ITEM 1. BUSINESS
Overview
PrivateBancorp, Inc. (“PrivateBancorp” or the “Company” and, together with its consolidated subsidiaries, “we,” “our” or “us”), a Delaware corporation incorporated in 1989, is a Chicago-based bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company is the holding company for The PrivateBank and Trust Company (“PrivateBank” or the “Bank”), an Illinois-chartered bank founded in Chicago in 1991.
Through the Bank, we provide customized business and personal financial services to middle market companies, as well as business owners, executives, entrepreneurs and families in the markets and communities we serve. As of December 31, 2016, we had total assets of $20.1 billion, including total loans of $15.1 billion, total deposits of $16.1 billion and total stockholders’ equity of $1.9 billion and operated out of 36 offices located in 13 states, including 23 full-service banking office locations in four states. Our full-service bank branches are located principally in the greater Chicago metropolitan area, with additional branches in the St. Louis, Milwaukee and Detroit metropolitan areas. We have non-depository commercial banking offices strategically located in major commercial centers to further our reach with our core client base of middle market companies.
Pending Transaction with Canadian Imperial Bank of Commerce
On June 29, 2016, the Company entered into a definitive merger agreement with Canadian Imperial Bank of Commerce (“CIBC”), a Canadian chartered bank, and CIBC Holdco Inc. (“Holdco”), a newly-formed Delaware corporation and a direct, wholly owned subsidiary of CIBC, which contemplates that the Company will merge with and into Holdco, with Holdco surviving the merger. Closing of the transaction remains subject to the receipt of required regulatory and stockholder approvals and other customary closing conditions. Following the merger, the Bank will be headquartered in Chicago, Illinois, retain its Illinois state banking charter and be an indirect, wholly owned subsidiary of CIBC.
If approved by our stockholders, under the terms of the definitive agreement, at the effective time of the merger, shareholders of the Company would have the right to receive $18.80 in cash and 0.3657 of a CIBC common share for each outstanding share of PrivateBancorp common stock. Based on the closing price of CIBC common shares on the NYSE as of February 27, 2017, of $90.04, total consideration for the transaction is valued at approximately $4.1 billion, or $51.73 per share of Company common stock. The actual transaction value would be based on the number of shares of common stock of the Company outstanding at the closing and the price of CIBC common stock as of the closing.
The full text of and additional information about the definitive merger agreement is included in the Company’s Current Report on Form 8-K filed with the Securities Exchange Commission (“SEC”) on July 6, 2016.
Our Vision and Strategy
Our vision is to be the premier commercial bank in the Midwest and profitably and responsibly grow our business while maintaining a strong asset quality profile. Our goal is to develop meaningful long-term full banking relationships with our clients by delivering high-touch service and customized product solutions across our platform. We are a Chicago-based bank that serves commercial clients across the country. Our seasoned banking teams serve our clients through a relationship-based approach to deliver banking and wealth management solutions to meet our clients’ comprehensive needs. Due to our commercial focus and relationship-based model, we currently operate with a significantly smaller branch network than banks of generally comparable size, and we offer commercial banking products, services and expertise that enable us to compete with larger banks for middle market commercial clients.
Our business has transformed and grown significantly over the past decade since we hired a substantial group of senior commercial middle market banking executives, including our CEO, from a large Chicago-based financial institution that, at the time, recently had been acquired by a global money center bank. We initially raised a substantial amount of private equity capital to support growth under the new leadership team and invested in adding a significant number of senior commercial bankers and other professionals needed to support the expected new business. As illustrated by the chart below, over the past decade, we have significantly expanded our business, growing our total loans from $4.2 billion at year end 2007 to $15.1 billion at year end 2016, a compounded annual growth rate of 15% over that period, and successfully transformed from a commercial real estate and construction-focused lender to a more comprehensive commercial bank with approximately two-thirds of our loan portfolio comprised of commercial loans (i.e., commercial and industrial loans and owner-occupied commercial real estate):
In addition to our large commercial banking business, we also have community banking and private wealth capabilities to meet our clients’ comprehensive needs and serve our markets and communities. We place significant emphasis on leveraging our high-touch, relationship-based approach to cross-sell products and value-added services to our clients, such as delivering:
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treasury management services to our commercial borrowers, which generates non-interest fee income and serves as an important source of stable, cost-effective deposits that we use to fund loan growth;
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interest rate and foreign currency risk management solutions to our commercial borrowers through our capital markets business;
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private banking and wealth management services to owners and executives of our commercial clients;
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consulting, advisory, custodial and trustee services to qualified and nonqualified retirement plans sponsored by our commercial clients; and
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personal banking products and residential mortgages to employees of our commercial clients.
Our growth strategy is primarily focused on organic growth across our lines of business and, since implementation of our strategic transformation, most of our growth has been organic and, over the past several years, through reinvesting most of our earnings in our business. In addition to our focus on cross-selling products and services to our existing clients and acquiring new clients through referrals and business development efforts, we have, as part of our organic growth strategy, expanded our business by recruiting experienced banking professionals with specialized industry expertise and relationships. A strategic priority for us, particularly given our limited retail branch network, has been expanding our stable core deposit gathering capabilities and diversifying our overall funding base to continue supporting organic loan growth over the long term. To address this strategic priority, in recent years we have considered various potential strategies to diversify our funding base, including potential acquisitions of retail banking franchises and other business initiatives. In June 2016, we agreed to a strategic combination with CIBC, which would result in us becoming part of a larger, financially strong North American organization and enhancing our sources of diversified, stable funding.
Our Business
We operate Commercial Banking, Community Banking and Private Wealth businesses and seek to generate loans and fee income, gather deposits and cross-sell products and services through each business. At the corporate level, we manage our investment portfolio, hedging activities, funding and liquidity, including the supplementing of deposits generated through our lines of business.
Commercial Banking
Our Commercial Banking business focuses on the specific needs of middle market companies and serves a broad range of industries, such as manufacturing, transportation, wholesale distribution, retail and certain specialty industries discussed below. Our Commercial Banking business also includes our Commercial Real Estate group, which serves the needs of professional real estate investors and developers, and our professionals focusing on specialized industries and products, such as healthcare, finance and insurance, construction and engineering services, security alarm finance and asset-based lending. We primarily target commercial clients with approximately $10 million to $2 billion in annual revenue, although the majority of our clients generate between $20 million and $500 million annually.
Due to our history and presence in Chicago, as well as the long-standing relationships that many of our senior executives and commercial bankers have here, our largest geographic market is the Chicago metropolitan area and surrounding areas in Illinois. Over the past decade, we have expanded our reach beyond Chicago and Illinois by establishing a National Commercial Banking group within our Commercial Banking business and opening several commercial banking offices in major commercial centers to build our brand, diversify our geographical exposure and expand our reach with our core client base. In addition to our bank branches in the Chicago metropolitan areas, we also conduct our banking business through branches in the St. Louis, Milwaukee and Detroit metropolitan areas and through commercial banking offices in Atlanta, Georgia; Cleveland, Ohio; Denver, Colorado; Miami, Florida; Des Moines, Iowa; Grand Rapids, Michigan; Indianapolis, Indiana; Kansas City, Missouri; Minneapolis, Minnesota; Pittsburgh, Pennsylvania; and Stamford, Connecticut. We may open additional commercial banking offices in other major commercial centers in the future to continue expanding our geographic reach and growing our Commercial Banking business.
Our Commercial Banking business also encompasses our Treasury Management, Loan Syndications and Capital Markets groups. A general overview of these groups, as well as the products and services delivered by our Commercial Banking teams, is set forth below.
Commercial Loans. We offer commercial borrowers revolving lines of credit for working capital needs, term loans to finance expansion, acquire inventory or equipment or otherwise support growth, and standby and performance letters of credit to facilitate transactions with trading partners. Included in our commercial loans are loans secured at least in part by non-residential owner-occupied commercial real estate where the cash flows from the borrowers’ business, as opposed to cash flows from the real estate itself, serve as the primary source of loan repayment. Also included within our commercial loans are leveraged loans, which are primarily underwritten on the recurring cash flow and earnings of the borrower, typically to finance leveraged buyouts, add-on acquisitions, recapitalizations and other strategic initiatives, and generally have higher debt-to-earnings ratios compared to other commercial loans.
At December 31, 2016, we had a $9.6 billion commercial loan portfolio, which comprised 64% of our total loan portfolio. We believe our commercial loan portfolio is well diversified among borrowers, industries and geographies. The average note size of our commercial loans is approximately $3.8 million, although given the nature of our business, we also have many significantly larger commercial loan relationships, including some that exceed $25 million.
As part of our Commercial Banking business, our relationship managers also source syndicated lending opportunities arranged by other banks in which we participate in a non-lead capacity, particularly in situations where we have a pre-existing relationship with the borrower and/or its principals or have an opportunity to cross-sell other products and services to them. Of our $15.1 billion in total loans outstanding at December 31, 2016, $3.0 billion, or 20%, were syndicated loans for which we were a non-lead participant; of this $3.0 billion, $2.2 billion were Shared National Credits (“SNCs”), which are loan transactions of at least $20 million that are shared by three or more regulated depository institutions. The SNCs in which we have participated in a non-lead role typically are led by one or more of the global money center banks or large super regional banks.
Commercial Real Estate Loans. We offer professional real estate investors and developers credit solutions for the construction, acquisition, redevelopment and refinancing for major core property types, including office, industrial, retail, multi-family, student housing and for-sale housing. We provide financing opportunities for privately-held, entrepreneurial real estate companies as well as for REITs and other institutional real estate clients. We generally are a short- and medium-term lender for commercial real estate properties. The majority of our investor and developer clients are based within our geographic footprint, although the properties financed for them may be located in other regions. Our commercial real estate specialists are located in the Chicago, Illinois; Atlanta, Georgia; Cleveland, Ohio; Denver, Colorado; Detroit, Michigan; Milwaukee, Wisconsin; Minneapolis, Minnesota; and St. Louis, Missouri markets. At December 31, 2016, we had a $4.1 billion commercial real estate portfolio (exclusive of construction loans) and a $418.0 million construction portfolio, which comprised 27% and 3%, respectively, of our total loan portfolio. The average note size of our commercial real estate loans is approximately $5.4 million, although as noted above, we also have many significantly larger credit relationships in our commercial real estate business.
Specialized Industries and Products. Within our Commercial Banking business, we have several teams of commercial bankers that focus on a particular industry or a specific product offering that can be offered across industries. These specialty banking teams employ relationship managers with relevant industry experience and/or specialized product knowledge in order to provide tailored banking solutions to fit the unique needs of clients in certain industries or offer sophisticated lending products to commercial borrowers. We believe that having banking professionals with expertise in and a focus on specialized industries and products enables us to build stronger relationships with clients and better serve their unique banking needs.
Our largest industry specialty is our healthcare team. We employ experienced healthcare industry professionals who understand the industry’s unique challenges and regulatory framework and the numerous healthcare sub-markets. We have a particular focus on the senior care sector, including independent, assisted living and skilled care/nursing facilities. Lending relationships in this
industry group are primarily with for-profit borrowers and the average size of the credit relationship per borrower tends to be larger compared to our non-specialty commercial lending portfolio. As of December 31, 2016, we had a $2.0 billion healthcare loan portfolio, which represented 21% of our commercial loan portfolio and 13% of our total loan portfolio. We also have professionals specializing in the following industries and products:
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Finance and Insurance Industry - focus on the needs of clients in the finance and insurance industry generally, with particular emphasis on a number of specific industries and product types, such as the following:
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Capital Call Bridge Loans to Private Equity Funds - providing lines of credit to private equity funds secured by limited partner capital commitments, which provide temporary liquidity as a “bridge” to the next investor capital call
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Specialty Finance - providing loans to nonbank specialty finance lenders that provide various types of financing, such as consumer financing, auto financing, equipment financing or other types of asset-based lending
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Financial Institutions - providing depository, cash management and lending products and services to community banks, financial sponsors, hedge funds, asset managers and futures commission merchants (“FCMs”);
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Construction and Engineering Industry - focuses on the needs of engineering firms, construction contractors (general, prime, sub and specialty) and building material suppliers;
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Security Alarm Industry - focuses on companies engaged in providing security and medical alert services;
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Asset-Based Lending - structure and originate lending solutions secured by a specific pool of assets, such as receivables, inventory or equipment, for commercial clients across a variety of industries; and
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Structured Finance - collaborate with our commercial banking relationship managers across a variety of industries to deliver leveraged financial solutions, such as loans underwritten according the quality of the client’s free cash flows, to our commercial clients.
Treasury Management. We have a team of treasury management professionals that work with our commercial banking relationship managers to deliver comprehensive treasury management solutions for our commercial clients to manage their cash and liquidity needs. We offer receivables solutions, such as remote capture and wholesale lockbox services, payables solutions, reporting, reconciliation and data integration solutions and deposit account and investment options for optimizing earnings on excess cash balances.
As a commercial-focused bank, our largest source of deposits is our commercial client base and, accordingly, we actively cross-sell our treasury management products and services to our commercial clients and focus on lending relationships where we believe we have an opportunity to acquire deposits and provide treasury management products and services. We offer our commercial clients an earnings credit rate, which reduces the amount of treasury management fees charged to a client based on the average balance maintained by the client in noninterest-bearing deposit accounts. As of December 31, 2016, approximately 75% of our commercial clients had a treasury management relationship with us. For the year ended December 31, 2016, treasury management was our largest source of non-interest income at $33.9 million, or 23%, of total non-interest income.
Loan Syndications. We have a loan syndications team that generates fee revenue by arranging for other lenders to participate in a loan transaction either at a borrower’s request or in connection with us strategically managing the composition of our loan portfolio to, among other things, mitigate our risk exposure to a single borrower, transaction or industry. In larger lending transactions, we may arrange loans on a best-efforts basis (in which we commit to extend only a portion of the total commitment, pro rata with other lenders, and the borrower obtains the full credit request only if the syndications team arranges sufficient commitments from other lenders or investors) or we may fully underwrite credit facilities (in which we commit to lend the full credit facility to the client and, following the initial closing, syndicate portions of that credit to other lenders). In this way, syndications allow us to structure, and serve as the lead arranger for lending transactions that we may not otherwise be able to participate in, as we are able to reduce our credit exposure to the client relationship and/or decrease loan concentrations by industry, type or size. Serving as the lead for these lending transactions may enhance our ability to retain or acquire the deposit and treasury management relationship and obtain future business from the borrower. In 2016, our syndications team generated $21.0 million, or 14%, of total non-interest income. We syndicate both commercial loans (68% of syndication fees in 2016) and commercial real estate loans (32% of syndication fees in 2016). As of December 31, 2016, of our $15.1 billion in total loans outstanding, we had $2.5 billion of retained balances from syndicated loan transactions for which we serve as the lead or co-lead.
Capital Markets. We have a team of capital markets professionals that work with our commercial banking relationship managers to assist our commercial clients with their risk management objectives by offering a suite of interest rate and foreign currency hedging solutions. Our interest rate management products, such as interest rate swaps, caps, floors, collars and swaptions, assist our borrower clients in protecting themselves from unexpected interest rate movements, achieving predictable debt service payments and balancing their mix of fixed and floating-rate debt. To assist clients with their management of foreign currency
transactions, we offer foreign currency wire transfers and facilitate collection of foreign currency drafts and checks, and to assist with their management of currency fluctuations, we offer foreign exchange forwards, window forwards, swaps and options. We also provide foreign currency risk management services to clients, such as developing foreign exchange policies and providing research. For the year ended December 31, 2016, our capital markets group generated $25.3 million, or 17%, of total non-interest income.
Community Banking
Our Community Banking business serves the personal, residential mortgage and small business banking needs of consumers and small businesses through our bank branches. Our Community Banking business is focused primarily on the Chicago metropolitan area, where most of our bank branches are located.
Retail Banking. Through a network of 23 full-service banking office locations, of which 20 are in Chicago and its surrounding communities, we provide traditional personal banking and investment products and services, including checking, savings and money market deposit accounts, certificates of deposit (“CDs”), health savings accounts, and personal lending products, such as home equity loans and lines of credit, auto loans (primarily for used cars), secured and unsecured loans (often used to fund educational costs or consolidate debt) and overdraft protection loans. We also offer retail deposit products through The Palladian PrivateBank, our online banking portal.
Residential Mortgage Banking. We offer a full range of residential mortgage loans for purchasing or refinancing one- to four-family residential properties, primarily through a correspondent model in which we originate loans for sale in the secondary market based on the underwriting standards of third-party investors and transfer servicing rights together with the sale of the loan. In certain cases, we retain originated mortgage loans for our portfolio, primarily jumbo and nonconforming loans. We currently do not service loans for other entities. We have residential mortgage origination teams in the Chicago, St. Louis, Milwaukee and Detroit markets to serve the residential mortgage needs of the communities in which we have bank branches. As of December 31, 2016, we employed 24 residential mortgage loan originators. During 2016, we originated and sold approximately $485.4 million of first mortgage loans, which generated $15.9 million, or 11%, of total non-interest income.
Small Business Banking. Our small business banking group focuses primarily on businesses with less than $10 million of revenue and their owners, as well as non-profit organizations. This group operates primarily through a Chicago-based team in our network of branch office locations and offers loans, deposits and treasury management products and services similar to those of our Commercial Banking business, but on a smaller scale. Because of the smaller size of businesses served by this group as compared to our Commercial Banking business, small business loans are generally underwritten based in part on the credit of the individual owners. We also are a participating lender in U.S. Small Business Administration loan programs. Consistent with our strategy of cross-selling products and services, we seek to identify opportunities for referring individual owners of our small business clients to our Private Wealth business and its dedicated team of private bankers.
Private Wealth
Our Private Wealth business provides private banking and financial advisory, trustee, and asset management services to high net-worth individuals (generally those with more than $1 million of investable assets) and asset management and retirement plan services to for-profit and not-for-profit corporate/institutional clients. We offer our Private Wealth services mostly in the Chicago market and from our banking offices in the St. Louis, Milwaukee and Detroit markets, where we have full-service Private Wealth teams. Consistent with our relationship-based model and focus on cross-selling products and services to our clients, our Private Wealth business places a particular emphasis on servicing our commercial banking clients and their owners and executives. As of December 31, 2016, approximately 23% of our commercial clients had a relationship with our Private Wealth business. The products and services offered to our Private Wealth clients include the following:
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Private Banking and Financial Advisory - Our private banking team delivers a full range of banking solutions to high net-worth individuals, including deposits, loans and lines of credit for personal, business and investment purposes, such as residential secured loans, lines secured by investment securities and other secured and unsecured lines of credit. We also assist clients with financial planning needs around life events such as retirement or education.
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Trustee Services - Our trust department serves as corporate custodian and/or trustee for a variety of personal trusts and retirement plans and provides other custodial, guardianship/conservatorship and estate administration services. We also offer escrow services for business transactions and legal settlements, qualified intermediary services for tax-deferred real estate transactions and “qualified custodian” services for clients who are holding assets on behalf of their clients.
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Asset Management - Our asset management team provides investment management services to individual and corporate/institutional clients, which involves creating asset allocation strategies for each client’s particular situation while using third-party investment managers to execute these strategies.
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Corporate Retirement Plan Services - Our trust and asset management teams provide consulting, advisory, custodial and trustee (either directed or full/discretionary) services to qualified and nonqualified retirement plans sponsored by our commercial clients.
Custody and escrow services involve safeguarding and administering client assets but do not involve providing investment management services. These assets are considered to be “non-managed” assets under management and administration (“AUMA”) and have a significantly lower fee structure than “managed” AUMA, which are assets for which we provide investment management services. As of December 31, 2016, we had total AUMA of $9.7 billion from which we generated $21.1 million of non-interest income, 89% of which was attributable to managed AUMA.
Deposit Generating Activities
We rely on a relationship-based approach to generate deposits through our Commercial Banking, Community Banking and Private Wealth businesses. Generating core deposits is one of our key strategic objectives for our lines of business, as deposits serve as our primary source of funding for loan growth. Given the commercial focus of our business, a majority of our deposit base is comprised of commercial accounts, which typically have larger average deposit balances than retail accounts. As of December 31, 2016, approximately 70% of our deposits were attributable to accounts managed in our Commercial Banking business, including certain non-traditional commercial deposits discussed below.
An important source of deposits for us are cash sweep programs operated by broker-dealers (“BDs”) with which we have entered into a contract to serve as a program bank. The contracts governing our participation as a program bank have a specified term, set forth the pricing terms for the deposits and generally provide for minimum and maximum deposit levels that the BDs will have with us at any given time. We believe these cash sweep program deposits provide a stable, cost-effective source of funding. The regulatory definition of “brokered deposits,” however, includes any non-proprietary funds deposited, or referred for deposit by a third party. As a result, our cash sweep program deposits are classified for regulatory purposes as brokered deposits. We refer to these and other similar deposits as “non-traditional” brokered deposits to distinguish them from traditional brokered time deposits that are acquired through deposit brokers in the wholesale market.
We also maintain access to a number of wholesale funding sources, including traditional brokered time deposits, which we use, as needed, to supplement our funding sources and manage liquidity. Over the past decade, as part of our strategic plan to transition to a middle market focused commercial bank, we have significantly reduced our reliance on traditional brokered time deposits.
We have a relatively small number of commercial depositors that maintain substantial balances with us (including BDs for which we serve as a cash sweep program bank), resulting in concentrations of large deposits. The table below provides detail on our large deposit relationships, a significant portion of which are financial services-related businesses. The amount of large deposits classified as brokered provided in the table below are primarily cash sweep program deposits.
Large Deposit Relationships
(Dollars in thousands)
For information regarding our deposits, see “Funding and Liquidity Management” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and Note 8 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
Investment and Hedging Activities
We maintain a managed investment securities portfolio intended to provide liquidity, maximize risk-adjusted total return, and provide a means to modify our asset/liability position as deemed appropriate. We invest primarily in collateralized mortgage obligations and residential and commercial mortgage-backed securities issued or guaranteed by U.S. Government agencies or U.S. Government-sponsored enterprises, which totaled 72% of our investment portfolio at December 31, 2016. We also invest in bank-qualified tax-exempt obligations of states and local political subdivisions, which totaled 12% of our investment portfolio at December 31, 2016. We also invest in U.S. Treasury and U.S. agency securities. The investment portfolio is one of the tools we use to manage our net asset/liability position in an attempt to mitigate the interest rate risk sensitivity and characteristics of our loan portfolio. For information regarding our investment portfolio, see “Investment Portfolio Management” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and Note 3 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
We also use interest rate derivatives as part of our asset/liability management strategy to hedge interest rate risk in our primarily floating-rate loan portfolio. These interest rate derivatives essentially convert certain floating-rate commercial loans to fixed-rate in order to reduce the variability in forecasted interest cash flows due to market interest rate changes. Depending on market conditions, we may reduce or expand this program and enter into additional interest rate swaps. For more information regarding our use of these cash flow hedges, and the potential impact on interest income and other non-interest income on our consolidated statements of income, see Note 17 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
Competition
We conduct business in the highly competitive financial services industry, which has been and continues to be impacted by significant and increasing government regulation, increasing technological demands and disruption and the presence of many new non-bank competitors. In particular, there is significant competition among commercial banking institutions in the Chicago market, which continues to be a fragmented market with a large number of banking organizations despite significant consolidation over the past decade, and in the broader Midwestern market in which most of our operations and relationships are located. According to the FDIC’s Summary of Deposits as of June 30, 2016 (the most recent date publicly available), there were 208 banking organizations operating in the Chicago metropolitan statistical area (“MSA”). As of such date, we had the seventh highest deposit market share in the Chicago MSA, and the third highest among banking organizations headquartered in the Chicago MSA, at 3.3%. The three largest banking organizations operating in the Chicago MSA (JPMorgan Chase Bank, NA, BMO Harris Bank, NA and Bank of America, NA) collectively had a 46.0% deposit market share.
We compete for loans, deposits, treasury management, wealth management and other financial products and services with community, regional, national, and international commercial banks, thrifts, credit unions, asset-based non-bank lenders, specialty finance companies, consumer finance companies, commercial and residential mortgage banking companies, investment banks, brokerage firms, investment advisors, and other providers of financial products and services. More specifically, with respect to our Commercial Banking business, because our core client base is middle market companies with $10 million to $2 billion of annual revenue, we generally find ourselves competing primarily with super-regional and national commercial banks, asset-based non-bank lenders and commercial mortgage banking companies. Many of these competitors have substantially greater financial resources, lending limits and larger office and branch networks, and greater access to lower cost deposits and capital, than we do and therefore may be able to compete more effectively on loan pricing or terms and/or offer products and services beyond what we offer. Additionally, the non-bank lenders are not subject to the same degree of regulation as that imposed on banking organizations and often are able to structure and price loans more aggressively than us. While we face pressure on loan structure, pricing and other terms for commercial lending relationships, we focus on lending transactions where we currently have, or believe we have the opportunity to develop, a comprehensive banking relationship with the client.
In all of our businesses, we seek to distinguish ourselves through consistent delivery of superior levels of client service, customized solutions and responsiveness expected by our clients rather than competing on price.
We also face competition in attracting and retaining qualified employees. Our ability to continue to compete effectively will depend upon our ability to attract new employees and retain and motivate existing employees, particularly our relationship bankers.
For more information on competition-related and other risks facing the Company, see “Risk Factors” in Item 1A
ITEM 1A. RISK FACTORS
Our business, financial condition and results of operations are subject to various risks, including those discussed below, which may affect the value of our securities. The risks discussed below are those that we believe are the most significant risks to our business plans and strategies and financial performance, although additional risks not presently known to us or that we currently deem less significant may also adversely affect our business, financial condition and results of operations, perhaps materially. Before making a decision to invest in our securities, you should carefully consider the risks and uncertainties described below and elsewhere in this report.
A significant portion of our loan portfolio is comprised of commercial loans, many of which are larger credit relationships, including some that are leveraged loans. The repayment of such loans is largely dependent upon the financial success and viability of the borrower and the state of the economy.
Our commercial loan portfolio, which includes commercial and industrial loans and owner-occupied commercial real estate loans, totaled $9.6 billion, or 64% of our total loan portfolio, at December 31, 2016. The repayment of the commercial loans is largely dependent upon the financial success and viability of the borrower, which generally is impacted by the state of the overall economy, rather than through the operation or liquidation of the underlying collateral. The collateral securing commercial loans, such as accounts receivable, inventory, equipment and real estate specific to the borrower’s use, may be difficult and costly to liquidate given its often unique nature. As a result, if a commercial loan defaults and we foreclose on the underlying collateral, we may not be able to recover the full principal amount of the loan, which would increase our credit costs.
A portion of our commercial and industrial loans are leveraged loans, which are primarily underwritten on the basis of the recurring earnings of the borrower, and have a higher ratio of debt-to-earnings and lower collateral coverage as compared to commercial and industrial loans not characterized as leveraged. As a result, in the event of a default, the loss potential generally is greater for leveraged loans as compared to more traditional commercial and industrial loans with more collateral coverage.
Over the past few years, the federal bank regulatory agencies have jointly issued updated supervisory guidance, and increased their examination focus, on leveraged lending by regulated institutions due to the significant growth in the volume of leveraged credit issued, developments in how some leveraged loans are structured and their desire to ensure risk management practices in the leveraged loan market keep pace with market developments. A majority of our leveraged loan portfolio are loans that are classified as “higher-risk assets” by the FDIC under its risk-based deposit insurance assessment framework. Refer to Table 13 in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” As we manage our overall risk appetite to adapt to market and economic conditions affecting the leveraged loan market, including reduced demand by the banking industry to participate in syndicated leveraged loan transactions, our future loan growth could be impacted.
Many of our commercial loans involve larger relationships. We had 182 individual credit relationships with credit commitments exceeding $25 million, most of which are commercial loans, which totaled $6.2 billion of commitments and represented $3.6 billion of outstanding loans, or 24% of our loan portfolio, at December 31, 2016. The borrowers in some of these credit relationships may be related to other obligors as guarantors or share related ownership structures. Of our largest commitments, commitments exceeding $50 million represented $916.4 million in total commitments and $336.4 million of outstanding loans at December 31, 2016, compared to $688.3 million in total commitments and $232.1 million of outstanding loans at December 31, 2015. Because of their size relative to our overall loan portfolio, the unexpected occurrence of an adverse event or development affecting one or more of these large client relationships could materially affect our results of operation and financial condition, including by causing quarterly fluctuations in our credit costs and credit quality metrics.
Consistent with our middle market commercial lending focus, we have several industry and product type concentrations within our loan portfolio. These particular industries and product types are subject to specific risks that could adversely affect our business.
Several industry and product type concentrations within our loan portfolio are subject to specific risks that could adversely affect our financial condition and results of operations to the extent they have correlated risk. Some of these portfolio concentrations and their particular risks include the following:
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Healthcare - This is the largest industry classification within our commercial loan portfolio, as 21% of our commercial loan portfolio, or $2.0 billion, at December 31, 2016, consisted of healthcare-related loans. Such loans are comprised primarily of loans secured by skilled nursing and assisted living facilities that are dependent, in part, on the receipt of payments and reimbursements under government contracts for services provided. Accordingly, our clients and their ability to service debt may be adversely impacted by the financial health of state or federal payors and the ability of governmental entities, many of which have experienced budgetary stress in the recent economic environment, to make payments for services previously provided. Additionally, across the healthcare industry, structural changes to the government reimbursement model may negatively impact performance for managed care facilities as borrowers adapt to these changes, which could impact their ability to service debt. As of December 31, 2016, 53% of the healthcare portfolio was secured by facilities in five states, with Illinois representing the highest percentage of facilities at 23%.
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Manufacturing - This is the second largest industry classification within our commercial loan portfolio, with 19% of our commercial loan portfolio, or $1.8 billion, at December 31, 2016 consisting of loans to borrowers whose primary business activity was manufacturing. During the second half of 2015 and into 2016, the U.S. manufacturing sector experienced a significant slowdown, as evidenced by declines or slowing rates of growth in a number of key indicators, due in part to
the economic headwinds of lower commodity prices (including oil and gas prices) and a strong U.S. dollar, with particular stress faced by durable goods manufacturing. Although the U.S. manufacturing sector began to rebound toward the end of 2016, the sector’s performance may continue to experience volatility due to the impact of commodity prices, currency exchange rates, possible U.S. corporate tax reform, U.S. political developments and broader geopolitical developments on this sector. Any stress or volatility experienced by the U.S. manufacturing sector specifically could adversely impact our existing loan portfolio and/or our future loan growth rate.
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Commercial Real Estate - In addition to our large commercial loan portfolio, we have a significant commercial real estate portfolio, with $4.1 billion of commercial real estate loans (excluding construction loans) as of December 31, 2016, representing 27% of our total loan portfolio. The commercial real estate industry has exhibited strong performance over the past several years, but significant new development volume in recent years, particularly in certain asset classes such as multifamily, could place pressure on rents and vacancy rates, which could adversely impact borrowers’ ability to service debt. Additionally, although commercial real estate values, and the net operating income generated by them, are influenced by the overall health of the U.S. economy, they also can be significantly impacted by other factors such as market interest rates, excess capacity or lack of supply of comparable properties in the particular market and global geopolitical events given the importance of foreign investor participation in U.S. real estate markets. If the value of commercial real estate were to decline materially due to the foregoing or other factors, a significant portion of our commercial real estate loan portfolio could become under-collateralized. If our commercial real estate loans were to become troubled during a time of depressed commercial real estate values, we may not be able to realize the value of the collateral that we anticipated at the time of originating the loan, which could increase our credit costs and have a material adverse effect on our financial condition and results of operations.
The success of our business is dependent on ongoing access to sufficient and stable, cost-effective sources of liquidity.
Our primary sources of funding are deposits and, to a lesser extent, Federal Home Loan Bank (“FHLB”) borrowings. We rely on these funding sources to provide sufficient liquidity to support our loan growth on a cost-effective basis while accommodating the transaction and cash management needs of our clients. Our deposit base is primarily comprised of commercial clients and institutional depositors and relatively concentrated in large relationships, with our ten largest deposit relationships comprising 15% of total deposits at December 31, 2016. At year end 2016, we had 31 client relationships with greater than $75 million in deposit balances, which totaled $4.4 billion, or 27%, of total deposits. The unanticipated loss of one or more large deposit relationships, or significant movements in large deposit accounts, could stress our liquidity and possibly require us to utilize higher cost contingency funding sources. A majority of our large deposit relationships of $75 million or more come from financial services clients, such as securities broker-dealers for which we serve as a cash sweep program bank, hedge funds and fund administrators and futures commission merchants. Financial services clients have a higher propensity to generate large transactional flows, which contributes to liquidity risk, and some of these deposits, particularly from hedge funds, fund administrators and futures commission merchants, may exhibit elevated volatility and be more sensitive to financial stress as compared to other commercial deposits due to the more complex liquidity and cash flow needs of financial services clients given the nature of their businesses. Additionally, large commercial deposits may be more sensitive to interest rate increases as compared to smaller retail deposits, which could cause our deposit costs to increase more quickly in a rising rate environment than if we had a larger retail deposit base. Since the U.S. presidential election in November 2016, market expectations about future interest rate increases have changed significantly and the Federal Reserve increased the federal funds target rate by 25 basis points in December 2016. If market interest rates continue to increase, we could experience more competition for deposits, as money market funds and other liquid fixed income alternatives could become more attractive to commercial depositors relative to bank deposits. In such case, our net interest margin could be negatively impacted if we must pay more to continue attracting sufficient commercial deposits to fund our growth and/or increase our reliance on wholesale funding sources, such as FHLB borrowings. Furthermore, if we were to experience increased challenges in attracting and maintaining stable, cost-effective sources of liquidity, we may need to moderate our loan growth to adhere to prudent risk management objectives.
As of December 31, 2016, we had outstanding borrowings from the FHLB of $1.6 billion. Because we rely on FHLB borrowings to supplement our deposits, if we were unable to borrow additional amounts from the FHLB because of insufficient eligible collateral or other conditions, we would need to supplement our deposits with an alternate source of funds, which could increase our cost of funding and may not match our funding needs as well as FHLB borrowings.
The importance of stable sources of funding is heightened for a predominantly commercial banking business because of unfunded commitments extended to commercial clients. Our total unfunded commitments to extend credit, including obligations to issue letters of credit, were $6.8 billion as of December 31, 2016. Given the large size of many of our credit relationships, significant draws on outstanding commitments by a few clients may adversely impact our liquidity and require us to utilize higher cost contingency funding.
A prolonged period of economic uncertainty or a downturn in economic conditions, in the U.S. or globally, could have a material adverse effect on our financial condition and results of operations.
Banking, and the financial industry in general, is reliant on the strength of the broader economy. Although the U.S. economy has experienced gradual improvement since the depths of the last recession in 2009, including significant improvement in the unemployment rate, there continue to be economic headwinds from muted GDP growth, limited wage growth, low inflation, and a strong U.S. dollar. Market conditions are also impacted by continued uncertainty related to U.S. and European fiscal issues, a slowdown in economic growth in China, the U.S. political climate at the national and local levels and the new U.S. Presidential administration, future U.S. corporate tax policy, global economic conditions and geopolitical tensions. In addition, the financial condition of the State of Illinois and the City of Chicago (higher corporate tax rates, significant budget deficits, large unfunded pension obligations and a deteriorating credit rating), where we do the majority of our business, may contribute to an adverse climate for doing business in the state and city, which could negatively impact us to the extent it leads to declines in business activity in Illinois and the greater Chicago metropolitan area. Although we do not hold direct obligations of the State of Illinois, such conditions can also negatively affect the market value of those municipal bonds that are obligations of municipalities domiciled in Illinois. The foregoing uncertainties could result in, among other things, a deterioration of credit quality, impairment of real estate and other collateral values or reduced demand for credit or other products and services we offer to clients, which could materially adversely affect our financial condition and results of operations.
Our allowance for loan losses may be insufficient to absorb losses in our loan portfolio.
Every loan we make carries a certain risk of non-payment. This risk is affected by, among other things:
•
the credit risks posed by the particular borrower and loan type;
•
the duration and structure of the loan;
•
in the case of a collateralized loan, the changes and uncertainties as to the future value of the collateral;
•
the ability to identify potential repayment issues in loans at an early stage; and
•
changes in economic and industry conditions.
We maintain an allowance for loan losses at a level management believes is sufficient to absorb credit losses inherent in our loan portfolio. The allowance for loan losses is assessed quarterly and represents an accounting estimate of probable losses in the portfolio at each balance sheet date based on a review of available and relevant information at that time. We determine the allowance using our historical default and loss information, current risk ratings for our loans and certain qualitative factors that are assessed by management. The application of qualitative factors, in particular, requires a significant amount of management judgment. We may incur aggregate losses on our loan portfolio that exceed, perhaps by a significant amount, the $185.8 million that we have reserved in the allowance at December 31, 2016, particularly if economic conditions were to materially worsen.
Because the predominantly commercial nature of our loan portfolio results in us having a greater number of larger credit relationships than many other banks of a generally comparable size, as evidenced by the fact that 24% of our loan portfolio at December 31, 2016 was comprised of credit relationships in amounts exceeding $25 million, adverse developments with respect to even a small number of credit relationships could lead to a significant increase in our allowance for loan losses and related provision expense in a given period. The occurrence of an adverse rating migration for one or more large loans, particularly a leveraged loan, could require a meaningful increase in our allowance for loan losses and related provision expense under our allowance methodology. In light of the foregoing, we may experience significant variability in our quarterly provision expense and charge-offs and overall credit quality trends.
We may be adversely affected by the failure of interest rates to meaningfully increase from their prolonged historically low levels.
Our operating results are largely dependent on our net interest income, which is the difference between the interest income earned on earning assets, primarily loans and investment securities, and the interest expense paid on deposits and borrowings. The spread between the yield on our interest-earning assets and our overall cost of funds has been compressed in the prolonged low interest rate environment, with our ability to increase contractual loan yields limited by continued strong competition in the lending market. Because we price loans primarily on a variable-rate basis (generally to LIBOR), we believe our balance sheet is well-positioned to benefit from a rising interest rate environment. However, it is more difficult to predict the impact of a rising interest rate environment on our cost of funds, as funding costs are significantly dependent on a number of factors outside of our control, such as client deposit behavior and deposit pricing pressure from competitors. Interest rates are affected by numerous factors, including monetary policy of the Federal Reserve and expectations regarding the same, and future interest rate levels are inherently difficult
to predict. Although the Federal Reserve increased by the target federal funds rate by 25 basis points in December 2015 and again in December 2016, market interest rates still remain near historically low levels. There can be no assurances as to when or if the Federal Reserve will continue to raise interest rates or the extent to which our net interest income will benefit if such increases occur.
Over the past several years, the Federal Reserve implemented various significant economic strategies that impacted interest rates, inflation, and the shape of the yield curve and future actions or strategies could further impact such conditions, which could adversely affect our operating results.
Over the past several years, the Federal Reserve implemented a series of domestic monetary policy initiatives in response to economic conditions, including the purchase of U.S. treasury securities and mortgage-backed securities (commonly known as “quantitative easing” (“QE”)). Among other things, QE strategies were intended to create or maintain a low interest rate environment and stimulate economic activity, and have theoretically caused interest rates to remain lower than they would have been without such involvement. The Federal Reserve formally ended the QE program during the fourth quarter of 2014, but market interest rates nevertheless remain highly dependent on actions of the Federal Reserve and market participants’ expectations about such actions. As discussed above, our net interest income is significantly dependent on the level of market interest rates given their impact on loan yields and deposit costs. More generally, market interest rates also influence many other elements of our business, such as asset management fees (as interest rates impact equity and fixed income values, which drive such fees), mortgage banking revenue (as interest rates impact the demand for mortgages and gains on sales to the secondary market), capital markets revenue (as interest rates, and expectations about future direction, impact client demand for interest rate derivatives and foreign currency volatility), syndication fees (as interest rates impact pricing and demand for syndicated loans), loan growth (as interest rates can impact the overall economy and, as a result, demand for new credit) and gains, losses and yields on our investment securities portfolio. Accordingly, actions by the Federal Reserve and market expectations about potential actions could adversely affect our operating results, including by creating volatility in such results.
Our business could be significantly impacted if we, or our third party service providers, suffer failure, cyber-attack or disruptions of information systems, our employees cause an operational failure or our clients suffer losses due to fraudulent or negligent acts by their employees or third parties in connection with their banking transactions.
We rely heavily on communications, data processing and other information processing systems to conduct and support our business, many of which are provided through third-parties. If our third party providers encounter difficulties or become the source of an attack on or breach of their operational systems, data or infrastructure, or if we have difficulty communicating with any such third party system, our business operations could suffer. Any failure or disruption to our systems, or those of a third party provider, could impede our transaction processing, service delivery, customer relationship management, data processing, financial reporting or risk management. Our computer systems, software and networks, and those of our third party providers, may be vulnerable to unauthorized access, loss or destruction of data (including confidential client information), account takeovers, unavailability of service, computer viruses, denial of service attacks, malicious social engineering or other malicious code, or cyber-attacks that circumvent our prevention measures or are beyond what we can reasonably anticipate, and such events could result in material loss. Additionally, we could suffer disruptions to our systems or damage to our network infrastructure from events that are wholly or partially beyond our control, such as electrical or telecommunications outages, natural disasters, widespread health emergencies or pandemics, or events arising from local or larger scale political events, including terrorist acts. Furthermore, in light of rapid technological advancements, we must continually mature our cybersecurity risk management program to address emerging risks. If significant failure, interruption or security breaches do occur in our processing systems or those of our third party providers, we could suffer significant damage to our reputation, a loss of customer business, additional regulatory scrutiny, or exposure to civil litigation, additional costs and possible financial liability.
Due the nature of our business, we regularly process transfers of large amounts of money to and from our clients’ accounts. To do so, we are dependent on the actions of our employees and instructions from our clients and, therefore, we are exposed to operational and fraud risks. We could be materially adversely affected from a financial or reputational perspective if our employees cause a significant operational failure that leads to significant client loss. Additionally, if our clients are victim to operational failure or fraud by their own employees or third parties relating to their accounts with us, we could suffer reputational harm and loss of business even if we have no liability for such failure or fraud.
The loss of one or more key employees or lending teams may adversely affect our business.
We are a relationship-driven organization. Our continued growth and development is dependent in large part upon the efforts of our key relationship managers who have primary contact with our clients and responsibility for maintaining personalized relationships with our client base. These personalized relationships are a key aspect of our business strategy. The loss of one or more of these key employees, or a lending team, could have a material adverse effect on our business if we are unable to hire
suitable replacements or we are unable to successfully retain the client relationships of departing employees. Uncertainty about the effect of the pending CIBC merger, or about the timing of closing the merger, could impact our ability to retain key employees during the pendency of the merger.
We have counterparty risk; the creditworthiness of other financial institutions could expose us to losses on contracts we have with these institutions and adversely affect our ability to provide services to our clients, specifically products and services relating to foreign exchange, interest rate derivatives and letters of credit.
Our ability to provide certain products and services could be adversely affected by the actions and financial health of other banks. Banks are interrelated as a result of lending, clearing, correspondent, counterparty and other relationships. As a result, defaults by, or even rumors or questions about, one or more banks, or the banking industry generally, have in the past led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of the transactions engaged in by us in the ordinary course of business, particularly in our capital markets group, expose us to credit risk in the event of default of a financial institution counterparty. While we hold collateral in most such transactions, collateral may be insufficient to mitigate our losses, as we may be unable to realize or liquidate at prices sufficient to recover the full amount of our exposure. Such losses could have a material and adverse effect on our financial condition and results of operations.
Our capital markets group offers to clients a range of foreign exchange and interest rate derivatives products. Although we do not engage in any proprietary trading and we structure these client-generated trading activities to mitigate our exposure to market risk, we remain exposed to various risks, the most significant of which is counterparty risk, which may be most significant in foreign exchange transactions where timing differences between settlement centers can result in us paying the counterparty before actually receiving the funds. In addition, for swaps we execute with counterparties to mitigate the market risk of our customer trades, we may be required to post collateral to secure our obligations related to those trades; if such a counterparty invokes the protection of insolvency laws, then the collateral posted to secure our obligations to that counterparty may be trapped with, and potentially subject to claims of creditors of, that counterparty.
We are highly regulated and may be adversely affected by a failure to comply with banking laws, regulations and regulatory expectations or changes in such laws, regulations and regulatory expectations.
We, like all banking organizations, are subject to extensive supervision, regulation and examination. This regulatory structure gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies to address not only compliance with applicable laws and regulations (including laws and regulations governing consumer protection, fair lending, privacy, information security and anti-money laundering and anti-terrorism laws), but also capital adequacy, asset quality, risk management, management ability and performance, earnings, liquidity, and various other factors. Under this structure, the regulatory agencies have broad discretion to impose restrictions and limitations on our operations if they determine, among other things, that our operations are unsafe or unsound, fail to comply with applicable law or regulations or are otherwise inconsistent with regulatory expectations or with the supervisory policies of these agencies. This supervisory framework could materially impact the conduct, growth and profitability of our operations. For example, regulatory scrutiny of compliance with consumer lending and protection laws and regulations has increased significantly over the past several years since the creation of the CFPB following enactment of the Dodd-Frank Act, particularly with respect to “unfair, deceptive or abusive” acts or practices and alleged fair lending violations. A failure by us to comply with applicable laws and regulations or expectations of our regulators (including the CFPB) relating to safe and sound banking or compliance practices could result in regulatory sanctions, civil money penalties or other adverse actions against us, which in turn could increase our compliance burden and costs of doing business, restrict our ability to expand our business or result in damage to our reputation.
Changes in laws, regulations and other regulatory requirements affecting the financial services industry, and the effects of such changes, are difficult to predict and may have unintended consequences. New regulations or changes in the regulatory environment could limit the types of financial services and products we may offer, the demand for existing products and services, and/or increase the ability of non-banks to offer competing financial services and products, among other things. We may incur increased costs related to additional staffing, professional services and information technology resources to support compliance or data collection and data analytics to satisfy evolving expectations for enhanced risk and liquidity management processes and new regulatory reporting requirements.
Since the U.S. federal elections in November 2016, there has been significant discussion about future financial regulatory reform. For example, in February 2017, President Trump issued an executive order calling for the U.S. Treasury Secretary to consult with the federal banking agencies and deliver a report on how existing financial regulation aligns with core principles articulated in the order to guide regulatory reform. Additionally, the Financial CHOICE Act has been introduced in the House Financial Services Committee, which would make intricate changes to the Dodd-Frank Act, such as provide a Dodd-Frank off-ramp for highly-rated banking organizations that satisfy a heightened leverage ratio requirement, repeal the Volcker Rule and Durbin Amendment, revamp
the CFPB and eliminate or substantially modify the federal banking agencies’ authority to exercise extraordinary powers in financial crises. At this time, it is uncertain whether or to what extent the executive order or proposed legislation such as the Financial CHOICE Act will result in any material changes to current financial industry laws and regulations and, if so, to what extent such changes would impact the Company, or the competitive landscape in the banking and broader financial services industry.
Changes in taxes and other assessments may significantly impact us and our clients.
The legislatures and administrations in the U.S. and state and local tax jurisdictions in which we operate regularly enact reforms to the tax and other assessment regimes to which we and our clients are subject. Such reforms include changes in the rate of assessments and, occasionally, enactment of temporary taxes. Any change in tax law, such as proposed changes to the statutory U.S. federal corporate income tax rate that has been discussed by Congress and the new U.S. Presidential administration, the current tax depreciation system and the deductibility of interest expense, or any other change made in connection with any comprehensive U.S. federal tax reform, may affect our tax position and the tax position and financial performance of our clients. The effects of these changes and any other changes that result from enactment of potential tax reforms cannot be quantified and there can be no assurance that any such reforms would not have an adverse effect upon our financial performance or our business, in part due to the impact on our clients. For example, if U.S. federal tax reform included a reduction in the deductibility of interest expense, that could impact the cash flow of our borrowers. Although a reduction in the statutory U.S. federal corporate rate may lower our tax provision expense in future periods, it may also significantly decrease the value of our deferred tax asset which would result in a reduction of net income in the period in which the tax change is enacted.
Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.
We conduct business in the highly competitive financial services industry, which has been and continues to be impacted by significant and increasing government regulation, increasing technological demands and disruption and the presence of many new non-bank competitors. Our future success will depend on our ability to compete effectively in this environment. With respect to our Commercial Banking business, we compete primarily with super-regional and national commercial banks, asset-based non-bank lenders and commercial mortgage banking companies. Many of these competitors have substantially greater financial resources, lending limits and larger office and branch networks, and greater access to lower cost deposits and capital, than we do and therefore may be able to compete more effectively on loan pricing or terms and/or offer products and services beyond what we offer. In recent years, in which credit costs and interest rates have been low, we have experienced significant competitive pressure in pricing and structuring loans in certain of our loan segments. Because we generate earnings primarily from the difference between the interest earned on loans and the interest we pay on deposits, this pricing pressure has impacted, and is expected to continue impacting, our margins.
Remaining competitive will require ongoing investments in technology to satisfy expectations of our clients, enhance service delivery, support new products and services and efficiently grow our business. Additionally, increasing our retail deposit gathering capabilities in a competitive environment may require significant investments by us, such as by enhancing digital strategies, opening new branches or acquiring retail deposit franchises, which also could impact our results of operations.
Risk Factors Related to the Merger
We will be subject to business uncertainties and contractual restrictions while the merger is pending, which could adversely affect our business.
Uncertainty about the effect of the merger on our employees and clients may have an adverse effect on the Company and, consequently, the surviving corporation. These uncertainties may impair our ability to attract, retain and motivate key personnel until the merger is completed, and could cause clients and others that deal with us to seek to change our existing business relationships. Retention of certain employees may be challenging during the pendency of the merger, as certain employees may experience uncertainty about their future roles. If key employees depart because of issues relating to uncertainty about the timing of closing the merger, the uncertainty and difficulty of integration or a desire not to remain with the business, our business prior to the merger (and CIBC’s business following the merger) could be negatively impacted. In addition, until the merger occurs, the merger agreement restricts us from making certain acquisitions or entering into new lines of business, entering into or modifying material contracts and taking other specified actions without the consent of CIBC. These restrictions may prevent or delay us from pursuing attractive business opportunities that may arise prior to the completion of the merger. The merger agreement also restricts us from increasing our dividend prior to the merger.
The merger agreement may be terminated in accordance with its terms and the merger may not be completed.
The merger agreement is subject to a number of conditions that must be fulfilled in order to complete the merger. Those conditions include, among others, the approval of the merger proposal by our stockholders, the receipt of all required regulatory approvals (which include approvals of the Office of the Superintendent of Financial Institutions (Canada), the Federal Reserve Board and the Illinois Department of Financial and Professional Regulation) and expiration or termination of all statutory waiting periods in respect thereof, the accuracy of representations and warranties under the merger agreement (subject to the materiality standards set forth in the merger agreement), CIBC’s and the Company’s performance of their respective obligations under the merger agreement in all material respects and each of CIBC’s and the Company’s receipt of a tax opinion to the effect that the merger will be treated as a “reorganization” within the meaning of Section 368(a) of the Code. These conditions to the closing of the merger may not be fulfilled in a timely manner or at all and, accordingly, the merger may be delayed or may not be completed.
In addition, if the merger is not completed by June 29, 2017, either CIBC or the Company may choose not to proceed with the merger, and the parties can mutually decide to terminate the merger agreement at any time, before or after our stockholder approval has been obtained. In addition, CIBC and the Company may elect to terminate the merger agreement in certain other circumstances. If the merger agreement is terminated under certain circumstances, we may be required to pay a termination fee of $150 million to CIBC.
Failure to complete the merger at all, or a material delay in completing the merger, could negatively impact our stock price and future business and financial results.
If the merger is not completed for any reason, including as a result of our stockholders declining to approve the merger agreement or the failure of the parties to obtain the required regulatory approvals, or if we and CIBC experience a material delay in completing the merger, our stock price and ongoing business may be adversely affected. In such case, we would be subject to a number of risks, including the following:
•
we may experience negative reactions from the financial markets;
•
our stock price, as well as the prices for our publicly-traded debt securities, could be materially impacted due to changing expectations from market participants about the timing or likelihood of completion of the merger and our future prospects;
•
we may experience negative reactions from our clients, employees and/or vendors, and if there is a material delay in completing the merger, we may find it more challenging to retain our clients and key employees due to the perceived uncertainty about the transaction;
•
we will have incurred substantial transaction-related expenses and will be required to pay certain costs relating to the merger, whether or not the merger is completed;
•
the merger agreement places certain restrictions on the conduct of our businesses prior to completion of the merger and such restrictions (the waiver of which is subject to the reasonable consent of CIBC) may prevent or delay us from making certain acquisitions or entering into new lines of business, entering into or modifying material contracts and taking other specified actions without the consent of CIBC during the pendency of the merger;
•
matters relating to the merger (including integration planning) require substantial commitments of time and resources by our management, which would otherwise have been devoted to other opportunities that may have been beneficial to us as an independent company; and
•
during the pendency of the merger, our stock price is likely to be impacted by factors affecting CIBC’s ongoing business, prospects and stock price because a majority of the merger consideration is in the form of CIBC common shares; the longer period of time that the merger is pending, the more our stockholders (including employee stockholders) may be exposed to fluctuations in the price of CIBC common shares, which could have an adverse impact on our business.
In addition to the above risks, if the merger agreement is terminated and our board of directors seeks another merger or business combination, our stockholders cannot be certain that we will be able to find a party willing to offer equivalent or more attractive consideration than the consideration CIBC has agreed to provide in the merger.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
The executive offices of PrivateBancorp are located in downtown Chicago, Illinois at 120 South LaSalle Street. This building which houses a majority of our general corporate functions is leased from an unaffiliated third party. We conduct our business primarily through the Bank at 23 full-service banking office locations in the greater Chicago, Detroit, Milwaukee, and St. Louis metropolitan areas. We also have business development offices located in Colorado, Connecticut, Florida, Georgia, Indiana, Iowa, Michigan, Minnesota, Missouri, Ohio and Pennsylvania. With the exception of 11 offices that are owned by us, all other facilities are leased from unaffiliated third parties. At certain Bank locations, excess space is leased to third parties.
We also own 30 automated teller machines (“ATMs”) primarily located at our banking facilities.
We believe our facilities in the aggregate are suitable and adequate to operate our banking and related business. Additional information with respect to premises, equipment and lease arrangements is presented in Note 6 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Following the announcement of the proposed transaction with CIBC, three putative class actions were filed on behalf of our public stockholders in the Circuit Court of Cook County, Chicago, Illinois. The three actions have been consolidated and styled In re PrivateBancorp, Inc. Shareholder Litigation, 2016-CH-08949. All of the actions name as defendants the Company and each of its directors individually, and assert that the directors breached their fiduciary duties in connection with the proposed transaction. Two of the complaints are also brought against CIBC and assert that the Company and CIBC aided and abetted the directors’ alleged breaches. The actions broadly allege that the transaction was the result of a flawed process, that the price is unfair, and that certain provisions of the merger agreement might dissuade a potential suitor from making a competing offer, among other things. The plaintiffs subsequently filed an amended complaint, adding a claim alleging breaches of the fiduciary duty of disclosure by the directors. Plaintiffs seek injunctive and other relief, including damages. The plaintiffs in the three actions have agreed in principle not to pursue the actions as a result of the inclusion of certain additional disclosures in the proxy statement for the Company’s special meeting of stockholders. The defendants, including the Company, believe the demands and complaints are without merit and there are substantial legal and factual defenses to the claims asserted, and the proxy statement for the special meeting disclosed all material information prior to the inclusion of the additional disclosures.
As of December 31, 2016, and in the ordinary course of business, there were various other legal proceedings pending against the Company and our subsidiaries that are incidental to our regular business operations. Management does not believe that the outcome of any of these proceedings will have, individually or in the aggregate, a material adverse effect on our business, results of operations, financial condition or cash flows.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY,
RELATED STOCKHOLDER MATTERS, AND
ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is traded under the symbol “PVTB” on the NASDAQ Global Select Market. As of February 27, 2017, we had approximately 438 stockholders of record. The following table sets forth the high and low intraday sales prices and quarter-end closing price of our common stock, dividends declared per share, dividend yield and book value per share during each quarter of 2016 and 2015. As of February 27, 2017, the closing market price of our common stock was $56.93 per share.
(1)
Ratios are presented on an annualized basis.
Payment of future dividends is within the discretion of the Board and will depend on the capital adequacy of the Company and the Bank. The Board does not have any current plans to increase future dividends, as our current strategy is focused on retaining capital to support growth in our balance sheet. The Board evaluates dividends on a quarterly basis and may adjust those plans from time to time; however, the merger agreement that we have entered into with CIBC restricts us from increasing our dividend prior to the merger without the prior consent of CIBC, which we would not expect to receive. A discussion regarding the restrictions applicable to our ability and the ability of the Bank to pay dividends to us is included in the “Bank Holding Company Regulation- Dividends” and “Bank Regulation-Dividends” sections of “Supervision and Regulation” in Item 1 and Note 16 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
Stock Performance Graph
The graph and table below illustrate, over a five-year period, the cumulative total return (defined as stock price appreciation plus dividends) to stockholders from an investment in our common stock against a published industry total return equity index and broad-market total return equity index. The published industry total return equity indices used in this comparison are the Center for Research in Security Prices index for NASDAQ Bank Stocks and the S&P Regional Banking Industry Index, and the broad-market total return equity index used in this comparison is the Russell 2000 Index. In 2017, we changed our published industry total return equity index from the NASDAQ Bank Index to the S&P Regional Banking Index. The S&P Regional Banking Index further aligns us with other banks of a relatively similar size.
Comparison of Five-Year Cumulative Total Return Among
PrivateBancorp, Inc., the NASDAQ Bank Index, and the Russell 2000 Index (1)
(1)
Assumes $100 invested on December 31, 2011 in PrivateBancorp’s common stock, the NASDAQ Bank Index, the Russell 2000 Index, and the S&P Regional Banking Industry Index with the reinvestment of all related dividends.
To the extent this Form 10-K is incorporated by reference into any other filing by us under the Securities Act of 1933 or the Securities Exchange Act of 1934, the foregoing “Stock Performance Graph” will not be deemed incorporated, unless specifically provided otherwise in such filing and shall not otherwise be deemed filed under such Acts.
Issuer Purchases of Equity Securities
The following table summarizes the Company’s monthly common stock purchases during the quarter ended December 31, 2016, which were made solely in connection with the administration of employee share-based compensation plans for employees. Under the terms of these plans, we accept shares of common stock from plan participants if they elect to surrender previously-owned shares upon exercise of options to cover the exercise price or, in the case of both restricted shares of common stock or stock options, the withholding of shares to satisfy tax withholding obligations associated with the vesting of restricted shares or exercise of stock options.
Issuer Purchases of Equity Securities
Unregistered Sales of Equity Securities
None.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Consolidated financial information reflecting a summary of our operating results and financial condition for each of the five years in the period ended December 31, 2016 is presented in the following table. This summary should be read in conjunction with the consolidated financial statements and accompanying notes included elsewhere in this Form 10-K. A more detailed discussion and analysis of the factors affecting our operating results and financial condition is presented in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.
(1)
Computed as total non-interest income less net securities gains (losses) and loss on early extinguishment of debt.
(2)
This is a non-U.S. GAAP financial measure. Refer to Table 25 of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K for a reconciliation from non-U.S. GAAP to U.S. GAAP.
(3)
Excludes covered assets.
(4)
Computed as total equity less preferred stock, goodwill, and other intangible assets divided by outstanding shares of common stock at end of year.
(5)
Computed as non-interest expense divided by the sum of net interest income on a tax equivalent basis (assuming a federal income tax rate of 35%) and non-interest income.
(6)
Effective January 1, 2015, the common equity Tier 1 ratio became a required regulatory capital measure and is calculated in accordance with the new capital rules. Refer to Table 25, “Non-U.S. GAAP Financial Measures” for a reconciliation from non-U.S. GAAP to U.S. GAAP for periods prior to 2015.
(7)
Computed as tangible common equity divided by tangible assets, where tangible common equity equals total equity less preferred stock, goodwill, and other intangible assets and tangible assets equals total assets less goodwill and other intangible assets.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion and analysis highlights the significant factors affecting our consolidated statements of income for the years ended 2016, 2015, and 2014 and consolidated statements of financial condition as of December 31, 2016 and 2015. When we use the terms “PrivateBancorp,” the “Company,” “we,” “us,” and “our,” we mean PrivateBancorp, Inc. and its consolidated subsidiaries. When we use the term “the Bank,” we are referring to our wholly-owned banking subsidiary, The PrivateBank and Trust Company. The following discussion should be read in conjunction with the consolidated financial statements, accompanying notes thereto, and other financial information presented in this Form 10-K.
Unless otherwise stated, all earnings per share data included in this section and through the remainder of this discussion are presented on a diluted basis.
PENDING TRANSACTION WITH CANADIAN IMPERIAL BANK OF COMMERCE
On June 29, 2016, the Company entered into a definitive merger agreement with Canadian Imperial Bank of Commerce (“CIBC”), a Canadian chartered bank, and CIBC Holdco Inc. (“Holdco”), a newly-formed Delaware corporation and a direct, wholly owned subsidiary of CIBC, which contemplates that the Company will merge with and into Holdco, with Holdco surviving the merger. Closing of the transaction remains subject to the receipt of required regulatory and stockholder approvals and other customary closing conditions. Following the merger, the Bank will be headquartered in Chicago, Illinois, retain its Illinois state banking charter and be an indirect, wholly owned subsidiary of CIBC.
OVERVIEW
For 2016, net income available to common stockholders was $208.4 million, increasing $23.0 million, or 12%, from 2015. Diluted earnings per share were $2.57 for 2016, an increase of 11% compared to $2.32 per diluted share for 2015. Results for the current year included $6.7 million of transaction-related expenses related to the pending merger with CIBC, which reduced earnings per share by $0.05 on an after-tax basis. Our return on average assets of 1.13% for 2016 was consistent with the prior year, and our return on average common equity was 11.4%, compared to 11.6% for 2015.
Net interest income increased by $68.0 million, or 13%, compared to 2015, reflecting higher interest income from $1.9 billion of growth in average interest-earning assets and the impact from a rise in short-term rates. Net interest margin was 3.30% for 2016, increasing four basis points from the prior year, primarily due to increased loan yields and the benefit from continued growth in noninterest-bearing funds in a higher rate environment, offset in part by increased costs for interest-bearing funds.
Non-interest income for the current year was $147.8 million, a 14% increase from 2015, with growth in all major fee categories, excluding deposit service charges and fees and other income as 2015 included a $4.1 million gain on the sale of our Georgia branch. As a result of the growth in net interest income and non-interest income, net revenue increased $86.3 million from 2015. Non-interest expense increased 12% from prior year, primarily due to higher salary and employee benefit expense, professional services and technology costs.
Growth in earning assets continued to benefit operating profit, which increased 15% from $315.5 million for 2015 to $362.5 million for 2016. The efficiency ratio was 50.7% for the year ended December 31, 2016 and included the impact of the $6.7 million in transaction-related expenses, compared to 51.4% for the year ended December 31, 2015.
Total loans grew $1.8 billion, or 13%, to $15.1 billion at December 31, 2016, primarily driven by growth in commercial and industrial and commercial real estate (“CRE”) loans. Total commercial loans and CRE loans comprised 64% and 27%, respectively, of total loans at December 31, 2016, compared to 65% and 25%, respectively, at December 31, 2015.
Asset quality remained strong, with nonperforming loans representing 0.56% of total loans at December 31, 2016, compared to 0.41% at December 31, 2015. The provision for loan losses, excluding covered assets, increased to $34.0 million in 2016 from $14.7 million in 2015, reflecting the impact of $1.8 billion in loan growth and some credit migration during the year. The provision for loan loss will fluctuate from period to period depending on the level of loan growth and unevenness in credit quality due to the size of individual credits. At December 31, 2016, our allowance for loan losses as a percentage of total loans was 1.23%, compared to 1.21% at December 31, 2015. The ratio of net charge-offs to average loans outstanding for the year was 0.06% for
2016, relatively consistent with 2015. Nonperforming assets to total assets were 0.47% at December 31, 2016, compared to 0.35% at December 31, 2015.
Total deposits increased $1.7 billion, or 12%, from December 31, 2015 to $16.1 billion, primarily due to increases in noninterest-bearing and interest-bearing demand deposits and money market deposits. Noninterest-bearing demand deposits represented 32% of total deposits at December 31, 2016, up from 30% at the prior year end. Our deposit base is predominately comprised of commercial client balances, which will fluctuate from time to time based on our clients’ business and liquidity needs. During 2016, deposit funding was supplemented with short-term borrowings, which increased by $1.2 billion from December 31, 2015. The loan-to-deposit ratio was 93.7% at December 31, 2016, compared to 92.5% at the prior year end.
Please refer to the remaining sections of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for greater discussion of the various components of our 2016 performance, statement of financial condition, and liquidity.
RESULTS OF OPERATIONS
The profitability of our operations depends on our net interest income, provision for loan and covered loan losses, non-interest income, and non-interest expense. Net interest income is dependent on the amount of and yields earned on interest-earning assets as compared to the amount of and rates paid on interest-bearing liabilities. Net interest income is sensitive to changes in market rates of interest as well as to the execution of our asset/liability management strategy. The provision for loan and covered loan losses is primarily affected by changes in the loan portfolio’s composition and performance, the identification of nonperforming loans and management’s assessment of the collectability of the loan portfolio, based on historical loss experience as well as current economic and market factors. Non-interest income consists primarily of fee revenue from asset management, mortgage banking, capital markets products, syndications, treasury management, loan and credit-related fees, and other services charges and fees. Net securities gains/losses, if any, are also included in non-interest income.
Net Interest Income
Net interest income is the primary source of the Company’s revenue. Net interest income is the difference between interest income and fees earned on interest-earning assets, such as loans and investments, and interest expense incurred on interest-bearing liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is affected by (1) the volume, pricing, mix and maturity of earning assets and interest-bearing liabilities; (2) the volume and value of noninterest-bearing sources of funds, such as noninterest-bearing deposits and equity; (3) the use of derivative instruments to manage interest rate risk; (4) the sensitivity of the balance sheet to fluctuations in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities, and repricing frequencies; (5) loan repayment behavior, which affects timing of recognition of certain loan fees as well as penalties; and (6) asset quality.
Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on interest-earning assets and the rate paid for interest-bearing liabilities that fund those assets. Net interest margin is expressed as the percentage of net interest income to average interest-earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds, principally noninterest-bearing demand deposits and equity, also support interest-earning assets.
The accounting policies underlying the recognition of interest income on loans, securities, and other interest-earning assets are included in Note 1 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
For purposes of this discussion, net interest income and any ratios or metrics that include net interest income as a component, such as net interest margin, have been adjusted to a fully tax-equivalent basis to more appropriately compare the returns on certain tax-exempt securities to those on taxable securities, assuming a federal income tax rate of 35%. The effect of the tax-equivalent adjustment is presented at the bottom of the following table.
Table 1 summarizes the changes in our average interest-earning assets and interest-bearing liabilities as well as the average interest rates earned and paid on these assets and liabilities, respectively, for the three years ended December 31, 2016. The table also presents the trend in net interest margin on a quarterly basis for 2016 and 2015, including the tax-equivalent yields on interest-earning assets and rates paid on interest-bearing liabilities. In addition, Table 2 details variances in income and expense for each of the major categories of interest-earning assets and interest-bearing liabilities and indicates the extent to which such variances are attributable to volume versus yield/rate changes.
Table 1
Net Interest Income and Margin Analysis
(Dollars in thousands)
(footnotes on following page)
Quarterly Net Interest Margin Trend
(1)
Interest income included $31.1 million, $31.0 million, and $26.4 million in net loan fees for the years ended December 31, 2016, 2015, and 2014, respectively.
(2)
Interest income and yields are presented on a tax-equivalent basis, assuming a federal income tax rate of 35%. This is a non-U.S. GAAP measure. Refer to Table 25, “Non-U.S. GAAP Financial Measures,” for a reconciliation of the effect of the tax-equivalent adjustment.
(3)
Includes loans held-for-sale and nonaccrual loans. Average loans on a nonaccrual basis for the recognition of interest income totaled $71.3 million for 2016, $57.9 million for 2015, and $82.7 million for 2014. Interest foregone on impaired loans was estimated to be approximately $3.0 million for the year ended December 31, 2016, $2.3 million for 2015 and $3.2 million for 2014, calculated based on the average loan portfolio yield for the respective period.
(4)
Covered interest-earning assets consist of loans acquired through a Federal Deposit Insurance Corporation (“FDIC”) assisted transaction that are subject to a loss share agreement and the related indemnification asset. Refer to the section below entitled “Covered Assets” for a detailed discussion.
(5)
2014 includes deposits held-for sale.
Table 2
Changes in Net Interest Income Applicable to Volumes and Interest Rates (1)
(Amounts in thousands)
(1)
For purposes of this table, changes which are not due solely to volume changes or rate changes are allocated to such categories in proportion to the absolute amounts of the change in each.
(2)
Interest income is presented on a tax-equivalent basis, assuming a federal income tax rate of 35%. Refer to Table 25, “Non-U.S. GAAP Financial Measures,” for a reconciliation of the effect of the tax-equivalent adjustment.
(3)
Covered interest-earning assets consist of loans acquired through a FDIC assisted transaction that are subject to a loss share agreement and the related indemnification asset. Refer to the section entitled “Covered Assets” for a detailed discussion.
Net Interest Income - 2016 compared to 2015
Net interest income on a tax-equivalent basis increased by $68.5 million, or 13%, to $587.3 million for the year ended December 31, 2016, compared to $518.7 million for the prior year. Tax-equivalent interest income increased by $83.3 million from 2015, largely driven by $1.4 billion in average loan growth, which contributed $58.5 million to interest income on a comparative basis. The impact of higher short-term interest rates on our largely variable rate loan portfolio primarily drove a $15.6 million increase to interest income compared to the prior year. Securities interest income on a tax-equivalent basis grew $8.8 million from 2015, primarily due to growth in the portfolio, while security yields continued to compress in the low rate environment. Interest expense increased by $14.8 million from 2015, largely related to higher deposit costs of $11.5 million, reflecting deposits indexed to a higher Fed Funds effective rate, higher rates paid on certain money market accounts, and growth in average interest-bearing deposits of $387.9 million. Interest expense on short-term borrowings increased by $2.8 million from the prior year, reflecting higher average short-term FHLB advances and repurchase agreement balances during 2016.
Average interest-earning assets growth of $1.9 billion from the prior year was primarily driven by higher average loan balances of $1.4 billion, with $642.0 million of the growth related to commercial and industrial loans and $711.4 million in CRE and construction loans. In addition, average securities balances increased by $532.5 million from 2015. Average interest-bearing liabilities grew $857.5 million from the prior year, reflecting $387.9 million in higher average deposit balances, as well as $529.3 million in higher average short-term and secured borrowings, due to an increased use of short-term FHLB advances and, to a lesser extent, repurchase agreements during 2016.
Net interest margin was 3.30% for 2016, compared to 3.26% for 2015. The yield on interest-earning assets increased by seven basis points from the prior year. Overall loan yields increased by 11 basis points from 2015, as improvements related to higher short-term rates were partially offset by continued pricing reductions resulting from the competitive environment and a lower contribution from our hedging program. Our overall loan yields continue to be aided by our hedging program, although at a reduced level as compared to 2015 due to higher short-term rates and a decline in the notional value of the active hedge program. Compared to 2015, loan fees were relatively unchanged at $31.1 million for 2016. Excluding the impact from loan fees, hedging, and movement in LIBOR, loan yields have continued to compress in the current environment. The yield on our securities portfolio declined 12 basis points from the prior year, reflecting accelerated prepayment speeds and reduced yields on securities purchased in the low rate environment.
Our cost of funds for 2016 increased by eight basis points from 2015, driven primarily by higher rates paid on deposits. Deposit costs increased by ten basis points from the prior year, reflecting the repricing of deposits tied to a higher Fed funds effective rate, as well as higher rates paid on certain money market accounts. Deposits tied to the Fed funds effective rate totaled $1.6 billion at December 31, 2016. Average noninterest-bearing deposits and average equity, our principal sources of net noninterest-bearing funds, increased in aggregate by $1.0 billion from 2015, adding five basis points of value to net interest margin due to higher volume and the increased value of noninterest-bearing liabilities in a higher rate environment.
In the prolonged low interest rate environment, competition remains strong, which has influenced loan pricing and structure. As a result, we have experienced a general decline in our loan yields due to pricing compression on new loans, including within certain of our specialty businesses, and, to a lesser extent, on loan renewals in the current environment. Future loan yields may be impacted by fluctuations in loan fees driven by acceleration of unamortized origination fees upon early payoff or refinancing, and prepayment and other fees received on certain event-driven actions in accordance with the loan agreement, as well as interest income recognized upon recovery of interest on nonaccrual loans. Approximately 70 percent of the loan portfolio at year end was tied to one-month LIBOR, which was 77 basis points at December 31, 2016, compared to 43 basis points a year ago and 53 basis points at September 30, 2016, with most of the fourth quarter increase occurring in December. An additional 16 percent of our loan portfolio is tied to prime, which increased in mid-December. The interest rate moves during December 2016 are expected to be more impactful to loan yields during the first quarter 2017, as a meaningful portion of our variable loan portfolio reprices toward the beginning of the month.
To the extent short-term interest rates continue to rise, the impact on deposit costs for our indexed deposits has greater predictability than our non-indexed deposits. Deposit costs will depend on various factors including client behavior, pricing pressure within the bank marketplace and from non-bank alternatives, the mix of our funding sources, and prices for alternative sources of deposits and funds. Depending on the pace and rate of future increases in deposit costs, net interest margin could be impacted.
Net Interest Income - 2015 compared to 2014
Net interest margin was 3.26% for 2015, compared to 3.22% for 2014, as the improvements in cost of funds from the $75.0 million partial redemption of our 10% Debentures in October 2014 more than offset lower loan and securities yields. Although contractual loan yields declined by four basis points from the prior year period, overall loan yields benefited from our hedging program, specialty lending activity, and higher loan fees. The eight basis point decrease in cost of funds for the year was driven primarily by interest savings from the partial redemption of 10% Debentures and, to a lesser extent, reduced borrowing costs from lower short-term FHLB yields in 2015 compared to 2014. Deposit costs increased one basis point from the prior year period. Average noninterest-bearing deposits and average equity, our principal sources of net noninterest-bearing funds, increased in aggregate by $804.6 million from 2014, but the low interest rate environment during the period reduced their value within the net interest margin, decreasing two basis points from 2014 to 2015.
Non-interest Income
Non-interest income is derived from a number of sources including fees from our various commercial products and services such as the sale of derivative products through our capital markets group, treasury management services, lending and servicing and syndication activities, our asset management business, our mortgage banking business and deposit services to our retail clients.
The following table presents a break-out of these multiple sources of revenue for the years ended December 31, 2016, 2015 and 2014.
Table 3
Non-Interest Income Analysis
(Dollars in thousands)
(1)
Year ended December 31, 2015 includes $4.1 million gain on sale of our Georgia branch completed in January 2015.
(2)
Year ended December 31, 2015 includes $466,000 of other-than-temporary impairment (“OTTI”) loss.
Non-interest Income - 2016 compared to 2015
Non-interest income for 2016 totaled $147.8 million, increasing $17.7 million, or 14%, from 2015. All fee revenue categories increased on a comparative basis, except deposits service charges and fees and other income as 2015 included a $4.1 million gain on the sale of our Georgia branch. Certain income sources, such as mortgage banking, capital markets products, and syndication fees, are transactional in nature and are significantly impacted by market forces (e.g., interest rates have a significant impact on mortgage banking volume and interest rate derivative products), and accordingly, tend to generate uneven income from period to period.
Assets under management and administration (“AUMA”) are impacted by the general performance in equity and fixed income markets. The pricing on asset management accounts varies depending on the type of services provided. Custody and escrow services involve safeguarding and administering client assets but do not involve investment management services. These assets are considered to be “non-managed” AUMA and have a significantly lower fee structure than “managed” AUMA. Managed AUMA are assets for which we provide investment management services, and fees from these assets are generally based on the market value of the assets on the last day of the prior quarter or month, which subject these fees to market volatility.
Asset management fee income increased $3.2 million, or 18%, from 2015, primarily related to fees earned from the addition of a single $2.4 billion corporate trust account (shown below in custody assets) during the first quarter 2015, growth in personal managed assets of 9%, and to a lesser extent, price adjustments on certain managed asset accounts. Funds in the large corporate trust account were gradually disbursed or redeployed over the course of 2016, with the account expected to be fully disbursed or redeployed by the end of 2017. Accordingly, the related contribution to our asset management fee income declined throughout 2016 and will continue to decline in 2017. Aggregate AUMA was $9.7 billion at December 31, 2016, growing $2.4 billion, or 33%, from the prior year, largely attributed to the previously mentioned sizeable corporate trust account, a large corporate retirement account added during second quarter 2016, and growth in personal managed assets.
The following table presents the composition of AUMA, as of the dates shown.
(1)
December 31, 2016 included a corporate trust account of $791.6 million for which we serve as a trustee but do not provide investment management services.
Income from our mortgage banking business, which includes gains on loans sold and certain mortgage related loan fees, grew $1.8 million, or 13%, from 2015, driven by a higher volume of loans sold and improved spreads compared to the prior year. We sold $485.4 million of mortgage loans in the secondary marked in 2016, generating a net gain of $12.2 million, compared to $470.9 million of mortgage loans sold in 2015, generating a net gain of $10.7 million. Higher amounts of mortgage loans sold related to both refinance and new home purchases in 2016 exceeded prior year levels.
The following table presents the composition of capital markets income as of the dates shown.
Capital markets products income was $25.3 million for 2016, increasing $6.8 million from 2015. Included in capital markets products income for 2016 was a $1.1 million positive CVA compared to a negative CVA of $373,000 for 2015. The CVA represents the credit component of fair value with regard to both client-based derivatives and the related matched derivatives with interbank dealer counterparties. Exclusive of CVA, capital markets products income increased by $5.3 million, or 28%, compared to 2015, reflecting higher average deal sizes, longer maturities, and higher spreads for interest rate contracts, partially offset by somewhat lower revenue in foreign exchange (“FX”) transactions as a result of spread compression. FX transactions generally provide a more stable source of fee income compared to the transactional nature of interest rate contracts, which are significantly influenced by clients’ views on the extent and timing of future interest rate movements. As shown in the table above, over the past three years, fees from interest rate contracts have fluctuated period to period due to both volume and size of transactions. Increased opportunities in the client interest rate derivatives business are expected in 2017 as a result of the meaningful interest rate movements in the fourth quarter 2016 and changing expectations about the timing and extent of future interest rate movements.
Treasury management income increased $3.3 million, or 11%, from 2015, reflecting higher volume across our treasury management platforms and ongoing success in cross-selling treasury management services to new commercial clients, partially offset by some price adjustments on certain services. We continue to build client relationships, with approximately 75% of our commercial clients using treasury management services at December 31, 2016. Cross-sell and implementation of treasury management services may lag the closing of a credit facility by three to six months on average. In a rising rate environment, growth in treasury management fees may be impacted as increases in the earnings credit rate allows clients to pay for more services with the same balances.
Loan, letter of credit and commitment fees increased $695,000, or 3%, from 2015, driven by a $1.1 million, or 11%, increase in unused commitment fees, partially offset by lower standby letter of credit fees. The majority of our unused commitment fees related to revolving credit facilities, which at December 31, 2016 totaled $11.0 billion, of which $6.1 billion were unused. In comparison, at December 31, 2015, commitments related to revolving credit facilities totaled $9.7 billion, of which $5.2 billion were unused.
Syndication fees of $21.0 million for 2016 grew $3.8 million from the prior year. The current year included two transactions which contributed $2.9 million of revenue in aggregate. During 2016, we were the lead or co-lead in 118 syndicated loan transactions, totaling $3.2 billion in commitments, while retaining $1.2 billion in commitments. In 2015, we were the lead or co-lead in 85 syndicated loan transactions, totaling $2.3 billion in commitments, while retaining $1.0 billion in commitments. Syndication fees per transaction typically vary depending on, among other factors, market conditions and the size and structure of the transaction, so the aggregate level of syndication fees earned by us in a given period is not entirely correlated with our volume of syndications and our syndication fees will fluctuate from period to period. While we generally expect increased syndication opportunities as we grow our loan portfolio and client relationships, our volume of syndication transactions depends on a number of factors, including portfolio management decisions, the mix of loans originated, and liquidity and demand by other institutions for syndicated loans. We believe that a number of macroeconomic conditions, such as declining commodity prices, and regulatory developments, such as enhanced regulatory focus on leveraged lending and CRE concentrations, have impacted market demand for syndicated loans, which could reduce our level of syndication fees in future periods.
Deposit services charges and fees and other income declined $2.1 million from 2015. Prior year results included a $4.1 million gain on branch sale in the prior year. Current year results included $2.9 million in gains on sale of several problem loans.
Non-interest Income - 2015 compared to 2014
Non-interest income for 2015 was $130.0 million, increasing $12.4 million, or 11%, compared to 2014, reflecting growth in all categories except syndication fees. Other income for 2015 included a $4.1 million gain on branch sale.
Asset management fee revenue increased $690,000, or 4%, from 2014, reflecting fees from new business added over the past year. We grew AUMA $645.1 million, or 10%, from year end 2014 to year end 2015, primarily attributable to continued client acquisition and cross-selling asset management services to our commercial client base. The largest growth (both from a dollar and percentage perspective) during this period came from corporate and institutional managed accounts, which generate proportionately higher fees than custody assets but lower fees than personal managed accounts.
Income from our mortgage banking business increased $3.8 million, or 37%, from 2014. The increase resulted from a higher volume of loans originated and sold reflecting lower long-term interest rates, favorable conditions in the housing market, and higher spreads for 2015 compared to 2014. During 2015, we sold $470.9 million of mortgage loans in the secondary market, generating gains of $11.6 million, compared to $359.6 million of mortgages loans sold in 2014, generating gains of $10.2 million.
Capital markets products income increased $483,000 from 2014 and included a $373,000 negative CVA compared to a negative CVA of $46,000 for 2014. Exclusive of CVA, capital markets income increased $810,000, or 4%, from 2014, reflecting increased transactions and growth in FX transactions, partially offset by a change in the mix of interest rate contracts to lower yielding products.
Treasury management income increased $3.2 million, or 12%, from 2014, primarily due to higher volume across our treasury management platforms. The increase from 2014 reflected the ongoing success in cross-selling treasury management services to new commercial clients as we continue to build client relationships.
Loan and credit-related fees increased $1.3 million, or 7%, from 2014, largely due to an increase in unused commitment fees and standby letter of credit fees. The majority of our unused commitment fees related to revolving facilities, which at December 31, 2015 totaled $9.7 billion, of which $5.2 billion were unused. In comparison, at December 31, 2014, commitments related to revolving facilities totaled $8.8 billion, of which $4.8 billion were unused. The growth in commitments related to revolving facilities over the year reflected new client relationships added since December 31, 2014.
Syndication fees were $17.2 million for 2015, decreasing $2.3 million from 2014. Syndication fees tend to fluctuate period to period depending on market conditions, loan origination trends, and portfolio management decisions.
Non-interest Expense
Table 4
Non-Interest Expense Analysis
(Dollars in thousands)
Note:
Certain reclassifications have been made to prior period amounts to conform to the current period presentation.
n/m
Not meaningful
(1)
Computed as non-interest expense, less non-interest income, divided by average total assets.
(2)
Computed as non-interest expense divided by the sum of net interest income on a tax equivalent basis and non-interest income. The efficiency ratio is presented on a tax-equivalent basis, assuming a federal income tax rate of 35%. Refer to Table 25, “Non-U.S. GAAP Financial Measures,” for a reconciliation of the effect of the tax-equivalent adjustment.
Non-interest Expense - 2016 compared to 2015
Non-interest expense increased $39.2 million, or 12%, compared to the prior year, primarily reflecting higher compensation, professional services, and technology expenses. Included in non-interest expense for 2016 were $6.7 million of transaction-related expenses associated with the pending merger with CIBC that were largely reflected in professional services expense.
Compensation expense, which is comprised of salaries and wages, share-based costs, incentive compensation, and payroll taxes, insurance, and retirement costs, increased $22.8 million, or 11%, from 2015. Salary and wages were up $10.5 million, or 9%, compared to the prior year, primarily reflecting a larger FTE base compared to December 31, 2015 and annual compensation and promotion adjustments. Share-based costs increased $1.9 million, or 10%, largely attributable to a higher volume of awards granted during first quarter 2016 that met a shortened expense recognition period related to certain retirement provisions and a higher level of annual awards granted. Incentive compensation and commissions increased $9.8 million, or 19%, from 2015, reflecting improved performance resulting in higher incentive compensation and commissions on a higher FTE base. Consistent with prior years, due in part to the start of a new year for payroll tax purposes and the payroll taxes associated with incentive compensation payments (most of which are paid in the first quarter of each year), we expect first quarter 2017 compensation expense to be seasonally higher compared to fourth quarter 2016. First quarter 2017 compensation expense will be impacted by the timing of expense recognition for the equity awards we granted in February 2017. The terms of these awards differed from prior year annual equity grants as contemplated by the terms of the CIBC merger agreement, which will result in a greater portion of the share-based expense being recognized at the time of grant rather than over the vesting period. We estimate that first quarter 2017 share-based costs will increase by approximately $8.5 million to $15.0 million, compared to first quarter 2016, with a most of this increase attributable to the changed award terms.
Technology and related costs increased $5.0 million, or 26%, from 2015 and included higher costs to third party service providers and amortization costs related to several larger projects as we continue investing in our business.
Marketing expense increased $1.4 million, or 9%, from the prior year, reflecting higher costs associated with sponsorships, contributions, and client development activities.
Professional services expense, which includes fees paid for legal services in connection with corporate activities, accounting, and consulting services, increased $7.6 million from 2015, primarily related to the transaction-related expenses mentioned above.
Insurance costs increased $1.8 million, or 13%, from 2015, primarily related to larger FDIC deposit insurance premiums in 2016, reflecting overall asset growth and, to a lesser extent, an increase in the rate paid due to changes in the overall composition of our balance sheet.
Other operating expenses increased $2.4 million, or 15%, from the prior year period. Other expenses include bank charges, costs associated with the CDARS® deposit product offering, intangible asset amortization, education-related costs, subscriptions, provision for unfunded commitments, and miscellaneous losses and expenses. The increase was attributable to higher subscriptions and dues, internal travel costs in connection with the pending CIBC merger and included a $5.4 million provision for unfunded commitments in 2016, compared to $519,000 release of reserve for unfunded commitments in 2015. These increases were partially offset by positive market value adjustments and gain on sale on various non-marketable investments, including partnership interests in various CRA investments and non-mortgage loans held-for-sale.
Our efficiency ratio was 50.7% for 2016, improving from 51.4% for 2015, as top-line revenue growth out-paced increases in operating costs during the current year. We expect some contribution to revenue in 2017 from the early January 2017 repricing of a larger portion of our floating-rate loan portfolio in response to interest rate moves during December 2016, which would positively impact our efficiency ratio.
Non-interest Expense - 2015 compared to 2014
Non-interest expense increased by $21.2 million, or 7%, from 2014, reflecting higher compensation, marketing, and insurance expenses. This was partially offset by a decrease in net foreclosed property expense, a release in the provision for unfunded commitments, and lower operating expenses.
Compensation expense increased by $22.8 million, or 13%, from 2014, due to increased incentive compensation accruals based on improved performance, additions to staff to support our growing business, and annual compensation adjustments. Salary and wages were up $7.4 million, or 7%, from the prior year primarily due to additional FTEs, as well as annual compensation adjustments. Share-based costs increased $3.3 million, or 21%, largely attributable to changes made to the retirement provisions of certain performance awards and a higher level of awards granted in 2015. Incentive compensation and commissions increased by $9.1
million, or 21%, compared to 2014, due to improved performance resulting in higher mortgage banking commissions and incentive compensation plan expense. Payroll taxes and insurance costs were up $3.1 million, or 15%, from the prior year reflecting a higher compensation base and greater healthcare insurance costs in 2015 as compared to 2014.
Marketing expense increased $2.7 million, or 20%, from 2014, as a result of our continued client development activities and increased advertising and branding investments.
Net foreclosed property expense, which includes write-downs on foreclosed properties, gains and losses on sales of foreclosed properties, taxes, and other expenses associated with the maintenance of foreclosed real estate (“OREO”), declined $4.5 million, or 52%, from 2014. OREO writedowns totaled $2.4 million in 2015, declining $4.1 million from 2014. In addition, property ownership costs, such as property management and real estate taxes, were down $1.3 million from 2014 as the population of OREO declined from $17.4 million at December 31, 2014 to $7.3 million at December 31, 2015.
Insurance expense increased $1.5 million, or 12%, from 2014, primarily due to higher FDIC deposit insurance in 2015 related to overall asset growth, and to a lesser extent, an increase in the rate paid as a result of changes in the overall composition of our balance sheet.
Loan and collection expense, which consists of certain non-reimbursable costs associated with loan origination and servicing and loan remediation costs for problem and nonperforming loans, increased $1.8 million, or 26%, from 2014. The increase was primarily due to increased mortgage origination costs related to a higher volume of mortgage loans sold compared to the prior year, along with problem loan resolutions on two specific credits during 2015.
Other operating expenses decreased $6.0 million, or 27%, from 2014, primarily reflecting a $522,000 release of reserves for unfunded commitments during 2015 related to specific credits previously reserved, compared to a $3.2 million provision recorded in 2014 largely related to $1.1 billion growth in commitments. Also included in other expenses during 2014 was $1.6 million of office relocation costs related to the Kansas City office space.
Income Taxes
Our provision for income taxes includes both federal and state income tax expense. An analysis of the provision for income taxes and the effective income tax rates for the periods 2016 through 2014 are presented in the following table.
Table 5
Income Tax Provision Analysis
(Dollars in thousands)
Generally, our effective income tax rate varies from the statutory federal income tax rate of 35% principally due to state income taxes, the effects of tax-exempt earnings from municipal securities and bank-owned life insurance, the effects of equity compensation, business expenses and tax credits.
The decline in our effective tax rate in 2016 compared to 2015 is attributable to larger levels of tax credits in 2016 and the $3.7 million impact of the early adoption of tax accounting changes for share-based payments in 2016.
Net deferred tax assets are included in other assets in the accompanying consolidated statements of financial condition and totaled $128.8 million at December 31, 2016, consisting of gross deferred tax assets of $138.5 million offset by gross deferred tax liabilities of $9.7 million.
We have concluded that it is more likely than not that the deferred tax assets will be realized and, accordingly, no valuation allowance was recorded as of December 31, 2016. This conclusion was based on the Company’s recent earnings history, on both a book and tax basis, and our outlook for earnings and taxable income in future periods. Proposed legislation that would reduce the U.S. statutory corporate income tax rate would likely result in a reduction in the carrying value of our deferred tax assets, the
significance of which would be dependent on the degree of reduction in the tax rate. The charge to earnings would be recorded in the period of enactment. However, we would benefit from increased earnings in periods where the lower tax rate is applied to pre-tax profits.
Taxable income in prior years and reversing deferred taxable temporary differences provide sources from which deferred tax assets may be absorbed. Additionally, we have relied on our expectation of generating pre-tax earnings in future periods, which should give rise to taxable income levels, exclusive of reversing temporary differences, that more likely than not will be sufficient to absorb the deferred tax assets.
Operating Segments Results
We have three primary business segments: Banking, Asset Management, and Holding Company Activities.
Banking
The Banking operating segment is comprised of commercial and personal banking services. Commercial banking services are primarily provided to corporations and other business clients and include a wide array of lending and cash management products. Personal banking services offered to individuals, professionals, and entrepreneurs include direct lending and depository services.
Our Banking segment is the Company’s most significant segment, representing 89% of our consolidated total assets and generating nearly all of our net income. The profitability of our Banking segment is dependent on net interest income, provision for loan and covered loan losses, non-interest income (exclusive of asset management fees), and non-interest expense. The net income for the Banking segment for the year ended December 31, 2016 was $228.9 million, a $26.0 million increase from net income of $202.9 million for the year ended December 31, 2015. The increase in net income for the Banking segment was primarily due to a $68.5 million increase in net interest income resulting from 13% loan growth during the year. Non-interest expenses increased $32.0 million due primarily to an increase in salaries and incentive compensation primarily driven by new hires, salary increases, and higher incentive compensation tied to improved performance. For the year ended December 31, 2015, net income for the Banking segment increased $27.4 million from the year ended December 31, 2014, and was primarily due to a $51.4 million increase in net interest income driven by 12% loan growth during 2014 and lower interest expense attributable to the $75.0 million partial redemption of our 10% Debentures in fourth quarter 2014.
Total loans for the Banking segment increased to $15.1 billion at December 31, 2016, from $13.3 billion at December 31, 2015. Total deposits increased to $16.1 billion at December 31, 2016 from $14.4 billion at December 31, 2015.
Asset Management
The Asset Management segment includes certain activities of our Private Wealth group, including investment management, personal trust and estate administration, custodial and escrow services, investment management services for 401(k) plans, and brokerage services. The private banking activities of our Private Wealth group are included with the Banking segment.
Net income from Asset Management increased to $4.2 million for 2016, compared to $3.2 million for 2015 and $2.5 million for 2014. The current year increase was attributable to a higher level of fee income from growth in AUMA, compared to the prior years. AUMA grew to $9.7 billion at December 31, 2016, from $7.3 billion at December 31, 2015 and $6.6 billion at December 31, 2014, attributable to growth in both managed and custody assets from new client acquisition, including sizeable corporate trust and corporate retirement accounts added during 2016.
Holding Company Activities
The Holding Company Activities segment consists of parent company-only activity and intersegment eliminations. The Holding Company’s most significant asset is its investment in the Bank. Undistributed earnings relating to this investment are not included in the Holding Company financial results. Holding Company financial results are represented primarily by interest expense on borrowings and operating expenses. Recurring operating expenses consist primarily of certain compensation expense and professional fees allocated to the Holding Company. The Holding Company Activities segment reported a net loss of $24.7 million for the year ended December 31, 2016, compared to a net loss of $20.8 million for the same period in 2015 and a net loss of $24.9 million for 2014. The increase in net loss in 2016 was due to higher non-interest expense in 2016 as a result of $6.7 million in transaction-related expenses. The Holding Company had $52.8 million in cash at December 31, 2016 compared to $61.5 million at December 31, 2015.
Additional information about our operating segments is also discussed in Note 21 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
FINANCIAL CONDITION
Total assets were $20.1 billion at December 31, 2016, a 16% increase from total assets of $17.3 billion at December 31, 2015. Total loans increased to $15.1 billion at year end 2016 from $13.3 billion at year end 2015, representing a 13% increase. Our total deposits increased to $16.1 billion at year end 2016 from $14.3 billion at year end 2015, representing a 12% increase. Total stockholders’ equity increased 13% from $1.7 billion at December 31, 2015 to $1.9 billion at December 31, 2016.
Investment Portfolio Management
We manage our investment securities portfolio to maximize the return on invested funds within acceptable risk guidelines, meet pledging and liquidity requirements, and adjust balance sheet interest rate sensitivity in an effort to protect net interest income levels against the impact of changes in interest rates. Investments in the portfolio are comprised of debt securities, primarily residential mortgage-backed securities and, to a lesser extent, state and municipal securities.
We may adjust the size and composition of our securities portfolio according to a number of factors, including expected liquidity needs, the current and forecasted interest rate environment, our actual and anticipated balance sheet growth rate, the relative value of various segments of the securities markets, and the broader economic and regulatory environment.
Debt securities that are classified as available-for-sale are carried at fair value and may be sold as part of our asset/liability management strategy in response to changes in interest rates, liquidity needs or significant prepayment risk. Unrealized gains and losses on available-for-sale securities represent the difference between the aggregate cost and fair value of the portfolio and are reported, on an after-tax basis, as a separate component of equity in accumulated other comprehensive income (“AOCI”). This balance sheet component will fluctuate as market interest rates and conditions change, with such changes affecting the aggregate fair value of the portfolio. In periods of significant market volatility, we may experience significant changes in AOCI.
Debt securities that are classified as held-to-maturity are securities for which we have the ability and intent to hold them until maturity and are accounted for using historical cost, as adjusted for amortization of premiums and accretion of discounts.
Table 6
Investment Securities Portfolio Valuation Summary
(Dollars in thousands)
* Less than 1%
As of December 31, 2016, our securities portfolio totaled $3.7 billion, increasing $611.7 million, or 20%, compared to December 31, 2015. During 2016, purchases of securities totaled $1.2 billion, with $549.0 million in the available-for-sale portfolio and $615.5 million in the held-to-maturity portfolio. The current year purchases in the investment portfolio primarily represented the reinvestment of proceeds from sales, maturities and paydowns in largely similar agency guaranteed residential and commercial mortgage-backed securities and state and municipal securities, as well as purchases of U.S. Treasury securities.
In conjunction with ongoing portfolio management and rebalancing activities, during 2016, we sold $45.4 million in state and municipal securities, resulting in a net securities gain of $1.1 million.
Investments in collateralized mortgage obligations and residential and commercial mortgage-backed securities comprise 72% of the total portfolio at December 31, 2016. All of the mortgage securities are backed by U.S. Government agencies or issued by U.S. Government-sponsored enterprises. All residential mortgage securities are comprised of fixed-rate, fully-amortizing collateral with final maturities of 30 years or less.
Investments in debt instruments of states and local municipalities comprised 12% of the total portfolio at December 31, 2016. This type of security has historically experienced very low default rates and provided a predictable cash flow because it generally is not subject to significant prepayment. For a portion of our state and local municipality debt instruments, insurance companies and state programs provide credit enhancement to improve the credit rating and liquidity of the issuance. Management considers underlying municipality credit strength and any credit enhancement when evaluating a purchase or sale decision.
We do not hold direct exposure to the obligations of the State of Illinois. We hold some bonds from municipalities in Illinois, but the finances of these municipalities are not primarily dependent on the finances of the State of Illinois.
At December 31, 2016, our reported equity reflected unrealized net securities losses on available-for-sale securities, net of tax, of $3.5 million, a decrease of $17.5 million from the unrealized net securities gains of $14.0 million at December 31, 2015, primarily due to increases in interest rates and the corresponding decrease in the market value of securities and unrealized net securities
gains. We continue to add, as needed, to the held-to-maturity portfolio to mitigate the potential future market volatility of adding bonds to the available-for-sale portfolio in a low interest rate environment.
During the year ended December 31, 2015, we identified three municipal debt securities from the same issuer totaling $1.1 million, which had credit rating downgrades during the period. We determined that the difference between amortized cost and fair value was other-than-temporary and, accordingly, recognized the $466,000 difference as a component of net securities gains in the consolidated statements of income. The securities were sold in January 2016 with no further losses recognized.
The following table summarizes activity in the Company’s investment securities portfolio during 2016. There were no transfers of securities between investment categories during the year.
Table 7
Investment Portfolio Activity
(Dollars in thousands)
(1)
The held-to-maturity portfolio is recorded at cost, with no adjustment for the $4.0 million unrealized loss in the portfolio at the beginning of 2016 or the decrease in market value of $19.3 million for the year ended December 31, 2016.
The following table presents the maturities of the different types of investment securities that we owned at December 31, 2016 and the corresponding interest rates.
Table 8
Maturity Distribution and Portfolio Yields
(Dollars in thousands)
(1)
The repricing distributions and yields to maturity of collateralized mortgage obligations and mortgage-backed securities are based on the average life of expected cash flows. Actual repricings and yields of the securities may differ from those reflected in the table depending upon actual interest rates and prepayment speeds.
(2)
The maturity date of state and municipal securities is based on contractual maturity, unless the bond, based on current market prices, is deemed to have a high probability that a call right will be exercised, in which case the call date is used as the maturity date.
Loan Portfolio and Credit Quality (excluding covered assets)
Our principal source of revenue arises from our lending activities, primarily composed of interest income and, to a lesser extent, loan origination and commitment fees, net of related costs. The accounting policies underlying the recording of loans in the consolidated statements of financial condition and the recognition and/or deferral of interest income and fees, net of costs, arising from lending activities are included in Note 1 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K.
The following discussion of our loan portfolio and credit quality excludes covered assets. Covered assets represent assets acquired through a FDIC-assisted acquisition that are subject to a loss share agreement and are presented separately on the consolidated statements of financial condition. For additional discussion of covered assets, refer to “Covered Assets” below in this “Management’s Discussion and Analysis”.
Portfolio Composition
Table 9
Loan Portfolio
(Dollars in thousands)
Total loans increased $1.8 billion during 2016 to $15.1 billion at December 31, 2016, compared to $13.3 billion at December 31, 2015, reflecting growth primarily in commercial and CRE loans. During the year ended December 31, 2016, new loans to new clients totaled $1.9 billion, and growth in existing clients, net of paydowns, totaled $1.7 billion. Payoffs were $1.8 billion for the year ended December 31, 2016. Our five-quarter trailing average loan growth was $395.4 million at December 31, 2016, increasing $51.6 million compared to $343.8 million a year ago. Revolving line usage on the overall loan portfolio decreased to 44% at December 31, 2016, from 47% at December 31, 2015, primarily reflecting the addition of new unfunded commitments.
Our loan growth was primarily driven by growth in the commercial and CRE loan portfolios, which increased $1.0 billion and $768.2 million, respectively, from December 31, 2015. Within the commercial loan portfolio, we saw growth in multiple industry segments from the prior year end, including finance and insurance, which increased $336.1 million, and healthcare, which increased $208.3 million. We also saw growth across multiple asset classes in the CRE portfolio during 2016. Multi-family is the largest asset class in the CRE portfolio, representing 24% of the total CRE portfolio at December 31, 2016, compared to 22% at December 31, 2015.
Heightened competition from both bank and non-bank lenders has affected, and continues to affect, borrowers’ expectations regarding both pricing and loan structure, which may impact our growth rate due to increasing availability in the market of financing alternatives offering terms outside our pricing and risk tolerances. Our primary strategy is focused on developing new relationships that generate opportunities to provide comprehensive banking services to our clients and, accordingly, we seek to maintain a disciplined approach when pricing and structuring new credit opportunities.
We generally earn higher yields on our commercial and industrial portfolio particularly related to our specialized lending products, such as healthcare and security alarm financing, than other segments of our loan portfolio. We also have greater potential to cross-sell other products and services, such as treasury management services, to our commercial and industrial lending clients.
In the normal course of our business, we participate in loan transactions that involve a number of banks in an effort to maintain and build client relationships while managing portfolio risk, with a view to cross-selling products and originating loans for the borrowers in the future. Although we often strive to lead or co-lead the arrangement, we also participate in transactions led by other banks when we have a relationship with, or seek to develop a relationship with, the borrower. Loan syndications assist us with decreasing credit exposure linked to individual client relationships or loan concentrations by industry, type or size. Of our $15.1 billion in total loans at December 31, 2016, we were party to $5.5 billion of loans with other financial institutions, consisting of $2.5 billion in retained balances in syndicated loans that were led or co-led by us and $3.0 billion for which we were a non-
lead participant in the syndicated loan. Within this $5.5 billion portfolio, $3.3 billion of loans were shared national credits (“SNCs”), of which we were the lead or co-lead in $1.1 billion and the non-lead participant in $2.2 billion. SNCs are defined as loan commitments of at least $20 million that are shared by three or more regulatory depository institutions. Of the $1.9 billion of new loans to new clients during 2016, approximately $419.3 million, or 22%, related to SNCs. To the extent financing opportunities we pursue exceed our risk appetite for larger credit exposures and we are not able to syndicate the loan transactions, our loan growth may be impacted.
The following table summarizes the composition of our commercial loan portfolio at December 31, 2016 and 2015 based on our most significant industry segments, as classified pursuant to the North American Industrial Classification System standard industry description. These categories are based on the nature of the client’s ongoing business activity as opposed to the collateral underlying an individual loan. To the extent that a client’s underlying business activity changes, classification differences between periods will arise.
Table 10
Commercial Loan Portfolio Composition by Industry Segment
(Dollars in thousands)
(1)
All other consists of numerous smaller balances across a variety of industries with no category greater than 2% of total loans.
(2)
Includes owner-occupied commercial real estate of $2.1 billion at December 31, 2016 and $1.9 billion at 2015.
Our healthcare portfolio within our commercial portfolio totaled $2.0 billion at December 31, 2016, compared to $1.8 billion at December 31, 2015. We have a specialized niche in the skilled nursing, assisted living, and residential care segment of the healthcare industry. Loan relationships to these providers tend to be larger extensions of credit with borrowers primarily represented by for-profit businesses. At December 31, 2016, 21% of our commercial loan portfolio and 13% of our total loan portfolio was composed of loans extended primarily to operators in this segment to finance the working capital needs and cost of facilities providing such services. The facilities securing the loans are dependent, in part, on the receipt of payments and reimbursements under government contracts for services provided. Accordingly, our clients and their ability to service this debt may be adversely impacted by the financial health of state or federal payors. In recent years, there have been reductions in the reimbursement rates in certain states and government entities are taking longer to reimburse providers. For example, in the State of Illinois, the Medicaid reimbursement rate was reduced and the budget impasse, which has resulted in the state operating without a budget since June 30, 2015, has contributed to reduced Medicaid payments to healthcare providers. Although our healthcare commercial loan portfolio is well diversified across 28 states, loans to borrowers in the State of Illinois represented our highest geographic concentration of healthcare loans at 23% of the healthcare commercial loan portfolio, or $454.7 million, as of December 31, 2016. The challenged financial condition of the State of Illinois has had some adverse effects on the cash flow position of some of our Illinois-based healthcare borrowers. Despite this impact on client cash flows, to date, the healthcare loan portfolio has experienced minimal defaults and losses. We are actively monitoring the Illinois budget situation and its potential impact on our borrowers to manage the risks presented by the state’s budget problems and overall challenged financial condition. In addition, across the broader healthcare industry, structural changes to government reimbursements may negatively impact performance for managed care facilities as borrowers adapt to the changes, particularly higher cost operators with thinner margins.
Our manufacturing portfolio, representing 19% of our commercial lending portfolio and 21% of the total portfolio at December 31, 2016, is well diversified among sub-industry and product types. The manufacturing industry classification is a key component of our core business. During the second half of 2015 and into 2016, the U.S. manufacturing sector experienced a significant slowdown, as evidenced by declines or slowing rates of growth in a number of key indicators, due in part to the economic headwinds of lower commodity prices (including oil and gas prices) and a strong U.S. dollar, with particular stress faced by durable goods manufacturing. Although the U.S. manufacturing sector began to rebound toward the end of 2016, the sector’s performance may continue to experience volatility due to the impact of commodity prices, currency exchange rates, possible U.S. corporate tax reform, U.S. political developments and broader geopolitical developments on this sector. Any stress or volatility experienced by the U.S. manufacturing sector specifically could adversely impact our existing loan portfolio and/or our future loan growth rate.
The third largest segment of our commercial loan portfolio is the finance and insurance portfolio, which increased $336.1 million, since December 31, 2015 and now represents 17% of our commercial lending portfolio at December 31, 2016 compared to 15% at December 31, 2015. Contributing to the increase year-over-year was growth in specialty finance loans, which totaled $496.1 million as of December 31, 2016, up from $388.2 million at December 31, 2015. This type of lending represents loans to nonbank specialty finance lenders that provide various types of financing to their customers, such as consumer financing, auto financing, equipment financing or other types of asset-based lending. The growth in this portfolio is a result of pursuing new opportunities to add specialized industry knowledge amongst our client relationship managers, with an expanded team in 2015 and a greater presence in the market. At December 31, 2016, amounts outstanding under bridge lines to private equity funds, which provide liquidity as a bridge to the next capital call from their investors, totaled $245.9 million, compared to $239.9 million at December 31, 2015. The draw repayment terms of such loans are generally between 90 and 120 days and, given their purpose, these draws generally remain outstanding for a short period of time. Amounts outstanding under these lines generally will fluctuate from quarter to quarter given their transactional nature.
The following table summarizes our CRE and construction loan portfolios by collateral type at December 31, 2016 and 2015.
Table 11
Commercial Real Estate and Construction Loan Portfolios by Collateral Type
(Dollars in thousands)
Of the combined CRE and construction portfolios, the three largest categories at December 31, 2016 were multi-family, retail and office, which represented 25%, 19% and 16% of the combined portfolios, respectively. Generally, we are a short-to-intermediate term real estate lender, and our CRE and construction portfolio strategies focus on core real estate classes in the markets in which we operate and established sponsors and developers with which we have prior experience, other banking relationships or the opportunity to offer comprehensive banking relationships. The multi-family asset type is diversified with a combination of stabilization of prior construction projects, existing property improvements, and stable assets with strong recurring cash flows. Payoffs during the year ended December 31, 2016 included property sales and refinancing into the long-term market.
Portfolio Risk Management
In conjunction with our commercial middle market focus, our lending activities sometimes involve larger credit relationships. Due to the larger size of these loans, the unexpected occurrence of an event or development with respect to one or more of these loans that adversely impacts the value of collateral securing the loan, the success of a workout strategy, or our ability to return the loan to performing status could materially and adversely affect our results of operations and financial condition.
The following table summarizes our credit relationships with commitments greater than $25 million as of December 31, 2016 and December 31, 2015:
Table 12
Client Relationships with Commitments Greater Than $25 Million
(Dollars in thousands)
As part of the risk-based deposit insurance assessment framework, the FDIC has established a regulatory classification of “higher-risk assets,” which include higher-risk commercial and industrial loans (funded and unfunded), construction and development loans (funded and unfunded), non-traditional mortgages, and higher-risk consumer loans. As part of our overall portfolio risk management, we have developed a plan to manage our level of higher-risk assets relative to our capital position and within our overall risk appetite and generally have focused in recent periods on being selective in originating loans that are classified as higher-risk assets. The following table summarizes our higher-risk assets as of December 31, 2016 and December 31, 2015.
Table 13 (1)
Higher-Risk Assets
(Amounts in thousands)
(1)
Loan category classification is based on the FDIC’s regulatory definition.
Higher-risk commercial and industrial loans include a majority of our total leveraged loan portfolio and are primarily underwritten on the recurring earnings of the borrower, where the ratio of debt-to-earnings is elevated compared to other commercial loans that are not characterized as higher-risk. Our higher-risk commercial and industrial loans are spread across multiple industries, generally command higher loan yields as a premium for underwriting the additional risk attributable to the leveraged position of the underlying borrower, and typically have lower collateral coverage than similar commercial and industrial loans that are not classified by the FDIC as higher-risk assets. Based on our historical experience, the loss factors and the probability of default for loans underwritten with such characteristics have generally been higher than our commercial and industrial loan portfolio as a whole and we take this into account in establishing our allowance for loan losses.
Maturity and Interest Rate Sensitivity of Loan Portfolio
The following table summarizes the maturity distribution of our loan portfolio as of December 31, 2016, by category, as well as the interest rate sensitivity of loans in these categories that have maturities in excess of one year.
Table 14
Maturities and Sensitivities of Loans to Changes in Interest Rates (1)
(Amounts in thousands)
(1)
Maturities are based on contractual maturity date. Actual timing of repayment may differ from those reflected in the table as clients may choose to pre-pay their outstanding balance prior to the contractual maturity date.
Of the $10.4 billion in loans maturing after one year with a floating interest rate, $1.2 billion are subject to interest rate floors, of which $386.9 million have such floors in effect at December 31, 2016. For further analysis and information related to interest rate sensitivity, see Item 7A
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
As a continuing part of our asset/liability management, we attempt to manage the impact of fluctuations in market interest rates on our net interest income. This effort entails providing a reasonable balance between interest rate risk, credit risk, liquidity risk and maintenance of yield. We may manage interest rate risk by structuring the asset and liability characteristics of our balance sheet and/or by executing derivatives designated as cash flow hedges. We currently use interest rate derivatives to hedge interest rate risk in our primarily floating-rate loan portfolio and, depending on market conditions, we may expand this program and enter into additional interest rate swaps.
Interest rate changes do not affect all categories of assets and liabilities equally or simultaneously. There are other factors that are difficult to measure and predict that would influence the effect of interest rate fluctuations on our consolidated statements of income.
The majority of our interest-earning assets are floating-rate instruments. At December 31, 2016, approximately 81% of the total loan portfolio is indexed to LIBOR, including 71% indexed to one month LIBOR, and 15% of the total loan portfolio is indexed to the prime rate. Of the $10.4 billion in loans maturing after one year with a floating interest rate, $1.2 billion are subject to interest rate floors, of which 33% were in effect at December 31, 2016 and are reflected in the interest sensitivity analysis below. Commencing in 2016, we have included contractual language in loan agreements that establishes a floor of 0% for loans with LIBOR indices, protecting the Company in the event of negative LIBOR rates. To manage the interest rate risk of our balance sheet, we have the ability to use a combination of financial instruments, including medium-term and short-term financings, variable-rate debt instruments, fixed-rate loans and securities and interest rate swaps.
We use a simulation model to estimate the potential impact of various interest rate changes on our income statement and our interest-earning asset and interest-bearing liability portfolios. The starting point of the analysis is the current size and nature of these portfolios at the beginning of the measurement period as well as the then-current applicable pricing structures. During the twelve-month measurement period, the model re-prices assets and liabilities based on the contractual terms and market rates in effect at the beginning of the measurement period assuming instantaneous parallel shifts in the applicable yield curves and instruments then remain at that new interest rate through the end of the twelve-month measurement period. The model analyzes changes in the portfolios based only on assets and liabilities at the beginning of the measurement period and does not assume any asset or liability growth over the following twelve months.
The sensitivity analysis is based on numerous assumptions including: the nature and timing of interest rate levels, the shape of the yield curve, prepayments on loans and securities, levels of excess deposits, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows and others. While our assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how client preferences or competitor influences might change. In addition, the simulation model assumes certain one-time instantaneous interest rate shifts that are consistent across all yield curves and do not continue to change over the measurement period. As such, these assumptions and modeling reflect an estimation of the sensitivity to interest rates or market risk and do not predict the timing and direction of interest rates or the shape and steepness of the yield curves. Therefore, the actual results may differ materially from these simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies.
Modeling the sensitivity of net interest income to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. These assumptions are periodically reviewed and updated in the context of various internal and external factors including balance sheet changes, product offerings, product mix, external micro and macroeconomic factors, anticipated client behavior and anticipated Company and market pricing behavior, all of which may occur in dynamic and non-linear fashion. We routinely conduct historical deposit re-pricing and deposit lifespan/retention analyses and adjust our forward-looking assumptions related to client and market behavior. Based on our analyses and judgments, we recently modified core deposit product repricing characteristics and retention periods, as well as average life estimates, used in our interest rate risk modeling which reflects higher interest rate sensitivity of our deposits.
Based on our current simulation modeling assumptions, the following table shows the estimated impact of an immediate change in interest rates as of December 31, 2016 and 2015.
Analysis of Net Interest Income Sensitivity
(Dollars in thousands)
The table above illustrates the estimated impact to our net interest income over a one-year period reflected in dollar terms and percentage change. As an example, if there had been an instantaneous parallel shift in the yield curve of +100 basis points on December 31, 2016, net interest income would increase by $44.9 million, or 7.4%, over a twelve-month period, as compared to a net interest income increase of $34.2 million, or 6.6%, if there had been an instantaneous parallel shift of +100 basis points at December 31, 2015. The increase in the above interest rate asset sensitivity at December 31, 2016 compared to December 31, 2015, is due to a net increase in rate-sensitive assets. Rate-sensitive assets, particularly loans indexed to short-term rates, increased during the year ended December 31, 2016. The increase was funded by rate-sensitive liabilities, primarily deposits and short-term borrowings. Overall asset sensitivity increased during 2016 due primarily to asset and liability compositional changes, including a decrease in our cash flow hedge portfolio. Based on our modeling, the Company remains in an asset sensitive position and expects to benefit from the rise in interest rates. We note, however, that 81% of our loans are indexed to LIBOR, mostly one-month LIBOR, and there can be no guarantee that action by the Federal Reserve to raise the target Fed funds rate will cause an immediate parallel shift in short-term LIBOR. We will continue to periodically review and refine, as appropriate, the assumptions used in our interest rate risk modeling.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of PrivateBancorp, Inc.
We have audited the accompanying consolidated statements of financial condition of PrivateBancorp, Inc. (the Company) as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in equity and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated February 28, 2017, expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Chicago, Illinois
February 28, 2017
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Amounts in thousands, except shares and per share data or otherwise noted)
See accompanying notes to consolidated financial statements.
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF INCOME
(Amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands)
See accompanying notes to consolidated financial statements.
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Amounts in thousands, except per share data)
(1)
Net of taxes and reclassification adjustments.
See accompanying notes to consolidated financial statements.
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)
See accompanying notes to consolidated financial statements.
PRIVATEBANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Amounts in thousands)
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations - PrivateBancorp, Inc. (“PrivateBancorp” or the “Company”) was incorporated in Delaware in 1989 and became a holding company registered under the Bank Holding Company Act of 1956, as amended. The PrivateBank and Trust Company (the “Bank” or the “PrivateBank”), the sole banking subsidiary of PrivateBancorp, was opened in Chicago in 1991. The Company completed its initial public offering in June 1999. The Bank provides customized business and personal financial services to middle market companies and business owners, executives, entrepreneurs and families in all of the markets and communities it serves.
On June 29, 2016, the Company entered into a definitive merger agreement with Canadian Imperial Bank of Commerce (“CIBC”), a Canadian chartered bank, and CIBC Holdco Inc. (“Holdco”), a newly-formed Delaware corporation and a direct, wholly owned subsidiary of CIBC, which contemplates that the Company will merge with and into Holdco, with Holdco surviving the merger. Closing of the transaction remains subject to the receipt of required regulatory and stockholder approvals and other customary closing conditions. Following the merger, the Bank will be headquartered in Chicago, Illinois, retain its Illinois state banking charter and be an indirect, wholly owned subsidiary of CIBC.
Under the terms of the definitive agreement, shareholders of the Company will receive $18.80 in cash and 0.3657 of a CIBC common share for each share of PrivateBancorp common stock. As of June 28, 2016, the last trading day before public announcement of the transaction, total consideration for the transaction was valued at approximately $3.8 billion, or $47.00 per share of common stock of the Company, based on CIBC’s closing stock price on June 28, 2016 of $77.11. As of such date, the aggregate consideration would have been paid with approximately $1.5 billion in cash and approximately 29.5 million common shares of CIBC, representing a 40 percent cash and 60 percent share mix. The actual transaction value will be based on the number of shares of common stock of the Company outstanding at the closing and the price of CIBC common stock as of the closing.
The full text of and additional information about the definitive merger agreement is included in the Company’s Current Report on Form 8-K filed with the Securities Exchange Commission (“SEC”) on July 6, 2016.
Direct costs related to the proposed transaction were expensed as incurred and totaled $6.7 million for the year ended December 31, 2016. These costs were primarily comprised of financial advisor and other professional services fees.
Principles of Consolidation and Basis of Presentation - The accompanying consolidated financial statements include the accounts and results of operations of the Company and its subsidiaries after elimination of all significant intercompany accounts and transactions. In general, investments in unconsolidated entities where the Company has the ability to exercise significant influence over the entities’ operating and financing decisions are accounted for using the equity method of accounting. Investments that do not meet the criteria for equity method accounting are accounted for using the cost method of accounting. Assets held in a fiduciary or agency capacity are not assets of the Company or its subsidiaries, and accordingly, are not included in the consolidated financial statements.
The accounting and reporting policies of the Company and its subsidiaries conform to U.S. generally accepted accounting principles (“U.S. GAAP”) and general practice within the banking industry. We use the accrual basis of accounting for financial reporting purposes.
Certain reclassifications have been made to prior year amounts to conform to the current year presentation.
In preparing the consolidated financial statements, we have considered the impact of events occurring subsequent to December 31, 2016 for potential recognition or disclosure in this annual report on Form 10-K. The following is a summary of the significant accounting policies adhered to in the preparation of the consolidated financial statements.
Business Combinations - Business combinations are accounted for under the acquisition method of accounting. Under the acquisition method, assets and liabilities of the business acquired are recorded at their estimated fair value as of the date of acquisition, with any excess of the cost of the acquisition over the fair value of the net tangible and identifiable intangible assets acquired recorded as goodwill. Results of operations of the acquired business are included in the consolidated statements of income from the effective date of acquisition.
Use of Estimates - The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from these estimates.
Cash and Cash Equivalents - For purposes of the consolidated statements of cash flows, management has defined cash and cash equivalents to include cash and due from banks, federal funds sold, and other interest-bearing deposits in banks. Generally, federal funds are sold for one-day periods, but not longer than 30 days. Short-term investments generally mature in less than 30 days. All cash and cash equivalents have maturities of three months or less.
Debt Securities - At the time of purchase, debt securities are classified as held-to-maturity or available-for-sale. Debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to-maturity securities are carried at amortized cost. Debt securities are classified as available-for-sale when management has the intent and ability to hold such securities for an indefinite period of time, but not necessarily to maturity. Any decision to sell available-for-sale securities would be based on various factors, including but not limited to asset/liability management strategies, changes in interest rates or prepayment risks, liquidity needs, or regulatory capital considerations. Available-for-sale securities are carried at fair value with unrealized gains and losses, net of related deferred income taxes, recorded as a separate component of other comprehensive income (“OCI”).
The historical cost of debt securities is adjusted for amortization of premiums and accretion of discounts over the life of the security, using the level-yield method. Amortization of premium and accretion of discount are included in interest income.
Purchases and sales of securities are recognized on a trade date basis. Realized securities gains or losses are reported in net securities gains (losses) in the consolidated statements of income. The cost of securities sold is based on the specific identification method. We conduct a quarterly assessment of our investment portfolio to determine whether any securities are other-than-temporarily impaired (“OTTI”). When assessing unrealized losses for OTTI, we consider the nature of the investment, the financial condition of the issuer, the extent and duration of unrealized loss, expected cash flows of underlying assets and market conditions. OTTI is considered to have occurred if the security is impaired and (1) if management intends to sell the security; (2) if it is more likely than not we will be required to sell the security before recovery of its amortized cost basis; or (3) if the present value of the expected cash flows is not sufficient to recover the entire amortized cost basis. For debt securities that we do not intend to sell or for which it is not more likely than not that the Company will be required to sell prior to recovery, the OTTI is separated into credit and noncredit components. The credit-related OTTI, represented by the expected loss in principal, is recognized in non-interest income, while noncredit-related OTTI is recognized in OCI. Noncredit-related OTTI results from other factors, including increased liquidity spreads and changes in risk-free interest rates. For securities we expect to sell prior to recovery, the entire impairment (i.e., the difference between the amortized cost basis and the fair value) is recognized in earnings.
Federal Home Loan Bank (“FHLB”) Stock - Investments in FHLB stock are restricted as to redemption and are carried at cost.
Loans Held-for-Sale - Loans held-for-sale (“LHFS”) represent mortgage loan originations intended to be sold in the secondary market and other loans that management has an active plan to sell. LHFS are carried at the lower of cost or fair value as determined on an individual asset basis or carried at fair value where the Company has elected fair value accounting. The Company has elected to measure certain residential mortgage loans originated as held-for-sale under the fair value option. Increases or decreases in the fair value of these LHFS are recognized in mortgage banking income in the consolidated statements of income. Mortgage loan origination costs related to LHFS that the Company accounts for under the fair value option are recognized in non-interest expense as incurred. Held-for-investment loans that have been transferred to LHFS are carried at the lower of cost or fair value. For these LHFS, any decreases in value below cost are recognized in other income in the consolidated statements of income and increases in fair value above cost are not recognized until the loans are sold. The credit component of any write down upon transfer to LHFS is reflected in charge-offs to the allowance for loan losses. Loan origination costs for LHFS carried at the lower of cost or fair value are capitalized as part of the carrying amount of the loans.
Gains and losses on the disposition of loans held-for-sale are determined using the specific identification method. Residential mortgage loans sold in the secondary market are sold without retaining servicing rights or other residual interests.
Originated Loans Held-for-Investment - Originated loans held-for-investment are carried at the principal amount outstanding, net of deferred loan fees and costs and any direct principal charge-offs, except for certain residential real estate loans for which the fair value option was elected. These residential real estate loans are measured at fair value as of each reporting date, with changes in fair value recognized in mortgage banking income in the consolidated statements of income. Interest income on loans is accrued based on principal amounts outstanding. Loan origination fees, fees for commitments that are expected to be exercised and certain direct loan origination costs are deferred and the net amount is amortized over the life of the related loan or commitment period as a yield adjustment. Other fees not associated with originating a loan are recognized as fee income when earned.
Delinquent and Nonaccrual Loans - Loans are reported as past due if contractual principal or interest payments are due and unpaid for 30 days or more. All loans that are over 90 days past due in principal or interest are considered “impaired” and placed
on nonaccrual status. Management may also place some loans on nonaccrual status before they are 90 days past due if they meet the below definition of “impaired.” When a loan is placed on nonaccrual status, accrued and unpaid interest credited to income is reversed and accretion of net deferred loan fees ceases. Subsequent receipts on nonaccrual loans are recorded as a reduction of principal, and interest income may only be recorded on a cash basis if the remaining recorded investment is deemed fully collectible. Nonaccrual loans are returned to accrual status when all delinquent principal and interest payments become current in accordance with the terms of the loan agreement and the financial position of the borrower and other relevant factors indicate there is no longer doubt as to such collectibility.
Restructured Loans - As part of our ongoing risk management practices and in certain circumstances, we may extend or modify the terms of a loan in an attempt to maximize the collection of amounts due when a borrower is experiencing financial difficulties. These modifications are structured on a loan-by-loan basis, and depending on the circumstances, may consist of reducing the interest rate, extending the maturity dates, reducing the principal balance, or other concession intended to minimize potential losses and maximize our chances of a more successful recovery on a troubled loan. The Company may also utilize a multiple note structure as a workout alternative for certain loans. The multiple note structure typically bifurcates a troubled loan into two separate notes, where the first note is reasonably assured of repayment and performance according to the modified terms, and the portion of the troubled loan that is not reasonably assured of repayment is charged-off. Loans that have been modified to accommodate a borrower who is experiencing financial difficulties, and for which the Company has granted a concession that it would not otherwise consider, are recognized as troubled debt restructurings (“TDRs”).
We consider many factors in determining whether to agree to a loan modification involving concessions, and seek a solution that will both minimize potential loss to the Company and attempt to help the borrower. We evaluate our borrowers’ current and forecasted future cash flows, their ability and willingness to make current contractual or proposed modified payments, the value of the underlying collateral (if applicable), the possibility of obtaining additional securities or guarantees, and the potential costs related to a repossession or foreclosure and the subsequent sale of the collateral.
TDRs may include loans continuing on accrual status, moving to nonaccrual or remaining on nonaccrual, depending on the individual facts and circumstances of the borrower. Generally, a nonaccrual loan that is restructured remains on nonaccrual for a period of at least six months to ensure that the borrower performs in accordance with the restructured terms including consistent and timely loan payments. However, the borrower’s performance prior to the restructuring or other significant events at the time of the restructuring may be considered in assessing whether the borrower can meet the new terms and may result in the loan being returned to accrual status after a shorter performance period or concurrent with the restructuring. In such situations, the loan will be reported as a “restructured loan accruing interest.” If the borrower’s performance under the new terms is not reasonably assured, the loan remains classified as a nonaccrual loan.
Impaired Loans - Impaired loans consist of nonaccrual loans (which include nonaccrual TDRs) and loans classified as accruing TDRs. A loan is considered impaired when, based on current information and events, either (i) management believes that it is probable that we will be unable to collect all amounts due (both principal and interest) according to the original contractual terms of the loan agreement or, (ii) it has been classified as a TDR. Once a loan is determined to be impaired, the amount of impairment is measured based on the loan’s observable fair value; fair value of the underlying collateral less estimated selling costs, if the loan is collateral-dependent; or the present value of expected future cash flows discounted at the loan’s effective interest rate.
If the measurement of the impaired loan is less than the recorded investment in the loan (including accrued interest, net of deferred loan fees and costs and unamortized premium or discount), impairment is recognized by creating a specific valuation reserve as a component of the allowance for loan losses. Non-TDR impaired loans and nonaccrual TDRs exceeding $500,000 are evaluated individually, while non-TDR impaired loans and nonaccrual TDRs less than $500,000 are evaluated as pools using historical loss experience, as well as management’s loss expectations, for the respective asset class and product type. All accruing TDRs, no matter the balance, are evaluated individually for impairment.
All impaired loans and their related reserves are reviewed and updated each quarter. Any impaired loan for which a determination has been made that the economic value is permanently reduced is charged-off against the allowance for loan losses to reflect its current economic value in the period in which the determination is made.
At the time a collateral-dependent loan is initially determined to be impaired, we review the existing appraisal. If the most recent appraisal is greater than one-year old, a new evaluation of the underlying collateral is obtained. For collateral-dependent impaired loans that are secured by real estate, we generally obtain "as is" appraisal values to evaluate impairment. When a collateral-dependent loan is secured by non-real estate collateral such as receivables, inventory, or equipment, the fair value is generally determined based upon appraisals, field exams, or receivable reports. The valuation techniques and inputs are reviewed internally by workout and/or asset-based specialists for reasonableness of estimated liquidation costs, collectability probabilities, and other market data. Appraisals for real estate collateral-dependent impaired loans in excess of $500,000 are updated with new independent
appraisals at least annually and are formally reviewed by our internal appraisal department. Additional diligence is performed at the six-month interval between annual appraisals. If during the course of the six-month review process there is evidence supporting a meaningful decline in the value of collateral, the appraised value is either adjusted downward or a new appraisal is required to support the value of the impaired loan. All appraisals and internal reviews are current under this methodology at December 31, 2016.
Allowance for Loan Losses (the “Allowance”) - We maintain an allowance for loan losses at a level management believes is sufficient to absorb credit losses inherent in our loan portfolio at the consolidated statements of financial condition date. The Allowance is assessed quarterly and represents an accounting estimate of probable losses in the portfolio at each statement of financial condition date based on a review of available and relevant information at that time. The Allowance contains reserves for identified probable losses relating to specific borrowing relationships that are considered to be impaired (“the specific allocated component” of the Allowance), and for probable losses inherent in the loan portfolio that have not been specifically identified (“the general allocated component” of the Allowance).
The specific allocated component of the Allowance is the summation of individual reserves related to impaired loans that are analyzed on a loan-by-loan basis at the consolidated statements of financial condition date. Impaired loans consist of nonaccrual loans (which include nonaccrual TDRs) and loans classified as accruing TDRs. See “Impaired Loans” section of this Note 1 for a detailed discussion of the specific allocated component of the Allowance.
The general allocated component of the Allowance is determined using a methodology that is a function of quantitative and qualitative factors and considerations applied to segments of our loan portfolio. Our methodology applies a historical loss model that takes into account at a product level (e.g., commercial, commercial real estate, construction, consumer) the default and loss history of similar products or sub-products using a look-back period that begins in 2010 and is updated with monthly data on a lagged quarter to the most recent period.
Our methodology uses our default and loss history over the look-back period to establish a probability of default (“PD”) for each product type (and, in some cases, sub-segments within a product type) and risk rating, as well as an expected loss given default (“LGD”) for each product type. For our consumer portfolio, we assign a PD to each delinquency period and LGD to collateral position or size of credit. Our methodology applies the PD and LGD to the applicable loan balances and produces a loss estimate by product that is inclusive of the loss emergence period.
We assess the appropriate balance of the general allocated component of the reserve at the model loss emergence period based on a variety of internal and external quantitative and qualitative factors giving consideration to conditions that we believe are not fully reflected in the model-generated loss estimates. Topics considered in this assessment include changes in lending practices and procedures (e.g., underwriting standards) internally and in our industry, changes in business or economic conditions, changes in the nature and volume of loans, changes in staffing or management in our lending teams, changes in the quality of our results from loan reviews (which includes credit quality trends and risk rating accuracy), changes in underlying collateral values, recent portfolio performance, concentration risks, and other external factors such as legal or regulatory matters relevant to management’s assessment of required reserve levels. In certain instances, these additional factors and judgments may lead to management’s conclusion that the appropriate level of the reserve differs from the amount determined through the model-driven quantitative framework, with respect to a given product type. In determining the amount of any qualitative adjustment to be made to the quantitative model output, management may adjust the PD and/or LGD for a product type (or a sub-segment within a product type) to reflect conditions that it does not believe are reflected in historical loss rates and apply those adjusted PDs and LGDs to determine the impact on the model output, with the result used to inform management’s determination of the appropriate qualitative adjustment to be made to the general allocated component for the product type.
The product segments we evaluate in the general allocated component methodology are commercial loans, commercial real estate loans, construction loans and consumer loans (which include personal loans, residential mortgage loans and home equity lines of credit). Our commercial loan portfolio includes lines of credit to businesses and term loans. Certain non-residential owner-occupied commercial real estate loans are also included in our commercial loan portfolio if the cash flows from the owner’s business serve as the primary source of loan repayment. Commercial loans contain risks unique to the business and market of each borrower and the repayment is dependent upon the financial success and viability of the borrower. These risks include, but are not limited to: reliance on sustained cash flow of the borrower to repay the loan and diminutive collateral to take recourse on as a secondary source of repayment for our leveraged loans, dependency on government receivables at the state and federal levels for our healthcare loans, reliance on conversion of assets rather than operating cash flows for our asset-based lending loans, and susceptibility of a slowdown in the manufacturing portfolio as a result of the recent commodity price fluctuations within the manufacturing industry.
Commercial real estate loans comprise loans secured by various types of collateral including one-to-four family non-owner occupied housing units located primarily in our target market areas, multi-family real estate, office buildings, warehouses, retail space,
mixed use buildings, and vacant land, the bulk of which is held for long-term investment or development. Risks inherent in real estate lending are related to the underlying net operating income, the market value of the property taken as collateral, and the general economic condition of the market in which the collateral is located. Repayment is generally dependent on the ability of the borrower to attract and retain tenants at rental rates that provide for a sufficient level of net operating income to cover debt service, and ultimately the long term financing options of the borrower.
Our construction loan portfolio consists of single-family residential properties, multi-family properties, and commercial projects, and includes both investment properties and properties that will be owner-occupied. Risks inherent in construction lending are similar to those in commercial real estate lending. Additional risks include unexpected cost increases or delays in constructing or improving a property, the borrower’s inability to generate funding until the project is complete, the greater sensitivity to interest rate movements and the real estate market that these borrowers face while a project is being completed or while a borrower is seeking a buyer, and the lack of availability of permanent financing. Construction loans, as a product segment, have the highest inherent risk in our portfolio.
Consumer loans are a smaller portion of our overall portfolio and consist of residential home mortgages, home equity lines of credit and personal loans. The risk issues associated with these products are closely correlated to the U.S. housing market and the local markets in which the collateral resides and include home prices, sales volume, unemployment rates, foreclosure rates, and delinquency rates. Some personal loans may be unsecured and therefore offer little secondary source of repayment.
Determination of the Allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows and collateral appraisal values on impaired loans; estimated losses on pools of homogeneous loans based on historical loss experience, risk ratings, product type, delinquency aging for consumer loans, and consideration of current economic trends and portfolio attributes, all of which may be susceptible to significant change. Default estimates are derived using a monthly rating migration approach over the appropriate look-back period for each segment for the commercial portfolio and delinquency aging for the consumer portfolio, and are estimated consistent with the loss emergence period for a particular product. In addition, we compare current model-derived and historic reserve levels to charge-off trends in considering the appropriate Allowance at each product level.
Credit exposures deemed to be uncollectible are charged-off against the Allowance, while recoveries of amounts previously charged-off are credited to the Allowance. A provision for loan losses, which is a charge against earnings, is recorded to bring the Allowance to a level that, in management’s judgment, is appropriate to absorb probable losses in the loan portfolio as of the consolidated statements of financial condition date.
Reserve for Unfunded Commitments - We maintain a reserve for unfunded commitments at a level we believe to be sufficient to absorb estimated probable losses related to unfunded credit facilities. The reserve is included in other liabilities in the consolidated statements of financial condition. The general reserve is computed using a methodology similar to that used to determine the general allocated component of the Allowance and is based on a model that uses recent commitment utilization patterns at the product level as a method of predicting future usage across the portfolio. The specific reserve is the summation of individual reserves related to unfunded commitments that are analyzed on a commitment-by-commitment basis. Net adjustments to the reserve for unfunded commitments are included in other non-interest expense in the consolidated statements of income.
Purchased Loans - U.S. GAAP requires purchased loans acquired through portfolio purchases or in a business combination (“purchased non-impaired loans”) to be recorded at fair value at the acquisition date and prohibits the “carrying over” or creation of valuation allowances in the initial accounting for loans acquired in a transfer. Differences between the purchase price and the unpaid principal balance at the date of acquisition are recorded in interest income over the life of the loan. Decreases in expected cash flows after the purchase date are recognized by recording an allowance for loan losses.
Purchased loans with evidence of credit deterioration at the time of the acquisition and where it is probable that not all contractual payments will be collected are considered purchased credit-impaired loans. Evidence of credit quality deterioration as of the purchase date may include statistics such as past due and nonaccrual status, declines in borrower FICO scores, and declines in loan-to-value ratios.
The fair values for purchased credit-impaired loans are determined by discounting cash flows expected to be collected using an observable discount rate for similar instruments with adjustments to the discount rate that management believes a market participant would consider in determining fair value. We estimate the timing and amount of cash flows expected to be collected at acquisition using internal models that incorporate management’s best estimate of current key assumptions, such as default rates, loss severity and payment speeds.
Under the applicable accounting guidance for purchased credit-impaired loans, any excess of cash flows expected at acquisition over the estimated fair value is referred to as the accretable yield and is recognized into interest income over the remaining life of the loan using the constant effective yield method when there is a reasonable expectation about the amount and timing of such cash flows. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the non-accretable difference. Decreases in expected cash flows subsequent to acquisition generally result in an allowance for loan losses. Subsequent increases in cash flows result in a reversal of the allowance for loan losses to the extent previously established or a prospective adjustment to the accretable yield. Purchased credit-impaired loans with common risk characteristics are accounted for on a pool basis as a single asset with a single composite interest rate and an aggregate expectation of cash flows. Because we are recognizing interest income on each pool of loans, they are all considered to be performing.
Covered Assets - Purchased loans and foreclosed loan collateral covered under loss share or similar credit protection agreements with the Federal Deposit Insurance Corporation (“FDIC”) are reported separately on the face of the consolidated statements of financial condition inclusive of the fair value of reimbursement cash flows the Company expects to receive from the FDIC under the agreement. The allowance for covered loan losses is determined without regard to the expected reimbursement from the FDIC with any provision for covered loan loss charges recorded in the consolidated statements of income net of such FDIC reimbursement.
Other Real Estate Owned (“OREO”) - OREO is comprised of property acquired through foreclosure proceedings or acceptance of a deed-in-lieu of foreclosure in partial or total satisfaction of certain loans. Properties are initially recorded at fair value less estimated selling costs. Any write-downs in the carrying value of a property at the time of acquisition are charged against the Allowance. Subsequent to initial recognition, OREO is recorded at the lower of the initial cost basis or current fair value less estimated selling costs. Any subsequent write-downs to reflect current fair value less estimated selling costs are recorded through a valuation allowance. Such write-downs, as well as gains or losses on disposition and revenues and expenses incurred in maintaining such properties, are reported in non-interest expense in the consolidated statements of income.
Depreciable Assets - Premises, leasehold improvements, furniture and equipment, and software on our servers are stated at cost less accumulated depreciation. Depreciation expense is determined by the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on a straight-line basis over the shorter of the life of the asset or the lease term. Rates of depreciation are generally based on the following useful lives: buildings, 30-40 years; leasehold improvements, typically 1-15 years; furniture and equipment, 3-7 years; and software a maximum of 3 years. Gains on dispositions are included in other non-interest income, and losses on dispositions are included in other non-interest expense in the consolidated statements of income. Maintenance and repairs are charged to operating expenses as incurred, while improvements that extend the useful life of assets are capitalized and depreciated over the estimated remaining life.
Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the estimated undiscounted future cash flows attributable to a long-lived asset are less than its carrying value. In that event, the Company recognizes a loss equal to the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis. Impairment losses are recorded in other non-interest expense in the consolidated statements of income.
Bank Owned Life Insurance (“BOLI”) - BOLI represents life insurance policies on the lives of certain Company officers or former officers for which the Company is the beneficiary. These policies are recorded as an asset on the consolidated statements of financial condition at their cash surrender values, or the amount that could be realized currently. The change in cash surrender value and insurance proceeds received are recorded as BOLI income in non-interest income in the consolidated statements of income.
Goodwill and Other Intangible Assets - Goodwill represents the excess of purchase price over the fair value of net assets acquired (including identifiable intangible assets) using the acquisition method of accounting. Other intangible assets represent purchased assets that lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability.
Goodwill is allocated to reporting units at acquisition. We have determined that our operating segments represent our reporting units under U.S. GAAP, and goodwill is allocated to the Banking and Asset Management reporting units. Subsequent to initial recognition, goodwill is not amortized but, instead, is tested for impairment at the reporting unit level at least annually, or more often if an event occurs or circumstances change that would indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. We perform our annual goodwill impairment assessment as of October 31 each year. In the event we conclude that all or a portion of our goodwill is impaired, a non-cash charge for the amount of such impairment would be recorded in earnings. Such a charge would have no impact on tangible or regulatory capital.
The goodwill impairment testing process is conducted by assigning net assets and goodwill to each reporting unit. In “step one,” the fair value of each reporting unit is compared to the recorded book value. Our step one calculation of each reporting unit’s fair value is based upon a simple average of two metrics: (1) a primary market approach, which measures fair value based upon trading multiples of independent publicly traded financial institutions of comparable size and character to the reporting units, and (2) an income approach, which estimates fair value based upon discounted cash flows and terminal value (using the perpetuity growth method). If the fair value of the reporting unit exceeds its carrying value, goodwill is not considered impaired and “step two” is not considered necessary. If the carrying value of a reporting unit exceeds its fair value, the impairment test continues (“step two”) by comparing the carrying value of the reporting unit’s goodwill to the implied fair value of goodwill. The implied fair value of goodwill is determined using the residual approach, where the fair value of a reporting unit is allocated to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit, calculated in step one, is the price paid to acquire the reporting unit. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. An impairment charge is recognized to the extent the carrying value of goodwill exceeds the implied fair value of goodwill.
The Company has the option at the time of our annual goodwill impairment test to perform a qualitative assessment for each reporting unit to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value before applying the existing two-step goodwill impairment test. If we conclude that this is the case, we would proceed with the existing two-step test, as described above. Otherwise, we would be able to bypass the two-step test and conclude that goodwill is not impaired from a qualitative perspective.
Identified intangible assets that have a finite useful life are amortized over that life in a manner that reflects the estimated decline in the economic value of the identified intangible asset and are subject to impairment testing whenever events or changes in circumstances indicate that the carrying value may not be recoverable. All of the Company’s other intangible assets have finite lives and are amortized over their estimated useful lives with varying periods not exceeding 12 years.
Fiduciary Assets and Assets under Management - Assets held in a fiduciary capacity for clients are not included in the consolidated financial statements as they are not assets of the Company or its subsidiaries. Fiduciary and asset management fees are generally determined based upon market values of assets under management as of a specified date during the period and are included as a component of non-interest income in the consolidated statements of income.
Advertising Costs - All advertising costs are expensed in the period they are incurred.
Loss Contingencies - Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated.
Derivative Instruments - We utilize an overall risk management strategy that incorporates the use of derivative instruments to reduce interest rate risk, as it relates to mortgage loan commitments and planned sales of loans, and foreign currency volatility. We also use these instruments to accommodate our clients as we provide them with risk management solutions, including interest rate and foreign currency contracts. None of the aforementioned end-user and client-related derivatives are designated as hedging instruments.
We also use interest rate derivatives to hedge variability in forecasted interest cash flows in our loan portfolio, which is comprised primarily of floating-rate loans. These derivatives are designated as cash flow hedges.
All derivative instruments are recorded at fair value in the consolidated statements of financial condition, after considering the effects of master netting agreements as allowed under authoritative accounting guidance.
On the date we enter into a derivative contract, we designate the derivative instrument as a fair value hedge, cash flow hedge, or as a freestanding derivative instrument. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk, such as interest rate risk, are considered to be fair value hedges. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that are attributable to a particular risk are considered to be cash flow hedges. We formally document the relationship between all hedging instruments and hedged items, as well as our risk management objective and strategy for undertaking each hedge transaction, at inception of the relationship.
For derivative instruments that are designated and qualify as a fair value hedge and are effective, the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in current earnings during the period of the change in fair values. For derivative instruments that are designated and qualify as a cash flow
hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of OCI. The unrealized gain or loss is reclassified into earnings in the same period the hedged item affects earnings. For all hedge relationships, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized in earnings during the period of change. For derivatives not designated in a hedge relationship, all changes in fair value are reported in current earnings during the period of change.
At the hedge’s inception and at least quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instruments have been highly effective in offsetting changes in the fair values or cash flows of the hedged item and whether they are expected to be highly effective in the future. If a derivative instrument designated as a hedge is terminated or ceases to be highly effective, hedge accounting is discontinued and the gain or loss is amortized to earnings over the remaining life of the hedged asset or liability (fair value hedge) or over the same period that the forecasted hedged transactions impact earnings (cash flow hedge). However, if the forecasted transaction is not probable of occurring, the gain or loss is included in earnings immediately.
The Company classifies cash flows from derivative instruments designated in a hedge relationship in the same category as the cash flows from the items being hedged as long as the derivatives do not include an other-than-insignificant financing element.
Income Taxes - The Company and its subsidiaries file a consolidated Federal income tax return. The provision for income taxes is based on income reported in the consolidated statements of income, rather than amounts reported on our income tax return.
We recognize a deferred tax asset or liability for the estimated future tax effects attributable to “temporary differences.” Temporary differences include differences between financial statement income and tax return income that are expected to reverse in future periods, as well as differences between the financial reporting and tax bases of assets and liabilities that are also expected to be settled in future periods. Deferred tax assets and liabilities are measured using the enacted tax rates that we expect will apply when the differences are reversed or settled. Changes in corporate income tax rates, if any, would impact the pricing of our deferred tax assets and liabilities in the period of enactment, with any changes in the valuation of deferred tax assets and liabilities reflected as an adjustment to income tax expense. A valuation allowance is recorded to reduce deferred tax assets to the amount management concludes is more likely than not to be realized.
We periodically review and evaluate the status of uncertain tax positions and may establish tax reserves for tax benefits that may not be realized. Any income tax-related interest and penalties are included in income tax expense.
Net Earnings Per Common Share - Basic income per common share is calculated using the two-class method. The two-class method is an earnings allocation formula that determines earnings per share for each share of common stock and participating securities according to dividends declared (distributed earnings) and participation rights in undistributed earnings. Distributed and undistributed earnings are allocated between common and participating security stockholders based on their respective rights to receive dividends. Share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are considered participating securities (e.g., the Company’s deferred stock units and certain restricted stock and unit awards). Undistributed net losses are not allocated to holders of participating securities, as they do not have a contractual obligation to fund the losses incurred by the Company. Net income attributable to common shares is then divided by the weighted-average number of common shares outstanding during the period, net of participating securities.
Diluted income per common share considers common stock issuable under the assumed release of unvested restricted stock awards and units and the assumed exercise of stock options granted under the Company’s stock plans (“potentially dilutive common stock equivalents”). The dilutive effect of share-based payment awards that are not deemed to be participating securities is calculated using the treasury stock method, which assumes that the proceeds from exercise are used to purchase common stock at the average market price for the period. The dilutive effect of participating securities is calculated using the more dilutive of the treasury stock method (which assumes that the participating securities are exercised/released) or the two-class method (which assumes that the participating securities are not exercised/released and earnings are reallocated between common and participating security stockholders). Potentially dilutive common stock equivalents are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive.
Treasury Stock - Treasury stock acquired is recorded at cost and is carried as a reduction of equity on the consolidated statements of financial condition.
Share-Based Compensation - Share-based compensation cost is recognized as expense for stock options, restricted stock awards, restricted stock units, and performance share units issued to employees and non-employee directors based on the fair value of these awards at the date of grant. A binomial option-pricing model is utilized to estimate the fair value of stock options, while the closing market price of the Company’s common stock at the date of grant is used for restricted stock awards, restricted stock units
and performance share units (“full value awards”). To the extent full value awards are subject to post-vesting transferability restrictions, a discount for lack of marketability may be applied to the grant date fair value. Additionally, the grant date fair value of full value awards is adjusted to reflect any market conditions that affect vesting of the awards. The costs are recognized ratably on a straight-line basis over the requisite service period, generally defined as the vesting period for the awards. For performance share units, an estimate is made as to the number of shares expected to vest as a result of actual performance against the performance criteria to determine the amount of compensation expense to be recognized. The estimate is re-evaluated quarterly and total compensation expense is adjusted for any change in the current period. When an award is granted to an employee who is retirement eligible or who will become retirement eligible prior to the end of the service period and will continue to vest after retirement, the compensation cost of these awards is recognized over the period up to the date an employee first becomes eligible to retire. The amortization of share-based compensation generally reflects estimated forfeitures adjusted for actual forfeiture experience. As compensation expense is recognized, a deferred tax asset is recorded that represents an estimate of the future tax deduction from exercise or release of restrictions. At the time share-based awards expire, are exercised or canceled, or as restrictions are released, we may be required to recognize an adjustment to income tax expense, depending on the market price of the Company’s stock at that time and the amount of the deferred tax asset relating to such awards. Share-based compensation expense is included in “salaries and wages” in the consolidated statements of income.
Comprehensive Income - Comprehensive income consists of two components, reported net income and OCI. OCI refers to revenue, expenses, gains, and losses that are recorded as an element of equity but are excluded from reported net income. OCI consists of unrealized gains (losses) on securities available-for-sale and changes in the fair value of derivative instruments designated as cash flow hedges, net of tax.
Segment Disclosures - An operating segment is a component of a business that (i) engages in business activities from which it may earn revenues and incur expenses; (ii) has operating results that are reviewed regularly by the entity’s chief operating decision maker to make decisions about resources to be allocated to the segment and assess its performance; and (iii) has discrete financial information available. Our chief operating decision maker evaluates the operations of the Company under three operating segments: Banking, Asset Management, and Holding Company.
Variable Interest Entities - A variable interest entity (“VIE”) is a partnership, limited liability company, trust, or other legal entity that does not have sufficient equity to permit it to finance its activities without additional subordinated financial support from other parties, or whose investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics are: (i) the power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance, (ii) the obligation to absorb the expected losses of the entity; and (iii) the right to receive the expected residual returns of the entity.
U.S. GAAP requires VIEs to be consolidated by the party that has a controlling financial interest in the VIE (i.e., the primary beneficiary). The Company is deemed to have a controlling financial interest and is the primary beneficiary of a VIE if it has both the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and an obligation to absorb losses or the right to receive benefits that could potentially be significant to the VIE.
2. RECENT ACCOUNTING PRONOUNCEMENTS
Recently Adopted Accounting Pronouncements
Accounting for Share-Based Payments When the Terms of an Award Provide that a Performance Target Could Be Achieved after the Requisite Service Period - On January 1, 2016, we adopted new accounting guidance issued by the Financial Accounting Standards Board (“FASB”) that clarifies the accounting for a performance target that affects vesting of a share-based payment award and that could be achieved after the requisite service period. The guidance indicates that such a performance target would not be reflected in the estimation of the award’s grant date fair value. Rather, compensation cost for such an award would be recognized over the requisite service period, if it is probable that the performance target will be achieved. The total amount of compensation cost recognized during and after the requisite service period would reflect the number of awards that are expected to vest and would be adjusted to reflect those awards that ultimately vest. The guidance is applied prospectively to awards that are granted or modified after the effective date. The adoption of this guidance did not impact our consolidated financial position or consolidated results of operations.
Amendments to the Consolidation Analysis - On January 1, 2016, we adopted new accounting guidance issued by the FASB that changes certain aspects of the variable interest and voting interest consolidation models. The amendments modify existing guidance on (1) the evaluation of whether limited partnerships and similar legal entities are variable interest entities (“VIEs”) or voting interest entities, (2) when fee arrangements represent variable interests in a VIE, and (3) the primary beneficiary determination for VIEs. Additionally, the guidance eliminates the presumption that a general partner controls a limited partnership
under the voting interest model and exempts reporting entities from consolidating money market funds that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940. The Company elected to apply the guidance through a cumulative effect adjustment as of January 1, 2016. The adoption of this guidance did not impact our consolidated financial position or consolidated results of operations.
Debt Issuance Costs - On January 1, 2016, we adopted new accounting guidance issued by the FASB that clarifies the presentation of debt issuance costs within the balance sheet. This guidance requires that an entity present debt issuance costs related to a recognized debt liability on the balance sheet as a direct deduction from the carrying amount of that debt liability, not as a separate asset. The standard does not affect the current guidance for the recognition and measurement for debt issuance costs. This guidance was applied retrospectively. The adoption of this guidance did not materially impact our consolidated financial position or consolidated results of operations.
Improvements to Employee Share-Based Payment Accounting - In March 2016, the FASB issued guidance that amends certain aspects of share-based payment accounting. The new guidance (1) requires all income tax effects of awards to be recognized in the income statement when the awards vest or are settled, and eliminates the accounting for additional paid-in-capital pools; (2) allows the Company to repurchase more of an employee's shares for tax withholding purposes without triggering liability accounting; (3) requires the Company to make an accounting policy election to either recognize forfeitures as they occur or estimate the number of awards expected to be forfeited; (4) requires the Company to present excess tax benefits as an operating activity on the statement of cash flows; and (5) clarifies that the Company must classify cash paid to a tax authority when shares are withheld to satisfy its statutory income tax withholding obligation as a financing activity on the statement of cash flows. Regarding the accounting policy election related to the accounting for forfeitures, the Company has elected to estimate the number of awards expected to be forfeited, consistent with our past practice of estimating forfeitures. As permitted under the new guidance, the Company has elected to early adopt the guidance for the Company’s financial statements that include periods beginning on January 1, 2016. The Company has applied the guidance related to items (1) and (4) prospectively; the guidance related to item (5) retrospectively; and the guidance related to items (2) and (3) using a modified retrospective transition method with a cumulative-effect adjustment to retained earnings. For the year ended December 31, 2016, the Company recognized a $3.7 million tax benefit in the consolidated statements of income within the income tax provision, representing the prospective application of the accounting change described in (1) above. Adoption of all other changes did not have an impact on our consolidated financial position or consolidated results of operations.
Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern - In August 2014, the FASB issued guidance that requires management to evaluate whether there are conditions and events that raise substantial doubt about an entity’s ability to continue as a going concern. The guidance requires new disclosures to the extent management concludes there is substantial doubt about an entity’s ability to continue as a going concern. The guidance was effective for the Company’s annual financial statements dated December 31, 2016. The adoption of this guidance did not impact our financial position or consolidated results of operations.
Accounting Pronouncements Pending Adoption
Revenue from Contracts with Customers - In May 2014, August 2015, March 2016, April 2016, May 2016 and December 2016, the FASB issued new revenue recognition guidance that will replace most of the existing revenue recognition guidance in U.S. GAAP. All arrangements involving the transfer of goods or services to customers are within the scope of the guidance, except for certain contracts subject to other U.S. GAAP guidance, including lease contracts and rights and obligations related to financial instruments. The standard’s core principle is that an entity should recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance also includes new disclosure requirements related to the nature, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The guidance is effective for the Company’s financial statements beginning January 1, 2018. The guidance allows an entity to apply the new standard either retrospectively or through a cumulative effect adjustment as of January 1, 2018. We have elected to implement this new accounting guidance using a cumulative-effect adjustment. This guidance does not apply to revenue associated with financial instruments, including loans, securities, and derivatives that are accounted for under other U.S. GAAP guidance. For that reason, we do not expect it to have a material impact on our consolidated results of operations for elements of the statement of income associated with financial instruments, including securities gains, interest income and interest expense. However, we do believe the new standard will result in new disclosure requirements. We are currently in the process of reviewing contracts to assess the impact of the new guidance on our service offerings that are in the scope of the guidance, including Treasury Management and Asset Management services. The Company is continuing to evaluate the effect of the new guidance on revenue sources other than financial instruments on our financial position and consolidated results of operations.
Recognition and Measurement of Financial Assets and Financial Liabilities - In January 2016, the FASB issued guidance that amends the accounting for certain financial asset and financial liabilities. The guidance will require the Company to (1) measure certain equity investments at fair value with changes in fair value recognized in earnings, (2) record changes in instrument-specific credit risk for financial liabilities measured under the fair value option in other comprehensive income, and (3) assess the realizability of deferred tax assets related to available-for-sale debt securities in combination with the Company’s other deferred tax assets. The standard does not change the guidance for classifying and measuring investments in debt securities and loans. The guidance amends certain disclosure requirements related to financial assets and financial liabilities. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2018. Certain provisions of the standard will be applied through a cumulative-effect adjustment as of January 1, 2018, and other provisions will be applied prospectively. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
Leases - In February 2016, the FASB issued guidance that amends the accounting for leases. Under the new guidance, lessees will need to recognize a right-of-use asset and a lease liability for the vast majority of leases. Operating leases will result in straight-line expense, while finance leases will result in a front-loaded expense pattern. Classification will be based on criteria that are largely similar to those applied in current lease accounting. Lessor accounting will remain similar to the current model. Lessors will classify leases as operating, direct financing, or sales-type, consistent with the current model. The new guidance will also require extensive quantitative and qualitative disclosures related to the revenue and expense recognized and expected to be recognized over the lease term, as well as significant judgments made by management. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2019, and early adoption is permitted. The new standard must be applied using a modified retrospective transition. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
Measurement of Credit Losses on Financial Instruments - In June 2016, the FASB issued guidance that changes the impairment model for most financial assets and certain other instruments that are not measured at fair value through net income. For financial assets subject to credit losses and measured at amortized cost and certain off-balance sheet credit exposures (including loans, held-to-maturity debt securities, and loan commitments), the new guidance will require the Company to record an allowance based on the estimated credit losses expected over the life of the financial instrument or pool of financial instruments. The estimate of lifetime expected credit losses must consider historical information, current conditions, and reasonable and supportable forecasts. The new guidance also amends the current other-than-temporary impairment model for available-for-sale debt securities. The new guidance will require the Company to record an allowance for estimated credit losses on available-for-sale securities when the fair value of the security is below the amortized cost of the asset. Additionally, the guidance expands the disclosure requirements related to the Company’s assumptions, models, and methods for estimating the allowance for credit losses. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2020. Early adoption is permitted beginning January 1, 2019. The new standard will be applied using a modified retrospective approach. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
Classification of Certain Cash Receipts and Cash Payments - In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments are presented and classified in the consolidated statements of cash flows. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2018, as well as interim periods thereafter, with early adoption permitted. The guidance will be applied using a retrospective transition method. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
Intra-Entity Transfers of Assets Other Than Inventory - In October 2016, the FASB issued guidance that will require an entity to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. This eliminates the current exception for all intra-entity transfers of an asset other than inventory that requires deferral of the tax effects until the asset is sold to a third party or otherwise recovered through use. The guidance is effective for the Company’s financial statements that include periods beginning after January 1, 2018, as well as periods thereafter. Early adoption is permitted. The guidance will be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
Interests Held through Related Parties that are Under Common Control - In October 2016, the FASB issued guidance that alters how a decision maker considers indirect interests in a VIE held through an entity under common control. Under the new ASU, if a decision maker is required to evaluate whether it is the primary beneficiary of a VIE, it will need to consider only its proportionate indirect interest in the VIE held through a common control party. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2017, as well as interim periods thereafter. The adoption of this guidance is not expected to have a material impact on our financial position or consolidated results of operations.
Restricted Cash - In November 2016, the FASB issued clarifying guidance that requires that the statement of cash flows include restricted cash in the beginning and end-of-period total amounts and that the statement of cash flows explain changes in restricted cash during the period. The guidance is effective for the Company’s financial statements that include periods beginning January 1, 2018, as well as interim periods thereafter. Early adoption is permitted. The amendments will be applied using a retrospective transition method. The Company is in the process of determining the effect of the new guidance on our financial position and consolidated results of operations.
3. SECURITIES
Securities Portfolio
(Amounts in thousands)
The carrying value of securities pledged to secure public deposits, FHLB advances, trust deposits, Federal Reserve Bank (“FRB”) discount window borrowing availability, derivative transactions, and standby letters of credit with counterparty banks and for other purposes as permitted or required by law, totaled $351.4 million and $421.9 million at December 31, 2016 and 2015, respectively. Of total pledged securities, securities pledged to creditors under agreements pursuant to which the collateral may be sold or re-pledged by the secured parties totaled $86.7 million and $100.2 million at December 31, 2016 and 2015, respectively.
Excluding securities issued or backed by the U.S. Government and its agencies and U.S. Government-sponsored enterprises, there were no investments in securities from one issuer that exceeded 10% of consolidated equity at December 31, 2016 or 2015.
The following table presents the fair values of securities with unrealized losses as of December 31, 2016 and 2015. The securities presented are grouped according to the time periods during which the securities have been in a continuous unrealized loss position.
Securities in Unrealized Loss Position
(Amounts in thousands)
There were $48.9 million of securities with $1.7 million in an unrealized loss position for greater than 12 months at December 31, 2016. At December 31, 2015, there were $248.5 million of securities with $5.8 million in an unrealized loss position greater than
12 months. The Company does not consider these unrealized losses to be credit-related. These unrealized losses relate to changes in interest rates and market spreads. We do not intend to sell the securities and we do not believe it is more likely than not that we will be required to sell the investments before recovery of their amortized cost bases, which may be at maturity.
We conduct a quarterly assessment of our investment portfolio to determine whether any securities are OTTI. During the year ended December 31, 2015, we identified three municipal debt securities from the same issuer totaling $1.1 million, which had credit rating downgrades during the period. We determined that the difference between amortized cost and fair value was other-than-temporary and, accordingly, recognized the $466,000 difference as a component of net securities gains in the consolidated statements of income. The securities were sold in January 2016 with no further losses recognized.
The following table presents the remaining contractual maturity of securities as of December 31, 2016 by amortized cost and fair value.
Remaining Contractual Maturity of Securities
(Amounts in thousands)
The following table presents gains (losses) on securities for the three years ended December 31, 2016, 2015, and 2014.
Securities Gains (Losses)
(Amounts in thousands)
(1)
Includes OTTI of $466,000 for the year ended December 31, 2015, and is reported in the consolidated statements of income and cash flows within net securities gains.
Refer to Note 12 for additional details of the securities available-for-sale portfolio and the related impact of unrealized gains (losses) on other comprehensive income.
All non-marketable Community Reinvestment Act (“CRA”) qualified investments, totaling $59.0 million and $54.2 million at December 31, 2016 and 2015, respectively, are recorded in other assets on the consolidated statements of financial condition. There has been no impairment recorded as of December 31, 2016, 2015 or 2014.
4. LOANS AND CREDIT QUALITY
The following loan portfolio and credit quality disclosures exclude covered loans. Covered loans represent loans acquired through a FDIC-assisted acquisition that are subject to a loss share agreement and are presented separately in the consolidated statements of financial condition. Refer to the “Covered Assets” section in this footnote for further information regarding covered loans.
Loan Portfolio
(Amounts in thousands)
We primarily lend to businesses and consumers in the market areas in which we have physical locations. We seek to diversify our loan portfolio by loan type, industry and borrower.
Loans Held-For-Sale
(Amounts in thousands)
(1)
Comprised of residential mortgage loan originations intended to be sold in the secondary market. The Company accounts for these loans under the fair value option. Refer to Note 20 for additional information regarding mortgage loans held-for-sale.
(2)
Amounts represent commercial, commercial real estate, construction and residential loans carried at the lower of aggregate cost or fair value, including one nonaccrual loan totaling $667,000 at December 31, 2015. Generally, the Company intends to sell these loans within 30-60 days from the date the intent to sell was established.
Carrying Value of Loans Pledged
(Amounts in thousands)
(1)
No borrowings were outstanding at December 31, 2016 or 2015.
(2)
Refer to Notes 9 and 10 for additional information regarding FHLB advances.
Related Party Loans
Some of our directors, and certain business entities for which they serve as an executive officer and/or in which they directly or indirectly own 10% or more of the equity, are or have been in the past, lending clients of the Bank. Additionally, two of our executive officers each had an immediate family member who had a small balance loan outstanding as of year end 2015 and 2016. Loans made to these individuals and their affiliated entities were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other unaffiliated persons and do not involve more than the normal risk of collectability. Such loans, in the aggregate, totaled $37.4 million and $39.4 million at December 31, 2016 and 2015, respectively, and were not greater than 5% of stockholders' equity.
Loan Portfolio Aging
(Amounts in thousands)
Impaired Loans
Impaired loans consist of nonaccrual loans (which include nonaccrual TDRs) and loans classified as accruing TDRs. A loan is considered impaired when, based on current information and events, either (i) management believes that it is probable that we
will be unable to collect all amounts due (both principal and interest) according to the original contractual terms of the loan agreement, or (ii) it has been classified as a TDR.
The following two tables present our recorded investment in impaired loans outstanding by product segment, including our recorded investment in impaired loans, which represents the principal amount outstanding, net of unearned income, deferred loan fees and costs, and any direct principal charge-offs.
Impaired Loans
(Amounts in thousands)
Average Recorded Investment and Interest Income Recognized on Impaired Loans (1)
(Amounts in thousands)
(1)
Represents amounts while classified as impaired for the periods presented.
Credit Quality Indicators
We attempt to mitigate risk through loan structure, collateral, monitoring, and other credit risk management controls. We have adopted an internal risk rating policy under which each loan is rated for credit quality with a numerical rating of 1 through 8. Loans rated 5 and better (1-5 ratings, inclusive) are considered “pass” rated credits that we believe exhibit acceptable financial
performance, cash flow, and leverage. Credits rated 6 are performing in accordance with contractual terms, but are considered “special mention” as they demonstrate potential weakness that, if left unresolved, may result in deterioration in our credit position and/or the repayment prospects for the credit. Borrowers rated special mention may exhibit adverse operating trends, high leverage, tight liquidity or other credit concerns. Loans rated 7 may be classified as either accruing (“potential problem”) or nonaccrual (“nonperforming”). Potential problem loans, like special mention, are loans that are performing in accordance with contractual terms, but for which management has some level of concern (greater than that of special mention loans) about the ability of the borrowers to meet existing repayment terms in future periods. Potential problem loans continue to accrue interest, but the ultimate collection of these loans in full is a risk due to the same conditions that characterize a 6-rated credit. These credits may also have somewhat increased risk profiles as a result of the current net worth and/or paying capacity of the obligor or guarantors or a declining value of the collateral pledged. These loans generally have a well-defined weakness that may jeopardize collection of the debt and are characterized by the distinct possibility that we may sustain some loss if the deficiencies are not resolved. Although these loans are generally identified as potential problem loans and require additional attention by management, they may never become nonperforming. Nonperforming loans include nonaccrual loans risk-rated 7 or 8 and have all the weaknesses inherent in a 7-rated potential problem loan with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently-existing facts, conditions and values, highly questionable and improbable. Special mention, potential problem and nonperforming loans are reviewed, at a minimum, on a quarterly basis, while all other rated credits over a certain dollar threshold, depending on loan type, are reviewed annually or more frequently as the circumstances warrant.
Credit Quality Indicators
(Dollars in thousands)
*
Less than 0.1%
Troubled Debt Restructured Loans
Troubled Debt Restructured Loans Outstanding
(Amounts in thousands)
(1)
Included in nonperforming loans.
At December 31, 2016 and 2015, credit commitments to lend additional funds to debtors whose loan terms have been modified in a TDR (both accruing and nonaccruing) totaled $13.4 million and $9.7 million, respectively. The following table presents the type of modification for loans that have been restructured and the post-modification recorded investment during the years ended December 31, 2016 and 2015.
Additions to Troubled Debt Restructurings During the Year
(Dollars in thousands)
(1)
Extension of maturity date also includes loans renewed at an existing rate of interest that is considered a below market rate for that particular loan’s risk profile.
(2)
Other concessions primarily include interest rate reductions, loan increases or deferrals of principal.
Additions to Troubled Debt Restructurings During the Year (Continued)
(Dollars in thousands)
(1)
Extension of maturity date also includes loans renewed at an existing rate of interest that is considered a below market rate for that particular loan’s risk profile.
(2)
Other concessions primarily include interest rate reductions, loan increases or deferrals of principal.
At the time an accruing loan becomes modified and meets the definition of a TDR, it is considered impaired and no longer included as part of the general loan loss reserve calculation. However, our general reserve methodology considers the amount and product type of the TDRs removed as a proxy for potentially heightened risk in the portfolio when establishing final reserve requirements.
As impaired loans, TDRs (both accruing and nonaccruing) are evaluated for impairment at the end of each quarter with a specific valuation reserve created, or adjusted (either individually or as part of a pool), if necessary, as a component of the allowance for loan losses. Refer to the “Impaired Loan” and “Allowance for Loan Loss” sections of Note 1 regarding our policy for assessing potential impairment on such loans. Our allowance for loan losses included $1.6 million and $3.9 million in specific reserves for nonaccrual TDRs at December 31, 2016 and 2015, respectively.
During the year ended December 31, 2016, two commercial loans totaling $8.0 million and one home equity loan totaling $187,000 became nonperforming within 12 months of being modified as an accruing TDR. During the year ended December 31, 2015, a single commercial real estate loan totaling $175,000 became nonperforming within 12 months of being modified as an accruing TDR. A loan typically becomes nonperforming and placed on nonaccrual status when the principal or interest payments are 90 days past due based on contractual terms or when an individual analysis of a borrower’s creditworthiness indicates a loan should be placed on nonaccrual status earlier than the 90-day past due date.
Other Real Estate Owned
The following table presents the composition of property acquired as a result of borrower defaults on loans secured by real property.
OREO Composition
(Amounts in thousands)
The recorded investment in consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process totaled $1.4 million at December 31, 2016, and $3.0 million at December 31, 2015.
Covered Assets
Covered assets represent acquired residential mortgage loans and foreclosed real estate covered under a loss share agreement with the FDIC and include an indemnification receivable representing the present value of the expected reimbursement from the FDIC related to expected losses on the acquired loans and foreclosed real estate under such agreement. The loss share agreement will expire on September 30, 2019. The carrying amount of covered assets is presented in the following table.
Covered Assets
(Amounts in thousands)
(1)
Includes $203,000 and $257,000 of purchased credit-impaired loans as of December 31, 2016 and December 31, 2015, respectively.
The recorded investment in residential mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process totaled $194,000 and $775,000 at December 31, 2016 and December 31, 2015, respectively.
5. ALLOWANCE FOR LOAN LOSSES AND RESERVE FOR UNFUNDED COMMITMENTS
The following allowance and credit quality disclosures exclude covered loans. Refer to Note 4 for a discussion regarding covered loans.
Allowance for Loan Losses and Recorded Investment in Loans
(Amounts in thousands)
(1)
Refer to Notes 1 and 4 for additional information regarding impaired loans.
(1)
Refer to Notes 1 and 4 for additional information regarding impaired loans.
(1)
Refer to Notes 1 and 4 for additional information regarding impaired loans.
Reserve for Unfunded Commitments (1)
(Amounts in thousands)
(1)
Unfunded commitments include commitments to extend credit, standby letters of credit and commercial letters of credit. Unfunded commitments related to covered assets are excluded as they are covered under a loss share agreement with the FDIC.
Refer to Note 19 for additional details of commitments to extend credit, standby letters of credit and commercial letters of credit.
6. PREMISES, FURNITURE, AND EQUIPMENT
Premises, Furniture, and Equipment
(Amounts in thousands)
Depreciation expense on premises, furniture, and equipment totaled $9.4 million, including $535,000 in impairment, in 2016, $8.5 million in 2015 and $8.7 million in 2014.
At December 31, 2016, we were obligated under certain non-cancellable operating leases for premises and equipment, which expire at various dates through the year 2031. Many of these leases contain renewal options, and certain leases provide a right of refusal to purchase the leased property during the lease term. Some leases contain escalation clauses calling for rentals to be adjusted for increased real estate taxes and other operating expenses, or proportionately adjusted for increases in the consumer price index. The following summary reflects the future minimum rental payments, by year, required under operating leases that, as of December 31, 2016, have initial or remaining non-cancellable lease terms in excess of one year.
Operating Leases (1)
(Amounts in thousands)
(1)
Minimum payments have not been reduced by minimum sublease rentals of $1.5 million due in the future under non-cancellable subleases.
(1)
Including amounts paid under short-term cancellable leases.
(2)
Does not include rental expense or sublease rental income for certain restructured leases.
7. GOODWILL AND OTHER INTANGIBLE ASSETS
Carrying Amount of Goodwill by Operating Unit
(Amounts in thousands)
In conjunction with our annual goodwill impairment test performed as of October 31, 2016, we elected to perform a qualitative assessment to determine whether it was more likely than not that the fair values of the Banking and Asset Management reporting units were less than their carrying values. Based on our analysis, we determined it was not more likely than not that the fair values of the Banking and Asset Management reporting units were less than their carrying values, and as such we bypassed the two-step quantitative goodwill impairment test and concluded that goodwill was not impaired as of October 31, 2016.
We are not aware of any events or circumstances subsequent to our annual goodwill impairment testing date of October 31, 2016 that would indicate impairment of goodwill allocated to the Banking and Asset Management reporting units at December 31, 2016. There were no impairment charges for goodwill allocated to the Banking and Asset Management reporting units recorded in 2015 or 2014.
We have other intangible assets capitalized on the consolidated statements of financial condition in the form of core deposit premiums and client relationships. These intangible assets are being amortized over their estimated useful lives, which range from 8 to 12 years.
We review other intangible assets for possible impairment whenever events or changes in circumstances indicate that carrying amounts may not be recoverable. During 2016, there were no events or circumstances that we believe indicate there may be impairment of other intangible assets, and no impairment charges for other intangible assets were recorded in 2016, 2015, or 2014.
Other Intangible Assets
(Amounts in thousands)
Scheduled Amortization of Other Intangible Assets
(Amounts in thousands)
8. DEPOSITS
Summary of Deposits
(Amounts in thousands)
(1)
Time deposits with a minimum denomination of $250,000 totaled $1.5 billion and $1.3 billion at December 31, 2016 and December 31, 2015, respectively.
Scheduled Maturities of Time Deposits
(Amounts in thousands)
Maturities of Time Deposits of $100,000 or More
(Amounts in thousands)
9. SHORT-TERM BORROWINGS
Summary of Short-Term Borrowings
(Dollars in thousands)
(1)
Our total availability of overnight Federal fund (“Fed funds”) borrowings is not a committed line of credit and is dependent upon lender availability.
(2)
Our borrowing capacity changes each quarter subject to available collateral and FRB discount factors.
(3)
As a member of the FHLB Chicago, the Bank has access to borrowing capacity which is subject to change based on the availability of acceptable collateral to pledge and the level of our investment in FHLB Chicago stock. At December 31, 2016, our borrowing capacity was $2.2 billion, of which $648.2 million is available, subject to making the required additional investment in FHLB Chicago stock.
Borrowings with maturities of one year or less are classified as short-term.
FHLB Advances - At December 31, 2016, FHLB advances totaled $1.6 billion, consisting of $1.5 billion in short-term borrowings, and $50.0 million classified as long-term debt. Qualifying residential, multi-family and commercial real estate (“CRE”) loans, home equity lines of credit, and residential mortgage-backed securities are pledged as collateral to secure current outstanding balances and additional borrowing availability.
Other Borrowings - At December 31, 2016, other borrowings consisted of cash received by counterparty in excess of derivative liability and the Company’s obligation to a third party bank under a commercial credit card servicing arrangement. At December 31, 2015, other borrowings represented cash received by counterparty in excess of derivative liability.
Secured Borrowings - Secured borrowings represent amounts related to certain loan participation agreements on loans we originated that were classified as secured borrowings because they did not qualify for sale accounting treatment. A corresponding amount is recorded within loans on the consolidated statements of financial condition.
Revolving Line of Credit - The Company has a 364-day revolving line of credit (the “Facility”) with a group of commercial banks allowing borrowing of up to $60.0 million, and maturing on the earlier of September 22, 2017 or the consummation of the Company’s merger with CIBC. The interest rate applied to borrowings under the Facility will be elected by the Company at the time an advance is made; interest rate elections include either 30-day or 90-day LIBOR plus 1.75% or Prime minus 0.50% at the time the advance
is made. Any amounts outstanding under the Facility upon or before maturity may be converted, at the Company’s option, to an amortized term loan, with the balance of such loan due September 22, 2019 (subject to earlier maturity upon consummation of the merger with CIBC, as previously noted). At December 31, 2016, no amounts were drawn on the Facility.
10. LONG-TERM DEBT
Long-Term Debt
(Dollars in thousands)
(1)
Under the final regulatory capital rules issued in July 2013, these instruments are grandfathered for inclusion as a component of Tier 1 capital, although the Tier 1 capital treatment for these instruments could be subject to phase-out in the event we were to make certain acquisitions. Furthermore, upon completion of our pending merger with CIBC, we do not expect the outstanding Trust Preferred Securities to continue to qualify as Tier 1 capital under FRB regulations as currently in effect.
(2)
Net of deferred financing costs of $2.1 million at December 31, 2016 and $2.2 million at December 31, 2015.
(3)
Net of deferred financing costs of $4.3 million at December 31, 2016 and $4.4 million at December 31, 2015.
(4)
Qualifies as Tier 2 capital for regulatory capital purposes.
(5)
Weighted average interest rate was 3.75% at December 31, 2016 and 2015.
The $167.7 million in junior subordinated debentures presented in the table above were issued to four separate wholly-owned trusts for the purpose of issuing Company-obligated mandatorily redeemable trust preferred securities. Refer to Note 11 for further information on the nature and terms of these and previously issued debentures.
At December 31, 2016, outstanding long-term FHLB advances were secured by qualifying residential, multi-family, commercial real estate, and home equity lines of credit. From time to time, we may pledge eligible real estate mortgage-backed securities to support additional borrowings. The advances include a prepayment feature and are subject to a prepayment fee.
We reclassify long-term debt to short-term borrowings when the remaining maturity becomes less than one year.
Scheduled Maturities of Long-Term Debt
(Amounts in thousands)
11. JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES HELD BY TRUSTS THAT ISSUED TRUST PREFERRED SECURITIES
As of December 31, 2016, we sponsored and wholly owned 100% of the common equity of four trusts that were formed for the purpose of issuing mandatorily redeemable trust preferred securities (“Trust Preferred Securities”) to third-party investors and investing the proceeds from the sale of the Trust Preferred Securities solely in a series of junior subordinated debentures of the Company (“Debentures”). The Debentures held by the trusts, which in aggregate totaled $167.7 million, net of deferred financing costs, at December 31, 2016, are the sole assets of each respective trust. Our obligations under the Debentures and related documents constitute a full and unconditional guarantee by the Company on a subordinated basis of all payments on the Trust Preferred Securities. We currently have the right to redeem, in whole or in part, subject to any required regulatory approval, all or any series of the Debentures at a redemption price of 100% of the principal amount plus accrued and unpaid interest. The repayment, redemption or repurchase of any of the Debentures would be subject to the terms of the applicable indenture and result in a corresponding repayment, redemption or repurchase of an equivalent amount of the related series of Trust Preferred Securities. Any redemption of the 10% Debentures held by the PrivateBancorp Capital Trust IV also would be subject to the terms of the replacement capital covenant described below.
In connection with the issuance in 2008 of the 10% Debentures, which rank junior to the other Debentures, we entered into a replacement capital covenant that relates to the redemption of the 10% Debentures and the related Trust Preferred Securities. Under the replacement capital covenant, as amended in October 2012, we committed, for the benefit of certain debt holders, that we would not repay, redeem or repurchase the 10% Debentures or the related Trust Preferred Securities prior to June 2048 unless we have (1) obtained any required regulatory approval, and (2) raised certain amounts of qualifying equity or equity-like replacement capital at any time after October 10, 2012. The replacement capital covenant benefits holders of our “covered debt” as specified under the terms of the replacement capital covenant. Currently, under the replacement capital covenant, the “covered debt” is the Debentures held by PrivateBancorp Statutory Trust II. In the event that the Company’s 7.125% subordinated debentures due 2042 are designated as or become the covered debt under the replacement capital covenant, the terms of such debentures provide that the Company is authorized to terminate the replacement capital covenant without any further action or payment. We may amend or terminate the replacement capital covenant in certain circumstances without the consent of the holders of the covered debt.
Under current accounting rules, the trusts qualify as variable interest entities for which we are not the primary beneficiary and therefore are ineligible for consolidation in our financial statements. The Debentures issued by us to the trusts are included in our consolidated statements of financial condition as “long-term debt” with the corresponding interest distributions recorded as interest expense. The common shares issued by the trusts and held by us are included in other assets in our consolidated statements of financial condition with the related dividend distributions recorded in other non-interest income.
Common Securities, Preferred Securities, and Related Debentures
(Dollars in thousands)
(1)
The Trust Preferred Securities accrue distributions at a rate equal to the interest rate on, and have a redemption date identical to the maturity date of, the corresponding Debentures. The Trust Preferred Securities are subject to mandatory redemption upon repayment of the Debentures at maturity or upon earlier redemption.
(2)
Reflects the coupon rate in effect at December 31, 2016. The coupon rates for Bloomfield Hills Statutory Trust I, PrivateBancorp Statutory Trust II and PrivateBancorp Statutory Trust III are variable based on three-month LIBOR plus 2.65%, 1.71% and 1.50%, respectively. The coupon rate for PrivateBancorp Capital Trust IV is fixed. Distributions on all Trust Preferred Securities are payable quarterly. We have the right to defer payment of interest on the Debentures at any time or from time to time for a period not exceeding ten years, in the case of the Debentures held by Trust IV, and five years, in the case of all other Debentures, without causing an event of default under the related indenture, provided no extension period may extend beyond the stated maturity of the Debentures. During such extension period, distributions on the Trust Preferred Securities would also be deferred, and our ability to pay dividends on our common stock would generally be prohibited. The Federal Reserve has the ability to prevent interest payments on the Debentures.
(3)
Net of deferred financing costs of $2.1 million at December 31, 2016.
12. EQUITY
Capital Stock
At December 31, 2016 and 2015, the Company had authority to issue 180 million shares of capital stock, consisting of one million shares of preferred stock, five million shares of non-voting common stock and 174 million shares of voting common stock. At December 31, 2016 and 2015, no shares of preferred stock or non-voting common stock were issued or outstanding. The Company had 79.8 million and 79.1 million shares of voting common stock issued and outstanding at December 31, 2016 and 2015, respectively.
The Company reissues treasury stock, when available, or new shares to fulfill its obligation to issue shares granted pursuant to the share-based compensation plans. Treasury shares are reissued at average cost. The Company held no shares in treasury at December 31, 2016 and 2,574 shares in treasury at December 31, 2015.
Comprehensive Income
Change in Accumulated Other Comprehensive Income (“AOCI”) by Component
(Amounts in thousands)
(1)
The amounts reclassified from AOCI for the available-for-sale securities are reported in net securities gains on the consolidated statements of income, while the amounts reclassified from AOCI for cash flow hedges are included in interest income on loans on the consolidated statements of income. For the year ended December 31, 2015, $466,000 was reclassified out of AOCI related to OTTI on available-for-sale securities and included in the consolidated statements of income within net securities gains.
(2)
The tax expense amounts reclassified from AOCI in connection with the available-for-sale securities reclassification and cash flow hedges reclassification are included in income tax provision on the consolidated statements of income.
13. EARNINGS PER COMMON SHARE
Basic and Diluted Earnings per Common Share
(Amounts in thousands, except per share data)
(1)
Participating stockholders are those that hold certain share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents. Such shares or units are considered participating securities (i.e., certain of the Company’s deferred, restricted stock and performance share units, and nonvested restricted stock awards).
(2)
Net income allocated to common stockholders for basic and diluted earnings per share may differ under the two-class method as a result of adding common stock equivalents for options to dilutive shares outstanding, which alters the ratio used to allocate earnings to common stockholders and participating securities for the purposes of calculating diluted earnings per share.
(3)
For the years ended December 31, 2016, 2015, and 2014, the weighted-average outstanding non-participating securities of 290,000, 360,000 and 1.2 million shares, respectively, were not included in the computation of diluted earnings per common share because their inclusion would have been antidilutive for the periods presented.
14. INCOME TAXES
Components of Income Taxes
(Amounts in thousands)
Reconciliation of Income Tax Provision to Statutory Federal Rate
(Amounts in thousands)
Differences between the amounts reported in the consolidated financial statements and the tax bases of assets and liabilities result in temporary differences for which deferred tax assets and liabilities have been recorded.
Deferred Tax Assets and Liabilities
(Amounts in thousands)
Deferred Tax Assets
At December 31, 2016, we have concluded that it is more likely than not that the deferred tax assets will be realized and, accordingly, no valuation allowance was recorded. This conclusion was based on our recent earnings history, on both a book and tax basis, and our outlook for earnings and taxable income in future periods. The net deferred tax asset is recorded on the statement of financial condition within other assets.
Taxable income in prior years and reversing deferred taxable temporary differences provide sources from which deferred tax assets may be absorbed. Additionally, we have relied on our expectation of generating pre-tax earnings in future periods, which should give rise to taxable income levels, exclusive of reversing temporary differences, that more likely than not will be sufficient to absorb the deferred tax assets.
Liabilities Associated with Unrecognized Tax Benefits
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
Roll Forward of Unrecognized Tax Benefits
(Amounts in thousands)
(1)
Not included in the unrecognized tax benefits presented above.
As of December 31, 2016 and 2015, we had $3.3 million and $126,000, respectively, of unrecognized tax benefits relating to uncertain tax positions that, if recognized, would impact the effective tax rate. It is reasonably possible that a significant portion of the liability for unrecognized tax benefits at December 31, 2016 could decrease in the next twelve months due to completion of state tax authorities’ exams or the expiration of statutes of limitations.
We file a U.S. federal income tax return and state income tax returns in various states. We are no longer subject to examinations by U.S. federal tax authorities for 2007 and prior years. We are also no longer subject to examinations by state tax authorities for 2008 and prior years.
15. SHARE-BASED COMPENSATION AND OTHER BENEFITS
Share-Based Plans
The Company adopted the 2011 Incentive Compensation Plan (the “2011 Plan”) in May 2011. In 2014, the Company’s stockholders approved an amendment and restatement of the 2011 Plan to add 2.0 million authorized shares for a total of approximately 6.7 million shares of common stock. The 2011 Plan is designed to align the interests of management with the interests of shareholders, foster retention, create a long-term focus and provide participants a competitive long-term incentive opportunity. The 2011 Plan allows for the issuance of incentive and non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units, equity-based performance stock and units, stock awards and other cash and share-based incentives to employees, including officers and non-employee directors of the Company and its subsidiaries. At December 31, 2016, 1.9 million shares were available for future grant under the 2011 Plan. The Company has three other share-based compensation plans for which no shares remain available for grant, but have unexercised awards outstanding at December 31, 2016. The Company issues shares from treasury, when available, or new shares to fulfill its obligation to issue shares pursuant to grants under the share-based compensation plans. To the extent new shares are issued, the Company believes as of December 31, 2016, there are adequate authorized shares to satisfy anticipated award issuances in 2017.
Financial Statement Impact
The following table presents the share-based compensation expense and related income tax benefits recognized for all equity awards in the accompanying consolidated statements of income for the years ended December 31, 2016, 2015 and 2014.
Effect of Recognizing Share-based Compensation Expense
(Amounts in thousands)
(1)
Based on an estimate of the number of shares expected to vest as a result of actual performance against the performance criteria at December 31, 2016, 2015 and 2014. For additional information regarding our performance share units, refer to the “Performance Share Units” section further in this Note.
Stock Options
Stock option awards have an exercise price equal to the closing price of the Company’s common stock on the date the awards are granted. Stock options vest three years from grant based on continuous service and have a ten-year term. The following table summarizes stock option activity for the years ended December 31, 2016, 2015 and 2014.
Stock Option Activity
(Amounts in thousands, except per share data)
(1)
Represents the average contractual life remaining in years.
(2)
Aggregate intrinsic value represents the total pretax intrinsic value of the “in-the-money” stock options, (i.e., the difference between our closing stock price on the last trading day of the respective year and the option exercise price, multiplied by the number of shares) that would have been received by the option holders if they had exercised their options on the last day of the respective year. This amount will fluctuate with changes in the fair value of our common stock.
Summary of Stock Options Outstanding and Exercisable
(Number of shares in thousands)
(1)
Represents the weighted-average contractual life remaining in years.
Stock Option Valuation Assumptions - The fair value of stock options is estimated at the date of grant using a binomial option-pricing model that utilizes the assumptions outlined in the following table.
Stock Option Valuation Assumptions
Expected life is based on historical exercise and termination behavior. Expected stock price volatility is based on historical volatility of our common stock combined with the implied volatility on the exchange-traded stock options that are derived from the value of our common stock. The risk-free interest rate is based on the implied yield currently available on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the option. The expected dividend yield represents the most recent annual dividend yield as of the date of grant. Management reviews and adjusts the assumptions used to calculate the fair value of an option on a periodic basis to reflect updated information.
Other Stock Option Information
(Dollars in thousands)
(1)
Amounts may be more or less than deferred tax benefit recorded during vesting period.
Restricted Stock and Restricted Unit Awards
We issue common stock with restrictions to certain key employees. The shares are restricted as to transfer, but are not restricted as to voting rights. Dividends are accrued and paid out at the same time the underlying shares are settled. The transfer restrictions generally lapse over a three year period and are contingent upon continued employment. We also issue restricted stock units which
settle in common stock when restrictions lapse which generally coincides with the vest date for most awards, however certain awards have a delayed settlement date. Restricted stock units are issued on similar terms as restricted common stock (with the exception of non-employee directors whose restrictions lapse in equal quarterly installments over a one-year period) and have the right to receive dividend equivalents at settlement, but no voting rights. The fair value of restricted stock and units is based on our closing stock price on the date of grant. For certain restricted stock unit awards with delayed settlement, a discount for lack of marketability (“DLOM”) was applied to the grant date fair value. The weighted-average DLOM applied to awards granted was 28% in 2016, 27% in 2015 and 24% in 2014. The following table summarizes our restricted stock and unit activity for the years ended December 31, 2016, 2015 and 2014.
Restricted Stock and Unit Awards Activity
(Number of shares/units in thousands)
(1)
Includes the effect of the DLOM.
(2)
Represents restricted stock units with a delayed settlement date.
Other Restricted Stock and Unit Award Information
(Dollars in thousands)
(1)
Amount may be more or less than deferred tax benefit recorded during vesting period.
Performance Share Units
Performance share units (“PSUs”) are a component of our executive compensation program which entitles recipients to receive the underlying shares of common stock subject to continued service and the Company’s achievement of specified performance criteria over a three-year period including a relative total shareholder return (“TSR”) multiplier. PSUs are granted at a target number of shares and based on the Company’s performance, the number of shares that vest can be adjusted downward to zero and upward to a maximum of 200%, based on relative TSR against an index of 50 banks over the same three-year period as the performance criteria. The PSUs vest in the quarter following the end of the performance period, after review and certification of the achievement of the specified performance criteria by the Company’s Compensation Committee of the Board of Directors. The PSUs will be settled and converted to shares of common stock two years after vesting, subject to recoupment under certain circumstances. Holders of PSUs are not entitled to vote or receive cash dividends until settlement, but do accrue a dividend equivalent at the same rate as dividend payments to stockholders from grant date until settlement and to be paid out at that time based on actual shares converted to common stock. The fair value of PSUs is based on our closing stock price on the date of grant,
adjusted to reflect any market conditions and is net of a DLOM due to the delayed settlement provisions. The following table summarizes our performance share unit activity for the years ended December 31, 2016, 2015 and 2014.
Performance Share Units Activity (1)
(Number of shares/units in thousands)
(1)
Presented at target level of performance.
(2)
Includes the effect of a 20% DLOM on awards granted in each 2016, 2015 and 2014.
(3)
2016 includes adjustments for achieving specific performance goals for PSUs granted in 2013.
(4)
Represents PSUs with a delayed settlement date.
Savings and Retirement Plan
The Company has a defined contribution retirement plan, The PrivateBancorp, Inc. Savings, Retirement and Employee Stock Ownership Plan (the “KSOP”), which allows employees to make contributions up to 75% of compensation on a pre-tax basis and/or after-tax basis through salary deferrals under Section 401(k) of the Internal Revenue Code. At the employees’ direction, employee contributions are invested among a variety of investment alternatives, including pooled-separate accounts maintained by an insurance carrier, mutual funds of registered investment companies and Company common stock. For employees who have met a 1 year service requirement and make voluntary contributions to the KSOP, we contribute an amount equal to $0.50 for each dollar contributed up to 6% of an employee’s compensation (subject to certain maximum compensation amounts as prescribed in Internal Revenue Service guidance). The Company’s matching contribution vests in increments of 20% annually for each year in which 1,000 hours are worked. The KSOP also allows for a discretionary company contribution. Although no such contribution was made for 2016, 2015 or 2014, the discretionary component vests in increments of 20% annually over a period of 5 years based on the employee’s years of service.
KSOP Plan Information
(Amounts in thousands)
(1)
Amounts reported include the fair value of Company shares held by KSOP disclosed above.
Deferred Compensation Plan
We maintain a non-qualified deferred compensation plan (the “Plan”) which allows eligible participants to defer the receipt of cash compensation or non-employee director fees otherwise payable to them. The purpose of the Plan is to further our ability to attract and retain high quality executives and non-employee directors. Employees who participate in the Plan may elect to defer up to 50% of annual base salary and 100% of annual bonus amounts not subject to a mandatory deferral and directors may elect to defer up to 100% of his or her cash portion of director’s fees earned and paid during the Plan year. Participants elect at the time amounts that are deferred whether such deferral amounts will be credited with “earnings” as if they were invested in either a fixed income account with interest credited based on our prime rate (not to exceed 120% of the applicable federal long-term rate) on the cash value of the funds deposited, or in deferred stock units (“DSUs”) in Company stock with earnings credited in the form of dividends equivalent to that paid to our common stockholders. Except for an “earnings” credit on the deferred amounts, we do not provide any contributions or credits to participants under the Plan. At December 31, 2016 and 2015, there were 145,271 and 133,481 DSUs, respectively, in the Plan. At the time of distribution, amounts credited in DSUs are paid in shares of our common stock while amounts credited in the fixed income account are paid in cash. All elections and payments under the Plan are subject to compliance with requirements of Section 409A of the Internal Revenue Code which may limit elections and require delay in payment of benefits in certain circumstances.
16. REGULATORY AND CAPITAL MATTERS
The Company and the Bank are subject to various regulatory requirements that impose requirements or restrictions on cash reserves, loans or advances, and dividends. The Bank is required to maintain reserves against deposits. Reserves are held either in the form of vault cash or noninterest-bearing balances maintained with the FRB and are based on the average daily balances and statutory reserve ratios prescribed by the type of deposit account. Reserve balances required to be maintained at the FRB were $257.5 million and $199.4 million at December 31, 2016 and 2015, respectively.
Under current FRB regulations, the Bank is limited in the amount it may loan or advance to PrivateBancorp, Inc. on an unconsolidated basis (the “Parent Company”). Loans or advances to a single subsidiary may not exceed 10% of the Bank’s capital stock and surplus (as defined) and loans to all subsidiaries may not exceed 20%. Loans from the Bank to the Parent Company are also required to meet certain collateral requirements.
Various state banking regulations limit the amount of dividends that may be paid to the Parent Company by the Bank and the payment of such dividends is contingent upon a number of factors including the Bank’s ability to meet applicable regulatory capital requirements, the strength of the Bank’s balance sheet, the Bank’s profitability and earnings and the Bank’s ability to satisfy its obligations and support any projected growth. During 2016 and 2015, the Bank paid no dividends to the Parent Company. As of December 31, 2016, the Bank had the capacity under banking regulation to pay dividends of $967.3 million, subject to the Company’s internal capital policy.
Under applicable regulatory capital adequacy guidelines, the Company and the Bank are subject to various capital requirements adopted and administered by the federal banking agencies. These guidelines specify minimum capital ratios calculated in accordance with the definitions in the guidelines, including the leverage ratio, which is Tier 1 capital as a percentage of adjusted average assets, and the Tier 1 risk-based capital, common equity Tier 1 and the total risk-based capital ratios, which are calculated based on risk-weighted assets and off-balance sheet items that have been weighted according to broad risk categories. These minimum ratios are shown in the table below.
To satisfy safety and soundness standards, banking institutions are expected to maintain capital levels in excess of the regulatory minimums depending on the risk inherent in the balance sheet, regulatory expectations and the changing risk profile of business activities. Under our capital management policy, we conduct periodic stress testing of our capital adequacy and target capital ratios at levels above regulatory minimums that we believe are appropriate based on various other risk considerations, including the current operating and economic environment and outlook, internal risk guidelines, and our strategic objectives as well as regulatory expectations.
As of December 31, 2016, the Company’s and the Bank’s capital position was in excess of all minimum regulatory capital adequacy requirements to which they are subject. As of December 31, 2016, the most recent regulatory notification classified the Bank as “well-capitalized” under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes would change the Bank’s classification for this purpose. Failure to meet minimum capital requirements could result in certain mandatory, and possible discretionary, actions by regulators which, if undertaken, could have a material effect on our consolidated financial statements.
The following table presents information about our capital measures and the related regulatory capital guidelines.
Capital Measurements
(Amounts in thousands)
n/a
Not applicable.
17. DERIVATIVE INSTRUMENTS
We utilize an overall risk management strategy that incorporates the use of derivative instruments to reduce both interest rate risk (relating to mortgage loan commitments and planned sales of loans) and foreign currency risk (relating to certain loans denominated in currencies other than the U.S dollar). We also use these instruments to accommodate our clients as we provide them with risk management solutions. None of the client-related and other end-user derivatives, noted in the table below, were designated as hedging instruments for accounting purposes at December 31, 2016 and 2015.
Notional Amounts and Fair Value of Derivative Instruments
(Amounts in thousands)
(1)
The remaining average notional amounts are shown for risk participation agreements.
(2)
Represents netting of derivative asset and liability balances, and related cash collateral, with the same counterparty subject to master netting agreements. Refer to Note 18 for additional information regarding master netting agreements.
Derivatives expose us to counterparty credit risk. Credit risk is managed through our standard underwriting process. Actual exposures are monitored against various types of credit limits established to contain risk within parameters. Additionally, credit risk is managed through the use of collateral, netting agreements, and the establishment of internal concentration limits by financial institution.
Certain of our derivative contracts contain embedded credit risk contingent features that if triggered either allow the derivative counterparty to terminate the derivative or require additional collateral. These contingent features are triggered if we do not meet specified financial performance indicators such as minimum capital ratios under the federal banking agencies’ guidelines. All such requirements were met at December 31, 2016 and December 31, 2015. The fair value of the derivatives with credit contingency features in a net liability position at December 31, 2016 totaled $2.1 million and $1.0 million of collateral was posted for these transactions. If the credit risk contingency features were triggered at December 31, 2016, no additional collateral would be required to be posted to derivative counterparties and $2.1 million in outstanding derivative instruments would be immediately settled.
Derivatives Designated in Hedge Relationships
We use interest rate derivatives to hedge variability in forecasted interest cash flows in our loan portfolio which is comprised primarily of floating-rate loans. These derivatives are designated as cash flow hedges. The objective of our hedging program is to use interest rate derivatives to manage our exposure to interest rate movements.
Cash Flow Hedges - Under our cash flow hedging program we enter into receive fixed/pay variable interest rate swaps to convert certain floating-rate commercial loan cash flows to fixed-rate to reduce the variability in forecasted interest cash flows due to market interest rate changes. We use regression analysis to assess the effectiveness of cash flow hedges at both the inception of the hedge relationship and on an ongoing basis. Ineffectiveness is generally measured as the amount by which the cumulative change in fair value of the hedging instrument exceeds the present value of the cumulative change in the expected cash flows of the hedged item. Measured ineffectiveness is recognized directly in other non-interest income in the consolidated statements of
income. During the year ended December 31, 2016, there were no gains or losses from cash flow hedge derivatives related to ineffectiveness that were reclassified to current earnings. The effective portion of the gains or losses on cash flow hedges are recorded, net of tax, in accumulated other comprehensive income (“AOCI”) and are subsequently reclassified to interest income on loans in the period that the hedged interest cash flows affect earnings. As of December 31, 2016, the maximum length of time over which forecasted interest cash flows are hedged is approximately four years. As of December 31, 2016, $2.3 million in net deferred gains, net of tax, recorded in AOCI are expected to be reclassified into earnings during the next twelve months. This amount could differ from amounts actually recognized due to changes in interest rates, hedge de-designations, and the addition of other hedges subsequent to December 31, 2016. There are no components of derivative gains or losses excluded from the assessment of hedge effectiveness related to our cash flow hedge strategy.
During the year ended December 31, 2016, there were no gains or losses from cash flow hedge derivatives reclassified to current earnings because it became probable that the original forecasted transaction would not occur. Refer to Note 12 for additional information regarding the changes in AOCI related to the interest rate swaps designated as cash flow hedges.
Derivatives Not Designated in Hedge Relationships
Client-Related Derivatives - We offer, through our capital markets group, over-the-counter interest rate and foreign exchange derivatives to our clients, including but not limited to, interest rate swaps, interest rate options (also referred to as caps, floors, collars, etc.), foreign exchange forwards and options, as well as cash products such as foreign exchange spot transactions. When our clients enter into an interest rate or foreign exchange derivative transaction with us, we generally mitigate our exposure to market risk through the execution of off-setting positions with inter-bank dealer counterparties. Although the off-setting nature of transactions originated by our capital markets group limits our market risk exposure, they do expose us to other risks including counterparty credit, settlement, and operational risk.
To accommodate our loan clients, we occasionally enter into risk participation agreements (“RPA”) with counterparty banks to either accept or transfer a portion of the credit risk related to their interest rate derivatives or transfer a portion of the credit risk related to our interest rate derivatives. This allows clients to execute an interest rate derivative with one bank while allowing for distribution of the credit risk among participating members. We have entered into written RPAs in which we accept a portion of the credit risk associated with an interest rate derivative of another bank’s loan client in exchange for a fee. We manage this credit risk through our loan underwriting process, and when appropriate, the RPA is backed by collateral provided by the clients under their loan agreement.
The current payment/performance risk of written RPAs is assessed using internal risk ratings which range from 1 to 8 with the latter representing the highest credit risk. The risk rating is based on several factors including the financial condition of the RPA’s underlying derivative counterparty, present economic conditions, performance trends, leverage, and liquidity.
The maximum potential amount of future undiscounted payments that we could be required to make under our written RPAs assumes that the underlying derivative counterparty defaults and that the floating interest rate index of the underlying derivative remains at zero percent. In the event that we would have to pay out any amounts under our RPAs, we will seek to maximize the recovery of these amounts from assets that our clients pledged as collateral for the derivative and the related loan.
Risk Participation Agreements
(Dollars in thousands)
Other End-User Derivatives - We use forward commitments to sell to-be-announced securities and other commitments to sell residential mortgage loans at specified prices to economically hedge the change in fair value of customer interest rate lock commitments and residential mortgage loans held-for-sale. The forward commitments to sell and the interest rate lock commitments
are considered derivatives. At December 31, 2016, the par value of our residential mortgage loans held-for-sale totaled $25.4 million, the notional value of our interest rate lock commitments totaled $37.4 million, and the notional value of our forward commitments to sell totaled $85.9 million.
We are also exposed at times to foreign exchange risk as a result of originating loans in which the principal and interest are settled in a currency other than U.S. dollars. As of December 31, 2016, our exposure was to the Euro, Canadian dollar, Danish kroner, British pound and Australian dollar on $38.4 million of loans. We manage this risk using forward currency derivatives.
Additionally, in connection with certain negotiated credit facilities, we receive warrants to acquire stock in privately-held client companies and are considered derivatives under current accounting standards. As of December 31, 2016, warrants totaled $263,000.
Gain (Loss) Recognized on Derivative Instruments
Not Designated in Hedging Relationship
(Amounts in thousands)
18. BALANCE SHEET OFFSETTING
Master Netting Agreements
Certain financial instruments, including repurchase agreements, securities lending arrangements and derivatives, may be eligible for offset in the consolidated balance sheet and/or subject to enforceable master netting or similar agreements. Authoritative accounting guidance permits the netting of financial assets and liabilities when a legally enforceable master netting agreement exists between us and a counterparty. A master netting agreement is an agreement between two counterparties who have multiple financial contracts with each other that provide for the net settlement of contracts through a single payment, in a single currency, in the event of default on or termination of any one contract. For those financial instruments subject to enforceable master netting agreements, assets and liabilities, and related cash collateral, with the same counterparty are reported on a net basis within the assets and liabilities on the consolidated statements of financial condition.
Derivative contracts may require us to provide or receive cash or financial instrument collateral. Collateral associated with derivative assets and liabilities subject to enforceable master netting agreements with the same counterparty is posted on a net basis. We have pledged cash or financial collateral in accordance with each counterparty’s collateral posting requirements for all of the Company’s derivative assets and liabilities in a net liability position as of December 31, 2016 and 2015. Certain collateral posting requirements are subject to posting thresholds and minimum transfer amounts, such that we are only required to post collateral once the posting threshold is met, and any adjustments to the amount of collateral posted must meet minimum transfer amounts.
As of December 31, 2016 and 2015, $5.2 million and $17.8 million of cash collateral pledged, respectively, was netted with the related financial liabilities on the consolidated statement of financial condition. To the extent not netted against fair values under
a master netting agreement, the excess collateral received or pledged is included in other short-term borrowings or other investments, respectively. There was no excess cash collateral pledged at December 31, 2016 and 2015. Any securities pledged to counterparties as financial instrument collateral remain on the consolidated statements of financial condition as long as we do not default.
The following table presents information about our financial assets and liabilities and the related collateral by derivative type (e.g., interest rate contracts). As we post collateral with counterparties on the basis of our net position in all financial contracts with a given counterparty, the information presented below aggregates the financial contracts entered into with the same counterparty.
Offsetting of Financial Assets and Liabilities
(Amounts in thousands)
(1)
All derivative contracts are over-the-counter contracts.
(2)
Represents financial instrument and related cash collateral entered into with the same counterparty and subject to a master netting agreement.
(3)
Collateralization is determined at the counterparty level. If overcollateralization exists, the amount shown is limited to the fair value of the financial instrument.
(4)
Financial instruments are disclosed at fair value. Financial instrument collateral is allocated pro-rata amongst the derivative liabilities to which it relates.
(1)
All derivative contracts are over-the-counter contracts.
(2)
Represents financial instrument and related cash collateral entered into with the same counterparty and subject to a master netting agreement.
(3)
Collateralization is determined at the counterparty level. If overcollateralization exists, the amount shown is limited to the fair value of the financial instrument.
(4)
Financial instruments are disclosed at fair value. Financial instrument collateral is allocated pro-rata amongst the derivative liabilities to which it relates.
19. COMMITMENTS, GUARANTEES, AND CONTINGENT LIABILITIES
Credit Extension Commitments and Guarantees
In the normal course of business, we enter into a variety of financial instruments with off-balance sheet risk to meet the financing needs of our clients and to conduct lending activities. These instruments principally include commitments to extend credit, standby letters of credit, and commercial letters of credit. These instruments involve, to varying degrees, elements of credit and liquidity risk in excess of the amounts reflected in the consolidated statements of financial condition.
Contractual or Notional Amounts of Financial Instruments (1)
(Amounts in thousands)
(1)
Includes covered loan commitments of $9.0 million and $9.7 million as of December 31, 2016 and 2015, respectively.
Commitments to extend credit are agreements to lend funds to, or issue letters of credit for the account of, a client as long as there is no violation of any condition established in the credit agreement. Commitments generally have fixed expiration dates or other termination clauses and variable interest rates tied to the prime rate or LIBOR and may require payment of a fee for the unused portion of the commitment or for the amounts issued but not drawn on letters of credit. All or a portion of unfunded commitments require regulatory capital support, except for unfunded commitments of less than one year that are unconditionally cancellable. Since many of our commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the borrowers. As of December 31, 2016, we had a reserve for unfunded commitments of $17.1 million, which reflects our estimate of inherent losses associated with these commitment obligations. The balance of this reserve changes based on a number of factors, including the balance of outstanding commitments and our assessment of the likelihood of borrowers to utilize these commitments. The reserve is recorded in other liabilities in the consolidated statements of financial condition.
Standby and commercial letters of credit are conditional commitments issued by us to guarantee the performance of a client to a third party. Standby letters of credit include performance and financial guarantees for clients in connection with contracts between our clients and third parties. Standby letters of credit are agreements where we are obligated to make payment to a third party on behalf of a client in the event the client fails to meet their contractual obligations. Commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn upon when the underlying transaction is consummated between the client and the third party. In most cases, the Company receives a fee for the amount of a letter of credit issued but not drawn upon.
In the event of a client’s nonperformance, our credit loss exposure is equal to the contractual amount of those commitments. We manage this credit risk in a similar manner to evaluating credit risk in extending loans to clients under our credit policies. We use the same credit policies in making credit commitments as for on-balance sheet instruments, mitigating exposure to credit loss through various collateral requirements, if deemed necessary. In the event of nonperformance by the clients, we have rights to the underlying collateral, which could include CRE, physical plant and property, inventory, receivables, cash and marketable securities.
The maximum potential future payments guaranteed by us under standby letters of credit arrangements are equal to the contractual amount of the commitment. The unamortized fees associated with standby letters of credit, which are included in other liabilities in the consolidated statements of financial condition, totaled $1.7 million as of December 31, 2016. We amortize these amounts into income over the commitment period. As of December 31, 2016, standby letters of credit had a remaining weighted-average term of approximately 13 months, with remaining actual lives ranging from less than 1 year to 6 years.
Other Commitments
The Company has unfunded commitments to CRA investments and other investment partnerships totaling $45.4 million at December 31, 2016. Of these commitments, $35.9 million related to legally-binding unfunded commitments for tax-credit investments and was included on the consolidated statements of financial condition within other liabilities and included within other assets as part of the carrying value of the investments.
Credit Card Settlement Guarantees
Our third-party corporate credit card provider issues corporate purchase credit cards on behalf of our commercial clients. The corporate purchase credit cards are issued to employees of certain of our commercial clients at the client’s direction and used for payment of business-related expenses. In most circumstances, these cards will be underwritten by our third-party provider. However, in certain circumstances, we may enter into a recourse agreement, which transfers the credit risk from the third-party provider to us in the event that the client fails to meet its financial payment obligation. In these circumstances, a total maximum exposure amount is established for our corporate client. In addition to the obligations presented in the prior table, the maximum potential future payments guaranteed by us under this third-party settlement guarantee were $21.3 million at December 31, 2016.
We believe that the estimated amounts of maximum potential future payments are not representative of our actual potential loss given our insignificant historical losses from this third-party settlement guarantee program. As of December 31, 2016, we have no recorded contingent liability in the consolidated financial statements for this settlement guarantee program, and management believes that the probability of any loss under this arrangement is remote.
Mortgage Loans Sold with Recourse
Certain mortgage loans sold in the secondary market have limited recourse provisions. The losses for the years ended December 31, 2016 and 2015 arising from limited recourse provisions were not material. Based on this experience, the Company has not established any liability for potential future losses relating to mortgage loans sold in prior periods.
Legal Proceedings
Following the announcement of the proposed transaction with CIBC, three putative class actions were filed on behalf of our public stockholders in the Circuit Court of Cook County, Chicago, Illinois. The three actions have been consolidated and styled In re PrivateBancorp, Inc. Shareholder Litigation, 2016-CH-08949. All of the actions name as defendants the Company and each of its directors individually, and assert that the directors breached their fiduciary duties in connection with the proposed transaction. Two of the complaints are also brought against CIBC and assert that the Company and CIBC aided and abetted the directors’ alleged breaches. The actions broadly allege that the transaction was the result of a flawed process, that the price is unfair, and that certain provisions of the merger agreement might dissuade a potential suitor from making a competing offer, among other things. The plaintiffs subsequently filed an amended complaint, adding a claim alleging breaches of the fiduciary duty of disclosure by the directors. Plaintiffs seek injunctive and other relief, including damages. The plaintiffs in the three actions have agreed in principle not to pursue the actions as a result of the inclusion of certain additional disclosures in the proxy statement for the Company’s special meeting of stockholders. The defendants, including the Company, believe the demands and complaints are without merit and there are substantial legal and factual defenses to the claims asserted, and the proxy statement for the special meeting disclosed all material information prior to the inclusion of the additional disclosures.
As of December 31, 2016, and in the ordinary course of business, there were various other legal proceedings pending against the Company and our subsidiaries that are incidental to our regular business operations. Management does not believe that the outcome of any of these proceedings will have, individually or in the aggregate, a material adverse effect on our business, results of operations, financial condition or cash flows.
20. ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS
We measure, monitor, and disclose certain of our assets and liabilities on a fair value basis. Fair value is used on a recurring basis to account for securities available-for-sale, mortgage loans held-for-sale, derivative assets, derivative liabilities, and certain other assets and other liabilities. In addition, fair value is used on a nonrecurring basis to apply lower-of-cost-or-market accounting to foreclosed real estate and certain other loans held-for-sale, evaluate assets or liabilities for impairment, including collateral-dependent impaired loans, and for disclosure purposes. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Depending on the nature of the asset or liability, we use various valuation techniques and input assumptions when estimating fair value.
U.S. GAAP requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value and establishes a fair value hierarchy that prioritizes the inputs used to measure fair value into three broad levels based on the reliability of the input assumptions. The hierarchy gives the highest priority to level 1 measurements and the lowest priority to level 3 measurements. The three levels of the fair value hierarchy are defined as follows:
•
Level 1 - Unadjusted quoted prices for identical assets or liabilities traded in active markets.
•
Level 2 - Observable inputs other than level 1 prices, such as quoted prices for similar instruments; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the asset or liability.
•
Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.
The categorization of where an asset or liability falls within the hierarchy is based on the lowest level of input that is significant to the fair value measurement.
Valuation Methodology
We believe our valuation methods are appropriate and consistent with other market participants. However, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. Additionally, the methods used may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values.
The following describes the valuation methodologies we use for assets and liabilities measured at fair value, including the general classification of the assets and liabilities pursuant to the valuation hierarchy.
Securities Available-for-Sale - Securities available-for-sale include U.S. Treasury, U.S. Agency, collateralized mortgage obligations, residential mortgage-backed securities, state and municipal securities, and foreign sovereign debt. Substantially all available-for-sale securities are fixed-income instruments that are not quoted on an exchange, but may be traded in active markets. The fair value of these securities is based on quoted market prices obtained from external pricing services. The principal markets for our securities portfolio are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets. U.S. Treasury securities have been classified in level 1 of the valuation hierarchy. All other remaining securities are generally classified in level 2 of the valuation hierarchy. In cases where significant credit valuation adjustments are incorporated into the estimation of fair value, reported amounts are classified as level 3. On a quarterly basis, the Company uses a variety of methods to validate the overall reasonableness of the fair values obtained from external pricing services, including evaluating pricing service inputs and methodologies, using exception reports based on analytical criteria, comparing prices obtained to prices received from other pricing sources, and reviewing the reasonableness of prices based on the Company’s knowledge of market liquidity and other market-related conditions.
Mortgage Loans Held-for-Sale - Mortgage loans held-for-sale represent residential mortgage loan originations intended to be sold in the secondary market. We have elected the fair value option for residential mortgage loans originated with the intention of selling to a third party. The election of the fair value option aligns the accounting for these loans with the related mortgage banking derivatives used to economically hedge them. These mortgage loans are measured at fair value as of each reporting date, with changes in fair value recognized through mortgage banking non-interest income. The fair value of mortgage loans held-for-sale is determined based on prices obtained for loans with similar characteristics from third party sources. On a quarterly basis, the Company validates the overall reasonableness of the fair values obtained from third party sources by comparing prices obtained to prices received from various other pricing sources, and reviewing the reasonableness of prices based on Company knowledge of market liquidity and other market-related conditions. Mortgage loans held-for-sale are classified in level 2 of the valuation hierarchy.
Residential Real Estate Loans Fair Value Option - Residential real estate loans fair value option represent residential real estate loans that originated as held-for-sale and subsequently transferred to loans held-for-investment. Similar to the mortgage loans held-for-sale, we have elected the fair value option for these loans. These residential real estate loans are measured at fair value as of each reporting date, with changes in fair value recognized through mortgage banking non-interest income. The fair value of these residential real estate loans is determined based on prices obtained for loans with similar characteristics from third-party sources. On a quarterly basis, the Company validates the overall reasonableness of the fair values obtained from third-party sources by comparing prices obtained to prices received from various other pricing sources, and reviewing the reasonableness of prices based on Company knowledge of market liquidity and other market-related conditions. Residential real estate loans fair value option are classified in level 2 of the valuation hierarchy.
Collateral-Dependent Impaired Loans - We do not record loans held-for-investment at fair value on a recurring basis. However, periodically, we record nonrecurring adjustments to reduce the carrying value of certain impaired loans based on fair value measurement. This population of impaired loans includes those for which repayment of the loan is expected to be provided solely by the underlying collateral. We measure the fair value of collateral-dependent impaired loans based on the fair value of the collateral securing these loans less estimated selling costs. A majority of collateral-dependent impaired loans are secured by real estate with the fair value generally determined based upon appraisals performed by a certified or licensed appraiser using a combination of valuation techniques such as sales comparison, income capitalization and cost approach and include inputs such as absorption rates, capitalization rates and comparables. We also consider other factors or recent developments that could result in adjustments to the collateral value estimates indicated in the appraisals. Accordingly, fair value estimates for collateral-dependent impaired loans are classified in level 3 of the valuation hierarchy. The carrying value of all impaired loans and the related specific reserves are disclosed in Note 4.
At the time a collateral-dependent loan is initially determined to be impaired, we review the existing appraisal. If the most recent appraisal is greater than one-year old, a new evaluation of the underlying collateral is obtained. For collateral-dependent impaired loans that are secured by real estate, we generally obtain "as is" appraisal values to evaluate impairment. When a collateral-dependent loan is secured by non-real estate collateral such as receivables, inventory, or equipment, the fair value is generally determined based upon appraisals, field exams, or receivable reports. The valuation techniques and inputs are reviewed internally by workout and/or asset-based specialists for reasonableness of estimated liquidation costs, collectability probabilities, and other market data. Appraisals for real estate collateral-dependent impaired loans in excess of $500,000 are updated with new independent appraisals at least annually and are formally reviewed by our internal appraisal department. Additional diligence is performed at the six-month interval between annual appraisals. If during the course of the six-month review process there is evidence supporting a meaningful decline in the value of collateral, the appraised value is either adjusted downward or a new appraisal is required to support the value of the impaired loan. As part of our internal review process, we consider other factors or recent developments that could adjust the valuations indicated in the appraisals or internal reviews. The Company’s internal appraisal review process validates the reasonableness of appraisals in conjunction with analyzing sales and market data from an array of market sources.
Covered Asset OREO and OREO - Covered asset OREO and OREO generated from our originated book of business are valued on a nonrecurring basis using third-party appraisals of each property and our judgment of other relevant market conditions and are classified in level 3 of the valuation hierarchy. As part of our internal review process, we consider other factors or recent developments that could adjust the valuations indicated in the appraisals or internal reviews. Updated appraisals on both OREO portfolios are typically obtained every twelve months and evaluated internally at least every six months. In addition, both property-specific and market-specific factors as well as collateral type factors are taken into consideration, which may result in obtaining more frequent appraisal updates or internal assessments. Appraisals are conducted by third-party independent appraisers under internal direction and engagement using a combination of valuation techniques such as sales comparison, income capitalization and cost approach and include inputs such as absorption rates, capitalization rate and comparables. Any appraisal with a value in excess of $250,000 is subject to a compliance review. Appraisals received with a value in excess of $1.0 million are subject to a technical review. Appraisals are either reviewed internally by our appraisal department or sent to an outside technical firm if appropriate. Both levels of review involve a scope appropriate for the complexity and risk associated with the OREO. To validate the reasonableness of the appraisals obtained, the Company compares the appraised value to the actual sales price of properties sold and analyzes the reasons why a property may be sold for less than its appraised value. Accordingly, these fair value estimates are classified in level 3 of the valuation hierarchy.
Derivative Assets and Derivative Liabilities - Derivative instruments with positive fair values are reported as an asset and derivative instruments with negative fair value are reported as liabilities, in both cases after taking into account the effects of master netting agreements. For derivative counterparties, we measure nonperformance risk on the basis of our net exposure to the counterparty. The fair value of derivative assets and liabilities is determined based on prices obtained from third-party advisors using standardized industry models, or based on quoted market prices obtained from external pricing services. Many factors affect derivative values, including the level of interest rates, the market’s perception of our nonperformance risk as reflected in our credit spread, and our assessment of counterparty nonperformance risk. The nonperformance risk assessment is based on our evaluation of credit risk, or if available, on observable external assessments of credit risk. Values of derivative assets and liabilities are primarily based on observable inputs and are classified in level 2 of the valuation hierarchy, with the exception of certain client-related derivatives, RPAs, and interest rate lock commitments and warrants, as discussed below. On a quarterly basis, the Company uses a variety of methods to validate the overall reasonableness of the fair values obtained from third-party advisors, including evaluating inputs and methodologies used by the third-party advisors, comparing prices obtained to prices received from other pricing sources, and reviewing the reasonableness of prices based on the Company’s knowledge of market liquidity and other market-related conditions. While we may challenge valuation inputs used in determining prices obtained from third parties based on our validation procedures, during the years ended December 31, 2016 and 2015, we did not alter the fair values ultimately provided by the third-party advisors.
Level 3 derivatives include RPAs, derivatives associated with clients whose loans are risk-rated 6 or higher (“watch list derivative”), interest rate lock commitments and warrants. Refer to “Credit Quality Indicators” in Note 4 for further discussion of risk ratings.
For the level 3 RPAs and watch list derivatives, the Company obtains prices from third-party advisors, consistent with the valuation processes employed for the Company’s derivatives classified in level 2 of the fair value hierarchy, and then applies loss factors to adjust the prices obtained from third-party advisors. The significant unobservable inputs that are employed in the valuation process for the RPAs and watch list derivatives that cause these derivatives to be classified in level 3 of the fair value hierarchy are the historic loss factors specific to the particular industry segment and risk rating category. The loss factors are updated quarterly and are derived and aligned with the loss factors utilized in the calculation of the Company’s general reserve component of the allowance for loan losses. Changes in the fair value measurement of RPAs and watch list derivatives are largely due to changes in the fair value of the derivative, risk rating adjustments and fluctuations in the pertinent historic average loss rate.
For the interest rate lock commitments on mortgage loans, the fair value is based on prices obtained for loans with similar characteristics from third-party sources, adjusted for the probability that the interest rate lock commitment will fund (the “pull-through” rate). The significant unobservable input that causes these derivatives to be classified in level 3 of the fair value hierarchy is the pull-through rate. Pull-through rates are derived using the Company’s historical data and reflect the Company’s best estimate of the likelihood that a committed loan will ultimately fund. Significant increases in this input in isolation would result in a significantly higher fair value measurement and significant decreases would result in a significantly lower fair value measurement.
The fair value of our warrants to acquire stock in privately-held client companies is based on a Black-Scholes option pricing model that estimates the asset value by using stated strike prices, estimated stock prices, option expiration dates, risk-free interest rates based on a duration-matched U.S. Treasury rate, and option volatility assumptions. The significant unobservable inputs that cause these derivatives to be classified in level 3 of the fair value hierarchy are the estimated stock prices, adjustments to the option expiration dates, and option volatility assumptions. The estimated stock prices are based on the most recent valuation of the privately-held client company, adjusted as deemed appropriate for changes in relevant market conditions. Option expiration dates are modified to account for the estimated actual remaining life relative to the stated expiration of the warrants. The option volatility assumptions are based on the volatility of publicly-traded companies that operate in similar industries as the privately-held client companies. Significant increases in these inputs in isolation would result in a significantly higher fair value measurement and significant decreases would result in a significantly lower fair value measurement.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents the hierarchy level and fair value for each major category of assets and liabilities measured at fair value at December 31, 2016 and 2015 on a recurring basis.
Fair Value Measurements on a Recurring Basis
(Amounts in thousands)
(1)
Represents loans accounted for under the fair value option.
If a change in valuation techniques, input assumptions or market observability/liquidity for an asset or liability occurred between periods, we would consider whether this would result in a transfer between the three levels of the fair value hierarchy. There have been no transfers of assets or liabilities between level 1 and level 2 of the valuation hierarchy between December 31, 2015 and December 31, 2016.
There have been no other changes in the valuation techniques we used for assets and liabilities measured at fair value on a recurring basis from December 31, 2015 to December 31, 2016.
Reconciliation of Beginning and Ending Fair Value for Those
Fair Value Measurements Using Significant Unobservable Inputs (Level 3) (1)
(Amounts in thousands)
(1)
Fair value is presented prior to giving effect to netting adjustments.
(2)
Amounts disclosed in this line are included in the consolidated statements of income as capital markets products income for derivatives and mortgage banking income for interest rate lock commitments.
(3)
Transfers in and transfers out are recognized at the end of each quarterly reporting period. In general, derivative assets and liabilities are transferred into Level 3 from Level 2 due to a lack of observable market data, as there was deterioration in the credit risk of the derivative counterparty. Conversely, derivative assets and liabilities are transferred out of Level 3 into Level 2 due to an improvement in the credit risk of the derivative counterparty.
Financial Instruments Recorded Using the Fair Value Option
Difference Between Aggregate Fair Value and Aggregate Remaining Principal Balance
for Loans Elected to be Carried at Fair Value
(Amounts in thousands)
(1)
The change in fair value is reflected in mortgage banking non-interest income.
As of December 31, 2016 and 2015, none of the mortgage loans held-for-sale were on nonaccrual or 90 days or more past due and still accruing interest. Changes in fair value due to instrument-specific credit risk for the year ended December 31, 2016 were not material.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
From time to time, we may be required to measure certain other financial assets at fair value on a nonrecurring basis. These adjustments to fair value usually result from the application of lower-of-cost-or-fair-value accounting or write-downs of individual assets when there is evidence of impairment.
The following table provides the fair value of those assets that were subject to fair value adjustments during the years ended December 31, 2016 and 2015 and still held at December 31, 2016 and 2015, respectively. All fair value measurements on a nonrecurring basis were measured using level 3 of the valuation hierarchy.
Fair Value Measurements on a Nonrecurring Basis
(Amounts in thousands)
(1)
Represents the fair value of loans adjusted to the appraised value of the collateral with a write-down in fair value or change in specific reserves during the respective period. These fair value adjustments are recorded against the allowance for loan losses.
(2)
Represents the fair value of foreclosed properties that were adjusted subsequent to their initial classification as foreclosed assets. Write-downs are recognized as a component of net foreclosed real estate expense in the consolidated statements of income.
There have been no changes in the valuation techniques we used for assets and liabilities measured at fair value on a nonrecurring basis from December 31, 2015 to December 31, 2016.
Additional Information Regarding Level 3 Fair Value Measurements
The following table presents information regarding the unobservable inputs developed by the Company for its level 3 fair value measurements.
Quantitative Information Regarding Level 3 Fair Value Measurements
(Dollars in thousands)
(1)
Represents fair value of underlying swap.
The significant unobservable inputs used in the fair value measurement of the watch list derivatives and RPAs are the historic loss factors. An increase (decrease) in the pertinent loss factor would result in a lower (higher) fair value measurement.
Estimated Fair Value of Certain Financial Instruments
U.S. GAAP requires disclosure of the estimated fair values of certain financial instruments, both assets and liabilities, on and off-balance sheet, for which it is practical to estimate the fair value. Because the disclosure of estimated fair values provided herein excludes the fair value of certain other financial instruments and all non-financial instruments, any aggregation of the estimated fair value amounts presented would not represent total underlying value. Examples of non-financial instruments having value not disclosed herein include the future earnings potential of significant customer relationships and the value of our asset management operations and other fee-generating businesses. In addition, other significant assets including property, plant, and equipment and goodwill are not considered financial instruments and, therefore, have not been included in the disclosure.
Various methodologies and assumptions have been utilized in management’s determination of the estimated fair value of our financial instruments, which are detailed below. The fair value estimates are made at a discrete point in time based on relevant market information. Because no market exists for a significant portion of these financial instruments, fair value estimates are based on judgments regarding future expected economic conditions, loss experience, and risk characteristics of the financial instruments. These estimates are subjective, involve uncertainties, and cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
In addition to the valuation methodology explained above for financial instruments recorded at fair value, the following methods and assumptions were used in estimating the fair value of financial instruments that are carried at cost in the consolidated statements of financial condition and includes the general classification of the assets and liabilities pursuant to the valuation hierarchy.
Short-term financial assets and liabilities - For financial instruments with a shorter-term or with no stated maturity, prevailing market rates, and limited credit risk, the carrying amounts approximate fair value. Those financial instruments include cash and due from banks, federal funds sold and interest-bearing deposits in banks (including the receivable for cash collateral pledged), accrued interest receivable, and accrued interest payable. Accrued interest receivable and accrued interest payable are classified consistent with the hierarchy of their corresponding assets and liabilities.
Other loans held-for-sale - Included in loans held-for-sale at December 31, 2016 and 2015 are $78.4 million and $73.1 million, respectively, of loans carried at the lower of aggregate cost or fair value. Fair value estimates are based on the actual agreed upon price in the agreement.
Securities held-to-maturity - Securities held-to-maturity include collateralized mortgage obligations, residential mortgage-backed securities, commercial mortgage-backed securities and state and municipal securities. Substantially all held-to-maturity securities are fixed income instruments that are not quoted on an exchange, but may be traded in active markets. The fair value of these securities is based on quoted market prices obtained from external pricing services. The principal markets for our securities portfolio are the secondary institutional markets, with an exit price that is predominantly reflective of bid level pricing in those markets.
FHLB stock - The carrying value of FHLB stock approximates fair value as the stock is non-marketable, and can only be sold to the FHLB or another member institution at par.
Loans - Other than certain residential real estate loans accounted for under the fair value option, the fair value of loans is calculated by discounting estimated cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. Cash flows are estimated by applying contractual payment terms to assumed interest rates. The estimate of maturity is based on contractual terms and includes assumptions that reflect our and the industry’s historical experience with repayments for each loan classification. The estimation is modified, as required, by the effect of current economic and lending conditions, collateral, and other factors.
Covered assets - Covered assets include acquired loans and foreclosed loan collateral covered under a loss share agreement with the FDIC (including the fair value of expected reimbursements from the FDIC). The fair value of covered assets is calculated by discounting contractual cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the asset. The estimate of maturity is based on contractual terms and includes assumptions that reflect our and the industry’s historical experience with repayments for each asset classification. The estimate is modified, as required, by the effect of current economic and lending conditions, collateral, and other factors.
Investment in BOLI - The cash surrender value of our investment in bank owned life insurance approximates the fair value.
Community reinvestment investments - The fair values of these instruments were estimated using an income approach (discounted cash flow) that incorporates current market rates.
Deposit liabilities - The fair values disclosed for noninterest-bearing deposits, savings deposits, interest-bearing demand deposits, and money market deposits are approximately equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair values for certificates of deposit and time deposits were estimated using present value techniques by discounting the future cash flows at rates based on internal models and broker quotes.
Short-term borrowings - The fair value of FHLB advances with remaining maturities of one year or less is estimated by discounting the obligations using the rates currently offered for borrowings of similar remaining maturities. The fair value of the repurchase obligation is considered to be equal to the carrying value because of its short-term nature. The fair value of secured borrowings and other borrowings is equal to the value of the loans they are collateralizing. See “Loans” above for further information. The carrying amount of the obligation for cash collateral held is considered to be its fair value because of its short-term nature.
Long-term debt - The fair value of the Company’s fixed-rate long-term debt was estimated using the unadjusted publicly-available market price as of period end.
FHLB advances with remaining maturities greater than one year and the Company’s variable-rate junior subordinated debentures are estimated by discounting future cash flows. For the FHLB advances with remaining maturities greater than one year, the Company discounts cash flows using quoted interest rates for similar financial instruments. For the Company’s variable-rate junior subordinated debentures, we interpolate a discount rate we believe is appropriate based on quoted interest rates and entity specific adjustments.
Commitments - Given the limited interest rate risk posed by the commitments outstanding at period end due to their variable rate structure, termination clauses provided in the agreements, and the market rate of fees charged, we have deemed the fair value of commitments outstanding to be immaterial.
Financial Instruments
(Amounts in thousands)
21. OPERATING SEGMENTS
We have three primary operating segments: Banking, Asset Management and the Holding Company. With respect to the Banking and Asset Management segments, each is delineated by the products and services that it offers. The Banking operating segment is comprised of commercial and personal banking services, including mortgage originations. Commercial banking services are primarily provided to corporations and other business clients and include a wide array of lending and cash management products. Personal banking services offered to individuals, professionals, and entrepreneurs include direct lending and depository services. The Asset Management segment includes certain activities of our PrivateWealth group, including investment management, personal trust and estate administration, custodial and escrow, retirement plans and brokerage services. The activities of the third operating segment, the Holding Company, include the direct and indirect ownership of our banking subsidiary, the issuance of debt and intersegment eliminations.
The accounting policies of the individual operating segments are the same as those of the Company as described in Note 1. Transactions between operating segments are primarily conducted at fair value, resulting in profits that are eliminated from consolidated results of operations.
Financial results for each segment are presented below. For segment reporting purposes, the statement of financial condition of Asset Management is included with the Banking segment.
Operating Segments Performance
(Amounts in thousands)
Operating Segments Performance (Continued)
(Amounts in thousands)
(1)
Deposit amounts represent the elimination of Holding Company cash accounts included in total deposits of the Banking segment.
22. VARIABLE INTEREST ENTITIES
The Company is required to consolidate VIEs in which it has a controlling financial interest. The following table summarizes the carrying amounts of the consolidated VIEs’ assets included in the Company’s statements of financial condition as adjusted for intercompany eliminations at December 31, 2016. At December 31, 2015, the Company did not have any VIEs that were consolidated in our financial statements.
Consolidated VIEs
(Amounts in thousands)
The Company sponsors and consolidates certain VIEs that invest in community development projects designed primarily to promote community welfare, such as economic rehabilitation and development of low-income areas by providing housing, services, or jobs for residents. These VIEs invest in community development projects through the extension of below-market loans that generate a return primarily through the realization of federal new markets tax credits. The consolidated VIEs’ loans are recognized within loans on the Company’s consolidated statements of financial condition. The federal new markets tax credits earned from equity investments in VIEs are recognized as a component of income tax expense, and interest income received on the loans is recognized within interest income on the Company’s consolidated statements of income. The assets of the consolidated VIEs are the primary source of funds to settle their respective obligations. The creditors of the VIEs do not have recourse to the general credit of the Company. The Company’s exposure to each consolidated VIE is limited to the amount of equity invested by the Company in the VIE.
The table below presents our interests in VIEs that are not consolidated in our financial statements at December 31, 2016 and 2015.
Nonconsolidated VIEs
(Amounts in thousands)
(1)
Net of deferred financing costs of $2.1 million and $2.2 million at December 31, 2016 and 2015 respectively.
(2)
Excludes personal loans and loans to non-for-profit entities.
Trust preferred capital securities issuances - As discussed in Note 11, we sponsor and wholly own 100% of the common equity of four trusts that were formed for the purpose of issuing Trust Preferred Securities to third-party investors and investing the proceeds therefrom in debentures issued by the Company. The trusts’ only assets are the debentures and the related interest receivable, which are included within long-term debt in our consolidated statements of financial condition. The Company is not the primary beneficiary of the trusts and accordingly, the trusts are not consolidated in our financial statements.
CRA investments and loans - We hold certain investments and loans that make investments to further our CRA initiatives. CRA investments are included within other assets and loans are included within loans in our consolidated statements of financial condition. Certain of these investments and loans meet the definition of a VIE, but the Company is not the primary beneficiary as we are a limited investor and do not have the power to direct their investment activities. Accordingly, we will continue to account for our interests in these investments and loans on an unconsolidated basis. Our maximum exposure to loss is limited to the carrying amount plus additional required future capital contributions.
A portion of our CRA investments are investments in limited liability entities that invest in affordable housing projects that qualify for low-income housing tax credits. These investments entitle the Company to tax credits through 2029. Any new investments in qualified affordable housing projects entered into on or after January 1, 2014, that meet certain conditions are accounted for using the proportional amortization method. Prior to January 1, 2014, the Company accounted for all of its investments in qualified affordable housing projects using the effective yield method and has elected to continue accounting for preexisting tax credit investments using the effective yield method as permitted under the accounting standards.
The carrying value of the Company’s tax credit investments in affordable housing projects totaled $42.9 million and $27.0 million as of December 31, 2016 and 2015, respectively. Commitments to provide future capital contributions totaling $35.9 million as of December 31, 2016, are expected to be paid through 2031. These investments are reviewed periodically for impairment. No impairment losses were recorded for the years ended December 31, 2016 and 2015. The following table summarizes the impact on the consolidated statement of income for the periods presented.
Affordable Housing Tax Credit Investments
(Amounts in thousands)
Restructured loans - For certain troubled commercial loans, we restructure the terms of the borrower’s debt in an effort to increase the probability of collecting amounts contractually due. Following a restructuring, the borrower entity typically meets the definition of a VIE, and economic events have proven that the entity’s equity is not sufficient to permit it to finance its activities without additional subordinated financial support or a restructuring of the terms of its financing. As we do not have the power to direct the activities that most significantly impact such troubled commercial borrowers’ operations, we are not considered the primary beneficiary even in situations where, based on the size of the financing provided, we are exposed to potentially significant benefits and losses of the borrowing entity. We have no contractual requirements to provide financial support to the borrowing entities beyond certain funding commitments established upon restructuring of the terms of the debt. Our interests in the troubled commercial borrowers include outstanding loans and related derivative assets. Our maximum exposure to loss is limited to these interests plus any additional future funding commitments.
23. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS
The following represents the condensed financial statements of PrivateBancorp, Inc., the parent company.
Statements of Financial Condition
(Parent Company only)
(Amounts in thousands)
Statements of Income
(Parent Company only)
(Amounts in thousands)
Statements of Cash Flows
(Parent Company only)
(Amounts in thousands)
24. QUARTERLY EARNINGS PERFORMANCE (UNAUDITED)
Quarterly Earnings Performance (1)
(Dollars in thousands, except per share data)
(1)
All ratios are presented on an annualized basis.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of the end of the period covered by this report (the “Evaluation Date”), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and its Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-15 and 15d-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms. There were no changes in the Company’s internal control over financial reporting during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Report On Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. The Company’s internal control over financial reporting is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.
Management, including our Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2016 was effective based on the specified criteria.
Ernst & Young LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K, has issued an attestation report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016. That report, which expresses an unqualified opinion on the Company’s internal control over financial reporting as of December 31, 2016, is included in this Item under the heading “Attestation Report of Independent Registered Public Accounting Firm.”
Attestation Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of PrivateBancorp, Inc.
We have audited PrivateBancorp, Inc.’s (the Company) internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of the Company as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the three years in the period ended December 31, 2016, of the Company and our report dated February 28, 2017 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Chicago, Illinois
February 28, 2017
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE
Certain information regarding our executive officers is included under “Executive Officers” in Item 1 of this Form 10-K and the information included therein is incorporated herein by reference.
All other information required to be disclosed pursuant to this item shall be included in an amendment to this report filed with the SEC on Form 10-K/A not later than 120 days after December 31, 2016 or incorporated by reference from our definitive proxy statement for the election of directors, to the extent required, not later than 120 days after December 31, 2016.
We have adopted a Code of Ethics as required by the NASDAQ listing standards and the rules of the SEC. The Code of Ethics applies to all of our directors, officers, including our Chief Executive Officer, Chief Financial Officer, and Controller and employees. The Code of Ethics is publicly available on our website at http://investor.theprivatebank.com or at www.theprivatebank.com. If we make substantive amendments to the Code of Ethics or grant any waiver, including any implicit waiver, that applies to any of our directors or executive officers, we will disclose the date and nature of such amendment or waiver on our website or in a report on Form 8-K in accordance with applicable NASDAQ and SEC rules.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required to be disclosed pursuant to this item shall be included in an amendment to this report filed with the SEC on Form 10-K/A not later than 120 days after December 31, 2016 or incorporated by reference from our definitive proxy statement for the election of directors, to the extent required, not later than 120 days after December 31, 2016.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information regarding security ownership of certain beneficial owners and management required to be disclosed pursuant to this item shall be included in an amendment to this report filed with the SEC on Form 10-K/A not later than 120 days after December 31, 2016 or incorporated by reference from our definitive proxy statement for the election of directors, to the extent required, not later than 120 days after December 31, 2016.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table sets forth information, as of December 31, 2016, relating to our equity compensation plans pursuant to which equity awards are authorized for issuance. Refer to Note 15 of “Notes to Consolidated Financial Statements” in Item 8 of this Form 10-K for additional information regarding our equity compensation plans.
(1)
Weighted-average exercise price is based solely on securities with an exercise price.
(2)
Includes all outstanding stock options under the Amended and Restated 2011 Incentive Compensation Plan (“2011 ICP”), the 2007 Long-Term Incentive Compensation Plan (“2007 LTICP”) and the Incentive Compensation Plan, all outstanding restricted stock units and performance share units under the 2011 ICP and 2007 LTICP, and shares underlying deferred stock units credited under the Deferred Compensation Plan, payable on a one-for-one basis in shares of our common stock.
(3)
Represents all remaining outstanding stock options under the Strategic Long Term Incentive Plan (“SLTIC Plan”). At December 31, 2016, the weighted-average remaining contractual term was less than 1 year. In 2007, our Board of Directors adopted the SLTIC Plan which provided for the granting of inducement equity awards to newly recruited officers and employees recruited to join the Company as part of our transformational business plan at that time. The SLTIC Plan was not submitted to stockholders for their approval, and since December 31, 2009, no further awards can be issued under this plan.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE
The information required to be disclosed pursuant to this item shall be included in an amendment to this report filed with the SEC on Form 10-K/A not later than 120 days after December 31, 2016 or incorporated by reference from our definitive proxy statement for the election of directors, to the extent required, not later than 120 days after December 31, 2016.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required to be disclosed pursuant to this item shall be included in an amendment to this report filed with the SEC on Form 10-K/A not later than 120 days after December 31, 2016 or incorporated by reference from our definitive proxy statement for the election of directors, to the extent required, not later than 120 days after December 31, 2016.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PRIVATEBANCORP, INC.
Registrant
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Larry D. Richman, Jennifer R. Evans and Kevin M. Killips, and each of them, the true and lawful attorney-in-fact and agents of the undersigned, with full power of substitution and resubstitution, for and in the name, place and stead of the undersigned, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and hereby grants to such attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully as to all intents and purposes as each of the undersigned might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on February 28, 2017.
Signatures
Title
/s/ Larry D. Richman
President, Chief Executive Officer and Director
Larry D. Richman
/s/ Kevin M. Killips
Chief Financial Officer and Principal Financial Officer
Kevin M. Killips
/s/ Paul E. Carey
Controller, Chief Accounting Officer and Principal Accounting Officer
Paul E. Carey
/s/ James M. Guyette
Chairman and Director
James M. Guyette
/s/ Diane M. Aigotti
Director
Diane M. Aigotti
/s/ Norman R. Bobins
Director
Norman R. Bobins
Signatures
Title
/s/ Michelle L. Collins
Director
Michelle L. Collins
/s/ Cheryl Mayberry McKissack
Director
Cheryl Mayberry McKissack
/s/ James B. Nicholson
Director
James B. Nicholson
/s/ Richard S. Price
Director
Richard S. Price
/s/ Edward W. Rabin, Jr.
Director
Edward W. Rabin, Jr.
/s/ William R. Rybak
Director
William R. Rybak
/s/ Alejandro Silva
Director
Alejandro Silva
EXHIBIT INDEX
(a)
Filed herewith.
(b)
This exhibit shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, or otherwise subject to the liability of that section, and shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934.
Exhibits 10.1 through 10.38 are management contracts or compensatory plans or arrangements.