-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, GLSywR0rkZhcizWWBgp+UX98Sl96yqIqiYi2hQYXT917R+9HFqZHsTeswjPYesk+ 0Fa5RWD8LMIOAZfJu6ni7w== 0000717809-97-000010.txt : 19970311 0000717809-97-000010.hdr.sgml : 19970311 ACCESSION NUMBER: 0000717809-97-000010 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970310 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: KEYSTONE FINANCIAL INC CENTRAL INDEX KEY: 0000717809 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 232289209 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: 1934 Act SEC FILE NUMBER: 000-11460 FILM NUMBER: 97553176 BUSINESS ADDRESS: STREET 1: ONE KEYSTONE PLZ - FRONT & MARKET STS STREET 2: P O BOX 3660 CITY: HARRISBURG STATE: PA ZIP: 17105-3660 BUSINESS PHONE: 7172331555 MAIL ADDRESS: STREET 1: ONE KEYSTONE PLZ STREET 2: PO BOX 3660 CITY: HARRISBURG STATE: PA ZIP: 171053660 FORMER COMPANY: FORMER CONFORMED NAME: NCB FINANCIAL CORP DATE OF NAME CHANGE: 19850115 10-K405 1 KEYSTONE FINANCIAL FORM 10-K [.tx]1-21 FORM 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 (X) Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 1996 OR ( ) Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from _____________to______________ - -------------------------------------------------------------------------------- Commission File Number 0-11460 KEYSTONE FINANCIAL, INC. Pennsylvania 23-2289209 (State of Incorporation) (IRS Employer ID No.) P.O. Box 3660 One Keystone Plaza Front and Market Streets Harrisburg, PA 17105-3660 Telephone: (717) 233-1555 - -------------------------------------------------------------------------------- Securities registered pursuant to section 12(g) of the Act: Common Stock, $2.00 par value. Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No_____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant as of February 28, 1997: Common Stock $2.00 Par Value -- $931,078,000. The number of shares outstanding of the registrant's class of common stock as of February 28, 1997: Common Stock $2.00 Par Value -- 37,329,000. DOCUMENTS INCORPORATED BY REFERENCE Portions of the annual shareholder report for the year ended December 31, 1996, are incorporated by reference into Parts I and II and portions of the Joint Proxy Statement/Prospectus of Keystone Financial, Inc. for the 1997 annual shareholders meeting are incorporated by reference into Part III. 1 FORM 10-K INDEX PART I PAGE - ------- ------- Item 1 Business 3 Item 2 Properties 11 Item 3 Legal Proceedings 12 Item 4 Submission of Matters to a Vote of Security Holders Not Applicable PART II - ------- Item 5 Market for Registrant's Common Equity and Related Stockholder Matters 13 Item 6 Selected Financial Data 13 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Item 8 Financial Statements and Supplementary Data 13 Item 9 Changes in and Disagreements with Accountants on Not Accounting and Financial Disclosure Applicable PART III - -------- Item 10 Directors and Executive Officers of the Registrant 14 Item 11 Executive Compensation 14 Item 12 Security Ownership of Certain Beneficial Owners and 14 Management Item 13 Certain Relationships and Related Transactions 14 PART IV - ------- Item 14 Exhibits, Financial Statement Schedules and Reports 15 on Form 8-K 2 PART I ITEM 1 - BUSINESS Introduction Keystone Financial, Inc. (Keystone) was formed in 1984 as a result of mergers between predecessor bank holding companies. Today, with assets of $5.2 billion, Keystone is the fifth largest banking corporation headquartered in the commonwealth of Pennsylvania. Keystone is the parent of six community banks and various nonbank subsidiaries. The subsidiary banks, which consist of American Trust Bank, N.A., Frankford Bank, N.A., Keystone National Bank, Mid-State Bank and Trust Company, Northern Central Bank, and Pennsylvania National Bank, operate in twenty-seven Pennsylvania counties, two Maryland counties and one county in West Virginia. Nonbank subsidiaries offer a variety of financial services including discount brokerage services, sales of mutual funds and annuities, asset management and investment advisory services, reinsurance, small equipment leasing, mortgage banking, and community development. None of the nonbank subsidiaries constitute a significant portion of Keystone's business. At December 31, 1996, Keystone and its subsidiaries had 2,444 full-time equivalent employees. Keystone and its subsidiaries do not have any portion of their business dependent upon a single or a limited number of customers, the loss of which would have a material adverse effect on their business; no portion of their assets are concentrated within a single industry or group of related industries. The businesses of Keystone are not seasonal in nature. For a further description of the nature of Keystone's business, refer to the section entitled "Nature of Operations" contained within Exhibit 13.1. Keystone's stock is traded in the over-the-counter market under the symbol of KSTN and is included in the National Market System of NASDAQ. During 1996, Keystone announced the signing of definitive agreements to merge with Financial Trust Corporation, a financial institution with $1.2 billion of assets headquartered in Carlisle, Pennsylvania, and to acquire First Financial Corporation, a thrift holding company with assets of $361 million based in Cumberland, Maryland. Refer to the Notes to the Financial Statements section under the caption "Mergers and Acquisitions" within Exhibit 13.1 for additional information. 3 Legislation and Competition Changes in banking legislation since 1982 have increased the competition experienced by banks and bank holding companies and expanded the opportunities to grow geographically and offer new types of financial services. Amendments to the Pennsylvania Banking Code in 1982 provided for the phased elimination of geographical branching restrictions for Pennsylvania banks and for the phased elimination of limitations on the number of Pennsylvania banks a bank holding company could own. In 1986, the Pennsylvania Banking Code was further amended to provide for the phased implementation of reciprocal interstate banking, limited initially to an eight-state region. Effective March 4, 1990, Pennsylvania state-chartered and national banks may, subject to regulatory approvals, establish or acquire branch offices anywhere in the state, and there is no numerical limit on the number of Pennsylvania banks a bank holding company may own. Also effective March 4, 1990, a bank holding company located in any state or the District of Columbia could acquire a Pennsylvania bank or bank holding company. Prior to the September 29, 1995 effective date of the federal Riegle-Neal Interstate Banking and Branching Efficiency Act discussed below, this latter provision was subject to a reciprocity requirement. The federal Interstate Banking and Branching Efficiency Act of 1994 (the "Interstate Act") can be expected to provide further impetus to interstate mergers and acquisitions of banking organizations. Effective September 29, 1995, the Interstate Act permits bank holding companies in any state to acquire bank holding companies or banks located in any other state. States may not opt out of this provision but may prohibit the acquisition of banks less than five years old. Effective June 1, 1997, banks located in different states may merge, and bank holding companies with subsidiary banks in more than one state may merge them to form interstate branch networks. States may permit interstate bank mergers prior to this date or may opt out of this provision altogether. They may also prohibit de novo interstate branching or interstate acquisitions of branches without acquiring the entire bank. In July 1995, Pennsylvania enacted amendments to the Pennsylvania Banking Code intended, effective immediately, to permit Pennsylvania banks to engage in interstate mergers, to permit Pennsylvania banks to establish de novo branches in other states and, subject to a reciprocity requirement, to permit out-of-state banks to establish de novo branches in Pennsylvania. At least until June 1, 1997, an interstate merger involving a Pennsylvania bank and interstate branching by a Pennsylvania bank or by an out-of-state bank into Pennsylvania will also require authorizing legislation by the state in which the out-of-state bank or branch is located. The Interstate Act will necessitate some further adjustments and clarifications in the state banking laws of Pennsylvania and other states, particularly as regards the powers, examination and supervision of state-chartered banks with interstate branches. 4 The result of these developments has been an increased volume of merger activity involving Pennsylvania banks and bank holding companies since 1982; larger banking organizations have sought to position themselves to enter into state-wide and inter-state banking; smaller banking organizations have sought to increase their size in order to remain competitive on a regional basis. At the same time, deregulation of the banking industry has increased the opportunities to offer new types of financial services and enhanced the potential for competition from savings and loan associations, insurance companies, brokerage firms, and other nonbank financial institutions. The market in which Keystone's banking subsidiaries operate is considered competitive. Banks and bank holding companies with significant operations in the Keystone market areas range in size from less than $100 million to over $50 billion in assets. In addition to commercial banks, competitors for loans, deposits, and other services include savings and loan associations, insurance companies, finance companies, credit unions, brokerage houses, direct lending by federal and state governments, and a proliferation of other types of financial institutions. Keystone differentiates itself from its financial institution competitors by focusing on the customers and delivering products customized to meet their financial needs. The operating banks of Keystone maintain local management presence to ensure close personal service and local decision-making on the issues which directly affect the customer. At the same time, this structure allows Keystone to standardize products and services and centralize a significant portion of operations, data processing, and other functions which are less directly related to customer contact. This approach enables Keystone to effect improved cost management through economies of scale derived from standardization and centralization of these functions. In summary, Keystone believes that it derives a competitive advantage from this approach by providing personal, localized service in a cost efficient manner. Although Keystone expects that competition will increase as a result of the factors described herein, the effects thereof, if any, on Keystone are not readily ascertainable. Regulation and Supervision of Bank Holding Companies Keystone is subject to regulation under the Bank Holding Company Act of 1956. A bank holding company is required to file annual reports and other information concerning its business operations and those of its subsidiaries with the Board of Governors of the Federal Reserve System (Federal Reserve Board). A bank holding company and each of its subsidiaries are also subject to examination by the Federal Reserve Board. 5 The Bank Holding Company Act requires the prior approval of the Federal Reserve Board in any case where a bank holding company proposes to acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank (unless it already owns a majority of such bank's voting shares), to merge or consolidate with any other bank holding company or to acquire all or substantially all of the assets of any bank. The Act further provides that the Federal Reserve Board shall not approve any such acquisition of voting shares or assets or any such merger or consolidation: (I) that would result in a monopoly or would be in furtherance of any combination or conspiracy to monopolize or attempt to monopolize the business of banking in any part of the United States or (ii) the effect of which may be substantially to lessen competition or to tend to create a monopoly in any section of the country, or that in any other manner would be in restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed in the public interest by the probable effect of the transaction in meeting the convenience and needs of the community to be served. The Bank Holding Company Act prohibits a bank holding company from engaging in, or from acquiring direct or indirect ownership or control of more than 5% of the voting shares of, any company engaged in nonbanking activities unless the Federal Reserve Board, by order or regulation, has found such activities to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board has by regulation determined that certain activities are so closely related to banking or to managing or controlling banks as to permit bank holding companies and subsidiaries formed for the purpose to engage in such activities, subject to Board approval in certain cases. These activities include operating a mortgage, consumer finance, credit card, or factoring company; servicing loans and other extensions of credit; providing certain investment and financial advice; leasing personal property; providing certain bookkeeping or financially-oriented data processing services; acting as an insurance agent for certain types of credit related insurance, and discount brokerage. Keystone Financial, Inc., is an affiliate of each of its subsidiary banks within the meaning of the Federal Reserve Act (Act). As an affiliate, Keystone is subject to certain restrictions imposed by the Act on extensions of credit by the banks to Keystone, on investment in the stock or other securities of Keystone by the banks and on the taking of such stock or securities as collateral for loans to any borrower. Further, under the Bank Holding Company Act and the regulations of the Federal Reserve Board, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of any property or the furnishing of services. 6 The Federal Reserve Board has adopted capital adequacy guidelines under which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications filed with the Board. In 1989, the Federal Reserve Board issued new risk-based capital adequacy guidelines that were fully phased-in at the end of 1992. Keystone is in compliance with all existing capital adequacy guidelines, including the risk-based guidelines. For a discussion of these capital adequacy guidelines and Keystone's capital position, reference is made to the caption "Shareholders' Equity", contained within the Financial Review section of Exhibit No. 13.1 . Regulation and Supervision of Banks The banking subsidiaries of Keystone include both state-chartered banks (Mid- State Bank and Trust Company and Northern Central Bank) and banks chartered under the laws of the United States (American Trust Bank, N.A., Frankford Bank, N.A., Keystone National Bank, and Pennsylvania National Bank). Keystone's state-chartered banks are under the supervision of the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation (FDIC) while the federally-chartered banks are supervised by the Office of the Comptroller of Currency (OCC). The supervisory agencies conduct regular examinations of the banks. All of the Keystone banking subsidiaries are federally-insured by the FDIC. In addition, the banks are subject, in certain instances, to the regulation of the Federal Reserve Board. The areas of operation of Keystone's subsidiary banks which are subject to regulation by federal and state laws, regulations and regulatory agencies include, among other things, reserves against deposits, maximum interest rates for specific classes of loans, truth-in-lending disclosure, permissible types of loans and investments, trust operations, issuance of securities, and payment of dividends. In addition, the FDIC and OCC have issued to state nonmember banks and national banks, respectively, capital adequacy and risk-based capital guidelines similar to those adopted by the Federal Reserve Board for bank holding companies, as referred to above. Keystone's subsidiary banks are in compliance with all such guidelines. As federally-insured banks, the state-chartered banks of Keystone must obtain the prior approval of the Pennsylvania Department of Banking and the FDIC before establishing any new branch banking office. The federally-chartered banks must obtain approval of the OCC and, to a limited extent, the Pennsylvania Department of Banking. Mergers of banks or thrifts located in Pennsylvania, Maryland, and West Virginia are subject to the prior approval of one or more of the following: The applicable state department of banking, the FDIC, the Federal Reserve Board, the OCC, or the Office of Thrift Supervision. The approvals depend upon several factors, including whether the merged institution is a federally-insured state bank, a member of the Federal Reserve System, a national bank or a federal savings bank. 7 As affiliates of Keystone, the banks are subject to provisions of the Federal Reserve Act which restrict the ability of banks to extend credit to affiliates, to invest in the stock or securities thereof, or to take such stock or securities as collateral for loans to any borrower. The business and earnings of the banks are affected by the monetary policies of the Federal Reserve Board which regulates the money supply in order to influence rates of inflation and economic growth. Among the techniques used to implement these objectives are open market dealings in United States Government securities, changes in the discount rate for bank borrowings from the Federal Reserve Banks and changes in the reserve requirements against bank deposits and borrowings. Changes in these policies can influence to a significant degree the overall growth and distribution of bank loans, investments and deposits, the interest rates charged by banks on loans and the cost to banks of obtaining funds, as well as the ability of banks to compete for loans and for funds with other types of financial institutions. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) was signed into law in 1989. FIRREA primarily affects the regulation of savings associations (thrifts) and savings and loan holding companies, rather than the regulation of commercial banks and bank holding companies. However, FIRREA does contain a number of provisions affecting banks and bank holding companies, such as provisions affecting thrift acquisitions, liability of commonly controlled depository institutions, receivership and conservatorship rights and procedures, increased deposit insurance premiums and substantially increased penalties for violation of banking statutes, regulations and orders. In 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). This law has established a new framework for the relationship between insured depository institutions and the various regulatory bodies. For a discussion of FDICIA and associated regulations, reference is made to the caption "Regulatory Matters", contained within the Financial Review section of Exhibit No. 13.1. In 1994, Congress enacted the Riegle Community Development and Regulatory Improvement Act ("CDRIA"), a broad-based law primarily focused on ensuring that banks deliver services to financially underserved communities. In that connection, CDRIA established a fund to award financial grants to community development financial institutions and to promote their partnering with banks. Beyond community development, CDRIA made numerous changes to many provisions of federal banking law, for example, streamlining the bank holding company application process, liberalizing the makeup of national bank boards of directors, simplifying the establishment of bank service corporations, modifying management interlock rules, and tightening currency transaction reporting under the Bank Secrecy Act. CDRIA also amended an array of consumer protection laws, including the Truth in Lending Act, the Real Estate Settlement Procedures Act, The Fair Credit Reporting Act, the Consumer Leasing Act, and the Flood Disaster Protection Act. 8 Late in 1996, Congress enacted the Economic Growth and Regulatory Paperwork Reduction Act (EGARPRA), which, like CDRIA, amended a variety of banking laws, by relieving certain regulatory burdens on banks and bank holding companies. Among other things, EGARPRA eliminated per branch capital requirements for national banks, eliminated branch applications for automated teller machines, expedited procedures for bank holding companies to engage in permissible nonbanking activities, modified rules for qualification of bank directors, liberalized standards for loans to bank insiders, and streamlined the bank examination process. In addition, EGARPRA recapitalized the Savings Association Insurance Fund of FDIC through special assessments on banks and thrift institutions and prepared for the development of a common bank charter for all insured depository institutions. EGARPRA also amended the Fair Credit Reporting Act and the Home Mortgage Disclosure Act and freed banks from liability under certain circumstances for environmental cleanup of real estate taken as loan collateral. Changing conditions in the economy and in the financial industry can be expected to continue to result in changes in legislation and regulatory policies which will affect the business of banks and competition between banks and among banks and other types of financial institutions. Statistical Disclosure The consolidated statistical disclosures found in the sections of Exhibit No. 13.1 entitled, "Selected Financial Data", "Financial Review", and "Supplemental Financial Information", are incorporated herein by reference. Also incorporated herein by reference are the following consolidated statistical disclosures appearing in the Notes to Consolidated Financial Statements section of Exhibit No. 13.1: the discussion of "Interest and Fees on Loans" appearing in the note captioned "Summarized Accounting Policies", the note captioned "Investments", and the table of total nonaccrual and restructured loan balances and related annual interest data appearing in the note captioned "Loans and Leases". 9 Executive Officers of the Corporation Each executive officer has held the position indicated for at least five years. Name Age Office with Keystone - ---------------- --- ---------------------- Carl L. Campbell 53 President, Chief Executive Officer and Director George H. Groves 52 Senior Executive Vice President and Chief Banking Officer Mark L. Pulaski 43 Senior Executive Vice President, Chief Administrative Officer, and Chief Financial Officer Ben G. Rooke 47 Executive Vice President, Counsel and Secretary The officers of Keystone Financial, Inc., serve at the pleasure of the Board of Directors and are not elected for any specified term of office. 10 ITEM 2 - PROPERTIES The headquarters of Keystone Financial, Inc., is located at One Keystone Plaza, Harrisburg, Pennsylvania. This office space is leased under an agreement scheduled to expire in 2002 with three consecutive renewal options each for five years. The main office of American Trust Bank, N.A. is located at 81 Baltimore Street in Cumberland, Maryland and is owned by American Trust Bank. Of the fourteen community offices of American Trust Bank, nine are owned and five are leased. Frankford Bank, N.A. is headquartered at 601 Dresher Road, Horsham, Pennsylvania in a facility which contains executive and administrative offices and a full-service banking center. Frankford operates twenty-eight banking facilities of which twenty-one are leased, and seven are owned. Six of the leased facilities are owned by and leased from Key Trust Company, a wholly-owned subsidiary of Keystone. Keystone National Bank is headquartered at, and conducts limited banking operations from, its leased facility at 2270 Erin Court, Lancaster, Pennsylvania. This facility is also utilized as the headquarters of its wholly-owned subsidiary, Keystone Financial Mortgage Corporation. Mid-State Bank and Trust Co. owns its headquarters located at 1130 Twelfth Avenue, Altoona, Pennsylvania. The five-story building contains executive offices as well as a full-service banking facility. The bank also owns an operations center, which houses the primary data processing facility for Keystone, and is located in Bellwood, Pennsylvania. Mid-State Bank owns twenty-three of its thirty-two banking offices, while the remaining nine offices are leased. In addition, Keystone and Mid-State lease office space for various administrative and back-office functions in three buildings in Altoona, including a building owned by a partnership in which a Keystone board member is a partner. The headquarters for Northern Central Bank is at 102 West Fourth Street, Williamsport, Pennsylvania, in a three-story building which contains executive offices and a full-service banking facility. An operations center is also located in Williamsport and both facilities are owned by Northern Central Bank. The bank owns a total of thirty of its banking offices while the six remaining offices are leased. Pennsylvania National Bank and Trust Company is headquartered at One South Centre Street in Pottsville, Pennsylvania, in a facility which contains executive and administrative offices as well as a full-service banking center. The Bank also owns an operations center located in St. Clair, Pennsylvania. In addition to 11 the headquarters facility, the Bank operates thirty banking offices of which twenty-three are owned by the Bank and seven are leased. Of the nonbanking subsidiaries, Keystone Financial Leasing Corporation, Keystone Financial Mortgage Corporation, and Martindale Andres & Company are headquartered in leased facilities in Pennsylvania. All of the above-mentioned facilities are in good and usable condition. ITEM 3 - LEGAL PROCEEDINGS Keystone and its subsidiaries are involved as plaintiff or defendant in litigation matters that arise in the ordinary course of their business. In the opinion of management, none of the pending litigation matters, individually or in the aggregate, would have a material adverse effect on Keystone's results of operations. 12 PART II ITEM 5 - MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information for this item is incorporated herein by reference to the section of Exhibit No. 13.1 entitled "Market Prices and Dividends". ITEM 6 - SELECTED FINANCIAL DATA The section entitled "Selected Financial Data" of Exhibit No. 13.1 is incorporated herein by reference. ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The section entitled "Financial Review" of Exhibit No. 13.1 is incorporated herein by reference. ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The sections of Exhibit No. 13.1 entitled "Report of Ernst & Young LLP, Independent Auditors", "Consolidated Financial Statements", and notes thereto, and "Quarterly Statements of Income" are incorporated herein by reference. 13 PART III ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11 - EXECUTIVE COMPENSATION ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Part III, Items 10 - 13, is incorporated herein by reference to the information appearing under the following captions in the definitive Joint Proxy Statement/Prospectus for Keystone's 1997 Annual Meeting of Shareholders: - -- Introduction - Trust Department Shares - -- Other Proposals for Keystone Shareholders-Election of Keystone Directors - -- Information Concerning Keystone-Keystone Executive Compensation - -- Information Concerning Keystone-Other Information Concerning Keystone Directors and Executive Officers - -- Information Concerning Keystone-5% Beneficial Owners of Keystone Common Stock The other information appearing in such Joint Proxy/Statement Prospectus, including without limitation that appearing under the captions "Other Information Concerning Keystone - Keystone Human Resources Committee 1996 Report on Executive Compensation" and "Other Information Concerning Keystone- Keystone Stock Price Performance Graph" is not incorporated herein. 14 PART IV ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) The response to this portion of Item 14 is listed below. (a)(3) Listing of Exhibits - The exhibits are listed on the Exhibit Index beginning on page 18 of this Form 10-K. (b) Reports on Form 8-K are listed below. (c) Exhibits - The exhibits listed on the Exhibit Index beginning on page 18 of this Form 10-K are filed herewith or are incorporated by reference. (d) Schedules - listed under Item 14 (a)(1)(2) below. Item 14(a)(1)(2) List of Financial Statements and Financial Statement Schedules The following consolidated financial statements and report of independent auditors of Keystone Financial, Inc. and subsidiaries, included in the annual report of the registrant to its shareholders for the year ended December 31, 1996, are incorporated by reference in Item 8: Report of independent auditors Consolidated statements of condition - December 31, 1996, and 1995 Consolidated statements of income - Years ended December 31, 1996, 1995, and 1994 Consolidated statements of changes in shareholders' equity -Years ended December 31, 1996, 1995, and 1994 Consolidated statements of cash flows - Years ended December 31, 1996, 1995, and 1994 Notes to consolidated financial statements Schedules to the consolidated financial statements as per Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and therefore have been omitted. 15 Item 14(b) Reports on Form 8-K During the quarter ended December 31, 1996, the registrant filed the following reports on Form 8-K: Date of Report Item Description - -------------------- ----- ---------------------------------------------- September 30, 1996 5 Earnings release for the third quarter November 26, 1996 5 Press release regarding First Financial Corporation of Western Maryland December 20, 1996 5 Press release regarding Financial Trust Corp. 16 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. (Registrant)Keystone Financial, Inc. By: Carl L. Campbell -------------------------------- Chief Executive Officer Date: March 7, 1997 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 7, 1997, by the following persons on behalf of the registrant and in the capacities indicated. Carl L. Campbell Mark L. Pulaski - ------------------------------------ ---------------------------------------- President, Chief Executive Officer, Senior Executive Vice President, Chief & Director Administrative Officer, and Chief Financial Officer Donald F. Holt - ------------------------------------ Senior Vice President, Controller, and Principal Accounting Officer A. Joseph Antanavage, Jr. June B. Barry - ------------------------------------ ---------------------------------------- Director Director J. Glenn Beall, Jr. Paul I. Detwiler, Jr. - ------------------------------------ ---------------------------------------- Director Director Donald Devorris Richard W. DeWald - ------------------------------------ ---------------------------------------- Director Director Gerald E. Field Walter W. Grant - ------------------------------------ ---------------------------------------- Director Director Philip C. Herr, II Uzal H. Martz, Jr. - ------------------------------------ ---------------------------------------- Director Director Max A. Messenger William L. Miller - ------------------------------------ ---------------------------------------- Director Director Don A. Rosini F. Dale Schoeneman - ------------------------------------ ---------------------------------------- Director Director Ronald C. Unterberger G. William Ward - ------------------------------------ ---------------------------------------- Director Director 17 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K) ================================================================================ Exhibit Description and Method No. of Filing ================================================================================ 3.1 Restated Articles of Incorporation of Keystone Financial, Inc., as amended through July 29, 1996, incorporated by reference to Exhibit 4.1 of Form S-4 of Keystone Financial, Inc. (No. 333-20283) filed on January 23, 1997. 3.2 By-Laws of Keystone Financial, Inc., as amended to May 14, 1992, incorporated by reference to Exhibit 3.2 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1992. 4.1 Keystone Financial, Inc. Series A Junior Partici- pating Preferred Stock Purchase Rights Agreement dated January 25, 1990, incorporated by reference to Exhibit 1 to Form 8-A filed on February 9, 1990. 4.2 Amendment No. 1 to Series A Junior Participating Preferred Stock Purchase Rights Agreement dated December 20, 1990, incorporated by reference to Exhibit 2 to the Form 8 Amendment dated December 20, 1990. The registrant hereby agrees to furnish to the Commission upon request copies of the instruments defining the rights of the holders of the long-term debt of the registrant and its consolidated subsidiaries. 10.1* Keystone Financial, Inc., Corporate Directors Deferred Compensation Plans, incorporated herein by reference to Exhibit 10.1 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1994. 10.2* Keystone Financial, Inc. 1988 Stock Incentive Plan, incorporated herein by reference to Exhibit 10.2 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1993. 18 ================================================================================ Exhibit Description and Method No. of Filing ================================================================================ 10.3* Keystone Financial, Inc. Management Incentive Compensation Plan as amended and restated, incorporated herein by reference to Exhibit 10.3 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1993. 10.4* Form of employment agreement between Keystone Financial, Inc. and Executive Officer Campbell, incorporated herein by reference to Exhibit 10.4 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1993. 10.5* Form of employment agreement between Keystone Financial, Inc. and Executive Officers Groves, Pulaski, and Rooke, incorporated herein by reference to Exhibit 10.5 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1993. 10.6* Keystone Financial, Inc. 1995 Management Stock Purchase Plan, incorporated herein by reference to Exhibit C of the Proxy Statement of Keystone Financial, Inc., dated April 7, 1995. 10.7* Keystone Financial, Inc. Savings Restoration Plan, as amended and restated effective January 1, 1994, and as corrected on June 14, 1994, incorporated herein by reference to Exhibit 10.7 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1994. 10.8* Keystone Financial, Inc. Supplemental Retirement Income Plan, incorporated herein by reference to Exhibit 10.7 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1993. 10.9* Keystone Financial, Inc.1990 Non-Employee Directors' Stock Option Plan, as amended, incorporated herein by reference to Exhibit 10.8 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1993. 19 ================================================================================ Exhibit Description and Method No. of Filing ================================================================================ 10.10* Keystone Financial, Inc. 1992 Stock Incentive Plan, incorporated herein by reference to Exhibit A of the Proxy Statement of Keystone Financial, Inc., dated April 2, 1992. 10.11* Keystone Financial, Inc. 1992 Director Fee Plan, as amended, incorporated herein by reference to Exhibit 10.11 of Form 10-K of Keystone Financial, Inc. for the year ended December 31, 1994. 10.12* Keystone Financial, Inc. Supplemental Deferred Compensation Plan, incorporated herein by reference to Exhibit 10.11 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1992. 10.13* Keystone Financial, Inc. form of Executive Split Dollar Agreements, Form A and Form B, incorporated herein by reference to Exhibit 10.1 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1993. 10.14* Keystone Financial, Inc. 1995 Non-Employee Directors' Stock Option Plan, incorporated herein by reference to Exhibit B of the Proxy Statement of Keystone Financial, Inc., dated April 7, 1995. 10.15* Keystone Financial, Inc. Management Stock Ownership Program, incorporated herein by reference to Exhibit 10.15 of Form 10-K of Keystone Financial, Inc., for the year ended December 31, 1995. 10.16* Keystone Financial, Inc. 1996 Performance Unit Plan, incorporated herein by reference to Exhibit 99.16 of Amendment No. 1 to Form S-4 of Keystone Financial, Inc. (No. 333-20283), filed contemporaneously herewith. 20 ================================================================================ Exhibit Description and Method No. of Filing ================================================================================ 10.17 Agreement and Plan of Reorganization dated as of December 19, 1996 between Keystone Financial, Inc. and Financial Trust Corp and Agreement and Plan of Merger dated as of December 19, 1996 between Keystone Financial, Inc. and Financial Trust Corp. incorporated herein by reference to Exhibit 2.1 of Form S-4 of Keystone Financial, Inc. (No. 333-20283) filed on January 23, 1997. 10.18 Agreement and Plan of Reorganization dated as of November 26, 1996 between Keystone Financial, Inc. and First Financial Corporation of Western Maryland incorporated herein by reference to Exhibit 2 to the Current Report on Form 8-K of First Financial Corporation of Western Maryland dated December 2, 1996. 13.1 Portions of the Annual Report to Shareholders of Keystone Financial, Inc., for the year ended December 31, 1996, filed herewith. 22.1 Subsidiaries of Registrant, filed herewith. 23.1 Consent of Ernst & Young LLP, independent auditors, filed herewith. 27.1 Financial Data Schedule, filed herewith. - -------------------------------------------------------------------------------- *The exhibits marked by an asterisk (*) are management contracts or compensatory plans or arrangements. 21 EX-13.1 2 PORTIONS OF THE ANNUAL REPORT
Selected Financial Data (in thousands except per share data) Year Ended December 31, - -------------------------------------------------------------------------------------- 1996 1995 1994 1993 1992 - --------------------------- ---------- ----------- ----------- ----------- ----------- Operations: - --------------------------- ---------- ----------- ----------- ----------- ----------- Interest income $384,521 $363,931 $313,202 $307,755 $330,645 Interest expense 174,758 166,579 124,784 125,245 152,718 - --------------------------- ---------- ----------- ----------- ----------- ----------- Net interest income 209,763 197,352 188,418 182,510 177,927 Provision for credit losses 9,858 7,859 9,484 7,940 16,053 Noninterest income 62,673 50,321 44,629 45,819 39,276 Noninterest expense 162,559 150,634 151,723 148,003 138,840 Income tax expense 30,544 27,866 20,481 21,037 16,568 - --------------------------- ---------- ----------- ----------- ----------- ----------- Net Income $69,475 $61,314 $51,359 $51,349 $45,742 - --------------------------- ---------- ----------- ----------- ----------- ----------- Pre-tax security gains, included above $556 $1,317 $834 $1,669 $1,750 Net interest spread 3.75% 3.77% 4.04% 4.07% 4.02% Impact of noninterest funds .74 .72 .59 .56 .65 - --------------------------- ---------- ----------- ----------- ----------- ----------- Net interest margin 4.49% 4.49% 4.63% 4.63% 4.67% - --------------------------- ---------- ----------- ----------- ----------- ----------- Per Share: - --------------------------- ---------- ----------- ----------- ----------- ----------- Net income $1.83 $1.73 $1.46 $1.47 $1.33 Dividends 0.98 0.93 0.86 0.79 0.73 Dividend payout ratio 53.55% 53.28% 59.22% 54.01% 55.27% Average shares outstanding 38,045,585 35,462,358 35,093,138 34,956,927 34,475,862 Balances at December 31: - --------------------------- ---------- ----------- ----------- ----------- ----------- Loans & leases $3,553,662 $3,365,716 $3,193,405 $2,775,198 $2,785,335 Allowance for credit losses 45,016 44,377 42,440 40,181 38,940 Total assets 5,231,268 5,074,785 4,706,000 4,419,726 4,311,779 Deposits 4,097,111 4,061,888 3,827,983 3,582,688 3,655,261 Shareholders' equity 507,307 480,694 407,774 412,880 378,314 Ratios: - --------------------------- ---------- ----------- ----------- ----------- ----------- Return on average assets 1.37% 1.29% 1.16% 1.19% 1.08% Return on average equity 14.11 14.06 12.71 12.98 12.58 Equity to assets, average 9.74 9.16 9.09 9.13 8.62 Risk adjusted capital ratios: Leverage ratio 9.64% 9.28% 8.84% 9.18% 8.66% "Tier 1" 13.54 13.65 12.96 14.05 13.06 "Total" capital 14.77 14.83 14.21 15.30 14.26 Loans to deposits, year end 86.74% 82.86% 83.42% 77.46% 76.20% Allowance for credit losses to loans 1.27 1.32 1.33 1.45 1.40 Nonperforming assets to loans 0.75% 0.78% 0.95% 1.32% 1.66% Loans 90 days past due 0.50 0.44 0.24 0.14 0.22 - --------------------------- ---------- ----------- ----------- ----------- ----------- Total risk elements to loans 1.25% 1.22% 1.19% 1.46% 1.88% - --------------------------- ---------- ----------- ----------- ----------- -----------
22 FINANCIAL REVIEW The purpose of this review is to provide additional information necessary to fully understand the consolidated financial condition and results of operations of Keystone Financial, Inc. (Keystone). Throughout this review, net interest income and the yield on earning assets are stated on a fully taxable-equivalent basis. In addition, balances represent daily average balances, unless otherwise indicated. Per share information has been adjusted to reflect a three-for-two stock split, in the form of a 50% stock dividend, declared in the third quarter of 1996. 1996 SUMMARY Performance Results - ------------------- Keystone's financial performance for 1996 reflected continued improvement as net income reached a record high of $69,475,000, a 13.3% improvement over 1995 net income of $61,314,000. Earnings per share also grew to $1.83 in 1996, a 5.8% improvement over the 1995 performance of $1.73. Keystone recorded strong performance in both return on average assets (ROA) and return on average equity (ROE). These traditional measures of financial institution performance provide a relative basis for comparison to Keystone's peer group. ROA and ROE for 1996 were 1.37% and 14.11%, respectively, a slight improvement over the comparable measures of 1.29% and 14.06% in 1995. Revenue expansion efforts continued to be the primary focus of Keystone's profit improvement initiatives during 1996. Total revenues, consisting of both net interest income and noninterest income, grew 9.5% from 1995 to 1996, including a 5.8% increase in net interest income and a 24.5% increase in revenue from noninterest sources. Net interest income growth was stimulated primarily by loan growth, including loans added in the late 1995 bank mergers, as net interest margin was constant from 1995 to 1996. Average loans increased by more than $165,000,000 or 5.1%. In addition, Keystone originated and sold an additional $282,000,000 of consumer mortgages and indirect automobile loans. These secondary market activities helped to fuel the increase in revenue from noninterest income as mortgages and indirect loans serviced for others increased to $576,000,000 and $174,000,000, respectively. Likewise, as assets under management grew, Keystone experienced growth in trust and investment advisory fees, which helped to further advance a strategic objective to deliver a complete line of financial service products to its customer base. Keystone's ratio of noninterest expense to revenues of 58.73% for 1996 reflected improvement over the ratio of 59.78% for 1995, as growth in noninterest expenses was 7.9%. Increases in salary and benefit costs were influenced by the addition of employees from late 1995 bank mergers, the acquisition of Martindale Andres (specialized investment advisory services) and the purchase of Key Investor (retail annuity products). Noninterest expenses benefited from a full-year reduction in the FDIC insurance premium. Excluding the influence of prior year acquisitions, total noninterest expenses grew approximately 3.4%. Finally, Keystone continued to sustain solid asset quality in its investment and loan portfolios, including a low level of nonperforming loans. Operating Philosophy - -------------------- Keystone's stated objective is to become the "financial services provider of choice" in the markets in which it operates. In order to achieve this objective, Keystone has adopted an operating philosophy it describes as "relationship banking". Under "relationship banking", Keystone strives to develop an intimate understanding of its customers' financial needs and formulate solutions that 23 meet those needs. By cultivating and deepening customer relationships, Keystone's operating philosophy will enable it to both enhance performance and sustain profitability momentum over time. Performance enhancement in the financial services industry depends significantly on two fundamental objectives: expansion of the revenue base through delivery of essential products and services and the creation of an efficient delivery and revenue support structure. Keystone's performance enhancement efforts start with revenue expansion, which is derived from three major activities: an understanding of customer needs, the development of new and improved products, and increased market penetration. Keystone has placed an emphasis on understanding its customers, as illustrated by its "relationship banking" approach. During 1996, Keystone began to organize and operate in "relationship banking" teams that have been positioned to better identify customer needs and to tailor Keystone's menu of products and services to meet those local needs. Keystone's product menu now includes a full array of intermediation banking products, as well as trust, investment management, brokerage, annuity, and insurance services. Finally, increased market penetration must result from identification of new ways to meet customer needs and from the development of convenient access channels to financial products and services. Expansion of Keystone's electronic delivery channels included its partnership in the convenience store ATM network, advanced function ATMs, and telephone banking. Each of these initiatives is an example of increased market penetration built on a foundation of customer convenience. Keystone's adherence to an operating philosophy designed to understand customer needs, develop products, and grow markets will enhance revenue generation capacity through delivery of a complete range of financial services. The second fundamental objective of Keystone's operating philosophy is focused on the creation of an efficient operating structure. Continuous improvement in the efficiency of an operating structure is achieved through enhancements to both service delivery channels and support operations. Keystone has made an effort to redefine its delivery channels by constant evaluation of facilities on the basis of their ability to generate revenues, meet the convenience requirements of customers, and moderate expense growth. During 1996, sustained efforts were made to improve the office delivery system by closing, consolidating, or redesigning facilities to tailor them to local needs. Keystone's current office network will continue to be an important ingredient in its delivery system by emphasizing personal interaction and the value-added features of traditional full-service offices. At the same time, Keystone continues to make investments to expand and redefine other elements of the system which place more emphasis on the convenience of ATMs, telephone banking, and other electronic delivery channels. These efforts, combined with initiatives to further consolidate, centralize, and refine business processes in support operations, form the foundation of Keystone's efficient operating structure. In order to sustain profitability momentum, management must foster a customer- focused environment that will result in increased market share, appropriate leverage of the infrastructure investment, and profitable growth. Together, Keystone's revenue expansion and efficient operating structure initiatives provide the underpinnings for performance enhancement and sustained profitability momentum. This corporate focus will enhance the quality of earnings from both the revenue and expense components of performance. Keystone will continue to manage this delicate balance between current performance and longer-term investment in order to solidify its position as a premier provider of financial services in its trade area. 24 Economic and Industry Trends - ---------------------------- Financial institution performance has always been influenced by the flow of economic tides, and 1996 was no exception. Economic conditions during the year included both favorable and unfavorable trends which affected the demand for both commercial and consumer financial services. Interest rates were generally lower than that experienced during 1995, though the average treasury yield curve, an indicator of overall interest rate trends, did steepen during the year. Uncommonly low levels of unemployment continued to suggest the specter of inflation and the possible need to tighten interest rates to moderate economic growth. Rates, however, remained at relatively low levels during the year. Low interest rates, low unemployment, and relatively low levels of inflation continued to buoy optimism in the stock market as the Dow Jones industrial average rose from 5117 at the end of 1995 to 6448 by December 31, 1996. Concerns still exist regarding potential overvaluation in the market and the potential for some degree of market adjustment. While these factors translated into a rather stable economic picture, commercial and retail customer preferences continued to affect financial institution performance. Commercial customers continued to express a preference for fixed-rate credit facilities to lock in the cost of funding. Retail customers, ever mindful of the higher investment returns accessible through the stock market, continued to show a predilection for competitively-priced deposit products and for investment products which provide the opportunity for higher returns commensurate with higher risk. Both commercial and retail customers continue to demand products and services designed to meet their individual financial needs and provide added value in terms of convenience, service, and price. Forward-Looking Statements - -------------------------- From time to time, Keystone has and will continue to make statements which may include "forward-looking" information. Keystone cautions that "forward-looking" information disseminated through financial presentations should not be construed as guarantees of future performance. Furthermore, actual results may differ from expectations contained in such "forward-looking" information as a result of factors which are not predictable. Financial institution performance can be affected by any number of factors, many of which are outside of management's direct control. Examples include, but are not limited to, the effect of prevailing economic conditions; the overall direction of government policies; unforseen changes in the general interest rate environment; the actions and policy directives of the Federal Reserve Board; competitive factors in the marketplace, and business risk associated with the management of the credit extension function and fiduciary activities. Each of these factors could affect estimates, assumptions, uncertainties, and risks considered in the development of "forward-looking" information, and could cause actual results to differ materially from management's expectations regarding future performance. 25 NET INTEREST INCOME The primary source of Keystone's revenue is net interest income, which represents the difference between interest on earning assets and interest expense on deposits and other borrowed funds. Net interest margin is net interest income expressed as a percentage of average earning assets. Net interest income and net interest margin are affected by changes in interest rates, changes in the relationship between rates, and by variations in the volume and mix of asset and liability balances. The following table summarizes changes in net interest income and margin during 1996 (in thousands):
1996 1995 Change - -------------------------------------------------------------------------------------- Yield/ Yield/ Yield/ Amount Rate Amount Rate Amount Rate ======================= ========== ========= ========== ========= =========== ======== Interest income $389,413 8.15% $369,549 8.19% $19,864 (0.04) Interest expense 174,758 4.40 166,579 4.42 8,179 0.02 - ----------------------- ---------- --------- ---------- --------- ----------- -------- Net interest income $214,655 $202,970 $11,685* ======================= ========== ========= ========== ========= =========== ======== Interest spread 3.75% 3.77% (0.02) Impact of noninterest funds 0.74 0.72 0.02 - ----------------------- ---------- --------- ---------- --------- ----------- -------- Net interest margin 4.49% 4.49% ---- ======================= ========== ========= ========== ========= =========== ======== * The change in net interest income was almost entirely the result of a favorable volume variance.
Interest Rates and Economic Trends - ---------------------------------- As the primary source of revenue for financial institutions, net interest income generation requires effective management of products and services subject to the constraints of overall economic conditions, competitive pressures, and the relative pace of changes in the interest rate climate. The period of economic expansion which began in 1992 exhibited no immediate sign of abatement during 1996 as the economy was characterized by an unprecedented rise in the value of equity markets, low interest rates, low inflation, low levels of unemployment, and generally favorable economic conditions. This combination of factors has sustained a climate of economic stability favorable to the financial condition of both consumer and commercial customers. While the state of the economy affected net interest income performance, so too did the influence of the overall interest rate environment. In summary, the 1996 average interest rate environment was remarkably similar to that of 1995. At the beginning of 1995, interest rates were high by comparison to those in place at the end of 1996. During 1995, rates began a steady descent only to begin rising slightly toward the end of that year. Rates continued to increase slightly throughout 1996, though average interest rates during the year remained below the average for 1995. Furthermore, the slope of the yield curve was slightly steeper during 1996, suggesting an opportunity to benefit from the extension of asset maturities. 26 The following is a comparison of the average yield curve for U.S. Treasury instruments for specific intervals between three months and thirty years, which serves as an illustration of the relative comparison of interest rate trends between 1996 and 1995. Three Six One Two Three Five Ten Thirty Months Months Year Years Years Years Years Years - ----------------------------------------------------------------------------- 1996 5.14% 5.28% 5.49% 5.83% 5.97% 6.17% 6.43% 5.70% 1995 5.63% 5.80% 5.92% 6.12% 6.22% 6.36% 6.55% 6.86% The similarity of average interest rates between the two years yielded only minor variations in the yield on earning assets and cost of funds. The similarity of performance in net interest margin belies the fact that Keystone has continued to actively manage product development, product delivery, and product pricing in response to changes in customer preferences. Keystone's relationship banking focus, securitization strategies, deposit product innovations, and development of alternative investment product opportunities are among the factors that influenced earning asset and funding mix changes. Despite the impact of these shifts, Keystone was able to actively manage its net interest margin and net interest income performance. Interest Income/Earning Assets - ------------------------------ Interest income reached $389,413,000 in 1996, compared to $369,549,000 in 1995, an increase of 5.4%. The improvement in interest income was driven almost exclusively by increases in the volume of earning assets, and more particularly loans, which grew 5.1%. The increase was especially noteworthy in light of Keystone's securitization and loan sales strategy, which limited loan growth in fixed-rate consumer mortgages and indirect loans. These loan categories have become an increasingly smaller portion of Keystone's overall loan mix due to this strategy. The successful execution of Keystone's "relationship banking" initiatives had a significant influence on the composition of its earning asset base. Under these initiatives, financial needs are identified by organizing the customer base according to demographic data, a process commonly described as life-cycle segmentation. An important element of this effort is the delivery of credit products which enhance and deepen a relationship-oriented product line. As a consequence of this effort, overall loans grew by $165,617,000 from 1995. On the commercial side, commercial loans and real estate secured loans grew by $44,141,000 and $27,440,000, respectively. Heavy emphasis was placed on the delivery of relationship products to the consumer market, and included growth of $92,943,000 in direct loans and $91,722,000 in auto leases. Included in Keystone's relationship-oriented product line is a full complement of mortgage loan products. Keystone's unique approach to the delivery of 27 mortgage services has been designed to complement the menu of other financial products and services available throughout Keystone, thus preserving and enhancing customer affinity. While a significant portion of originated loans are sold into the secondary market, the sale and servicing expertise of Keystone Financial Mortgage Corporation has provided a significant competitive advantage in attracting and retaining customers. While Keystone executed its initiatives related to the profitable management of its relationship-based product lines, attention was also focused on commodity- based financial services, primarily indirect automobile loans. Keystone's securitization and sales strategy, which calls for the securitization of non- relationship credit products, accommodated the credit needs of this market segment and provided a steady stream of servicing income for Keystone. This strategy, along with its mortgage banking approach, has allowed Keystone to preserve precious deposit funding sources to execute its relationship-oriented consumer and commercial product lines. The result of these strategic initiatives was a relatively constant yield on earning assets of 8.15% in 1996 compared to 8.19% in 1995, despite the drop in overall interest rates. Interest Expense/Funding Sources - -------------------------------- Perhaps the most significant challenge facing financial institutions is the continuing need to generate a sufficient volume of funding sources to accommodate the intermediation process. Successful management of this process is a prerequisite for sustained or improved net interest income performance. As more investment options become available to depositors, Keystone has continued to emphasize the development of innovative, competitively-priced products designed to be responsive to consumer preferences. The continuing success of Keystone's "Variable-Rate CD" as well as the introduction of the "Indexed Money Market Account" are two examples of the successful execution of this strategy. Additionally, Keystone will continue to emphasize the convenience and responsiveness of its life cycle packages which have been designed to meet the needs of customers in each life-cycle segment, including convenient access to savings and investment products. In 1996, total deposits rose 4.8% while the cost of interest-bearing funds, which included both interest-bearing deposits and other interest-bearing liabilities, declined slightly from 4.42% to 4.40%. Customer preferences for the convenience and the rate of return advantages provided by both the Indexed Money Market Account and the Variable Rate CD, when contrasted with more traditional core- deposit categories, fueled this growth. Given the lower overall level of interest rates, Keystone was also able to sustain, and in some cases increase the volume of funding from large certificates of deposits and short-term borrowings. Net Interest Spread and Net Interest Margin - ------------------------------------------- Keystone's two primary sources of revenue are net interest income, which comprised over 77% of revenues, and noninterest income which is just below 23%. Comparable levels of net interest income and noninterest income during 1995 were 80% and 20%, respectively. While revenue from noninterest sources has become an increasingly important component of Keystone's overall revenue mix, net interest income continues to provide the largest source of revenue. Net interest margin includes the effect of interest spread, the investment of noninterest funds, and the level of nonearning assets. In 1996, interest spread remained relatively constant with 1995 as the difference between earning asset yields and the cost of funding sources declined only slightly from 3.77% in 1995 to 3.75% in 1996. The influence of noninterest funds, which included the impact of a higher level 28 of demand deposits, increased slightly from 72 basis points in 1995 to 74 basis points in 1996. As a consequence, net interest margin remained constant at 4.49% in both 1996 and 1995. Quarterly Performance - --------------------- The following tables provide a comparative summary of earning asset yields, funding costs, and other information for each of the four quarters of 1996 and 1995 (in thousands): 1996 - --------------------------------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ============================== =========== ========== ========== ========== Asset yield 8.12% 8.05% 8.16% 8.21% Funding cost 4.45 4.43 4.34 4.38 - ------------------------------ ----------- ---------- ---------- ---------- Interest spread 3.67% 3.62% 3.82% 3.83% - ------------------------------ ----------- ---------- ---------- ---------- Net interest margin 4.42% 4.37% 4.56% 4.57% - ------------------------------ ----------- ---------- ---------- ---------- Net interest income $54,101 $53,095 $53,669 $53,790 ============================== =========== ========== ========== ========== 1995 - --------------------------------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ============================== =========== ========== ========== ========== Asset yield 8.18% 8.14% 8.24% 8.19% Funding cost 4.48 4.50 4.45 4.23 - ------------------------------ ----------- ---------- ---------- ---------- Interest spread 3.70% 3.64% 3.79% 3.96% - ------------------------------ ----------- ---------- ---------- ---------- Net interest margin 4.45% 4.37% 4.51% 4.63% - ------------------------------ ----------- ---------- ---------- ---------- Net interest income $51,719 $49,844 $50,212 $51,195 ============================== =========== ========== ========== ========== Quarterly performance reflects the similarity of the overall interest rate environment between 1995 and 1996. Both earning asset yields and the overall cost of funds were virtually constant from year to year. During the third quarter of 1996, compression of net interest margin was attributed primarily to a higher relative cost of funds and slightly lower asset yields. This compression was influenced by both competitive pressures, and by consumer preference for higher cost deposit products, including the "Variable Rate CD". These same competitive pressures will continue to require management attention in order to maintain or improve margin performance. Despite this compression, Keystone achieved a higher level of net interest income during 1996, primarily due to volume increases. PROVISION FOR CREDIT LOSSES The provision for credit losses increased from $7,859,000 in 1995 to $9,858,000 in 1996, an increase of $1,999,000. The increase in the provision was responsive to both loan growth and the higher overall level of charge-offs during the year. At the same time, other important asset quality performance measures, such as the relationship of the allowance for credit losses to loans and the ratio of total risk elements to year-end loans, remained stable. See the Allowance for Credit Losses and Asset Quality section of this review for additional information. 29 NONINTEREST INCOME The most significant improvement in Keystone's 1996 performance occurred in the level of noninterest income, which grew nearly 25% and now represents approximately 23% of Keystone's revenue. Over the last several years, Keystone has sought to enhance and diversify its noninterest revenue stream both by offering an expanded array of financial service products and by intensifying efforts to deliver existing financial services. Continued strength in trust income, deposit service charges, and fee income was augmented by the successful expansion of Keystone's investment advisory services, mortgage banking activity, and fees from the servicing of indirect loans. The resulting improvement, which also included a $2,000,000 gain from the sale of the credit card portfolio during the first quarter of 1996, reflected growth in noninterest revenue of $12,352,000 to $62,673,000. The generation of increased noninterest revenues will remain a key component of Keystone's overall revenue expansion efforts. The largest single source of noninterest income within Keystone was trust and investment advisory fees. Revenues from these activities have been positively influenced by both expanded product offerings and intensified marketing efforts to customers. At the end of 1995, Keystone acquired Martindale Andres & Company, a highly successful investment advisory services firm specializing in serving return-oriented institutional customers and high net- worth individuals. At the same time, Keystone continued to develop its more established trust services, including employee benefit and personal trust accounts. Aggregate assets under management at December 31, 1996 totaled $2,793,416,000, a 16% increase from 1995. Late in 1996, Keystone began the process of converting its common trust funds into a family of mutual funds under its "KeyPremier" label. Under legislation passed in the second half of 1996, this type of conversion was permitted without tax consequences to existing common fund shareholders. The "KeyPremier" family of funds will make the investment advisory capabilities of Martindale Andres more readily accessible to a broader base of corporate and retail customers. The introduction of these funds provides another ingredient in the establishment of a more complete mix of financial products and services, an important source of fee income, and an appropriate leverage of the investment expertise of Martindale Andres. Fees from these expanded activities are expected to influence the pace of income growth as it relates to asset management activities. Secondary market activities are becoming an ever-increasing component of Keystone's noninterest income and consist principally of the fees from the origination and sale of mortgage and indirect automobile loans. Aggregate revenues from these activities totaled $11,038,000 in 1996 compared to $7,807,000 in 1995, an increase of 41.4% and represented nearly 18% of the total noninterest revenue stream. As of the end of 1996, Keystone was servicing approximately $576,000,000 of mortgage loans and $174,000,000 of indirect automobile loans for secondary market investors. Since 1993, Keystone's mortgage banking activities have been conducted through Keystone Financial Mortgage Corporation (KFMC), a wholly-owned subsidiary of Keystone. The centralization of mortgage activities through KFMC has allowed Keystone to leverage market opportunities available through its expansive community office network. Similarly, Keystone established its Keystone Dealer Finance Center (KDFC), a centralized operating unit designed to provide a consistent source of automobile financing to customers serviced throughout Keystone's network of automobile dealers. Securitization and sale of both mortgage and indirect automobile loans has enabled the financing of these activities to be self-funding, thus preserving core sources of funding for "relationship-banking" activities. At the same time, Keystone has been able to generate significant levels of noninterest income attributable to the fees earned for the servicing of these loans to investors in the secondary market. 30 Revenue from deposit service charges continued to remain a critical component of Keystone's fee generation activities. Service charges on deposits grew 11% to $14,611,000, a $1,406,000 increase from 1995. In late 1996, Keystone introduced "KeyFree", its new free-checking option which offers yet another product developed to attract new customers and introduce them to other products and services available through Keystone's delivery channels. This initiative is expected to favorably influence both net interest income and other fee income as customers become acquainted with Keystone's offerings of credit facilities, deposit services, and alternative investment products. At the same time, successful implementation of this initiative has the potential to constrain the level of growth in deposit service fee income in future years. The delivery of financial services through electronic delivery channels is now providing an expanding source of revenue generation for Keystone. This trend provided a steady increase in ATM-related revenues including surcharging from foreign users of ATM services and fees from Keystone's KeyCheck debit card. Total revenues of $3,338,000, nearly 24% of fees included in other income, were derived from these electronic delivery channels, a 31% increase from 1995. Each of these fee-generating activities is based on providing improved and convenient delivery of financial services to customers. In yet another significant initiative in the generation of fee income, Keystone acquired KeyInvestor Services, a distributor of investment products. Prior to the acquisition of KeyInvestor in August, 1996, Keystone was providing such services through its relationship with the Laughlin Group. The purchase of this company now allows Keystone to make this product line a more integral part of its internally-managed menu of products and services. NONINTEREST EXPENSE Noninterest expenses for 1996 increased to $162,559,000, a 7.9% increase over 1995 expenses of $150,634,000. Keystone's ratio of noninterest expense to revenues of 58.73%, a common measure of expense management efficiency, reflected an improvement over the ratio of 59.78% for 1995. Increases in salary and benefit costs were influenced by the addition of employees from the late 1995 bank mergers, the acquisition of Martindale Andres, and the purchase of KeyInvestor during 1996. The overall growth rate of overhead expenses was also affected by the costs associated with increased activity levels, including merchant banking services and ATM-related expenditures. At the same time, the overall rate of expense growth was favorably influenced by the full-year reduction in Federal Deposit Insurance Corporation (FDIC) insurance premiums. Excluding the influence of acquisitions, total noninterest expenses grew at a rate of approximately 3.4%. Salary expenses, the largest single component of Keystone's overhead structure, grew to $69,270,000, an 11.5% increase over the 1995 expenses of $62,115,000. The average number of full-time equivalent employees grew nearly 6% from 2,315 in 1995 to 2,445 in 1996. Nearly all of this increase was attributed to the various mergers and acquisitions which incurred in late 1995. Excluding such increases, salary expenses rose 5.5%, a majority of which related to overall average merit increase of 5.0%. During 1996, Keystone aggressively pursued the development of an integrated compensation program designed to support its key business strategies. This development has included the reconstruction of existing incentive programs and the creation of new programs designed to reward employee efforts toward achievement of greater revenue and profitability growth. 31 As a consequence, future increases in compensation costs are likely to be even more closely tied to the achievement of desired performance levels. Benefit expenses, which consist principally of costs associated with providing employee health care, were $12,562,000 in 1996, a 15.3% increase from the $10,898,000 reflected in 1995. Keystone's health care coverage is managed under a "point-of-service" program which mandates the use of "primary care physicians" and "hospital providers" who meet pre-established standards for delivery of quality and cost-effective health care. Such costs are largely influenced by the level of health care needs and usage by the Keystone employee base. During 1995, Keystone was advantaged by favorable claims experience, while 1996 reflected a return to more normalized trends. Despite this increase, the adoption of the "point-of-service" program continues to favorably influence employee access to quality cost-effective health care systems. The cost of office reconfiguration and technology investments has influenced, and will continue to affect the rate of growth in occupancy and, more significantly, equipment-related expenses. In 1996, Keystone continued to expand its network of ATMs, including the phase-in of selectively located, full-service ATMs and the partnership with Sheetz, Inc., a major convenience store chain. Under agreement with Sheetz, Keystone has installed ATMs in nearly 150 Sheetz store locations, increasing Keystone's aggregate ATM network to approximately 325. Office configurations and technology investment have been strategically executed to provide convenient customer access to banking services. Similar initiatives, which include the evolution of the KeyCall telephone call center, continue to be developed and will result in equipment expense growth that is likely to continue to outpace the growth in aggregate overhead expenses. Largely due to the expanded ATM network, the level of customer activity associated with access to electronic delivery channels has expanded dramatically, including 13% growth in overall ATM activity. The expense growth associated with increased availability and uses of these channels must be evaluated with the growth in associated fee revenues. Keystone has also introduced and expanded electronic access by commercial customers through KeyCash Manager, a PC-based cash management system. Occupancy expenses have grown at a slower pace than equipment and technology costs. During 1996, Keystone completed a comprehensive review of its community office network. The objective of this review, which was conducted with the help of a nationally-recognized consulting firm specializing in such analyses, was to maximize Keystone's office locations as "financial centers" within their defined markets. This includes effective utilization and integration of these offices as product distribution points for both intermediation and alternative investment financial products. A majority of the changes to the community office network, which included initiatives to consolidate, upgrade or close specific offices, were initiated in the second half of 1996, will be completed by the end of 1997, and are expected to limit the rate of growth in occupancy expenses. The most significant reduction in noninterest expenses occurred in FDIC premium expenses which declined from $4,957,000 in 1995 to $778,000 in 1996. In the third quarter of 1995, the FDIC announced that the Bank Insurance Fund (BIF) reached its recapitalization level, thus effecting a dramatic reduction in BIF insurance premiums, particularly for those institutions classified as "well- capitalized". At the same time, the Savings Association Insurance Fund (SAIF), which provides insurance for the thrift industry, remained undercapitalized and faced an impending funding shortfall on the bonds that had been issued to shore up the fund. During the third quarter, a one-time premium was levied upon thrifts and those banks which had acquired thrift deposits. This new legislation averted a potential crisis and allowed for a phase-in of premium reductions on 32 thrift deposits until such time that the SAIF fund is recapitalized. At the same time, this legislation included provisions which may result in the merger of bank and thrift charters, thus eliminating an outdated and ineffective structure in favor of a modernized approach consistent with the evolution of the financial services industry. The final category of noninterest expense, other expenses, grew 10.4% from $47,579,000 in 1995 to $52,538,000 in 1996. Absent the influence of the mergers and acquisitions, these expenses reflected a growth rate of 7.5%, or approximately $3,600,000. Nearly one third of this increase was attributed to the aforementioned one-time SAIF insurance assessment on thrift deposits that had been acquired in previous years. Another significant component of the increase related to the rise in merchant card volumes and the increased processing expense associated with merchant card activities. As previously noted, these increased costs are directly related to the increase in fee income associated with these activities. Other increases in expenses included the impact of legal fees incurred as a result of the introduction of the KeyPremier funds, losses on dispositions of office facilities, and expenses for the write-off of obsolete forms and supplies due to mergers. Income Taxes Keystone recorded tax expense of $30,544,000 in 1996, an increase from $27,866,000 recorded in 1995. The increase was influenced primarily by higher levels of taxable income as the effective tax rate reached 30.5% in 1996 versus 31.2% in 1995. BALANCE SHEET OVERVIEW - ---------------------- Period end assets reached $5,231,268,000 at December 31, 1996, a 3.1% increase over the assets of $5,074,785,000 as of the end of 1995. The average volume of assets grew 6.1% from $4,763,336,000 in 1995 to $5,054,658,000 in 1996. Asset growth, particularly loan growth, was affected by both the execution of Keystone's securitization and sale strategy and by competitive issues associated with the generation of deposit funding. Average loans grew to $3,432,131,000, a 5.1% growth rate, while deposits reached $4,047,151,000 a 5.0% increase, as the majority of growth occurred as a result of the impact of the late 1995 bank mergers. 33 LOANS Keystone's "Relationship Banking" strategy continues to influence the volume and mix of its loan portfolio. Aggregate loans comprised nearly 72% of its overall earning asset base. A breakdown of Keystone's loan categories was as follows (in thousands):
1996 1995 Change - ------------------------ --------------------- ------------------- ------------------- Amount % Amount % Amount % ======================== ============= ======= ============ ====== ============ ====== Commercial $474,501 14% $430,360 13% $44,141 10% Floor plan financing 150,052 4 147,002 5 3,050 2 Commercial-real estate secured 896,688 26 869,248 27 27,440 3 Consumer mortgages 766,787 22 785,410 24 (18,623) (2) Direct consumer 548,224 16 455,281 14 92,943 20 Indirect consumer 330,463 10 405,519 12 (75,056) (19) Lease financing 265,416 8 173,694 5 91,722 53 - ------------------------ ------------- ------- ------------ ------ ------------ ------ $3,432,131 100% $3,266,514 100% $165,617 5% ======================== ============= ======= ============ ====== ============ ======
The focus of Keystone's "Relationship Banking" concept is on gaining an understanding of customers' financial needs and identifying the appropriate mix of products and services which will meet those needs. This concept applies equally to both consumer and commercial customers and has affected trends with respect to the composition of Keystone's loan portfolio. The most significant growth has occurred in commercial loans, direct consumer credit, and leases. At the same time, overall growth patterns have been offset by the influence of Keystone's securitization strategy on consumer mortgages and indirect consumer loans. Keystone's commercial loan trade area is dominated by moderately-sized businesses with traditional forms of commercial credit needs including business term loans, lines of credit, and certain tax-advantaged loans to political subdivisions. During 1996, commercial credit volume increased by 10%. Approximately half of this increase was due to loans added in late 1995 mergers. Other categories of commercial loans include floor plan financings and commercial loans secured by real estate, which grew slightly from 1995 levels. Both consumer mortgages and indirect consumer loans reflected declines during the year, primarily as a result of the secondary marketing activity in these categories. While certain segments of the consumer mortgage market, primarily adjustable-rate mortgages, remained a key component of Keystone's loan portfolio, most fixed-rate consumer mortgages were sold in the secondary market. Similarly, indirect automobile loans, which are originated through Keystone's network of automobile dealers, actually declined by 19% from 1995 levels as the vast majority of new loans since the second half of 1995 have been securitized and sold in the secondary market. As a consequence, the overall growth of loans has been reduced. At the end of 1996, Keystone was servicing approximately $576,000,000 of mortgage loans and $174,000,000 of indirect loans for secondary market investors. 34 The cornerstone of Keystone's retail lending strategy, and the loan category most closely associated with its consumer "relationship banking" strategy, is direct consumer loans. These loans include substantial levels of home equity, installment, and personal lines of credit. These credit vehicles, which are closely identified with Keystone's life cycle segmentation strategy, grew 20% to $548,224,000 and comprised 16% of Keystone's overall loan portfolio. Given Keystone's focus on its retail customer base, it is anticipated that such balances will continue to become a more significant component of the overall lending mix. An increasingly important growth component of Keystone's loan portfolio related to the popularity of leasing as a credit vehicle for automobile acquisition. Total automobile lease financings grew to $265,416,000, and now represent 8% of the total loan portfolio. 35 ALLOWANCE FOR CREDIT LOSSES AND ASSET QUALITY Keystone's allowance for credit losses at December 31, 1996, was $45,016,000 and reflected a relationship of the allowance to loans of 1.27%. Comparable measures at the end of 1995 were $44,377,000 and 1.32%. The following table sets forth summarized activity within the allowance for credit losses for the past five years (in thousands):
1996 1995 1994 1993 1992 ============================= =========== ========== ========== ========== =========== Balance at January 1, $44,377 $42,440 $40,181 $38,940 $35,770 Allowance obtained through mergers/acquisitions ----- 1,750 2,096 ----- ----- Allowance transferred out ----- (815) ----- ----- ----- Loans charged off: Commercial (1,785) (788) (4,322) (2,704) (7,422) Real estate-secured: Commercial (1,434) (1,504) (4,076) (2,834) (2,286) Consumer (572) (442) (414) (385) (630) Consumer (6,331) (5,238) (2,722) (3,370) (4,540) Lease financing (1,330) (786) (198) (238) (283) - ----------------------------- ----------- ---------- ---------- ---------- ----------- Total loans charged off (11,452) (8,758) (11,732) (9,531) (15,161) - ----------------------------- ----------- ---------- ---------- ---------- ----------- Recoveries: Commercial 442 266 494 1,539 789 Real estate-secured: Commercial 430 538 849 359 373 Consumer 132 133 200 58 182 Consumer 1,052 806 839 832 887 Lease financing 177 158 29 44 47 - ----------------------------- ----------- ---------- ---------- ---------- ----------- Total recoveries 2,233 1,901 2,411 2,832 2,278 - ----------------------------- ----------- ---------- ---------- ---------- ----------- Net loans charged off (9,219) (6,857) (9,321) (6,699) (12,883) Provision charged to operations 9,858 7,859 9,484 7,940 16,053 - ----------------------------- ----------- ---------- ---------- ---------- ----------- Balance at December 31, $45,016 $44,377 $42,440 $40,181 $38,940 ============================= =========== ========== ========== ========== =========== Ratio of allowance to year-end loans 1.27% 1.32% 1.33% 1.45% 1.40% ============================= =========== ========== ========== ========== ===========
The following statistics are relevant to activity that has occurred within the allowance for credit losses during the most recent five year period: 1996 1995 1994 1993 1992 - --------------------------------- -------- ------- -------- ------- -------- Ratio to Average Loans: Provision 0.28% 0.24% 0.33% 0.29% 0.57% Net charge-offs 0.27% 0.21% 0.32% 0.24% 0.46% 36 Although net charge-offs as a percentage of average loans have not grown significantly, the composition of the types of loans that have been charged-off has changed. Current trends reflect increases in consumer charge-offs, consistent with national trends. At the same time, net charge-offs of commercial credits have moderated. Although management does not anticipate net charge-offs to increase in excess of current levels, adverse changes in economic conditions could result in less favorable credit quality trends. Risk Elements - ------------- The overall level of risk elements is an important component in the evaluation of the adequacy of the allowance for credit losses. Risk elements are composed of both nonperforming assets (NPA) and loans past due 90 days or more. The relative level of these risk elements provides an indication of the level of credit risk within the loan portfolio. Nonperforming assets include nonaccrual loans, restructurings, and other real estate (ORE). Nonaccrual loans are loans for which interest income is not accrued due to concerns about the collection of interest and/or principal. Restructured loans may involve renegotiated interest rates, repayment terms, or both, because of a deterioration in the financial condition of the borrower. ORE activity in 1996 reflected no unusual or significant fluctuations in balances. The following table provides a comparative summary of nonperforming assets and total risk elements at the end of each of the last five years (in thousands):
1996 1995 1994 1993 1992 - ----------------------------- --------- ---------- ---------- ---------- ---------- Nonaccrual loans $18,913 $16,740 $24,403 $23,661 $29,385 Restructurings 393 503 144 5,066 5,941 - ----------------------------- --------- ---------- ---------- ---------- ---------- Nonperforming loans 19,306 17,243 24,547 28,727 35,326 Other real estate 7,414 8,984 5,870 8,097 10,835 - ----------------------------- --------- ---------- ---------- ---------- ---------- Nonperforming assets 26,720 26,227 30,417 36,824 46,161 Loans past due 90 days or more 17,649 14,995 7,744 3,977 6,256 - ----------------------------- --------- ---------- ---------- ---------- ---------- Total risk elements $44,369 $41,222 $38,161 $40,801 $52,417 - ----------------------------- --------- ---------- ---------- ---------- ----------
Substantially all of the loans in the nonaccrual category at December 31, 1996, were contractually past due as to principal or interest. The relationships of nonperforming assets and total risk elements to total loans and to the allowance for credit losses provide important measures of asset quality. The allowance for credit losses must be adequate to absorb credit risk in these categories and in the remainder of the loan portfolio. The following table summarizes the total risk element components expressed as a percentage of year-end loans and relevant coverage provided by the allowance for credit losses. 37
1996 1995 1994 1993 1992 - ------------------------------------------- ------- ------- ------- ------- ------- Ratio to Year-End Loans: Nonperforming assets 0.75% 0.78% 0.95% 1.32% 1.66% 90 days past due 0.50 0.44 0.24 0.14 0.22 - ------------------------------------------- ------- ------- ------- ------- ------- Total risk elements 1.25% 1.22% 1.19% 1.46% 1.88% - ------------------------------------------- ------- ------- ------- ------- ------- Coverage Ratios: Ending allowance to nonperforming loans 233% 257% 173% 140% 110% Ending allowance to risk elements* 122% 138% 131% 123% 94% Ending allowance to net charge-offs 4.9x 6.5x 4.6x 6.0x 3.0x - ------------------------------------------- ------- ------- ------- ------- ------- * Excludes ORE.
While Keystone experienced some reduction in specific asset quality measures from 1995, virtually all measures were consistent with, or better than, historical trends. One exception was in the volume of loans in the category of 90 days or more past due. Credits included in this category, and in less severe past-due categories, have the potential to migrate into more severe classifications. Keystone continues to reflect favorable coverage ratios, which provide an indication of Keystone's ability to absorb the potential adverse impact of deterioration. Keystone will continue to apply vigorous monitoring and collection efforts to manage the level of adversely classified assets. Credit risk associated with nonperforming assets also can be measured in terms of exposure to specific categories of loans. The following table provides the components of nonperforming assets, detailed by loan categories, at the end of each of the past five years, (in thousands):
- ------------------------------- ---------- --------- ---------- --------- --------- 1996 1995 1994 1993 1992 - ------------------------------- ---------- --------- ---------- --------- --------- Commercial $4,306 $4,213 $5,233 $8,198 $10,841 Commercial real estate: Construction and development 764 1,260 4,535 3,797 5,067 Permanent 11,889 10,389 9,999 12,429 13,681 Residential real estate 918 612 4,359 3,316 4,719 Consumer 1,429 769 421 987 1,018 - ------------------------------- ---------- --------- ---------- --------- --------- Nonperforming loans 19,306 17,243 24,547 28,727 35,326 Other real estate 7,414 8,984 5,870 8,097 10,835 - ------------------------------- ---------- --------- ---------- --------- --------- Total nonperforming assets $26,720 $26,227 $30,417 $36,824 $46,161 - ------------------------------- ---------- --------- ---------- --------- ---------
38 Management also closely monitors the level of credits included in less severe past-due categories. The following is a comparative summary of these categories at the end of 1996 and 1995 (in thousands): 1996 % of Total 1995 % of Total Loans Loans - ------------------ ---------- ------------- ---------- -------------- 30-59 days $44,637 1.3% $42,930 1.3% 60-89 days 14,453 0.4 15,591 0.5 Over 90 days 17,649 0.5 14,995 0.4 - ------------------ ---------- ------------- ---------- -------------- $76,739 2.2% $73,516 2.2% - ------------------ ---------- ------------- ---------- -------------- As previously discussed, the level of past due credits in the 90-days past due category increased since the end of 1995. Economic lethargy and stress on the consumers' credit condition caused by high debt levels, appear to be the principal contributing factors. Collections centralization, which was finalized during 1996, has allowed for improved monitoring of the portfolio and enhanced collection techniques through state-of-the-art technology. Management has identified approximately $9,074,000 of loans outstanding where concern exists as to the potential for future classification into one of the risk element categories. Substantially all of these loans were current at the end of 1996. Overall Assessment - ------------------ Keystone has assessed all of the above factors in the establishment of the allowance for credit losses. The determination as to the adequacy of the allowance reflects management's judgment, and was based upon appraisals, estimates, local market conditions, and other such information that requires subjective analysis. These factors, which are prone to change, are monitored by management to evaluate their potential impact on management's assessment of the adequacy of the allowance. Based on its evaluation of loan quality, management believes that the allowance for credit losses was adequate to absorb the credit risk within the loan portfolio. INVESTMENTS Keystone has established corporate investment policies that address various aspects of portfolio management including, but not limited to, quality standards, liquidity and maturity limits, investment concentrations, and regulatory guidelines. Compliance with these policies is reported regularly to the Board of Directors. Keystone's objectives with respect to investment management include maintenance of appropriate asset liquidity, facilitation of asset/liability management strategies, and maximization of return. 39 At December 31, 1996, Keystone's investments represented 23.6% of total assets. The following is a summary of the carrying values of investments at December 31, 1996 and 1995 (in thousands):
1996 1995 - ----------------------------------- ------------------------ ------------------------ Available Held to Available Held to for Sale Maturity for Sale Maturity - ----------------------------------- ------------ ----------- ------------ ----------- Negotiable money market investments $194,566 $ ----- $237,102 $ ----- U.S. Treasury securities 198,376 ----- 255,357 ----- U.S. Government agency obligations 380,462 230,402 273,396 237,122 Obligations of states and political subdivisions ----- 134,194 872 132,541 Corporate and other 82,976 15,362 71,183 15,599 - ----------------------------------- ------------ ----------- ------------ ----------- $856,380 $379,958 $837,910 $385,262 =================================== ============ =========== ============ ===========
In 1994, the Financial Accounting Standards Board (FASB) issued Statement No. 119, "Disclosures About Derivative Financial Instruments and the Fair Value of Financial Instruments". This accounting standard defined two distinct types of off-balance sheet derivative activities: "trading" activities and "end-user" activities. Keystone does not engage in derivatives trading activities and has made only limited use, as an end-user, of interest rate swaps. These swaps, together with other strategies, have been used to manage Keystone's overall exposure to the effect of changes in interest rates. Keystone has also made use of forward mortgage commitments as well as put options and short sales of U.S. Treasury securities. These instruments were executed to reduce the market risk associated with interest rate fluctuations in fixed consumer mortgages and the indirect automobile loans held for sale. Further disclosures of these activities are included in the footnotes of the financial statements. The FASB continues to study the impact of derivatives on financial performance and is currently considering a comprehensive change to the application of accounting principles, including possible income statement recognition for interest rate swaps used to hedge interest rate risk. Such changes are not expected to have a material impact on future financial statement presentations and will be closely monitored by Keystone. A broader definition of derivatives would include any financial instrument which derives its value or contractual cash flows from the price of some other security or index. Keystone's investment policy governs the nature and extent of on- balance sheet financial derivative holdings, which currently include both collateralized mortgage obligations and structured notes. This policy limits Keystone's exposure to derivatives risk by defining restrictions on the amount of credit, prepayment, extension, and interest-rate risk associated with derivative financial instruments. Keystone's aggregate investment in this form of financial derivative holdings is substantially composed of U.S. Government Agency holdings. The weighted average life of Keystone's fixed rate investments was 3.08 years at December 31, 1996. Ratings for state & municipal, and corporate issues are provided by major rating agencies, principally Moody's and Standard & Poor's. At the end of 1996, the portion of all state & municipal holdings rated "AAA" was 93.7% and the portion of all corporate issues rated "A" or better was 98.5%. 40 The relationship of market value to the amortized cost of investments at December 31, 1996, was 100.2% compared to 100.8% at the end of 1995. At December 31, 1996, investments "held-to-maturity", which are carried at amortized cost, contained gross unrealized gains and losses of $5,461,000 and $1,893,000, respectively. Unrealized gains and losses included in the carrying value of the "available-for-sale" investments of $2,935,000 and $4,628,000, respectively, were reflected, on a net of tax basis, as an adjustment to shareholders' equity. Keystone holds no concentration of corporate or municipal investment securities of any single issuer which exceeds 10% of shareholders' equity. DEPOSITS - -------- Customer deposits remain Keystone's major source of funding. The following presentation provides a summary of changes in Keystone's deposit funding sources from 1995 to 1996 (in thousands): Change ========== 1996 1995 Amount % ================================= ============ ============ ============= ====== Noninterest-bearing demand $497,260 $474,571 $22,689 5% NOW 426,312 431,387 (5,075) (1) Savings 391,692 419,721 (28,029) (7) Indexed money market 44,644 2,953 41,691 100+ Other money market 359,241 420,273 (61,032) (14) Time deposits less than $100,000 2,082,963 1,882,702 200,261 11 Time deposits $100,000 or more 245,039 222,842 22,197 10 - --------------------------------- ------------ ------------ ------------- ------ $4,047,151 $3,854,449 $192,702 5% ================================= ============ ============ ============= ====== Perhaps the most significant challenge facing financial institutions is the need to sustain and increase cost-effective funding sources. During 1996, Keystone realized deposit growth of 5%, the majority of which related to deposits added in the late 1995 mergers. As in 1995, the most significant trend in Keystone's deposit activity related to the migration of funds from more traditional savings, NOW, and money market accounts into deposit vehicles more closely aligned with consumer preferences for liquidity, flexibility, and a rate of return commensurate with alternate investment offerings. While overall interest rates remained comparable to 1995, consumers continued to seek higher returns than those offered on more traditional deposit products, resulting in growth in both "Indexed Money Market Accounts", and the "Variable Rate CD". These products now represent $460,454,000 or 11.4% of Keystone's overall deposit funding mix, compared to 5.9% in 1995. Each of these products, whose returns are tied to externally administered interest rate indices, have provided customers with the flexibility and convenience necessary in a changing interest rate environment. The increased need to generate funding sources to support loan and investment activity is a critical component of Keystone's "Relationship Banking" strategy. Product packages for consumer life-cycle segments have been designed to include deposit and investment products commensurate with the life-cycle needs of its customer base. The desire to provide product packages responsive to these needs has led to the development of KeyFree, a fee-free checking product designed to meet the needs of certain segments of Keystone's consumer base. This product 41 offering is expected to increase the level of demand deposit balances and provide new Keystone customers with an introduction to the more complete menu of financial services available through Keystone's product offerings. Certificates of deposit of $100,000 or more are considered less stable relative to other core deposit funding sources because they are short-term in nature and generally subject to competitive bid. Keystone's dependence on this source of funds, when measured as a percent of total deposits, rose slightly from 5.8% in 1995 to 6.1% in 1996. This increase was principally driven by the need to secure funding that would support loan demand. Keystone's use of other funding management tools, including loan securitization strategies, is expected to further reduce Keystone's limited reliance on this funding source. OTHER BORROWED FUNDS Keystone has selectively accessed sources of funding other than traditional core deposits. The following table provides a summary of the change in other borrowed funds from 1995 to 1996 (in thousands): Change ============================ =========== =========== ======================== 1996 1995 Amount % ============================ =========== =========== ============= ========== Short-term borrowings $265,527 $210,025 $55,502 26% FHLB borrowings 151,924 176,636 (24,712) (14) Long-term debt 3,117 5,055 (1,938) (38) - ---------------------------- ----------- ----------- ------------- ---------- $420,568 $391,716 $28,852 7% ============================ =========== =========== ============= ========== Keystone will also selectively access these funding sources to provide short-term liquidity, to meet funding requirements, or to support specific business mix changes. Keystone is currently considering the issuance of other forms of funding such as commercial paper and medium-term notes, which are expected to provide Keystone with funding for strategic holding company activities. Each of the Keystone banks is a member of a Federal Home Loan Bank, and as such, can access a number of credit products which are utilized to provide various forms of funding. Keystone has primarily accessed fixed-rate borrowings with maturities of between one and three years. SHAREHOLDERS' EQUITY Shareholders' equity at December 31, 1996 reached $507,307,000 versus $480,694,000 at the end of 1995 and resulted in an equity to assets ratio of 9.70%. The management of capital as the foundation of asset and profitability growth represents a challenge critical to the long range viability of financial institutions. Maintenance of appropriate levels of capital is subjected to a myriad of constraints and restrictions imposed by regulatory authorities, dividend requirements, acquisition opportunities, and other factors which must be balanced against the need for capital levels adequate to sustain vital business activities. Keystone's capital management policies have been designed to ensure maintenance of appropriate levels of capital under a variety of economic conditions. The principal source of new capital for Keystone is earnings retention, which is a function of its return on beginning equity and the dividends paid to shareholders. Keystone, in its capital management policies, has set forth specific guidelines to ensure a favorable, consistent, and sustainable pattern of dividend payments. Dividend declarations during 1996 equated to a 7.7% payout 42 on year-end 1995 book value. Many financial institutions, including Keystone, continued to generate earnings retention levels in excess of asset growth rates which has resulted in increased relative levels of capital. Under guidelines set forth in its capital management policies, Keystone has sought to execute strategies and tactics which would moderate capital growth and increase the level of earning assets, which would serve to improve the leverage of its capital base. The acquisition of treasury stock and the annual dividend to shareholders were both executed pursuant to Keystone's capital management strategies. Despite these efforts, the ability to manage capital levels continues to be constrained by external factors. Among these factors are the desire to preserve pooling-of-interest accounting treatment for future merger opportunities as well as Keystone's objective to preserve "well-capitalized" ratings for its member banks. Bank regulators have set forth requirements for risk-based capital, which resulted in the establishment of international capital standards for banks. These requirements set forth minimum "leverage", "Tier 1" and "Total" capital ratios and provide a measure of capital adequacy that is more risk responsive than previous regulatory guidelines. Risk-based capital standards included the establishment of ranges of capital adequacy which extend from "significantly undercapitalized" to "well capitalized". These assessments of capital adequacy directly influence the focus of regulatory oversight, including the premium rates charged for deposit insurance. Regulators, including both the Federal Reserve Board and the Office of the Comptroller of the Currency, have recently finalized a new risk-based supervisory approach designed to encourage management focus on the most effective use of limited capital and the generation of the highest possible returns with the least amount of associated risk. As the regulatory oversight process becomes increasingly focused on capital issues, Keystone and other financial institutions will be challenged to develop a capital measurement system that will ensure effective management of capital levels and associated business risk. Keystone will continue to be responsive to the need to balance both capital adequacy levels and business risk issues. The following table provides Keystone's risk-based capital position at the end of 1996 and a comparison to the various regulatory capital requirements. "Well Minimum Keystone Capitalized" Requirements ========================= ============= =============== =============== Leverage ratio 9.64% 5.00% 4.00% "Tier 1" capital ratio 13.54% 6.00% 4.00% "Total" capital ratio 14.77% 10.00% 8.00% Failure to meet any one of the minimum capital ratios would result in an institution being classified as "undercapitalized" or "significantly undercapitalized". Such classifications could disrupt dividends, capital distributions, or affiliate management fees. In addition, other restrictions, prohibitions, and related supervisory actions would be likely depending upon the overall level of capital. Keystone anticipates no significant problems in meeting the current or future capital standards. Intangible assets, consisting primarily of core deposit intangibles and goodwill, totaled $13,711,000 at December 31, 1996 or 2.8% of "Tier 1" capital. ASSET/LIABILITY MANAGEMENT The process by which financial institutions manage earning assets and funding sources under different interest rate environments is called asset/liability 43 management. The primary goal of asset/liability management is to increase net interest income within an acceptable range of overall risk tolerance. Two important performance barometers are net interest margin and liquidity. Net interest margin is increased by widening interest spread while controlling interest rate sensitivity. The adequacy of liquidity is determined by the ability to meet the cash flow requirements of both depositors and customers requesting bank credit. Asset/liability management occurs at each of the subsidiary banks, with overall coordination and support provided by the Keystone Asset/Liability Management Committee (ALCO). Interest Rate Risk - ------------------ Interest rate risk can be quantified by measuring the change in net interest margin relative to changes in market interest rates. Risk is identified by reviewing repricing characteristics of interest-earning assets and interest-bearing liabilities. Keystone's asset/liability management policy sets forth guidelines that limit the level of interest rate risk within specified tolerance ranges. Keystone and its subsidiary banks utilize a variety of techniques to measure and monitor interest rate risk, including the use of simulation analysis. In order to quantify the impact of changes in interest rates on net interest income, Keystone conducts quarterly interest rate shock simulations. These simulations are used to determine whether corrective action may be warranted or required in order to adjust the overall interest rate risk profile. Keystone's asset/liability management policy limits interest rate risk exposure to 5% of net interest income for the succeeding twelve-month period and 8% for the succeeding twenty-four-month period. The results of these simulations are reported to Keystone's Board of Directors on a quarterly basis. Management has determined that Keystone maintained a level of interest rate risk consistent with its asset/liability management policy limits at December 31, 1996. Management augments rate shock simulations with GAP interest rate sensitivity analysis and with market value of portfolio equity (MVPE) computations. GAP is defined as the volume difference between interest rate-sensitive assets and liabilities. GAP is used by management to assist in evaluating the results of rate shock simulations, to identify areas that may warrant corrective action, and to identify interest rate risk exposure for periods beyond one year. By utilizing GAP to manage longer term interest rate risk, Keystone attempts to minimize fluctuations in net interest margin and thereby achieve consistent net interest income growth during periods of changing interest rates. MVPE is a more comprehensive measure that attempts to quantify the impact of aggregate interest rate risk exposure on the intrinsic value of financial institutions, and is particularly useful in quantifying the impact of changing interest rates on that intrinsic value. This measurement tool, while valuable as a gauge of longer-term interest rate risk, is less useful as a tool to provide strategic solutions to the management of that risk. 44 The following table provides an analysis of Keystone's interest rate sensitivity as measured under GAP at December 31, 1996 compared to 1995:
December December 31, 1996 31, 1995 - -------------------- ------------ ------------ ------------ ------------ ------------- 1 month 3 months 6 months 1 year 1 year - -------------------- ------------ ------------ ------------ ------------ ------------- Assets $1,414,460 $1,682,142 $1,938,113 $2,414,260 $2,803,095 Liabilities 1,097,518 1,810,735 2,160,635 2,540,283 2,316,327 Off balance sheet ----- ----- ----- ----- 7,000 Cumulative GAP 316,942 (128,593) (222,522) (126,023) 493,768 As a percent of total assets 6.06% (2.46%) (4.25%) (2.41%) 9.73% Gap ratio 1.29 .93 .90 .95 1.22 ==================== ============ ============ ============ ============ =============
Recent trends suggest that certain segments of the customer base and certain core products are more sensitive to changing interest rates than reflected in historical GAP presentations. During 1996, Keystone enhanced its GAP analysis by modifying the treatment of certain categories of loans and deposits, primarily more refined loan prepayment assumptions, to more accurately reflect potential repricing opportunities. While rate shock simulations, GAP analysis, and MVPE computations provide measures of interest rate risk, such presentations cannot accurately reflect all actual repricing opportunities which will occur within loan and deposit categories. The information provided by these analyses, however, provides some indication of the potential for interest rate adjustment, but does not necessarily mean that the rate adjustment will occur, or that it will occur in accordance with the assumptions. Despite these inherent limitations, Keystone believes that the tools used to manage its level of interest rate risk provide an appropriate reflection of interest rate risk exposure. Liquidity - --------- Liquidity is defined as Keystone's ability to meet maturing obligations and customers' demand for funds on a continuous basis. Liquidity is sustained by stable core deposits, a diversified mix of liabilities, strong credit perception, and the maintenance of sufficient assets convertible to cash without material loss or disruption of normal operations. Keystone monitors liquidity through regular computations of prescribed liquidity ratios at each of the affiliate banks. Banks which fail to meet the prescribed minimum standards for these ratios must set forth tactics to promptly comply with policy guidelines and provide mandatory progress reports to Keystone's ALCO and to Keystone's Board of Directors. Keystone actively manages liquidity within a defined range and has developed reasonable liquidity contingency plans, including ensuring availability of alternate funding sources to maintain adequate liquidity under a variety of business conditions. Keystone's primary sources of liquidity are funds derived through earnings and deposit balances. Liquidity is also provided by scheduled maturities of loans and investment securities, as well as the early payoff of customer loan balances. Liquidity may also be influenced by the volume and timing of securitization activity for both mortgages and indirect automobile loans. Consideration is given to the maturity of assets and expected future growth/funding needs when developing investment strategies. These liquidity sources may also be augmented by other forms of liability liquidity, such as FHLB borrowings. These various sources of funding have been used to support increases in overall earning asset balances during the year. Keystone's operating, investing, and financing activities are conducted within the overall constraints of Keystone's liquidity management policy. Parent company liquidity represents another important aspect of liquidity management. Within Keystone, the parent company relies on the banking subsidiaries to provide funding for dividends to shareholders and unallocated corporate expenses. The amount of dividends from bank subsidiaries to the parent company is constrained by both state and federal regulations, which have not historically limited Keystone's practices. Based upon the inherent strength and profitability of the Keystone banks, holding company liquidity is deemed adequate. 45 REGULATORY MATTERS Keystone and its banking affiliates are subject to periodic examinations by one or more of the various regulatory agencies. During 1996, examinations were conducted at the holding company and at Keystone's various banking and nonbanking subsidiaries. These examinations included, but were not limited to, procedures designed to review lending practices, credit quality, liquidity, compliance, and capital adequacy of Keystone and its subsidiaries. No comments were received from the various regulatory bodies which would have a material effect on Keystone's liquidity, capital resources, or operations. The Federal Deposit Insurance Corporation Improvement Act (FDICIA), established a new framework for the relationship between insured depository institutions and the various regulatory bodies. FDICIA regulations, which addressed capital adequacy, brokered deposits, annual audits, expanded regulatory requirements, audit committee composition, and truth in savings provisions have been finalized and enacted throughout Keystone. As previously discussed, the evolution of the regulatory process has resulted in a new and different emphasis on understanding and evaluating risk management processes within financial institutions. As an alternative to the risk analysis of discrete bank activities such as lending, investments, operations, etc., the new approach entails measurement and evaluation of risk on an institution-wide basis. Compliance with this shift in emphasis has obvious implications, including the development of a more systemic view of risk management, the design of the entire range of bank and alternative product offerings, and the need for risk diversification. Keystone and its subsidiary banks are mindful of the risk factors defined by the regulators and their responsibility to effectively measure and manage these risks. Keystone has closely monitored its compliance with banking regulations and will continue to monitor and evolve with future regulations as set forth by the various bank regulatory bodies. INFLATION Keystone's ability to cope with the impact of inflation is best determined by an analysis of its ability to respond to changing interest rates and manage noninterest income and expense. As discussed in the asset/liability management section of this review, Keystone manages the mix of interest rate-sensitive assets and liabilities in order to limit the impact of changing interest rates on net interest income. Inflation also has a direct impact on noninterest income and expense, such as service fees, salary expense and benefits, and other overhead expenses. Inflationary pressure over the last several years has been relatively modest, although concern exists over the sustained strength of the economy and the potential impact on inflationary pressure. Management will continue to monitor the impact of these pressures on the pricing of its products and services and on the control of overhead expenses. 1995 VS 1994 Summary Keystone's 1995 net income was $61,314,000 compared to $51,359,000, an increase of 19.4%. Likewise, earnings per share grew to $1.73 versus $1.46 in 1994, an increase of 18.5%. Results in 1994 had included a $7,000,000 pre-tax charge related to both the acquisition of Frankford Bank and a restructuring charge associated with the consolidation of certain back-office loan and deposit activities. Even after adjusting for the impact of the special charges in 1994, earnings per share improved approximately 7.5% in 1995. ROA and ROE reached 1.29% and 14.06%, respectively, in 1995 and compared favorably with the ROA of 1.27% and ROE of 13.87% in 1994, as adjusted for the aforementioned charges. The improvement in core profitability achieved in 1995 was attributed to several factors. Net interest income, which is Keystone's largest revenue source, grew 4.2% despite the effect of higher average interest rates on funding costs, which grew at a pace faster than the growth in asset yields. Strong loan demand was also an essential ingredient to improved levels of net interest income. Keystone's continued strength in overall asset quality, including a reduced level of net charge-offs, resulted in a lower provision for credit losses. Significant growth occurred in the area of noninterest revenue, particularly in secondary market activities. Increases included fees from the origination and servicing of mortgage loans as well as gains from the securitization and sale of both mortgages and indirect automobile loans. Net of security transactions, noninterest revenues rose nearly 12%. Expenses in 1995 were favorably influenced by the reduction in the FDIC insurance premium, while 1994 expenses had been affected by the aforementioned charges. Excluding the impact of these items in both 1995 and 1994, noninterest expenses grew about 6%. 46 Interest Income Interest income rose to $369,549,000 in 1995, and reflected a 15.6% improvement from 1994. Excluding the impact of merger and acquisition activity on year-to-year performance, the increase in interest income attributable to internal growth was 13.1%. Earning asset yields reached 8.19% compared to 7.59% in 1994. The increase in earning asset yields, while partially driven by a pattern of higher rates, was also influenced by absolute increases in the volume of earning assets, and by the favorable effect of an improved mix of earning assets. In fact, the growth in interest income was equally attributable to the improvement in the volume of earning assets, including a higher mix of loans, and the increase in interest rates. Loan totals included an increased emphasis on higher-yielding consumer leases and credit lines which contributed significantly to the improvement in yields. Growth also occurred in commercial real estate lending and in the volume of consumer adjustable-rate mortgages. The overall growth in loan balances was achieved despite the impact of securitization and sale of both fixed-rate mortgage loans and indirect consumer automobile loans. Interest Expense The cost of funds rose to 4.42% for 1995 compared to 3.55% in 1994, an increase of 87 basis points, while the yield on earning assets rose only 60 basis points. The increase in funding costs was also influenced by changes in deposit mix. Consumer impatience with the low relative rates offered on both money market and traditional savings deposits, motivated customers to take opportunities to improve returns by extending maturities and to take advantage of new product offerings that were more responsive to changes in interest rates. The most significant growth occurred in certificates of deposit in maturities of between 18-47 months, which grew over $220 million, or 55.7%. Additionally, the variable 47 rate CD, which was introduced in 1994, rose over $120 million, or 118%. These growth trends were driven by the reductions in NOW, money market, and savings deposits. Keystone also experienced growth in large certificates of deposit, IRAs, and FHLB borrowings. Net Interest Income As a result of these trends on interest income and interest expense, net interest income reached $202,970,000, an increase of $8,248,000 over 1994. Interest spread compressed by 27 basis points as the difference between earning asset yields and the cost of fund sources went from 4.04% in 1994 to 3.77% in 1995. The increase in noninterest-bearing funds, which was influenced by both higher reinvestment rates and increased demand deposit balances, contributed 72 basis points to net interest margin versus 59 basis points in 1994. This served to partially offset the compression of net interest spread. The effect of these changes was a reduction in net interest margin of 14 basis points, from 4.63% in 1994 to 4.49% in 1995. Provision for Credit Losses The provision for credit losses declined from $9,484,000 in 1994 to $7,859,000 in 1995, a reduction of $1,625,000. The reduction in the loan loss provision was responsive to an overall reduction in net charge-offs, which declined by $2,464,000 from 1994 to 1995. Noninterest Income Keystone's evolution into a full-service financial services company dramatically influenced the rate of growth in noninterest revenues. Keystone steadily expanded its focus on financial services, including the establishment of a separate specialized mortgage banking company. Strategies which commenced in 1995 included Keystone's entry into the securitization of indirect automobile loans. Primarily as a consequence of these efforts, noninterest revenues, excluding security gains, grew 11.9% from 1994 to 1995 and represented 19.3% of total combined net interest income and noninterest revenues, compared to 18.3% in 1994. Results in 1995 were reflective of Keystone's successful implementation of its focused mortgage banking strategy as related revenues increased from $3,557,000 in 1994 to $6,111,000 in 1995. Keystone's efforts to develop this important customer service were aided by reductions in long-term interest rates, which served to spur demand for mortgage products. As of the end of 1995, Keystone was servicing a total of $520,809,000 of loans which have been sold in the secondary market. The growth in other secondary market activities included a gain of $900,000 from the securitization of approximately $66,000,000 of indirect automobile loans. Trust and asset management revenues are generated primarily from personal trust and employee benefit management services. In 1994, Keystone sold the corporate trust segment of its trust business, which consisted primarily of services associated with municipal bond issues. Although annual revenues from corporate trust services comprised only a small portion of overall trust services, revenues during 1995 represented the first full-year impact of the loss of revenue from this business segment. After adjusting 1994 revenues to exclude fees from corporate trust activities, trust income reflected a 10% growth from 1994 to 1995, as trust income grew to $12,557,000. This growth can be attributed to an increase in assets under management, including those added in the late 1995 acquisition of Martindale Andres. 48 Service charges on deposit accounts, which remain the largest source of noninterest revenues, grew 4.8% from $12,606,000 in 1994 to $13,205,000 in 1995. Excluding secondary market revenue, the largest increase in noninterest revenues occurred in fee income which includes revenue from credit card activities, fees from electronic banking services, and brokerage fees. Fee income grew about 24% from $9,762,000 in 1994 to $12,135,000 in 1995. During 1995, growth was particularly strong in credit card activities, primarily the generation of merchant income, and in fees generated from consumer use of electronic services such as ATMs and debit cards. Other income declined from $3,383,000 in 1994 to $1,253,000 in 1995, a decrease of $2,130,000. Results in 1994 had been influenced primarily by the gain of $1.2 million attributable to the aforementioned sale of the corporate trust business. Noninterest Expense Noninterest expenses remained constant in 1995 at $150,634,000 compared to $151,723,000 in 1994. While 1995 expenses were favorably affected by a reduction in the premium from FDIC insurance, performance in 1994 had been negatively impacted by merger expenses and by a restructuring charge. In 1995, changes to the assessment methodology for FDIC premiums were mandated by FDICIA and the realization of a fully-funded bank insurance fund resulted in a premium refund in the third quarter followed by a reduced assessment in the fourth quarter. In 1994, pre-tax charges associated with mergers were approximately $4,500,000, while expenses associated with restructuring certain loan and deposit activities totaled $2,500,000. Absent the effect of these items, "core" operating expenses rose 6.2%. The following summary provides a comparison of 1995 and 1994 noninterest expenses by excluding the favorable impact of reduced FDIC premiums in 1995 and the unfavorable effect of the merger and restructuring charges in 1994. Change ------ 1995 1994 Amount % - -------------------------------- ------------ ------------ ---------- --------- Total noninterest expenses $150,634 $151,723 $(1,089) (0.7)% FDIC savings 3,082 ----- 3,082 Merger and restructuring ----- (7,000) 7,000 - -------------------------------- ------------ ------------ ---------- --------- Adjusted noninterest expenses $153,716 $144,723 $8,993 6.2% - -------------------------------- ------------ ------------ ---------- --------- The adjusted 1995 growth rate of "core" operating expenses of 6.2% was influenced by the impact of the mergers in late 1995, and by the acquisition of American Savings Bank in late 1994. The incremental noninterest expense increase attributable to the mergers and acquisitions accounted for approximately one third of the 6.2% increase in expenses. The remaining increase related to the effect of Keystone's continuing investment in human resources, technology and infrastructure. 49 The following is a comparison of the individual components of noninterest expenses, in total, and as adjusted for the merger and restructuring expenses in 1994, and the reduced FDIC premium expense in 1995.
Actual Noninterest Adjusted Noninterest Expenses Expenses - ------------------------------------------------ --------------------------------- 1995 1994 Change 1995 1994 Change - -------------- ---------- ----------- ---------- ---------- ----------- ---------- Salaries $62,115 $62,327 $(212) $62,115 $58,627 $3,488 Benefits 10,898 11,908 (1,010) 10,898 11,658 (760) Occupancy 12,650 12,134 516 12,650 12,134 516 Furniture & Equipment 12,435 11,257 1,178 12,435 11,257 1,178 Deposit Insurance 4,957 8,039 (3,082) 8,039 8,039 ----- Other 47,579 46,058 1,521 47,579 43,008 4,571 - -------------- ---------- ----------- ---------- ---------- ----------- ---------- $150,634 $151,723 $(1,089) $153,716 $144,723 $8,993 - -------------- ---------- ----------- ---------- ---------- ----------- ----------
Adjusted salary expenses rose $3,488,000 or 5.9%. The primary driver of the increase in core salary expenses was an average overall merit increase of 4.5%. Expenses associated with providing employee health care comprise the most significant component of employee benefit expense. Keystone's health care program alternatives have had a dramatic influence on the cost of providing health care benefits both to pre-existing employees as well as employees who have joined Keystone as a consequence of merger and acquisition activity. Keystone has also been advantaged by the effect of favorable claims experience. The most significant relative increase in noninterest expenses occurred in furniture and equipment expense, which rose 10.5% from $11,257,000 in 1994 to $12,435,000 in 1995. Keystone's overall strategic plan includes a commitment to focus on the customer, which will be fulfilled by a willingness to make appropriate investment in technology, training, and infrastructure. The increase in this component of overhead had its origin in a number of strategic initiatives occurring both prior to, and during, 1995. These initiatives included the expansion of multi-function ATMs and further implementation of the "Keystone Visionary Office" concept. Occupancy expenses grew 4.2% from $12,134,000 in 1994 to $12,650,000 in 1995. The most significant reduction in noninterest expense occurred in FDIC insurance, which declined by $3,082,000 from $8,039,000 in 1994 to $4,957,000 in 1995. The reduction was primarily due to the aforementioned third quarter refund. Additionally, fourth quarter premiums were reduced to $0.04 per $100 of deposits and contributed to the overall reduction in FDIC premium expense. The final category of noninterest expenses, other expenses, grew $1,521,000 from $46,058,000 in 1994, to $47,579,000 in 1995. After adjusting for the impact of merger expenses in 1994, core expenses grew $4,571,000 or 10.6% in 1995. This growth in core expenses was attributed, in part, to the increases associated with revenue enhancement opportunities. For example, credit card expenses rose $1,349,000, or nearly 30% of the increase in core expenses, but were accompanied by a 35% rise in credit card and related merchant income. Likewise, marketing 50 expenses, which were linked to a number of revenue enhancement initiatives, rose $843,000 during 1995. Other significant increases occurred in telephone expense, which rose $655,000, and problem loan expense, which grew by $550,000 from 1994 to 1995. Income Taxes Keystone recorded tax expense of $27,866,000 in 1995 an increase from $20,481,000 recorded in 1994. The increase was influenced primarily by higher levels of taxable income and by the national tax policy changes generally unfavorable to financial institutions. Likewise, the effective tax rate rose to 31.2% in 1995 versus 28.5% in 1994. 51 Report of Ernst & Young LLP, Independent Auditors Shareholders and Board of Directors Keystone Financial, Inc. We have audited the accompanying consolidated statements of condition of Keystone Financial, Inc. and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the management of Keystone Financial, Inc. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Keystone Financial, Inc. and subsidiaries at December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Pittsburgh, Pennsylvania January 31, 1997 52 Consolidated Statements of Condition December 31, - ----------------------------------------------------------------------------- (in thousands, except share data) 1996 1995 - ------------------------------------------------ -------------- ------------- ASSETS - ------------------------------------------------ -------------- ------------- Cash and due from banks $167,403 $182,459 Federal funds sold and other 78,354 109,422 Investment securities available for sale 856,380 837,910 Investment securities held to maturity (market values 1996 - $383,526; 1995-$393,835) 379,958 385,262 Loans held for resale 51,225 57,454 Loans and leases 3,553,662 3,365,716 Allowance for credit losses (45,016) (44,377) - ------------------------------------------------ -------------- ------------- Net loans 3,508,646 3,321,339 Premises and equipment 74,407 70,888 Other assets 114,895 110,051 - ------------------------------------------------ -------------- ------------- TOTAL ASSETS $5,231,268 $5,074,785 - ------------------------------------------------ -------------- ------------- LIABILITIES - ------------------------------------------------ -------------- ------------- Noninterest-bearing deposits $511,931 $532,663 Interest-bearing deposits 3,585,180 3,529,225 - ------------------------------------------------ -------------- ------------- Total deposits 4,097,111 4,061,888 Federal funds purchased and security repurchase agreements 299,895 260,543 Other short-term borrowings 26,175 19,298 - ------------------------------------------------ -------------- ------------- Total short-term borrowings 326,070 279,841 FHLB borrowings 205,929 163,771 Long-term debt 2,154 4,048 Other liabilities 92,697 84,543 - ------------------------------------------------ -------------- ------------- TOTAL LIABILITIES 4,723,961 4,594,091 - ------------------------------------------------ -------------- ------------- SHAREHOLDERS' EQUITY - ------------------------------------------------ -------------- ------------- Preferred stock; $1.00 par value, authorized 8,000,000 shares; none issued or outstanding ----- ----- Common stock: $2.00 par value, authorized 75,000,000; issued 38,228,160 - 1996 and 25,256,369 - 1995 76,456 50,512 Surplus 73,201 93,177 Retained earnings 368,172 337,557 Deferred KSOP benefit expense (1,249) (1,750) Treasury stock; 1996 - 320,000 shares at cost (8,186) ----- Net unrealized securities gains (losses), net of tax (1,087) 1,198 - ------------------------------------------------ -------------- ------------- TOTAL SHAREHOLDERS' EQUITY 507,307 480,694 - ------------------------------------------------ -------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $5,231,268 $5,074,785 ================================================ ============== ============= The accompanying notes are an integral part of the consolidated financial statements. 53 Consolidated Statements of Income Year Ended December 31, - -------------------------------------------------------------------------------- (in thousands except per share data) 1996 1995 1994 - --------------------------------------- ------------- ------------ ------------- INTEREST INCOME - --------------------------------------- ------------- ------------ ------------- Loans and fees on loans $301,856 $288,122 $240,387 Investments - taxable 65,057 57,462 58,589 Investments - tax-exempt 7,517 8,402 9,222 Federal funds sold and other 5,403 8,309 3,840 Loans held for resale 4,688 1,636 1,164 - --------------------------------------- ------------- ------------ ------------- 384,521 363,931 313,202 - --------------------------------------- ------------- ------------ ------------- INTEREST EXPENSE - --------------------------------------- ------------- ------------ ------------- Deposits 153,132 145,090 111,171 Short-term borrowings 11,524 10,195 6,671 FHLB borrowings 9,767 10,827 6,446 Long-term debt 335 467 496 - --------------------------------------- ------------- ------------ ------------- 174,758 166,579 124,784 - --------------------------------------- ------------- ------------ ------------- NET INTEREST INCOME 209,763 197,352 188,418 Provision for credit losses 9,858 7,859 9,484 - --------------------------------------- ------------- ------------ ------------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 199,905 189,493 178,934 - --------------------------------------- ------------- ------------ ------------- NONINTEREST INCOME - --------------------------------------- ------------- ------------ ------------- Trust and investment advisory fees 15,201 12,557 11,808 Service charges on deposit accounts 14,611 13,205 12,606 Fee income 14,086 12,135 9,762 Mortgage banking income 7,467 6,111 3,557 Other secondary market income 3,571 1,696 311 Reinsurance income 2,266 2,047 2,368 Other income 4,915 1,253 3,383 Net gains - equity securities 204 293 546 Net gains - debt securities 352 1,024 288 - --------------------------------------- ------------- ------------ ------------- 62,673 50,321 44,629 - --------------------------------------- ------------- ------------ ------------- NONINTEREST EXPENSE - --------------------------------------- ------------- ------------ ------------- Salaries 69,270 62,115 62,327 Employee benefits 12,562 10,898 11,908 Occupancy expense, net 13,348 12,650 12,134 Furniture and equipment expense 14,063 12,435 11,257 Deposit insurance 778 4,957 8,039 Other expense 52,538 47,579 46,058 - --------------------------------------- ------------- ------------ ------------- 162,559 150,634 151,723 - --------------------------------------- ------------- ------------ ------------- Income before income taxes 100,019 89,180 71,840 Income tax expense 30,544 27,866 20,481 - --------------------------------------- ------------- ------------ ------------- NET INCOME $69,475 $61,314 $51,359 - --------------------------------------- ------------- ------------ ------------- PER SHARE DATA - --------------------------------------- ------------- ------------ ------------- Net income $1.83 $1.73 $1.46 Dividends $0.98 $0.93 $0.86 Average number of shares outstanding 38,045,585 35,462,358 35,093,138 - --------------------------------------- ------------- ------------ ------------- The accompanying notes are an integral part of the consolidated financial statements. 54 Consolidated Statements of Changes in Shareholders' Equity
Deferred Net Unrealized Issued and KSOP Securities Share- Outstanding Common Retained Benefit Treasury Gains(Losses), Holders' Common Shares Stock Surplus Earnings Expense Stock Net of Tax Equity - ----------------------------------------------------------------------------------------------------------------------------------- (in thousands, except share data) - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT JANUARY 1, 1994 23,390,863 $46,782 $93,052 $271,574 ($2,750) ($13) $4,235 $412,880 - ----------------------------------------------------------------------------------------------------------------------------------- 1994 Net income - - - 51,359 - - - 51,359 Dividends ($0.86/share) - - - (30,985) - - - (30,985) Stock issued: Benefit plans 211,464 422 2,985 - - - - 3,407 KSOP Plan 17,545 35 460 - - - - 495 Dividend reinvestment 83,575 168 2,265 - - - - 2,433 Deferred KSOP benefit expense - - - - 500 - - 500 Acquisition of treasury stock (690,000) - - - - (20,563) - (20,563) Retirement of treasury shares (228) (1) (1) - - - - (2) Issuance of stock for acquisitions 317,403 635 8,113 - - - - 8,748 Net unrealized loss on available for sale securities - - - - - - (20,497) (20,497) Other 30,455 61 (62) - - - - (1) - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1994 23,361,077 48,102 106,812 291,948 (2,250) (20,576) (16,262) 407,774 - ----------------------------------------------------------------------------------------------------------------------------------- 1995 Net income - - - 61,314 - - - 61,314 Dividends ($0.93/share) - - - (33,092) - - - (33,092) Stock issued: Benefit plans 276,056 552 4,686 - - - - 5,238 KSOP Plan 20,821 42 571 - - - - 613 Dividend reinvestment 88,508 176 2,480 - - - - 2,656 Deferred KSOP benefit expense - - - - 500 - - 500 Acquisition of treasury stock (211,625) - - - - (6,363) - (6,363) Mergers and acquisitions 1,721,532 1,640 (21,372) 17,387 - 26,939 - 24,594 Net unrealized gain on available for sale securities - - - - - - 17,460 17,460 - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1995 25,256,369 50,512 93,177 337,557 (1,750) - 1,198 480,694 - ----------------------------------------------------------------------------------------------------------------------------------- 1996 Net income - - - 69,475 - - - 69,475 Dividends ($0.98/share) - - - (38,860) - - - (38,860) Stock issued: Stock split 12,725,360 25,451 (25,510) - - - - (59) Benefit plans 136,687 273 2,561 - - - - 2,834 KSOP Plan 11,940 24 278 - - - - 302 Dividend reinvestment 97,804 196 2,695 - - - - 2,891 Deferred KSOP benefit expense - - - - 501 - - 501 Acquisition of treasury stock (320,000) - - - - (8,186) - (8,186) Net unrealized loss on available for sale securities - - - - - - (2,285) (2,285) - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE AT DECEMBER 31, 1996 37,908,160 $76,456 $73,201 $368,172 ($1,249) ($8,186) ($1,087) $507,307 - ----------------------------------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements.
55 Consolidated Statements of Cash Flows
Year Ended December 31, - -------------------------------------------------------------------------------------- (in thousands) 1996 1995 1994 - ------------------------------------------------ -------------- ---------- ----------- OPERATING ACTIVITIES: Net income $69,475 $61,314 $51,359 Adjustments to reconcile net income to net cash provided by operating activities: Provision for credit losses 9,858 7,859 9,484 Provision for depreciation and amortization 13,190 12,423 9,749 Deferred income taxes 13,395 9,288 996 Sale of loans held for resale 441,716 157,803 107,193 Origination of loans held for resale (466,469) (162,678) (119,808) Increase in interest receivable (3,395) (1,129) (3,800) Increase (decrease) in interest payable (100) 2,638 4,132 Other (6,752) (24,915) 18,710 - ------------------------------------------------ -------------- ---------- ----------- NET CASH PROVIDED BY OPERATING ACTIVITIES 70,918 62,603 78,015 - ------------------------------------------------ -------------- ---------- ----------- INVESTING ACTIVITIES: Cash received in bank mergers ----- 49,639 67,923 Net (increase) decrease in interest-earning deposits (3,332) (6,589) 19,078 Available for sale securities: Sales 76,825 113,317 75,722 Maturities 1,104,599 609,111 582,789 Purchases (1,205,881) (747,817) (612,283) Held to maturity securities: Maturities 108,438 103,343 83,807 Purchases (103,268) (55,258) (78,637) Net increase in loans (208,560) (119,270) (324,554) Proceeds from sales of loans 47,051 33,016 41,289 Purchases of loans (1,986) (15,869) (42,647) Purchases of premises and equipment (15,043) (14,622) (9,344) Other (357) (876) (215) - ------------------------------------------------ -------------- ---------- ----------- NET CASH USED BY INVESTING ACTIVITIES (201,514) (51,875) (197,072) - ------------------------------------------------ -------------- ---------- ----------- FINANCING ACTIVITIES: Net increase in deposits 35,223 41,745 89,597 Net increase in short-term borrowings 46,229 25,813 18,549 Proceeds from FHLB borrowings 402,867 138,352 38,371 Repayments of FHLB borrowings (360,708) (129,967) (19,484) Net increase (decrease) in long-term debt (1,894) (2,006) 64 Acquisition of treasury stock (8,186) (6,363) (20,563) Cash dividends (38,860) (33,092) (30,985) Other 6,469 8,507 6,832 - ------------------------------------------------ -------------- ---------- ----------- NET CASH PROVIDED BY FINANCING ACTIVITIES 81,140 42,989 82,381 - ------------------------------------------------ -------------- ---------- ----------- INCREASE (DECREASE) IN CASH & CASH EQUIVALENTS (49,456) 53,717 (36,676) - ------------------------------------------------ -------------- ---------- ----------- Cash and cash equivalents at beginning of year 258,659 204,942 241,618 - ------------------------------------------------ -------------- ---------- ----------- CASH AND CASH EQUIVALENTS AT END OF YEAR $209,203 $258,659 $204,942 - ------------------------------------------------ -------------- ---------- ----------- The accompanying notes are an integral part of the consolidated financial statements.
56 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Summarized Accounting Policies The accounting policies discussed below are followed consistently by Keystone Financial, Inc., and its subsidiaries (Keystone). These policies are in accordance with generally accepted accounting principles and conform to common practices in the banking industry. Nature of Operations: Keystone provides a wide range of commercial and consumer banking and financial services to a diverse client base through its banking subsidiaries. The client base includes individual, business, public, and institutional customers primarily located in Pennsylvania, Maryland, and West Virginia. Lending services include secured and unsecured commercial loans, residential and commercial mortgages, installment loans, revolving consumer loans and lease financing. Deposit services include a variety of checking, savings, time, money market, and individual retirement accounts. Money management services are available to customers through a variety of techniques, all of which are designed to improve cash flow, control disbursements, and increase return on investments. A full spectrum of trust and investment advisory services is offered by specialists, including administration of trusts and estates, investment management, administration of retirement and employee benefit plans, and other fiduciary responsibilities. Keystone's nonbanking subsidiaries perform specialized services including mortgage banking, small-ticket equipment leasing, discount brokerage services, investment advisor services, and reinsurance. Keystone is subject to the regulations of certain federal and state agencies and undergoes periodic examinations by certain regulatory authorities. Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from the estimates, and such differences may be material to the financial statements. Principles of Consolidation: The consolidated financial statements include the accounts of: Keystone Financial, Inc., the parent company; its wholly-owned banking subsidiaries consisting of Mid-State Bank and Trust Company; Northern Central Bank; Pennsylvania National Bank and Trust Company; American Trust Bank, N.A., and its subsidiaries, Keystone Brokerage, Inc., LBCMD Corporation and Key Investor Services, Inc.; Frankford Bank, N.A., and its subsidiary, Keystone Financial Leasing Corporation; Keystone National Bank and its subsidiary, Keystone Financial Mortgage Corporation; and the parent company's nonbanking subsidiaries consisting of Keystone Financial Unlimited, Key Trust Co., Martindale Andres & Co.; Keystone Life Insurance Company; Keystone Investment Services, Inc.; and two community development corporations. All significant intercompany accounts have been eliminated in consolidation. Trading Account Assets: Securities classified as trading account assets are held for resale in anticipation of short-term market movements and are carried at fair value with market adjustments recorded against income. Keystone has made limited use of trading account portfolios. 57 Investments: Keystone classifies its securities as either "held-to-maturity" or "available-for-sale" at the time of purchase. Debt securities are classified as held-to-maturity based upon management's positive ability and intent to hold such securities to maturity. Held-to-maturity securities are stated at cost, adjusted for amortization of premiums and accretion of discounts (amortized cost). Debt securities not classified as trading or held-to-maturity and marketable equity securities not classified as trading are classified as available-for-sale. Available-for-sale securities are stated at fair value, with unrealized gains and losses, net of tax, reported as a component of shareholders' equity. The cost of debt securities classified as held-to-maturity or available-for-sale is adjusted for amortization of premiums and accretion of discounts to maturity, or in the case of a mortgage-backed security, over the estimated life of the security. Such amortization/accretion, as well as interest and dividends, is included in interest income from investments. Realized gains and losses and declines in value judged to be other than temporary are included in net securities gains (losses). The cost of securities sold is based on the specific identification method, and sales are reported as of the trade date. Loans Held for Resale: Loans held for resale, primarily consisting of fixed-rate consumer mortgages and indirect automobile loans, are valued at the lower of cost or market, determined on an aggregate basis. Mortgage Servicing Rights: An asset is recognized for mortgage servicing rights acquired through purchase or origination. If mortgage loans are sold or securitized with servicing retained, the total cost of the mortgage loans is allocated to the loans and the servicing rights based on their relative fair values. Keystone performs a periodic review for impairment in the market value of recorded mortgage servicing rights. Interest and Fees on Loans: Interest income on loans is accrued based upon the principal amount outstanding. Loan origination fees and certain direct loan origination costs have been deferred and the net amount amortized as an adjustment of the related loan yield over the estimated contractual life of the related loans. Keystone places loans and leases on nonaccrual when collection of principal is in doubt, or when interest is 90 days past due, unless the loan is well-secured and in the process of collection. Classification of a loan as nonaccrual is also considered when the financial condition of the borrower is in a state of significant deterioration. When loans are placed on nonaccrual, including those identified as impaired under FASB Statement No. 114, loan interest receivable is reversed. Interest payments received on these loans and leases are applied as a reduction of the principal balance when concern exists as to the ultimate collection of principal; otherwise such payments are recognized as interest income. Loans and leases are removed from nonaccrual when they have performed in accordance with contract terms for a reasonable period of time and when concern no longer exists as to their collectability. 58 Impaired Loans: Impaired loans are defined as those loans for which it is probable that contractual amounts due will not be received. Impaired loans are reported at the present value of expected future cash flows using the loan's effective interest rate, or as a practical expedient, at the loans' observable market price or the fair value of the collateral if the loan is collateral dependent. The determination of impairment requires judgement including estimates of the amount and timing of cash flows. Loans included as components of risk elements are not deemed to be impaired when it is probable that contractual amounts due will be received through the normal collection process, subsequent disposition of collateral, etc. Identification of impaired loans is the primary obligation of the credit extension function and is augmented by the normal loan review process. Factors which are considered in the identification of impaired loans include, but are not limited to: classification into nonaccrual or workout status; a history of payment delinquency; adverse industry trends; and a general understanding of a customer's financial status. An insignificant delay or payment shortfall, such as those attributable to seasonal payment waivers, would not necessarily require treatment as an impaired loan when other factors make it probable that contractual amounts will be received. The majority of loans classified as impaired on an individual basis are commercial loans and commercial loans secured by real estate. Other loans, such as residential real estate and consumer loans and leases are aggregated for the purpose of measuring impairment due to their homogeneous risk characteristics and their predisposition of statistically valid historical analysis. Loans, including impaired loans, are charged-off when they are deemed to be substantially uncollectible. Keystone's adoption of the accounting standards for impaired loans has had no material impact on the comparability of the results of operations or statement of condition before and after the date of adoption. Direct Lease Financing: Financing of equipment, principally consisting of automobiles and business equipment, is provided to customers under lease arrangements accounted for as direct financing leases. These leases are reported in the consolidated statements of condition under the loan caption as a net amount, consisting of the aggregate of lease payments receivable and estimated residual values, less unearned income. Income is recognized in a manner which results in an approximate level yield over the lease term. Allowance for Credit Losses: The allowance for credit losses is maintained at a level believed adequate by management to absorb potential loan and lease losses. Management's determination of the adequacy of the allowance is based on periodic evaluation of the risk characteristics of the loans and leases, credit loss experience, economic conditions, appraisals, valuation estimates, and such other relevant factors which, in management's judgment, deserve recognition. This evaluation is inherently subjective as it requires material estimates including the amount and timing of expected future cash flows on impaired loans, which might be susceptible to significant change. Premises and Equipment: Bank premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed generally on the straight-line method over the estimated useful lives of the related assets. Other Real Estate: Other real estate is comprised of property acquired through a foreclosure proceeding, an acceptance of a deed in lieu of foreclosure, or an in-substance foreclosure. Balances are carried at the lower of the related loan balance or estimated fair value less estimated disposition costs. Any losses realized upon disposition of the property, and holding costs prior thereto, are charged against income. Trust Assets and Income: Assets held in a fiduciary capacity by the subsidiary banks are not assets of the banks and are therefore not included in the consolidated financial statements. Pensions: The provision for pension expense was actuarially determined using the projected unit credit actuarial cost method. The funding policy is to contribute an amount sufficient to meet the requirements of ERISA, subject to Internal Revenue Code contribution limitations. Stock Options: Stock options are accounted for under Accounting Principles Board Opinion (APB) No. 25. Stock options are granted at exercise prices not less than the fair value of the common stock on the date of grant. Under APB 25, no 59 compensation expense is recognized related to Keystone's stock option plans. In January, 1996, Keystone adopted the disclosure requirements of FASB Statement No. 123, "Accounting for Stock-Based Compensation." As permitted under this new standard, Keystone disclosed the pro forma impact to net income and earnings per share that would occur if compensation expense was recognized based on the estimated fair value of the options on the date of the grant. Transfers and Servicing of Financial Assets and Extinguishments of Liabilities: In June 1996, the Financial Accounting Standards Board (FASB) issued Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". This statement provides new accounting and reporting standards for sales, securitizations, and servicing of receivables and other financial assets, for certain secured borrowing and collateral transactions, and for extinguishments of liabilities. Various provisions of the standard will become effective for transactions occurring after December 31, 1996, and all other provisions will become effective for transactions occurring after December 31, 1997. Adoption of the new standard is not expected to have a significant impact on Keystone's financial condition or results of operations. Income Taxes: The provision for income taxes is based on the results of operations and the impact of tax rate changes on the carrying amount of deferred tax assets and liabilities. In computing the tax liability, the results of operations are adjusted principally for the tax effect of tax-exempt income. Per Share Information: Net income per share is calculated by dividing net income by the weighted average number of shares of common stock outstanding during each period. Historical shares outstanding and per share data have been restated to reflect the 1996 three-for-two stock split. Treasury Stock: The acquisition of treasury stock is recorded under the cost method. The later disposition or sale of the treasury stock is recorded using the average cost inventory method. Financial Derivatives and other Hedging Activity: Interest rate swap contracts are utilized to hedge specific credit and/or funding activities, and the differential of interest paid or received is reflected in interest income or expense. The fair value of these swap contracts is appropriately disclosed in a footnote to these financial statements and is not recognized in the financial statements. Forward mortgage commitments, as well as put options and short sales of U.S. Treasury securities, are used to reduce the market risk, associated with interest rate fluctuations, of fixed-rate consumer mortgages and the indirect automobile loans held for sale. Changes in the market value of the forward mortgage commitments, as well as the securities underlying the put options and short sales, are recognized in income when the related changes in the fair values of the loans being hedged are recognized. Cash Flow Information: Keystone considers cash and due from banks and federal funds sold as cash and cash equivalents. Interest paid on deposits and other borrowings aggregated $174,858,000, $163,120,000, and $120,652,000 in 1996, 1995, and 1994, respectively. Cash payments for income taxes approximated $17,150,000, $17,050,000, and $24,854,000 for 1996, 1995, and 1994, respectively. Reclassifications: Certain amounts reported in the 1995 annual report have been reclassified to conform with the 1996 presentation. These reclassifications did not impact Keystone's financial condition or results of operations. 60 Investments The amortized cost, related fair value, and unrealized gains and losses for investment securities classified as available-for-sale or held-to-maturity were as follows at December 31 (in thousands):
- ------------------------------------------------------------------------------------- 1996 Available for Sale - ------------------------------------------------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - --------------------------------------- ------------ --------------------- ---------- Negotiable money market investments $194,566 $15 $15 $194,566 U.S. Treasury securities 198,099 798 521 198,376 U.S. Government agency obligations 383,150 1,316 4,004 380,462 Corporate and other securities 82,258 806 88 82,976 - --------------------------------------- ------------ --------- ----------- ---------- Total $858,073 $2,935 $4,628 $856,380 - --------------------------------------- ------------ --------- ----------- ---------- 1996 Held to Maturity - ------------------------------------------------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - --------------------------------------- ------------ --------------------- ---------- U.S. Government agency obligations $230,402 $1,997 $1,680 $230,719 Obligations of states and political subdivisions 134,194 3,308 135 137,367 Corporate and other securities 15,362 156 78 15,440 - --------------------------------------- ------------ --------- ----------- ---------- Total $379,958 $5,461 $1,893 $383,526 - --------------------------------------- ------------ --------- ----------- ----------
61
- ------------------------------------------------------------------------------------- 1995 Available for Sale - ------------------------------------------------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - ----------------------------------------- ----------- -------------------- ---------- Negotiable money market investments $237,107 $11 $16 $237,102 U.S. Treasury securities 254,483 1,254 380 255,357 U.S. Government agency obligations 272,934 1,306 844 273,396 Obligations of states and political subdivisions 847 25 --- 872 Corporate and other securities 70,844 947 608 71,183 - ----------------------------------------- ----------- --------- ---------- ---------- Total $836,215 $3,543 $1,848 $837,910 - ----------------------------------------- ----------- --------- ---------- ---------- 1995 Held to Maturity - ------------------------------------------------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - ----------------------------------------- ----------- -------------------- ---------- U.S. Government agency obligations $237,122 $4,423 $338 $241,207 Obligations of states and political subdivisions 132,541 4,242 102 136,681 Corporate and other securities 15,599 367 19 15,947 - ----------------------------------------- ----------- --------- ---------- ---------- Total $385,262 $9,032 $459 $393,835 - ----------------------------------------- ----------- --------- ---------- ----------
62
- ------------------------------------------------------------------------------------- 1994 Available for Sale - ------------------------------------------------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - ---------------------------------------- ------------ -------------------- ---------- Negotiable money market investments $140,015 $1 $29 $139,987 U.S. Treasury securities 370,625 141 11,053 359,713 U.S. Government agency obligations 234,495 72 13,249 221,318 Corporate and other securities 35,674 26 923 34,777 - ---------------------------------------- ------------ --------- ---------- ---------- Total $780,809 $240 $25,254 $755,795 - ---------------------------------------- ------------ --------- ---------- ---------- 1994 Held to Maturity - ---------------------------------------- -------------------------------------------- Amortized Unrealized Fair Cost Gains Losses Value - ---------------------------------------- ------------ -------------------- ---------- U.S. Treasury securities $5,905 $--- $100 $5,805 U.S. Government agency obligations 258,568 199 13,584 245,183 Obligations of states and political subdivisions 135,934 2,554 3,583 134,905 Corporate and other securities 17,995 65 990 17,070 - ---------------------------------------- ------------ --------- ---------- ---------- Total $418,402 $2,818 $18,257 $402,963 - ---------------------------------------- ------------ --------- ---------- ----------
Net securities gains recognized in 1996 of $556,000 included gross gains of $583,000 and gross losses of $27,000. During 1995, securities with a total book value of $4,871,000 and a total market value of $5,158,000 were transferred from held-to-maturity to available-for-sale pursuant to the Financial Accounting Standards Board staff's special report on FASB Statement No. 115. Investment securities having a carrying value of $483,125,000 at December 31, 1996, were pledged to secure public and trust deposits and security repurchase agreements. 63 The following tables display at December 31, 1996, the amortized cost, related fair values, and the weighted average yield (tax equivalent basis) available thereon of maturing investment securities (in thousands):
- ----------------------------------------------------------------------------------------------------------------------------------- Available for Sale - ----------------------------------------------------------------------------------------------------------------------------------- After One, After Five, Within One Year But Within Five Years But Within Ten Years After Ten Years - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Amortized Fair Amortized Fair Amortized Fair Amortized Fair Cost Value Yield Cost Value Yield Cost Value Yield Cost Value Yield - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Negotiable money market investments $194,566 $194,566 5.32% $ - $ - -% $ - $ - -% $ - $ - -% U.S. Treasury securities 44,089 44,079 5.55 154,010 154,297 5.97 - - - - - - Government agency obligations 16,993 16,974 5.89 338,766 336,344 6.11 14,871 14,820 5.97 12,520 12,324 5.69 Corporate and other securities 10,626 10,658 6.39 32,174 32,192 6.40 375 375 7.50 39,083 39,751 8.12 - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Total $266,274 $266,277 5.44% $524,950 $522,833 6.09% $15,246 $15,195 6.01% $51,603 $52,075 7.54% - --------------------------------------------------------- ------------------------- ------------------------ ----------------------
- ----------------------------------------------------------------------------------------------------------------------------------- Held to Maturity - ----------------------------------------------------------------------------------------------------------------------------------- After One, After Five, Within One Year But Within Five Years But Within Ten Years After Ten Years - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Amortized Fair Amortized Fair Amortized Fair Amortized Fair Cost Value Yield Cost Value Yield Cost Value Yield Cost Value Yield - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Government agency obligations $ 825 $ 822 7.79% $34,054 $34,217 6.39% $101,250 $101,275 7.08% $ 94,273 $ 94,405 7.24% Obligations of states and political subdivisions 8,323 8,398 8.53 23,384 24,341 8.77 18,556 19,149 7.93 83,931 85,479 8.07 Corporate and other securities - - - 9,963 9,925 6.00 5,399 5,515 7.37 - - - - --------------------------------------------------------- ------------------------- ------------------------ ---------------------- Total $9,148 $9,220 8.46% $67,401 $68,483 7.16% $125,205 $125,939 7.22% $178,204 $179,884 7.63% - --------------------------------------------------------- ------------------------- ------------------------ ----------------------
64 Loans and Leases The composition of loans and leases was as follows at December 31, (in thousands):
1996 1995 - ---------------------------------------------------------------------------------- Consumer financings: Consumer loans $883,467 $841,560 Net investment in direct lease financing receivables 301,483 184,554 - ---------------------------------------------------------------------------------- 1,184,950 1,026,114 Loans secured by real estate: Consumer 794,010 828,059 Commercial 870,578 868,314 - ---------------------------------------------------------------------------------- 1,664,588 1,696,373 Commercial 704,124 643,229 - ---------------------------------------------------------------------------------- Total $3,553,662 $3,365,716 ==================================================================================
At December 31, 1996, all of the outstanding consumer real estate loans were pledged under blanket collateral agreements to secure outstanding Federal Home Loan Bank borrowings. No industry-related concentrations are deemed to exist. Activity within the allowance for credit losses was summarized as follows (in thousands):
1996 1995 1994 - ----------------------------------------------- ------------------------------------ Balance at January 1 $44,377 $42,440 $40,181 Allowance obtained through acquisitions/ mergers ----- 1,750 2,096 Allowance transferred out ----- (815) ----- Recoveries on loans previously charged off 2,233 1,901 2,411 Loans charged off (11,452) (8,758) (11,732) - ----------------------------------------------- ------------------------------------ Net loans charged off (9,219) (6,857) (9,321) Provision charged to operations 9,858 7,859 9,484 - ----------------------------------------------- ------------------------------------ Balance at December 31 $45,016 $44,377 $42,440 =============================================== ====================================
65 Total nonaccrual and restructured loan balances and related annual interest data were as follows (in thousands): 1996 1995 1994 - ------------------------------------- ---------- ---------- ---------- Nonaccrual $18,913 $16,740 $24,403 Restructured 393 503 144 - ------------------------------------- ---------- ---------- ---------- Total $19,306 $17,243 $24,547 - ------------------------------------- ---------- ---------- ---------- Interest computed at original terms $1,850 $1,794 $2,454 Interest recognized 580 571 615 - ------------------------------------- ---------- ---------- ---------- At December 31, 1996, there were no significant commitments to lend additional funds on these loans. The recorded investment in impaired loans at December 31, 1996 totaled $6,938,000, with a related allowance for credit losses of $1,476,000. Comparable amounts at the end of 1995 totaled $8,271,000 and $2,034,000, respectively. Certain directors and executive officers of Keystone and its subsidiaries, and their associates, were indebted to the bank subsidiaries during 1996. Such loans were made in the ordinary course of business and on customary terms. Loan activity during 1996 with these related parties was as follows (in thousands): Beginning Balance Additions Repayments Ending Balance - --------------------- ---------------- ----------------- ---------------- $158,874 $79,209 $92,060 $146,023 Financial Derivatives and Other Hedging Activity Keystone engages in activities associated with the use of off-balance sheet derivative financial instruments (derivatives) and hedges to manage its exposure to changes in interest rates. Activities include limited interest rate swap activity, forward commitments for mortgage banking inventory management, the use of short sales and put options to hedge against the potential deterioration in the value of indirect auto financings held for sale, and loan commitments and standby letters of credit made in the ordinary course of its banking business. At December 31, 1996, Keystone had one interest rate swap contract with an original notional amount of $7,000,000, maturing in January, 1997. This contract is a "receive floating"/"pay fixed" swap, with the receive rate at six-month LIBOR and the pay rate at 8.31%. This contract, which is currently in a net pay position, hedges a fixed-rate loan funded by short-term certificates of deposit. The credit condition of Keystone's counterparties met Keystone's credit policy standards. This contract had a current valuation of $(79,000), which represents the estimated costs to terminate the swap contract. Keystone utilizes derivative instruments to hedge balance sheet amounts and unrealized gains/(losses) are not recognized in the financial statements. 66 Keystone has entered into forward mortgage commitments related to management of its mortgage banking inventory. Under the terms of these commitments, Keystone agreed to deliver a specified volume of mortgage loans with a specified portfolio yield, and received a pre-established price commitment pursuant to timely delivery of the mortgage loans. The purpose of these arrangements is to manage the effect of interest rate changes on these loans between the date of the original loan commitment and the date of delivery for sale into the secondary market. At December 31, 1996, Keystone had entered into commitments to deliver approximately $21,341,000 of mortgage loans for sale into the secondary market. The delivery dates for these commitments are short-term in nature and will expire at various dates in the first half of 1997. Keystone has made use of both put options and short sales of U.S. Treasury securities to hedge against declines in market value, due to interest rate fluctuations, of indirect automobile loans awaiting securitization. At December 31, 1996 Keystone had outstanding short-sales totaling $31,000,000. The market value at December 31, 1996 of the U.S. Treasury securities needed to fulfill these commitments approximated the agreed-upon sales prices. Thus, there were no significant gains or losses inherent in the transactions. Loan commitments and standby letters of credit have credit risk substantially the same as involved in extending loans to customers. At December 31, 1996, outstanding commitments for loans and standby letters of credit were as follows (in thousands): Loan commitments $831,387 --------------------------- ------------ Standby letters of credit $62,923 --------------------------- ------------ Premises and Equipment The following summarizes premises and equipment at December 31, (in thousands): 1996 1995 - ---------------------------------------------- ----------- ----------- Land $9,236 $8,129 Buildings 61,888 59,987 Equipment 83,967 75,999 Leasehold improvements 13,371 10,091 - ---------------------------------------------- ----------- ----------- 168,462 154,206 Accumulated depreciation and amortization (94,055) ( 83,318) - ---------------------------------------------- ----------- ----------- Total $74,407 $70,888 ============================================== =========== =========== Depreciation and amortization expense amounted to $11,146,000 in 1996, $9,946,000 in 1995, and $8,909,000 in 1994. Keystone and its subsidiaries lease various equipment and buildings. In 1996, 1995, and 1994, total rent expense amounted to $6,687,000, $5,775,000, and $5,794,000, respectively. Future annual minimum lease payments do not significantly exceed historic levels. 67 Federal Home Loan Bank Borrowings The subsidiary banks of Keystone are members of a Federal Home Loan Bank (FHLB) and, as such, can take advantage of the FHLB program for overnight and term advances at published daily rates, which are advantageous to members as compared to issuing notes directly in the market. Under the terms of a blanket collateral agreement, advances from the FHLB are collateralized by first mortgage loans and securities. Advances available under this agreement are limited by available and qualifying collateral and the amount of FHLB stock held by the borrower. At December 31, 1996, Keystone member banks could borrow an additional $859,947,000 based on qualifying collateral. Such additional borrowing would require that the banks increase their investment in FHLB stock by $101,147,000. Outstanding borrowings from the Federal Home Loan Bank are summarized as follows (in thousands): December 31, - --------------------------------------------------------------- 1996 1995 - ------------------------------------ ------------- ------------ Due 1996, 4.68% to 6.89% $----- $67,956 Due 1997, 5.48% to 7.04% 60,095 63,916 Due 1998, 5.45% to 7.71% 48,848 21,229 Due 1999, 4.75% to 6.51% 26,086 5 Due 2000, 5.54% to 6.28% 2,500 2,505 Due 2001, 4.92% to 6.80% 66,000 6,000 After 2001, 5.50% to 7.23% 2,400 2,160 - ------------------------------------ ------------- ------------ $205,929 $163,771 - ------------------------------------ ------------- ------------ Of the December 31, 1996 outstanding balance, $80,000,000 is subject to conversion to adjustable rates at the option of the FHLB at various dates in 1997. In the event the FHLB elects to convert the borrowings to adjustable rates, Keystone has the option to pre-pay the borrowings without penalty. 68 Long-term Debt Long-term debt at December 31 consisted of the following (in thousands): 1996 1995 - ----------------------------------------------- ----------- ----------- Parent: KSOP Note payable, interest at prime plus 0.25%, 8.5% at December 31, 1996 $1,249 $1,750 Subsidiaries: Note payable 131 1,341 Bank note payable, interest at 67.5% of prime, 4.95% at December 31, 1996 666 833 Various mortgages payable 108 124 - ----------------------------------------------- ----------- ----------- Total $2,154 $4,048 =============================================== =========== =========== The KSOP note payable reflects the amortized balance of a $3,500,000 borrowing, the proceeds of which were used to purchase 186,000 shares of previously authorized but unissued Keystone common stock on July 1, 1992. The original note is payable in 84 equal monthly installments ending on July 31, 1999. The loan bears interest at the prime rate plus 0.25% and requires monthly amortization of principal and interest. The loan is subject to various debt covenants, including reporting requirements, and other customary conditions. See the note on "Employee Benefit Plans" for additional information. Shareholders' Equity Series A Junior Participating Preferred Stock (Preferred Stock) (par value $1.00 per share, with voting powers and dividends and liquidation rights per share equal to 187.5 times that of the current common stock) has been established in connection with the adoption of a Shareholders' Rights Plan (Rights Plan). Under the Rights Plan, 200,000 shares of Preferred Stock are reserved for issuance on the exercise of rights attached to the outstanding common stock. The rights are exercisable only if a person or group acquires or announces a tender or exchange offer to acquire 20% or more of the common stock. In the event a person or group acquires a 20% position, each right not owned by the person or group will entitle its holder to purchase at the exercise price of $56.00, a number of shares of common stock, 5.333 one-thousandths (0.005333) of a share of Preferred Stock, or other securities or assets of Keystone or common shares of the acquiring company having a market value equal to twice the exercise price. At any time after a person or group acquires 20% or more (but less than 50%) of the outstanding common stock, the Board of Directors may exchange part or all of the rights (other than the rights held by the person or group) for shares of common or 5.333 one-thousandths of a share of Preferred Stock on a one-for-one basis. The Board of Directors is entitled to redeem the rights for one cent per right at any time before a 20% position has been acquired. Unless extended, the rights will expire on February 8, 2000. Stock-based Compensation Keystone provides eligible employees and directors with various stock option and stock purchasing plans which are more fully described below. Effective January 1, 1996, Keystone adopted the disclosure provisions of FASB Statement No. 123, 69 "Accounting for Stock-Based Compensation". As permitted under this new standard, Keystone continues to account for its plans in accordance with APB Opinion No. 25 and related interpretations. As such, no compensation expense has been recognized for its stock option plans and employee stock purchase plan. Keystone has an employee "Stock Incentive Plan" and a "Nonemployee Directors' Stock Option Plan." Under the terms of these plans, Keystone has reserved for issuance a total of 2,250,000 shares of common stock for qualifying employees and nonemployee directors, of which approximately 1,124,000 are available for future grants. The plans provide for the issuance of nonqualified options and, under the employee plan, incentive stock options. Options are granted at an exercise price not less than the fair market value of Keystone common stock on the date of grant, vest in two years, and expire approximately ten years after the grant date. Keystone also has outstanding options pursuant to a predecessor plan and plans of acquired banks. The following table provides a summary of options outstanding under the "Stock Incentive Plan," the "Nonemployee Directors' Stock Option Plan," and other predecessor or acquired plans. 70 Weighted Average Exercise Common Price Shares - ---------------------------- ------------ ------------ - ---------------------------- ------------ ------------ January 1, 1994 $13.58 1,622,156 Granted $22.27 547,500 Exercised $ 9.41 (241,818) Terminated $15.76 (38,422) - ---------------------------- ------------ ------------ December 31, 1994 $16.41 1,889,416 - ---------------------------- ------------ ------------ Granted $19.83 157,489 Exercised $ 9.59 (279,300) Terminated $20.08 (50,829) - ---------------------------- ------------ ------------ December 31, 1995 $17.59 1,716,776 - ---------------------------- ------------ ------------ Granted $20.36 262,351 Exercised $10.57 (83,725) Terminated $20.62 (48,355) - ---------------------------- ------------ ------------ December 31, 1996 $18.20 1,847,047 - ---------------------------- ------------ ------------ The following table summarizes information about stock options outstanding at December 31, 1996:
- ----------------------------------------------------------- ------------------------- Options Outstanding Options Exercisable - ----------------------------------------------------------- ------------------------- Weighted- Average Weighted- Weighted- Range of Remaining Average Average Exercise Number Contractual Exercise Number Exercise Prices Outstanding Life Price Exercisable Price - ---------------- ------------- ------------- -------------- ------------- ----------- $4.95-$6.98 31,108 0.77 $5.48 31,108 $5.48 $7.26-$10.88 279,688 3.67 $9.15 279,688 $9.15 $11.13-$15.67 281,026 4.56 $14.03 276,676 $14.06 $19.25-$24.75 1,255,225 7.24 $21.47 732,518 $21.65 - ------------------------------ ------------- -------------- ------------- ----------- $4.95-$24.75 1,847,047 6.18 $18.20 1,319,990 $17.03 - ------------------------------ ------------- -------------- ------------- -----------
71 Under the "Employee Stock Purchase Plan", eligible employees are provided an opportunity to purchase Keystone common stock at a discount from market price. The Plan provides for the purchase of stock through payroll deductions at a price which is the lesser of 85% of the fair market value of the common stock as of the first or last day of the annual purchase period. The purchase period commences on July 1 and ends on June 30. Through modifications made to the plan in 1995, Keystone reserved 750,000 shares of common stock, of which 653,000 remain available for future purchases. The amount of common shares issued under this program in 1996, 1995, and 1994 were as follows: Price Per Shares Share Issued -------------------------- --------------- -------------- 1996 $15.79 97,196 1995 $15.90 74,249 1994 $17.78 59,848 The following pro forma amounts indicate the net income and earnings per share that would have resulted if compensation expense for the stock option plans and employee stock purchase plan was determined under the recognition provisions of Statement No. 123 using the fair value of the awards at the grant date. - -------------------------------------------------------------------------- 1996 1995 - -------------------------------------------------------------------------- Net Income As reported $69,475 $61,314 (in thousands) Pro forma 68,448 60,838 Earnings per share As reported $1.83 $1.73 Pro forma 1.80 1.72 - -------------------------------------------------------------------------- The pro forma effect is not fully reflected in 1995 since Statement No. 123 is applicable only to options granted subsequent to December 31, 1994, and Keystone's options have a two-year vesting period. The weighted-average grant-date fair values of options granted during 1996 and 1995 under the stock option plan were $2.69 and $3.05, respectively. The fair value of each option grant was estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used in the option pricing model for grants in 1996 and 1995, respectively: dividend yield of 4.6% and 4.3%; expected volatility of 15% for both years; risk-free interest rates of 5.50% and 7.88%; and expected lives of 7 years for both the 1996 and 1995 Plan options. Pro forma compensation expense for the employees' purchase rights was estimated using the Black-Scholes model with the following assumptions for 1996 and 1995, respectively: dividend yield of 4.1% and 4.8%; an expected life of 1 year for both years; expected volatility of 12% and 13%; and risk-free interest rates of 5.75% and 5.64%. The weighted-average fair value of those purchase rights granted in 1996 and 1995 was $7.03 and $5.77, respectively. The Black-Scholes model is predominantly used to value traded options which differ from Keystone's options. This model requires the use of numerous assumptions, many of which are subjective in nature. Therefore, the pro forma results are estimates of the impact to operations if compensation expense had been recognized for all stock based compensation plans and are not indicative of the impact on future periods. On March 30, 1995, the Board of Directors approved the Management Stock Ownership Program (the "Program"). The Program is intended, among other things, to promote alignment of management and shareholder interests and to encourage management to focus on value creation. To accomplish these purposes, the Program establishes stock ownership goals for executive and senior officers of the Corporation to be achieved over a five-year period. In order to assist the officers in attaining their stock ownership goals, a related plan provides for nonrecourse, noninterest-bearing loans, in amounts not to exceed 50% of the officer's stock ownership goal, to be used to purchase shares of Keystone common stock at fair market value. The loans are secured by collateral having an initial value of 120% of the loan amount and consisting of the shares of Keystone stock purchased with the loan plus additional shares of stock or other acceptable collateral owned by the executive. The aggregate number of shares which may be issued and sold pursuant to the Plan is limited to 750,000 shares of Common Stock, subject to proportionate adjustment in the event of stock splits and similar events. During 1996 and 1995, 19,000 and 72,000 shares, respectively, were issued under the Plan. At December 31, 1996 and 1995, the amount executives participating in the Program owed Keystone for financed purchases totaled $1,786,000 and $1,384,000, respectively. Keystone has a dividend reinvestment plan for shareholders under which additional shares of Keystone common stock may be purchased at market value with reinvested dividends and voluntary cash payments. Keystone has reserved 900,000 shares of common stock for this Plan, and approximately 466,000 shares remain unissued. The following number of shares of Keystone common stock were purchased pursuant to this plan: 132,000 in 1996, 133,000 in 1995, and 125,000 in 1994. 72 Employee Benefit Plans Keystone provides a noncontributory defined benefit plan covering substantially all full-time employees. Plan benefits are based on years of service and qualifying compensation during the final years of employment. A summary of the components of net periodic pension expense for Keystone's defined benefit plan was as follows for the years ended December 31 (in thousands):
1996 1995 1994 - -------------------------------------------------- ---------- ---------- ----------- Service cost benefits earned during the period $2,214 $2,213 $2,170 Interest cost on projected benefit obligation 4,334 3,795 3,644 Actual return on plan assets (8,353) (11,397) 791 Net amortization and deferral 2,108 6,010 (5,959) - -------------------------------------------------- ---------- ---------- ----------- Pension expense $303 $621 $646 ================================================== ========== ========== ===========
The following table sets forth the funded status and amounts recognized in Keystone's consolidated statement of condition as of December 31, (in thousands): 1996 1995 - -------------------------------------------------------- ----------- ----------- Actuarial present value of the accumulated benefit obligation, including vested benefits of $50,029 in 1996 and $47,154 in 1995 $50,421 $47,544 - -------------------------------------------------------- ----------- ----------- Actuarial present value of projected benefit obligation for service rendered to date $(62,348) $(59,227) Fair value of plan assets 75,705 70,377 - -------------------------------------------------------- ----------- ----------- Plan assets in excess of projected benefit obligation 13,357 11,150 Unrecognized net assets at transition (3,386) (4,054) Unrecognized net gain (5,848) (2,539) Unrecognized prior service cost (1,256) (1,487) - -------------------------------------------------------- ----------- ----------- Prepaid pension expense, included in other assets $2,867 $3,070 ======================================================== =========== =========== Actual assumptions used in the determination of the projected benefit obligation were as follows: 1996 1995 1994 - --------------------------------------------------- -------- -------- ------- Rate of increase in future compensation levels 5.50% 5.50% 5.50% Expected long-term rate of return on plan assets 8.50 8.00 8.00 Weighted average discount rate 7.50 7.50 7.75 =================================================== ======== ======== ======= The unrecognized net assets at transition and the unrecognized prior service costs are being amortized over the expected service lives of eligible employees, which approximate 15 years. Trusteed pension plan assets consist primarily of equity and fixed income securities and short-term investments. A 401(k) deferred savings plan covers eligible employees of Keystone. The plan provides for a matching employer contribution equal to 60% of the employee contribution, limited to 5% of employee compensation. Matching contributions are paid entirely in Keystone stock. 73 In July 1992, Keystone established a leveraged KSOP and borrowed $3,500,000 for the purpose of acquiring 186,000 shares of Keystone stock. The shares purchased by the KSOP are used to meet matching contribution requirements of the 401(k) plan. Dividends received on shares held by the KSOP are used to service the principal and interest payments on the borrowing. Debt service is also provided by matching cash contributions required under the original 401(k) plan. Benefit expense is recognized based on a percentage of total debt service for the current year to total debt service over the life of the borrowing. Group-based annual incentive plans include the Long-Term Incentive Plan (LTIP), Management Incentive Compensation Program (MICP) and Profit Enhancement Requires Quality (PERQ). Employees earn awards under these plans based on the profitability of their operating unit and/or Keystone. Expenses for the 401(k) plan, LTIP, MICP, and PERQ were $5,303,000 in 1996, $5,213,000 in 1995, and $3,699,000 in 1994. Income Taxes Deferred income taxes reflect the tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred tax assets and liabilities are as follows (in thousands): December 31, - ----------------------------------------- ------------------------- Deferred tax assets: 1996 1995 - ----------------------------------------- ------------ ------------ Allowance for credit losses $14,402 $13,954 Unrealized losses on securities available-for-sale 585 ----- Deferred expenses 945 1,849 Deferred loan fees 13 1,040 Deferred compensation 2,227 1,745 - ----------------------------------------- ------------ ------------ Deferred tax liabilities: - ----------------------------------------- ------------ ------------ Lease financing activities (33,950) (20,526) Unrealized gains on securities available-for-sale ----- (645) Tax over book depreciation (937) (306) Core deposit amortization (1,494) (1,685) Other (953) (1,043) - ----------------------------------------- ------------ ------------ Net deferred tax liability $(19,162) $(5,617) ========================================= ============ ============ 74 The provision for income taxes consisted of the following components (in thousands): - -------------------------------------------------------------------- 1996 1995 1994 - --------------------------------- --------- --------- --------- Deferred provision $14,775 $11,104 $996 Current provision: Federal taxes 15,093 16,283 19,199 State taxes 676 479 286 - --------------------------------- --------- --------- --------- Total $30,544 $27,866 $20,481 ================================= ========= ========= ========= A reconciliation of income tax expense and the amounts which would have been recorded based upon statutory rates (35%) was as follows (in thousands): 1996 1995 1994 - ------------------------------------ ---------- ---------- ---------- Provision on pre-tax income at statutory rates $35,007 $31,213 $25,144 Tax exempt interest income (3,522) (4,273) (4,556) Other (941) 926 (107) - ------------------------------------ ---------- ---------- ---------- Total $30,544 $27,866 $20,481 - ------------------------------------ ---------- ---------- ---------- Effective Rate 30.5% 31.2% 28.5% ==================================== ========== ========== ========== Regulatory Capital Requirements Bank regulators have set forth requirements for risk-based capital, which resulted in the establishment of international capital standards for banks. 75 The following table provides Keystone's risk-based capital position at the end of 1996 and 1995 and a comparison to the various regulatory capital requirements (in thousands):
- ----------------------------------------------------------------------------------------- Well 1996 1995 Capitalized Minimum Amount Ratio Amount Ratio Ratio Ratio - --------------------- ---------- ---------- ----------- -------- -------------- --------- Total capital (to risk-weighted assets) $539,699 14.77% $504,620 14.83% 10% 8% Tier 1 capital (to risk-weighted assets) $494,683 13.54% $464,456 13.65% 6% 4% Tier 1 capital (to average assets) $494,683 9.64% $464,456 9.28% 5% 4% - --------------------- ---------- ---------- ----------- -------- -------------- ---------
At December 31, 1996 and 1995, each significant subsidiary of Keystone had capital at or above the well capitalized level for each of the three ratios. Failure to meet any one of the minimum capital ratios would result in an institution being classified as "undercapitalized" or "significantly undercapitalized". Such classifications could disrupt dividends, capital distributions, or affiliate management fees. In addition, other restrictions, prohibitions, and related supervisory actions would be likely depending upon the overall level of capital. Keystone anticipates no problems in meeting the current or future capital standards. As of December 31, 1996, each subsidiary bank had been categorized as "well capitalized" by its primary regulator at its most recent examination. Restrictions Under Federal Reserve regulations, depository institutions must maintain reserves in the form of cash or amounts on deposit with Federal Reserve Banks. For the year ended December 31, 1996, Keystone's bank subsidiaries maintained average reserve balances of approximately $64,000,000 in compliance therewith. Dividends that may be paid to Keystone by the subsidiary banks are limited by state and federal regulations. The related amount available for dividends aggregated $146,373,000 at December 31, 1996. Federal Reserve regulations also limit each subsidiary bank as to the amount it may loan its affiliates, including Keystone. At December 31, 1996, the maximum amount available for loans to affiliates approximated 10% of consolidated net assets. Fair Value of Financial Instruments FASB Statement No. 107 requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by 76 comparison with independent markets, and, in many cases, could not be realized in immediate settlement of the instrument. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of Keystone Financial, Inc. 77 The following schedule displays at December 31, the carrying values and related estimated fair values for financial instruments (in thousands):
1996 1995 - ------------------------------------------------------------------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value - --------------------------------- ------------ ------------ ------------ ------------ Financial Assets: Cash and due from banks $167,403 $167,403 $182,459 $182,459 Federal funds sold and other 78,354 78,354 109,422 109,422 Investment securities available for sale 856,380 856,380 837,910 837,910 Investment securities held to maturity 379,958 383,526 385,262 393,835 Loans held for resale 51,225 51,225 57,454 57,454 Loans, net of allowance for credit losses 3,177,381 3,211,254 3,136,785 3,169,901 - --------------------------------- ------------ ------------ ------------ ------------ Total Financial Assets $4,710,701 $4,748,142 $4,709,292 $4,750,981 - --------------------------------- ------------ ------------ ------------ ------------ Leases 331,265 184,554 Premises and equipment 74,407 70,888 Other assets 114,895 110,051 - --------------------------------- ------------ ------------ ------------ ------------ Total Assets $5,231,268 $5,074,785 - --------------------------------- ------------ ------------ ------------ ------------ Financial Liabilities: Time deposits $2,414,979 $2,423,504 $2,267,296 $2,292,161 Other deposits 1,682,132 1,682,132 1,794,592 1,794,592 Short-term borrowings 326,070 326,070 279,841 279,841 FHLB borrowings 205,929 203,443 163,771 164,601 Long-term debt 2,154 2,154 4,048 4,048 - --------------------------------- ------------ ------------ ------------ ------------ Total Financial Liabilities $4,631,264 $4,637,303 $4,509,548 $4,535,243 - --------------------------------- ------------ ------------ ------------ ------------ Other liabilities 92,697 84,543 - --------------------------------- ------------ ------------ ------------ ------------ Total Liabilities $4,723,961 $4,594,091 - --------------------------------- ------------ ------------ ------------ ------------ Off-Balance Sheet Instruments: - --------------------------------- ------------ ------------ ------------ ------------ Lending commitments and letters of credit $----- $(2,625) $----- $(574) - --------------------------------- ------------ ------------ ------------ ------------ All other $----- $(79) $----- $(402) ================================= ============ ============ ============ ============
78 The following methods and assumptions were used to estimate fair market value disclosures for financial instruments: Cash and short-term instruments: The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets' fair values. Investment securities (including mortgage-backed securities): Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. Loans receivable: For variable-rate loans that reprice frequently and don't have significant changes in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of comparable credit quality. The carrying amount of accrued interest approximates its fair value. Deposit liabilities: The fair values disclosed for demand deposits (e.g., interest and noninterest checking, savings, and certain types of money market accounts) are reported at a value equal to the amount payable on demand at the reporting date. The carrying amounts for variable-rate, fixed-term money market accounts and certificates of deposit approximate their fair market value at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities. Short-term borrowings: The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings approximate their fair values. FHLB and long-term borrowings: The fair values of Keystone's FHLB and long-term borrowings are estimated using discounted cash flow analyses, based on Keystone's current incremental borrowing rates for similar types of borrowings. Unfunded lending commitments and letters of credit: Fair values for Keystone's unfunded lending commitments and letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter parties' credit standings. Other off-balance sheet instruments: Fair values for off-balance sheet instruments including interest rate swaps, forward mortgage commitments, and securities underlying put options and short sales are based on dealer quotes and current trading prices. The fair values represent the estimated amounts that Keystone would receive or pay to terminate the contracts, taking into account current interest rates. 79 Mergers and Acquisitions During the fourth quarter of 1996, Keystone announced the signing of a definitive agreement to merge with Financial Trust Corporation (Financial Trust), a financial institution with $1.2 billion of assets headquartered in Carlisle, Pennsylvania. Under the terms of the agreement, each Financial Trust shareholder will receive Keystone common stock at a fixed exchange ratio of 1.65 shares for each Financial Trust share. The transaction will be accounted for under the pooling of interests method of accounting. The following table provides a summary of the consolidated operating results and financial condition on a pro forma basis as of and for the year ended December 31, 1996 (in thousands): Keystone Financial Keystone (As reported) Trust Pro forma - ------------------------ --------------- --------------- --------------- Net Interest Income $209,763 $52,356 $262,119 Net Income 69,475 20,031 89,506 Assets 5,231,268 1,219,311 6,450,579 Liabilities 4,723,961 1,066,212 5,790,173 Shareholders' Equity 507,307 153,099 660,406 - ------------------------ --------------- --------------- --------------- During the fourth quarter of 1996, Keystone also announced the signing of a definitive agreement to acquire First Financial Corporation (First Financial), a thrift holding company with assets of $361 million based in Cumberland, Maryland. Under the terms of the agreement with First Financial, each of its shareholders will receive Keystone common stock at a fixed exchange ratio of 1.29 shares for each First Financial share, or an equivalent amount of cash. The stock issuance will amount to between 55% and 60% of the total consideration, and as such, the transaction will be accounted for as a purchase. Both the Financial Trust and First Financial acquisitions are subject to regulatory and shareholder approval and are expected to be consummated during the first half of 1997. During the fourth quarter of 1995, Keystone completed mergers of two Pennsylvania bank holding companies, Shawnee Financial Services Corporation (Shawnee) and National American Bancorp (NAB); and the acquisition of Martindale Andres & Company (Martindale), a Philadelphia-based asset management firm. The Shawnee and NAB mergers resulted in the issuance of 501,000 and 1,158,000 shares, respectively, of Keystone stock in exchange for 80,200 and 579,000 shares of Shawnee and NAB, respectively. The bank subsidiaries of both Shawnee and NAB were merged into existing Keystone affiliated banks and the mergers were accounted for under the pooling-of-interests method of accounting. Due to the immaterial impact of both transactions to Keystone's financial position and results of operation, prior periods were not restated. Consolidated results of Keystone include Shawnee's and NAB's results of operations from the consummation dates of October 10, 1995 and December 29, 1995, respectively. The acquisition of Martindale Andres, which occurred on November 30, 1995 was accounted for under the purchase method of accounting and, accordingly, the results of Martindale's operations were included in Keystone's consolidated results beginning December 1, 1995. Proforma results of operations of Keystone as though Martindale had been acquired as of January 1 of the respective periods, would not have been materially different from the consolidated results presented herein. The purchase price, consisting of both cash and shares of Keystone common stock, was not significant to Keystone's financial condition. 80 On November 1, 1994, Keystone completed the purchase of American Savings Bank (American), a state-chartered savings bank with assets of approximately $135,000,000, which was merged into an affiliate bank. Former shareholders of American received cash, in the approximate amount of $5,774,000 and 317,000 shares of Keystone common stock, with total consideration valued at approximately $14,522,000. The transaction was accounted for under the purchase method of accounting and resulted in the recognition of intangible assets totaling approximately $8,539,000. The intangible assets consist primarily of core deposit intangibles which will be amortized on an accelerated basis over a period of ten years. 81 Parent Company Financial Statements The following parent company condensed statements reflect the financial condition and results of operations of Keystone (in thousands): Statements of Condition December 31, - ------------------------------------------------------------------------- 1996 1995 - ----------------------------------------------- ------------ ------------ Assets: Cash $423 $1,274 Investment securities 22,076 9,176 Investments in: Subsidiary banks 450,587 442,890 Other subsidiaries 50,775 23,976 Other assets 119 21,298 - ----------------------------------------------- ------------ ------------ TOTAL ASSETS $523,980 $498,614 - ----------------------------------------------- ------------ ------------ Liabilities: Long-term debt $1,250 $1,750 Other liabilities 15,423 16,170 - ----------------------------------------------- ------------ ------------ TOTAL LIABILITIES 16,673 17,920 Shareholders' Equity 507,307 480,694 - ----------------------------------------------- ------------ ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $523,980 $498,614 =============================================== ============ ============ Statements of Income Year Ended December 31, - -------------------------------------------- ----------------------------------- 1996 1995 1994 - -------------------------------------------- ---------- ----------- ----------- Income: Dividends from subsidiaries: Bank subsidiaries $63,365 $38,910 $59,335 Other subsidiaries ----- ----- ----- Expenses 2,331 6,837 7,210 - -------------------------------------------- ---------- ----------- ----------- Income before taxes and undistributed earnings of subsidiaries 61,034 32,073 52,125 Income taxes (benefit) (333) (2,539) (3,430) Equity in undistributed earnings of subsidiaries 8,108 26,702 (4,196) - -------------------------------------------- ---------- ----------- ----------- NET INCOME $69,475 $61,314 $51,359 ============================================ ========== =========== =========== 82 Statements of Cash Flows Year Ended December 31, - ------------------------------------------ ----------------------------------- 1996 1995 1994 - ------------------------------------------ ----------- ----------- ----------- OPERATING ACTIVITIES: Net income $69,475 $61,314 $51,359 Equity in undistributed (earnings) losses (8,108) (26,702) 4,196 Other 712 (10,514) 5,637 - ------------------------------------------ ----------- ----------- ----------- NET CASH PROVIDED BY OPERATING ACTIVITIES 62,079 24,098 61,192 - ------------------------------------------ ----------- ----------- ----------- INVESTING ACTIVITIES: Net (increase) decrease in investments (12,900) 9,160 (9,490) Investments in subsidiaries (8,451) (1,842) (7,270) - ------------------------------------------ ----------- ----------- ----------- NET CASH PROVIDED BY (USED BY) INVESTING ACTIVITIES (21,351) 7,318 (16,760) - ------------------------------------------ ----------- ----------- ----------- FINANCING ACTIVITIES: Cash dividends declared (38,860) (33,092) (30,985) KSOP activity: Common stock proceeds 302 613 495 Payment of debt (501) (500) (500) Acquisition of treasury stock (8,186) (6,363) (20,563) Proceeds from issuance of common stock under benefits plans 5,725 7,894 6,340 Other (59) 500 (2) - ------------------------------------------ ----------- ----------- ----------- NET CASH USED BY FINANCING ACTIVITIES (41,579) (30,948) (45,215) - ------------------------------------------ ----------- ----------- ----------- Increase (decrease) in cash (851) 468 (783) Cash at beginning of year 1,274 806 1,589 - ------------------------------------------ ----------- ----------- ----------- CASH AT END OF YEAR $423 $1,274 $806 ========================================== =========== =========== =========== 83 SUPPLEMENTAL FINANCIAL INFORMATION Net Interest Income Keystone's largest source of revenue is net interest income, which is the difference between interest on earning assets and interest expense on deposits and other borrowed funds. The following table provides a summary of net interest income performance for the three years ended December 31, 1996: 1996 - ------------------------------------------------------------------------------- (in thousands) Average Yield/ Balance Interest Rate - ------------------------------------------------------------------------------- ASSETS - ------------------------------------------------------------------------------- Federal funds sold and other $101,505 $5,403 5.32% Investment securities: Negotiable money market investments 153,631 8,583 5.59 Taxable investment securities 909,854 56,538 6.21 Nontaxable investment securities(1) 128,736 10,944 8.50 Loans held for resale 53,656 4,688 8.74 Consumer loans (2) (3) 1,144,103 101,214 8.85 Real estate loans (1) (2) (3) 1,663,475 146,681 8.82 Commercial loans (1) (2) (3) 624,553 55,362 8.86 - ------------------------------------------------------------------------------- Total earning assets 4,779,513 $389,413 8.15% - ------------------------------------------------------------------------------- Allowance for credit losses (44,978) Other assets 320,123 - ------------------------------------------------------------------------------- Total Assets $5,054,658 - ------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------- NOW $426,312 $5,773 1.35% Savings 391,692 7,735 1.97 Money market 403,885 9,500 2.35 Time deposits 2,328,002 130,124 5.59 Short-term borrowings 265,527 11,524 4.34 FHLB borrowings 151,924 9,767 6.43 Long-term debt 3,117 335 9.01 - ------------------------------------------------------------------------------- Total interest-bearing liabilities 3,970,459 $174,758 4.40% - ------------------------------------------------------------------------------- Demand deposits 497,260 Other liabilities 94,609 Shareholders' equity 492,330 - ------------------------------------------------------------------------------- Total Liabilities and Equity $5,054,658 - ------------------------------------------------------------------------------- Interest rate spread 3.75% - ------------------------------------------------------------------------------- Net interest income and net interest margin $214,655 4.49% Tax-equivalent adjustment (4,892) - ------------------------------------------------------------------------------- Net interest income $209,763 - ------------------------------------------------------------------------------- 84 1995 - ------------------------------------------------------------------------------- (in thousands) Average Yield/ Balance Interest Rate - ------------------------------------------------------------------------------- ASSETS - ------------------------------------------------------------------------------- Federal funds sold and other $140,723 $ 8,309 5.90% Investment securities: Negotiable money market investments 98,541 5,773 5.86 Taxable investment securities 853,024 51,735 6.06 Nontaxable investment securities(1) 130,178 12,290 9.44 Loans held for resale 21,378 1,636 7.65 Consumer loans (2) (3) 1,034,494 91,537 8.85 Real estate loans (1) (2) (3) 1,654,658 145,782 8.81 Commercial loans (1) (2) (3) 577,362 52,487 9.09 - ------------------------------------------------------------------------------- Total earning assets 4,510,358 $369,549 8.19% - ------------------------------------------------------------------------------- Allowance for credit losses (44,040) Other assets 297,018 - ------------------------------------------------------------------------------- Total Assets $4,763,336 - ------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------- NOW $431,387 $ 7,306 1.69% Savings 419,721 8,641 2.06 Money market 423,226 10,601 2.50 Time deposits 2,105,544 118,542 5.63 Short-term borrowings 210,025 10,195 4.85 FHLB borrowings 176,636 10,827 6.13 Long-term debt 5,055 467 9.24 - ------------------------------------------------------------------------------- Total interest-bearing liabilities 3,771,594 $166,579 4.42% - ------------------------------------------------------------------------------- Demand deposits 474,571 Other liabilities 81,085 Shareholders' equity 436,086 - ------------------------------------------------------------------------------- Total Liabilities and Equity $4,763,336 - ------------------------------------------------------------------------------- Interest rate spread 3.77% - ------------------------------------------------------------------------------- Net interest income and net interest margin $202,970 4.49% Tax-equivalent adjustment (5,618) - ------------------------------------------------------------------------------- Net interest income $197,352 - ------------------------------------------------------------------------------- 85 - ------------------------------------------------------------------------------- 1994 - ------------------------------------------------------------------------------- (in thousands) Average Yield/ Balance Interest Rate - ------------------------------------------------------------------------------- ASSETS - ------------------------------------------------------------------------------- Federal funds sold and other $88,855 $ 3,840 4.32% Investment securities: Negotiable money market investments 86,977 3,703 4.26 Taxable investment securities 962,001 54,984 5.72 Nontaxable investment securities(1) 138,949 13,556 9.76 Loans held for resale 15,624 1,164 7.45 Consumer loans (2) (3) 830,669 72,168 8.69 Real estate loans (1) (2) (3) 1,534,542 124,682 8.13 Commercial loans (1) (2) (3) 556,471 45,409 8.16 - ------------------------------------------------------------------------------- Total earning assets 4,214,088 $319,506 7.59% - ------------------------------------------------------------------------------- Allowance for credit losses (40,939) Other assets 272,283 - ------------------------------------------------------------------------------- Total Assets $4,445,432 - ------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------------------------------------------------- NOW $449,330 $ 7,261 1.62% Savings 457,065 9,278 2.03 Money market 506,229 11,126 2.20 Time deposits 1,776,172 83,507 4.70 Short-term borrowings 188,662 6,671 3.54 FHLB borrowings 130,264 6,446 4.95 Long-term debt 6,676 495 7.41 - ------------------------------------------------------------------------------- Total interest-bearing liabilities 3,514,398 $124,784 3.55% - ------------------------------------------------------------------------------- Demand deposits 462,414 Other liabilities 64,628 Shareholders' equity 403,992 - ------------------------------------------------------------------------------- Total Liabilities and Equity $4,445,432 - ------------------------------------------------------------------------------- Interest rate spread 4.04% - ------------------------------------------------------------------------------- Net interest income and net interest margin $194,722 4.63% Tax-equivalent adjustment (6,304) - ------------------------------------------------------------------------------- Net interest income $188,418 - ------------------------------------------------------------------------------- 86 The following table sets forth for the periods indicated a summary of the changes in interest earned and interest paid resulting from changes in volume and changes in rates (in thousands): 1996 change from 1995 Total Change due to(4) Change Volume Rate - ------------------------------------------------------------------------------- Interest income on: Federal funds sold and other ($2,906) ($2,172) ($ 734) Investment securities(1) 6,267 6,778 (511) Loans held for resale 3,052 2,790 262 Loans and leases (1)(2)(3) 13,451 14,750 (1,299) - ------------------------------------------------------------------------------- 19,864 22,146 (2,282) Interest expense on: NOW 1,533 85 1,448 Savings 906 562 344 Money market 1,101 (412) 1,513 Time deposits (11,582) (11,548) (34) Short-term borrowings (1,329) (2,490) 1,161 FHLB borrowings 1,060 1,570 (510) Long-term debt 132 200 (68) - ------------------------------------------------------------------------------- (8,179) (12,033) 3,854 - ------------------------------------------------------------------------------- Net Interest Income Change - Tax Equivalent $11,685 $10,113 $1,572 - ------------------------------------------------------------------------------- 1995 change from 1994 Total Change due to(4) Change Volume Rate - ------------------------------------------------------------------------------- Interest income on: Federal funds sold and other $ 4,469 $ 2,745 $1,724 Investment securities(1) ( 2,445) ( 6,536) 4,091 Loans held for resale 472 440 32 Loans and leases (1)(2)(3) 47,547 28,849 18,698 - ------------------------------------------------------------------------------- 50,043 25,498 24,545 Interest expense on: NOW (45) 296 (341) Savings 637 767 (130) Money market 525 2,092 (1,567) Time deposits (35,035) (18,066) (16,969) Short-term borrowings (3,524) (821) (2,703) FHLB borrowings (4,381) (2,623) (1,758) Long-term debt 28 135 (107) - ------------------------------------------------------------------------------- (41,795) (18,220) (23,575) - ------------------------------------------------------------------------------- Net Interest Income Change - Tax Equivalent $8,248 $ 7,278 $970 - ------------------------------------------------------------------------------- (1) Interest income and yields are adjusted to a fully taxable-equivalent basis using a 35% tax rate. (2) Non-performing loans are included in the average balances. (3) Interest on loans includes fees on loans of $3,876,000 in 1996, $2,300,000 in 1995, and $3,616,000 in 1994. (4) The change in interest due to both rate and volume has been allocated to the volume and rate changes in proportion to the absolute dollar amounts of each change. 87 GAP Interest rate sensitivity is evidenced by the changes in net interest income and net interest margin relative to changes in market interest rates. One indicator of interest rate sensitivity is GAP, which measures the volume difference between interest rate sensitive assets and liabilities. The following table provides a detailed analysis of Keystone's GAP position at the end of 1996 (in thousands):
Rate Sensitive - -------------------------------------------------------------------------------------------------------------------- 1 to 90 91 to 180 181 to 360 1 to 2 Beyond Days Days Days Years 2 Years Total - -------------------------------------------------------------------------------------------------------------------- ASSETS - -------------------------------------------------------------------------------------------------------------------- Federal funds sold and other $ 78,354 $ - $ - $ - $ - $ 78,354 Investment securities 263,590 33,021 71,689 270,647 597,391 1,236,338 Loans held for resale 51,225 - - - - 51,225 Consumer loans 273,012 82,230 153,102 252,048 424,558 1,184,950 Consumer mortgages 111,596 84,469 165,022 54,030 378,893 794,010 Commercial real estate loans 376,794 42,738 67,385 64,378 319,283 870,578 Commercial loans 527,571 13,513 18,949 28,836 115,255 704,124 - -------------------------------------------------------------------------------------------------------------------- Total earning assets 1,682,142 255,971 476,147 669,939 1,835,380 4,919,579 - -------------------------------------------------------------------------------------------------------------------- Other assets - - - - 311,689 311,689 - -------------------------------------------------------------------------------------------------------------------- TOTAL ASSETS $1,682,142 $ 255,971 $476,147 $669,939 $2,147,069 $5,231,268 ==================================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY - -------------------------------------------------------------------------------------------------------------------- NOW $ 153,615 $ - $ - $ - $ 261,561 $ 415,176 Savings 106,220 - - - 260,055 366,275 Money market 200,632 3,382 3,382 - 181,353 388,749 Time deposits 1,013,271 302,083 331,790 419,723 348,113 2,414,980 Short-term borrowings 323,290 1,570 1,210 - - 326,070 FHLB borrowings 11,597 42,821 43,266 29,176 79,069 205,929 Long-term debt 2,110 44 - - - 2,154 - -------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 1,810,735 349,900 379,648 448,899 1,130,151 4,119,333 - -------------------------------------------------------------------------------------------------------------------- Demand deposits - - - - 511,931 511,931 Other liabilities - - - - 92,697 92,697 Shareholders' equity - - - - 507,307 507,307 - -------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $1,810,735 $ 349,900 $ 379,648 $448,899 $2,242,086 $5,231,268 ==================================================================================================================== Interest Rate Sensitivity $ (128,593) $ (93,929) $ 96,499 $221,040 $ (95,017) - -------------------------------------------------------------------------------------------------------------------- Cumulative GAP $ (128,593) $(222,522) $(126,023) $ 95,017 - --------------------------------------------------------------------------------------------------------------------
88 Other Liquidity Elements The predominant source of income from earning assets is derived from the loan portfolio. Commercial loans and commercial loans secured by real estate comprise 44% of total loans and are closely monitored in terms of the volume of loans which are sensitive to changes in interest rates. The following table shows the maturity of commercial loans and commercial loans secured by real estate as of December 31, 1996, classified according to the sensitivity to changes in interest rates within various time intervals (in thousands):
After One But Within After Within Five Five One Year Years Years Total - ------------------------------------ ----------- ---------- ----------- ------------ Commercial $374,975 $201,318 $127,831 $704,124 Commercial real estate 174,860 326,154 369,564 870,578 - ------------------------------------ ----------- ---------- ----------- ------------ $549,835 $527,472 $497,395 $1,574,702 - ------------------------------------ ----------- ---------- ----------- ------------ Loans maturing after one year with: Fixed interest rates: Commercial $79,460 $35,287 Commercial real estate 150,165 205,982 Variable interest rates: Commercial 121,858 92,544 Commercial real estate 175,989 163,582 - ------------------------------------ ----------- ---------- ----------- ------------ Total $527,472 $497,395 ==================================== =========== ========== =========== ============
Deposits with balances exceeding $100,000 and short-term borrowings are not considered core funding sources because they are generally short-term in nature and are subject to competitive bids. The following is a maturity summary of deposits of $100,000 or more at December 31, 1996 (in thousands): Certificates of Other Time Deposit of Deposits of $100,000 or more $100,000 or more - ----------------------------------- ------------------ ------------------ 3 months or less $122,460 $6,102 Over 3 months through 6 months 33,213 3,237 Over 6 months through 12 months 41,163 4,297 Over 12 months 60,109 18,175 - ----------------------------------- ------------------ ------------------ Total $256,945 $31,811 =================================== ================== ================== 89 The following table presents the amounts and interest rates for federal funds purchased and security repurchase agreements for each of the last three years (in thousands):
1996 1995 1994 - ---------------------------------------------- ------------ ----------- ------------ Balance at December 31, $299,895 $260,543 $239,652 Weighted average interest rate at year end 4.67% 4.34% 4.75% Maximum amount outstanding at any month end $299,895 $260,543 $239,652 Average amount outstanding during the year $248,814 $197,374 $177,833 Weighted average interest rate during the year 4.45% 4.89% 3.71% - ---------------------------------------------- ------------ ----------- ------------
Investment Portfolio Analysis - ----------------------------- Keystone's investment policy specifically addresses the use of derivatives and other hedging activities and provides for specific restrictions on the type and extent of Keystone's exposure. A narrow definition of financial derivatives includes off-balance sheet instruments such as futures, forwards, swaps, and options which are designed to manage various types of business risks. Keystone has made limited use of the off-balance sheet derivatives known as "interest rate swaps" as a means to manage the income exposure associated with changes in interest rates, as well as forward commitments, put options, and short sales to manage exposure to market risk. A broader definition of derivatives would include any financial instrument which derives its value, or contractually required cash flows, from the price of some other security or index. Keystone's investment in this form of financial derivatives is limited to some forms of collateralized mortgage obligations (CMO's) and structured notes. The following is a brief description of both "on" and "off"-balance sheet derivatives and other hedging activity utilized by Keystone. Interest Rate Swaps - ------------------- Interest rate swaps are "off"-balance sheet instruments which provide for the exchange of interest payments on a specified principal amount (notional amount) for a specified period of time. Investment policy requires that Keystone may execute a swap contract only as a hedge of an interest rate position and not for the purpose of speculation or trading. That policy further requires that swap contracts must be approved in advance by the affiliate banks' president and parent company executives, and that swap counterparties must be reviewed for credit worthiness on at least an annual basis. Keystone's policy also sets forth specific limitations on exposure to a single counterparty and sets an aggregate limit on the notional value of interest rate swaps at 50% of capital. At December 31, 1996 Keystone's swap activity aggregated $7,000,000 in amortized notional value. Other Hedging Activity - ---------------------- Forward mortgage commitments, as well as put options and short sales of U.S. Treasury securities, are used to reduce the market risk, associated with interest rate fluctuations, of fixed-rate consumer mortgages and indirect automobile loans held for sale. In accordance with Keystone's written policy, such transactions 90 must be ratified by the Board of Directors and can only be executed as a hedge of market risk and not for the purpose of speculation or trading. Such activity is self-limited by the level of loan production. CMO's - ----- Purchases of CMO's are restricted principally to U.S. Government issues that have passed various regulatory standards associated with mortgage extension or prepayment risk. All Keystone CMO holdings can be disaggregated into groupings which more accurately define the extent of mortgage extension or prepayment risk, and include PAC's (planned amortization class), VADM's (very accurately defined maturity), TAC's (targeted amortization class) and others. All CMO's are subject to at least annual examination to ensure compliance with regulatory standards. CMO's which fail to meet these standards are disclosed to the Board of Directors and are subjected to special review and monitoring procedures. Other more volatile forms of CMO's include interest-only, principal-only, and inverse floating bonds, which are subject to even more stringent limits set forth in Keystone's investment policy. At December 31, 1996, Keystone had none of these volatile forms of CMO's in its investment portfolio. An even higher-risk form of CMO's, known as CMO residuals, are specifically designated as prohibited investments under Keystone's investment policy. Structured Notes - ---------------- A structured note is a debt security whose cash flow characteristics, including coupon rate or redemption date may be dependent on one or more indices or future cash flow adjustment. Keystone's activity in structured notes has been limited to U.S. Government Agency "step- up" notes purchased in years prior to 1995, which have specified call or redemption features, or are subject to pre-specified coupon adjustments. Keystone's investment in structured notes is also limited by investment policy guidelines and aggregated $3,500,000 at the end of 1996. 91 The following presentation provides an analysis of the composition of investments included in both investments available-for-sale and investments held-to-maturity. This comparison includes a detailed presentation of derivative financial instruments included in the U.S. Government agency category (in thousands): December 31, 1996 - -------------------------------------- ---------------------------------------- Amortized Market Unrealized Cost Value Gain/(Loss) - -------------------------------------- ------------- ------------ ------------- U.S. Government Agency Obligations: Conventional $446,397 $444,233 $(2,164) Mortgage-backed 100,308 100,727 419 CMO's: PAC's1 32,202 31,949 (253) VADM's2 5,517 5,409 (108) TAC's3 12,927 12,785 (142) Other 12,701 12,603 (98) Structured notes 3,500 3,475 (25) - -------------------------------------- ------------- ------------ ------------- Subtotal 613,552 611,181 (2,371) - -------------------------------------- ------------- ------------ ------------- Negotiable money market instruments 194,566 194,566 ----- U.S. Treasury securities 198,099 198,376 277 State and political subdivision obligations 134,194 137,367 3,173 Corporate and other 97,620 98,416 796 - -------------------------------------- ------------- ------------ ------------- Total $1,238,031 $1,239,906 $1,875 ====================================== ============= ============ ============= 1. A PAC(planned amortization class) has a principal payment schedule that is guaranteed within a predetermined range of mortgage prepayment rates, i.e. has built-in call protection, lower prepayment risk and lower average life variability. 2. A VADM(very accurately defined maturity) has a stated final payment date which provides protection from mortgage payment extension risk. 3. A TAC(targeted amortization class) has a payment schedule that offers some call protection if mortgage prepayments increase, but little to no extension protection if prepayments slow down. Credit Risk and Loan Portfolio Analysis Keystone's objective as a lending institution is to profitably meet the credit needs of the communities in which it operates. Credit risk and lending practices are governed by written policies and procedures which have been designed to provide for an acceptable level of risk and compensating return. These policies have also established requirements for lending authority, underwriting practices, collateral standards, lending concentrations, geographic limits, and other important elements of the credit process. Significant policies are reviewed, at a minimum, on an annual basis. Keystone maintains a corporate loan review function which is independent of the underwriting and administrative process. Loan review performs continuous reviews to determine adherence to credit policies, assess the effectiveness of the credit process, and objectively evaluate the quality of the loan portfolio. In connection with these reviews, adversely classified credits within the portfolio are identified and included on a classified loan report, which is reviewed by management on a monthly basis. 92 Loan Composition - ---------------- Keystone maintains a diverse loan portfolio. The composition of Keystone's loan portfolio is illustrated in the following comparison of loan balances at the end of each of the last five years (in thousands):
1996 1995 1994 1993 1992 - ------------------ ------------- ------------- ------------ ------------- ------------ Commercial: Commercial and industrial $498,657 $448,639 $398,450 $374,790 $387,707 Floor plan financing 168,521 163,431 146,582 112,740 110,478 Obligations of political subdivisions 36,946 31,159 29,796 29,253 35,757 - ------------------ ------------- ------------- ------------ ------------- ------------ 704,124 643,229 574,828 516,783 533,942 - ------------------ ------------- ------------- ------------ ------------- ------------ Commercial Real Estate: Commercial and industrial 683,358 680,161 692,962 660,379 654,720 Multi-family residential 76,830 73,079 64,277 69,749 43,961 Obligations of political subdivisions 29,686 33,010 31,023 27,037 35,778 Construction and land development 72,083 73,211 57,634 52,754 58,431 Agricultural 8,621 8,853 9,563 9,896 13,605 - ------------------ ------------- ------------- ------------ ------------- ------------ 870,578 868,314 855,459 819,815 806,495 - ------------------ ------------- ------------- ------------ ------------- ------------ Consumer: Real estate 794,010 $828,059 $811,945 $703,543 $721,536 Installment 552,533 562,592 587,951 486,750 437,962 Home equity 294,459 239,915 209,323 166,786 178,401 Personal lines of credit 36,475 39,053 42,167 26,451 50,474 Leases 301,483 184,554 111,732 55,070 56,525 - ------------------ ------------- ------------- ------------ ------------- ------------ 1,978,960 1,854,173 1,763,118 1,438,600 1,444,898 - ------------------ ------------- ------------- ------------ ------------- ------------ Total $3,553,662 $3,365,716 $3,193,405 $2,775,198 $2,785,335 ================== ============= ============= ============ ============= ============
93 Concentration Risk - ------------------ The diversity of Keystone's loan portfolio is an end result of Keystone's effort to manage credit risk. Keystone's credit policy has established specific limits on the level of credit to a borrower or single group of borrowers, which serve to reduce concentration risk. This diversity is evidenced by the absence of industry and customer concentrations. o The largest group of customers in a single industry to whom Keystone provides credit extensions is automobile dealers. At December 31, 1996 credit extensions totaling $203,728,000 were outstanding, and consisted of floor plan and related commercial loans and mortgages. o Keystone has no dependence on a single customer. The top ten credit relationships account for only 4.8% of the total loans outstanding at the end of 1996. Geographic Risk - --------------- In addition to industry or customer concentrations, credit risk is also affected by the geographic characteristics of the loan portfolio. The credit risk profile of Keystone's portfolio is enhanced by the stable economic climate and the industry diversification of Keystone's-defined market. o The overwhelming majority of Keystone's lending activities, approximately 97%, are conducted within its own defined market. o Keystone has no foreign loan exposure. Categories of Exposure - ---------------------- Keystone's loan portfolio can be evaluated in terms of its exposure to certain types of loans which are presumed to exhibit a higher degree of credit risk. Examples include credit extensions for highly leveraged transactions, speculative real estate ventures, or certain commercial real estate loans. These types of loans may subject a lender to a higher level of loss from economic downturns, dramatic changes in interest rates, or depressed real estate markets. The following comments provide insight into this aspect of Keystone's loan profile. o Keystone has not been active in the organization, syndication, or purchase of highly leveraged transactions. o Keystone's commercial real estate lending practice requires an evaluation of the borrower's ability to repay debt from cash flow provided through operations. The underlying value of real estate is viewed as a secondary source of repayment. In addition, Keystone's lending practices generally require guarantees, endorsements, and other forms of recourse which provide additional security for such credits. 94 Keystone has examined its exposure to commercial and commercial real estate loans. This examination included a review of all customer account relationships and classification of credits into risk-related categories. The following table summarizes the commercial and commercial real estate segments of the portfolio (in thousands): December 31, 1996 - ----------------------------------------------------------- Average Balance Relationship - ----------------------------- ------------ -------------- Commercial loans $704,124 Commercial real estate 870,578 - ----------------------------- ------------ -------------- $1,574,702 $104 - ----------------------------- ------------ -------------- At December 31, 1996, approximately 48% of the balance of commercial real estate was nonowner occupied. Individual categories of nonowner-occupied in excess of $50 million were office buildings and apartment/rental units which totaled $127,741,000 and $104,064,000, respectively. Secondary Market Activity - ------------------------- Keystone sells a significant portion of its fixed consumer mortgages and securitized indirect automobile loans to secondary market investors. Keystone recognizes an income stream from the servicing of these loans subsequent to the sale. The sale of these loans enables mortgage loans and indirect automobile loans to be self-funding activities. Allocation of Allowance - ----------------------- The allowance for credit losses is maintained at a level adequate to absorb losses associated with credit risk. Management exercises its judgment to allocate the allowance to specific categories of loans. The following table summarizes the allocation of the allowance for credit losses at December 31, (in thousands): 1996 1995 1994 1993 1992 - -------------------------- --------- ---------- --------- ---------- ---------- Commercial $9,594 $11,226 $10,501 $10,543 $10,418 Real estate secured: Commercial 7,696 7,637 6,884 9,373 10,479 Consumer 1,541 1,322 1,615 2,106 2,443 Consumer 12,566 7,602 6,888 6,661 7,949 General risk 13,619 16,590 16,552 11,498 7,651 - -------------------------- --------- ---------- --------- ---------- ---------- $45,016 $44,377 $42,440 $40,181 $38,940 ========================== ========= ========== ========= ========== ========== While management has apportioned the allowance to the different loan categories, the allowance is general in nature and is available for the loan portfolio in its entirety. Keystone assesses the reasonableness of the allocation of the allowance by preparing a percentage-based comparison of the allocated allowance to the actual loan portfolio. At December 31, the following comparison is provided: 95
1996 1995 1994 1993 1992 - ------------------------------ ---------- ---------- --------- ---------- --------- Commercial: % of Total loans 20% 19% 18% 19% 19% % Allocation of allowance 21% 25% 25% 26% 27% Commercial real estate: % of Total loans 24% 26% 27% 30% 29% % Allocation of allowance 17% 17% 16% 23% 27% Consumer real estate: % of Total loans 22% 25% 25% 25% 26% % Allocation of allowance 3% 3% 4% 5% 6% Consumer: % of Total loans 34% 30% 30% 26% 26% % Allocation of allowance 28% 17% 16% 17% 20% General Risk: % Allocation of allowance 31% 38% 39% 29% 20% - ------------------------------ ---------- ---------- --------- ---------- --------- Total loans 100% 100% 100% 100% 100% - ------------------------------ ---------- ---------- --------- ---------- --------- Allocation of allowance 100% 100% 100% 100% 100% - ------------------------------ ---------- ---------- --------- ---------- ---------
96 QUARTERLY INFORMATION Income Performance
(in thousands, except per share data) 1996 - ------------------------------ ----------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter - ------------------------------ ------------- ------------- ------------ ------------ Interest income $97,911 $96,599 $94,596 $95,415 Interest expense 45,073 44,700 42,161 42,824 - ------------------------------ ------------- ------------- ------------ ------------ Net interest income 52,838 51,899 52,435 52,591 Provision for credit losses 3,522 2,312 2,036 1,988 - ------------------------------ ------------- ------------- ------------ ------------ Net interest income after provision 49,316 49,587 50,399 50,603 Noninterest income 16,536 15,373 14,782 15,426 Security transactions 3 ----- 101 452 Noninterest expense 40,762 40,781 39,519 41,497 - ------------------------------ ------------- ------------- ------------ ------------ Income before income taxes 25,093 24,179 25,763 24,984 Income Taxes 7,233 7,154 8,030 8,127 - ------------------------------ ------------- ------------- ------------ ------------ Net income $17,860 $17,025 $17,733 $16,857 - ------------------------------ ------------- ------------- ------------ ------------ Tax effect of security transactions $ 1 $----- $35 $158 - ------------------------------ ------------- ------------- ------------ ------------ Earnings per share $0.47 $0.45 $0.47 $0.44 Dividends per share $0.26 $0.24 $0.24 $0.24 Average shares outstanding 38,043,623 38,164,065 38,022,920 37,950,453 - ------------------------------ ------------- ------------- ------------ ------------
97
1995 - ------------------------------ ----------------------------------------------------- (in thousands, except per Fourth Third Second First share data) Quarter Quarter Quarter Quarter - ------------------------------ ------------- ------------- ------------ ------------ Interest income $93,646 $91,426 $90,101 $88,758 Interest expense 43,239 42,930 41,378 39,032 - ------------------------------ ------------- ------------- ------------ ------------ Net interest expense 50,407 48,496 48,723 49,726 Provision for credit losses 1,357 2,160 2,258 2,084 - ------------------------------ ------------- ------------- ------------ ------------ Net interest income after provision 49,050 46,336 46,465 47,642 Noninterest income 12,427 13,112 12,011 11,454 Security transactions 925 6 354 32 Noninterest expense 38,338 36,806 37,557 37,933 - ------------------------------ ------------- ------------- ------------ ------------ Income before income taxes 24,064 22,648 21,273 21,195 Income Taxes 7,860 7,215 6,252 6,539 - ------------------------------ ------------- ------------- ------------ ------------ Net income $16,204 $15,433 $15,021 $14,656 - ------------------------------ ------------- ------------- ------------ ------------ Tax effect of security transactions $324 $2 $124 $11 - ------------------------------ ------------- ------------- ------------ ------------ Earnings per share $0.45 $0.43 $0.43 $0.42 Dividends per share $0.24 $0.23 $0.23 $0.23 Average shares outstanding 36,142,553 35,352,675 35,197,571 35,146,901 - ------------------------------ ------------- ------------- ------------ ------------
98 STOCK INFORMATION Market Prices and Dividends The common stock of Keystone Financial, Inc. is traded in the over-the-counter market under the symbol KSTN and is listed in the National Market System of NASDAQ. At the close of business on January 31, 1997, there were approximately 12,094 shareholders of record. The table below sets forth the quarterly range of high and low closing sales prices for Keystone common stock as reported by NASDAQ and dividends declared per common share. Quarterly Closing Cash Sales Price Range Dividends - ----------------------------------------------------------- High Low - -------------------- ------------ ------------ ------------ 1996 - -------------------- ------------ ------------ ------------ I $22.83 $19.83 $0.24 II 22.75 20.75 0.24 III 25.33 21.67 0.24 IV 27.75 24.50 0.26 - -------------------- ------------ ------------ ------------ $0.98 ==================== ============ ============ ============ 1995 - -------------------- ------------ ------------ ------------ I $20.17 17.50 $0.23 II 19.33 18.00 0.23 III 21.50 18.50 0.23 IV 22.67 19.67 0.24 - -------------------- ------------ ------------ ------------ $0.93 ==================== ============ ============ ============ While Keystone is not obligated to pay cash dividends, the Board of Directors presently intends to continue the policy of paying quarterly dividends. Future dividends will depend, in part, upon the earnings and financial condition of Keystone. The payment of dividends is subject to applicable regulatory rules and policies. See the dividend and loan restriction information listed in the notes to the consolidated financial statements. 99 EX-22.1 3 SUBSIDIARIES OF REGISTRANT Jurisdiction of Incorporation ------------------ First Tier Subsidiaries of Registrant: American Trust Bank, N.A. United States Frankford Bank, N.A. United States Keystone National Bank United States Mid-State Bank and Trust Company Pennsylvania Northern Central Bank Pennsylvania Pennsylvania National Bank and Trust Company United States Keystone Financial Unlimited Pennsylvania Key Trust Company Pennsylvania Keystone CDC, Inc. Pennsylvania Keystone Financial Community Development Corporation I, Inc. Pennsylvania Keystone Financial Life Insurance Company Arizona Keystone Investment Services, Inc. Delaware Martindale Andres & Company Pennsylvania Second Tier Subsidiaries of Registrant: Keystone Financial Leasing Corporation Pennsylvania LBCMD Corporation Delaware Keystone Financial Mortgage Corporation Pennsylvania Keystone Brokerage, Inc. Pennsylvania Key Investor Services, Inc. Maryland Key Investor Services, Inc. Pennsylvania Key Investor Services, Inc. West Virginia ATB Holding Company, Inc. Delaware ATB Real Estate Investment Trust, Inc. Maryland 100 EX-23.1 4 CONSENT OF INDEPENDENT AUDITORS CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Regarding: 1) Registration Statement on Form S-8 relating to the 1988 Stock Incentive Plan (File #33-38427). 2) Registration Statement on Form S-3 relating to the Dividend Reinvestment Plan (File #333-02063). 3) Registration Statement on Form S-8 relating to the 1992 Director Fee Plan (File #33-48031). 4) Registration Statement on Form S-3 relating to the Main Line Bancshares, Inc. Stock Option Agreements (File #33-50526). 5) Registration Statement on Form S-8 relating to the 1990 Non- Employee Directors' Stock Option Plan (File #33-59372). 6) Registration Statement on Form S-8 relating to the 1992 Stock Incentive Plan (File #33-68800). 7) Registration Statement on Form S-8 relating to the Elmwood Bancorp, Inc. Key Employee Stock Compensation Program (File #33-77358) 8) Registration Statement on Form S-8 relating to the Amended and Restated Nonqualified Stock Option Agreement with Donald E. Stone (File #33-77354). 9) Registration Statement on Form S-8 relating to The Frankford Corporation 1983 Incentive Stock Option Plan (File #33-82088). 10) Registration Statement on Form S-8 relating to the 1995 Employee Stock Purchase Plan (File #33-91572). 11) Registration Statement on Form S-8 relating to the 1995 Management Stock Purchase Plan (File #33-91574). 12) Registration Statement on Form S-8 relating to the National American Bancorp, Inc. 1994 Employee Stock Option Plan (File # 333-02065). 13) Registration Statement on Form S-8 relating to the 1995 Non-Employee Director's Stock Option Plan (File # 333-04281). We consent to the incorporation by reference in the above listed Registration Statements of our report dated, January 31, 1997, with respect to the consolidated financial statements of Keystone Financial, Inc. and subsidiaries incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 1996. ERNST & YOUNG LLP Pittsburgh, Pennsylvania March 7, 1997 101 EX-27.1 5 FINANCIAL DATA SCHEDULE
9 This schedule contains summary financial information extracted from the financial statements and statistical disclosures referenced within item 14(a)(1)(2) and item 1 of the Form 10-K and is qualified in its entirety by reference to such financial statements and statistical disclosures. 1,000 12-MOS DEC-31-1996 DEC-31-1996 167,403 36,642 41,712 0 856,380 379,958 383,526 3,553,662 45,016 5,231,268 4,097,111 326,070 92,697 208,083 0 0 76,456 430,851 5,231,268 301,856 72,574 10,091 384,521 153,132 174,758 209,763 9,858 556 162,559 100,019 69,475 0 0 69,475 1.83 1.83 3.75 18,913 17,649 393 9,074 44,377 11,452 2,233 45,016 45,016 0 0
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