties. Presently, the Company is seeking to lease 50,000 square feet of the headquarters building.
Other main facilities of UMB Bank, n.a. are located at 928 Grand Boulevard (185,000 square feet), 906 Grand Boulevard (140,000 square feet), and 1008 Oak Street (180,000 square feet) all in downtown Kansas City, Missouri. The 928 Grand and 906 Grand buildings house support functions. The 928 Grand building finished a major rehabilitation during 2004. The 928 building is also connected to the companys headquarters building by an enclosed elevated pedestrian walkway. The 1008 Oak building, which opened during the second quarter of 1999, houses the Companys operations, item processing, and data processing functions.
UMB Bank, n.a. is leasing 64,263 square feet in the Equitable Building, which is located in the heart of the commercial sector of downtown St. Louis, Missouri. This location has a full service banking center and is home to operations and administrative support functions as well.
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.
At December 31, 2005, the Companys affiliate banks operated a total of five main banking centers with 135 detached facilities, the majority of which are owned by the Company. The ability to obtain strategic new banking facilities in key growth areas within the Companys footprint could affect future performance.
Additional information with respect to premises and equipment is presented in Note 1 and 8 to the Consolidated Financial Statements in Item 8, pages 52 and 60 of this report.
ITEM 3. LEGAL PROCEEDINGS
In the normal course of business, the Company and its subsidiaries are named defendants in various lawsuits and counter-claims. In the opinion of management, after consultation with legal counsel, none of these lawsuits are expected to have a materially adverse effect on the financial position or results of operations of the Company.
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, 2005.
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 1,901 shareholders of record. 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 62 and 63 of this report. Information concerning securities the Company issued under equity compensation plans is contained in Item 12, page 85 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, 2005:
ISSUER PURCHASE OF EQUITY SECURITIES
On April 26, 2005 the Company announced a plan to purchase up to one million shares of common stock. This plan will terminate on April 26, 2006. The Company has not made any repurchases other than through this plan. The Company typically executes all share repurchases in accordance with the safe-harbor provisions of Rule 10b-18 of the Exchange Act. Rule 10b-18 provides a safe harbor for purchases in a given day if the Company satisfies the manner, timing 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 16 through 40, 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, 2005. It should be read in conjunction with the accompanying Consolidated Financial Statements and other financial statistics appearing elsewhere in the report.
SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
The information included or incorporated by reference in this report contains forward-looking statements of expected future developments within the meaning of and pursuant to the safe harbor provisions established by Section 21E of the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. These forward-looking statements may refer to financial condition, results of operations, plans, objectives, future financial performance and business of the Company, including, without limitation:
Forward-looking statements are not guarantees of future performance or results. You are cautioned not to put undue reliance on any forward-looking statement which speaks only as of the date it was made. Forward-looking statements reflect managements expectations and are based on currently available data; however, they involve risks, uncertainties and assumptions. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
Any forward-looking statements should be read in conjunction with information about risks and uncertainties set forth in this report and in documents incorporated herein by reference. 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.
Results of Operations
The average loan to deposit ratio of the Companys subsidiary banks has been, and is expected to continue be lower than industry average. The Company plans to continue its efforts to further diversify its fee-based operations to help reduce the Companys exposure to changes in interest rates. This includes asset and treasury management, investment services, deposit service charges and other fee-based services.
As some of the Companys fee-based businesses are the direct result of the market value of its customers investments, the overall health of the equity and financial markets plays an important role in the recognition of fee income, particularly in trust, mutual fund servicing and investment management areas of the Company. To counter this market risk, the Company took action in several areas. In 2005, the Company aligned its brokerage and personal wealth management groups to better position itself to serve its customers. In 2005, the Company added 12 actively managed mutual funds and 14 passively managed investments to its asset management offerings. The Company benefited from record net flows of $842 million into the UMB Scout Funds (which are managed by a subsidiary of the Company) during the year, more than twice the $305 million of net flows registered in 2004, and almost ten times the net flows in 2002. Also, the Companys mutual fund servicing business had strong sales from both existing and new customers throughout 2005 due to a renewed effort on sales in 2004 and 2005.
During 2005, the Company focused on helping customers transition from paper payment options to electronic payment solutions by providing innovative products and services such as paycard and remote deposit capture. Additionally, the Company is investing in a significantly upgraded treasury management platform in order to enable enhanced information reporting and transaction initiation via the Internet; improve control of service through online self-administration; and strengthen system security. The Company has also adopted a wholesale health savings and flexible spending account strategy focusing on healthcare providers and third-party administrators. This strategy resulted in UMB achieving several prominent customer wins. These items did not have a significant impact on 2005 earnings, but are enabling the Company to position itself with respect to fee-based income in future years.
The interest rate environment has a direct impact on the Companys net interest income as the Companys balance sheet is structured to be both very liquid and short in duration. This position adversely impacts the Companys net interest income in a declining rate environment. As rates increase, liabilities will typically reprice more quickly than assets which puts pressure on overall net interest income. However, in an increasing rate environment, this position should, over time, benefit the Company. Management believes that once rates stabilize at a higher rate, then net interest income will improve. Item 7a, Quantitative and Qualitative Disclosures about Market Risk, discusses in detail the impact of rising and declining rates on net interest income.
On the expense side, management initiated a Voluntary Separation Plan (VSP) in early 2005 for certain individuals to take early retirement. Over 100 associates participated in this plan. Although this plan had a one-time cost of approximately $4.4 million in 2005, ongoing savings are anticipated. At this time, management does not anticipate offering the VSP in 2006 or future years. A comprehensive board-approved incentive plan was also introduced in 2005 to encourage associates to focus on profitable activities.
Additionally, management implemented a branch rationalization strategy in 2005 in which we sold eleven branches, closed five branches and opened four new branches in strategic locations. This had a favorable impact on 2005 income as a result of the net gains from the sales and closures. Along with this strategy, a renewed focus has been placed on the branch distribution network across the Company footprint. This has enabled the Company to experience growth outside of its main headquarters in Kansas City, MO.
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 local, regional and national competition for retail customers and competes nationally with respect to its trust and asset management business. This increased competition continues to have the impact of compressing margins and income from the Companys fee based businesses. As this competition is anticipated to continue, management is addressing these competitive concerns through the implementation of new core systems in 2005 and 2006 including customer relationship management; corporate treasury management; imaging and other network improvements.
The Company recorded consolidated net income of $56.3 million for the year ended December 31, 2005. This represents a 31.5 percent increase over 2004. Net income for 2004 decreased 27.2 percent compared to 2003. Basic earnings per share for the year ended December 31, 2005 were $2.61 per share compared to $1.98 in 2004 and $2.70 in 2003. Basic earnings per share for 2005 increased 31.8 percent over 2004 per share earnings, which had decreased 26.7 percent over 2003. Fully diluted earnings per share for the year ended December 31, 2005, were $2.60 per share compared to $1.97 in 2004 and $2.70 in 2003.
The Companys net interest income increased to $188.3 million in 2005 compared to $179.1 million in 2004 and $193.2 million in 2003. The $9.2 million increase in net interest income in 2005 as compared to 2004 is primarily a result of a favorable volume variance partially offset by an unfavorable rate variance. See Table 1 on pages 19 and 20. The volume variance was mostly driven by an 18.3 percent increase in loans and loans held for sale in 2005 as compared to 2004. Although interest rates increased during 2005, the Company experienced an unfavorable rate variance in 2005 as compared to 2004 as its liabilities repriced more quickly than its assets. The Company anticipates that its yields will continue to slowly improve if rates gradually rise or remain stable. The $14.1 million decrease in net interest income in 2004 as compared to 2003 was primarily a result of an unfavorable rate variance caused by margin compression triggered by historically low interest rates. See Table 1 on pages 19 and 20.
The Company had an increase of $23.8 million, or 10.4 percent in noninterest income in 2005 as compared to 2004 and a $17.8 million, or 7.2 percent decrease in 2004 compared to 2003. The increase in 2005 as compared to 2004 is primarily a result of increases in trust and securities processing due to increased inflows into the UMB Scout funds; increases in service charges as a result of a new overdraft program; net gains on the sales and closures of banking facilities and gain on the sale of employee benefit accounts. The decrease in 2004 from 2003 was the result of a few reasons. The Company sold its merchant bankcard discount operation in 2003, which processed credit and debit card activity for commercial and retail merchants, and realized a one-time gain of $8.3 million. Decreases in fee-based income contributed to the remaining decrease in noninterest income for 2004 compared to 2003. The most significant decrease in fee-based income was related to trust and securities processing which experienced a decrease due to the gain recognized from the sale of the employee benefit accounts in early 2004.
Noninterest expense increased in 2005 by $8.0 million, or 2.3 percent compared to 2004 and decreased in 2004 by $1.0 million, or 0.3 percent compared to 2003. The $8.0 million increase from 2004 was partially attributable to a $4.4 million charge for the VSP offered by the Company in 2005. Additionally, there were increases in processing fees (largely due to an increase in shareholder servicing and other administration fees paid to investment advisors related to the Scout Funds); bankcard expenses (linked to enhanced rebate programs for consumer and commercial card customers); and other expense (non-operating charge-offs and charitable contributions). These increases were partially offset by personnel related efficiencies and a decrease in marketing and business development expense. The $1.0 million decrease in 2004 as compared to 2003 was primarily due to lower salaries and employee benefit accounts as fully realized from the sale of the 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).
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 affect net interest income. Table 1 summarizes the change in net interest income resulting from changes in volume and rates for 2005, 2004 and 2003.
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, 2005, 2004 and 2003. Net interest income, average balance sheet amounts and the corresponding yields earned and rates paid for the years 2001 through 2005 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 an increase in net interest income of $9.2 million, or 5.1 percent, for the year 2005 compared to 2004. This followed a decline of $14.1 million, or 7.3 percent, for the year 2004 compared to 2003. As illustrated in Table 1, the 2005 increase is primarily a result of a favorable volume variance due mostly to a $350 million, or 12.6 percent, increase in average loan balances. The increase in interest rates also had a corresponding increase in the rate variance for earning assets. However, the same increase in rates affected liabilities repricing more quickly than asset repricing, causing an overall unfavorable rate variance for 2005 as compared to 2004. As illustrated in Table 1, the 2004 decrease in net interest margin as compared to 2003 is mostly due to an unfavorable rate variance. Interest rates hit a low in mid-2004 before beginning to increase in the second half of 2004. Although the duration of the Companys portfolio is relatively short, an increase in rates has a more immediate impact on liabilities than it does assets. On the liability side, a significant portion of the Companys funding sources reprice frequently (in particular, interest-bearing demand and savings and federal funds purchased and repurchase agreements). To illustrate the asset side, at the end of 2005, 57.8 percent of the Companys loans are fixed rate loans (see Table 17 on page 43) and the average maturity of the investment portfolio is 23 months (see discussion under Securities on page 31).
Management believes that the overall outlook in its net interest income is positive. The highest yielding assets, loans, have increased from an average of $2.87 billion at the end of 2004 to an average of $3.39 billion at the end of 2005. 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. If rates continue to increase, the rate impact on both loans and investment yields will be favorable. Given the term of the Companys earning assets, a sustained higher rate environment has historically had a positive impact on the Companys net interest income and management expects that this will occur in the future. Management is continuing a strategic initiative to emphasize commercial and consumer loan growth through marketing, product enhancements and streamlining the approval process for its consumer loan product suite. These efforts are designed to increase volumes of new applications and booked loans.
During 2006, approximately $984 million of securities are expected to mature and be reinvested. Management believes that the securities portfolio continues to be an opportunity for both interest income and yield improvement, depending upon rate changes. In late 2004, management adopted a portfolio modification plan designed to improve interest income by extending the average life of its investment portfolio. The Company intends to continue to implement this extension strategy over the course of the next three to five quarters. The original plan called for a modest extension of 6 to 12 months to the average portfolio life. The total investment portfolio had an average life of 23.0 months and 15.3 months as December 31, 2005 and December 31, 2004, respectively. This increase is a result of implementing the extension strategy. It should be noted that the Company has a significant portfolio of extremely short-term discount notes as of the end of both 2005 and 2004. These securities are held due to the seasonal fluctuation related to public fund deposits which are expected to flow out of the bank in a relatively short period. At December 31, 2005, the amount of such discount notes was approximately $840 million, and without these discount notes, the average life of the core investment portfolio would have been 30.4 months. At December 31, 2004, the amount of such discount notes was approximately $1.0 billion, and without these discount notes, the average life of the core investment portfolio would have been 21.0 months. Therefore, the core investment portfolio, without the short-term discount notes, had an increase in average life of 9.4 months in 2005. Continued implementation of this plan is subject to market conditions including the existing yield curve and a sufficient supply of securities with acceptable risk/reward characteristics. The effectiveness of this plan is uncertain as it is dependent upon future market conditions including interest rate changes.
Overall, if interest rates continue to rise at a measured pace and given the term and changing mix of the Companys balance sheet, management expects net interest income to increase. Management believes the Company will obtain additional improvement in net interest income once rates stabilize.
Provision and Allowance for Loan Losses
The allowance for loan losses (ALL) represents managements judgment of the 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, migration analysis, 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.
In 2004, the Company partially decentralized its loan approval process by increasing the lending authority limits of 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 expensed an additional $0.4 million, or 7.5 percent, related to the provision for loan losses in 2005 as compared to 2004. This compares to a $6.6 million, or 55% decrease in the provision for loan losses in 2004 as compared to 2003. As illustrated on Table 4 below, the ALL decreased from 1.49% of total loans as of December 31, 2004 to 1.20% of total loans as of December 31, 2005. This decrease was due to both a sustained decrease in nonperforming loans as a percentage of total loans in 2005, as well as continued low charge-offs in 2005, 2004 and 2003 (See Table 4 below).
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, 2005. 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.
Table 4 presents a five-year summary of the Companys ALL. Also, please see Credit Risk under Risk Management on pages 43 and 44 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 and provide steady income, as fee-based services are non-credit related 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. Fee-based services that have been emphasized include trust and securities processing, securities trading/brokerage and cash/treasury 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.
SUMMARY OF NONINTEREST INCOME (in thousands)
Noninterest income (summarized in table 5) increased by $23.8 million, or 10.4 percent, in 2005 as compared to 2004. This compares to a decrease in noninterest income of $17.8 million, or 7.2 percent in 2004 as compared to 2003. The increase in noninterest income in 2005 as compared to 2004 is primarily a result of increases in fee based services including trust and securities processing; service charges on deposits and bankcard fees. Additional increases are a result of significant gains on the sales of assets and deposits, net (due to the sale of certain branch locations during 2005) and the sale of employee benefit accounts (the final earnout payment was received in early 2005).
The decrease in noninterest income in 2004 as compared to 2003 was primarily a result of a decrease in trading and investment banking, the sale of the merchant discount operation in December 2003, and a significant decline in 2004 trust income due to the sale of the employee benefit accounts in 2004. 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.
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 mutual fund assets servicing. These fees increased $6.7 million in 2005 compared to 2004 and decreased $10.7 million in 2004 compared to 2003. The increase in trust and securities processing fees in 2005 as compared to 2004 was primarily a result of two items. First, there was a $4.3 million increase in fund administration fees from UMB Fund Services as a result of services performed for new clients. The remaining increase is primarily attributable to increases in management fees from the UMB Scout Funds due to $842 million of net inflows into the funds during 2005. As the income from these two segments are mostly linked to the market value of assets, the related income will be affected by changes in the securities markets. Management continues to emphasize sales of services to both new and existing clients as well as increasing and improving the distribution channels which lead to increased inflows into the UMB Scout funds. The decrease in trust and securities processing in 2004 as compared to 2003 is primarily related to the sale of the Companys employee benefits business and the loss of the assets under management from such employee benefit accounts.
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 increased $0.3 million, or 1.8% in 2005 compared to 2004 and as compared to a decrease of $2.9 million, or 14.1 percent in 2004 compared to 2003. 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 and 2005.
Service charges on deposit accounts increased $5.9 million, or 8.0 percent, in 2005 compared to 2004 and $2.8 million, or 4.0 percent, in 2004 compared to 2003. The increase in 2005 over 2004 was primarily a result of a $7.5 million increase in individual overdraft and return item charges partially offset by a decrease in corporate service charges. The increase in individual overdraft and return item charges is primarily due to pricing increases and changes in overdraft and collection procedures in the second half of 2004. As 2005 was the first full year of these new overdraft and collection procedures, the impact on future years is uncertain as it is greatly affected by customer behavior. This increase from overdraft and return item charges was partially offset by decreases in corporate service charges. Corporate service charge income was adversely affected by increases in earnings credits on compensating balances. Due to the increase in interest rates, the earnings credits on compensating balances also increased correspondingly. Management has implemented a new tiered earnings credit policy in January 2006 which should help mitigate the impact of future increases in interest rates. Another area of potential future growth relates to the Companys HSA (Health Savings Account) and FSA (Flexible Spending Account) healthcare initiatives where the Company provides the payment mechanisms to support HSAs and FSAs. These accounts could favorably impact fee income, interchange fee from electronic payments and the amount of deposits and assets under management. To date, the Company has entered into agreements with certain major healthcare providers, but the volume of such business and revenues associated with it cannot be reasonably forecast. The increase in service charge income in 2004 as compared to 2003 is also related to the 2004 implementation of new overdraft procedures. Corporate service charge income is also affected by the shift of customer payments from paper to electronic 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.
Brokerage fees continue to decline. Brokerage fee income decreased by $1.8 million, or 23.3 percent in 2005 compared to 2004. Brokerage fee income declined by $1.9 million, or 19.8 percent in 2004 compared to 2003. The primary reason for this decline is the continued decline in retail brokerage fee income due to decreased demand. Management has attempted to address this trend by realigning the brokerage business with its Private Client Services division under new leadership. Management believes that this realignment will enable increases to future brokerage income through better distribution channels, as well as an increased sales focus.
Bankcard fees increased by $1.9 million in 2005 compared to 2004 after remaining relatively flat in 2004 as compared to 2003. The higher fees in 2005 reflect both an increase in overall card volume and the average per transaction dollar amount. In 2005, the credit card rebate programs were modified to encourage increased usage by both consumer and commercial customers. Additionally, the rise in gasoline prices as well as the general health of the economy impacted transaction activity. Continued growth in the commercial card segments and rapid transfer from offline to online debit card activity in the consumer segment is anticipated.
Gains on sales of assets and deposits, net, increased by $7.1 million in 2005 as compared to 2004 net gains of $2.2 million. There were no similar gains in 2003. The 2005 gains were primarily attributable to net gains on the sales of eleven banking facilities. Other gains in 2005 included a $2.4 million gain related to the condemnation sale of a downtown Kansas City banking facility to the city, as well as a $1.2 million gain on the sale of a portion of land related to another Kansas City banking facility. The gain in 2004 was primarily related to the condemnation sale of a downtown Kansas City parking lot.
Gains on sale of employee benefit accounts represent earnout payments received in 2005 and 2004 as a result of the sale of employee benefit accounts announced in May 2003. The accounts were transferred in the first month of 2004 and a gain of $1.2 million was recognized in such year. In the first quarter of 2005, an earnout payment of $3.6 million was received based on the income received during the first twelve months on accounts transferred in 2004.
Gain on sale of merchant discount operation was recorded in December 2003 for $8.3 million. 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.
Other income increased $1.9 million, or 12.6 percent, in 2005 compared to 2004 and increased $1.1 million, or 8.4 percent, in 2004 compared to 2003.
Noninterest expense in 2005 increased $8.0 million, or 2.3 percent, compared to 2004, primarily due to a one-time charge related to the VSP, higher processing fees, bankcard fees and other noninterest expense items. These items were partially offset by decreases in salary and benefit costs, as well as a decrease in marketing and business development. Noninterest expense remained relatively flat in 2004 as compared to 2003 by decreasing by 0.3 percent, or $1.0 million. As discussed below, it is anticipated that noninterest expense will increase in 2006 primarily due to investments in technology and personnel.
SUMMARY OF NONINTEREST EXPENSE (in thousands)
Salaries and employee benefits increased a nominal $0.3 million, or 0.2 percent, in 2005 compared to 2004 and decreased $7.0 million in 2004 compared to 2003. Although the overall change in salary and benefit expense from 2004 to 2005 was small, there was a $4.4 million charge for payments made to employees under the VSP. These higher costs were offset by decreases in staffing levels during 2005. To illustrate, the Companys full time equivalent employees dropped from 3,587 at year-end 2004 to 3,433 in 2005. Further improvements came from a $1.7 million decrease in health insurance related costs due primarily to the implementation of a new partially self-funded insurance program in 2005. In 2006, the implementation of new Statement of Financial Accounting Standards (SFAS) No. 123 (R), Share-Based Payment will impact the expense recognized from equity based compensation. It is anticipated that an additional $0.4 million of expense will be recognized in 2006 for stock options outstanding at December 31, 2005. Additional expense will be recognized for additional grants made in 2006. Further, the hiring of certain key strategic sales personnel in late 2005 and the anticipated hiring of additional strategic sales personnel in 2006 will have an unfavorable impact on salary expense in 2006. The decrease in salary and benefits in 2004 was primarily the result of the savings achieved through the reduction of staffing levels due to the sale of the Companys employee benefit business. The number of full time equivalent employees dropped from 3,807 at year-end 2003 to 3,587 at year end 2004.
Occupancy, net expense remained relatively flat from 2005 as compared to 2004, but had increased by $1.4 million, or 5.7 percent in 2004 as compared to 2003. The increase in 2004 as compared to 2003 was 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. 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 have increased moderately in both 2005 and 2004. Equipment costs increased $0.6 million, or 1.4 percent, in 2005 compared to 2004 and increased $0.8 million, or 1.8 percent, in 2004 compared to 2003. The increases in 2005 and 2004 are primarily due to software upgrades to core systems. Due to commitments made to acquire or upgrade other core software systems (Check 21 imaging software; commercial treasury management software upgrades; voice over internet protocol software; interactive voice response software upgrades; and customer relationship management software), management anticipates equipment costs to increase during 2006.
Marketing and business development decreased $2.0 million, or 13.1 percent, in 2005 as compared to 2004 due to a management shift in television and other media advertising to more local community sponsorships. It is anticipated that although this decreased level will continue, it will be partially offset by increases in 2006 as a result of new marketing campaigns. Marketing expenses increased by $1.8 million in 2004 over 2003 due to brand positioning, product enhancement and support costs and an increased emphasis on business development.
Processing fees increased $2.2 million, or 10.4 percent, in 2005 compared to 2004 and increased $1.0 million, or 5.2 percent, in 2004 compared to 2003. The 2005 and 2004 increases were primarily the result of an increase in shareholder servicing and other administration fees paid to investment advisors related to the Scout Funds as a result of increases in assets under management for both years. The amount of such fees paid in future years is dependent upon assets under management (affected by both fund inflows as well as market values), and is expected to generally correlate to trends in the equity markets.
Legal and consulting fees were relatively flat in 2005 as compared to 2004, but had increased by $1.5 million, or 20.0 percent, in 2004 compared to 2003. The 2004 increase was primarily attributable to increased on-going legal costs associated with the Scout Funds and with professional fees associated with Sarbanes-Oxley Act of 2002 compliance.
Bankcard expenses increased by $2.5 million, or 27.3 percent, in 2005 as compared to 2004. Bankcard expenses had also increased by $1.0 million, or 12.7 percent, in 2004 as compared to 2003. The increases in both 2005 and 2004 are primarily attributable to the implementation of a new platinum rebate program in 2005 for individual customers and enhancements to the rebate program for corporate customers in 2004.
Other expenses increased $4.7 million, or 36.0 percent, in 2005 compared to 2004 and remained relatively flat in 2004 as compared to 2003. The significant increase in 2005 as compared to 2004 is a result of many items including: a $1.8 million increase in operational charge-offs primarily due to the new overdraft program; a $0.5 million increase in charitable contributions; and the remainder from a variety of non-operating charge-offs. Management does not anticipate that such non-operating charge-offs will repeat in 2006.
Income tax expense totaled $20.0 million in 2005, compared to $8.9 million in 2004, and compared to $17.1 million in 2003. These expense levels equate to effective rates of 26.2 percent, 17.2 percent, and 22.5 percent for 2005, 2004, and 2003 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 increase in the effective tax rate in 2005 as compared to 2004 was a result of a $1.9 million reduction in federal and state rehabilitation tax credits and net tax-exempt income representing a smaller percentage of pre-tax net income. In 2005, tax-exempt income represented approximately 25.0 percent of pre-tax income as compared to 36.7 percent of pre-tax income in 2004. This had a 4.1 percentage point impact on the effective tax rate in 2005 as compared to 2004. 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 the 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 in 2004. Further, the
effective income tax rate for 2003 included 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 slightly in 2006 as no significant federal or state tax credits are anticipated.
The Companys operations are strategically aligned into six major segments: Commercial Banking and Lending, Corporate Services, Banking Services, Consumer Services, Asset Management, and Investment Services Group. The segments 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 segments for the years ended December 31, 2005, 2004 and 2003. The Treasury and Other Adjustments category includes items not directly associated with any other segment.
Commercial Banking and Lendings 2005 pre-tax net income decreased from 2004 by $1.3 million, or 6.3 percent, to $19.9 million. In 2004, the pre-tax net income increased from 2003 by $7.6 million, or 56.1 percent, to $21.2 million. For 2005, the decrease in net income was driven primarily by a decrease in net interest income of $1.1 million or 2.2 percent over 2004. This decrease was caused by higher funding costs associated with interest rate increases throughout the year. A higher provision for loan losses, due to increases in loan balances, also contributed to the reduction in net income. The net interest income increase in 2004 was due to the sustained low interest rate environment compared to 2003 and the corresponding impact on repricing of earning assets in that environment. The increase should be at a more measured pace than 2005. Slow improvement in net interest income is expected if interest rates continue to gradually rise or level off in 2006.
Corporate Services pre-tax net income increased $4.9 million to $29.5 million compared to a decrease of $9.6 million to $24.7 million in 2004. For 2005, the increase is largely due to higher net interest income of $5.8 million or 14.8 percent. The increase in 2005 is related to positive rate and volume variances compared to 2004 as interest rates rise. The decline in margin in 2004 was due to lower yields on deposit balances as interest rates remained at historically low levels last year. Challenges for this segment arise from competitive pressures, as well as the technological challenges due to the movement from paper to electronic processing. If interest rates continue to increase in 2006, pressure will be placed on deposit service charge income which is impacted by earnings credits. The Company has focused significant resources into creating and enhancing products to keep the Company in step with the clients changing needs. 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. Management believes that the HSA product will be a source for growth in both deposit balances and noninterest income in 2006.
Banking Services pre-tax net income was $3.8 million in 2005, a decrease of $4.9 million from 2004. The 2004 net income decreased by $2.7 million from 2003. For 2005, the decrease is primarily attributable to a decrease in net interest income of $2.1 million and an increase in noninterest expense of $2.2 million. Net interest income is down due primarily to a $60 million, or 33%, decline in deposits as the increase in earnings credit rate decreased the required amount of compensating balances. A change in deposit mix from noninterest bearing deposits to interest bearing repurchase agreements also helped fuel this movement. This trend started in 2004 where net interest income decreased $0.5 million from 2003. If this trend continues, future increases in interest rates would have an adverse effect on interest margin. Noninterest expense is up due to VSP expenses as well as Fed pricing increases. Noninterest expense was up $0.4 million in 2004.
Consumer Services pre-tax net income increased $17.6 million to $9.5 million, compared to a loss of $8.1 million in 2004. The 2005 increase is attributable to a $12.2 million dollar increase in noninterest income, a $4.8 million increase in net interest income, and a $0.7 million increase in noninterest expense. Fee income increased as a result of net account growth, the implementation of new service charges on depository products and from the sale of banking facilities. The increase in the net interest income occurred as assets repriced in a higher interest rate environment and core deposits lagged. The Company continued to manage noninterest expenses very closely
with emphasis on automation and staff efficiency. Management anticipates continued growth in service fee income in 2006. Consumer Services ability to increase net interest margin in 2006 will be dependent upon its ability to grow deposits and higher yielding consumer loans. Further, variable-rate consumer loan products such as home equity lines of credit will benefit in a rising interest rate environment. Management believes that noninterest expense will increase in 2006 as a result of planned new branch openings and the investment in new product lines.
Asset Managements pre-tax net income was $5.8 million, which is a decrease of $0.2 million or 2.5% from 2004. This is compared to a $1.0 million decrease in income from 2003 to 2004. The $1.9 million increase in noninterest income from 2004 to 2005 was offset by a $1.7 million increase in noninterest expense and a $0.4 million decrease in net interest income. Noninterest income increased as a result of increased inflows into the Scout Funds. Noninterest expense also increased related to increased distribution fees from the funds related to the increased inflows of cash. These fees are driven by asset values maintained in the funds. Management has had success in its efforts to increase cash inflows to the UMB Scout Funds and will continue to focus sales efforts to continue this trend. In March 2005, the UMB Scout Funds held a shareholder meeting to approve changes to the individual fund structures and organization. The most significant change related to fee unbundling. In the past, Scout Investment Advisors, a wholly-owned subsidiary of the Company, collected a fee from the funds and was responsible for paying expenses on behalf of the funds. Effective April 1, 2005, Scout Investment Advisors charges an advisory fee and the individual funds pay direct expenses including accounting, administration, transfer agency and audit fees. The Company anticipates the overall decrease in expenses paid by the Company will be greater than the reduced revenue received. Therefore, overall net income should increase.
Investment Services Groups pre-tax net income increased $2.0 million or 30.5 percent to $8.7 million in 2005, compared to a decrease of 24.7% to $6.7 million in 2004 from 2003. For 2005, the increase is mostly due to a $2.3 million increase in net interest income attributable to both higher interest rates and increased volume due to higher deposits. Net interest income was down in 2004 compared to 2003 due to lower average deposits maintained by mutual fund customers. Management believes that increased income from new customers added in 2005 will continue in 2006, depending upon 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 $20.9 million for 2005, compared to a net loss of $16.2 million for 2004. The net loss for all years includes unallocated income tax expense for the consolidated Company. This segment includes the gain on the one-time sale of the merchant bankcard discount processing activity that appears as noninterest income in 2003. It also includes the one-time sale of the employee benefits accounts and federal and state rehabilitation tax credits during 2004.
Balance Sheet Analysis
Loans and Loans Held For Sale
Loans represent the Companys largest source of interest income. Loan balances increased by $524.2 million in 2005 due to managements effort to focus on new commercial and consumer loan relationships, as well as the overall improvement in the economy. Commercial and real estate loans had the most significant growth in outstanding balances in 2005 as compared to 2004
Included in Table 7 is a five-year breakdown of loans by type. (It should be noted that 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 62.8 percent and 60.1 percent of total loans at the end of 2005 and 2004, respectively. The Company targets customers that will utilize multiple banking services and products.
ANALYSIS OF LOANS BY TYPE (in thousands)
Commercial loans represent the largest percent of total loans. Commercial loans increased in volume as well as percentage of total loans in 2005 from 2004. The increase is primarily a result of several factors including a renewed focus on sales efforts; a new incentive plan for loan officers and increased loan authority for regional presidents. Management anticipates loan growth in 2006 to be at a more measured pace than in 2005.
As a percentage of total loans, commercial real estate and real estate construction loans now comprises 18.1% of total loans, compared to 17.4% at the end of 2004. 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 overall in 2005 as compared to 2004, but have decreased slightly as a percentage of total loans. The absolute increase in such loans represents the continued emphasis in this segment.
The increase in bankcard loans in 2004 was due primarily to increased promotional activity and reward programs. 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 also shown an increase in total amount outstanding, but have decreased as a percentage of loans. As many of these loans are linked to automobile financings, 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, although low in overall balances, have grown more rapidly than overall loan growth. The growth in these loans is primarily attributable to home equity lines of credits (HELOC). The HELOC growth is a result of the success of multiple promotions, as well as market penetration within the Companys current customer base through its current distribution channels. Continued expansion of this portfolio is anticipated.
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 43 and 44 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 46.8% of earning assets as of December 31, 2005, compared to 54.1% at year-end 2004. Securities totaled $3.5 billion at December 31, 2005, compared to $3.8 billion at year-end 2004. Collateral pledging requirements for public funds and loan demand are expected to be the primary factors impacting changes in the level of security holdings.
Securities available for sale comprised 97.6% of the Companys securities portfolio at December 31, 2005, compared to 95.3% at year-end 2004. In order to improve the yields of the securities portfolio, the Company has altered the mix and duration of its portfolio. The mix has changed by reducing the outstanding balances of U.S. Treasury Notes and moving to Mortgage-Backed Securities of U.S. Agencies and State and Political Subdivisions. Securities available for sale had a net unrealized loss of $33.9 million at year-end, compared to a net unrealized loss of $16.7 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 $21.6 million at year-end 2005, compared to an unrealized loss of $10.6 million for 2004.
The securities portfolio achieved an average yield on a tax-equivalent basis of 3.3% for 2005, compared to 2.9% in 2004 and 3.1% in 2003. The increase in yield is due to the replacement of lower yielding securities with higher yielding securities, as well as an increase in the average life of the portfolio. 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 23.0 months at December 31, 2005 compared to 15.3 months at year-end 2004. As discussed above under Results of Operations, Net Interest Income on page 21, Management has adopted a portfolio modification plan designed to improve noninterest margin.
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 58 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 has 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, 2005.
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 sold position was $142.5 million at year-end 2005 compared to the net sold position at year-end 2004 of $0.
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 $475.2 million in 2005 and $568.5 million in 2004.
At December 31, 2005, the Company held securities bought under agreements to resell of $284.1 million compared to $293.6 million at year-end 2004. 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 $110.6 million in 2005 and $253.9 million in 2004.
The Investment Banking Division also maintains an active securities trading inventory. The average holdings in the securities trading inventory in 2005 were $64.4 million, compared to $67.3 million in 2004, and were 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 segments in order to attract and retain additional core deposits. A retail deposit campaign in mid-year was very successful in attracting new dollars and customers. Deposits totaled $5.9 billion at December 31, 2005 and $5.4 billion at year-end 2004. Deposits averaged $5.1 billion in 2005 and $5.0 billion in 2004. The Company continually strives to expand, improve and promote its cash management services in order to attract and retain commercial funding customers.
Noninterest-bearing demand deposits averaged $1.9 billion during both 2005 and 2004. These deposits represented 36.8% of average deposits in 2005, compared to 37.5% in 2004. 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 $1.3 billion at December 31, 2005, and $1.4 billion at year-end 2004. This liability averaged $971.5 million in 2005 and $975.1 million in 2004. 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 twelve fixed-rate advances at December 31, 2005, 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 trends, demands, commitments, events or uncertainties that would materially change its capital position or affect its liquidity in the foreseeable future. The Company anticipates an increased level of capital expenditures in the near term with respect to technology. These technology investments are mostly attributable to meeting the demands of a shift in the payments landscape from paper-based to electronic-based. This capital investment which is discussed under Noninterest Expense section of this Item on page 27 is not anticipated to have a material impact on the Companys overall capital position due to its strong capital and liquidity. Capital is managed for each subsidiary based upon its respective risks and growth opportunities as well as regulatory requirements.
Total shareholders equity was $833.5 million at December 31, 2005, compared to $819.2 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 2005 and 2004, the Company acquired 222,519 and 87,364 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 16.14% and total capital ratio of 16.99% 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 page 45 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, 2005, 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 62 and 63.
Commitments, Contractual Obligations and 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. These commitments and contingent liabilities are not required to be recorded on the Companys balance sheet. Since commitments associated with letters of credit and lending and financing arrangements may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. See Table 14 below, as well as Note 14, Commitments, Contingencies and Guarantees in the Notes to Consolidated Financial Statements under Item 8 on pages 71 and 72 for detailed information and further discussion of these arrangements. Management does not anticipate any material losses from its off-balance sheet arrangements.
COMMITMENTS, CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS (in thousands)
The table below details the contractual obligations for the Company as of December 31, 2005. 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 of America. 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.
Allowance for Loan Losses
The Companys allowance for loan losses represents managements judgment of the loan losses inherent in the loan portfolio. The allowance is maintained and computed at each bank at a level that such individual bank management considers adequate. The allowance is reviewed quarterly, considering such items as historical trends, internal ratings, migration analysis, current economic conditions, loan growth and individual impairment testing.
Larger commercial loans are individually reviewed for potential impairment. Those larger commercial loans that management deems probable that the borrower cannot meets its contractual obligations with respect to payment or timing are deemed to be impaired under Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan. These loans are then reviewed for potential impairment based on managements estimate of the borrowers ability to repay the loan given the availability of cash flows, collateral and other legal options. Any allowance related to the impairment of an individually impaired loan is based on the present value of discounted expected future cash flows, the fair value of the underlying collateral, or the fair value of the loan. Based on this analysis, some loans that are classified as impaired under SFAS 114 do not have a specific allowance as there is no related impairment as the discounted expected future cash flows or the fair value of the underlying collateral exceeds the Companys basis in such impaired loan.
The Company also maintains an internal risk grading system for other loans not subject to individual impairment. An estimate of the inherent loan losses on such risk-graded loans is based on a migration analysis which computes the net charge-off experience related to each risk category.
An estimate of inherent losses is computed on remaining loans based on the type of loan. Each type of loan is segregated into a pool based on the nature of such loans. This includes remaining commercial loans that have a low risk grade, as well as homogenous loans. Homogenous loans include automobile loans; credit card loans and other consumer loans. Allowances are established for each pool based on the loan type using historical loss rates, certain statistical measures and loan growth.
An estimate of the total inherent loss is based on the above three computations. From this an adjustment not to exceed ten percent can be made based on other factors management considers to be important in evaluating the probable losses in the portfolio such as general economic conditions, loan trends, risk management and loan administration and changes in internal policies.
Goodwill and Other Intangibles
Goodwill is tested annually for impairment. Goodwill is assigned to various reporting units based upon those which were expected to benefit from the synergies of the combination at the time of the acquisition. The
company tests impairment at the reporting unit level by estimating the fair value of the reporting unit. If managements estimate of the fair value of the reporting unit exceeds the carrying amount of the goodwill, no impairment is deemed to occur. In order to estimate the fair value of the reporting units, management uses multiples of earnings and assets from recent acquisition of similar banking and fund servicing entities as such entities have comparable operations and economic characteristics. The Company has performed annual impairment tests of goodwill since the inception of SFAS 142, Accounting for Goodwill. As a result of such impairment tests, the Company has not recognized an impairment charge.
For customer based identifiable intangibles, the Company is amortizing the intangible over their estimated useful lives of up to ten years.
Impairment of long-lived assets
Long-lived assets, including identifiable intangible assets, premises and equipment, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset or group of assets may not be recoverable. The impairment review for long-lived assets 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. No events or changes in circumstances occurred in 2003, 2004 or 2005 which would indicate that the carrying amount of an asset or group of assets may not be recoverable.
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, or, the loan is past due for a period of ninety days or more unless the loan is both well-secured and in the process of collection. 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, Accounting for Stock-Based Compensation, pro forma net income and earnings per share are disclosed in Note 1 to the Consolidated Financial Statements. The pro forma disclosures reflect the impact on earnings as if the fair value method had been applied to outstanding stock options using the Black-Scholes valuation method. Please see the discussion of FAS 123(R), issued in December 2004, under Note 2, New Accounting Pronouncements in the Notes to the Consolidated Financial Statements under Item 8 on page 54.
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 Companys primary method for measuring and analyzing consolidated interest rate risk is the Net Interest Income Simulation Analysis. The Company also uses a Net Portfolio Value model to measure market value risk under various rate change scenarios and a gap analysis to measure maturity and repricing relationships between interest-earning assets and interest-bearing liabilities at specific points in time. The Company does not use hedges or swaps to manage interest rate risk except for limited use of futures contracts to offset interest rate risk on certain securities held in its trading portfolio.
Overall, the Company manages interest rate risk by positioning the balance sheet to maximize net interest income while maintaining an acceptable level of interest rate and credit risk, remaining mindful of the relationship among profitability, liquidity, interest rate risk and credit risk.
Net Interest Income Modeling
The Companys primary interest rate risk tool, the Net Interest Income Simulation Analysis, measures interest rate risk and the effect of interest rate changes on net interest income and net interest margin. 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 (e.g. ramp) 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.
Table 15 shows the net interest income increase or decrease over the next twelve months as of December 31, 2005 and 2004.
MARKET RISK (in thousands)
The Company is less sensitive to an increase or decrease in rates than a year ago. This is due to the fact that overall rates were higher in 2005 than in 2004, the Companys average life of the investment portfolio has gradually lengthened and the Company has more time-deposits than a year ago. Overall, the Company remains susceptible to a decrease in interest rates because of this increase in time-deposits as well as an increase in the amount of variable rate loans. These variable rate loans could reprice downward in a falling interest rate environment (See Table 17 below). However, this same asset sensitivity projects the Company to be favorably affected by a gradual increase in interest rates.
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 16 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)