Item 1.
BUSINESS
General
Commerce Bancshares, Inc., a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. Through a second tier wholly-owned bank holding company, it owns all the outstanding capital stock of Commerce Bank (the “Bank”), which is headquartered in Missouri. The Bank engages in general banking business, providing a broad range of retail, mortgage banking, corporate, investment, trust, and asset management products and services to individuals and businesses. Commerce Bancshares, Inc. also owns, directly or through the Bank, various non-banking subsidiaries. Their activities include private equity investment, securities brokerage, insurance agency, and leasing activities. A list of Commerce Bancshares, Inc.'s subsidiaries is included as Exhibit 21.
Commerce Bancshares, Inc. and its subsidiaries (collectively, the "Company") is one of the nation’s top 50 bank holding companies, based on asset size. At December 31, 2019, the Company had consolidated assets of $26.1 billion, loans of $14.8 billion, deposits of $20.5 billion, and equity of $3.1 billion. The Company’s operations are consolidated for purposes of preparing the Company’s consolidated financial statements. The Company's principal markets, which are served by 164 branch facilities, are located throughout Missouri, Kansas, and central Illinois, as well as Tulsa and Oklahoma City, Oklahoma and Denver, Colorado. Its two largest markets are St. Louis and Kansas City, which serve as central hubs for the Company. The Company also has offices supporting its commercial customers in Dallas, Houston, Cincinnati, Nashville, Des Moines, Indianapolis, and Grand Rapids, and operates a commercial payments business with sales representatives covering the continental United States of America (“U.S.”).
The Company’s goal is to be the preferred provider of financial services in its communities, based on strong customer relationships built through providing top quality service with a strong risk management culture, and employing a strong balance sheet with exceptional capital levels. The Company operates under a super-community banking format which incorporates large bank product offerings coupled with deep local market knowledge, augmented by experienced, centralized support in select, critical areas. The Company’s focus on local markets is supported by an experienced team of bankers assigned to each market coupled with industry specialists. The Company also uses regional advisory boards, comprised of local business persons, professionals and other community representatives, who assist the Company in responding to local banking needs. In addition to this local market, community-based focus, the Company offers sophisticated financial products usually only available at much larger financial institutions.
The markets the Bank serves are mainly located in the lower Midwest, which provides natural sites for production and distribution facilities and serve as transportation hubs. The economy has been well-diversified in these markets with many major industries represented, including telecommunications, automobile, technology, financial services, aircraft and general manufacturing, health care, numerous service industries, and food and agricultural production. The real estate lending operations of the Bank are predominantly centered in its lower Midwestern markets. Historically, these markets have tended to be less volatile than in other parts of the country. Management believes the diversity and nature of the Bank’s markets has a mitigating effect on real estate loan losses in these markets.
From time to time, the Company evaluates the potential acquisition of various financial institutions. In addition, the Company regularly considers the purchase and disposition of real estate assets and branch locations. The Company seeks merger or acquisition partners that are culturally similar, have experienced management and either possess significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. The Company has not completed any bank acquisitions since 2013.
Employees
The Company employed 4,576 persons on a full-time basis and 259 persons on a part-time basis at December 31, 2019. The Company provides a comprehensive array of flexible benefit programs to its employees with a focus on financial and physical wellness. The Company's financial benefits package includes a company-matching 401(k) savings plan, a 529 college savings plan, and employee educational and adoption assistance programs. The Company's health and wellness package includes health, dental, vision, life and various other insurances, as well as a wellness program that incentivizes employees to live a healthy and balanced lifestyle. The Company has developed several training and development programs designed to challenge and develop the management and leadership skills of employees, promote collaboration amongst various internal departments and geographic locations, and share best-practices to meet the needs of customers and communities. The Company has also developed numerous training courses targeted to develop interpersonal and technical skills, as well as, to provide training on new banking regulations. None of the Company's employees are represented by collective bargaining agreements.
Competition
The Company operates in the highly competitive environment of financial services. The Company regularly faces competition from banks, savings and loan associations, credit unions, brokerage companies, mortgage companies, insurance companies, trust companies, credit card companies, private equity firms, leasing companies, securities brokers and dealers, financial technology companies, e-commerce companies, mutual fund companies, and other companies providing financial services. Some of these competitors are not subject to the same regulatory restrictions as domestic banks and bank holding companies. Some other competitors are significantly larger than the Company, and therefore have greater economies of scale, greater financial resources, higher lending limits, and may offer products and services that the Company does not provide. The Company competes by providing a broad offering of products and services to support the needs of customers, matched with a strong commitment to customer service. The Company also competes based on quality, innovation, convenience, reputation, industry knowledge, and price. In its two largest markets, the Company has approximately 12% of the deposit market share in Kansas City and approximately 8% of the deposit market share in St. Louis.
Operating Segments
The Company is managed in three operating segments: Commercial, Consumer, and Wealth. The Commercial segment provides a full array of corporate lending, merchant and commercial bank card products, leasing, and international services, as well as business and government deposit, investment, and cash management services. The Consumer segment includes the retail branch network, consumer installment lending, personal mortgage banking, and consumer debit and credit bank card activities. The Wealth segment provides traditional trust and estate planning services, brokerage services, and advisory and discretionary investment portfolio management services to both personal and institutional corporate customers. In 2019, the Commercial, Consumer and Wealth segments contributed 52%, 24% and 24% of total segment pre-tax income, respectively. See the section captioned "Operating Segments" in Item 7, Management's Discussion and Analysis, of this report and Note 13 to the consolidated financial statements for additional discussion on operating segments.
Government Policies
The Company's operations are affected by federal and state legislative changes, by the United States government, and by policies of various regulatory authorities, including those of the numerous states in which they operate. These include, for example, the statutory minimum legal lending rates, domestic monetary policies of the Board of Governors of the Federal Reserve System, United States fiscal policy, international currency regulations and monetary policies, the U.S. Patriot Act, and capital adequacy and liquidity constraints imposed by federal and state bank regulatory agencies.
Supervision and Regulation
The following information summarizes existing laws and regulations that materially affect the Company's operations. It does not discuss all provisions of these laws and regulations, and it does not include all laws and regulations that affect the Company presently or may affect the Company in the future.
General
The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended (BHC Act). Under the BHC Act, the Federal Reserve Board’s prior approval is required in any case in which the Company proposes to acquire all or substantially all the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. With certain exceptions, the BHC Act also prohibits the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any non-banking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries, and may not acquire voting control of non-banking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, the Bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). Under the terms of the CRA, banks have a continuing obligation, consistent with safe and sound operation, to help meet the credit needs of their communities, including providing credit to individuals residing in low- and moderate-income areas. The Bank has a current CRA rating of “outstanding.”
The Company is required to file various reports and additional information with the Federal Reserve Board. The Federal Reserve Board regularly performs examinations of the Company. The Bank is a state-chartered Federal Reserve member bank and is subject to regulation, supervision and examination by the Federal Reserve Bank of Kansas City and the Missouri Division of Finance. The Bank is also subject to regulation by the Federal Deposit Insurance Corporation (FDIC). In addition, there are numerous other federal and state laws and regulations which control the activities of the Company, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates,
loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. The Bank is subject to federal and state consumer protection laws, including laws designed to protect customers and promote fair lending. These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, and their respective state law counterparts. If the Company fails to comply with these or other applicable laws and regulations, it may be subject to civil monetary penalties, imposition of cease and desist orders or other written directives, removal of management and, in certain circumstances, criminal penalties. This regulatory framework is intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.
In addition to its regulatory powers, the Federal Reserve Bank affects the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. government securities and oversees changes in the discount rate on bank borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These methods are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets, and the level of inflation. The monetary policies of the Federal Reserve have a significant effect on the operating results of financial institutions, most notably on the interest rate environment. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and fiscal authorities, the Company makes no prediction as to possible future changes in interest rates, deposit levels or loan demand, or their effect on the financial statements of the Company.
The financial industry operates under laws and regulations that are under regular review by various agencies and legislatures and are subject to change. The Company currently operates as a bank holding company, as defined by the Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act), and the Bank qualifies as a financial subsidiary under the GLB Act, which allows it to engage in investment banking, insurance agency, brokerage, and underwriting activities that were not available to banks prior to the GLB Act. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities.
The Company must also comply with the requirements of the Bank Secrecy Act (BSA). The BSA is designed to help fight drug trafficking, money laundering, and other crimes. Compliance is monitored by the Federal Reserve. The BSA was enacted to prevent banks and other financial service providers from being used as intermediaries for, or to hide the transfer or deposit of money derived from, criminal activity. Since its passage, the BSA has been amended several times. These amendments include the Money Laundering Control Act of 1986 which made money laundering a criminal act, as well as the Money Laundering Suppression Act of 1994 which required regulators to develop enhanced examination procedures and increased examiner training to improve the identification of money laundering schemes in financial institutions.
The USA PATRIOT Act, established in 2001, substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the U.S. The regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent, and report money laundering and terrorist financing. The regulations include significant penalties for non-compliance.
The Company is subject to regulation under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2011 (Dodd-Frank Act). Among its many provisions, the Dodd-Frank Act required stress-testing for certain financial services companies and established a new council of “systemic risk” regulators. The Dodd Frank Act also established the Consumer Financial Protection Bureau (CFPB) which is authorized to supervise certain financial services companies and has responsibility to implement, examine for compliance with, and enforce “Federal consumer financial law.” The Company is subject to examinations by the CFPB. The Dodd-Frank Act, through Title VI, commonly known as the Volcker Rule, placed trading restrictions on financial institutions and separated investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. The Volcker Rule also restricts financial institutions from investing in and sponsoring certain types of investments.
In May 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act was signed into law which provides a number of limited amendments to the Dodd-Frank Act. Notable provisions of the legislation include: an increase in the asset threshold from $50 billion to $250 billion, above which the Federal Reserve is required to apply enhanced prudential standards; an exemption from the Volker Rule for insured depository institutions with less than $10 billion in consolidated assets; modifications to the Liquidity Coverage and Supplementary Leverage ratios; and the elimination of Dodd-Frank company-run stress tests for banks and bank holding companies with less than $250 billion in assets. While most of these provisions affect institutions larger than the Company, the Company is no longer required to prepare stress testing as specified by the Dodd-Frank Act.
Subsidiary Bank
Under Federal Reserve policy, the bank holding company, Commerce Bancshares, Inc. (the "Parent"), is expected to act as a source of financial strength to its bank subsidiary and to commit resources to support it in circumstances when it might not otherwise do so. In addition, loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Deposit Insurance
Substantially all of the deposits held by the Bank are insured up to applicable limits (generally $250,000 per depositor for each account ownership category) by the FDIC's Deposit Insurance Fund (DIF) and are subject to deposit insurance assessments to maintain the DIF. In 2011, the FDIC released a final rule to implement provisions of the Dodd-Frank Act that affect deposit insurance assessments. Among other things, the Dodd-Frank Act raised the minimum designated reserve ratio from 1.15% to 1.35% of estimated insured deposits, removed the upper limit of the designated reserve ratio, required that the designated reserve ratio reach 1.35% by September 30, 2020, and required the FDIC to offset the effect of increasing the minimum designated reserve ratio on depository institutions with total assets of less than $10 billion. The Dodd-Frank Act provided the FDIC flexibility in the implementation of the increase in the designated reserve ratio and also required that the FDIC redefine the assessment base to average consolidated assets minus average tangible equity.
On June 30, 2016, the DIF rose above 1.15%, resulting in a reduction of the initial assessment rate for all banks and implementing a 4.5 basis point surcharge on insured depository institutions with total consolidated assets of $10 billion or more. Effective October 1, 2018, this surcharge was eliminated as the DIF reached its required level of 1.35% of estimated insured deposits. This had the effect of reducing the Company’s insurance costs by $1.5 million in the fourth quarter of 2018. The Company's deposit insurance expense was $6.7 million in 2019 and $11.5 million in 2018.
Payment of Dividends
The Federal Reserve Board may prohibit the payment of cash dividends to shareholders by bank holding companies if their actions constitute unsafe or unsound practices. The principal source of the Parent's cash revenues is cash dividends paid by the Bank. The amount of dividends paid by the Bank in any calendar year is limited to the net profit of the current year combined with the retained net profits of the preceding two years, and permission must be obtained from the Federal Reserve Board for dividends exceeding these amounts. The payment of dividends by the Bank may also be affected by factors such as the maintenance of adequate capital.
Capital Adequacy
The Company is required to comply with the capital adequacy standards established by the Federal Reserve, which are based on the risk levels of assets and off-balance sheet financial instruments. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to judgments by regulators regarding qualitative components, risk weightings, and other factors.
A new comprehensive capital framework was established by the Basel Committee on Banking Supervision, which was effective for large and internationally active U.S. banks and bank holding companies on January 1, 2015. A key goal of the new framework, known as "Basel III," was to strengthen the capital resources of banking organizations during normal and challenging business environments. Basel III increased minimum requirements for both the quantity and quality of capital held by banking organizations. The rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The capital conservation buffer is intended to absorb losses during periods of economic stress. Failure to maintain the buffer will result in constraints on dividends, stock repurchases and executive compensation. The rule also adjusted the methodology for calculating risk-weighted assets to enhance risk sensitivity. At December 31, 2019, the Company's capital ratios are well in excess of those minimum ratios required by Basel III.
The Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires each federal banking agency to take prompt corrective action to resolve the problems of insured depository institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. Pursuant to FDICIA, the FDIC promulgated regulations defining the following five categories in which an insured depository institution will be placed, based on the level of its capital ratios: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Under the prompt corrective action provisions of FDICIA, an insured depository institution generally will be classified as well-capitalized (under the Basel III rules mentioned above) if it has a Tier 1 capital ratio of at least 8%, a common equity Tier 1 capital ratio of at least
6.5%, a total capital ratio of at least 10%, and a Tier 1 leverage ratio of at least 5%. An institution that, based upon its capital levels, is classified as “well-capitalized,” “adequately capitalized,” or “undercapitalized,” may be treated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and opportunity for hearing, determines that an unsafe or unsound condition, or an unsafe or unsound practice warrants such treatment. At each successive lower capital category, an insured depository institution is subject to more restrictions and prohibitions, including restrictions on growth, restrictions on interest rates paid on deposits, restrictions or prohibitions on payment of dividends, and restrictions on the acceptance of brokered deposits. Furthermore, if a bank is classified in one of the undercapitalized categories, it is required to submit a capital restoration plan to the federal bank regulator, and the holding company must guarantee the performance of that plan. The Bank has consistently maintained regulatory capital ratios above the “well-capitalized” standards.
Stress Testing
As required by the Dodd-Frank Act, the Company performed stress tests as specified by the Federal Reserve requirement and published results beginning in 2014 through 2017. On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act was enacted, which eliminated the required stress testing under the Dodd-Frank Act for banks with consolidated assets of less than $250 billion. The Company continues to perform periodic stress-testing based on its own internal criteria.
Executive and Incentive Compensation
Guidelines adopted by federal banking agencies prohibit excessive compensation as an unsafe and unsound practice, and describe compensation as "excessive" when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. The Federal Reserve Board has issued comprehensive guidance on incentive compensation intended to ensure that the incentive compensation policies do not undermine safety and soundness by encouraging excessive risk taking. This guidance covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, based on key principles that (i) incentives do not encourage risk-taking beyond the organization's ability to identify and manage risk, (ii) compensation arrangements are compatible with effective internal controls and risk management, and (iii) compensation arrangements are supported by strong corporate governance, including active and effective board oversight. Deficiencies in compensation practices may affect supervisory ratings and enforcement actions may be taken if incentive compensation arrangements pose a risk to safety and soundness.
Transactions with Affiliates
The Federal Reserve Board regulates transactions between the Bank and its subsidiaries. Generally, the Federal Reserve Act and Regulation W, as amended by the Dodd-Frank Act, limit the Company’s banking subsidiary and its subsidiaries to lending and other “covered transactions” with affiliates. The aggregate amount of covered transactions a banking subsidiary or its subsidiaries may enter into with an affiliate may not exceed 10% of the capital stock and surplus of the banking subsidiary. The aggregate amount of covered transactions with all affiliates may not exceed 20% of the capital stock and surplus of the banking subsidiary.
Covered transactions with affiliates are also subject to collateralization requirements and must be conducted on arm’s length terms. Covered transactions include (a) a loan or extension of credit by the banking subsidiary, including derivative contracts, (b) a purchase of securities issued to a banking subsidiary, (c) a purchase of assets by the banking subsidiary unless otherwise exempted by the Federal Reserve, (d) acceptance of securities issued by an affiliate to the banking subsidiary as collateral for a loan, and (e) the issuance of a guarantee, acceptance or letter of credit by the banking subsidiary on behalf of an affiliate.
Certain transactions with the Company's directors, officers or controlling persons are also subject to conflicts of interest regulations. Among other things, these regulations require that loans to such persons and their related interests be made on terms substantially the same as for loans to unaffiliated individuals, and must not create an abnormal risk of repayment or other unfavorable features for the financial institution. See Note 2 to the consolidated financial statements for additional information on loans to related parties.
Available Information
The Company’s principal offices are located at 1000 Walnut Street, Kansas City, Missouri (telephone number 816-234-2000). The Company makes available free of charge, through its website at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. Additionally, a copy of our electronically filed materials can be found at www.sec.gov. These filings include the annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports.
Statistical Disclosure
The information required by Securities Act Guide 3 - “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.
Item 1a.
Item 1a.
RISK FACTORS
Making or continuing an investment in securities issued by the Company, including its common and preferred stock, involves certain risks that you should carefully consider. If any of the following risks actually occur, the Company's business, financial condition or results of operations could be negatively affected, the market price for your securities could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of Commerce Bancshares, Inc.
Difficult market conditions may affect the Company’s industry.
The concentration of the Company’s banking business in the United States particularly exposes it to downturns in the U.S. economy. While current economic conditions are favorable, there remain risks in that environment.
In particular, the Company may face the following risks in connection with market conditions:
•
In 2019, the United States economy entered the longest expansion in its history. Despite some weakness in consumer confidence in late 2019, the expansion keeps progressing, seemingly boosted by tax reform in 2018 and a lower interest rate environment. Unemployment levels remain low and the stock market has performed well in 2019 and early 2020.
•
The U.S. economy is affected by global events and conditions, including U.S. trade disputes and renewed trade agreements with various countries. Although the Company does not directly hold foreign debt or have significant activities with foreign customers, the global economy, the strength of the U.S. dollar, international trade conditions, and oil prices may ultimately affect interest rates, business import/export activity, capital expenditures by businesses, and investor confidence. Unfavorable changes in these factors may result in declines in consumer credit usage, adverse changes in payment patterns, reduced loan demand, and higher loan delinquencies and default rates. These could impact the Company’s future loan losses and provision for loan losses, as a significant part of the Company’s business includes consumer and credit card lending.
•
In addition to the results above, a slowdown in economic activity may cause declines in financial services activity, including declines in bank card, corporate cash management and other fee businesses, as well as the fees earned by the Company on such transactions.
•
The process used to estimate losses inherent in the Company’s loan portfolio requires difficult, subjective, and complex judgments, including consideration of economic conditions and how these economic predictions might impair the ability of its borrowers to repay their loans. If an instance occurs that renders these predictions no longer capable of accurate estimation, this may in turn impact the reliability of the process.
•
Competition in the industry could intensify as a result of the increasing consolidation of financial services companies in connection with current market conditions, thereby reducing market prices for various products and services which could in turn reduce the Company’s revenues.
The performance of the Company is dependent on the economic conditions of the markets in which the Company operates.
The Company’s success is heavily influenced by the general economic conditions of the specific markets in which it operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides financial services primarily throughout the states of Missouri, Kansas, central Illinois, Oklahoma, and Colorado. It also has a growing presence in additional states through its commercial banking offices in: Texas, Iowa, Indiana, Michigan, Ohio, and Tennessee. As the Company does not have a significant banking presence in other parts of the country, a prolonged economic downturn in these markets could have a material adverse effect on the Company’s financial condition and results of operations.
The Company operates in a highly competitive industry and market area.
The Company operates in the financial services industry and has numerous competitors including other banks and insurance companies, securities dealers, brokers, trust and investment companies, mortgage bankers, and financial technology companies. Consolidation among financial service providers and new changes in technology, product offerings and regulation continue to challenge the Company's marketplace position. As consolidation occurs, larger regional and national banks may enter the Company's markets and add to existing competition. Large, national financial institutions have substantial capital, technology and marketing resources. These new competitors may lower fees to grow market share, which could result in a loss of customers and lower fee revenue for the Company. They may have greater access to capital at a lower cost than the Company, and may have higher loan limits, both of which may adversely affect the Company’s ability to compete effectively. The Company must continue to make investments in its products and delivery systems to stay competitive with the industry, or its financial performance may suffer.
The soundness of other financial institutions could adversely affect the Company.
The Company’s ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institution counterparties. Financial services institutions are interrelated because of trading, clearing, counterparty or other relationships. The Company has exposure to many different industries and counterparties and routinely executes transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual funds, and other institutional clients. Transactions with these institutions include overnight and term borrowings, interest rate swap agreements, securities purchased and sold, short-term investments, and other such transactions. Because of this exposure, defaults by, or rumors or questions about, one or more financial services institutions or the financial services industry in general, could lead to market-wide liquidity problems and defaults by other institutions. Many of these transactions expose the Company to credit risk in the event of default of its counterparty or client, while other transactions expose the Company to liquidity risks should funding sources quickly disappear. In addition, the Company’s credit risk may be exacerbated when the collateral held cannot be realized or is liquidated at prices not sufficient to recover the full amount of the exposure due to the Company. Any such losses could materially and adversely affect results of operations.
The Company is subject to extensive government regulation and supervision.
As part of the financial services industry, the Company is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds, and the banking system, not shareholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy, and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations, and policies for possible changes. Changes to statutes, regulations, or regulatory policies, including changes in interpretation or implementation of statutes, regulations, or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products it may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations, or policies could result in sanctions by regulatory agencies, civil money penalties, and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition, and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.
Significant changes in federal monetary policy could materially affect the Company’s business.
The Federal Reserve System regulates the supply of money and credit in the United States. Its policies determine in large part the cost of funds for lending and interest rates earned on loans and paid on borrowings and interest-bearing deposits. Credit conditions are influenced by its open market operations in U.S. government securities, changes in the member bank discount rate, and bank reserve requirements. Changes in Federal Reserve Board policies are beyond the Company’s control and difficult to predict, and such changes may result in lower interest margins and a lack of demand for credit products.
The Company is subject to both interest rate and liquidity risk.
With oversight from its Asset-Liability Management Committee, the Company devotes substantial resources to monitoring its liquidity and interest rate risk on a monthly basis. The Company's net interest income is the largest source of overall revenue to
the Company, representing 61% of total revenue for the year ended December 31, 2019. The interest rate environment in which the Company operates fluctuates in response to general economic conditions and policies of various governmental and regulatory agencies, particularly the Federal Reserve Board, which regulates the supply of money and credit in the U.S. Changes in monetary policy, including changes in interest rates, will influence loan originations, deposit generation, demand for investments and revenues, and costs for earning assets and liabilities, and could significantly impact the Company’s net interest income.
After raising rates four times in 2018, the Federal Reserve Board lowered the benchmark interest rate three times during 2019 for a total of 75 basis points. Future economic conditions or other factors could shift monetary policy resulting in increases or additional decreases in the benchmark rate. Furthermore, changes in interest rates could result in unanticipated changes to customer deposit balances and funding costs and affect the Company’s source of funds for future loan growth.
The impact of the phase-out of LIBOR is uncertain.
In 2017, the United Kingdom Financial Conduct Authority, which regulates LIBOR, announced that LIBOR would likely be discontinued at the end of 2021 as panel banks would no longer be required to submit estimates that are used to construct LIBOR. U.S. regulatory authorities have voiced similar support for phasing out LIBOR. The Company has a significant number of loans, derivative contracts, borrowings and other financial instruments with attributes that are either directly or indirectly dependent on LIBOR. The impact of alternatives to LIBOR on the valuations, pricing and operation of the Company's financial instruments is not yet known. The Company is coordinating with industry groups to identify an appropriate replacement rate for contracts expiring after 2021, as well as preparing for this transition as it relates to new and existing contracts and customers. The Company has established a LIBOR Transition Program, which is lead by the LIBOR Transition Steering Committee (Committee) whose purpose is to guide the overall transition process for the Company. The Committee is an internal, cross-functional team with representatives from all relevant business lines, support functions and legal counsel. An initial LIBOR impact and risk assessment has been performed, which identified the associated risks across products, systems, models, and processes. The Committee is assessing the results of the assessment and developing and prioritizing actions. Additionally, LIBOR fallback language has been included in key loan provisions of new and renewed loans in preparation for transition from LIBOR to the new benchmark rate when such transition occurs.
The Company may be adversely affected if the interest rates currently tied to LIBOR on the Company's loans, derivatives, and other financial instruments are not able to be transitioned to an alternative rate. Furthermore, the Company may be faced with disputes or litigation with counterparties regarding interpretation and enforcement of fallback language in new and renewed loans as the transition to a new benchmark rate continues to evolve.
The Company’s asset valuation may include methodologies, models, estimations and assumptions which are subject to differing interpretations and could result in changes to asset valuations that may materially adversely affect its results of operations or financial condition.
The Company uses estimates, assumptions, and judgments when certain financial assets and liabilities are measured and reported at fair value. Assets and liabilities carried at fair value inherently result in greater financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices and/or other observable inputs provided by independent third-party sources, when available. When such third-party information is not available, fair value is estimated primarily by using cash flow and other financial modeling techniques utilizing assumptions such as credit quality, liquidity, interest rates and other relevant inputs. Changes in underlying factors, assumptions, or estimates in any of these areas could materially impact the Company’s future financial condition and results of operations. Furthermore, if models used to calculate fair value of financial instruments are inadequate or inaccurate due to flaws in their design or execution, upon sale, the Company may not realize the cash flows of a financial instrument as modeled and could incur material, unexpected losses.
During periods of market disruption, including periods of significantly rising or high interest rates, rapidly widening credit spreads or illiquidity, it may be difficult to value certain assets if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes in active markets with significant observable data that become illiquid due to the current financial environment. In such cases, certain asset valuations may require more subjectivity and management judgment. As such, valuations may include inputs and assumptions that are less observable or require greater estimation. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of assets as reported within the Company’s consolidated financial statements, and the period-to-period changes in value could vary significantly. Decreases in value may have a material adverse effect on results of operations or financial condition.
The Company’s investment portfolio values may be adversely impacted by deterioration in the credit quality of underlying collateral within the various categories of investment securities it owns.
The Company generally invests in securities issued by municipal entities, government-backed agencies or privately issued securities, with collateral that are highly rated and evaluated at the time of purchase, however, these securities are subject to changes
in market value due to changing interest rates and implied credit spreads. While the Company maintains prudent risk management practices over bonds issued by municipalities, credit deterioration in these bonds could occur and result in losses. Certain mortgage and asset-backed securities (which are collateralized by residential mortgages, credit cards, automobiles, mobile homes or other assets) may decline in value due to actual or expected deterioration in the underlying collateral. Under accounting rules, when the impairment is due to declining expected cash flows, some portion of the impairment, depending on the Company’s intent to sell and the likelihood of being required to sell before recovery, must be recognized in current earnings. This could result in significant losses.
The allowance for credit losses may be insufficient or future credit losses could increase.
The allowance for loan losses at December 31, 2019 reflects management's best estimate of probable loan losses that have been incurred within the existing loan portfolio as of the balance sheet date. See the section captioned “Allowance for Loan Losses” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this report for further discussion related to the Company’s process for determining the appropriate level of the allowance for probable loan losses at December 31, 2019.
In 2016, the Financial Accounting Standards Board (FASB) issued a new accounting standard "Measurement of Credit Losses on Financial Instruments" (ASU 2016-13), which became effective January 1, 2020 and was adopted by the Company at that time. This new standard significantly altered the way the allowance for credit losses is determined. The new standard utilizes a life of loan loss concept and required significant operational changes, especially in data collection and analysis. The level of the allowance will be based on management’s methodology that utilizes historical net charge-off rates, and adjusts for the impacts in the reasonable and supportable forecast and other qualitative factors. Key assumptions include the application of historical loss rates, prepayment speeds, forecast results of a reasonable and supportable period, the period to revert to historical loss rates, and qualitative factors. Although credit losses have been stable during the past several years, an unforeseen deterioration of financial market conditions could result in larger credit losses, which may negatively affect the Company's results of operations and could significantly increase its allowance for credit losses. The Company’s allowance level is subject to review by regulatory agencies, and that review could also result in adjustments to the allowance for credit losses. Additionally, the Company's provision for credit losses may be more volatile in the future under the new standard, due to macroeconomic variables that influence the Company's loss estimates, and the volatility in credit losses may be material to the Company's earnings.
New lines of business or new products and services may subject the Company to additional risk.
From time to time, the Company may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and new products or services, the Company may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives and shifting market preferences may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business, or new product or service, could have a significant impact on the effectiveness of the Company’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business and new products or services could have a material adverse effect on the Company’s financial condition and results of operations.
A successful cyber attack or other computer system breach could significantly harm the Company, its reputation and its customers.
The Company relies heavily on communications and information systems to conduct its business, and as part of its business, the Company maintains significant amounts of data about its customers and the products they use. Information security risks continue to increase due to new technologies, the increasing use of the Internet and telecommunication technologies (including mobile devices) to conduct financial and other business transactions, and the increased sophistication and activities of organized crime, perpetrators of fraud, hackers, and others. The Company makes significant investments in various technology to identify and prevent intrusions into its information system. The Company also has policies and procedures designed to prevent or limit the effect of failure, interruption or security breach of its information systems, offers ongoing training to employees, hosts tabletop exercises to test response readiness, and performs regular audits using both internal and outside resources. However, there can be no assurances that any such failures, interruptions or security breaches will not occur, or if they do occur, that they will be adequately addressed. In addition to unauthorized access, denial-of-service attacks or other operational disruptions could overwhelm Company websites and prevent the Company from adequately serving customers. Should any of the Company's systems become compromised or customer information be obtained by unauthorized parties, the reputation of the Company could be damaged, relationships with existing customers may be impaired, and the Company could be subject to lawsuits, all of which could result in lost business and have a material adverse effect on the Company’s business, financial condition and results of operations.
The Company’s operations rely on certain external vendors.
The Company relies on third-party vendors to provide products and services necessary to maintain day-to-day operations. For example, the Company outsources a portion of its information systems, communication, data management, and transaction processing to third parties. Accordingly, the Company is exposed to the risk that these vendors might not perform in accordance with the contracted arrangements or service level agreements because of changes in the vendor’s organizational structure, financial condition, support for existing products and services, or strategic focus. Such failure to perform could be disruptive to the Company’s operations, which could have a materially adverse impact on its business, financial condition and results of operations. These third parties are also sources of risk associated with operational errors, system interruptions or breaches and unauthorized disclosure of confidential information. If the vendors encounter any of these issues, the Company could be exposed to disruption of service, damage to reputation and litigation. Because the Company is an issuer of both debit and credit cards, it is periodically exposed to losses related to security breaches which occur at retailers that are unaffiliated with the Company (e.g., customer card data being compromised at retail stores). These losses include, but are not limited to, costs and expenses for card reissuance as well as losses resulting from fraudulent card transactions.
The Company continually encounters technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services, including the entrance of financial technology companies offering new financial service products. The Company regularly upgrades or replaces technological systems to increase efficiency, enhance product and service capabilities, eliminate risks of end-of-lifecycle products, reduce costs, and better serve our customers. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company’s operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. The Company may encounter significant problems and may not be able to effectively implement new technology-driven products and services and may not be successful in marketing the new products and services to its customers. These problems might include significant time delays, cost overruns, loss of key people, and technological system failures. Failure to successfully keep pace with technological change affecting the financial services industry or failure to successfully complete the replacement of technological systems could have a material adverse effect on the Company’s business, financial condition and results of operations.
The Company plans to convert its core customer and deposit systems during 2020 and may encounter significant adverse developments.
The Company will replace its core customer and deposit systems and other ancillary systems (collectively referred to as core system). The core system is used to track customer relationships and deposit accounts. The core system is integrated with channel applications that are used to service customer requests by bank personnel or directly by customers (such as online banking and mobile applications). The new core system will provide a new platform based on current technology and will enable the Company to integrate other systems more efficiently, and is a significant improvement compared to our current core system. However, changing the core system will subject the Company to operational risks during and after the conversion, including disruptions to our technology systems, which may adversely impact our customers. We have plans, policies and procedures designed to prevent or limit the risks of a failure during or after the conversion of our core system. However, there can be no assurance that any such adverse development will not occur or, if they do occur, that they will be timely and adequately remediated. The ultimate impact of any adverse development could damage our reputation, result in a loss of customer business, subject us to regulatory scrutiny, or expose us to civil litigation and possibly financial liability, any of which could have a material effect on the Company’s business, financial condition, and results of operations.
Commerce Bancshares, Inc. relies on dividends from its subsidiary bank for most of its revenue.
Commerce Bancshares, Inc. is a separate and distinct legal entity from its banking and other subsidiaries. It receives substantially all of its revenue from dividends from its subsidiary bank. These dividends, which are limited by various federal and state regulations, are the principal source of funds to pay dividends on its preferred and common stock and to meet its other cash needs. In the event the subsidiary bank is unable to pay dividends, the Company may not be able to pay dividends or other obligations, which would have a material adverse effect on the Company's financial condition and results of operations.
The Company must attract and retain skilled employees.
The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people can be intense, and the Company spends considerable time and resources attracting, hiring, and retaining qualified people for its various business lines and support units. The unexpected loss of the services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, and years of industry experience, as well as the difficulty of promptly finding qualified replacement personnel.
Item 1b.
Item 1b.
UNRESOLVED STAFF COMMENTS
None
Item 2.
Item 2.
PROPERTIES
The main offices of the Company are located in Kansas City and St. Louis, Missouri. The Company owns its main offices and leases unoccupied premises to the public. The larger office buildings include:
The Company has an additional 159 branch locations in Missouri, Illinois, Kansas, Oklahoma and Colorado which are owned or leased.
Item 3.
Item 3.
LEGAL PROCEEDINGS
Item 4.
Item 4.
MINE SAFETY DISCLOSURES
Not applicable
Information about the Company's Executive Officers
The following are the executive officers of the Company as of February 25, 2020, each of whom is designated annually. There are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was designated an executive officer.
PART II
Item 5.
Item 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Commerce Bancshares, Inc.
Common Stock Data
Commerce Bancshares, Inc. common shares are listed on the Nasdaq Global Select Market (NASDAQ) under the symbol CBSH. The Company had 3,557 common shareholders of record as of December 31, 2019. Certain of the Company's shares are held in "nominee" or "street" name and the number of beneficial owners of such shares is approximately 92,000.
Performance Graph
The following graph presents a comparison of Company (CBSH) performance to the indices named below. It assumes $100 invested on December 31, 2014 with dividends invested on a cumulative total shareholder return basis.
The Company has a long history of paying dividends. 2019 marked the 51st consecutive year of growth in our regular common dividend, and the Company has also issued an annual 5% common stock dividend for the past 26 years. However, payment of future dividends is within the discretion of the Board of Directors and will depend, among other factors, on earnings, capital requirements, and the operating and financial condition of the Company. The Board of Directors makes the dividend determination quarterly.
The following table sets forth information about the Company’s purchases of its $5 par value common stock, its only class of common stock registered pursuant to Section 12 of the Exchange Act, during the fourth quarter of 2019.
The Company’s stock purchases shown above were made under authorizations by the Board of Directors. December purchases include 438,009 shares purchased under the accelerated share repurchase ("ASR") program discussed in Note 14 to the consolidated financial statements. Under the most recent authorization in November 2019 of 5,000,000 shares, 4,430,958 shares remained available for purchase at December 31, 2019.
Item 6.
Item 6.
SELECTED FINANCIAL DATA
The required information is set forth below in Item 7.
Item 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Forward-Looking Statements
This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of Commerce Bancshares, Inc. and its subsidiaries (the "Company"). This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include the risk factors identified in Item 1a Risk Factors and the following: changes in economic conditions in the Company’s market area; changes in policies by regulatory agencies, governmental legislation and regulation; fluctuations in interest rates; changes in liquidity requirements; demand for loans in the Company’s market area; changes in accounting and tax principles; estimates made on income taxes; failure of litigation settlement agreements to become final in accordance with their terms; and competition with other entities that offer financial services.
Overview
The Company operates as a super-community bank and offers a broad range of financial products to consumer and commercial customers, delivered with a focus on high-quality, personalized service. It is the largest bank holding company headquartered in Missouri, with its principal offices in Kansas City and St. Louis, Missouri. Customers are served from 316 locations in Missouri, Kansas, Illinois, Oklahoma and Colorado and commercial offices throughout the nation's midsection. A variety of delivery platforms are utilized, including an extensive network of branches and ATM machines, full-featured online banking, a mobile application, and a centralized contact center.
The core of the Company’s competitive advantage is its focus on the local markets in which it operates, its offering of competitive, sophisticated financial products, and its concentration on relationship banking and high-touch service. In order to enhance shareholder value, the Company targets core revenue growth. To achieve this growth, the Company focuses on strategies that will expand new and existing customer relationships, offer opportunities for controlled expansion in additional markets, utilize improved technology, and enhance customer satisfaction.
Various indicators are used by management in evaluating the Company’s financial condition and operating performance. Among these indicators are the following:
•
Net income and earnings per share - Net income attributable to Commerce Bancshares, Inc. was $421.2 million, a decrease of 2.8% compared to the previous year. The return on average assets was 1.67% in 2019, and the return on average common equity was 14.06%. Diluted earnings per share decreased 0.6% in 2019 compared to 2018.
•
Total revenue - Total revenue is comprised of net interest income and non-interest income. Total revenue in 2019 increased $20.8 million, or 1.6% over 2018, driven by growth in non-interest income of $23.4 million. Growth in non-interest income resulted principally from an increase in trust fees and a one-time gain of $11.5 million resulting from the sale of our corporate trust business.
•
Non-interest expense - Total non-interest expense increased 4.0% this year compared to 2018, mainly due to higher expense for salaries and benefits.
•
Asset quality - Net loan charge-offs totaled $49.7 million in 2019, an increase of $7.4 million over those recorded in 2018, and averaged .35% of loans compared to .30% in the previous year. Total non-performing assets, which include non-accrual loans and foreclosed real estate, amounted to $10.6 million at December 31, 2019, compared to $13.9 million at December 31, 2018, and represented .07% of loans outstanding at December 31, 2019.
•
Shareholder return - During 2019, the Company paid cash dividends of $.99 per share on its common stock, representing an increase of 16.1% over the previous year, and paid dividends of 6% on its preferred stock. In 2019, the Company issued its 26th consecutive annual 5% common stock dividend, and in January 2020, the Company's Board of Directors authorized an increase of 8.9% in the common cash dividend. The Company purchased 4,670,114 shares of treasury stock in 2019. Total shareholder return, including the change in stock price and dividend reinvestment, was 16.8%, 13.7%, and 9.6% over the past 5, 10, and 15 years, respectively.
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.
Key Ratios
(1)
Includes loans held for sale.
(2)
Revenue includes net interest income and non-interest income.
(3)
The efficiency ratio is calculated as non-interest expense (excluding intangibles amortization) as a percent of revenue.
(4)
Risk-based capital information was prepared under Basel III requirements, which were effective January 1, 2015.
(5)
The tangible common equity to tangible assets ratio is a measurement which management believes is a useful indicator of capital adequacy and utilization. It provides a meaningful basis for period to period and company to company comparisons, and also assist regulators, investors and analysts in analyzing the financial position of the Company. Tangible common equity and tangible assets are non-GAAP measures and should not be viewed as substitutes for, or superior to, data prepared in accordance with GAAP.
The following table is a reconciliation of the GAAP financial measures of total equity and total assets to the non-GAAP measures of total tangible common equity and total tangible assets.
Selected Financial Data
*
Restated for the 5% stock dividend distributed in December 2019.
Results of Operations
N.M. - Not meaningful.
Net income attributable to Commerce Bancshares, Inc. (net income) for 2019 was $421.2 million, a decrease of $12.3 million, or 2.8%, compared to $433.5 million in 2018. Diluted income per common share was $3.58 in 2019, compared to $3.60 in 2018. The decline in net income resulted from a decrease of $2.5 million in net interest income, as well as increases of $29.6 million in non-interest expense, $7.7 million in the provision for loan losses and $3.1 million in income taxes. These decreases in net income were partly offset by increases of $23.4 million in non-interest income and $4.1 million in investment securities gains, coupled with a decrease of $3.2 million in non-controlling interest expense. The return on average assets was 1.67% in 2019 compared to 1.76% in 2018, and the return on average common equity was 14.06% in 2019 compared to 16.16% in 2018. At December 31, 2019, the ratio of tangible common equity to assets increased to 10.99%, compared to 10.45% at year end 2018.
During 2019, net interest income declined mainly due to an increase of $38.0 million in interest expense on interest-bearing deposits and borrowings, largely due to higher rates paid, while lower average balances on investment securities also resulted in lower interest income this year. These decreases in interest income were partly offset by growth of $38.3 million in interest earned on loans, resulting from higher loan yields and average balances. Total rates earned on average earning assets grew 10 basis points this year, while funding costs for deposits and borrowings increased 23 basis points. The provision for loan losses totaled $50.4 million, an increase of $7.7 million over the previous year and exceeded net loan charge-offs by $750 thousand. Net loan charge-offs increased $7.4 million in 2019 compared to 2018, mainly due to higher credit card and business loan net charge-offs. The increase in business loan net charge-offs was primarily the result of a loan charge-off related to a single leasing customer.
Non-interest income grew 4.7% in 2019, mainly due to growth in trust fees, loan fees and sales, and gains on sales of assets. Net investment securities gains of $3.6 million were recorded in 2019 and were mainly comprised of net gains realized on sales of equity investments. Non-interest expense grew $29.6 million in 2019 compared to 2018, largely due to higher salaries and benefits and data processing and software expense, which increased $24.7 million and $6.9 million, respectively.
Net income attributable to Commerce Bancshares, Inc. for 2018 was $433.5 million, an increase of $114.2 million, or 35.7%, compared to $319.4 million in 2017. Diluted income per common share increased 37.0% to $3.60 in 2018, compared to $2.62 in 2017. The growth in net income resulted from increases of $90.1 million in net interest income and $40.1 million in non-interest income, as well as decreases of $6.5 million in non-interest expense, $4.6 million in income tax expense and $2.6 million in the provision for loan losses. These increases in net income were partly offset by a $25.5 million decrease in investment securities gains. The return on average assets was 1.76% in 2018 compared to 1.28% in 2017, and the return on average common equity was 16.16% in 2018 compared to 12.46% in 2017. At December 31, 2018, the ratio of tangible common equity to assets increased to 10.45%, compared to 9.84% at year end 2017.
As compared to 2017, the increase in net interest income in 2018 resulted mainly from increased rates on the Company’s loan and investment portfolios, partially offset by higher rates paid on interest-bearing deposits and borrowings. Total rates earned on average earning assets grew 44 basis points in 2018, while funding costs for deposits and borrowings increased 15 basis points. Non-interest income grew 8.7% in 2018, primarily from growth in bank card, trust and deposit fee income. Investment securities net losses in 2018 were mainly comprised of net losses on sales of available for sale debt securities of $9.7 million and an $8.9 million adjustment to recognize dividend income on a liquidated equity security. These losses were offset by realized and unrealized net gains on the Company’s portfolio of private equity securities of $13.8 million, as well as gains of $4.3 million on sales and
fair value adjustments on equity securities. Additionally, net securities gains in 2017 included a gain of $32.0 million on the appreciation of securities donated to a related foundation, which did not recur in 2018.
Non-interest expense declined $6.5 million in 2018 compared to 2017, with the decrease resulting from a $32.0 million donation of appreciated securities to a charitable organization in 2017 that did not recur in 2018. This decrease in non-interest expense was partly offset by increases in salaries and benefits, data processing and software, and marketing expense, which increased $19.9 million, $5.0 million, and $4.2 million, respectively. The provision for loan losses totaled $42.7 million, a decrease of $2.6 million from 2017.
The Company distributed a 5% stock dividend for the 26th consecutive year on December 18, 2019. All per share and average share data in this report has been restated for the 2019 stock dividend.
Critical Accounting Policies
The Company's consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company's reported results and financial position for the current period or future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Current economic conditions may require the use of additional estimates, and some estimates may be subject to a greater degree of uncertainty due to the current instability of the economy. The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses and fair value measurement.
Allowance for Loan Losses
The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company's estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal banking loans, including personal real estate, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further discussion of the methodology used in establishing the allowance is provided in the Allowance for Loan Losses section of Item 7 and in Note 1 to the consolidated financial statements.
Fair Value Measurement
Investment securities, including available-for-sale, trading, equity and other securities, residential mortgage loans held for sale, derivatives and deferred compensation plan assets and associated liabilities are recorded at fair value on a recurring basis. Additionally, from time to time, other assets and liabilities may be recorded at fair value on a nonrecurring basis, such as impaired loans that have been reduced based on the fair value of the underlying collateral, other real estate (primarily foreclosed property), non-marketable equity securities and certain other assets and liabilities. These nonrecurring fair value adjustments typically involve write-downs of individual assets or application of lower of cost or fair value accounting.
Fair value is an estimate of the exchange price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (i.e., not a forced transaction, such as a liquidation or distressed sale) between market participants at the measurement date and is based on the assumptions market participants would use when pricing an asset or liability. Fair value measurement and disclosure guidance establishes a three-level hierarchy for disclosure of assets and liabilities recorded at fair value. The fair value hierarchy, the extent to which fair value is used to measure assets and liabilities and the valuation methodologies and key inputs used are discussed in Note 17 on Fair Value Measurements.
At December 31, 2019, assets and liabilities measured using observable inputs that are classified as either Level 1 or Level 2 represented 98.8% and 99.1% of total assets and liabilities recorded at fair value, respectively. Valuations generated from model-based techniques that use at least one significant assumption not observable in the market are considered Level 3, and the Company's Level 3 assets totaled $104.6 million, or 1.2% of total assets recorded at fair value on a recurring basis. Unobservable assumptions reflect estimates of assumptions market participants would use in pricing the asset or liability. Fair value measurements for assets and liabilities where limited or no observable market data exists often involves significant judgments about assumptions, such as determining an appropriate discount rate that factors in both liquidity and risk premiums, and in many cases may not reflect amounts exchanged in a current sale of the financial instrument. In addition, changes in market conditions may reduce the availability
of quoted prices or observable data. For example, reduced liquidity in the capital markets or changes in secondary market activities could result in observable market inputs becoming unavailable. Therefore, when market data is not available, the Company would use valuation techniques requiring more management judgment to estimate the appropriate fair value.
Net Interest Income
Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.
Net interest income totaled $821.3 million in 2019, decreasing $2.5 million compared to $823.8 million in 2018. On a tax equivalent (T/E) basis, net interest income totaled $835.4 million, and decreased $4.6 million from 2018. This decrease included combined growth of $38.0 million in interest expense on deposits and borrowings, due to higher average rates paid and higher average balances. In addition, interest earned on investment securities decreased $5.2 million, mainly due to lower average balances, while loan interest income (T/E) grew $38.6 million due to higher rates earned and higher average balances. The net yield on earning assets (T/E) was 3.48% in 2019 compared with 3.53% in 2018.
During 2019, loan interest income (T/E) grew $38.6 million over 2018 mainly due to higher rates earned coupled with increased average balances for business, business real estate and personal real estate loan categories. The average tax equivalent rate earned on the loan portfolio increased 18 basis points to 4.71% in 2019 compared to 4.53% in 2018. In addition, average loan balances increased 2.1%, or $298.6 million, this year. Increased interest of $17.5 million earned on business loans was the main driver of overall higher loan interest income, due to growth of $251.1 million in average business loan balances and a 16 basis point increase in the average rate. While higher rates also contributed to the increase in interest income, rates were impacted by actions taken by the Federal Reserve during the second half of 2019 to lower short-term interest rates, as many of these loans contain variable interest rate terms. Business real estate interest was higher by $10.1 million as a result of an increase in average balances of $121.2 million, along with an increase in the average rate of 17 basis points. Personal real estate loan interest income increased $5.2 million and resulted from growth in average balances of $84.9 million and a nine basis point increase in the average rate earned. Interest on consumer loans increased $3.3 million as the average rate grew 36 basis points, but was partly offset by a decline in average balances of $79.9 million, or 4.0%. Interest on consumer credit card loans grew $1.5 million over the prior year as the average rate earned increased 26 basis points, while average balances declined $4.0 million.
Tax equivalent interest income on total investment securities decreased $5.2 million during 2019, as average balances declined $74.4 million and the average rate earned decreased three basis points. The average rate on the total investment portfolio was 2.81% in 2019 compared to 2.84% in 2018, while the average balance of the total investment securities portfolio (excluding unrealized fair value adjustments on available for sale debt securities) was $8.7 billion in 2019 compared to an average balance of $8.8 billion in 2018. The decrease in interest income was mainly due to lower interest and dividend income earned on equity and other securities, coupled with decreases in interest earned on state and municipal obligations, government-sponsored enterprise (GSE) obligations and U.S. government securities. Interest income on equity securities decreased $10.0 million, due to the receipt of $8.9 million in dividend income in the second quarter of 2018, which was related to a liquidated equity security that was carried at fair value. Interest on other securities decreased $3.9 million mainly due to receipts of non-recurring equity investment dividends in 2018, but was partly offset by higher average balances. Interest income on state and municipal obligations decreased $4.5 million, due to lower average balances of $189.7 million, partly offset by an increase of 10 basis points in the average rate earned. Interest income on GSE's decreased $1.5 million, due to a decline in average balances of $117.1 million, partly offset by an increase of 40 basis points in the average rate earned. Interest earned on U.S. government securities fell $752 thousand and was mainly impacted by a decline of $3.0 million in inflation income on treasury inflation-protected securities (TIPS). In addition, average balances declined $70.6 million, while the average rate earned increased 10 basis points. Partly offsetting these decreases in interest income was growth of $12.1 million and $3.3 million in interest earned on mortgage-backed and asset-backed securities, respectively. The growth in mortgage-backed interest resulted mainly from an increase of $391.0 million in average balances, coupled with a three basis point increase in the average rate earned. Asset-backed securities interest increased due to growth of 38 basis points in the average rate earned, partly offset by a decline of $83.1 million in average balances.
During 2019, interest expense on deposits increased $27.3 million over 2018 and resulted mainly from a 20 basis point increase in the overall average rate paid on deposits. Interest expense on interest checking and money market accounts increased $11.9 million due to higher rates paid, which rose 11 basis points. The growth in interest expense on certificates of deposit was due to both higher rates paid on all certificates of deposit and higher average balances in certificates of deposit over $100,000, which grew $281.9 million, or 25.3%. The overall rate paid on total deposits increased from .34% in 2018 to .54% in the current year. Interest expense on borrowings increased $10.7 million due to both higher rates paid and higher average balances of federal funds purchased and customer repurchase agreements. The overall average rate incurred on all interest bearing liabilities was .67% in 2019, compared to .44% in 2018.
Net interest income totaled $823.8 million in 2018, increasing $90.1 million, or 12.3%, compared to $733.7 million in 2017. On a tax equivalent (T/E) basis, net interest income totaled $840.1 million, and increased $73.5 million over 2017. This increase included growth of $76.8 million in loan interest income (T/E), resulting from higher average balances and higher rates earned. In addition, interest earned on investment securities increased $13.2 million, mainly due to higher rates earned and the receipt of $8.9 million in dividend income during the second quarter of 2018, as mentioned above. Interest expense on deposits and borrowings combined was $65.4 million and increased $21.6 million, mostly due to higher rates paid. The net yield on earning assets (T/E) was 3.53% in 2018 compared with 3.19% in 2017.
During 2018, loan interest income (T/E) grew $76.8 million over 2017 mainly due to higher rates earned coupled with increased average balances for most loan categories. The average tax equivalent rate earned on the loan portfolio increased 46 basis points to 4.53% in 2018 compared to 4.07% in 2017. The higher rates earned on the loan portfolio in 2018 were partly related to short-term increases in interest rates, which enabled much of the Company's loan portfolio to re-price higher than 2017. In addition, average loan balances increased 2.3%, or $314.4 million, in 2018. Increased interest on business loans was the main driver of overall higher loan interest income, mostly due to higher rates, as many of these loans contain variable interest rate terms. Average business loan balances also grew $131.0 million in 2018. Increases in average balances and rates on construction and business real estate loans drove interest income growth a combined $27.6 million in 2018. Interest on personal real estate loans increased $5.1 million as average balances were higher by $74.1 million or 3.7%, and the average rate grew 11 basis points. Interest on consumer loans grew $8.0 million over 2017 as the average rate earned increased 45 basis points, but was partly offset by a decline in average balances of $25.6 million. Consumer credit card loan interest was higher by $3.9 million due to growth of $24.9 million in average balances, coupled with a 13 basis point increase in the average rate earned.
Tax equivalent interest income on total investment securities increased $13.2 million during 2018, as the average rate earned increased 33 basis points, while average balances declined $661.6 million. The average rate on the total investment portfolio was 2.84% in 2018 compared to 2.51% in 2017, while the average balance of the total investment securities portfolio (excluding unrealized fair value adjustments on available for sale debt securities) was $8.8 billion in 2018 compared to an average balance of $9.5 billion in 2017. The increase in interest income was mainly due to higher interest earned on mortgage-backed securities, coupled with increased interest and dividend income on equity and other securities. These increases were partly offset lower interest earned on state and municipal securities. Interest income on mortgage-backed securities increased $22.1 million, due to an increase in average balances of $419.0 million and an increase of 29 basis points in the average rate earned. Interest income on equity securities increased due to dividend income of $8.9 million recorded in 2018 (mentioned previously), while interest on other securities increased $1.9 million due to an increase in receipts of non-recurring equity investment dividends during 2018. Interest earned on U.S. government securities grew $2.0 million, which included growth of $2.1 million in inflation-adjusted interest on TIPS. Partly offsetting these increases in interest income were declines of $19.2 million, $2.5 million and $1.2 million in interest earned on state and municipal, asset-backed and GSE securities, respectively. The decline in state and municipal interest resulted from a decline of $310.0 million in average balances coupled with a lower tax equivalent rate due to tax law changes in 2018. Asset-backed securities interest decreased mainly due to a decline of $627.9 million in average balances, partly offset by higher average rates. Interest earned on GSE's declined mainly due to lower average balances, partly offset by growth in the average rate. Interest earned on deposits with banks increased $4.0 million mainly due to an 88 basis point increase in average rates earned and an increase of $112.7 million in average balances.
During 2018, interest expense on deposits increased $14.9 million over 2017 and resulted mainly from an 11 basis point increase in the overall average rate paid on deposits. Interest expense on interest checking and money market accounts increased $10.5 million due to higher rates paid, which rose nine basis points. The growth in interest expense on certificates of deposit was largely due to higher rates paid on certificates of deposit over $100,000, which increased 54 basis points, partly offset by lower total average certificate of deposit balances, which fell $363.3 million, or 17.5%. The overall rate paid on total deposits increased from .23% in 2017 to .34% in 2018. Interest expense on borrowings increased due to higher rates paid on customer repurchase agreements, partly offset by the elimination of all Federal Home Loan Bank (FHLB) borrowings in 2018. The overall average rate incurred on all interest bearing liabilities was .44% in 2018, compared to .29% in 2017.
Provision for Loan Losses
The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed adequate by management based on the factors mentioned in the “Allowance for Loan Losses” section of this discussion. The provision for loan losses totaled $50.4 million in 2019, an increase of $7.7 million from the 2018 provision of $42.7 million. In 2018, the provision exceeded net loan charge-offs by $400 thousand, increasing the allowance for loan losses by the same amount, whereas the 2019 provision was $750 thousand greater than net loan charge-offs for the year.
Net loan charge-offs for the year totaled $49.7 million and increased $7.4 million compared to $42.3 million in 2018. The increase in net loan charge-offs over the previous year was mainly the result of higher net charge-offs on credit card loans and business loans, which increased $4.8 million and $2.0 million, respectively. In addition, personal real estate loan net charge-offs increased $391 thousand, while construction loan and business real estate loan net recoveries decreased $518 thousand and $318 thousand, respectively. Partly offsetting these increases in net charge-offs were lower net charge-offs on consumer loans, which decreased $732 thousand from the prior year. The allowance for loan losses totaled $160.7 million at December 31, 2019, an increase of $750 thousand compared to the prior year, and represented 1.09% of outstanding loans at year end 2019, compared to 1.13% at December 31, 2018.
Non-Interest Income
*
Total revenue is calculated as net interest income plus non-interest income.
The table below is a summary of net bank card transaction fees for the years ended December 31, 2019, 2018 and 2017, respectively.
Non-interest income totaled $524.7 million, an increase of $23.4 million, or 4.7%, compared to $501.3 million in 2018. Bank card fees decreased $3.7 million, or 2.2%, from the prior year, largely due to a decline in net corporate card fees of $5.3 million. This decline was partly offset by growth in net credit card fees of $1.2 million and net debit card fees of $287 thousand. The decline in net corporate card from the prior year was due to lower interchange income and higher network and rewards expense, while the growth in net credit and debit card fees was mainly due to higher interchange income. Net credit card revenue also grew due to lower rewards expense. Trust fee income increased $7.7 million, or 5.2%, as a result of continued growth in private client trust fees (up 6.5%), which comprised 76.4% of trust fee income in 2019. The market value of total customer trust assets totaled $56.7 billion at year end 2019, which was an increase of 13.3% over year end 2018 balances. Deposit account fees increased $1.5 million, or 1.6%, mainly due to growth of $3.0 million in corporate cash management fees. This increase was partly offset by declines of $872 thousand in overdraft and return item fees and $636 thousand in deposit account service charges. In 2019, corporate cash management fees comprised 43.2% of total deposit fees, while overdraft fees comprised 31.9% of total deposit fees. Capital market fees grew $425 thousand, or 5.5%, compared to the prior year, while loan fees and sales increased $3.0 million, or 23.9%, mainly due to growth in mortgage banking revenue. Total mortgage banking revenue totaled $10.8 million in 2019 compared to $8.2 million in 2018 and increased as a result of higher loan originations in 2019. Other non-interest income increased $14.5 million, or 28.3%, mainly due to a one-time gain of $11.5 million resulting from the sale of the Company's corporate trust business in the fourth quarter of 2019. In addition, cash sweep commissions increased $2.7 million and higher gains of $2.4 million were recorded on sales of leased assets to customers upon lease termination. These increases were partly offset by gains of $6.6 million recorded on the sales of branch properties in 2018.
During 2018, non-interest income increased $40.1 million, or 8.7%, to $501.3 million compared to $461.3 million in 2017. Bank card fees increased $16.5 million over 2017. This growth included increases of $4.1 million in net debit card fees and $14.8 million in net corporate card fees, partly offset by a decline of $1.6 million, or 11.1%, in net credit card fees, and $836 thousand, or 4.2%, in net merchant fees. Trust fee income increased $12.8 million, or 9.5%, as a result of growth in both private client (up 11.1%) and institutional trust (up 6.4%) fees. The market value of total customer trust assets totaled $50.0 billion at year end 2018, which was an increase of 2.7% over year end 2017 balances. Deposit account fees increased $4.5 million, or 4.9%, due to growth of $2.4 million in corporate cash management fees, $1.1 million in deposit account service charges and $892 thousand in overdraft and return item fees. Capital market fees declined $275 thousand, or 3.4%, due to lower sales volumes, while consumer brokerage services revenue increased $1.2 million, or 8.0%, mainly due to growth in advisory and fixed annuity fees. Loan fees and sales decreased $1.2 million in 2018 compared to 2017, mainly due to declines in mortgage banking revenue as a result of lower originations of fixed-rate loans in 2018. Other non-interest income increased $6.7 million, or 15.0%, over 2017 mainly due to gains of $6.6 million recorded on the sales of branch properties in 2018. In addition, cash sweep commissions, interest rate
swap fees, and fees from sales of tax credits increased $1.6 million, $2.1 million, and $1.6 million, respectively, over 2017. These increases were partly offset by lower gains of $1.1 million on sales of leased assets to customers upon lease termination.
Investment Securities Gains (Losses), Net
Net gains and losses on investment securities during 2019, 2018 and 2017 are shown in the table above. Included in these amounts are gains and losses arising from sales of securities from the Company’s available for sale debt portfolio, including credit-related losses on debt securities identified as other-than-temporarily impaired. Also shown are gains and losses relating to private equity investments, which are primarily held by the Parent’s majority-owned private equity subsidiaries. These include fair value adjustments, in addition to gains and losses realized upon disposition. The portions of private equity investment gains and losses that are attributable to minority interests are reported as non-controlling interest in the consolidated statements of income, and resulted in expense of $348 thousand in 2019, compared to expense of $2.8 million in 2018 and income of $575 thousand in 2017.
Net securities gains of $3.6 million were recorded in 2019, which included $214 thousand in net losses realized on bond sales resulting from the Company's sale of approximately $400 million (book value) of bonds, mainly municipal securities, treasuries and asset-backed securities. Net securities gains also included $3.3 million in gains from sales of equity investments and a $1.1 million in gain from the sale of a private equity investment. These gains were offset by net losses totaling $727 thousand of fair value adjustments on private equity investments, in addition to net gains totaling $344 thousand of fair value adjustments on equity investments.
Net securities losses of $488 thousand were recorded in 2018, which included $9.7 million in net losses realized on bond sales resulting from the Company's sale of approximately $680 million (book value) of bonds, mainly mortgage and asset-backed securities. Net securities losses also included $8.9 million in losses related to an adjustment for dividend income on a liquidated investment. These losses were offset by net gains totaling $13.8 million of fair value adjustments on private equity investments, in addition to fair value adjustments and net gains realized on sales of equity investments.
Net securities gains of $25.1 million were recorded in 2017, which included $31.1 million in gains realized upon donation of appreciated stock and $10.6 million in net gains realized on sales of equity securities. These gains were offset by net losses of $9.7 million realized on sales of available for sale debt securities, resulting from the Company's sale of approximately $790 million of bonds, mainly mortgage and asset-backed securities. Additionally, net securities losses included $499 thousand in net losses realized on the sale of private equity investments and $5.8 million in losses related to fair value adjustments on private equity investments.
Non-Interest Expense
Non-interest expense was $767.4 million in 2019, an increase of $29.6 million, or 4.0%, over the previous year. Salaries and benefits expense increased $24.7 million, or 5.3%, mainly due to higher full-time salaries and medical expense. Full-time salaries expense increased due to growth in consumer, commercial, information technology and other support unit salaries expense. Full-time equivalent employees totaled 4,858 at December 31, 2019, reflecting a 1.3% increase over 2018. Occupancy expense increased $1.1 million, or 2.4%, mainly due to higher real estate taxes and building depreciation expense, partly offset by a decline in utilities expense. Equipment expense increased $936 thousand, or 5.2%, due to higher equipment depreciation expense. Data processing and software expense increased $6.9 million, or 8.0%, primarily due to higher costs for service providers and higher bank card processing expense. Marketing expense increased $1.4 million, or 6.6%, due to increased marketing efforts to support consumer and healthcare banking initiatives, partly offset by bank card marketing initiatives in the prior year. Deposit insurance expense declined $4.9 million, or 42.2%, from the prior year mainly due to reduced FDIC insurance rates.
In 2018, non-interest expense was $737.8 million, a decrease of $6.5 million, or .9%, from 2017. Salaries and benefits expense increased $19.9 million, or 4.4%, mainly due to higher full-time salaries and medical expense. Growth in salaries expense was driven by increases in full-time salaries in information technology, consumer, wealth, commercial and other support units, while incentive compensation expense declined slightly from 2017. Full-time equivalent employees totaled 4,795 at December 31, 2018, reflecting a small decrease from 2017. Occupancy expense increased $432 thousand, or .9%, mainly due to higher rent, utilities and building services expense, while equipment expense decreased $443 thousand, or 2.4%, due to lower equipment depreciation. Supplies and communication expense decreased $2.2 million, or 9.4%, mainly due to lower voice and data network costs. Data processing and software expense increased $5.0 million, or 6.1%, primarily due to higher third party processing costs. Marketing expense increased $4.2 million, or 25.9%, due to new bank card initiatives and consumer marketing initiatives in 2018. Deposit insurance expense declined $2.4 million, or 17.4%, from the prior year mainly due to decreases in average assets, a lower assessment rate, and the elimination of the special FDIC surcharge in the fourth quarter of 2018. Community service costs decreased $31.9 million due to the contribution of appreciated securities to a related foundation during 2017, which did not recur in 2018. Other non-interest expense increased $938 thousand, or 1.5%, over the prior year mainly due to higher costs for professional fees (up $2.4 million) and directors fees (up $936 thousand). These increases were partly offset by lower bank card fraud losses (down $961 thousand).
Income Taxes
Income tax expense was $109.1 million in 2019, compared to $105.9 million in 2018 and $110.5 million in 2017. The effective tax rate, including the effect of non-controlling interest, was 20.6% in 2019 compared to 19.6% in 2018 and 25.7% in 2017.
Due to the enactment of new federal tax reform legislation in December 2017, federal tax rates were lowered from 35% to 21%, which lowered the Company's effective tax rate for years 2018 and after. The Company's effective tax rate in the years noted above were lower than the federal statutory rates mainly due to tax-exempt interest on state and local municipal obligations. Additional information about income tax expense is provided in Note 9 to the consolidated financial statements.
Financial Condition
Loan Portfolio Analysis
Classifications of consolidated loans by major category at December 31 for each of the past five years are shown in the table below. This portfolio consists of loans which were acquired or originated with the intent of holding to their maturity. Loans held for sale are separately discussed in a following section. A schedule of average balances invested in each loan category below is disclosed within the Average Balance Sheets section of Management's Discussion and Analysis of Financial Condition and Results of Operations below.
The contractual maturities of business and real estate loan categories at December 31, 2019, and a breakdown of those loans between fixed rate and floating rate loans are as follows.
The following table shows loan balances at December 31, 2019, segregated between those with fixed interest rates and those with variable rates that fluctuate with an index.
Total loans at December 31, 2019 were $14.7 billion, an increase of $597.5 million, or 4.2%, over balances at December 31, 2018. The growth in loans during 2019 occurred in the business, construction, personal real estate and consumer loan categories, while business real estate, consumer credit card, revolving home equity and overdraft loan categories declined from the prior year. Business loans increased $459.0 million, or 9.0%, reflecting growth in lease lending and commercial and industrial loans, while commercial card and tax-advantaged lending declined. Construction loans increased $29.7 million, or 3.4% mainly due to growth in commercial construction lending. Business real estate loans decreased $42.2 million, or 1.5%, due mainly to decreases in multi-family real estate lending. Personal real estate loans increased $227.7 million, or 10.8%, due to increased loan originations. The Company sells certain long-term fixed rate mortgage loans to the secondary market, and loan sales in 2019 totaled $239.0 million, compared to $193.5 million in 2018. Consumer loans increased $8.6 million, or .4%, mainly due to an increase in health service financing loans, offset by a decline in fixed rate home equity loans and the continued run off of marine and recreational vehicle loan balances. Consumer credit card loans decreased $49.2 million, or 6.0% and revolving home equity loan balances declined $27.1 million, or 7.2%, compared to balances at year end 2018.
The Company currently holds approximately 28% of its loan portfolio in the Kansas City market, 29% in the St. Louis market, and 43% in other regional markets. The portfolio is diversified from a business and retail standpoint, with 63% in loans to businesses and 37% in loans to consumers. The Company believes a diversified approach to loan portfolio management, strong underwriting criteria and an aversion toward credit concentrations, from an industry, geographic and product perspective, have contributed to low levels of problem loans and loan losses experienced over the last several years.
The Company participates in credits of large, publicly traded companies which are defined by regulation as shared national credits, or SNCs. Regulations define SNCs as loans exceeding $100 million that are shared by three or more financial institutions. The Company typically participates in these loans when business operations are maintained in the local communities or regional markets and opportunities to provide other banking services are present. At December 31, 2019, the balance of SNC loans totaled approximately $1.1 billion, with an additional $1.4 billion in unfunded commitments, compared to a balance of $830.2 million, with an additional $1.3 billion in unfunded commitments, at year end 2018.
Commercial Loans
Business
Total business loans amounted to $5.6 billion at December 31, 2019 and include loans used mainly to fund customer accounts receivable, inventories, and capital expenditures. The business loan portfolio includes tax-advantaged loans and leases which carry tax free interest rates. These loans totaled $858.1 million at December 31, 2019, a decline of $44.4 million, or 4.9%, from December 31, 2018 balances. The business loan portfolio also includes direct financing and sales type leases totaling $584.3 million, which are used by commercial customers to finance capital purchases ranging from computer equipment to office and transportation equipment. These leases increased $26.9 million, or 4.8%, over 2018. The Company has outstanding energy-related loans totaling $197.4 million at December 31, 2019, which are further discussed within the Energy Lending section of the Risk Elements of Loan Portfolio section located within Management's Discussion and Analysis of Financial Condition and Results of Operations. Also included in the business portfolio are corporate card loans, which totaled $293.7 million at December 31, 2019 and are made in conjunction with the Company’s corporate card business for corporate trade purchases. Corporate card loans are made to corporate, non-profit and government customers nationwide, but have very short-term maturities, which limits credit risk.
Business loans, excluding corporate card loans, are made primarily to customers in the regional trade area of the Company, generally the central Midwest, encompassing the states of Missouri, Kansas, Illinois, and nearby Midwestern markets, including Iowa, Oklahoma, Colorado, Texas and Ohio. This portfolio is diversified from an industry standpoint and includes businesses engaged in manufacturing, wholesaling, retailing, agribusiness, insurance, financial services, public utilities, health care, and other service businesses. Emphasis is upon middle-market and community businesses with known local management and financial stability. Consistent with management’s strategy and emphasis upon relationship banking, most borrowing customers also maintain deposit accounts and utilize other banking services. Net loan charge-offs in this category totaled $4.1 million in 2019 (mainly representing a charge-off related to the bankruptcy of a single leasing customer), compared to net loan charge-offs of $2.1 million recorded in 2018. Non-accrual business loans were $7.5 million (.1% of business loans) at December 31, 2019 compared to $9.0 million at December 31, 2018.
Real Estate-Construction and Land
The portfolio of loans in this category amounted to $899.4 million at December 31, 2019, which was an increase of $29.7 million, or 3.4%, from the prior year and comprised 6.1% of the Company’s total loan portfolio. Commercial construction and land development loans totaled $705.1 million, or 78.4% of total construction loans at December 31, 2019. These loans increased $40.6 million from 2018 year end balances, driving the growth in the total construction portfolio. Commercial construction loans are made during the construction phase for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, apartment complexes, shopping centers, hotels and motels, and other commercial properties. Commercial land development loans relate to land owned or developed for use in conjunction with business properties. Residential construction and land development loans at December 31, 2019 totaled $194.3 million, or 21.6% of total construction loans. A stable construction market has contributed to low loss rates on these loans, with net loan recoveries of $117 thousand and $635 thousand recorded in 2019 and 2018, respectively.
Real Estate-Business
Total business real estate loans were $2.8 billion at December 31, 2019 and comprised 19.2% of the Company’s total loan portfolio. This category includes mortgage loans for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, multi-family housing, farms, shopping centers, hotels and motels, churches, and other commercial properties. The business real estate borrowers and/or properties are generally located in local and regional markets where Commerce does business, and emphasis is placed on owner-occupied lending (37.0% of this portfolio), which presents lower risk levels. Additional information about business real estate loans by borrower is disclosed within the Real Estate - Business Loans section of the Risk Elements of Loan Portfolio section located within Management's Discussion and Analysis of Financial Condition and Results of Operations. At December 31, 2019, balances of non-accrual loans amounted to $1.0 million, or less than .1% of business real estate loans, down from $1.7 million at year end 2018. The Company experienced net loan recoveries of $60 thousand in 2019, compared to net loan recoveries of $378 thousand in 2018.
Personal Banking Loans
Real Estate-Personal
At December 31, 2019, there were $2.4 billion in outstanding personal real estate loans, which comprised 16.0% of the Company’s total loan portfolio. The mortgage loans in this category are mainly for owner-occupied residential properties. The Company originates both adjustable and fixed rate mortgage loans, and at December 31, 2019, 32% of the portfolio was comprised of adjustable rate loans, while 68% was comprised of fixed rate loans. The Company does not purchase any loans from outside parties or brokers, and has never maintained no-document products. Levels of mortgage loan origination activity increased in 2019, with originations of $871.6 million in 2019 compared to $563.0 million in 2018. Net loans retained by the Company increased $227.7 million, driven by growth in new loan production due to the lower interest rate environment. Loans sold to the secondary market increased $45.5 million. The loan sales were made under an initiative to originate and sell certain long term fixed rate loans, resulting in sales of $239.0 million in 2019 compared to $193.5 million in 2018. The Company has experienced lower loan losses in this category than many others in the industry and believes this is partly because of its conservative underwriting culture, stable markets, and the fact that it does not purchase loans from brokers. Net loan charge-offs in 2019 totaled $56 thousand, a slight increase from net loan recoveries of $335 thousand in 2018. Balances of non-accrual loans in this category decreased to $1.7 million at December 31, 2019, compared to $1.8 million at year end 2018.
Consumer
Consumer loans consist of private banking, automobile, motorcycle, marine, tractor/trailer, recreational vehicle (RV), fixed rate home equity, patient health care financing and other types of consumer loans. These loans totaled $2.0 billion at year end 2019. Approximately 46% of the consumer portfolio consists of automobile loans, 21% in private banking loans, 4% in motorcycle loans, 14% in fixed rate home equity loans, 10% in healthcare financing loans and 2% in marine and RV loans. Total consumer
loans increased $8.6 million at year end 2019 compared to year end 2018. Growth of $28.9 million in patient healthcare financing and $21.3 million in private banking loans was partially offset by declines of $14.7 million in fixed rate home equity loans, $15.6 million in marine and RV loans, and $17.5 million in motorcycle loans. Net charge-offs on total consumer loans were $8.6 million in 2019, compared to $9.3 million in 2018, averaging .4% and .5% of consumer loans in 2019 and 2018, respectively. Consumer loan net charge-offs included marine and RV loan net charge-offs of $393 thousand, which were 1.0% of average marine and RV loans in 2019, compared to 1.2% in 2018.
Revolving Home Equity
Revolving home equity loans, of which 98% are adjustable rate loans, totaled $349.3 million at year end 2019. An additional $750.9 million was available in unused lines of credit, which can be drawn at the discretion of the borrower. Home equity loans are secured mainly by second mortgages (and less frequently, first mortgages) on residential property of the borrower. The underwriting terms for the home equity line product permit borrowing availability, in the aggregate, generally up to 80% or 90% of the appraised value of the collateral property at the time of origination. Net charge-offs totaled $209 thousand in 2019, compared to $55 thousand in 2018.
Consumer Credit Card
Total consumer credit card loans amounted to $765.0 million at December 31, 2019 and comprised 5.2% of the Company’s total loan portfolio. The credit card portfolio is concentrated within regional markets served by the Company. The Company offers a variety of credit card products, including affinity cards, rewards cards, and standard and premium credit cards, and emphasizes its credit card relationship product, Special Connections. Approximately 40% of the households that own a Commerce credit card product also maintain a deposit relationship with the subsidiary bank. At December 31, 2019, approximately 93% of the outstanding credit card loan balances had a floating interest rate, compared to 92% in the prior year. Net charge-offs amounted to $35.4 million in 2019, an increase of $4.8 million over $30.6 million in 2018.
Loans Held for Sale
At December 31, 2019, loans held for sale were comprised of certain long-term fixed rate personal real estate loans and loans extended to students while attending colleges and universities. The personal real estate loans are carried at fair value and totaled $9.2 million at December 31, 2019. The student loans, carried at the lower of cost or fair value, totaled $4.6 million at December 31, 2019. Both of these portfolios are further discussed in Note 2 to the consolidated financial statements.
Allowance for Loan Losses
The Company has an established process to determine the amount of the allowance for loan losses which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of a specific allowance component based on certain individually evaluated loans and a general component based on estimates of reserves needed for pools of loans.
Loans subject to individual evaluation generally consist of business, construction, business real estate and personal real estate loans on non-accrual status, and include troubled debt restructurings that are on non-accrual status. These non-accrual loans are evaluated individually for impairment based on factors such as payment history, borrower financial condition and collateral. For collateral dependent loans, appraisals of collateral (including exit costs) are normally obtained annually but discounted based on date last received and market conditions. From these evaluations of expected cash flows and collateral values, specific allowances are determined.
Loans which are not individually evaluated are segregated by loan type and sub-type and are collectively evaluated. These loans consist of commercial loans (business, construction and business real estate) which have been graded pass, special mention, or substandard, and also include all personal banking loans except personal real estate loans on non-accrual status. Collectively-evaluated loans include certain troubled debt restructurings with similar risk characteristics. Allowances for both personal banking and commercial loans use methods which consider historical and current loss trends, loss emergence periods, delinquencies, industry concentrations and unique risks. Economic conditions throughout the Company's markets, as monitored by Company credit officers, are also considered in the allowance determination process.
The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses rest upon various judgments and assumptions made by management. In addition to past loan loss experience, various qualitative factors are considered, such as current loan portfolio composition and characteristics, trends in delinquencies, portfolio risk ratings, levels of non-performing assets, credit concentrations, collateral values, and prevailing regional and national economic conditions. The Company has internal credit administration and loan review staff that continuously review loan quality and report the results of their reviews and examinations to the Company’s senior management and Board of Directors. Such reviews also assist management in establishing the level of the allowance. In using this process and the information available, management must consider various
assumptions and exercise considerable judgment to determine the overall level of the allowance for loan losses. Because of these subjective factors, actual outcomes of inherent losses can differ from original estimates. The Company’s subsidiary bank continues to be subject to examination by several regulatory agencies, and examinations are conducted throughout the year, targeting various segments of the loan portfolio for review. Refer to Note 1 to the consolidated financial statements for additional discussion on the allowance and charge-off policies.
At December 31, 2019, the allowance for loan losses was $160.7 million, compared to $159.9 million at December 31, 2018. The percentage of allowance to loans decreased to 1.09% at December 31, 2019 compared to 1.13% at year end 2018. Total loans delinquent 90 days or more and still accruing were $19.9 million at December 31, 2019, an increase of $3.2 million compared to year end 2018, mainly driven by a $3.5 million increase in construction loan delinquencies on one larger loan and a $955 thousand increase in consumer credit card loans delinquent 90 days or more, partly offset by a decrease of $1.6 million in consumer loan delinquencies. Non-accrual loans at December 31, 2019 were $10.2 million, a decrease of $2.3 million over the prior year, mainly due to a decrease in business and business real-estate non-accrual loans of $1.5 million and $685 thousand, respectively. The 2019 year end balance of non-accrual loans was comprised of $7.5 million of business loans, $1.0 million of business real estate loans and $1.7 million of personal real estate loans.
Net loan charge-offs totaled $49.7 million in 2019, representing a $7.4 million increase compared to net charge-offs of $42.3 million in 2018. The increase was largely due to higher credit card loan and business loan charge-offs of $4.8 million and $2.0 million, respectively. In addition, personal real estate loan net charge-offs increased $391 thousand, while construction loan and business real estate net recoveries decreased $518 thousand and $318 thousand, respectively. Partly offsetting these increases in net charge-offs were lower net loan charge-offs of $732 thousand on consumer loans. Consumer credit card net charge-offs were 4.63% of average consumer credit card loans in 2019 compared to 3.98% in 2018. Consumer credit card loan net charge-offs as a percentage of total net charge-offs decreased to 71.3% in 2019 compared to 72.3% in 2018. Consumer loan net charge-offs were .44% of average consumer loans in 2019, compared to .46% in 2018, and represented 17.2% of total net loan charge-offs in 2019.
The ratio of net charge-offs to total average loans outstanding in 2019 was .35%, compared to .30% in 2018 and .31% in 2017. The provision for loan losses in 2019 was $50.4 million, compared to provisions of $42.7 million in 2018 and $45.2 million in 2017.
The Company considers the allowance for loan losses of $160.7 million adequate to cover losses inherent in the loan portfolio at December 31, 2019.
The schedules which follow summarize the relationship between loan balances and activity in the allowance for loan losses:
(A)
Net of unearned income, before deducting allowance for loan losses, excluding loans held for sale.
The following schedule provides a breakdown of the allowance for loan losses by loan category and the percentage of each loan category to total loans outstanding at year end.
Risk Elements of Loan Portfolio
Management reviews the loan portfolio continuously for evidence of problem loans. During the ordinary course of business, management becomes aware of borrowers that may not be able to meet the contractual requirements of loan agreements. Such loans are placed under close supervision with consideration given to placing the loan on non-accrual status, the need for an additional allowance for loan loss, and (if appropriate) partial or full loan charge-off. Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. After a loan is placed on non-accrual status, any interest previously accrued but not yet collected is reversed against current income. Interest is included in income only as received and only after all previous loan charge-offs have been recovered, so long as management is satisfied there is no impairment of collateral values. The loan is returned to accrual status only when the borrower has brought all past due principal and interest payments current, and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled. Loans that are 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are comprised of those personal banking loans that are exempt under regulatory rules from being classified as non-accrual. Consumer installment loans and related accrued interest are normally charged down to the fair value of related collateral (or are charged off in full if no collateral) once the loans are more than 120 days delinquent. Credit card loans and the related accrued interest are charged off when the receivable is more than 180 days past due.
The following schedule shows non-performing assets and loans past due 90 days and still accruing interest.
The table below shows the effect on interest income in 2019 of loans on non-accrual status at year end.
Non-accrual loans, which are also classified as impaired, totaled $10.2 million at year end 2019, a decrease of $2.3 million from the balance at year end 2018. The decrease from December 31, 2018 occurred mainly in business loans, which decreased $1.5 million, and business real estate loans, which decreased $685 thousand. At December 31, 2019, non-accrual loans were comprised primarily of business (73.3%), personal real estate (16.6%), and business real estate (10.1%) loans. Foreclosed real estate totaled $365 thousand at December 31, 2019, a decrease of $1.0 million when compared to December 31, 2018. Total non-performing assets remain low compared to the overall banking industry in 2019, with the non-performing assets to total loans ratio
at .07% at December 31, 2019. Total loans past due 90 days or more and still accruing interest were $19.9 million as of December 31, 2019, an increase of $3.2 million when compared to December 31, 2018. Balances by class for non-accrual loans and loans past due 90 days and still accruing interest are shown in the "Delinquent and non-accrual loans" section of Note 2 to the consolidated financial statements.
In addition to the non-performing and past due loans mentioned above, the Company also has identified loans for which management has concerns about the ability of the borrowers to meet existing repayment terms. They are classified as substandard under the Company’s internal rating system. The loans are generally secured by either real estate or other borrower assets, reducing the potential for loss should they become non-performing. Although these loans are generally identified as potential problem loans, they may never become non-performing. Such loans totaled $164.8 million at December 31, 2019, compared with $145.7 million at December 31, 2018, resulting in an increase of $19.1 million or 13.1%. The increase in potential problem loans was largely driven by a $35.2 million increase in business real estate loans, which was partly offset by a $14.1 million decrease in business loans.
At December 31, 2019, the Company had $79.5 million of loans whose terms have been modified or restructured, meeting the definition of a troubled debt restructuring. These loans have been extended to borrowers who are experiencing financial difficulty and who have been granted a concession, as defined by accounting guidance, and are further discussed in the "Troubled debt restructurings" section in Note 2 to the consolidated financial statements. This balance includes certain commercial loans totaling $55.9 million, which are classified as substandard and included in the table above because of this classification.
Loans with Special Risk Characteristics
Management relies primarily on an internal risk rating system, in addition to delinquency status, to assess risk in the loan portfolio, and these statistics are presented in Note 2 to the consolidated financial statements. However, certain types of loans are considered at high risk of loss due to their terms, location, or special conditions. Construction and land loans and business real estate loans are subject to higher risk because of the impact that volatile interest rates and a changing economy can have on real estate value, and because of the potential volatility of the real estate industry. Certain home equity loans have contractual features that could increase credit exposure in a market of declining real estate prices, when interest rates are steadily increasing, or when a geographic area experiences an economic downturn. For these home equity loans, higher risks could exist when 1) loan terms require a minimum monthly payment that covers only interest, or 2) loan-to-collateral value (LTV) ratios at origination are above 80%, with no private mortgage insurance. Information presented below for home equity loans is based on LTV ratios which were calculated with valuations at loan origination date. The Company does not attempt to obtain updated appraisals or valuations unless the loans become significantly delinquent or are in the process of being foreclosed upon. For credit monitoring purposes, the Company analyzes delinquency information, current FICO scores, and line utilization. This has remained an effective means of evaluating credit trends and identifying problem loans, partly because the Company offers standard, conservative lending products.
Real Estate - Construction and Land Loans
The Company’s portfolio of construction and land loans, as shown in the table below, amounted to 6.1% of total loans outstanding at December 31, 2019. The largest component of construction and land loans was commercial construction, which increased $51.2 million during the year ended December 31, 2019. At December 31, 2019, multi-family residential construction loans totaled approximately $213.4 million, or 31.8%, of the commercial construction loan portfolio.
Real Estate - Business Loans
Total business real estate loans were $2.8 billion at December 31, 2019 and comprised 19.2% of the Company’s total loan portfolio. These loans include properties such as manufacturing and warehouse buildings, small office and medical buildings, churches, hotels and motels, shopping centers, and other commercial properties. Approximately 37.0% of these loans were for owner-occupied real estate properties, which present lower risk profiles.
Revolving Home Equity Loans
The Company has revolving home equity loans that are generally collateralized by residential real estate. Most of these loans (91.9%) are written with terms requiring interest-only monthly payments. These loans are offered in three main product lines: LTV up to 80%, 80% to 90%, and 90% to 100%. As shown in the following tables, the percentage of loans with LTV ratios greater than 80% has remained a small segment of this portfolio, and delinquencies have been low and stable. The weighted average FICO score for the total portfolio balance at December 31, 2019 was 792. At maturity, the accounts are re-underwritten and if they qualify under the Company's credit, collateral and capacity policies, the borrower is given the option to renew the line of credit or to convert the outstanding balance to an amortizing loan. If criteria are not met, amortization is required, or the borrower may pay off the loan. Over the next three years, approximately 12.5% of the Company's current outstanding balances are expected to mature. Of these balances, 92.9% have a FICO score above 700. The Company does not expect a significant increase in losses as these loans mature, due to their high FICO scores, low LTVs, and low historical loss levels.
* Percentage of total principal outstanding of $349.3 million at December 31, 2019.
* Percentage of total principal outstanding of $376.4 million at December 31, 2018.
Other Consumer Loans
Within the consumer loan portfolio are several direct and indirect product lines comprised mainly of loans secured by automobiles, motorcycles, marine, and RVs. Outstanding balances for auto loans were $908.3 million and $910.5 million at December 31, 2019 and 2018, respectively. The balances over 30 days past due amounted to $13.2 million at December 31, 2019, compared to $17.8 million at the end of 2018, and comprised 1.5% of the outstanding balances of these loans at December 31, 2019 compared to 2.0% at December 31, 2018. For the year ended December 31, 2019, $414.9 million of new auto loans were originated, compared to $365.0 million during 2018. At December 31, 2019, the automobile loan portfolio had a weighted average FICO score of 756.
Outstanding balances for motorcycle loans were $71.9 million at December 31, 2019, compared to $89.4 million at December 31, 2018. The balances over 30 days past due amounted to $1.3 million and $2.1 million at December 31, 2019 and 2018, respectively, and comprised 1.9% of the outstanding balances of these loans at December 31, 2019, compared to 2.4% at December 31, 2018. For the year ended December 31, 2019, $26.5 million of new motorcycle loans were originated, compared to $15.0 million during 2018.
Marine and RV loan production has been significantly curtailed since 2008 with few new originations. While loss rates have remained low over the last five years, the loss ratios experienced for marine and RV loans in 2019 decreased over the prior year but have been higher than for other consumer loan products, at 1.0% and 1.2% in 2019 and 2018, respectively. Balances over 30 days past due for marine and RV loans decreased $1.1 million at year end 2019 compared to 2018.
The table below provides the total outstanding principal and other data for this group of direct and indirect lending products at December 31, 2019 and 2018.
Consumer Credit Card Loans
Additionally, the Company offers low introductory rates on selected consumer credit card products. Out of a portfolio at December 31, 2019 of $765.0 million in consumer credit card loans outstanding, approximately $144.8 million, or 18.9%, carried a low promotional rate. Within the next six months, $64.9 million of these loans are scheduled to convert to the ongoing higher contractual rate. To mitigate some of the risk involved with this credit card promotional feature, the Company performs credit checks and detailed analysis of the customer borrowing profile before approving the loan application. Management believes that the risks in the consumer loan portfolio are reasonable and the anticipated loss ratios are within acceptable parameters.
Energy Lending
The Company's energy lending portfolio was comprised of lending to the petroleum and natural gas sectors and totaled $197.4 million at December 31, 2019, an increase of $53.6 million from year end 2018, as shown in the table below.
Investment Securities Analysis
Investment securities are comprised of securities that are classified as available for sale, equity, trading or other. The largest component, available for sale debt securities, decreased 1.9% during 2019 to $8.4 billion (excluding unrealized gains/losses in fair value) at year end 2019. During 2019, debt securities of $1.8 billion were purchased, which included $167.1 million in state and municipal securities, $1.4 billion in agency mortgage-backed securities, $55.7 million in non-agency mortgage-based securities, and $106.6 million in asset-backed securities. Total sales, maturities and pay downs were $1.9 billion during 2019. During 2020, maturities and pay downs of approximately $1.3 billion are expected to occur. The average tax equivalent yield earned on total investment securities was 2.81% in 2019 and 2.84% in 2018.
At December 31, 2019, the fair value of available for sale securities was $8.6 billion, which included a net unrealized gain in fair value of $136.1 million, compared to a net unrealized loss of $64.6 million at December 31, 2018. The overall unrealized gain in fair value at December 31, 2019 included net gains of $42.4 million in state and municipal securities and net gains of $63.4 million in mortgage and asset-backed securities. The portfolio also included unrealized net gains of $23.9 million and $5.9 million on U.S. government and federal agency obligations and other debt securities, respectively.
Available for sale investment securities at year end for the past two years are shown below:
At December 31, 2019, the available for sale portfolio included $3.9 billion of agency mortgage-backed securities, which are collateralized bonds issued by agencies including FNMA, GNMA, FHLMC, FHLB, Federal Farm Credit Banks and FDIC. Non-agency mortgage-backed securities totaled $809.8 million and included $526.0 million collateralized by commercial mortgages and $283.8 million collateralized by residential mortgages at December 31, 2019. Certain non-agency mortgage-backed securities are other-than-temporarily impaired, and the processes for determining impairment and the related losses are discussed in Note 3 to the consolidated financial statements.
At December 31, 2019, U.S. government obligations included TIPS of $461.8 million, at fair value. Other debt securities include corporate bonds, notes and commercial paper.
The types of securities held in the available for sale security portfolio at year end 2019 are presented in the table below. Additional detail by maturity category is provided in Note 3 to the consolidated financial statements.
*Based on call provisions and estimated prepayment speeds.
Equity securities include common and preferred stock with readily determinable fair values that totaled $2.9 million at December 31, 2019, compared to $2.6 million at December 31, 2018.
Other securities totaled $137.9 million at December 31, 2019 and $129.2 million at December 31, 2018. These include Federal Reserve Bank stock and Federal Home Loan Bank (Des Moines) stock held by the bank subsidiary in accordance with debt and
regulatory requirements. These are restricted securities and are carried at cost. Also included are private equity investments which are held by a subsidiary qualified as a Small Business Investment Company. These investments are carried at estimated fair value, but are not readily marketable. While the nature of these investments carries a higher degree of risk than the normal lending portfolio, this risk is mitigated by the overall size of the investments and oversight provided by management, and management believes the potential for long-term gains in these investments outweighs the potential risks.
Other securities at year end for the past two years are shown below:
In addition to its holdings in the investment securities portfolio, the Company invests in long-term securities purchased under agreements to resell, which totaled $850.0 million at December 31, 2019 and $700.0 million at December 31, 2018. These investments mature in 2020 through 2023 and have fixed rates or variable rates that fluctuate with published indices. The counterparties to these agreements are other financial institutions from whom the Company has accepted collateral of $886.3 million in marketable investment securities at December 31, 2019. The average rate earned on these agreements during 2019 was 1.99%.
The Company also holds offsetting repurchase and resale agreements totaling $200.0 million at December 31, 2019 and $450.0 million at December 31, 2018, which are further discussed in Note 20 to the consolidated financial statements. These agreements involve the exchange of collateral under simultaneous repurchase and resale agreements with the same financial institution counterparty. These repurchase and resale agreements have been offset against each other in the balance sheet, as permitted under current accounting guidance. The agreements mature in 2020 and earned an average of 45 basis points during 2019.
Deposits and Borrowings
Deposits, including both individual and corporate customers, are the primary funding source for the Bank and are acquired from a broad base of local markets. Total period-end deposits were $20.5 billion at December 31, 2019, compared to $20.3 billion last year, reflecting an increase of $196.8 million, or 1.0%.
Average deposits declined by $221.4 million, or 1.1%, in 2019 compared to 2018, resulting from declines in average demand deposits, which decreased $352.8 million, primarily driven by lower balances in business demand deposits. Additionally, average money market deposit account balances decreased $734.0 million in 2019. Partially offsetting these decreases in deposit balances was growth in average certificates of deposit balances, which increased $289.6 million, and in average interest checking balances, which increased $524.0 million in 2019.
The following table shows year end deposit balances by type, as a percentage of total deposits.
Core deposits, which include non-interest bearing, interest checking, savings, and money market deposits, supported 75% and 77% of average earning assets in 2019 and 2018, respectively. Average balances by major deposit category for the last six years are disclosed in the Average Balance Sheets section of Management's Discussion and Analysis of Financial Condition and results of Operations below. A maturity schedule of certificates of deposits outstanding at December 31, 2019 is included in Note 7 on Deposits in the consolidated financial statements.
The Company’s primary sources of overnight borrowings are federal funds purchased and securities sold under agreements to repurchase (repurchase agreements). Balances in these accounts can fluctuate significantly on a day-to-day basis and generally have one day maturities. Total balances of federal funds purchased and repurchase agreements outstanding at December 31, 2019 were $1.9 billion, a $105.6 million decrease from the $2.0 billion balance outstanding at year end 2018. On an average basis, these borrowings increased $308.0 million, or 20.3%, during 2019, due to an increase of $143.0 million in repurchase agreements, and an increase of $165.0 million in federal funds purchased. The average rate paid on total federal funds purchased and repurchase agreements was 1.61% during 2019 and 1.30% during 2018.
Historically, the majority of the Company’s long-term debt has been comprised of fixed rate advances from the FHLB. During 2019, the Company borrowed $250.0 million of short-term funds from the FHLB, and those borrowings were repaid by the Company in October 2019. The average rate paid on FHLB advances was 2.19% during 2019. No advances were taken in 2018.
Liquidity and Capital Resources
Liquidity Management
Liquidity is managed within the Company in order to satisfy cash flow requirements of deposit and borrowing customers while at the same time meeting its own cash flow needs. The Company has taken numerous steps to address liquidity risk and has developed a variety of liquidity sources which it believes will provide the necessary funds for future growth. The Company manages its liquidity position through a variety of sources including:
•
A portfolio of liquid assets including marketable investment securities and overnight investments,
•
A large customer deposit base and limited exposure to large, volatile certificates of deposit,
•
Lower long-term borrowings that might place demands on Company cash flow,
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Relatively low loan to deposit ratio promoting strong liquidity,
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Excellent debt ratings from both Standard & Poor’s and Moody’s national rating services, and
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Available borrowing capacity from outside sources.
The Company’s most liquid assets include available for sale debt securities, federal funds sold, balances at the Federal Reserve Bank, and securities purchased under agreements to resell. At December 31, 2019 and 2018, such assets were as follows:
There were no federal funds sold at December 31, 2019, which are funds lent to the Company’s correspondent bank customers with overnight maturities. At December 31, 2019, the Company had lent funds totaling $850.0 million under long-term resale agreements to other large financial institutions. The agreements mature in years 2020 through 2023. Under these agreements, the Company holds marketable securities, safekept by a third-party custodian, as collateral. This collateral totaled $886.3 million in fair value at December 31, 2019. Interest earning balances at the Federal Reserve Bank, which have overnight maturities and are used for general liquidity purposes, totaled $395.9 million at December 31, 2019. The Company’s available for sale investment portfolio includes scheduled maturities and expected pay downs of approximately $1.3 billion during 2020, and these funds offer substantial resources to meet either new loan demand or help offset reductions in the Company’s deposit funding base. The Company pledges portions of its investment securities portfolio to secure public fund deposits, repurchase agreements, trust funds, letters of credit issued by the FHLB, and borrowing capacity at the Federal Reserve Bank. At December 31, 2019 and 2018, total investment securities pledged for these purposes were as follows:
* Includes securities pledged for collateral swaps, as discussed in Note 20 to the consolidated financial statements
The average loans to deposits ratio is a measure of a bank's liquidity, and the Company’s average loans to deposits ratio was 71.5% at December 31, 2019. Core customer deposits, defined as non-interest bearing, interest checking, savings, and money market deposit accounts, totaled $18.5 billion and represented 90.2% of the Company’s total deposits at December 31, 2019. These core deposits are normally less volatile, often with customer relationships tied to other products offered by the Company promoting long lasting relationships and stable funding sources. Total core deposits decreased $153.1 million at year end 2019 compared to year end 2018, with declines in wealth management and commercial deposits of $104.7 million and $101.8 million, respectively. This decrease was partially offset by growth of $51.8 million in consumer deposits. While the Company considers core consumer and wealth management deposits less volatile, corporate deposits could decline if interest rates increase significantly or if corporate customers increase investing activities and reduce deposit balances. If these corporate deposits decline, the Company's funding needs can be met by liquidity supplied by investment security maturities and pay downs expected to total $1.3 billion over the next year, as noted above. In addition, as shown in the table of collateral available for future advances below, the Company has borrowing capacity of $3.6 billion through advances from the FHLB and the Federal Reserve.
Certificates of deposit of $100,000 or greater totaled $1.4 billion at December 31, 2019. These deposits are normally considered more volatile and higher costing, and comprised 6.7% of total deposits at December 31, 2019.
Other important components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are mainly comprised of federal funds purchased, and repurchase agreements, as follows:
Federal funds purchased, which totaled $20.0 million at December 31, 2019, are unsecured overnight borrowings obtained mainly from upstream correspondent banks with which the Company maintains approved lines of credit. Retail repurchase agreements are offered to customers wishing to earn interest in highly liquid balances and are used by the Company as a funding source considered to be stable, but short-term in nature. Repurchase agreements are collateralized by securities in the Company’s investment portfolio. Total repurchase agreements at December 31, 2019 were comprised of non-insured customer funds totaling $1.8 billion, and securities pledged for these retail agreements totaled $1.9 billion.
The Company pledges certain assets, including loans and investment securities to both the Federal Reserve Bank and the FHLB as security to establish lines of credit and borrow from these entities. Based on the amount and type of collateral pledged, the FHLB establishes a collateral value from which the Company may draw advances against the collateral. Additionally, this collateral is used to enable the FHLB to issue letters of credit in favor of public fund depositors of the Company. The Federal Reserve Bank also establishes a collateral value of assets pledged and permits borrowings from the discount window. The following table reflects the collateral value of assets pledged, borrowings, and letters of credit outstanding, in addition to the estimated future funding capacity available to the Company at December 31, 2019.
The Company receives outside ratings from both Standard & Poor’s and Moody’s on both the consolidated company and its subsidiary bank, Commerce Bank. These ratings are as follows:
The Company considers these ratings to be indications of a sound capital base and strong liquidity and believes that these ratings would help ensure the ready marketability of its commercial paper, should the need arise. No commercial paper has been outstanding during the past ten years. The Company has no subordinated or hybrid debt instruments which would affect future borrowing capacity. Because of its lack of significant long-term debt, the Company believes that, through its Capital Markets Group or in other public debt markets, it could generate additional liquidity from sources such as jumbo certificates of deposit, privately-placed corporate notes or other forms of debt.
The cash flows from the operating, investing and financing activities of the Company resulted in a net decrease in cash, cash equivalents and restricted cash of $301.4 million in 2019, as reported in the consolidated statements of cash flows. Operating activities, consisting mainly of net income adjusted for certain non-cash items, provided cash flow of $512.8 million and has historically been a stable source of funds. Investing activities used cash of $730.2 million, mainly from an increase in the loan portfolio, partly offset by activity in the investment securities portfolio. Growth in the loan portfolio used cash of $647.9 million, purchases of long-term resale agreements used cash of $150.0 million, and net purchases of land, buildings and equipment used $40.5 million, while sales and maturities (net of purchases) of investment securities provided cash of $108.3 million. Investing activities are somewhat unique to financial institutions in that, while large sums of cash flow are normally used to fund growth in investment securities, loans, or other bank assets, they are normally dependent on the financing activities described below.
During 2019, financing activities used cash of $84.1 million. The Company paid cash dividends of $122.5 million on common and preferred stock, and federal funds purchases and short-term securities sold under agreements to repurchase used cash in the amount of $105.6 million. Treasury stock purchases used cash of $284.9 million during 2019 and included a cash outflow of $150.0 million related to the Company's accelerated share repurchase agreement. Growth in deposits partially offset these cash outflows by providing cash of $435.3 million. Future short-term liquidity needs for daily operations are not expected to vary significantly, and the Company believes it maintains adequate liquidity to meet these cash flows. The Company’s sound equity base, along with its long-term low debt level, common and preferred stock availability, and excellent debt ratings, provide several alternatives for future financing. Future acquisitions may utilize partial funding through one or more of these options.
Cash outflows resulting from the Company’s transactions in its common and preferred stock were as follows:
The Parent faces unique liquidity constraints due to legal limitations on its ability to borrow funds from its bank subsidiary. The Parent obtains funding to meet its obligations from two main sources: dividends received from bank and non-bank subsidiaries (within regulatory limitations) and management fees charged to subsidiaries as reimbursement for services provided by the Parent, as presented below:
These sources of funds are used mainly to pay cash dividends on outstanding stock, pay general operating expenses, and purchase treasury stock. At December 31, 2019, the Parent’s investment securities totaled $4.4 million at fair value, consisting mainly of preferred stock and non-agency mortgage-backed securities. To support its various funding commitments, the Parent maintains a $20.0 million line of credit with its subsidiary bank. There were no borrowings outstanding under the line during 2019 or 2018.
Company senior management is responsible for measuring and monitoring the liquidity profile of the organization with oversight by the Company’s Asset/Liability Committee. This is done through a series of controls, including a written Contingency Funding Policy and risk monitoring procedures, which include daily, weekly and monthly reporting. In addition, the Company prepares forecasts to project changes in the balance sheet affecting liquidity and to allow the Company to better plan for forecasted changes.
Capital Management
Under Basel III capital guidelines, at December 31, 2019 and 2018, the Company met all capital adequacy requirements and had regulatory capital ratios in excess of the levels established for well-capitalized institutions, as shown in the following table.
*under Prompt Corrective Action requirements
The Company maintains a treasury stock buyback program under authorizations by its Board of Directors and periodically purchases stock in the open market. During 2018, the Company purchased 1.2 million shares through market purchases. During 2019, the Company purchased 4.7 million shares, including 2.4 million shares purchased under an accelerated share repurchase (ASR) agreement. The ASR agreement is further discussed in Note 14 to the consolidated financial statements. At December 31, 2019, 4.4 million shares remained available for purchase under the current Board authorization.
The Company’s common stock dividend policy reflects its earnings outlook, desired payout ratios, the need to maintain adequate capital levels and alternative investment options. Per share cash dividends paid by the Company increased 16.1% in 2019 compared with 2018, and the Company increased its first quarter 2020 cash dividend 8.9%, making 2020 the Company's 52nd consecutive year of regular cash dividend increases. The Company also distributed its 26th consecutive annual 5% stock dividend in December 2019.
Commitments, Contractual Obligations, and Off-Balance Sheet Arrangements
In the normal course of business, various commitments and contingent liabilities arise that are not required to be recorded on the balance sheet. The most significant of these are loan commitments totaling $11.2 billion (including approximately $5.1 billion in unused, approved credit card lines) and the contractual amount of standby letters of credit totaling $377.3 million at December 31, 2019. As many commitments expire unused or only partially used, these totals do not necessarily reflect future cash requirements. Management does not anticipate any material losses arising from commitments or contingent liabilities and believes there are no material commitments to extend credit that represent risks of an unusual nature.
A table summarizing contractual cash obligations of the Company at December 31, 2019 and the expected timing of these payments follows:
* Includes operating leases signed but not yet commenced.
** Includes principal payments only.
The Company funds a defined benefit pension plan for a portion of its employees. Under the funding policy for the plan, contributions are made as necessary to provide for current service and for any unfunded accrued actuarial liabilities over a reasonable period. No contributions to the defined benefit plan were made in 2019 or 2018, and the Company is not required nor does it expect to make a contribution in 2020.
The Company has investments in low-income housing partnerships generally within the areas it serves. These partnerships supply funds for the construction and operation of apartment complexes that provide affordable housing to that segment of the population with lower family income. If these developments successfully attract a specified percentage of residents falling in that lower income range, federal (and sometimes state) income tax credits are made available to the partners. The tax credits are normally recognized over ten years, and they play an important part in the anticipated yield from these investments. In order to continue receiving the tax credits each year over the life of the partnership, the low-income residency targets must be maintained. Under the terms of the partnership agreements, the Company has a commitment to fund a specified amount that will be due in installments over the life of the agreements, which ranges from 8 to 17 years. At December 31, 2019, the investments totaled $37.3 million and are recorded as other assets in the Company’s consolidated balance sheet. Unfunded commitments, which are recorded as liabilities, amounted to $19.4 million at December 31, 2019.
The Company regularly purchases various state tax credits arising from third-party property redevelopment. These credits are either resold to third parties or retained for use by the Company. During 2019, purchases and sales of tax credits amounted to $90.6 million and $84.9 million, respectively. Fees from the sales of tax credits were $3.5 million, $4.9 million and $3.3 million in 2019, 2018 and 2017, respectively. At December 31, 2019, the Company had outstanding purchase commitments totaling $160.9 million that it expects to fund in 2020. These commitments, along with the commitments for the next five years, are included in the table above.
Interest Rate Sensitivity
The Company’s Asset/Liability Management Committee (ALCO) measures and manages the Company’s interest rate risk on a monthly basis to identify trends and establish strategies to maintain stability in net interest income throughout various rate environments. Analytical modeling techniques provide management insight into the Company’s exposure to changing rates. These techniques include net interest income simulations and market value analysis. Management has set guidelines specifying acceptable limits within which net interest income and market value may change under various rate change scenarios. These measurement tools indicate that the Company is currently within acceptable risk guidelines as set by management.
The Company’s main interest rate measurement tool, income simulation, projects net interest income under various rate change scenarios in order to quantify the magnitude and timing of potential rate-related changes. Income simulations are able to capture option risks within the balance sheet where expected cash flows may be altered under various rate environments. Modeled rate movements include “shocks, ramps and twists.” Shocks are intended to capture interest rate risk under extreme conditions by immediately shifting rates up and down, while ramps measure the impact of gradual changes and twists measure yield curve risk. The size of the balance sheet is assumed to remain constant so that results are not influenced by growth predictions.
The Company also employs a sophisticated simulation technique known as a stochastic income simulation. This technique allows management to see a range of results from hundreds of income simulations. The stochastic simulation creates a vector of potential rate paths around the market’s best guess (forward rates) concerning the future path of interest rates and allows rates to randomly follow paths throughout the vector. This allows for the modeling of non-biased rate forecasts around the market consensus. Results give management insight into a likely range of rate-related risk as well as worst and best-case rate scenarios.
Additionally, the Company uses market value analyses to help identify longer-term risks that may reside on the balance sheet. This is considered a secondary risk measurement tool by management. The Company measures the market value of equity as the net present value of all asset and liability cash flows discounted along the current swap curve plus appropriate market risk spreads. It is the change in the market value of equity under different rate environments, or effective duration, that gives insight into the magnitude of risk to future earnings due to rate changes. Market value analyses also help management understand the price sensitivity of non-marketable bank products under different rate environments.
The tables below show the effects of gradual shifts in interest rates over a twelve month period on the Company’s net interest income versus the Company's net interest income in a flat rate scenario. Simulation A presents two rising rate scenarios and a falling rate scenario, and in each scenario, rates are assumed to change evenly over 12 months. In these scenarios, the balance sheet remains flat with the exception of deposit balances, which may fluctuate based on changes in rates. For instance, the Company may experience deposit disintermediation if the spread between market rates and bank deposit rates widens as rates rise.
The sensitivity of deposit balances to changes in rates is particularly difficult to estimate in exceptionally low rate environments. Since the future effects of changes in rates on deposit balances cannot be known with certainty, the Company conservatively models alternate scenarios with greater deposit attrition as rates rise. Simulation B illustrates results from these higher attrition scenarios to provide added perspective on potential effects of higher rates.
The Company utilizes these simulations both for monitoring interest rate risk and for liquidity planning purposes. While the future effects of rising rates on deposit balances cannot be known, the Company maintains a practice of running multiple rate scenarios to better understand interest rate risk and its effect on the Company’s performance.
Under Simulation A, in the two rising rate scenarios, higher variable rate loan volumes and a slight decline in deposit sensitivity contributed to increases in income if rates rise relative to the previous period. However, this was more than offset by changes in rates earned on the Company’s long-term structured repurchase agreements. In the fourth quarter of 2019, lower market rates increased structured repurchase agreement rates and income in the Base scenario which are expected to decline again if rates rise, reducing the benefit of higher rates.
In Simulation B, the assumed higher levels of deposit attrition were modeled to be replaced by wholesale borrowed funds with higher costs than in Simulation A and resulted in a reduction in net interest income under both rising rate scenarios. In the 100 basis point falling scenario shown in Simulation A, it is assumed that deposits would increase $154.8 million along with an increase in earning assets, but rates on loans would fall faster than deposit rates. Additionally, this scenario results in lower net interest income than in the base calculation. The 100 basis point falling scenario is presented only in Simulation A as the results would be the same under Simulation B.
Projecting deposit activity in a historically low interest rate environment is difficult, and the Company cannot predict how deposits will react to shifting rates. The comparison provided above provides insight into potential effects of changes in rates and deposit levels on net interest income. The Company believes that its approach to interest rate risk has appropriately considered its susceptibility to both rising and falling rates and has adopted strategies which minimize the impact of interest rate risk.
Derivative Financial Instruments
The Company maintains an overall interest rate risk management strategy that permits the use of derivative instruments to modify exposure to interest rate risk. Such instruments include interest rate swaps, interest rate floors, interest rate caps, credit risk participation agreements, foreign exchange contracts, mortgage loan commitments, forward sale contracts, and forward to-be-announced (TBA) contracts. The Company’s interest rate risk management strategy includes the ability to modify the re-pricing characteristics of certain assets and liabilities so that changes in interest rates do not adversely affect the net interest margin and cash flows. Interest rate floors with a total notional amount of $1.5 billion have been entered into since the beginning of 2018 as part of this strategy to manage interest rate risk. All of these derivative instruments utilized by the Company are further discussed in Note 19 on Derivative Instruments.
In all of these contracts, the Company is exposed to credit risk in the event of nonperformance by counterparties, who may be bank customers or other financial institutions. The Company controls the credit risk of its financial contracts through credit approvals, limits and monitoring procedures. Because the Company generally enters into transactions only with high quality counterparties, there have been no losses associated with counterparty nonperformance on derivative financial instruments.
The following table summarizes the notional amounts and estimated fair values of the Company’s derivative instruments at December 31, 2019 and 2018. Notional amount, along with the other terms of the derivative, is used to determine the amounts to be exchanged between the counterparties. Because the notional amount does not represent amounts exchanged by the parties, it is not a measure of loss exposure related to the use of derivatives nor of exposure to liquidity risk.
Operating Segments
The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The results are determined based on the Company’s management accounting process, which assigns balance sheet and income statement items to each responsible segment. These segments are defined by customer base and product type. The management process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. Each segment is managed by executives who, in conjunction with the Chief Executive Officer, make strategic business decisions regarding that segment. The three reportable operating segments are Consumer, Commercial, and Wealth. Additional information is presented in Note 13 on Segments in the consolidated financial statements.
The Company uses a funds transfer pricing method to value funds used (e.g., loans, fixed assets, cash, etc.) and funds provided (deposits, borrowings, and equity) by the business segments and their components. This process assigns a specific value to each new source or use of funds with a maturity, based on current swap rates, thus determining an interest spread at the time of the transaction. Non-maturity assets and liabilities are valued using weighted average pools. The funds transfer pricing process attempts to remove interest rate risk from valuation, allowing management to compare profitability under various rate environments. The Company also assigns loan charge-offs and recoveries (labeled in the table below as “provision for loan losses”) directly to each operating segment instead of allocating an estimated loan loss provision. The operating segments also include a number of allocations of income and expense from various support and overhead centers within the Company.
The table below is a summary of segment pre-tax income results for the past three years.
Consumer
The Consumer segment includes consumer deposits, consumer finance, and consumer debit and credit cards. During 2019, income before income taxes for the Consumer segment increased $14.2 million, or 15.0%, compared to 2018. This increase was due to growth of $21.0 million, or 7.1%, in net interest income and an increase in non-interest income of $9.0 million, or 7.1%. Net interest income increased due to a $27.8 million increase in net allocated funding credits assigned to the Consumer segment's loan and deposit portfolios and growth of $3.4 million in loan interest income, partly offset by an increase of $10.1 million in deposit interest expense. Non-interest income increased mainly due to growth in mortgage banking revenue and net credit card fees, (mainly higher interchange fees and lower rewards expense), partly offset by a decline in deposit fees (mainly overdraft and deposit account service fees). These increases to income were partly offset by growth of $11.4 million, or 4.0%, in non-interest expense. Non-interest expense increased over the prior year due to higher salaries expense, data processing and software expense and allocated servicing and support costs (mainly teller services, online banking, installment loan and management fees). The provision for loan losses totaled $45.0 million, a $4.4 million increase over the prior year, which was mainly due to higher net charge-offs on consumer credit card loans. Total average loans in this segment decreased $107.1 million, or 4.6%, in 2019 compared to 2018 mainly due to a decline in auto and other consumer loans. Average deposits increased $25.8 million over the prior year, resulting from growth in interest checking, savings, and certificate of deposit balances, partly offset by a decline in money market deposit accounts.
During 2018, income before income taxes for the Consumer segment increased $10.9 million, or 13.1%, compared to 2017. This increase was mainly due to growth of $17.9 million, or 6.5%, in net interest income and an increase in non-interest income of $4.9 million, or 4.0%. Net interest income increased due to a $14.2 million increase in net allocated funding credits and growth of $5.3 million in loan interest income, partly offset by an increase of $1.6 million in deposit interest expense. Non-interest income increased mainly due to growth in net debit card fees, (mainly lower network expense and higher interchange fees), deposit fees (mainly deposit account service fees and overdraft and return item fees) and mortgage banking revenue, partly offset by higher credit card rewards expense. These increases to income were partly offset by growth of $12.0 million, or 4.4%, in non-interest expense. Non-interest expense increased over 2017 due to an increase in full-time salaries expense and higher allocated servicing and support costs, mainly marketing, information technology and management fees. The provision for loan losses totaled $40.6 million, a slight decrease from 2017, which was mainly due to lower net charge-offs on home equity loans, partly offset by higher consumer credit card loan net charge-offs. Total average loans in this segment decreased $45.1 million, or 1.9%, in 2018 compared to 2017 mainly due to a decline in auto and other personal loans. Average deposits increased $19.9 million over 2017, resulting from growth in interest checking and savings accounts, partly offset by declines in demand, money market deposit accounts, and certificate of deposit balances.
Commercial
The Commercial segment provides corporate lending (including the Small Business Banking product line within the branch network), leasing, international services, and business, government deposit, and related commercial cash management services, as well as merchant and commercial bank card products. The segment includes the Capital Markets Group, which sells fixed-income securities to correspondent banks, corporations, public institutions, municipalities, and individuals and also provides securities safekeeping and bond accounting services. Pre-tax income for 2019 decreased $14.7 million, or 5.9%, compared to 2018, mainly due to a decrease in net interest income and increases in non-interest expense and the provision for loan losses. Net interest income decreased $2.2 million, or .6%, due to a decline of $13.2 million in net allocated funding credits and higher interest expense of $18.4 million on deposits and customer repurchase agreements, partly offset by an increase of $29.3 million in loan interest income. The provision for loan losses increased $3.1 million over last year, due to higher lease loan net charge-offs (related to a charge-off on a single lease loan), partly offset by lower business loan net charge-offs. Non-interest income increased $1.4 million, or .7%, over 2018 due to higher deposit account fees (mainly corporate cash management), cash sweep commissions, and gains on sales of leased assets to customers upon lease termination. These increases were partly offset by lower net corporate card fees (driven by lower interchange income and higher network and rewards expense) and lower tax credit sales fees. Non-interest expense increased $10.8 million, or 3.6%, during 2019, mainly due to increases in salaries expense and allocated support costs (mainly information technology, marketing and commercial sales and product support). These increases were partly offset by lower deposit insurance expense and allocated servicing costs (mainly teller services and deposit operations). Average segment loans increased $310.9 million, or 3.5%, compared to 2018, with growth occurring in business and business real estate loans. Average deposits decreased $180.9 million, or 2.3%, due to declines in business demand and money market deposit accounts, partly offset by growth in certificate of deposit balances.
Pre-tax income for 2018 increased $16.5 million, or 7.1%, compared to 2017, mainly due to increases in net interest income and non-interest income, partly offset by higher non-interest expense. Net interest income increased $15.9 million, or 4.8%, due to growth of $70.6 million in loan interest income, partly offset by a decline of $32.3 million in net allocated funding credits and higher interest expense of $22.5 million on deposits and customer repurchase agreements. The provision for loan losses increased $1.3 million over 2017, due to higher net charge-offs on business loans and lower recoveries on construction loans, partly offset by lower commercial card loan net charge-offs. Non-interest income increased $18.0 million, or 9.7%, over 2017 due to higher net corporate card fees (driven by higher fees), swap fees, tax credit sales fees and deposit account fees (mainly corporate cash management). These increases were partly offset by lower gains on sales of leased assets to customers upon lease termination. Non-interest expense increased $16.0 million, or 5.7%, during 2018, mainly due to increases in salaries expense and allocated support and service costs (mainly information technology and commercial sales and product support fees). Average segment loans increased $304.7 million, or 3.5%, compared to 2017, with growth occurring in commercial and industrial, construction, and healthcare loans. Average deposits decreased $271.8 million, or 3.3%, due to declines in business demand deposits, money market deposit accounts, and certificates of deposit, partly offset by growth in interest checking deposits.
Wealth
The Wealth segment provides traditional trust and estate planning, advisory and discretionary investment management services, brokerage services, and includes Private Banking accounts. At December 31, 2019, the Trust group managed investments with a market value of $34.4 billion and administered an additional $22.3 billion in non-managed assets. It also provides investment management services to The Commerce Funds, a series of mutual funds with $2.9 billion in total assets at December 31, 2019. In 2019, pre-tax income for the Wealth segment was $107.4 million, compared to $96.4 million in 2018, an increase of $10.9 million, or 11.3%. Net interest income increased $1.1 million, or 2.4%, due to a $4.3 million increase in loan interest income and a $1.7 million increase in net allocated funding credits, partly offset by higher interest expense of $4.9 million. Non-interest
income increased $10.6 million, or 6.1%, over the prior year largely due to higher private client fund trust fees and cash sweep commissions. Non-interest expense increased $555 thousand, or .4%, resulting from higher salaries and benefits expense and higher allocated costs for information technology. The provision for loan losses increased $206 thousand, mainly due to higher revolving home equity loan net charge-offs. Average assets increased $45.0 million, or 3.6%, during 2019 mainly due to growth in personal real estate and consumer loan balances. Average deposits decreased $39.2 million, or 2.1%, due to declines in interest checking account balances, partially offset by higher balances of demand deposits. During the fourth quarter of 2019, the Company sold its corporate trust business, which was included in the Wealth segment.
In 2018, pre-tax income for the Wealth segment was $96.4 million, compared to $84.9 million in 2017, an increase of $11.5 million, or 13.5%. Net interest income decreased $318 thousand, or .7%, due to a $5.3 million decrease in net allocated funding credits, partly offset by a $5.5 million increase in loan interest income. Non-interest income increased $14.9 million, or 9.4%, over 2017 largely due to higher private client and institutional trust fees, brokerage fees and cash sweep commissions. These increases were partly offset by write downs on software costs. Non-interest expense increased $3.1 million, or 2.6%, resulting from higher salary and benefit costs, data processing expense and allocated support and corporate management fee costs, partly offset by lower trust losses. The provision for loan losses decreased $73 thousand, mainly due to personal real estate loan net recoveries. Average assets increased $25.2 million, or 2.1%, during 2018 mainly due to higher personal real estate and consumer loans. Average deposits decreased $219.0 million, or 10.5%, due to declines in money market deposit accounts and long-term certificates of deposit over $100,000.
The segment activity, as shown above, includes both direct and allocated items. Amounts in the “Other/Elimination” column include activity not related to the segments, such as certain administrative functions, the investment securities portfolio, and the effect of certain expense allocations to the segments. Also included in this category is the difference between the Company’s provision for loan losses and net loan charge-offs, which are generally assigned directly to the segments. In 2019, the pre-tax income in this category was $82.2 million, compared to $104.9 million in 2018. This decrease was due to lower unallocated net interest income of $22.4 million and higher unallocated non-interest expense of $6.8 million. Unallocated securities gains were $3.6 million in 2019, compared to securities losses of $488 thousand in 2018. Also, the unallocated loan loss provision increased $52 thousand, as the provision was $1.1 million in excess of charge-offs in 2019, while the provision was $1.0 million in excess of charge offs in 2018. Additionally in 2019, a $11.5 million gain on the sale of Company's corporate trust business, mentioned above, was also recorded in the Other segment.
Impact of Recently Issued Accounting Standards
Leases In February 2016, the FASB issued ASU 2016-02, "Leases", in order to increase transparency and comparability by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The ASU primarily affects lessee accounting, which requires the lessee to recognize a right-of-use (ROU) asset and a liability to make lease payments for those leases classified as operating leases under previous GAAP. The ASU provides guidance as to the definition of a lease, identification of lease components, and sale and leaseback transactions. The FASB issued elections and expedients within the original ASU and additional amendments, clarifying the lease guidance for certain implementation issues. The Company has adopted the package of expedients, the lease component expedient as well as the disclosure expedient. Additionally, for leases with a term of 12 months or less, an election was made not to recognize lease assets and lease liabilities. The Company adopted the new accounting standard as of January 1, 2019, and a lease liability of $28.1 million and a ROU asset of $27.5 million were recognized. The impact of the adoption and required disclosures are discussed in Note 6 to the consolidated financial statements.
Premium Amortization The FASB issued ASU 2017-08, "Premium Amortization on Purchased Callable Debt Securities", in March 2017. Under former guidance, many entities amortize the premium on purchased callable debt securities over the contractual life of the instrument. As a result, upon the exercise of a call on a callable debt security held at a premium, the unamortized premium is recorded as a loss in earnings. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium to the earliest call date, and more closely align the amortization period to expectations incorporated in market pricing of the instrument. The amendments were effective January 1, 2019 and did not have a significant effect on the Company's consolidated financial statements.
Financial Instruments ASU 2016-13, "Measurement of Credit Losses on Financial Instruments", known as the current expected credit loss (CECL) model, was issued in June 2016, and has been followed by additional clarifying guidance on specified implementation issues. This new standard is effective for fiscal years beginning after December 15, 2019 and was adopted by the Company on January 1, 2020 using the modified retrospective method.
This new measurement approach requires the calculation of expected lifetime credit losses and is applied to financial assets measured at amortized cost, including loans and held-to-maturity securities, as well as certain off-balance sheet credit exposures such as loan commitments. The standard also changes the impairment model of available for sale debt securities.
The allowance for loan losses under the previously required incurred loss model that is reported on the Company's consolidated balance sheets is different under the requirements of the CECL model. Upon adoption in the first quarter of 2020, a cumulative-effect adjustment for the change in the allowance for credit losses will be recognized in retained earnings. The cumulative-effect adjustment to retained earnings, net of taxes, will be comprised of the impact to the allowance for credit losses on outstanding loans and leases and the impact to the liability for off-balance sheet commitments. There is no implementation impact on held-to-maturity debt securities as the Company does not hold any debt securities within the scope of CECL.
The new accounting standard does not require the use of a specific loss estimation method for purposes of determining the allowance for credit losses. The Company selected a methodology that uses historical net charge-off rates, adjusted by the impacts of a reasonable and supportable forecast and the impacts of other qualitative factors to determine the expected credit losses. Key assumptions include the application of historical loss rates, prepayment speeds, forecast results of a reasonable and supportable period, the period to revert to historical loss rates, and qualitative factors. The forecast is determined using projections of certain macroeconomic variables, such as, unemployment rate, prime rate, BBB corporate yield, and housing price index. The model design and methodology requires management judgment.
The allowance for credit losses on the commercial portfolio is expected to decrease due to the relatively short contractual lives of the commercial loan portfolios coupled with an economic forecast predicting stable macroeconomic factors similar to the current environment. The allowance for credit losses on the personal banking loan portfolio is expected to increase due to the relatively longer contractual lives of certain portfolios, primarily those collateralized with personal real estate. Because the commercial loan portfolio represents 63% of total loans at December 31, 2019, the change in its allowance for credit losses will have a more significant impact on the total allowance for credit losses, resulting in a potential net reduction in the allowance for credit losses. Based on preliminary results, the Company expects its allowance for loan losses to total loans ratio to decline from 1.09% at December 31, 2019, to within a range of approximately 0.85% to 1.05% upon adoption. Offsetting the overall reduction in the allowance for credit losses for outstanding loans and leases is an expected increase in the liability for off-balance sheet loan commitments. The liability will increase as the loss estimation is required to expand over the contractual commitment period.
Preliminary results indicate the adoption adjustment will result in an immaterial impact to retained earnings. The Company is currently performing quality reviews on preliminary results and is planning to finalize the impact in the 1st quarter of 2020. The adoption adjustment is subject to the completion of the Company’s governance and quality review processes that are in process.
Moving beyond the impact of the adoption of CECL, volatility in the allowance for credit losses, and therefore earnings, will likely be experienced due to changes in the relevant forward-looking information including forecasts of macroeconomic conditions utilized in the CECL model and other key assumptions that are applied to the remaining life of the loan and lease portfolios.
Intangible Assets The FASB issued ASU 2017-04, "Simplifying the Test for Goodwill Impairment", in January 2017. Under current guidance, a goodwill impairment loss is measured by comparing the implied fair value of a reporting unit's goodwill with the carrying amount of that goodwill by following procedures that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Under the new amendments, the goodwill impairment test compares the fair value of a reporting unit with its carrying amount and an impairment charge is measured as the amount by which the carrying amount exceeds the reporting unit's fair value. The amendments were effective for impairment tests beginning January 1, 2020 and did not have a significant effect on the Company's consolidated financial statements.
Financial Instruments The FASB issued ASU 2018-13, "Changes to the Disclosure Requirements of Fair Value Measurement", in August 2018. The amendments in the ASU eliminate or modify certain disclosure requirements for fair value measurements in Topic 820, Fair Value Measurement. In addition, the amendments in the ASU also require the addition of new disclosure requirements on fair value measurement, including the disclosure of changes in unrealized gains and losses for the period included in AOCI for recurring Level 3 fair value measurements and the range and weighted average of significant unobservable inputs used to develop Level 3 fair value measurements. The guidance was effective January 1, 2020 and did not have a significant effect on the Company's consolidated financial statements.
Retirement Benefits The FASB issued ASU 2018-14, "Compensation - Retirement Benefits-Defined Benefit Plans-General (Subtopic 715-20)", in August 2018. The amendments in the ASU eliminate disclosures that are no longer considered cost beneficial and clarify specific requirements of disclosures. In addition, the amendments in the ASU also add new disclosures, including the explanation of the reasons for significant gains and losses related to changes in the benefit obligation for the period. The amendments were effective January 1, 2020 and did not have a significant effect on the Company's consolidated financial statements.
Intangible Assets The FASB issued ASU 2018-15, "Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract", in August 2018. Under current guidance the accounting for implementation costs of a hosting arrangement that is a service contract is not specifically addressed. Under the new amendments, the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract are aligned with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software or hosting arrangements that include internal-use software license. The guidance was effective January 1, 2020 and did not have a significant effect on the Company's consolidated financial statements.
Income Taxes The FASB issued ASU 2019-12, "Simplifying the Accounting for Income Taxes", in December 2019. The amendments in the ASU eliminate certain exceptions under current guidance for investments, intraperiod allocations, and the methodology for calculating interim income tax. In addition, the amendments also add new guidance to simplify accounting for income taxes. The amendments are effective January 1, 2021, but early adoption is permitted. The Company is still assessing the impact on the Company's consolidated financial statements.
Corporate Governance
The Company has adopted a number of corporate governance measures. These include corporate governance guidelines, a code of ethics that applies to its senior financial officers and the charters for its audit and risk committee, its committee on compensation and human resources, and its committee on governance/directors. This information is available on the Company’s Web site www.commercebank.com under Social Responsibility.
SUMMARY OF QUARTERLY STATEMENTS OF INCOME
* Restated for the 5% stock dividend distributed in 2019.
AVERAGE BALANCE SHEETS - AVERAGE RATES AND YIELDS
(A)
Loans on non-accrual status are included in the computation of average balances. Included in interest income above are loan fees and late charges, net of amortization of deferred loan origination fees and costs, which are immaterial. Credit card income from merchant discounts and net interchange fees are not included in loan income.
AVERAGE BALANCE SHEETS - AVERAGE RATES AND YIELDS
(B)
Interest income and yields are presented on a fully-taxable equivalent basis using a federal income tax rate of 21% in 2019 and 2018, and 35% in prior periods. Loan interest income includes tax free loan income (categorized as business loan income) which includes tax equivalent adjustments of $6,282,000 in 2019, $5,931,000 in 2018, $10,357,000 in 2017, $9,537,000 in 2016, $8,332,000 in 2015 and $7,640,000 in 2014. Investment securities interest income includes tax equivalent adjustments of $7,845,000 in 2019, $10,306,000 in 2018, $22,565,000 in 2017, $21,847,000 in 2016, $21,386,000 in 2015 and $20,784,000 in 2014. These adjustments relate to state and municipal obligations, trading securities, equity securities, and other securities.
QUARTERLY AVERAGE BALANCE SHEETS - AVERAGE RATES AND YIELDS
(A)
Includes tax equivalent calculations.
QUARTERLY AVERAGE BALANCE SHEETS - AVERAGE RATES AND YIELDS
(A)
Includes tax equivalent calculations.
Item 7a.
Item 7a.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is disclosed within the Interest Rate Sensitivity section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 8.
Item 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors
Commerce Bancshares, Inc.:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Commerce Bancshares, Inc. and subsidiaries (the Company) as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, cash flows, and changes in equity for each of the years in the three-year period ended December 31, 2019, and the related notes (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2019, 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) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 25, 2020 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current period audit of the consolidated financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the consolidated financial statements and (2) involved our especially challenging, subjective, or complex judgment. The communication of a critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Assessment of the allowance for loan losses related to loans collectively evaluated for impairment
As discussed in Notes 1 and 2 to the consolidated financial statements, the Company’s allowance for loan losses related to loans collectively evaluated for impairment (ASC 450 ALL) was $157.9 million of a total allowance for loan losses of $160.7 million as December 31, 2019, or 1.07% of total loans. The Company estimated the ASC 450 ALL using a historical loss methodology utilizing a loss emergence period, which is applied to loans based on loan risk ratings. Such amounts are adjusted for certain qualitative factors which include an evaluation of the performance and status of loans, current loan portfolio composition and characteristics, trends in delinquencies, portfolio risk ratings, levels of non-performing assets, and prevailing regional and national economic and business conditions.
We identified the assessment of the ASC 450 ALL as a critical audit matter because it involved significant measurement uncertainty requiring complex auditor judgment, and knowledge and experience in the industry. In addition, auditor judgment was required to evaluate the sufficiency of audit evidence obtained. This assessment encompassed the evaluation of the process used to estimate the ASC 450 ALL, including the following key factors and assumptions (1) historical losses in the Company’s portfolio over time, (2) an estimate of the length of time between a specific loss event and when the first loss is identified (known as the estimated loss emergence period), and (3) loan risk ratings; and the development and evaluation of qualitative adjustments.
The primary procedures we performed to address the critical audit matter included the following. We tested certain internal controls related to the Company’s ASC 450 ALL process, including controls related to the (1) development and approval of the ASC 450 ALL methodology, (2) determination of the key factors and assumptions used to estimate the ASC 450 ALL, (3) determination of qualitative adjustments, and (4) analysis of the ASC 450 ALL results, trends, and ratios. We evaluated the Company’s process to develop the ASC 450 ALL estimate by testing certain sources of data, factors, and assumptions, and considered the relevance and reliability of such data, factors, and assumptions. We evaluated that the historical losses in the Company’s portfolio are representative of the credit characteristics of the current portfolio. We tested the estimated loss emergence period based on historical loss data, including the relevance of the parameters used in the estimate. We involved credit risk professionals with specialized industry knowledge and experience, who assisted in:
•evaluating the Company’s ASC 450 ALL methodology for compliance with U.S. generally accepted accounting principles,
•assessing the structured process for the determination of the magnitude of the qualitative adjustments,
•evaluating the qualitative factors and the effect of those factors on the ASC 450 ALL compared with relevant credit factors and consistency with credit trends, and
•testing individual loan grades for a selection of commercial loans by evaluating the financial performance of the borrower and the underlying collateral.
We evaluated the collective results of the procedures performed to assess the sufficiency of the audit evidence obtained related to the Company’s ASC 450 ALL.
We have served as the Company’s auditor since 1971.
Kansas City, Missouri
February 25, 2020
Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See accompanying notes to consolidated financial statements.
Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(A) Available for sale debt securities, equity securities, and other securities.
See accompanying notes to consolidated financial statements.
Commerce Bancshares, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
See accompanying notes to consolidated financial statements.
Commerce Bancshares, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
Nature of Operations
Commerce Bancshares, Inc. and its subsidiaries (the Company) conducts its principal activities from approximately 316 branch and ATM locations throughout Missouri, Kansas, Illinois, Oklahoma and Colorado. Principal activities include retail and commercial banking, investment management, securities brokerage, mortgage banking, trust, and private banking services. The Company also maintains commercial banking offices in Dallas, Houston, Cincinnati, Nashville, Des Moines, Indianapolis, and Grand Rapids.
Basis of Presentation
The Company follows accounting principles generally accepted in the United States of America (GAAP) and reporting practices applicable to the banking industry. The preparation of financial statements under GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and notes. These estimates are based on information available to management at the time the estimates are made. While the consolidated financial statements reflect management’s best estimates and judgments, actual results could differ from those estimates. The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries (after elimination of all material intercompany balances and transactions). Certain prior year amounts have been reclassified to conform to the current year presentation. Such reclassifications had no effect on net income or total assets. Management has evaluated subsequent events for potential recognition or disclosure through the date these consolidated financial statements were issued.
The Company, in the normal course of business, engages in a variety of activities that involve variable interest entities (VIEs). A VIE is a legal entity that lacks equity investors or whose equity investors do not have a controlling financial interest in the entity through their equity investments. However, an enterprise 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. An enterprise that is the primary beneficiary must consolidate the VIE. The Company’s interests in VIEs are evaluated to determine if the Company is the primary beneficiary both at inception and when there is a change in circumstances that requires a reconsideration.
The Company is considered to be the primary beneficiary in a rabbi trust related to a deferred compensation plan offered to certain employees. The assets and liabilities of this trust, which are included in the accompanying consolidated balance sheets, are not significant. The Company also has variable interests in certain entities in which it is not the primary beneficiary. These entities are not consolidated. These interests include affordable housing limited partnership interests, holdings in its investment portfolio of various asset and mortgage-backed bonds that are issued by securitization trusts, and managed discretionary trust assets that are not included in the accompanying consolidated balance sheets.
Cash, Cash Equivalents and Restricted Cash
In the accompanying consolidated statements of cash flows, cash and cash equivalents include “Cash and due from banks”, “Federal funds sold and short-term securities purchased under agreements to resell”, and “Interest earning deposits with banks” as segregated in the accompanying consolidated balance sheets. Restricted cash is comprised of cash collateral on deposit with another financial institution to secure interest rate swap transactions. Restricted cash is included in other assets in the consolidated balance sheets and totaled $20.3 million and $8.2 million at December 31, 2019 and 2018, respectively.
Regulations of the Federal Reserve System require cash balances to be maintained at the Federal Reserve Bank, based on certain deposit levels. The minimum reserve requirement for the Bank at December 31, 2019 totaled $160.7 million. Other interest earning cash balances held at the Federal Reserve Bank totaled $395.9 million.
Loans and Related Earnings
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balances, net of undisbursed loan proceeds, the allowance for loan losses, and any deferred fees and costs on originated loans. Origination fee income received on loans and amounts representing the estimated direct costs of origination are deferred and amortized to interest income over the life of the loan using the interest method.
Interest on loans is accrued based upon the principal amount outstanding. Interest income is recognized primarily on the level yield method. Loan and commitment fees, net of costs, are deferred and recognized in income over the term of the loan or commitment as an adjustment of yield. Annual fees charged on credit card loans are capitalized to principal and amortized over 12 months to loan fees and sales. Other credit card fees, such as cash advance fees and late payment fees, are recognized in income as an adjustment of yield when charged to the cardholder’s account.
Non-Accrual Loans
Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Business, construction real estate, business real estate, and personal real estate loans that are contractually 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection. Consumer, revolving home equity and credit card loans are exempt under regulatory rules from being classified as non-accrual. When a loan is placed on non-accrual status, any interest previously accrued but not collected is reversed against current income, and the loan is charged off to the extent uncollectible. Principal and interest payments received on non-accrual loans are generally applied to principal. Interest is included in income only after all previous loan charge-offs have been recovered and is recorded only as received. The loan is returned to accrual status only when the borrower has brought all past due principal and interest payments current, and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled. A six month history of sustained payment performance is generally required before reinstatement of accrual status.
Troubled Debt Restructurings
A loan is accounted for as a troubled debt restructuring if the Company, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that it would not otherwise consider. A troubled debt restructuring typically involves (1) modification of terms such as a reduction of the stated interest rate, loan principal, or accrued interest, (2) a loan renewal at a stated interest rate lower than the current market rate for a new loan with similar risk, or (3) debt that was not reaffirmed in bankruptcy. Business, business real estate, construction real estate and personal real estate troubled debt restructurings with impairment charges are placed on non-accrual status. The Company measures the impairment loss of a troubled debt restructuring in the same manner as described below. Troubled debt restructurings which are performing under their contractual terms continue to accrue interest which is recognized in current earnings.
Impaired Loans
Loans are evaluated regularly by management for impairment. Included in impaired loans are all non-accrual loans, as well as loans that have been classified as troubled debt restructurings. Once a loan has been identified as impaired, impairment is measured based on either the present value of the expected future cash flows at the loan’s initial effective interest rate or the fair value of the collateral if collateral dependent. Factors considered in determining impairment include delinquency status, cash flow analysis, credit analysis, and collateral value and availability.
Loans Held For Sale
Loans held for sale include student loans and certain fixed rate residential mortgage loans. These loans are typically classified as held for sale upon origination based upon management's intent to sell the production of these loans. The student loans are carried at the lower of aggregate cost or fair value, and their fair value is determined based on sale contract prices. The mortgage loans are carried at fair value under the elected fair value option. Their fair value is based on secondary market prices for loans with similar characteristics, including an adjustment for embedded servicing value. Changes in fair value and gains and losses on sales are included in loan fees and sales. Deferred fees and costs related to these loans are not amortized but are recognized as part of the cost basis of the loan at the time it is sold. Interest income related to loans held for sale is accrued based on the principal amount outstanding and the loan's contractual interest rate.
Occasionally, other types of loans may be classified as held for sale in order to manage credit concentration. These loans are carried at the lower of cost or fair value with gains and losses on sales recognized in loan fees and sales.
Allowance/Provision for Loan Losses
The allowance for loan losses is maintained at a level believed to be appropriate by management to provide for probable loan losses inherent in the portfolio as of the balance sheet date, including losses on known or anticipated problem loans as well as for loans which are not currently known to require specific allowances. Management has established a process to determine the amount of the allowance for loan losses which assesses the risks and losses inherent in its portfolio. Business, construction real estate and business real estate loans are normally larger and more complex, and their collection rates are harder to predict. These loans are more likely to be collateral dependent and are allocated a larger reserve, due to their potential volatility. Personal real
estate, credit card, consumer and revolving home equity loans are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Management’s process provides an allowance consisting of a specific allowance component based on certain individually evaluated loans and a general component based on estimates of reserves needed for pools of loans.
Loans subject to individual evaluation generally consist of business, construction real estate, business real estate and personal real estate loans on non-accrual status. These impaired loans are evaluated individually for the impairment of repayment potential and collateral adequacy. Other impaired loans identified as performing troubled debt restructurings are collectively evaluated because they have similar risk characteristics. Loans which have not been identified as impaired are segregated by loan type and sub-type and are collectively evaluated. Reserves calculated for these loan pools are estimated using a consistent methodology that considers historical loan loss experience by loan type, loss emergence periods, delinquencies, current economic factors, loan risk ratings and industry concentrations.
The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses is based on various judgments and assumptions made by management. The amount of the allowance for loan losses is influenced by several qualitative factors which include collateral valuation, evaluation of performance and status, current loan portfolio composition and characteristics, trends in delinquencies, portfolio risk ratings, levels of non-performing assets, and prevailing regional and national economic and business conditions.
The estimates, appraisals, evaluations, and cash flows utilized by management may be subject to frequent adjustments due to changing economic prospects of borrowers or properties. These estimates are reviewed periodically and adjustments, if necessary, are recorded in the provision for loan losses in the periods in which they become known.
Loans, or portions of loans, are charged off to the extent deemed uncollectible. Loan charge-offs reduce the allowance for loan losses, and recoveries of loans previously charged off are added back to the allowance. Business, business real estate, construction real estate and personal real estate loans are generally charged down to estimated collectible balances when they are placed on non-accrual status. Consumer loans and related accrued interest are normally charged down to the fair value of related collateral (or are charged off in full if no collateral) once the loans are more than 120 days delinquent. Credit card loans are charged off against the allowance for loan losses when the receivable is more than 180 days past due. The interest and fee income previously capitalized but not collected on credit card charge-offs is reversed against interest income.
Direct Financing and Sales Type Leases
The net investment in direct financing and sales type leases is included in loans on the Company’s consolidated balance sheets and consists of the present values of the sum of the future minimum lease payments and estimated residual value of the leased asset. Revenue consists of interest earned on the net investment and is recognized over the lease term as a constant percentage return thereon.
Investments in Debt and Equity Securities
The majority of the Company's investment portfolio is comprised of debt securities that are classified as available for sale. From time to time, the Company sells securities and utilizes the proceeds to reduce borrowings, fund loan growth, or modify its interest rate profile. Securities classified as available for sale are carried at fair value. Changes in fair value, excluding certain losses associated with other-than-temporary impairment (OTTI), are reported in other comprehensive income (loss), a component of stockholders’ equity. Securities are periodically evaluated for OTTI in accordance with guidance provided in ASC 320-10-35. For securities with OTTI, the entire loss in fair value is required to be recognized in current earnings if the Company intends to sell the securities or believes it likely that it will be required to sell the security before the anticipated recovery. If neither condition is met, but the Company does not expect to recover the amortized cost basis, the Company determines whether a credit loss has occurred, and the loss is then recognized in current earnings. The noncredit-related portion of the overall loss is reported in other comprehensive income (loss). Gains and losses realized upon sales of securities are calculated using the specific identification method and are included in investment securities gains (losses), net, in the consolidated statements of income. Purchase premiums and discounts are amortized to interest income using a level yield method over the estimated lives of the securities. For certain callable debt securities purchased at a premium, the amortization is instead recorded to the earliest call date. For mortgage and asset-backed securities, prepayment experience is evaluated quarterly to determine if a change in a bond's estimated remaining life is necessary. A corresponding adjustment is then made in the related amortization of premium or discount accretion.
Equity securities include common and preferred stock with readily determinable fair values. These are also carried at fair value. Prior to January 1, 2018, changes in fair value were recorded in other comprehensive income. The Company's adoption of ASU 2016-01, "Recognition and Measurement of Financial Assets and Financial Liabilities", effective January 1, 2018, required that all subsequent changes in fair value be recorded in current earnings. The adoption also required a reclassification of the
unrealized gain in fair value on equity securities (recorded in accumulated other comprehensive income at December 31, 2017) to retained earnings. The amount of this reclassification was $33.3 million, net of tax.
Certain equity securities do not have readily determinable fair values. The Company has elected under ASU 2016-01 to measure these at cost minus impairment, if any, plus or minus changes resulting from observable price changes for the identical or similar investment of the same issuer. The Company has not recorded any impairment or other adjustments to the carrying amount of these investments.
Other securities include Federal Reserve Bank stock and Federal Home Loan Bank stock, which are held for debt and regulatory purposes. They are carried at cost and periodically evaluated for other-than-temporary impairment. Also included are investments in portfolio concerns held by the Company’s private equity subsidiaries, which consist of both debt and equity instruments. Private equity investments are carried at fair value in accordance with ASC 946-10-15, with changes in fair value reported in current earnings. In the absence of readily ascertainable market values, fair value is estimated using internally developed methods. Changes in fair value which are recognized in current earnings and gains and losses from sales are included in investment securities gains (losses), net in the consolidated statements of income.
Trading account securities, which are debt securities bought and held principally for the purpose of resale in the near term, are carried at fair value. Gains and losses, both realized and unrealized, are recorded in non-interest income.
Purchases and sales of securities are recognized on a trade date basis. A receivable or payable is recognized for pending transaction settlements.
Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase
Securities purchased under agreements to resell and securities sold under agreements to repurchase are treated as collateralized financing transactions, not as purchases and sales of the underlying securities. The agreements are recorded at the amount of cash advanced or received.
The Company periodically enters into securities purchased under agreements to resell with large financial institutions. Securities pledged by the counterparties to secure these agreements are delivered to a third party custodian.
Securities sold under agreements to repurchase are a source of funding to the Company and are offered to cash management customers as an automated, collateralized investment account. From time to time, securities sold may also be used by the Bank to obtain additional borrowed funds at favorable rates. These borrowings are secured by a portion of the Company's investment security portfolio and delivered either to the dealer custody account at the FRB or to the applicable counterparty.
The fair value of collateral either received from or provided to a counterparty is monitored daily, and additional collateral is obtained, returned, or provided by the Company in order to maintain full collateralization for these transactions.
As permitted by current accounting guidance, the Company offsets certain securities purchased under agreements to resell against securities sold under agreements to repurchase in its balance sheet presentation. These agreements are further discussed in Note 20, Resale and Repurchase Agreements.
Premises and Equipment
Land is stated at cost, and buildings and equipment are stated at cost, including capitalized interest when appropriate, less accumulated depreciation. Depreciation is computed using a straight-line method, utilizing estimated useful lives; generally 30 years for buildings, 10 years for building improvements, and 3 to 10 years for equipment. Leasehold improvements are amortized over the shorter of 10 years or the remaining lease term. Maintenance and repairs are charged to non-interest expense as incurred.
Premises and equipment also includes the Company's right-of-use leased assets, which is mainly comprised of operating leases for branches, office space, ATM locations, and certain equipment.
Foreclosed Assets
Foreclosed assets consist of property that has been repossessed and is comprised of commercial and residential real estate and other non-real estate property, including auto and recreational and marine vehicles. The assets are initially recorded at fair value less estimated selling costs, establishing a new cost basis. Initial valuation adjustments are charged to the allowance for loan losses. Fair values are estimated primarily based on appraisals, third-party price opinions, or internally developed pricing models. After initial recognition, fair value estimates are updated periodically. Declines in fair value below cost are recognized through
valuation allowances which may be reversed when supported by future increases in fair value. These valuation adjustments, in addition to gains and losses realized on sales and net operating expenses, are recorded in other non-interest expense.
Goodwill and Intangible Assets
Goodwill is not amortized but is assessed for impairment on an annual basis or more frequently in certain circumstances. When testing for goodwill impairment, the Company may initially perform a qualitative assessment. Based on the results of this qualitative assessment, if the Company concludes it is more likely than not that a reporting unit's fair value is less than its carrying amount, a quantitative analysis is performed. Quantitative valuation methodologies include a combination of formulas using current market multiples, based on recent sales of financial institutions within the Company's geographic marketplace. If the fair value of a reporting unit is less than the carrying amount, additional analysis is required to measure the amount of impairment. The Company has not recorded impairment resulting from goodwill impairment tests. However, adverse changes in the economic environment, operations of the reporting unit, or other factors could result in a decline in fair value.
Intangible assets that have finite useful lives, such as core deposit intangibles and mortgage servicing rights, are amortized over their estimated useful lives. Core deposit intangibles are amortized over periods of 8 to 14 years, representing their estimated lives, using accelerated methods. Mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income, considering appropriate prepayment assumptions. Core deposit intangibles are reviewed for impairment whenever events or changes in circumstances indicate their carrying amount may not be recoverable. Impairment is indicated if the sum of the undiscounted estimated future net cash flows is less than the carrying value of the intangible asset. Mortgage servicing rights, while initially recorded at fair value, are subsequently amortized and carried at the lower of the initial capitalized amount (net of accumulated amortization), or estimated fair value. The Company evaluates its mortgage servicing rights for impairment on a quarterly basis, using estimated prepayment speeds of the underlying mortgage loans serviced and stratifications based on the risk characteristics of the underlying loans. A valuation allowance has been established, through a charge to earnings, to the extent the amortized cost exceeds the estimated fair value. However, the Company has not recorded other-than-temporary impairment losses on either of these types of intangible assets.
Income Taxes
Amounts provided for income tax expense are based on income reported for financial statement purposes and do not necessarily represent amounts currently payable under tax laws. Deferred income taxes are provided for temporary differences between the financial reporting bases and income tax bases of the Company’s assets and liabilities, net operating losses, and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax rates that are expected to apply to taxable income when such assets and liabilities are anticipated to be settled or realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized as tax expense or benefit in the period that includes the enactment date of the change. In determining the amount of deferred tax assets to recognize in the financial statements, the Company evaluates the likelihood of realizing such benefits in future periods. A valuation allowance is established if it is more likely than not that all or some portion of the deferred tax asset will not be realized. The Company recognizes interest and penalties related to income taxes within income tax expense in the consolidated statements of income.
The Company and its eligible subsidiaries file a consolidated federal income tax return. State and local income tax returns are filed on a combined, consolidated or separate return basis based upon each jurisdiction’s laws and regulations.
In December 2017, tax reform legislation was enacted that changed the maximum corporate tax rate for years 2018 and beyond. As such, deferred tax assets and liabilities were revalued in 2017 to account for the change in future tax rates. Additional information about current and deferred income taxes is provided in Note 9, Income Taxes.
Non-Interest Income
Non-interest income is mainly comprised of revenue from contracts with customers. For that revenue (excluding certain revenue associated with financial instruments, derivative and hedging instruments, guarantees, lease contracts, transferring and servicing of financial assets, and other specific revenue transactions), the Company applies the following five-step approach when recognizing revenue: (i) identify the contract with the customer, (ii) identify the performance obligations, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations, and (v) recognize revenue when (or as) the performance obligation is satisfied. The Company’s contracts with customers are generally short term in nature, with a duration of one year or less, and most contracts are cancellable by either the Company or its customer without penalty. Performance obligations for customer contracts are generally satisfied at a single point in time, typically when the transaction is complete and the customer has received the goods or service, or over time. For performance obligations satisfied over time, the Company recognizes the value of the goods or services transferred to the customer when the performance obligations have been transferred
and received by the customer. Payments for satisfied performance obligations are typically due when or as the goods or services are completed, or shortly thereafter, which usually occurs within a single financial reporting period.
In situations where payment is made before the performance obligation is satisfied, the fees are deferred until the performance obligations pertaining to those goods or services are completed. In cases where payment has not been received despite satisfaction of its performance obligations, the Company accrues an estimate of the amount due in the period that the performance obligations have been satisfied. For contracts with variable components, the Company only recognizes revenue to the extent that it is probable that the cumulative amount recognized will not be subject to a significant reversal in future periods. Generally, the Company’s contracts do not include terms that require significant judgment to determine whether a variable component is included within the transaction price. The Company generally acts in a principal capacity, on its own behalf, in most of its contracts with customers. For these transactions, revenue and the related costs to provide the goods or services are presented on a gross basis in the financial statements. In some cases, the Company acts in an agent capacity, deriving revenue through assisting third parties in transactions with the Company’s customers. In such transactions, revenue and the related costs to provide services is presented on a net basis in the financial statements. These transactions primarily relate to fees earned from bank card and related network and rewards costs and the sales of annuities and certain limited insurance products.
Derivatives
Most of the Company's derivative contracts are accounted for as free-standing instruments. These instruments are carried at fair value, and changes in fair value are recognized in current earnings. They include interest rate swaps and caps, which are offered to customers to assist in managing their risks of adverse changes in interest rates. Each contract between the Company and a customer is offset by a contract between the Company and an institutional counterparty, thus minimizing the Company's exposure to rate changes. The Company also enters into certain contracts, known as credit risk participation agreements, to buy or sell credit protection on specific interest rate swaps. It also purchases and sells forward foreign exchange contracts, either in connection with customer transactions, or for its own trading purposes. In 2015, the Company began an origination and sales program of certain personal real estate mortgages. Derivative instruments under this program include mortgage loan commitments, forward loan sale contracts, and forward contracts to sell certain to-be-announced (TBA) securities.
The Company's interest rate risk management policy permits the use of hedge accounting for derivatives, and the Company has entered into interest rate floor contracts as protection from the potential for declining interest rates in the commercial loan portfolio. These floors were designated and qualified as cash flow hedges. In a cash flow hedge, the changes in fair value are recorded in accumulated other comprehensive income and recognized in the income statement when the hedged cash flows affect earnings. Both at hedge inception and on an ongoing basis, the Company assesses whether the interest rate floors used in the hedging relationships are highly effective in offsetting changes in the cash flows of the hedged items.
The Company has master netting arrangements with various counterparties but does not offset derivative assets and liabilities under these arrangements in its consolidated balance sheets. However, interest rate swaps that are executed under central clearing requirements are presented net of variation margin as mandated by the statutory terms of the Company's contract with its clearing counterparty.
Additional information about derivatives held by the Company and valuation methods employed is provided in Note 17, Fair Value Measurements and Note 19, Derivative Instruments.
Pension Plan
The Company’s pension plan is described in Note 10, Employee Benefit Plans. Historically, the Company has reported all components of net periodic pension cost in salaries and employee benefits in its consolidated statements of income. Upon the adoption of ASU 2017-07 "Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost", in 2018, only the service cost component of net periodic pension cost is reported in salaries and employee benefits in the accompanying consolidated statements of income, while the other components are reported in other non-interest expense. The funded status of the plan is recognized as an asset or liability in the consolidated balance sheets, and changes in that funded status are recognized in the year in which the changes occur through other comprehensive income. Plan assets and benefit obligations are measured as of the fiscal year end of the plan. The measurement of the projected benefit obligation and pension expense involve actuarial valuation methods and the use of various actuarial and economic assumptions. The Company monitors the assumptions and updates them periodically. Due to the long-term nature of the pension plan obligation, actual results may differ significantly from estimations. Such differences are adjusted over time as the assumptions are replaced by facts and values are recalculated.
Stock-Based Compensation
The Company’s stock-based employee compensation plan is described in Note 11, Stock-Based Compensation and Directors Stock Purchase Plan. In accordance with the requirements of ASC 718-10-30-3 and 35-2, the Company measures the cost of stock-based compensation based on the grant-date fair value of the award, recognizing the cost over the requisite service period, which is generally the vesting period. The fair value of an option award is estimated using the Black-Scholes option-pricing model while the fair value of a nonvested stock award is the common stock (CBSH) market price. The expense recognized for stock-based compensation is included in salaries and benefits in the accompanying consolidated statements of income. The Company recognizes forfeitures as a reduction to expense only when they have occurred.
Treasury Stock
Purchases of the Company’s common stock are recorded at cost. Upon re-issuance for acquisitions, exercises of stock-based awards or other corporate purposes, treasury stock is reduced based upon the average cost basis of shares held.
Income per Share
Basic income per share is computed using the weighted average number of common shares outstanding during each year. Diluted income per share includes the effect of all dilutive potential common shares (primarily stock appreciation rights) outstanding during each year. The Company applies the two-class method of computing income per share. The two-class method is an earnings allocation formula that determines income per share for common stock and for participating securities, according to dividends declared and participation rights in undistributed earnings. The Company’s nonvested stock awards are considered to be a class of participating security. All per share data has been restated to reflect the 5% stock dividend distributed in December 2019.
2. Loans and Allowance for Loan Losses
Major classifications within the Company’s held for investment loan portfolio at December 31, 2019 and 2018 are as follows:
Loans to directors and executive officers of the Parent and the Bank, and to their affiliates, are summarized as follows:
Management believes all loans to directors and executive officers have been made in the ordinary course of business with normal credit terms, including interest rate and collateral considerations, and do not represent more than a normal risk of collection. The activity in the table above includes draws and repayments on several lines of credit with business entities. There were no outstanding loans at December 31, 2019 to principal holders (over 10% ownership) of the Company’s common stock.
The Company’s lending activity is generally centered in Missouri, Kansas, Illinois and other nearby states including Oklahoma, Colorado, Iowa, Ohio, Texas, and others. The Company maintains a diversified portfolio with limited industry concentrations of credit risk. Loans and loan commitments are extended under the Company’s normal credit standards, controls, and monitoring features. Most loan commitments are short or intermediate term in nature. Commercial loan maturities generally range from one to seven years. Collateral is commonly required and would include such assets as marketable securities and cash equivalent assets, accounts receivable and inventory, equipment, other forms of personal property, and real estate. At December 31, 2019, unfunded loan commitments totaled $11.2 billion (which included $5.1 billion in unused approved lines of credit related to credit card loan agreements) which could be drawn by customers subject to certain review and terms of agreement. At December 31, 2019, loans totaling $4.0 billion were pledged at the FHLB as collateral for borrowings and letters of credit obtained to secure public deposits. Additional loans of $1.6 billion were pledged at the Federal Reserve Bank as collateral for discount window borrowings.
The Company has a net investment in direct financing and sales type leases to commercial and industrial and tax-exempt entities of $795.8 million and $752.2 million at December 31, 2019 and 2018, respectively, which is included in business loans on the Company’s consolidated balance sheets. This investment includes deferred income of $71.8 million and $62.6 million at December 31, 2019 and 2018, respectively. The net investment in operating leases amounted to $14.7 million and $16.1 million at December 31, 2019 and 2018, respectively, and is included in other assets on the Company’s consolidated balance sheets.
Allowance for loan losses
A summary of the activity in the allowance for losses during the previous three years follows:
The following table shows the balance in the allowance for loan losses and the related loan balance at December 31, 2019 and 2018, disaggregated on the basis of impairment methodology. Impaired loans evaluated under ASC 310-10-35 include loans on non-accrual status which are individually evaluated for impairment and other impaired loans deemed to have similar risk characteristics, which are collectively evaluated. All other loans are collectively evaluated for impairment under ASC 450-20.
Impaired loans
The table below shows the Company’s investment in impaired loans at December 31, 2019 and 2018. These loans consist of all loans on non-accrual status and other restructured loans whose terms have been modified and classified as troubled debt restructurings. These restructured loans are performing in accordance with their modified terms, and because the Company believes it probable that all amounts due under the modified terms of the agreements will be collected, interest on these loans is being recognized on an accrual basis. They are discussed further in the "Troubled debt restructurings" section below.
The following table provides additional information about impaired loans held by the Company at December 31, 2019 and 2018, segregated between loans for which an allowance for credit losses has been provided and loans for which no allowance has been provided.
Total average impaired loans during 2019 and 2018 are shown in the table below.
The table below shows interest income recognized during the years ended December 31, 2019, 2018 and 2017 for impaired loans held at the end of each respective period. This interest all relates to accruing restructured loans, as discussed in the "Troubled debt restructurings" section below.
Delinquent and non-accrual loans
The following table provides aging information on the Company’s past due and accruing loans, in addition to the balances of loans on non-accrual status, at December 31, 2019 and 2018.
Credit quality
The following table provides information about the credit quality of the Commercial loan portfolio, using the Company’s internal rating system as an indicator. The internal rating system is a series of grades reflecting management’s risk assessment, based on its analysis of the borrower’s financial condition. The “pass” category consists of a range of loan grades that reflect increasing, though still acceptable, risk. Movement of risk through the various grade levels in the “pass” category is monitored for early identification of credit deterioration. The “special mention” rating is applied to loans where the borrower exhibits material negative financial trends due to borrower specific or systemic conditions that, if left uncorrected, threaten its capacity to meet its debt obligations. The borrower is believed to have sufficient financial flexibility to react to and resolve its negative financial situation. It is a transitional grade that is closely monitored for improvement or deterioration. The “substandard” rating is applied to loans where the borrower exhibits well-defined weaknesses that jeopardize its continued performance and are of a severity that the distinct possibility of default exists. Loans are placed on “non-accrual” when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment.
The credit quality of Personal Banking loans is monitored primarily on the basis of aging/delinquency, and this information is provided in the table in the above section on "Delinquent and non-accrual loans". In addition, FICO scores are obtained and updated on a quarterly basis for most of the loans in the Personal Banking portfolio. This is a published credit score designed to measure the risk of default by taking into account various factors from a borrower's financial history. The bank normally obtains a FICO score at the loan's origination and renewal dates, and updates are obtained on a quarterly basis. Excluded from the table below are certain personal real estate loans for which FICO scores are not obtained because the loans generally pertain to commercial customer activities and are often underwritten with other collateral considerations. These loans totaled $198.2 million at December 31, 2019 and $201.7 million at December 31, 2018. The table also excludes consumer loans related to the Company's patient healthcare loan program, which totaled $199.2 million at December 31, 2019 and $170.3 million at December 31, 2018. As the healthcare loans are guaranteed by the hospital, customer FICO scores are not obtained for these loans. The personal real estate loans and consumer loans excluded below totaled less than 8% of the Personal Banking portfolio. For the remainder of loans in the Personal Banking portfolio, the table below shows the percentage of balances outstanding at December 31, 2019 and 2018 by FICO score.
Troubled debt restructurings
As mentioned previously, the Company's impaired loans include loans which have been classified as troubled debt restructurings, as shown in the table below. Restructured loans are those extended to borrowers who are experiencing financial difficulty and who have been granted a concession. Restructured loans are placed on non-accrual status if the Company does not believe it probable that amounts due under the contractual terms will be collected. Commercial performing restructured loans are primarily comprised of certain business, construction and business real estate loans classified as substandard, but renewed at rates judged to be non-market. These loans are performing in accordance with their modified terms, and because the Company believes it probable that all amounts due under the modified terms of the agreements will be collected, interest on these loans is being recognized on an accrual basis. Troubled debt restructurings also include certain credit card and other small consumer loans under various debt management and assistance programs. Modifications to these loans generally involve removing the available line of credit, placing loans on amortizing status, and lowering the contractual interest rate. Certain personal real estate, revolving home equity, and consumer loans were classified as consumer bankruptcy troubled debt restructurings because they were not reaffirmed by the borrower in bankruptcy proceedings. Interest on these loans is being recognized on an accrual basis, as the borrowers are continuing to make payments. Other consumer loans classified as troubled debt restructurings consist of various other workout arrangements with consumer customers.
The table below shows the balance of troubled debt restructurings by loan classification at December 31, 2019, in addition to the outstanding balances of these restructured loans which the Company considers to have been in default at any time during the past twelve months. For purposes of this disclosure, the Company considers "default" to mean 90 days or more past due as to interest or principal.
For those loans on non-accrual status also classified as restructured, the modification did not create any further financial effect on the Company as those loans were already recorded at net realizable value. For those performing commercial loans classified as restructured, there were no concessions involving forgiveness of principal or interest and, therefore, there was no financial impact to the Company as a result of modification to these loans. No financial impact resulted from those performing loans where the debt was not reaffirmed in bankruptcy, as no changes to loan terms occurred in that process. However, the effects of modifications to loans under various debt management and assistance programs were estimated to decrease interest income by approximately $1.2 million on an annual, pre-tax basis, compared to amounts contractually owed. Other modifications to consumer loans mainly involve extensions and other small modifications that did not include the forgiveness of principal or interest.
The allowance for loan losses related to troubled debt restructurings on non-accrual status is determined by individual evaluation, including collateral adequacy, using the same process as loans on non-accrual status which are not classified as troubled debt restructurings. Those performing loans classified as troubled debt restructurings are accruing loans which management expects to collect under contractual terms. Performing commercial loans having no other concessions granted other than being renewed at non-market interest rates are judged to have similar risk characteristics as non-troubled debt commercial loans and are collectively evaluated based on internal risk rating, loan type, delinquency, historical experience and current economic factors. Performing personal banking loans classified as troubled debt restructurings resulted from the borrower not reaffirming the debt during bankruptcy and have had no other concession granted, other than the Bank's future limitations on collecting payment deficiencies or in pursuing foreclosure actions. As such, they have similar risk characteristics as non-troubled debt personal banking loans and are evaluated collectively based on loan type, delinquency, historical experience and current economic factors.
If a troubled debt restructuring defaults and is already on non-accrual status, the allowance for loan losses continues to be based on individual evaluation, using discounted expected cash flows or the fair value of collateral. If an accruing, troubled debt restructuring defaults, the loan's risk rating is downgraded to non-accrual status and the loan's related allowance for loan losses is determined based on individual evaluation, or if necessary, the loan is charged off and collection efforts begin.
The Company had commitments of $4.7 million at December 31, 2019 to lend additional funds to borrowers with restructured loans, compared to $1.8 million at December 31, 2018.
Loans held for sale
The Company designates certain long-term fixed rate personal real estate loans as held for sale, and the Company has elected the fair value option for these loans. The election of the fair value option aligns the accounting for these loans with the related economic hedges discussed in Note 19. The loans are primarily sold to FNMA, FHLMC, and GNMA. At December 31, 2019, the fair value of these loans was $9.2 million, and the unpaid principal balance was $8.9 million.
The Company also designates certain student loan originations as held for sale. The borrowers are credit-worthy students who are attending colleges and universities. The loans are intended to be sold in the secondary market, and the Company maintains contracts with Sallie Mae to sell the loans within 210 days after the last disbursement to the student. These loans are carried at lower of cost or fair value, which totaled $4.6 million at December 31, 2019.
At December 31, 2019, none of the loans held for sale were on non-accrual status or 90 days past due and still accruing.
Foreclosed real estate/repossessed assets
The Company’s holdings of foreclosed real estate totaled $365 thousand and $1.4 million at December 31, 2019 and 2018, respectively. Personal property acquired in repossession, generally autos and marine and recreational vehicles (RV), totaled $5.5 million and $2.0 million at December 31, 2019 and 2018, respectively. The December 31, 2019 balance of repossessed assets also included trailers with an asset value of $3.4 million, which were acquired due to the bankruptcy of a single leasing customer. Upon acquisition, these assets are recorded at fair value less estimated selling costs at the date of foreclosure, establishing a new cost basis. They are subsequently carried at the lower of this cost basis or fair value less estimated selling costs.
3. Investment Securities
Investment securities, at fair value, consisted of the following at December 31, 2019 and 2018:
The Company has elected to measure equity securities with no readily determinable fair value at cost minus impairment, if any, plus or minus changes resulting from observable price changes for the identical or similar investment of the same issuer. This portfolio includes the Company's holdings of Visa Class B shares, which have a carrying value of zero, as there have not been observable price changes in orderly transactions for identical or similar investments of the same issuer. During the year-ended December 31, 2019, the Company did not record any impairment or other adjustments to the carrying amount of its portfolio of equity securities with no readily determinable fair value.
Other investment securities include Federal Reserve Bank (FRB) stock, Federal Home Loan Bank (FHLB) stock, and investments in portfolio concerns held by the Company's private equity subsidiaries. FRB stock and FHLB stock are held for debt and regulatory purposes. Investment in FRB stock is based on the capital structure of the investing bank, and investment in FHLB stock is tied to the level of borrowings from the FHLB. These holdings are carried at cost. The private equity investments, in the absence of readily ascertainable market values, are carried at estimated fair value.
The majority of the Company’s investment portfolio is comprised of available for sale debt securities, which are carried at fair value with changes in fair value reported in accumulated other comprehensive income (AOCI). A summary of the available for sale debt securities by maturity groupings as of December 31, 2019 is shown in the following table. The weighted average yield for each range of maturities was calculated using the yield on each security within that range weighted by the amortized cost of each security at December 31, 2019. Yields on tax exempt securities have not been adjusted for tax exempt status. The investment portfolio includes agency mortgage-backed securities, which are guaranteed by agencies such as FHLMC, FNMA, GNMA and FDIC, in addition to non-agency mortgage-backed securities, which have no guarantee but are collateralized by residential and commercial mortgages. Also included are certain other asset-backed securities, which are primarily collateralized by credit cards, automobiles, student loans, and commercial loans. These securities differ from traditional debt securities primarily in that they may have uncertain maturity dates and are priced based on estimated prepayment rates on the underlying collateral.
* Rate does not reflect inflation adjustment on inflation-protected securities
Investments in U.S. government and federal agency obligations include U.S. Treasury inflation-protected securities, which totaled $461.8 million, at fair value, at December 31, 2019. Interest paid on these securities increases with inflation and decreases with deflation, as measured by the Consumer Price Index. At maturity, the principal paid is the greater of an inflation-adjusted principal or the original principal. Included in state and municipal obligations are $9.9 million, at fair value, of auction rate securities, which were purchased from bank customers in 2008. Interest on these bonds is currently being paid at the maximum failed auction rates.
For debt securities classified as available for sale, the following table shows the unrealized gains and losses (pre-tax) in AOCI, by security type.
The Company’s impairment policy requires a review of all securities for which fair value is less than amortized cost. Special emphasis is placed on securities whose credit rating has fallen below Baa3 (Moody's) or BBB- (Standard & Poor's), whose fair values have fallen more than 20% below purchase price for an extended period of time, or those which have been identified based on management’s judgment. These securities are placed on a watch list and cash flow analyses are prepared on an individual security basis. Inputs to these models include factors such as cash flow projections, contractual payments required, expected delinquency rates, credit support from other tranches, prepayment speeds, collateral loss severity rates (including loan to values), and various other information related to the underlying collateral (including current delinquencies). Stress tests are performed at varying levels of delinquency rates, prepayment speeds and loss severities in order to gauge probable ranges of credit loss. At December 31, 2019, the fair value of securities on this watch list was $51.6 million compared to $57.7 million at December 31, 2018.
As of December 31, 2019, the Company had recorded other-than-temporary impairment (OTTI) on certain non-agency mortgage-backed securities with a current par value of $17.5 million. These securities, which are part of the watch list mentioned above, had an aggregate fair value of $13.1 million at December 31, 2019. The cumulative credit-related portion of the impairment on these securities, which was recorded in earnings, totaled $13.3 million. The Company does not intend to sell these securities and believes it is not likely that it will be required to sell the securities before the recovery of their amortized cost.
The credit-related portion of the loss on these securities was based on the cash flows projected to be received over the estimated life of the securities, discounted to present value, and compared to the current amortized cost bases of the securities. Significant inputs to the cash flow models used to calculate the credit losses on these securities at December 31, 2019 included the following:
The following table presents a rollforward of the cumulative OTTI credit losses recognized in earnings on all available for sale debt securities.
Debt securities with unrealized losses recorded in AOCI are shown in the table below, along with the length of the impairment period.
The available for sale debt portfolio included $1.7 billion of securities that were in a loss position at December 31, 2019, compared to $5.4 billion at December 31, 2018. The total amount of unrealized loss on these securities was $12.9 million at December 31, 2019, a decrease of $87.0 million compared to the unrealized loss at December 31, 2018. This decrease in losses was mainly due to a declining interest rate environment.
The following table presents proceeds from sales of securities and the components of investment securities gains and losses which have been recognized in earnings.
Investment securities with a fair value of $4.3 billion were pledged at both December 31, 2019 and 2018 to secure public deposits, securities sold under repurchase agreements, trust funds, and borrowings at the Federal Reserve Bank. Securities pledged under agreements pursuant to which the collateral may be sold or re-pledged by the secured parties approximated $204.9 million, while the remaining securities were pledged under agreements pursuant to which the secured parties may not sell or re-pledge the collateral. Except for obligations of various government-sponsored enterprises such as FNMA, FHLB and FHLMC, no investment in a single issuer exceeds 10% of stockholders’ equity.
4. Premises and Equipment
Premises and equipment consist of the following at December 31, 2019 and 2018:
Depreciation expense of $30.8 million in 2019, $28.6 million in 2018 and $29.1 million in 2017, was included in occupancy expense and equipment expense in the consolidated statements of income. Repairs and maintenance expense of $17.0 million, $16.9 million and $16.4 million for 2019, 2018 and 2017, respectively, was included in occupancy expense and equipment expense. There has been no interest expense capitalized on construction projects in the past three years.
Right of use leased assets are comprised mainly of operating leases for branches, office space, ATM locations, and certain equipment, as described in Note 6.
5. Goodwill and Other Intangible Assets
The following table presents information about the Company's intangible assets which have estimable useful lives.
The carrying amount of goodwill and its allocation among segments at December 31, 2019 and 2018 is shown in the table below. As a result of ongoing assessments, no impairment of goodwill was recorded in 2019, 2018 or 2017. Further, the annual assessment of qualitative factors on January 1, 2020 revealed no likelihood of impairment as of that date.
Changes in the net carrying amount of goodwill and other net intangible assets for the years ended December 31, 2019 and 2018 are shown in the following table.
Mortgage servicing rights (MSRs) are initially recorded at fair value and subsequently amortized over the period of estimated servicing income. They are periodically reviewed for impairment at a tranche level, and if impairment is indicated, recorded at fair value. Temporary impairment, including impairment recovery, is effected through a change in a valuation allowance. At December 31, 2019, temporary impairment of $327 thousand had been recognized. The fair value of the MSRs is based on the present value of expected future cash flows, as further discussed in Note 17 on Fair Value Measurements.
Aggregate amortization expense on intangible assets for the years ended December 31, 2019, 2018 and 2017 was $1.5 million, $1.3 million and $1.3 million, respectively. The following table shows the estimated future amortization expense based on existing asset balances and the interest rate environment as of December 31, 2019. The Company’s actual amortization expense in any given period may be different from the estimated amounts depending upon the acquisition of intangible assets, changes in mortgage interest rates, prepayment rates and other market conditions.
6. Leases
The Company adopted ASU 2016-02, "Leases", and its related amendments on January 1, 2019 using a modified retrospective approach. The Company's leasing activities include leasing certain real estate and equipment, providing lease financing to commercial customers, and leasing office space to third parties. The Company adopted the package of practical expedients permitted within the new standard, along with the lease component expedient for all lease classes and the disclosure expedient. The Company uses the FHLB fixed-advance rate at lease commencement or at any subsequent remeasurement event date based on the remaining lease term to calculate the liability for each lease.
Lessee
The Company primarily has operating leases for branches, office space, ATM locations, and certain equipment. As of December 31, 2019, the right-of-use asset for operating leases, reported within premises and equipment, net, and lease liability, reported within other liabilities, recognized on the Company's consolidated balance sheets totaled $26.3 million and $27.0 million, respectively. Total lease cost for the year ended December 31, 2019 was $7.3 million. For leases with a term of 12 months or less, an election was made not to recognize lease assets and lease liabilities for all asset classes, and to recognize lease expense for these leases on a straight-line basis over the lease term. The Company's leases have remaining terms of 1 month to 34 years, most of which contain renewal options. However, the renewal options are generally not included in the leased asset or liability because the option exercises are uncertain.
The maturities of operating leases are included in the table below.
(1) Excludes $6.5 million of legally binding minimum lease payments for operating leases signed but not yet commenced.
(2) Calculated using the interest rate for each lease.
The following table presents the average lease term and discount rate of operating leases.
Supplemental cash flow information related to operating leases is included in the table below.
The Company adopted the new lease standard using the effective date as the date of initial application as noted above, and as required, the table below provides the disclosure for periods prior to adoption. Under ASC Topic 840, Leases, rent expense amounted to $7.7 million and $7.3 million in 2018 and 2017, respectively. Future minimum lease payments as of December 31, 2018 are shown below, which include leases that have not yet commenced.
Lessor
The Company has net investments in direct financing and sales-type leases to commercial, industrial, and tax-exempt entities. These leases are included within business loans on the Company's consolidated balance sheets. The Company primarily leases various types of equipment, trucks and trailers, and office furniture and fixtures. Lease agreements may include options for the lessee to renew or purchase the leased equipment at the end of the lease term. The Company has elected to adopt the lease component expedient in which the lease and nonlease components are combined into the total lease receivable. The Company also leases office space to third parties, and these leases are classified as operating leases. The leases may include options to renew or to expand the leased space, and currently the leases have remaining terms of 1 month to 8 years.
The following table provides the components of lease income.
(1) Includes rent of $75 thousand from Tower Properties Company, a related party.
The following table presents the components of the net investments in direct financing and sales-type leases.
The maturities of lease receivables are included in the table below.
7. Deposits
At December 31, 2019, the scheduled maturities of certificates of deposit were as follows:
The following table shows a detailed breakdown of the maturities of certificates of deposit, by size category, at December 31, 2019.
The aggregate amount of certificates of deposit that exceeded the $250,000 FDIC insurance limit totaled $1.1 billion at December 31, 2019.
8. Borrowings
At December 31, 2019, the Company's borrowings primarily consisted of federal funds purchased and securities sold under agreements to repurchase (repurchase agreements). The following table sets forth selected information for federal funds purchased and repurchase agreements.
Federal funds purchased and repurchase agreements comprised the majority of the Company's short-term borrowings (borrowings with an original maturity of less than one year) at December 31, 2019, and $1.8 billion of these borrowings were repurchase agreements, which generally have one day maturities and are mainly comprised of non-insured customer funds secured by a portion of the Company's investment portfolio. Additional information about the securities pledged for repurchase agreements is provided in Note 20 on Resale and Repurchase Agreements.
The Bank is a member of the Des Moines FHLB and has access to term financing from the FHLB. These borrowings are secured under a blanket collateral agreement including primarily residential mortgages as well as all unencumbered assets and stock of the borrowing bank. At December 31, 2019, the Bank had no outstanding advances from the FHLB. The FHLB also issues letters of credit to secure the Bank's obligations to certain depositors of public funds, which totaled $396.6 million at December 31, 2019.
9. Income Taxes
The components of income tax expense from operations for the years ended December 31, 2019, 2018 and 2017 were as follows:
The components of income tax (benefit) expense recorded directly to stockholders’ equity for the years ended December 31, 2019, 2018 and 2017 were as follows:
Significant components of the Company’s deferred tax assets and liabilities at December 31, 2019 and 2018 were as follows:
Management believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the total deferred tax assets.
A reconciliation between the expected federal income tax expense using the federal statutory tax rate and the Company's actual income tax expense is provided below. The federal statutory tax rate was 21% in 2019 and 2018, and 35% in 2017. The effective tax rate is calculated by dividing income taxes by income before income taxes less the non-controlling interest expense.
The gross amount of unrecognized tax benefits was $1.4 million and $1.3 million at December 31, 2019 and 2018, respectively, and the total amount of unrecognized tax benefits that would impact the effective tax rate, if recognized, was $1.1 million and $993 thousand, respectively. The activity in the accrued liability for unrecognized tax benefits for the years ended December 31, 2019 and 2018 was as follows:
The Company and its subsidiaries are subject to income tax by federal, state and local government taxing authorities. Tax years 2016 through 2019 remain open to examination for U.S. federal income tax and for major state taxing jurisdictions.
10. Employee Benefit Plans
Employee benefits charged to operating expenses are summarized in the table below. Substantially all of the Company’s employees are covered by a defined contribution (401(k)) plan, under which the Company makes matching contributions.
A portion of the Company’s employees are covered by a noncontributory defined benefit pension plan, however, participation in the pension plan is not available to employees hired after June 30, 2003. All participants are fully vested in their benefit payable upon normal retirement date, which is based on years of participation and compensation. Since January 2011, all benefits accrued under the pension plan have been frozen. However, the accounts continue to accrue interest at a stated annual rate. Certain key executives also participate in a supplemental executive retirement plan (the CERP) that the Company funds only as retirement benefits are disbursed. The CERP carries no segregated assets. The CERP continues to provide credits based on hypothetical contributions in excess of those permitted under the 401(k) plan. In the tables presented below, the pension plan and the CERP are presented on a combined basis.
Under the Company’s funding policy for the defined benefit pension plan, contributions are made to a trust as necessary to satisfy the statutory minimum required contribution as defined by the Pension Protection Act, which is intended to provide for current service accruals and for any unfunded accrued actuarial liabilities over a reasonable period. To the extent that these
requirements are fully covered by assets in the trust, a contribution might not be made in a particular year. No contributions to the defined benefit plan were made in 2019 or 2018. The Company made a discretionary contribution of $5.5 million to its defined benefit pension plan in 2017 in order to reduce pension guarantee premiums. The minimum required contribution for 2020 is expected to be zero. The Company does not expect to make any further contributions in 2020 other than the necessary funding contributions to the CERP. Contributions to the CERP were $25 thousand, $24 thousand and $439 thousand during 2019, 2018 and 2017, respectively.
The following items are components of the net pension cost for the years ended December 31, 2019, 2018 and 2017.
The following table sets forth the pension plans’ funded status, using valuation dates of December 31, 2019 and 2018.
The accumulated benefit obligation, which represents the liability of a plan using only benefits as of the measurement date, was $120.6 million and $112.1 million for the combined plans on December 31, 2019 and 2018, respectively.
Amounts not yet reflected in net periodic benefit cost and included in accumulated other comprehensive income (loss) at December 31, 2019 and 2018 are shown below, including amounts recognized in other comprehensive income during the periods. All amounts are shown on a pre-tax basis.
The estimated net loss and prior service cost to be amortized from accumulated other comprehensive income into net periodic pension cost in 2020 is $1.9 million.
The following assumptions, on a weighted average basis, were used in accounting for the plans.
The following table shows the fair values of the Company’s pension plan assets by asset category at December 31, 2019 and 2018. Information about the valuation techniques and inputs used to measure fair value are provided in Note 17 on Fair Value Measurements.
(a)
This category represents bonds (excluding mortgage-backed securities) issued by agencies such as the Federal Home Loan Bank, the Federal Home Loan Mortgage Corp and the Federal National Mortgage Association.
(b)
This category represents mortgage-backed securities issued by the agencies mentioned in (a).
(c)
This category represents investment grade bonds issued in the U.S., primarily by domestic issuers, representing diverse industries.
(d)
This category represents investments in individual common stocks and equity funds. These holdings are diversified, largely across the financial services, technology services, healthcare, electronic technology, and producer manufacturing industries.
The investment policy of the pension plan is designed for growth in principal, within limits designed to safeguard against significant losses within the portfolio. The policy sets guidelines, which may change from time to time, regarding the types and percentages of investments held. Currently, the policy includes guidelines such as holding bonds rated investment grade or better and prohibiting investment in Company stock. The plan does not utilize derivatives. Management believes there are no significant concentrations of risk within the plan asset portfolio at December 31, 2019. Under the current policy, the long-term investment target mix for the plan is 35% equity securities and 65% fixed income securities. The Company regularly reviews its policies on investment mix and may make changes depending on economic conditions and perceived investment risk.
The assumed overall expected long-term rate of return on pension plan assets used in calculating 2019 pension plan expense was 5.0%. Determination of the plan’s expected rate of return is based upon historical and anticipated returns of the asset classes invested in by the pension plan and the allocation strategy currently in place among those classes. The rate used in plan calculations may be adjusted by management for current trends in the economic environment. The 10-year annualized return for the Company’s pension plan was 7.3%. During 2019, the plan’s assets gained 14.8% of their value, compared to a loss of 1.7% in 2018. Returns for any plan year may be affected by changes in the stock market and interest rates. The Company expects to incur pension expense of $402 thousand in 2020, compared to $2.0 million in 2019.
The Company utilizes mortality tables published by the Society of Actuaries to incorporate mortality assumptions into the measurement of the pension benefit obligation. At December 31, 2019, the Company utilized an updated mortality table and projection scale, which decreased the pension benefit obligation on that date by approximately $1.1 million.
The following future benefit payments are expected to be paid:
11. Stock-Based Compensation and Directors Stock Purchase Plan*
The Company’s stock-based compensation is provided under a stockholder-approved plan that allows for issuance of various types of awards, including stock options, stock appreciation rights, restricted stock and restricted stock units, performance awards and stock-based awards. During the past three years, stock-based compensation has been issued in the form of nonvested stock awards and stock appreciation rights. At December 31, 2019, 2,249,326 shares remained available for issuance under the plan. The stock-based compensation expense that was charged against income was $13.9 million, $12.8 million and $12.1 million for the years ended December 31, 2019, 2018 and 2017, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $3.0 million, $3.2 million and $4.5 million for the years ended December 31, 2019, 2018 and 2017, respectively.
Nonvested Restricted Stock Awards
Nonvested stock is awarded to key employees by action of the Company's Compensation and Human Resources Committee and Board of Directors. These awards generally vest after 4 to 7 years of continued employment, but vesting terms may vary according to the specifics of the individual grant agreement. There are restrictions as to transferability, sale, pledging, or assigning, among others, prior to the end of the vesting period. Dividend and voting rights are conferred upon grant of restricted stock awards. A summary of the status of the Company’s nonvested share awards as of December 31, 2019 and changes during the year then ended is presented below.
The total fair value (at vest date) of shares vested during 2019, 2018 and 2017 was $19.9 million, $21.5 million and $23.8 million, respectively.
Stock Appreciation Rights
Stock appreciation rights (SARs) are granted with exercise prices equal to the market price of the Company’s stock at the date of grant. SARs generally vest ratably over 4 years of continuous service and have 10-year contractual terms. All SARs must be settled in stock under provisions of the plan. A summary of SAR activity during 2019 is presented below.
In determining compensation cost, the Black-Scholes option-pricing model is used to estimate the fair value of SARs on date of grant. The Black-Scholes model is a closed-end model that uses various assumptions as shown in the following table. Expected volatility is based on historical volatility of the Company’s stock. The Company uses historical exercise behavior and other factors to estimate the expected term of the SARs, which represents the period of time that the SARs granted are expected to be outstanding. The risk-free rate for the expected term is based on the U.S. Treasury zero coupon spot rates in effect at the time of grant. The per share average fair value and the model assumptions for SARs granted during the past three years are shown in the table below.
Additional information about stock options and SARs exercised is presented below.
As of December 31, 2019, there was $27.7 million of unrecognized compensation cost related to unvested SARs and stock awards. This cost is expected to be recognized over a weighted average period of approximately 3.0 years.
Directors Stock Purchase Plan
The Company has a directors stock purchase plan whereby outside directors of the Company and its subsidiaries may elect to use their directors’ fees to purchase Company stock at market value each month end. Remaining shares available for issuance under this plan were 33,914 at December 31, 2019. In 2019, 21,904 shares were purchased at an average price of $61.14, and in 2018, 32,454 shares were purchased at an average price of $54.92.
* All share and per share amounts in this note have been restated for the 5% common stock dividend distributed in 2019.
12. Accumulated Other Comprehensive Income (Loss)
The table below shows the activity and accumulated balances for components of other comprehensive income (loss). The largest component is the unrealized holding gains and losses on available for sale debt securities. Unrealized gains and losses on debt securities for which an other-than-temporary impairment (OTTI) has been recorded in current earnings are shown separately below. Another component is the amortization from other comprehensive income of losses associated with pension benefits, which occurs as the losses are included in current net periodic pension cost. The remaining component is gains in fair value on certain interest rate floors that have been designated as cash flow hedging instruments.
(1) The pre-tax amounts reclassified from accumulated other comprehensive income to current earnings are included in "investment securities gains (losses), net" in the consolidated statements of income.
(2) The pre-tax amounts reclassified from accumulated other comprehensive income to current earnings are included in "interest and fees on loans" in the consolidated statements of income.
The requirement to revalue deferred tax assets and liabilities in the period of enactment stranded the effects of the tax rate change, mandated by the Tax Cuts and Jobs Act, in accumulated other comprehensive income. In response, the FASB issued ASU 2018-02, "Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income", which the Company adopted on January 1, 2018. This ASU allowed the reclassification of the stranded tax effects from accumulated other comprehensive income (loss) (as shown in the table above) to retained earnings.
New accounting guidance, which was effective January 1, 2018, required the reclassification of unrealized gains on equity securities from accumulated other comprehensive income (loss) to retained earnings (also shown above).
13. Segments
The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments: Consumer, Commercial, and Wealth. The Consumer segment includes the consumer portion of the retail branch network (loans, deposits and other personal banking services), indirect and other consumer financing, and consumer debit and credit card loan and fee businesses. Residential mortgage origination, sales and servicing functions are included in this consumer segment, but residential mortgage loans retained by the Company are not considered part of this segment. The Commercial segment provides corporate lending (including the Small Business Banking product line within the branch network), leasing, international services, and business, government deposit, and related commercial cash management services, as well as merchant and commercial bank card products. The Commercial segment also includes the Capital Markets Group, which sells fixed income securities and provides securities safekeeping and bond accounting services. The Wealth segment provides traditional trust and estate planning, advisory and discretionary investment management, and brokerage services. This segment also provides various loan and deposit related services to its private banking customers.
The Company’s business line reporting system derives segment information from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. This information is based on internal management accounting procedures and methods, which have been developed to reflect the underlying economics of the businesses. These methodologies are applied in connection with funds transfer pricing and assignment of overhead costs among segments. Funds transfer pricing was used in the determination of net interest income by assigning a standard cost (credit) for funds used for (provided by) assets and liabilities based on their maturity, prepayment and/or repricing characteristics. Income and expense that directly relate to segment operations are recorded in the segment when incurred. Expenses that indirectly support the segments are allocated based on the most appropriate method available.
The Company uses a funds transfer pricing method to value funds used (e.g., loans, fixed assets, and cash) and funds provided (e.g., deposits, borrowings, and equity) by the business segments and their components. This process assigns a specific value to each new source or use of funds with a maturity, based on current swap rates, thus determining an interest spread at the time of the transaction. Non-maturity assets and liabilities are valued using weighted average pools. The funds transfer pricing process attempts to remove interest rate risk from valuation, allowing management to compare profitability under various rate environments.
The following tables present selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues between the three segments. Management periodically makes changes to methods of assigning costs and income to its business segments to better reflect operating results. If appropriate, these changes are reflected in prior year information presented below.
Segment Income Statement Data
The segment activity, as shown above, includes both direct and allocated items. Amounts in the “Other/Elimination” column include activity not related to the segments, such as that relating to administrative functions, the investment securities portfolio, and the effect of certain expense allocations to the segments. The provision for loan losses in this category contains the difference between net loan charge-offs assigned directly to the segments and the recorded provision for loan loss expense. Included in this category’s net interest income are earnings of the investment portfolio, which are not allocated to a segment.
Segment Balance Sheet Data
The above segment balances include only those items directly associated with the segment. The “Other/Elimination” column includes unallocated bank balances not associated with a segment (such as investment securities and federal funds sold), balances relating to certain other administrative and corporate functions, and eliminations between segment and non-segment balances. This column also includes the resulting effect of allocating such items as float, deposit reserve and capital for the purpose of computing the cost or credit for funds used/provided.
The Company’s reportable segments are strategic lines of business that offer different products and services. They are managed separately because each line services a specific customer need, requiring different performance measurement analyses and marketing strategies. The performance measurement of the segments is based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The information is also not necessarily indicative of the segments’ financial condition and results of operations if they were independent entities.
14. Common and Preferred Stock*
On December 18, 2019, the Company distributed a 5% stock dividend on its $5 par common stock for the 26th consecutive year. All per common share data in this report has been restated to reflect the stock dividend.
The Company applies the two-class method of computing income per share, as nonvested share-based awards that pay nonforfeitable common stock dividends are considered securities which participate in undistributed earnings with common stock. The two-class method requires the calculation of separate income per share amounts for the nonvested share-based awards and for common stock. Income per share attributable to common stock is shown in the following table. Nonvested share-based awards are further discussed in Note 11 on Stock-Based Compensation.
Basic income per share is based on the weighted average number of common shares outstanding during the year. Diluted income per share gives effect to all dilutive potential common shares that were outstanding during the year. Presented below is a summary of the components used to calculate basic and diluted income per common share, which have been restated for all stock dividends.
Unexercised stock appreciation rights of 356 thousand, 235 thousand and 167 thousand were excluded from the computation of diluted income per share for the years ended December 31, 2019, 2018 and 2017, respectively, because their inclusion would have been anti-dilutive.
On August 7, 2019, the Company entered into an accelerated share repurchase ("ASR") agreement with Morgan Stanley & Co. LLC (Morgan Stanley). Under this ASR agreement, the Company paid $150.0 million to Morgan Stanley and received from Morgan Stanley 1,994,327 shares of the Company’s common stock, representing approximately 75% of the estimated total number of shares to be delivered by Morgan Stanley at the conclusion of the program. Final settlement occurred on December 30, 2019 at which time the remaining shares, totaling 438,009, were received by the Company. The specific number of shares that the Company ultimately repurchased was based on the volume-weighted-average price per share of the Company’s common stock during the repurchase period.
In the Annual Meeting of the Shareholders, held on April 17, 2019, a proposal to increase the shares of Company common stock authorized for issuance under its articles of incorporation was approved. The approval increased the authorized shares from 120,000,000 to 140,000,000.
The Company has 6,000,000 depositary shares outstanding, representing 6,000 shares of 6.00% Series B Non-Cumulative Perpetual Preferred Stock, par value $1.00 per share, having an aggregate liquidation preference of $150.0 million (“Series B Preferred Stock”). Each depositary share has a liquidation preference of $25 per share. Dividends on the Series B Preferred Stock, if declared, accrue and are payable quarterly, in arrears, at a rate of 6.00%. The Series B Preferred Stock qualifies as Tier 1 capital for the purposes of the regulatory capital calculations. In the event that the Company does not declare and pay dividends on the Series B Preferred Stock for the most recent dividend period, the ability of the Company to declare or pay dividends on, purchase, redeem or otherwise acquire shares of its common stock or any securities of the Company that rank junior to the Series B Preferred Stock is subject to certain restrictions under the terms of the Series B Preferred Stock.
The Company maintains a treasury stock buyback program authorized by its Board of Directors. The most recent authorization in November 2019 approved future purchases of 5,000,000 shares of the Company's common stock. At December 31, 2019, 4,430,958 shares of common stock remained available for purchase under the current authorization.
The table below shows activity in the outstanding shares of the Company’s common stock during the past three years. Shares in the table below are presented on an historical basis and have not been restated for the annual 5% stock dividends.
* Except as noted in the above table, all share and per share amounts in this note have been restated for the 5% common stock dividend distributed in 2019.
15. Regulatory Capital Requirements
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and additional discretionary actions by regulators that could have a direct material effect on the Company’s financial statements. The regulations require the Company to meet specific capital adequacy guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Company’s capital classification is also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
The following tables show the capital amounts and ratios for the Company (on a consolidated basis) and the Bank, together with the minimum capital adequacy and well-capitalized capital requirements, at the last two year ends.
The minimum required ratios for well-capitalized banks (under prompt corrective action provisions) are 6.5% for Tier I common capital, 8.0% for Tier I capital, 10.0% for Total capital and 5.0% for the leverage ratio.
At December 31, 2019 and 2018, the Company met all capital requirements to which it is subject, and the Bank’s capital position exceeded the regulatory definition of well-capitalized.
16. Revenue from Contracts with Customers
The Company adopted ASU 2014-09, "Revenue from Contracts with Customers," and its related amendments on January 1, 2018. The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of 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. For the year ended December 31, 2019, approximately 61% of the Company’s total revenue was comprised of net interest income, which is not within the scope of this guidance. Of the remaining revenue, those items that were subject to this guidance mainly included fees for bank card, trust, deposit account services and consumer brokerage services.
The adoption of ASU 2014-09 did not require any significant change to the Company's revenue recognition processes. However, application of the new guidance resulted in a reclassification of certain bank card related network and rewards costs, previously classified as non-interest expense, to a reduction to non-interest income in the Company’s consolidated statements of income. The reclassification had no effect on prior period net income or net income per share. The Company adopted ASU 2014-09 on a full retrospective basis, in which each prior reporting period has been presented in accordance with the new guidance. The table below shows the effect of this reclassification on bank card fee income and non-interest expense for the year ended December 31, 2017.
The following table disaggregates non-interest income subject to ASU 2014-09 by major product line.
(1) This revenue is not within the scope of ASU 2014-09, and includes fees relating to capital market activities, loan fees and sales, derivative instruments, standby letters of credit and various other transactions.
The following table presents the opening and closing receivable balances for the years ended December 31, 2019 and 2018 for the Company’s significant revenue categories subject to ASU 2014-09.
For these revenue categories, none of the transaction price has been allocated to performance obligations that are unsatisfied as of the end of a reporting period. A description of these revenue categories follows.
Bank Card Transaction Fees
The following table presents the components of bank card fee income.
The majority of debit and credit card fees are reported in the Consumer segment, while corporate card and merchant fees are reported in the Commercial segment.
Debit and Credit Card Fees
The Company issues debit and credit cards to its retail and commercial banking customers who use the cards to purchase goods and services from merchants through an electronic payment system. As a card issuer, the Company earns fees, including interchange income, for processing the cardholder’s purchase transaction with a merchant through a settlement network. Purchases are charged directly to a customer’s checking account (in the case of a debit card), or are posted to a customer’s credit card account. The fees earned are established by the settlement network and are dependent on the type of transaction processed but are typically based on a per unit charge. Interchange income, the largest component of debit and credit card fees, is settled daily through the networks. The services provided to the cardholders include issuing and maintaining cards, settling purchases with merchants, and maintaining memberships in various card networks to facilitate processing. These services are considered one performance obligation, as one of the services would not be performed without the others. The performance obligation is satisfied as services are rendered for each purchase transaction, and income is immediately recognized.
In order to participate in the settlement network process, the Company must pay various transaction-related costs, established by the networks, including membership fees and a per unit charge for each transaction. These expenses are recorded net of the card fees earned.
Consumer credit card products offer cardholders rewards that can be later redeemed for cash or goods or services to encourage card usage. Reward programs must meet network requirements based on the type of card issued. The expense associated with the rewards granted are recorded net of the credit card fees earned.
Commercial card products offer cash rewards to corporate cardholders to encourage card usage in facilitating corporate payments. The Company pays cash rewards based on contractually agreed upon amounts, normally as a percent of each sales transaction. The expense associated with the cash rewards program is recorded net of the corporate card fees earned.
Merchant Fees
The Company offers merchant processing services to its business customers to enable them to accept credit and debit card payments. Merchant processing activities include gathering merchant sales information, authorizing sales transactions and collecting the funds from card issuers using the networks. The merchant is charged a merchant discount fee for the services based on agreed upon pricing between the merchant and the Company. Merchant fees are recorded net of outgoing interchange costs paid to the card issuing banks and net of other network costs as shown in the table above.
Merchant services provided are considered one performance obligation, as one of the services would not be performed without the others. The performance obligation is satisfied as services are rendered for each settlement transaction and income is immediately recognized. Income earned from merchant fees settles with the customer according to terms negotiated in individual customer contracts. The majority of customers settle with the Company at least monthly.
Trust Fees
The following table shows the components of revenue within trust fees, which are reported within the Wealth segment.
The Company provides trust and asset management services to both private client and institutional trust customers including asset custody, investment advice, and reporting and administrative services. Other specialized services such as tax preparation, financial planning, representation and other related services are provided as needed. Trust fees are generally earned monthly and billed based on a rate multiplied by the fair value of the customer's trust assets. The majority of customer trust accounts are billed monthly. However, some accounts are billed quarterly, and a small number of accounts are billed semi-annually or annually, in accordance with agreements in place with the customer. The Company accrues trust fees monthly based on an estimate of fees due and either directly charges the customer’s account the following month or invoices the customer for fees due according to the billing schedule.
The Company maintains written product pricing information which is used to bill each trust customer based on the services provided. Providing trust services is considered to be a single performance obligation that is satisfied on a monthly basis, involving the monthly custody of customer assets, statement rendering, periodic investment advice where applicable, and other specialized services as needed. As such, performance obligations are considered to be satisfied at the conclusion of each month while trust fee income is also recorded monthly.
Deposit Account Charges and Other Fees
The following table shows the components of revenue within deposit account charges and other fees.
Approximately half of this revenue is reported in the Consumer segment, while the remainder is reported in the Commercial segment.
The Company provides corporate cash management services to its business and non-profit customers to meet their various transaction processing needs. Such services include deposit and check processing, lockbox, remote deposit, reconciliation, on-line banking and other similar transaction processing services. The Company maintains unit prices for each type of service, and the customer is billed based on transaction volumes processed monthly. The customer is usually billed either monthly or quarterly, however, some customers may be billed semi-annually or annually. The customer may pay for the cash management services
provided either by paying in cash or using the value of deposit balances (formula provided to the customer) held at the Company. The Company’s performance obligation for corporate cash management services is the processing of items over a monthly term, and the obligations are satisfied at the conclusion of each month.
Overdraft fees are charged to customers when daily checks and other withdrawals to customers’ accounts exceed balances on hand. Fees are based on a unit price multiplied by the number of items processed whose total amounts exceed the available account balance. The daily overdraft charge is calculated and the fee is posted to the customer’s account each day. The Company’s performance obligations for overdraft transactions is based on the daily transaction processed and the obligation is satisfied as each day’s transaction processing is concluded.
Other deposit fees include numerous smaller fees such as monthly statement fees, foreign ATM processing fees, identification restoration fees, and stop payment fees. Such fees are mostly billed to customers directly on their monthly deposit account statements, or in the case of foreign ATM processing fees, the fee is charged to the customer on the day that transactions are processed. Performance obligations for all of these various services are satisfied at the time that the service is rendered.
Consumer Brokerage Services
The following shows the components of revenue within consumer brokerage services, and nearly all of this revenue is reported in the Company's Wealth segment.
Consumer brokerage services revenue is comprised of commissions received upon the execution of purchases and sales of mutual fund shares and equity securities, in addition to sales of annuities and certain limited insurance products in an agency capacity. Also, fees are earned on professionally managed advisory programs through arrangements with sub-advisors. Payment from the customer is due upon settlement date for purchases and sales of securities, at the purchase date for annuities and insurance products, and upon inception of the service period for advisory programs.
Most of the contracts (except advisory contracts) encompass two types of performance obligations. The first is an obligation to provide account maintenance, record keeping and custodial services throughout the contract term. The second is the obligation to provide trade execution services for the customers' purchases and sales of products mentioned above. The first obligation is satisfied over time as the service period elapses, while the second type of obligation is satisfied upon the execution of each purchase/sale transaction. Contracts for advisory services contain a single performance obligation comprised of providing the management services and related reporting/administrative services over the contract term.
The transaction price of the contracts (except advisory contracts) is a commission charged at the time of trade execution. The commission varies across different security types, insurance products and mutual funds. It is generally determined by standardized price lists published by the Company and its mutual fund and insurance vendors. Because the transaction price relates specifically to the trade execution, it has been allocated to that performance obligation and is recorded at the time of execution. The fee for advisory services is charged to the customer in advance of the quarterly service period, based on the account balance at the beginning of the period. Revenue is recognized ratably over the service period.
Other Non-Interest Income from Contracts with Customers
Other non-interest income from contracts with customers consists mainly of various customer deposit related fees such as ATM fees and gains on sales of tax credits, foreclosed assets, and bank premises and equipment. Performance obligations for these services consist mainly of the execution of transactions for sales of various properties or providing specific deposit related transactions. Fees from these revenue sources are recognized when the performance obligation is completed, at which time cash is received by the Company.
17. Fair Value Measurements
The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities and to determine fair value disclosures. Various financial instruments such as available for sale debt securities, equity securities, trading debt securities, certain investments relating to private equity activities, and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets and liabilities on a nonrecurring basis, such as mortgage servicing rights and certain other investment securities. These nonrecurring fair value adjustments typically involve lower of cost or fair value accounting, or write-downs of individual assets.
Fair value is 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, the Company uses various valuation techniques and assumptions when estimating fair value. For accounting disclosure purposes, a three-level valuation hierarchy of fair value measurements has been established. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
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Level 1 - inputs to the valuation methodology are quoted prices for identical assets or liabilities in active markets.
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Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs that are observable for the assets or liabilities, either directly or indirectly (such as interest rates, yield curves, and prepayment speeds).
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Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value. These may be internally developed, using the Company’s best information and assumptions that a market participant would consider.
When determining the fair value measurements for assets and liabilities required or permitted to be recorded or disclosed at fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability. When possible, the Company looks to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, the Company looks to observable market data for similar assets and liabilities. Nevertheless, certain assets and liabilities are not actively traded in observable markets, and the Company must use alternative valuation techniques to derive an estimated fair value measurement.
Instruments Measured at Fair Value on a Recurring Basis
The table below presents the carrying values of assets and liabilities measured at fair value on a recurring basis at December 31, 2019 and 2018. There were no transfers among levels during these years.
*
The fair value of each class of derivative is shown in Note 19.
.
Valuation methods for instruments measured at fair value on a recurring basis
Following is a description of the Company’s valuation methodologies used for instruments measured at fair value on a recurring basis:
Residential mortgage loans held for sale
The Company originates fixed rate, first lien residential mortgage loans that are intended for sale in the secondary market. Fair value is based on quoted secondary market prices for loans with similar characteristics, which are adjusted to include the embedded servicing value in the loans. This adjustment represents an unobservable input to the valuation but is not considered significant given the relative insensitivity of the valuation to changes in this input. Accordingly, these loan measurements are classified as Level 2.
Available for sale debt securities
For available for sale securities, changes in fair value, including that portion of other-than-temporary impairment unrelated to credit loss, are recorded in other comprehensive income. As mentioned in Note 3 on Investment Securities, the Company records the credit-related portion of other-than-temporary impairment in current earnings. This portfolio comprises the majority of the assets which the Company records at fair value. Most of the portfolio, which includes government-sponsored enterprise, mortgage-backed and asset-backed securities, are priced utilizing industry-standard models that consider various assumptions, including time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace. These measurements are classified as Level 2 in the fair value hierarchy. Where quoted prices are available in an active market, the measurements are classified as Level 1. Most of the Level 1 measurements apply to U.S. Treasury obligations.
The fair values of Level 1 and 2 securities in the available for sale portfolio are prices provided by a third-party pricing service. The prices provided by the third-party pricing service are based on observable market inputs, as described in the sections below. On a quarterly basis, the Company compares a sample of these prices to other independent sources for the same and similar securities. Variances are analyzed, and, if appropriate, additional research is conducted with the third-party pricing service. Based on this research, the pricing service may affirm or revise its quoted price. No significant adjustments have been made to the prices provided by the pricing service. The pricing service also provides documentation on an ongoing basis that includes reference data, inputs and methodology by asset class, which is reviewed to ensure that security placement within the fair value hierarchy is appropriate.
Valuation methods and inputs, by class of security:
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U.S. government and federal agency obligations
U.S. treasury bills, bonds and notes, including inflation-protected securities, are valued using live data from active market makers and inter-dealer brokers. Valuations for stripped coupon and principal issues are derived from yield curves generated from various dealer contacts and live data sources.
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Government-sponsored enterprise obligations
Government-sponsored enterprise obligations are evaluated using cash flow valuation models. Inputs used are live market data, cash settlements, Treasury market yields, and floating rate indices such as LIBOR, CMT, and Prime.
•
State and municipal obligations, excluding auction rate securities
A yield curve is generated and applied to bond sectors, and individual bond valuations are extrapolated. Inputs used to generate the yield curve are bellwether issue levels, established trading spreads between similar issuers or credits, historical trading spreads over widely accepted market benchmarks, new issue scales, and verified bid information. Bid information is verified by corroborating the data against external sources such as broker-dealers, trustees/paying agents, issuers, or non-affiliated bondholders.
•
Mortgage and asset-backed securities
Collateralized mortgage obligations and other asset-backed securities are valued at the tranche level. For each tranche valuation, the process generates predicted cash flows for the tranche, applies a market based (or benchmark) yield/spread for each tranche, and incorporates deal collateral performance and tranche level attributes to determine tranche-specific spreads to adjust the benchmark yield. Tranche cash flows are generated from new deal files and prepayment/default assumptions. Tranche spreads are based on tranche characteristics such as average life, type, volatility, ratings, underlying
collateral and performance, and prevailing market conditions. The appropriate tranche spread is applied to the corresponding benchmark, and the resulting value is used to discount the cash flows to generate an evaluated price.
Valuation of agency pass-through securities, typically issued under GNMA, FNMA, FHLMC, and SBA programs, are primarily derived from information from the to-be-announced (TBA) market. This market consists of generic mortgage pools which have not been received for settlement. Snapshots of the TBA market, using live data feeds distributed by multiple electronic platforms, are used in conjunction with other indices to compute a price based on discounted cash flow models.
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Other debt securities
Other debt securities are valued using active markets and inter-dealer brokers as well as bullet spread scales and option adjusted spreads. The spreads and models use yield curves, terms and conditions of the bonds, and any special features (e.g., call or put options and redemption features).
The available for sale portfolio includes certain auction rate securities. Due to the illiquidity in the auction rate securities market in recent years, the fair value of these securities cannot be based on observable market prices. The fair values of these securities are estimated using a discounted cash flows analysis which is discussed more fully in the Level 3 Inputs section of this note. Because many of the inputs significant to the measurement are not observable, these measurements are classified as Level 3 measurements.
Equity securities with readily determinable fair values
Equity securities are priced using the market prices for each security from the major stock exchanges or other electronic quotation systems. These are generally classified as Level 1 measurements. Stocks which trade infrequently are classified as Level 2.
Trading debt securities
The securities in the Company’s trading portfolio are priced by averaging several broker quotes for similar instruments and are classified as Level 2 measurements.
Private equity investments
These securities are held by the Company’s private equity subsidiaries and are included in other investment securities in the consolidated balance sheets. Due to the absence of quoted market prices, valuation of these nonpublic investments requires significant management judgment. These fair value measurements, which are discussed in the Level 3 Inputs section of this note, are classified as Level 3.
Derivatives
The Company’s derivative instruments include interest rate swaps and floors, foreign exchange forward contracts, and certain credit risk guarantee agreements. When appropriate, the impact of credit standing as well as any potential credit enhancements, such as collateral, has been considered in the fair value measurement.
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Valuations for interest rate swaps are derived from a proprietary model whose significant inputs are readily observable market parameters, primarily yield curves used to calculate current exposure. Counterparty credit risk is incorporated into the model and calculated by applying a net credit spread over LIBOR to the swap's total expected exposure over time. The net credit spread is comprised of spreads for both the Company and its counterparty, derived from probability of default and other loss estimate information obtained from a third party credit data provider or from the Company's Credit Department when not otherwise available. The credit risk component is not significant compared to the overall fair value of the swaps. The results of the model are constantly validated through comparison to active trading in the marketplace.
Parties to swaps requiring central clearing are required to post collateral (generally in the form of cash or marketable securities) to an authorized clearing agency that holds and monitors the collateral. In January 2017, the Company's clearing counterparty made rule changes to characterize a component of this collateral as a legal settlement of the derivative contract exposure. As a result, this component, known as variation margin, is no longer accounted for separately from the derivative as collateral, but is considered in determining the fair value of the derivative.
Valuations for interest rate floors are also derived from a proprietary model whose significant inputs are readily observable market parameters, primarily yield curves and volatility surfaces. The model uses market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fall below the strike rates of the floors. The model also incorporates credit valuation adjustments of both the Company's and the counterparties' non-
performance risk. The credit valuation adjustment component is not significant compared to the overall fair value of the floors.
The fair value measurements of interest rate swaps and floors are classified as Level 2 due to the observable nature of the significant inputs utilized.
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Fair value measurements for foreign exchange contracts are derived from a model whose primary inputs are quotations from global market makers and are classified as Level 2.
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The Company’s contracts related to credit risk guarantees are valued under a proprietary model which uses unobservable inputs and assumptions about the creditworthiness of the counterparty (generally a Bank customer). Customer credit spreads, which are based on probability of default and other loss estimates, are calculated internally by the Company's Credit Department, as mentioned above, and are based on the Company's internal risk rating for each customer. Because these inputs are significant to the measurements, they are classified as Level 3.
•
Derivatives relating to residential mortgage loan sale activity include commitments to originate mortgage loans held for sale, forward loan sale contracts, and forward commitments to sell TBA securities. The fair values of loan commitments and sale contracts are estimated using quoted market prices for loans similar to the underlying loans in these instruments. The valuations of loan commitments are further adjusted to include embedded servicing value and the probability of funding. These assumptions are considered Level 3 inputs and are significant to the loan commitment valuation; accordingly, the measurement of loan commitments is classified as Level 3. The fair value measurement of TBA contracts is based on security prices published on trading platforms and is classified as Level 2.
Assets held in trust
Assets held in an outside trust for the Company’s deferred compensation plan consist of investments in mutual funds. The fair value measurements are based on quoted prices in active markets and classified as Level 1. The Company has recorded an asset representing the total investment amount. The Company has also recorded a corresponding liability, representing the Company’s liability to the plan participants.
The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
Gains and losses on the Level 3 assets and liabilities in the table above are reported in the following income categories:
Level 3 Inputs
As shown above, the Company's significant Level 3 measurements which employ unobservable inputs that are readily quantifiable pertain to auction rate securities (ARS) held by the Bank, investments in portfolio concerns held by the Company's private equity subsidiaries, and held for sale residential mortgage loan commitments. ARS are included in state and municipal securities and totaled $9.9 million at December 31, 2019, while private equity investments, included in other securities, totaled $94.1 million.
Information about these inputs is presented in the table and discussions below.
The fair values of ARS are estimated using a discounted cash flows analysis in which estimated cash flows are based on mandatory interest rates paid under failing auctions and projected over an estimated market recovery period. Under normal conditions, ARS traded in weekly auctions and were considered liquid investments. The Company's estimate of when these auctions might resume is highly judgmental and subject to variation depending on current and projected market conditions. Few auctions of these securities have been successful in recent years, and most secondary transactions have been privately arranged. Estimated cash flows during the period over which the Company expects to hold the securities are discounted at an estimated market rate. These securities are comprised of bonds issued by various states and municipalities for healthcare and student lending purposes, and market rates are derived for each type. Market rates are calculated at each valuation date using a LIBOR or Treasury based rate plus spreads representing adjustments for liquidity premium and nonperformance risk. The spreads are developed internally by employees in the Company's bond department. An increase in the holding period alone would result in a higher fair value measurement, while an increase in the estimated market rate (the discount rate) alone would result in a lower fair value measurement. The valuation of the ARS portfolio is reviewed on a quarterly basis by the Company's chief investment officers.
The fair values of the Company's private equity investments are based on a determination of fair value of the investee company less preference payments assuming the sale of the investee company. Investee companies are normally non-public entities. The fair value of the investee company is determined by reference to the investee's total earnings before interest, depreciation/amortization, and income taxes (EBITDA) multiplied by an EBITDA factor. EBITDA is normally determined based on a trailing prior period adjusted for specific factors including current economic outlook, investee management, and specific unique circumstances such as sales order information, major customer status, regulatory changes, etc. The EBITDA multiple is based on management's review of published trading multiples for recent private equity transactions and other judgments and is derived for each individual investee. The fair value of the Company's investment is then calculated based on its ownership percentage in the investee company. On a quarterly basis, these fair value analyses are reviewed by a valuation committee consisting of investment managers and senior Company management.
The significant unobservable inputs used in the fair value measurement of the Company’s derivative commitments to originate residential mortgage loans are the percentage of commitments that are actually funded and the mortgage servicing value that is inherent in the underlying loan value. A significant increase in the rate of loans that fund would result in a larger derivative asset or liability. A significant increase in the inherent mortgage servicing value would result in an increase in the derivative asset or a reduction in the derivative liability. The probability of funding and the inherent mortgage servicing values are directly impacted by changes in market rates and will generally move in the same direction as interest rates.
Instruments Measured at Fair Value on a Nonrecurring Basis
For assets measured at fair value on a nonrecurring basis during 2019 and 2018, and still held as of December 31, 2019 and 2018, the following table provides the adjustments to fair value recognized during the respective periods, the level of valuation assumptions used to determine each adjustment, and the carrying value of the related individual assets or portfolios at December 31, 2019 and 2018.
Valuation methods for instruments measured at fair value on a nonrecurring basis
Following is a description of the Company’s valuation methodologies used for other financial and nonfinancial instruments measured at fair value on a nonrecurring basis.
Collateral dependent impaired loans
While the overall loan portfolio is not carried at fair value, the Company periodically records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral dependent loans when establishing the allowance for loan losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan. In determining the value of real estate collateral, the Company relies on external and internal appraisals of property values depending on the size and complexity of the real estate collateral. The Company maintains a staff of qualified appraisers who also review third party appraisal reports for reasonableness. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Values of all loan collateral are regularly reviewed by credit administration. Unobservable inputs to these measurements, which include estimates and judgments often used in conjunction with appraisals, are not readily quantifiable. These measurements are classified as Level 3. Changes in fair value recognized for partial charge-offs of loans and loan impairment reserves on loans held by the Company at December 31, 2019 and 2018 are shown in the table above.
Mortgage servicing rights
The Company initially measures its mortgage servicing rights at fair value and amortizes them over the period of estimated net servicing income. They are periodically assessed for impairment based on fair value at the reporting date. Mortgage servicing rights do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The fair value measurements are classified as Level 3.
Long-lived assets
When investments in branch facilities and various office buildings are determined to be impaired, their carrying values are written down to estimated fair value, or estimated fair value less cost to sell if the property is held for sale. Fair value is estimated in a process which considers current local commercial real estate market conditions and the judgment of the sales agent and often involves obtaining third party appraisals from certified real estate appraisers. The carrying amounts of these real estate holdings are regularly monitored by real estate professionals employed by the Company. These fair value measurements are classified as Level 3. Unobservable inputs to these measurements, which include estimates and judgments often used in conjunction with appraisals, are not readily quantifiable.
18. Fair Value of Financial Instruments
The carrying amounts and estimated fair values of financial instruments held by the Company are set forth below. Fair value estimates are made at a specific point in time based on relevant market information. They do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for many of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, risk characteristics and economic conditions. These estimates are subjective, involve uncertainties, and cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
The estimated fair values of the Company’s financial instruments and the classification of their fair value measurement within the valuation hierarchy are as follows at December 31, 2019 and 2018:
19. Derivative Instruments
The notional amounts of the Company’s derivative instruments are shown in the table below. These contractual amounts, along with other terms of the derivative, are used to determine amounts to be exchanged between counterparties and are not a measure of loss exposure. With the exception of the interest rate floors (discussed below), the Company's derivative instruments are accounted for as free-standing derivatives, and changes in their fair value are recorded in current earnings.
The largest group of notional amounts relate to interest rate swap contracts sold to commercial customers who wish to modify their interest rate sensitivity. The customers are engaged in a variety of businesses, including real estate, manufacturing, retail
product distribution, education, and retirement communities. These customer swaps are offset by matching contracts purchased by the Company from other financial dealer institutions. Contracts with dealers that require central clearing are novated to a clearing agency who becomes the Company's counterparty. Because of the matching terms of the offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings.
Many of the Company’s interest rate swap contracts with large financial institutions contain contingent features relating to debt ratings or capitalization levels. Under these provisions, if the Company’s debt rating falls below investment grade or if the Company ceases to be “well-capitalized” under risk-based capital guidelines, certain counterparties can require immediate and ongoing collateralization on interest rate swaps in net liability positions or instant settlement of the contracts. The Company maintains debt ratings and capital well above these minimum requirements.
As of December 31, 2019, the Company has entered into three interest rate floors with a combined notional value of $1.5 billion, to hedge the risk of declining interest rates on certain floating rate commercial loans indexed to one month LIBOR. The first interest rate floor has a purchased strike rate of 2.25% and became effective on January 1, 2020 and matures on January 1, 2026. The second interest rate floor has a purchased strike rate of 2.50% and is effective on June 1, 2020 and matures on June 1, 2026. The third interest rate floor has a purchased strike rate of 2.00% and is effective December 15, 2020 and matures on December 15, 2026. The premiums paid for these floors totaled $31.3 million. As of December 31, 2019, the maximum length of time over which the Company is hedging its exposure to the variability in future cash flows is approximately 7.0 years. The interest rate floors qualified and were designated as cash flow hedges and were assessed for effectiveness using regression analysis. The change in the fair value of the interest rate floors are recorded in AOCI, net of the amortization of the premium paid, which is recorded against interest and fees on loans in the consolidated statements of income. As of December 31, 2019, net deferred gains on the interest rate floors totaled $40.4 million (pre-tax) and were recorded in AOCI in the consolidated balance sheet. As of December 31, 2019, it is expected that $4.1 million (pre-tax) of interest rate floor premium amortization will be reclassified from AOCI into earnings over the next twelve months.
The Company also contracts with other financial institutions, as a guarantor or beneficiary, to share credit risk associated with certain interest rate swaps through risk participation agreements. The Company’s risks and responsibilities as guarantor are further discussed in Note 21 on Commitments, Contingencies and Guarantees. In addition, the Company enters into foreign exchange contracts, which are mainly comprised of contracts to purchase or deliver foreign currencies for customers at specific future dates.
Under its program to sell residential mortgage loans in the secondary market, the Company designates certain newly-originated residential mortgage loans as held for sale. Derivative instruments arising from this activity include mortgage loan commitments and forward loan sale contracts. Changes in the fair values of the loan commitments and funded loans prior to sale that are due to changes in interest rates are economically hedged with forward contracts to sell residential mortgage-backed securities in the to-be-announced (TBA) market. These forward TBA contracts are also considered to be derivatives and are settled in cash at the security settlement date.
The fair values of the Company’s derivative instruments, whose notional amounts are listed above, are shown in the table below. Information about the valuation methods used to determine fair value is provided in Note 17 on Fair Value Measurements.
The Company's policy is to present its derivative assets and derivative liabilities on a gross basis in its consolidated balance sheets and these are reported in other assets and other liabilities. Certain collateral posted to and from the Company's clearing counterparty has been offset against the fair values of cleared swaps, such that at December 31, 2019 in the table below, the positive fair values of cleared swaps were reduced by $617 thousand and the negative fair values of cleared swaps were reduced by $28.5 million. At December 31, 2018, the positive fair values of cleared swaps were reduced by $8.1 million and the negative fair values of cleared swaps were reduced by $6.5 million.
The pre-tax effects of derivative instruments on the consolidated statements of income are shown in the tables below.
* No hedging relationship existed during 2017.
The following table shows the extent to which assets and liabilities relating to derivative instruments have been offset in the consolidated balance sheets. It also provides information about these instruments which are subject to an enforceable master netting arrangement, irrespective of whether they are offset, and the extent to which the instruments could potentially be offset. Also shown is collateral received or pledged in the form of other financial instruments, which is generally cash or marketable securities. The collateral amounts in this table are limited to the outstanding balances of the related asset or liability (after netting is applied); thus amounts of excess collateral are not shown. Most of the derivatives in the following table were transacted under master netting arrangements that contain a conditional right of offset, such as close-out netting, upon default.
While the Company is party to master netting arrangements with most of its swap derivative counterparties, the Company does not offset derivative assets and liabilities under these arrangements on its consolidated balance sheet. Collateral exchanged between the Company and dealer bank counterparties is generally subject to thresholds and transfer minimums, and usually consist of marketable securities. By contract, these may be sold or re-pledged by the secured party until recalled at a subsequent valuation date by the pledging party. For those swap transactions requiring central clearing, the Company posts cash or securities to its clearing agent. Collateral positions are valued daily, and adjustments to amounts received and pledged by the Company are made as appropriate to maintain proper collateralization for these transactions. Swap derivative transactions with customers are generally secured by rights to non-financial collateral, such as real and personal property, which is not shown in the table below.
20. Resale and Repurchase Agreements
The following table shows the extent to which assets and liabilities relating to securities purchased under agreements to resell (resale agreements) and securities sold under agreements to repurchase (repurchase agreements) have been offset in the consolidated balance sheets, in addition to the extent to which they could potentially be offset. Also shown is collateral received or pledged, which consists of marketable securities. The collateral amounts in the table are limited to the outstanding balances of the related asset or liability (after netting is applied); thus amounts of excess collateral are not shown. The agreements in the following table were transacted under master netting arrangements that contain a conditional right of offset, such as close-out netting, upon default.
Resale and repurchase agreements are agreements to purchase/sell securities subject to an obligation to resell/repurchase the same or similar securities. They are accounted for as collateralized financing transactions, not as sales and purchases of the securities portfolio. The securities collateral accepted or pledged in resale and repurchase agreements with other financial institutions also may be sold or re-pledged by the secured party, but is usually delivered to and held by third party trustees. The Company generally retains custody of securities pledged for repurchase agreements with customers.
The Company is party to agreements commonly known as collateral swaps. These agreements involve the exchange of collateral under simultaneous repurchase and resale agreements with the same financial institution counterparty. These repurchase and resale agreements have the same principal amounts, inception dates, and maturity dates and have been offset against each other in the consolidated balance sheets, as permitted under the netting provisions of ASC 210-20-45. The collateral swaps totaled $200.0 million at December 31, 2019 and $450.0 million at December 31, 2018. At December 31, 2019, the Company had posted collateral of $204.3 million in marketable securities, consisting of agency mortgage-backed bonds, and had accepted $209.6 million in agency mortgage-backed bonds.
The table below shows the remaining contractual maturities of repurchase agreements outstanding at December 31, 2019 and 2018, in addition to the various types of marketable securities that have been pledged by the Company as collateral for these borrowings.
21. Commitments, Contingencies and Guarantees
The Company engages in various transactions and commitments with off-balance sheet risk in the normal course of business to meet customer financing needs. The Company uses the same credit policies in making the commitments and conditional obligations described below as it does for on-balance sheet instruments. The following table summarizes these commitments at December 31:
Commitments to extend credit are legally binding agreements to lend to a borrower providing there are no violations of any conditions established in the contract. As many of the commitments are expected to expire without being drawn upon, the total commitment does not necessarily represent future cash requirements. Refer to Note 2 on Loans and Allowance for Loan Losses for further discussion.
Commercial letters of credit act as a means of ensuring payment to a seller upon shipment of goods to a buyer. The majority of commercial letters of credit issued are used to settle payments in international trade. Typically, letters of credit require presentation of documents which describe the commercial transaction, evidence shipment, and transfer title.
The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured, and in the event of nonperformance by the customer, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.
At December 31, 2019, the Company had recorded a liability in the amount of $2.6 million, representing the carrying value of the guarantee obligations associated with the standby letters of credit. This amount will be accreted into income over the remaining life of the respective commitments. Commitments outstanding under these letters of credit, which represent the maximum potential future payments guaranteed by the Company, were $377.3 million at December 31, 2019.
The Company regularly purchases various state tax credits arising from third-party property redevelopment. These credits are either resold to third parties or retained for use by the Company. During 2019, purchases and sales of tax credits amounted to $90.6 million and $84.9 million, respectively. At December 31, 2019, the Company had outstanding purchase commitments totaling $160.9 million that it expects to fund in 2020.
The Company periodically enters into risk participation agreements (RPAs) as a guarantor to other financial institutions, in order to mitigate those institutions’ credit risk associated with interest rate swaps with third parties. The RPA stipulates that, in the event of default by the third party on the interest rate swap, the Company will reimburse a portion of the loss borne by the financial institution. These interest rate swaps are normally collateralized (generally with real property, inventories and equipment) by the third party, which limits the credit risk associated with the Company’s RPAs. The third parties usually have other borrowing relationships with the Company. The Company monitors overall borrower collateral, and at December 31, 2019, believes sufficient collateral is available to cover potential swap losses. The RPAs are carried at fair value throughout their term, with all changes in fair value, including those due to a change in the third party’s creditworthiness, recorded in current earnings. The terms of the RPAs, which correspond to the terms of the underlying swaps, range from 3 to 11 years. At December 31, 2019, the fair value of the Company's guarantee liability RPAs was $230 thousand, and the notional amount of the underlying swaps was $208.9 million. The maximum potential future payment guaranteed by the Company cannot be readily estimated and is dependent upon the fair value of the interest rate swaps at the time of default.
The Company has various legal proceedings pending at December 31, 2019, arising in the normal course of business. While some matters pending against the Company specify damages claimed by plaintiffs, others do not seek a specified amount of damages or are at very early stages of the legal process. The Company records a loss accrual for all legal and regulatory matters for which it deems a loss is probable and can be reasonably estimated. Some matters, which are in the early stages, have not yet progressed to the point where a loss amount can be determined to be probable and estimable.
22. Related Parties
The Company’s Chief Executive Officer, its Executive Chairman, and its former Vice Chairman are directors of Tower Properties Company (Tower) and, together with members of their immediate families, beneficially own approximately 67% of the outstanding stock of Tower. At December 31, 2019, Tower owned 211,996 shares of Company stock. Tower is primarily engaged in the business of owning, developing, leasing and managing real property.
Payments from the Company and its affiliates to Tower are summarized below. These payments, with the exception of dividend payments, relate to property management services, including construction oversight, on three Company-owned office buildings and related parking garages in downtown Kansas City.
Tower has a $13.5 million line of credit with the Bank which is subject to normal credit terms and has a variable interest rate. The line of credit is collateralized by Company stock and based on collateral value had a maximum borrowing amount of approximately $11.5 million at December 31, 2019. There were no borrowings under this line during 2019, and no balance outstanding at December 31, 2019. There were no borrowings during 2018, and the maximum borrowings during 2017 were $5.2 million. There was no balance outstanding at December 31, 2018 or 2017. Interest paid on borrowings during the last three years was not significant. Letters of credit may be collateralized under this line of credit; however, there were no letters of credit outstanding during 2019, 2018 or 2017, and thus, no fees were received during these periods. From time to time, the Bank extends additional credit to Tower for construction and development projects. No construction loans were outstanding during 2019, 2018 and 2017.
Tower leases office space in the Kansas City bank headquarters building owned by the Company. Rent paid to the Company totaled $75 thousand in 2019, $74 thousand in 2018, and $74 thousand in 2017, at $17.00, $16.69 and $15.75 per square foot, respectively.
Directors of the Company and their beneficial interests have deposit accounts with the Bank and may be provided with cash management and other banking services, including loans, in the ordinary course of business. Such loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other unrelated persons and did not involve more than the normal risk of collectability.
As discussed in Note 21 on Commitments, Contingencies and Guarantees, the Company regularly purchases various state tax credits arising from third-party property redevelopment and resells the credits to third parties. During 2019, the Company sold state tax credits to its Executive Chairman, its former Vice Chairman, its Chief Executive Officer, and its Chief Credit Officer in the amount of $865 thousand, $663 thousand, $166 thousand, and $83 thousand, respectively, for personal tax planning. During 2018, the Company sold state tax credits to its Executive Chairman, its former Vice Chairman, and its Chief Executive Officer in the amount of $831 thousand, $759 thousand, and $119 thousand, respectively. During 2017, the Company sold state tax credits to its Executive Chairman, its former Vice Chairman, and its Chief Executive Officer in the amount of $694 thousand, $598 thousand, and $67 thousand, respectively. The terms of the sales and the amounts paid were the same as the terms and amounts paid for similar tax credits by persons not related to the Company.
23. Parent Company Condensed Financial Statements
Following are the condensed financial statements of Commerce Bancshares, Inc. (Parent only) for the periods indicated:
Dividends paid by the Parent to its shareholders were substantially provided from Bank dividends. The Bank may distribute common dividends without prior regulatory approval, provided that the dividends do not exceed the sum of net income for the current year and retained net income for the preceding two years, subject to maintenance of minimum capital requirements. The Parent charges fees to its subsidiaries for management services provided, which are allocated to the subsidiaries based primarily on total average assets. The Parent makes cash advances to its private equity subsidiaries for general short-term cash flow purposes. Advances may be made to the Parent by its subsidiary bank holding company for temporary investment of idle funds. Interest on such advances is based on market rates.
In 2017, the Bank borrowed $50.0 million from the Parent as part of its strategy to manage FDIC insurance premiums. The note has a rolling 13 month maturity, and the interest rate is a variable rate equal to the one year treasury rate.
For the past several years, the Parent has maintained a $20.0 million line of credit for general corporate purposes with the Bank. The Parent has not borrowed under this line during the past three years.
At December 31, 2019, the fair value of the investment securities held by the Parent consisted of investments of $2.8 million in preferred stock with readily determinable fair values, $188 thousand in equity securities that do not have readily determinable fair values, and $1.4 million in non-agency mortgage-backed securities.
Item 9.
Item 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants on accounting and financial disclosure.
Item 9a.
Item 9a.
CONTROLS AND PROCEDURES
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934. Based on this evaluation, our principal executive officer and our principal financial officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our evaluation under the framework in Internal Control - Integrated Framework (2013), our management concluded that our internal control over financial reporting was effective as of December 31, 2019.
The Company’s internal control over financial reporting as of December 31, 2019 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report which follows.
Changes in Internal Control Over Financial Reporting
No change in the Company’s internal control over financial reporting occurred that has materially affected, or is reasonably likely to materially affect, such controls during the last quarter of the period covered by this report.
Report of Independent Registered Public Accounting Firm
To the Shareholders and Board of Directors
Commerce Bancshares, Inc.:
Opinion on Internal Control Over Financial Reporting
We have audited Commerce Bancshares, Inc.'s and subsidiaries (the Company) internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, cash flows, and changes in equity for each of the years in the three-year period ended December 31, 2019, and the related notes (collectively, the consolidated financial statements), and our report dated February 25, 2020 expressed an unqualified opinion on those consolidated financial statements.
Basis for Opinion
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 are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. 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 of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
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.
Kansas City, Missouri
February 25, 2020
Item 9b.
Item 9b.
OTHER INFORMATION
None
PART III
Item 10.
Item 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Items 401, 405 and 407(c)(3), (d)(4) and (d)(5) of Regulation S-K regarding executive officers, directors, and corporate governance is included at the end of Part I of this Form 10-K under the caption “Information about the Company's Executive Officers” and under the captions “Proposal One - Election of the 2023 Class of Directors”, “Delinquent Section 16(a) Reports”, “Audit and Risk Committee Report”, “Committees of the Board" and "Shareholder Proposals and Nominations" in the definitive proxy statement, which is incorporated herein by reference.
The Company’s senior financial officer code of ethics for the chief executive officer and senior financial officers of the Company, including the chief financial officer, principal accounting officer or controller, or persons performing similar functions, is available at www.commercebank.com. Amendments to, and waivers of, the code of ethics are posted on this Web site.
Item 11.
Item 11.
EXECUTIVE COMPENSATION
The information required by Items 402 and 407(e)(4) and (e)(5) of Regulation S-K regarding executive compensation is included under the captions “Compensation Discussion and Analysis”, “Executive Compensation”, “Director Compensation”, “Compensation and Human Resources Committee Report”, and “Compensation and Human Resources Committee Interlocks and Insider Participation” in the definitive proxy statement, which is incorporated herein by reference.
Item 12.
Item 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Items 201(d) and 403 of Regulation S-K is included under the captions “Equity Compensation Plan Information” and “Security Ownership of Certain Beneficial Owners and Management” in the definitive proxy statement, which is incorporated herein by reference.
Item 13.
Item 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by Items 404 and 407(a) of Regulation S-K is covered under the captions “Proposal One - Election of the 2023 Class of Directors” and “Corporate Governance” in the definitive proxy statement, which is incorporated herein by reference.
Item 14.
Item 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 9(e) of Schedule 14A is included under the captions “Pre-approval of Services by the External Auditor” and “Fees Paid to KPMG LLP” in the definitive proxy statement, which is incorporated herein by reference.
PART IV
Item 15.
Item 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this report:
Page
(1)
Financial Statements:
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Cash Flows
Consolidated Statements of Changes in Equity
Notes to Consolidated Financial Statements
Summary of Quarterly Statements of Income
(2)
Financial Statement Schedules:
All schedules are omitted as such information is inapplicable or is included in the financial statements.
(b) The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed below.
Item 16.
FORM 10-K SUMMARY
None.
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 this 25th day of February 2020.
COMMERCE BANCSHARES, INC.
By:
/s/ THOMAS J. NOACK
Thomas J. Noack
Senior Vice President & Secretary
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 the 25th day of February 2020.
By:
/s/ JOHN W. KEMPER
John W. Kemper
Chief Executive Officer
By:
/s/ CHARLES G. KIM
Charles G. Kim
Chief Financial Officer
By:
/s/ PAUL A. STEINER
Paul A. Steiner
Controller
(Chief Accounting Officer)
David W. Kemper
Terry D. Bassham
John R. Capps
Earl H. Devanny, III
W. Thomas Grant, II
Karen L. Daniel
John W. Kemper
All the Directors on the Board of Directors*
Jonathan M. Kemper
Benjamin F. Rassieur, III
Todd R. Schnuck
Andrew C. Taylor
Kimberly G. Walker
____________
*
The Directors of Registrant listed executed a power of attorney authorizing Thomas J. Noack, their attorney-in-fact, to sign this report on their behalf.
By:
/s/ THOMAS J. NOACK
Thomas J. Noack
Attorney-in-Fact