Item 1. Business
The disclosures set forth in this item are qualified by Item 1A
Item 1A. Risk Factors
Investing in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Company’s common stock could decline significantly, and shareholders could lose all or part of their investment.
The Company operates in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations.
The Company is subject to extensive regulation, supervision, and examination by federal and state banking authorities. Any change in applicable regulations or laws could have a substantial adverse impact on the Company and its operations. Additional legislation and regulations that could significantly affect the Company’s powers, authority, and operations may be enacted or adopted in the future, which could have a material adverse effect on the Company’s results of operations and financial condition. Further, in the performance of their supervisory duties and enforcement powers, the Company’s banking regulators have significant discretion and authority to prevent or remedy practices they deem as unsafe or unsound or violations of law. The exercise of regulatory authority may have a negative impact on the Company’s operations, which may be material to its results of operations and financial condition.
The Company in the future may become subject to additional supervisory actions and/or enhanced regulation that could have a material negative effect on its business, operating flexibility, financial condition and the value of its common stock.
Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the KDFI (for state-chartered banks), the Federal Reserve (for bank holding companies), and the FDIC as the insurer of bank deposits, have the authority to compel or restrict certain actions on the Company’s part if they determine that the Company has insufficient capital or is otherwise operating in a manner that may be deemed to be inconsistent with safe and sound banking practices. Under this authority, bank regulators can require the Company to enter into informal or formal enforcement orders, including board resolutions, memoranda of understanding, written agreements and consent or cease and desist orders, pursuant to which the Company would be required to take identified corrective actions to address cited concerns and to refrain from taking certain actions.
If the Company is unable to comply with the terms of its current or future regulatory orders to which it may become subject, then it could become subject to additional, heightened supervisory actions and orders, possibly including cease and desist orders, prompt corrective actions, and/or other regulatory enforcement actions. If the Company’s regulators were to take such additional supervisory actions, then we could, among other things, become subject to significant restrictions on our ability to develop any new business, as well as restrictions on our existing business, and we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, or both. If one or more of the Company’s banks were unable to comply with regulatory requirements, such banks could ultimately face failure. The terms of any such supervisory action could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.
Our nonperforming assets adversely affect our results of operations and financial condition and take significant management time to resolve.
Nonperforming assets are made up of nonperforming loans, other real estate owned, and other foreclosed assets. Nonperforming loans include nonaccrual loans, performing restructured loans, and loans 90 days or more past due and still accruing interest. Nonperforming assets adversely affect the Company’s net income in several ways. The Company does not record interest income on nonaccrual loans or other real estate owned, thereby adversely affecting interest income. When the Company repossesses collateral in foreclosures and similar proceedings, it is required to record the property at its fair value less estimated selling costs, which typically decreases net income. The Company’s level of nonperforming assets have improved considerably in the last few years, but remain elevated at 3.0% of total assets at year-end 2015. However, 44% of nonperforming assets consist of performing restructured loans.
Nonperforming loans and other real estate owned also increase our risk profile and the amount of capital the Company’s regulators believe is appropriate in light of such risks. While the Company seeks to reduce its problem loans through workouts, restructurings, and otherwise, decreases in the value of these assets, the underlying collateral, or our borrowers’ performance or financial conditions have adversely affected, and may continue to adversely affect, the Company’s results of operations and financial condition. Moreover, the resolution of nonperforming assets requires significant time commitments from management of our banks, which can be detrimental to the performance of their other responsibilities. There can be no assurance that the Company will not experience further increases in nonperforming loans in the future. If economic conditions do not improve or worsen in our markets, the Company could continue to incur additional losses relating to an increase in nonperforming assets.
Losses from loan defaults may exceed the allowance established for that purpose, which will have an adverse effect on the Company’s financial condition.
Volatility and deterioration in the broader economy increases the Company’s risk of credit losses, which could have a material adverse effect on its operating results. If a significant number of loans in the Company’s portfolio are not repaid, it would have an adverse effect on its earnings and overall financial condition. The Company’s bank subsidiaries each maintain an allowance for loan losses to provide for losses inherent in the loan portfolio. The allowance for loan losses reflects management’s best estimate of probable incurred credit losses in their loan portfolio at the balance sheet date. This evaluation is primarily based upon a review of the bank’s historical loan loss experience, known risks contained in the bank’s loan portfolio, composition and growth of the bank’s loan portfolio, and other economic and qualitative factors. Additionally, a bank’s regulators may require additional provision for the loan portfolio in connection with their examinations, agreements, or orders. The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. As a result, the Company’s allowance for loan losses may be inadequate to cover actual losses in its loan portfolio. Consequently, the Company risks having additional future provision for loan losses that may materially affect its earnings.
If the Company’s local markets experience a prolonged recession or economic downturn, it may be required to make further increases in its allowance for loan losses and to charge off additional loans, which would adversely affect its results of operations and capital.
Substantially all of the Company’s loans are to businesses and individuals located in Kentucky. A continuing or prolonged decline in the Central and Northern Kentucky economies could negatively impact demand for the Company’s products and services, the ability of customers to repay their loans, collateral values securing loans, and the stability of funding sources. This could result in a material adverse effect on the Company’s financial condition, results of operations and prospects. Further, approximately 90% of the Company’s investments in municipal bonds are issued by political subdivisions or agencies located in Kentucky.
The Company’s level of nonperforming loans continue to improve, but remain elevated at 3.4% of total loans at year-end 2015. Nonaccrual loans as a percent of total loans was 0.9% at year-end 2015, an improvement from 1.2% a year earlier. Performing restructured loans comprise 74% of nonperforming loans as of December 31, 2015. Generally, the Company’s nonperforming loans and assets reflect operating difficulties of individual borrowers; however, the overall weak economy and slow growth of recent years has become a significant contributing factor to the elevated levels of nonperforming loans. Sluggish sales and excess inventory in the residential housing market has been the primary cause of elevated delinquencies and foreclosures in recent years. If trends in the housing and real estate markets worsen, the Company could experience an increase in delinquencies and credit losses. As a result, the Company may be required to increase its provision for loan losses and charge off additional loans in the future, which could adversely affect the Company’s financial condition and results of operations, perhaps materially. If additional provisions and charge-offs cause the Company to experience losses, it may be required to contribute additional capital to its bank subsidiaries to maintain capital ratios required by regulators.
The Company’s exposure to credit risk is increased by its real estate development lending.
Real estate development lending has historically been considered to be higher credit risk than that of other types of lending, such as for single-family residential properties. At year-end 2015, $7.3 million or 6% of the outstanding balance of real estate development loans was classified as impaired. Real estate development loans typically involve larger loan balances to a single borrower or related borrowers. These loans can be affected by adverse conditions in real estate markets or the economy in general because commercial real estate borrowers’ ability to repay their loans depends on successful development and, in most cases, sale of the underlying property. These loans also involve greater risk because they generally are not fully amortized over the loan period, but have a balloon payment due at maturity of the loan. A borrower’s ability to make a balloon payment typically depends on being able to either refinance the loan or timely sell the underlying property. In the current economic environment, the ability of borrowers to refinance or sell newly developed property or vacant land remains challenging. If the real estate markets were to worsen or not improve, the Company likely will experience increased credit losses and require additional provisions to our allowance for loan losses, which would adversely impact the Company’s earnings and financial condition.
Changes in consumer use of banks and changes in consumer spending and saving habits could adversely affect our financial results.
Technology and other changes now allow many consumers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This “disintermediation” could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and saving habits could adversely affect the Company’s operations, and it may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.
Maintaining or increasing the Company’s market share may depend on lowering prices and market acceptance of new products and services.
The Company’s success depends, in part, on its ability to adapt products and services to evolving industry standards. There is increasing pressure to provide products and services at lower prices. Lower prices can reduce net interest margin and revenues from fee-based products and services. In addition, the widespread adoption of new technologies, including internet services, could require the Company to make substantial expenditures to modify or adapt existing products and services. Also, these and other capital investments may not produce expected growth in earnings anticipated at the time of the expenditure. The Company might not be successful in introducing new products and services, achieving market acceptance of its products and services, or developing and maintaining loyal customers.
The Company’s investment securities portfolio is comparatively larger than other community banks and it is more dependent on its investment portfolio to generate net income.
The Company relies more heavily on its investment securities portfolio as a source of interest income than many other community banks because its loan portfolio makes up a smaller proportion of its earning assets. If the Company is not able to successfully manage the interest rate spread on the investment portfolio, its net interest income will decrease, which would adversely affect its results of operations and negatively impact net income. Investment securities tend to have a lower risk than loans, and as such, generally provide a lower yield. For 2015, average investment securities made up 35.0% of the Company’s average total assets. Interest income on investment securities accounted for 21.5% of total interest income for 2015.
The Company periodically sells investment securities at irregular intervals in the normal course of business to execute its current asset/liability management strategies. This will result in the realization of either a net gain or loss. Moreover, proceeds from sales may be reinvested in investment securities with lower yields, which could reduce future earnings from investment securities. The Company monitors its investment securities portfolio for deteriorating values and for other-than-temporary impairment. Any material other-than-temporary impairment charges would likewise have an adverse effect on the Company’s results of operations and could lead to additional losses.
The Company is exposed to risk of environmental liability when it takes title to properties.
In the course of its business, the Company may foreclose on and take title to real estate. As a result, it could be subject to environmental liabilities with respect to these properties. The Company may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. Additionally, if the Company is the owner or former owner of a contaminated site, it may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination stemming from the property. If the Company becomes subject to significant environmental liabilities, it could have a material adverse effect on its business, results of operations, and financial condition.
The Company cannot accurately predict the effect of the current economy on its future results of operations or the market price of its stock.
The national economy and the financial services sector in particular continue to face challenges stemming from the economic recession of 2007 to 2009. The Company cannot accurately predict the severity or duration of an economic slowdown, which can adversely impacted its performance and the markets it serves. Any deterioration in the economies of the nation as a whole or in the Company’s local markets would have an adverse effect, which could be material, on the Company’s financial condition, results of operations, and prospects and could also cause the market price of the Company’s stock to decline. While it is impossible to predict how long these conditions may exist, the economic slowdown could continue to present risks for some time for our industry and the Company.
Interest rate volatility could significantly harm the Company’s results of operations.
The Company’s results of operations are affected by the monetary and fiscal policies of the federal government, the policies of its regulators, and the prevailing interest rates in the United States and the Company’s markets. In addition, it is increasingly common for the Company’s competitors, who may be aggressively seeking to attract deposits as a result of liquidity concerns arising from changing economic or other conditions, to pay rates on deposits that are much higher than normal market rates. A significant component of the Company’s earnings is net interest income, which is the difference between the income from interest earning assets, such as loans, and the expense on interest bearing liabilities, such as deposits. A change in market interest rates could adversely affect the Company’s earnings if market interest rates change such that the interest it pays on deposits and borrowings increases faster than the interest it collects on loans and investments; or, alternatively, if interest rates earned on earning assets decline faster than those rates paid on interest paying liabilities. Consequently, as with most financial institutions, the Company is sensitive to interest rate fluctuations. Changes in market interest rates may also affect the level of voluntary prepayments on loans and mortgage-back investment securities resulting in the receipt of funds that may be reinvested at a lower rate.
The FDIC periodically amends its deposit insurance rate assessment structure, which can increase costs to the Company.
Under the Federal Deposit Insurance Act, as amended by the Dodd-Frank Act, the FDIC must establish and implement a plan to restore the deposit insurance fund’s designated reserve ratio to 1.35% of insured deposits by 2020. The FDIC must continue to assess and consider the appropriate level of the reserve ratio annually by considering each of the following: risk of loss to the insurance fund; economic conditions affecting the banking industry; the prevention of sharp swings in the assessment rates; and any other factors the FDIC deems important. The FDIC’s current fund management strategy includes a targeted long-term reserve ratio of 2.0%.
The Dodd-Frank Act required changes to a number of components of the FDIC insurance assessment. While these changes have resulted in a lower amount of deposit insurance assessments for the Company, future changes in assessment rates or methodology could adversely impact the Company’s future earnings and liquidity in a material amount.
Any future losses may require the Company to raise additional capital; however, such capital may not be available to us on favorable terms or at all.
The Company is required by federal and state regulatory authorities to maintain certain levels of capital to support its operations. The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on the Company’s future financial condition and performance. Accordingly, the Company cannot make assurances with respect to its ability to raise additional capital on favorable terms, or at all. If the Company cannot raise additional capital when needed, its ability to further expand its operations through internal growth and acquisitions could be materially impaired and its financial condition and liquidity could be materially and adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.
The tightening of available liquidity could limit the Company’s ability to replace deposits and fund loan demand, which could adversely affect its earnings and capital levels.
Liquidity is crucial to the Company’s business. A tightening of the credit and liquidity markets and the Company’s inability to obtain adequate funding to replace deposits may negatively affect its earnings and capital levels. In addition to deposit growth, maturity of investment securities, and loan payments from borrowers, the Company relies from time to time on advances from the Federal Home Loan Bank and other wholesale funding sources to fund loans and replace deposits. In the event of a downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to the Company. The Company’s liquidity position could be significantly constrained if it were unable to access funds from the Federal Home Loan Bank or other wholesale funding sources.
The Company’s financial condition and outlook may be adversely affected by damage to its reputation.
The Company’s financial condition and outlook is highly dependent upon perceptions of its business practices and reputation. Its ability to attract and retain customers and employees could be adversely affected to the extent its reputation is damaged. Negative public opinion could result from its actual or alleged conduct in any number of activities, including regulatory actions taken against the Company, lending practices, corporate governance, regulatory compliance, mergers of its subsidiaries, or sharing or inadequate protection of customer information. Damage to the Company’s reputation could give rise to loss of customers and legal risks, which could have an adverse impact on its financial condition.
The Company faces strong competition from financial services companies and other companies that offer banking services.
The Company conducts most of its operations in Central and Northern Kentucky. The banking and financial services businesses in these areas are highly competitive and increased competition in its primary market areas may adversely impact the level of its loans and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. These competitors include national banks, regional banks, and other community banks. The Company also faces competition from other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks, and other financial intermediaries. The Company’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers, and a range in quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking customers, it may be unable to increase its loans and level of deposits.
The price of the Company’s common stock may fluctuate significantly, and this may make it difficult to resell the stock when you want or at prices you find attractive.
The Company cannot predict how its common stock will trade in the future. The market value of its common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:
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general economic conditions and conditions in the financial markets;
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changes in global financial markets, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility, and other geopolitical events;
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conditions in our local and national credit, mortgage, and housing markets;
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developments with respect to financial institutions generally, including government regulation;
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our dividend practice; and
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actual and anticipated quarterly fluctuations in our operating results and earnings.
The market value of the Company’s common stock may also be impacted by conditions affecting the financial markets in general, including price and trading fluctuations. These conditions may result in: (1) volatility in the level of, and fluctuations in, the market prices of stocks generally and, in turn, the Company’s common stock and (2) sales of substantial amounts of the Company’s common stock in the market, in each case that could be unrelated or disproportionate to changes in the Company’s operating performance. These broad market fluctuations may adversely affect the market value of the Company’s common stock.
There may be future sales of additional common stock or other dilution of the Company’s equity, which may adversely affect the market price of the Company’s common stock.
The Company is not restricted from issuing additional common or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of the Company’s common stock could decline as a result of sales by the Company of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
The Company’s board of directors is authorized generally to cause it to issue additional common and preferred stock without any action on the part of the Company’s shareholders, except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, the board has the power, without shareholder approval, to set the terms of any series of preferred stock that may be issued, including voting rights, dividend rights, preferences, and other terms. This could include preferences over the common stock with respect to dividends or upon liquidation. If the Company issues preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, or if the Company issues preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.
You may not receive dividends on the Company’s common stock.
Holders of the Company’s common stock are entitled to receive dividends only when, as, and if its board of directors declares them and as permitted by its regulators. Although the Company historically (up through 2009) declared quarterly cash dividends on its common stock, it is not required to do so.
The Company’s ability to pay dividends depends upon the results of operations of its subsidiary banks and certain regulatory considerations.
The Parent Company is a bank holding company that conducts substantially all of its operations through its subsidiary banks. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal and state regulatory considerations and the receipt of dividends and other distributions from its bank subsidiaries.
The trading volume in the Company’s common stock is less than that of many other similar companies.
The Company’s common stock is listed for trading on the NASDAQ Global Select Stock Market. As of December 31, 2015, the 50-day average trading volume of the Company’s common stock on NASDAQ was 11,789 shares or .16% of the total common shares outstanding of 7,499,748. An efficient public trading market is dependent upon the existence in the marketplace of willing buyers and willing sellers of a stock at any given time. The Company has no control over such individual decisions of investors and general economic and market conditions. Given the lower trading volume of the Company’s common stock, larger sales volumes of its common stock could cause the value of its common stock to decrease. Moreover, due to its lower trading volume, it may take longer to liquidate your position in the Company’s common stock without detrimentally affecting the price.
The Company’s common stock constitutes equity and is subordinate to its existing and future indebtedness, and is effectively subordinated to all the indebtedness and other non-common equity claims against its subsidiaries.
Shares of the Company’s common stock represent equity interests in the Parent Company and do not constitute indebtedness. Accordingly, the shares of the Company’s common stock rank junior to all of its indebtedness and to other non-equity claims on Farmers Capital Bank Corporation with respect to assets available to satisfy such claims.
The Company’s right to participate in any distribution of assets of any of its subsidiaries upon the subsidiary’s liquidation or otherwise, and thus the ability of the Company’s common stockholders to benefit indirectly from such distribution, will be subject to the prior claims of creditors of that subsidiary. As a result, holders of the Company’s common stock are effectively subordinated to all existing and future liabilities and obligations of its subsidiaries, including claims of depositors.
The current economic environment exposes the Company to higher credit losses and expenses and may result in lower earnings or increase the likelihood of losses.
Although the Company remains well-capitalized, it continues to operate in a very challenging and uncertain economic environment. Financial institutions, including the Company, continue to be adversely effected by difficult economic conditions that have impacted not only local markets, but on a national and global scale. Substantial deterioration in real estate and other financial markets in recent years, although improving, have and may continue to adversely impact the Company’s financial performance. Declines in real estate values and home sales volumes, along with historically low labor participation rates and other economic stresses, can decrease the value of collateral securing loans extended to borrowers, particularly that of real estate loans. A decrease in the value of real estate securing loans may make it more difficult for the Company to recover amounts it is owed in the event of default by a borrower.
Current economic conditions may result in a higher degree of financial stress on the Company’s borrowers and their customers which could impair the Company’s ability to collect payments on loans, potentially increasing loan delinquencies, nonperforming assets, foreclosures, and losses. Current market forces have and may in the future cause the value of investment securities or other assets held by the Company to deteriorate, resulting in impairment charges, higher losses, and lower regulatory capital levels.
Market volatility could adversely impact the Company’s results of operations, liquidity position, and access to additional capital.
The capital and credit markets experienced heavy volatility and disruptions during much of the most recent economic downturn, with unprecedented levels of volatility and other disruptions. In many cases, this led to downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If similar market disruptions and volatility recur, the Company may experience a material adverse effect on its results of operations and liquidity position or on its ability to access additional capital.
Risks associated with unpredictable economic and political conditions may be amplified as a result of limited market area.
Commercial banks and other financial institutions, including the Company, are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. These conditions and other factors beyond the Company’s control may adversely affect profitability. In addition, almost all of the Company’s primary business area is located in Central and Northern Kentucky. Significant downturns in this economic region may result in a deterioration of the Company’s credit quality, reduce demand for credit, and may harm the financial stability of the Company’s customers. Due to the Company’s regional market area, these negative conditions may have a more noticeable effect on the Company than would be experienced by an institution with a larger, more diverse market area.
The Company’s results of operations are significantly affected by the ability of its borrowers to repay their loans.
Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is affected by:
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unanticipated declines in borrower income or cash flow;
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changes in economic and industry conditions;
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the duration of the loan; and
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in the case of a collateralized loan, uncertainties as to the future value of the collateral.
Due to the fact that the outstanding principal balances can be larger for commercial loans than other types of loans, such loans present a greater risk to the Company than other types of loans when non-payment by a borrower occurs.
Consumer loans typically have shorter terms and lower balances with higher yields compared to real estate mortgage loans, but generally carry higher risks of frequency of default than real estate mortgage and commercial loans. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.
Inability to hire or retain certain key professionals, management, and staff could adversely affect the Company’s revenues and net income.
The Company relies on key personnel to manage and operate its business, including major revenue generating functions such as its loan and deposit portfolios. The loss of key staff may adversely affect the Company’s ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.
The Company’s controls and procedures may fail or be circumvented.
The Company’s management regularly reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, can provide only reasonable, not absolute, assurances that the objectives of the system of controls are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material and adverse effect on the Company’s business, results of operations, and financial condition.
Because the nature of the financial services business involves a high volume of transactions, the Company faces significant operational risks.
Operational risk is the risk of loss resulting from operations, including, but not limited to, the risk of fraud by employees or persons outside of the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Company could suffer financial loss, face regulatory action and suffer damage to its reputation.
A failure in or breach, including cyber attacks, of the Company’s operational or security systems, or those of its third party vendors and other service providers, could disrupt its businesses, result in the disclosure or misuse of confidential or proprietary information, damage its reputation, increase its costs and cause losses.
As a financial institution, the Company is susceptible to fraudulent activity that may be committed against it or its customers and that may result in financial losses to the Company or its customers, privacy breaches against its customers, or damage to the Company’s reputation. Such fraudulent activity may be in various forms, including check fraud, electronic fraud, wire fraud, phishing, and other dishonest acts. In recent periods, there has been a rise in electronic fraudulent activity within the financial services industry, especially in the commercial banking sector, due to cyber criminals targeting commercial bank accounts. Consistent with industry trends, the Company has also experienced an increase in attempted electronic fraudulent activity.
In addition, the Company’s operations rely on the secure processing, storage and transmission of confidential and other information on its computer systems and networks. Although the Company takes protective measures to maintain the confidentiality, integrity and availability of its and its customers’ information, and modifies these protective measures as circumstances warrant, the nature of the threats continues to evolve. As a result, the Company’s computer systems, software and networks and those of its customers may be vulnerable to unauthorized access, loss or destruction of data (including confidential customer information), account takeovers, unavailability of service, computer viruses or other malicious code, cyber attacks and other events that could have an adverse security impact and result in significant losses by the Company and its customers. Despite the defensive measures the Company takes to manage its internal technological and operational infrastructure, these threats may originate externally from third parties, such as foreign governments, organized crime and other hackers, and outsource or infrastructure-support providers and application developers, or the threats may originate from within the Company. Given the increasingly high volume of transactions, certain errors may be repeated or compounded before they can be discovered and remedied.
The Company also faces the risk of operational disruption, failure, termination or capacity constraints of any of the third parties that facilitate its business activities, including exchanges, clearing agents, clearing houses or other financial intermediaries. Such parties could also be the source of an attack on, or breach of, the Company’s operational systems, data or infrastructure. In addition, as interconnectivity with its customers grows, the Company increasingly faces the risk of operational failure with respect to its customers’ electronic systems.
Although to date the Company has not experienced any material losses relating to cyber attacks or other information security breaches, there can be no assurance that it will not suffer such losses in the future. The Company’s risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats, the outsourcing of some of the Company’s business operations, and the continued uncertain global economic environment. As cyber threats continue to evolve, the Company may be required to expend significant additional resources to continue to modify or enhance its protective measures or to investigate and remediate any information security vulnerabilities.
The Company maintains an insurance policy which it believes provides sufficient coverage at a manageable expense for an institution of its size and scope with similar technological systems. However, the Company cannot assure that this policy will afford coverage for all possible losses or would be sufficient to cover all financial losses, damages, penalties, including lost revenues, should it experience any one or more of its or a third party’s systems failing or experiencing an attack.
The Company’s operations rely on certain external vendors.
The Company utilizes certain external vendors to provide products and services necessary to maintain its day-to-day operations. The Company is exposed to the risk that such vendors fail to perform under these arrangements. This could result in disruption to the Company’s business and have a material adverse impact on the Company’s results of operations and financial condition. There can be no assurance that the Company’s policies and procedures designed to monitor and mitigate vendor risks will be effective in preventing or limiting the effect of vendor non-performance.
Significant legal actions could subject the Company to substantial uninsured liabilities.
From time to time the Company is subject to claims related to its operations. These claims and legal actions, including supervisory actions regulators, could involve large monetary claims and significant costs to defend. To protect the Company from the cost of these claims, it maintains insurance coverage in amounts and with deductibles that are believed to be appropriate for its operations. However, the insurance coverage may not cover all claims against the Company or continue to be available at a reasonable cost. As a result, the Company may be exposed to substantial uninsured liabilities, which could have a material adverse effect on the Company’s business, results of operations, and financial condition.
The Company is subject to claims and litigation pertaining to fiduciary responsibility.
The Company’s customers or others may make claims and take legal action against us related to fiduciary responsibilities. If claims and legal action against the Company are not resolved in a favorable manner to the Company, it could result in a material financial liability or damage to our reputation.
The Dodd-Frank Act may increase the Company’s costs of operations which could adversely impact the Company's results of operations, financial condition or liquidity.
The goals of the Dodd-Frank Act include restoring public confidence in the financial system, preventing another financial crisis, and allowing regulators to identify failings in the system before another crisis can occur. As part of the reform, the Dodd-Frank Act created the Financial Stability Oversight Council, with oversight authority for monitoring and regulating systemic risk, and the Bureau of Consumer Financial Protection, which has broad regulatory and enforcement powers over consumer financial products and services. The Dodd-Frank Act also changes the responsibilities of the current federal banking regulators, imposes additional corporate governance and disclosure requirements in areas such as executive compensation and proxy access, and limits or prohibits proprietary trading and hedge fund and private equity activities of banks. It also impacts areas such as deposit insurance, mortgage lending, capital requirements, securitizations, and insurance.
The scope of the Dodd-Frank Act impacts many aspects of the financial services industry and requires the development and adoption of numerous implementing regulations, some of which have yet to be finalized. Consequently, the effects of the Dodd-Frank Act on the financial services industry and the Company will depend, in large part, upon the extent to which regulators exercise the authority granted to them and the approaches taken to implement the regulations. The Company continually assesses the impact of the Dodd-Frank Act on its business and operations and believes that compliance with these new laws and regulations will likely result in higher costs, but the probable impact cannot be measured with a high degree of certainty. Compliance with the new laws and regulations could adversely impact the Company’s results of operations, financial condition, or liquidity, any of which may impact the market price of the Company’s common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Company owns or leases buildings that are used in the normal course of its business. The corporate headquarters is located at 202 W. Main Street, Frankfort, Kentucky, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statement and Supplementary Data,” of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.
Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2015.
Corporate Headquarters
202 - 208 W. Main Street, Frankfort, KY
Banking Offices
Farmers Bank:
125 W. Main Street, Frankfort, KY
555 Versailles Road, Frankfort, KY
1401 Louisville Road, Frankfort, KY
154 Versailles Road, Frankfort, KY
1301 US 127 South, Frankfort, KY (leased)
128 S. Main Street, Lawrenceburg, KY
201 West Park Shopping Center, Lawrenceburg, KY
838 N. College Street, Harrodsburg, KY
United Bank:
100 United Drive, Versailles, KY
146 N. Locust Street, Versailles, KY
206 N. Gratz, Midway, KY
200 E. Main Street, Georgetown, KY
100 Farmers Bank Drive, Georgetown, KY (leased)
100 N. Bradford Lane, Georgetown, KY
3285 Main Street, Stamping Ground, KY
2509 Sir Barton Way, Lexington, KY
3098 Harrodsburg Road, Lexington, KY (leased)
201 N. Main Street, Nicholasville, KY
995 S. Main Street (Kroger Store), Nicholasville, KY (leased)
986 N. Main Street, Nicholasville, KY
106 S. Lexington Avenue, Wilmore, KY
First Citizens:
425 W. Dixie Avenue, Elizabethtown, KY
3030 Ring Road, Elizabethtown, KY
111 Towne Drive (Kroger Store), Elizabethtown, KY (leased)
645 S. Dixie Blvd., Radcliff, KY
4810 N. Preston Highway, Shepherdsville, KY
157 Eastbrooke Court, Mt. Washington, KY
Citizens Northern:
103 Churchill Drive, Newport, KY
7300 Alexandria Pike, Alexandria, KY
164 Fairfield Avenue, Bellevue, KY
8730 US Highway 42, Florence, KY
34 N. Ft. Thomas Avenue, Ft. Thomas, KY
2911 Alexandria Pike, Highland Heights, KY
2774 Town Center Blvd., Crestview Hills, KY (leased)
Data Processing Center
102 Bypass Plaza, Frankfort, KY
Other
201 W. Main Street, Frankfort, KY
The Company considers its properties to be suitable and adequate based on its present needs.
Item 3.
Item 3. Legal Proceedings
As of December 31, 2015, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted. It is the opinion of management, after discussion with legal counsel, that the disposition or ultimate resolution of such claims and legal actions will not have a material effect upon the consolidated financial statements of the Company.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Beginning January 1, 2014, the Company changed the payment form of its board meeting fees and quarterly fees from 100% cash to 50% in cash and 50% in Company common stock. The shares are issued as part of a plan adopted by the board of directors. Each director has elected to participate by entering an agreement with the Company to accept common stock in lieu of cash for 50% of the director’s board meeting and quarterly fees. As the shares are only issued to directors as part of a plan approved by the board, the shares are exempt from the registration requirements of the Securities Act of 1933, as amended (the “1933 Act”), as a sale not involving any public offering under Section 4(2) of the 1933 Act. The value of the shares issued in payment is determined by the closing price of the Company’s common stock on the NASDAQ Global Select Market on the business trading day immediately preceding the meeting day for board meeting fees and the business trading day immediately preceding the first meeting of the quarter for each quarterly fee. Attendance for committee meetings will continue to be paid completely in cash. As employee directors are not paid director’s fees, only non-employee directors receive stock under this plan.
During 2015, the Company issued a total of 4,030 shares of common stock to its non-employee directors under this plan as compensation for $104 thousand of director fees. The cash retained by the Company by issuing common stock in lieu of paying cash is used for general corporate purposes. There are no brokers involved in the issuance of stock to directors and no commissions or other broker fees are paid.
At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock. No stated expiration dates have been established under any of the previous authorizations. There were no shares of common stock repurchased by the Company during the quarter ended December 31, 2015. There are 84,971 shares that may still be purchased under the various authorizations, though no shares have been purchased since 2008.
Performance Graph
The following graph sets forth a comparison of the five-year cumulative total returns among the shares of Company Common Stock, the NASDAQ Composite Index ("broad market index"), and Southeastern Banks Under $1 Billion Market-Capitalization ("peer group index"). Cumulative shareholder return is computed by dividing the sum of the cumulative amount of dividends for the measurement period and the difference between the share price at the end and the beginning of the measurement period by the share price at the beginning of the measurement period.
The broad market index includes over 3,000 domestic and international based common shares listed on The NASDAQ Stock Market. The peer group index consists of 29 banking companies in the Southeastern United States. The Company is included among those in the peer group index.
Corporate Address
The headquarters of Farmers Capital Bank Corporation is located at:
202 West Main Street
Frankfort, Kentucky 40601
Direct correspondence to:
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone: (502) 227-1668
www.farmerscapital.com
Annual Meeting
The annual meeting of shareholders of Farmers Capital Bank Corporation will be held Tuesday, May 10, 2016 at 11:00 a.m. at the main office of Farmers Bank & Capital Trust Company, Frankfort, Kentucky.
Form 10-K
For a free copy of Farmers Capital Bank Corporation's Annual Report on Form 10-K filed with the Securities and Exchange Commission, please write:
Mark A. Hampton, Executive Vice President, Chief Financial Officer, and Secretary
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone: (502) 227-1668
Web Site Access to Filings
All reports filed electronically by the Company with the United States Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are available at no cost on the Company’s website at www.farmerscapital.com.
NASDAQ Market Participants
J.J.B. Hilliard, W.L. Lyons, LLC
(502) 588-8400
(800) 444-1854
Raymond James & Associates, Inc.
(800) 248-8863
UBS Securities, LLC
(859) 269-6900
(502) 589-4000
The Transfer Agent and Registrar for Farmers Capital Bank Corporation is American Stock Transfer & Trust Company, LLC.
American Stock Transfer & Trust Company, LLC
Shareholder Relations
59 Maiden Lane - Plaza Level
New York, NY 10038
Phone: (800) 937-5449
Fax: (718) 236-2641
Email: Info@amstock.com
Website: www.amstock.com
Additional information is set forth under the captions “Shareholder Information” and “Common Stock Price” on pages 68 to 69 under Part II, Item 7 and Note 18 “Regulatory Matters” in the notes to the Company's 2015 audited consolidated financial statements on pages 112 to 115 of this Form 10-K and is hereby incorporated by reference.
Item 6.
Item 6. Selected Financial Data
1Represents total common equity less intangible assets divided by the number of common shares outstanding at the end of the period.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Glossary of Financial Terms
Allowance for loan losses
A valuation allowance to offset credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred losses in the remainder of the portfolio at the balance sheet date. Management estimates the allowance balance required using past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. Actual losses could differ significantly from the amounts estimated by management.
Dividend payout ratio
Cash dividends paid on common shares, divided by net income.
Basis points
Each basis point is equal to one hundredth of one percent. Basis points are calculated by multiplying percentage points times 100. For example: 3.7 percentage points equals 370 basis points.
Interest rate sensitivity
The relationship between interest sensitive earning assets and interest bearing liabilities.
Net charge-offs
The amount of total loans charged off net of recoveries of loans that have been previously charged off.
Net interest income
Total interest income less total interest expense.
Net interest margin
Taxable equivalent net interest income expressed as a percentage of average earning assets.
Net interest spread
The difference between the taxable equivalent yield on earning assets and the rate paid on interest bearing funds.
Other real estate owned
Real estate not used for banking purposes. For example, real estate acquired through foreclosure.
Provision for loan losses
The charge against current income needed to maintain an adequate allowance for loan losses.
Return on average assets (ROA)
Net income (loss) divided by average total assets. Measures the relative profitability of the resources utilized by the Company.
Return on average equity (ROE)
Net income (loss) divided by average shareholders’ equity. Measures the relative profitability of the shareholders' investment in the Company.
Tax equivalent basis (TE)
Income from tax-exempt loans and investment securities has been increased by an amount equivalent to the taxes that would have been paid if this income were taxable at statutory rates. In order to provide comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.
Weighted average number of common shares outstanding
The number of shares determined by relating (a) the portion of time within a reporting period that common shares have been outstanding to (b) the total time in that period.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following pages present management’s discussion and analysis of the consolidated financial condition and results of operations of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”) in Newport, KY. All significant intercompany transactions and balances are eliminated in consolidation.
At year-end 2015, Farmers Bank had two primary subsidiaries, which include EG Properties, Inc., and Farmers Capital Insurance Corporation (“Farmers Insurance”). EG Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Farmers Bank. Farmers Insurance is an insurance agency in Frankfort, KY. Leasing One Corporation, a company formed to lease commercial property, was dissolved effective at year-end 2015. United Bank has one direct subsidiary, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank. First Citizens has one subsidiary, HBJ Properties, LLC. HBJ Properties, LLC is involved in real estate management and liquidation for certain repossessed properties of First Citizens. Citizens Northern has one direct subsidiary, ENKY Properties, Inc., which is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.
The Company had two active nonbank subsidiaries in 2015, FCB Services, Inc. (“FCB Services”), and FFKT Insurance Services, Inc. (“FFKT Insurance”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT Properties, Inc., which was dissolved effective December 31, 2014, was formed to manage and liquidate certain real estate properties repossessed by the Company. At year-end 2015, the Company had three subsidiaries organized as Delaware statutory trusts that were not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. In January 2016, the Company terminated one of the three trusts as a result of the early extinguishment of debt issued to the trust. For additional information, refer to Note 24 of the Company’s 2015 audited consolidated financial statements.
For a complete list of the Company’s subsidiaries, please refer to the discussion under the heading “Organization” included in Part 1, Item 1 of this Form 10-K. The following discussion should be read in conjunction with the audited consolidated financial statements and related footnotes that follow.
Forward-Looking Statements
This report contains forward-looking statements with the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Statements in this report that are not statements of historical fact are forward-looking statements. In general, forward-looking statements relate to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements. Although management of the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.
Various risks and uncertainties may cause actual results to differ materially from those indicated by the Company’s forward-looking statements. In addition to the risks described under Part 1, Item 1A “Risk Factors” in this report, factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which the Company and its subsidiaries operate) and lower interest margins; competition for the Company’s customers from other providers of financial services; deposit outflows or reduced demand for financial services and loan products; government legislation, regulation, and changes in monetary and fiscal policies (which changes from time to time and over which the Company has no control); changes in interest rates; changes in prepayment speeds of loans or investment securities; inflation; material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; changes in the level of non-performing assets and charge-offs; changes in the number of common shares outstanding; the capability of the Company to successfully enter into a definitive agreement for and close anticipated transactions; unexpected claims or litigation against the Company; expected insurance or other recoveries; technological or operational difficulties; the impact of new accounting pronouncements and changes in policies and practices that may be adopted by regulatory agencies; acts of war or terrorism; the ability of the Parent Company to receive dividends from its subsidiaries; the impact of larger or similar financial institutions encountering difficulties, which may adversely affect the banking industry or the Company; the Company or its subsidiary banks’ ability to maintain required capital levels and adequate funding sources and liquidity; and other risks or uncertainties detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.
The Company’s forward-looking statements are based on information available at the time such statements are made. The Company expressly disclaims any intent or obligation to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or other changes.
Application of Critical Accounting Policies
The Company’s audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices applicable to the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility between reporting periods. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.
The most significant accounting policies followed by the Company are presented in Note 1 of the Company’s 2015 audited consolidated financial statements. These policies, along with the disclosures presented in other financial statement notes and in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and fair value measurements to be the accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
Allowance for Loan Losses
The allowance for loan losses represents credit losses specifically identified in the loan portfolio, as well as management's estimate of probable incurred credit losses in the loan portfolio at the balance sheet date. Determining the amount of the allowance for loan losses and the related provision for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant changes. The loan portfolio also represents the largest asset group on the consolidated balance sheets. Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions “Asset Quality” and “Nonperforming Assets” in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as Notes 1 and 4 of the Company’s 2015 audited consolidated financial statements.
Fair Value Measurements
The carrying value of certain financial assets and liabilities of the Company is impacted by the application of fair value measurements, either directly or indirectly. Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as investment securities classified as available for sale and money market mutual funds. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established.
The Company estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. Active markets are those where transaction volumes are sufficient to provide objective pricing information with reasonably narrow bid/ask spreads and where quoted prices do not vary widely. When the financial instruments are not actively traded, other observable market inputs such as quoted prices of securities with similar characteristics may be used, if available, to determine fair value. Inactive markets are characterized by low transaction volumes, price quotations that vary substantially among market participants, or in which minimal information is released publicly.
When observable market prices do not exist, the Company estimates fair value primarily by using cash flow and other financial modeling methods. The valuation methods may also consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Changes in these underlying factors, assumptions, or estimates in any of these areas could materially impact the amount of revenue or loss recorded.
Additional information regarding fair value measurements can be found in Notes 1 and 19 of the Company’s 2015 audited consolidated financial statements. The following is a summary of the Company’s more significant assets that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by the Company:
Available For Sale Investment Securities and Money Market Mutual Funds
Investment securities classified as available for sale and money market mutual funds are measured and reported at fair value on a recurring basis. These instruments are valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:
●
Mutual funds and equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities; and
●
Government-sponsored agency debt securities, obligations of states and political subdivisions, mortgage-backed securities, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.
At December 31, 2015, all of the Company’s available for sale investment securities and money market mutual funds were measured using observable market data.
Other Real Estate Owned
Other real estate owned (“OREO”) includes properties acquired by the Company through, or in lieu of, actual loan foreclosures and initially carried at fair value less estimated costs to sell. Fair value is generally based on third party appraisals of the property that includes comparable sales data. The carrying value of each OREO property is updated at least annually and more frequently when market conditions significantly impact the value of the property. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. OREO is subsequently accounted for at the lower of carrying amount or fair value less estimated costs to sell. At December 31, 2015, OREO was $21.8 million compared to $32.0 million at year-end 2014.
Impaired Loans
Loans are considered impaired when it is probable that the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. Impaired loans are measured at the present value of expected future cash flows, discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral based on recent appraisals if the loan is collateral dependent. If the value of an impaired loan is less than the unpaid balance, the difference is credited to the allowance for loan losses with a corresponding charge to provision for loan losses. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of a loan is confirmed.
Appraisals used in connection with valuing collateral-dependent loans may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments consist mainly of estimated costs to sell that are not included in certain appraisals or to update appraised collateral values as a result of market declines of similar properties for which a newer appraisal is available. These adjustments can be significant. Impaired loans were $37.2 million and $44.0 million at year-end 2015 and 2014, respectively.
EXECUTIVE LEVEL OVERVIEW
The Company offers a variety of financial products and services at its 34 banking locations in 21 communities throughout Central and Northern Kentucky. The Company has four separately chartered commercial banks that operate under a community banking philosophy. This philosophy focuses primarily on understanding the banking needs of those in our local and surrounding communities and providing them with competitively priced products and a high level of personalized service. The most significant products and services the Company offers include consumer and business lending, checking, savings, and other deposit accounts, automated teller machines, electronic bill payments, and providing trust services and other traditional banking products and services. The primary goals of the Company are to continually improve profitability and shareholder value, increase and maintain a strong capital position, provide excellent service to our customers through our community banking structure, and to provide a challenging and rewarding work environment for our employees.
The Company generates a significant amount of its revenue, cash flows, and net income from interest income and net interest income. The ability to properly manage net interest income under changing market environments is crucial to the success of the Company. Managing credit risk also has a significant influence on the operating results of the Company. While the overall economy has largely improved since the recessionary period between 2007 and 2009 (“Recession”), the Company continues to face an elevated level of nonperforming assets that built up following the Recession. The Company has focused a significant amount of effort to reduce its nonperforming assets over the last several years which has led to a substantial decline of nearly 60% when compared with its peak of $135 million during 2010. Nonperforming assets are at the lowest level since the first quarter of 2009.
As a result of increased business development efforts, the loan portfolio of the Company grew during 2015, the first year-over-year increase since 2008. Although end of period loan balances increased in the comparison, the Company continues its commitment to strong credit underwriting standards, which has at times hindered the opportunity to increase loans. Soft loan demand in the early to middle part of 2015 resulted in a decrease in the average loan balance of $35.2 million or 3.6% compared to a year earlier. Strengthened credit underwriting standards put in place since the Recession have resulted in steady improvement in the overall credit quality of the loan portfolio and a decrease to the allowance for loan losses.
The economic and business environment outlook for 2016 overall is positive, although individual indicators are mixed. In 2016, the Company intends to build on its recent loan growth and continue to reduce nonperforming assets. To further increase profitability, the Company will focus on increasing productivity and lowering operating costs. Since redeeming the final portion of its preferred stock during 2015, the Company is now considering additional alternatives as to the best use of its capital going forward to build shareholder value. In January 2016, the Company announced a dividend of $0.07 per common share and the early extinguishment of $15 million of debt. These two events reflect the initiatives of prudent use of capital and increasing shareholder value. The early extinguishment of debt resulted in a $4.1 million or $.36 per common share gain.
RESULTS OF OPERATIONS
The Company reported net income of $15.0 million for 2015 a decrease of $1.5 million or 8.9% compared to $16.5 million for 2014. On a per common share basis, net income was $1.95 and $1.94 for 2015 and 2014, respectively. Per common share net income was positively impacted by the Company’s redemption of its outstanding preferred shares, which decreased preferred dividends by $1.5 million in the comparison. The preferred share redemptions took place in three separate transactions of 10,000 shares each beginning in the second quarter of 2014 and concluding in June 2015. Selected income statement amounts and related information is presented in the table below.
bp - basis points.
The more significant components related to the Company’s results of operations are included below.
Interest Income
Interest income results from interest earned on earning assets, which primarily includes loans and investment securities. Interest income is affected by volume (average balance), the composition of earning assets, and the related rates earned on those assets. Total interest income for 2015 was $61.2 million, a decrease of $3.1 million or 4.8% compared to $64.4 million for 2014. The decrease in interest income was driven by lower interest from loans of $2.0 million or 4.0%, which was negatively impacted primarily by a decline in the average balance and, to a lesser degree, a lower average rate earned. Interest income on investment securities decreased $1.2 million or 8.1%, driven by a lower average rate earned.
The decrease in the average balance of loans has been accelerated by early payoffs primarily in the earlier part of 2015. The early payoffs relate to several larger balance credits that were refinanced by competitors with terms below the Company’s underwriting standards. In recent years, the Company has focused on strengthening its credit underwriting standards, which has improved the overall credit quality of the loan portfolio. When high quality loan demand is low, available funds are redirected to lower yielding investment securities or cash equivalents or used to manage liquidity. The average interest rates on loans decreased three basis points during 2015, which is reflective of the sluggish economy, competitive factors, and the Company’s ongoing strategy to be more selective in pricing both its loans and deposits.
The overall interest rate environment at year-end 2015, as measured by the Treasury yield curve, remains at very low levels when compared with historical trends. The yield curve flattened in the year-over-year comparison, particularly when comparing the two and ten-year maturity periods. The yields on shorter-term maturity periods, particularly six-month and two-year, increased more significantly than the yields related to longer periods such as the ten and thirty-year maturities. The six-month and two-year maturities increased 37 and 36 basis points, respectively, while yields on the ten and thirty-year maturities increased 8 and 26 basis points, respectively. At year-end 2015, the short-term federal funds interest rate target range was between 0.25% and 0.50%, which was increased during December 2015 from a target of zero to 0.25%. The Federal Reserve Board (“Federal Reserve”) has indicated that it will continue to assess progress toward its objective of maximum employment and two percent inflation when determining the timing and size of future adjustments to the target rate. At December 31, 2015, the national and Kentucky unemployment rates were 5.0% and 5.3%, respectively. At year-end 2015, the national inflation rate was 0.7% based on the Consumer Price Index published by the Bureau of Labor Statistics.
Interest Expense
Interest expense results from incurring interest on interest bearing liabilities, which are made up of interest bearing deposits, federal funds purchased, securities sold under agreements to repurchase, and other borrowed funds. Interest expense is affected by volume, composition of interest bearing liabilities, and the related rates paid on those liabilities. Total interest expense was $8.6 million for 2015, a decrease of $1.5 million or 14.9% compared to $10.2 million for 2014. The decrease in interest expense is attributed primarily to lower interest on deposits of $1.3 million or 30.4%. Both rate declines and lower volume contributed to the decrease, with a significant amount of the decrease related to time deposits. The Company has continued to aggressively reprice higher-rate maturing time deposits downward to lower market rates or to allow them to mature without renewal. Interest expense on long-term borrowings decreased $216 thousand or 3.7%, primarily due to a lower average balance of Federal Home Loan Bank (“FHLB”) borrowings.
Net Interest Income
Net interest income is the most significant component of the Company’s operating earnings. Net interest income is the excess of the interest income earned on earning assets over the interest paid for funds to support those assets. The two most common metrics used to analyze net interest income are net interest spread and net interest margin. Net interest spread represents the difference between the taxable equivalent yields on earning assets and the rates paid on interest bearing liabilities. Net interest margin represents the percentage of taxable equivalent net interest income to average earning assets. Net interest margin will exceed net interest spread because of the existence of noninterest bearing sources of funds, principally demand deposits and shareholders’ equity, which are also available to fund earning assets.
Changes in net interest income and margin result from the interaction between the volume and composition of earning assets, their related yields, and the associated cost and composition of the interest bearing liabilities. Accordingly, portfolio size, composition, and the related yields earned and the average rates paid have a significant impact on net interest spread and margin. The table following this discussion represents the major components of interest earning assets and interest bearing liabilities on a tax equivalent basis. To compare the tax-exempt asset yields to taxable yields, amounts in the table are adjusted to pretax equivalents based on the marginal corporate Federal tax rate of 35%.
Tax equivalent net interest income was $54.3 million for 2015, a decrease of $1.6 million or 2.8% compared to $55.8 million for 2014. Net interest margin was 3.29% for 2015, a decrease of eight basis points from 3.37% for the prior year. The decrease in net interest margin was driven by a seven basis point decline in net interest spread, which was 3.14% for 2015 compared to 3.21% for 2014.
The Company actively monitors and proactively manages the rate sensitive components of both its assets and liabilities in a continuously changing and difficult market environment. Competition in the Company’s market areas continues to be intense, and market interest rates remain very low by historical measures. The Federal Reserve increased the short-term federal funds target rate by a quarter percent in December 2015, the first change to this rate since December 2008, and has indicated that it expects only gradual adjustments in its stance on monetary policy.
Similar to the short-term federal funds target rate, the prime interest rate rose a quarter percent in December 2015. The Company uses the prime interest rate as part of its pricing model primarily on variable rate commercial real estate loans. The prime interest rate can have a significant impact on the Company’s interest income from loans that reprice based on changes to this rate. The Company’s variable interest rate loans contain provisions that limit the amount of increase or decrease in the interest rate during the life of a loan. This will limit the increase or decrease in interest income on loans that have interest rates tied to the prime interest rate. For 2015, the average yield earned on loans was 5.17%, which exceeded the prime interest rate of 3.50% at year-end. Predicting the direction and timing of future interest rates is uncertain.
For 2015, the average rate of the Company’s two most significant components of net interest income, loans and time deposits, both declined. The average rate earned on the Company’s loan portfolio for 2015 declined three basis points to 5.17% and the average rate paid on time deposits decreased 16 basis points to 0.64% compared to 2014. The Company expects its net interest margin to remain relatively flat in the near term based on internal modeling using expectations about future market interest rates, loan volume, the maturity structure of the Company’s earning assets and liabilities, and other factors. Future results, however, could be significantly different than expectations.
Distribution of Assets, Liabilities and Shareholders’ Equity: Interest Rates and Interest Differential
1Average yields on securities available for sale have been calculated based on amortized cost.
2Income and yield stated at a fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.
3Loan balances include principal balances on nonaccrual loans.
4Loan fees included in interest income amounted to $1.3 million for 2015, 2014, and 2013.
The following table is an analysis of the change in net interest income.
Analysis of Changes in Net Interest Income (tax equivalent basis)
1The changes which are not solely due to rate or volume are allocated on a percentage basis using the absolute values of rate and volume variances as a basis for allocation.
2Income stated at fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.
Provision for Loan Losses
The Company recorded a credit to the provision for loan losses in the amount of $3.4 million and $4.4 million for 2015 and 2014, respectively. The allowance for loan losses as a percentage of outstanding loans (net of unearned income) was 1.08% at December 31, 2015 compared to 1.50% at year-end 2014. The credit to the provision for loan losses is attributed to continued improvement in the credit quality of the loan portfolio. The decrease in the credit to the provision is mainly driven by growth of $27.3 million in the loan portfolio during 2015 compared to a decline of $67.9 million in loans outstanding during 2014. Further information about improvements in the Company’s overall credit quality is included under the captions “Allowance for Loan Losses” and “Nonperforming Loans” that follows.
Net charge-offs were $224 thousand and $2.2 million for 2015 and 2014, respectively, down $2.0 million or 90.0% in the comparison. Net charge-offs were 0.02% of average loans outstanding for 2015 compared to 0.23% for the prior year.
Noninterest Income
The components of noninterest income are as follows for the periods indicated:
NM - not meaningful.
The more significant items impacting noninterest income are included below.
●
Service charges and fees on deposits decreased primarily due to lower overdraft fees of $351 thousand or 7.7%, reflecting a decrease in volume attributed in part to overall trends in consumer behavior. All other services charges and fees on deposits increased $140 thousand or 4.3% net.
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Allotment processing fees are down 13.8% in the comparison due to lower volume. The decrease in volume relates to the U.S. Department of Defense (“DOD”) policy that became effective January 1, 2015, which restricts the types of purchases active service members are able to make using the military allotment system for payment.
●
The increase in other service charges, commissions, and fees is attributed primarily to higher interchange fees of $169 thousand or 5.7% due to higher debit card transaction volumes. The Company also received a nonrecurring fee of $63 thousand during 2015 related to credit card merchant activity.
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The decrease in trust fees was driven by unusually large nonrecurring estate fees of $412 thousand during the last half of 2014, offset by nonrecurring fees of $131 thousand in the current year. Overall, trust assets at year-end 2015 were down $7.5 million or 1.2% from a year ago driven mainly by lower market values of managed assets.
●
The net loss on investment securities for in the prior year includes $95 thousand attributed to a municipal bond issuer participating in the Build America Bond (“BAB”) program. The issuer exercised its extraordinary redemption privilege, which was triggered by Federal budget sequestration events. Since the carrying value of the bond exceeded the par value due to unamortized premium, the Company recorded a loss on this investment during 2014. The remaining unamortized premium of BAB investments at December 31, 2015 was $16 thousand, with the related carrying amount of the investments totaling $971 thousand.
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Net gains on the sale of mortgage loans in the current quarter includes $131 thousand related to two larger-balance commercial mortgage loans with an aggregate balance of $12.3 million. The prior year includes a nonrecurring loss of $92 thousand, made up of a $46 thousand related to a group of loans reclassified from held for sale to held for investment and a group of loans sold for a loss of $46 thousand. The volume of loans sold in 2015 increased $10.9 million or 38.0% compared to 2014.
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The decrease in income from company-owned life insurance was driven by a $276 thousand tax-free death benefit that exceeded the cash surrender value during the prior year.
●
The decrease in other income relates mainly to the Company’s equity interest in its tax credit partnerships and to a nonrecurring receipt of $113 thousand during 2014 related to a legal settlement. The Company recorded income of $358 thousand related to these partnerships for 2014 and no income related to the partnerships during the current year. The cumulative share of losses related to the partnerships exceeds the amount invested, resulting in a carrying value of the partnerships of zero.
Noninterest Expense
The components of noninterest expense are as follows for the periods indicated:
The more significant items impacting noninterest expenses are included below.
●
Salaries and employee benefits increased due to higher salary and related payroll taxes of $1.3 million or 5.5%, and an increase in benefits expenses of $911 thousand or 17.1%. The increase in salaries is due to both normal employee annual increases combined with discretionary bonuses in 2015 to certain key employees totaling $495 thousand, of which $231 thousand was paid in 2016. The increase in benefits expenses was driven mainly by claims activity related to the Company’s self-funded health insurance plan and an increase in the actuary-determined benefit expenses related to postretirement medical costs. Postretirement benefit expenses increased mainly due to changes in actuary assumptions used to value the plan liability and expense, primarily the assumption related to the discount rate. The Company had 501 full time equivalent employees at year-end 2015, down from 510 a year earlier.
●
Occupancy expenses decreased mainly due to lower maintenance and utilities costs of $66 thousand or 8.9% and $65 thousand or 7.6%, respectively. Maintenance and utilities costs during 2014 were high due to several large expenses related to repairs.
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Data processing and communication expense increased 6.7%. The increase is mainly due to higher costs related to technology updates in the normal course of business.
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The decrease to deposit insurance expense for 2015 is primarily a result of the improved risk rating by the Federal Deposit Insurance Corporation (“FDIC”) at the Company’s bank subsidiaries. The improved ratings reduced the assessment rate used to determine the amount payable for deposit insurance.
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Other real estate expenses decreased as a result of lower impairment charges of $1.5 million or 58.1%, lower development, operating, and maintenance expenses of $1.5 million or 78.1%, and lower net loss on property sales of $588 thousand or 75.8%. The decrease in development, operating, and maintenance expenses were primarily related to increasing the marketability of two real estate construction projects to better position them for sale during the prior year. The two properties were subsequently sold.
Income Taxes
Income tax expense was $5.3 million for 2015, a decrease of $806 thousand or 13.2% compared to $6.1 million for 2014. The effective income tax rates were 26.1% and 27.0% for 2015 and 2014, respectively. The decrease in income tax expense and the effective tax rate for 2015 is attributed primarily to lower pretax income, which was driven by a higher mix of tax-exempt versus taxable sources of revenue. The effective income tax rates are lower than the U.S. statutory federal rate of 35% primarily as a result of tax-exempt interest income from loans and investment securities, income from life insurance policies, and premium income associated with the Company’s captive insurance subsidiary.
FINANCIAL CONDITION
Total assets of the Company were $1.8 billion at year-end 2015, down $6.7 million or 0.4% compared with year-end 2014. The Company’s overall financial condition continued to improve in the current year. The loan portfolio grew $27.3 million or 2.9% to $959 million during 2015, the first year-over-year increase since 2008. Total nonperforming assets were $54.1 million at year-end. While still elevated, nonperforming assets have declined $80.5 million or 59.8% from their peak of $135 million in the first quarter of 2010. Although net interest margin fell eight basis points to 3.29%, loan quality metrics continued to improve throughout the year. Regulatory capital levels remain significantly above the “well-capitalized” threshold, even after the redemption of the final portion of the Company’s preferred stock in the amount of $10.0 million during the year.
Temporary Investments
Temporary investments consist of interest bearing deposits in other banks, federal funds sold and securities purchased under agreements to resell, and money market mutual funds. The Company uses these funds in the management of liquidity and interest rate sensitivity or as a short-term holding prior to subsequent movement into other investments with higher yields or for other purposes. At December 31, 2015, temporary investments were $92.1 million, an increase of $18.0 million or 24.2% compared to $74.1 million at year-end 2014.
Investment Securities
The investment securities portfolio is comprised primarily of residential mortgage-backed securities, tax-exempt securities of states and political subdivisions, and debt securities issued by U.S. government-sponsored agencies. Substantially all of the Company’s investment securities are designated as available for sale. Total investment securities had a carrying amount of $586 million at year-end 2015, a decrease of $44.3 million or 7.0% compared to $630 million at year-end 2014. Proceeds received from maturing or called investment securities not needed to fund higher-earning loans are either reinvested in similar investments or used to manage liquidity, such as for deposit outflows or other payment obligations. The Company periodically sells investment securities in response to its overall asset/liability management strategy to lock in gains, increase yield, restructure expected future cash flows, and/or enhance its capital position.
The decrease in investment securities was driven by net maturities, calls, and sales of $145 million in the aggregate, which outpaced purchases totaling $110 million. The remainder of the decrease was due to $5.6 million of net premium amortization and a $3.0 million decrease in the market value adjustment related to securities classified as available for sale. The decrease in the value of the available for sale securities portfolio is attributed to a general shift downward in bond prices during the fourth quarter, primarily for the two- and three-year maturity periods. In general, as market interest rates increase, the value of fixed rate investments decrease.
At year-end 2015, investment securities included $5.9 million amortized cost amounts of single-issuer trust preferred capital securities of a U.S. based global financial services firm with an estimated fair value of $5.1 million, down from $5.5 million at year-end 2014. The investment continues to perform according to contractual terms and is rated as investment grade by major rating agencies. The issuer of the securities announced in the first quarter of 2015 an increase in per share common dividend payments and authorization of a common equity repurchase plan. The Company does not intend to sell its investment in these securities, nor does the Company believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company believes these securities are not impaired due to reasons of credit quality or other factors, but rather the unrealized loss is primarily attributed to continuing uncertainties in both international and domestic economies and market volatility. The Company believes that it will collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will recover as they approach their maturity dates.
The Company attributes the unrealized losses in other sectors of the investment securities portfolio to changes in market interest rates and volatility, and thus identifies them as temporary. As discussed further above, market interest rates generally increased throughout 2015. Investment securities with an unrealized loss at December 31, 2015 are performing according to their contractual terms, and the Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company does not have the intent to sell these securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors. All investment securities in the Company’s portfolio are currently performing.
Funds made available from sold, matured, or called bonds are redirected to fund higher yielding loan growth when available, reinvested to purchase additional investment securities, or otherwise employed to improve the composition of the balance sheet and liquidity. The purchase of nontaxable obligations of states and political subdivisions is one of the primary means of managing the Company’s tax position. The impact of the alternative minimum tax related to the Company’s ability to acquire tax-free obligations at an attractive yield is routinely monitored. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages.
The following table summarizes the carrying values of investment securities on December 31, 2015, 2014, and 2013. The investment securities are divided into available for sale and held to maturity securities. Available for sale securities are carried at estimated fair value and held to maturity securities are carried at amortized cost. Corporate debt securities consist primarily of debt issued by a large global financial services firm. Mutual funds and equity securities are attributed to the Company’s captive insurance subsidiary.
The following table presents an analysis of the contractual maturity and tax equivalent weighted average interest rates of investment securities at December 31, 2015. Available for sale securities are stated at estimated fair value and held to maturity securities are stated at amortized cost. Mortgage-backed securities are included in maturity categories based on their stated maturity dates. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. Mutual funds and equity securities have no stated maturity date and are not included in the maturity schedule that follows.
Available for Sale
Held to Maturity
The calculation of the weighted average interest rates for each category is based on the weighted average amortized cost of the securities. The weighted average tax rates on exempt state and political subdivisions are computed based on the marginal corporate Federal tax rate of 35%.
Loans
Loans, net of unearned income, were $959 million at December 31, 2015, an increase of $27.3 million or 2.9% compared to year-end 2014. The loan portfolio grew during the last three quarters of 2015, with three larger-balance commercial real estate loans totaling $26.1 million in the aggregate driving the increase in the fourth quarter. The Company continues a measured and cautious approach to loan originations while working to further reduce its level of nonperforming assets as economic growth remains slow. Generating high quality loans continues to be a challenge, and the increase in outstanding loans occurred despite early payoffs of several larger balance credits. These early payoffs were primarily the result of several larger credits that were refinanced by competitors, many of which were with terms below the Company’s underwriting standards. Loan payments include $4.5 million related to nonaccrual loans and $3.9 million related to performing restructured loans.
From time to time the Company may purchase a limited amount of loans originated by otherwise nonaffiliated third parties. The Company performs its own risk assessment and makes the credit decision on each loan prior to purchase. The Company purchased smaller balance commercial loans totaling $8.3 million and $3.8 million in the aggregate during 2015 and 2014, respectively. The average amount of the purchased loans was $115 thousand for 2015 and $80 thousand for 2014.
The composition of the loan portfolio is summarized in the table that follows. Based on economic forecasts and other available information, the Company expects continued gradual improvements to the local and regional economy during the coming year. An improving economy, particularly where the labor force participation rates increase, could lead to continued growth in the loan portfolio.
On an average basis, loans represented 56.6% of earning assets for 2015, a decrease of 183 basis points compared to 58.5% for 2014. As loan demand changes, available funds are reallocated between temporary investments or investment securities, which typically involve a decrease in credit risk and result in lower yields. The Company does not have direct exposure to the subprime mortgage market. The Company does not originate subprime mortgages nor has it invested in bonds that are secured by such mortgages. Subprime mortgage lending is defined by the Company generally as lending to a borrower that would not qualify for a mortgage loan at prevailing market rates or whereby the underwriting decision is based on limited or no documentation of the ability to repay.
The following table presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2015 which, based on remaining scheduled repayments of principal, are due in the periods indicated.
Loan Maturities
The table below presents the amount of commercial, financial, and agricultural loans and loans secured by real estate outstanding at December 31, 2015 that are due after one year, classified according to sensitivity to changes in interest rates.
Interest Sensitivity
Asset Quality
The Company’s loan portfolio is subject to varying degrees of credit risk. Credit risk is mitigated by diversification within the portfolio, limiting exposure to any single customer or industry, rigorous lending policies and underwriting criteria, and collateral requirements. The Company maintains policies and procedures to ensure that the granting of credit is done in a sound and consistent manner. This includes policies on a company-wide basis that require certain minimum standards to be maintained by its subsidiary banks. However, the policies also permit the subsidiary companies authority to adopt standards that are no less stringent than those included in the company-wide policies. Credit decisions are made at the subsidiary bank level under guidelines established by policy. The Company’s internal audit department performs loan reviews at each subsidiary bank during the year. This review evaluates loan administration, credit quality, documentation, compliance with Company loan standards, and the adequacy of the allowance for loan losses on a consolidated and subsidiary basis.
The provision for loan losses represents charges or credits made to earnings to maintain an allowance for loan losses at a level considered adequate to provide for probable incurred credit losses at the balance sheet date. The allowance for loan losses is a valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses and related provision for loan losses generally fluctuate relative to the level of nonperforming and impaired loans, but other factors impact the amount of the allowance. The Company estimates the adequacy of the allowance using a risk-rated methodology based on the Company’s past loan loss experience, known and inherent risks in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral securing loans, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires significant judgment and the use of estimates that may be susceptible to change.
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current risk factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Actual loan losses could differ significantly from the amounts estimated by management.
The Company’s risk-rated methodology includes segregating non-impaired watch list and past due loans from the general portfolio and allocating a loss percentage to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a separate loss percentage. Each of these loss rates considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into portfolio segments having similar risk characteristics identified as follows: real estate loans, commercial loans, and consumer loans. Each of these portfolio segments is assigned a loss percentage based on their respective sixteen quarter rolling historical loss rates, adjusted for qualitative risk factors.
The qualitative risk factors used in the methodology are consistent with the guidance in the most recent Interagency Policy Statement on the Allowance for Loan Losses issued. Each factor is supported by a detailed analysis performed at each subsidiary bank and is both measureable and supportable. Some factors include a minimum allocation in some instances where loss levels are extremely low and it is determined to be prudent from a safety and soundness perspective. Qualitative risk factors that are used in the methodology include the following for each loan portfolio segment:
●Delinquency trends
●Management experience risk
●Trends in net charge-offs
●Concentration of credit risk
●Trends in loan volume
●Economic conditions risk
●Lending philosophy risk
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
While the overall economy experienced further improvement in 2015, the Company continued its steady progress in reducing its level of nonperforming assets. The Recession resulted in an accumulation of nonperforming assets, and significant deterioration in the Company’s credit quality and collateral values, primarily in residential real estate lending. Credit quality has improved significantly over the last few years, as loan underwriting standards have been strengthened and nonperforming asset levels have declined nearly 60% from the peak that occurred in 2010. Although overall economic growth remains slow, the key economic measures have largely recovered from the Recession. In Kentucky, housing starts continue to gradually increase and foreclosure rates are at the lowest rate since 2007. At year-end 2015, the national and Kentucky unemployment rate was 5.0% and 5.3%, respectively. Unemployment rates have improved significantly from a year ago, but labor force participation rates remain near 30-year lows.
With the continued improvement in the credit quality of the loan portfolio, the level of nonperforming assets are at the lowest level since the first quarter of 2009. Nonperforming loans were $32.2 million at year-end, a decrease of $3.7 million for the year and $75.7 million or 70.1% since peaking at $108 million in the first quarter of 2010. The Company includes accruing restructured loans as a component of its nonperforming loans. Such loans were $23.8 million at year-end 2015 and account for 74.0% of nonperforming loans. Of the $23.8 million in accruing restructured loans, $22.2 million consist of three larger-balance credit relationships secured by various types of real estate collateral. Nonaccrual loans were $8.4 million at year-end 2015, down $3.1 million or 27.2% for the year. Nonperforming assets as a percent of total assets fell eight basis points to 3.0%. High levels of nonperforming assets generally result in loan charge-offs, provisions for loan losses, and impairment charges on repossessed real estate. The Company works with its loan customers on an individual case-by-case basis in order to maximize loan repayments on its challenged credits and typically does not restructure those that are past due.
Impaired loans are those in which the Company does not expect to receive full payment under the contractual terms. Impaired loans are measured at the present value of expected future cash flows discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral taking into consideration estimated costs to sell if the loan is collateral dependent. Collateral values are updated in accordance with policy guidelines by obtaining independent third party appraisals and monitoring sales activity of similar properties in our market area.
At year-end 2015, the Company had $2.9 million in specific reserves allocated to impaired loans. Of this total, $1.2 million or 41.1% is attributed to a group of loans to a single creditor totaling $7.3 million secured by a combination of a real estate development and residential real estate properties. This group of collateral dependent loans is classified as performing restructured loans at year-end 2015.
The Company recorded a credit to the provision for loan losses of $3.4 million in 2015, or $935 thousand lower than the $4.4 million recorded in 2014. The decreased credit is due to loan portfolio growth of $27.3 million or 2.9% during 2015 compared to a decline of $67.9 million or 6.8% during 2014. Historical loss rates, adjusted for current risk factors, have improved due to lower recent charge-off activity that has replaced higher levels that had been included in the early part of the Company’s look-back period used in its allowance for loan losses methodology. The decrease in historical loss rates and charge-off activity is due primarily to stabilizing real estate values, which serves as collateral for nearly 90% of the Company’s loan portfolio. The rapid declines in real estate values experienced beginning in 2008 and continuing through 2011 have leveled off significantly, and the allowance for loan losses reflects this improvement. The Company has also implemented stronger credit underwriting standards in recent years, which has improved overall credit quality measures.
While historical loss rates may continue improving in the near term due to elevated charge-offs falling out of the look-back period, this improvement may not necessarily correlate to a lower provision for loan losses. Other qualitative factors, such as changes in loan volume, the overall makeup of the portfolio, economic conditions, and other risk factors applied to historical loss rates may offset to some degree the impact of decreases to the historical loss rates. Certain credit quality measures are summarized in the table that follows for the periods indicated. Several of these measures are at the best level in the last three years.
1Based on quarter-end balances over the previous three years.
Net charge-offs were $224 thousand for 2015, a decrease of $2.0 million or 90.0% compared to 2014. Net charge-offs were 0.02% of average loans outstanding for 2015 compared to 0.23% for the prior year. Net charge-offs for the current and prior year are each well below the $14.2 million peak which occurred in the early part of the post-recession period of 2009. The allowance for loan losses as a percentage of outstanding loans was 1.08% and 1.50% at year-end 2015 and 2014, respectively. As a percentage of nonperforming loans, the allowance for loan losses was 32.0% and 38.9% at year-end 2015 and 2014, respectively. The allowance for loan losses as a percentage of nonaccrual loans was 123% and 121% at year-end 2015 and 2014, respectively.
The relatively low amount of the allowance for loan losses as a percentage of nonperforming loans is due mainly to the makeup of nonperforming loans, where performing restructured loans represent 74.0% of total nonperforming loans outstanding at year-end 2015. The allowance attributed to credits that are restructured with lower interest rates generally represents the difference in the present value of future cash flows calculated at the loan’s original effective interest rate and the new lower rate. This typically results in a reserve for loan losses that is less severe than for other loans that are collateral dependent. The allowance specifically allocated to impaired loans was $2.9 million or 7.9% of such loans at year-end 2015 compared with $3.4 million or 7.7% a year earlier.
The table below summarizes the loan loss experience for the past five years.
Allowance For Loan Losses
The following table presents an estimate of the allocation of the allowance for loan losses by type for the dates indicated. Although specific allocations exist, the entire allowance is available to absorb losses in any particular category.
Additional information concerning the Company’s asset quality is presented under the caption “Nonperforming Assets” which follows and “Investment Securities” beginning on page 49.
Nonperforming Assets
The Company’s nonperforming assets consist of nonperforming loans, OREO, and other foreclosed assets. Nonperforming loans include nonaccrual loans, performing restructured loans, and loans 90 days or more past due and still accruing interest. Nonaccrual loans are considered to be an indicator of potential losses. The accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Restructured loans occur when a lender, because of economic or legal reasons related to a borrower’s financial difficulty, grants a concession to the borrower that it would not otherwise consider. Restructured loans typically include a reduction of the stated interest rate or an extension of the maturity date. The Company gives careful consideration to identifying which of its challenged credits merit a restructuring of terms that it believes will result in maximum loan repayments and mitigate possible losses. Cash flow projections are carefully scrutinized prior to restructuring any credits; past due credits are typically not granted concessions.
Nonperforming assets were $54.1 million at year-end 2015, a decrease of $13.9 million or 20.4% compared to $67.9 million at year-end 2014. Such assets have been reduced to the lowest level since peaking at $135 million in the first quarter of 2010. Nonperforming assets increased sharply during 2009 mainly as a result of prolonged weaknesses in the overall economy.
Nonperforming assets by category are presented in the table below for the dates indicated.
Additional details related to nonperforming loans were as follows at year-end 2015 and 2014:
Nonperforming Loans
Nonperforming loan activity during 2015 was as follows:
The Company gives careful consideration to identifying which of its challenged credits merit a restructuring of terms that it believes will result in maximum loan repayments and mitigate possible losses. From time to time the Company may modify a customer’s loan, but such modifications may or may not meet the criteria for classification as a restructured troubled debt. Modifications that do not meet the criteria of a troubled debt include:
●
repricing a loan to a current market rate of interest to a borrower with good credit and adequate collateral value in order to retain the customer;
●
changing the payment frequency from monthly to quarterly, semi-annually, or annually where the loan is performing, the borrower has good credit and adequate collateral value, and the Company believes valid reasons exist for the change; or
●
extending the interest only payment period of a performing loan where the borrower has good credit and adequate collateral value in instances where a project may still be in a phase of development or leasing-up, and where the Company believes completion will occur in the near future, or such extension is otherwise in the Company’s best interest.
As modifications are made, management evaluates whether the modification meets the criteria to be classified as a troubled debt. These criteria include two components:
1.
The bank makes a concession on the loan terms that it would not otherwise consider, and
2.
The borrower is experiencing financial difficulty.
The Company’s loan policy provides guidance to its lending personnel regarding restructured loans to ensure those that are troubled debt are properly identified. Additional attention is given to restructured loans through the oversight of the Chief Credit Officer at the Parent Company to ensure that modifications meeting criteria for restructured loans are identified and properly reported.
The table below sets forth on an aggregate basis at December 31, 2015, the types of non-troubled debt restructurings by loan type, number of loans, average loan balance and modification type:
In each of the modifications identified in the table above, management determined the loan was not in troubled condition due to the financial condition of the borrower and related collateral.
The Company has not engaged in loan splitting. Loan splitting is a practice that may occur in work-out situations whereby a loan is divided into two parts - a performing part and a nonperforming part. This benefits a lender by potentially replacing one impaired loan by one smaller good loan and one smaller bad loan. Overall charge-offs and reserve amounts are potentially reduced and the effects of adverse loan classifications may be diminished.
The Company’s comprehensive risk-grading and loan review program includes a review of loans to assess risk and assign a grade to those loans, a review of delinquencies, and an assessment of loans for needed charge-offs or placement on nonaccrual status. The Company had loans in the amount of $54.2 million and $64.7 million at year-end 2015 and year-end 2014, respectively, which were performing but considered potential problem loans and are not included in the nonperforming loan totals in the tables above. These loans, however, are considered in establishing an appropriate allowance for loan losses. The balance outstanding for potential problem credits is mainly a result of lingering weaknesses in the overall economy that continue to strain some of the Company’s customers. Potential problem loans include a variety of borrowers and are secured primarily by various types of real estate including commercial, construction properties, and residential real estate developments. The $10.5 million or 16.2% decrease during the year in the level of potential problem loans is attributed primarily to an overall improvement in credit quality similar to that of the overall portfolio. At December 31, 2015, the five largest potential problem credits were $12.3 million in the aggregate compared to $13.9 million at year-end 2014.
Potential problem loans are identified on the Company’s watch list and consist of loans that require close monitoring by management. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower’s ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower’s financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Certain loans on the Company’s watch list are also considered impaired and specific allowances related to these loans are established in accordance with the appropriate accounting guidance.
Other real estate owned includes real estate properties acquired by the Company through, or in lieu of, actual loan foreclosures. At year-end 2015, OREO was $21.8 million, a decrease of $10.1 million or 31.7% compared to $32.0 million at year-end 2014. OREO has declined $30.7 million or 58.4% from its peak of $52.6 million, which occurred at year-end 2012.
OREO activity for 2015 was as follows:
The reduction in OREO was driven by property sales and impairment charges of $10.5 million and $1.1 million, respectively, which more than offset new acquisitions. Six larger-balance properties with a carrying value of $6.7 million in the aggregate were sold during 2015. This includes three larger-balance residential real estate development properties that sold for $3.5 million in total with a net loss of $75 thousand, and three larger-balance commercial real estate properties sold for $3.1 million in total with a net loss of $123 thousand. The Company’s had two OREO properties at year-end 2015 with a carrying amount in excess of $2.0 million each: one commercial real estate property of $2.6 million, and one commercial rental real estate property of $2.6 million.
Deposits
The Company’s primary source of funding for its lending and investment activities results from its customer deposits, which consist of noninterest and interest bearing demand, savings, and time deposits. A summary of the Company’s deposits is presented in the table that follows. The decrease in time deposits is a result of the Company’s high liquidity position and from its strategy to lower overall funding costs, mainly by allowing higher-rate certificates of deposit to roll off or reprice at significantly lower interest rates. Many of those balances have been moved into interest or noninterest bearing demand accounts or savings accounts by the customer. As rates have decreased throughout the deposit portfolio, many customers have opted to transfer funds from maturing time deposits or investments from other sources into short-term demand or savings accounts. The Company has not sought out or accepted brokered deposits in the past nor does it have plans to do so in the future.
A summary of the Company’s deposits is as follows for the dates indicated:
A summary of average balances for deposits by type and the related weighted average rates paid is as follows for the periods presented:
Maturities of time deposits of $100,000 or more outstanding at December 31, 2015 are summarized as follows:
Short-term Borrowings
Short-term borrowings include funding sources with an original maturity of one year or less. The Company’s short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase, which are generally on an overnight basis. Short-term borrowings primarily represent funds that have been swept out of the deposit accounts of certain qualifying commercial customers into repurchase agreements and accounted for as secured borrowings. A summary of short-term borrowings is as follows:
Long-term Borrowings
Long-term borrowings include funding sources with an original maturity greater than one year. The Company’s long-term borrowings are comprised of securities sold under agreements to repurchase, FHLB advances, and subordinated notes payable to unconsolidated trusts. Long-term securities sold under agreements to repurchase primarily represent obligations related to the Company’s balance sheet leverage transaction that originated in 2007. In this transaction, the Company borrowed $200 million through multiple fixed rate repurchase agreements and used the proceeds to purchase fixed rate Government National Mortgage Association (“GNMA”) bonds that are pledged as collateral. The Company is required to secure the borrowed funds with GNMA bonds valued at 106% of the outstanding principal balance of the borrowings. Principal payments have reduced the outstanding balance of the obligation to $100 million at year-end 2015, with a weighted average interest rate of 3.95%. These borrowings are callable quarterly and mature in November 2017.
The Company has $1.5 million of other long-term repurchase agreements outstanding at year-end 2015 made in the ordinary course of business with commercial customers. These borrowings have a weighted average fixed rate of 0.88% with portions maturing in each subsequent year through 2019.
FHLB advances to the Company’s subsidiary banks are secured by restricted holdings of FHLB stock which participating banks are required to own as well as certain mortgage loans as required by the FHLB. FHLB advances are made pursuant to several different credit programs, which have their own interest rates and range of maturities. Interest rates on FHLB advances are fixed and range between 2.99% and 5.81%, with a weighted average rate of 3.98%. Remaining maturities of FHLB advances extend over multiple time periods through 2020, with a weighted average remaining term of 1.8 years. FHLB advances are generally used to increase the Company’s lending activities and to aid the efforts of asset and liability management by utilizing various repayment options offered by the FHLB. Long-term advances from the FHLB totaled $18.8 million and $19.0 million at December 31, 2015 and 2014, respectively. This represents a decrease of $155 thousand or 0.8% and is attributed to scheduled repayment activity. The Company has not initiated any long-term FHLB borrowings since 2008.
In 2005 and 2007, the Company completed a total of three private offerings of trust preferred securities through separate Delaware statutory trusts (the “Trusts”) sponsored by the Company in the aggregate amount of $47.5 million. The combined $25.0 million proceeds from the first two trusts (“Trusts I and II”) established in 2005 were used to fund the acquisition of Citizens Bancorp. Proceeds from the third trust (“Trust III”) were used primarily to acquire Company shares through a tender offer during 2007. The Company owns all of the common securities of each of the three Trusts. Subsequent to year-end 2015, the Company terminated Trust II as a result of the early extinguishment of debt issued to the trust. Refer to Note 24 of the Company’s 2015 audited consolidated financial statements for additional information.
The Trusts used the proceeds from the sale of preferred securities, plus capital of $1.5 million contributed by the Company to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities. Amounts and general terms related to the Trusts at year-end 2015 are summarized in the table below.
The subordinated notes of the Trusts are redeemable in whole or in part, without penalty, at the Company’s option and are junior in right of payment of all present and future senior indebtedness of the Company. The weighted average interest rate in effect as of the last determination date in 2015 and 2014 was 1.94% and 1.71%, respectively.
Contractual Obligations
The Company’s contractual obligations to make future payments as of December 31, 2015 are as follows:
Long-term FHLB debt represents FHLB advances pursuant to several different credit programs. Long-term FHLB debt, subordinated notes payable, and securities sold under agreements to repurchase are more fully described under the caption “Long-term Borrowings” above and in Note 9 of the Company’s 2015 audited consolidated financial statements. Payments for borrowings in the table above do not include interest. Postretirement benefit obligations are determined by actuaries and estimated based on various assumptions with payouts projected over the next ten years. Estimates can vary significantly each year due to changes in significant assumptions. Operating leases include standard business equipment used in the Company’s day-to-day business as well as the lease of certain branch sites. Operating lease terms generally range from one to five years, with the ability to extend certain branch site leases at the Company’s option. Payments related to leases are based on actual payments specified in the contracts. Employment agreements represent annual minimum base salary amounts payable by the Company to six employees. The Company has employment agreements with its Chief Executive Officer, Chief Operating Officer, Chief Financial Officer, and three key officers of its subsidiaries.
Guarantees
During 2007, the Parent Company entered into a guarantee agreement whereby it agreed to become unconditionally and irrevocably the guarantor of the obligations of three of its subsidiary banks in connection with the $200 million balance sheet leverage transaction. Principal payments by the bank subsidiaries have reduced the outstanding balance of the obligation to $100 million at year-end 2015, which matures in 2017. The borrowings are required to be secured by GNMA bonds valued at 106% of the amount outstanding, although the banks typically maintain an amount in excess of the required minimum. Should any of the subsidiary banks default on its borrowings under the agreement, the GNMA bonds securing the borrowings would be liquidated to satisfy amounts due. If the value of the GNMA bonds fall below the obligation under the contract, the Parent Company is obligated to cover any such shortfall in absence of the subsidiary banks’ ability to do so. The Parent Company believes its subsidiary banks are fully capable of fulfilling their obligations under the borrowing arrangement and that the Parent Company will not be required to make any payments under the guarantee agreement.
Effects of Inflation
The majority of the Company’s assets and liabilities are monetary in nature. Therefore, the Company differs greatly from most commercial and industrial companies that have significant investments in nonmonetary assets, such as fixed assets and inventories. However, inflation does have an important impact on the growth of assets in the banking industry and on the resulting need to increase equity capital at higher than normal rates in order to maintain an appropriate equity to assets ratio. Inflation also affects other noninterest expense, which tends to rise during periods of general inflation.
Market Risk Management
Market risk is the risk of loss arising from adverse changes in market prices and rates. The Company’s market risk is comprised primarily of interest rate risk created by its core banking activities of extending loans and receiving deposits. The Company’s success is largely dependent upon its ability to manage this risk. Interest rate risk is defined as the exposure of the Company’s net interest income to adverse movements in interest rates. Although the Company manages other risks, such as credit and liquidity risk, management considers interest rate risk to be its most significant risk, which could potentially have the largest and a material effect on the Company’s financial condition and results of operations. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates earned on assets and paid on liabilities do not change at the same speed, to the same extent, or on the same basis. Other events that could have an adverse impact on the Company’s performance include changes in general economic and financial conditions, general movements in market interest rates, and changes in consumer preferences. The Company’s primary purpose in managing interest rate risk is to effectively invest the Company’s capital and to manage and preserve the value created by its core banking business.
Management believes the most significant impact on financial and operating results is the Company’s ability to react to changes in interest rates. Management seeks to maintain an essentially balanced position between interest sensitive assets and liabilities in order to protect against the effects of wide interest rate fluctuations.
The Parent Company and each of its subsidiary banks has a Corporate Asset and Liability Management Committee (“ALCO”) which monitors the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity. The Parent Company ALCO also provides guidance and support to each ALCO of the Company’s subsidiary banks and is responsible for monitoring risks on a company-wide basis. The Parent Company ALCO has established minimum standards in its asset and liability management policy that each subsidiary bank must adopt. However, the subsidiary banks are permitted to deviate from these standards so long as the deviation is no less stringent than that of the Corporate policy.
The Company uses a simulation model as a tool to monitor and evaluate interest rate risk exposure. The model is designed to measure the sensitivity of net interest income and net income to changing interest rates over future periods. Forecasting net interest income and its sensitivity to changes in interest rates requires the Company to make assumptions about the volume and characteristics of many attributes, including assumptions relating to the replacement of maturing earning assets and liabilities. Other assumptions include, but are not limited to, projected prepayments, projected new volume, and the predicted relationship between changes in market interest rates and changes in customer account balances. These effects are combined with the Company’s estimate of the most likely rate environment to produce a forecast for the next twelve months. The forecasted results are then compared to the effect of a gradual 200 basis point increase and decrease in market interest rates on the Company’s net interest income and net income. Because assumptions are inherently uncertain, the model cannot precisely estimate net interest income and net income or the effect of interest rate changes on net interest income and net income. Actual results could differ significantly from simulated results.
At December 31, 2015, the model indicated that if rates were to gradually increase by 200 basis points over the next twelve months, then net interest income (TE) and net income would decrease 0.33% and 0.96%, respectively, compared to forecasted results. The model indicated that if rates were to gradually decrease by 200 basis points over the next twelve months, then net interest income (TE) and net income would decrease 1.91% and 5.81%, respectively, compared to forecasted results.
In the current low interest rate environment, it is not practical or possible to reduce certain deposit rates by the same magnitude as rates on earning assets. The average rate paid on the Company’s deposits is already below 2%. This situation magnifies the model’s predicted results when modeling a decrease in interest rates, as earning assets with higher yields have more of an opportunity to reprice at lower rates than lower-rate deposits.
LIQUIDITY
Liquidity measures the ability to meet current and future cash flow needs as they become due. For financial institutions, liquidity reflects the capacity to meet loan demand, accommodate possible outflows in deposits, and to react and capitalize on interest rate market opportunities. A financial institution’s ability to meet its current financial obligations is dependent upon the structure of its balance sheet, its ability to liquidate assets, and its access to alternative sources of funds. The Company’s goal is to meet its near-term funding needs by maintaining a level of liquid funds through its asset/liability management. For the longer term, the liquidity position is managed by balancing the maturity structure of the balance sheet. This process allows for an orderly flow of funds over an extended period of time. The Company’s ALCOs, both at the bank subsidiary and consolidated level, meet regularly and monitor the composition of the balance sheet to ensure comprehensive management of interest rate risk and liquidity.
The Company's objective as it relates to liquidity is to ensure that its subsidiary banks have funds available to meet deposit withdrawals and credit demands without unduly penalizing profitability. In order to maintain a proper level of liquidity, the subsidiary banks have several sources of funds available on a daily basis. For assets, those sources of funds include liquid assets that are readily marketable or that can be pledged, or which mature in the near future. These assets primarily include cash and due from banks, federal funds sold, investment securities, and cash flow generated by the repayment of principal and interest on loans and investment securities. For liabilities, sources of funds primarily include the subsidiary banks' core deposits, FHLB and other borrowings, and federal funds purchased and securities sold under agreements to repurchase. While maturities and scheduled amortization of loans and investment securities are generally a predictable source of funds, deposit outflows and mortgage prepayments are influenced significantly by general interest rates, economic conditions, and competition in our local markets.
The Company uses a liquidity ratio metric to help measure its ability to meet its cash flow needs. This ratio is monitored by ALCO at both the bank and consolidated level. The liquidity ratio is based on current and projected levels of sources and uses of funds. This measure is useful in analyzing cash needs and formulating strategies to achieve desired results. For example, a low liquidity ratio could indicate that the Company’s ability to fund loans might become more difficult. A high liquidity ratio could indicate that the Company may have a disproportionate amount of funds in low yielding assets, which is more likely to occur during periods of sluggish loan demand or economic difficulties. The Company’s liquidity position, as measured by its liquidity ratio, decreased at year-end 2015 when compared to year-end 2014, but is within its ALCO guidelines. The Company’s liquidity ratio remains elevated mainly as a result of its overall net funding position and weak, quality loan demand. The Company continues a cautious lending strategy while continuing efforts to reduce its level of nonperforming assets in a slow growing economic environment.
As of December 31, 2015, the Company had $236 million of additional borrowing capacity under various FHLB, federal funds, and other agreements. However, there is no guarantee that these sources of funds will continue to be available to the Company, or that current borrowings can be refinanced upon maturity, although the Company is not aware of any events or uncertainties that are likely to cause a decrease in the Company’s liquidity from these sources.
Liquidity at the Parent Company level is primarily affected by the receipt of dividends from its subsidiary banks, cash balances maintained, and borrowings from nonaffiliated sources. Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. Capital ratios at all four of the Company’s subsidiary banks exceed regulatory established “well-capitalized” status at December 31, 2015 under the prompt corrective action regulatory framework.
The Parent Company’s primary uses of cash include the payment of dividends to its preferred and common shareholders, injecting capital into subsidiaries, paying interest expense on borrowings, and payments for general operating expenses. The Company redeemed 20,000 shares, or two-thirds, of its original amount of outstanding preferred stock during 2014 in two separate partial redemptions of 10,000 shares each and redeemed the remaining 10,000 shares of preferred stock during the second quarter of 2015.
The Parent Company had cash balances of $36.0 million at year-end 2015, an increase of $3.9 million or 12.1% compared to $32.1 million at year-end 2014. Significant cash receipts of the Parent Company for 2015 include dividend payments from its bank subsidiaries of $14.4 million, a return of capital from nonbank subsidiaries in the amount of $1.4 million, and management fees from subsidiaries of $2.5 million. Significant cash payments by the Parent Company in 2015 include $10.0 million to redeem the final portion of its outstanding preferred stock, $3.0 million for salaries, payroll taxes, and employee benefits, $862 thousand for interest on trust preferred borrowings, and $508 thousand for the payment of dividends on its previously outstanding preferred stock.
Liquid assets consist of cash and cash equivalents and available for sale investment securities. At December 31, 2015, consolidated liquid assets were $703 million, a decrease of $24.6 million or 3.4% from year-end 2014. The decrease in liquid assets was driven by lower available for sale investment securities of $44.2 million or 7.1%, offset by higher money market mutual funds of $11.0 million and higher interest bearing deposits with other banks in the amount of $7.6 million or 11.3%. Although liquid assets decreased in the comparison, liquid assets remain elevated mainly as a result of the Company’s overall net funding position and weak, high-quality loan demand. The overall funding position of the Company changes as loan demand, deposit levels, and other sources and uses of funds fluctuate.
Net cash provided by operating activities was $25.9 million and $29.0 million for 2015 and 2014, respectively. This represents a decrease of $3.1 million or 10.6%, led by a decrease in net mortgage loans sold and a lower net loss on the sale and write downs of OREO. Net cash flow from investing activities was $15.9 million for 2015 and $57.3 million for 2014. This represents a decrease of $41.4 million or 72.3%, driven by loan activity, partially offset by net investment securities. For loans, the Company had net cash outflow representing overall principal advances of $28.2 million in 2015 compared to net principal collections of $56.7 million for 2014. For investment securities, the Company had net cash inflows of $35.8 million for 2015 compared with net cash outflows of $7.0 million for the prior year. Net cash inflows related to investments represent net sale, maturity, and call activity, where proceeds received from the sale, maturity, and calls exceed purchase of investment securities. For 2015, excess cash flows from investment activity were used more to fund new loans, deposit runoff, and the redemption of the final portion of the Company’s preferred stock. In 2014, cash inflows were used to fund deposit runoff, debt repayments, and the redemption of a portion of the Company’s preferred stock.
Net cash used in financing activities was $22.2 million for 2015, a decrease of $31.4 million or 58.5% from $53.6 million for 2014. The decrease was driven by preferred stock redemptions, long-term and short-term borrowing activity, and deposit activity. The Company redeemed $10.0 million of its preferred stock outstanding in 2015 and $20.0 million in 2014. The company had net proceeds on long and short-term borrowings of $556 thousand and $5.8 million, respectively, for the current year compared to net repayments of $8.2 million and $533 thousand, respectively, for 2014. Net outflows related to deposits were $18.2 million for 2015, a decrease of $4.9 million compared to $23.1 million for 2014.
Information relating to commitments to extend credit is disclosed in Note 15 of the Company’s 2015 audited consolidated financial statements. These transactions are entered into in the ordinary course of providing traditional banking services and are considered in managing the Company’s liquidity position. The Company does not expect these commitments to significantly affect the liquidity position in future periods. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options, or similar instruments.
CAPITAL RESOURCES
Shareholders’ equity was $176 million at year-end 2015, an increase of $2.8 million or 1.6% compared to $173 million at year-end 2014. Net income for the period increased shareholders’ equity by $15.0 million, partially offset by the redemption of the remaining portion of the Company’s preferred stock in the amount of $10.0 million during the second quarter, and a $2.0 million after-tax decrease in the unrealized gain on available for sale investment securities. The decrease in the unrealized gain on available for sale investment securities is attributed to an increase in market interest rates. Generally, as market interest rates rise, the value of fixed rate investments such as those held by the Company, decreases.
On January 9, 2009, the Company issued 30,000 shares of Series A, no par value cumulative perpetual preferred stock. The Company redeemed 20,000 of the preferred shares during 2014. On June 8, 2015, the Company redeemed the final 10,000 shares at the stated liquidation value of $1,000 per share, plus accrued dividends of $58 thousand. There was no additional debt or equity issued by the Company in connection with any of the shares redeemed.
At December 31, 2015 and 2014, the Company’s tangible capital ratio was 9.89% and 9.68%, respectively. The tangible capital ratio is defined as tangible equity as a percentage of tangible assets. Tangible common equity to tangible assets, which further excludes outstanding preferred stock, was 9.89% at year-end 2015, up 77 basis points compared to 9.12% at year-end 2014.
Consistent with the objective of operating a sound financial organization, the Company’s goal is to maintain capital ratios well above the regulatory minimum requirements. The Company's capital ratios as of December 31, 2015 and the regulatory minimums were as follows:
1Common Equity Tier 1 (“CET1”) Risk-based, Tier 1 Risk-based, and Total Risk-based Capital ratios are computed by dividing Common Equity Tier 1, Tier 1, or Total Capital, as defined by regulation, by a risk-weighted sum of the assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
2Tier 1 Leverage ratio is computed by dividing Tier 1 Capital by total quarterly average assets, as defined by regulation.
In July 2013, banking regulators issued final rules to bring U.S. banking organizations into compliance with the Basel III capital framework effective in 2015. The Company remains well-capitalized under the new rules, including meeting the effective minimum capital ratios with a fully phased-in capital conservation buffer. For further information, see discussion in Part I, Item 1 under the caption “Capital” beginning on page 15 of this Form 10-K.
The table below represents an analysis of dividend payout ratios and equity to asset ratios for the previous five years.
Subsidiary Banks
The Company’s subsidiary banks are subject to capital-based regulatory requirements which place banks in one of five categories based upon their capital levels and other supervisory criteria. These five categories are: (1) well-capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. To be well-capitalized, a bank must have a CET1 Risk-based Capital ratio of at least 6.5%, a Tier 1 Risk-based Capital ratio of 8%, a Total Risk-based Capital ratio of at least 10%, and a Tier 1 Leverage ratio of at least 5%. As of December 31, 2015, each of the Company’s four subsidiary banks had the following capital ratios for regulatory purposes:
United Bank. During January 2014, United Bank entered into a Memorandum of Understanding (“Memorandum”) with the FDIC and Kentucky Department of Financial Institutions (“KDFI”), which replaced regulatory agreements dating back to November 2009 primarily relating to the bank’s level of nonperforming assets. This Memorandum was terminated in March 2015. In connection with the termination of the Memorandum, the Board of Directors of United Bank agreed to adopt a resolution which included many of the same provisions as the Memorandum, including the requirement to seek approval from the FDIC and KDFI prior to the payment of dividends to the Parent Company. United Bank has both complied with and satisfied the terms of the resolution. As of January 2016, all regulatory agreements and board resolutions between the FDIC, KDFI, and United Bank have been terminated.
Citizens Northern. The FDIC and KDFI entered into a Memorandum with Citizens Northern in September 2010. This Memorandum was terminated and replaced in July 2013. The updated Memorandum included provisions that required the bank to maintain a Tier 1 leverage ratio at or above 9.0% and to obtain regulatory approval before declaring or paying a dividend to the Parent Company. The Memorandum was terminated in August 2015 following a joint examination by the FDIC and KDFI, which found satisfactory compliance with the terms of the Memorandum and overall improvement in financial condition.
Share Buy Back Program
At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock. No stated expiration dates have been established under any of the previous authorizations. There are 84,971 shares that may still be purchased under the various authorizations, though no shares have been purchased since 2008.
Shareholder Information
As of February 4, 2016, the Company had 2,804 shareholders of record, which includes individual participants in securities positions listings.
Common Stock Price
The Company’s common stock is traded on the NASDAQ Stock Market LLC exchange in the Global Select Market tier, with sales prices reported under the symbol: FFKT. The table below lists the high and low sales prices of the Company’s common stock for 2015 and 2014.
The closing price per share of the Company’s common stock on December 31, 2015, the last trading day of the Company’s fiscal year, was $27.11. There were no dividends declared on the Company’s common stock in 2015 or 2014.
Recently Issued Accounting Standards
See Note 1 - “Summary of Significant Accounting Policies,” under the caption “Recently Issued But Not Yet Effective Accounting Standards,” in the Company’s 2015 audited consolidated financial statements for further information about recently issued accounting pronouncements and their expected impact on the Company’s financial statements.
2014 Compared to 2013
The Company reported net income of $16.5 million or $1.94 per common share in 2014 compared to $13.4 million or $1.54 per common share for 2013. This represents an increase of $3.0 million or $.40 per common share. The increase in net income is primarily attributed to a decrease in the provision for loan losses of $1.8 million, an increase in noninterest income of $1.2 million or 5.2%, and lower net interest income and noninterest expenses of $539 thousand or 1.0% and $2.3 million or 3.7%, respectively. Income tax expense increased $1.7 million or 37.5%.
For 2014, the decrease in net interest income from 2013 was driven by lower interest income of $2.4 million or 3.6%, which more than offset a reduction in interest expense of $1.8 million or 15.4%. Interest income on loans decreased $3.6 million or 6.7%, partially offset by an increase in interest from investment securities of $1.2 million or 9.2%. Interest expense on deposits decreased $1.7 million or 28.2%. Interest income on loans was negatively impacted by both volume declines and a lower average rate earned. The increase in interest income on investment securities was driven by higher volume. Interest expense on deposits decreased primarily due to the repricing of higher-rate time deposits to lower market interest rates and a lower average balance outstanding. Net interest margin was 3.37% for 2014, down three basis points from 3.40% for 2013. Net interest spread was 3.21%, down two basis points compared to 3.23%.
The Company recorded a credit to the provision for loan losses in the amount of $4.4 million and $2.6 million for 2014 and 2013, respectively. The increased credit was due to continued overall improvement in the credit quality of the loan portfolio combined with a $67.9 million or 6.8% decline in loans outstanding. Nonperforming loans, impaired loans, early stage delinquencies, and watch list loans all improved during 2014. Historical loss rates, adjusted for current risk factors, also improved as lower charge-off activity replaced the higher levels that spiked upward starting in 2009.
Nonperforming loans decreased $14.6 million or 28.9% in 2014. The allowance for loan losses was $14.0 million at year-end 2014 and $20.6 million at year-end 2013. As a percentage of loans net of unearned income, the allowance for loan losses decreased 56 basis points to 1.50% at year-end 2014 compared to 2.06% a year earlier.
Noninterest income for 2014 was $23.3 million, an increase of $1.2 million or 5.2% compared to $22.1 million for 2013. The increase was driven mainly by income related to the Company’s equity interest in its three tax credit partnerships and trust fees. The Company recorded income of $358 thousand related to these partnerships for 2014 compared with a loss of $304 thousand in the prior year. Trust fees were up $575 thousand or 28.9%, boosted by unusually large nonrecurring estate fees of $412 thousand during the last half of 2014. Income from company-owned life insurance increased $269 thousand or 28.0%, driven by a tax-free death benefit that exceeded the cash surrender value by $276 thousand. Service charges and fees on deposits decreased $395 thousand or 4.8% primarily due to lower overdraft fees of $325 thousand or 6.6%, reflecting a decrease in volume attributed in part to overall trends in consumer behavior. Net gains on the sale of loans decreased $546 thousand or 52.7% due to a 51.0% decline in mortgage loan origination activity.
Total noninterest expenses were $59.3 million for 2014, a decrease of $2.3 million or 3.7% compared to $61.6 million for 2013. The decrease in noninterest expenses was made up primarily by lower expenses related to repossessed real estate of $1.7 million or 24.0% and lower deposit insurance expense of $519 thousand or 22.9%. Other noninterest expense and intangible asset amortization decreased $484 thousand or 6.2% and $135 thousand or 25.0%, respectively.
The $1.7 million decrease in expenses related to repossessed real estate was driven by lower impairment charges of $2.9 million or 52.4%, partially offset by an increase in the net loss on property sales of $594 thousand and higher development, operating, and maintenance expenses of $617 thousand. Deposit insurance expense decreased $519 thousand mainly from the improved risk ratings used in determining the related insurance premiums. The decrease in other noninterest expense is attributable to ongoing cost saving efforts involving numerous line items, the most significant of which was lower internet banking related expenses of $260 thousand or 31.1%. Amortization of intangible assets declined as a result of actuarial determined reductions related to core deposit and customer relationship intangible assets arising from previous business acquisitions.
Income tax expense was $6.1 million for 2014, an increase of $1.7 million or 37.5% compared to $4.4 million for 2013. The effective income tax rates were 27.0% and 24.8% for 2014 and 2013, respectively. The increase in income tax expense and the effective tax rate is attributed primarily to higher pretax income, which was driven by a higher proportion of taxable versus tax-exempt sources of revenue.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required by this item is incorporated by reference to Part II, Item 7 under the caption “Market Risk Management” beginning on page 64 of this Form 10-K.
Item 8.
Item 8. Financial Statements and Supplementary Data
MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING
The management of Farmers Capital Bank Corporation has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements include amounts that are based on management’s best estimates and judgments. Management also prepared other information in the annual report and is responsible for its accuracy and consistency with the financial statements.
The Company’s 2015 consolidated financial statements have been audited by BKD, LLP (“BKD”) independent accountants. Management has made available to BKD all financial records and related data, as well as the minutes of Boards of Directors’ meetings. Management believes that all representations made to BKD during the audit were valid and appropriate.
Lloyd C. Hillard, Jr.
Mark A. Hampton
President and Chief Executive Officer
Executive Vice President, Chief Financial Officer, and Secretary
March 11, 2016
Report of Independent Registered Public Accounting Firm
Audit Committee, Board of Directors
and Stockholders
Farmers Capital Bank Corporation
Frankfort, Kentucky
We have audited Farmers Capital Bank Corporation’s (Company) internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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 report on internal control over financial reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists 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.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company, (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements of the Company and our report dated March 11, 2016, expressed an unqualified opinion thereon.
Louisville, Kentucky
March 11, 2016
Report of Independent Registered Public Accounting Firm
Audit Committee, Board of Directors
and Stockholders
Farmers Capital Bank Corporation
Frankfort, Kentucky
We have audited the accompanying consolidated balance sheets of Farmers Capital Bank Corporation (Company) as of December 31, 2015 and 2014, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2015. The Company’s management is responsible for these financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. Our audits included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2015 and 2014, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 11, 2016, expressed an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
Louisville, Kentucky
March 11, 2016
Consolidated Balance Sheets
See accompanying notes to consolidated financial statements.
Consolidated Statements of Income
See accompanying notes to consolidated financial statements.
Consolidated Statements of Comprehensive Income
See accompanying notes to consolidated financial statements.
Consolidated Statements of Changes in Shareholders’ Equity
See accompanying notes to consolidated financial statements.
Consolidated Statements of Cash Flows
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
The accounting and reporting policies of Farmers Capital Bank Corporation and subsidiaries conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”) and general practices applicable to the banking industry. Significant accounting policies are summarized below.
Principles of Consolidation and Nature of Operations
The consolidated financial statements include the accounts of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”) in Newport, KY.
Farmers Bank’s significant subsidiaries include EG Properties, Inc., and Farmers Capital Insurance Corporation (“Farmers Insurance”). EG Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Farmers Bank. Farmers Insurance is an insurance agency in Frankfort, KY. Leasing One Corporation, a company formed to lease commercial property, was dissolved effective at year-end 2015. United Bank has one wholly-owned subsidiary, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank. First Citizens has one wholly-owned subsidiary, HBJ Properties, LLC. HBJ Properties, LLC is involved in real estate management and liquidation for certain repossessed properties of First Citizens. Citizens Northern has one wholly-owned subsidiary, ENKY Properties, Inc. ENKY Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.
The Company has two active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”) and FFKT Insurance Services, Inc. (“FFKT Insurance”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT Properties, Inc., a company formed to manage and liquidate certain real estate properties repossessed by the Company, was dissolved effective at year-end 2014. The Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation. In January 2016, the Company terminated one of the three trusts as a result of the early extinguishment of debt issued to the trust. Refer to Note 24 for additional information.
The Company provides financial services at its 34 locations in 21 communities throughout Central and Northern Kentucky to individual, business, agriculture, government, and educational customers. Its primary deposit products are checking, savings, and term certificate accounts. Its primary lending products are residential mortgage, commercial lending, and consumer installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Other services include, but are not limited to, cash management services, issuing letters of credit, safe deposit box rental, and providing funds transfer services. Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates used in the preparation of the financial statements are based on various factors including the current interest rate environment and the general strength of the local economy. Changes in the overall interest rate environment can significantly affect the Company’s net interest income and the value of its recorded assets and liabilities. Actual results could differ from those estimates used in the preparation of the financial statements. The allowance for loan losses, carrying value of other real estate owned, actuarial assumptions used to calculate postretirement benefits, and the fair values of financial instruments are estimates that are particularly subject to change.
Reclassifications
Certain amounts in the accompanying consolidated financial statements presented for prior years have been reclassified to conform to the 2015 presentation. These reclassifications do not affect net income or total shareholders’ equity as previously reported.
Segment Information
The Company provides a broad range of financial services to individuals, corporations, and others through its 34 banking locations throughout Central and Northern Kentucky. These services primarily include the activities of lending, receiving deposits, providing cash management services, safe deposit box rental, and trust activities. While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.
Cash Flows
For purposes of reporting cash flows, cash and cash equivalents include the following: cash on hand, deposits from other financial institutions that have an initial maturity of less than 90 days when acquired by the Company, federal funds sold, and securities purchased under agreements to resell, and money market mutual funds. Generally, federal funds sold and securities purchased under agreements to resell are purchased and sold for one-day periods. Net cash flows are reported for loan, deposit, and short-term borrowing transactions.
Investment Securities
Investments in debt and equity securities are classified into three categories. Securities that management has the positive intent and ability to hold until maturity are classified as held to maturity. Securities that are bought and held specifically for the purpose of selling them in the near term are classified as trading securities. The Company had no securities classified as trading during 2015, 2014, or 2013. All other securities are classified as available for sale. Securities are designated as available for sale if they might be sold before maturity. Securities classified as available for sale are carried at estimated fair value. Unrealized holding gains and losses for available for sale securities are reported net of deferred income taxes in other comprehensive income. Investments classified as held to maturity are carried at amortized cost. Amortized cost basis for investment securities includes adjustments made to the cost for previous other-than-temporary impairment (“OTTI”) recognized in earnings, amortization, accretion, and collection of cash.
Interest income includes amortization and accretion of purchase premiums or discounts. Premiums and discounts on securities are amortized using the interest method over the expected life of the securities without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated. Realized gains and losses on the sales of securities are recorded on the trade date and computed on the basis of specific identification of the adjusted cost of each security and are included in noninterest income.
The Company evaluates investment securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. A decline in the market value of investment securities below cost that is deemed other-than-temporary results in a charge to earnings and the establishment of a new cost basis for the security. Substantially all of the Company’s investment securities are debt securities. In estimating OTTI for debt securities, management considers each of the following: (1) the length of time and extent to which fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether market decline was affected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery in fair value. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time. The Company had no OTTI losses during any year in each of the three years in the period ended December 31, 2015.
Investment securities classified as available for sale or held-to-maturity are generally evaluated for OTTI under Financial Accounting Standard Board (“FASB”) Accounting Standards CodificationTM (“ASC”) Topic 320, “Investments-Debt and Equity Securities.” In determining OTTI under ASC Topic 320 the Company considers many factors, including those enumerated above. When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis. If the Company intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, OTTI is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If the Company does not intend to sell the security and it is not more likely than not that it will be required to sell the security before recovery of its amortized cost basis, OTTI is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. The previous amortized cost basis less OTTI recognized in earnings becomes the new amortized cost basis of the investment.
Federal Home Loan Bank and Federal Reserve Bank Stock
Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank stock is carried at cost on the consolidated balance sheets under the caption “Other assets.” These stocks are classified as restricted securities and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income. The amount outstanding at December 31, 2015 and 2014 was $9.4 million.
Loans and Interest Income
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their unpaid principal amount outstanding adjusted for any charge-offs and deferred fees or costs on originated loans. Interest income on loans is recognized using the interest method based on loan principal amounts outstanding during the period. Interest income also includes amortization and accretion of any premiums or discounts over the expected life of acquired loans at the time of purchase or business acquisition. Loan origination fees, net of certain direct origination costs, are deferred and amortized as yield adjustments over the contractual term of the loans.
The Company disaggregates certain disclosure information related to loans, the related allowance for loan losses, and credit quality measures by either portfolio segment or by loan class. The Company segregates its loan portfolio segments based on similar risk characteristics as follows: real estate loans, commercial loans, and consumer loans. Portfolio segments are further disaggregated into classes for certain required disclosures as follows:
Loan disclosures include presenting certain disaggregated information based on recorded investment. The recorded investment in a loan includes its principal amount outstanding adjusted for certain items that include net deferred loan costs or fees, unamortized premiums or discounts, charge offs, and accrued interest. The Company had a total of $285 thousand and $506 thousand of net deferred loan costs at year-end 2015 and 2014, respectively, included in the carrying amount of loans on the balance sheet, which represents .03% and .05% of average loans outstanding for 2015 and 2014, respectively. The amount of net deferred loans costs are not material and are omitted from the computation of the recorded investment included in Note 4 that follows. Similarly, accrued interest receivable on loans was $2.9 million and $3.1 million at year-end 2015 and 2014, respectively, or 0.3% of average loans for both years and has also been omitted from certain information presented in Note 4.
The Company has a loan policy in place that is amended and approved from time to time as needed to reflect current economic conditions and product offerings in its markets. The policy establishes written procedures concerning areas such as the lending authorities of loan officers, committee review and approval of certain credit requests, underwriting criteria, policy exceptions, appraisal requirements, and loan review. Credit is extended to borrowers based primarily on their ability to repay as demonstrated by income and cash flow analysis.
Loans secured by real estate make up the largest segment of the Company’s loan portfolio. If a borrower fails to repay a loan secured by real estate, the Company may liquidate the collateral in order to satisfy the amount owed. Determining the value of real estate is a key component to the lending process for real estate backed loans. If the fair value of real estate (less estimated cost to sell) securing a collateral dependent loan declines below the outstanding loan amount, the Company will write down the carrying value of the loan and thereby incur a loss. The Company uses independent third party state certified or licensed appraisers in accordance with its loan policy to mitigate risk when underwriting real estate loans. Cash flow analysis of the borrower, loan to value limits as adopted by loan policy, and other customary underwriting standards are also in place which are designed to maximize credit quality and mitigate risks associated with real estate lending.
Commercial loans are made to businesses and are secured mainly by assets such as inventory, accounts receivable, machinery, fixtures and equipment, or other business assets. Commercial lending involves significant risk, as loan repayments are more dependent on the successful operation or management of the business and its cash flows. Consumer lending includes loans to individuals mainly for personal autos, boats, or a variety of other personal uses and may be secured or unsecured. Loan repayment associated with consumer loans is highly dependent upon the borrower’s continuing financial stability, which is heavily influenced by local unemployment rates. The Company mitigates its risk exposure to each of its loan segments by analyzing the borrower’s repayment capacity, imposing restrictions on the amount it will loan compared to estimated collateral values, limiting the payback periods, and following other customary underwriting practices as adopted in its loan policy.
The accrual of interest on loans is discontinued when it is determined that the collection of interest or principal is doubtful, or when a default of interest or principal has existed for 90 days or more, unless such loan is well secured and in the process of collection. Past due status is based on the contractual terms of the loan. Interest accrued but not received for a loan placed on nonaccrual status is reversed against interest income. Cash payments received on nonaccrual loans generally are applied to principal until qualifying for return to accrual status. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. The Company’s policy for placing a loan on nonaccrual status or subsequently returning a loan to accrual status does not differ based on its portfolio class or segment.
Commercial and real estate loans delinquent in excess of 120 days and consumer loans delinquent in excess of 180 days are charged off, unless the collateral securing the debt is of such value that any loss appears to be unlikely. In all cases, loans are charged off at an earlier date if classified as loss under the Company’s loan grading process or as a result of regulatory examination. The Company’s charge-off policy for impaired loans does not differ from the charge-off policy for loans outside the definition of impaired.
Loans Held for Sale
The Company’s operations include a limited amount of mortgage banking. Mortgage banking activities include the origination of fixed-rate residential mortgage loans for sale to various third-party investors. Mortgage loans originated and intended for sale in the secondary market, principally under programs with the Federal National Mortgage Association, are carried at the lower of cost or estimated fair value determined in the aggregate and included in net loans on the balance sheet until sold. These loans are sold with the related servicing rights either retained or released by the Company depending on the economic conditions present at the time of origination. Mortgage loans held for sale included in net loans totaled $715 thousand and $380 thousand at December 31, 2015 and December 31, 2014, respectively. Mortgage banking revenues, including origination fees, servicing fees, net gains on sales of mortgage loans, and other fee income were 1.6%, 1.1%, and 1.6% of the Company’s total revenue for the years ended December 31, 2015, 2014, and 2013, respectively.
Provision and Allowance for Loan Losses
The provision for loan losses represents charges or credits made to earnings to maintain an allowance for loan losses at a level considered adequate to provide for probable incurred credit losses at the balance sheet date. The allowance for loan losses is a valuation allowance increased by the provision for loan losses and decreased by net charge-offs. Loan losses are charged against the allowance when management believes the uncollectibility of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance.
The Company estimates the adequacy of the allowance using a risk-rated methodology which is based on the Company’s past loan loss experience, known and inherent risks in the loan portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral securing loans, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires significant judgment and the use of estimates that may be susceptible to change.
The allowance for loan losses consists of specific and general components. The specific component relates to loans that are individually classified as impaired. The general component covers non-impaired loans and is based on historical loss experience adjusted for current risk factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. Actual loan losses could differ significantly from the amounts estimated by management.
The Company’s risk-rated methodology includes segregating non-impaired watch list and past due loans from the general portfolio and allocating a loss percentage to these loans depending on their status. For example, watch list loans, which may be identified by the internal loan review risk-rating process or by regulatory examiner classification, are assigned a certain loss percentage while loans past due 30 days or more are assigned a separate loss percentage. Each of these loss rates considers past experience as well as current factors. The remainder of the general loan portfolio is segregated into portfolio segments having similar risk characteristics identified as follows: real estate loans, commercial loans, and consumer loans. Each of these portfolio segments is assigned a loss percentage based on their respective sixteen quarter rolling historical loss rates, adjusted for qualitative risk factors.
The qualitative risk factors used in the methodology are consistent with the guidance in the most recent Interagency Policy Statement on the Allowance for Loan Losses issued. Each factor is supported by a detailed analysis performed at each subsidiary bank and is both measureable and supportable. Some factors include a minimum allocation in some instances where loss levels are extremely low and it is determined to be prudent from a safety and soundness perspective. Qualitative risk factors that are used in the methodology include the following for each loan portfolio segment:
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Delinquency trends
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Trends in net charge-offs
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Trends in loan volume
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Lending philosophy risk
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Management experience risk
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Concentration of credit risk
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Economic conditions risk
A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
The Company accounts for impaired loans in accordance with ASC Topic 310, “Receivables.” ASC Topic 310 requires that impaired loans be measured at the present value of expected future cash flows, discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral if the loan is collateral dependent. Impaired loans may also be classified as nonaccrual. In many circumstances, however, the Company continues to accrue interest on an impaired loan. Cash receipts on accruing impaired loans are applied to the recorded investment in the loan, including any accrued interest receivable. Cash payments received on nonaccrual impaired loans generally are applied to principal until qualifying for return to accrual status. Loans that are part of a large group of smaller-balance homogeneous loans, such as residential mortgage, consumer, and smaller-balance commercial loans, are collectively evaluated for impairment. Troubled debt restructurings are measured at the present value of estimated future cash flows using the loan’s effective interest rate at inception, or at the fair value of collateral. The Company determines the amount of reserve for troubled debt restructurings that subsequently default in accordance with its accounting policy for the allowance for loan losses.
Mortgage Servicing Rights
Mortgage servicing rights are recognized in other assets on the Company’s consolidated balance sheet at their initial fair value on loans sold with servicing retained. Fair value is based on market prices for comparable mortgage servicing contracts when available, or alternatively, is based on a valuation model that calculates the present value of estimated future net servicing income. Mortgage servicing rights are subsequently measured using the amortization method in which the mortgage servicing right is expensed in proportion to, and over the period of, the estimated future net servicing income of the underlying loans. Impairment is evaluated based on the fair value of the rights, grouping the underlying loans by interest rates. Impairment of a grouping is reported as a valuation allowance. Capitalized mortgage servicing rights were $691 thousand and $694 thousand at December 31, 2015 and 2014, respectively. No impairment of the asset was determined to exist on either of these dates. Mortgage loans serviced for others totaled $200 million and $206 million at December 31, 2015 and 2014, respectively. Mortgage loans serviced for others are not included in the Company’s balance sheets.
Fair Value of Financial Instruments
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 19. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, which are issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Intangible Assets
Intangible assets consist of core deposit and customer relationship intangible assets arising from business acquisitions. Intangible assets are initially measured at fair value and then amortized on an accelerated method over their estimated useful lives, which range between seven and ten years. Such assets are evaluated for impairment whenever changes in circumstances indicate that such an evaluation is necessary. Core deposit intangibles were fully amortized at year-end 2015 and customer relationship intangibles were fully amortized at year-end 2014.
Other Real Estate Owned
Other real estate owned (“OREO”) and held for sale in the accompanying consolidated balance sheets includes properties acquired by the Company through, or in lieu of, actual loan foreclosures. OREO is initially carried at fair value less estimated costs to sell. Fair value of assets is generally based on third party appraisals of the property that includes comparable sales data. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. These assets are subsequently accounted for at the lower of carrying amount or fair value less estimated costs to sell. Operating costs after acquisition are expensed.
Income Taxes
Income tax expense is the total of current year income tax due or refundable and the change in deferred tax assets and liabilities, except for the deferred tax assets and liabilities related to business combinations or components of other comprehensive income. Deferred income tax assets and liabilities result from temporary differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements that will result in taxable or deductible amounts in future years. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in years in which those temporary differences are expected to be recovered or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through income tax expense. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
The Company files a consolidated federal income tax return with its subsidiaries. Federal income tax expense or benefit has been allocated to subsidiaries on a separate return basis. The Company’s policy is to record the accrual of interest and/or penalties relative to income tax matters, if any, in income tax expense.
Premises and Equipment
Premises, equipment, and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation is computed primarily on the straight-line method over the estimated useful lives generally ranging from two to seven years for furniture and equipment and generally ten to 40 years for buildings and related components. Leasehold improvements are amortized over the shorter of the estimated useful lives or terms of the related leases on the straight-line method. Maintenance, repairs, and minor improvements are charged to operating expenses as incurred and major improvements are capitalized. The cost of assets sold or retired and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is included in noninterest income. Land is carried at cost.
Company-owned Life Insurance
The Company has purchased life insurance policies on certain key employees with their knowledge and written consent. Company-owned life insurance is recorded on the consolidated balance sheet at its cash surrender value, which is the amount that can be realized under the insurance contract at the balance sheet date. The related change in cash surrender value and proceeds received under the policies are reported on the consolidated statements of income under the caption “Income from company-owned life insurance.”
Related Party Transactions
In the ordinary course of business, the Company offers loan and deposit products to its directors, executive officers, and principal shareholders - including affiliated companies of which they are principal owners (“Related Parties”). These products are offered on substantially the same terms as those prevailing at the time for comparable transactions with unrelated parties, and these receivables and deposits are included in loans and deposits in the Company’s consolidated balance sheets. Additional information related to these transactions can be found in Note 4 and Note 7.
The Company makes payments to Related Parties in the normal course of business for various services, primarily related to legal fees. For example, certain directors of the Parent Company and its subsidiary banks are partners in law firms that act as counsel to the Company. The following table represents the amount and type of payments to Related Parties, other than director fees, for the periods indicated:
Retirement Plans
The Company maintains a 401(k) salary savings plan and records expense based on the amount of its matching contributions of employee deferrals. The Company also has a nonqualified supplemental retirement plan for certain key employees that it acquired in connection with the Citizens Northern acquisition. Supplemental retirement plan expense allocates the benefits over years of service.
Net Income Per Common Share
Basic net income per common share is determined by dividing net income available to common shareholders by the weighted average total number of common shares issued and outstanding. Net income available to common shareholders represents net income adjusted for preferred stock dividends including dividends declared, accretion of discounts on preferred stock issuances, and cumulative dividends related to the current dividend period that have not been declared as of the end of the period.
Diluted net income per common share is determined by dividing net income available to common shareholders by the total weighted average number of common shares issued and outstanding plus amounts representing the dilutive effect of stock options outstanding and outstanding warrants. The effects of stock options and outstanding warrants are excluded from the computation of diluted earnings per common share in periods in which the effect would be antidilutive. Dilutive potential common shares are calculated using the treasury stock method.
Net income per common share computations were as follows for the years ended December 31, 2015, 2014, and 2013.
Stock options for 22,049 shares of common stock were not included in the determination of diluted net income per common share for 2013 because they were antidilutive. There were no stock options outstanding at year-end 2015 and 2014.
Comprehensive Income
Comprehensive income is defined as the change in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. For the Company this includes net income, the after tax effect of changes in the net unrealized gains and losses on available for sale investment securities, and the after tax changes to the funded status of postretirement benefit plans.
Dividend Restrictions
Banking regulations require maintaining certain capital levels which limit the amount of dividends paid to the Company by its bank subsidiaries. Generally, capital distributions are limited to undistributed net income for the current and prior two years.
Restrictions on Cash
The Company is required to maintain funds in cash and/or on deposit with the Federal Reserve Bank in accordance with reserve requirements specified by the Federal Reserve Board of Governors. The required reserve was $18.0 million and $20.5 million at December 31, 2015 and 2014, respectively.
Equity
Outstanding common shares purchased by the Company are retired. When common shares are purchased, the Company allocates a portion of the purchase price of the common shares that are retired to each of the following balance sheet line items: common stock, capital surplus, and retained earnings. The Company did not purchase any of its outstanding common shares during 2015 or 2014.
Trust Assets
Assets of the Company’s trust departments, other than cash on deposit at subsidiary banks, are not included in the accompanying financial statements because they are not assets of the Company.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the assets has been relinquished. Control over transferred assets is deemed to be surrendered when the assets have been isolated from the Company, the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.
Long-term Assets
Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Stock-Based Compensation
The Company recognizes compensation cost for its Employee Stock Purchase Plan (“ESPP”) and for stock options granted based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of ESPP and stock option awards. Compensation cost is recognized over the required service period, generally defined as the vesting period, on a straight-line basis. There have been no stock options granted by the Company since 2004. All previously outstanding options expired in 2014.
The ESPP was approved by the Company’s shareholders in 2004. The purpose of the ESPP is to provide a means by which eligible employees may purchase, at a discount, shares of the Company’s common stock through payroll withholding. The purchase price of the shares is equal to 85% of their fair market value on specified dates as defined in the plan. The ESPP was effective beginning July 1, 2004. There were 6,329, 6,894, and 8,893 shares issued under the plan during 2015, 2014, and 2013, respectively. Compensation expense related to the ESPP included in the accompanying statements of income was $31 thousand, $32 thousand, and $36 thousand in 2015, 2014, and 2013, respectively.
Following are the weighted average assumptions used and estimated fair market value for the ESPP, which is considered a compensatory plan under ASC Topic 718, “Compensation-Stock Compensation.”
Recently Issued But Not Yet Effective Accounting Standards
In January 2015, the FASB issued Accounting Standards Update (“ASU”) No. 2015-01, “Income Statement-Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items.” This ASU amends U.S. GAAP by removing the concept of extraordinary items, including deleting the definition of “extraordinary items” from the FASB Master Glossary. The revised guidance provides that the nature and financial effects of each event or transaction that is unusual in nature or occurs infrequently or both shall be presented as a separate component of income from continuing operations or, alternatively, disclosed in notes to the financial statements.
The amendments are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015, with early adoption permitted. A reporting entity may apply the amendments prospectively or retrospectively. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In April 2015, the FASB issued ASU No. 2015-03, “Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs.” This ASU addresses balance sheet presentation requirements for debt issuance costs and debt discounts and premiums. ASU No. 2015-03 requires that debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This ASU is effective for financial statements issued for fiscal years beginning after December 15, 2015, and for interim periods within those fiscal years. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In May 2015, the FASB issued ASU No. 2015-07, “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent).” This ASU applies to entities that elect to measure the fair value of an investment using the net asset value per share (or its equivalent) practical expedient. The amendments in this ASU remove the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also clarify that certain disclosure requirements are limited to investments for which the entity has elected to measure the fair value using the practical expedient, and not all investments eligible to be measured at fair value using the practical expedient. The amendments in ASU 2015-07 are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015, with early application permitted. Entities are required to apply the amendments retrospectively to all periods presented. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In August 2015, the FASB issued ASU No. 2015-14, “Revenue from Contracts with Customers (Topic 606): Deferral of the Effective Date.” This ASU defers the effective date of the guidance in ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606).” ASU No. 2015-14 permits public business entities to apply the guidance in ASU No. 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within those reporting periods. Earlier application is permitted, but only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within those reporting periods. The Company is evaluating the potential impact of ASU 2014-09 on its consolidated financial position, results of operations, and cash flows, although it currently does not expect there to be a material impact upon adoption.
In August 2015, the FASB issued ASU No. 2015-15, “Interest-Imputation of Interest (Subtopic 835-30): Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements-Amendments to SEC Paragraphs Pursuant to Staff Announcement at June 18, 2015 EITF Meeting.” This ASU amends FASB ASC Subtopic 835-30 by adding paragraphs which concern line-of-credit arrangements. According to the FASB, ASU No. 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs, which requires entities to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability, did not address presentation or subsequent measurement of debt issuance costs related to line-of-credit arrangements. ASU 2015-15 states that the SEC staff would not object to the deferral and presentation of debt issuance costs as an asset and subsequent amortization of the deferred costs over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the line-of-credit arrangement. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In September 2015, the FASB issued ASU No. 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments,” to amend the guidance for amounts that are adjusted in a merger or acquisition. The amendments in this ASU require that a company that makes an acquisition recognize adjustments to provisional amounts identified during the measurement period in the reporting period in which it determines the adjustment amounts. The amendments require that the buyer record, in the same period's financial statements, the effect on earnings of changes in depreciation, amortization, or other effects on earnings as a result of the change to the provisional amounts and calculate them as if the accounting had been completed at the acquisition date. For public companies this ASU is effective for fiscal years that start after December 15, 2015, including interim periods within those fiscal years. This ASU should be applied prospectively to adjustments to provisional amounts that occur after the effective date of this ASU. Early application is permitted for financial statements that have not been issued. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In January 2016, the FASB issued ASU No. 2016-01, “Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities,” to address certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The amendments include, but are not limited to:
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Requiring most equity investments to be measured at fair value with changes in fair value recognized in net income;
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Simplified impairment testing for equity investments without readily determinable fair value;
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Eliminating disclosure of the method(s) and significant assumptions used in fair value estimates for financial instruments measured at amortized cost for public business entities;
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Eliminating entry price use for certain fair value disclosures by public business entities - looking forward, exit price will now be required; and
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Requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or in financial statement notes.
This standard will be effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods for calendar year-end companies. The Company does not expect there to be a material impact on its consolidated financial position, results of operations, or cash flows upon adoption.
In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842),” to improve financial reporting about leasing transactions. This ASU will require organizations that lease assets (“lessees”) to recognize a lease liability and a right-of-use asset on its balance sheet for all leases with terms of more than twelve months. A lease liability is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis and a right-of-use asset represents the lessee’s right to use, or control use of, a specified asset for the lease term. The amendments in this ASU simplify the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. This ASU leaves the accounting for the organizations that own the assets leased to the lessee (“lessor”) largely unchanged except for targeted improvements to align it with the lessee accounting model and Topic 606, Revenue from Contracts with Customers.
For public companies, the amendments in ASU 2016-02 are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is evaluating the potential impact of ASU 2016-02 on its consolidated financial position, results of operations, and cash flows.
Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.
2. Accumulated Other Comprehensive Income
The following table presents changes in accumulated other comprehensive income by component, net of tax, for the periods indicated.
The following table presents amounts reclassified out of accumulated other comprehensive income by component for the period indicated. Line items in the statement of income affected by the reclassification are also presented.
3. Investment Securities
The following tables summarize the amortized cost and estimated fair values of the securities portfolio at December 31, 2015 and 2014 and the corresponding amounts of gross unrealized gains and losses. The summary is divided into available for sale and held to maturity securities.
At year-end 2015 and 2014, the Company held no investment securities of any single issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of shareholders’ equity.
The amortized cost and estimated fair value of the securities portfolio at December 31, 2015, by contractual maturity, are detailed below. The summary is divided into available for sale and held to maturity securities. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Mutual funds and equity securities in the available for sale portfolio at December 31, 2015 consist of investments by the Company’s captive insurance subsidiary. These securities have no stated maturity and are not included in the maturity schedule that follows.
Mortgage-backed securities are stated separately due to the nature of payment and prepayment characteristics of these securities, as principal is not due at a single date.
Gross realized gains and losses on the sale of available for sale investment securities were as follows for the year indicated.
Investment securities with a carrying value of $315 million and $294 million at December 31, 2015 and 2014, respectively, were pledged to secure public and trust deposits, repurchase agreements, and for other purposes.
Investment securities with unrealized losses at year-end 2015 and 2014 not recognized in income are presented in the tables below. The tables segregate investment securities that have been in a continuous unrealized loss position for less than twelve months from those that have been in a continuous unrealized loss position for twelve months or more. The table also includes the fair value of the related securities.
Unrealized losses included in the tables above have not been recognized in income since they have been identified as temporary. The Company evaluates investment securities for other-than-temporary impairment at least quarterly, and more frequently when economic or market conditions warrant. Many factors are considered, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was effected by macroeconomic conditions, and (4) whether the Company has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an OTTI charge exists involves a high degree of subjectivity and judgment and is based on the information available to the Company at a point in time.
At December 31, 2015, the Company’s investment securities portfolio had gross unrealized losses of $3.2 million, an increase of $228 thousand compared to year-end 2014. Of the total gross unrealized losses at December 31, 2015, $1.8 million or 56.7% relates to investments that have been in a continuous loss position for 12 months or more. Unrealized losses on corporate debt securities and mortgage-backed securities make up $794 thousand and $638 thousand, respectively, of the total unrealized loss on investment securities in a continuous loss position of 12 months or more.
Corporate debt securities in the Company’s investment securities portfolio at December 31, 2015 include single-issuer trust preferred capital securities with an unrealized loss of $793 thousand and a carrying value of $5.1 million. At year-end 2014, these securities had an unrealized loss of $354 thousand. These securities were issued by a national and global financial services firm and were purchased by the Company during 2007. The securities are currently performing and continue to be rated as investment grade by major rating agencies. The issuer of the securities announced in the first quarter of 2015 an increase in per share common dividend payments and authorization of a common equity purchase plan. The Company does not intend to sell these securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company believes these securities are not impaired due to reasons of credit quality or other factors, but rather the unrealized loss is primarily attributed to continuing uncertainties in both international and domestic economies and market volatility. The Company believes that it will collect all amounts due according to the contractual terms of these securities and that the fair values of these securities will recover as they approach their maturity dates.
The Company attributes the unrealized losses in other sectors of its investment securities portfolio to changes in market interest rates and volatility. Investment securities with unrealized losses at December 31, 2015 are performing according to their contractual terms, and the Company does not expect to incur a loss on these securities unless they are sold prior to maturity. The Company does not have the intent to sell these securities nor does it believe it is likely that it will be required to sell these securities prior to their anticipated recovery. The Company does not consider any of the securities to be impaired due to reasons of credit quality or other factors.
4. Loans and Allowance for Loan Losses
Major classifications of loans are summarized in the following table.
From time to time the Company may purchase a limited amount of loans originated by otherwise nonaffiliated third parties. The Company performs its own risk assessment and makes the credit decision on each loan prior to purchase. The Company purchased smaller balance commercial loans totaling $8.3 million and $3.8 million in the aggregate during 2015 and 2014, respectively. The average amount of the purchased loans was $115 thousand for 2015 and $80 thousand for 2014.
Loans with a carrying value of $440 million and $441 million at December 31, 2015 and December 31, 2014, respectively, were pledged to secure borrowings and lines of credit. Such borrowings primarily include FHLB advances and short-term borrowing arrangements with the Federal Reserve.
Loans to directors, executive officers, and principal shareholders of the Parent Company and its subsidiaries (including loans to affiliated companies of which they are principal owners) and loans to members of the immediate family of such persons were $18.5 million at December 31, 2015. Such loans were made in the normal course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other customers and did not involve more than the normal risk of collectability. An analysis of the activity with respect to these loans is presented in the table below.
Activity in the allowance for loan losses by portfolio segment was as follows for each of the three years in the period ended December 31, 2015:
The following tables present individually impaired loans by class of loans for the dates indicated.
The following tables present the balance of the allowance for loan losses and the recorded investment in loans by portfolio segment based on impairment method as of December 31, 2015 and 2014.
The following tables present the recorded investment in nonperforming loans by class of loans as of December 31, 2015 and 2014.
The Company has allocated $1.9 million and $2.2 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings and that are in compliance with those terms as of December 31, 2015 and 2014, respectively. The Company had no commitments to lend additional amounts to customers with outstanding loans that are classified as troubled debt restructurings at December 31, 2015 and 2014.
The Company had three credits modified as troubled debt restructurings during 2015. Additionally, troubled debt restructurings increased as a result of the purchase of a previously-participated portion of a loan to a nonaffiliated bank during the first quarter of 2015. This loan was participated prior to it being restructured. The purchase price paid represented a discount of $482 thousand or 15% of the purchased principal amount. The loan is performing under the terms of the restructuring and the borrower’s financial position has steadily improved. Accretion of the discount was recognized over the contractual life of the loan, which ended in June 2015. There is no further accretion to be recognized. The total outstanding balance related to this credit, which was renewed during June 2015, was $11.2 million at December 31, 2015. This represents 47.2% of the Company’s total restructured loans and is the largest such individual credit. This credit was restructured in 2012 following an interest rate concession and extended amortization term.
The following table presents loans by class modified as troubled debt restructurings that occurred during the year ended December 31, 2015. There were no loans modified as troubled debt restructurings during 2014.
The troubled debt restructurings identified above increased the allowance for loan losses by $356 thousand for 2015. There were no charge-offs related to these loans.
There were no payment defaults during 2015 or 2014 for credits that were restructured during the previous twelve months.
The tables below present an age analysis of past due loans 30 days or more by class of loans as of the dates indicated. Past due loans that are also classified as nonaccrual are included in their respective past due category.
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends and conditions. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes large-balance loans and non-homogeneous loans, such as commercial real estate and certain residential real estate loans. Loan rating grades, as described further below, are assigned based on a continuous process. The amount and adequacy of the allowance for loan loss is determined on a quarterly basis. The Company uses the following definitions for its risk ratings:
Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the borrower’s repayment ability, weaken the collateral or inadequately protect the Company’s credit position at some future date. These credits pose elevated risk, but their weaknesses do not yet justify a substandard classification.
Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.
Doubtful. Loans classified as doubtful have all the weaknesses inherent of those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loans not meeting the criteria above which are analyzed individually as part of the above described process are considered to be pass rated loans, which are considered to have a low risk of loss. Based on the most recent analysis performed, the risk category of loans by class of loans is as follows for the dates indicated. Each of the following tables excludes immaterial amounts attributed to accrued interest receivable.
The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For consumer loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the consumer loans outstanding based on payment activity as of December 31, 2015 and 2014.
5. Other Real Estate Owned
OREO was as follows as of the date indicated:
OREO activity for 2015 and 2014 was as follows:
At December 31, 2015, the Company had a total of $1.6 million of loans secured by residential real estate mortgages that were in the process of foreclosure.
6. Premises and Equipment
Premises and equipment consist of the following.
Depreciation and amortization of premises and equipment was $3.5 million, $3.5 million, and $3.4 million for 2015, 2014, and 2013, respectively.
7. Deposit Liabilities
Major classifications of deposits are summarized as follows for the dates indicated:
At December 31, 2015, the scheduled maturities of time deposits were as follows:
Time deposits that meet or exceed the Federal Deposit Insurance Corporation (“FDIC”) limit of $250 thousand were $23.3 million and $28.0 million at December 31, 2015 and 2014, respectively.
Deposits from directors, executive officers, and principal shareholders of the Parent Company and its subsidiaries (including deposits from affiliated companies of which they are principal owners) and deposits from members of the immediate family of such persons were $28.1 million and $19.8 million at December 31, 2015 and 2014, respectively. Such deposits were accepted in the normal course of business on substantially the same terms as those prevailing at the time for comparable transactions with other customers.
8. Federal Funds Purchased and Other Short-term Borrowings
Federal funds purchased and other short-term borrowings represent borrowings with an original maturity of one year or less. All of the Company’s short-term borrowings are made up of federal funds purchased and securities sold under agreements to repurchase, which represent borrowings that generally mature one business day following the date of the transaction. Information on federal funds purchased and other short-term borrowings is as follows:
Refer to Note 9 for a summary that includes short-term repurchase agreements disaggregated by the class of securities pledged.
9. Securities Sold Under Agreements to Repurchase and Other Long-term Borrowings
Long-term securities sold under agreements to repurchase and other borrowings represent borrowings with an original maturity of greater than one year. The table below displays a summary of the ending balance and average rate for borrowed funds on the dates indicated.
Long-term FHLB advances are made pursuant to several different credit programs, which have their own interest rates and range of maturities. At December 31, 2015, interest rates on all FHLB advances are fixed and range between 2.99% and 5.81%, averaging 3.98%, over a remaining weighted average maturity period of 1.8 years. At December 31, 2014, interest rates on FHLB advances ranged between 2.99% and 5.81%, averaging 3.99%, over a remaining weighted average maturity period of 2.8 years. Long-term FHLB borrowings of $18.0 million at year-end 2015 and 2014 were callable quarterly. None of the long-term FHLB advances are convertible to a floating interest rate.
For FHLB advances, the subsidiary banks pledge FHLB stock and fully disbursed, otherwise unencumbered, 1-4 family first mortgage loans as collateral for these advances as required by the FHLB. Based on this collateral and the Company’s holdings of FHLB stock, the Company is eligible to borrow up to an additional $119 million from the FHLB at year-end 2015.
During 2005, the Company completed two private offerings of trust preferred securities through two separate Delaware statutory trusts sponsored by the Company. Farmers Capital Bank Trust I (“Trust I”) sold $10.0 million of preferred securities and Farmers Capital Bank Trust II (“Trust II”) sold $15.0 million of preferred securities. The proceeds from the offerings were used to fund the cash portion of the acquisition of Citizens Bancorp, Inc., the former parent company of Citizens Northern. The trust preferred securities mature September 30, 2035 and are redeemable at any time by the Trust at par. Subsequent to year-end 2015, the Company terminated Trust II as a result of the early extinguishment of debt issued to the trust. Refer to Note 24 for additional information.
Farmers Capital Bank Trust III (“Trust III”), a Delaware statutory trust sponsored by the Company, was formed during 2007 for the purpose of financing the cost of acquiring Company shares under a share repurchase program. Trust III sold $22.5 million of trust preferred securities to the public with an initial fixed rate of 6.60% through October 2012, thereafter at a variable rate of interest, reset quarterly, equal to the 3-month LIBOR plus a predetermined spread of 132 basis points. The trust preferred securities mature on November 1, 2037 and are redeemable at any time by the Trust at par. Trust I, Trust II, and Trust III are hereafter collectively referred to as the “Trusts.”
The Trusts used the proceeds from the sale of preferred securities, plus capital contributed to establish the trusts, to purchase the Company’s subordinated notes in amounts and bearing terms that parallel the amounts and terms of the respective preferred securities. The subordinated notes to Trust I and Trust II mature in 2035 and in 2037 for Trust III, and bear a floating interest rate (current three-month LIBOR plus 150 basis points in the case of the notes held by Trust I, current three-month LIBOR plus 165 basis points in the case of the notes held by Trust II, and current three-month LIBOR plus 132 basis points in the case of the notes held by Trust III). Interest on the notes is payable quarterly. Interest payments to the Trusts and distributions to preferred shareholders by the Trusts may be deferred for 20 consecutive quarterly periods. There have been no deferrals of interest payments during the life of the Trusts.
The subordinated notes are redeemable in whole or in part, without penalty, at the Company’s option. The notes are junior in right of payment of all present and future senior indebtedness. At December 31, 2015 and 2014 the balance of the subordinated notes payable to Trust I, Trust II, and Trust III was $10.3 million, $15.5 million, and $23.2 million, respectively. The interest rates in effect as of the last determination date for 2015 were 2.10%, 2.26%, and 1.65% for Trust I, Trust II, and Trust III, respectively. For 2014 these rates were 1.76%, 1.91%, and 1.55% for Trust I Trust II, and Trust III, respectively.
The Company is not considered the primary beneficiary of the Trusts; therefore the Trusts are not consolidated into its financial statements. Accordingly, the Company does not report the securities issued by the Trusts as liabilities, but instead reports as liabilities the subordinated notes issued by the Company and held by the Trusts. The Company, which owns all of the common securities of the Trusts, accounts for its investment in each of the Trusts as other assets. The Company records interest expense on the corresponding notes issued to the Trusts on its statements of income.
The subordinated notes, net of the Company’s investment in the Trusts, may be included in Tier 1 capital (with certain limitations applicable) under current regulatory capital guidelines and interpretations. The net amount of subordinated notes in excess of the limit may be included in Tier 2 capital, subject to restrictions. At year-end 2015 and 2014, the Company’s Tier 1 capital included $47.5 million, which represents the full amount of the subordinated notes net of the Company’s investment in the Trusts.
The Company entered into a balance sheet leverage transaction in 2007 whereby it borrowed $200 million in multiple fixed rate term repurchase agreements with an initial weighted average cost of 3.95% and invested the proceeds in Government National Mortgage Association (“GNMA”) bonds, which were pledged as collateral. The Company is required to secure the borrowed funds by GNMA bonds valued at 106% of the outstanding principal balance. The borrowings have an outstanding balance of $100 million at December 31, 2015, are callable on a quarterly basis, and mature in November 2017. The repurchase agreements are held by three of the Company’s subsidiary banks and are guaranteed by the Parent Company. The Company has $1.5 million of other long-term repurchase agreements outstanding at December 31, 2015 made in the ordinary course of business with commercial customers. The average interest rate related to these other fixed rate borrowings is 0.88%.
Maturities of long-term borrowings at December 31, 2015 are as follows:
Securities sold under agreements to repurchase represent transactions where the Company sells certain of its investment securities and agrees to repurchase them at a specific date in the future. Securities sold under agreements to repurchase are accounted for as secured borrowing and reflect the amount of cash received in connection with the transaction.
Securities sold under agreements to repurchase are collateralized by U.S. government agency securities, primarily mortgage-backed securities. The Company may be required to provide additional collateral securing the borrowings in the event of principal pay downs or a decrease in the market value of the pledged securities. The Company mitigates this risk by monitoring the market value and liquidity of the collateral and ensuring that it holds a sufficient level of eligible securities to cover potential increases in collateral requirements.
The following table represents the remaining maturity of both short and long-term repurchase agreements disaggregated by the class of securities pledged.
10. Income Taxes
The components of income tax expense are as follows:
An analysis of the difference between the effective income tax rates and the statutory federal income tax rate follows.
The tax effects of the significant temporary differences that comprise deferred tax assets and liabilities at December 31, 2015 and 2014 are as follows:
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2015.
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
At year-end 2015, no unrecognized tax benefits remain that would favorably affect the effective income tax rate in future periods.
The Company’s policy is to record the accrual of interest or penalties relative to unrecognized tax benefits, if any, in its income tax expense accounts. There was no amount accrued for interest at December 31, 2015 and 2014. No penalties were accrued or recorded during any year in the three years ended December 31, 2015.
The Company files U.S. federal and various state income tax returns. The Company is no longer subject to income tax examinations by taxing authorities for the years before 2012.
11. Retirement Plans
The Company maintains a salary savings plan that covers substantially all of its employees. The Company matches voluntary tax deferred employee contributions at 50% of eligible deferrals up to a maximum of 6% of the participants’ compensation. The Company may, at the discretion of its Board, contribute an additional amount based upon a percentage of covered employees’ salaries. The Company did not make a discretionary contribution during 2015, 2014, or 2013. Discretionary contributions are allocated among participants in the ratio that each participant’s compensation bears to all participants’ compensation. Eligible employees are presented with numerous investment alternatives related to the salary savings plan. Those alternatives include various stock and bond mutual funds ranging from traditional growth funds to more stable income funds as well as an option to invest in bank certificates of deposits. Company shares are not an available investment alternative in the salary savings plan. Total retirement plan expense for 2015, 2014, and 2013 was $531 thousand, $483 thousand, and $528 thousand, respectively.
In connection with its acquisition of Citizens Northern, the Company acquired nonqualified supplemental retirement plans for certain key employees. Benefits provided under these plans are unfunded, and payments to plan participants are made by the Company.
The following schedules set forth a reconciliation of the changes in the supplemental retirement plans’ benefit obligation and funded status for the years ended December 31, 2015 and 2014.
The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated.
The following table presents estimated future benefit payments in the period indicated.
Amounts recognized in accumulated other comprehensive income as of December 31, 2015 and 2014 are as follows:
The estimated cost that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year is as follows:
12. Common Stock Options
During 1997, the Company’s Board of Directors approved a nonqualified stock option plan (the “Plan”), subsequently approved by the Company’s shareholders, that provided for the granting of stock options to key employees and officers of the Company. The Plan provided for the granting of options to purchase up to 450,000 shares of the Company’s common stock at a price equal to the fair value of the Company’s common stock on the date the option was granted. The options expired after ten years from the grant date and had to be held for a minimum of one year before they could be exercised. Forfeited options were available for the granting of additional stock options under the Plan.
Options forfeited from the initial grant in 1997 were used to grant options during 2000 and 2004. Total options granted were 450,000, 54,000, and 40,049 in the years 1997, 2000, and 2004, respectively. All unexercised options granted under the Plan expired during 2014 and the Company no longer grants options under the Plan. There were no options exercised or granted in any year in the three-year periods ending December 31, 2015, nor were there any modifications or cash paid to settle stock option awards during those periods.
13. Postretirement Medical Benefits
The Company provides lifetime medical and dental benefits upon retirement for certain employees meeting the eligibility requirements as of December 31, 1989 (“Plan 1”). Additional participants are not eligible to be included in Plan 1 unless they met the requirements on this date. There were 38 of such participants in Plan 1 at year-end 2015. During 2003, the Company implemented an additional postretirement health insurance program (“Plan 2”). Under Plan 2, any employee meeting the service requirement of 20 years of full time service to the Company and is at least age 55 years of age upon retirement is eligible to continue their health insurance coverage. Under both plans, retirees not yet eligible for Medicare have coverage identical to the coverage offered to active employees. Under both plans, Medicare-eligible retirees are provided with a Medicare Advantage plan. The Company pays 100% of the cost of Plan 1. The Company and the retirees each pay 50% of the cost under Plan 2. Both plans are unfunded. Employees hired on or after January 1, 2016 are not eligible for benefits under Plan 2. The following schedules set forth a reconciliation of the changes to the benefit obligation and funded status of the plans for the years ended December 31, 2015 and 2014.
The following table provides disclosure of the net periodic benefit cost as of December 31 for the years indicated. The Company expects benefit payments of $393 thousand for 2016.
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. For measurement purposes, the rate of increase in pre-Medicare medical care claims costs was 6.5%, 6.0%, and 5.5% for 2016, 2017, and 2018, respectively, then grading down by .25% annually to 4.75% for 2021 and thereafter. For dental claims cost, it was 5% for 2016 and thereafter. A 1% change in the assumed health care cost trend rates would have the following incremental effects:
The following table presents estimated future benefit payments in the period indicated.
Amounts recognized in accumulated other comprehensive income as of December 31, 2015 and 2014 are as follows:
The estimated costs that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year are as follows:
14. Leases
The Company leases certain branch sites and banking equipment under various operating leases. Branch site leases have renewal options of varying lengths and terms. The following table presents estimated future minimum rental commitments under these leases for the period indicated.
Rent expense was $419 thousand, $407 thousand, and $399 thousand for 2015, 2014, and 2013, respectively.
15.
Financial Instruments With Off-Balance Sheet Risk
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. The financial instruments include commitments to extend credit in the form of unused lines of credit and standby letters of credit.
These financial instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. Total commitments to extend credit were $172 million and $161 million at December 31, 2015 and 2014, respectively. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of credit, if deemed necessary by the Company, is based on management’s credit evaluation of the counter-party. Collateral held varies, but may include accounts receivable, marketable securities, inventory, premises and equipment, residential real estate, and income producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Since many of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. The credit risk involved in issuing letters of credit is essentially the same as that received when extending credit to customers. The fair value of these instruments is not considered material for disclosure. The Company had $10.5 million and $13.3 million in irrevocable letters of credit outstanding at December 31, 2015 and 2014, respectively.
The contractual amount of financial instruments with off-balance sheet risk was as follows at year-end:
16. Concentration of Credit Risk
The Company’s bank subsidiaries actively engage in lending, primarily in their home counties around Central and Northern Kentucky and adjacent areas. Collateral is received to support these loans as deemed necessary. The more significant categories of collateral include cash on deposit with the Company’s banks, marketable securities, income producing properties, commercial real estate, home mortgages, and consumer durables. Loans outstanding, commitments to make loans, and letters of credit range across a large number of industries and individuals. The obligations are significantly diverse and reflect no material concentration in one or more areas, other than most of the Company’s loans are in Kentucky and secured by real estate and thus significantly affected by changes in the Kentucky economy.
17.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. As of December 31, 2015, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted. It is the opinion of management, after discussion with legal counsel, that the disposition or ultimate resolution of such claims and legal actions will not have a material effect upon the consolidated financial statements of the Company.
18.
Regulatory Matters
The Company and its subsidiary banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements will initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the banks must meet specific capital guidelines that involve quantitative measures of the banks’ assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and its subsidiary banks’ capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Company and its subsidiary banks to maintain minimum amounts and ratios (set forth in the tables below). Prior to January 1, 2015, this included minimums of Tier 1 and total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital to average assets (as defined). U.S. banking regulators adopted final rules related to standards on bank capital adequacy and liquidity (commonly referred to “Basel III”) that were effective for the Company beginning on January 1, 2015, subject to a phase-in period for certain provisions extending through January 1, 2019. The rules include a new common equity Tier 1 capital ratio, an increase to the minimum Tier 1 capital ratio, an increase to risk-weightings of certain assets, implementation of a new capital conservation buffer in excess of the required minimum (which is set to be phased in beginning in 2016), and changes to how regulatory capital is defined. The Company and each of its bank subsidiaries met the minimum capital ratios and a fully phased-in capital conservation buffer under the new rules at year-end 2015.
As of December 31, 2015, the most recent notification from the FDIC categorized the banks as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the banks must maintain minimum Common Equity Tier 1 Risk-based, Tier 1 Risk-based, Total Risk-based, and Tier 1 Leverage ratios as set forth in the tables below. There are no conditions or events since that notification that management believes have changed the institutions’ category.
The regulatory capital amounts and ratios of the consolidated Company and its subsidiary banks are presented in the following tables for the dates indicated.
1Common Equity Tier 1 Risk-based, Tier 1 Risk-based, and Total Risk-based Capital ratios are computed by dividing a bank’s Common Equity Tier 1, Tier 1, or Total Capital, as defined by regulation, by a risk-weighted sum of the bank’s assets, with the risk weighting determined by general standards established by regulation. The safest assets (e.g., government obligations) are assigned a weighting of 0% with riskier assets receiving higher ratings (e.g., ordinary commercial loans are assigned a weighting of 100%).
2Tier 1 Leverage ratio is computed by dividing a bank’s Tier 1 Capital by its total quarterly average assets, as defined by regulation.
Payment of dividends by the Company’s subsidiary banks is subject to certain regulatory restrictions as set forth in national and state banking laws and regulations. Generally, capital distributions are limited to undistributed net income for the current and prior two years, subject to the capital requirements as summarized above.
On June 8, 2015, the Company redeemed the final 10,000 shares of its remaining outstanding Series A preferred stock. The shares were redeemed at the stated liquidation value of $1,000 per share, plus accrued dividends. The Company originally issued 30,000 shares of its Series A preferred stock in 2009. The redemption was the third and final partial redemption of the original shares issued. No additional debt or equity was issued in connection with any of the shares redeemed.
Summary of Regulatory Agreements
United Bank
During January 2014, United Bank entered into a Memorandum of Understanding (“Memorandum”) with the FDIC and Kentucky Department of Financial Institutions (“KDFI”), which replaced regulatory agreements dating back to November 2009 primarily relating to the bank’s level of nonperforming assets. This Memorandum was terminated in March 2015. In connection with the termination of the Memorandum, the Board of Directors of United Bank agreed to adopt a resolution which included many of the same provisions as the Memorandum, including the requirement to seek approval from the FDIC and KDFI prior to the payment of dividends to the Parent Company. United Bank has both complied with and satisfied the terms of the resolution. As of January 2016, all regulatory agreements and board resolutions between the FDIC, KDFI, and United Bank have been terminated.
Citizens Northern
The FDIC and KDFI entered into a Memorandum with Citizens Northern in September 2010. This Memorandum was terminated and replaced in July 2013. The updated Memorandum included provisions that required the bank to maintain a Tier 1 leverage ratio at or above 9.0% and to obtain regulatory approval before declaring or paying a dividend to the Parent Company. The Memorandum was terminated in August 2015 following a joint examination by the FDIC and KDFI, which found satisfactory compliance with the terms of the Memorandum and overall improvement in financial condition.
19. Fair Value Measurements
ASC Topic 820, “Fair Value Measurements and Disclosures,” defines fair value, establishes a framework for measuring fair value, and sets forth disclosures about fair value measurements. ASC Topic 825, “Financial Instruments,” allows entities to choose to measure certain financial assets and liabilities at fair value. The Company has not elected the fair value option for any of its financial assets or liabilities.
ASC Topic 820 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. It also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. This Topic describes three levels of inputs that may be used to measure fair value:
Level 1:
Quoted prices for identical assets or liabilities in active markets that the entity has the ability to access at the measurement date.
Level 2:
Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.
Level 3:
Significant unobservable inputs that reflect a reporting entity’s own assumptions supported by little or no market activity, about the assumptions that market participants would use in pricing the asset or liability.
Following is a description of the valuation method used for instruments measured at fair value on a recurring basis. For this disclosure, the Company only has available for sale investment securities and money market mutual funds classified as cash equivalents that meet the requirement. The carrying value of the $11.0 million in money market mutual funds is equivalent to its fair value and based on Level 1 inputs.
Available for sale investment securities
Valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:
●
Mutual funds and equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities and are considered Level 1 inputs.
●
Government-sponsored agency debt securities, obligations of states and political subdivisions, mortgage-backed securities, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources and are considered Level 2 inputs.
Fair value disclosures for available for sale investment securities as of December 31, 2015 and 2014 are as follows:
The Company is required to measure and disclose certain other assets and liabilities at fair value on a nonrecurring basis in periods following their initial recognition. The Company’s disclosure about assets and liabilities measured at fair value on a nonrecurring basis consists of impaired loans and OREO. The carrying value of these assets are adjusted to fair value on a nonrecurring basis through impairment charges as described more fully below.
Impairment charges on collateral-dependent loans are recorded by either an increase to the provision for loan losses and related allowance or by direct loan charge-offs. The fair value of collateral-dependent impaired loans with specific allocations of the allowance for loan losses is measured based on recent appraisals of the underlying collateral. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments consist mainly of estimated costs to sell that are not included in certain appraisals or to update appraised collateral values as a result of market declines of similar properties for which a newer appraisal is available. These adjustments can be significant and typically result in a Level 3 classification of the inputs for determining fair value.
OREO includes properties acquired by the Company through, or in lieu of, actual loan foreclosures and is carried at fair value less estimated costs to sell. Fair value of OREO at acquisition is generally based on third party appraisals of the property that includes comparable sales data and is considered as Level 3 inputs. The carrying value of each OREO property is updated at least annually and more frequently when market conditions significantly impact the value of the property. If the carrying amount of the OREO exceeds fair value less estimated costs to sell, an impairment loss is recorded through noninterest expense.
The following table represents the carrying amount of assets measured at fair value on a nonrecurring basis and still held by the Company as of the dates indicated. The amounts in the table only represent assets whose carrying amount has been adjusted by impairment charges during the period in a manner as described above; therefore, these amounts will differ from the total amounts outstanding. With the exception of those calculated using the collateral valuation method, collateral-dependent impaired loan amounts in the tables below exclude restructured loans since they are measured based on present value techniques, which are outside the scope of the fair value reporting framework.
The following table presents impairment charges recorded in earnings on assets measured at fair value on a nonrecurring basis.
The following table presents quantitative information about unobservable inputs for assets measured on a nonrecurring basis using Level 3 measurements. As previously discussed, the fair value of real estate securing collateral-dependent impaired loans and OREO are based on current third party appraisals. It is often necessary, however, for the Company to discount the appraisal amounts supporting its impaired loans and OREO. These discounts relate primarily to marketing and other holding costs that are not included in certain appraisals or to update values as a result of market declines of similar properties for which newer appraisals are available. Discounts also result from contracts to sell properties entered into during the period. The range of discounts is presented in the table below for 2015 and 2014. The upper end of the range identified in the table related to OREO for each year is the result of write-downs on relatively small properties. The weighted average column represents a better indicator of the discounts applied to the appraisals.
Fair Value of Financial Instruments
The table that follows represents the estimated fair values of the Company’s financial instruments made in accordance with the requirements of ASC Topic 825, “Financial Instruments.” ASC Topic 825 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. The estimated fair value amounts have been determined by the Company using available market information and present value or other valuation techniques. These derived fair values are subjective in nature, involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. ASC Topic 825 excludes certain financial instruments and all nonfinancial instruments from the disclosure requirements. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.
The following methods and assumptions were used to estimate the fair value of each class of financial instruments not presented elsewhere for which it is practicable to estimate that value.
Cash and Cash Equivalents, Accrued Interest Receivable, and Accrued Interest Payable
The carrying amount is a reasonable estimate of fair value due to the relatively short time between the origination of the instrument and its expected realization or settlement.
Investment Securities Held to Maturity
Fair value is based on quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities or with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.
Loans
The fair value of loans is estimated by discounting expected future cash flows using current discount rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Expected future cash flows are projected based on contractual cash flows adjusted for estimated prepayments.
Federal Home Loan Bank and Federal Reserve Bank Stock
It is not practical to determine the fair value of Federal Home Loan Bank and Federal Reserve Bank stock due to restrictions placed on its transferability.
Deposit Liabilities
The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date and fair value approximates carrying value. The fair value of fixed maturity certificates of deposit is estimated by discounting the expected future cash flows using the rates currently offered for certificates of deposit with similar remaining maturities.
Federal Funds Purchased and Other Short-term Borrowings
The carrying amount is the estimated fair value for these borrowings which reprice frequently in the near term.
Securities Sold Under Agreements to Repurchase, Subordinated Notes Payable, and Other Long-term Borrowings
The fair value of these borrowings is estimated by discounting the expected future cash flows using rates currently available for debt with similar terms and remaining maturities. For subordinated notes payable, the Company uses its best estimate to determine an appropriate discount rate since active markets for similar debt transactions are very limited.
Commitments to Extend Credit and Standby Letters of Credit
Pricing of these financial instruments is based on the credit quality and relationship, fees, interest rates, probability of funding, compensating balance, and other covenants or requirements. Loan commitments generally have fixed expiration dates, variable interest rates and contain termination and other clauses that provide for relief from funding in the event there is a significant deterioration in the credit quality of the customer. Many loan commitments are expected to, and typically do, expire without being drawn upon. The rates and terms of the Company’s commitments to lend and standby letters of credit are competitive with others in the various markets in which the Company operates. There are no unamortized fees relating to these financial instruments, as such the carrying value and fair value are both zero.
The following table presents the estimated fair values of the Company’s financial instruments and the level within the fair value hierarchy in which the fair value measurements fall at December 31, 2015 and 2014. Information for available for sale investment securities is presented within this footnote in greater detail above.
20. Parent Company Financial Statements
Condensed Balance Sheets
Condensed Statements of Income and Comprehensive Income
Condensed Statements of Cash Flows
21.
Quarterly Financial Data (Unaudited)
22. Intangible Assets
Acquired core deposit intangible assets were as follows as of December 31 for the years indicated.
Aggregate amortization expense of core deposit and customer relationship intangible assets was $449 thousand, $405 thousand, and $540 thousand for 2015, 2014, and 2013, respectively. Customer relationship intangibles in the amount of $2.4 million recorded in connection with a prior business acquisition during 2004 were removed from the gross carrying amount and accumulated amortization for 2014 due to being fully amortized. Core deposit intangibles in the amount of $4.5 million have been removed from the gross carrying amount and accumulated amortization for 2015 due to being fully amortized.
23. Preferred Stock
On January 9, 2009, as part of the U.S. Department of Treasury’s (“Treasury”) Capital Purchase Program (“CPP”), the Company issued 30,000 shares of Series A, no par value cumulative perpetual preferred stock to the Treasury for $30.0 million. The Company also issued a warrant to the Treasury as part of the CPP. In June 2012, the Treasury conducted an auction in which it sold all of its investment in the Company’s Series A preferred stock to private investors. The Company received no proceeds as part of the transaction. In July 2012, the Company repurchased the warrant it issued to the Treasury. Upon settlement of the warrant repurchase, the Treasury had no remaining equity stake in the Company.
The Company redeemed 20,000 shares of its outstanding preferred stock during 2014 at its stated liquidation value of $1 thousand per share, plus accrued dividends. The shares were approved and redeemed in two separate partial redemptions of 10,000 shares each, one of which occurred in second quarter and the other in the fourth quarter.
On June 8, 2015, the Company redeemed the final 10,000 shares of its Series A preferred stock. The shares were redeemed at the stated liquidation value of $1 thousand per share, plus accrued dividends. The redemption was the third and final partial redemption of the original shares issued. No additional debt or equity was issued in connection with any of the shares redeemed.
24. Subsequent Events
Extinguishment of Subordinated Debt
In January 2016, the Company terminated Trust II as a result of the early extinguishment of debt issued to the trust and recorded a related pretax gain of $4.1 million. Trust II was a Delaware statutory trust established by the Company in 2005 for the purpose of issuing preferred securities through a private offering. The proceeds from the offering were loaned to the Company in exchange for junior subordinated debentures with terms that parallel those of the preferred securities.
The Company became aware that all $15 million of the trust preferred securities issued by Trust II would be auctioned off as part of the liquidation of a larger pooled collateralized debt obligation. The Company placed a bid of $10.9 million for the securities, which was accepted by the trustee. The Company then canceled the preferred and common securities issued by the trust and extinguished the debentures. Since the accepted bid was less than the $15 million carrying value, the Company recognized a gain on the early extinguishment of debt upon cancellation, which occurred in the first quarter of 2016.
Announcement of Common Dividend
On January 25, 2016, the Company announced that its Board of Directors approved a quarterly cash dividend on the Company’s common stock of $0.07 per share. This is the first dividend on common stock declared by the Company since the fourth quarter of 2009. The dividend is payable on April 1, 2016 to shareholders of record at the close of business on March 1, 2016.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of our management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on their evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures and internal control over financial reporting are, to the best of their knowledge, effective to ensure that information required to be disclosed by the Company in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
The Company’s Chief Executive Officer and Chief Financial Officer have also concluded that there were no changes in the Company’s internal control over financial reporting or in other factors that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting or any corrective actions with regard to significant deficiencies and material weaknesses in internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Management Responsibility. Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system is designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the reliability of financial reporting and the presentation of published financial statements. However, all internal control systems, no matter how well designed, have inherent limitations.
General Description of Internal Control over Financial Reporting. Internal control over financial reporting refers to a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer and effected by the Company’s Board of Directors, management and other personnel, 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 and includes those policies and procedures that:
●
Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of Company assets;
●
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Company’s receipts and expenditures are being made only in accordance with the authorization of the Company’s management and members of the Company’s Board of Directors; and
●
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, uses or dispositions of Company assets that could have a material effect on the Company’s financial statements.
Inherent Limitations in Internal Control over Financial Reporting. Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented or overridden by collusion or other improper activities. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process, and it is possible to design into the process safeguards to reduce, though not eliminate, this risk.
Management’s Assessment of the Company’s Internal Control over Financial Reporting. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015. In making this assessment, the Company’s management used the criteria for effective internal control over financial reporting set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013).
As a result of our assessment of the Company’s internal control over financial reporting, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2015 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
BKD, LLP, the independent registered public accounting firm that audited the Company’s consolidated financial statements included in this Annual Report on Form 10-K, has also audited the effectiveness of the Company’s internal control over financial reporting as of December 31, 2015. The audit report on the effectiveness of the Company’s internal control over financial reporting is included in this Annual Report on page 72.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
1R. Terry Bennett, Chairman of the Company’s board of directors, and J. Barry Banker, Vice Chairman, are considered executive officers in name only for purposes of Regulation O.
2Also a director of Farmers Bank, United Bank, First Citizens, Citizens Northern, FCB Services, Farmers Insurance (Chairman), FFKT Insurance, EGT Properties, and an administrative trustee of Farmers Capital Bank Trust I, Farmers Capital Bank Trust II, and Farmers Capital Bank Trust III.
3Includes years of service with the Parent Company and its subsidiaries.
The Company has adopted a Code of Ethics that applies to the Company’s directors, officers, and employees, including the Company’s chief executive officer and chief financial officer. The Company makes available its Code of Ethics on its Internet website at www.farmerscapital.com. Any amendments to the Code of Ethics and any waiver applicable to the Company’s chief executive officer and chief financial officer will also be posted on the website.
Additional information required by Item 10 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 10, 2016, which will be filed with the Commission on or about April 1, 2016, pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by Items 11 through 14 is hereby incorporated by reference from the Company's definitive proxy statement in connection with its annual meeting of shareholders scheduled for May 10, 2016, which will be filed with the Commission on or about April 1, 2016, pursuant to Regulation 14A.
PART IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules
(a)1.
Financial Statements
The following consolidated financial statements and report of independent registered public accounting firm of the Company is included in Part II, Item 8 on pages 71 through 124:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Comprehensive Income
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a)2.
Financial Statement Schedules
All schedules are omitted for the reason they are not required, or are not applicable, or the required information is disclosed elsewhere in the financial statements and related notes thereto.
(a)3.
Exhibits:
3.1
Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation (incorporated by reference to the Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006 (File No. 000-14412)).
3.2
Articles of Amendment to Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation dated January 6, 2009 (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
3.3
Articles of Amendment to Second Amended and Restated Articles of Incorporation of Farmers Capital Bank Corporation dated November 16, 2009 (incorporated by reference to the Current Report on Form 8-K dated November 17, 2009 (File No. 000-14412)).
3.4
Amended and Restated Bylaws of Farmers Capital Bank Corporation (incorporated by reference to the Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2015 (File No. 000-14412)).
4.1*
Junior Subordinated Indenture, dated as of July 21, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.
4.2*
Amended and Restated Trust Agreement, dated as of July 21, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.3*
Guarantee Agreement, dated as of July 21, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.4*
Junior Subordinated Indenture, dated as of July 26, 2005, between Farmers Capital Bank Corporation and Wilmington Trust Company, as Trustee, relating to unsecured junior subordinated deferrable interest notes that mature in 2035.
4.5*
Amended and Restated Trust Agreement, dated as of July 26, 2005, among Farmers Capital Bank Corporation, as Depositor, Wilmington Trust Company, as Property and Delaware Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.6*
Guarantee Agreement, dated as of July 26, 2005, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.7*
Indenture, dated as of August 14, 2007 between Farmers Capital Bank Corporation, as Issuer, and Wilmington Trust Company, as Trustee, relating to fixed/floating rate junior subordinated debt due 2037.
4.8*
Amended and Restated Declaration of Trust, dated as of August 14, 2007, by Farmers Capital Bank Corporation, as Sponsor, Wilmington Trust Company, as Delaware and Institutional Trustee, the Administrative Trustees (as named therein), and the Holders (as defined therein).
4.9*
Guarantee Agreement, dated as of August 14, 2007, between Farmers Capital Bank Corporation, as Guarantor, and Wilmington Trust Company, as Guarantee Trustee.
4.10
Form of Certificate for Fixed Rate Cumulative Perpetual Preferred Stock, Series A (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
4.11
Letter Agreement, dated January 9, 2009, between Farmers Capital Bank Corporation and the United States Treasury, with respect to the issuance and sale of the Series A preferred stock and the Warrant, and Securities Purchase Agreement-Standard Terms attached thereto as Exhibit A (incorporated by reference to the Current Report on Form 8-K dated January 13, 2009 (File No. 000-14412)).
10.1
Employee Stock Purchase Plan of Farmers Capital Bank Corporation (incorporated by reference to Form S-8 effective June 24, 2004 (File No. 333-116801)).
10.2
Nonqualified Stock Option Plan of Farmers Capital Bank Corporation (incorporated by reference to Form S-8 effective September 8, 1998 (File No. 333-63037)).
10.3
Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K/A filed December 26, 2012).
10.4
Amendment No. 1 to Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 30, 2013).
10.5
Amendment No. 2 to Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 8, 2014).
10.6
Amendment No. 3 to Employment agreement dated December 10, 2012 between Farmers Capital Bank Corporation and Lloyd C. Hillard, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 9, 2015).
10.7
Employment agreement dated December 17, 2013 between Farmers Capital Bank Corporation and Rickey D. Harp (incorporated by reference to Exhibit 10.1 to Form 8-K filed December 30, 2013).
10.8
Employment agreement dated October 28, 2014 between Farmers Capital Bank Corporation and Mark A. Hampton (incorporated by reference to Exhibit 10.1 to Form 8-K filed October 28, 2014).
10.9
Employment agreement dated November 18, 2015 between Farmers Capital Bank Corporation and J. David Smith, Jr. (incorporated by reference to Exhibit 10.1 to Form 8-K filed November 19, 2015).
21**
Subsidiaries of the Registrant
23.1**
Consent of Independent Registered Public Accounting Firm
31.1**
CEO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2**
CFO Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32**
CEO and CFO Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101**
Interactive Data Files
* Exhibit not included pursuant to Item 601(b)(4)(iii) and (v) of Regulation S-K. The Company will provide a copy of such exhibit to the Securities and Exchange Commission upon request.
** Filed with this Annual Report on Form 10-K.
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.
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 and on the dates indicated.
/s/ Lloyd C. Hillard, Jr.
President, Chief Executive Officer and Director
March 11, 2016
Lloyd C. Hillard, Jr.
(principal executive officer of the Registrant)
/s/ R. Terry Bennett
Chairman
March 3, 2016
R. Terry Bennett
/s/ David Y. Phelps
Vice Chairman
March 2, 2016
David Y. Phelps
/s/ J. Barry Banker
Director
February 25, 2016
J. Barry Banker
/s/ Michael J. Crawford
Director
February 26, 2016
Michael J. Crawford
/s/ John R. Farris
Director
March 2, 2016
John R. Farris
/s/ William C. Nash
Director
February 29, 2016
Dr. William C. Nash
/s/ David R. O’Bryan
Director
March 1, 2016
David R. O’Bryan
/s/ Fred N. Parker
Director
March 1, 2016
Fred N. Parker
/s/ Marvin E. Strong, Jr.
Director
February 29, 2016
Marvin E. Strong, Jr.
/s/ Fred Sutterlin
Director
March 2, 2016
Fred Sutterlin
/s/ Judy Worth
Director
March 3, 2016
Judy Worth
/s/ Mark A. Hampton
Executive Vice President, Chief Financial Officer, and Secretary
March 11, 2016
Mark A. Hampton
(principal financial and accounting officer)
INDEX OF EXHIBITS