UnionBanCal 10-K 2011
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
For the fiscal year ended December 31, 2010
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
For the transition period from to
Commission file number 1-15081
Registrant's telephone number, including area code: (415) 765-2969
registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: Common Stock par value $1.00 per share
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý
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 ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No ý
Aggregate market value of voting and non-voting common equity held by non-affiliates of the registrant: Not applicable; all of the voting stock of the registrant is owned by its parent, The Bank of Tokyo-Mitsubishi UFJ, Ltd.
As of January 31, 2011, the number of shares outstanding of the registrant's Common Stock was 136,330,829.
DOCUMENTS INCORPORATED BY REFERENCE
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION (I) (1) (a) AND (b) OF FORM 10-K AND IS THEREFORE FILING THIS FORM WITH THE REDUCED DISCLOSURE FORMAT.
This report includes forward-looking statements, which include expectations for our operations and business and our assumptions for those expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly compared to our expectations. See Part I, Item 1A. "Risk Factors," and the other risks described in this report for factors to be considered when reading any forward-looking statements in this filing.
This report includes forward-looking statements, which are subject to the "safe harbor" created by section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended. We may make forward-looking statements in our Securities and Exchange Commission (SEC) filings, press releases, news articles and when we are speaking on behalf of UnionBanCal Corporation. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include the words "believe," "expect," "target," "anticipate," "intend," "plan," "seek," "estimate," "potential," "project," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," "might," or "may." These forward-looking statements are intended to provide investors with additional information with which they may assess our future potential. All of these forward-looking statements are based on assumptions about an uncertain future and are based on information known to our management at the date of these statements. We do not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made.
In this document, for example, we make forward-looking statements, which discuss our expectations about:
There are numerous risks and uncertainties that could cause actual outcomes and results to differ materially from those discussed in our forward-looking statements. Many of these factors are beyond our ability to control or predict and could have a material adverse effect on our financial condition and results of operations or prospects. Such risks and uncertainties include, but are not limited to, those listed in Part I, Item 1 "Business" under the captions "Competition", "Monetary Policy and Economic Conditions" and "Supervision and Regulation" Item 1A "Risk Factors" and Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations".
Readers of this document should not rely unduly on any forward-looking statements, which reflect only our management's belief as of the date of this report and should consider all uncertainties and risks disclosed throughout this document and in our other reports to the SEC, including, but not limited to, those discussed below. Any factor described in this report could by itself, or together with one or more other factors, adversely affect our business, future prospects, results of operations or financial condition.
All reports that we file electronically with the Securities and Exchange Commission (SEC), including the Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and current reports on Form 8-K, as well as any amendments to those reports, are accessible at no cost on our internet website at www.unionbank.com as soon as reasonably practicable after we electronically file such reports with, or furnish them to, the SEC. These filings are also accessible on the SEC's website at www.sec.gov.
As used in this Form 10-K, the term "UnionBanCal" and terms such as "our Company," "we," "us" and "our" refer to UnionBanCal Corporation, Union Bank, N.A., one or more of their consolidated subsidiaries, or to all of them together.
We are a California-based, financial holding and commercial bank holding company whose major subsidiary, Union Bank, N.A., is a commercial bank. (On December 18, 2008, Union Bank, N.A. changed its name from Union Bank of California, N.A.) Union Bank provides a wide range of financial services to consumers, small businesses, middle-market companies and major corporations, primarily in California, Oregon, Washington and Texas, as well as nationally and internationally. As of December 31, 2010, Union Bank operated 400 full-service branches in California, Oregon, Washington and Texas, as well as two international offices.
On April 30, 2010, Union Bank acquired certain assets and assumed certain liabilities of Frontier Bank (Frontier) from the Federal Deposit Insurance Corporation (FDIC) in an FDIC-assisted transaction. Additionally on April 16, 2010, Union Bank acquired certain assets and assumed certain liabilities of Tamalpais Bank (Tamalpais) from the FDIC in an FDIC-assisted transaction. For both acquisitions, we entered into loss share agreements with the FDIC, whereby the FDIC will cover a substantial portion of any future losses on acquired loans (FDIC covered loans) and other real estate owned (OREO) from these acquisitions.
On November 4, 2008, we became a privately held company. All of our issued and outstanding shares of common stock are now owned by BTMU. Prior to the transaction, BTMU owned approximately 64 percent of our outstanding shares of common stock.
Our operations are divided into two reportable segments. These segments and their financial information are described more fully in "Business Segments" of our Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) and in Note 24 to our Consolidated Financial Statements included in this Form 10-K.
Retail Banking. Retail Banking offers our customers a wide spectrum of financial products under one convenient umbrella. Our broad line of checking and savings, investment, loan and fee-based banking products is designed to meet individual and business needs. These products are offered through 346 full-service branches in California and 53 full-service branches in Oregon and Washington. In addition, Retail Banking offers e-banking through our website and check cashing services at our Cash & Save® locations.
Corporate Banking. Corporate Banking offers a wide array of financial products to both middle market and corporate businesses headquartered throughout the U.S. Corporate Banking focuses its activities on specific specialized industries, such as power and utilities, petroleum, real estate, healthcare, equipment leasing and commercial finance, as well as general corporate and middle market lending in regional markets throughout the U.S. Corporate Banking relationship managers provide credit services, including commercial loans, accounts receivable and inventory financing, project financing, trade financing and real estate financing. In addition to credit services, Corporate Banking offers its customers a broad range of global treasury
management solutions, as well as foreign exchange and various interest rate risk and energy risk management products which are delivered through deposit managers and product specialists with significant industry expertise and experience in businesses of all sizes including numerous vertical industry niches such as U.S. correspondent banks and government entities. Corporate Banking also provides its high net worth clients credit and deposit products, trust and estate services, wealth planning and various investment related products and services through Union Bank subsidiaries, UnionBanc Investment Services, LLC (UBIS), and HighMark Capital Management, Inc. (HighMark). UBIS and HighMark also provide investment products and services to middle market and corporate clients. Corporate Banking, through its Institutional Services Division, also provides custody, corporate trust, and retirement plan services.
At January 31, 2011, we had 10,715 full-time equivalent employees.
Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California, Oregon, Washington and Texas, as well as nationally and internationally. Our competitors include a large number of state and national banks, thrift institutions, credit unions, finance companies, mortgage banks and major foreign-affiliated or foreign banks, as well as many financial and nonfinancial firms that offer services similar to those offered by us, including many large securities firms and financial services subsidiaries of commercial and manufacturing companies. Some of our competitors are insurance companies or community or regional banks that have strong local market positions. Other competitors include large financial institutions that have substantial capital, technology and marketing resources, which are well in excess of ours. Competition in our industry may further intensify as a result of the recent and increasing level of consolidation of financial services companies, particularly in our principal markets resulting from adverse economic and market conditions. Larger financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively. In addition, some of our current commercial banking customers may seek alternative banking sources if they develop credit needs larger than we may be able to accommodate. We also experience competition, especially for deposits, from internet-based banking institutions and other financial companies, which do not always have a physical presence in our market footprint and have grown rapidly in recent years.
Banks, securities firms and insurance companies can now combine as a "financial holding company." Financial holding companies can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Many of our competitors have elected to become financial holding companies, including several large finance companies, securities firms and insurance companies. A number of foreign banks have either acquired financial holding companies or obtained financial holding company status in the U.S., further increasing competition in the U.S. market. In 2008, UnionBanCal Corporation, BTMU and MUFG obtained approval from the Board of Governors of the Federal Reserve System to become financial holding companies under the Bank Holding Company Act of 1956, as amended (the BHCA). We sought this new status from the Federal Reserve Board to provide us maximum flexibility to pursue new business opportunities as the banking and financial services industry undergoes rapid and profound changes.
Technology and other changes increasingly allow parties to complete financial transactions electronically, and in many cases, without banks. For example, consumers can pay bills and transfer funds over the internet and by telephone without banks. Many non-bank financial service providers have lower overhead costs and are subject to fewer regulatory constraints. If consumers do not use banks to complete their financial transactions, we could potentially lose fee income, deposits and income generated from those deposits.
Current federal law has made it easier for out-of-state banks to enter and compete in the states in which we operate. Competition in our principal markets may further intensify as a result of the Dodd-Frank Act which,
among other things, permits out of state de novo branching by national banks, state banks and foreign banks from other states.
The primary factors in competing for business include pricing, convenience of office locations and other delivery methods, range of products offered, customer relationships and level of service delivered. We believe that continued emphasis on enhanced services and distribution systems, an expanded customer base, increased productivity and strong credit quality, together with a substantial capital base, will better position us to meet the challenges provided by this competition.
Our earnings and businesses are affected not only by general economic conditions (both domestic and international), but also by the monetary policies of various governmental regulatory authorities of the U.S. and foreign governments and international agencies. In particular, our earnings and growth may be affected by actions of the Federal Reserve Board in connection with its implementation of national monetary policy through its open market operations in U.S. Government securities, control of the discount rate for borrowings by financial institutions and the federal funds rate and establishment of reserve requirements against both member and non-member financial institutions' deposits. These actions have a significant effect on the overall growth and distribution of loans and leases, investments and deposits, as well as on the rates earned on securities, loans and leases or paid on deposits. It is difficult to predict future changes in monetary policies and their effect on our business, particularly in light of the current challenging economic conditions.
Overview. Bank holding companies and banks are extensively regulated under both federal and state law. This regulation is intended primarily for the protection of depositors, the deposit insurance fund, and other clients of the institution, and not for the benefit of the investors in the stock or other securities of the bank holding company. Financial service companies are also frequent targets of civil litigation. Set forth below is a summary description of material laws and regulations that relate to our operation and those of our subsidiaries, including Union Bank. This summary description of applicable laws and regulations does not purport to be complete and is qualified in its entirety by reference to such laws and regulations. Financial statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies, and a change in them, including changes in how they are interpreted or implemented, could have a material effect on our business.
Bank Holding Company Act (the BHCA) and the Gramm-Leach-Bliley (GLB) Act. We, MUFG and BTMU are subject to regulation under the BHCA, which also subjects us to Federal Reserve Board reporting and examination requirements. Generally, the BHCA restricts our ability to invest in non-banking entities, and we may not acquire more than 5 percent of the voting shares of any domestic bank without the prior approval of the Federal Reserve Board. Our activities are limited, with some exceptions, to banking, the business of managing or controlling banks, and other activities that the Federal Reserve Board deems to be so closely related to banking as to be a proper incident thereto.
The GLB Act allows "financial holding companies" to offer banking, insurance, securities and other financial products. Among other things, the GLB Act amended the BHCA in order to provide a framework for engaging in new financial activities by bank holding companies. In 2008, UnionBanCal Corporation, BTMU and MUFG obtained approval from the Federal Reserve Board to become financial holding companies under the BHCA. In order to maintain our status as a financial holding company, we must continue to satisfy certain ongoing criteria, such as capital, managerial and Community Reinvestment Act (CRA) requirements.
Under the GLB Act, "financial subsidiaries" of banks may engage in some types of activities beyond those permitted to banks themselves, provided certain conditions are met. At this time, Union Bank has no plans to form any "financial subsidiaries."
Under the Dodd-Frank Act and Federal Reserve Board regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks and may not conduct its operations in an unsafe or unsound manner. Under these requirements, a holding company may be required to contribute additional capital to an undercapitalized subsidiary bank. However, this additional capital may be required at times when a bank holding company may not have the resources to provide such support.
On July 21, 2010, President Obama signed into law the Dodd-Frank Act. This new legislation has affected U.S. financial institutions, including UnionBanCal Corporation and Union Bank, in many ways, some of which have increased, or may increase in the future, the cost of doing business and have presented other challenges to the financial services industry. Many of the new law's provisions are in the process of being implemented by rules and regulations of the federal banking agencies, the scope and impact of which cannot yet be fully determined. The new law contains many provisions which may have particular relevance to the business of UnionBanCal Corporation and Union Bank. While the full effect of these provisions of the Dodd-Frank Act on Union Bank cannot be predicted at this time, they may result in adjustments to our FDIC deposit insurance premiums, increased capital and liquidity requirements, increased supervision, increased regulatory and compliance risks and costs and other operational costs and expenses, reduced fee-based revenues and restrictions on some aspects of our operations, and increased interest expense on our demand deposits. The Dodd-Frank Act also created authority on the part of the FDIC for the liquidation of systemically important nonbank financial companies, including bank holding companies. Liquidation proceedings will be funded by borrowings from the U.S. Treasury and risk-based assessments on covered financial companies, which includes the possibility, in circumstances where there is a shortfall after assessments on creditors of the failed company, of assessments on bank holding companies with consolidated assets of $50 billion or more, such as our Company. The Dodd-Frank Act also changed the existing standard for the preemption of state consumer financial laws to allow a court or the Office of the Comptroller of the Currency (OCC) to preempt a state consumer financial law only if it discriminates against national banks, prevents or significantly interferes with the exercise by the national bank of its powers or the state law is preempted by another federal law. This change in the preemption standard was designed to allow greater regulation of national banks under state law.
Comptroller of the Currency. Union Bank, as a national banking association, is subject to broad federal regulation and oversight extending to all its operations by the OCC, its primary regulator, and also by the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC). As part of this authority, Union Bank is required to file periodic reports with the OCC and is subject to ongoing supervision and examination by the OCC.
The OCC has extensive enforcement authority over all national banks. If, as a result of an examination of a bank, the OCC determines that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of the bank's operations are unsatisfactory or that the bank or its management is violating or has violated any law or regulations, various remedies are available to the OCC. These remedies include the power to enjoin "unsafe or unsound" practices, to require affirmative action to correct any conditions resulting from any violation or practice, to issue an administrative order that can be judicially enforced to direct an increase in capital, to restrict the growth of the bank, to assess civil monetary penalties, to remove officers and directors, and ultimately to terminate the bank's deposit insurance. The OCC, as well as other federal agencies, including the FDIC, have adopted, or are in the process of adopting, regulations and guidelines establishing safety and soundness standards, including but not limited to such matters as loan underwriting and documentation, internal controls and audit systems, information systems, interest rate risk exposure, asset growth and quality, management standards and earnings and compensation and other employee benefits. However, the OCC has broad authority to address activity it deems to constitute an unsafe or unsound practice and is not limited by the specific standards set forth in the regulations.
Financial Stability Oversight Council. The Dodd-Frank Act authorized the creation of the Financial Stability Oversight Committee (FSOC) to provide oversight of all risks created within the U.S. economy from the activities of financial services companies, end the expectation that some institutions are "too big to fail," and provide a basis for enhanced prudential regulation. The FSOC must determine which bank holding companies
and nonbank financial companies pose risks to U.S. financial stability, and subject those companies to the supervision and regulation of the Federal Reserve Board. Bank holding companies over $50 billion in consolidated assets are considered to be "large interconnected bank holding companies" and automatically designated as "systemically significant." Union Bank expects to be designated as "systemically significant" and therefore, expects to face heightened prudential standards including capital, leverage, and liquidity, as well as credit exposure reporting, concentration limits, stress testing and resolution plans.
Consumer Financial Protection Bureau. The Dodd-Frank Act authorized the creation of the Consumer Financial Protection Bureau (CFPB). The CFPB will have direct supervision and examination authority over banks with more than $10 billion in assets, including us. Among the CFPB's responsibilities will be implementing and enforcing federal consumer financial laws, reviewing the business practices of financial services providers for legal compliance, monitoring the marketplace for transparency on behalf of consumers and receiving complaints and questions from consumers about consumer financial products and services.
Other Regulatory Oversight. Our subsidiaries are also subject to extensive regulation, supervision, and examination by various other federal and state regulatory agencies. In addition, Union Bank and its subsidiaries are subject to certain restrictions under the Federal Reserve Act and related regulations, including restrictions on affiliate transactions. As a holding company, the principal source of our cash has been dividends and interest received from Union Bank. Dividends payable by Union Bank to us are subject to restrictions under a formula imposed by the OCC unless express approval is given to exceed these limitations. For more information regarding restrictions on loans and dividends by Union Bank to its affiliates and on transactions with affiliates, see Notes 19 and 23 to our consolidated financial statements included in this Form 10-K.
The Federal Deposit Insurance Act, as amended (FDIA), requires federal bank regulatory authorities to take "prompt corrective action" in dealing with inadequately capitalized banks. The FDIA establishes five tiers of capital measurement ranging from "well-capitalized" to "critically undercapitalized." It is our policy to maintain capital ratios above the minimum regulatory requirements for "well-capitalized" institutions for both Union Bank and us. Management believes that, at December 31, 2010, Union Bank and UnionBanCal met the requirements for "well-capitalized" institutions.
Deposits of Union Bank are insured up to statutory limits by the FDIC and, accordingly, are subject to deposit insurance assessments. Amendments to the FDIA in 2005-2006 created a new assessment system designed to more closely tie what banks pay for deposit insurance to the risks they pose and adopted a new base schedule of rates that the FDIC can adjust up or down, depending on the revenue needs of the insurance fund. As a result of this legislation, Union Bank has been subject to annual assessments on deposits since 2007. The initial assessment rate was approximately 5 basis points. Prior to this change, Union Bank was not paying any insurance assessments on deposits under the FDIC's risk-related assessment system. An FDIC credit for prior contributions offset the assessment in 2007 and part of 2008. As part of the Deposit Insurance Fund Restoration Plan adopted by the FDIC in October 2008, beginning on April 1, 2009, the FDIC initial base assessment rates were set between 12 and 45 basis points. In addition, on June 30, 2009, the FDIC imposed a special assessment on banks related to the financial crisis. Union Bank's special assessment totaled $34 million and was paid on September 30, 2009.
In November 2009, in light of the challenge to the federal deposit insurance fund from the severe U.S. recession, the FDIC issued a rule mandating that insured depository institutions prepay their quarterly risk-based assessments to the FDIC for the fourth quarter of 2009, and all of 2010, 2011 and 2012. Union Bank's prepayment totaled $353 million and was paid on December 30, 2009. Under this rule, each depository institution was required to record the entire amount of its prepayment as an asset, or a prepaid expense, and is allowed to count the payments as a depreciating asset. The prepaid assessments bear a zero-percent risk weight for risk-based capital purposes. The FDIC will not refund or collect additional prepaid assessments because of a decrease or growth in deposits over the prepayment period. However, if the prepaid assessment is not exhausted by June 30, 2013, the remaining amount of the prepayment will be returned to the depository institution. The prepaid assessments are in lieu of additional special assessments at this time;
however, there can be no assurance that the FDIC will not impose additional special assessments or increase annual assessments in the future.
On February 17, 2011, the FDIC adopted rules to revise the deposit insurance assessment system for larger institutions, including Union Bank. Under a "scorecard" system, banks have a performance score and a loss-severity score that are combined into a total score which is translated into an initial assessment rate. The FDIC has the ability to adjust components of the scorecard to produce accurate relative risk rankings. The initial base assessment rate ranges from 10 to 50 basis points. The Dodd-Frank Act requires the FDIC to revise the deposit insurance assessment system to base assessments on the average total consolidated assets of the institution, rather than upon deposits payable in the U.S. as was previously the case. The Dodd-Frank Act also eliminates the ceiling on the size of the FDIC's insurance fund and increases the floor of the size of the fund, which will require a general increase in assessment levels for larger institutions, including Union Bank. On October 19, 2010, the FDIC proposed a comprehensive, long-range "restoration" plan for the deposit insurance fund to ensure that the ratio of the fund's reserves to insured deposits reaches 1.35 percent by 2020, as required by the Dodd-Frank Act. Based upon updated projections for the fund, the new restoration plan would forgo the uniform 3 basis point assessment rate increase previously scheduled to go into effect on January 1, 2011, and would keep the current rate schedule in effect. The FDIC's proposal also envisions eventually building the fund's reserve ratio to 2.0 percent. Base assessment rates would adjust downward over time as the fund reached specified reserve levels. The ultimate effect of these legislative and regulatory developments cannot be predicted with any certainty.
If any insured depository institution becomes insolvent and the FDIC is appointed its conservator or receiver, the FDIC may, in most cases, disaffirm or repudiate any contract to which such institution is a party, if the FDIC determines that performance of the contract would be burdensome, and that disaffirmance or repudiation of the contract would promote the orderly administration of the institution's affairs. In addition, the FDIC as conservator or receiver may enforce most contracts entered into by the institution notwithstanding any provision providing for termination, default, acceleration or exercise of rights upon or solely by reason of insolvency of the institution, appointment of a conservator or receiver for the institution, or exercise of rights or powers by a conservator or receiver for the institution.
The FDIA provides that, in the event of the liquidation or other resolution of an insured depository institution, the claims of its depositors (including claims by the FDIC as subrogee of insured depositors) and certain claims for administrative expenses of the FDIC as receiver would be afforded a priority over other general unsecured claims against such an institution. If an insured depository institution fails, insured and uninsured depositors along with the FDIC will be placed ahead of unsecured, non-deposit creditors, in order of priority of payment.
There are additional requirements and restrictions in the laws of the U.S. and the states of California, Oregon, Texas, and Washington, as well as other states in which Union Bank and its subsidiaries may conduct operations. These include restrictions on the levels of lending and the nature and amount of investments, as well as activities as an underwriter of securities, the opening and closing of branches and the acquisition of other financial institutions. The consumer lending and finance activities of Union Bank are also subject to extensive regulation under various federal and state laws. These statutes impose requirements on the making, enforcement and collection of consumer loans and on the types of disclosures that must be made in connection with such loans. As described above, provisions of the Dodd-Frank Act appear to have been intended to generally increase state consumer protection regulation of national banks.
Union Bank is also subject to the CRA. The CRA generally requires the federal banking agencies to evaluate the record of a financial institution in meeting the needs of local communities, including low- and moderate-income neighborhoods. In addition to substantial penalties and corrective measures that may be required for a violation of certain fair lending laws, the federal banking agencies may take compliance with such laws and the CRA into account when regulating and supervising other activities, and in evaluating whether to approve applications for permission to engage in new activities or for acquisitions of other banks or companies or de novo branching. An unsatisfactory CRA rating may be the basis for denying the application.
Based on the most current examination report dated June 1, 2009, Union Bank's compliance with CRA was rated "outstanding."
We are also subject to the Equal Credit Opportunity Act of 1974, and the implementing regulations thereunder. The statute requires financial institutions and other firms engaged in the extension of credit to make credit equally available to all creditworthy customers without regard to sex or marital status. Moreover, the statute makes it unlawful for any creditor to discriminate against any applicant with respect to any aspect of a credit transaction: (1) on the basis of race, color, religion, national origin, sex or marital status, or age (provided the applicant has the capacity to contract); (2) because all or part of the applicant's income derives from any public assistance program; or (3) because the applicant has in good faith exercised any right under the Consumer Credit Protection Act. In addition, a creditor may not make any oral or written statement, in advertising or otherwise, to customers or prospective customers that would discourage, on a prohibited basis, application for credit.
Union Bank has offices in Canada and the Cayman Islands. Any international activities of Union Bank are also subject to the laws and regulations of the jurisdiction where business is being conducted, which may change from time to time and affect Union Bank's business opportunities and competitiveness in these jurisdictions. Furthermore, due to BTMU's controlling ownership of us, regulatory requirements adopted or enforced by the Government of Japan may have an effect on the activities and investments of Union Bank and us in the future.
The activities of Union Bank subsidiaries, HighMark and UBIS, are subject to the rules and regulations of the SEC, as well as those of state securities regulators. UBIS is also subject to the rules and regulations of the Financial Industry Regulatory Authority (FINRA).
Under Federal Reserve Board rules, Union Bank is affiliated with the HighMark Funds. The HighMark Funds is a registered investment company, subject to the rules and regulations of the SEC.
Broker/Dealer Regulation. Union Bank is not registered as a broker or dealer. The GLB Act and applicable regulations require us to conduct non-exempted securities brokerage or dealer activities through our registered broker-dealer, UBIS. These laws and regulations also limit compensation we may pay our bank employees for referrals of brokerage business and limit Union Bank's ability to advertise securities brokerage services.
Bank Secrecy Act. The banking industry is now subject to significantly increased regulatory controls and processes regarding the Bank Secrecy Act and anti-money laundering laws. Failure to comply with these additional requirements may adversely affect the ability to obtain regulatory approvals for future initiatives requiring regulatory approval, including acquisitions. Under the USA PATRIOT Act, federal banking regulators must consider the effectiveness of a financial institution's anti-money laundering program prior to approving an application for a merger, acquisition or other activities requiring regulatory approval. Failure to comply with these requirements can also subject an insured depository institution to monetary fines, penalties and other sanctions.
Sarbanes-Oxley Act. In November 2008, we became a privately-held company. All of our issued and outstanding shares of common stock are now owned by BTMU. We file periodic reports with the SEC in accordance with the reduced disclosure format permitted for certain wholly-owned subsidiaries of publicly-held companies, and the Sarbanes-Oxley Act applies to us.
Among other provisions, Section 302(a) of the Sarbanes-Oxley Act requires our Chief Executive Officer and Chief Financial Officer to certify that our quarterly and annual reports do not contain any untrue statement or omission of a material fact and to make additional certifications as to the adequacy of our internal controls over financial reporting and other matters.
In response to these requirements, we have established a Disclosure Committee to monitor compliance with these rules. Membership of the Disclosure Committee is comprised of senior management from
throughout our organization whom we believe collectively provide an extensive understanding of our operations. As part of our compliance with the Sarbanes-Oxley Act, we evaluate our internal control process quarterly and we test and assess our internal controls over financial reporting annually.
Basel Committee Capital Standards. The Basel Committee on Banking Supervision (Basel Committee) proposed new international capital standards for banking organizations (Basel II) in June 2004, and the new framework is currently being evaluated and implemented by bank supervisory authorities worldwide. Basel II updates the original international bank capital accord (Basel I), which has been in effect since 1988. Basel II is intended to improve the consistency of capital regulations internationally, make regulatory capital more risk sensitive, and promote enhanced risk-management practices among large, internationally active banking organizations.
We do not meet the criteria in the new U.S. rules which would make adoption of the new Basel II rules mandatory. However, MUFG, which owns all of our issued and outstanding shares of common stock through its wholly-owned subsidiary BTMU, is subject to the requirements of Basel II under the rules of the Japan Financial Services Agency (JFSA). In addition, the rules of the JFSA require subsidiaries of Japanese banks and bank holding companies that represent more than 2 percent of the parent's consolidated risk-weighted assets to also comply with Basel II. Because we meet this criterion, the JFSA requirement is applicable to us. We currently provide risk-weighted assets calculations to BTMU for incorporation into their Basel II reports, primarily applying the JFSA Standardized Approach to Basel II. In order to facilitate the JFSA requirements, we expect to adopt the advanced approach to the Basel II rules as in effect in the U.S., subject to approval by our U.S. bank regulators. In December 2010, the U.S. Federal banking agencies proposed new rules to establish permanent floors for minimum risk-based capital requirements for banking organizations that adopt Basel II under the advanced approach. The proposed floors would be equal to the current Basel I minimum ratios for tier 1 risk-based capital and total risk-based capital and would be calculated according to the general risk-based capital requirements of the Basel I standard. The implementation of Basel II is not expected to impact our ability to comply with the minimum capital requirements set forth by the U.S. federal banking agencies. BTMU is reimbursing us for expenditures that we are incurring for Basel II projects that we would not have undertaken for our own risk management purposes.
In addition to the Basel II framework, the Basel Committee is developing further proposed revisions to the capital standards which include narrowing the definition of capital, increasing capital requirements for specific exposures, introducing short-term liquidity coverage and term funding standards, and establishing an international leverage ratio. In September 2010, the Basel Committee announced that new liquidity risk metrics would become minimum standards in January 2015 (the Liquidity Coverage Ratio) and January 2018 (the Net Stable Funding Ratio) after observation periods that would commence in January 2011 and January 2012, respectively. The observation periods are intended to enable banking supervisors to obtain more robust reporting over these periods. The intent is to assess the impact of the new standards on individual banks, the banking sector and the broader markets. To the extent that the standards produce any unintended consequences, revisions to the Liquidity Coverage Ratio would be made by mid-2013 and by mid-2016 for the Net Stable Funding Ratio. The announcement was preceded by a consultative document issued for comment in December 2009 and an annex in July 2010 that revised some of the definitions in the original consultative document. Many aspects of the standards are uncertain and are subject to interpretation.
Also in September 2010, the Basel Committee announced new, higher capital standards that increase minimum capital ratios plus add a capital conservation buffer. The revised standards call for a fully phased-in minimum common equity ratio of 4.5 percent plus a capital conservation buffer of 2.5 percent, and also introduce new deductions from allowable equity capital. The Basel Committee also announced that a countercyclical buffer of zero percent to 2.5 percent of common equity or other fully loss-absorbing capital will be implemented according to national circumstances as an extension of the conservation buffer. These rules were finalized with the issuance of the final Basel III rules on December 16, 2010. Finally, on January 13, 2011, the Basel Committee issued minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. In order for an instrument
issued by a bank to be included in additional (i.e., non-common) Tier 1 or Tier 2 capital, it must meet or exceed minimum requirements. As with the liquidity risk metrics, many aspects of the standards are uncertain and are subject to interpretation, with further clarification required by U.S. regulators. The new standards are to be fully phased-in by January 2019, with observation periods beginning in January 2011. It is expected that clarifying guidance for U.S. banks will be provided by the U.S. bank regulatory agencies through customary rulemaking procedures.
Customer Information Security. The federal bank regulatory agencies have adopted guidelines for safeguarding confidential, personal customer information. The guidelines require each financial institution, under the supervision and ongoing oversight of its board of directors or an appropriate committee, to create, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information, protect against any anticipated threats or hazards to the security or integrity of such information and protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. Union Bank has adopted a customer information security program that has been approved by its Board of Directors.
Overdraft and Interchange Fees. In November 2009, the Federal Reserve Board adopted amendments under its Regulation E that impose new restrictions on banks' abilities to charge overdraft services and fees. The final rule prohibits financial institutions from charging fees for paying overdrafts on ATM and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Regulation E has resulted in decreased revenues and increased compliance costs for the banking industry and Union Bank. The Dodd-Frank Act, through a provision known as the Durbin Amendment, requires the Federal Reserve Board to establish standards for interchange fees that are "reasonable and proportional" to the cost of processing the debit card transaction and imposes other requirements on card networks. On December 16, 2010, the Federal Reserve Board proposed an interchange fee cap of twelve cents per transaction. If such a fee cap is implemented, we expect it will result in decreased revenues and increased compliance costs for the banking industry and Union Bank.
Congress, the U.S. Treasury and the federal banking regulators have taken broad action since September 2008 to address volatility in the U.S. financial system and the U.S. recession. The most sweeping of these actions, the Dodd-Frank Act, is discussed above. In October 2008, the Emergency Economic Stabilization Act of 2008 (the EESA) was enacted. Pursuant to the EESA, the maximum deposit insurance amount was temporarily increased from $100,000 to $250,000 per depositor, such increase subsequently made permanent by the Dodd-Frank Act. Pursuant to its Temporary Liquidity Guarantee Program, the FDIC has guaranteed newly issued senior unsecured debt of participating financial institutions and their qualifying holding companies. Union Bank elected to participate and, during the first quarter of 2009, issued $1 billion principal amount of FDIC-guaranteed senior notes under this program.
In October 2008, the U.S. Treasury enacted a voluntary Capital Purchase Program under its Troubled Asset Relief Program (TARP) pursuant to which the Treasury purchased senior preferred stock of qualifying U.S. financial institutions. Many banks and bank holding companies participated in this program. UnionBanCal, as a wholly-owned subsidiary of a foreign bank, was not eligible to participate in the Capital Purchase Program.
Possible Future Legislation and Regulatory Initiatives
The recent economic and political environment has led to a number of proposed legislative, governmental and regulatory initiatives, described above, that may significantly impact our industry. These and other initiatives could significantly change the competitive and operating environment in which we and our subsidiaries operate. We cannot predict whether these or any other proposals will be enacted or the ultimate impact of any such initiatives on our operations, competitive situation, financial condition or results of operations.
See our Consolidated Financial Statements starting on page 86 of this Form 10-K for financial information about UnionBanCal Corporation and its subsidiaries.
We are subject to numerous risks and uncertainties, including but not limited to the following information:
U.S. and global economies have experienced a serious recession, unprecedented volatility in the financial markets, and significant deterioration in sectors of the U.S. consumer and business economy, all of which continue to present challenges for the banking and financial services industry and for UnionBanCal Corporation; the U.S. Government has responded to these circumstances with a variety of measures; there can be no assurance that these measures will successfully address these circumstances.
Over the past three years, adverse financial and economic developments have impacted the U.S. and global economies and financial markets and have presented challenges for the banking and financial services industry and for UnionBanCal Corporation. These developments include a general recession both globally and in the U.S. and have contributed to substantial volatility in the financial markets.
In response, various significant economic and monetary stimulus measures have been enacted and considered by the U.S. Congress. Refer to "Supervision and Regulation" in Item 1 of this Form 10-K for discussion of certain of these measures.
It cannot be predicted whether U.S. Governmental actions will result in lasting improvement in financial and economic conditions affecting the U.S. banking industry and the U.S. economy. It also cannot be predicted whether and to what extent the efforts of the U.S. Government to combat the mixed economic conditions will continue. If, notwithstanding the government's fiscal and monetary measures, the U.S. economy were to deteriorate, this would continue to present significant challenges for the U.S. banking and financial services industry and for our Company. In addition, as a wholly-owned subsidiary of a foreign bank, we have not been eligible to participate in some federal programs such as the U.S. Treasury's Capital Purchase Program and may not qualify for participation in future federal programs.
Recently, certain sovereign borrowers have encountered difficulties in financing renewals of their indebtedness. If this trend continues or worsens, it could have adverse impacts on costs in the global debt markets which could increase funding costs for banks generally. Further, European regulators announced in 2010 findings from capital stress tests on many European banks. The confidence in the transparency and
robustness in these stress tests remains unclear. These combined factors, if continuing to worsen, could further increase the uncertainty in global markets.
Difficult market conditions have adversely affected the U.S. banking industry
Dramatic declines in the housing market in the U.S. in general, and in California in particular, during 2008 and continuing in 2009 and 2010, with falling or sluggish home prices and increasing foreclosures, unemployment and under-employment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities as well as commercial and investment banks. These write-downs, initially of mortgage-backed securities but spreading to credit default swaps and other derivative securities, residential and commercial real estate loans and small business and other commercial loans, in turn, have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to fail. These adverse economic conditions have led to an increased level of commercial and consumer delinquencies, reduced consumer confidence, increased market volatility and widespread reduction of business activity generally. The resulting economic pressure on consumers and lack of confidence in the financial markets adversely affected our business, financial condition and results of operations in 2009 and this effect continued, although to a lessened degree, in 2010. Although the economic conditions in our markets and in the U.S. generally may be showing signs of improvement, there can be no assurance that these conditions will continue to improve. These conditions may again decline in the near future. In addition, turbulent political and economic conditions in foreign countries have negatively impacted the U.S. financial markets and economy in general and may do so in the future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:
The effects of changes or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us
We are subject to significant federal and state regulation and supervision, which is primarily for the benefit and protection of our customers and the Deposit Insurance Fund and not for the benefit of investors in our securities. In the past, our business has been materially affected by these regulations. This will continue and likely intensify in the future. Laws, regulations or policies, including accounting standards and interpretations, currently affecting us and our subsidiaries may change at any time. Regulatory authorities may also change their interpretation of these statutes and regulations. Therefore, our business may be adversely affected by changes in laws, regulations, policies or interpretations or regulatory approaches to compliance and enforcement, as well as by supervisory action or criminal proceedings taken as a result of noncompliance which could result in the imposition of significant civil money penalties or fines. Changes in laws and regulations may also increase our expenses by imposing additional supervision, fees, taxes or restrictions on our operations. Compliance with laws and regulations, especially new laws and regulations, increases our expenses and diverts management attention from our business operations.
On July 21, 2010, President Obama signed into law the Dodd-Frank Act. This new legislation has affected U.S. financial institutions, including UnionBanCal Corporation and Union Bank, in many ways, some of which have increased, or may increase in the future, the cost of doing business and present other challenges to the financial services industry. Due to our size, we will likely be designated as "systemically significant" to the financial health of the U.S. economy and, as a result, may be subject to additional regulations. Many of the new law's provisions are in the process of being implemented by rules and regulations of the federal banking agencies, the scope and impact of which cannot yet be fully determined. The new law contains many provisions which may have particular relevance to the business of UnionBanCal Corporation and Union Bank. While the full effect of these provisions of the Dodd-Frank Act on Union Bank cannot be predicted at this time, they may result in adjustments to our FDIC deposit insurance premiums, increased capital and liquidity requirements, increased supervision, increased regulatory and compliance risks and costs and other operational costs and expenses, reduced fee-based revenues and restrictions on some aspects of our operations, and increased interest expense on our demand deposits, some or all of which may be material.
On February 11, 2011, the U.S. Treasury released a White Paper addressing possible solutions to the current problems with Government Sponsored Entities Fannie Mae and Freddie Mac (GSEs). The Treasury White Paper presents three possible long-term options to wind down the GSEs, reform the mortgage market and better target government support of affordable housing. While the specific nature of the reform and its impact on the financial services industry in general, and on Union Bank in particular, is unclear at this time, such reform, if enacted, is likely to have a substantial impact on the mortgage market and could potentially reduce our income from mortgage originations by increasing mortgage costs or lowering originations. The GSE reform could also reduce real estate prices, which could reduce the value of collateral securing outstanding mortgage loans. This reduction of collateral value could negatively impact the value or perceived collectibility of these mortgage loans and may increase our allowance for loan losses.
International laws, regulations and policies affecting us, our subsidiaries and the business we conduct may change at any time and affect our business opportunities and competitiveness in these jurisdictions. Due to our ownership by BTMU, laws, regulations, policies, fines and other supervisory actions adopted or enforced by the Government of Japan and the Federal Reserve Board may adversely affect our activities and investments and those of our subsidiaries in the future. In addition to changes in required capital resulting from the Dodd-Frank Act, the Basel Committee published in December 2010 guidelines for the Basel III global regulatory framework for capital and liquidity, including calibration for increased capital requirements approved by the G20 leadership in November 2010. Current U.S. regulatory leverage ratio requirements are more stringent than those proposed by Basel III, which will be further assessed prior to finalization. New liquidity standards are expected to be adopted by U.S. bank regulatory agencies with some modifications. These new liquidity standards could require that we raise and maintain additional liquidity. While the ultimate implementation of these proposals in the U.S. is subject to the discretion of the U.S. bank regulators, these
proposals, if adopted, could restrict our ability to grow during favorable market conditions or require us to raise additional capital. As a result, our business, results of operations, financial condition or prospects could be adversely affected. Refer to "Supervision and Regulation-Basel Committee Capital Standards" in Item 1 of this Form 10-K for additional information regarding the Basel Committee capital standards.
We maintain systems and procedures designed to comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of criminal or civil penalties (which can be substantial) for noncompliance. In some cases, liability may attach even if the noncompliance was inadvertent or unintentional and even if compliance systems and procedures were in place at the time. There may be other negative consequences from a finding of noncompliance, including restrictions on certain activities and damage to our reputation.
Additionally, our business is affected significantly by the fiscal and monetary policies of the U.S. federal government and its agencies. We are particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Under a long-standing policy of the Federal Reserve Board, a bank holding company is expected to act as a source of financial and managerial strength for its subsidiary banks. As a result of that policy, we may be required to commit financial and other resources to our subsidiary bank in circumstances where we might not otherwise do so. Among the instruments of monetary policy available to the Federal Reserve Board are (a) conducting open market operations in U.S. Government securities, (b) changing the discount rates on borrowings by depository institutions and the federal funds rate, and (c) 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 Federal Reserve Board may have a material effect on our business, prospects, results of operations and financial condition.
Refer to "Supervision and Regulation" in Item 1 of this Form 10-K for discussion of certain existing and proposed laws and regulations that may affect our business.
Higher credit losses could require us to increase our allowance for credit losses through a charge to earnings
When we loan money or commit to loan money, we incur credit risk, or the risk of losses if our borrowers do not repay their loans. We reserve for credit losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of credit losses inherent in our loan portfolio and our unfunded credit commitments. The process for determining the amount of the allowance is critical to our financial results and condition. It requires difficult, subjective and complex judgments about the future impact from current economic conditions that might impair the ability of our borrowers to repay their loans.
We might underestimate the credit losses inherent in our loan portfolio and have credit losses in excess of the amount reserved. Or, we might increase the allowances because of changing economic conditions, which we conclude have caused losses to be sustained in our portfolio. For example, in a rising interest rate environment, borrowers with adjustable rate loans could see their payments increase. In the absence of offsetting factors such as increased economic activity and higher wages, this could reduce borrowers' ability to repay their loans, resulting in our increasing the allowance. Continued volatility in fuel and energy costs could also adversely impact some borrowers' ability to repay their loans. We might also increase the allowance because of unexpected events. Any increase in the credit allowance would result in a charge to earnings.
Future legislative or regulatory actions responding to perceived financial and market problems could impair our rights against borrowers and decrease our revenue from other customers
Under current bankruptcy laws, courts cannot force a modification of mortgage and home equity loans secured by primary residences. In response to the financial crisis, in 2009, legislation was proposed to allow mortgage loan "cram-downs," which would empower courts to modify the terms of mortgage and home equity
loans including to reduce the principal amounts to reflect lower underlying property values. Although this legislation has not moved forward at this time, legislation of this type could result in our writing down the value of our residential mortgage and home equity loans to reflect their lower loan values. There is also risk that home equity loans in a second lien position (i.e., behind a mortgage) could experience significantly higher losses to the extent they become unsecured as a result of a cram-down. The availability of principal reductions or other mortgage loan modifications could make bankruptcy a more attractive option for troubled borrowers, leading to increased bankruptcy filings and accelerated defaults.
Recent changes in federal rules have imposed new restrictions on banks' abilities to charge overdraft services and fees and can be expected to result in decreased revenues and increased compliance costs for the industry and Union Bank. See "Supervision and RegulationOverdraft and Interchange Fees" in Item 1 of this Form 10-K for additional information.
We report certain assets, including investments and securities, at fair value. Generally, for assets that are reported at fair value, we use quoted market prices or valuation models that utilize market data inputs and assumptions to estimate fair value. Because generally accepted accounting principles require fair value measurements to reflect appropriate adjustments for risks related to liquidity and the use of unobservable assumptions, we may recognize unrealized losses even if we believe that the asset in question presents minimal credit risk. During periods of adverse conditions in the capital markets, we may be required to recognize other-than-temporary impairments with respect to securities in our portfolio.
Significant increases in market interest rates on loans, or the perception that an increase may occur, could adversely affect both our ability to originate new loans and our ability to grow. Conversely, decreases in interest rates could result in an acceleration of loan prepayments. An increase in market interest rates could also adversely affect the ability of our floating-rate borrowers to meet their higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and charge offs, which could adversely affect our business.
Fluctuations in interest rates on deposits or other funding sources could adversely affect our margin spread
Changes in market interest rates on deposits or other funding sources, including changes in the relationship between short-term and long-term market interest rates or between different interest rate indices, can impact, and has in past years impacted, our net interest spread, that is, the difference between the interest rates we charge on interest earning assets, such as loans, and the interest rates we pay on interest bearing liabilities, such as deposits or other borrowings. This impact could result in a decrease in our interest income relative to interest expense. Changes in interest rates can also affect the level of loan refinancing activity, which impacts the amount of prepayment penalty income we receive on loans we hold. Recently, the banking industry has operated in an extremely low interest rate environment relative to historical averages. If a rising rate environment were to ensue, it could present new challenges for the industry and Union Bank.
Our deposit customers may pursue alternatives to bank deposits or seek higher yielding deposits, which may increase our funding costs and adversely affect our liquidity position
Checking and savings account balances and other forms of deposits can decrease when our deposit customers perceive alternative investments, such as the stock market, other non-depository investments or higher yielding deposits, as providing superior expected returns. Technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments or other deposit accounts, including products offered by other financial institutions or non-bank service providers. Future increases in short-term interest rates could increase such transfers of deposits to higher yielding deposits or other
investments either with us or with external providers. In addition, our level of deposits may be affected by lack of consumer confidence in financial institutions, which have caused fewer depositors to be willing to maintain deposits that are not fully insured by the FDIC. Depositors may withdraw certain deposits from Union Bank and place them in other institutions or invest uninsured funds in investments perceived as being more secure, such as securities issued by the U.S. Treasury. These consumer preferences may force us to pay higher interest rates or reduce fees to retain certain deposits and may constrain liquidity as we seek to meet funding needs caused by reduced deposit levels.
In addition, we have benefited from a "flight to quality" by consumers and businesses seeking the relative safety of bank deposits over the past few years. As interest rates rise from historically low levels during the current period, our newly acquired deposits may not be as stable or as interest rate insensitive as similar deposits may have been in the past, and as a recovery in the economy ensues, some existing or prospective deposit customers of banks generally, including Union Bank, may be inclined to pursue other investment alternatives.
Efforts and initiatives we undertake to retain and increase deposits, including deposit pricing, can increase our costs. During 2010, our interest bearing deposits decreased $10.3 billion, or 19 percent, as a result of a planned deposit decline resulting from targeted rate reductions. For additional information, see "Management's Discussion and Analysis of Financial Condition and Results of OperationsExecutive Overview" in this report on Form 10-K. When bank customers move money out of bank deposits in favor of alternative investments or into higher yielding deposits, we can lose a relatively inexpensive source of funds, increasing our funding cost.
The recent repeal of federal prohibitions on payment of interest on demand deposits could increase our interest expense
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could commence offering interest on demand deposits, including business demand deposits, to compete for clients. We do not yet know what interest rates other institutions may offer. Our interest expense will increase and our net interest margin will decrease if we begin offering interest on business demand deposits to attract additional customers or maintain current customers.
Banking is a highly competitive business. We compete actively for loan, deposit, and other financial services business in California, Oregon, Washington, and Texas as well as nationally and internationally. Our competitors include a large number of state and national banks, thrift institutions, credit unions, finance companies, mortgage banks and major foreign-affiliated or foreign banks, as well as many financial and nonfinancial firms that offer services similar to those offered by us, including many large securities firms and financial services subsidiaries of commercial and manufacturing companies. Some of our competitors are insurance companies or community or regional banks that have strong local market positions. Other competitors include large financial institutions that have substantial capital, technology and marketing resources, which are well in excess of ours. Competition in our industry may further intensify as a result of the recent and increasing level of consolidation of financial services companies, particularly in our principal markets resulting from adverse economic and market conditions. Larger financial institutions may have greater access to capital at a lower cost than us, which may adversely affect our ability to compete effectively. In addition, some of our current commercial banking customers may seek alternative banking sources if they develop credit needs larger than we may be able to accommodate. We also experience competition, especially for deposits, from internet-based banking institutions and other financial companies, which do not always have a physical presence in our market footprint and have grown rapidly in recent years. Competition in our principal markets may further intensify as a result of the Dodd-Frank Act, which, among other things, permits out of state de novo branching by national banks, state banks and foreign banks from other states.
From time to time the Financial Accounting Standards Board and the SEC change the financial accounting and reporting standards that govern the preparation of our financial statements or new interpretations of existing standards emerge as standard industry practice. These changes can be very difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in our restating prior period financial statements.
Technology and other changes increasingly allow parties to complete financial transactions electronically, and in many cases, without banks. For example, consumers can pay bills and transfer funds over the internet and by telephone without banks. Many non-bank financial service providers have lower overhead costs and are subject to fewer regulatory constraints. If consumers do not use banks to complete their financial transactions, we could potentially lose fee income, deposits and income generated from those deposits.
The continuing war on terrorism, overseas military conflicts and unrest in other countries could adversely affect U.S. and global economic conditions
Acts or threats of terrorism and actions taken by the U.S. or other governments as a result of such acts or threats and other international hostilities, as well as political unrest in various regions, may result in a disruption of U.S. and global economic and financial conditions and could adversely affect business, economic and financial conditions in the U.S. and globally and in our principal markets.
Adverse economic factors affecting certain industries we serve could adversely affect our business
We are subject to certain industry-specific economic factors. For example, a significant portion of our total loan portfolio is related to residential real estate, especially in California. Increases in residential mortgage loan interest rates could have an adverse effect on our operations by depressing new mortgage loan originations, and could negatively impact our title and escrow deposit levels. Additionally, a continued or further downturn in the residential real estate and housing industries in California could have an adverse effect on our operations and the quality of our real estate loan portfolio. These factors could adversely impact the quality of our residential construction and residential mortgage portfolios in various ways, including by decreasing the value of the collateral for our mortgage loans. These factors could also negatively affect the economy in general and thereby our overall loan portfolio.
We provide financing to businesses in a number of other industries that may be particularly vulnerable to industry-specific economic factors and are impacting the performance of our commercial real estate and commercial and industrial portfolios. The commercial real estate industry in the U.S., and in California in particular, has been increasingly adversely impacted by the recessionary environment and lack of liquidity in the financial markets. The home building and mortgage industry in California has been especially adversely impacted by the deterioration in residential real estate markets. Poor economic conditions and financial access for commercial real estate developers and homebuilders could continue to adversely affect property values, resulting in higher nonperforming assets and charge offs in this sector. Our commercial and industrial portfolio, and the communications and media industry, the retail industry, the energy industry and the technology industry in particular, are also being impacted by recessionary market conditions. Continued volatility in fuel prices and energy costs could adversely affect businesses in several of these industries. Conditions and credit markets remain uncertain and could produce elevated levels of charge-offs. Industry-specific risks are beyond our control and could adversely affect our portfolio of loans, potentially resulting in an increase in nonperforming loans or charge offs and a slowing of growth or reduction in our loan portfolio.
The government of the State of California currently faces economic and fiscal challenges, the long-term impact of which on the State's economy cannot be predicted with any certainty. Economic conditions in California are subject to various challenges at this time, including significant deterioration in the residential real estate sector and the California state government's budgetary and fiscal difficulties. California continues to have a high unemployment rate, with reported figures of 12.4 percent in December 2010. Also, California markets have experienced among the worst property value declines in the U.S.
For the past several years, the State government of California has experienced budget shortfalls or deficits which have led to protracted negotiations between the Governor and the State Legislature over how to address the budget gap. This challenging situation continues at the present time. In addition, municipalities and other governmental units within California have been experiencing budgetary difficulties. Concerns also have arisen regarding the outlook for the State of California's governmental obligations, as well as those of California municipalities and other governmental units.
A substantial majority of our assets, deposits and interest and fee income is generated in California. As a result, poor economic conditions in California may cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. If the budgetary and fiscal difficulties of the California State government and California municipalities and other governmental units continue or economic conditions in California decline further, we expect that our level of problem assets could increase and our prospects for growth could be impaired.
Since November 2008, BTMU, a wholly-owned subsidiary of MUFG, has owned all of the outstanding shares of our common stock. As a result, BTMU can elect all of our directors and can control the vote on all matters, including: approval of mergers or other business combinations; a sale of all or substantially all of our assets; issuance of any additional common stock or other equity securities; incurrence of debt other than in the ordinary course of business; the selection and tenure of our Chief Executive Officer; payment of dividends with respect to our common stock or other equity securities; and other matters that might be favorable to BTMU or MUFG.
A majority of our directors are independent of BTMU and are not officers or employees of UnionBanCal Corporation or any of our affiliates, including BTMU. However, because of BTMU's control over the election of our directors, it could at any time change the composition of our Board of Directors so that the Board would not have a majority of independent directors.
The Bank of Tokyo-Mitsubishi UFJ's and Mitsubishi UFJ Financial Group's credit ratings and financial or regulatory condition could adversely affect our operations
Adverse changes to our credit ratings, reputation or creditworthiness could have a negative effect on our operations. We generally fund our operations independently of BTMU and MUFG and believe our business is not necessarily closely related to the business or outlook of BTMU or MUFG. However, if BTMU and MUFG's credit ratings or financial condition or prospects were to decline, this could adversely affect our credit rating or harm our reputation or perceived creditworthiness. In February 2011, Moody's Japan K.K. changed the outlook for the Government of Japan's bond ratings to negative from stable and consequently changed the outlook to negative from stable for the long-term debt credit ratings of Japan's three largest banks, including BTMU, noting that a downgrade in the government rating would result in a downgrade in the banks' ratings, absent a material improvement in their standalone credit quality. At this time, we cannot predict the actions, if any, which other rating agencies may take on this subject, nor the ultimate effect of these developments on our credit rating. On March 11, 2011, a large earthquake and tsunami occurred in Japan causing widespread destruction. The ultimate impact of this natural disaster on the economy of Japan and its government debt credit ratings and the credit ratings of Japan's three largest banks, including BTMU, cannot be predicted at this time.
BTMU and MUFG are also subject to regulatory oversight, review and supervisory action (which can include fines or penalties) by Japanese and U.S. regulatory authorities. Our business operations and expansion plans could be negatively affected by regulatory concerns or supervisory action in the U.S. and in Japan against BTMU or MUFG.
The views of BTMU and MUFG regarding possible new businesses, strategies, acquisitions, divestitures or other initiatives, including compliance and risk management processes, may differ from ours. This may prevent, delay or hinder us from pursuing individual initiatives or cause us to incur additional costs and subject us to additional oversight.
Also, as part of BTMU's risk management processes, BTMU manages global credit and other types of exposures and concentrations on an aggregate basis, including exposures and concentrations at UnionBanCal. Therefore, at certain levels or in certain circumstances, our ability to approve certain credits or other banking transactions and categories of customers is subject to the concurrence of BTMU. We may wish to extend credit or furnish other banking services to the same customers as BTMU. Our ability to do so may be limited for various reasons, including BTMU's aggregate exposure and marketing policies.
Certain directors' and officers' ownership interests in MUFG's common stock or service as a director or officer or other employee of both us and BTMU could create or appear to create potential conflicts of interest, especially since both we and BTMU compete in U.S. banking markets.
As a holding company, a substantial portion of our cash flow typically comes from dividends our bank and non-bank subsidiaries pay to us. Various statutory provisions restrict the amount of dividends our subsidiaries can pay to us without regulatory approval. In addition, if any of our subsidiaries were to liquidate, that subsidiary's creditors will be entitled to receive distributions from the assets of that subsidiary to satisfy their claims against it before we, as a holder of an equity interest in the subsidiary, will be entitled to receive any of the assets of the subsidiary.
Risks associated with potential acquisitions or divestitures or restructurings may adversely affect us
We have in the past, and may in the future, seek to expand our business by acquiring other businesses which we believe will enhance our business. We cannot predict the frequency, size or timing of our acquisitions, as this will depend on the availability of prospective target opportunities at valuation levels we find attractive and the competition for such opportunities from other parties. There can be no assurance that our acquisitions will have the anticipated positive results, including results related to: the total cost of integration; the time required to complete the integration; the amount of longer-term cost savings; continued growth; or the overall performance of the acquired company or combined entity. We also may encounter difficulties in obtaining required regulatory approvals and unexpected contingent liabilities can arise from the businesses we acquire.
Our purchase and assumption and loss share agreements with the FDIC relating to our Frontier Bank and Tamalpais Bank transactions have specific compliance, servicing, notification and reporting requirements. Any failure to comply with the requirements of the loss share agreements, or to properly service the loans and other real estate owned (OREO) covered by any loss share arrangement, may cause individual loans or loan pools to lose their eligibility for loss share payments from the FDIC, potentially resulting in material losses that are currently not anticipated.
Integration of an acquired business can be complex and costly. If we are not able to integrate successfully past or future acquisitions, there is a risk that results of operations could be adversely affected.
In addition, we continue to evaluate the performance of all of our businesses and may sell or restructure a business. Any divestitures or restructurings may result in significant expenses and write-offs, including those related to goodwill and other intangible assets, which could have a material adverse effect on our business, results of operations and financial condition and may involve additional risks, including difficulties in obtaining any required regulatory approvals, the diversion of management's attention from other business concerns, the disruption of our business and the potential loss of key employees.
We may not be successful in addressing these or any other significant risks encountered in connection with any acquisition, divestiture or restructuring we might make.
Our business model relies, in part, upon cross-marketing the products and services offered by us and our subsidiaries to our customers. Laws that restrict our ability to share information about customers within our corporate organization could adversely affect our business, results of operations and financial condition. See "Supervision and Regulation" in Item 1 of this Form 10-K.
Third-party vendors provide key components of our business infrastructure such as internet connections, network access and mutual fund distribution and we do not control their actions. Among other services provided by these vendors, third-party vendors play a key role in the implementation of our integrated banking platform. Any problems caused by these third parties, including those as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers, implement our integrated banking platform and otherwise to conduct our business. Replacing these third-party vendors is not always possible or within our control and could also entail significant delay and expense.
Our business could suffer if we fail to attract, retain and successfully integrate skilled personnel
Our success depends, in large part, on our ability to attract and retain key personnel, including executives. Any of our current employees, including our senior management, may terminate their employment with us at any time. Competition for qualified personnel in our industry can be intense. We may not be successful in attracting and retaining sufficient qualified personnel. We may also incur increased expenses and be required to divert the attention of other senior executives to recruit replacements for the loss of any key personnel.
In the past few years, we have experienced significant turnover among members of management, primarily due to retirement. We must successfully integrate any new management personnel that we bring into the organization in order to achieve our operating objectives as new management becomes familiar with our business.
In February 2011, the FDIC issued proposed rules under the Dodd-Frank Act which are intended to prevent compensation arrangements that would encourage inappropriate risk taking, are deemed to be excessive, or that may lead to material losses. In certain circumstances, a portion of incentive-based compensation awarded to executive officers of large financial institutions, including Union Bank, would be deferred to future periods. The FDIC has also proposed rules which would increase deposit premiums for institutions with compensation practices deemed to increase risk to the institution. Over time, these proposed rules, upon their adoption, could have the effect of making it more difficult for banks to attract and retain skilled personnel.
The challenging operating environment and current operational initiatives may strain our available resources
There are an increasing number of matters in addition to our core operations which require our attention and resources. These matters include implementation of our integrated banking platform, adoption of the Basel II capital guidelines, various strategic initiatives, integration of the operations of our recent FDIC-assisted acquisitions, a disruptive economic environment, a challenging regulatory environment, including the possible effects of the Dodd-Frank Act and regulations adopted thereunder, and integration of new employees, including key members of management. Our ability to execute our core operations and to implement other important initiatives may be adversely affected if our resources are insufficient or if we are unable to allocate available resources effectively. Also, our ability to constrain or reduce operating expense levels may be limited by the costs of increasing regulatory requirements and expectations.
Significant legal or regulatory proceedings could subject us to substantial uninsured liabilities
We are from time to time subject to claims and proceedings related to our present or previous operations. These claims, which could include supervisory or enforcement actions by bank regulatory authorities, or criminal proceedings by prosecutorial authorities, could involve demands for large monetary amounts, including civil money penalties or fines imposed by government authorities, and significant defense costs. To mitigate the cost of some of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations. However, our insurance coverage does not cover any civil money penalties or fines imposed by government authorities and may not cover all other claims that have been or might be brought against us or continue to be available to us at a reasonable cost. As a result, we may be exposed to substantial uninsured liabilities, which could adversely affect our business, prospects, results of operations and financial condition.
Under a tax election we have made, we are required to file our California franchise tax returns as a member of a unitary group that includes MUFG's U.S. operations, including its branch activities and its U.S. affiliates. Increases or decreases in the taxable profits of MUFG's U.S. operations could increase or decrease our effective tax rate. We review MUFG's financial information on a quarterly basis to determine the rate at which to recognize our California income taxes. However, all of the information relevant to determining the effective California tax rate may not be available until after the end of the period to which the tax relates, primarily due to MUFG's March 31 fiscal year-end. Our California effective tax rate can change during the calendar year, or between calendar years, as additional information becomes available. If we understate our tax obligations, we could be subject to penalties. Our effective tax rates also could be affected by valuation changes in our deferred tax assets and liabilities, changes in tax laws or their interpretation and by the outcomes of examinations of our income tax returns by the tax authorities.
Our credit ratings are important in order to maintain liquidity.
Major credit rating agencies regularly evaluate the securities of UnionBanCal Corporation and the securities and deposits of Union Bank, and their ratings of our long-term debt and other securities and also of our short-term obligations are based on a number of factors, including our financial strength, ability to generate earnings, and other factors, some of which are not entirely within our control, such as conditions affecting the financial services industry and the economy. In light of the difficulties in the financial services industry, the financial markets and the economy, there can be no assurance that we will maintain our current long-term and short-term ratings. In addition, Moody's Investors Service and Fitch, Inc. have announced that the ratings of a number of large U.S. banks, not including Union Bank, may be negatively affected because the passage of the Dodd-Frank Act makes it less likely that the government would step in to rescue a troubled bank. It is unclear whether other rating agencies will respond in a similar way or whether perceived reduction in systemic support could lead or contribute to negative downward pressure on our credit ratings.
If our long-term or short-term credit ratings suffer downgrades, such downgrades could adversely affect access to liquidity and could significantly increase our cost of funds, trigger additional collateral or funding requirements, and decrease the number of commercial depositors, investors and counterparties willing to lend to us, thereby curtailing our business operations and reducing our ability to generate income.
Certain of our derivative instruments contain provisions that require us to maintain a specified credit rating. If our credit rating were to fall below the specified rating, the counterparties to these derivative instruments could terminate the contract and demand immediate payment or demand immediate and ongoing full overnight collateralization for those derivative instruments in net liability positions.
Adverse changes in the credit ratings, operations or prospects of our parent companies, BTMU and MUFG, could also adversely impact our credit ratings.
We are subject to many types of operational risks throughout our organization. Operational risk is the potential loss from our operations due to factors, such as failures in internal control, systems failures or external events, that do not fall into the market risk or credit risk categories described in "Management's Discussion and Analysis of Financial Condition and Results of OperationsBusiness Segments." Operational risk includes execution risk related to operational initiatives, including implementation of our integrated banking platform, reputational risk, legal and compliance risk, the risk of fraud or theft by employees, customers or outsiders, unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems. A discussion of risks associated with regulatory compliance appears above under the caption "The effects of changes or increases in, or supervisory enforcement of, banking or other laws and regulations or governmental fiscal or monetary policies could adversely affect us."
We depend on the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and our employees in our day-to-day and ongoing operations. Our dependence upon automated systems to record and process transactions may further increase the risk that technical system flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. Failures in our internal control or operational systems could impair our ability to operate our business and result in potential liability to customers, reputational damage and regulatory intervention, any of which could harm our operating results and financial condition.
We may also be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control, such as computer hacking or viruses, electrical, internet or telecommunications outages or unexpected difficulties with the implementation of our integrated banking platform, which may give rise to disruption of service to customers and to financial loss or liability. Our business recovery plan may not work as intended or may not prevent significant interruptions of our operations.
As a financial institution, our earnings and capital are subject to risks associated with negative public opinion. Negative public opinion could result from our actual or alleged conduct in any number of activities, including lending practices, the failure of any product or service sold by us to meet our customers' expectations or applicable regulatory requirements, governmental enforcement actions, corporate governance and acquisitions, or from actions taken by regulators and community organizations in response to those activities. We generally fund our operations independently of BTMU and MUFG and believe our business is not necessarily closely related to the business or outlook of BTMU or MUFG. However, negative public opinion could also result from regulatory concerns regarding, or supervisory or other governmental actions in the U.S. or Japan against, us or Union Bank, or BTMU or MUFG. Negative public opinion can adversely affect our ability to keep and attract and/or retain lending and deposit customers and employees and can expose us to litigation
and regulatory action and increased liquidity risk. Actual or alleged conduct by one of our businesses can result in negative public opinion about our other businesses. Negative public opinion could also affect our credit ratings, which are important for some commercial deposit customers and also to our access to the capital markets and unsecured wholesale or other borrowings; significant changes in these ratings could change the cost and availability of these sources of funding.
Our risk management framework is made up of various processes and strategies to manage our risk exposure. Types of risk to which we are subject include liquidity risk, credit risk, market risk, interest rate risk, operational risk, legal risk, compliance risk, reputation risk, fiduciary risk and private equity risk, among others. Our framework to manage risk, including the framework's underlying assumptions, may not be effective under all conditions and circumstances. If our risk management framework proves ineffective, we could suffer unexpected losses and our business, financial condition, results of operations or prospects could be materially adversely affected.
Since November 2008, all of our issued and outstanding shares of common stock have been owned by MUFG through its wholly-owned subsidiary BTMU. As such, we would have been no longer required to file periodic reports with the SEC pursuant to the Securities Exchange Act of 1934 (the Exchange Act); however, we have elected to voluntarily register our common stock under the Exchange Act and for so long as we maintain that registration in effect we will be required to continue to file such periodic reports with the SEC in accordance with a reduced disclosure format permitted for certain wholly-owned subsidiaries.
Our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by us in reports we file or submit under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms. Any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.
These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people or by an unauthorized override of the controls. Accordingly, because of the inherent limitations in our control system, misstatements due to error or fraud may occur and not be detected.
We may take actions to maintain client satisfaction that may result in losses or adversely affect our earnings
We may find it necessary to take actions or incur expenses in order to maintain client satisfaction even though we are not required to do so by law. The risk that we will need to take such actions and incur the resulting losses or reductions in earnings is greater in periods when financial markets and the broader economy are performing poorly or are particularly volatile. As a result, such actions may adversely affect our business, financial condition, results of operations or prospects, perhaps materially.
We may be adversely affected by the soundness of other financial institutions
As a result of trading, clearing or other relationships, we have exposure to many different counterparties and routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers, dealers and investment banks. Many of these transactions expose us to credit risk in the event of a default by a counterparty. In addition, our credit risk may be exacerbated when the collateral we hold cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or
derivative exposure due to us. Any such losses could have a material adverse effect on our business, results of operations, financial condition or prospects.
Our financial results depend on management's selection of accounting methods and certain assumptions and estimates
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Our management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management's judgment of the most appropriate manner to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in our reporting materially different results than would have been reported under a different alternative.
Certain accounting policies are critical to presenting our financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include allowance for credit losses, acquired loans, FDIC indemnification asset, valuation of financial instruments, other-than-temporary impairment, hedge accounting, pension obligations, annual goodwill impairment analysis, and income taxes. Because of the uncertainty of estimates involved in these matters, we may be required to do one or more of the following: significantly increase or decrease the allowance for loan losses or sustain loan losses that are significantly different than the reserve provided, recognize significant impairment on goodwill, or significantly increase or decrease our accrued tax liability. Any of these could adversely affect our business, results of operations, and financial condition.
At December 31, 2010, we operated 346 full-service branches in California, 53 full-service branches in Oregon and Washington, one branch in Texas and two international offices. We own the property occupied by 144 of the domestic offices and lease the remaining properties for periods of five to 16 years.
We own two administrative facilities in San Francisco, two in Los Angeles, and three in San Diego. Other administrative offices in Arizona, California, Illinois, Massachusetts, New York, Oregon, Texas, Virginia, and Washington operate under leases expiring in one to sixteen years.
Rental expense for branches and administrative premises is described in Note 6 to our Consolidated Financial Statements included in this Form 10-K.
Cynthia Larsen v. Union Bank, N.A.: This putative class action was filed on July 15, 2009 by Union Bank customer Cynthia Larsen. In October of 2009, the action was transferred from the Northern District of California to the Multidistrict Litigation action (MDL) in the Southern District of Florida. Omnibus motions to dismiss the complaints in many of the suits included in the MDL, including Larsen, were denied on March 12, 2010. Plaintiffs allege that, by posting charges to their accounts in order from highest to lowest amount, the Bank charged them more overdraft fees than it would have charged them had the Bank posted items to their accounts in chronological order.
Plaintiffs' complaint asserts common-law causes of action for breach of contract and breach of duty of an implied duty of good faith, unconscionability, conversion, unjust enrichment and statutory violation of the
California Business & Professions Code section 17200 et seq. Plaintiffs seek unspecified damages, return or refund of all improper overdraft fees, disgorgement of profits derived from the Bank's alleged conduct, injunctive relief, and attorneys' fees and costs. Plaintiffs seek to represent a putative class of other Union Bank customers who were charged overdraft charges as a result of "re-sequencing" within the applicable statute of limitations period. Union Bank intends to vigorously defend the case. Trial is currently scheduled for March 2012.
We are subject to various other pending and threatened legal actions that arise in the normal course of business. We maintain reserves for losses from legal actions that are both probable and estimable. In addition, we believe the disposition of all claims currently pending will not have a material adverse effect on our consolidated financial condition, operating results or liquidity.
On November 4, 2008, we became a wholly-owned subsidiary of BTMU and our common stock was delisted from the New York Stock Exchange. All of our issued and outstanding shares of common stock are now held by BTMU, and there is presently no established public trading market for our common stock.
See page 35 of this Form 10-K.
See pages 37 through 85 of this Form 10-K.
See pages 69 through 73 of this Form 10-K.
See pages 86 through 177 of this Form 10-K.
Disclosure Controls. Our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have concluded that the design and operation of our disclosure controls and procedures are effective as of December 31, 2010. This conclusion is based on an evaluation conducted under the supervision, and with the participation, of management. Disclosure controls and procedures are those controls and procedures that are designed to ensure that information required to be disclosed in this filing is recorded, processed, summarized and reported in a timely manner and in accordance with the SEC's rules and regulations and to ensure that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Controls Over Financial Reporting. Management's Report on Internal Control Over Financial Reporting regarding the effectiveness of internal controls over financial reporting is presented on page 176. The Report of Independent Registered Public Accounting Firm is presented on page 173. During the quarter ended December 31, 2010, there were no changes in our internal controls over financial reporting that materially affected, or are reasonably likely to affect, our internal controls over financial reporting.
Certain information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
Code of Ethics
We have adopted a Code of Ethics applicable to senior financial officers, including our Chief Executive Officer, Chief Financial Officer and Controller. A copy of this Code of Ethics is posted on our website. To the extent required by SEC rules, we intend to disclose promptly any amendment to, or waiver from any provision of, the Code of Ethics applicable to senior financial officers on our website. Our website address is www.unionbank.com.
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
The information called for by this item has been omitted pursuant to General Instruction I(2) of Form 10-K.
The following is a description of the fees billed to UnionBanCal by Deloitte & Touche LLP for 2010 and 2009. All fees were approved by our Audit & Finance Committee.
with service auditors reports and audits of employee benefit plans. For 2010, additional costs relating to Basel II and International Financial Reporting Standards were incurred. Fees associated with Basel II, which totaled $915 thousand, are reimbursable by BTMU.
The Audit & Finance Committee also considered whether the provision of the services other than audit services is compatible with maintaining Deloitte & Touche LLP's independence. All of the services described above were approved by the Audit & Finance Committee in accordance with the following policy.
Pre-approval of Services by Deloitte & Touche LLP
The Audit & Finance Committee has adopted a policy for pre-approval of audit and permitted non-audit services by Deloitte & Touche LLP. The Audit & Finance Committee will consider annually and, if appropriate, approve, the provision of audit services by its independent registered public accounting firm and consider and, if appropriate, pre-approve, the provision of certain defined audit and non-audit services. The Policy provides that:
The Audit & Finance Committee will also consider on a case-by-case basis and, if appropriate, approve specific engagements that are not otherwise pre-approved.
Any proposed engagement that does not fit within the definition of a pre-approved service may be presented to the Audit & Finance Committee for consideration at its next regular meeting or, if earlier consideration is required, to the Audit & Finance Committee Chair. The Chair reports any specific approval of services at the Audit & Finance Committee's next regular meeting. The Audit & Finance Committee regularly reviews summary reports detailing all services being provided by its independent registered public accounting firm.
(a)(1) Financial Statements
Our Consolidated Financial Statements, Report of Independent Registered Public Accounting Firm and Management's Report on Internal Control Over Financial Reporting are set forth on pages 86 through 176 of this Form 10-K. (See table of contents on page 33).
(a)(2) Financial Statement Schedules
All schedules to our Consolidated Financial Statements are omitted because of the absence of the conditions under which they are required or because the required information is included in our Consolidated Financial Statements or accompanying notes.
UnionBanCal Corporation and Subsidiaries
UnionBanCal Corporation and Subsidiaries
This report includes forward-looking statements, which include expectations for our operations and business, and our assumptions for those expectations. Do not rely unduly on forward-looking statements. Actual results might differ significantly from our expectations. Please also refer to Part I, Item 1A "Risk Factors" for a discussion of some factors that may cause results to differ.
You should read the following discussion and analysis of our consolidated financial position and results of our operations for the years ended December 31, 2010, 2009 and 2008 together with our Consolidated Financial Statements and the Notes to Consolidated Financial Statements included in this Form 10-K. Averages, as presented in the following tables, are substantially all based upon daily average balances.
As used in this Form 10-K, the term "UnionBanCal" and terms such as "our Company", "we," "us" and "our" refer to UnionBanCal Corporation, Union Bank, N.A., one or more of their consolidated subsidiaries, or to all of them together.
We are a California-based financial holding company and bank holding company whose major subsidiary, Union Bank, N.A. (the Bank), is a commercial bank. We provide a wide range of financial services to consumers, small businesses, middle-market companies and major corporations, primarily in California, Oregon, Washington and Texas, as well as nationally and internationally. We had consolidated assets of $79.1 billion at December 31, 2010.
On November 4, 2008, we became a privately held company (privatization transaction). All of our issued and outstanding shares of common stock are owned by The Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU). Prior to the privatization transaction, BTMU owned approximately 64 percent of our outstanding shares of common stock.
We are providing you with an overview of what we believe are the most significant factors and developments that impacted our 2010 results and that could impact our future results. Further detailed information can be found elsewhere in this Form 10-K. In addition, we ask that you carefully read this entire document and any other reports that we refer to in this Form 10-K for more detailed information that will assist your understanding of trends, events and uncertainties that impact us.
Frontier Bank and Tamalpais Bank Acquisitions
On April 30, 2010, Union Bank acquired certain assets and assumed certain liabilities of Frontier Bank (Frontier) from the Federal Deposit Insurance Corporation (FDIC) in an FDIC-assisted transaction. Additionally, on April 16, 2010, Union Bank acquired certain assets and assumed certain liabilities of Tamalpais Bank (Tamalpais) from the FDIC in an FDIC-assisted transaction. For both acquisitions, we entered into loss share agreements with the FDIC, whereby the FDIC will cover a substantial portion of any future losses on acquired loans (FDIC covered loans) and other real estate owned (OREO). We refer to the acquired assets subject to the loss share agreements collectively as "FDIC covered assets."
The acquisitions have been accounted for under the acquisition method of accounting. The assets acquired and liabilities assumed were recorded at their estimated, provisional fair values at their respective acquisition dates. See Note 2 to our Consolidated Financial Statements in this Form 10-K for additional information regarding these acquisitions.
In 2010, the U.S. economy showed signs of improvement following two consecutive years of a recession and unprecedented volatility in the financial markets.
Our sources of revenue are net interest income (predominantly from loans and deposits, as well as from investment securities and other funding sources) and noninterest income. In 2010, total revenue was comprised of 73 percent net interest income and 27 percent noninterest income. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that impact our revenue sources.
Our primary sources of liquidity are core deposits and wholesale funding. Core deposits consist of total deposits, excluding brokered deposits and time deposits of $100,000 and over. Wholesale funding includes unsecured funds raised from interbank and other sources, both domestic and international, and secured funds raised by selling securities under repurchase agreements and by borrowing from the Federal Home Loan Bank of San Francisco (FHLB). We evaluate and monitor the stability and reliability of our various funding sources to help ensure that we have sufficient liquidity when adverse situations arise.
Our net interest income increased $175 million, or 8 percent, to $2.4 billion in 2010 from 2009. Our net interest margin decreased 16 basis points from 2009 to 3.24 percent in 2010. This decrease was primarily driven by an increase in lower yielding investment securities stemming from growth in our interest bearing deposits, which far outpaced our loan demand. Partially offsetting this decrease was lower rates paid on interest bearing liabilities driven by targeted rate reductions in interest bearing deposits. This resulted in a decrease in the annualized average all-in-cost of funds from 0.84 percent in 2009 to 0.56 percent in 2010. During the second half of 2010, the balance sheet was repositioned to counteract the effects of a soft loan market by redeploying interest bearing deposits in banks into securities and to remix the securities portfolio to generate an improvement in the average yield.
In 2010, our noninterest income increased 27 percent from 2009 to $923 million primarily due to higher securities gains and trading account revenue and accretion of income for the acquisition-related indemnification asset, partially offset by reductions in service charges on deposit accounts. Our noninterest expense increased $0.3 billion, or 14 percent, to $2.4 billion from 2009 to 2010 primarily due to higher base salaries and incentive compensation accruals, certain reserves for contingencies, an asset impairment charge, and acquisition-related expenses. These increases were partially offset by lower provision for losses on off-balance sheet commitments and lower privatization-related intangible asset amortization.
Our effective tax rate was 30 percent in 2010, compared to 71 percent in 2009. Our effective tax rate in 2009 reflected a net income tax benefit, as we had a loss before taxes. The change in the effective tax rate was primarily due to pre-tax loss in the prior year compared to pre-tax income in the current year, as well as the impact of tax credits, state income taxes and an adjustment to our unrecognized tax benefits.
Balance Sheet Highlights
Our total assets decreased $6.5 billion, or 8 percent, to $79.1 billion at December 31, 2010 from December 31, 2009, primarily as a result of our efforts to enhance the composition of our assets and liabilities. Securities available for sale declined $1.8 billion, or 8 percent, to $20.8 billion at December 31, 2010 and lower yielding interest bearing deposits in banks declined $6.4 billion, or 97 percent, to $0.2 billion at December 31, 2010 from the corresponding balances at December 31, 2009. Our total liabilities decreased $7.3 billion, or 10 percent, to $68.7 billion at December 31, 2010 from the prior year primarily due to a $10.3 billion, or 19 percent, decrease in interest bearing deposits. This planned deposit decline resulted from targeted rate reductions, and was partially offset by a $1.4 billion, or 32 percent, increase in long-term debt consisting of FHLB advances and the issuance of $0.4 billion of senior bank note in the fourth quarter of 2010. Our stockholder's equity of $10.1 billion at December 31, 2010 grew $0.5 billion, or 6 percent, from December 31, 2009. Total loans increased $0.9 billion, or 2 percent, to $48.1 billion at December 31, 2010, from December 31, 2009, primarily resulting from the Frontier and Tamalpais acquisitions. Total loans,
excluding FDIC covered loans, declined $0.6 billion, or 1 percent, as compared to December 31, 2009. This decrease was primarily in the construction and commercial mortgage classes, due to tighter underwriting standards, proactive portfolio management, and lower loan demand.
Although period average total assets and total deposits increased in 2010 from prior year, period end total assets and total deposits decreased in 2010 from prior year, primarily due to our efforts to enhance our balance sheet composition, which occurred in the latter part of 2010.
In 2010, the total provision for credit losses was $168 million compared to $1,165 million in 2009. The decrease in 2010 from the prior year was primarily due to improved credit quality of the loan portfolio, as well as a change in the portfolio mix and a lower projected loss component of our nonaccrual loans in 2010 compared to 2009. See further discussion below under "Allowance for credit losses."
Our nonperforming assets totaled $1.1 billion and $1.4 billion at December 31, 2010 and December 31, 2009, respectively. Our nonperforming assets, excluding FDIC covered assets, totaled $0.9 billion and $1.4 billion at December 31, 2010 and December 31, 2009, respectively. The decrease in nonperforming assets, excluding FDIC covered assets, from December 31, 2009 resulted from lower levels of nonaccrual loans primarily in our commercial, financial, and industrial portfolio and our construction portfolio as a result of increased sales and charge-offs of problem loans in 2010. Total net loan charge-offs were $366 million and $499 million in 2010 and 2009, respectively. During 2010 and 2009, we sold nonperforming loans of $419 million and $128 million, respectively.
UnionBanCal Corporation's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the U.S. (US GAAP) and the general practices of the banking industry, which include management estimates and judgements. The financial information contained within our statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. For example, we use a discount factor and other assumptions to determine the fair value of assets and liabilities. A change in the discount factor or another important assumption could significantly increase or decrease the values of those assets and liabilities and result in either a beneficial or an adverse impact to our financial results. We use historical loss factors, adjusted for current conditions, to estimate the inherent credit loss present in our loan and lease portfolio. Actual losses could differ significantly from the loss factors that we use. Other significant estimates that we use include the fair values of our acquired loans, FDIC indemnification asset, and certain derivatives and securities, assumptions used in measuring our pension obligations, and assumptions regarding our effective income tax rates.
For each financial reporting period, our most significant estimates are presented to and discussed with the Audit & Finance Committee of our Board of Directors.
All of our significant accounting policies are identified in Note 1 to our Consolidated Financial Statements included in this Form 10-K. The following describes our most critical accounting policies and our basis for estimating our allowance for credit losses, acquired loans, FDIC indemnification asset, valuation of financial instruments, other-than-temporary impairment, hedge accounting, pension obligations, annual goodwill impairment analysis and income taxes.
Allowance for credit losses
The allowance for credit losses, which consist of the allowances for loan and off-balance sheet commitments, are estimates of the losses that may be sustained in our loan and lease portfolio as well as for certain off-balance sheet commitments such as unfunded loan commitments, standby letters of credit, and commercial lines of credit that are not for sale. The allowances are based on two methods of accounting. The first requires that losses be accrued for groups of loans when they are probable of occurring and estimable; the second requires that losses be accrued for individually impaired loans based on the difference between the value of collateral, present value of estimated future cash flows or price that is observable in the secondary market and the loan balance.
Our allowance for credit losses have four components: the formula allowance, the specific allowance for impaired loans, the unallocated allowance, and the allowance for off-balance sheet commitments (included in other liabilities). Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses a method based, in part, on historical losses as an indicator of future losses and, as a result, could differ from the losses incurred in the future. This history is updated quarterly to include data that, in management's judgment, makes the historical data more relevant. Moreover, management adjusts the historical loss estimates for current conditions that would more accurately capture probable losses inherent in the portfolio. The specific allowance uses various techniques to arrive at an estimate of loss. Discounted cash flows, fair market value of collateral and secondary market information are all used to estimate those losses. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The unallocated allowance is intended to capture losses that are attributable to various economic events, as well as to industry or geographic sectors, whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. Our allowance for off-balance sheet commitments is measured in approximately the same manner as the allowance for our loans but includes an estimate of likely utilization based upon historical data. For further information regarding our allowance for loan losses, see "Allowance for credit losses" and Note 4 to our Consolidated Financial Statements in this Form 10-K.
Acquired loans are recorded at estimated provisional fair values at acquisition date in accordance with the Financial Accounting Standards Board Accounting Standards Codification (ASC) 805 "Business Combinations," factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded for acquired loans as of the acquisition date.
In conjunction with the FDIC-assisted acquisitions of Frontier and Tamalpais, we acquired certain loans with evidence of credit quality deterioration subsequent to their origination and for which it was probable, at acquisition, that we would be unable to collect all contractually required payments receivable. We elected to account for all acquired loans, except for revolving lines of credit, within the scope of the accounting guidance using the same methodology. In accordance with applicable accounting guidance, we may aggregate loans that have common risk characteristics into pools and thereby use a composite interest rate and estimate of cash flows expected to be collected for the pools. We have aggregated all of the purchased credit-impaired loans into pools based on common risk characteristics, which then become the unit of account. Once a pool is assembled, the integrity of the pool must be maintained. Significant judgment is required in evaluating whether individual loans have common risk characteristics for purposes of establishing pools of loans.
At the time of the acquisition, all acquired loans were recorded at estimated provisional fair values, including an estimate of losses that are expected to be incurred over the estimated remaining lives of the loans. Many of the assumptions and estimates underlying the estimation of the initial fair value and the ongoing updates to management's expectation of future cash flows are both significant and subjective, particularly considering the current economic environment. The economic environment and the lack of market liquidity
and transparency are factors that have influenced, and may continue to affect, these assumptions and estimates.
We estimated the fair value of acquired loans at the acquisition date based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, risk classification, fixed or variable interest rate, term of loan and whether or not the loan was amortizing, and current discount rates. Loans were grouped together according to similar characteristics and were treated in the aggregate when applying various valuation techniques. The discount rates used for loans were based on current market rates for new originations of comparable loans, where available, and include adjustments for liquidity concerns. To the extent comparable market rates are not readily available, a discount rate was derived based on the assumptions of market participants' cost of funds, servicing costs and return requirements for comparable risk assets. In either case, the discount rate does not include a factor for credit losses as that has been included in the estimated cash flows. The initial estimate of cash flows to be collected was derived from assumptions such as default rates and loss severities.
The accounting guidance for purchased credit-impaired loans provides that the excess of the cash flows initially expected to be collected over the fair value of the loans at the acquisition date (i.e., the accretable yield) should be accreted into interest income at a level rate of return over the term of the loan, provided that the timing and amount of future cash flows is reasonably estimable. The initial estimate of cash flows expected to be collected must be updated each subsequent reporting period based on updated assumptions regarding default rates, loss severities, and other factors that are reflective of current market conditions. If we have probable decreases in cash flows expected to be collected (other than due to decreases in interest rate indices), we charge the provision for credit losses, resulting in an increase to the allowance for loan losses. If we have probable and significant increases in cash flows expected to be collected, we first reverse any previously established allowance for loan losses and then increase interest income as a prospective yield adjustment over the remaining life of the pool of loans. The impacts of changes in variable interest rates are recognized prospectively as adjustments to interest income. As described above, the process of estimating cash flows expected to be collected has a significant impact on the initial recorded amount of the purchased credit-impaired loans and on subsequent recognition of impairment losses and interest income. Estimating these cash flows requires a significant level of management judgment as certain of the underlying assumptions are highly subjective. For further information regarding our acquired loans, see Note 2 to our Consolidated Financial Statements in this Form 10-K.
FDIC Indemnification Asset
In conjunction with the FDIC-assisted acquisitions of Frontier and Tamalpais, we entered into loss share agreements with the FDIC. The purchase and assumption and loss share agreements have specific compliance, servicing, notification and reporting requirements. Any failure to comply with the requirements of the loss share agreements, or to properly service the loans and OREO covered by any loss share arrangement, may cause individual loans or loan pools to lose their eligibility for loss share payments from the FDIC, potentially resulting in material losses that are currently not anticipated. At the date of the acquisition, we recorded provisional fair value amounts receivable under the loss share agreements as an indemnification asset. Subsequent to the acquisition, the indemnification asset is tied to the losses in the FDIC covered loans and is not being accounted for under fair value. The FDIC indemnification asset is accounted for on the same basis as the related FDIC covered loans and is the present value of the cash flows that we expect to collect from the FDIC under the loss share agreements. The difference between the present value and the undiscounted cash flows that we expect to collect from the FDIC is accreted into noninterest income over the life of the FDIC indemnification asset. The FDIC indemnification asset is adjusted for any changes in expected cash flows based on loan performance. Any increases in cash flows of the loans due to decreases in expected credit losses over those originally expected will lower the accretion rate recorded in noninterest income. Any decreases in cash flows of the loans over those originally expected will increase the FDIC indemnification asset. For further
information regarding our FDIC indemnification asset, see Note 2 to our Consolidated Financial Statements in this Form 10-K.
Valuation of Financial Instruments
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., exit price) in an orderly transaction between market participants at the measurement date. In determining fair value, we utilize valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs reflect market-derived or market-based information obtained from independent sources (e.g., interest rates, yield curves, foreign exchange rates, volatilities and credit curves), while unobservable inputs reflect our estimates of assumptions that would be considered by market participants. Valuation adjustments may be made to ensure the financial instruments are recorded at fair value. These adjustments include amounts that reflect counterparty credit quality and that consider our creditworthiness in determining the fair value of our trading liabilities.
Based on the observability of the inputs used in the valuation, we classify our financial assets and liabilities measured and disclosed at fair value within a three-level hierarchy (i.e., Level 1, Level 2 and Level 3). This hierarchy ranks the quality and reliability of the information used to determine fair values with Level 1 deemed most reliable and Level 3 having at least one significant unobservable input. The degree of management judgment required in measuring fair value increases with the higher level of measurement within the three-level hierarchy.
The following table reflects financial instruments measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009.
For detailed information on our measurement of fair value of financial instruments and our related valuation methodologies, see Note 17 to our Consolidated Financial Statements included in this Form 10-K.
Debt securities available for sale and debt securities held to maturity are subject to impairment testing when a security's fair value is lower than its amortized cost. Debt securities with unrealized losses are considered other-than-temporarily impaired if we intend to sell the security, if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, or if we do not expect to recover the entire amortized cost basis of the security. If we intend to sell the security, or if it is more likely than not that we will be required to sell the security before recovery, an other-than-temporary impairment writedown is recognized in earnings equal to the entire difference between the amortized cost basis and fair value of the debt security. However, even if we do not expect to sell a debt security we must evaluate the expected cash flows to be received and determine if a credit loss exists. In the event of a credit loss, only the amount of impairment associated with the credit loss is recognized in income. Amounts related to factors other than credit losses are recorded in other comprehensive income.
Quarterly, we evaluate our private capital investments for impairment by reviewing the investee's business model, current and projected financial performance, liquidity and overall economic and market conditions. For further information regarding our other-than-temporarily impairment, see Note 3 to our Consolidated Financial Statements in this Form 10-K.
In order to manage the risk of adverse changes in the fair value or cash flows of certain financial instruments (e.g., loans, debt and securities) associated with changes in interest rates, foreign currency exchange rates, or other factors, derivative instruments may be acquired to mitigate such adverse changes that might occur in the future. Most of the derivative instruments acquired for this purpose qualify for hedge accounting treatment under US GAAP.
The determination of whether a hedging relationship qualifies for hedge accounting requires an analysis of whether the hedge is expected to be highly effective at inception and on an ongoing basis. For example, at the end of each reporting period, a retrospective assessment must be made as to whether the hedge was highly effective based on the actual results for that period. When a hedge is designated for a group of similar financial instruments, judgments must be made as to whether the individual items in that group share similar risks and characteristics to be hedged collectively. Hedge accounting is discontinued prospectively if the hedge relationship ends, or it is no longer highly probable that the forecasted transaction will occur. For further information regarding our hedge accounting, see Note 18 to our Consolidated Financial Statements in this Form 10-K.
Our pension obligations and related assets of our defined retirement benefit plan are presented in Note 10 to our Consolidated Financial Statements included in this Form 10-K. Plan assets consist primarily of marketable equity and debt instruments. Plan obligations and the annual benefit expense are estimated by management utilizing actuarially based data and key assumptions. Key assumptions in measuring the plan obligations and determining the pension benefit expense are the discount rate, the rate of compensation increases, and the estimated future return on plan assets. Our discount rate is calculated using a yield curve based on Aa3 or better rated bonds. This yield curve is matched to the anticipated timing of the actuarially determined estimated pension benefit payments to determine the weighted average discount rate. Compensation increase assumptions are based upon historical experience and anticipated future management actions. Asset returns are based upon the anticipated average rate of earnings expected on the invested funds of the plan.
Our net actuarial losses (pretax) increased $68 million in 2010 from 2009. At December 31, 2010, the net actuarial loss totaled $595 million, which included $77 million representing the excess of the fair value of plan assets over the market-related value of plan assets, which is recognized separately through the asset
smoothing method over four years. The remaining $518 million of the net actuarial loss is separated between non-amortizing of $187 million and $331 million subject to amortization over 8.7 years. The cumulative net actuarial loss resulted primarily from differences between expected and actual rate of return on plan assets and the discount rate. Included in our 2011 net periodic pension cost will be $38 million of amortization related to net actuarial losses. We estimate that our total 2011 net periodic pension cost will be approximately $46 million, assuming no contributions in 2011. The primary reasons for the increase in net periodic pension cost for 2011 compared to $9 million in 2010 is the amortization of unrecognized losses and a decrease in the discount rate from 6.25 percent to 5.75 percent, offset by a higher asset base resulting in higher expected return on assets. The 2011 estimate for net periodic pension cost was actuarially determined using a discount rate of 5.75 percent, an expected return on plan assets of 8.00 percent and an expected compensation increase assumption of 4.70 percent.
A 50 basis point increase in the discount rate, expected return on plan assets, or the rate of increase in future compensation levels would increase (decrease) 2011 periodic pension cost by ($17) million, ($9) million, and $4 million, respectively. A 50 basis point decrease in the discount rate, expected return on plan assets, or the rate of increase in future compensation levels would increase (decrease) 2011 periodic pension cost by $19 million, $9 million, and ($4) million, respectively. For further information regarding our pension obligations, see Note 10 to our Consolidated Financial Statements in this Form 10-K.
We review our goodwill for impairment on an annual basis, and whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In testing for a potential impairment of goodwill, we estimate the fair value of goodwill allocated to our designated operating segments and compare this value to the aggregate carrying value of goodwill for those operating units. At December 31, 2010, our goodwill balance was $2.5 billion.
Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions and selecting an appropriate control premium. Additionally, significant judgment is involved in determining if an indicator of impairment has occurred. Such indicators may include: a significant decline in expected future cash flows, a significant adverse change in the business climate, unanticipated competition and/or slower than expected growth rates.
The annual goodwill impairment test as of April 1, 2010 was performed during the second quarter of 2010, and no impairment was recognized.
During the second quarter of 2009, we changed the date of our annual goodwill impairment test from January 1 to April 1. The change was made to more closely align the impairment testing date with the testing date used by BTMU, as we became a wholly-owned subsidiary of BTMU in the fourth quarter of 2008.
The change in goodwill impairment testing date is deemed a change in accounting principle. Management believes that the change in accounting principle will not delay, accelerate, or avoid a goodwill impairment charge. Management determined that the change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively.
Due to the current uncertainties in the economic environment, there can be no assurance that our estimates relating to our recent goodwill impairment testing will prove to be accurate predictions of future circumstances. It is possible that we may be required to record charges relating to goodwill impairment losses in future periods either as a result of our annual impairment testing or upon the occurrence of other triggering events. Changes relating to any such future impairment losses could be material. For further information regarding our annual goodwill impairment analysis, see Note 5 to our Consolidated Financial Statements in this Form 10-K.
UnionBanCal and its subsidiaries are subject to the income tax laws of the U.S., its states, and other jurisdictions where we conduct business. These laws are complex and subject to different interpretations. The calculation of our provision for income taxes and related accruals requires the use of estimates and judgment. Income tax expense includes our estimate of amounts to be reported in our income tax returns, as well as deferred taxes, which arise principally from temporary differences between the period in which certain income and expenses are recognized for financial accounting purposes and the period in which they are reported in our tax returns. Deferred tax assets are evaluated for realization based on the expectation of future events, including the reversal of existing temporary differences and our ability to earn future taxable income.
We provide reserves for unrecognized tax benefits in accordance with the guidance related to accounting for uncertainty in income taxes. In applying the accounting guidance, we consider the relative risks and merits of positions taken in tax returns filed and to be filed, considering statutory, judicial, and regulatory guidance applicable to those positions. The guidance requires us to make assumptions and judgments about potential outcomes that lie outside management's control. To the extent the tax authorities disagree with our conclusions, and depending on the final resolution of those disagreements, our effective tax rate may be materially affected in the period of final settlement with the tax authorities.
The State of California requires us to elect to file our franchise tax returns as a member of a unitary group that includes either all worldwide operations of MUFG (worldwide election) or only U.S. operations of MUFG (water's-edge election). In 2010, we made a water's-edge election for our 2009 California tax return and we have reflected that election in our income tax expense for both 2010 and 2009. However, the election was effective as of April 1, 2009, and therefore, MUFG's worldwide taxable profits were included in our California franchise tax return through March 31, 2009, MUFG's fiscal year-end. Going forward, changes in taxable profits of MUFG's U.S. operations will impact our effective tax rate. Taxable profits of MUFG's U.S. operations are impacted most significantly by changes in the U.S. economy, and decisions that they may make about the timing of the recognition of credit losses or other matters. When taxable profits of MUFG's U.S. operations rise, our effective tax rate in California will rise, and when they decrease, our rate will decrease. We review MUFG's financial information on a quarterly basis in order to determine the rate at which to recognize our California income taxes. However, all of the information relevant to determining the effective California tax rate may not be available until after the end of the period to which the tax relates, primarily due to the difference between our and MUFG's fiscal year-ends. Our California effective tax rate can change during the calendar year or between calendar years as additional information becomes available. If we understate our tax obligations we could be subject to penalties. Recent amendments to California tax law now impose an automatic 20 percent penalty for an understatement of tax in excess of $1 million for any taxable year beginning on or after January 1, 2003 for which the statute of limitations on assessment has not expired. For further information regarding our income taxes, see Note 12 to our Consolidated Financial Statements in this Form 10-K.
The following table shows the major components of net interest income and net interest margin.
Net interest income, on a taxable-equivalent basis, in 2010 increased $174 million, or 8 percent, compared to 2009. Our net interest margin, on a taxable-equivalent basis, in 2010 decreased by 16 basis points to 3.24 percent compared to 2009. These results were primarily due to the following:
Net interest income in 2009, on a taxable-equivalent basis, increased $199 million, or 10 percent, from 2008 and our net interest margin decreased by 36 basis points to 3.40 percent from 2008, partially as a result of a decrease in our interest rate spread (the difference between our earning assets yield and total interest bearing liabilities rate) attributable to a significant growth in lower yielding interest bearing deposits in banks, which was driven by our excess liquidity. These results were primarily due to the following:
The following table shows the changes in the components of net interest income on a taxable-equivalent basis for 2010, 2009 and 2008. The changes in net interest income between periods have been reflected as attributable either to volume or to rate changes. For purposes of this table, changes that are not solely due to volume or rate changes are allocated to rate. Loan fees of $134 million, $101 million and $67 million for the years ended 2010, 2009 and 2008, respectively, are included in this table. Adjustments have not been made for interest received from a prior period.
We recorded a provision for loan losses of $182 million, $1,114 million and $515 million in 2010, 2009 and 2008, respectively. We had a reversal of the provision for losses on off-balance sheet commitments of $14 million in 2010 and recorded a provision for losses on off-balance sheet commitments of $51 million and
$35 million in 2009 and 2008, respectively. The provisions for loan losses and (reversal of) provision for losses on off-balance sheet commitments are charged (credited) to income to bring our total allowance for credit losses to a level deemed appropriate by management based on the factors discussed under "Allowance for credit losses".
The provision decreases in 2010 compared to the previous two years are primarily due to improved credit quality of the loan portfolio, as well as a change in the category mix and a lower projected loss component of our nonaccrual loans in 2010 compared to 2009 and 2008.
The following tables detail our noninterest income and noninterest expense for the years ended December 31, 2010, 2009 and 2008.
nm = not meaningful
The core efficiency ratio, excluding the privatization transaction, is a non-GAAP financial measure that is used by management to measure the efficiency of our operations, focusing on those costs most relevant to our core activities. The following table shows the calculation of this ratio for the years ended December 31, 2010, 2009 and 2008.
The primary contributors to the changes in our noninterest income and noninterest expense for 2010 compared to 2009 are presented below.
The increase in our noninterest income was the result of several factors:
The increase in our noninterest expense was the result of several factors:
The primary contributors to the changes in our noninterest income and noninterest expense for 2009 compared to 2008 are presented below.
The decrease in our noninterest income was due to several factors:
The increase in noninterest expense was due to several factors:
The income tax expense and effective tax rate include both federal and state income taxes. In 2010, the income tax expense was $239 million with an effective tax rate of 30 percent, compared to a benefit of $161 million and an effective tax rate of 71 percent in 2009. The 2010 expense was driven primarily by our pre-tax income, and was favorably affected primarily by tax credits. Our 2010 income tax expense was increased, however, by an adjustment to our unrecognized tax benefits. The income tax benefit in 2009 was driven primarily by our pre-tax loss in addition to the favorable impact of tax credits. The 2009 benefit was slightly reduced by our California franchise tax liability.
The State of California requires us to elect to file our franchise tax returns as a member of a unitary group that includes either all worldwide operations of MUFG (worldwide election) or only U.S. operations of MUFG (water's-edge election). In 2010, we made a water's-edge election for our 2009 California tax return and such election is binding for seven years. We have reflected that election in our income tax expense for both 2010 and 2009. In 2008, the income tax expense was $128 million with an effective tax rate of 31 percent. The 2008 expense was driven primarily by our pre-tax income, and was favorably affected primarily by tax credits. The 2008 state income tax expense reflects the worldwide election in place at that time and, thus, reflects the financial results of MUFG's worldwide operations.
We invest in low income housing credit (LIHC) investments, as well as other credit generating activities. The credits generated by these investments reduced our overall effective tax rate from the statutory rate in 2010, 2009 and 2008.
We continually monitor and evaluate the potential impact of current events and circumstances on the estimates and assumptions used in the analysis of our income tax positions and, accordingly, our effective tax rate may fluctuate in the future. Our evaluation takes into consideration the status of current taxing authorities' examinations of our tax returns. In the course of its examination of our federal tax returns for the years 1998 through 2006, the IRS has disallowed the tax deductions claimed with respect to certain leveraged leasing transactions, referred to as "lease-in/lease-outs" (LILOs). We believe our tax treatment of these LILOs was consistent with applicable tax law, regulations and case law, and we intend to defend our position vigorously. We have paid the balance of tax and interest assessed and have filed a refund suit in the Court of Federal Claims. A trial date has not yet been set.
Accounting for uncertain tax positions establishes a "more-likely-than-not" recognition threshold that must be met before a tax benefit can be recognized in the financial statements. For tax positions that meet the more-likely-than-not threshold, an enterprise should recognize the largest amount of tax benefit that is greater than 50 percent likely of being realized upon final settlement with the taxing authority.
The amounts of unrecognized tax benefits at December 31, 2010, 2009 and 2008 were $233 million, $202 million and $191 million, respectively. Of these amounts, $91 million, $71 million and $64 million, respectively, would affect the effective tax rate, if recognized. Unrecognized tax benefits that do not affect the effective tax rate would result in adjustments to other income tax accounts, primarily deferred taxes. Accrued interest expense on unrecognized tax benefits at December 31, 2010, 2009 and 2008, was none, $1 million and $16 million, respectively. The net changes to unrecognized tax benefits and accrued interest resulted in an increase in our effective tax rate of 3 percent in 2010, a decrease of 4 percent in 2009 and an increase of 4 percent in 2008. The increases in our unrecognized tax benefits in 2010 and 2009 were due to the addition to our reserves for uncertain income tax positions.
For additional information regarding income tax expense, including a reconciliation between the effective tax rate and the statutory tax rate and changes in unrecognized tax benefits, see Note 12 to our Consolidated Financial Statements included in this Form 10-K.
Management of the securities portfolio involves the maximization of return while maintaining prudent levels of quality, market risk and liquidity. At December 31, 2010, approximately 95 percent of our securities, based upon amortized cost, were investment grade. The amortized cost, gross unrealized gains, gross unrealized losses and fair values of securities are detailed in Note 3 to our Consolidated Financial Statements included in this Form 10-K.
Our securities available for sale are recorded at fair value with the change in fair value recognized in accumulated other comprehensive income. Our Asset and Liability Management (ALM) Securities portfolio, which consists of available for sale U.S. Government, state and municipal, and mortgage-backed securities held for ALM purposes, totaled $20.6 billion at December 31, 2010.
Our securities held to maturity consist of collateralized loan obligations (CLO) securities, which are known as Cash Flow CLOs. A Cash Flow CLO is a structured finance product that securitizes a diversified pool of loan assets into multiple classes of notes from the cash flows generated by such loans. Cash Flow CLOs pay the note holders through the receipt of interest and principal repayments from the underlying loans unlike other types of CLOs that pay note holders through the trading and sale of underlying collateral. During the first quarter of 2009, we reclassified our CLOs from available for sale to held to maturity. We consider the held to maturity classification to be more appropriate because we have the ability and the intent to hold these securities to maturity.
Analysis of Securities
The following tables show the remaining contractual maturities and expected yields of the securities based upon amortized cost at December 31, 2010. Equity securities do not have a stated maturity and are included in the Total column only.
Securities Available For Sale