10-K 1 d54428_10-k.txt FORM 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2002 |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 0-26481 FINANCIAL INSTITUTIONS, INC. (Exact Name of Registrant as specified in its charter) NEW YORK 16-0816610 (State of Incorporation) (I.R.S. Employer Identification Number) 220 Liberty Street Warsaw, NY 14569 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number Including Area Code: (585) 786-1100 Securities Registered Pursuant to Section 12(b) of the Act: NONE Securities Registered Pursuant to Section 12(g) of the Act: Title of Class: COMMON STOCK, PAR VALUE $.01 PER SHARE 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 twelve 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). 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 amendments to this Form 10-K. |_| Aggregate market value of common stock held by non-affiliates of the registrant, computed by reference to the closing price as of close of business on June 30, 2002 was $319,871,757. As of March 12, 2003 there were issued and outstanding, exclusive of treasury shares, 11,109,664 shares of the Registrant's Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's proxy statement filed with the Securities and Exchange Commission in connection with the 2003 Annual Meeting of Shareholders are incorporated by reference in Part III of this Annual Report on Form 10-K. FINANCIAL INSTITUTIONS, INC. 2002 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS PART I Item 1. Business 3 Item 2. Properties 19 Item 3. Legal Proceedings 20 Item 4. Submission of Matters to a Vote of Security Holders 20 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 20 Item 6. Selected Financial Data 21 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 23 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 42 Item 8. Financial Statements and Supplementary Data 45 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74 PART III Item 10. Directors and Executive Officers of the Registrant 74 Item 11. Executive Compensation 74 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 74 Item 13. Certain Relationships and Related Transactions 74 PART IV Item 14. Controls and Procedures 74 Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 75 2 PART I Item I. Business General Financial Institutions, Inc. (the "Company" or "FII") is a financial holding company headquartered in Warsaw, New York, which is located 45 miles southwest of Rochester and 45 miles southeast of Buffalo. The Company operates a super-community bank holding company - a bank holding company that owns multiple community banks that are separately managed. The Company owns four commercial banks that provide consumer, commercial and agricultural banking services in Western and Central New York State: Wyoming County Bank ("WCB"), The National Bank of Geneva ("NBG"), First Tier Bank & Trust ("FTB") and Bath National Bank ("BNB"), collectively referred to as the "Banks". During 2002, the Company completed a geographic realignment of the subsidiary banks, which involved the merger of the subsidiary formerly known as The Pavilion State Bank ("PSB") into NBG and transfer of other branch offices between subsidiary banks. In recent years, the Company has grown through a combination of internal growth, the opening of new branch offices and acquisitions. The Company became qualified in May 2000 as a financial holding company (see Gramm-Leach-Bliley Act discussion beginning on page 14), and has since incorporated two financial services subsidiaries into its operations: Burke Group, Inc. ("BGI") and The FI Group, Inc. ("FIGI"), collectively referred to as the "Financial Services Group" ("FSG"). BGI is an employee benefits and compensation consulting firm acquired by the Company in October 2001. FIGI is a brokerage subsidiary that commenced operations as a start-up company in March 2000. In February 2001, the Company formed FISI Statutory Trust I ("FISI"), to accommodate the private placement of $16.2 million in capital securities, the proceeds of which were utilized to partially fund the acquisition of Bath National Corporation ("BNC"). The capital securities are identified on the consolidated statements of financial condition as guaranteed preferred beneficial interests in corporation's junior subordinated debentures. We make available free of charge through our website at www.fiiwarsaw.com all reports we electronically file with, or furnish to, the Securities and Exchange Commission, or "SEC," including our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to those reports, as soon as reasonably practicable after those documents are filed with, or furnished to, the SEC. These filings are also accessible on the SEC's website at www.sec.gov. As a super-community bank holding company, the Company's strategy has been to manage its bank subsidiaries on a decentralized basis. This strategy provides the Banks the flexibility to efficiently serve their markets and respond to local customer needs. While generally operating on a decentralized basis, the Company has consolidated selected lines of business, operations and support functions in order to achieve economies of scale, greater efficiency and operational consistency. In furtherance of this objective, the Company hired a Senior Credit Executive in September 2002 to review Company-wide credit policies and develop and implement recommendations for strengthened, centralized credit administration. By increasing the use of existing technology and by further centralizing back-office operations, management believes substantial additional growth can be accomplished without incurring proportionately greater operational costs. The relative sizes and profitability of the Company's operating subsidiaries in thousands of dollars as of and for the year ended December 31, 2002, are depicted in the following table: Percent Percent Subsidiary Assets of Total Net Income of Total -------------------------------------------------------------------------------- Wyoming County Bank $ 674,755 32 $ 10,565 40 The National Bank of Geneva 721,090 34 9,765 37 Bath National Bank 495,055 24 5,001 19 First Tier Bank & Trust 203,382 10 2,775 10 Financial Services Group 5,052 -- 246 1 Parent and eliminations, net 5,700 -- (1,896) (7) ---------- --- -------- ---- Total $2,105,034 100 $ 26,456 100 ========== === ======== ==== 3 Mergers and Acquisitions On December 13, 2002, BNB acquired the two Chemung County branch offices of BSB Bank & Trust Company of Binghamton, New York. The two offices purchased, located in Elmira and Elmira Heights, had deposit liabilities totaling $44.2 million at the time of acquisition. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, of approximately $1.5 million has been recorded as goodwill. In accordance with Statement of Financial Accounting Standard (SFAS) No. 142, "Goodwill and Other Intangible Assets," the Company is not required to amortize goodwill recognized in this acquisition. The Company also recorded a $2.0 million intangible asset attributable to core deposits, which is being amortized using the straight-line method over seven years. The 2002 results of operations include the results from the branches from the date of acquisition (December 13, 2002). On May 1, 2002, FII acquired all of the common stock of the Bank of Avoca ("BOA") in exchange for 47,036 shares of FII common stock. BOA was a community bank with its main office located in Avoca, New York, as well as a branch office in Cohocton, New York. Subsequent to the acquisition, BOA was merged with BNB. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price ($1.5 million) over the fair value of identifiable tangible and intangible assets acquired ($18.4 million), less liabilities assumed ($17.3 million), of approximately $0.4 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company recorded a $146,000 core deposit intangible asset, which is being amortized using the straight-line method over seven years. The 2002 results of operations for BOA are included in the income statements from the date of acquisition (May 1, 2002). On October 22, 2001, the Company acquired the Burke Group, Inc. ("BGI"), an employee benefits administration and compensation consulting firm, with offices in Honeoye Falls and Syracuse, New York. BGI's expertise includes design and consulting for retirement and employee welfare plans, administrative services for defined contribution and benefit plans, actuarial services and post employment benefits. Under the terms of the agreement, BGI shareholders received primarily common stock as consideration for their ownership in BGI. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price ($3.3 million including earned amounts and contingent amounts to date - see Note 2 of the notes to consolidated financial statements for additional discussion regarding the merger consideration) over the fair value of identifiable tangible and intangible assets acquired ($1.7 million), less liabilities assumed ($1.7 million), of approximately $3.3 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company also recorded a $500,000 intangible asset for a customer list which is being amortized using the straight-line method over five years. The results of operations for BGI are included in the income statements from the date of acquisition (October 22, 2001). On May 1, 2001, FII acquired all of the common stock of Bath National Corporation ("BNC") , and its wholly-owned subsidiary bank, Bath National Bank. BNB is a full service community bank headquartered in Bath, New York, which has 9 branch locations in Steuben, Yates, Ontario and Schuyler Counties. The Company paid $48.00 per share in cash for each of the outstanding shares of BNC common stock with an aggregate purchase price of approximately $62.6 million. The acquisition was accounted for under the purchase method of accounting, and accordingly, the excess of the purchase price ($62.6 million) over the fair value of identifiable tangible and intangible assets acquired ($295.4 million), less liabilities assumed ($269.9 million), of approximately $37.1 million has been recorded as goodwill. Goodwill was amortized in 2001 using the straight-line method over 15 years, since the transaction was consummated prior to June 30, 2001, the effective date of SFAS No. 142. However, in accordance with SFAS No. 142, the Company ceased goodwill amortization on January 1, 2002. The results of operations for BNB are included in the income statements from the date of acquisition (May 1, 2001). 4 Forward Looking Statements This Report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that involve substantial risks and uncertainties. When used in this report, or in the documents incorporated by reference herein, the words "anticipate", "believe", "estimate", "expect", "intend", "may", and similar expressions identify such forward-looking statements. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. These forward-looking statements are based on the current expectations of the Company or the Company's management and are subject to a number of risks and uncertainties, including but not limited to, economic, competitive, regulatory, and other factors affecting the Company's operations, markets, products and services, as well as expansion strategies and other factors discussed elsewhere in this report filed by the Company with the Securities and Exchange Commission. Many of these factors are beyond the Company's control. Market Area and Competition The Company provides a wide range of consumer and commercial banking services to individuals, municipalities and businesses through a network of 47 branches and 62 ATMs in thirteen contiguous counties of Western and Central New York State: Allegany, Cattaraugus, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Schuyler, Seneca, Steuben, Wyoming and Yates Counties. The Company's market area is geographically and economically diversified in that it serves both rural markets and, increasingly, the larger more affluent markets of suburban Rochester and suburban Buffalo. Rochester and Buffalo are the two largest cities in New York State outside of New York City, with combined metropolitan area populations of over two million people. The Company anticipates increasing its presence in the markets around these two cities. The Company faces significant competition in both making loans and attracting deposits, as Western and Central New York have a high density of financial institutions. The Company's competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial service companies. Its most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks and credit unions. The Company faces additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies. Lending Activities General. The Company, through its banking subsidiaries, offers a broad range of loans including commercial and agricultural working capital and revolving lines of credit, commercial and agricultural mortgages, equipment loans, crop and livestock loans, residential mortgage loans and home equity lines of credit, home improvement loans, student loans, automobile loans, personal loans and credit cards. The Company sells most of its newly originated fixed rate residential mortgage loans in the secondary market. Under the Company's decentralized management philosophy, each of the banks determines individually which loans are sold and which are retained for the portfolio. The Company retains the servicing rights on most mortgage loans it sells and realizes monthly service fee income. Underwriting Standards. The Company's loan policy establishes the general parameters of the types of loans that are desirable, emphasizing cash flow and collateral coverage. Under the decentralized management structure, credit decisions are made at the subsidiary bank level by officers who generally have had long personal experience with most of their commercial and many of their individual borrowers. The Company hired a Senior Credit Executive in September 2002 to review Company-wide credit policies and develop and implement recommendations for strengthened, centralized credit administration. Each subsidiary bank's loan policy must comply with the Company's overall loan policy. These policies establish the lending authority of individual loan officers as well as the loan authority of the banks' loan committees. The policy limits exposure to any one borrower or affiliated group of borrowers to a limit of $8,000,000 unless the amount above that number has liquid collateral pledged as security or has a U.S. Government agency guarantee. The subsidiary bank CEO and Senior Loan Administrator each have 5 loan authority up to $250,000 while other lending authorities are generally $100,000 or less. The CEO and Senior Loan Administrator can approve loans up to $500,000 jointly. Each subsidiary bank has an External Loan Committee that consists of up to three lending officers and at least two outside bank directors. The External Loan Committee may approve loans up to $2,000,000. Loans over $2,000,000 require the approval of the Company's Executive Loan Committee. The Executive Loan Committee consists of the Company's CEO, Chief Credit Officer (non-voting), each subsidiary bank CEO, and each subsidiary bank Senior Loan Administrator. To assure the maximum salability of the residential loan products for possible resale into the secondary mortgage markets, the Company has formally adopted the underwriting, appraisal, and servicing guidelines of the Federal Home Loan Mortgage Corporation ("Freddie Mac") as part of its standard loan policy and procedures manual. Commercial Loans. The Company, through its banking subsidiaries, originates commercial loans in its primary market areas and underwrites them based on the borrower's ability to service the loan from operating income. The Company, through its banking subsidiaries, offers a broad range of commercial lending products, including term loans and lines of credit. Short and medium-term commercial loans, primarily collateralized, are made available to businesses for working capital (including inventory and receivables), business expansion (including acquisition of real estate, expansion and improvements) and the purchase of equipment. As a general practice, a collateral lien is placed on any available real estate, equipment or other assets owned by the borrower and a personal guarantee of the borrower is obtained. At December 31, 2002, $43.5 million, or 16.6%, of the aggregate commercial loan portfolio was at fixed rates while $219.1 million, or 83.4%, was at variable rates. The Company also utilizes government loan guarantee programs offered by the Small Business Administration (or "SBA") and Rural Economic and Community Development (or "RECD") when appropriate. See "Government Guarantee Programs" below. Commercial Real Estate Loans. In addition to commercial loans secured by real estate, the Company, through its banking subsidiaries, makes commercial real estate loans to finance the purchase of real property which generally consists of real estate with completed structures. Commercial real estate loans are secured by first liens on the real estate, typically have variable interest rates and are amortized over a 10 to 20 year period. The underwriting analysis includes credit verification, appraisals and a review of the borrower's financial condition. At December 31, 2002, $49.1 million, or 14.8%, of the aggregate commercial real estate loan portfolio was at fixed rates while $283.0 million, or 85.2%, was at variable rates. Agricultural Loans. Agricultural loans are offered for short-term crop production, farm equipment and livestock financing and agricultural real estate financing, including term loans and lines of credit. Short and medium-term agricultural loans, primarily collateralized, are made available for working capital (crops and livestock), business expansion (including acquisition of real estate, expansion and improvement) and the purchase of equipment. The Banks also closely monitor commodity prices and inventory build-up in various commodity categories to better anticipate price changes in key agricultural products that could adversely affect the borrowers' ability to repay their loans. At December 31, 2002 the Company has $118.1 million in loans to the dairy industry which represents 9% of the total loan portfolio. The dairy industry is under stress from an extended period of low milk prices. The Company routinely evaluates the effect of those price changes on the cash flow of borrowers and the values of collateral supporting those loans. At December 31, 2002, $20.1 million, or 8.6%, of the agricultural loan portfolio was at fixed rates while $213.7 million, or 91.4%, was at variable rates. The Banks utilize government loan guarantee programs offered by the SBA and the Farm Service Agency (or "FSA") of the United States Department of Agriculture where available and appropriate. See "Government Guarantee Programs" below. Residential Real Estate Loans. The Banks originate fixed and variable rate one-to-four family residential real estate loans collateralized by owner-occupied properties located in its market areas. A variety of real estate loan products which generally are amortized over five to 30 years are offered. Loans collateralized by one-to-four family residential real estate generally have been originated in amounts of no more than 80% of appraised value or have mortgage insurance. Mortgage title insurance and hazard insurance are normally required. The Company sells most newly originated fixed rate one-to-four family residential mortgages to Freddie Mac and retains the rights to service the mortgages. At December 31, 2002, the servicing portfolio totaled $301.4 million in residential mortgages, the majority of which have been sold to 6 Freddie Mac. At December 31, 2002, $188.1 million, or 74.7%, of residential real estate loans retained in portfolio was at fixed rates while $63.8 million, or 25.3%, was at variable rates. Consumer and Home Equity Loans. The Banks originate direct and indirect credit automobile loans, recreational vehicle loans, boat loans, home improvement loans, fixed and open-ended home equity loans, personal loans (collateralized and uncollateralized), student loans and deposit account collateralized loans. Visa cards that provide consumer credit lines are also issued. The terms of these loans typically range from 12 to 120 months and vary based upon the nature of the collateral and the size of loan. The majority of the consumer lending program is underwritten on a secured basis using the customer's home or the financed automobile, mobile home, boat or recreational vehicle as collateral. At December 31, 2002, $158.8 million, or 65.8%, of aggregate consumer and home equity loans was at fixed rates while $82.7 million, or 34.2%, was at variable rates. Government Guarantee Programs. The Banks participate in government loan guarantee programs offered by the SBA, RECD and FSA. At December 31, 2002, the Banks had loans with an aggregate principal balance of $44.8 million that were covered by guarantees under these programs. The guarantees only cover a certain percentage of these loans. By participating in these programs, the Banks are able to broaden their base of borrowers while minimizing credit risk. Delinquencies and Nonperforming Assets. The Banks have several procedures in place to assist in maintaining the overall quality of the Company's loan portfolio. Specific underwriting guidelines have been established to be followed by the lending officers. The Company requires each bank subsidiary to report delinquencies on a monthly basis, and the Senior Credit Executive, as part of the Company's ongoing centralized loan administration function, monitors these levels to identify adverse trends. Classification of Assets. Through the loan review process, the Banks maintain internally classified loan lists which, along with delinquency reporting, helps management assess the overall quality of the loan portfolio and the allowance for loan losses. Loans classified as "substandard" are those loans with clear and defined weaknesses such as a higher leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition, which may jeopardize recoverability of the debt. Loans classified as "doubtful" are those loans which have characteristics similar to substandard accounts but with an increased risk that a loss may occur, or at least a portion of the loan may require a charge-off if liquidated at present. Loans are charged-off when it becomes evident that such balances are not collectible. A loan is generally placed on nonaccrual status and ceases accruing interest when the payment of principal or interest is delinquent for 90 days, or earlier in some cases, unless the loan is in the process of collection and the underlying collateral further supports the carrying value of the loan. Allowance for Loan Losses. The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. The allowance reflects management's estimate of the amount of probable loan losses in the portfolio, based on the following factors: - the amount of historical charge-off experience; - the evaluation of the loan portfolio by the loan review function; - levels and trends in delinquencies and non-accruals; - trends in volume and terms; - effects of changes in lending policy; - experience, ability and depth of management; - national and local economic trends and conditions; and - concentration of credit. Management presents a quarterly review of the allowance for loan losses to each subsidiary bank's Board of Directors as well as to the Company's Board of Directors, indicating any change in the 7 allowance since the last review and any recommendations as to adjustments in the allowance. In order to determine the allowance for loan losses, the risk classification and delinquency status of loans and other factors are considered, such as collateral value, government guarantees, portfolio composition, trends in economic conditions and the financial strength of borrowers. Specific allowances for loans which have been individually evaluated for impairment are established when required. An allowance is also established for groups of loans with similar risk characteristics, based upon average historical charge-off experience taking into account levels and trends in delinquencies, loan volumes, economic and industry trends and concentrations of credit. Investment Activities General. The Company's investment securities policy is contained within the overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, the Company considers the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability and risk diversification. The Board of each subsidiary bank adopts an asset/liability policy containing an investment securities policy within the parameters of the Company's overall asset/liability policy. The FII Treasurer, guided by the separate ALCO Committees of each subsidiary bank, is responsible for securities portfolio decisions within the established policies. The Company's investment securities strategy centers on providing liquidity to meet loan demand and redeeming liabilities, meeting pledging requirements, managing overall interest rate risk and maximizing portfolio yield. Subsidiary bank policies generally limit security purchases to the following: - U.S. treasury securities; - U.S. government agency and government sponsored agency securities; - mortgage-backed pass-through securities and collateralized mortgage obligations ("CMOs") issued by the Federal National Mortgage Association ("FNMA"), the Government National Mortgage Association ("GNMA") and Freddie Mac ("FHLMC"); - investment grade municipal securities, including tax, revenue and bond anticipation notes and general obligation and revenue notes and bonds; - certain creditworthy un-rated securities issued by municipalities; and investment grade corporate debt. The Company currently does not participate in hedging programs, interest rate swaps, or other activities involving the use of off-balance sheet derivative financial instruments. SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," requires recognition of derivatives as either assets or liabilities, with the instruments measured at fair value. The accounting for gains and losses resulting from changes in fair value of the derivative instrument depends on the intended use of the derivative and the type of risk being hedged. The Company adopted SFAS No. 133 on January 1, 2001. The adoption of this statement did not have a material effect on the Company's financial position or results of operations. Additionally, the Company's investment policy limits investments in corporate bonds to no more than 10% of total investments and to bonds rated as Baa or better by Moody's Investor Services, Inc. or BBB or better by Standard & Poor's Ratings Services at the time of purchase. Sources of Funds General. Deposits and borrowed funds, primarily Federal Home Loan Bank ("FHLB") advances and sweep repurchase agreements, are the primary sources of the Company's funds for use in lending, investing and for other general purposes. In addition, repayments on loans, proceeds from sales of loans and securities, and cash flows from operations provide additional sources of funds. Deposits. The Company, through its banking subsidiaries, offers a variety of deposit account products with a range of interest rates and terms. The deposit accounts consist of savings, interest-bearing 8 checking accounts, checking accounts, money market accounts, savings, club accounts and certificates of deposit. The Company offers certificates of deposit with balances in excess of $100,000 at preferential rates (jumbo certificates) to local municipalities, businesses, and individuals as well as Individual Retirement Accounts ("IRAs") and other qualified plan accounts. To enhance its deposit product offerings, the Company provides commercial checking accounts for small to moderately-sized commercial businesses, as well as a low-cost checking account service for low-income customers. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. The Banks' deposits are obtained predominantly from the areas in which the Banks' branch offices are located. The Banks rely primarily on competitive pricing of their deposit products, customer service and long-standing relationships with customers to attract and retain these deposits. Borrowed Funds. Borrowings consist primarily of advances entered into with the FHLB and repurchase agreements. The Company anticipates the continued use of borrowings as a source of funding loan growth. Guaranteed Preferred Beneficial Interests in Corporation's Junior Subordinated Debentures. The Company formed a trust in February 2001 to accommodate the private placement of $16.2 million in capital securities, the proceeds of which were utilized to partially fund the acquisition of BNC. Supervision and Regulation The supervision and regulation of financial holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds regulated by the FDIC and the banking system as a whole, and not for the protection of shareholders or creditors of bank holding companies. The various bank regulatory agencies have broad enforcement power over bank holding companies and banks, including the power to impose substantial fines, operational restrictions and other penalties for violations of laws and regulations. The following description summarizes some of the laws to which the Company and its subsidiaries are subject. References to applicable statutes and regulations are brief summaries and do not claim to be complete. They are qualified in their entirety by reference to such statutes and regulations. Management believes the Company is in compliance in all material respects with these laws and regulations. Changes in the laws, regulations or policies that impact the Company cannot necessarily be predicted, but they may have a material effect on the business and earnings of the Company. The Company The Company is a financial holding company registered under the Bank Holding Company Act of 1956, as amended, and is subject to supervision, regulation and examination by the Federal Reserve Board. The Bank Holding Company Act and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. Regulatory Restrictions on Dividends; Source of Strength. It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the holding company's expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company's ability to serve as a source of strength to its banking subsidiaries. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. Such support may be required at times when, absent this Federal Reserve Board policy, a holding company may not be inclined to provide it. As discussed below, a bank holding company in certain circumstances could be required to guarantee the capital plan of an undercapitalized banking subsidiary. 9 Safe and Sound Banking Practices. Bank holding companies are not permitted to engage in unsafe and unsound banking practices. The Federal Reserve Board's Regulation Y, for example, generally requires a holding company to give the Federal Reserve Board prior notice of any redemption or repurchase of its own equity securities, if the consideration to be paid, together with the consideration paid for any repurchases or redemptions in the preceding year, is equal to 10% or more of the company's consolidated net worth. The Federal Reserve Board may oppose the transaction if it believes that the transaction would constitute an unsafe or unsound practice or would violate any law or regulation. Depending upon the circumstances, the Federal Reserve Board could take the position that paying a dividend would constitute an unsafe or unsound banking practice. The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their non-banking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis, if those activities caused a substantial loss to a depository institution. The penalties can be as high as $1,000,000 for each day the activity continues. Anti-Tying Restrictions. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates. Capital Adequacy Requirements. The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. Under the guidelines, specific categories of assets are assigned different risk weights, based generally on the perceived credit risk of the asset. These risk weights are multiplied by corresponding asset balances to determine a "risk-weighted" asset base. The guidelines require a minimum total risk-based capital ratio of 8.0% (of which at least 4.0% is required to consist of Tier 1 capital elements). Total capital is the sum of Tier 1 and Tier 2 capital. As of December 31, 2002, the Company's ratio of Tier 1 capital to total risk-weighted assets was 9.82% and the ratio of total capital to total risk-weighted assets was 11.08%. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition-Capital Resources." In addition to the risk-based capital guidelines, the Federal Reserve Board uses a leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. The leverage ratio is a company's Tier 1 capital divided by three-month average consolidated assets. Certain highly-rated bank holding companies may maintain a minimum leverage ratio of 3.0%, but other bank holding companies may be required to maintain a leverage ratio of up to 200 basis points above the regulatory minimum. As of December 31, 2002, the Company's leverage ratio was 6.96%. The federal banking agencies' risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming that they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Imposition of Liability for Undercapitalized Subsidiaries. Bank regulators are required to take "prompt corrective action" to resolve problems associated with insured depository institutions whose capital declines below certain levels. In the event an institution becomes "undercapitalized," it must submit a capital restoration plan. The capital restoration plan will not be accepted by the regulators unless each company having control of the undercapitalized institution guarantees the subsidiary's compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution's holding company is entitled to a priority of payment in bankruptcy. 10 The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution's assets at the time it became undercapitalized or the amount necessary to cause the institution to be "adequately capitalized." The bank regulators have greater power in situations where an institution becomes "significantly" or "critically" undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates. Acquisitions by Bank Holding Companies. The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors. Control Acquisitions. The Change in Bank Control Act prohibits a person or group of persons from acquiring "control" of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% of more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, would, under the circumstances set forth in the presumption, constitute acquisition of control of the Company. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Company's outstanding common stock, or otherwise obtaining control or a "controlling influence" over the Company. The Banks Wyoming County Bank ("WCB") and First Tier Bank & Trust ("FTB") are New York State-chartered banks. The National Bank of Geneva ("NBG") and Bath National Bank ("BNB") are national banks chartered by the Office of the Comptroller of Currency. All of the deposits of the four subsidiary banks are insured by the FDIC through the Bank Insurance Fund. FTB is a member of the Federal Reserve System. The Banks are subject to supervision and regulation that subject them to special restrictions, requirements, potential enforcement actions and periodic examination by the FDIC, the Federal Reserve Board and the New York State Banking Department (in the case of the state-chartered banks) and the Office of the Comptroller of Currency (in the case of the national banks). Because the Federal Reserve Board regulates the bank holding company parent of the Banks, the Federal Reserve Board also has supervisory authority which directly affects the banks. Restrictions on Transactions with Affiliates and Insiders. Transactions between the holding company and its subsidiaries, including the Banks, are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the holding company and its affiliates be on terms substantially the same, or at least as favorable to the banks, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as "insiders") contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also 11 an aggregate limitation on all loans to insiders and their related interests. These loans cannot exceed the institution's total unimpaired capital and surplus, and the FDIC may determine that a lesser amount is appropriate. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions. Restrictions on Distribution of Subsidiary Bank Dividends and Assets. Dividends paid by the Banks have provided a substantial part of the Company's operating funds and, for the foreseeable future, it is anticipated that dividends paid by the Banks will continue to be its principal source of operating funds. Capital adequacy requirements serve to limit the amount of dividends that may be paid by the subsidiaries. Under federal law, the subsidiaries cannot pay a dividend if, after paying the dividend, a particular subsidiary will be "undercapitalized." The FDIC may declare a dividend payment to be unsafe and unsound even though the bank would continue to meet its capital requirements after the dividend. Because the Company is a legal entity separate and distinct from its subsidiaries, the Company's right to participate in the distribution of assets of any subsidiary upon the subsidiary's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a priority of payment over the claims of holders of any obligation of the institution to its shareholders, including any depository bank holding company (such as the Company) or any shareholder or creditor thereof. Examinations. The New York State Banking Department (in the case of WCB and FTB), the Office of the Comptroller of the Currency (in the case of NBG and BNB), the Federal Reserve Board and the FDIC periodically examine and evaluate the Banks. Based upon such examinations, the appropriate regulator may revalue the assets of the institution and require that it establish specific reserves to compensate for the difference between what the regulator determines the value to be and the book value of such assets. Audit Reports. Insured institutions with total assets of $500 million or more at the beginning of a fiscal year must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution's holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. In addition, financial statements prepared in accordance with generally accepted accounting principles, management's certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. The FDIC Improvement Act of 1991 requires that independent audit committees be formed, consisting of outside directors only. The committees of institutions with assets of more than $3 billion must include members with experience in banking or financial management, must have access to outside counsel and must not include representatives of large customers. Capital Adequacy Requirements. The FDIC has adopted regulations establishing minimum requirements for the capital adequacy of insured institutions. The FDIC may establish higher minimum requirements if, for example, a bank has previously received special attention or has a high susceptibility to interest rate risk. The FDIC's risk-based capital guidelines generally require banks to have a minimum ratio of Tier 1 capital to total risk-weighted assets of 4.0% and a ratio of total capital to total risk-weighted assets of 8.0%. The capital categories have the same definitions for the Company. As of December 31, 2002, the ratio of Tier 1 capital to total risk-weighted assets for the Banks was 8.94% for WCB, 8.90% for NBG, 9.70% for BNB, and 9.45% for FTB, and the ratio of total capital to total risk-weighted assets was 10.20% for WCB, 10.16% for NBG, 10.95% for BNB, and 10.70% for FTB. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources." The FDIC's leverage guidelines require banks to maintain Tier 1 capital of no less than 4.0% of average total assets, except in the case of certain highly rated banks for which the requirement is 3.0% of average total assets. As of December 31, 2002, the ratio of Tier 1 capital to average total assets (leverage ratio) 12 was 6.64% for WCB, 6.71% for NBG, 5.93% for BNB, and 5.67% for FTB. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources." Corrective Measures for Capital Deficiencies. The federal banking regulators are required to take "prompt corrective action" with respect to capital-deficient institutions. Agency regulations define, for each capital category, the levels at which institutions are "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." A "well-capitalized" bank has a total risk-based capital ratio of 10.0% or higher; a Tier 1 risk-based capital ratio of 6.0% or higher; a leverage ratio of 5.0% or higher; and is not subject to any written agreement, order or directive requiring it to maintain a specific capital level for any capital measure. An "adequately capitalized" bank has a total risk-based capital ratio of 8.0% or higher; a Tier 1 risk-based capital ratio of 4.0% or higher; a leverage ratio of 4.0% or higher (3.0% or higher if the bank was rated a composite 1 in its most recent examination report and is not experiencing significant growth); and does not meet the criteria for a well-capitalized bank. A bank is "undercapitalized" if it fails to meet any one of the ratios required to be adequately capitalized. In addition to requiring undercapitalized institutions to submit a capital restoration plan, agency regulations contain broad restrictions on certain activities of undercapitalized institutions including asset growth, acquisitions, branch establishment and expansion into new lines of business. With certain exceptions, an insured depository institution is prohibited from making capital distributions, including dividends, and is prohibited from paying management fees to control persons if the institution would be undercapitalized after any such distribution or payment. As an institution's capital decreases, the FDIC's enforcement powers become more severe. A significantly undercapitalized institution is subject to mandated capital raising activities, restrictions on interest rates paid and transactions with affiliates, removal of management and other restrictions. The FDIC has only very limited discretion in dealing with a critically undercapitalized institution and is virtually required to appoint a receiver or conservator. Banks with risk-based capital and leverage ratios below the required minimums may also be subject to certain administrative actions, including the termination of deposit insurance upon notice and hearing, or a temporary suspension of insurance without a hearing in the event the institution has no tangible capital. Deposit Insurance Assessments. The bank subsidiaries must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by the FDIC Improvement Act. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. The FDIC maintains a process for raising or lowering all rates for insured institutions semi-annually if conditions warrant a change. Under this system, the FDIC has the flexibility to adjust the assessment rate schedule twice a year without seeking prior public comment, but only within a range of five cents per $100 above or below the premium schedule adopted. Changes in the rate schedule outside the five cent range above or below the current schedule can be made by the FDIC only after a full rulemaking with opportunity for public comment. The Deposit Insurance Fund Act of 1996 contained a comprehensive approach to recapitalizing the Savings Association Insurance Fund and to assuring the payment of the Financing Corporation's bond obligations. Under this law, banks insured under the Bank Insurance Fund are required to pay a portion of the interest due on bonds that were issued by the Financing Corporation in 1987 to help shore up the ailing Federal Savings and Loan Insurance Corporation. 13 Enforcement Powers. The FDIC and the other federal banking agencies have broad enforcement powers, including the power to terminate deposit insurance, impose substantial fines and other civil and criminal penalties and appoint a conservator or receiver. Failure to comply with applicable laws, regulations and supervisory agreements could subject the Company or its banking subsidiaries, as well as the officers, directors and other institution-affiliated parties of these organizations, to administrative sanctions and potentially substantial civil money penalties. Brokered Deposit Restrictions. Adequately capitalized institutions cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or roll over brokered deposits. Cross-Guarantee Provisions. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee" provision which generally makes commonly controlled insured depository institutions liable to the FDIC for any losses incurred in connection with the failure of a commonly controlled depository institution. Community Reinvestment Act. The Community Reinvestment Act of 1977 ("CRA") and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank's record in meeting the needs of its service area when considering applications regarding establishing branches, mergers or other bank or branch acquisitions. FIRREA requires federal banking agencies to make public a rating of a bank's performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the subsidiary banks are also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Banks must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations. Changing Regulatory Structure Gramm Leach-Bliley Act The Gramm-Leach-Bliley Act ("Gramm-Leach") was signed into law on November 12, 1999. Gramm-Leach permits, subject to certain conditions, combinations among banks, securities firms and insurance companies beginning March 11, 2000. Under Gramm-Leach, bank holding companies are permitted to offer their customers virtually any type of financial service including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking. In order to engage in these additional financial activities, a bank holding company must qualify and register with the Board of Governors of the Federal Reserve System as a "financial holding company" by demonstrating that each of its bank subsidiaries is "well capitalized," "well managed," and has at least a "satisfactory" rating under the CRA. On May 12, 2000 the Company received approval from the Federal Reserve Bank of New York to become a financial holding company. Gramm-Leach establishes that the federal banking agencies will regulate the banking activities of financial holding companies and banks' financial subsidiaries, the U.S. Securities and Exchange Commission will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers' nonpublic, personal information. 14 The major provisions of Gramm-Leach are: Financial Holding Companies and Financial Activities. Title I establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company system to engage in a full range of financial activities through qualification as a new entity known as a financial holding company. A bank holding company that qualifies as a financial holding company can expand into a wide variety of services that are financial in nature, provided that its subsidiary depository institutions are well-managed, well-capitalized and have received at least a "satisfactory" rating on their last CRA examination. Services that have been deemed to be financial in nature include securities underwriting, dealing and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities and merchant banking. Title I also required the FDIC to adopt regulations implementing Section 121 of Title I, regarding permissible activities and investments of insured state banks. Final regulations adopted by the FDIC in January 2001, in the form of amendments to Part 362 of the FDIC rules and regulations, provide the framework for subsidiaries of state nonmember banks to engage in financial activities that Gramm-Leach permits national banks to conduct through a financial subsidiary. The regulations require that prior to commencing such financial activities, a state nonmember bank must notify the FDIC of its intent to do so, and must certify that it is well-managed and that it and all of its subsidiary insured depository institutions are well-capitalized after deducting its investment in the new subsidiary. Furthermore, the regulations require that the notifying bank must, and must continue to, (i) disclose the capital deduction in published financial statements, and (ii) comply with sections 23A and 23B of the Federal Reserve Act and (iii) comply with all required financial and operational safeguards. Activities permissible for financial subsidiaries of national banks, and, pursuant to Section 362 of the FDIC rules and regulations, also permissible for financial subsidiaries of state nonmember banks, include, but are not limited to, the following: (a) Lending, exchanging, transferring, investing for others, or safeguarding money or securities; (b) Insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker for purposes of the foregoing, in any State; (c) Providing financial, investment, or economic advisory services, including advising an investment company; (d) Issuing or selling instruments representing interests in pools of assets permissible for a bank to hold directly; and (e) Underwriting, dealing in, or making a market in securities. Securities Activities. Title II narrows the exemptions from the securities laws previously enjoyed by banks, requires the Federal Reserve Board and the SEC to work together to draft rules governing certain securities activities of banks and creates a new, voluntary investment bank holding company. Insurance Activities. Title III restates the proposition that the states are the functional regulators for all insurance activities, including the insurance activities of federally-chartered banks, and bars the states from prohibiting insurance activities by depository institutions. The law encourages the states to develop uniform or reciprocal rules for the licensing of insurance agents. Privacy. Under Title V, federal banking regulators were required to adopt rules that have limited the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. Federal banking regulators issued final rules on May 10, 2000 to implement the privacy provisions of Title V. Under the rules, financial institutions must provide: - initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates; - annual notices of their privacy policies to current customers; and - a reasonable method for customers to "opt out" of disclosures to nonaffiliated third parties. 15 Compliance with the rules is mandatory after July 1, 2001. The Company and the banks were in full compliance with the rules as of or prior to their respective effective dates. Safeguarding Confidential Customer Information. Under Title V, federal banking regulators are required to adopt rules requiring financial institutions to implement a program to protect confidential customer information. In January 2000, the federal banking agencies adopted guidelines requiring financial institutions to establish an information security program to: - identify and assess the risks that may threaten customer information; - develop a written plan containing policies and procedures to manage and control these risks; - implement and test the plan; and - adjust the plan on a continuing basis to account for changes in technology, the sensitivity of customer information and internal or external threats to information security. The Banks' approved security programs appropriate to their size and complexity and the nature and scope of their operations prior to the July 1, 2001 effective date of the regulatory guidelines. The implementation of the programs is an ongoing process. Community Reinvestment Act Sunshine Requirements. In February 2001, the federal banking agencies adopted final regulations implementing Section 711 of Title VII, the CRA Sunshine Requirements. The regulations require nongovernmental entities or persons and insured depository institutions and affiliates that are parties to written agreements made in connection with the fulfillment of the institution's CRA obligations to make available to the public and the federal banking agencies a copy of each agreement. The regulations impose annual reporting requirements concerning the disbursement, receipt and use of funds or other resources under these agreements. The effective date of the regulations was April 1, 2001. Neither the Company nor the banks is a party to any agreement that would be the subject of reporting pursuant to the CRA Sunshine Requirements. The Company continues to evaluate the strategic opportunities presented by the broad powers granted to bank holding companies that elect to be treated as financial holding companies. In the event that the Company determines that access to the broader powers of a financial holding company is in the best interests of the Company, its shareholders and the banks, the Company will file the appropriate election with the Federal Reserve Board. USA Patriot Act As part of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 ("USA Patriot Act"), signed into law on October 26, 2001, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 ("IMLAFATA"). IMLAFATA authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies, or other financial institutions. During 2002, the Department of Treasury issued a number of regulations relating to enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions. Covered financial institutions also are barred from dealing with foreign "shell" banks. In addition, IMLAFATA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. Regulations were also adopted during 2002 to implement minimum standards to verify customer identity, to encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, to prohibit the anonymous use of "concentration accounts," and to require all covered financial institutions to have in place a Bank Secrecy Act compliance program. IMLAFATA also amends the Bank Holding Company Act and the Bank Merger 16 Act to require the federal banking agencies to consider the effectiveness of a financial institution's anti-money laundering activities when reviewing an application under these acts. The Banks have in place a Bank Secrecy Act compliance program, and they engage in very few transactions of any kind with foreign financial institutions or foreign persons. Sarbanes-Oxley Act On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the "Act") implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board which will enforce auditing, quality control and independence standards and will be funded by fees from all publicly traded companies, the law restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client will require pre-approval by the issuer's audit committee members. In addition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, legal counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself. Longer prison terms and increased penalties will also be applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a company's financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan "blackout" periods, and loans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company's securities within two business days of the change. The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statement's materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States of America and filed with the SEC reflect all material correcting adjustments that are identified by a "registered public accounting firm" in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC. Effective August 29, 2002, as directed by Section 302(a) of the Act, the Company's chief executive officer and chief financial officer are each required to certify that the Company's quarterly and annual reports do not contain any untrue statement of a material fact. The Act imposes several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Company's internal controls; they have made certain disclosures to the Company's auditors and the audit committee of the Board of Directors about the Company's internal controls; and they have included information in the Company's quarterly and annual reports about their evaluation and whether there have been significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation. Fair Credit Reporting Act In 1970, the U. S. Congress the Fair Credit Reporting Act (the "FCRA") in order to ensure the confidentiality, accuracy, relevancy and proper utilization of consumer credit report information. Under the framework of the FCRA, the United States has developed a highly advanced and efficient credit 17 reporting system. The information contained in that broad system is used by financial institutions, retailers and other creditors of every size in making a wide variety of decisions regarding financial transactions. Employers, and law enforcement agencies have also made wide use of the information collected and maintained in databases made possible by the FCRA. The FCRA affirmatively preempts state law in a number of areas, including the ability of entities affiliated by common ownership to share and exchange information freely, the requirements on credit bureaus to reinvestigate the contents of reports in response to consumer complaints, among others. By its terms, the preemption provision of the FCRA will terminate as of December 31, 2003. Termination of the preemption provisions could significantly impact the ability of the existing credit bureau system to continue operating. The Company may incur additional costs, and be required to implement additional costly procedures and systems in the event that the preemption provisions of the FCRA terminate at the end of 2003, and New York, or other states, adopts legislation that would have the effect of prohibiting the continued sharing of information such as that currently collected by credit bureaus throughout the United States. The likelihood of the FCRA preemption provisions terminating by their terms, and of the adoption of such restrictive provisions by state legislatures, cannot be estimated at this time. Expanding Enforcement Authority The Federal Reserve Board, the Office of the Comptroller of Currency, the New York State Superintendent of Banks and the FDIC possess extensive authority to police unsafe or unsound practices and violations of applicable laws and regulations by depository institutions and their holding companies. For example, the FDIC may terminate the deposit insurance of any institution which it determines has engaged in an unsafe or unsound practice. The agencies can also assess civil money penalties, issue cease and desist or removal orders, seek injunctions, and publicly disclose such actions. Effect On Economic Environment The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits. Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. 18 Item 2. Properties The Company's headquarters and operations center is located in Warsaw, New York. This facility is leased for a nominal rent from the Wyoming County Industrial Development Agency for local tax reasons and the Company has the right to purchase it for nominal consideration beginning in November, 2006. The following table lists the properties of each of the Company's subsidiaries:
TYPE OF LEASED OR EXPIRATION ENTITY \ LOCATION FACILITY OWNED OF LEASE ----------------- -------- ----- -------- Wyoming County Bank Warsaw................................... Main Office Own -- Attica................................... Branch Own -- Batavia.................................. Branch Lease October 2011 Batavia (In-Store)....................... Branch Lease August 2008 Dansville................................ Branch Lease March 2003 East Aurora.............................. Branch Lease December 2012 Geneseo.................................. Branch Own -- Lakeville................................ Branch Own -- Mount Morris............................. Branch Own -- North Java............................... Branch Own -- North Warsaw............................. Branch Own -- Pavilion................................. Branch Own -- Strykersville............................ Branch Own -- Williamsville............................ Branch Lease May 2003 Wyoming.................................. Branch Own -- Yorkshire................................ Branch Lease November 2007 The National Bank of Geneva Geneva................................... Main Office Own -- Geneva................................... Drive-up Branch Own -- Geneva (Plaza)........................... Branch Ground Lease January 2016 Caledonia................................ Branch Lease April 2006 Canandaigua.............................. Branch Own -- Honeoye Falls............................ Branch Lease April 2007 Leroy.................................... Branch Own -- North Chili.............................. Branch Lease July 2015 Ovid..................................... Branch Own -- Penn Yan................................. Branch Own -- Victor................................... Branch Own -- Waterloo................................. Branch Own -- Bath National Bank Bath..................................... Main Office Own -- Bath..................................... Drive-up Branch Own -- Avoca.................................... Branch Own -- Avoca.................................... Drive-up Branch Lease September 2004 Cohocton................................. Branch Lease August 2005 Dundee................................... Branch Own -- Elmira................................... Branch Own -- Elmira Heights........................... Branch Lease November 2008 Erwin.................................... Branch Lease August 2004 Hammondsport............................. Branch Own -- Hornell.................................. Branch Own -- Horseheads............................... Branch Lease September 2012 Naples................................... Branch Own -- Wayland.................................. Branch Own -- First Tier Bank & Trust Olean.................................... Main Office Own -- Olean.................................... Drive-up Branch Own -- Allegany................................. Branch Own -- Cuba..................................... Branch Lease November 2007 Ellicottville............................ Branch Own -- Salamanca................................ Branch Own -- Burke Group Honeoye Falls............................ Main Office Lease December 2018 Syracuse................................. Branch Lease April 2005
19 Item 3. Legal Proceedings From time to time the Company and its subsidiaries are parties to or otherwise involved in legal proceedings arising in the normal course of business. Management does not believe that there is any pending or threatened proceeding against the Company or its subsidiaries which, if determined adversely, would have a material effect on the Company's business, results of operations or financial condition. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted during the fourth quarter of the year ended December 31, 2002 to a vote of security holders. PART II Item 5. Market for Registrant's Common Stock and Related Stockholder Matters The common stock of the Company is traded under the symbol of FISI on the Nasdaq National Market. At March 12, 2003, the Company had 11,109,664 shares of common stock outstanding (exclusive of treasury shares) and had approximately 2,175 shareholders of record. The high and low prices listed below represent actual sales transactions as reported by Nasdaq.
Sales Price Cash Dividends High Low Close Declared ---------------------------------------------------------------- 2002 First Quarter $ 30.000 $ 23.330 $ 29.110 $ 0.13 Second Quarter 38.850 28.740 37.860 0.14 Third Quarter 38.250 24.350 27.150 0.15 Fourth Quarter 32.040 25.050 29.360 0.16 2001 First Quarter 20.000 13.000 19.625 0.11 Second Quarter 24.250 18.000 22.400 0.12 Third Quarter 26.650 21.000 23.440 0.12 Fourth Quarter 24.850 17.100 23.400 0.13
Since becoming publicly traded the Company has paid regular quarterly cash dividends on its common stock, and the Board of Directors presently intends to continue the payment of regular quarterly cash dividends, subject to the need for those funds for debt service and other purposes. However, because substantially all of the funds available for the payment of dividends are derived from the Banks, future dividends will depend upon the earnings of the Banks', their financial condition and need for funds. Furthermore, there are a number of federal banking policies and regulations that restrict the Company's ability to pay dividends. For further discussion on dividend restrictions, please refer to page 9, as these restrictions may have the effect of reducing the amount of dividends that the Company can declare to its shareholders. 20 Item 6. Selected Financial Data
(Dollars in thousands) December 31 -------------------------------------------------------------------- 2002 2001 2000 1999 1998 -------------------------------------------------------------------- Selected Financial Condition Data Total assets $2,105,034 $1,794,296 $1,289,327 $1,136,460 $976,185 Loans, net 1,300,232 1,146,976 873,262 752,324 645,857 Securities available for sale 596,862 428,423 257,823 197,134 154,171 Securities held to maturity 47,125 61,281 76,947 81,356 91,016 Deposits 1,708,523 1,433,658 1,078,111 949,531 850,455 Borrowed funds 195,479 190,389 62,384 56,336 13,862 Shareholders' equity 178,294 149,187 131,618 117,539 96,578 (Dollars in thousands) For the years ended December 31 -------------------------------------------------------------------- 2002 2001 2000 1999 1998 -------------------------------------------------------------------- Selected Results of Operations Data Interest income $ 118,439 $ 114,468 $ 96,467 $ 78,692 $ 72,660 Interest expense 42,585 49,694 43,605 31,883 30,958 -------------------------------------------------------------------- Net interest income 75,854 64,774 52,862 46,809 41,702 Provision for loan losses 6,119 4,958 4,211 3,062 2,732 -------------------------------------------------------------------- Net interest income after Provision for loan loss 69,735 59,816 48,651 43,747 38,970 Noninterest income 22,189 15,782 9,409 8,055 6,591 Noninterest expense (3) 53,049 43,352 30,156 27,032 24,602 -------------------------------------------------------------------- Income before income taxes 38,875 32,246 27,904 24,770 20,959 Income taxes 12,419 11,033 9,804 8,813 7,354 -------------------------------------------------------------------- Net income $ 26,456 $ 21,213 $ 18,100 $ 15,957 $ 13,605 ====================================================================
At or for the years ended December 31 ------------------------------------------------------------ 2002 2001 2000 1999 1998 ------------------------------------------------------------ Per Common Share Data Net income - basic $ 2.26 $ 1.79 $ 1.51 $ 1.38 $ 1.22 Net income - diluted 2.23 1.77 1.51 1.38 1.22 Cash dividends declared 0.58 0.48 0.42 0.31 0.26 Book value 14.46 11.93 10.36 9.05 7.94 Market value 29.36 23.40 13.61 12.12 -- Selected Financial Ratios and Other Data Performance Ratios: Return on common equity 17.01% 15.84% 15.78% 16.16% 16.28% Return on assets 1.35 1.34 1.51 1.54 1.48 Common dividend payout 25.66 26.82 27.81 22.46 21.31 Net interest rate spread 3.96 3.96 3.98 4.19 4.24 Net interest margin (1) 4.37 4.62 4.87 5.00 5.06 Efficiency ratio 50.62 48.49 45.19 45.55 46.64 Noninterest income to average total assets (2) 1.11 0.96 0.76 0.75 0.69 Noninterest expenses to average total assets 2.70 2.73 2.52 2.61 2.68 Average interest-earning assets to average interest bearing liabilities 117.82 119.67 123.25 124.86 123.05 Asset Quality Ratios: Non-performing loans to total loans 2.81% 0.86% 0.80% 0.75% 0.93% Non-performing assets to total loans and other real estate 2.90 0.94 0.91 0.88 1.24 Allowance for loan losses to non-performing loans 58 190 195 199 157 Allowance for loan losses to total loans 1.64 1.64 1.56 1.50 1.46 Net charge-offs during the period to average loans outstanding during the year 0.30 0.23 0.21 0.17 0.21 Capital ratios: Equity to total assets 8.47% 8.31% 10.21% 10.34% 9.89% Average common equity to average assets 7.47 7.84 8.78 8.63 8.09 Other Data: Number of full-service offices 47 41 32 29 28 Loans serviced for others (in millions) $ 356.4 $ 302.3 $ 205.2 $ 200.2 $ 177.8 Full time equivalent employees 685 608 441 411 384
(1) Net interest income divided by average interest earning assets. A tax-equivalent adjustment to interest earned from tax-exempt securities has been computed using a federal tax rate of 35%. (2) Noninterest income excludes net gain (loss) on sale of securities available for sale. (3) Noninterest expense includes goodwill amortization, which amounted to $1,653,000 for 2001 compared to zero in all other years presented. 21
---------------------------------------- (Dollars in thousands) First Second Third Fourth Quarter Quarter Quarter Quarter ---------------------------------------- Selected Quarterly Financial Information 2002 Results of operations data: Interest income $28,560 $29,927 $30,343 $29,609 Interest expense 10,483 10,941 10,810 10,351 Net interest income 18,077 18,986 19,533 19,258 Provision for loan losses 1,007 1,181 1,452 2,479 Net interest income after provision for loan losses 17,070 17,805 18,081 16,779 Noninterest income 4,937 5,157 5,687 6,408 Noninterest expense 12,100 13,093 13,418 14,438 Income before income taxes 9,907 9,869 10,350 8,749 Income taxes 3,250 3,225 3,466 2,478 Net income 6,657 6,644 6,884 6,271 Per common share data: Net income - basic $ 0.57 $ 0.57 $ 0.59 $ 0.53 Net income - diluted 0.56 0.56 0.58 0.53 Cash dividends declared 0.13 0.14 0.15 0.16 Book value 12.26 13.23 14.03 14.46 Market value 29.11 37.86 27.15 29.36 2001 Results of operations data: Interest income $25,754 $29,152 $30,231 $29,331 Interest expense 12,165 13,167 13,093 11,269 Net interest income 13,589 15,985 17,138 18,062 Provision for loan losses 811 1,026 1,563 1,558 Net interest income after provision for loan losses 12,778 14,959 15,575 16,504 Noninterest income 2,785 3,452 4,002 5,543 Noninterest expense 8,244 10,409 11,309 13,390 Income before income taxes 7,319 8,002 8,268 8,657 Income taxes 2,514 2,817 2,908 2,794 Net income 4,805 5,185 5,360 5,863 Per common share data: Net income - basic $ 0.40 $ 0.44 $ 0.45 $ 0.50 Net income - diluted 0.40 0.43 0.45 0.49 Cash dividends declared 0.11 0.12 0.12 0.13 Book value 10.88 11.20 11.85 11.93 Market value 9.63 22.40 23.44 23.40
22 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION The principal objective of this discussion is to provide an overview of the financial condition and results of operations of Financial Institutions, Inc. and its subsidiaries for the three years ended December 31, 2002. This discussion and tabular presentations should be read in conjunction with the accompanying consolidated financial statements and accompanying notes. CRITICAL ACCOUNTING POLICIES The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, those policies that Management believes are the most important to the Company's financial position and results, requires Management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the financial statements. The Company has numerous accounting policies, of which the most significant are presented in Note 1 of the notes to consolidated financial statements. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are reported in the financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, Management has determined that the accounting policies with respect to the allowance for loan losses and goodwill require subjective or complex judgments important to the Company's financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below. Allowance for Loan Losses Arriving at an appropriate level of allowance for loan losses involves a high degree of judgment. The Company's allowance for loan losses provides for probable losses based upon evaluations of known and inherent risks in the loan portfolio. Management uses historical information to assess the adequacy of the allowance for loan losses and considers the prevailing business environment; as it is affected by changing economic conditions and various external factors, which may impact the portfolio in ways currently unforeseen. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off. For additional discussion related to the Company's accounting policies for the allowance for loan losses, see Note 1 of the notes to consolidated financial statements. Goodwill In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations and further clarifies the criteria for the initial recognition and measurement of intangible assets separate from goodwill. SFAS No. 142 prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets are subject to at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. SFAS No. 142 also requires that reporting units be identified for the purpose of assessing impairment of goodwill. For additional discussion related to the Company's accounting policy for goodwill and other intangible assets, see Note 1 of the notes to the consolidated financial statements. 23 OVERVIEW Net income in 2002 was $26.5 million, or 25% more than the $21.2 million earned in 2001. In 2000, net income was $18.1 million. Diluted earnings per share for the year ended December 31, 2002 was $2.23, compared to $1.77 in 2001 and $1.51 in 2000. The return on average common equity in 2002 was 17.01%, compared to 15.84% in 2001 and 15.78% in 2000. The return on average assets in 2002 was 1.35%, compared to 1.34% in 2001 and 1.51% in 2000. In accordance with a new accounting standard, goodwill was no longer required to be amortized effective January 1, 2002. In 2001, goodwill amortization, none of which was tax deductible, totaled $1.7 million. There was no goodwill amortization in 2000. Accordingly, excluding the effect of goodwill amortization, net income for 2001 would have been $22.9 million, or $1.92 per diluted common share. Based on these pro forma results, there would have been a $3.6 million or 16% increase in net income for 2002 compared to 2001. Nonperforming assets at December 31, 2002 were $38.4 million compared to $11.0 million at December 31, 2001, an increase of $27.4 million. Nonaccrual loans account for $22.9 million and restructured loans $4.1 million of the increase in nonperforming assets. The increase in nonperforming assets for 2002 reflects recent deterioration in the commercial and agricultural portfolios at NBG and to a lesser extent BNB, which resulted in downgrades to a number of commercial and agricultural loans at these banks. These downgrades occurred in the course of loan portfolio reviews performed by the Company's senior credit executive, its outside auditors and, with respect to loans at NBG and BNB, the Office of the Comptroller of the Currency ("OCC"), as well as being reflective of current economic conditions in the Company's market area. Beginning with the hiring of the Senior Credit Executive in September 2002, the Company has begun implementation of that aspect of its strategic plan which calls for improved credit administration on a Company-wide basis, by increasing consistency among subsidiary banks in reporting and grading loans, and strengthening the review and oversight process of subsidiary bank lending and credit administration at the Company level. To facilitate the implementation plan, the Company plans to add additional credit administration staff and loan workout specialists in the early part of 2003. See "Nonaccrual Loans and Nonperforming Assets" for additional discussion. Aside from the increase in nonperforming assets, the Company concluded another solid year of strong earnings growth and continued execution of its corporate strategic plan in 2002. The Company completed a geographic realignment of the subsidiary banks, which involved the merger of PSB into NBG and transfer of other branch offices between subsidiary banks. These changes were the forerunner to the Company's organization wide re-branding initiative commenced in January 2003. In addition, FII expanded markets with BNB's purchase of Bank of Avoca and two Chemung County offices of BSB Bank & Trust Company. These transactions are discussed in further detail below. On May 1, 2002, FII acquired all of the common stock of the Bank of Avoca ("BOA") in exchange for 47,036 shares of FII common stock. BOA was a community bank with total assets of $18.4 million with its main office located in Avoca, New York, as well as a branch office in Cohocton, New York. Subsequent to the acquisition, BOA was merged with BNB. The acquisition was accounted for under the purchase method of accounting. The results of operations for BOA are included in the income statement from the date of acquisition. On December 13, 2002, BNB acquired the two Chemung County branch offices of BSB Bank & Trust Company of Binghamton, New York. The two offices purchased, located in Elmira and Elmira Heights, had deposit liabilities totaling $44.2 million at the time of acquisition. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, of approximately $1.5 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company also recorded a $2.0 million intangible asset attributable to core deposits, which is being amortized using the straight-line method over seven years. 24 LENDING ACTIVITIES Set forth below is selected information concerning the composition of the Company's loan portfolio.
At December 31 --------------------------------------------------------------------- (Dollars in thousands) 2002 2001 2000 1999 1998 --------------------------------------------------------------------- Commercial $ 262,630 $ 232,379 $ 169,832 $ 140,376 $ 117,750 Commercial real estate 332,134 274,702 166,041 137,648 106,897 Agricultural 233,769 186,623 165,367 151,534 123,754 Residential real estate 251,898 240,141 201,160 189,149 181,828 Consumer and home equity 241,461 232,205 184,745 145,038 125,198 ----------- ----------- --------- --------- --------- Total loans, gross 1,321,892 1,166,050 887,145 763,745 655,427 Allowance for loan losses (21,660) (19,074) (13,883) (11,421) (9,570) ----------- ----------- --------- --------- --------- Total loans, net $ 1,300,232 $ 1,146,976 $ 873,262 $ 752,324 $ 645,857 =========== =========== ========= ========= =========
Gross loans increased to $1.322 billion at December 31, 2002 from $1.166 billion at December 31, 2001, an increase of $155.8 million or 13.4%, principally from continued expansion of the commercial, commercial real estate and agricultural loan portfolios. Commercial loans increased $30.2 million or 13.0%, while commercial real estate loans increased by $57.4 million or 20.9%. At December 31, 2002, commercial loans totaled $262.6 million, representing 19.9% of total loans, and commercial real estate loans totaled $332.1 million, representing 25.1% of total loans. At December 31, 2002, agricultural loans, which include agricultural real estate loans, represented 17.7% of the total loan portfolio. During 2002, agricultural loans increased by $47.1 million or 25.3%, to $233.8 million. The increases in commercial, commercial real estate and agricultural loans reflects the Company's expanded business development efforts. As of December 31, 2002, residential real estate loans grew by $11.8 million or 4.9% from December 31, 2001, and totaled $251.9 million or 19.1% of total loans. The relatively small percentage increase in residential real estate loans in comparison to commercial loan types corresponds with the Company's trend towards selling newly originated residential real estate mortgages, which is evidenced by the increase in the sold and serviced loan portfolio to $301.4 million at December 31, 2002 from $246.0 million at December 31, 2001. During 2002 and 2001, the Company sold residential real estate loans totaling $139.4 million and $117.4 million, respectively. The Company also offers a broad range of consumer loan products. Consumer and home equity loans grew by $9.3 million or 4.0%, in 2002 and ended the year at $241.5 million, representing 18.2% of the total loan portfolio. The relatively small percentage increase in consumer products is a reflection of slower growth in the Company's indirect lending program. Gross loans increased to $1.166 billion at December 31, 2001 from $887.1 million at December 31, 2000, an increase of $279.0 million or 31.4%. The acquisition of BNB accounted for $189.5 million of the loan growth with the balance of $89.5 million generated principally from continued expansion of the commercial loan portfolio. Commercial loans increased $62.6 million ($40.5 million from the BNB acquisition) or 36.8%, while commercial real estate loans increased by $108.7 million ($56.9 million from the BNB acquisition) or 65.4%. At December 31, 2001, commercial loans totaled $232.4 million, representing 19.9% of total loans, and commercial real estate loans totaled $274.7 million, representing 23.6% of total loans. At December 31, 2001, agricultural loans, which include agricultural real estate loans, represented 16.0% of the total loan portfolio. During 2001, agricultural loans increased by $21.2 million ($7.2 million from the BNB acquisition), or 12.9%, to $186.6 million. As of December 31, 2001, residential real estate loans grew by $39.0 million ($50.5 million from the BNB acquisition) or 19.4% from December 31, 2000, and totaled $240.1 million or 20.6% of total loans. Considering BNB residential real estate loans acquired amounted to $50.5 million, the residential real estate portfolio decreased $11.5 million in 2001, a result of the Company selling newly originated 25 residential real estate mortgages while retaining the servicing rights. Consumer and home equity loans grew by $47.5 million ($34.4 million from the BNB acquisition) or 25.7%, in 2001 and ended the year at $232.2 million, representing 19.9% of the total loan portfolio. Nonaccrual Loans and Nonperforming Assets The significant increase in nonperforming assets is primarily the result of recent deterioration in the commercial and agricultural loan portfolios at NBG and BNB. The decline in asset quality was first identified by the Company's annual loan review procedures. Subsequently, the Company's outside auditors and the Senior Credit Executive and his staff identified additional credit and credit administration issues, primarily at NBG and to a lesser extent BNB. Concurrently NBG's and BNB's regulator, the OCC, was completing its regularly scheduled safety and soundness examinations. During their examinations the OCC identified additional credits for nonperforming status. The results of each of these reviews is reflected in the nonperforming assets reported as of December 31, 2002. Among the loans at NBG that were re-classified from performing to nonperforming were a group of loans made to a company controlled by a director of NBG (who was not re-appointed in January 2003) which aggregated $4.2 million, and a single loan to a company controlled by another director of NBG (who became a non-voting director emeritus in January 2003) with a balance of $0.7 million. The Company's internal loan review process has indicated that there may be potential Regulation O issues with respect to these and certain other loans made by NBG to its directors arising out of the approval process for additional extensions of credit. Total nonperforming loans increased by $27.1 million for the full year 2002, including $22.7 million in the fourth quarter of 2002, to $37.1 million at year end. In the fourth quarter of 2002 nonperforming loans increased by $15.4 million at NBG and $4.8 million at BNB. The OCC has indicated that it expects to deliver final Reports of Examination for NBG and BNB, late in the first or early in the second quarter of 2003. The total fourth quarter 2002 increase was comprised of $18.6 million in nonaccrual loans and loans 90 days or more delinquent and still accruing and $4.1 million in loans that are considered troubled debt restructurings. Commercial loans account for $13.5 million and agricultural loans $9.2 million of the total increase. The Company has performed a comprehensive analysis of each impaired loan over $250,000, including the borrower's paying capacity, assessed the collateral supporting the loans outstanding and made appropriate allocations of loss allowances. Included in the $18.6 million fourth quarter increase in nonaccrual and 90 day delinquent loans were $14.2 million of loans on which payment is current as of December 31, 2002. Despite the fact that these loans are current, either the loan structure, the borrower's financial outlook, the borrower's debt service capabilities or other items made it prudent to classify these loans nonperforming at December 31, 2002. Also included in the fourth quarter increase were $4.1 million in restructured loans, all of which were current with respect to the modified terms. The majority of the nonperforming loans are secured by various forms of collateral including receivables, inventory, livestock, equipment, real property, and other assets. For each of the nonperforming loans added in the fourth quarter, the Company has performed a comprehensive assessment of collateral values and borrower paying capacity. The results of this assessment showed that provision for loan losses of $2.5 million was required and recorded in the fourth quarter. 26 The following table sets forth information regarding nonaccrual loans and other nonperforming assets.
At December 31 ---------------------------------------------------- (Dollars in thousands) 2002 2001 2000 1999 1998 ---------------------------------------------------- Nonaccrual loans (1) Commercial $12,760 $ 2,623 $1,044 $1,159 $1,250 Commercial real estate 8,407 3,344 1,619 1,373 995 Agricultural 8,739 1,529 2,881 1,455 2,340 Residential real estate 1,065 921 835 413 733 Consumer and home equity 915 541 217 375 423 ------- ------- ------ ------ ------ Total nonaccrual loans 31,886 8,958 6,596 4,775 5,741 Restructured loans 4,129 -- -- -- -- Accruing loans 90 days or more delinquent 1,091 1,064 521 969 360 ------- ------- ------ ------ ------ Total nonperforming loans 37,106 10,022 7,117 5,744 6,101 Other real estate owned 1,251 947 932 969 2,084 ------- ------- ------ ------ ------ Total nonperforming assets $38,357 $10,969 $8,049 $6,713 $8,185 ======= ======= ====== ====== ====== Total nonperforming loans to total loans 2.81% 0.86% 0.80% 0.75% 0.93% Total nonperforming assets to total loans and other real estate 2.90% 0.94% 0.91% 0.88% 1.24%
(1) Although, loans are generally placed on nonaccrual status when they become 90 days or more past due they may be placed on nonaccrual status earlier if they have been identified by the Company as presenting uncertainty with respect to the collectibility of interest or principal. Analysis of the Allowance for Loan Losses The allowance for loan losses represents the estimated amount of probable credit losses inherent in the Banks' loan portfolios. The Company performs periodic, systematic reviews of its Banks' portfolios to identify these probable losses, and to assess the overall collectibility of these portfolios. While in the past the Company has relied on an outside loan review firm to perform loan reviews at each of the subsidiary banks, the hiring of a Senior Credit Executive in September 2002 and the anticipated hiring of additional staff in 2003 will enable the Company to perform these reviews using its own personnel. In addition, the Senior Credit Executive will review and oversee loan administration on a Company-wide basis to improve quality control and consistency in the application of Company credit policies among the four subsidiary banks. These reviews result in the identification and quantification of loss factors, which are used in determining the amount of the allowance for loan losses. In addition, the Company periodically evaluates prevailing economic and business conditions, industry concentrations, changes in the size and characteristics of the portfolio and other pertinent factors. The allowance for loan losses is allocated to cover the estimated losses in each loan category based on the results of this detailed review. The process used by the Company to determine the overall allowance for loan losses is based on this analysis, taking into consideration management's judgment. Allowance methodology is reviewed on a periodic basis and modified as appropriate. Based on this analysis, the Company believes that the allowance for loan losses is fairly stated at December 31, 2002. At December 31, 2002, the Company's allowance for loan losses totaled $21.7 million, an increase of $2.6 million over the previous year end. The allowance as a percentage of total loans was 1.64% at December 31, 2002 and 2001. The ratio of allowance for loan losses to nonperforming loans was 58% at December 31, 2002 versus 190% at December 31, 2001. The decline in this coverage ratio is a result of the previously discussed increase in nonperforming loans. The Company is actively monitoring these problem credits. Despite the decline in the ratio of allowance for loan losses to nonperforming loans, the allowance for loan losses at December 31, 2002 represents the estimated probable losses in the loan portfolio based on the Company's comprehensive assessment of collateral values and borrower paying 27 capacity on impaired loans in excess of $250,000 together with the Company's assessment of current economic conditions in the Company's market area. The following table sets forth an analysis of the activity in the allowance for loan losses for the periods indicated.
Years Ended December 31 ------------------------------------------------------ (Dollars in thousands) 2002 2001 2000 1999 1998 ------------------------------------------------------ Balance at beginning of year $19,074 $13,883 $11,421 $ 9,570 $8,145 Addition resulting from acquisitions 174 2,686 -- -- -- Charge-offs: Commercial 1,771 1,003 466 312 263 Commercial real estate 944 394 629 139 687 Agricultural 106 58 85 12 19 Residential real estate 98 178 113 461 215 Consumer and home equity 1,499 1,319 905 663 488 ------- ------- ------- ------- ------ Total charge-offs 4,418 2,952 2,198 1,587 1,672 Recoveries: Commercial 210 58 206 88 106 Commercial real estate 69 23 22 23 84 Agricultural 36 -- 1 -- -- Residential real estate 67 19 5 163 42 Consumer and home equity 329 399 215 102 133 ------- ------- ------- ------- ------ Total recoveries 711 499 449 376 365 Net charge-offs 3,707 2,453 1,749 1,211 1,307 Provision for loan losses 6,119 4,958 4,211 3,062 2,732 ------- ------- ------- ------- ------ Balance at end of year $21,660 $19,074 $13,883 $11,421 $9,570 ======= ======= ======= ======= ====== Ratio of net charge-offs during the year to average loans outstanding during the year 0.30% 0.23% 0.21% 0.17% 0.21% Ratio of allowance for loan losses to total loans 1.64% 1.64% 1.56% 1.50% 1.46% Ratio of allowance for loan losses to nonperforming loans 58% 190% 195% 199% 157%
The following table summarizes the loan delinquencies (excluding past due nonaccrual loans) in the loan portfolio as of December 31, 2002: 60-89 90 Days (Dollars in thousands) Days or More ------ ------- Commercial $ 585 $ 363 Commercial real estate 204 155 Agricultural -- 37 Residential real estate 263 80 Consumer and home equity 547 456 ------ ------ Total $1,599 $1,091 ====== ====== 28 Allocation of Allowance for Loan Losses The following table sets forth the allocation of the allowance for loan losses by loan category at the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio.
At December 31 ------------------------------------------------------------------ 2002 2001 2000 ------------------------------------------------------------------ Amount Percent Amount Percent Amount Percent of of Loans of of Loans of of Loans Allowance in Each Allowance in Each Allowance in Each for Category for Category for Category Loan to Total Loan to Total Loan to Total (Dollars in thousands) Losses Loans Losses Loans Losses Loans ------------------------------------------------------------------ Commercial $ 5,321 19.9% $ 4,376 19.9% $ 2,924 19.1% Commercial real estate 4,725 25.1 3,611 23.6 1,902 18.7 Agricultural 3,711 17.7 2,341 16.0 2,270 18.7 Residential real estate 1,414 19.1 1,700 20.6 1,186 22.7 Consumer and home equity 2,007 18.2 2,578 19.9 1,818 20.8 Unallocated 4,482 -- 4,468 -- 3,783 -- ------- ----- ------- ----- ------- ----- Total $21,660 100% $19,074 100% $13,883 100% ======= ===== ======= ===== ======= ===== At December 31 ------------------------------------------- 1999 1998 ------------------------------------------- Amount Percent Amount Percent of of Loans of of Loans Allowance in Each Allowance in Each for Category for Category Loan to Total Loan to Total (Dollars in thousands) Losses Loans Losses Loans ------------------------------------------- Commercial $ 1,909 18.4% $2,461 17.9% Commercial real estate 2,071 18.0 1,629 16.3 Agricultural 1,443 19.8 1,106 18.9 Residential real estate 914 24.8 1,370 27.8 Consumer and home equity 1,270 19.0 1,303 19.1 Unallocated 3,814 -- 1,701 -- ------- ----- ------ ----- Total $11,421 100% $9,570 100% ======= ===== ====== =====
Loan Maturity and Repricing Schedule The following table sets forth certain information as of December 31, 2002, regarding the amount of loans maturing or repricing in the portfolio. Demand loans having no stated schedule of repayment and no stated maturity and overdrafts are reported as due in one year or less. Adjustable and floating-rate loans are included in the period in which interest rates are next scheduled to adjust rather than the period in which they contractually mature, and fixed-rate loans are included in the period in which the final contractual repayment is due.
At December 31, 2002 ---------------------------------------------------------- One Within Through After One Five Five (Dollars in thousands) Year Years Years Total -------- -------- -------- ---------- Commercial $123,491 $ 97,690 $ 41,449 $ 262,630 Commercial real estate 12,207 42,581 277,346 332,134 Agricultural 56,908 63,212 113,649 233,769 Residential real estate 6,204 23,646 222,048 251,898 Consumer and home equity 13,031 126,914 101,516 241,461 -------- -------- -------- ---------- Total loans $211,841 $354,043 $756,008 $1,321,892 ======== ======== ======== ========== Loans maturing after one year: With a predetermined interest rate $207,683 $227,582 With a floating or adjustable rate 146,360 528,426
29 INVESTING ACTIVITIES U.S. Treasury and Agency Securities. At December 31, 2002, the U.S. Treasury and Agency securities portfolio totaled $120.6 million, all of which was classified as available for sale. The portfolio consisted of $1.0 million in U. S. Treasury securities and $119.6 million in U. S. federal agency securities. The U.S. federal agency security portfolio consists of predominately callable securities. These callable securities provide higher yields than similar securities without call features. At December 31, 2001, the U.S. Treasury and Agency securities portfolio totaled $185.4 million, of which $183.5 million was classified as available for sale. The portfolio consisted of $10.8 million in U. S. Treasury securities and $174.6 million in U. S. federal agency securities. The $64.8 million decline in the Company's investment in U.S. Treasury and Agency securities during 2002 resulted from funds being invested in other security classes, such as state and municipal obligations and mortgage backed securities which are discussed in further detail below. State and Municipal Obligations. At December 31, 2002, the portfolio of state and municipal obligations totaled $222.0 million, of which $174.9 million was classified as available for sale. At that date, $47.1 million was classified as held to maturity, with a fair value of $48.1 million. . At December 31, 2001, the portfolio of state and municipal obligations totaled $202.6 million, of which $143.2 million was classified as available for sale. At that date, $59.4 million was classified as held to maturity, with a fair value of $60.3 million. Over the past few years, more favorable yields on new purchases of these securities, when compared to taxable investment alternatives, has led to growth in this portfolio. In addition, the Company has expanded its overall municipal banking relationship business which includes both deposit activities and investing in obligations issued by those municipalities. Mortgage-Backed Securities. Mortgage-backed securities, all of which were classified as available for sale, totaled $283.5 million and $90.0 million at December 31, 2002 and 2001, respectively. The portfolio was comprised of $193.4 million of mortgage-backed pass-through securities and $90.1 million of collateralized mortgage obligations (CMOs) at December 31, 2002. Over 99% of the mortgage backed pass-through securities were agency issued debt (FNMA, FHLMC, or GNMA). Over 75% of the agency mortgage-backed pass-through securities were in fixed rate securities that were predominately formed with mortgages having a balloon payment of five or seven years. The adjustable rate agency mortgage-backed securities portfolio is principally indexed to the one-year Treasury bill. The CMO portfolio consists of $52.2 million of government agency issues, $26.4 million of privately issued AAA rated securities, and includes $11.5 million of Student Loan Marketing Association (SLMA) floaters, which are securities backed by student loans. At December 31, 2001 the portfolio consisted of $80.0 million of mortgage-backed pass-through securities and $10.0 million of CMOs. All of the mortgage-backed securities at December 31, 2001 were agency issued (FNMA, FHLMC, GNMA) obligations. The significant increase in mortgage-backed securities is a result of a strategy to further diversify the Company's investment portfolio, enhance yields, and increase cash flows from the portfolio. Corporate Bonds. The corporate bond portfolio, all of which was classified as available for sale, totaled $13.9 million and $7.9 million at December 31, 2002 and 2001, respectively. The portfolio was purchased to further diversify the investment portfolio and increase investment yield. The Company's investment policy limits investments in corporate bonds to no more than 10% of total investments and to bonds rated as Baa or better by Moody's Investors Service, Inc. or BBB or better by Standard & Poor's Ratings Services at the time of purchase. Equity Securities. At December 31, 2002 and 2001, available for sale equity securities totaled $3.9 million and $3.8 million, respectively. Included in the portfolio in each year is $3.0 million of FHLMC preferred stock. 30 Security Yields and Maturities Schedule The following table sets forth certain information regarding the carrying value, weighted average yields and contractual maturities of the Company's debt securities portfolio as of December 31, 2002. No tax equivalent adjustments were made to the weighted average yields.
December 31, 2002 ---------------------------------------------------------------------- More than One More than Five One Year or Less Year to Five Years Years to Ten Years ---------------------------------------------------------------------- Weighted Weighted Weighted Amortized Average Amortized Average Amortized Average (Dollars in thousands) Cost Yield Cost Yield Cost Yield ---------------------------------------------------------------------- Available for Sale: US Treasury and Agency $ 1,983 6.62% $ 60,763 5.52% $ 45,760 3.78% Mortgage-backed securities 1,455 5.96 45,823 4.86 93,235 4.87 State and municipal obligations 10,973 4.66 108,374 4.05 43,568 4.27 Corporate bonds 2,741 6.46 6,972 5.46 -- -- ---------------------------------------------------------------------- Total debt securities available for sale $17,152 5.28% $221,932 4.67% $182,563 4.46% ====================================================================== Held to Maturity: State and municipal obligations $25,649 3.08% $ 18,236 4.48% $ 2,756 4.90% ---------------------------------------------------------------------- Total debt securities held to maturity $25,649 3.08% $ 18,236 4.48% $ 2,756 4.90% ====================================================================== December 31, 2002 ----------------------------------------------- After Ten Years Total ----------------------------------------------- Weighted Weighted Amortized Average Amortized Average (Dollars in thousands) Cost Yield Cost Yield ----------------------------------------------- Available for Sale: US Treasury and Agency $ 9,075 5.66% $117,581 4.88% Mortgage-backed securities 137,234 3.66 277,747 4.28 State and municipal obligations 4,066 4.90 166,981 4.17 Corporate bonds 4,062 8.33 13,775 6.51 ----------------------------------------------- Total debt securities available for sale $154,437 3.93% $576,084 4.42% =============================================== Held to Maturity: State and municipal obligations $ 484 5.78% $ 47,125 3.75% ----------------------------------------------- Total debt securities held to maturity $ 484 5.78% $ 47,125 3.75% ===============================================
FUNDING ACTIVITIES Borrowings Outstanding borrowings at December 31, 2002 and 2001 are summarized as follows: (Dollars in thousands) 2002 2001 ------- -------- Short-term borrowings: Federal funds purchased and securities sold under repurchase agreements $60,679 $ 60,957 FHLB advances 26,000 42,135 Other 510 678 ------- -------- Total short-term borrowings $87,189 $103,770 ======= ======== Long-term borrowings: FHLB advances $86,822 $ 65,097 Other 5,268 5,322 ------- -------- Total long-term borrowings $92,090 $ 70,419 ======= ======== Information related to Federal funds purchased and securities sold under repurchase agreements as of and for the years ended December 31, 2002, 2001 and 2000 is summarized as follows: (Dollars in thousands) 2002 2001 2000 ------- ------- ------- Weighted average interest rate at year-end 1.50% 1.88% 4.26% Maximum outstanding at any month-end $61,951 $65,474 $26,135 Average amount outstanding during the year $47,924 $33,157 $ 7,939 The average amounts outstanding are computed using daily average balances. Related interest expense for 2002, 2001 and 2000 was $951,000, $1,108,000 and $400,000, respectively. At December 31, 2002, the Company had outstanding various short and long-term FHLB advances with maturity dates extending through 2009. The FHLB advances bear interest at fixed rates ranging from 31 1.40% to 6.71% and the weighted average interest rate amounted to 4.29% as of December 31, 2002. The Company's FHLB advances include $20.0 million in fixed-rate callable borrowings, which can be called by the FHLB on a quarterly basis. FHLB advances are collateralized by $6.3 million of FHLB stock and mortgage loans with a carrying value of $138.1 million at December 31, 2002. At December 31, 2002, the Company had remaining credit available of $13.0 million under lines of credit with the FHLB. The Company also had $56.2 million of remaining credit available under unsecured lines of credit with various banks at December 31, 2002. During 2001, the Company also obtained lines of credit with Farmer Mac permitting borrowings to a maximum of $50.0 million. However, no advances were outstanding against the Farmer Mac lines at December 31, 2002. Other long-term borrowings consist primarily of a $5.0 million advance on a credit agreement with another commercial bank, which was executed to aid in funding the acquisition of BNB during 2001. The credit agreement requires monthly payments of interest only, at a variable interest rate of LIBOR plus 1.50%, with 3.30% being the rate in effect at December 31, 2002. The credit agreement expires in April 2004. Guaranteed Preferred Beneficial Interests in Corporations Junior Subordinated Debentures On February 22, 2001, the Company established FISI Statutory Trust I (the "Trust"), which is a statutory business trust formed under Connecticut law. The Trust exists for the exclusive purposes of (i) issuing and selling 30 year guaranteed preferred beneficial interests in the Corporation's junior subordinated debentures ("capital securities") in the aggregate amount of $16.2 million at a fixed rate of 10.20%, (ii) using the proceeds from the sale of the capital securities to acquire the junior subordinated debentures issued by the Company and (iii) engaging in only those other activities necessary, advisable or incidental thereto. The junior subordinated debentures are the sole assets of the Trust and, accordingly, payments under the corporation obligated junior debentures are the sole revenue of the Trust. All of the common securities of the Trust are owned by the Company. The Company used the net proceeds from the sale of the capital securities to partially fund the BNB acquisition. As of December 31, 2002 and 2001, respectively, $16.2 million and $12.4 million of the capital securities qualified as Tier I capital under regulatory definitions. The Company's primary source of funds to pay interest on the debentures owed to the Trust are current dividends from its subsidiary banks. Accordingly, the Company's ability to service the debentures is dependent upon the continued ability of the subsidiary banks to pay dividends to the Company. Since the capital securities are classified as debt for financial statement purposes, the tax-deductible expense associated with the capital securities is recorded as interest expense in the consolidated statements of income. The Company incurred $487,000 in costs to issue the securities and the costs are being amortized over 20 years using the straight-line method. Deposits The Banks offer a broad array of core deposit products including checking accounts, interest-bearing transaction accounts, savings and money market accounts and certificates of deposit under $100,000. These core deposits totaled $1.507 billion or 88.2% of total deposits of $1.709 billion at December 31, 2002. The core deposit base consists almost exclusively of in-market accounts. Core deposits are supplemented with certificates of deposit over $100,000, which amounted to $201.8 million as of December 31, 2002, largely from in-market municipal, business and individual customers. As of December 31, 2002, brokered certificates of deposit included in certificates of deposit over $100,000 totaled $71.6 million. Total deposits at December 31, 2001 amounted to $1.434 billion, an increase of $355.6 million or 33.0% from $1.078 billion at December 31, 2000. Core deposit products were $1.199 billion or 83.6% of total deposits at December 31, 2001. Certificates of deposit over $100,000 totaled $234.5 million at December 31, 2001, which included $44.9 million in brokered certificates of deposit. 32 The daily average balances, percentage composition and weighted average rates paid on deposits for each of the years ended December 31, 2002, 2001 and 2000 are presented below:
For the year ended December 31 ---------------------------------------------------------------------------------------------- 2002 2001 2000 ---------------------------------------------------------------------------------------------- Percent Percent Percent Of Total Weighted Of Total Weighted Of Total Weighted Average Average Average Average Average Average Average Average Average (Dollars in thousands) Balance Deposits Rate Balance Deposits Rate Balance Deposits Rate ---------------------------------------------------------------------------------------------- Interest-bearing checking $ 354,687 22.2% 1.43% $ 172,022 13.2% 1.23% $113,344 11.4% 1.36% Savings and money market 366,708 23.0 1.57 253,128 19.4 2.07 193,027 19.3 2.66 Certificates of deposit under $100,000 438,587 27.5 3.80 376,256 28.9 5.36 294,926 29.5 5.63 Certificates of deposit over $100,000 217,150 13.6 3.53 319,974 24.6 4.97 260,757 26.1 6.32 Non-interest bearing accounts 219,028 13.7 -- 181,831 13.9 -- 136,614 13.7 -- ---------------------------------------------------------------------------------------------- Total average deposits $1,596,160 100.0% 2.20% $1,303,211 100.0% 3.33% $998,668 100.0% 3.98% ==============================================================================================
The following table indicates the amount of the Company's certificates of deposit by time remaining until maturity as of December 31, 2002:
At December 31, 2002 ---------------------------------------------------------------- 3 Months Over 3 To Over 6 To Over 12 (Dollars in thousands) Or Less 6 Months 12 Months Months Total ---------------------------------------------------------------- Certificates of deposit less than $100,000 $141,266 $ 85,340 $165,620 $ 94,019 $486,245 Certificates of deposit of $100,000 or more 39,820 23,405 53,452 85,074 201,751 -------- -------- -------- -------- -------- Total certificates of deposit $181,086 $108,745 $219,072 $179,093 $687,996 ======== ======== ======== ======== ========
33 NET INCOME ANALYSIS Average Balance Sheet The following table sets forth certain information relating to the Company's consolidated statements of financial condition and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the years indicated. Such yields and rates were derived by dividing interest income or expense by the average balances of interest-earning assets or interest-bearing liabilities, respectively, for the years shown. Tax equivalent adjustments have been made. All average balances are average daily balances. Nonaccrual loans are included in the yield calculations in this table.
Year ended December 31 ----------------------------------------------------------------------------------- 2002 2001 -------------------------------------- --------------------------------------- Average Interest Average Interest Outstanding Earned/ Yield/ Outstanding Earned/ Yield/ (Dollars in thousands) Balance Paid Rate Balance Paid Rate -------------------------------------- --------------------------------------- Interest-earning assets: Federal funds sold and interest bearing deposits $ 28,889 $ 494 1.71% $ 8,634 $ 358 4.15% Investment securities (1): Taxable 364,356 19,109 5.24 251,794 15,288 6.07 Non-taxable 211,358 13,109 6.20 170,151 11,279 6.63 ----------- ------- ------- ----------- -------- ------- Total investment securities 575,714 32,218 5.59 421,945 26,567 6.30 Loans (2): Commercial and agricultural 766,818 52,177 6.80 611,866 51,244 8.38 Residential real estate 234,813 19,362 8.25 227,784 20,193 8.86 Consumer and home equity 233,173 18,776 8.05 217,070 20,045 9.23 ----------- ------- ------- ----------- -------- ------- Total loans 1,234,804 90,315 7.31 1,056,720 91,482 8.66 Total interest-earning assets 1,839,407 123,027 6.69 1,487,299 118,407 7.96 Allowance for loan losses (20,030) (16,825) Other non-interest earning assets 145,639 117,698 ----------- ----------- Total assets $ 1,965,016 $ 1,588,172 =========== =========== Interest-bearing liabilities: Savings and money market $ 366,708 $ 5,768 1.57% $ 253,128 $ 5,244 2.07% Interest-bearing checking 354,687 5,059 1.43 172,022 2,110 1.23 Certificates of deposit 655,737 24,340 3.71 696,230 36,060 5.18 Borrowed funds 167,883 5,741 3.42 107,530 4,840 4.50 Guaranteed preferred beneficial interests in corporations junior subordinated debentures 16,200 1,677 10.35 13,892 1,440 10.37 ----------- ------- ------- ----------- -------- ------- Total interest-bearing liabilities 1,561,215 42,585 2.73 1,242,802 49,694 4.00 ----------- ------- ------- ----------- -------- ------- Non-interest bearing demand deposits 219,028 181,831 Other non-interest-bearing liabilities 20,306 21,318 ----------- ----------- Total liabilities 1,800,549 1,445,951 Stockholders' equity (3) 164,467 142,221 ----------- ----------- Total liabilities and stockholders' equity $ 1,965,016 $ 1,588,172 =========== =========== Net interest income $80,442 $ 68,713 ======= ======== Net interest rate spread 3.96% 3.96% ====== ====== Net earning assets $ 278,192 $ 244,497 =========== =========== Net interest income as a percentage of average interest-earning assets 4.37% 4.62% ====== ====== Ratio of average interest-earning assets to average interest-bearing liabilities 117.82% 119.67% ====== ====== Year ended December 31 -------------------------------------- 2000 -------------------------------------- Average Interest Outstanding Earned/ Yield/ (Dollars in thousands) Balance Paid Rate -------------------------------------- Interest-earning assets: Federal funds sold and interest bearing deposits $ 3,039 $ 184 6.05% Investment securities (1): Taxable 202,160 12,955 6.41 Non-taxable 106,483 7,369 6.92 ----------- ------- ------- Total investment securities 308,643 20,324 6.58 Loans (2): Commercial and agricultural 464,995 45,142 9.71 Residential real estate 194,014 17,276 8.90 Consumer and home equity 166,944 16,120 9.66 ----------- ------- ------- Total loans 825,953 78,538 9.51 Total interest-earning assets 1,137,635 99,046 8.70 Allowance for loan losses (12,509) Other non-interest earning assets 72,390 ----------- Total assets $ 1,197,516 =========== Interest-bearing liabilities: Savings and money market $ 193,027 $ 5,135 2.66% Interest-bearing checking 113,344 1,537 1.36 Certificates of deposit 555,683 33,086 5.95 Borrowed funds 60,978 3,847 6.31 Guaranteed preferred beneficial interests in corporations junior subordinated debentures -- -- -- ----------- ------- ------- Total interest-bearing liabilities 923,032 43,605 4.72 ----------- ------- ------- Non-interest bearing demand deposits 136,614 Other non-interest-bearing liabilities 14,906 ----------- Total liabilities 1,074,552 Stockholders' equity (3) 122,964 ----------- Total liabilities and stockholders' equity $ 1,197,516 =========== Net interest income $55,441 ======= Net interest rate spread 3.98% ====== Net earning assets $ 214,603 =========== Net interest income as a percentage of average interest-earning assets 4.87% ====== Ratio of average interest-earning assets to average interest-bearing liabilities 123.25% ======
(1) Amounts shown are amortized cost for held to maturity securities and fair value for available for sale securities. In order to make pre-tax income and resultant yields on tax-exempt securities comparable to those on taxable securities and loans, a tax-equivalent adjustment to interest earned from tax-exempt securities has been computed using a federal tax rate of 35%. (2) Net of deferred loan fees and costs, and loan discounts and premiums. (3) Includes unrealized gains/(losses) on securities available for sale. 34 Net Interest Income Net interest income, the principal source of the Company's earnings, was $75.9 million in 2002, an $11.1 million or 17% increase over 2001. Average earning assets increased $352 million or 24% to $1.839 billion for the year ended December 31, 2002. Average loans increased $178 million or 17% to $1.235 billion for 2002 and accounted for 51% of the growth in average earning assets. Investment securities represented 44% of the growth in average earning assets and increased $154 million or 36% to $576 million for 2002. The Company's yield on average earning assets was 6.69% for 2002 down 127 basis points from 2001. The Company's loan portfolio yield was 7.31% and tax-equivalent investment yield was 5.59% for 2002 down 135 basis points and 71 basis points, respectively, from 2001. The principal reason for the decline in loan and investment yields was the reinvestment of investment portfolio cash flows and the acquisition of new loan assets at lower yields, reflective of the fall in overall market interest rates. Lower loan yields were influenced by tighter margins on loan products reflecting competitive pricing pressures as well as the impact of declining rates on variable rate loan products. Total average interest-bearing liabilities were $1.561 billion for the year ended December 31, 2002 representing a $318 million increase over 2001 and represented 90% of the average increased funding required to support the growth in average earning assets. In 2002 there were significant changes to the mix of interest bearing liabilities with increases over 2001 in average savings and money market balances of $114 million, average interest bearing checking balances of $183 million, while certificates of deposit declined $40 million. The shift from certificates of deposit to savings, money market, and interest bearing checking deposits is related to the overall lower level of market interest rates, the Company's deposit pricing strategies, and customer preference in deposit product selection. As market interest rates have fallen the Company has lowered the offering rates on certificates of deposits to a greater degree then on savings, money market, and interest bearing checking accounts. The compression in the spread between the offering rates on these products as well as customer preference for deposit products with greater liquidity has contributed to the shift in deposit mix. The Company's cost of interest bearing liabilities at 2.73% for 2002 dropped 127 basis points from 2001 with the drop limited by the Company's pricing strategy on savings, money market, and interest-bearing checking products. Interest bearing liabilities represented 84.9% of the funding sources for earning assets in 2002 compared to 83.6% in 2001 with the balance of earning assets being funded by net noninterest bearing funding sources. Net noninterest bearing funding sources represent the amount of zero interest cost funds such as demand deposits and equity that are available to fund earning assets after funding non-interest earning assets. Coupling these zero interest cost net non interest bearing fund sources, which had no change in cost year over year, with interest bearing liabilities results in a total cost of funds for the Company in 2002 of 2.32% down 102 basis points from the 2001 total cost of funds of 3.34%. The result of a 127 basis point decline in earning asset yield while the cost of funds fell 102 basis points was a drop of 25 basis points in the net interest margin to 4.37% in 2002 from 4.62% in 2001. The growth in earning assets for 2002 mitigated the drop in net interest margin resulting in the increase of $11.1 million in 2002 in net interest income. Net interest income was $64.8 million in 2001 compared with $52.9 million in 2000, an increase of $11.9 million or 22%. Average earning assets grew by $349.7 million to $1.487 billion in 2001, or 31% over 2000, which offset the effects of a 25 basis point decline in the net interest margin from 4.87% in 2000 to 4.62% in 2001. The increase in average earning assets in 2002 compared to 2001 and also 2001 compared to 2000, as well as the increases in net interest income in those periods were impacted by the acquisition of BNC on May, 1, 2001 which was accounted for under the purchase method of accounting. 35 Rate/Volume Analysis The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by current year rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
Year ended December 31 --------------------------------------------------------------------------------- 2002 vs. 2001 2001 vs. 2000 --------------------------------------------------------------------------------- Increase/(Decrease) Total Increase/(Decrease) Total Due To Increase/ Due To Increase/ (Dollars in thousands) Volume Rate (Decrease) Volume Rate (Decrease) --------------------------------------------------------------------------------- Interest-earning assets: Federal funds sold and interest-bearing deposits $ 349 $ (213) $ 136 $ 232 $ (58) $ 174 Investment securities: Taxable 5,957 (2,136) 3,821 3,012 (679) 2,333 Non-taxable 2,565 (735) 1,830 4,098 (188) 3,910 -------- -------- -------- ------- ------- ------- Total investment securities 8,522 (2,871) 5,651 7,110 (867) 6,243 Loans: Commercial and agricultural 11,249 (10,316) 933 12,375 (6,273) 6,102 Residential real estate 595 (1,426) (831) 2,994 (77) 2,917 Consumer and home equity 1,300 (2,569) (1,269) 4,638 (713) 3,925 -------- -------- -------- ------- ------- ------- Total loans 13,144 (14,311) (1,167) 20,007 (7,063) 12,944 -------- -------- -------- ------- ------- ------- Total interest-earning assets 22,015 (17,395) 4,620 27,349 (7,988) 19,361 ======== ======== ======== ======= ======= ======= Interest-bearing liabilities: Savings and money market 1,807 (1,283) 524 1,431 (1,322) 109 Interest-bearing checking 2,606 343 2,949 721 (148) 573 Certificates of deposit (1,500) (10,220) (11,720) 7,329 (4,355) 2,974 Borrowed funds 2,059 (1,158) 901 2,108 (1,115) 993 Guaranteed preferred beneficial interests in corporation's junior subordinated debentures 240 (3) 237 1,440 -- 1,440 -------- -------- -------- ------- ------- ------- Total interest-bearing liabilities 5,212 (12,321) (7,109) 13,029 (6,940) 6,089 ======== ======== ======== ======= ======= ======= Net interest income $ 16,803 $ (5,074) $ 11,729 $14,320 $(1,048) $13,272 ======== ======== ======== ======= ======= =======
Provision for Loan Losses The provision for loan losses represents management's estimate of the expense necessary to maintain the allowance for loan losses at a level representing losses probable in the portfolio. The provision for loan losses was $6.1 million in 2002, compared to $5.0 million in 2001 and $4.2 million in 2000. The increase in the provision for loan losses of $1.1 million in 2002 over 2001 was principally due to the increased level of impaired loans and the related specific allowance allocations required on those loans based on analysis of the collateral value and borrower paying capacity performed by the Company. The provision for loan losses exceeded net loan charge-offs by $2.4 million in 2002, by $2.5 million in 2001, and $2.5 million in 2000. Nonperforming loans were $37.1 million at December 31, 2002, representing 2.81% of total loans outstanding at year-end. Nonperforming loans at year-end 2001 were $10.0 million, representing 0.86% of total loans outstanding. In 2002 net loan charge-offs were $3.7 million or 0.30% of average loans, compared to net loan charge-offs of $2.5 million or 0.23% of average loans for 2001. The ratio of the allowance for loan losses to nonperforming loans was 58% at December 31, 2002 versus 190% at December 31, 2001. The ratio of allowance for loan losses to total loans was 1.64% at December 31, 2002 and 2001. 36 Noninterest Income The following table presents the major categories of noninterest income during the years indicated:
Year Ended December 31 ---------------------------- (Dollars in thousands) 2002 2001 2000 ------- ------- ------ Service charges on deposits ..................... $10,603 $ 7,653 $5,003 Financial services group fees and commissions ... 5,629 2,690 1,151 Mortgage banking activities ..................... 2,279 2,190 1,536 Gain on sale or call of securities .............. 285 531 27 Other ........................................... 3,393 2,718 1,692 ------- ------- ------ Total noninterest income ...................... $22,189 $15,782 $9,409 ======= ======= ======
Noninterest income increased 41% to $22.2 million in 2002 compared to $15.8 million in 2001. The increase in noninterest income is partially attributed to the growth in deposits and related service fees. In addition, the increase in FSG fees and commissions reflects the ongoing expansion of the financial services line of business. The year ended December 31, 2002 reflects a full year of fees and commissions generated by the Company's employee benefits administration and compensation consulting firm, BGI, which was acquired during the fourth quarter of 2001. The Company has focused on growing fee income, and the integration of BGI with the Company's existing broker/dealer and trust businesses is expected to further enhance the Company's ability to generate additional fee income. Mortagage banking activities include gains and losses from the sale of loans, mortgage servicing income and the amortization and impairment of mortgage servicing rights. Noninterest income increased 67.7% to $15.8 million in 2001 compared to $9.4 million in 2000. Service charges on deposit accounts increased significantly in 2001, which reflects the benefit of the continued growth in core deposits and the related fee-based products and services. The increase in FSG fees and commissions results from FIGI, the Company's brokerage subsidiary, commencing operations in March 2000, enabling FII to retain a higher portion of commissions on mutual fund sales. Also, BGI was acquired during October 2001 and contributed to the increase. The increase in mortgage banking activities results from the increase in the gain on sale of residential mortgage loans and an increase in the serviced loan portfolio. Noninterest Expense The following table presents the major categories of noninterest expense during the years indicated:
Year Ended December 31 ----------------------------- (Dollars in thousands) 2002 2001 2000 ------- ------- ------- Salaries and employee benefits ............. $30,093 $22,958 $16,803 Occupancy and equipment .................... 7,285 6,050 4,614 Supplies and postage ....................... 2,371 1,953 1,500 Amortization of goodwill ................... -- 1,653 -- Amortization of other intangible assets .... 898 728 737 Computer and data processing ............... 1,759 1,501 877 Professional fees .......................... 1,612 1,326 826 Other ...................................... 9,031 7,183 4,799 ------- ------- ------- Total noninterest expense ................ $53,049 $43,352 $30,156 ======= ======= =======
Noninterest expense increased 22% to $53.0 million in 2002 compared to $43.4 million in 2001. The Company's largest component of noninterest expense, salaries and employee benefits, increased 31% in 2002, a reflection of staffing additions from recent years acquisitions and other additions necessary to support the Company's growth. The increase also results from overhead coupled with integrating the newly acquired companies, expenditures associated with maintaining the Company's investment in technology and costs connected with opening new branch offices. In contrast, goodwill amortization 37 expense recognized on the BNB acquisition, which amounted to $1.7 million in 2001, ceased on January 1, 2002 with the adoption of SFAS No. 142. The Company's efficiency ratio, which measures the amount of overhead required to produce a dollar of revenue, has remained at relatively low levels. For the years ended December 31, 2002, 2001 and 2000, the efficiency ratio was 50.6%, 48.5% and 45.2%, respectively. Noninterest expense increased 44% to $43.4 million in 2001 compared to $30.2 million in 2000. The increase was partially attributed to $6.2 million in noninterest expense from the acquired companies, BNB and BGI. The Company's largest component of noninterest expense, salaries and employee benefits, increased 36.6% in 2001, a reflection of staffing additions from acquisitions and additions necessary to support the Company's growth. Income Tax Expense The provision for income taxes provides for Federal and New York State income taxes, which amounted to $12.4 million, $11.0 million and $9.8 million for the years ended December 31, 2002, 2001 and 2000, respectively. The increasing trend corresponds generally to increased levels of taxable income. The effective tax rate for 2002 was 31.9%, compared to 34.2% in 2001 and 35.1% in 2000. The lower effective tax rate in 2002 is primarily attributable to the elimination of non-deductible goodwill amortization expense recognized in 2001. Segment Information In accordance with the provisions of SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," the Company's reportable segments are comprised of WCB, NBG, BNB and FTB as the Company evaluates performance on an individual bank basis. During 2002 the Company completed a geographic realignment of the subsidiary banks, which involved the merger of the subsidiary formerly known as PSB into NBG and subsequent transfer of branches between NBG and WCB. Accordingly, the Company restated segment results to reflect the merger and transfers for each of the years presented Financial information related to the Company's segments is presented in Note 17 of the notes to consolidated financial statements. Recent Accounting Developments In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The statement supersedes SFAS No. 121 and is effective for fiscal years beginning after June 15, 2002 although early adoption is encouraged. SFAS No. 144 retains many of the fundamental principles of SFAS No. 121, but differs from it in that it excludes goodwill and intangible assets from its provisions and provides greater direction relating to the implementation of its principles. The provisions of SFAS No. 144 are not expected to have a material impact on the Company's consolidated financial statements. In June 2002, the FASB issued SFAS No. 145, "Recission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." SFAS No. 145 addresses a number of different issues and is effective at various dates in 2002 and 2003, with earlier application encouraged. None of the provisions of SFAS No. 145 had or are expected to have a material impact on the Company's consolidated financial statements. In July 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. SFAS No. 142 does not apply to costs associated with an exit activity that involves an entity newly acquired in a business combination. The provisions of SFAS No. 146 are not expected to have a material impact on the Company's consolidated financial statements. 38 In October 2002, FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions", an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9 (SFAS No. 147). This statement removes acquisitions of financial institutions from the scope of both Statement No. 72 and Interpretation No. 9 and requires that those transactions, which constitute a business combination, be accounted for in accordance with SFAS No. 141 and SFAS No. 142. Thus, the requirement in paragraph 5 of Statement No. 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of SFAS No. 147. SFAS No. 147 also clarifies that an acquisition that does not meet the definition of a business combination because the transferred net assets and activities do not constitute a business is an acquisition of net assets. Those acquisitions should be accounted for in the same manner as any other net asset acquisition and do not give rise to goodwill. SFAS No. 147 is effective for acquisitions on or after October 1, 2002 with mandatory implementation effective January 1, 2002 for existing intangibles. The adoption of SFAS No. 147 did not have a material impact on the Company's consolidated financial statements. FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," was issued in November 2002. FASB Interpretation No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FASB Interpretation No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company has provided the required disclosures. The Company adopted the recognition and measurement provisions of FASB Interpretation No. 45 effective January 1, 2003. Such adoption did not have a material impact on the Company's consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The amendments to SFAS No. 123 as provided in SFAS No. 148 are effective for financial statements for fiscal years ending after December 15, 2002, while the interim reporting requirements are effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. FASB Interpretation No. 46, "Consolidation of Variable Interest Entities," was issued in January 2003. FASB Interpretation No. 46 clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FASB Interpretation No. 46 requires an enterprise to consolidate a variable interest entity if that enterprise has a variable interest (or combination of variable interests) that will absorb a majority of the entity's expected losses if they occur, receive a majority of the entity's expected returns if they occur, or both. It also requires that both the primary beneficiary and all other enterprises with a significant variable interest in a variable interest entity make certain disclosures. FASB Interpretation No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of the provisions of FASB Interpretation No. 46 is not expected to have a material impact on the Company's consolidated financial statements. 39 LIQUIDITY AND CAPITAL RESOURCES Liquidity The objective of maintaining adequate liquidity is to assure the ability of the Company and its subsidiaries to meet their financial obligations. These obligations include the withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. The Company and its subsidiaries achieve liquidity by maintaining a strong base of core customer funds, maturing short-term assets, the ability to sell securities, lines of credit, and access to capital markets. Liquidity at the subsidiary bank level is managed through the monitoring of anticipated changes in loans, core deposits, and wholesale funds. The strength of the subsidiary bank's liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources which include credit lines with the other banking institutions, the FHLB, Farmer Mac, and the Federal Reserve Bank. The primary source of liquidity for the parent company is dividends from subsidiaries, lines of credit, and access to capital markets. Dividends from subsidiaries are limited by various regulatory requirements related to capital adequacy and earnings trends. The Company's subsidiaries rely on cash flows from operations, core deposits, borrowings, short-term liquid assets, and, in the case of non-banking subsidiaries, funds from the parent company. In the normal course of business, the Company has outstanding commitments to extend credit which are not reflected in the Company's consolidated financial statements. The commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. At December 31, 2002 letters of credit totaling $13.4 million and unused loan commitments of $316.6 million were contractually available. Comparable amounts for these commitments at December 31, 2001 were $8.6 million and $265.9 million, respectively. The total commitment amounts do not necessarily represent future cash requirements as many of the commitments are expected to expire without funding. The Company's cash and cash equivalents were $48.4 million at December 31, 2002, a decrease of $4.8 million from the balance of $53.2 million at December 31, 2001. The primary factor leading to the decrease in cash relates to the Company's more effective management of the Federal Reserve Bank reserve requirements for the subsidiary banks. 40 Capital Resources The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. The guidelines require a minimum total risk-based capital ratio of 8.0%. Leverage ratio is also utilized in assessing capital adequacy with a minimum requirement that can range from 3.0% to 5.0%. The following table reflects the changes in the components of those ratios:
(Dollars in thousands) 2002 2001 2000 ---------- ---------- ----------- Total shareholders' equity $ 178,294 $ 149,187 $ 131,618 Less: Unrealized gains/(losses) on securities available or sale 10,368 2,176 (144) Goodwill and other intangible assets 44,547 39,166 2,381 Disallowed mortgage servicing asset 120 90 -- Plus: Minority interests in consolidated subsidiaries 161 475 458 Qualifying trust preferred securities 16,200 12,408 -- ---------- ---------- ----------- Total Tier 1 capital $ 139,620 $ 120,638 $ 129,839 ========== ========== =========== Adjusted average assets $2,005,837 $1,718,034 $ 1,273,657 Tier 1 leverage ratio 6.96% 7.02% 10.19% Total Tier 1 capital $ 139,620 $ 120,638 $ 129,839 Plus: Qualifying allowance for loan losses 17,813 15,417 11,607 Nonqualifying trust preferred securities -- 3,792 -- ---------- ---------- ----------- Total risk-based capital $ 157,433 $ 139,847 $ 141,446 ========== ========== =========== Net risk-weighted assets $1,421,160 $1,229,811 $ 926,291 Total risk-based capital ratio 11.08% 11.37% 15.27%
The Company's Tier 1 leverage ratio was 6.96% at December 31, 2002 and is well-above minimum regulatory capital requirements. The ratio declined slightly from 7.02% at December 31, 2001. Total Tier 1 capital of $139.6 million at December 31, 2002 increased $19.0 million from $120.6 million at December 31, 2001. The increase in Tier 1 capital relates primarily to the increase in retained earnings resulting from 2002 net income of $26.5 million and reduced by $7.9 million in preferred and common dividends declared during 2002. The Company's total risk-weighted capital ratio was 11.08% at December 31, 2002 and is well-above minimum regulatory capital requirements. The ratio declined slightly from 11.37% at December 31, 2001. Total risk-based capital was $157.4 million at December 31, 2002 an increase of $17.6 million from $139.8 million at December 31, 2001. The increase is attributed to the $19.0 million increase in Tier 1 capital previously discussed plus a $2.4 million increase in qualifying allowance for loan losses, offset by a $3.8 million decrease in nonqualifying trust preferred securities. The Company and all subsidiary banks are well capitalized. For further information related to regulatory capital see Note 15 of the notes to consolidated financial statements. 41 Item 7A. Quantitative and Qualitative Disclosures About Market Risk MARKET RISK The principal objective of the Company's interest rate risk management is to evaluate the interest rate risk inherent in certain assets and liabilities, determine the appropriate level of risk to the Company given its business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the guidelines approved by the Company's Board of Directors. The Company's senior management is responsible for reviewing with the Board its activities and strategies, the effect of those strategies on the net interest margin, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. Senior Management develops an Asset-Liability Policy that meets strategic objectives and regularly reviews the activities of the subsidiary banks. Each subsidiary bank board adopts an Asset-Liability Policy within the parameters of the overall FII Asset-Liability Policy and utilizes an asset/liability committee comprised of senior management of the bank under the direction of the bank's board. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring the Company's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or re-price within that time period. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or re-pricing within a specific time period and the amount of interest-bearing liabilities maturing or re-pricing within that same time period. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. At December 31, 2002, the one-year gap position, the difference between the amount of interest-earning assets maturing or re-pricing within one year and interest-bearing liabilities maturing or re-pricing within one year, was $405.9 million, or 19.3% of total assets. Accordingly, over the one-year period following December 31, 2002, the Company will have an estimated $405.9 million more in assets re-pricing than liabilities. Generally if rate-sensitive assets re-price sooner than rate-sensitive liabilities, earnings will be positively impacted in a rising rate environment. Conversely, in a declining rate environment, earnings will generally be negatively impacted. If rate-sensitive liabilities re-price sooner than rate-sensitive assets then generally earnings will be negatively impacted in a rising rate environment. Conversely, in a declining rate environment earnings will generally be positively impacted. Management believes that the positive gap position at December 31, 2002 will not have a material adverse effect on the Company's operating results. Gap Analysis The following table (the "Gap Table") sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2002 which management anticipates, based upon certain assumptions, to re-price or mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which re-price or mature during a particular period were determined in accordance with the earlier of the re-pricing date or the contractual maturity of the asset or liability. The table sets forth an approximation of the projected re-pricing of assets and liabilities at December 31, 2002, on the basis of contractual maturities, anticipated prepayments and scheduled rate adjustments within the selected time intervals. All non-maturity deposits (demand deposits and savings deposits) were assumed to become rate sensitive over time, with 1%, 3%, 4%, 15%, 14% and 63% of such deposits assumed to re-price in the periods of less than 30 days, 31 to 180 days, 181 to 365 days, 1 to 3 years, 3 to 5 years and more than 5 years, respectively. Prepayment and re-pricing rates can have a significant impact on the estimated gap. While management believes the assumptions used in modeling the Gap Table are reasonable, there can be no assurances. 42 Gap Table
---------------------------------------------------------------------------------------------- December 31, 2002 ---------------------------------------------------------------------------------------------- Volumes Subject to Repricing Within ---------------------------------------------------------------------------------------------- 0-30 31-180 181-365 1-3 3-5 >5 Non- (Dollars in thousands) days days days years years years Sensitive Total ---------------------------------------------------------------------------------------------- Interest-earning assets: Federal funds sold and and interest-bearing deposits $ -- $ -- $ 75 $ -- $ -- $ -- $ -- $ 75 Investment securities (1) 87,973 63,849 63,462 123,416 68,889 236,398 -- 643,987 Loans (2) 430,279 231,013 152,030 298,558 144,963 61,327 3,722 1,321,892 -------- -------- --------- -------- -------- --------- -------- ---------- Total interest-earning assets 518,252 294,862 215,567 421,974 213,852 297,725 3,722 1,965,954 -------- -------- --------- -------- -------- --------- -------- ---------- Interest-bearing liabilities: Interest-bearing checking, savings and money market deposits 4,679 23,140 27,070 105,833 89,762 529,288 -- 779,772 Certificates of deposit 76,425 209,473 219,300 155,857 25,437 1,504 -- 687,996 Borrowed funds (3) 34,305 13,155 15,194 43,534 33,858 55,433 -- 195,479 -------- -------- --------- -------- -------- --------- -------- ---------- Total interest-bearing liabilities 115,409 245,768 261,564 305,224 149,057 586,225 -- 1,663,247 -------- -------- --------- -------- -------- --------- -------- ---------- Period gap $402,843 $ 49,094 $ (45,997) $116,750 $ 64,795 $(288,500) $ 3,722 $ 302,707 ======== ======== ========= ======== ======== ========= ======== ========== Cumulative gap $402,843 $451,937 $ 405,940 $522,690 $587,485 $ 298,985 $302,707 ======== ======== ========= ======== ======== ========= ======== Period gap to total assets 19.14% 2.33% (2.19%) 5.55% 3.08% (13.71%) 0.18% 14.38% ======== ======== ========= ======== ======== ========= ======== ========== Cumulative gap to total assets 19.14% 21.47% 19.28% 24.83% 27.91% 14.20% 14.38% ======== ======== ========= ======== ======== ========= ======== Cumulative interest-earning assets to cumulative interest- bearing liabilities 449.06% 225.13% 165.19% 156.33% 154.55% 117.98% 118.20% ======== ======== ========= ======== ======== ========= ========
(1) Amounts shown include the amortized cost of held to maturity securities and the fair value of available for sale securities. (2) Amounts shown include principal balance net of deferred loan fees and costs, unamortized premiums and discounts. (4) Amounts shown include guaranteed preferred beneficial interests in Corporation's junior subordinated debentures. Certain shortcomings are inherent in the method of analysis presented in the Gap Table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features which restrict changes in interest rates, both on a short-term basis and over the life of the asset. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. As a result of these shortcomings, the Company directs more attention on simulation modeling, such as "net interest income at risk" discussed below, rather than gap analysis. Even though the gap analysis reflects a ratio of cumulative gap to total assets within acceptable limits, the net interest income at risk simulation modeling is considered by management to be more informative in forecasting future income at risk. 43 Net Interest Income at Risk Analysis In addition to the Gap Analysis, management uses a "rate shock" simulation to measure the rate sensitivity of the balance sheet. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income and economic value of equity. The following table sets forth the results of the modeling analysis at December 31, 2002:
Change in Interest Net Interest Income Economic Value of Equity Rates in Basis Points --------------------------------- ---------------------------------- (Rate Shock) Amount $ Change % Change Amount $ Change % Change ------------ ------ -------- -------- ------ -------- -------- (Dollars in thousands) 200 $77,807 $ 4,294 5.84% $364,403 $ (9,922) (2.65%) 100 77,015 3,502 4.76% 367,038 (7,287) (1.95%) Static 73,513 -- -- 374,325 -- -- (100) 68,860 (4,653) (6.33%) 363,378 (10,947) (2.92%) (200) 62,686 (10,827) (14.73%) 361,073 (13,252) (3.54%)
The Company measures net interest income at risk by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of plus or minus 200 basis points over a period of 12 months. As of December 31, 2002, a 200 basis point increase in rates would increase net interest income by $4.3 million, or 5.84%, over the next twelve month period. Conversely, a 200 basis point decrease in rates would decrease net interest income by $10.8 million, or 14.73%, over a 12 month period. This simulation is based on management's assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of the future results and is based on many assumptions that, if changed, could cause a different outcome. 44 Item 8. Financial Statements and Supplementary Data FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2002 AND 2001
(Dollars in thousands, except per share amounts) 2002 2001 ----------- ----------- Assets Cash, due from banks and interest-bearing deposits $ 48,429 $ 52,171 Federal funds sold -- 1,000 Securities available for sale, at fair value 596,862 428,423 Securities held to maturity (fair value of $48,089 and $62,317 at December 31, 2002 and 2001, respectively) 47,125 61,281 Loans, net 1,300,232 1,146,976 Premises and equipment, net 27,254 24,467 Goodwill 40,593 36,829 Other assets 44,539 43,149 ----------- ----------- Total assets $ 2,105,034 $ 1,794,296 =========== =========== Liabilities And Shareholders' Equity Liabilities: Deposits: Demand $ 240,755 $ 224,628 Savings, money market and interest-bearing checking 779,772 572,563 Certificates of deposit 687,996 636,467 ----------- ----------- Total deposits 1,708,523 1,433,658 Short-term borrowings 87,189 103,770 Long-term borrowings 92,090 70,419 Guaranteed preferred beneficial interests in corporation's junior subordinated debentures 16,200 16,200 Accrued expenses and other liabilities 22,738 21,062 ----------- ----------- Total liabilities 1,926,740 1,645,109 Shareholders' equity: 3% cumulative preferred stock, $100 par value, authorized 10,000 shares, issued and outstanding 1,666 shares in 2002 and 2001 167 167 8.48% cumulative preferred stock, $100 par value, authorized 200,000 shares, issued and outstanding 175,755 shares in 2002 and 175,855 shares in 2001 17,575 17,585 Common stock, $0.01 par value, authorized 50,000,000 shares, issued 11,303,533 shares in 2002 and 2001 113 113 Additional paid-in capital 19,728 17,195 Retained earnings 131,320 112,786 Accumulated other comprehensive income 10,368 2,176 Treasury stock, at cost - 199,719 shares in 2002 and 282,219 shares in 2001 (977) (835) ----------- ----------- Total shareholders' equity 178,294 149,187 ----------- ----------- Total liabilities and shareholders' equity $ 2,105,034 $ 1,794,296 =========== ===========
See accompanying notes to consolidated financial statements. 45 FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(Dollars in thousands, except per share amounts) 2002 2001 2000 -------- -------- ------- Interest income: Loans $ 90,315 $ 91,482 $78,538 Securities 27,630 22,628 17,745 Other 494 358 184 -------- -------- ------- Total interest income 118,439 114,468 96,467 -------- -------- ------- Interest expense: Deposits 35,167 43,414 39,758 Borrowings 5,741 4,840 3,847 Guaranteed preferred beneficial interests in corporation's junior subordinated debentures 1,677 1,440 -- -------- -------- ------- Total interest expense 42,585 49,694 43,605 -------- -------- ------- Net interest income 75,854 64,774 52,862 Provision for loan losses 6,119 4,958 4,211 -------- -------- ------- Net interest income after provision for loan losses 69,735 59,816 48,651 -------- -------- ------- Noninterest income: Service charges on deposits 10,603 7,653 5,003 Financial services group fees and commissions 5,629 2,690 1,151 Mortgage banking activities 2,279 2,190 1,536 Gain on sale and call of securities 285 531 27 Other 3,393 2,718 1,692 -------- -------- ------- Total noninterest income 22,189 15,782 9,409 -------- -------- ------- Noninterest expense: Salaries and employee benefits 30,093 22,958 16,803 Occupancy and equipment 7,285 6,050 4,614 Supplies and postage 2,371 1,953 1,500 Amortization of goodwill -- 1,653 -- Amortization of other intangible assets 898 728 737 Computer and data processing 1,759 1,501 877 Professional fees 1,612 1,326 826 Other 9,031 7,183 4,799 -------- -------- ------- Total noninterest expense 53,049 43,352 30,156 -------- -------- ------- Income before income taxes 38,875 32,246 27,904 Income taxes 12,419 11,033 9,804 -------- -------- ------- Net income $ 26,456 $ 21,213 $18,100 ======== ======== ======= Earnings per common share: Basic $ 2.26 $ 1.79 $ 1.51 Diluted $ 2.23 $ 1.77 $ 1.51
See accompanying notes to consolidated financial statements. 46 FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
3% 8.48% Additional (Dollars in thousands, Preferred Preferred Common Paid in Retained except per share amounts) Stock Stock Stock Capital Earnings ----- ----- ----- ------- -------- Balance - December 31, 1999 $ 176 $ 17,636 $113 $ 16,448 $ 86,361 Purchase of 48 shares of 3% preferred stock (5) -- -- 3 -- Purchase of 490 shares of 8.48% preferred stock -- (49) -- (2) -- Purchase of 33,300 shares of common stock -- -- -- -- -- Issue 2,288 shares of common stock - directors plan -- -- -- 23 -- Comprehensive income: Net income -- -- -- -- 18,100 Unrealized gain on securities available for sale (net of tax of $1,757) -- -- -- -- -- Less: Reclassification adjustment for gains included in net income (net of tax of $11) -- -- -- -- -- Net unrealized gain on securities available for sale (net of tax of $1,746) -- -- -- -- -- Total comprehensive income -- -- -- -- -- Cash dividends declared: 3% Preferred - $3.00 per share -- -- -- -- (5) 8.48% Preferred - $8.48 per share -- -- -- -- (1,491) Common - $0.42 per share -- -- -- -- (4,617) ----- -------- ---- -------- --------- Balance - December 31, 2000 $ 171 $ 17,587 $113 $ 16,472 $ 98,348 Purchase of 45 shares of 3% preferred stock (4) -- -- 2 -- Purchase of 11 shares of 8.48% preferred stock -- (2) -- -- -- Purchase of 1,000 shares of common stock -- -- -- -- -- Issue 1,141 shares of common stock - directors plan -- -- -- 23 -- Issue 34,452 shares of common stock - Burke Group, Inc. acquisition -- -- -- 698 -- Comprehensive income: Net income -- -- -- -- 21,213 Unrealized gain on securities available for sale (net of tax of $1,803) -- -- -- -- -- Less: Reclassification adjustment for gains included in net income (net of tax of $215) -- -- -- -- -- Net unrealized gain on securities available for sale (net of tax of $1,588) -- -- -- -- -- Total comprehensive income -- -- -- -- -- Cash dividends declared: 3% Preferred - $3.00 per share -- -- -- -- (5) 8.48% Preferred - $8.48 per share -- -- -- -- (1,491) Common - $0.482 per share -- -- -- -- (5,279) ----- -------- ---- -------- --------- Balance - December 31, 2001 $ 167 $ 17,585 $113 $ 17,195 $ 112,786 Purchase of 100 shares of 8.48% preferred stock -- (10) -- -- -- Purchase of 22,240 shares of common stock -- -- -- -- -- Issue 1,049 shares of common stock - directors plan -- -- -- 33 -- Issue 19,955 shares of common stock - exercised stock options -- -- -- 342 -- Issue 36,700 shares of common stock - Burke Group, Inc. earnout -- -- -- 840 -- Issue 47,036 shares of common stock - Bank of Avoca acquisition -- -- -- 1,318 -- Comprehensive income: Net income -- -- -- -- 26,456 Unrealized gain on securities available for sale (net of tax of $5,603) -- -- -- -- -- Less: Reclassification adjustment for gains included in net income (net of tax of $115) -- -- -- -- -- Net unrealized gain on securities available for sale (net of tax of $5,488) -- -- -- -- -- Total comprehensive income -- -- -- -- -- Cash dividends declared: 3% Preferred - $3.00 per share -- -- -- -- (5) 8.48% Preferred - $8.48 per share -- -- -- -- (1,491) Common - $0.58 per share -- -- -- -- (6,426) ----- -------- ---- -------- --------- Balance - December 31, 2002 $ 167 $ 17,575 $113 $ 19,728 $ 131,320 ===== ======== ==== ======== ========= Accumulated Other Comprehensive Total (Dollars in thousands, Income Treasury Shareholders' except per share amounts) (Loss) Stock Equity ------ ----- ------ Balance - December 31, 1999 $ (2,661) $(534) $ 117,539 Purchase of 48 shares of 3% preferred stock -- -- (2) Purchase of 490 shares of 8.48% preferred stock -- -- (51) Purchase of 33,300 shares of common stock -- (401) (401) Issue 2,288 shares of common stock - directors plan -- 6 29 Comprehensive income: Net income -- -- 18,100 Unrealized gain on securities available for sale (net of tax of $1,757) 2,533 -- 2,533 Less: Reclassification adjustment for gains included in net income (net of tax of $11) (16) -- (16) --------- Net unrealized gain on securities available for sale (net of tax of $1,746) -- -- 2,517 --------- Total comprehensive income -- -- 20,617 --------- Cash dividends declared: 3% Preferred - $3.00 per share -- -- (5) 8.48% Preferred - $8.48 per share -- -- (1,491) Common - $0.42 per share -- -- (4,617) -------- ----- --------- Balance - December 31, 2000 $ (144) $(929) $ 131,618 Purchase of 45 shares of 3% preferred stock -- -- (2) Purchase of 11 shares of 8.48% preferred stock -- -- (2) Purchase of 1,000 shares of common stock -- (12) (12) Issue 1,141 shares of common stock - directors plan -- 4 27 Issue 34,452 shares of common stock - Burke Group, Inc. acquisition -- 102 800 Comprehensive income: Net income -- -- 21,213 Unrealized gain on securities available for sale (net of tax of $1,803) 2,636 -- 2,636 Less: Reclassification adjustment for gains included in net income (net of tax of $215) (316) -- (316) --------- Net unrealized gain on securities available for sale (net of tax of $1,588) -- -- 2,320 --------- Total comprehensive income -- -- 23,533 --------- Cash dividends declared: 3% Preferred - $3.00 per share -- -- (5) 8.48% Preferred - $8.48 per share -- -- (1,491) Common - $0.482 per share -- -- (5,279) -------- ----- --------- Balance - December 31, 2001 $ 2,176 $(835) $ 149,187 Purchase of 100 shares of 8.48% preferred stock -- -- (10) Purchase of 22,240 shares of common stock -- (571) (571) Issue 1,049 shares of common stock - directors plan -- 4 37 Issue 19,955 shares of common stock - exercised stock options -- 84 426 Issue 36,700 shares of common stock - Burke Group, Inc. earnout -- 160 1,000 Issue 47,036 shares of common stock - Bank of Avoca acquisition -- 181 1,499 Comprehensive income: Net income -- -- 26,456 Unrealized gain on securities available for sale (net of tax of $5,603) 8,362 -- 8,362 Less: Reclassification adjustment for gains included in net income (net of tax of $115) (170) -- (170) --------- Net unrealized gain on securities available for sale (net of tax of $5,488) -- -- 8,192 --------- Total comprehensive income -- -- 34,648 --------- Cash dividends declared: 3% Preferred - $3.00 per share -- -- (5) 8.48% Preferred - $8.48 per share -- -- (1,491) Common - $0.58 per share -- -- (6,426) -------- ----- --------- Balance - December 31, 2002 $ 10,368 $(977) $ 178,294 ======== ===== =========
See accompanying notes to consolidated financial statements. 47 FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000
(Dollars in thousands) 2002 2001 2000 --------- --------- --------- Cash flows from operating activities: Net income $ 26,456 $ 21,213 $ 18,100 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 5,697 5,984 3,032 Provision for loan losses 6,119 4,958 4,211 Deferred income tax benefit (1,060) (112) (965) Proceeds from sale of loans held for sale 139,426 117,446 25,880 Origination of loans held for sale (140,569) (119,994) (27,029) Gain on sale and call of securities (285) (531) (27) Gain on sale of loans held for sale (1,542) (1,513) (382) Loss (gain) on sale of other assets 54 131 (88) Minority interest in net income of subsidiaries 175 104 90 Increase in other assets (2,609) (1,518) (5,919) Increase (decrease) in accrued expenses and other liabilities 698 (625) 3,735 --------- --------- --------- Net cash provided by operating activities 32,560 25,543 20,638 Cash flows from investing activities: Purchase of securities: Available for sale (425,269) (377,111) (100,150) Held to maturity (35,152) (21,933) (21,124) Proceeds from maturity and call of securities: Available for sale 232,379 200,315 28,688 Held to maturity 43,419 37,381 25,248 Proceeds from sale and call of securities 45,059 91,412 14,022 Loan originations less principal payments (143,622) (87,814) (123,618) Proceeds from sales of premises and equipment 73 174 41 Purchase of premises and equipment (5,251) (4,359) (3,234) Net cash paid in equity method investment (2,400) -- -- Net cash acquired (paid) in purchase acquisitions 42,156 (49,072) -- --------- --------- --------- Net cash used in investing activities (248,608) (211,007) (180,127) Cash flows from financing activities: Net increase in deposits 213,913 124,080 128,580 Net (decrease) increase in short-term borrowings (16,581) 46,497 807 Proceeds from long-term borrowings 23,056 28,912 7,089 Repayment of long-term borrowings (1,386) (179) (1,848) Proceeds from guaranteed preferred beneficial interests in corporation's junior subordinated debentures, net of costs -- 15,713 -- Purchase of preferred and common shares (581) (16) (454) Issuance of preferred and common shares 463 27 29 Dividends paid (7,578) (6,551) (5,788) --------- --------- --------- Net cash provided by financing activities 211,306 208,483 128,415 --------- --------- --------- Net (decrease) increase in cash and cash equivalents (4,742) 23,019 (31,074) Cash and cash equivalents at the beginning of the year 53,171 30,152 61,226 --------- --------- --------- Cash and cash equivalents at the end of the year $ 48,429 $ 53,171 $ 30,152 ========= ========= ========= Supplemental disclosure of cash flow information: Cash paid during year for: Interest $ 44,309 $ 46,912 $ 40,436 Income taxes 14,295 10,793 10,821 Noncash investing and financing activities: Fair value of noncash assets acquired in purchase acquisitions $ 19,020 $ 282,534 $ -- Fair value of liabilities assumed in purchase acquisitions 61,603 271,644 -- Issuance of common stock in purchase acquisitions/earnouts 2,499 800 --
See accompanying notes to consolidated financial statements. 48 FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Basis of Presentation Financial Institutions, Inc. ("FII"), a financial holding company organized under the laws of New York State, and subsidiaries (the "Company") provide deposit, lending and other financial services to individuals and businesses in Central and Western New York State. FII and subsidiaries are each subject to regulation by certain federal and state agencies. The consolidated financial statements include the accounts of FII, its four banking subsidiaries, Wyoming County Bank (99.65% owned) ("WCB"), The National Bank of Geneva (100% owned) ("NBG"), First Tier Bank & Trust (100% owned) ("FTB") and Bath National Bank (100% owned) ("BNB"), collectively referred to as the "Banks". During 2002, the Company completed a geographic realignment of the subsidiary banks, which involved the merger of the subsidiary formerly known as The Pavilion State Bank ("PSB") into NBG and transfer of other branch offices between subsidiary banks. The merger and transfers were accounted for at historical cost as a combination of entities under common control. Also included are the accounts of the Burke Group, Inc. (100% owned) ("BGI") and The FI Group, Inc. (100% owned) ("FIGI"), collectively referred to as the "Financial Services Group". BGI is an employee benefits and compensation consulting firm acquired by the Company in October 2001. FIGI is a brokerage subsidiary that commenced operations in March 2000. In February 2001, the Company formed FISI Statutory Trust I ("FISI") (100% owned), to accommodate the private placement of $16.2 million in capital securities, the proceeds of which were utilized to partially fund the acquisition of BNB. The capital securities are identified on the consolidated statements of financial condition as guaranteed preferred beneficial interests in corporation's junior subordinated debentures. The consolidated financial information included herein combines the results of operations, the assets, liabilities and shareholders' equity of the Company and its subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and prevailing practices in the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, and the reported revenues and expenses for the period. Actual results could differ from those estimates. Amounts in the prior years' consolidated financial statements are reclassified when necessary to conform with the current year's presentation. Cash Equivalents For purposes of the consolidated statements of cash flows, interest-bearing deposits and federal funds sold are considered cash equivalents. Securities The Company classifies its debt securities as either available for sale or held to maturity. Debt securities which the Company has the ability and positive intent to hold to maturity are carried at amortized cost and classified as held to maturity. Investments in other debt and equity securities are classified as available for sale and are carried at estimated fair value. Unrealized gains or losses related to securities available for sale are included in accumulated other comprehensive income, a component of shareholders' equity, net of the related deferred income tax effect. A decline in the fair value of any security below cost that is deemed other than temporary is charged to income resulting in the establishment of a new cost basis for the security. Interest income includes interest earned on the securities adjusted for amortization of premiums and accretion of discounts on the 49 related securities using the interest method. Realized gains or losses from the sale of available for sale securities are recognized on the trade date using the specific identification method. Loans Loans are stated at the principal amount outstanding, net of discounts and deferred loan origination fees and costs which are recorded in interest income based on the interest method. Mortgage loans held for sale are stated at the lower of aggregate cost or market value as determined by the current fair value. Interest income on loans is recognized based on loan principal amounts outstanding at applicable interest rates. Accrual of interest on loans is suspended and all unpaid accrued interest is reversed when management believes, after considering collection efforts and the period of time past due, that reasonable doubt exists with respect to the collectibility of interest. Income is subsequently recognized to the extent collected, assuming the principal balance is expected to be recovered. The Company services residential mortgage loans for other institutions. Servicing fees are recognized when payments are received. The Company capitalizes servicing assets when servicing rights are retained after selling loans to other institutions. Capitalized servicing assets are reported in other assets and are amortized to noninterest income in proportion to, and over the period of, the estimated future net servicing income. Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to amortized cost. Impairment is determined by stratifying rights by predominant risk characteristics, such as interest rates and terms, using discounted cash flows and market-based assumptions. Impairment is recognized through a valuation allowance, to the extent that fair value is less than the capitalized asset. Mortgage banking activities consist of fees earned for servicing mortgage loans sold to third parties, gains (or losses) recognized on sales of mortgages, amortization of capitalized mortgage servicing assets and impairment losses recognized on capitalized mortgage servicing assets. Allowance for Loan Losses The allowance for loan losses is established through charges to income and is maintained at a level to provide for probable losses in the portfolio. The allowance is determined by management's periodic evaluation of the loan portfolio based on such factors as: current economic conditions; the current financial condition of the borrowers; the economic environment in which they operate; delinquency in loan payments; and the value of any collateral held. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses and may require additions to the allowance based on their judgments about information available to them at the time of their examinations. A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts of principal and interest under the original terms of the agreement. Accordingly, the Company measures certain impaired commercial and agricultural loans based on the present value of future cash flows discounted at the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. The Company has excluded large groups of small balance, homogeneous loans which include commercial and agricultural loans less than $250,000, all residential mortgages, home equity and consumer loans that are collectively evaluated for impairment. Federal Home Loan Bank (FHLB) Stock As a member of the FHLB system, the Company is required to maintain a specified investment in FHLB stock. This non-marketable investment, which is carried at cost, must be at an amount at least equal to the greater of 5% of the outstanding advance balance or 1% of the aggregate outstanding residential mortgage loans held by the Company. Included in other assets is FHLB stock totaling $6.3 million and $5.8 million, at December 31, 2002 and 2001, respectively. 50 Premises and Equipment Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed using straight-line and accelerated methods over estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of lease terms or the useful lives of the assets. Goodwill and Other Intangible Assets Statement of Financial Accounting Standards (SFAS) No. 142 requires that goodwill (including goodwill reported in prior acquisitions) no longer be amortized to earnings, but instead be reviewed for impairment annually, with impairment losses charged to earnings when they occur. The Company adopted SFAS No. 142 effective January 1, 2002. In accordance with SFAS No. 142, the Company ceased goodwill amortization on January 1, 2002 and evaluates goodwill for impairment annually. Prior to January 1, 2002, goodwill was amortized over a period of 15 years. Other intangible assets are being amortized on the straight-line method, over the expected periods to be benefited. Intangible assets are periodically reviewed for impairment or when events or changed circumstances may affect the underlying basis of the assets. Equity Method Investment During 2002, the Company made a $2.4 million cash investment to acquire a 50% interest in Mercantile Adjustment Bureau, LLC, a full-service accounts receivable management firm located in Rochester, New York. The Company has accounted for this investment using the equity method and the investment is included in other assets on the consolidated statements of financial condition. Stock Compensation The Company uses a fixed award stock option plan to compensate certain key members of management of the Company and its subsidiaries. The Company accounts for issuance of stock options under the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Under APB No. 25, compensation expense is recorded on the date the options are granted only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, "Accounting for Stock-Based Compensation," established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed under SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above and has adopted only the disclosure requirements of SFAS No. 123, as amended by SFAS No. 148, "Accounting for Stock Based Compensation - Transition and Disclosure." Had the Company determined compensation cost based on the fair value method under SFAS No. 123, the Company's net income and earnings per share would have been reduced to the following:
Years ended December 31 (Dollars in thousands, except per share amounts) 2002 2001 2000 ---------- ---------- ---------- Reported net income $ 26,456 $ 21,213 $ 18,100 Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (274) (288) (202) ---------- ---------- ---------- Pro forma net income $ 26,182 $ 20,925 $ 17,898 ========== ========== ========== Basic earnings per share: Reported $ 2.26 $ 1.79 $ 1.51 Pro forma $ 2.23 $ 1.77 $ 1.49 Diluted earnings per share: Reported $ 2.23 $ 1.77 $ 1.51 Pro forma $ 2.20 $ 1.75 $ 1.49
51 The weighted-average fair value of options granted during the years ended December 31, 2002, 2001, and 2000 amounted to $11.90, $5.53 and $3.72, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model and the following weighted-average assumptions: For the years ended December 31 ------------------------------- 2002 2001 2000 ----- ----- ----- Dividend yield 1.94% 2.43% 2.98% Expected life (in years) 10.00 10.00 10.00 Expected volatility 38.14% 20.00% 20.00% Risk-free interest rate 4.98% 4.99% 6.17% Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and the respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period which includes the enactment date. Financial Instruments With Off-Balance Sheet Risk The Company's financial instruments with off-balance sheet risk are commercial letters of credit and mortgage, commercial and credit card loan commitments. These financial instruments are reflected in the statement of financial condition upon funding. Financial Services Group Fees and Commissions Financial services group fees and commissions consist of commissions from sales of investment products and services to customers, fees and commissions from trust services provided to customers, and fees and commissions earned from design, consulting, administrative and actuarial services provided to employee benefits plans and their sponsors. Fees and commissions are recognized when earned. New Accounting Pronouncements In October 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The statement supersedes SFAS No. 121 and is effective for fiscal years beginning after June 15, 2002 although early adoption is encouraged. SFAS No. 144 retains many of the fundamental principles of SFAS No. 121, but differs from it in that it excludes goodwill and intangible assets from its provisions and provides greater direction relating to the implementation of its principles. The provisions of SFAS No. 144 are not expected to have a material impact on the Company's consolidated financial statements. In October 2002, FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions", an amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9 (SFAS No. 147). This statement removes acquisitions of financial institutions from the scope of both Statement No. 72 and Interpretation No. 9 and requires that those transactions, which constitute a business combination, be accounted for in accordance with SFAS No. 141 and SFAS No. 142. Thus, the requirement in paragraph 5 of Statement No. 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset no longer applies to acquisitions within the scope of SFAS No. 147. SFAS No. 147 also clarifies that an acquisition that does not meet the definition of a business combination because the transferred net assets and activities do not constitute a business is an acquisition of net assets. Those acquisitions should be accounted for in the same manner as any other net asset acquisition and do not give rise to goodwill. SFAS No. 147 is effective for acquisitions on or after October 1, 2002 with mandatory implementation effective January 1, 2002 for existing intangibles. The adoption of SFAS No. 147 did not have a material impact on the Company's consolidated financial statements. 52 (2) Mergers and Acquisitions On December 13, 2002, BNB acquired the two Chemung County branch offices of BSB Bank & Trust Company of Binghamton, New York. The two offices purchased, located in Elmira and Elmira Heights, had deposit liabilities totaling $44.2 million at the time of acquisition. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, of approximately $1.5 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company also recorded a $2.0 million intangible asset attributable to core deposits, which is being amortized using the straight-line method over seven years. On May 1, 2002, FII acquired all of the common stock of the Bank of Avoca ("BOA") in exchange for 47,036 shares of FII common stock. BOA was a community bank with its main office located in Avoca, New York, as well as a branch office in Cohocton, New York. Subsequent to the acquisition, BOA was merged with BNB. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price ($1.5 million) over the fair value of identifiable tangible and intangible assets acquired ($18.4 million), less liabilities assumed ($17.3 million), of approximately $0.4 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company recorded a $146,000 core deposit intangible asset, which is being amortized using the straight-line method over seven years. The 2002 results of operations for BOA are included in the income statements from the date of acquisition (May 1, 2002). On October 22, 2001, the Company acquired the Burke Group, Inc. ("BGI"), an employee benefits administration and compensation consulting firm, with offices in Honeoye Falls and Syracuse, New York. BGI's expertise includes design and consulting for retirement and employee welfare plans, administrative services for defined contribution and benefit plans, actuarial services and post employment benefits. The agreement provided for merger consideration of $1,500,000 to BGI shareholders. Merger consideration payments of $200,000 in cash and 34,452 shares of FII common stock (valued at $800,000 in accordance with merger agreement) were made on October 22, 2001. The balance of the merger consideration of $500,000 was paid on October 22, 2002 in the form of 18,852 shares of FII common stock as provided for in the agreement. In addition the agreement provided for the payment of earned amount consideration based on achievement of financial performance targets. For the period ending December 31, 2001 those targets were achieved and $500,000 in earned amount consideration was paid on April 1, 2002 in the form of 17,848 shares of FII common stock. For the period ending December 31, 2002 financial performance targets were also achieved and $750,000 in the form of FII common stock will be paid on April 1, 2003 based on the Company's average closing stock price for the 30 day period preceding the payment date. The agreement further provides for payment of contingent consideration in the form of FII common stock based on other financial performance targets for the periods ending December 31, 2002, 2003, and 2004 with the maximum amount of payments for 2003 and 2004 being $2,250,000, and $2,500,000 respectively. For the year ended December 31, 2002 financial performance for contingent consideration was achieved and $590,000 in contingent consideration will be paid on April 1, 2003 based on the Company's average closing price for the 30 day period preceding the payment date. The acquisition was accounted for as a business combination using the purchase method of accounting, and accordingly, the excess of the purchase price ($3.3 million including earned amounts and contingent amounts to date) over the fair value of identifiable tangible and intangible assets acquired ($1.7 million), less liabilities assumed ($1.7 million), of approximately $3.3 million has been recorded as goodwill. In accordance with SFAS No. 142, the Company is not required to amortize goodwill recognized in this acquisition. The Company also recorded a $500,000 intangible asset for a customer list which is being amortized using the straight-line method over five years. The results of operations for BGI are included in the income statements from the date of acquisition (October 22, 2001). On May 1, 2001, FII acquired all of the common stock of Bath National Corporation ("BNC") , and its wholly-owned subsidiary bank, Bath National Bank. BNB is a full service community bank headquartered in Bath, New York, which has 9 branch locations in Steuben, Yates, Ontario and Schuyler Counties. The 53 Company paid $48.00 per share in cash for each of the outstanding shares of BNC common stock with an aggregate purchase price of approximately $62.6 million. The acquisition was accounted for under the purchase method of accounting, and accordingly, the excess of the purchase price ($62.6 million) over the fair value of identifiable tangible and intangible assets acquired ($295.4 million), less liabilities assumed ($269.9 million), of approximately $37.1 million has been recorded as goodwill. Goodwill was amortized in 2001 using the straight-line method over 15 years, since the transaction was consummated prior to June 30, 2001, the effective date of SFAS No. 142. However, in accordance with SFAS No. 142, the Company ceased goodwill amortization on January 1, 2002. The results of operations for BNB are included in the income statements from the date of acquisition (May 1, 2001). (3) Securities The aggregate amortized cost and fair value of securities available for sale and securities held to maturity follow:
December 31, 2002 --------------------------------------------------- Gross Unrealized Amortized -------------------- Fair (Dollars in thousands) Cost Gains Losses Value --------- ------- ------ -------- Securities Available for Sale: U.S. Treasury and agency $117,581 $ 3,058 $ 13 $120,626 Mortgage-backed securities 277,747 5,809 79 283,477 State and municipal obligations 166,981 7,959 17 174,923 Corporate bonds 13,775 203 55 13,923 Equity securities 3,010 903 -- 3,913 -------- ------- ------ -------- Total securities available for sale $579,094 $17,932 $ 164 $596,862 ======== ======= ====== ======== Securities Held to Maturity: State and municipal obligations $ 47,125 $ 969 $ 5 $ 48,089 -------- ------- ------ -------- Total securities held to maturity $ 47,125 $ 969 $ 5 $ 48,089 ======== ======= ====== ======== December 31, 2001 --------------------------------------------------- Gross Unrealized Amortized -------------------- Fair (Dollars in thousands) Cost Gains Losses Value --------- ------- ------ -------- Securities Available for Sale: U.S. Treasury and agency $182,812 $ 1,949 $1,268 $183,493 Mortgage-backed securities 89,396 1,014 416 89,994 State and municipal obligations 141,637 2,220 635 143,222 Corporate bonds 7,824 121 35 7,910 Equity securities 3,082 722 -- 3,804 -------- ------- ------ -------- Total securities available for sale $424,751 $ 6,026 $2,354 $428,423 ======== ======= ====== ======== Securities Held to Maturity: U.S. Treasury and agency $ 1,950 $ 68 $ -- $ 2,018 State and municipal obligations 59,331 981 13 60,299 -------- ------- ------ -------- Total securities held to maturity $ 61,281 $ 1,049 $ 13 $ 62,317 ======== ======= ====== ========
54 The amortized cost and fair value of debt securities by contractual maturity are as follows: December 31, 2002 ---------------------------------------------------- Available for Sale Held to Maturity ------------------------ ---------------------- Amortized Fair Amortized Fair (Dollars in thousands) Cost Value Cost Value --------- -------- --------- ------- Due in one year or less $ 17,152 $ 17,429 $25,649 $25,804 Due in one to five years 221,932 230,817 18,236 19,007 Due in five to ten years 182,563 187,662 2,756 2,787 Due after ten years 154,437 157,041 484 491 -------- -------- ------- ------- $576,084 $592,949 $47,125 $48,089 ======== ======== ======= ======= Maturities of mortgage-backed securities are classified in accordance with the contractual repayment schedules. Expected maturities will differ from contractual maturities since issuers generally have the right to prepay obligations. Proceeds from the sale and call of securities available for sale during 2002 were $45,059,000; realized gross gains were $615,000 and gross losses were $330,000. Proceeds from the sale and call of securities available for sale during 2001 were $91,412,000; realized gross gains were $617,000 and gross losses were $86,000. Proceeds from the sale and call of securities available for sale during 2000 were $14,022,000; realized gross gains were $52,000 and gross losses were $25,000. Gains and losses were computed using the specific identification method. There were no transfers between held to maturity and available for sale securities in 2002, 2001 or 2000. Securities held to maturity and available for sale with carrying values of $475,567,000 and $340,989,000 were pledged as collateral for municipal deposits and repurchase agreements at December 31, 2002 and 2001, respectively. (4) Loans Loans outstanding at December 31, 2002 and 2001 are summarized as follows: (Dollars in thousands) 2002 2001 ----------- ----------- Commercial $ 262,630 $ 232,379 Commercial real estate 332,134 274,702 Agricultural 233,769 186,623 Residential real estate 251,898 240,141 Consumer and home equity 241,461 232,205 ----------- ----------- Loans, gross 1,321,892 1,166,050 Allowance for loan losses (21,660) (19,074) ----------- ----------- Loans, net $ 1,300,232 $ 1,146,976 =========== =========== 55 The following table sets forth the changes in the allowance for loan losses for the years indicated. Years ended December 31 (Dollars in thousands) 2002 2001 2000 ------- ------- ------- Balance at beginning of year $19,074 $13,883 $11,421 Addition resulting from acquisitions 174 2,686 -- Charge-offs: Commercial 1,771 1,003 466 Commercial real estate 944 394 629 Agricultural 106 58 85 Residential real estate 98 178 113 Consumer and home equity 1,499 1,319 905 ------- ------- ------- Total charge-offs 4,418 2,952 2,198 Recoveries: Commercial 210 58 206 Commercial real estate 69 23 22 Agricultural 36 -- 1 Residential real estate 67 19 5 Consumer and home equity 329 399 215 ------- ------- ------- Total recoveries 711 499 449 ------- ------- ------- Net charge-offs 3,707 2,453 1,749 Provision for loan losses 6,119 4,958 4,211 ------- ------- ------- Balance at end of year $21,660 $19,074 $13,883 ======= ======= ======= The following table sets forth information regarding nonaccrual loans and other nonperforming assets at December 31: (Dollars in thousands) 2002 2001 ------- ------- Nonaccrual loans: Commercial $12,760 $ 2,623 Commercial real estate 8,407 3,344 Agricultural 8,739 1,529 Residential real estate 1,065 921 Consumer and home equity 915 541 ------- ------- Total nonaccrual loans 31,886 8,958 Restructured loans 4,129 -- Accruing loans 90 days or more delinquent 1,091 1,064 ------- ------- Total nonperforming loans 37,106 10,022 Other real estate owned 1,251 947 ------- ------- Total nonperforming assets $38,357 $10,969 ======= ======= The recorded investment in loans that are considered to be impaired totaled $24,626,000 and $8,289,000 at December 31, 2002 and 2001, respectively. The allowance for loan losses related to impaired loans amounted to $4,462,000 and $1,778,000 at December 31, 2002 and 2001, respectively. The average recorded investment in impaired loans during 2002, 2001 and 2000 was $25,332,000, $10,842,000 and $8,202,000, respectively. Interest income recognized on impaired loans, while such loans were impaired, during 2002, 2001 and 2000 was approximately $455,000, $392,000 and $316,000, respectively. 56 In the normal course of business there are various outstanding commitments to extend credit which are not reflected in the accompanying consolidated financial statements. Loan commitments have off-balance-sheet credit risk until commitments are fulfilled or expire. The credit risk amounts are equal to the contractual amounts, assuming that the amounts are ultimately advanced in full and that the collateral or other security is of no value. The Company's policy generally requires customers to provide collateral, usually in the form of customers' operating assets or property, prior to the disbursement of approved loans. At December 31, 2002, letters of credit totaling $13,359,000 and unused loan commitments and lines of credit of $316,595,000 were contractually available. Comparable amounts for these letters of credit and commitments at December 31, 2001 were $8,602,000 and $265,933,000, respectively. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without funding, the total commitment amounts do not necessarily represent future cash requirements. Loans outstanding by subsidiary banks to certain officers, directors, or companies in which they have 10% or more beneficial ownership, including officers and directors of the Company, as well as its subsidiaries ("Insiders"), approximated $36,406,000 and $25,592,000 at December 31, 2002 and 2001, respectively. An analysis of activity with respect to insider loans during the year ended December 31, 2002 is as follows: (Dollars in thousands) Balance as of December 31, 2001 $ 25,592 New loans to insiders 12,322 Repayments received from insiders (4,658) Other changes * 3,150 -------- Balance as of December 31, 2002 $ 36,406 ======== * Other changes relate primarily to existing loans with directors elected during 2002. These loans were made on substantially the same terms, including interest rate and collateral, as comparable transactions with other customers. Included in the nonperforming asset totals are loans to two NBG directors totaling $4,934,000. The Company has performed an assessment of the collateral on these loans and has allocated $524,000 of the allowance for loan losses to these loans. As of December 31, 2002, the Company had no significant concentration of credit risk in the loan portfolio outside of normal geographic concentration pertaining to the communities that the Company serves. There is no significant exposure to highly leveraged transactions and there are no foreign credits in the loan portfolio. Loans serviced for others amounting to $356,419,000 and $302,258,000 at December 31, 2002 and 2001, respectively, are not included in the consolidated statements of financial condition. The Company had capitalized mortgage servicing rights of $1,243,000 and $944,000 as of December 31, 2002 and 2001, respectively. Proceeds from the sale of loans were $139,426,000, $117,446,000 and $25,880,000 in 2002, 2001 and 2000, respectively. Net gain on the sale of loans included in mortgage banking activities on the income statement, was $1,542,000, $1,513,000 and $382,000 in 2002, 2001 and 2000, respectively. Included in net loans are loans held for sale with commitments to be sold totaling $6,971,000 and $5,828,000 at December 31, 2002 and 2001, respectively. The Company enters into forward contracts for future delivery of residential mortgage loans at a specified yield to reduce the interest rate risk associated with fixed rate residential mortgage loans held for sale and commitments to fund residential mortgages. Credit risk arises from the possible inability of the other parties to comply with the contract terms. Substantially all of the Company's contracts are with government-sponsored enterprises or government agencies (FHLMC and FHA). 57 (5) Premises and Equipment A summary of premises and equipment at December 31, 2002 and 2001 follows: (Dollars in thousands) 2002 2001 -------- -------- Land and land improvements $ 3,320 $ 2,584 Buildings and leasehold improvements 24,275 21,599 Furniture, fixtures, equipment and vehicles 19,129 16,967 -------- -------- Premises and equipment, gross 46,724 41,150 Accumulated depreciation and amortization (19,470) (16,683) -------- -------- Premises and equipment, net $ 27,254 $ 24,467 ======== ======== Depreciation and amortization expense amounted to $2,879,000, $2,403,000 and $1,866,000 for the years ended December 31, 2002, 2001 and 2000, respectively. (6) Goodwill and Other Intangible Assets As discussed in Note 1, the Company adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," on January 1, 2002. Under SFAS No. 142, goodwill is no longer amortized, but is reviewed for impairment at least annually. Identifiable intangible assets acquired in a business combination are amortized over their useful lives. The following table presents the consolidated results of operations for the years ended December 31, 2002 and 2001, adjusted as though the adoption of SFAS No. 142 occurred as of January 1, 2000.
Years ended December 31 (Dollars in thousands, except per share amounts) 2002 2001 2000 ---------- ---------- ---------- Reported net income $ 26,456 $ 21,213 $ 18,100 Goodwill amortization add-back -- 1,653 -- ---------- ---------- ---------- Adjusted net income $ 26,456 $ 22,866 $ 18,100 ========== ========== ========== Basic earnings per share: Reported $ 2.26 $ 1.79 $ 1.51 Goodwill amortization add-back -- 0.15 -- ---------- ---------- ---------- Adjusted $ 2.26 $ 1.94 $ 1.51 ========== ========== ========== Diluted earnings per share: Reported $ 2.23 $ 1.77 $ 1.51 Goodwill amortization add-back -- 0.15 -- ---------- ---------- ---------- Adjusted $ 2.23 $ 1.92 $ 1.51 ========== ========== ==========
Goodwill resulting from the previously disclosed mergers and acquisitions (see Note 2) amounted to $40.6 million and $36.8 million at December 31, 2002 and 2001, respectively. Goodwill amortization expense included in the results of operations for 2001 amounted to $1.7 million, which was non-deductible for income tax purposes. In accordance with SFAS No. 142, there is no goodwill amortization included in 2002. 58 The following table presents the change in the carrying amount of goodwill allocated by business segment for the years ended December 31, 2002 and 2001: Financial Services BNB Group (Dollars in thousands) Segment Segment Total -------- ------------------ -------- Balance as of December 31, 2000 $ -- $ -- $ -- Goodwill acquired during the period 37,188 794 37,982 Contingent earnout -- 500 500 Amortization expense (1,653) -- (1,653) -------- ------ -------- Balance as of December 31, 2001 $ 35,535 $1,294 $ 36,829 Goodwill acquired during the period 1,925 -- 1,925 Contingent earnout -- 1,840 1,840 Goodwill adjustments (119) 118 (1) -------- ------ -------- Balance as of December 31, 2002 $ 37,341 $3,252 $ 40,593 ======== ====== ======== During 2002, the Company performed a goodwill impairment analysis as required by SFAS No. 142 and determined no impairment existed. A summary of the major classes of amortizable intangible assets (included in other assets on the consolidated statements of financial condition) at December 31, 2002 and 2001 follows: (Dollars in thousands) 2002 2001 -------- ------- Core deposits $ 11,452 $ 8,937 Customer list 500 500 -------- ------- Other intangible assets, gross 11,952 9,437 Accumulated amortization (7,998) (7,100) -------- ------- Other intangible assets, net $ 3,954 $ 2,337 ======== ======= Intangible amortization expense for these other intangible assets amounted to $898,000, $728,000 and $737,000 for the years ended December 31, 2002, 2001 and 2000, respectively. Amortization of other intangible assets was computed using the straight-line method over the estimated lives of the respective assets, which primarily range from 5 to 10 years. Based on the current level of intangible assets, estimated amortization expense for other intangible assets is as follows: Year ending December 31, (Dollars in thousands) 2003 $1,222 2004 804 2005 526 2006 494 2007 320 Thereafter 588 ------ $3,954 ====== 59 (7) Deposits Scheduled maturities for certificates of deposit at December 31, 2002 are as follows: Mature in year ending December 31, (Dollars in thousands) 2003 $508,902 2004 115,925 2005 39,736 2006 10,365 2007 12,953 Thereafter 115 -------- $687,996 ======== Certificates of deposit greater than $100,000 totaled $201,751,000 and $234,450,000 at December 31, 2002 and 2001, respectively. Interest expense on certificates of deposit greater than $100,000 amounted to $7,682,000, $15,922,000 and $15,962,000 for the years ended December 31, 2002, 2001 and 2000, respectively. As of December 31, 2002 and 2001, overdrawn deposits included in loans on the consolidated statements of financial condition amounted to $3,459,000 and $2,553,000, respectively. (8) Borrowings Outstanding borrowings at December 31, 2002 and 2001 are summarized as follows: (Dollars in thousands) 2002 2001 ------- -------- Short-term borrowings: Federal funds purchased and securities sold under repurchase agreements $60,679 $ 60,957 FHLB advances 26,000 42,135 Other 510 678 ------- -------- Total short-term borrowings $87,189 $103,770 ======= ======== Long-term borrowings: FHLB advances $86,822 $ 65,097 Other 5,268 5,322 ------- -------- Total long-term borrowings $92,090 $ 70,419 ======= ======== Information related to Federal funds purchased and securities sold under repurchase agreements as of and for the years ended December 31, 2002, 2001 and 2000 is summarized as follows: (Dollars in thousands) 2002 2001 2000 ------- ------- ------- Weighted average interest rate at year-end 1.50% 1.88% 4.26% Maximum outstanding at any month-end $61,951 $65,474 $26,135 Average amount outstanding during the year $47,924 $33,157 $ 7,939 The average amounts outstanding are computed using daily average balances. Related interest expense for 2002, 2001 and 2000 was $951,000, $1,108,000 and $400,000, respectively. At December 31, 2002, the Company had outstanding various short and long-term FHLB advances with maturity dates extending through 2009. The FHLB advances bear interest at fixed rates ranging from 1.40% to 6.71% and the weighted average interest rate amounted to 4.29% as of December 31, 2002. 60 The Company's FHLB advances include $20.0 million in fixed-rate callable borrowings, which can be called by the FHLB on a quarterly basis. FHLB advances are collateralized by $6.3 million of FHLB stock and mortgage loans with a carrying value of $138.1 million at December 31, 2002. At December 31, 2002, the Company had remaining credit available of $13.0 million under lines of credit with the FHLB. The Company also had $56.2 million of remaining credit available under unsecured lines of credit with various banks at December 31, 2002. During 2001, the Company also obtained lines of credit with Farmer Mac permitting borrowings to a maximum of $50.0 million. However, no advances were outstanding against the Farmer Mac lines at December 31, 2002. Other long-term borrowings consist primarily of a $5.0 million advance on a credit agreement with another commercial bank, which was executed to aid in funding the acquisition of BNB during 2001. The credit agreement requires monthly payments of interest only, at a variable interest rate of LIBOR plus 1.50%. As of December 31, 2002 the interest rate was 3.30%. The credit agreement expires in April 2004. The aggregate maturities of long-term borrowings at December 31, 2002 are as follows: Mature in year ending December 31, (Dollars in thousands) 2004 $31,868 2005 8,179 2006 11,183 2007 14,213 2008 5,278 Thereafter 21,369 ------- $92,090 ======= (9) Guaranteed Preferred Beneficial Interests in Corporations Junior Subordinated Debentures On February 22, 2001, the Company established FISI Statutory Trust I (the "Trust"), which is a statutory business trust formed under Connecticut law. The Trust exists for the exclusive purposes of (i) issuing and selling 30 year guaranteed preferred beneficial interests in the Corporation's junior subordinated debentures ("capital securities") in the aggregate amount of $16.2 million at a fixed rate of 10.20%, (ii) using the proceeds from the sale of the capital securities to acquire the junior subordinated debentures issued by the Company and (iii) engaging in only those other activities necessary, advisable or incidental thereto. The junior subordinated debentures are the sole assets of the Trust and, accordingly, payments under the corporation obligated junior debentures are the sole revenue of the Trust. All of the common securities of the Trust are owned by the Company. The Company used the net proceeds from the sale of the capital securities to partially fund the BNB acquisition. As of December 31, 2002 and 2001, respectively, $16.2 million and $12.4 million of the capital securities qualified as Tier I capital under regulatory definitions. The Company's primary source of funds to pay interest on the debentures owed to the Trust are current dividends from its subsidiary banks. Accordingly, the Company's ability to service the debentures is dependent upon the continued ability of the subsidiary banks to pay dividends to the Company. Since the capital securities are classified as debt for financial statement purposes, the tax-deductible expense associated with the capital securities is recorded as interest expense in the consolidated statements of income. The Company incurred $487,000 in costs to issue the securities. The costs are being amortized over 20 years using the straight-line method and are included in other assets on the consolidated statements of financial condition. 61 (10) Income Taxes Total income taxes for the years ended December 31, 2002, 2001 and 2000 were allocated as follows: (Dollars in thousands) 2002 2001 2000 ------- ------- ------- Income from operations $12,419 $11,033 $ 9,804 Shareholders' equity, for unrealized gain on securities available for sale 5,488 1,588 1,746 ------- ------- ------- $17,907 $12,621 $11,550 ======= ======= ======= Income tax expense (benefit) attributable to operations for the years ended December 31, 2002, 2001 and 2000 consists of: (Dollars in thousands) 2002 2001 2000 -------- -------- -------- Current: Federal $ 10,828 $ 8,676 $ 8,380 State 2,651 2,469 2,389 -------- -------- -------- Total current 13,479 11,145 10,769 Deferred: Federal (908) (68) (785) State (152) (44) (180) -------- -------- -------- Total deferred (1,060) (112) (965) -------- -------- -------- Total income taxes $ 12,419 $ 11,033 $ 9,804 ======== ======== ======== The following is a reconciliation of the actual and statutory tax rates applicable to income from operations for the years ended December 31, 2002, 2001 and 2000:
2002 2001 2000 ------ ------ ------ Statutory rate 35.0% 35.0% 35.0% Increase (decrease) resulting from: Tax exempt interest income (7.8) (8.1) (6.0) State taxes, net of federal income tax benefit 4.2 4.9 5.1 Goodwill amortization -- 1.8 -- Other 0.5 0.6 1.0 ------ ------ ------ Total 31.9% 34.2% 35.1% ====== ====== ======
62 The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are presented as follows:
(Dollars in thousands) 2002 2001 -------- ------- Deferred tax assets: Allowance for loan losses $ 8,216 $ 7,165 Core deposit intangible 822 773 Interest on nonaccrual loans 869 750 Other 946 395 -------- ------- Total gross deferred tax assets 10,853 9,083 Deferred tax liabilities: Prepaid pension costs 1,017 1,150 Unrealized gain on securities available for sale 6,976 1,488 Depreciation of premises and equipment 917 693 Loan servicing assets 479 354 Other 697 476 -------- ------- Total gross deferred tax liabilities 10,086 4,161 -------- ------- Net deferred tax asset, at year-end * $ 767 $ 4,922 Net deferred tax asset, at beginning of year 4,922 4,581 -------- ------- Decrease (increase) in net deferred tax asset 4,155 (341) Net deferred tax asset acquired 368 1,470 Initial purchase accounting adjustments, net (95) 347 Change in unrealized gain/loss on securities available for sale (5,488) (1,588) -------- ------- Deferred tax benefit $ (1,060) $ (112) ======== =======
* Included in other assets on the consolidated statements of financial condition Realization of deferred tax assets is dependent upon the generation of future taxable income or the existence of sufficient taxable income within the carry-back period. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, management considers the scheduled reversal of the deferred tax liabilities, the level of historical taxable income and projected future taxable income over the periods in which the temporary differences comprising the deferred tax assets will be deductible. Based on its assessment, management determined that no valuation allowance is necessary at December 31, 2002 and 2001. The Company has Federal and state net operating loss carryforwards of $510,000 which expire in 2021. The utilization of the tax net operating carryforwards is subject to limitations imposed by the Internal Revenue Code. The Company believes these limitations will not prevent the carryforward benefits from being utilized. 63 (11) Lease Commitments At December 31, 2002, the Company was obligated under a number of noncancellable operating leases for land, buildings and equipment. Certain of these leases provide for escalation clauses and contain renewal options calling for increased rentals if the lease is renewed. Future minimum lease payments on operating leases at December 31, 2002 were as follows: Operating lease payments in year ending December 31, (Dollars in thousands) 2003 $ 646 2004 579 2005 520 2006 462 2007 400 Thereafter 2,136 ------ $4,743 ====== (12) Retirement Plans and Postretirement benefits Defined Benefit Plan The Company has a defined benefit pension plan covering substantially all employees. The benefits are based on years of service and the employee's highest average compensation during five consecutive years of employment. The Company's funding policy is to contribute annually an actuarially determined amount to cover current service cost plus amortization of prior service costs. The following table sets forth the defined benefit pension plan's change in benefit obligation and change in plan assets using the most recent actuarial data measured at September 30:
(Dollars in thousands) 2002 2001 2000 -------- -------- -------- Change in benefit obligation: Benefit obligation at beginning of year $(13,608) $(12,114) $(11,740) Service cost (1,071) (1,249) (766) Interest cost (968) (890) (806) Actuarial (loss) gain (1,303) 72 603 Benefits paid 559 470 476 Plan expenses 109 103 119 -------- -------- -------- Benefit obligation at end of year (16,282) (13,608) (12,114) Change in plan assets: Fair value of plan assets at beginning of year 15,240 17,180 15,706 Actual (loss) return on plan assets (831) (1,367) 1,588 Employer contribution 552 -- 481 Benefits paid (559) (470) (476) Plan expenses (108) (103) (119) -------- -------- -------- Fair value of plan assets at end of year 14,294 15,240 17,180 -------- -------- -------- Funded status (1,988) 1,632 5,066 Unamortized net asset at transition (141) (179) (217) Unrecognized net loss (gain) subsequent to transition 4,722 1,292 (1,433) Unamortized prior service cost 322 345 (57) -------- -------- -------- Prepaid benefit cost, included in other assets $ 2,915 $ 3,090 $ 3,359 ======== ======== ======== Weighted average discount rate 6.75% 7.25% 7.50% Expected long-term rate of return 8.50% 8.50% 8.50% Rate of compensation increase 4.00% 5.00% 5.00%
64 Pension expense consists of the following components for the years ended December 31:
(Dollars in thousands) 2002 2001 2000 ------- ------- ------- Service cost $ 1,071 $ 850 $ 766 Interest cost on projected benefit obligation 968 890 806 Expected return on plan assets (1,297) (1,429) (1,307) Amortization of net transition asset (38) (38) (38) Amortization of unrecognized prior service cost 22 (3) (3) ------- ------- ------- Net periodic pension expense $ 726 $ 270 $ 224 ======= ======= =======
Defined Contribution Plan The Company also sponsors a defined contribution profit sharing (401(k)) plan covering substantially all employees. The Company matches certain percentages of each eligible employee's contribution to the plan. Expense for the plan amounted to $1,057,000, $708,000 and $524,000 in 2002, 2001 and 2000, respectively. Postretirement Benefits Prior to December 31, 2001, BNB provided health and dental care benefits to retired employees who met specified age and service requirements through a postretirement health and dental care plan in which both BNB and the retiree shared the cost. The plan provided for substantially the same medical insurance coverage as for active employees until their death and was integrated with Medicare for those retirees aged 65 or older. In 2001, the plan's eligibility requirements were amended to curtail eligible benefit payments to only retired employees and active participants who were fully vested under the Plan. The accrued liability related to this plan amounted to $844,000 and $741,000 as of December 31, 2002 and 2001, respectively. Expense for the plan amounted to $172,000 and $80,000 for the years ended December 31, 2002 and 2001, respectively. (13) Stock Compensation Plans The Company has a Management Stock Incentive Plan and a Directors' Stock Incentive Plan. Under the plans, the Company may grant stock options to its directors, directors of its subsidiaries, and key employees to purchase shares of common stock, shares of restricted stock and stock appreciation rights. Grants under the plans may be made to up to 10% of the number of shares of common stock issued, including treasury shares. The exercise price of each option equals the market price of the Company's stock on the date of the grant. The maximum term of each option is ten years and the options' generally vest between three and five years. 65 The following is a summary of the status of the Company's stock option plans as of December 31, 2002, 2001 and 2000, as well changes in the plans during the years then ended: Weighted Stock Average Options Exercise Outstanding Price ----------- -------- Balance December 31, 1999 $ 319,042 $14.00 Granted 70,638 13.45 Cancelled (5,162) (13.56) --------- ------ Balance December 31, 2000 384,518 13.90 Granted 115,637 18.94 Cancelled (3,474) (13.65) --------- ------ Balance December 31, 2001 496,681 15.08 Granted 52,353 27.41 Exercised (19,955) 13.95 Cancelled (74,792) (13.99) --------- ------ Balance December 31, 2002 $ 454,287 $16.73 ========= ====== Exercisable at: December 31, 2002 $ 224,284 $14.75 December 31, 2001 153,826 13.92 December 31, 2000 65,986 14.00 The following table summarizes information about stock options outstanding and exercisable at December 31, 2002:
Outstanding Exercisable ----------------------------------- --------------------- Weighted Weighted Weighted Number Average Average Number Average Range of of Stock Exercise Life of Stock Exercise Exercise Price Options Price (in years) Options Price ---------------- -------- -------- ---------- -------- -------- $11.75 to $14.17 330,551 $13.91 6.71 200,490 $13.89 $19.03 to $21.44 37,000 21.35 8.33 12,333 21.35 $21.45 to $23.87 34,383 22.59 8.72 11,461 22.59 $23.88 to $26.29 37,486 25.33 9.08 -- -- $26.30 to $28.72 4,950 26.45 9.68 -- -- $31.15 to $33.57 917 33.15 9.43 -- -- $33.58 to $36.00 9,000 36.00 9.35 -- -- ------- ------ ------ ------- ------ 454,287 $16.73 7.28 224,284 $14.75 ======= ====== ====== ======= ======
66 (14) Earnings Per Common Share Basic earnings per share, after giving effect to preferred stock dividends, has been computed using weighted average common shares outstanding. Diluted earnings per share reflects the effects, if any, of incremental common shares issuable upon exercise of dilutive stock options. Earnings per common share have been computed based on the following:
Years Ended December 31 ----------------------------- (Dollars and shares in thousands) 2002 2001 2000 ------- ------- ------- Net income $26,456 $21,213 $18,100 Less: Preferred stock dividends 1,496 1,496 1,496 ------- ------- ------- Net income available to common shareholders $24,960 $19,717 $16,604 ======= ======= ======= Weighted average number of common shares outstanding used to calculate basic earnings per common share 11,068 10,994 10,995 Add: Effect of dilutive options 150 132 1 ------- ------- ------- Weighted average number of common shares used to calculate diluted earnings per common share 11,218 11,126 10,996 ======= ======= =======
(15) Regulatory Capital The Company is subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material impact on the Company's financial statements. For evaluating regulatory capital adequacy, companies are required to determine capital and assets under regulatory accounting practices. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios. The leverage ratio requirement is based on period-end capital to average total assets during the previous three months. Compliance with risk-based capital requirements is determined by dividing regulatory capital by the sum of a company's weighted asset values. Risk weightings are established by the regulators for each asset category according to the perceived degree of risk. As of December 31, 2002 and 2001, the Company and each subsidiary bank met all capital adequacy requirements to which they are subject. As of December 31, 2002, the most recent notification from the Federal Deposit Insurance Corporation categorized the Company and its subsidiary banks as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Company's category. Payments of dividends by the subsidiary banks to FII are limited or restricted in certain circumstances under banking regulations. At December 31, 2002, an aggregate of $9,609,000 was available for payment of dividends by the subsidiary banks to FII without the approval from the appropriate regulatory authorities. 67 The following is a summary of the actual capital amounts and ratios for the Company and its subsidiary banks as of December 31:
2002 ------------------------------------------------------------------ Actual Regulatory Capital Minimum Requirements Well-Capitalized ----------------- -------------------- ------------------ (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- Leverage capital (Tier 1) as percent of three-month average assets: Company $139,620 6.96% $ 80,233 4.00% $100,292 5.00% BNB 24,505 5.93 16,527 4.00 20,658 5.00 FTB 11,356 5.67 8,017 4.00 10,022 5.00 NBG 48,420 6.71 28,870 4.00 36,087 5.00 WCB 44,175 6.64 26,592 4.00 33,240 5.00 As percent of risk-weighted, period-end assets: Core capital (Tier 1): Company 139,620 9.82 56,846 4.00 85,270 6.00 BNB 24,505 9.70 10,110 4.00 15,165 6.00 FTB 11,356 9.45 4,807 4.00 7,210 6.00 NBG 48,420 8.90 21,758 4.00 32,637 6.00 WCB 44,175 8.94 19,761 4.00 29,642 6.00 Total capital (Tiers 1 and 2): Company 157,433 11.08 113,693 8.00 142,116 10.00 BNB 27,669 10.95 20,220 8.00 25,275 10.00 FTB 12,861 10.70 9,613 8.00 12,017 10.00 NBG 55,243 10.16 43,515 8.00 54,394 10.00 WCB 50,369 10.20 39,522 8.00 49,403 10.00 2001 ------------------------------------------------------------------ Actual Regulatory Capital Minimum Requirements Well-Capitalized ----------------- -------------------- ------------------ (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio ------ ----- ------ ----- ------ ----- Leverage capital (Tier 1) as percent of three-month average assets: Company $120,638 7.02% $ 68,721 4.00% $ 85,902 5.00% BNB 27,428 8.43 13,008 4.00 16,260 5.00 FTB 8,951 6.08 5,893 4.00 7,366 5.00 NBG 37,415 6.96 21,506 4.00 26,883 5.00 PSB 12,154 7.02 6,922 4.00 8,652 5.00 WCB 35,437 6.56 21,538 4.00 26,922 5.00 As percent of risk-weighted, period-end assets: Core capital (Tier 1): Company 120,638 9.81 49,192 4.00 73,789 6.00 BNB 27,428 14.18 7,741 4.00 11,611 6.00 FTB 8,951 8.94 4,003 4.00 6,005 6.00 NBG 37,415 9.24 16,191 4.00 24,287 6.00 PSB 12,154 9.14 5,318 4.00 7,978 6.00 WCB 35,347 8.95 15,792 4.00 23,688 6.00 Total capital (Tiers 1 and 2): Company 139,847 11.37 98,385 8.00 122,981 10.00 BNB 29,851 15.43 15,481 8.00 19,352 10.00 FTB 10,206 10.20 8,006 8.00 10,008 10.00 NBG 42,487 10.50 32,382 8.00 40,478 10.00 PSB 13,822 10.40 10,637 8.00 13,296 10.00 WCB 40,301 10.21 31,585 8.00 39,481 10.00
68 (16) Fair Value of Financial Instruments The "fair value" of a financial instrument is defined as the price a willing buyer and a willing seller would exchange in other than a distressed sale situation. The following table presents the carrying amounts and estimated fair values of the Company's financial instruments at December 31, 2002 and 2001:
2002 2001 ------------------------- ------------------------- Carrying Fair Carrying Fair (Dollars in thousands) Amount Value Amount Value ---------- ---------- ---------- ---------- Financial Assets Cash and cash equivalents $ 48,429 $ 48,429 $ 53,171 $ 53,171 Securities 643,987 644,951 489,704 490,740 FHLB and FRB stock 8,558 8,558 7,732 7,732 Loans, net 1,300,232 1,345,314 1,146,976 1,174,381 Financial Liabilities Deposits: Interest Bearing: Savings and interest bearing demand 779,772 779,772 572,563 572,563 Time deposits 687,996 691,020 636,467 635,425 Non-interest bearing demand 240,755 240,755 224,628 224,628 ---------- ---------- ---------- ---------- Total deposits 1,708,523 1,711,547 1,433,658 1,432,616 Borrowings: Short-term 87,189 88,027 103,770 103,770 Long-term 92,090 101,772 70,419 74,042 Guaranteed preferred beneficial interests in corporation's junior subordinated debentures 16,200 19,082 16,200 17,596
The following methods and assumptions were used to estimate the fair value of each class of financial instruments. Cash and cash equivalents: The carrying amounts reported in the consolidated statements of financial condition for cash, due from banks, interest-bearing deposits and Federal funds sold approximate the fair value of those assets. Securities: Fair value is based on quoted market prices, where available. Where quoted market prices are not available, fair value is based on quoted market prices of comparable instruments. FHLB and FRB stock: The carrying amounts reported in the consolidated statements of financial condition for FHLB and FRB stock approximate the fair value of those assets. Loans: For variable rate loans that reprice frequently, fair value approximates carrying amount. The fair value for fixed rate loans is estimated through discounted cash flow analysis using interest rates currently being offered for loans with similar terms and credit quality. The fair value of loans held for sale is based on quoted market prices and investor commitments. For nonperforming loans, fair value is estimated by discounting expected cash flows at a rate commensurate with the risk associated with the estimated cash flows. Deposits: The fair value for savings, interest bearing and non-interest bearing demand accounts is equal to the carrying amount because of the customer's ability to withdraw funds immediately. The fair value of time deposits is estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments. 69 Borrowings: Carrying value approximates fair value for short-term borrowings. The fair value for long-term borrowings is estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments. Guaranteed Preferred Beneficial Interests in Corporation's Junior Subordinated Debentures: The fair value for guaranteed preferred beneficial interests in corporation's junior subordinated debentures is estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments. (17) Segment Information Reportable segments are comprised of WCB, NBG, BNB and FTB as the Company evaluates performance on an individual bank basis. As stated in Note 1, during 2002 the Company completed a geographic realignment of the subsidiary banks, which involved the merger of the subsidiary formerly known as PSB into NBG and subsequent transfer of branches between NBG and WCB. Accordingly, the Company restated segment results to reflect the merger and transfers for each of the years presented. All of the revenue, expenses, assets and liabilities of PSB have been reallocated to the WCB and NBG segments. The reportable segment information as of and for the years ended December 31, 2002, 2001 and 2000 follows:
(Dollars in thousands) 2002 2001 2000 ----------- ----------- ----------- Net interest income WCB $ 28,577 $ 27,039 $ 24,790 NBG 26,853 24,732 22,148 BNB 14,048 8,184 -- FTB 8,175 6,041 5,173 Financial Services Group -- -- -- ----------- ----------- ----------- Total segment net interest income 77,653 65,996 52,111 Parent and eliminations, net (1,799) (1,222) 751 ----------- ----------- ----------- Total net interest income $ 75,854 $ 64,774 $ 52,862 =========== =========== =========== Net income WCB $ 10,565 $ 9,643 $ 8,463 NBG 9,765 9,777 8,245 BNB 5,001 1,142 -- FTB 2,775 1,827 1,523 Financial Services Group 246 143 5 ----------- ----------- ----------- Total segment net income 28,352 22,532 18,236 Parent and eliminations, net (1,896) (1,319) (136) ----------- ----------- ----------- Total net income $ 26,456 $ 21,213 $ 18,100 =========== =========== =========== Assets WCB $ 674,755 $ 632,058 $ 572,650 NBG 721,090 642,827 581,306 BNB 495,055 362,645 -- FTB 203,382 161,763 131,638 Financial Services Group 5,052 2,788 172 ----------- ----------- ----------- Total segment assets 2,099,334 1,802,081 1,285,766 Parent and eliminations, net 5,700 (7,785) 3,561 ----------- ----------- ----------- Total assets $ 2,105,034 $ 1,794,296 $ 1,289,327 =========== =========== ===========
70 (18) Condensed Parent Company Only Financial Statements The following are the condensed statements of condition of FII as of December 31, 2002 and 2001, and the condensed statements of income and cash flows for the years ended December 31, 2002, 2001 and 2000: Condensed Statements of Condition (Dollars in thousands) 2002 2001 -------- -------- Assets: Cash and due from subsidiaries $ 14,267 $ 7,186 Securities available for sale, at fair value 1,268 1,333 Investment in subsidiaries 186,703 163,053 Other assets 5,099 5,236 -------- -------- Total assets $207,337 $176,808 ======== ======== Liabilities and shareholders' equity Due to subsidiaries $ 16,702 $ 16,702 Short-term borrowings 500 500 Long-term borrowings 5,000 5,000 Other liabilities 6,841 5,419 Shareholders' equity 178,294 149,187 -------- -------- Total liabilities and shareholders' equity $207,337 $176,808 ======== ======== Condensed Statements of Income (Dollars in thousands) 2002 2001 2000 ------- ------- -------- Dividends from subsidiaries $22,015 $16,643 $ 30,115 Other income 8,542 7,577 6,178 ------- ------- -------- Total income 30,557 24,220 36,293 Expenses 11,477 9,602 6,190 ------- ------- -------- Income before income taxes and effect of subsidiaries' earnings and dividends 19,080 14,618 30,103 Income tax benefit (expense) 1,160 788 (33) ------- ------- -------- Income before effect of subsidiaries' earnings and dividends 20,240 15,406 30,070 Equity in undistributed earnings (dividends in excess of earnings) of subsidiaries 6,216 5,807 (11,970) ------- ------- -------- Net income $26,456 $21,213 $ 18,100 ======= ======= ======== 71 Condensed Statements of Cash Flows
(Dollars in thousands) 2002 2001 2000 -------- -------- -------- Cash flows from operating activities: Net income $ 26,456 $ 21,213 $ 18,100 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 878 711 620 Dividends in excess of earnings (equity in undistributed earnings) of subsidiaries (6,216) (5,807) 11,970 Deferred income tax benefit (176) (102) (56) Gain on sale of securities (161) -- -- Decrease (increase) in accrued dividends receivable from subsidiaries -- 22,962 (22,962) Increase in other assets (4,953) (1,139) (181) Increase in accrued expense and other liabilities 1,393 1,562 230 -------- -------- -------- Net cash provided by operating activities 17,221 39,400 7,721 -------- -------- -------- Cash flows from investing activities: Purchase of available for sale securities (26) -- (140) Proceeds from sale of available for sale securities 256 -- -- Investment in Mercantile Adjustment Bureau, LLC (2,400) -- -- Equity investment in subsidiaries, net -- (63,381) -- Purchase of premises and equipment, net (274) (1,109) (340) -------- -------- -------- Net cash used in investing activities (2,444) (64,490) (480) -------- -------- -------- Cash flows from financing activities: Proceeds from short-term borrowings -- 500 -- Proceeds from long-term borrowings -- 5,000 -- Repayment of long-term borrowings -- -- (1,698) Proceeds from issuance of guaranteed preferred beneficial interests in corporation's junior subordinated debentures -- 16,200 -- Purchase of preferred and common shares (581) (16) (454) Issuance of preferred and common shares 463 27 29 Dividends paid (7,578) (6,551) (5,788) -------- -------- -------- Net cash (used in) provided by financing activities (7,696) 15,160 (7,911) -------- -------- -------- Net increase (decrease) in cash and cash equivalents 7,081 (9,930) (670) Cash and cash equivalents at the beginning of the year 7,186 17,116 17,786 -------- -------- -------- Cash and cash equivalents at the end of the year $ 14,267 $ 7,186 $ 17,116 ======== ======== ========
72 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Financial Institutions, Inc.: We have audited the accompanying consolidated statements of financial condition of Financial Institutions, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in shareholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 the 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Financial Institutions, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. As discussed in Notes 1 and 6 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002 upon adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." /s/ KPMG LLP Buffalo, New York February 26, 2003 73 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10. Directors and Executive Officers of the Registrant Information regarding directors and all of the executive officers of the Registrant on pages 3, 4, 10, 12, 13 and 14 of the Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed with the U.S. Securities and Exchange Commission is incorporated herein by reference thereto. Item 11. Executive Compensation Information regarding executive compensation on pages 8 through 10 of the Registrant's Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed with the U.S. Securities and Exchange Commission is incorporated herein by reference thereto. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Information regarding security ownership of certain beneficial owners of the Company's management on page 5 of the Registrant's Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed with the U.S. Securities and Exchange Commission is incorporated herein by reference thereto. Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions on pages 13 and 14 of the Registrant's Proxy Statement for its 2003 Annual Meeting of Shareholders to be filed with the U.S. Securities and Exchange Commission is incorporated herein by reference thereto. PART IV Item 14. Controls and Procedures Within 90 days of the date of this report, the Company, under the supervision of its Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of disclosure controls and procedures. As part of this review, the Company identified two control issues at a subsidiary bank that if not corrected could impact the effectiveness of the Company's internal disclosure controls and procedures. The two areas of concern at the subsidiary bank were disclosure controls over the timing of problem loan identification and disclosure controls over lending to insiders under Regulation O. Since the identification of these issues, new procedures have been put in place to evaluate and assess the process of loan grading and problem loan identification at each subsidiary bank. The Company is also adding credit administration and loan workout personnel at the holding company level to improve insider loan reporting and to facilitate earlier intervention with respect to problem loans. Based on their evaluation of the effectiveness of disclosure controls and procedures, and following the implementation of the above described actions, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in ensuring that all material information required to be filed in the Company's periodic SEC reports is made known to them in a timely fashion. Except, as described herein, there have been no significant changes in the Company's internal controls, or in factors that could significantly affect the Company's internal controls, subsequent to the date the Chief Executive Officer and Chief Financial Officer completed their evaluation. 74 Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) List of Documents Filed as Part of this Report (1) Financial Statements. The financial statements listed below and the Independent Auditors' Report are included in this Annual Report on Form 10-K: Independent Auditors' Report Consolidated Statements of Financial Condition as of December 31, 2002 and 2001 Consolidated Statements of Income for the years ended December 31, 2002, 2001 and 2000 Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income for the years ended December 31, 2002, 2001 and 2000 Consolidated Statements of Cash Flows the years ended December 31, 2002, 2001 and 2000 Notes to Consolidated Financial Statements (2) Schedules. All schedules are omitted since the required information is either not applicable, not required, or is contained in the respective financial statements or in the notes thereto. 75 (3) Exhibits. The following is a list of all exhibits filed or incorporated by reference as part of this Registration Statement.
Exhibit No. Description Location ----------- -------------------------------------------------- ----------------------------------------- 3.1 Amended and Restated Certificate of Contained in Exhibit 3.1 of the Incorporation Registrant's Registration Statement on Form S-1 dated June 25, 1999 (File No. 333-76865) (The "S-1 Registration Statement") 3.2 Amended and Restated Bylaws Contained in Exhibit 3.1 of the Form 10-K for the year ended December 31, 2001 dated March 11, 2002 10.1 1999 Management Stock Incentive Plan Contained in Exhibit 10.1 of the S-1 Registration Statement 10.2 1999 Directors Stock Incentive Plan Contained in Exhibit 10.2 of the S-1 Registration Statement 11 Statement of Computation of Per Share Earnings Contained in Note 14 of the Registrant's Consolidated Financial Statements Under Item 8 Filed Herewith 21 Subsidiaries of Financial Institutions, Inc. Filed Herewith 23 Consent of KPMG LLP Filed Herewith 24 Power of Attorney Filed Herewith 99.1 Certification Pursuant to 18 U.S.C. Section 1350, Filed Herewith As adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, Filed Herewith As adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K The Company filed no Current Reports on Form 8-K during the quarter ended December 31, 2002. 76 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. FINANCIAL INSTITUTIONS, INC. Date: March 14, 2003 By: /s/ Peter G. Humphrey ------------------------------- Peter G. Humphrey President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
Signatures Title Date ---------- ----- ---- /s/ Peter G. Humphrey President, Chief Executive Officer March 14, 2003 -------------------------- (Principal ExecutiveOfficer), Peter G. Humphrey Chairman of the Board and Director /s/ Ronald A. Miller Senior Vice President and March 14, 2003 -------------------------- Chief Financial Officer Ronald A. Miller (Principal Accounting Officer) * Director March 14, 2003 -------------------------- John E. Benjamin * Director and Senior Vice President March 14, 2003 -------------------------- Jon J. Cooper * Director March 14, 2003 -------------------------- Barton P. Dambra * Director March 14, 2003 -------------------------- Samuel M. Gullo * Director March 14, 2003 -------------------------- Pamela Davis Heilman * Director March 14, 2003 -------------------------- Susan R. Holliday * Director March 14, 2003 -------------------------- W.J. Humphrey, Jr. * Director March 14, 2003 -------------------------- H. Jack South * Director March 14, 2003 -------------------------- John R. Tyler, Jr. * Director March 14, 2003 -------------------------- Bryan G. vonHahmann * Director March 14, 2003 -------------------------- James H. Wyckoff
* The undersigned, acting pursuant to a power of attorney, has signed this Annual Report on Form 10-K for and on behalf of the persons indicated above as such persons' true and lawful attorney-in-fact and their names, places and stead, in the capacities and on the date indicated above. /s/ Ronald A. Miller -------------------------- Ronald A. Miller Attorney-in-fact 77 Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 CERTIFICATION I, Peter G. Humphrey, certify that: 1. I have reviewed this annual report on Form 10-K of Financial Institutions, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 14, 2003 /s/ Peter G. Humphrey ---------------------------- Peter G. Humphrey Chief Executive Officer 78 CERTIFICATION I, Ronald A. Miller, certify that: 1. I have reviewed this annual report on Form 10-K of Financial Institutions, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 14, 2003 /s/ Ronald A. Miller ---------------------------- Ronald A. Miller Chief Financial Officer 79