Item 1. Business
General
First Citizens BancShares, Inc. (BancShares) was incorporated under the laws of Delaware on August 7, 1986, to become the holding company of First-Citizens Bank & Trust Company (FCB), its banking subsidiary. FCB opened in 1898 as the Bank of Smithfield, Smithfield, North Carolina, and later changed its name to First-Citizens Bank & Trust Company. BancShares has expanded through de novo branching and acquisitions and now operates in 21 states providing a broad range of financial services to individuals, businesses and professionals. As of December 31, 2017, BancShares had total assets of $34.53 billion.
Throughout its history, the operations of BancShares have been significantly influenced by descendants of Robert P. Holding, who came to control FCB during the 1920s. Robert P. Holding’s children and grandchildren have served as members of the Board of Directors, as chief executive officers and in other executive management positions and, since our formation in 1986, have remained shareholders controlling a large percentage of our common stock.
Our Chairman of the Board and Chief Executive Officer, Frank B. Holding, Jr., is the grandson of Robert P. Holding. Hope Holding Bryant, Vice Chairman of BancShares, is Robert P. Holding’s granddaughter. Peter M. Bristow, President and Corporate Sales Executive of BancShares, is the brother-in-law of Frank B. Holding, Jr. and Hope Holding Bryant.
FCB seeks to meet the financial needs of both individuals and commercial entities in its market areas through a wide range of retail and commercial banking services. Loan services include various types of commercial, business and consumer lending. Deposit services include checking, savings, money market and time deposit accounts. We also provide mortgage lending, a full-service trust department, wealth management services for businesses and individuals, and other activities incidental to commercial banking. FCB’s wholly-owned subsidiaries, First Citizens Investor Services, Inc. (FCIS) and First Citizens Asset Management, Inc. (FCAM), provide various investment products and services: as a registered broker/dealer, FCIS provides a full range of investment products, including annuities, discount brokerage services and third-party mutual funds; as registered investment advisors, FCIS and FCAM provide investment management services and advice.
We deliver products and services to our customers through our extensive branch network as well as digital banking, telephone banking and various ATM networks. Services offered at most offices include taking of deposits, cashing of checks and providing for individual and commercial cash needs. Business customers may conduct banking transactions through the use of remote image technology.
The financial services industry is highly competitive. FCB competes with national, regional and local financial services providers. In recent years, the ability of non-bank financial entities to provide services has intensified competition. Non-bank financial service providers are not subject to the same significant regulatory restrictions as traditional commercial banks. More than ever, customers have the ability to select from a variety of traditional and nontraditional alternatives.
FCB’s primary deposit markets are North Carolina and South Carolina. FCB’s deposit market share in North Carolina was 4.1 percent as of June 30, 2017, based on the FDIC Deposit Market Share Report, which makes FCB the fourth largest bank in North Carolina. The three banks larger than FCB based on deposits in North Carolina as of June 30, 2017, controlled 76.5 percent of North Carolina deposits. In South Carolina, FCB was the fourth largest bank in terms of deposit market share with 8.8 percent at June 30, 2017. The three larger banks represent 44.9 percent of total deposits in South Carolina as of June 30, 2017.
Statistical information regarding our business activities is found in Management’s Discussion and Analysis.
Geographic Locations and Employees
As of December 31, 2017, FCB operated 545 branches in Arizona, California, Colorado, Florida, Georgia, Illinois, Kansas, Maryland, Minnesota, Missouri, New Mexico, North Carolina, Oklahoma, Oregon, South Carolina, Tennessee, Texas, Virginia, Washington, West Virginia and Wisconsin. BancShares and its subsidiaries employ approximately 6,379 full-time staff and approximately 420 part-time staff for a total of 6,799 employees.
Business Combinations
FCB recently purchased certain assets and assumed certain liabilities of the following banks from the Federal Deposit Insurance Corporation (FDIC):
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Guaranty Bank (Guaranty) of Milwaukee, Wisconsin on May 5, 2017
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Harvest Community Bank (HCB) of Pennsville, New Jersey on January 13, 2017
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First CornerStone Bank (FCSB) of King of Prussia, Pennsylvania on May 6, 2016
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North Milwaukee State Bank (NMSB) of Milwaukee, Wisconsin on March 11, 2016
On December 18, 2017, FCB and HomeBancorp, Inc. (HomeBancorp) entered into a definitive merger agreement. Under the terms of the agreement, cash consideration of $15.03 will be paid to the shareholders of HomeBancorp for each share of HomeBancorp's common stock totaling approximately $113.6 million. The transaction is expected to close no later than the second quarter of 2018, subject to the receipt of regulatory approvals and the approval of HomeBancorp’s shareholders. The merger will increase FCB's footprint in Central and Western Florida.
On September 1, 2016, FCB completed the merger of Midlothian, Virginia-based Cordia Bancorp, Inc. (Cordia) and its subsidiary, Bank of Virginia (BVA) into FCB. Under the terms of the merger agreement, cash consideration of $5.15 was paid to Cordia’s shareholders for each of their shares of Cordia’s common stock, with total consideration paid of $37.1 million. The merger strengthened FCB's presence in the greater Richmond, Virginia area as Cordia operated six BVA branches in Richmond, Midlothian, Chesterfield, Colonial Heights and Chester, Virginia.
FDIC Shared-Loss Termination
On March 28, 2017, FCB entered into an agreement with the FDIC to terminate the shared-loss agreement for Venture Bank. Under the terms of the agreement, FCB made a net payment of $285 thousand to the FDIC as consideration for early termination of the shared-loss agreement. The early termination resulted in a one-time expense of $45 thousand during the first quarter of 2017.
On June 14, 2016, FCB terminated five of its nine shared-loss agreements with the FDIC, including Temecula Valley Bank (TVB), Sun American Bank (SAB), Williamsburg First National Bank (WFNB), Atlantic Bank & Trust (ABT) and Colorado Capital Bank (CCB). The resulting positive net impact to pre-tax earnings from the early termination of the FDIC shared-loss agreements was $16.6 million during 2016. See the FDIC-Assisted Transactions section in Management's Discussion and Analysis for more details.
Regulatory Considerations
The various laws and regulations administered by the bank regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt, and acquisition of financial institutions and other companies; they also affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted, and location of offices.
Numerous statutes and regulations apply to and restrict the activities of FCB, including limitations on the ability to pay dividends, capital requirements, reserve requirements, deposit insurance requirements and restrictions on transactions with related persons and entities controlled by related persons. The impact of these statutes and regulations is discussed below and in the accompanying consolidated financial statements.
Dodd-Frank Act. The Dodd-Frank Act, enacted in 2010, significantly restructured the financial services regulatory environment and imposed significant regulatory and compliance changes, increased capital, leverage and liquidity requirements, including through the expansion of the scope of oversight responsibility of certain federal agencies through the creation of new oversight bodies. For example, the Dodd-Frank Act established the Consumer Financial Protection Bureau (CFPB) with broad powers to supervise and enforce consumer protection laws.
Other significant changes resulting from the Dodd-Frank Act include:
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Capital Planning and Stress Testing. The Dodd-Frank Act mandated that stress tests be developed and performed to ensure that financial institutions have sufficient capital to absorb losses and support operations during multiple economic and bank scenarios. Bank holding companies with total consolidated assets between $10 billion and $50 billion, including BancShares, perform annual stress tests using defined scenarios as provided by the Federal Reserve. The results of stress testing activities are considered by our Risk Committee in combination with other risk management and monitoring practices as part of our risk management program.
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The Volcker Rule. The Dodd-Frank Act prohibits banks and their affiliates from engaging in proprietary trading and investing in and sponsoring hedge funds and private equity funds. The Volcker Rule, which became effective in July 2015, does not significantly impact the operations of BancShares and its subsidiaries, as we do not have any significant engagement in the businesses prohibited by the Volcker Rule.
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Ability-to-Repay and Qualified Mortgage Rule. Creditors are required to comply with mortgage reform provisions prohibiting the origination of any residential mortgages that do not meet rigorous Qualified Mortgage standards or Ability-
to-Repay standards. All mortgage loans originated by FCB meet Ability-to-Repay standards and a substantial majority also meets Qualified Mortgage standards.
BancShares
General. As a financial holding company registered under the Bank Holding Company Act (BHCA) of 1956, as amended, BancShares is subject to supervision, regulation, and examination by the Federal Reserve Board (Federal Reserve). BancShares is also registered under the bank holding company laws of North Carolina and is subject to supervision, regulation, and examination by the North Carolina Commissioner of Banks (NCCOB).
Permitted Activities. A bank holding company is limited to managing or controlling banks, furnishing services to or performing services for its subsidiaries, and engaging in other activities that the Federal Reserve determines by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In addition, bank holding companies that qualify and elect to be financial holding companies, such as BancShares, may engage in any activity, or acquire and retain the shares of a company engaged in any activity, that is either (i) financial in nature or incidental to such financial activity (as determined by the Federal Reserve in consultation with the Secretary of the Treasury) or (ii) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally (as solely determined by the Federal Reserve), without prior approval of the Federal Reserve. Activities that are financial in nature include securities underwriting and dealing, serving as an insurance agent and underwriter, and engaging in merchant banking.
Status Requirements. To maintain financial holding company status, a financial holding company and all of its depository institution subsidiaries must be well-capitalized and well-managed. A depository institution subsidiary is considered to be well-capitalized if it satisfies the requirements for this status under applicable Federal Reserve capital requirements. A depository institution subsidiary is considered “well managed” if it received a composite rating and management rating of at least “satisfactory” in its most recent examination. If a financial holding company ceases to meet these capital and management requirements, the Federal Reserve may impose limitations or conditions on the conduct of its activities.
Capital Requirements. The Federal Reserve imposes certain capital requirements on bank holding companies under the BHCA, including a minimum leverage ratio and a minimum ratio of “qualifying” capital to risk-weighted assets. These requirements are described below under “The Subsidiary Bank - FCB - Current Capital Requirements (Basel III)”. As of December 31, 2017, the risk-based Tier 1, common equity Tier 1, total capital, and leverage capital ratios of BancShares were 12.88 percent, 12.88 percent, 14.21 percent and 9.47 percent, respectively, and each capital ratio listed above exceeded the applicable minimum requirements as well as the well-capitalized standards. Subject to its capital requirements and certain other restrictions, BancShares is able to borrow money to make capital contributions to FCB and such loans may be repaid from dividends paid by FCB to BancShares.
Source of Strength. Under the Dodd-Frank Act, bank holding companies are required to act as a source of financial and managerial strength to their subsidiary banks. Under this requirement, BancShares is expected to commit resources to support FCB, including times when BancShares may not be in a financial position to provide such resources. Any capital loans made by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
Safety and Soundness. The federal bank regulatory agencies have adopted guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. There are a number of obligations and restrictions imposed on bank holding companies and their subsidiary banks by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and to the FDIC insurance fund in the event of a depository institution default.
Limits on Dividends and Other Payments. BancShares is a legal entity, separate and distinct from its subsidiaries. Revenues of BancShares primarily result from dividends received from FCB. There are various legal limitations applicable to the payment of dividends by FCB to BancShares and to the payment of dividends by BancShares to its shareholders. The payment of dividends by FCB or BancShares may be limited by certain factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit FCB or BancShares from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of FCB or BancShares, could be deemed to constitute such an unsafe or unsound practice.
Under the Federal Deposit Insurance Act (FDIA), insured depository institutions, such as FCB, are prohibited from making capital distributions, including the payment of dividends, if, after making such distributions, the institution would become “undercapitalized” (as such term is used in the statute). Additionally, under Basel III capital requirements, banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall. Based on FCB’s current financial condition, BancShares currently does not expect these provisions to have any material impact on its ability to receive dividends from FCB. BancShares' non-bank subsidiaries pay dividends to BancShares periodically on a non-regulated basis.
Subsidiary Bank - FCB
General. FCB is a state-chartered bank, subject to supervision and examination by, and the regulations and reporting requirements of, the FDIC and the NCCOB. Deposit obligations are insured by the FDIC to the maximum legal limits.
Capital Requirements (Basel III). Bank regulatory agencies approved Basel III regulatory capital guidelines aimed at strengthening existing capital requirements through a combination of higher minimum capital requirements, new capital conservation buffers and more conservative definitions of capital and balance sheet exposure. BancShares and FCB implemented the requirements of Basel III effective January 1, 2015, subject to a transition period for several aspects of the rule. The table below describes the minimum and well-capitalized requirements in 2017 and the fully-phased-in requirements that become effective in 2019.
The transitional period began in 2016 and the capital conservation buffer requirement was phased in beginning January 1, 2016, at 0.625 percent of risk-weighted assets, increasing each year until fully implemented at 2.5 percent on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of common equity Tier 1 to risk-weighted assets above the minimum, but below the conservation buffer will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.
Failure to meet minimum capital requirements may result in certain actions by regulators that could have a direct material effect on our consolidated financial statements. As of December 31, 2017, FCB exceeded the applicable minimum requirements as well as the well-capitalized standards.
Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, prudently managing our interest rate exposures, ensuring our capital positions remain strong and actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends and to take advantage of favorable economic conditions and opportunities when appropriate.
Transactions with Affiliates. Pursuant to Sections 23A and 23B of the Federal Reserve Act, Regulation W and Regulation O, the authority of FCB to engage in transactions with related parties or “affiliates” or to make loans to insiders is limited. Loan transactions with an affiliate generally must be collateralized and certain transactions between FCB and its affiliates, including the sale of assets, the payment of money or the provision of services, must be on terms and conditions that are substantially the same, or at least as favorable to FCB, as those prevailing for comparable nonaffiliated transactions. In addition, FCB generally may not purchase securities issued or underwritten by affiliates.
FCB receives management fees from its subsidiaries and BancShares for expenses incurred for performing various functions on their behalf. These fees are charged to each company based upon the estimated cost for usage of services by that company. The fees are eliminated from the consolidated financial statements.
Community Reinvestment Act. FCB is subject to the requirements of the Community Reinvestment Act of 1977 (CRA). The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low and moderate income neighborhoods. If FCB receives a rating from the Federal Reserve of less than “satisfactory” under the CRA, restrictions would be imposed on our operating activities. In addition, in order for a financial holding company, like BancShares, to commence any new activity permitted by the BHCA or to acquire any company engaged in any new activity permitted by the BHCA, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. FCB currently has a “satisfactory” CRA rating.
Anti-Money Laundering and OFAC Regulation. Governmental policy in recent years has been aimed at combating money laundering and terrorist financing. The Bank Secrecy Act of 1970 (BSA) and subsequent laws and regulations require financial institutions to take steps to prevent the use of their systems to facilitate the flow of illegal or illicit money or terrorist funds. The USA Patriot Act of 2001 (Patriot Act) significantly expanded anti-money laundering (AML) and financial transparency laws and regulations by imposing new compliance and due diligence obligations, including standards for verifying customer identification at account opening and maintaining expanded records, as well as rules promoting cooperation among financial institutions, regulators and law enforcement entities in identifying persons who may be involved in terrorism or money laundering. Additional rules which were finalized in 2016 must be implemented by May 2018, and create expanded obligations regarding customer due diligence, including the identification of beneficial owners of business entities. FCB has begun the process necessary to implement these additional rules in late April 2018. An institution subject to the BSA, such as FCB, must additionally provide AML training to employees, designate an AML compliance officer and annually audit the AML program to assess its effectiveness. The United States has imposed economic sanctions on transactions with certain designated foreign countries, nationals and others. As these rules are administrated by the United States Department of the Treasury's Office of Foreign Assets Control (OFAC), these are generally known as the OFAC rules. Failure of a financial institution to maintain and implement adequate BSA, AML and OFAC programs, or to comply with all the relevant laws and regulations, could have serious legal and reputational consequences, including material fines and sanctions.
Consumer Laws and Regulations. FCB is also subject to certain laws and regulations designed to protect consumers in transactions with banks. These laws include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, Real Estate Settlement Procedures Act, Home Mortgage Disclosure Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Fair Housing Act and the Servicemembers Civil Relief Act. The laws and related regulations mandate certain disclosures and regulate the manner in which financial institutions transact business with certain customers. FCB must comply with these consumer protection laws and regulations in its relevant lines of business.
Available Information
BancShares does not have its own separate Internet website. However, FCB’s website (www.firstcitizens.com) includes a hyperlink to the SEC’s website where the public may obtain copies of BancShares’ annual reports on Form 10-K, quarterly reports on 10-Q, current reports on Form 8-K, and amendments to those reports, free of charge, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC. Interested parties may also directly access the SEC’s website (www.sec.gov), which contains reports and other information electronically filed by BancShares.
Item 1A.
Item 1A. Risk Factors
The risks and uncertainties that management believes are material are described below. The risks listed are not the only risks that BancShares faces. Additional risks and uncertainties that are not currently known or that management does not currently deem material could also have a material adverse impact on our financial condition and/or the results of our operations or our business. If such risks and uncertainties were to materialize or the likelihoods of the risks were to increase, the market price of our common stock could significantly decline.
Operational Risks
We face cybersecurity risks where breaches of our and our vendors' information systems could expose us to attacks resulting in the unauthorized disclosure or loss of customer information, which could damage our business reputation and expose us to significant financial liability
We maintain and transmit large amounts of sensitive information electronically, including personal and financial information of our customers. In addition to our own systems, we also rely on external vendors to provide certain services and are therefore exposed to their information security risks. While we attempt to mitigate internal and external information security risks, the volume of business conducted through electronic devices continues to grow, and our computer systems and network infrastructure,
as well as those of our external vendors and customers, present security risks including susceptibility to various attacks and/or identity theft.
As the result of our internet activities, we are also subject to risks arising from a broad range of cybersecurity attacks from both domestic and international sources which seek to obtain customer information for fraudulent purposes or, in some cases, to disrupt our business activities. Information security issues could result in reputational damage and lead to a material adverse impact on our business, financial condition and financial results of operations.
We are exposed to losses related to credit and debit card fraud
As technology continues to evolve, criminals are using increasingly more sophisticated techniques to commit and hide fraudulent activity. Fraudulent activity can come in many forms, including debit card/credit card fraud, check fraud, electronic scanning devices attached to ATM machines, social engineering and phishing attacks to obtain personal information, and fraudulent impersonation of our clients through the use of falsified or stolen credentials. To counter the increased sophistication of these fraudulent activities, we have increased our spending on systems, technologies and controls to detect and prevent such fraud. Combating fraudulent activities as they evolve will result in continued ongoing investments in the future.
New technologies, and our ability to efficiently and effectively develop, market, and deliver new products and services to our customers, present competitive risks
The rapid growth of new technologies, including internet services, smart phones and other mobile devices, requires us to continuously evaluate our product and service offerings to ensure they remain competitive. Our success depends in part on our ability to adapt and deliver our products and services in a manner responsive to evolving industry standards and consumer preferences. New technologies by banks and non-bank service providers may create risks that our products and services are no longer competitive with then-current standards, and could negatively affect our ability to attract or maintain a loyal customer base. These risks may affect our ability to grow and could reduce both our revenue streams from certain products and services and our revenues generated by our net interest margins. Our results of operations and financial condition could be adversely affected.
We depend on key personnel for our success
Our success depends to a great extent on our ability to attract and retain key personnel. We have an experienced management team that our board of directors believes is capable of managing and growing our business. Losses of or changes in our current executive officers or other key personnel and their responsibilities may disrupt our business and could adversely affect our financial condition, results of operations and liquidity. There can be no assurance that we will be successful in retaining our current executive officers or other key personnel, or hiring additional key personnel to assist in executing our growth, expansion and acquisition strategies.
We are subject to litigation risks, and our expenses related to litigation may adversely affect our results
We are subject to litigation risks in the ordinary course of our business. Claims and legal actions, including supervisory actions by our regulators, that may be initiated against us from time to time, could involve large monetary sums and significant defense costs. During the last credit crisis, we saw both the number of cases and our expenses related to those cases increase. The outcomes of such cases are always uncertain until finally adjudicated or resolved.
We establish reserves for legal claims when payments associated with the claims become probable and our liability can be reasonably estimated. We may still incur legal costs for a matter even if we have not established a reserve. In addition, the actual amount paid in resolution of a legal claim may be substantially higher than any amounts reserved for the matter. The ultimate resolution of a legal proceeding, depending on the remedy sought and any relief granted, could materially adversely affect our results of operations and financial condition.
Substantial legal claims or significant regulatory action against us could have material adverse financial effects or cause significant reputational harm to us, which in turn could seriously harm our business prospects. We may be exposed to substantial uninsured legal liabilities and/or regulatory actions which could adversely affect our results of operations and financial condition. For additional information, see Note T, “Commitments and Contingencies,” to the Consolidated Financial Statements in this Form 10-K.
We face significant operational risks in our businesses
Safely conducting and growing our business requires that we create and maintain an appropriate operational and organizational control infrastructure. Operational risk can arise in numerous ways, including employee fraud, customer fraud, and control lapses in bank operations and information technology. Our dependence on our employees, and internal and third party automated systems, to record and process transactions may further increase the risk that technical failures or system-tampering will result in losses that are difficult to detect. We may be subject to disruptions of our operating systems arising from events that are wholly or partially
beyond our control. Failure to maintain appropriate operational infrastructure and oversight can lead to loss of service to customers, legal actions, and noncompliance with various laws and regulations. We have implemented internal controls that are designed to safeguard and maintain our operational and organizational infrastructure and information. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Our business and financial performance could be impacted by natural disasters, acts of war or terrorist activities
Natural disasters (including but not limited to earthquakes, hurricanes, tornadoes, floods, fires, explosions), acts of war and terrorist activities could hurt our performance (i) directly through damage to our facilities or other impact to our ability to conduct business in the ordinary course, and (ii) indirectly through such damage or impacts to our customers, suppliers or other counterparties. In particular, a significant amount of our business is concentrated in North Carolina and South Carolina, including in coastal areas where our retail and commercial customers could be impacted by hurricanes. We could also suffer adverse results to the extent that disasters, wars or terrorist activities affect the broader markets or economy. Our ability to minimize the consequences of such events is in significant measure reliant on the quality of our disaster recovery planning and our ability, if any, to forecast the events.
Our financial performance depends upon our ability to attract and retain clients for our products and services, which ability may be adversely impacted by weakened consumer and/or business confidence, and by any inability on our part to predict and satisfy customers’ needs and demands
Our financial performance is subject to risks associated with the loss of client confidence and demand. A fragile or weakening economy, or ambiguity surrounding the economic future, may lessen the demand for our products and services. Our performance may also be negatively impacted if we should fail to attract and retain customers because we are not able to successfully anticipate, develop and market products and services that satisfy market demands. Such events could impact our performance through fewer loans, reduced fee income and fewer deposits, each of which could result in reduced net income.
We rely on external vendors
Third party vendors provide key components of our business infrastructure, including certain data processing and information services. A number of our vendors are large national entities with dominant market presence in their respective fields, and their services could be difficult to quickly replace in the event of failure or other interruption in service. Failures of certain vendors to provide services could adversely affect our ability to deliver products and services to our customers. External vendors also present information security risks. We monitor vendor risks, including the financial stability of critical vendors. The failure of a critical external vendor could disrupt our business and cause us to incur significant expense.
Our business is highly quantitative and requires widespread use of financial models for day-to-day operations; these models may produce inaccurate predictions that significantly vary from actual results
We rely on quantitative models to measure risks and to estimate certain financial values. Such models may be used in many processes including, but not limited to, the pricing of various products and services, classifications of loans, setting interest rates on loans and deposits, quantifying interest rate and other market risks, forecasting losses, measuring capital adequacy, and calculating economic and regulatory capital levels. Models may also be used to estimate the value of financial instruments and balance sheet items. Inaccurate or erroneous models present the risk that business decisions relying on the models will prove inefficient or ineffective. Additionally, information we provide to our investors and regulators may be negatively impacted by inaccurately designed or implemented models. For further information on models, see the Risk Management section included in Item 7 of this Form 10-K.
Failure to maintain effective system of internal control over financial reporting could have a material adverse effect on our results of operations and financial condition and disclosures
We must have effective internal controls over financial reporting in order to provide reliable financial reports, to effectively prevent fraud, and to operate successfully as a public company. If we were unable to provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. As part of our ongoing monitoring of our internal controls over financial reporting, we may discover material weaknesses or significant deficiencies requiring remediation. A “material weakness” is a deficiency, or a combination of deficiencies, in internal controls over financial reporting such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.
We continually work to improve our internal controls; however, we cannot be certain that these measures will ensure appropriate and adequate controls over our future financial processes and reporting. Any failure to maintain effective controls or to timely implement any necessary improvement of our internal controls could, among other things, result in losses from fraud or error,
harm our reputation, or cause investors to lose confidence in our reported financial information, each of which could have a material adverse effect on our results of operations and financial condition and the market value of our common stock.
The value of our goodwill may decline in the future
At December 31, 2017, we had $150.6 million of goodwill recorded as an asset on our balance sheet. We test goodwill for impairment at least annually, comparing the estimated fair value of a reporting unit with its net book value. We also test goodwill for impairment when certain events occur, such as a significant decline in our expected future cash flows, a significant adverse change in the business climate, or a sustained decline in the price of our common stock. These tests may result in a write-off of goodwill deemed to be impaired, which could have a significant impact on our financial results; however, any such write-off would not impact our regulatory capital ratios, given that regulatory capital ratios are calculated using tangible capital amounts.
We may be adversely affected by risks associated with completed, pending or any potential future acquisitions
We plan to continue to grow our business organically. However, we have pursued and expect to continue to pursue acquisition opportunities that we believe support our business strategies and may enhance our profitability. We must generally satisfy a number of material conditions prior to consummating any acquisition including, in many cases, federal and state regulatory approval. We may fail to complete strategic and competitively significant business opportunities as a result of our inability to obtain any required regulatory approvals in a timely manner or at all.
Acquisitions of financial institutions or assets of financial institutions involve operational risks and uncertainties, and acquired companies or assets may have unknown or contingent liabilities, exposure to unexpected asset quality problems that require write downs or write-offs, difficulty retaining key employees and customers, and other issues that could negatively affect our results of operations and financial condition.
We may not be able to realize projected cost savings, synergies or other benefits associated with any such acquisition. Failure to efficiently integrate any acquired entities or assets into our existing operations could significantly increase our operating costs and have material adverse effects on our financial condition and results of operations. There can be no assurance that we will be successful in identifying or consummating any potential acquisitions.
Accounting standards may change and increase our operating costs and/or otherwise adversely affect our results
The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) periodically modify the standards that govern the preparation of our financial statements. The nature of these changes is not predictable and could impact how we record transactions in our financial statements, which could lead to material changes in assets, liabilities, shareholders’ equity, revenues, expenses and net income. In some cases, we could be required to apply new or revised standards retroactively, resulting in changes to previously-reported financial results or a cumulative adjustment to retained earnings. Application of new accounting rules or standards could require us to implement costly technology changes.
Credit Risks
Our concentration of loans to borrowers within the medical and dental industry could impair our earnings if those industries experience economic difficulties
Statutory or regulatory changes (e.g., Affordable Care Act), or economic conditions in the market generally, could negatively impact the borrowers' businesses and their ability to repay their loans with us, which could have a material adverse effect on our financial condition and results of operations. Additionally, smaller practices such as those in the dental industry generally have fewer financial resources in terms of capital or borrowing capacity than larger entities, and generally have a heightened vulnerability to negative economic conditions. Consequently, we could be required to increase our allowance for loan losses through additional provisions on our income statement, which would reduce reported net income. See Note D for additional discussion.
Economic conditions in real estate markets and our reliance on junior liens may adversely impact our business and our results of operations
Real property collateral values may be impacted by economic conditions in the real estate market and may result in losses on loans that, while adequately collateralized at the time of origination, become inadequately collateralized. Our reliance on junior liens is concentrated in our non-commercial revolving mortgage loan portfolio. Approximately two-thirds of the revolving mortgage portfolio is secured by junior lien positions and lower real estate values for collateral underlying these loans may cause the outstanding balance of the senior lien to exceed the value of the collateral, resulting in a junior lien loan that is effectively unsecured. Inadequate collateral values, rising interest rates and unfavorable economic conditions could result in greater delinquencies, write-downs or charge-offs in future periods, which could have a material adverse impact on our results of operations and capital adequacy.
Our allowance for loan losses may prove to be insufficient to absorb losses in our loan portfolio
We maintain an allowance for loan losses that is designed to cover losses on loans that borrowers may not repay in their entirety. We believe that we maintain an allowance for loan losses at a level adequate to absorb probable losses inherent in the loan portfolio as of the corresponding balance sheet date, and in compliance with applicable accounting and regulatory guidance. However, the allowance may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially and adversely affect our operating results. Accounting measurements related to impairment and the allowance require significant estimates that are subject to uncertainty, and revisions driven by new information and changing circumstances. The significant uncertainties surrounding our borrowers' abilities to conduct their businesses successfully through changing economic environments, competitive challenges, and other factors complicate our estimates of the risk and/or amount of loss on any loan. Due to the degree of uncertainty and the susceptibility to change, the actual losses may vary from current estimates. We also expect fluctuations in the allowance due to economic changes nationally as well as locally within the states we conduct business.
As an integral part of their examination process, our banking regulators periodically review the allowance and may require us to increase it for loan losses by recognizing additional provisions for loan losses charged to expense or to decrease the allowance by recognizing loan charge-offs, net of recoveries. Any such required additional loan loss provisions or charge-offs could have a material adverse effect on our financial condition and results of operations.
If we fail to effectively manage credit risk, our business and financial condition will suffer
We must effectively manage credit risk. There are risks inherent in making any loan, including risks of repayment, risks with respect to the period of time over which the loan may be repaid, risks relating to proper loan underwriting and guidelines, risks resulting from changes in economic and industry conditions, risks inherent in dealing with individual borrowers and risks resulting from uncertainties as to the future value of collateral. There is no assurance that our loan approval procedures and our credit risk monitoring are or will be adequate to or will reduce the inherent risks associated with lending. Our credit administration personnel, policies and procedures may not adequately adapt to changes in economic or other conditions affecting customers and the quality of our loan portfolio. Any failure to manage such credit risks may materially adversely affect our business, and our consolidated results of operations and financial condition.
Our financial condition could be adversely affected by the soundness of other financial institutions
Financial services institutions are interrelated as a result of trading, clearing, counterparty and/or other relationships. We have exposure to numerous financial service providers, including banks, securities brokers and dealers, and other financial service providers. Although we monitor the financial conditions of financial institutions with which we have credit exposure, transactions with those institutions expose us to credit risk through the possibility of counterparty default.
Market Risks
Unfavorable economic conditions could adversely affect our business
Our business is subject to periodic fluctuations based on national, regional and local economic conditions. These fluctuations are not predictable, cannot be controlled, and may have a material adverse impact on our operations and financial condition. Our banking operations are located within several states but are locally oriented and community-based. Our retail and commercial banking activities are primarily concentrated within the same geographic footprint. Our markets include the Southeast, Mid-Atlantic, Midwest, and Western United States, with our greatest presence in North Carolina and South Carolina. Worsening economic conditions within our markets, particularly within North Carolina and South Carolina, could have a material adverse effect on our financial condition, results of operations and cash flows. Accordingly, we expect to continue to be dependent upon local business conditions as well as conditions in the local residential and commercial real estate markets we serve. Unfavorable changes in unemployment, real estate values, interest rates and other factors could weaken the economies of the communities we serve. In recent years, economic growth and business activity across a wide range of industries has been slow and uneven, and there can be no assurance that economic conditions will continue to improve or that these conditions will not worsen. In addition, the political environment, the level of U.S. debt and global economic conditions can have a destabilizing effect on financial markets. Weakness in any of our market areas could have an adverse impact on our earnings, and consequently our financial condition and capital adequacy.
Accounting for acquired assets may result in earnings volatility
Fair value discounts that are recorded at the time an asset is acquired are accreted into interest income based on U.S. GAAP. The rate at which those discounts are accreted is unpredictable, the result of various factors including prepayments and changes in credit quality. Post-acquisition deterioration results in the recognition of provision expense and allowance for loan and lease losses. Additionally, the income statement impact of adjustments to the indemnification asset recorded in certain FDIC-assisted transactions may occur over a shorter period of time than the adjustments to the covered assets.
Fair value discount accretion, post-acquisition impairment and adjustments to the indemnification asset may result in significant volatility in our earnings. Volatility in earnings could unfavorably influence investor interest in our common stock thereby depressing the market value of our stock and the market capitalization of our company.
The performance of equity securities and corporate bonds in the investment portfolio could be adversely impacted by the soundness and fluctuations in the market values of other financial institutions
Our investment securities portfolio contains certain equity securities and corporate bonds of other financial institutions. As a result, a portion of our investment securities portfolio is subject to fluctuation due to changes in the financial stability and market value of other financial institutions, as well as interest rate sensitivity to economic and market conditions. Such fluctuations could have an adverse effect on our results of operations.
Failure to effectively manage our interest rate risk could adversely affect us
Our results of operations and cash flows are highly dependent upon net interest income. Interest rates are sensitive to economic and market conditions that are beyond our control, including the actions of the Federal Reserve Board’s Federal Open Market Committee (FOMC). Changes in monetary policy could influence interest income and interest expense as well as the fair value of our financial assets and liabilities. If changes in interest rates on our interest-earning assets are not equal to the changes in interest rates on our interest-bearing liabilities, our net interest income and, therefore, our net income, could be adversely impacted.
As interest rates rise, our interest expense will increase and our net interest margins may decrease, negatively impacting our performance and, potentially, our financial condition. To the extent banks and other financial service providers were to compete for interest-bearing deposit accounts through higher interest rates, our deposit base could be reduced if we are unwilling to pay those higher rates; if we should determine to compete with those higher interest rates, our cost of funds could increase and our net interest margins could be reduced. Additionally, higher interest rates will impact our ability to originate new loans. Increases in interest rates could adversely affect the ability of our borrowers to meet higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and net charge-offs, which could adversely affect our business and financial condition.
Although we maintain an interest rate risk monitoring system, the forecasts of future net interest income are estimates and may be inaccurate. Actual interest rate movements may differ from our forecasts, and unexpected actions by the FOMC may have a direct impact on market interest rates.
Liquidity Risks
If our current level of balance sheet liquidity were to experience pressure, that could affect our ability to pay deposits and fund our operations
Our deposit base represents our primary source of core funding and balance sheet liquidity. We normally have the ability to stimulate core deposit growth through reasonable and effective pricing strategies. However, in circumstances where our ability to generate needed liquidity is impaired, we need access to noncore funding such as borrowings from the Federal Home Loan Bank (FHLB) and the Federal Reserve, Federal Funds purchased lines, and brokered deposits. While we maintain access to these noncore funding sources, some sources are dependent on the availability of collateral as well as the counterparty’s willingness and ability to lend.
Capital Adequacy Risks
Our ability to grow is contingent on access to capital
Our primary capital sources have been retained earnings and debt issued through both private and public markets. Rating agencies regularly evaluate our creditworthiness and assign credit ratings to our debt and the debt of FCB. The ratings of the agencies are based on a number of factors, some of which are outside our control. In addition to factors specific to our financial strength and performance, the rating agencies also consider conditions generally affecting the financial services industry. There can be no assurance that we will maintain our current credit ratings. Rating reductions could adversely affect our access to funding sources and the cost of obtaining funding.
Based on existing capital levels, BancShares and FCB are well-capitalized under current leverage and risk-based capital standards. Our ability to grow is contingent on our ability to generate sufficient capital to remain well-capitalized under current and future capital adequacy guidelines.
We are subject to capital adequacy and liquidity guidelines and, if we fail to meet these guidelines, our financial condition would be adversely affected
Under regulatory capital adequacy guidelines and other regulatory requirements, BancShares, together with FCB, must meet certain capital and liquidity guidelines, subject to qualitative judgments by regulators about components, risk weightings, and other factors.
The Federal Reserve Bank (FRB) issued capital rules that established a new comprehensive capital framework for U.S. banking institutions and established a more conservative definition of capital. These requirements, known as Basel III, became effective January 1, 2015, and, as a result, we became subject to enhanced minimum capital and leverage ratios. These requirements could adversely affect our ability to pay dividends, restrict certain business activities or compel us to raise capital, each of which may adversely affect our results of operations or financial condition. In addition, the costs associated with complying with more stringent capital requirements, such as the requirement to formulate and submit capital plans based on pre-defined stress scenarios on an annual basis, could have an adverse effect on us. See the Supervision and Regulation section included in Item 7 of this Form 10-K for additional information regarding the capital requirements under the Dodd-Frank Act and Basel III.
Compliance Risks
We operate in a highly regulated industry; the laws and regulations that govern our operations, taxes, corporate governance, executive compensation and financial accounting, or reporting, including changes in them or our failure to comply with them, may adversely affect us
We are subject to extensive regulation and supervision that govern almost all aspects of our operations. In addition to a multitude of regulations designed to protect customers, depositors and consumers, we must comply with other regulations that protect the deposit insurance fund and the stability of the United States' (U.S.) financial system, including laws and regulations which, among other matters, prescribe minimum capital requirements; impose limitations on our business activities and investments; limit the dividends or distributions that we can pay; restrict the ability of our bank subsidiaries to guarantee our debt; and impose certain specific accounting requirements that may be more restrictive and may result in greater or earlier charges to earnings or reductions in our capital than accounting principles generally accepted in the United States (GAAP). Compliance with laws and regulations can be difficult and costly, and changes in laws and regulations often impose additional compliance costs.
The Sarbanes-Oxley Act of 2002 and the related rules and regulations issued by the SEC and NASDAQ, as well as numerous other recently enacted statutes and regulations, including the Dodd-Frank Act and regulations promulgated thereunder, have increased the scope, complexity and cost of corporate governance and reporting and disclosure practices, including the costs of completing our external audit and maintaining our internal controls. Such additional regulation and supervision may limit our ability to pursue business opportunities.
The failure to comply with these various rules and regulations could subject us to restrictions on our business activities, including mergers and acquisitions, fines and other penalties, any of which could adversely affect our results of operations, capital base and the price of our common stock.
We may be adversely affected by changes in U.S. tax and other laws and regulations
Corporate tax rates affect our profitability and capital levels. The U.S. corporate tax code may be further reformed by the U.S. Congress and additional guidance may be issued by the U.S. Department of the Treasury relevant to the Tax Cuts and Jobs Act that was signed into law on December 22, 2017. It is not possible at this time to quantify the ongoing impacts additional reform or guidance might have on our business or financial condition.
Strategic Risks
We encounter significant competition which may reduce our market share and profitability
We compete with other banks and specialized financial service providers in our market areas. Our primary competitors include local, regional and national banks; credit unions; commercial finance companies; various wealth management providers; independent and captive insurance agencies; mortgage companies; and non-bank providers of financial services. Some of our larger competitors, including certain banks with a significant presence in our market areas, have the capacity to offer products and services we do not offer. Some of our non-bank competitors operate in less stringent regulatory environments, and certain competitors are not subject to federal and/or state income taxes. The fierce competitive pressures that we face adversely affect pricing for many of our products and services.
Certain provisions in our Certificate of Incorporation and Bylaws may prevent a change in management or a takeover attempt that you might consider to be in your best interests
Certain provisions contained in our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws could delay or prevent the removal of directors and other management. The provisions could also delay or make more difficult a tender offer, merger, or proxy contest that you might consider to be in your best interests. For example, our Certificate of Incorporation and/or Bylaws:
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allow our Board of Directors to issue and set the terms of preferred shares without further shareholder approval;
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limit who can call a special meeting of shareholders; and
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establish advance notice requirements for nominations for election to the Board of Directors and proposals of other business to be considered at annual meetings of shareholders.
These provisions, as well as provisions of the BHCA and other relevant statutes and regulations which require advance notice and/or applications for regulatory approval of changes in control of banks and bank holding companies, may discourage bids for our common stock at a premium over market price, adversely affecting its market price. Additionally, the fact that the Holding family holds or controls shares representing a majority of the voting power of our common stock may discourage potential takeover attempts and/or bids for our common stock at a premium over market price.
The market price of our stock may be volatile
Although publicly traded, our common stock has less liquidity and public float than many other large publicly traded financial services companies. Low liquidity increases the price volatility of our stock and could make it difficult for our shareholders to sell or buy our common stock at specific prices.
Excluding the impact of liquidity, the market price of our common stock can fluctuate widely in response to other factors, including expectations of financial and operating results, actual operating results, actions of institutional shareholders, speculation in the press or the investment community, market perception of acquisitions, rating agency upgrades or downgrades, stock prices of other companies that are similar to us, general market expectations related to the financial services industry, and the potential impact of government actions affecting the financial services industry.
We rely on dividends from FCB
As a financial holding company, we are a separate legal entity from FCB. We derive most of our revenue and cash flow from dividends paid by FCB. These dividends are the primary source from which we pay dividends on our common stock and interest and principal on our debt obligations. State and federal laws impose restrictions on the dividends that FCB may pay to us. In the event FCB is unable to pay dividends to us for an extended period of time, we may not be able to service our debt obligations or pay dividends on our common stock.
Item 2.
Item 2. Properties
As of December 31, 2017, BancShares operated branch offices at 545 locations in Arizona, California, Colorado, Florida, Georgia, Illinois, Kansas, Maryland, Minnesota, Missouri, New Mexico, North Carolina, Oklahoma, Oregon, South Carolina, Tennessee, Texas, Virginia, Washington, West Virginia and Wisconsin. FCB owns many of the buildings and leases other facilities from third parties.
BancShares' headquarters facility, a nine-story building with approximately 163,000 square feet, is located in Raleigh, North Carolina. In addition, we occupy separate facilities in Raleigh and in Columbia, South Carolina, that serve as our data and operations centers.
Additional information relating to premises, equipment and lease commitments is set forth in Note F of BancShares’ Notes to Audited Consolidated Financial Statements.
Item 3.
Item 3. Legal Proceedings
BancShares and various subsidiaries have been named as defendants in various legal actions arising from our normal business activities in which damages in various amounts are claimed. Although the amount of any ultimate liability with respect to those matters cannot be determined, in the opinion of management, no legal actions currently exist that are expected to have a material effect on BancShares’ consolidated financial statements. Additional information related to legal proceedings is set forth in Note T in BancShares’ Notes to Consolidated Financial Statements.
Part II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
BancShares has two classes of common stock-Class A common and Class B common. Shares of Class A common have one vote per share, while shares of Class B common have 16 votes per share. BancShares’ Class A common stock is listed on the NASDAQ Global Select Market under the symbol FCNCA. The Class B common stock is traded on the over-the-counter market and quoted on the OTC Bulletin Board under the symbol FCNCB. As of December 31, 2017, there were 1,332 holders of record of the Class A common stock and 214 holders of record of the Class B common stock. The market volume for Class B common stock is extremely limited. On many days there is no trading and, to the extent there is trading, it is generally low volume.
The average monthly trading volume for the Class A common stock was 417,888 shares for the fourth quarter of 2017 and 570,633 shares for the year ended December 31, 2017. The Class B common stock monthly trading volume averaged 4,431 shares in the fourth quarter of 2017 and 1,912 shares for the year ended December 31, 2017.
The per share cash dividends declared by BancShares on both the Class A and Class B common stock, the high and low sales prices per share of BancShares Class A common stock as reported on NASDAQ, and the high and low bid prices for BancShares Class B common stock as reported in the OTC Bulletin Board, for each quarterly period during 2017 and 2016, are set forth in the following table. Over-the-counter bid prices for BancShares Class B common stock represent inter-dealer prices without retail markup, markdown or commissions, and may not represent actual transaction prices.
A cash dividend of 35 cents per share was declared by the Board of Directors on January 30, 2018, payable on April 2, 2018, to holders of record as of March 19, 2018. Payment of dividends is made at the discretion of the Board of Directors and is contingent upon satisfactory earnings as well as projected future capital needs. BancShares’ principal source of liquidity for payment of shareholder dividends is the dividend it receives from FCB. FCB is subject to various requirements under federal and state banking laws that restrict the payment of dividends and its ability to lend to BancShares. Subject to the foregoing, it is currently management’s expectation that comparable cash dividends will continue to be paid in the future.
During 2017, our Board authorized the purchase of up to 800,000 shares of Class A common stock. The shares may be purchased from time to time at management's discretion from November 1, 2017 through October 31, 2018. It does not obligate BancShares to purchase any particular amount of shares and purchases may be suspended or discontinued at any time. The Board's action replaced existing authority to purchase up to 200,000 shares in effect during the twelve months preceding November 1, 2017.
There were no shares of Class A or Class B common stock purchased by BancShares during the year ended December 31, 2017.
The following graph compares the cumulative total shareholder return (CTSR) of our Class A common stock during the previous five years with the CTSR over the same measurement period of the NASDAQ - Banks Index and the NASDAQ - U.S. Index. Each trend line assumes that $100 was invested on December 31, 2012, and that dividends were reinvested for additional shares.
Item 6.
Item 6. Selected Financial Data
Table 1
FINANCIAL SUMMARY AND SELECTED AVERAGE BALANCES AND RATIOS
(1) The taxable-equivalent adjustment was $4,519, $5,093, $6,326, $3,988 and $2,660 for the years 2017, 2016, 2015, 2014, and 2013, respectively.
(2) Average loan and lease balances include PCI loans, non-PCI loans and leases, loans held for sale and nonaccrual loans and leases.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s discussion and analysis of earnings and related financial data are presented to assist in understanding the financial condition and results of operations of First Citizens BancShares, Inc. and Subsidiaries (BancShares). This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes presented within this report. Intercompany accounts and transactions have been eliminated. See Note A in the Notes to the Consolidated Financial Statements included in Part II, Item 8, of this Report for more detail. Although certain amounts for prior years have been reclassified to conform to statement presentations for 2017, the reclassifications had no effect on shareholders’ equity or net income as previously reported. Unless otherwise noted, the terms "we", "us" and "BancShares" refer to the consolidated financial position and consolidated results of operations for BancShares.
FORWARD-LOOKING STATEMENTS
Statements in this Report and exhibits relating to plans, strategies, economic performance and trends, projections of results of specific activities or investments, expectations or beliefs about future events or results and other statements that are not descriptions of historical facts may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
Forward-looking information is inherently subject to risks and uncertainties, and actual results could differ materially from those currently anticipated due to a number of factors which include, but are not limited to, factors discussed in our Annual Report on Form 10-K and in other documents filed by us from time to time with the Securities and Exchange Commission.
Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “forecasts,” “projects,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of BancShares’ management about future events.
Factors that could influence the accuracy of those forward-looking statements include, but are not limited to, the financial success or changing strategies of our customers, customer acceptance of our services, products and fee structure, the competitive nature of the financial services industry, our ability to compete effectively against other financial institutions in our banking markets, actions of government regulators, the level of market interest rates and our ability to manage our interest rate risk, changes in general economic conditions that affect our loan and lease portfolio, the abilities of our borrowers to repay their loans and leases, the values of real estate and other collateral, the impact of the FDIC-assisted transactions, the risks discussed in Item 1A. Risk Factors above and other developments or changes in our business that we do not expect.
Actual results may differ materially from those expressed in or implied by any forward-looking statements. Except to the extent required by applicable law or regulation, BancShares undertakes no obligation to revise or update publicly any forward-looking statements for any reason.
CRITICAL ACCOUNTING POLICIES
The accounting and reporting policies of BancShares are in accordance with accounting principles generally accepted in the United States (GAAP) and conform to general practices within the banking industry. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions to arrive at the carrying value of assets and liabilities and amounts reported for revenues and expenses. Our financial position and results of operations can be materially affected by these estimates and assumptions. Critical accounting policies are those policies that are most important to the determination of our financial condition and results of operations or that require management to make assumptions and estimates that are subjective or complex. The most critical accounting and reporting policies include those related to the allowance for loan and lease losses, fair value estimates, the payable to the FDIC for shared-loss agreements, defined benefit pension plan assumptions, and income taxes. Accounting policies are discussed in Note A in the Notes to Consolidated Financial Statements.
The following is a summary of our critical accounting policies that are material to our consolidated financial statements and are highly dependent on estimates and assumptions.
Allowance for loan and lease losses. The allowance for loan and lease losses (ALLL) reflects the estimated losses resulting from the inability of our customers to make required loan and lease payments. The ALLL is based on management's evaluation of the risk characteristics of the loan and lease portfolio under current economic conditions and considers such factors as the financial condition of the borrower, fair market value of collateral and other items that, in our opinion, deserve current recognition in estimating incurred losses. Our evaluation process is based on economic data, historical experience and current trends among delinquencies, defaults and nonperforming assets.
A primary component of determining the general allowance for performing and classified loans not analyzed specifically is the actual loss history of the various loan classes. Loan loss factors based on historical experience may be adjusted for significant factors that, in management's judgment, affect the collectability of the portfolio at the balance sheet date. For non-purchased credit impaired (non-PCI) commercial loans and leases, management incorporates historical net loss data to develop the applicable loan loss factors. For the non-PCI noncommercial segment, management incorporates specific loan class and delinquency status trends into the loan loss factors. Loan loss factors may be adjusted quarterly based on changes in the level of historical net charge-offs and updates by management, such as the number of periods included in the calculation of loss factors, loss severity and portfolio attrition.
Purchased credit impaired (PCI) loans are aggregated into loan pools based upon common risk characteristics or evaluated at the loan level. At each balance sheet date, BancShares evaluates whether the estimated cash flows and corresponding present value of its loans determined using their effective interest rates has decreased and if so, recognizes provision for loan losses. Management continuously monitors and actively manages the credit quality of the entire loan portfolio and adjusts the ALLL to an appropriate level. By assessing the probable estimated incurred losses in the loan portfolio on a quarterly basis, management is able to adjust specific and general loss estimates based upon the most recent information available.
Management considers the established ALLL adequate to absorb incurred losses for loans and leases outstanding at December 31, 2017, although future adjustments may be necessary based on changes in economic conditions, collateral values, erosion of the borrower's access to liquidity and other factors. If the financial condition of our borrowers were to deteriorate, resulting in an impairment of their ability to make payments, our estimates would be updated and additions to the allowance may be required. In addition, various regulatory agencies periodically review the ALLL as an integral part of their examination process. These agencies may require the recognition of additions to the ALLL based on their judgments of information available to them at the time of their examination. See Note E in the Notes to Consolidated Financial Statements for additional disclosures.
Fair value estimates. Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. Certain assets and liabilities are measured at fair value on a recurring basis. Examples of recurring uses of fair value include available for sale securities and loans held for sale. At December 31, 2017, the percentage of total assets measured at fair value on a recurring basis was 20.9 percent. There were no liabilities measured at fair value on a recurring basis at December 31, 2017. We also measure certain assets at fair value on a non-recurring basis either to evaluate assets for impairment or for disclosure purposes. Examples of non-recurring uses of fair value include impaired loans, other real estate owned (OREO), goodwill and intangible assets. As required under GAAP, the assets acquired and liabilities assumed in business combinations are recognized at their fair values as of the acquisition dates. Fair values estimated as part of a business combination are determined using valuation methods and assumptions established by management.
Fair value is determined using different inputs and assumptions based upon the instrument that is being valued. Where observable market prices from transactions for identical assets or liabilities are not available, we identify market prices for similar assets or liabilities. If observable market prices are unavailable or impracticable to obtain for any such similar assets or liabilities, we look to other modeling techniques which often incorporate unobservable inputs that are inherently subjective and require significant judgment. Fair value estimates requiring significant judgments are determined using various inputs developed by management with the appropriate skills, understanding and knowledge of the underlying asset or liability to ensure the development of fair value estimates is sound. Typical pricing sources used in estimating fair values include, but are not limited to, active markets with high trading volume, third party pricing services, external appraisals, valuation models and commercial and residential evaluation reports. In certain cases, our assessments with respect to assumptions that market participants would make may be inherently difficult to determine, and the use of different assumptions could result in material changes to these fair value measurements. See Note M in the Notes to Consolidated Financial Statements for additional disclosures regarding fair value.
FDIC shared-loss payable. Certain shared-loss agreements include clawback provisions that require payments to the FDIC if actual losses and expenses do not exceed a calculated amount. Our estimate of the clawback payments based on current loss and expense projections are recorded as a payable to the FDIC. Projected cash flows are discounted to reflect the estimated timing of the payments to the FDIC. See Note T in the Notes to Consolidated Financial Statements for additional disclosures.
Defined benefit pension plan assumptions. BancShares has a noncontributory qualified defined benefit pension plan that covers qualifying employees (BancShares plan) and certain legacy Bancorporation employees are covered by a noncontributory qualified defined benefit pension plan (Bancorporation plan). The calculation of the benefit obligations, the future value of plan assets, funded status and related pension expense under the pension plans require the use of actuarial valuation methods and assumptions. The valuations and assumptions used to determine the future value of plan assets and liabilities are subject to management judgment and may differ significantly depending upon the assumptions used. The discount rate used to estimate the present value of the benefits to be paid under the pension plans reflect the interest rate that could be obtained for a suitable investment used to fund the benefit obligations, which was 3.76 percent for both the BancShares and Bancorporation plans during 2017, compared to 4.30
percent during 2016. For the calculation of pension expense, the assumed discount rate was 4.30 percent for both the BancShares and Bancorporation plans during 2017, compared to 4.68 percent during 2016.
We also estimate a long-term rate of return on pension plan assets that is used to estimate the future value of plan assets. We consider such factors as the actual return earned on plan assets, historical returns on the various asset classes in the plans and projections of future returns on various asset classes. The calculation of pension expense was based on an assumed expected long-term return on plan assets of 7.50 percent for both of the BancShares and Bancorporation plans during 2017 and 2016.
The assumed rate of future compensation increases is reviewed annually based on actual experience and future salary expectations. We used an assumed rate of compensation increase of 4.00 percent for both the BancShares and Bancorporation plans to calculate pension expense during 2017 and 2016. Assuming other variables remain unchanged, an increase in the rate of future compensation increases results in higher pension expense for periods following the increase in the assumed rate of future compensation increases. See Note N in the Notes to Consolidated Financial Statements for additional disclosures.
Income taxes. Management estimates income tax expense using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the amount of assets and liabilities reported in the consolidated financial statements and their respective tax bases. In estimating the liabilities and corresponding expense related to income taxes, management assesses the relative merits and risks of various tax positions considering statutory, judicial and regulatory guidance. Because of the complexity of tax laws and regulations, interpretation is difficult and subject to differing judgments. Accrued income taxes payable represents an estimate of the net amounts due to or from taxing jurisdictions based upon various estimates, interpretations and judgments.
We evaluate our effective tax rate on a quarterly basis based upon the current estimate of net income, the favorable impact of various credits, statutory tax rates expected for the year and the amount of tax liability in each jurisdiction in which we operate. Annually, we file tax returns with each jurisdiction where we have tax nexus and settle our return liabilities.
Changes in estimated income tax liabilities occur periodically due to changes in actual or estimated future tax rates and projections of taxable income, interpretations of tax laws, the complexities of multi-state income tax reporting, the status of examinations being conducted by various taxing authorities and the impact of newly enacted legislation or guidance as well as income tax accounting pronouncements. See Note P in the Notes to Consolidated Financial Statements for additional disclosures.
CURRENT ACCOUNTING PRONOUNCEMENTS
Recently Adopted Accounting Pronouncements
Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2017-03, Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint Ventures (Topic 323): Amendments to SEC Paragraphs Pursuant to Staff Announcements at the September 22, 2016 and November 17, 2016 EITF Meetings (SEC Update)
This ASU adds an SEC paragraph and amends other Topics pursuant to an SEC Staff Announcement that states a registrant should evaluate ASUs that have not yet been adopted, including ASU 2014-09, Revenue from Contracts with Customers (Topic 606), ASU 2016-02, Leases (Topic 842), and ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, to determine the appropriate financial statement disclosures about the potential material effects of those ASUs on the financial statements when adopted. If a registrant does not know or cannot reasonably estimate the impact that adoption of the ASUs referenced are expected to have on the financial statements, then in addition to making a statement to that effect, the registrant should consider additional qualitative financial statement disclosures to assist the reader in assessing the significance of the impact the adoption will have on the financial statements, and a comparison to the registrant's current accounting policies. A registrant should describe the status of its process to implement the new standards and the significant matters yet to be addressed.
This ASU also addresses the accounting for tax benefits resulting from investments in qualified affordable housing projects where the decision to apply the proportional amortization method of accounting is an accounting policy decision to be applied consistently to all investments that meet the conditions, rather than a decision to be applied to individual investments that qualify for the use of the proportional amortization method.
The amendments in this ASU are effective upon issuance. We adopted the guidance effective in the first quarter of 2017. The disclosures required by this ASU are included within the “Recently Issued Accounting Pronouncements” section below. The adoption did not have an impact to our consolidated financial position or consolidated results of operations.
FASB ASU 2016-17, Consolidation (Topic 810): Interests Held Through Related Parties That Are Under Common Control
This ASU does not change the characteristics of a primary beneficiary in current GAAP; however, it requires that a reporting entity, in determining whether it satisfies the second characteristic of a primary beneficiary, to include all of its direct variable interests in a VIE and, on a proportionate basis, its indirect variable interests in a VIE held through related parties, including related parties that are under common control with the reporting entity. If, after performing that assessment, a reporting entity that is the single decision maker of a VIE concludes that it does not have the characteristics of a primary beneficiary, the amendments continue to require that reporting entity to evaluate whether it and one or more of its related parties under common control, as a group, have the characteristics of a primary beneficiary, then the party within the related party group that is most closely associated with the VIE is the primary beneficiary.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. We adopted the guidance effective in the first quarter of 2017. The adoption did not have an impact to our consolidated financial position or consolidated results of operations.
FASB ASU 2016-07, Investments-Equity Method and Joint Ventures (Topic 323): Simplifying the Transition to the Equity Method of Accounting
This ASU eliminates the requirement that when an investment qualifies for use of the equity method as a result of an increase in the level of ownership interest or degree of influence, an investor must adjust the investment, results of operations, and retained earnings retroactively on a step-by-step basis as if the equity method had been in effect during all previous periods that the investment had been held. The ASU requires that the equity method investor add the cost of acquiring the additional interest in the investee to the current basis of the investor's previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting. Therefore, upon qualifying for the equity method of accounting, no retroactive adjustment of the investment is required. Further, the ASU requires that an entity that has an available-for-sale equity security that becomes qualified for the equity method of accounting recognize through earnings, the unrealized gain or loss in accumulated other comprehensive income at the date the investment becomes qualified for use of the equity method.
The amendments in this ASU are effective for all entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. We adopted the guidance effective in the first quarter of 2017. The adoption did not have an impact on our consolidated financial position or consolidated results of operations.
Recently Issued Accounting Pronouncements
FASB ASU 2018-02, Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
This ASU requires a reclassification from accumulated other comprehensive income (AOCI) to retained earnings for stranded tax effects resulting from the newly enacted federal corporate income tax rate in the Tax Cuts and Jobs Act of 2017 (Tax Act), which was enacted on December 22, 2017. The Tax Act included a reduction to the corporate income tax rate from 35 percent to 21 percent effective January 1, 2018. The amount of the reclassification would be the difference between the historical corporate income tax rate and the newly enacted 21 percent corporate income tax rate.
The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. We will adopt the guidance during the first quarter of 2018. The change in accounting principle will be accounted for as a cumulative-effect adjustment to the balance sheet resulting in a $27.2 million increase to retained earnings and a corresponding decrease to AOCI on January 1, 2018.
FASB ASU 2017-07, Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost
This ASU requires employers to present the service cost component of the net periodic benefit cost in the same income statement line item as other employee compensation costs arising from services rendered during the period. Employers will present the other components separately from the line item that includes the service cost. In addition, only the service cost component of net benefit cost is eligible for capitalization.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We will adopt the guidance during the first quarter of 2018. BancShares does not anticipate any material impact to our consolidated financial position or consolidated results of operations as a result of the adoption.
FASB ASU 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment
This ASU eliminates Step 2 from the goodwill impairment test. Under Step 2, an entity had to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedure that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under the amendments in this ASU, an entity should perform its annual, or interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity should recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. Additionally, an entity should consider income tax effects from any tax deductible goodwill on the carrying amount of the reporting unit when measuring the goodwill impairment loss, if applicable. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. This ASU eliminates the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative test.
This ASU will be effective for BancShares' annual or interim goodwill impairment tests for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. We expect to adopt the guidance for our annual impairment test in fiscal year 2020. BancShares does not anticipate any impact to our consolidated financial position or consolidated results of operations as a result of the adoption.
FASB ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments
This ASU addresses the diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments in this ASU provide guidance on (1) debt prepayment or debt extinguishment costs; (2) settlement of zero-coupon debt instruments; (3) contingent consideration payments made after a business combination; (4) proceeds from the settlement of insurance claims; (5) proceeds from the settlement of corporate-owned life insurance policies, including bank-owned life insurance policies; (6) distributions received from equity method investees; (7) beneficial interests in securitization transactions; and (8) separately identifiable cash flows and application of the predominance principle.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Early adoption is permitted. The guidance requires application using a retrospective transition method. We will adopt the guidance during the first quarter of 2018. BancShares does not anticipate a material impact to our Consolidated Statements of Cash Flows.
FASB ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments
This ASU eliminates the delayed recognition of the full amount of credit losses until the loss was probable of occurring and instead will reflect an entity's current estimate of all expected credit losses. The amendments in this ASU broaden the information that an entity must consider in developing its expected credit loss estimate for assets measured either collectively or individually. The ASU does not specify a method for measuring expected credit losses and allows an entity to apply methods that reasonably reflect its expectations of the credit loss estimate based on the entity's size, complexity and risk profile. In addition, the disclosures of credit quality indicators in relation to the amortized cost of financing receivables, a current disclosure requirement, are further disaggregated by year of origination.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for fiscal years beginning after December 15, 2018. We will adopt the guidance by the first quarter of 2020 with a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. For BancShares, the standard will apply to loans, unfunded loan commitments and debt securities held to maturity. We have formed a cross-functional team co-led by Finance and Risk Management and engaged a third party to assist with the adoption. The implementation team has developed a detailed project plan and is staying informed about the broader industry's perspective and insights, and identifying and researching key decision points. We have completed the readiness assessment and gap analysis related to data, modeling IT, accounting policy, controls and reporting which has enabled us to determine the areas of focus and estimate total body of work. Our current critical activities include model design, accounting policy development, data feasibility remediation, evaluation of reporting and disclosure solutions and completion of specific work stream project plans. We will continue to evaluate the impact the new standard will have on our consolidated financial statements as the final impact will be dependent, among other items, upon the loan portfolio composition and credit quality at the adoption date, as well as economic conditions, financial models used and forecasts at that time.
FASB ASU 2016-02, Leases (Topic 842)
This ASU increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The key difference between existing standards and this
ASU is the requirement for lessees to recognize on their balance sheet all lease contracts. An entity may make an accounting election by classification to not recognize leases with terms less than 12 months on their balance sheet. Both a right-of-use asset, representing the right to use the leased asset, and a lease liability, representing the contractual obligation, are required to be recognized on the balance sheet of the lessee at lease commencement. Further, this ASU requires lessees to classify leases as either operating or finance leases, which are substantially similar to the current operating and capital leases classifications. The distinction between these two classifications under the new standard does not relate to balance sheet treatment, but relates to treatment in the statements of income and cash flows. Lessor guidance remains largely unchanged with the exception of how a lessor determines the appropriate lease classification for each lease to better align the lessor guidance with revised lessee classification guidance.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. For BancShares, the impact of this ASU will primarily relate to its accounting and reporting of leases as a lessee. We will adopt during the first quarter of 2019. We have engaged a third party and completed an inventory of all leases and their terms and service contracts with embedded leases. While we continue to evaluate the impact of the new standard, we expect an increase to the Consolidated Balance Sheets for right-of-use assets and associated lease liabilities, as well as resulting depreciation expense of the right-of-use assets and interest expense of the lease liabilities in the Consolidated Statements of Income, for arrangements previously accounted for as operating leases. Additionally, adding these assets to our balance sheet will impact our total risk-weighted assets used to determine our regulatory capital levels. Our impact analysis on this change in accounting principle estimates an increase to the Consolidated Balance Sheets for total lease liability ranging between $65.0 million and $85.0 million, as the initial gross up of both assets and liabilities. Capital is expected to be impacted by an estimated four to six basis points. These preliminary ranges are subject to change and will continue to be refined closer to adoption.
FASB ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities
This ASU addresses certain aspects of recognition, measurement, presentation and disclosure of certain financial instruments. The amendments in this ASU (1) require most equity investments to be measured at fair value with changes in fair value recognized in net income; (2) simplify the impairment assessment of equity investments without a readily determinable fair value; (3) eliminate the requirement to disclose the method(s) and significant assumptions used to estimate the fair value for financial instruments measured at amortized cost on the balance sheet; (4) require public business entities to use exit price notion, rather than entry prices, when measuring fair value of financial instruments for disclosure purposes; (5) require separate presentation of financial assets and financial liabilities by measurement category and form of financial assets on the balance sheet or the accompanying notes to the financial statements; (6) require separate presentation in other comprehensive income of the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in accordance with the fair value option for financial instruments; and (7) state that a valuation allowance on deferred tax assets related to available-for-sale securities should be evaluated in combination with other deferred tax assets.
The amendments in this ASU are effective for public business entities for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. We will adopt the ASU during the first quarter of 2018. The change in accounting principle will be accounted for as a cumulative-effect adjustment to the balance sheet resulting in an $18.7 million increase to retained earnings and a decrease to AOCI on January 1, 2018. With the adoption of this ASU equity securities can no longer be classified as available for sale, as such marketable equity securities will be disclosed as a separate line item on the balance sheet with changes in the fair value of equity securities reflected in net income.
For equity investments without a readily determinable fair value, BancShares has elected to measure the equity investments using the measurement alternative which requires BancShares to make a qualitative assessment of whether the investment is impaired at each reporting period. Under the measurement alternative these investments will be measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for an identical or similar investment of the same issuer. If a qualitative assessment indicates that the investment is impaired, BancShares will have to estimate the investment's fair value in accordance with ASC 820 and, if the fair value is less than the investment's carrying value, recognize an impairment loss in net income equal to the difference between carrying value and fair value. Equity investments without a readily determinable fair value are recorded within other assets in the consolidated balance sheets.
FASB ASU 2014-09, Revenue from Contracts with Customers (Topic 606)
In May 2014, the FASB issued a standard on the recognition of revenue from contracts with customers with the core principle being for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services. The new standard also results in enhanced disclosures about revenue, provides guidance for transactions that were not previously addressed comprehensively
and improves guidance for multiple-element arrangements. In March 2016, the FASB issued ASU 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations, to improve the operability and understandability of the implementation guidance on principal versus agent considerations. In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, to clarify guidance for identifying performance obligations and licensing implementation. In May 2016, the FASB issued ASU 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients, to clarify and improve the guidance for certain aspects of Topic 606. In December 2016, the FASB issued ASU 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, to clarify guidance for certain aspects of Topic 606. In September 2017, the FASB issued ASU 2017-13, Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update). This ASU adds SEC paragraphs to the new revenue and leases sections of the Codification pursuant to an SEC Staff announcement made on July 20, 2017 as well as supersedes certain SEC paragraphs related to previous SEC staff announcements. In November 2017, the FASB issued ASU 2017-14, Income Statement - Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606) (SEC Update), to supersede, amend and add SEC paragraphs to the Codification to reflect the August 2017 issuance of SEC staff Accounting Bulletin (SAB) 116 and SEC Release No. 33-10403.
Per ASU 2015-14, Deferral of the Effective Date, this guidance was deferred and is effective for fiscal periods beginning after December 15, 2017, including interim reporting periods within that reporting period. We will adopt the guidance during the first quarter of 2018. Our revenue is comprised of net interest income on financial assets and liabilities, which is explicitly excluded from the scope of the new guidance, and noninterest income. The contracts that are in scope of the guidance are primarily related to service charges on deposit accounts, cardholder and merchant income, wealth advisory services income, other service charges and fees, sales of other real estate, insurance commissions and miscellaneous fees. Based on our overall assessment of revenue streams and review of related contracts affected by the ASU, BancShares does not anticipate a material impact to our consolidated financial position or consolidated results of operations as a result of the adoption.
EXECUTIVE OVERVIEW
BancShares’ earnings and cash flows are primarily derived from our commercial and retail banking activities. We gather deposits from retail and commercial customers and also secure funding through various non-deposit sources. We invest the liquidity generated from these funding sources in interest-earning assets, including loans and leases, investment securities and overnight investments. We also invest in bank premises, hardware, software, furniture and equipment used to conduct our commercial and retail banking business. We provide treasury services products, cardholder and merchant services, wealth management services and various other products and services typically offered by commercial banks.
BancShares conducts its banking operations through its wholly-owned subsidiary FCB, a state-chartered bank organized under the laws of the state of North Carolina.
Our strong financial position enables us to pursue growth through strategic acquisitions that enhance organizational value by providing us the opportunity to grow capital and enhance earnings. These transactions allow us to strengthen our presence in existing markets as well as expand our footprint in new markets.
Interest rates have presented significant challenges to commercial banks’ efforts to generate earnings and shareholder value. Our strategy continues to focus on maintaining an interest rate risk profile that will benefit net interest income in a rising rate environment. Management drives to this goal by focusing on core customer deposits and loans in the targeted interest rate risk profile. Additionally, our initiatives focus on growth of noninterest income sources, control of noninterest expenses, optimization of our branch network, and further enhancements to our technology and delivery channels.
In lending, we continue to focus our activities within our core competencies of retail, small business, commercial and commercial real estate lending to build a diversified portfolio. Our low to moderate risk appetite continues to govern all lending activities.
Our initiatives also pursue additional non-interest fee income through enhanced credit card offerings, and expanded wealth management and merchant services. We have redesigned our credit card programs to offer more competitive products, intended to both increase the number of accounts and frequency of card usage. Enhancements include more comprehensive reward programs and improved card benefits. In wealth management, we have broadened our products and services to better align with the specialized needs and desires of those customers.
Our goals are to increase efficiencies and control costs while effectively executing an operating model that best serves our customers’ needs. We seek the appropriate footprint and staffing levels to take efficient advantage of the revenue opportunities in each of our markets. Management is pursuing opportunities to improve our operational efficiency and increase profitability through expense reductions, while continuing enterprise sustainability projects to stabilize the operating environment. Such initiatives include the automation of certain manual processes, elimination of duplicated and outdated systems, enhancements to existing technology, reduction of discretionary spending and actively managing personnel expenses. We review vendor agreements and larger third party contracts for cost savings. We also seek to increase profitability through optimizing our branch network.
Recent Economic and Industry Developments
Various external factors influence the focus of our business efforts and the results of our operations can change significantly based on those external factors. Based on the latest real gross domestic product (GDP) information available, the Bureau of Economic Analysis’ advance estimate of fourth quarter 2017 GDP growth was 2.6 percent, down from 3.2 percent GDP growth in the third quarter 2017. The estimated real GDP growth during the quarter was due to positive contributions from personal consumption expenditures, residential and nonresidential fixed investments, exports, and state, local and federal government spending, partially offset by negative contributions from private inventory investments and an increase in imports. For all of 2017, the economy grew by 2.3 percent, compared to an increase of 1.5 percent in 2016.
The U.S. unemployment rate dropped from 4.7 percent in December 2016 to 4.1 percent in December 2017. However, according to the U.S. Department of Labor, nonfarm payroll employment growth in 2017 was 2.1 million, compared to 2.2 million in 2016.
The Federal Reserve’s Federal Open Market Committee (FOMC) indicated in the fourth quarter that the labor market continued to strengthen and economic activity expanded at a solid rate. In light of the cumulative progress made during the fourth quarter, the FOMC decided to raise the target range for the federal funds rate by 0.25 percent to 1.5 percent. In determining the timing and size of future adjustments to the target range for the federal funds rate, the FOMC will assess realized and expected economic conditions relative to its objectives of maximum employment and 2.0 percent inflation. The FOMC expects that economic activity will expand at a moderate pace and labor market conditions will remain strong with gradual increases in the federal funds rate in the future.
The housing market remained solid during the year, fueled by low mortgage interest rates, economic growth and job creation. An estimated 608,000 new homes were purchased in 2017, up 8.3 percent, from the 2016 figure of 561,000. Purchases of existing homes in 2017 and 2016 remained flat at 5.5 million.
The trends in the banking industry are similar to those of the broader economy as shown in the latest national banking results from the third quarter of 2017. FDIC-insured institutions reported a 5.7 percent increase in net income compared to the third quarter of 2016, mainly attributable to an increase in net operating revenue and higher net interest income. Across the industry, banking industry average net interest margin increased to 3.30 percent in the third quarter of 2017 from 3.18 percent in the same quarter a year ago. Total loans and leases increased by 3.5 percent from the same quarter a year ago primarily due to growth in residential mortgage loans.
EARNINGS PERFORMANCE SUMMARY
For the year ended December 31, 2017, net income was $323.8 million, or $26.96 per share, compared to $225.5 million, or $18.77 per share, during 2016. The $98.3 million, or 43.6 percent, increase in net income was primarily due to higher net interest income, resulting from strong loan growth and higher interest income earned on investment securities and overnight investments, lower provision expense and higher noninterest income, largely related to gains earned on the acquisitions of HCB and Guaranty and higher fee-based income, partially offset by increases in noninterest expense and income taxes.
Key financial highlights for 2017 include:
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Loan growth was strong during 2017, as net balances increased by $1.86 billion to $23.60 billion, primarily driven by originated portfolio growth and net loans acquired from HCB and Guaranty.
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Deposit growth continued in 2017, up $1.10 billion to $29.27 billion, primarily due to organic growth in demand deposit account balances, interest-bearing savings and checking accounts, and the addition of deposit balances from the HCB and Guaranty acquisitions.
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The yield on the investment portfolio continued to improve, while deposit funding costs remained relatively unchanged.
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Earnings in 2017 included gains of $134.7 million recognized in connection with the HCB and Guaranty acquisitions.
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Core fee-based business contributed to higher noninterest income, led by growth of $20.1 million in merchant and cardholder income primarily reflecting increases in sales volume.
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The allowance for loan and lease losses as a percentage of total loans and leases declined to 0.94 percent at December 31, 2017, compared to 1.01 percent at December 31, 2016, primarily due to favorable experience in certain loan loss factors.
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Provision expense related to loan and lease losses decreased $7.2 million primarily due to lower loan loss estimates.
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Net charge-offs as a percentage of average loans and leases remained low at 0.10 percent in 2017, unchanged from 2016.
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Earnings in the fourth quarter of 2017 included additional income tax expense of $25.8 million related to the re-measurement of deferred taxes as a result of the Tax Act. Although earnings per share for the three and twelve months ended December 31, 2017 were up compared to the same periods in the prior year, the increase in income tax expense had a negative impact on earnings per share.
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BancShares remained well-capitalized at December 31, 2017 under Basel III capital requirements with a total risk-based capital ratio of 14.21 percent, Tier 1 risk-based capital ratio of 12.88 percent, common equity Tier 1 ratio of 12.88 percent and leverage capital ratio of 9.47 percent.
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For the fourth quarter of 2017, BancShares declared and paid dividends of $0.35 per share of outstanding common stock to shareholders, which is approximately a 17 percent increase from the $0.30 per share in previous periods.
The return on average assets was 0.94 percent during 2017, compared to 0.70 percent during 2016. The return on average shareholders' equity was 10.10 percent and 7.51 percent for the respective periods. Excluding the deferred tax asset valuation adjustment of $25.8 million resulting from the Tax Act, return on average assets and return on average shareholders' equity during 2017 would have been 1.02 percent and 10.90 percent, respectively.
Net interest income for the year ended December 31, 2017 increased by $115.2 million, or 12.2 percent, to $1.06 billion. Interest income was up $115.9 million due to higher interest income earned on loans, investments and excess cash held in overnight investments. The year-to-date taxable-equivalent net interest margin for 2017 was 3.30 percent, compared to 3.14 percent during 2016. The margin increase was primarily due to higher loan balances and improved yields on investments and excess cash held in overnight investments.
BancShares recorded net provision expense of $25.7 million for loan and lease losses for 2017, compared to $32.9 million net provision expense for 2016. The net provision expense on non-PCI loans and leases was $29.1 million for 2017, compared to $34.9 million in 2016. The $5.7 million decrease in 2017 was primarily due to favorable experience in certain in loan loss factors. The PCI loan portfolio net provision credit was $3.4 million for the year ended 2017, compared to a net provision credit of $1.9 million during the same period of 2016. The PCI provision credit increased by $1.5 million, primarily due to improved future projected cash flows and improved default rates.
Noninterest income was $641.0 million for the year ended 2017, compared to $488.1 million for 2016. Excluding the $134.7 million in gains from the HCB and Guaranty acquisitions in 2017 and the $5.8 million in gains from the NMSB and FCSB acquisitions in 2016, total noninterest income increased $24.0 million. This growth was primarily due to a $20.1 million increase in merchant and cardholder income, gain of $12.5 million recognized on the early termination of two forward-starting FHLB advances, higher service charges on deposit accounts of $11.8 million and an increase of $6.5 million in wealth management services income. These increases were partially offset by lower securities gains of $22.4 million and the positive impact from the FDIC shared-loss termination of $16.6 million recognized in 2016.
Noninterest expense was $1.13 billion for the year ended December 31, 2017, compared to $1.05 billion for the same period in 2016. The $82.8 million increase was attributable to higher personnel expenses of $55.6 million, an increase in merchant and cardholder processing expense of $8.8 million, higher processing fees paid to third parties of $6.7 million, primarily acquisition related, higher equipment expense of $5.0 million and increases of $4.0 million and $3.7 million in consultant services and merger-related expenses, respectively.
Income tax expense was $219.9 million and $125.6 million for the years ended 2017 and 2016, respectively. The increase in 2017 was primarily due to higher pre-tax earnings and an additional income tax expense of $25.8 million from the re-measurement of deferred taxes as a result of the Tax Act.
Loan balances during 2017 increased by $1.86 billion, or 8.6 percent, since December 31, 2016. This increase was primarily driven by $1.46 billion of organic growth in the non-PCI portfolio and the addition of $447.7 million in non-PCI loans from the Guaranty acquisition. The PCI portfolio declined over this period by $46.2 million, as a result of continued loan runoff of $208.8 million, offset by net loans acquired from Guaranty and HCB, which were $97.6 million and $65.0 million, respectively, at December 31, 2017.
The allowance for loan and lease losses as a percentage of total loans was 0.94 percent at December 31, 2017 compared to 1.01 percent at December 31, 2016. At December 31, 2017, BancShares’ nonperforming assets, including nonaccrual loans and OREO, decreased $2.7 million to $144.3 million from $147.0 million at December 31, 2016.
At December 31, 2017, deposits were $29.27 billion, an increase of $1.10 billion, or 3.9 percent, since December 31, 2016. The increase was due to organic growth of $553.4 million primarily in demand deposit account balances, interest-bearing savings and checking accounts, and the addition of deposit balances from the HCB and Guaranty acquisitions of $551.6 million at December 31, 2017, offset by runoff in time deposits and lower money market account balances.
BUSINESS COMBINATIONS
HomeBancorp, Inc.
On December 18, 2017, FCB and HomeBancorp entered into a definitive merger agreement. The agreement provides for the acquisition of Tampa, Florida-based HomeBancorp by FCB. Under the terms of the agreement, cash consideration of $15.03 will be paid to the shareholders of HomeBancorp for each share of HomeBancorp's common stock totaling approximately $113.6 million. The transaction is expected to close no later than the second quarter of 2018, subject to the receipt of regulatory approvals and the approval of HomeBancorp's shareholders, and will be accounted for under the acquisition method of accounting. The merger will allow FCB to expand its presence in Florida and enter into two new markets in Tampa and Orlando. As of September 30, 2017, HomeBancorp reported $954.9 million in consolidated assets, $699.4 million in deposits and $637.5 million in loans.
Guaranty Bank
On May 5, 2017, FCB entered into an agreement with the FDIC, as Receiver, to purchase certain assets and assume certain liabilities of Guaranty of Milwaukee, Wisconsin. The acquisition provides FCB with the opportunity to grow capital and enhance earnings.
The Guaranty transaction was accounted for under the acquisition method of accounting and, accordingly, assets acquired and liabilities assumed were recorded at their estimated fair values on the acquisition date. Fair values are preliminary and subject to refinement for up to one year after the closing date of the relevant acquisition as additional information regarding closing date fair values becomes available. As of December 31, 2017, there have been no refinements to the fair value of these assets acquired and liabilities assumed.
The fair value of the assets acquired was $875.1 million, including $574.6 million in non-PCI loans, $114.5 million in PCI loans and $9.9 million in core deposit intangible. Liabilities assumed were $982.7 million, of which $982.3 million were deposits. The total gain on the transaction was $122.7 million which is included in noninterest income in the Consolidated Statements of Income.
Table 2 provides the identifiable assets acquired and liabilities assumed at their estimated fair values as of the acquisition date.
Table 2
GUARANTY BANK NET ASSETS ACQUIRED AND NET LIABILITIES ASSUMED
Merger-related expenses of $7.4 million from the Guaranty transaction were recorded in the Consolidated Statements of Income for the year ended December 31, 2017. Loan-related interest income generated from Guaranty was approximately $20.5 million since the acquisition date.
Based on such credit factors as past due status, nonaccrual status, loan-to-value, credit scores and other quantitative and qualitative considerations, the acquired loans were divided into loans with evidence of credit quality deterioration, which are accounted for under ASC 310-30 (included in PCI loans), and loans that do not meet this criteria, which are accounted for under ASC 310-20 (included in non-PCI loans).
Harvest Community Bank
On January 13, 2017, FCB entered into an agreement with the FDIC, as Receiver, to purchase certain assets and assume certain liabilities of HCB of Pennsville, New Jersey. The acquisition provides FCB with the opportunity to grow capital and enhance earnings.
The HCB transaction was accounted for under the acquisition method of accounting and, accordingly, assets acquired and liabilities assumed were recorded at their estimated fair values on the acquisition date. Fair values are preliminary and subject to refinement for up to one year after the closing date of the relevant acquisition as additional information regarding closing date fair values becomes available. As of December 31, 2017, there have been no refinements to the fair value of these assets acquired and liabilities assumed.
The fair value of the assets acquired was $111.6 million, including $85.1 million in PCI loans and $850 thousand in core deposit intangible. Liabilities assumed were $121.8 million, of which the majority were deposits. As a result of the transaction, FCB recorded a gain on the acquisition of $12.0 million which is included in noninterest income in the Consolidated Statements of Income.
Table 3 provides the identifiable assets acquired and liabilities assumed at their estimated fair values as of the acquisition date.
Table 3
HARVEST COMMUNITY BANK NET ASSETS ACQUIRED AND NET LIABILITIES ASSUMED
Merger-related expenses of $1.2 million were recorded in the Consolidated Statements of Income for the year ended December 31, 2017. Loan-related interest income generated from HCB was approximately $3.8 million for the year ended December 31, 2017.
All loans resulting from the HCB transaction were recorded at the acquisition date with a discount attributable, at least in part, to credit quality deterioration, and are therefore accounted for as PCI under ASC 310-30.
Cordia Bancorp, Inc.
On September 1, 2016, FCB completed the merger of Cordia and its subsidiary, BVA, into FCB. Under the terms of the merger agreement, cash consideration of $5.15 was paid to Cordia’s shareholders for each of their shares of Cordia’s common stock, with total consideration paid of $37.1 million. The Cordia transaction was accounted for under the acquisition method of accounting and, accordingly, assets acquired and liabilities assumed were recorded at their estimated fair values on the acquisition date. These fair values were subject to refinement for up to one year after the closing date of the acquisition. The measurement period ended on August 31, 2017.
The fair value of assets acquired was $349.3 million, including $241.4 million in loans and $2.2 million in core deposit intangible. Liabilities assumed were $323.1 million, including $292.2 million in deposits. As a result of the transaction, FCB recorded $10.8 million of goodwill. The amount of goodwill recorded represents the excess purchase price over the estimated fair value of the net assets acquired. This premium paid reflects the increased market share and related synergies that are expected to result from the acquisition. None of the goodwill is deductible for income tax purposes as the merger is accounted for as a qualified stock purchase.
Merger-related expenses of $260 thousand and $3.8 million were recorded in the Consolidated Statements of Income for the years ended December 31, 2017 and 2016, respectively. Loan-related interest income generated from Cordia was approximately $5.6 million and $4.2 million for the years ended December 31, 2017 and 2016, respectively.
Due to the immaterial amount of loans resulting from the Cordia transaction that had evidence of credit quality deterioration, all loans were accounted for as non-PCI loans under ASC 310-20.
First CornerStone Bank
On May 6, 2016, FCB entered into an agreement with the FDIC, as Receiver, to purchase certain assets and assume certain liabilities of FCSB of King of Prussia, Pennsylvania. The FCSB transaction was accounted for under the acquisition method of accounting and, accordingly, assets acquired and liabilities assumed were recorded at their estimated fair values on the acquisition date. These fair values were subject to refinement for up to one year after the closing date of the acquisition. The measurement period ended on May 5, 2017.
The fair value of the assets acquired was $87.4 million, including $43.8 million in loans and $390 thousand of core deposit intangible. Liabilities assumed were $96.9 million, of which the majority were deposits. The fair value of the net liabilities assume was $9.5 million and cash received from the FDIC was $12.5 million. The total gain on the transaction was $3.0 million which is included in noninterest income in the Consolidated Statements of Income.
Merger-related expenses were immaterial for the year ended December 31, 2017 and $1.0 million was recorded in the Consolidated Statements of Income for the year ended December 31, 2016. Loan-related interest income generated from FCSB was approximately $1.7 million and $1.6 million for the years ended December 31, 2017 and 2016, respectively.
All loans resulting from the FCSB transaction were recorded at the acquisition date with a discount attributable, at least in part, to credit quality deterioration, and are therefore accounted for as PCI loans under ASC 310-30.
North Milwaukee State Bank
On March 11, 2016, FCB entered into an agreement with the FDIC, as Receiver, to purchase certain assets and assume certain liabilities of NMSB of Milwaukee, Wisconsin. The NMSB transaction was accounted for under the acquisition method of accounting and, accordingly, assets acquired and liabilities assumed were recorded at their estimated fair values on the acquisition date. These fair values were subject to refinement for up to one year after the closing date of the acquisition. The measurement period ended on March 10, 2017.
The fair value of the assets acquired was $53.6 million, including $36.9 million in loans and $240 thousand of core deposit intangible. Liabilities assumed were $60.9 million, of which $59.2 million were deposits. The fair value of the net liabilities assumed was $7.3 million and cash received from the FDIC was $10.2 million. The total gain on the transaction was $2.9 million which is included in noninterest income in the Consolidated Statements of Income.
Merger-related expenses of $112 thousand and $517 thousand were recorded in the Consolidated Statements of Income for the years ended December 31, 2017 and 2016, respectively. Loan-related interest income generated from NMSB was approximately $2.4 million and $1.9 million for the years ended December 31, 2017 and 2016, respectively.
All loans resulting from the NMSB transaction were recorded at the acquisition date with a discount attributable, at least in part, to credit quality deterioration, and are therefore accounted for as PCI loans under ASC 310-30.
FDIC-ASSISTED TRANSACTIONS
BancShares completed eleven FDIC-assisted transactions during the period beginning in 2009 through 2017. These transactions provided us significant contributions to capital and earnings. Prior to its merger into BancShares in 2014, First Citizens Bancorporation, Inc. (Bancorporation) completed three FDIC-assisted transactions: Georgian Bank of Atlanta, Georgia (acquired in 2009); Williamsburg First National Bank of Williamsburg, South Carolina (acquired in 2010); and Atlantic Bank & Trust of Charleston, South Carolina (acquired in 2011). Nine of the fourteen FDIC-assisted transactions (including the three completed by Bancorporation) included shared-loss agreements that, for their terms, protect us from a substantial portion of the credit and asset quality risk we would otherwise incur.
Table 4 provides information regarding the fair value of loans at the acquisition date for the fourteen FDIC-assisted transactions consummated from 2009 through 2017.
Table 4
FDIC-ASSISTED TRANSACTIONS
(1) Date of transaction and fair value of loans acquired represent when Bancorporation acquired the entities and the fair value of the loans on that date.
As of December 31, 2017, shared-loss agreements are still active for First Regional Bank (FRB), Georgian Bank (GB) and United Western Bank (UWB). Shared-loss protection remains for single family residential loans acquired from UWB and GB in the amount of $67.8 million. FRB remains in a recovery period, where any recoveries are shared with the FDIC, until March 2020.
FDIC shared-loss termination. During 2017, FCB entered into an agreement with the FDIC to terminate the shared-loss agreement for Venture Bank (VB). Under the terms of the agreement, FCB made a payment of $285 thousand to the FDIC as consideration for early termination of the shared-loss agreement. The early termination resulted in an adjustment of $240 thousand to the FDIC shared-loss receivable and a $45 thousand loss on the termination of the shared-loss agreement. In addition to the shared-loss agreement termination for VB, FCB terminated five shared-loss agreements in 2016, including Temecula Valley Bank, Sun American Bank, Williamsburg First National Bank, Atlantic Bank & Trust and Colorado Capital Bank. In connection with the 2016 termination, FCB recognized a positive net impact to pre-tax earnings of $16.6 million.
Table 5 provides the various terms of each shared-loss agreement and the components of the receivable from the FDIC.
Table 5
SHARED-LOSS PROVISIONS FOR FDIC-ASSISTED TRANSACTIONS
Table 6
AVERAGE BALANCE SHEETS
Loans and leases include PCI and non-PCI loans, nonaccrual loans and loans held for sale. Interest income on loans and leases includes accretion income and loan fees. Loan fees were $55.8 million, $37.5 million, $30.9 million, $16.4 million and $14.1 million for the years ended 2017, 2016, 2015, 2014, and 2013, respectively. Yields related to loans, leases and securities exempt from both federal and state income taxes, federal income taxes only, or state income taxes only are stated on a taxable-equivalent basis assuming statutory federal income tax rates of 35.0 percent for each period and state income tax rates of 3.1 percent, 3.1 percent, 5.5 percent, 6.2 percent, and 6.9 percent for the years ended 2017, 2016, 2015, 2014, and 2013, respectively. The taxable-equivalent adjustment was $4,519, $5,093, $6,326, $3,988 and $2,660 for the years ended 2017, 2016, 2015, 2014, and 2013, respectively.
Table 6
AVERAGE BALANCE SHEETS (continued)
Table 7 isolates the changes in taxable-equivalent net interest income due to changes in volume and interest rates for 2017 and 2016.
Table 7
CHANGES IN CONSOLIDATED TAXABLE EQUIVALENT NET INTEREST INCOME
Loans and leases include PCI loans, non-PCI loans, nonaccrual loans, and loans held for sale. Interest income on loans and leases includes accretion income and loan fees. The rate/volume variance is allocated equally between the changes in volume and rate.
NET INTEREST INCOME
Net interest income of $1.06 billion for the year ended December 31, 2017 increased by $115.2 million, or 12.2 percent, compared to the same period in 2016. Interest income was up $115.9 million primarily due to higher non-PCI loan interest income of $79.0 million as a result of originated loan growth and the contribution from the Guaranty acquisition, a $24.5 million improvement in interest income earned on investments and a $12.3 million increase in interest income earned on excess cash held in overnight investments. Interest expense increased by $712 thousand resulting from higher interest expense on short-term FHLB borrowings and repurchase obligations. This increase was partially offset by lower interest on deposits, primarily from continued run-off of time deposits, and long-term obligations. Net interest income for the year ended December 31, 2016 was $944.7 million, a $19.8 million increase from 2015, primarily due to strong core originated loan growth, higher investment interest income and a decrease in interest expense, offset by a decline in loan interest income on PCI loans.
Interest income from loans and leases was $955.6 million during 2017, an increase of $79.2 million compared to 2016. The increase was primarily the result of a $79.0 million increase in non-PCI loan interest income due to originated loan growth and the contribution from Guaranty. Interest income increased $18.5 million between 2016 and 2015, reflecting an increase in non-PCI loan interest income due to originated loan growth, partially offset by a decline in PCI loan interest income due to portfolio run-off.
Interest income earned on investment securities was $121.2 million, $96.8 million, and $88.3 million during 2017, 2016, and 2015, respectively. The $24.4 million increase in 2017 was due to a 26 basis point improvement in the investment yield resulting from reinvesting investment securities cash flows from maturities and sales into higher yielding short duration mortgage-backed securities. Interest income earned on investment securities in 2016 increased $8.5 million, compared to 2015, primarily due to a
20 basis point improvement in the investment yield resulting from reinvesting investment securities cash flows from maturities and sales into higher yielding short duration mortgage-based securities.
Interest expense on interest-bearing deposits was $16.2 million in 2017, a decrease of $2.0 million, compared to 2016, primarily due to a decline in time deposit balances. Interest expense on interest-bearing deposits decreased $3.1 million between 2016 and 2015 primarily due to a decline in time deposit balances and funding costs. Interest expense on borrowings was $27.6 million in 2017, an increase of $2.7 million, compared to 2016, primarily related to an increase in short-term borrowings, partially offset by a decline in interest paid on long-term borrowings. Interest expense on borrowings increased $1.8 million between 2016 and 2015 primarily related to an increase in long-term borrowings, partially offset by a decline in interest paid on short-term borrowings.
The year-to-date taxable-equivalent net interest margin for 2017 was 3.30 percent, compared to 3.14 percent during 2016. The margin increase was primarily due to higher loan balances and improved yields on investments and excess cash held in overnight investments. Investment yields improved 26 basis points compared to 2016 primarily due to reinvesting investment securities cash flows from maturities, sales and paydowns into higher yielding short duration securities, mainly U.S. Treasury and mortgage-backed securities. The yield on overnight investments improved 57 basis points compared to 2016 primarily due to the positive impact of three 25 basis point increases in the federal funds rate since the fourth quarter of 2016. The year-to-date taxable equivalent net interest margin decreased 8 basis points to 3.14 percent in 2016, compared to 2015, primarily due to higher yielding PCI loan portfolio run-off, partially offset by the favorable impacts of originated loan growth, higher yields on investments and lower funding costs.
Average interest-earning assets increased $1.94 billion, or by 6.4 percent, for the year ended December 31, 2017. Growth in average interest-earning assets during 2017 was primarily due to originated loan growth funded largely by deposit growth and loans acquired from Guaranty and HCB. The year-to-date taxable-equivalent yield on interest-earning assets improved 16 basis points in 2017 to 3.44 percent. The increase was primarily the result of higher yields on investments and excess cash held in overnight investments. Average interest-earning assets increased $1.38 billion between 2016 and 2015 primarily due to originated loan growth and net loans acquired in the NMSB, FCSB and Cordia acquisitions.
Average interest-bearing liabilities increased $418.0 million for the full year of 2017, compared to 2016 primarily due to growth in interest-bearing savings and checking accounts and incremental FHLB borrowings of $175.0 million in 2017. Average interest-bearing liabilities increased $171.6 million between 2016 and 2015 primarily due to incremental FHLB borrowings of $150.0 million in 2016. The rate paid on interest-bearing liabilities remained flat at 0.22 percent for the full year 2017 and 2016 and decreased 1 basis point between 2016 and 2015, primarily due to lower deposit and borrowing costs.
NONINTEREST INCOME
Table 8
NONINTEREST INCOME
Noninterest income is an essential component of our total revenue and is critical to our ability to sustain adequate profitability levels. The primary sources of noninterest income have traditionally consisted of gains on acquisitions, gains on the sale of investment securities as well as fees and service charge generated from cardholder services, merchant services, deposit accounts,
wealth management services and mortgage lending and servicing. Recoveries on PCI loans that have been previously charged-off are additional sources of noninterest income. BancShares records the portion of recoveries not covered under shared-loss agreements as noninterest income rather than as an adjustment to the allowance for loan losses. Charge-offs on PCI loans are recorded against the discount recognized on the date of acquisition versus through the allowance for loan losses unless an allowance was established subsequent to the acquisition date due to declining expected cash flow.
For the year ended December 31, 2017, total noninterest income was $641.0 million, compared to $488.1 million for the same period in 2016, an increase of $153.0 million, or by 31.3 percent. Excluding $134.7 million in gains on the HCB and Guaranty acquisitions in 2017 and the $5.8 million in gains on the FCSB and NMSB acquisitions in 2016, total noninterest income increased $24.0 million, or by 5.0 percent. The year-to-date change was attributable to the following:
•
Merchant and cardholder services income increased by $20.1 million due to increases in sales volume and income from the Guaranty acquisition.
•
Other income increased by $12.7 million, driven primarily by the early termination of two forward-starting FHLB advances which resulted in a realized gain of $12.5 million.
•
Service charges on deposit accounts increased by $11.8 million, primarily attributable to the Guaranty acquisition, as well as increased fees charged on certain transactions.
•
Wealth management services income increased by $6.5 million, driven primarily by an increase in sales volume on annuity products, increased brokerage income, and higher commissions earned on trust services.
•
Lower FDIC shared-loss receivable adjustments of $3.5 million primarily due to a decrease in OREO and loan expenses related to shared-loss agreements.
•
Mortgage income increased $2.9 million primarily attributable to interest rate movements and mortgage servicing rights retained related to the sale of certain residential mortgage loans.
•
Gains on sales of securities decreased by $22.4 million due to lower investment portfolio sales in 2017 compared to 2016.
•
Net impact from the FDIC shared-loss termination of $16.6 million recognized in 2016.
For the year ended December 31, 2016, total noninterest income was $488.1 million, compared to $467.1 million for the same period in 2015, an increase of $21.0 million, or by 4.5 percent. Excluding the $5.8 million in gains on the FCSB and NMSB acquisitions in 2016 and the $42.9 million in gains on the CCBT acquisition in 2015, total noninterest income increased $58.1 million, or by 13.7 percent. The year-to-date change was attributable to the following:
•
Merchant and cardholder services income increased by $17.6 million, reflecting sales volume growth.
•
Net impact from the FDIC shared-loss termination of $16.6 million.
•
Gains on sales of securities increased by $15.9 million.
•
Lower FDIC receivable adjustments of $9.3 million resulting from a reduction in claims and lower amortization expense due to the early termination of the shared-loss agreements.
NONINTEREST EXPENSE
Table 9
NONINTEREST EXPENSE
For the year ended December 31, 2017, total noninterest expense was $1.13 billion, compared to $1.05 billion for the same period in 2016, an increase of $82.8 million, or 7.9 percent. The year-to-date change was primarily attributable to the following:
•
Personnel expense, which includes salaries, wages and employee benefits, increased by $55.6 million primarily driven by acquired bank personnel, merit increases, staff additions, and payroll incentive plans.
•
Merchant processing expense increased by $7.4 million aligned with higher sales volumes during 2017.
•
Processing fees paid to third parties increased by $6.7 million primarily due to core processing expenses related to the acquisitions of Guaranty and HCB.
•
Equipment expense increased by $5.0 million attributable to investments in new technology as well as upgrades to existing equipment.
•
Consultant expenses increased by $4.0 million primarily due to regulatory, accounting and compliance-related services.
•
Merger-related expense increased by $3.7 million primarily driven by costs associated with the Guaranty and HCB acquisitions in 2017.
For the year ended December 31, 2016, total noninterest expense was $1.05 billion, compared to $1.04 billion for the same period in 2015, an increase of $9.8 million, or 0.9 percent. The year-to-date change was primarily attributable to the following:
•
Processing expenses for merchant and cardholder services increased by $12.6 million aligned with higher sales volume.
•
Other expense increased by $10.7 million primarily as a result of higher operational losses, including losses on debit and credit cards of $4.5 million and costs related to branch closures of $3.2 million.
•
Occupancy expense increased by $4.4 million as a result of repairs to bank buildings related to Hurricane Matthew and an increase in depreciation expense for technological investments put into production during 2016.
•
FDIC insurance expense increased $2.6 million due to a higher surcharge imposed during 2016.
•
Employee benefits expense decreased by $8.8 million driven primarily by lower pension costs as a result of an increase to the discount rate used to estimate pension expense in 2016.
•
Merger-related expense decreased by $8.8 million due primarily to increased costs related to the Bancorporation merger in 2015.
INCOME TAXES
For 2017, income tax expense was $219.9 million compared to $125.6 million during 2016 and $122.0 million during 2015, reflecting effective tax rates of 40.5 percent, 35.8 percent and 36.7 percent during the respective periods. The increase in the effective tax rate during 2017 was primarily due to the re-measurement of deferred tax assets as a result of the Tax Act which was enacted on December 22, 2017 and reduces the federal corporate income tax rate to 21 percent effective January 1, 2018. 2017 tax expense includes a provisional $25.8 million to reflect the Tax Act changes. The ultimate impact may differ from this provisional amount due to additional analysis, changes in interpretations and assumptions and additional regulatory guidance that may be issued. A reduction in the North Carolina corporate income tax rate applicable to the 2016 tax year contributed to the lower effective tax rate for 2016 compared to 2015. Based upon current 2018 projections, we expect the 2018 effective tax rate will be approximately 23 percent. The actual 2018 effective tax rate will depend upon the nature and amount of future income and expenses as well as transactions with discrete tax effects.
INTEREST-EARNING ASSETS
Interest-earning assets include loans and leases, investment securities, and overnight investments, all of which reflect varying interest rates based on the risk level and repricing characteristics of the underlying asset. Riskier investments typically carry a higher interest rate, but expose us to higher levels of market risk.
We have historically focused on maintaining high-asset quality, which results in a loan and lease portfolio subjected to strenuous underwriting and monitoring procedures. We avoid high-risk industry concentrations, but we do maintain a concentration of owner-occupied real estate loans to borrowers in medical and medical-related fields. Our focus on asset quality also influences the composition of our investment securities portfolio.
Interest-earning assets averaged $32.21 billion in 2017, compared to $30.27 billion in 2016. The increase of $1.94 billion, or 6.4 percent, was primarily the result of strong originated loan growth and the loans acquired in the Guaranty and HCB acquisitions.
Investment securities
The primary objective of the investment portfolio is to generate incremental income by deploying excess funds into securities that have minimal liquidity and credit risk and low to moderate interest rate risk. Other objectives include acting as a stable source of liquidity, serving as a tool for asset and liability management and maintaining an interest rate risk profile compatible with BancShares' objectives. Additionally, purchases of equities and corporate bonds in other financial institutions have been made largely under a long-term earnings optimization strategy. Changes in the total balance of our investment securities portfolio result from trends in balance sheet funding and market performance. Generally, when inflows arising from deposit and treasury services products exceed loan and lease demand, we invest excess funds into the securities portfolio or into overnight investments. Conversely, when loan demand exceeds growth in deposits and short-term borrowings, we allow any overnight investments to decline and use proceeds from maturing securities and prepayments to fund loan demand. See Note C in the Notes to Consolidated Financial Statements for additional disclosures regarding investment securities.
The fair value of investment securities was $7.18 billion at December 31, 2017, an increase of $173.6 million when compared to $7.01 billion at December 31, 2016. This follows an increase of $145.1 million in total investment securities from December 31, 2015 to December 31, 2016. The increase in 2017 and 2016 was primarily attributable to investing overnight funds into the investment portfolio and a decline in the net pre-tax unrealized losses on the available for sale portfolio.
As of December 31, 2017, investment securities available for sale had a net pre-tax unrealized loss of $48.8 million, compared to a net pre-tax unrealized loss of $72.7 million as of December 31, 2016. Available for sale securities are reported at fair value and unrealized gains and losses are included as a component of other comprehensive income, net of deferred taxes. After evaluating the securities with unrealized losses, management concluded that no other than temporary impairment existed as of December 31, 2017.
Sales of investment securities for 2017 resulted in a net realized gain of $4.3 million compared to a net realized gain of $26.7 million in 2016. The net realized gain of $4.3 million in 2017 includes gross gains of $11.6 million and gross losses of $7.3 million.
At December 31, 2017, mortgage-backed securities represented 74.5 percent of investment securities available for sale, compared to U.S. Treasury, equity securities, corporate bonds and other, which represented 23.1 percent, 1.5 percent, 0.8 percent and 0.1 percent of the portfolio, respectively. Overnight investments are with the Federal Reserve Bank and other financial institutions.
Due primarily to deployment of overnight funds and spread tightening in mortgage-backed securities products since December 31, 2016, the carrying value of mortgage-backed securities has increased by $174.0 million. U.S. Treasury securities increased $7.5 million benefiting from rising interest rates in 2017. Government agency securities decreased $40.4 million as the maturities proceeds were reinvested primarily into other types of securities in the investment portfolio. Equity securities, comprised of investments in other financial institutions, increased $21.7 million since December 31, 2016 primarily due to higher market prices at December 31, 2017.
Table 10
INVESTMENT SECURITIES
Table 11 presents the investment securities portfolio at December 31, 2017 segregated by major category with ranges of contractual maturities, average contractual maturities and taxable equivalent yields.
Table 11
INVESTMENT SECURITIES
(1) Mortgage-backed securities, which are not due at a single maturity date, have been included in maturity groupings based on the contractual maturity. The expected life of mortgage-backed securities will differ from contractual maturities because borrowers have the right to prepay the underlying mortgage loans.
Table 12 provides information on investment securities issued by any one issuer exceeding ten percent of shareholders' equity.
Table 12
INVESTMENT SECURITIES - ISSUERS EXCEEDING TEN PERCENT OF SHAREHOLDERS' EQUITY
Loans and leases
Loans and leases were $23.60 billion at December 31, 2017, a net increase of $1.86 billion, or 8.6 percent, since December 31, 2016. This increase was primarily driven by $1.46 billion of organic growth in the non-PCI portfolio and the addition of $447.7 million in non-PCI loans from the Guaranty acquisition. The PCI portfolio declined over this period by $46.2 million, as a result of loan run-off of $208.8 million, offset by net loans acquired from Guaranty and HCB, which were $97.6 million and $65.0 million, respectively, at December 31, 2017. Loans and leases were $21.74 billion at December 31, 2016, a net increase of $1.50 billion, or 7.4 percent, from December 31, 2015 primarily due to organic non-PCI loan growth of $1.41 billion and the addition of $225.0 million in non-PCI loans from the Cordia acquisition, offset by a net decline in the PCI portfolio of $141.3 million.
BancShares reports non-PCI and PCI loan portfolios separately and each portfolio is further divided into commercial and non-commercial. Additionally, loans are assigned to loan classes, which further disaggregate loans based upon common risk characteristics, such as commercial real estate, commercial & industrial or residential mortgage. Table 13 provides the composition of non-PCI and PCI loans and leases for the past five years.
Non-PCI Loans and Leases
The non-PCI portfolio includes loans that management has the intent and ability to hold and is reported at the principal balance outstanding, net of deferred loan fees and costs. Non-PCI loans include originated commercial, originated noncommercial, purchased non-credit impaired loans and leases and certain purchased revolving credit. Purchased non-credit impaired loans included as non-PCI do not have evidence of credit deterioration at acquisition. Purchased non-impaired loans are initially recorded at their fair value at the date of acquisition.
Non-PCI loans at December 31, 2017 were $22.83 billion, an increase of $1.90 billion from $20.93 billion at December 31, 2016. Non-PCI loans represented 96.8 percent and 96.3 percent of total loans and leases at December 31, 2017 and December 31, 2016, respectively.
Non-PCI Commercial Loans
The non-PCI commercial loan portfolio is composed of Commercial Mortgage, Commercial and Industrial, Construction and Land Development, Lease Financing, Other Commercial Real Estate and Other Commercial loans. Non-PCI commercial loans were $14.80 billion at December 31, 2017, an increase of $1.04 billion, or 7.5 percent, compared to December 31, 2016, following an increase of $1.13 billion, or 8.9 percent, between December 31, 2016 and December 31, 2015. The increase from both periods was primarily due to strong originated loan growth. The Guaranty acquisition also positively contributed $2.5 million to the non-PCI commercial loan portfolio during 2017.
Non-PCI commercial mortgage loans were $9.73 billion at December 31, 2017. The December 31, 2017 balance increased $702.8 million, or 7.8 percent, since December 31, 2016, following an increase of $751.7 million, or 9.1 percent, between December 31, 2016 and December 31, 2015. We attribute the growth in both years to improving confidence among small business customers and our continued focus on this segment.
Non-PCI commercial and industrial loans were $2.73 billion at December 31, 2017, an increase of $162.9 million, or 6.3 percent, since December 31, 2016, following an increase of $198.5 million, or 8.4 percent, between December 31, 2016 and December 31, 2015. We attribute the growth from both periods to our continued focus on small business customers, particularly among medical, dental or other professional customers.
Non-PCI other commercial real estate loans were $473.4 million at December 31, 2017, an increase of $122.1 million, or 34.8 percent, since December 31, 2016, following an increase of $30.3 million, or 9.4 percent, between December 31, 2016 and December 31, 2015. The current year growth reflects originated loan growth and contributions from the Guaranty acquisition.
Non-PCI Noncommercial Loans
The non-PCI noncommercial loan portfolio is composed of Residential Mortgage, Revolving Mortgage, Consumer and Construction and Land Development loans. Non-PCI noncommercial loans were $8.03 billion at December 31, 2017, an increase of $866.8 million, or 12.1 percent, compared to December 31, 2016, following an increase of $509.0 million, or 7.6 percent between December 31, 2016 and December 31, 2015 primarily due to originated loan growth in both periods. The Guaranty acquisition also positively contributed $445.2 million to the non-PCI noncommercial loan portfolio during 2017.
At December 31, 2017, residential mortgage loans were $3.52 billion, an increase of $634.7 million or 22.0 percent, since December 31, 2016, following an increase of $193.1 million, or 7.2 percent, between December 31, 2016 and December 31, 2015. The increase from both periods reflects originated loan growth and the current year growth was also attributable to the large residential mortgage loan portfolio of $391.4 million acquired in the Guaranty transaction. While a majority of residential mortgage loans originated were sold to investors, other loans, including affordable housing loans, medical mortgage loans and certain construction loans, were originated based on our intent to retain them in the loan portfolio.
At December 31, 2017, revolving mortgage loans were $2.70 billion, an increase of $100.2 million, or 3.9 percent, since December 31, 2016, following an increase of $78.2 million, or 3.1 percent, between December 31, 2016 and December 31, 2015. The increase from both periods was primarily the result of originated loan growth. The increase in 2017 was also attributable to loans acquired in the Guaranty acquisition which were $42.2 million.
At December 31, 2017, consumer loans were $1.56 billion, an increase of $115.0 million, or 8.0 percent, compared to December 31, 2016, following an increase of $226.3 million, or 18.6 percent, between December 31, 2016 and December 31, 2015. Growth in both periods primarily reflects increases in indirect auto lending and our credit card portfolio as well as loans acquired in the Guaranty acquisition during 2017 and the Cordia acquisition during 2016.
Management believes 2017 organic loan growth resulted from improved economic conditions and our initiatives to broaden and diversify the loan portfolio through loan products with high growth potential. Management has maintained sound underwriting standards across all loan products while achieving this growth. Originated loan growth in 2018 will be dependent on overall economic conditions and will continue to be impacted by intense competition for loans and other external factors.
PCI Loans
The PCI portfolio includes loans acquired in a transfer, including business combinations, where there is evidence of credit deterioration since origination and it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments. All nonrevolving loans are evaluated at acquisition and where a discount is required at least in part due to credit quality, the loans are accounted for under the guidance in ASC Topic 310-30. PCI loans are valued at fair value at the date of acquisition.
PCI loans at December 31, 2017 were $763.0 million, representing 3.2 percent of total loans and leases, a decrease of $46.2 million, or 5.7 percent from $809.2 million at December 31, 2016 as a result of continued loan run-off of $208.8 million, offset by net loans acquired from Guaranty and HCB, which were $97.6 million and $65.0 million, respectively, at December 31, 2017.
PCI commercial loans were $396.9 million at December 31, 2017, a decrease of $103.0 million, or 20.6 percent, since December 31, 2016, following a decrease of $93.6 million, or 15.8 percent, between December 31, 2016 and December 31, 2015. At December 31, 2017, PCI noncommercial loans were $366.1 million, an increase of $56.9 million, or 18.4 percent, since December 31, 2016, following a decrease of $47.7 million, or 13.4 percent, between December 31, 2016 and December 31, 2015.
Table 13
LOANS AND LEASES
(1) Non-PCI loans include originated and purchased non-impaired loans, including non-accrual and TDR loans.
Allowance for loan and lease losses (ALLL)
The ALLL was $221.9 million at December 31, 2017, representing an increase of $3.1 million since December 31, 2016, following an increase of $12.6 million between December 31, 2016 and December 31, 2015. The ALLL as a percentage of total loans was 0.94 percent at December 31, 2017, compared to 1.01 percent and 1.02 percent at December 31, 2016 and December 31, 2015, respectively. The decline in the ALLL ratio from both periods was primarily due to favorable experience in certain loan loss factors.
BancShares has continued to sustain improvement in credit quality indicators which have reduced the ALLL ratio since December 31, 2016 and December 31, 2015. In the commercial non-PCI loan portfolio, loans with higher credit risk ratings continued to migrate to lower credit risk ratings. The noncommercial non-PCI loan portfolio has sustained low net charge-offs, partially offset by higher delinquency trends.
At December 31, 2017, the ALLL allocated to non-PCI loans was $211.9 million, or 0.93 percent of non-PCI loans and leases, compared to $205.0 million, or 0.98 percent, at December 31, 2016, and $189.9 million, or 0.98 percent, at December 31, 2015.
The increase in the dollar amount of reserves was primarily attributable to originated loan growth.
The ALLL allocated to originated non-PCI loans and leases of $211.3 million at December 31, 2017 was 1.00 percent of originated non-PCI loans and leases, compared to 1.09 percent and 1.14 percent at December 31, 2016 and December 31, 2015, respectively. The decline in the allowance ratio was primarily related to the sustained favorable credit quality trends, offset by originated loan growth. Originated non-PCI loans were $21.13 billion, $18.82 billion, and $16.60 billion at December 31, 2017, December 31, 2016 and December 31, 2015, respectively, and do not include purchased revolving, purchased non-PCI loans or PCI loans.
The ALLL allocated to PCI loans at December 31, 2017 was $10.0 million, or 1.31 percent of PCI loans, compared to $13.8 million, or 1.70 percent, at December 31, 2016, and $16.3 million, or 1.72 percent, at December 31, 2015. The ALLL for PCI loans decreased from both periods primarily due to improved projected cash flows, lower estimated default rates and continued portfolio run-off.
Provision
BancShares recorded $25.7 million net provision expense for loan and lease losses during 2017, compared to net provision expense of $32.9 million for 2016 and $20.7 million for 2015. The decrease in provision expense in 2017 was primarily due to favorable experience in certain loan loss factors, offset by loan growth.
Provision expense on non-PCI loans and leases was $29.1 million during 2017, compared to $34.9 million and $22.9 million in 2016 and 2015, respectively. The decrease in provision expense in 2017 primarily resulted from lower reserves on impaired loans and sustained low loan loss rates. Net charge-offs on non-PCI loans and leases were $22.3 million, $19.7 million, and $15.9 million for 2017, 2016, and 2015, respectively. On an annualized basis, net charge-offs of non-PCI loans and leases represented 0.10 percent of average non-PCI loans and leases during 2017, compared to 0.10 percent during 2016 and 0.09 percent during 2015.
The net provision credit for commercial construction and land development non-PCI loans was $4.3 million for the year ended December 31, 2017, compared to net provision expense of $12.9 million for the same period of 2016. The decrease in provision expense was primarily the result of updating loan loss factors for this portfolio given a decrease in loss experience. This follows an increase in provision expense when comparing 2016 to 2015, primarily the result of updating of loan loss factors for an increase in loss experience.
Commercial mortgage non-PCI loans had a net provision credit of $5.7 million in 2017, compared to $21.9 million in 2016. The net provision credit in both years was primarily the result of improvements in credit risk ratings and lower loan defaults.
The provision expense for commercial and industrial non-PCI loans was $10.7 million for the year ended December 31, 2017 compared to $14.6 million for the year ended December 31, 2016. The decrease was primarily the result of updating loan loss factors for this portfolio given a decrease in loss experience as well as lower loan growth within this portfolio as compared to the prior year. Provision expense also decreased when comparing 2016 to 2015 primarily due to lower loan growth.
The provision expense for residential mortgage non-PCI loans was $2.1 million in 2017, compared to $801 thousand in 2016. The increase in provision expense was primarily due to higher loan growth within this portfolio compared to the previous year. This follows a decrease in provision expense for 2016 compared to 2015 as a result of updating loan loss factors primarily related to delinquency trends.
The provision expense for revolving mortgage non-PCI loans was $2.5 million in 2017, compared to $7.4 million in 2016. The decrease in provision expense was primarily the result of updating loan loss factors for a decrease in loss experience. Provision expense for revolving mortgage non-PCI loans increased in 2016 compared to 2015 as a result of updating loan loss factors for this portfolio primarily related to an increase in loss experience as well as loan growth within this portfolio compared to the prior year.
The provision expense for consumer non-PCI loans was $17.1 million in 2017, compared to $18.6 million in 2016. The decrease in provision expense in resulted from lower loan growth within this portfolio compared to the prior year and updating loan loss factors primarily related to loan defaults. This follows an increase in provision expense for 2016 compared to 2015 as a result of updating loan loss factors for this portfolio primarily related to delinquency trends.
The PCI loan portfolio net provision credit was $3.4 million during the year ended December 31, 2017, compared to net provision credits of $1.9 million and $2.3 million during the same periods of 2016 and 2015, respectively. The higher net provision credit was attributable to improved projected cash flows and improved default rates. Net charge-offs on PCI loans were $296 thousand during 2017, compared to $614 thousand and $3.0 million for the same periods of 2016 and 2015, respectively. Net charge-offs of PCI loans represented 0.04 percent, 0.07 percent, and 0.27 percent of average PCI loans for 2017, 2016, and 2015, respectively.
Management considers the ALLL adequate to absorb estimated probable losses that relate to loans and leases outstanding at December 31, 2017, although future adjustments may be necessary based on changes in economic conditions and other factors. In addition, various regulatory agencies periodically review the ALLL as part of their exam process which could result in adjustments to the ALLL based on information available to them at the time of their examination. See "Critical Accounting Policies" and Note A in the Notes to Consolidated Financial Statements for discussion of our accounting policies for the ALLL.
Table 14 provides details of the ALLL and provision components by loan class for the past five years.
Table 14
ALLOWANCE FOR LOAN AND LEASE LOSSES
(1) During 2013, BancShares modified the ALLL model and the methodology for estimating losses on unfunded commitments. As a result of these modifications, $7.4 million of the balance previously reported as a reserve of unfunded commitments was reclassified to the ALLL.
Table 15 provides trends of the ALLL ratios for the past five years.
Table 15
ALLOWANCE FOR LOAN AND LEASE LOSSES RATIOS
Table 16 details the allocation of the ALLL among the various loan types. See Note E in the Notes to Consolidated Financial Statements for additional disclosures regarding the ALLL.
Table 16
ALLOCATION OF ALLOWANCE FOR LOAN AND LEASE LOSSES
NONPERFORMING ASSETS
Nonperforming assets include nonaccrual loans and leases and OREO resulting from both non-PCI and PCI loans. The accrual of interest on non-PCI loans and leases is discontinued when we deem that collection of additional principal or interest is doubtful. Non-PCI loans and leases are generally removed from nonaccrual status when they become current for some sustained period of time as to both principal and interest and concern no longer exists as to the collectability of principal and interest. Accretion of income for PCI loans is discontinued when we are unable to estimate the amount or timing of cash flows. PCI loans may begin or resume accretion of income when information becomes available that allows us to estimate the amount and timing of future cash flows. In addition, impaired, accruing non-PCI loans less than 90 days past due that have not been restructured are closely monitored by management. There were none to report at December 31, 2017, compared to $652 thousand at December 31, 2016.
Table 17 provides details on nonperforming assets and other risk elements.
Table 17
NONPERFORMING ASSETS
At December 31, 2017, BancShares’ nonperforming assets, including nonaccrual loans and OREO, were $144.3 million, or 0.61 percent, of total loans and leases plus OREO, compared to $147.0 million, or 0.67 percent, at December 31, 2016 and $169.0 million, or 0.83 percent, at December 31, 2015.
For the year, nonperforming assets decreased by $2.7 million, or 1.9 percent, compared to December 31, 2016. The decline in nonperforming assets from December 31, 2016 results from a $10.1 million decline in OREO balances due to problem asset resolutions, offset by a $7.4 million increase in nonaccrual loans and leases, primarily in residential and revolving mortgage loans.
Nonperforming assets decreased by $22.0 million, or 13.02 percent, between December 31, 2016 and December 31, 2015 due to declines in nonaccrual loans and leases and OREO balances due to problem asset resolutions.
Of the $144.3 million in nonperforming assets at December 31, 2017, $366 thousand related to loans and OREO covered by shared-loss agreements, compared to $565 thousand at December 31, 2016 and $9.8 million at December 31, 2015. Covered nonperforming assets continue to decline due to the expiration and termination of FDIC shared-loss agreements and loan resolutions.
OREO includes foreclosed property and branch facilities that we have closed but not sold. Once acquired, net book values of OREO are reviewed at least annually to evaluate if write-downs are required. Real estate appraisals are reviewed by the appraisal review department to ensure the quality of the appraised value in the report. The level of review is dependent on the value and type of the collateral, with higher value and more complex properties receiving a more detailed review. Changes to the value of the assets between scheduled valuation dates are monitored through continued communication with brokers and monthly reviews
by the asset manager assigned to each asset. The asset manager uses the information gathered from brokers and other market sources to identify any significant changes in the market or the subject property as they occur. Valuations are then adjusted or new appraisals are ordered to ensure the reported values reflect the most current information. Since OREO is carried at the lower of cost or market less estimated selling costs, only when fair values have declined are adjustments recorded. Decisions regarding write-downs are based on factors that include appraisals, previous offers received on the property, market conditions and the number of days the property has been on the market.
TROUBLED DEBT RESTRUCTURINGS
We have selectively agreed to modify existing loan terms to provide relief to customers who are experiencing financial difficulties or other circumstances that could affect their ability to meet debt obligations. Typical modifications include short-term deferral of interest or modification of payment terms. Nonperforming TDRs are not accruing interest and are included as nonperforming assets within nonaccrual loans and leases. TDRs which are accruing at the time of restructure and continue to perform based on the restructured terms are considered performing. See Note A in the Notes to Consolidated Financial Statements for discussion of our accounting policies for TDRs.
Total PCI and non-PCI loans classified as TDRs as of December 31, 2017 were $164.6 million, compared to $150.9 million at December 31, 2016, and $144.8 million at December 31, 2015. At December 31, 2017, accruing non-PCI TDRs were $112.2 million, an increase of $10.7 million from $101.5 million at December 31, 2016, primarily due to an increase in revolving mortgage loan modifications. At December 31, 2017, nonaccruing non-PCI TDRs were $33.9 million, an increase of $10.8 million from $23.1 million at December 31, 2016, primarily related to an increase in residential and revolving mortgage loan modifications. The increase in residential mortgage loans modifications is primarily related to non-payment on nonconforming loans. Revolving mortgage loan modifications increased as customers entered the repayment phase of the note or the line of credit matured and the customer needed adjustments to make payments manageable. PCI TDRs continue to decline as a result of loan pay downs and pay offs.
Between December 31, 2016 and December 31, 2015, accruing TDRs increased $14.2 million, primarily related to an increase in commercial and residential mortgage loan modifications, and nonaccruing TDRs decreased $8.2 million, primarily due to payoffs in the commercial loan portfolio.
Table 18 provides further details on performing and nonperforming TDRs for the last five years.
Table 18
TROUBLED DEBT RESTRUCTURINGS
INTEREST-BEARING LIABILITIES
Interest-bearing liabilities include interest-bearing deposits, short-term borrowings and long-term obligations. Interest-bearing liabilities were $19.59 billion at December 31, 2017, an increase of $125.7 million from December 31, 2016, primarily resulting from additional FHLB borrowings of $175.0 million during 2017. This increase was offset by a FHLB borrowing maturity of $10.0 million, lower customer repurchase agreements of $34.6 million, a redemption of $5.0 million aggregate principal amount of Trust Preferred Securities issued by FCB/SC Capital Trust II and a $1.9 million decrease in interest-bearing deposit accounts. Average interest-bearing liabilities increased $418.0 million, or by 2.2 percent, from 2016 to 2017, due to organic growth in interest-bearing checking and savings deposits and incremental FHLB borrowings of $175.0 million during 2017.
Deposits
At December 31, 2017, total deposits were $29.27 billion, an increase of $1.10 billion, or 3.9 percent, since December 31, 2016 and an increase of $1.23 billion, or 4.6 percent, between December 31, 2016 and December 31, 2015. The increase for both periods was due to organic growth in demand deposit accounts, checking with interest and savings accounts, offset by run-off in time deposits and lower money market account balances. Demand deposits increased by $1.11 billion during 2017, following an increase of $856.1 million during 2016. Time deposits decreased by $419.0 million during 2017, following a decrease of $278.1 million in 2016. Additionally, deposit balances from the Guaranty acquisition of $541.3 million contributed to the increase during 2017.
Table 19 provides deposit balances as of December 31, 2017, December 31, 2016 and December 31, 2015.
Table 19
DEPOSITS
Due to our focus on maintaining a strong liquidity position, core deposit retention remains a key business objective. We believe that traditional bank deposit products remain an attractive option for many customers but, as economic conditions improve, we recognize that our liquidity position could be adversely affected as bank deposits are withdrawn and invested elsewhere. Our ability to fund future loan growth is significantly dependent on our success at retaining existing deposits and generating new deposits at a reasonable cost.
Table 20
MATURITIES OF TIME DEPOSITS OF $100,000 OR MORE
Short-term Borrowings
At December 31, 2017, short-term borrowings were $693.8 million compared to $603.5 million at December 31, 2016. The increase was due to reclassifications of $90.0 million in FHLB borrowings, subordinated notes payable of $15.0 million and a repurchase agreement of $30.0 million from long-term obligations, offset by a FHLB borrowing maturity of $10.0 million and lower customer repurchase agreement balances. Table 21 provides information on short-term borrowings.
Table 21
SHORT-TERM BORROWINGS
Long-term obligations
Long-term obligations were $870.2 million at December 31, 2017, an increase of $37.3 million from December 31, 2016, due to additional FHLB borrowings of $175.0 million during 2017. This increase was partially offset by FHLB borrowings of $90.0 million, subordinated notes payable of $15.0 million and a repurchase agreement of $30.0 million with maturities less than one year being reclassified from long-term obligations, as well as a redemption of $5.0 million aggregate principal amount of Trust Preferred Securities issued by FCB/SC Capital Trust II.
At December 31, 2017 and December 31, 2016, long-term obligations included $120.1 million and $125.3 million, respectively, in junior subordinated debentures representing obligations to FCB/NC Capital Trust III, FCB/SC Capital Trust II, and SCB Capital Trust I, special purpose entities and grantor trusts for $116.5 million and $121.5 million, on each of those dates, of trust preferred securities. FCB/NC Capital Trust III, FCB/SC Capital Trust II and SCB Capital Trust I's (the Trusts) trust preferred securities mature in 2036, 2034 and 2034, respectively, and may be redeemed at par in whole or in part at any time. BancShares has guaranteed all obligations of the Trusts.
On January 17, 2018, BancShares prepaid four FHLB advances totaling $325.0 million resulting in a net gain of $13.6 million. On February 7, 2018, BancShares acquired $2.0 million aggregate principal amount of Trust Preferred Securities issued by FCB/NC Capital Trust III. BancShares paid approximately $1.8 million, plus unpaid accrued distributions on the securities for the current distribution period. On February 9, 2018, BancShares prepaid four additional FHLB advances totaling $350.0 million resulting in a net gain of $12.1 million.
SHAREHOLDERS’ EQUITY AND CAPITAL ADEQUACY
We are committed to effectively managing our capital to protect our depositors, creditors and shareholders. We continually monitor the capital levels and ratios for BancShares and FCB to ensure they exceed the minimum requirements imposed by regulatory authorities and to ensure they are appropriate, given growth projections, risk profile and potential changes in the regulatory environment. Failure to meet certain capital requirements may result in actions by regulatory agencies that could have a material impact on our consolidated financial statements.
In accordance with GAAP, the unrealized gains and losses on certain assets and liabilities, net of deferred taxes, are included in accumulated other comprehensive income (AOCI) within shareholders' equity. These amounts are excluded from shareholders' equity in the calculation of our capital ratios under current regulatory guidelines. In the aggregate, these items represented a net decrease in shareholders' equity of $122.3 million at December 31, 2017, compared to a net reduction of $135.2 million at December 31, 2016. The $12.9 million increase in AOCI from December 31, 2016 primarily reflects a decrease in unrealized losses on investment securities available for sale as a result of higher market interest rates and higher market prices on our equity securities.
During 2017, our Board authorized the purchase of up to 800,000 shares of Class A common stock. The shares may be purchased from time to time at management's discretion from November 1, 2017 through October 31, 2018. It does not obligate BancShares to purchase any particular amount of shares and purchases may be suspended or discontinued at any time. The Board's action replaced existing authority to purchase up to 200,000 shares in effect during the twelve months preceding November 1, 2017. As of December 31, 2017, no purchases had occurred pursuant to either authorization.
Table 22 provides information on capital adequacy for BancShares as of December 31, 2017, 2016 and 2015.
Table 22
ANALYSIS OF CAPITAL ADEQUACY
(1) Regulatory minimum and well-capitalized requirements are based on 2016 Basel III regulatory capital guidelines.
(2) The capital conservation buffer, which only applies to minimum risk-based capital requirements, became effective under Basel III guidelines January 1, 2016; therefore, this data is not applicable for periods prior to January 1, 2016.
As aligned with expectations and incorporated in our capital planning process, BancShares remained well-capitalized under Basel III capital requirements with a leverage capital ratio of 9.47 percent, Tier 1 risk-based capital ratio of 12.88 percent, common equity Tier 1 ratio of 12.88 percent and total risk-based capital ratio of 14.21 percent at December 31, 2017. BancShares had a capital conservation buffer above minimum risk-based capital requirements of 6.21 percent at December 31, 2017. The buffer exceeded the 1.25 percent requirement and, therefore, results in no limit on distributions.
BancShares had no trust preferred capital securities included in Tier 1 capital at December 31, 2017 or December 31, 2016, compared to $32.1 million at December 31, 2015. Effective January 1, 2015, 75 percent of our trust preferred capital securities were excluded from Tier 1 capital, and the remaining 25 percent were phased out on January 1, 2016 under Basel III requirements. At December 31, 2017 and December 31, 2016, BancShares had $116.5 million and $121.5 million, respectively, of trust preferred capital securities that were excluded from Tier 1 capital as a result of Basel III implementation. Trust preferred capital securities continue to be a component of total risk-based capital.
At December 31, 2017 and December 31, 2016, Tier 2 capital of BancShares included $0 and $3.0 million, respectively, of qualifying subordinated debt acquired in the Bancorporation merger with a scheduled maturity date of June 1, 2018. Under current regulatory guidelines, when subordinated debt is within five years of its scheduled maturity date, issuers must discount the amount included in Tier 2 capital by 20 percent for each year until the debt matures. Once the debt is within one year of its scheduled maturity date, no amount of the debt is allowed to be included in Tier 2 capital.
RISK MANAGEMENT
Risk is inherent in any business. Senior management has primary responsibility for day-to-day management of the risks we face with accountability of and support from all company associates. The Board of Directors strives to ensure that risk management is part of the business culture and that policies and procedures for identifying, assessing, measuring, monitoring, and managing risk are part of the decision-making process. The Board of Director’s role in risk oversight is an integral part of our overall Enterprise Risk Management Framework. The Board of Directors administers its risk oversight function primarily through the Board Risk Committee.
The Board Risk Committee structure is designed to allow for information flow and timely escalation of risk related issues. The Board Risk Committee is directed to monitor and advise the Board of Directors regarding risk exposures, including credit, market, capital, liquidity, operational, compliance, strategic, legal, and reputational risks; review, approve and monitor adherence to the risk appetite and supporting risk tolerance levels; and evaluate, monitor and oversee the adequacy and effectiveness of the Enterprise Risk Management Framework. The Board Risk Committee also reviews reports of examination by and communications from regulatory agencies; the results of internal and third party testing, analyses and reviews, related to risks; risk management; and any other matters within the scope of the Committee’s oversight responsibilities. The Board Risk Committee reviews and monitors management's response to certain risk related regulatory or audit issues. In addition, the Board Risk Committee may coordinate with the Audit Committee for the review of financial statements and related risks, information security and other areas of joint responsibility.
In combination with other risk management and monitoring practices, the results of enterprise wide stress testing activities are considered a key part of our risk management program. One key component of enterprise wide stress testing includes stress tests as mandated in the Dodd-Frank Act. The Dodd-Frank Act requires that stress tests be developed and performed to ensure that financial institutions have sufficient capital to absorb losses and support operations during multiple economic and bank scenarios. Bank holding companies with total consolidated assets between $10 billion and $50 billion, including BancShares, will undergo annual company-run stress tests. As directed by the Federal Reserve, summaries of BancShares’ results in the severely adverse stress tests are available to the public.
Credit risk management
Credit risk is the risk of not collecting payments pursuant to the contractual terms of loans, leases and certain investment securities. Loans and leases, other than acquired loans, are underwritten in accordance with our credit policies and procedures and are subject to periodic ongoing reviews. Acquired loans, regardless of whether PCI or non-PCI, are recorded at fair value as of the acquisition date and are subject to periodic reviews to identify any further credit deterioration. Our independent credit review function conducts risk reviews and analyses of both acquired and originated loans to ensure compliance with credit policies and to monitor asset quality trends and borrower financial strength. The risk reviews include portfolio analysis by geographic location, industry, collateral type and product. We strive to identify potential problem loans as early as possible, to record charge-offs or write-downs as appropriate and to maintain an adequate ALLL that accounts for losses that are inherent in the loan and lease portfolio.
We maintain a well-diversified loan and lease portfolio and seek to minimize the risks associated with large concentrations within specific geographic areas, collateral types or industries. Despite our focus on diversification, several characteristics of our loan portfolio subject us to significant risk, such as our concentrations of real estate secured loans, revolving mortgage loans and medical-and dental-related loans.
We have historically carried a significant concentration of real estate secured loans but actively mitigate that exposure through our underwriting policies that primarily rely on borrower cash flow rather than underlying collateral values. When we do rely on underlying real property values, we favor financing secured by owner-occupied real property and, as a result, a large percentage of our real estate secured loans are owner occupied. At December 31, 2017, loans secured by real estate were $18.10 billion, or 76.7 percent, of total loans and leases compared to $16.54 billion, or 76.1 percent, of total loans and leases at December 31, 2016, and $15.59 billion, or 77.0 percent, at December 31, 2015.
Table 23
GEOGRAPHIC DISTRIBUTION OF REAL ESTATE COLLATERAL
Among real estate secured loans, our revolving mortgage loans (also known as Home Equity Lines of Credit or HELOCs) present a heightened risk due to long commitment periods during which the financial position of individual borrowers or collateral values may deteriorate significantly. In addition, a large percentage of our revolving mortgage loans are secured by junior liens. Substantial declines in collateral values could cause junior lien positions to become effectively unsecured. Revolving mortgage loans secured by real estate were $2.77 billion, or 11.7 percent, of total loans at December 31, 2017, compared to $2.64 billion, or 12.1 percent, at December 31, 2016, and $2.58 billion, or 12.7 percent, at December 31, 2015.
Except for loans acquired through mergers and acquisitions, we have not purchased revolving mortgages in the secondary market nor have we originated these loans to customers outside of our market areas. All originated revolving mortgage loans were underwritten by us based on our standard lending criteria. The revolving mortgage loan portfolio consists largely of variable rate lines of credit which allow customer draws during the entire contractual period of the line of credit, typically 15 years. Approximately 78.9 percent of the revolving mortgage portfolio relates to properties in North Carolina and South Carolina. Approximately 35.3 percent of the loan balances outstanding are secured by senior collateral positions while the remaining 64.7 percent are secured by junior liens.
We actively monitor the portion of our HELOC loans that are in the interest-only period and when they will mature. Approximately 83.6 percent of outstanding balances at December 31, 2017, require interest-only payments, while the remaining require monthly payments equal to the greater of 1.5 percent of the outstanding balance or $100. When HELOC loans switch from interest-only to fully amortizing, including principal and interest, some borrowers may not be able to afford the higher monthly payments. As of December 31, 2017, approximately 5 percent of the HELOC portfolio is due to mature by the end of 2019 with remaining loan maturities spread similarly over future years thereafter. In the normal course of business, the bank will work with each borrower as they approach the revolving period maturity date to discuss options for refinance or repayment.
Loans and leases to borrowers in medical, dental or related fields were $4.86 billion as of December 31, 2017, which represents 20.6 percent of total loans and leases, compared to $4.66 billion or 21.5 percent of total loans and leases at December 31, 2016, and $4.28 billion or 21.2 percent of total loans and leases at December 31, 2015. The credit risk of this industry concentration is mitigated through our underwriting policies that emphasize reliance on adequate borrower cash flow rather than underlying collateral value and our preference for financing secured by owner-occupied real property. Except for this single concentration, no other industry represented more than 10 percent of total loans and leases outstanding at December 31, 2017.
Interest rate risk management
Interest rate risk (IRR) results principally from assets and liabilities maturing or repricing at different points in time, from assets and liabilities repricing at the same point in time but in different amounts, and from short-term and long-term interest rates changing in different magnitudes.
We assess our short-term IRR by forecasting net interest income over 24 months under various interest rate scenarios and comparing those results to forecast net interest income assuming stable rates. Rate shock scenarios represent an instantaneous and parallel shift in rates, up or down, from a base yield curve. Despite the current increase in market interest rates, the overall rate on interest-bearing deposits remains at cycle lows and as such, it is unlikely that the rates on most interest-bearing deposits can decline materially from current levels. Our shock projections incorporate assumptions of likely customer migration from low rate deposit instruments to intermediate term fixed rate instruments, such as certificates of deposit, as rates rise. Various other IRR scenarios
are modeled to supplement shock scenarios. This may include interest rate ramps, changes in the shape of the yield curve and changes in the relationships of FCB rates to market rates. Table 24 provides the impact on net interest income over 24 months resulting from various instantaneous interest rate shock scenarios as of December 31, 2017 and 2016.
Table 24
NET INTEREST INCOME SENSITIVITY SIMULATION ANAYLYSIS
Net interest income sensitivity metrics at December 31, 2017 compared to December 31, 2016 remained relatively stable with the slight decline in the -100 bps, +100 bps and +200 bps scenarios primarily driven by growth in the fixed rate loan portfolio. FCB assumes that a portion of low cost non-maturity deposits will be replaced with higher cost time deposits in rising rate shock scenarios and at +300 bps net interest income could modestly increase as a the rise in asset yields is enough to offset the higher deposit expenses.
Long-term interest rate risk exposure is measured using the economic value of equity (EVE) sensitivity analysis to study the impact of long-term cash flows on earnings and capital. EVE represents the difference between the sum of the present value of all asset cash flows and the sum of the present value of the liability cash flows. EVE sensitivity analysis involves discounting cash flows of balance sheet items under different interest rate scenarios. Cash flows will vary by interest rate scenario, resulting in variations in EVE. The base-case measurement and its sensitivity to shifts in the yield curve allow management to measure longer-term repricing and option risk in the balance sheet. Table 25 presents the EVE profile as of December 31, 2017 and 2016.
Table 25
ECONOMIC VALUE OF EQUITY MODELING ANALYSIS
The economic value of equity metrics at December 31, 2017 compared to December 31, 2016 remained relatively stable with the minor improvement in the -100 bps, +100 bps and +200 bps scenarios primarily due to the growth in demand deposit account balances. However, given the extended period of historically low market rates and FCB's balance sheet risk management, the economic value of equity could be negatively impacted if rates suddenly increase at least +300 bps where FCB expects that some of the non-maturity deposit balances will be replace with higher cost time deposits. This will reduce the economic value of equity as the duration of FCB's deposit book shortens.
We do not typically utilize interest rate swaps, floors, collars or other derivative financial instruments to attempt to hedge our overall balance sheet rate sensitivity and interest rate risk.
Table 26 provides loan maturity distribution and information regarding the sensitivity of loans and leases to changes in interest rates.
Table 26
LOAN MATURITY DISTRIBUTION AND INTEREST RATE SENSITIVITY
Liquidity risk management
Liquidity risk is the risk that an institution is unable to generate or obtain sufficient cash or its equivalents on a cost-effective basis to meet commitments as they fall due. The most common sources of liquidity risk arise from mismatches in the timing and value of on-balance sheet and off-balance sheet cash inflows and outflows. In general, on-balance sheet mismatches generate liquidity risk when the effective maturity of assets exceeds the effective maturity of liabilities. A commonly cited example of a balance sheet liquidity mismatch is when long-term loans (assets) are funded with short-term deposits (liabilities). Other forms of liquidity risk include market constraints on the ability to convert assets into cash at expected levels, an inability to access funding sources at sufficient levels at a reasonable cost, and changes in economic conditions or exposure to credit, market, operational, legal and reputation risks that can affect an institution’s liquidity risk profile.
We utilize various limit-based measures to monitor, measure and control liquidity risk across three different types of liquidity:
•
Tactical liquidity measures the risk of a negative cash flow position whereby cash outflows exceed cash inflows over a short-term horizon out to nine weeks;
•
Structural liquidity measures the amount by which illiquid assets are supported by long-term funding; and
•
Contingent liquidity utilizes cash flow stress testing across three crisis scenarios to determine the adequacy of our liquidity.
We aim to maintain a diverse mix of liquidity sources to support the liquidity management function, while aiming to avoid funding concentrations by diversifying our external funding with respect to maturities, counterparties and nature. Our primary source of liquidity is our retail deposit book due to the generally stable balances and low cost it offers. Additional sources include cash in excess of our reserve requirement at the Federal Reserve Bank, and various other correspondent bank accounts and unencumbered securities, which totaled $3.70 billion at December 31, 2017, compared to $3.88 billion at December 31, 2016. Another source of available funds is advances from the FHLB of Atlanta. Outstanding FHLB advances were $835.2 million as of December 31, 2017, and we had sufficient collateral pledged to secure $5.24 billion of additional borrowings. Also, at December 31, 2017, $2.77 billion in noncovered loans with a lendable collateral value of $2.08 billion were used to create additional borrowing capacity at the Federal Reserve Bank. We also maintain Federal Funds lines and other borrowing facilities which had $665.0 million of available capacity at December 31, 2017.
We entered into forward-starting advances with the FHLB of Atlanta in June 2016 to receive $200.0 million of fixed rate long-term funding. There were two advances of $100.0 million each scheduled to fund in June 2018, but both advances were terminated in December 2017. BancShares received cash of $12.5 million associated with the early termination and recorded this as a gain in other noninterest income in the Consolidated Statements of Income.
COMMITMENTS AND CONTRACTUAL OBLIGATIONS
Table 27 identifies significant obligations and commitments as of December 31, 2017 representing required and potential cash outflows. See Note T for additional information regarding total commitments.
Table 27
COMMITMENTS AND CONTRACTUAL OBLIGATIONS
FOURTH QUARTER ANALYSIS
For the quarter ended December 31, 2017, BancShares reported consolidated net income of $54.4 million, compared to $52.7 million for the corresponding period of 2016. Per share income was $4.53 for the fourth quarter of 2017 and $4.39 for the same period a year ago.
Income tax expense totaled $68.7 million in the fourth quarter of 2017, up from $28.4 million in the fourth quarter of 2016, representing effective tax rates of 55.8 percent and 35.0 percent during the respective periods. The increase in income tax expense was due to higher pre-tax earnings during the fourth quarter and the increase in the effective tax rate was primarily due to the impact of the Tax Act, which was enacted on December 22, 2017. Earnings in the fourth quarter of 2017 included income tax expense of $25.8 million due primarily to the re-measurement of deferred taxes as a result of the Tax Act reducing the federal tax rate to 21 percent effective January 1, 2018.
Net interest income increased $30.9 million, or by 12.6 percent, to $274.8 million over the fourth quarter of 2016. The increase was primarily due to higher non-PCI loan interest income of $21.0 million as a result of originated loan growth and the contribution from the Guaranty acquisition, a $5.7 million improvement in interest income earned on investments and a $3.7 million increase in interest income earned on excess cash held in overnight investments. Interest income earned on overnight investments was positively impacted by three 25 basis point increases in the federal funds rate since the fourth quarter of 2016. These favorable impacts were offset by an increase in interest expense of $324 thousand primarily related to higher rates paid on short-term borrowings.
The taxable-equivalent net interest margin for the fourth quarter of 2017 was 3.34 percent, an increase of 20 basis points from the same quarter in the prior year. The margin improvement was primarily due to improved loan and investment yields and higher loan balances.
BancShares recorded a net provision credit of $2.8 million for loan and lease losses during the fourth quarter of 2017, compared to a net provision expense of $16.0 million for the fourth quarter of 2016. The net provision credit in the current quarter was primarily due to favorable experience in certain loan loss factors.
Noninterest income was $140.2 million for the fourth quarter of 2017, an increase of $15.5 million from the same period of 2016. The increase was primarily driven by a gain of $12.5 million related to the early termination of two forward-starting FHLB advances. Noninterest income also benefited from higher merchant and cardholder income of $6.0 million resulting from higher sales volume, a $4.8 million increase in service charges on deposit accounts, primarily related to the Guaranty acquisition, and a $3.2 million increase in wealth management fees. These increases were partially offset by lower securities gains of $9.5 million and a decrease of $3.9 million in mortgage income, primarily due to mortgage servicing rights valuation adjustments in the fourth quarter of 2016.
Noninterest expense was $294.6 million for the fourth quarter of 2017, an increase of $23.1 million from the same quarter last year, due to a $16.1 million increase in personnel expenses, primarily due to higher wages from the Guaranty and HCB acquisitions, annual merit increases and higher benefit costs. Noninterest expense also increased due to growth in cardholder and merchant processing expense of $3.0 million resulting from higher sales volume and an increase of $2.4 million and $1.4 million in consultant services and processing fees paid to third parties, respectively.
Table 28 provides quarterly information for each of the quarters in 2017 and 2016. Table 29 analyzes the components of changes in net interest income between the fourth quarter of 2017 and 2016.
Table 28
SELECTED QUARTERLY DATA
(1) Average loan and lease balances include PCI loans, non-PCI loans and leases, loans held for sale and nonaccrual loans and leases.
Table 29
CONSOLIDATED TAXABLE EQUIVALENT RATE/VOLUME VARIANCE ANALYSIS - FOURTH QUARTER
Loans and leases include PCI loans, non-PCI loans, nonaccrual loans and loans held for sale. Interest income on loans and leases includes accretion income and loan fees. Loan fees were $15.6 million and $12.1 million for the three months ended December 31, 2017 and 2016, respectively. Yields related to loans, leases and securities exempt from both federal and state income taxes, federal income taxes only, or state income taxes only are stated on a taxable-equivalent basis assuming statutory federal income tax rates of 35.0 percent for each period and state income tax rates of 3.1 percent and 3.1 percent for the three months ended December 31, 2017 and 2016, respectively. The taxable-equivalent adjustment was $1,233 and $1,413 for the three months ended December 31, 2017 and 2016, respectively. The rate/volume variance is allocated equally between the changes in volume and rate.
Item 9A.