10-K 1 tenk.txt TENK.TXT U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 ---------- FORM 10-K (MARK ONE) [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended DECEMBER 31, 2004 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________________ to ____________________ Commission File Number 0-26366 ROYAL BANCSHARES OF PENNSYLVANIA, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-2812193 ------------------------------- ------------------- (State of other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 732 MONTGOMERY AVENUE, NARBERTH, PENNSYLVANIA 19072 --------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (610) 668-4700 ------------------------------------------------ (Issuer's telephone number, including area code) --------------------------------------------------------------------------- (Former name, former address and former year, if changed since last report) Securities registered pursuant to Section NONE 12(b) of the Act: Securities registered pursuant to Section CLASS A COMMON STOCK 12(g) of the Act: ($2.00 PAR VALUE) CLASS B COMMON STOCK ($.10 PAR VALUE) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 of 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contended, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] The aggregate market value of Registrant's Common Stock held by non-affiliates is $98,464,214, based on the June 30, 2004 closing price of the Registrant's Common Stock of $00.00 per share (restated for stock dividend). As of February 28, 2005, the Registrant had 10,482,060 and 1,978,347 shares outstanding of Class A and Class B common stock, respectively. Portions of the following documents are incorporated by reference: the definitive Proxy Statement of the Registrant relating to Registrant's Annual meeting of Shareholders to be held on May 18, 2005--Part III. 1 PART I ITEM 1. BUSINESS ROYAL BANCSHARES Royal Bancshares of Pennsylvania, Inc. ("Royal Bancshares"), is a Pennsylvania business corporation and a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "Holding Company Act"). Royal Bancshares is supervised by the Board of Governors of the Federal Reserve System (Federal Reserve Board). Its legal headquarters is located at 732 Montgomery Avenue, Narberth, PA. On June 29, 1995, pursuant to the plan of reorganization approved by the shareholders of Royal Bank America, formerly Royal Bank of Pennsylvania ("Royal Bank"), all of the outstanding shares of common stock of Royal Bank were acquired by Royal Bancshares and were exchanged on a one-for-one basis for common stock of Royal Bancshares. The principal activities of Royal Bancshares is owning and supervising Royal Bank, which engages in a general banking business in principally Montgomery, Philadelphia and Berks counties in Pennsylvania and Southern New Jersey. Royal Bancshares also has a wholly owned non-bank subsidiary, Royal Investments of Delaware, Inc., which is engaged in investment activities. At December 31, 2004, Royal Bancshares had consolidated total assets of approximately $1.21 billion, total deposits of approximately $742 million and shareholders' equity of approximately $141 million. From time to time, Royal Bancshares may include forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters in this and other filings with the Securities and Exchange Commission. The Private Securities Litigation Reform Act of 1995 provides safe harbor for forward-looking statements. When we use words such as "believes", or "expects," "anticipates" or similar expressions, we are making forward-looking statements. In order to comply with the terms of the safe harbor, Royal Bancshares notes that a variety of factors could cause Royal Bancshares actual results and experience to differ materially from the anticipated results or other expectations expressed in Royal Bancshares forward-looking statements. The risks and uncertainties that may affect the operations, performance development and results of Royal Bancshares business include the following: general economic conditions, including their impact on capital expenditures; interest rate fluctuations: business conditions in Royal Banking industry; the regulatory environment; rapidly changing technology and evolving banking industry standards; competitive factors, including increased competition with community, regional and national financial institutions; new service and product offerings by competitors and price pressures and similar items. Royal Bancshares has three reportable operating segments, Community Banking, Tax Liens, and Equity Investments which resulted from the adoption of FIN46(R) as described in Note B of the Notes to Consolidated Financial Statements included in this Report. The segment reporting information in Note B is incorporated by reference into this Item 1. ROYAL BANK AMERICA Royal Bank was incorporated in the Commonwealth of Pennsylvania on July 30, 1963, was chartered by the Commonwealth of Pennsylvania Department of Banking and commenced operation as a Pennsylvania state-chartered bank on October 22, 1963. Royal Bank is the successor of the Bank of King of Prussia, the principal ownership of which was acquired by The Tabas Family in 1980. Royal Bank is an insured bank by the Federal Deposit Insurance Corporation (the "FDIC"). During 2004, Royal Bank started a banking division called Royal Asian Bank ("Royal Asian") which operates three branches in Pennsylvania and anticipates opening two branches in Northern New Jersey in early 2005. Royal Bank derives its income principally from interest charged on loans and interest on investment securities and fees received in connection with the origination of loans and other services. Royal Bank's principal expenses are interest expense on deposits and operating expenses. Principally operating revenues, deposit growth and the repayment of outstanding loans provide funds for activities. Service Area. Royal Bank's primary service area includes Montgomery, Chester, Bucks, Delaware, Berks and Philadelphia counties, New Jersey and the State of Delaware. This area includes residential areas and industrial and commercial businesses of the type usually found within a major metropolitan area. Royal Bank serves this area from twenty 2 branches located throughout Montgomery, Philadelphia and Berks counties and New Jersey. Royal Bank also considers the states of Pennsylvania, New Jersey, New York and Delaware as a part of its service area for certain products and services. Frequently, Royal Bank will do business with clients located outside of its service area. Royal Bank has loans in twenty-nine states via participations with other lenders who have broad experience in those respective markets. Royal Bank's legal headquarters are located at 732 Montgomery Avenue, Narberth, PA. Royal Bank conducts business operations as a commercial bank offering checking accounts, savings and time deposits, and loans, including residential mortgages, home equity and SBA loans. Royal Bank also offers safe deposit boxes, collections, internet banking and bill payment along with other customary bank services (excluding trust) to its customers. Drive-up, ATM, and night depository facilities are available. Services may be added or deleted from time to time. The services offered and the business of Royal Bank is not subject to significant seasonal fluctuations. Royal Bank is a member of the Federal Reserve Fedline Wire Transfer System. Competition. The financial services industry in our service area is extremely competitive. Competitors within our service area include banks and bank holding companies with greater resources. Many competitors have substantially higher legal lending limits. In addition, savings banks, savings and loan associations, credit unions, money market and other mutual funds, mortgage companies, leasing companies, finance companies and other financial services companies offer products and services similar to those offered by Royal Bank, on competitive terms. Many bank holding companies have elected to become financial holding companies under the Gramm-Leach-Bliley Act of 1999, which give a broader range of products with which Royal Bank must compete. Although the long-range effects of this development cannot be predicted, it will likely further narrow the differences and intensify competition among commercial banks, investment banks, insurance firms and other financial services companies. Employees. Royal Bancshares employed approximately 183 persons on a full-time equivalent basis as of December 31, 2004. Deposits. At December 31, 2004, total deposits of Royal Bank were distributed among demand deposits (9%), money market deposit accounts, savings and Super Now (64%) and time deposits (27%). At year-end 2004, deposits decreased $49 million from year-end 2003, or 6%, primarily due to maturing brokered deposits and reduction in the Money Market accounts due to a reduction of interest rates paid. Lending. At December 31, 2004, Royal Bank had a total loan portfolio of $469 million, representing 39% of total assets. The loan portfolio is categorized into commercial demand, commercial mortgages, residential mortgages (including home equity lines of credit), construction, real estate tax liens and installment loans. At year-end 2004, loans decreased $46 million from year end 2003, or 9.0% primarily due to an increased number of loans being paid in full as compared to new origination. Current market and regulatory trends in banking are changing the basic nature of the banking industry. Royal Bank intends to keep pace with the banking industry by being competitive with respect to interest rates and new types or classes of deposits insofar as it is practical to do so consistent with Royal Bank's size, objective of profit maintenance and stable capital structure. NON-BANK SUBSIDIARIES On June 30, 1995, Royal Bancshares established a special purpose Delaware investment company, Royal Investment of Delaware, ("RID") as a wholly owned subsidiary. Its legal headquarters is at 103 Springer Building, 3411 Silverside Road, Wilmington, DE. RID buys, holds and sells investment securities. At December 31, 2004, total assets of RID were $21.4 million, of which $16.1 million was held in cash and cash equivalents and $5.3 million was held in investment securities. Royal Bancshares through its wholly owned subsidiary Royal Bank hold a 60% ownership in Crusader Servicing Corporation ("CSC"). Its legal headquarters is at 732 Montgomery Avenue, Narberth, PA. CSC acquires, through auction, delinquent property tax liens in various jurisdictions, assuming a lien position that is generally superior to any mortgage liens 3 on the property, and obtaining certain foreclosure rights as defined by local statute. At December 31, 2004, total assets of CSC were $50.2 million. On June 23, 2003, Royal Bancshares through its wholly owned subsidiary Royal Bank of Pennsylvania established Royal Investments of Pennsylvania, LLC ("RIP") as a wholly owned subsidiary. Its legal headquarters is at 732 Montgomery Avenue, Narberth, Pennsylvania. RIP was formed to invest in equity real estate ventures subject to limitations imposed by regulation. At December 31, 2004, total assets of RIP prior to consolidation under FIN46(R) were $10.4 million. During the early part of 2005, RIP changed its name to Royal Investments America. On October 27, 2004, Royal Bancshares formed two Delaware trust affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust II from the completion of an aggregate of $25.0 million private placement of trust preferred securities. WEBSITE ACCESS TO COMPANY REPORTS We post publicly available reports required to be filed with the SEC on our website, www.royalbankamerica.com, as soon as reasonably practicable after filing such reports with the SEC. The required reports are available free of charge through our website. PRODUCTS AND SERVICES WITH REPUTATION RISK Royal Bancshares offers a diverse range of financial and banking products and services. In the event one or more customers and/or governmental agencies become dissatisfied or object to any product or service offered by Royal Bancshares or any of its subsidiaries, whether legally justified or not, negative publicity with respect to any such product or service could have a negative impact on Royal Bancshares's reputation. The discontinuance of any product or service, whether or not any customer or governmental agency has challenged any such product or service, could have a negative impact on Royal Bancshares' reputation. FUTURE ACQUISITIONS Royal Bancshares' acquisition strategy consists of identifying financial institutions, insurance agencies and other financial companies with business philosophies that are similar to our business philosophies, which operate in strong markets that are geographically compatible with our operations, and which can be acquired at an acceptable cost. In evaluating acquisition opportunities, we generally consider potential revenue enhancements and operating efficiencies, asset quality, interest rate risk, and management capabilities. Royal Bancshares currently has no formal commitments with respect to future acquisitions although discussions with acquisition candidates take place occasionally. CONCENTRATIONS, SEASONALITY Royal Bancshares does not have any portion of its business dependent on a single or limited number of customers, the loss of which would have a material adverse effect on its business. No substantial portion of loans or investments is concentrated within a single industry or group of related industries, except a significant majority of loans are secured by real estate much of which is located in southeastern Pennsylvania. The business of Royal Bancshares and its subsidiaries is not seasonal in nature. ENVIRONMENT COMPLIANCE Royal Bancshares and its subsidiaries' compliance with federal, state and local environment protection laws had no material effect on capital expenditures, earnings or their competitive position in 2004, and is not expected to have a material effect on such expenditures, earnings or competitive position in 2005. SUPERVISION AND REGULATION Bank holding companies and banks operate in a highly regulated environment and are regularly examined by federal and state regulatory authorities. 4 The following discussion concerns various federal and state laws and regulations and the potential impact of such laws and regulation on Royal Bancshares and its subsidiaries. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provisions themselves. Proposals to change laws and regulations are frequently introduced in Congress, the state legislatures, and before the various bank regulatory agencies. Royal Bancshares cannot determine the likelihood or timing of any such proposals or legislations or the impact they may have on Royal Bancshares and its subsidiaries. A change in law, regulations or regulatory policy may have a material effect on Royal Bancshares's business. Holding Company. Royal Bancshares, as a Pennsylvania business corporation, is subject to the jurisdiction of the Securities and Exchange Commission (the "SEC") and of state securities commissions for matters relating to the offering and sale of its securities. Accordingly, if Royal Bancshares wishes to issue additional shares of its Common Stock, in order, for example, to raise capital or to grant stock options, Royal Bancshares will have to comply with the registration requirements of the Securities Act of 1933 as amended, or find an applicable exemption from registration. Royal Bancshares is subject to the provisions of the Holding Company Act, and to supervision, regulation and examination by the Federal Reserve Board. The Holding Company Act requires Royal Bancshares to secure the prior approval of the Federal Reserve Board before it owns or controls, directly or indirectly, more than 5% of the voting shares of any corporation, including another bank. In addition, the Holding Company Act prohibits Royal Bancshares from acquiring more than 5% of the voting shares of, or interest in, or all or substantially all of the assets of, any bank located outside Pennsylvania, unless such an acquisition is specifically authorized by laws of the state in which such bank is located. A bank holding company also is prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any such company engaged in non-banking activities unless the Federal Reserve Board, by order or regulation, has found such activities to be closely related to banking or managing or controlling banks as to be a proper incident thereto. In making this determination, the Federal Reserve Board considers whether the performance of these activities by a bank holding company would offer benefits to the public that outweigh possible adverse effects. As a bank holding company, Royal Bancshares is required to file an annual report with the Federal Reserve Board and any additional information that the Federal Reserve Board may require pursuant to the Holding Company Act. The Federal Reserve Board may also make examinations of the holding company and any or all of subsidiaries. Further, under the Holding Company Act and the Federal Reserve Board's regulation, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection, with any extension of credit or provision of credit of any property or services. The so called "anti-tying" provisions state generally that a bank may not extend credit, lease, sell property or furnish any service to a customer on the condition that the customer obtain additional credit or service from Royal Bank, its bank holding company or any other subsidiary of its bank holding company, or on the condition that the customer not obtain other credit or services from a competitor of Royal Bank, its bank holding company or any subsidiary of its bank holding company. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act and by state banking laws on any extensions of credit to Royal Bank holding company or any of its subsidiaries, on investments in the stock or other securities of Royal Bank holding company and on taking of such stock or securities as collateral for loans to any borrower. Under the Pennsylvania Banking Code of 1965, as amended, the ("Code"), Royal Bancshares is permitted to control an unlimited number of banks. However, Royal Bancshares would be required under the Holding Company Act to obtain the prior approval of the Federal Reserve Board before it could acquire all or substantially all of the assets of any bank, or acquiring ownership or control of any voting shares of any bank other than Royal Bank, if, after such acquisition, the registrant would own or control more than 5% of the voting shares of such bank. The Holding Company Act has been amended by the Riegle-Neal Interstate Banking and Branching Act of 1994, which authorizes bank holding companies subject to certain limitations and restrictions to acquire banks located in any state. In 1995, the Code was amended to harmonize Pennsylvania law with the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 to enable Pennsylvania institutions to participate fully in interstate banking and to remove obstacles to the choice by banks from other states engaged in interstate banking to select Pennsylvania as a head office location. 5 A bank holding company located in Pennsylvania, another state, the District of Columbia or a territory or possession of the United States may control one or more banks, bank and trust companies, national banks, interstate banks and, with the prior written approval of the Pennsylvania Department of Banking, may acquire control of a bank and trust company or a national bank located in Pennsylvania. A Pennsylvania-chartered institution may maintain branches in any other state, the District of Columbia, or a territory or possession of the United States upon the written approval of the Pennsylvania Department of Banking. Federal law also prohibits the acquisition of control of a bank holding company without prior notice to certain federal bank regulators. Control is defined for this purpose as the power, directly or indirectly, to direct the management or policies of Royal Bank or bank holding company or to vote 25% or more of any class of voting securities of Royal Bank holding company. Royal Bank. The deposits of Royal Bank are insured by the FDIC. Royal Bank is subject to supervision, regulation and examination by the Pennsylvania Department of Banking and by the FDIC. In addition, Royal Bank is subject to a variety of local, state and federal laws that affect its operation. The Pennsylvania Department of Banking and the FDIC routinely examine Pennsylvania state-chartered, non-member banks such as Royal Bank in areas such as reserves, loans, investments, management practices and other aspects of operations. These examinations are designed for the protection of depositors rather that Royal Bancshares' shareholders. Federal and state banking laws and regulations govern, among other things, the scope of a bank's business, the investments a bank may make, the reserves against deposits a bank must maintain, the types and terms of loans a bank may make and the collateral it may take, the activities of banks with respect to mergers and consolidations, and the establishment of branches. Pennsylvania law permits statewide branching. Under the Federal Deposit Insurance Act ("FDIC Act"), the FDIC possesses the power to prohibit institutions regulated by it (such as Royal Bank) from engaging in any activity that would be an unsafe and unsound banking practice or in violation of applicable law. Moreover, the FDIC Act: (i) empowers the FDIC to issue cease-and-desist or civil money penalty orders against Royal Bank or its executive officers, directors and/or principal shareholders based on violations of law or unsafe and unsound banking practices; (ii) authorizes the FDIC to remove executive officers who have participated in such violations or unsound practices; (iii) restricts lending by Royal Bank to its executive officers, directors, principal shareholders or related interests thereof; (iv) restricts management personnel of a bank from serving as directors or in other management positions with certain depository institutions whose assets exceed a specified amount or which have an office within a specified geographic area. Additionally, the FDIC Act provides that no person may acquire control of Royal Bank unless the FDIC has been given 60-days prior written notice and within that time has not disapproved the acquisition or extended the period for disapproval. Under the Community Reinvestment Act ("CRA"), the FDIC uses a five-point rating scale to assign a numerical score for a bank's performance in each of three areas: lending, service and investment. Under the CRA, the FDIC is required to: (i) assess the records of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community (including low-and moderate-income neighborhoods) which they serve, and (ii) take this record into account in its evaluation of any application made by any such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of bank shares. The CRA also requires the federal banking agencies to make public disclosures of their evaluation of each bank's record of meeting the credit needs of its entire community, including low-and moderate-income neighborhoods. This evaluation will include a descriptive rate ("outstanding," "satisfactory," "needs to improve" or "substantial noncompliance") and a statement describing the basis for the rating. After its most recent examination of Royal Bank under CRA, the FDIC gave Royal Bank a CRA rating of satisfactory. A subsidiary bank of a holding company is subject to certain restrictions imposed by the Federal Reserve Act, as amended, on any extensions of credit to Royal Bank holding company or its subsidiaries, on investments in the stock or other securities of Royal Bank holding company or its subsidiaries, and on taking such stock or securities as collateral for loans. The Federal Reserve Act, as amended, and Federal Reserve Board regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the 6 terms upon which any person who becomes a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship. From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of Royal Bank. It cannot be predicted whether any such legislation will be adopted or how such legislation would affect the business of Royal Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, Royal Bank's business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Under Bank Secrecy Act ("BSA"), banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions in any one day of which Royal Bank is aware that exceed $10,000 in the aggregate. Civil and criminal penalties are provided under the BSA for failure to file a required report, for failure to supply information required by the BSA or for filing a false or fraudulent report. FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991 GENERAL. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDIC Improvement Act") includes several provisions that have a direct impact on Royal Bank. The most significant of these provisions are discussed below. The FDIC is required to conduct periodic full-scope, on-site examinations of Royal Bank. In order to minimize losses to the deposit insurance funds, the FDIC Improvement Act establishes a format to monitor FDIC-insured institutions and to enable "prompt corrective action" by the appropriate federal supervisory agency if an institution begins to experience any difficulty. The FDIC Improvement Act establishes five "capital" categories. They are: (1) well capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly undercapitalized, and (5) critically undercapitalized. The overall goal of these capital measures is to impose scrutiny and operational restrictions on banks as they descend the capital categories from well capitalized to critically undercapitalized. Under current regulations, a "well-capitalized" institution is one that has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based capital ratio, a 5% Tier 1 Leverage Ratio, and is not subject to any written order or final directive by the FDIC to meet and maintain a specific capital level. Royal Bank is presently categorized as a "well-capitalized" institution. An "adequately capitalized" institution is one that meets the required minimum capital levels, but does not meet the definition of a "well-capitalized" institution. The existing capital rules generally require banks to maintain a Tier 1 Leverage Ratio of at least 4% and an 8% total risk-based capital ratio. Since the risk-based capital requirement is measured in the form of Tier 1 capital, this also will mean that a bank would need to maintain at least 4% Tier 1 risk-based capital ratio. An institution must meet each of the required minimum capital levels in order to be deemed "adequately capitalized." An "undercapitalized" institution is one that fails to meet one or more of the required minimum capital levels for an "adequately capitalized" institution. Under the FDIC Improvement Act, an "undercapitalized" institution must file a capital restoration plan and is automatically subject to restrictions on dividends, management fees and asset growth. In addition, the institution is prohibited from making acquisitions, opening new branches or engaging in new lines of business without the prior approval of its primary federal regulator. A number of other restrictions may be imposed. A "critically undercapitalized" institution is one that has a tangible equity (Tier 1 capital) ratio of 2% or less. In addition to the same restrictions and prohibitions that apply to "undercapitalized" and "significantly undercapitalized" institutions, any institution that becomes "critically undercapitalized" is prohibited from taking the following actions without the prior written approval of its primary federal supervisory agency: engaging in any material transactions other than in the usual course of business; extending credit for highly leveraged transactions; amending its charter or bylaws; making any material changes in accounting methods; engaging in certain transactions with affiliates; paying excessive compensation or bonuses; and paying interest on liabilities exceeding the prevailing rates in the institution's market area. In addition, a "critically undercapitalized" institution is prohibited from paying interest or principal on its subordinated debt and is subject to being placed in conservatorship or receivership if its tangible equity capital level is not increased within certain mandated time frames. 7 REAL ESTATE LENDING GUIDELINES. Pursuant to the FDIC Improvement Act, the FDIC has issued real estate lending guidelines that establish loan-to-value ("LTV") ratios for different types of real estate loans. A LTV ratio is generally defined as the total loan amount divided by the appraised value of the property at the time the loan is originated. If a bank does not hold a first lien position, the total loan amount would be combined with the amount of all senior liens when calculating the ratio. In addition to establishing the LTV ratios, the FDIC's real estate guidelines require all real estate loans to be based upon proper loan documentation and a recent independent appraisal of the property. The FDIC's guidelines establish the following limits for LTV ratios: Loan Category LTV Limit ----------------------------------------- --------- Raw Land 65% Land Development Construction: Commercial, Multifamily (includes condos and co-ops), and other Nonresidential 80% Improved Property 85% Owner occupied 1-4 Family and Home Equity (without credit enhancements) 90% The guidelines provide exceptions to the LTV ratios for government-backed loans; loans facilitating the sale of real estate acquired by the lending institution in the normal course of business; loans where Royal Bank's decision to lend is not based on the offer of real estate as collateral and such collateral is taken only out of an abundance of caution; and loans renewed, refinanced, or restructured by the original lender to the same borrower, without the advancement of new money. The regulation also allows institutions to make a limited amount of real estate loans that do not conform to the proposed LTV ratios. Under this exception, Royal Bank would be allowed to make real estate loans that do not conform to the LTV ratio limits, up to an amount not to exceed 100% of Royal Bank's total capital. TRUTH IN SAVINGS ACT. The FDIC Improvement Act also contains the Truth in Savings Act. The purpose of this Act is to require the clear and uniform disclosure of the rates of interest that are payable on deposit accounts by Royal Bank and the fees that are assessable against deposit accounts, so that consumers can make a meaningful comparison between the competing claims of banks with regard to deposit accounts and products. This Act requires Royal Bank to include, in a clear and conspicuous manner, the following information with each periodic statement of a deposit account: (1) the annual percentage yield earned, (2) the amount of interest earned, (3) the amount of any fees and charges imposed and (4) the number of days in the reporting period. This Act allows for civil lawsuits to be initiated by customers if Royal Bank violates any provision or regulation under this Act. GRAMM-LEACH-BLILEY ACT OF 1999. On November 12, 1999, President Clinton signed the Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act. The Financial Services Modernization Act repeals the two affiliation provisions of the Glass-Steagall Act: o Section 20, which restricted the affiliation of Federal Reserve Member Banks with firms "engaged principally" in specified securities activities; and o Section 32, which restricts officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the Financial Services Modernization Act contains provisions that expressly preempt any state insurance law. The law establishes a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers. It revises and expands the framework of the Holding Company Act to permit a holding company to engage in a full range of financial activities through a new entity known as a Financial Holding Company. "Financial activities" is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. 8 In general, the Financial Services Modernization Act: o Repeals historical restrictions on, and eliminates many federal and state law barriers to, affiliations among banks, securities firms, insurance companies, and other financial service providers; o Provides a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies; o Broadens the activities that may be conducted by national banks, banking subsidiaries of bank holding companies, and their financial subsidiaries; o Provides an enhanced framework for protecting the privacy of consumer information; o Adopts a number of provisions related to the capitalization, membership, corporate governance, and other measures designed to modernize the Federal Home Loan Bank system; o Modifies the laws governing the implementation of the CRA; and o Addresses a variety of other legal and regulatory issues affecting both day-to-day operations and long-term activities of financial institutions. In order for Royal Bancshares to take advantage of the ability to affiliate with other financial service providers, Royal Bancshares must become a "Financial Holding Company." To become a Financial Holding Company, a company must file a declaration with the Federal Reserve, electing to engage in activities permissible for Financial Holding Companies and certifying that it is eligible to do so because all of its insured depository institution subsidiaries are well-capitalized and well-managed. In addition, the Federal Reserve Board must determine that each insured depository institution subsidiary of Royal Bancshares has at least a "satisfactory" CRA rating. Royal Bancshares currently meets the requirements to make an election to become a Financial Holding Company. Royal Bancshares' management has not determined at this time whether it will seek an election to become a Financial Holding Company. Royal Bancshares continues to examine its strategic business plan to determine whether, based, among other factors, on market conditions, the relative financial conditions of Royal Bancshares and its subsidiaries, regulatory capital requirements and general economic conditions, Royal Bancshares desires to utilize any of the expanded powers provided in the Financial Service Modernization Act. The Financial Services Modernization Act also includes a new section of the FDIC Act governing subsidiaries of state banks that engage in "activities as principal that would only be permissible" for a national bank to conduct in a financial subsidiary. It expressly preserves the ability of a state bank to retain all existing subsidiaries. Because Pennsylvania permits commercial banks chartered by the state to engage in any activity permissible for national banks, Royal Bank will be permitted to form subsidiaries to engage in the activities authorized by the Financial Services Modernization Act, to the same extent as a national bank. In order to form a financial subsidiary, Royal Bank must be well-capitalized, and Royal Bank would be subject to the same capital deduction, risk management and affiliate transaction rules as applicable to national banks. Although the long-range effect of the Financial Services Modernization Act cannot be predicted, Royal Bancshares and Royal Bank do not believe that the Financial Services Modernization Act will have a material adverse effect on its operations in the near-term. However, to the extent that it permits banks, securities firms, and insurance companies to affiliate, the financial services industry may experience further consolidation. The Financial Services Modernization Act is intended to grant to community banks certain powers as a matter of right that larger institutions have accumulated on an ad hoc basis. Nevertheless, this act may have the result of increasing the amount of competition that Royal Bancshares and Royal Bank face from larger institutions and other types of companies offering financial products, many of which may have substantially more financial resources than Royal Bancshares and Royal Bank. 9 USA PATRIOT ACT OF 2001. In October 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington D.C., which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcements' and the intelligence communities' abilities to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. SARBANES-OXLEY ACT OF 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted "SOX". The stated goals of the SOX are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. SOX is the most far-reaching U.S. securities legislation enacted in some time. SOX generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the SEC under the Securities Exchange Act of 1934, or the Exchange Act. Given the extensive SEC role in implementing rules relating too many of SOX's new requirements, the final scope of the requirements remains to be determined. The SOX addresses, among other matters: o New requirements for audit committees of reporting companies, including independence, expertise, and responsibilities; o Certification of financial statements by the chief executive officer and chief financial officer; o The forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; o Increased disclosure and reporting obligations for the reporting company and their directors and executive officers with other banks regulatory requirements; o Disclosure of off-balance sheet transactions; o A prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulatory requirements; o Disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; o "Real time" filing of periodic reports; o The formation of an independent public accounting oversight board; o New standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; and o Various increased civil and criminal penalties for fraud and other violations of securities laws. Section 404 of SOX requires Royal Bancshares to include in its Annual Report on Form 10-K for fiscal years ending after November 15, 2004, a report by its management and an attestation report by its independent registered public accounting firm on the adequacy of Royal Bancshares' internal control over financial reporting. Management's internal control report must, among other things, set forth management's assessment of the effectiveness of Royal Bancshares' internal control over financial reporting as of the end of its most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. See Item 9A of this Report. 10 REGULATION W. Transactions between a bank and its "affiliates" are quantitatively and qualitatively restricted under the Sections 23A and 23B of Federal Reserve Act. The FDIC Act applies Sections 23A and 23B to insured nonmember banks in the same manner and to the same extent as if they were members of the Federal Reserve System. The Federal Reserve Board has also recently issued Regulation W, which codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions. Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, Royal Bank's holding company and companies that are under common control with Royal Bank. Royal Bancshares is considered to be an affiliate of Royal Bank. In general, subject to certain specified exemptions, a bank or its subsidiaries are limited in their ability to engage in "covered transactions" with affiliates: o To an amount equal to 10% of Royal Bank's capital and surplus, in the case of covered transactions with any one affiliate; and o To an amount equal to 20% of Royal Bank's capital and surplus, in the case of covered transactions with all affiliates. In addition, a bank and its subsidiaries may engage in covered transactions and other specified transactions only on terms and under circumstances that are substantially the same, or at least as favorable to Royal Bank or its subsidiary, as those prevailing at the time for comparable transactions with nonaffiliated companies. A "covered transaction" includes: o A loan or extension of credit to an affiliate; o A purchase of, or an investment in, securities issued by an affiliate; o A purchase of assets from an affiliate, with some exceptions; o The acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any party; and o This issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. In addition, under Regulation W: o A bank and its subsidiaries may not purchase a low-quality asset from an affiliate; o Covered transactions and other specified transactions between a bank or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices; and o With some exceptions, each loan or extension of credit by a bank to an affiliate must be secured by collateral with a market value ranging from 100% to 130%, depending on the type of collateral, of the amount of the loan or extension of credit. Regulation W generally excludes all non-bank and non-savings association subsidiaries of banks from treatment as affiliates, except to the extent that the Federal Reserve Board decides to treat these subsidiaries as affiliates. Concurrently with the adoption of Regulation W, the Federal Reserve Board has proposed a regulation which would further limit the amount of loans that could be purchased by a bank from an affiliate to not more than 100% of Royal Bank's capital and surplus. MONETARY POLICY The earnings of Royal Bank are affected by the policies of regulatory authorities including the Federal Reserve Board. An important function of the Federal Reserve System is to influence the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities, changes in reserve requirements against member bank deposits and limitations on interest rates that member banks may pay on time and savings deposits. These instruments are used in varying combinations to influence overall growth and 11 distribution of bank loans and investments and deposits. Their use may also affect rates charged on loans or paid for deposits. The policies and regulations of the Federal Reserve Board have had and will probably continue to have a significant effect on its reserve requirements, deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect Royal Bank's operations in the future. The effect of such policies and regulations upon the future business and earnings of Royal Bank cannot be predicted. EFFECTS OF INFLATION Inflation has some impact on Royal Bancshares' operating costs. Unlike many industrial companies, however, substantially all of Royal Bancshares' assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on Royal Bancshares' performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services. CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES The accounting and reporting policies of Royal Bancshares conform to accounting principles generally accepted in the United States of America and general practices within the financial services industry. Critical accounting policies, judgments and estimates relate to loans, the allowance for loan losses and deferred tax assets. The policies which significantly affect the determination of Royal Bancshares's financial position, results of operations and cash flows, are summarized in Note A "Summary of Significant Accounting Polices" of the Notes to Consolidated Financial Statements and are discussed in the section captioned "Recent Accounting Pronouncements" of Management's Discussion and Analysis of Financial Condition and Results of Operations, included in Items 7 and 8 of this Report, each of which is incorporated herein by reference. Royal Bancshares considers that the determination of the allowance for loan losses involves a higher degree of judgment and complexity than its other significant accounting policies. The allowance for loan losses is calculated with the objective of maintaining a reserve level believed by management to be sufficient to absorb estimated credit losses. Management's determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires material estimates, including, among others, expected default probabilities, loss given default, expected commitment usage, the amounts of timing of expected future cash flows on impaired loans, mortgages, and general amounts for historical loss experience. The process also considers economic conditions, uncertainties in estimating losses and inherent risks in the loan portfolio. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required that would adversely impact earnings in future periods. Royal Bancshares recognizes deferred tax assets and liabilities for the future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to management's judgment based upon available evidence that future realization is more likely than not. If management determines that Royal Bancshares may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount. AVAILABLE INFORMATION Upon a shareholder's written request, a copy of Royal Bancshares' Annual Report on 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as required to be filed with the SEC pursuant to Securities Exchange Act Rule 13a-1, may be obtained without charge, on our website www.royalbankamerica.com or from Jeffrey T. Hanuscin, Chief Financial Officer, Royal Bank America, 732 Montgomery Avenue, Narberth, PA 19072. 12 ITEM 2. PROPERTIES Royal Bank has twenty banking offices, which are located in Pennsylvania and New Jersey. ROYAL BANK AMERICA Narberth Office (1) Villanova Office King of Prussia Office (1) ------------------------ ------------------------------- -------------------------- 732 Montgomery Avenue 801 East Lancaster Avenue Rt. 202 at Wilson Road Narberth, PA 19072 Villanova, PA 19085 King of Prussia, PA 19406 Walnut Street Office Shillington Office Bridgeport Office (1) ------------------------ ------------------------------- -------------------------- 1230 Walnut Street 516 East Lancaster Avenue 105 W. 4th Street Philadelphia, PA 19107 Shillington, PA 19607 Bridgeport, PA 19406 Fairmont Office (1) Trooper Office (1) Henderson Road Office ------------------------ ------------------------------- -------------------------- 401 Fairmont Avenue Trooper and Egypt Roads Bielder and Henderson Roads Philadelphia, PA 19123 Trooper, PA 19401 King of Prussia, PA 19406 Castor Office (1) Reading Office Phoenixville Office (1) ------------------------ ------------------------------- -------------------------- 6331 Castor Avenue 501 Washington Avenue 808 Valley Forge Road Philadelphia, PA 19149 Reading, PA 19601 Phoenixville, PA 19460 15th Street Office Jenkintown Office (1) Turnersville Office ------------------------ ------------------------------- -------------------------- 30 South Street 600 Old York Road 3501 Black Horse Pike Philadelphia, PA 19102 Jenkintown, PA 19046 Turnersville, NJ 08012 Grant Avenue Office (1) Narberth Training Center (1)(2) Storage Facility (1) ------------------------ ------------------------------- -------------------------- 1650 Grant Avenue 814 Montgomery Avenue 3836 Spring Garden Street Philadelphia, PA 19115 Narberth, PA 19072 Philadelphia, PA 19104
ROYAL ASIAN BANK DIVISION Northeast Office Cheltenham Office Upper Darby Office ------------------------ ------------------------------- -------------------------- 6526 Castor Avenue 418 Oak Lane 7001 West Chester Pike Philadelphia, PA 19149 Philadelphia, PA 19126 Upper Darby, PA 19082
Loan Production Office ---------------------- 215 Main Street Fort Lee, NJ 07024 (1) Owned (2) Used for employee training Royal Bank owns eleven of the above properties. One property is subject to a mortgage. The remaining ten properties are leased with expiration dates between 2005 and 2012. During 2004, Royal Bank made aggregate lease payments of approximately $664,000. Royal Bank believes that all of its properties are attractive, adequately insured, and well maintained and are adequate for Royal Bank's purposes. Royal Bank also owns a property located at 144 Narberth Avenue, Narberth, PA, which may serve as a site for future expansion. ITEM 3. LEGAL PROCEEDINGS Management, after consulting with Royal Bancshares's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of Royal Bancshares. There are no proceedings pending other than routine litigation incident to the business of Royal Bancshares. In addition, no material proceedings are known to be contemplated by governmental authorities against Royal Bancshares. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 13 PART II ITEM 5. MARKET FOR ROYAL BANK'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS On September 6, 1988, Royal Bancshares' Class A Common Stock commenced trading on the NASDAQ National Market System (NASDAQ/NMS). Royal Bancshares' NASDAQ Symbol is RBPAA and is included in the NASDAQ National Market Stock Table, which is published in most major newspapers. There is no market for Royal Bancshares' Class B Common Stock, as such is prohibited by the terms of the Class B Common Stock. The following table shows the range of high, low-end and closing bid prices for Royal Bancshares' stock as reported by NASDAQ. BID PRICES 2004 HIGH LOW CLOSE ----------------------------------- -------- -------- -------- First Quarter...................... $ 26.471 $ 23.922 $ 25.000 Second Quarter..................... 25.588 20.931 24.314 Third Quarter...................... 24.892 21.618 23.794 Fourth Quarter..................... 29.304 23.441 26.490 2003 HIGH LOW CLOSE ----------------------------------- -------- -------- -------- First Quarter...................... $ 20.713 $ 17.061 $ 18.704 Second Quarter..................... 21.146 18.618 20.588 Third Quarter...................... 26.384 20.118 25.808 Fourth Quarter..................... 26.105 23.357 24.510 (Source: This summary reflects information supplied by NASDAQ.) The bid information shown above is derived from statistical reports of the NASDAQ Stock Market and reflects inter-dealer prices without retail mark-up, mark-down or commissions and may not necessarily represent actual transactions. The bid prices reflect the 2% stock dividend that was declared on December 15, 2004. The NASDAQ Stock Market, Inc., is a wholly-owned subsidiary of National Association of Securities Dealers, Inc. The approximate number of recorded holders of Royal Bancshares' Class A and Class B Common Stock, as of February 28, 2005, is shown below: TITLE OF CLASS NUMBER OF RECORD HOLDERS ----------------------------------- ------------------------ Class A Common Stock 367 Class B Common Stock 147 Because substantially all of the holders of Class B Common Stock are also holders of Class A Common stock the number of record holders of the two classes on a combined basis was approximately 420 as of February 28, 2005. 14 SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS The following two tables discloses the number of outstanding options, warrants and rights granted by Royal Bancshares to participants in equity compensation plans, as well as the number of securities remaining available for future issuance under the plans. The tables provide this information separately for equity compensation plans that have and have not been approved by security holders.
(c) Number of securities (a) remaining available for Number of securities to (b) future issuance under be issued upon Weighted-average equity compensation exercise of outstanding exercise price of plans (excluding options, warrants and outstanding options, securities reflected in rights warrants and rights column (a)) ------------------------ ------------------------ ------------------------ OUTSIDE DIRECTORS STOCK OPTION PLAN Equity compensation plan approved by stockholders 79,044 $ 17.29 66,903 Equity compensation plan not approved by stockholders -- -- -- ------------------------ ------------------------ Total 79,044 $ 17.29 66,903
(c) Number of securities (a) remaining available for Number of securities to (b) future issuance under be issued upon Weighted-average equity compensation exercise of outstanding exercise price of plans (excluding options, warrants and outstanding options, securities reflected in rights warrants and rights column (a)) ------------------------ ------------------------ ------------------------ EMPLOYEES STOCK OPTION PLAN Equity compensation plan approved by stockholders 593,539 $ 19.18 77,026 Equity compensation plan not approved by stockholders -- -- -- ------------------------ ------------------------ Total 593,539 $ 19.18 77,026
DIVIDENDS Subject to certain limitations imposed by law, the Board of Directors of Royal Bancshares may declare a dividend on shares of common stock. Stock dividends. On October 20, 1999, the Board of Directors of Royal Bancshares declared a 5% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on January 17, 2000, to shareholders of record on January 3, 2000. The stock dividend resulted in the issuance of 382,857 additional shares of Class A Common Stock and 84,234 additional shares of Class B Common Stock. On January 17, 2001, the Board of Directors of Royal Bancshares declared a 5% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 12, 2001, to shareholders of record on January 29, 2001. The stock dividend resulted in the issuance of 408,197 additional shares of Class A Common Stock and 86,614 additional shares of Class B Common Stock. 15 On January 16, 2002, the Board of Directors of Royal Bancshares declared a 6% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 8, 2002, to shareholders of record on January 28, 2002. The stock dividend resulted in the issuance of 517,635 additional shares of Class A common stock and 108,282 additional shares of Class B common stock. On January 15, 2003, the Board of Directors of Royal Bancshares declared a 3% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 12, 2003, to shareholders of record on January 29, 2003. The stock dividend resulted in the issuance of 281,196 additional shares of Class A common stock and 55,820 additional shares of Class B common stock. On January 21, 2004, the Board of Directors of Royal Bancshares declared a 2% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on February 18, 2004, to shareholders of record on February 4, 2004. The stock dividend resulted in the issuance of 195,861 additional shares of Class A common stock and 38,216 additional shares of Class B common stock. On December 15, 2004, the Board of Directors of Royal Bancshares declared a 2% stock dividend on both its Class A Common Stock and Class B Common Stock shares payable on January 12, 2005, to shareholders of record on December 29, 2004. The stock dividend resulted in the issuance of 200,814 additional shares of Class A common stock and 38,865 additional shares of Class B common stock. Future stock dividends, if any, will be at the discretion of the Board of Directors and will be dependent on the level of earnings and compliance with regulatory requirements. Cash Dividends. Royal Bancshares paid cash dividends in each quarter of 2004 and 2003 for holders of Class A Common Stock and for holders of Class B Common Stock. This resulted in a charge to retained earnings of approximately $12.2 million and $11.3 million for 2004 and 2003, respectively. The following table sets forth on a quarterly basis dividends, paid to holders of each Class A and Class B Common Stock for 2004 and 2003, adjusted to give effect to the stock dividends paid. CASH DIVIDENDS PER SHARE ----------------------------- 2004 CLASS A CLASS B ---------------------------------------- ------------- ------------- First Quarter........................... $ .2500 $ .2875 Second Quarter.......................... $ .2500 $ .2875 Third Quarter........................... $ .2500 $ .2875 Fourth Quarter.......................... $ .2500 $ .2875 CASH DIVIDENDS PER SHARE ----------------------------- 2003 CLASS A CLASS B ---------------------------------------- ------------- ------------- First Quarter........................... $ .2375 $ .2731 Second Quarter.......................... $ .2375 $ .2731 Third Quarter........................... $ .2375 $ .2731 Fourth Quarter.......................... $ .2500 $ .2875 Future dividends must necessarily depend upon net income, capital requirements, and appropriate legal restrictions and other factors relevant at the time the Board of Directors of Royal Bancshares considers dividend policy. Cash necessary to fund dividends available for dividend distributions to the shareholders of Royal Bancshares must initially come from dividends paid by Royal Bank to Royal Bancshares. Therefore, the restrictions on the Royal Bank's dividend payments are directly applicable to Royal Bancshares. Under the Pennsylvania Banking Code of 1965, as amended, Royal Bank places a restriction on the availability of capital surplus for payment of dividends. Under the Pennsylvania Business Corporation Law of 1988, as amended, Royal Bancshares may pay dividends only if after payment Royal Bancshares would be able to pay its debts as they become due in the usual course of business and the total assets are greater than the sum of its total liabilities plus the amount that would be needed if Royal Bancshares were to be dissolved at the time of the dividend to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the dividend. See Regulatory Matters Note to the Consolidated Financial Statements in Item 8 of this report. 16 ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial and operating information for Royal Bancshares should be read in conjunction with Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and accompanying notes in Item 8:
YEARS ENDED DECEMBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA) --------------------------------------------------------- INCOME STATEMENT DATA (IN THOUSANDS) 2004 2003 2002 2001 2000 ---------------------------------------------------- --------- --------- --------- --------- --------- Interest income $ 67,541 $ 72,320 $ 77,104 $ 69,224 $ 58,875 Interest expense 27,301 29,941 36,491 31,808 22,549 --------- --------- --------- --------- --------- Net interest income 40,240 42,379 40,613 37,416 36,326 Provision for loan losses 6 674 250 -- 250 --------- --------- --------- --------- --------- Net interest income after loan losses 40,234 41,705 40,363 37,416 36,076 Gains on sale of loans 480 637 767 372 -- Gains on sale of real estate 2,102 568 455 188 53 Gains (losses) on investment securities 810 719 790 60 (1,302) Income related to equity investments ("VIE") 7,133 -- -- -- -- Other income 2,635 1,780 1,188 1,118 1,207 --------- --------- --------- --------- --------- Total other income 13,160 3,704 3,200 1,738 (42) Income before other expenses & income taxes 53,394 45,410 43,563 39,154 36,034 Non-interest expense Salaries and benefits 10,767 9,959 9,440 10,479 7,979 Expenses related to equity investments ("VIE") 4,780 -- -- -- -- Other 9,900 8,929 9,481 7,124 5,813 --------- --------- --------- --------- --------- Total operating expenses 25,447 18,888 18,921 17,603 13,792 --------- --------- --------- --------- --------- Income before taxes 27,947 26,522 24,642 21,551 22,242 Incomes taxes 7,914 7,996 7,237 5,797 7,982 --------- --------- --------- --------- --------- Net income $ 20,033 $ 18,526 $ 17,405 $ 15,754 $ 14,260 ========= ========= ========= ========= ========= Basic earnings per share (1) $ 1.60 $ 1.49 $ 1.41 $ 1.29 $ 1.18 --------- --------- --------- --------- --------- Diluted earnings per share (1) $ 1.59 $ 1.49 $ 1.38 $ 1.27 $ 1.16 --------- --------- --------- --------- ---------
(1) Earnings per share has the weighted average number of shares used in the calculation adjusted to reflect a 2% stock dividend in December 2004, a 2% stock dividend in January 2004, a 3% stock dividend in 2003, a 6% stock dividend in 2002, a 5% stock dividend in 2001, and a 5% stock dividend in 2000. 17
AS OF DECEMBER 31, ---------------------------------------------------------------------------- BALANCE SHEET DATA (IN THOUSANDS) 2004 2003 2002 2001 2000 --------------------------------- ------------ ------------ ------------ ------------ ------------ Total assets $ 1,205,274 $ 1,154,410 $ 1,088,484 $ 930,980 $ 630,081 Total average assets 1,194,008 1,160,354 1,048,875 788,419 573,780 Loans, net 454,775 500,131 564,264 634,347 411,973 Total deposits 742,382 791,059 820,840 701,860 472,582 Total borrowings 222,000 212,000 124,500 70,225 30,000 Total stockholders equity 140,876 134,833 121,331 108,449 103,502 Total average stockholders equity 137,622 127,728 114,655 105,072 99,746 Return on average assets 1.7% 1.6% 1.7% 2.0% 2.5% Return on average equity 14.6% 14.5% 15.2% 15.0% 14.3% Average equity to average assets 11.5% 11.0% 10.9% 13.3% 17.4% Cash dividend payout ratio 60.9% 61.1% 60.8% 56.9% 55.0%
AVERAGE BALANCES The following table represents the average daily balances of assets, liabilities and shareholders' equity and the respective interest paid on interest bearing assets and interest bearing liabilities, as well as average rates for the periods indicated:
2004 2003 -------------------------------------------- ------------------------------------------ AVERAGE YIELD/ AVERAGE YIELD/ BALANCE INTEREST RATE BALANCE INTEREST RATE ------------ ------------ ------------ ------------ ------------ ------------ ASSETS (In thousands) Interest bearing deposits $ 34,702 $ 409 1.18% $ 40,856 $ 475 1.16% Federal funds 8,644 102 1.18% 13,598 142 1.04% Investment securities Held to maturity 141,799 6,365 4.49% 46,302 3,087 6.67% Available for sale 399,361 20,621 5.16% 446,210 22,007 4.93% ------------ ------------ ------------ ------------ ------------ ------------ Total investment securities 541,160 26,986 4.99% 492,512 25,094 5.10% Loans Commercial and Industrial 199,645 14,241 7.13% 225,224 15,812 7.02% Real estate secured 267,757 25,504 9.53% 333,168 30,532 9.16% Other loans 4,124 299 7.25% 4,373 265 6.06% ------------ ------------ ------------ ------------ ------------ ------------ Total loans 471,526 40,044 8.49% 562,765 46,609 8.28% ------------ ------------ ------------ ------------ ------------ ------------ Total interest earnings assets 1,056,032 67,541 6.40% 1,109,731 72,320 6.52% Non interest earnings assets Cash & due from banks 9,720 8,348 Other assets 142,455 56,780 Allowance for loan loss (12,503) (12,472) Unearned discount (1,696) (2,033) ------------ ------------- Total non-interest earning assets 137,976 50,623 ------------ ------------- Total assets $ 1,194,008 $ 1,160,354 ============ ============= 2002 ------------------------------------------- AVERAGE YIELD/ BALANCE INTEREST RATE ------------ ------------ ----------- ASSETS (In thousands) Interest bearing deposits $ 32,760 $ 682 2.08% Federal funds 16,780 272 1.62% Investment securities Held to maturity 53,226 4,019 7.55% Available for sale 297,457 18,817 6.33% ------------ ------------ ----------- Total investment securities 350,683 22,836 6.51% Loans Commercial and Industrial 230,556 17,020 7.38% Real estate secured 383,816 36,070 9.40% Other loans 2,784 224 8.05% ------------ ------------ ----------- Total loans 617,156 53,314 8.64% ------------ ------------ ----------- Total interest earnings 1,017,379 77,104 7.58% assets Non interest earnings assets Cash & due from banks 8,597 Other assets 38,039 Allowance for loan loss (12,108) Unearned discount (3,032) ------------ Total non-interest earning assets 31,496 ------------ Total assets $ 1,048,875 ------------
18
2004 2003 -------------------------------------------- ------------------------------------------ AVERAGE YIELD/ AVERAGE YIELD/ BALANCE INTEREST RATE BALANCE INTEREST RATE ------------ ------------ ------------ ------------ ------------ ------------ LIABILITIES & SHAREHOLDERS' EQUITY Deposits: Savings $ 24,278 $ 152 0.63% $ 23,714 $ 182 0.77% Now 34,181 244 0.71% 32,510 339 1.04% Money market 426,895 7,721 1.81% 442,873 9,661 2.18% Time deposits 218,756 8,577 3.92% 269,293 12,011 4.46% ------------ ------------ ------------ ------------ ------------ ------------ Total interest bearing deposits 704,110 16,694 2.37% 768,390 22,193 2.89% Federal funds -- -- -- -- -- -- Borrowings 221,741 8,744 3.94% 183,339 7,748 4.23% Obligation through equity investments 55,558 1,639 2.95% -- -- -- Subordinate debt 4,448 224 5.06% -- -- -- ------------ ------------ ------------ ------------ ------------ ------------ Total interest bearing liabilities 985,857 27,301 2.77% 951,729 29,941 3.15% ------------ ------------ ------------ ------------ ------------ ------------ Non interest bearing deposits 57,789 56,814 Other liabilities 12,740 24,083 ------------ ------------ Total liabilities 1,056,386 1,032,626 Shareholders' equity 137,622 127,728 ------------ ------------ Total liabilities and Shareholders' equity $ 1,194,008 $ 1,160,354 ============ ============ Net interest income $ 40,240 $ 42,379 ============ ============ Net interest margin 3.81% 3.82% ============ ============ 2002 ------------------------------------------- AVERAGE YIELD/ BALANCE INTEREST RATE ------------ ------------ ----------- LIABILITIES & SHAREHOLDERS' EQUITY Deposits: Savings $ 25,658 $ 370 1.44% Now 34,866 697 2.00% Money market 270,454 8,491 3.14% Time deposits 385,370 19,358 5.02% ------------ ------------ ------------ Total interest bearing deposits 716,348 28,916 4.04% Federal funds -- -- -- Borrowings 137,460 7,575 5.51% Obligation through equity investments -- -- -- Subordinate debt -- -- -- ------------ ------------ ------------ Total interest bearing liabilities 853,808 36,491 4.27% ------------ ------------ ------------ Non interest bearing deposits 53,800 Other liabilities 26,602 ------------ Total liabilities 934,210 Shareholders' equity 114,665 ------------ Total liabilities and Shareholders' equity $ 1,048,875 ============ Net interest income $ 40,613 ============ Net interest margin 3.99% ============
(1) Nonaccruing loans have been included in the appropriate average loan balance category, but interest on these loans has not been included. 19 RATE VOLUME The following table sets forth a rate/volume analysis, which segregates in detail the major factors contributing to the change in net interest income for the years ended December 31, 2004 and 2003, as compared to respective previous periods, into amounts attributable to both rate and volume variances.
2004 VS 2003 2003 VS 2002 CHANGES DUE TO: CHANGES DUE TO: -------------------------------- -------------------------------- VOLUME RATE TOTAL VOLUME RATE TOTAL -------- -------- -------- -------- -------- -------- (IN THOUSANDS) INTEREST INCOME Interest bearing deposits in banks $ (73) $ 7 $ (66) $ 142 $ (349) $ (207) Federal funds sold (57) 17 (40) (45) (85) (130) Investments securities Held to maturity 4,573 (1,295) 3,278 (491) (441) (932) Available for sale (2,384) 998 (1,386) 7,972 (4,782) 3,190 -------- -------- -------- -------- -------- -------- Total investment securities 2,189 (297) 1,892 7,481 (5,223) 2,258 Loans Commercial and industrial (1,820) 249 (1,571) (387) (821) (1,208) Mortgages secured by real estate (6,192) 1,164 (5,028) (4,659) (880) (5,538) Other loans (16) 50 34 106 (65) 41 -------- -------- -------- -------- -------- -------- Total loans (8,028) 1,463 (6,565) (4,940) (1,766) (6,705) -------- -------- -------- -------- -------- -------- Total increase (decrease) in interest income (5,969) 1,190 (4,779) 2,638 (7,423) (4,784) INTEREST EXPENSE Deposits Savings $ 4 $ (34) $ (30) $ (26) $ (162) $ (188) Now and Money Market (959) (1,076) (2,035) 4,109 (3,297) 812 Time deposits (2,106) (1,328) (3,434) (5,353) (1,994) (7,347) -------- -------- -------- -------- -------- -------- Total deposits (3,061) (2,438) (5,499) (1,270) (5,453) (6,723) Borrowings 3,200 (341) 2,859 2,182 (2,009) 173 -------- -------- -------- -------- -------- -------- Total increase(decrease) in interest expense 139 (2,779) (2,640) 912 (7,462) (6,550) Total increase(decrease) in net interest income $ (6,108) $ 3,969 $ (2,139) $ 1,726 $ 39 $ 1,766 ======== ======== ======== ======== ======== ========
LOANS The following table reflects the composition of the loan portfolio of Royal Bank and the percent of gross outstandings represented by each category at the dates indicated.
AS OF DECEMBER 31, (IN THOUSANDS) ---------------------------------------------------------------------------------- 2004 2003 2002 ------------------------ ------------------------ ------------------------ Comm'l and Industrial $ 208,204 44% $ 225,268 44% $ 241,373 42% Real Estate Secured 258,747 55% 286,997 55% 333,972 57% Other 4,087 1% 4,942 1% 3,509 1% ---------- ---------- ---------- ---------- ---------- ---------- Total gross loans 471,038 100% 517,207 100% 578,854 100% Unearned income (1,540) (1,203) (1,082) Discount on loans purchased -- (290) (1,038) ---------- ---------- ---------- 469,498 515,714 576,734 Allowance for loan loss (12,519) (12,426) (12,470) ---------- ---------- ---------- Total net loans $ 456,979 $ 503,288 $ 564,264 ========== ========== ========== AS OF DECEMBER 31, (IN THOUSANDS) ----------------------------------------------------- 2001 2000 ------------------------ ------------------------ Comm'l and Industrial $ 218,498 34% $ 193,398 45% Real Estate Secured 417,028 64% 230,999 54% Other 13,909 2% 4,561 1% ---------- ---------- ---------- ---------- Total gross loans 649,435 100% 428,958 100% Unearned income (1,056) (1,992) Discount on loans purchased (2,144) (3,020) ---------- ---------- 646,235 423,946 Allowance for loan loss (11,888) (11,973) ---------- ---------- Total net loans $ 634,347 $ 411,973 ========== ==========
20 ANALYSIS OF ALLOWANCE FOR LOAN LOSS
YEAR ENDING DECEMBER 31, (IN THOUSANDS) -------------------------------------------------------------------- 2004 2003 2002 2001 2000 ---------- ---------- ---------- ---------- ---------- Total Loans $ 469,498 $ 515,714 $ 576,734 $ 646,235 $ 423,946 ========== ========== ========== ========== ========== Daily average loan balance $ 471,526 $ 562,765 $ 617,156 $ 543,854 $ 404,794 ========== ========== ========== ========== ========== Allowance for loan loss: Balance at the beginning of the year $ 12,426 $ 12,470 $ 11,888 $ 11,973 $ 11,737 Charge offs by loan type: Commercial -- 22 47 82 523 Real estate 204 789 878 435 105 ---------- ---------- ---------- ---------- ---------- Total charge offs 204 811 925 517 628 Recoveries by loan type: Commercial 37 26 19 212 596 Individual 4 2 32 32 4 Real estate 250 65 1,206 188 14 ---------- ---------- ---------- ---------- ---------- Total recoveries 291 93 1,257 432 614 ---------- ---------- ---------- ---------- ---------- Net recoveries (loan charge offs) 87 (718) 332 (85) (14) Provision for loan loss 6 674 250 -- 250 ---------- ---------- ---------- ---------- ---------- Balance at end of year $ 12,519 $ 12,426 $ 12,470 $ 11,888 $ 11,973 ========== ========== ========== ========== ========== Net charge offs to average loans 0.02% (0.13%) 0.05% (0.02%) -- ========== ========== ========== ========== ========== Allowance to total loans at year end 2.67% 2.41% 2.16% 1.84% 2.82% ========== ========== ========== ========== ==========
The allowance for loan losses is established through provisions for loan losses based on management's on-going evaluation of the risks inherent in Royal Bank's loan portfolio. Factors considered in the evaluation process include growth of the loan portfolio, risk characteristics of the types of loans in the portfolio, geographic and large borrower concentrations, current regional economic and real estate market conditions that could affect the ability of borrowers to pay, the value of underlying collateral, and trends in loan delinquencies and charge-offs. Royal Bank utilizes an internal rating system to monitor and evaluate the credit risk inherent in its loan portfolio. All loans approved by the loan committee, executive board committee and the Board of Directors are initially assigned a rating of pass. The Vice President of Special Assets and the loan review committee are expected to recommend changes in loan ratings when facts come to their attention that warrant an upgrade or downgrade in a loan rating. Problem and potential problem assets are assigned the three lowest ratings. Such ratings coincide with the "Substandard", "Doubtful" and "Loss" classifications used by federal regulators in their examination of financial institutions. Generally, an asset is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligors and/or the collateral pledged. Substandard assets have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. Assets classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristics that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, highly questionable and improbable. Assets classified as Loss are those considered uncollectable and of such little value that their continuance as assets is not warranted. On a regular basis, the Loan Review Committee and senior management review the status of each loan. While Royal Bank believes that it has established an adequate allowance for loan losses, there can be no assurance that the regulators, in reviewing Royal Bank's loan portfolio, will not request Royal Bancshares to materially increase its allowances for loan losses. Although management believes that adequate specific and general loan loss allowances have been established, actual losses are dependant upon future events and, as such, further additions to the level of specific and general loss allowances could become necessary. 21 LOANS AND LEASE FINANCING RECEIVABLES The following table summarizes the loan portfolio by loan category and amount that corresponds to the appropriate regulatory definitions.
AS OF DECEMBER 31, (IN THOUSANDS) --------------------------------- 2004 2003 2002 --------- --------- --------- Loans secured by real estate Construction and land development $ 106,428 $ 107,463 $ 82,736 Secured by 1-4 family residential properties: Revolving, open-end loans secured by 1-4 family residential properties and extended under lines of credit 7,369 5,854 7,564 All other loans secured by 1-4 family residential properties: Secured by first liens 36,136 50,716 116,248 Secured by junior liens 4,515 3,796 3,418 Secured by multi family (5 or more) residential properties 15,256 21,728 33,017 Secured by nonfarm nonresidential properties 85,545 97,902 87,448 Commercial and industrial loans to US addresses 208,204 225,268 241,373 Loans to individuals for household, family, and other personal expenditures 1,346 1,182 3,146 Obligations of state and political subdivisions in the US 1,769 3,134 3,541 All other loans 4,470 163 363 Less: Any unearned income on loans listed above 1,540 1,492 2,120 --------- --------- --------- Total loans and leases, net of unearned income $ 469,498 $ 515,714 $ 576,734 ========= ========= =========
CREDIT QUALITY The following table presents the principal amounts of nonaccruing loans and other real estate.
AS OF DECEMBER 31, (IN THOUSANDS) ----------------------------------------------------------------------- 2004 2003 2002 2001 2000 ----------- ----------- ----------- ----------- ----------- Non-accruing loans (1)(2) $ 4,526 $ 11,328 $ 11,908 $ 10,794 $ 3,548 Other real estate 5,424 4,371 1,444 884 -- ----------- ----------- ----------- ----------- ----------- Total nonperforming assets $ 9,950 $ 15,699 $ 13,352 $ 11,678 $ 3,548 =========== =========== =========== =========== =========== Nonperforming assets to total assets 0.83% 1.36% 1.23% 1.25% 0.56% =========== =========== =========== =========== =========== Nonperforming loans to total loans 0.96% 2.20% 2.06% 1.67% 0.84% =========== =========== =========== =========== =========== Allowance for loan loss to nonperforming loans 276.54% 109.69% 104.72% 110.14% 337.46% =========== =========== =========== =========== ===========
(1) Generally, a loan is placed on nonaccruing status when it has been delinquent for a period of 90 days or more unless the loan is both well secured and in the process of collection. (2) If interest had been accrued on these nonaccruing loans, such income would have approximated $209,000 for 2004, $401,000 for 2003, $473,000 for 2002, $526,000 for 2001, $319,000 for 2000. 22 INVESTMENT SECURITIES The contractual maturity distribution and weighted average rate of Royal Bancshares' investments held to maturity and available for sale portfolios at December 31, 2004 are presented in the following table. Weighted average rates on tax-exempt obligations have been computed on a fully taxable equivalent basis assuming a tax rate of 35%.
AS OF DECEMBER 31, 2004 (IN THOUSANDS) ------------------------------------------------------------------------------ AFTER 1 YEAR BUT AFTER 5 YEARS, BUT WITHIN 1 YEAR WITHIN 5 YEARS WITHIN 10 YEARS ----------------------- ----------------------- ------------------------ AMOUNT RATE AMOUNT RATE AMOUNT RATE ---------- ---------- ---------- ---------- ---------- ---------- SECURITIES HELD TO MATURITY Mortgage backed securities $ -- --% $ 52 9.0% $ -- --% Agencies -- --% 125,000 3.6% 60,000 4.0% Other securities 16,695 8.3% 10,300 5.7% -- --% ---------- ---------- ---------- ---------- ---------- ---------- Total $ 16,695 8.3% $ 135,352 3.7% $ 60,000 4.0% ========== ========== ========== ========== ========== ========== AVAILABLE FOR SALE Mortgage backed securities $ -- --% $ 4,128 3.5% $ 6,028 3.5% CMO'S -- --% -- --% -- --% Agencies -- --% -- --% 58,793 3.8% Foreign 6,380 8.2% 3,125 8.0% -- --% Trust Preferred -- --% -- --% -- --% Other securities 21,227 3.4% 110,475 5.5% 3,843 5.7% ---------- ---------- ---------- ---------- ---------- ---------- Total $ 27,607 4.5% $ 117,728 5.5% $ 68,664 3.9% ========== ========== ========== ========== ========== ========== AFTER 10 YEARS TOTAL ------------------------ ------------------------ AMOUNT RATE AMOUNT RATE ---------- ---------- ---------- ---------- SECURITIES HELD TO MATURITY Mortgage backed securities $ 180 3.8% $ 232 5.0% Agencies -- --% 185,000 3.7% Other securities -- --% 26,995 7.3% ---------- ---------- ---------- ---------- Total $ 180 3.8% $ 212,227 4.2% ========== ========== ========== ========== AVAILABLE FOR SALE Mortgage backed securities $ 42,039 4.5% $ 52,195 4.3% CMO'S 29,473 4.4% 29,473 4.4% Agencies 34,512 4.9% 93,305 4.2% Foreign -- --% 9,505 8.1% Trust Preferred 39,562 9.7% 39,562 9.7% Other securities 1,348 6.0% 136,893 5.2% ---------- ---------- ---------- ---------- Total $ 146,935 6.0% $ 360,934 5.3% ========== ========== ========== ==========
The following tables presents the consolidated book values and approximate fair value at December 31, 2004 and 2003, respectively, for each major category of Royal Bancshares' investment securities portfolio for held to maturity securities and available for sale securities. 23
AS OF DECEMBER 31, (IN THOUSANDS) --------------------------------------------------------------------- 2004 2003 2002 --------------------- --------------------- --------------------- AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE COST VALUE --------- --------- --------- --------- --------- --------- SECURITIES HELD TO MATURITY Mortgage backed securities $ 232 232 $ 340 $ 340 $ 538 $ 538 US agencies 185,000 184,267 91,630 91,333 -- -- Other securities 26,995 27,366 21,121 22,602 30,076 32,207 --------- --------- --------- --------- --------- --------- Total $ 212,227 $ 211,865 $ 113,091 $ 114,275 $ 30,614 $ 32,745 ========= ========= ========= ========= ========= ========= SECURITIES AVAILABLE FOR SALE Mortgage backed securities $ 81,303 $ 81,669 $ 110,596 $ 111,875 $ 235,965 $ 236,633 US agencies 94,997 93,305 122,785 121,112 -- -- Trust preferred securities 37,196 39,562 36,251 37,139 39,160 37,329 Other securities 141,679 146,398 161,488 170,713 130,598 135,405 --------- --------- --------- --------- --------- --------- Total $ 355,175 $ 360,934 $ 431,120 $ 440,839 $ 405,723 $ 409,367 ========= ========= ========= ========= ========= =========
DEPOSITS The average balance of Royal Bank's deposits by major classifications for each of the last three years is presented in the following table.
AS OF DECEMBER 31, (IN THOUSANDS) ----------------------------------------------------------------------- 2004 2003 2002 --------------------- --------------------- --------------------- AVERAGE AVERAGE AVERAGE BALANCE RATE BALANCE RATE BALANCE RATE --------- --------- --------- --------- --------- --------- Demand deposits: Non interest bearing $ 57,789 --% $ 56,814 --% $ 53,800 --% Interest bearing (NOW) 34,181 0.71% 32,510 1.04% 34,866 2.00% Money market deposits 426,895 1.81% 442,873 2.18% 270,454 3.14% Savings deposits 24,278 0.63% 23,714 0.77% 25,658 1.44% Certificate of deposit 218,756 3.92% 269,293 4.46% 385,370 5.02% --------- --------- --------- Total deposits $ 761,899 $ 825,204 $ 770,148 ========= ========= =========
24 The remaining maturity of Certificates of Deposit of $100,000 or greater: AS OF DECEMBER 31, (IN THOUSANDS) ----------------------- MATURITY 2004 2003 -------- ---------- ---------- Three months or less $ 13,309 $ 6,396 Over three months through twelve months 27,426 47,549 Over twelve months through five years 48,590 46,128 Over five years 1,271 4,050 ---------- ---------- Total $ 90,596 $ 104,123 ========== ========== SHORT AND LONG TERM BORROWINGS
YEAR ENDING DECEMBER 31, (IN THOUSANDS) --------------------------------------------------------- 2004 2003 2002 2001 2000 --------- --------- --------- --------- ---------- Short term borrowings $ 17,500 $ -- $ 3,000 $ 30,000 $ 3,000 Long term borrowings: Other borrowings -- -- -- 2,725 -- Obligations through equity investments 56,249 -- -- -- -- Subordinated debt 25,774 -- -- -- -- FHLB advances 204,500 212,000 124,500 67,500 30,000 --------- --------- --------- --------- --------- Total borrowings $ 304,023 $ 212,000 $ 127,500 $ 100,225 $ 30,000 ========= ========= ========= ========= =========
25 ITEM 7. MANAGEMENT'S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements of Royal Bancshares and related notes (see Item 8). FINANCIAL CONDITION Total assets increased $51 million, or 4%, to $1.21 billion at December 31, 2004 from $1.15 billion at year-end 2003. Cash and Cash Equivalents. Cash and cash equivalents are comprised of cash on hand, and cash in interest bearing and non-interest bearing accounts in banks, in addition to federal funds sold. Cash and cash equivalents increased $2.0 million, to $27.1 million at December 31, 2004. The average balance of cash and cash equivalents was approximately $53.1 million for 2004 versus $62.8 million for 2003. The majority of this average balance is held in interest-bearing accounts or invested daily in overnight fed funds. The average balance of these funds that earn interest was $43.3 million in 2004. The increase in the balance of cash and cash equivalents at year end was primarily due to larger balances maintained with the Federal Reserve Bank along with pending funding needs. Investment Securities Held to Maturity. Held to maturity ("HTM") investment securities represents approximately 13.4% of average earning assets during 2004 and are comprised of primarily government agency bonds and corporate debt securities of investment grade quality, at the time of purchase. During 2004, HTM investment securities increased by $99.1 million to $212.2 million at December 31, 2004, from $113.1 million at December 31, 2003. The increase was primarily due to a change with the investments committee strategy to hold government agency bonds with a maximum maturity of five years as Held to Maturity. Investment Securities Available for Sale. AFS investment securities represent 37.8% of average earning assets during 2004 and are primarily comprised of government secured agency bonds and government secured mortgaged-backed securities, capital trust security issues of regional banks, domestic corporate debt and U.S. denominated foreign corporate debt. At December 31, 2004, AFS investment securities were $360.9 million as compared to $440.8 million at December 31, 2003, a decrease of $79.9 million. This decrease was primarily due to maturities, calls and principal payments of existing portfolio. Loans. Royal Bancshares' primary earning assets are loans, representing approximately 44.7% of average earning assets during 2004. The loan portfolio has historically been comprised primarily of business demand loans and commercial mortgages in roughly equal amounts, and to a significantly lesser extent, consumer loans comprised of one to four family residential and home equity loans. During 2004, total loans decreased $45.3 million from $500.1 million at December 31, 2003 to $454.8 million at December 31, 2004 primarily due to an increased number of loans being paid in full as compared to new originations. In the current interest rate environment, Royal Bank has avoided lending in transactions where its management perceived the risk/reward ratio to be too high. Deposits. Royal Bancshares' deposits are the primary source of funding. Total deposits decreased $48.7 million, or 6.2%, from $791.1 million at December 31, 2003 to $742.4 million at December 31, 2004. This decrease in deposits is primarily due to allowing brokered deposits to mature and not replacing the high cost funds. At December 31, 2004, brokered deposits were $65.3 million as compared to $80.9 million at December 31, 2003. Certificate of deposit accounts decreased $34.4 million, or 14.5% from $236.9 million at December 31, 2003 to $202.5 million at December 31, 2004. Other deposit categories comprised of demand, NOW, money markets and savings deposits decreased $14.3 million during 2004 over their levels at December 31, 2004. The decrease in all savings categories is primarily due to a reduction in interest rates offered. FHLB Borrowings. Borrowings are comprised of long-term borrowings (advances) and short-term borrowings (overnight borrowings, advances). Long-term FHLB borrowings decreased $7.5 million to $204.5 million at December 31, 2004 from $212.0 million at December 31, 2003 due to an advance being reclassified as a result of its remaining maturity being less than one year. At December 31, 2004 short term FHLB borrowings was $17.5 million. The average balance of borrowings during 2004 was $221.7 million versus $183.3 million for 2003. 26 Other Borrowings. During 2004, Royal Bancshares completed a private placement of preferred trust securities in the aggregate amount of $25 million for a term of 30 years with a call feature of 5 years. In addition, as result of the adoption of FIN46(R) Royal Bancshares consolidated into its statement of condition $56.2 million of debt related to real estate equity investment of which $0 is guaranteed by Royal Bancshares. Shareholders' Equity. Shareholders' equity increased $6.0 million or 4.5% in 2004 to $140.9 million primarily due to net income of $20.0 million partially offset by $12.2 million in cash dividends paid in 2004. Additionally, shareholders' equity was affected by the decrease in market value of AFS investment securities during 2004, which resulted in an downward adjustment of $2.6 million. RESULTS OF OPERATIONS General. Royal Bancshares' results of operations depend primarily on net interest income, which is the difference between interest income on interest earning assets and interest expense on interest bearing liabilities. Interest earning assets consist principally of loans and investment securities, while interest bearing liabilities consist primarily of deposits. Net income is also affected by the provision for loan losses and the level of non-interest income as well as by non-interest expenses, including salary and employee benefits, occupancy expenses and other operating expenses. Net Income. Net income in 2004 was $20.0 million as compared to $18.5 million in 2003 and $17.4 million in 2002. Basic earnings per share were $1.60, $1.49 and $1.41 for 2004, 2003, and 2002, respectively. The $1.5 million increase in net income for 2004 represents an 8% increase over 2003, and is primarily attributable to an increase in non-interest income specifically with income from Bank Owned Life Insurance and gains from the disposition of Other Real Estate Owned. The $1.1 million increase in net income for 2003 represents a 6% increase over 2002, and is primarily attributed to the reduction of interest paid on deposits and borrowings as compared to income relating to loans and investment security portfolio, and to lesser extent, non-recurring fees and accretion income. Net Interest Income. Net interest income is Royal Bancshares' primary source of income. Its level is a function of the average balance of interest-earning assets, the average balance of interest-bearing liabilities, and the spread between the yield on assets and liabilities. In turn, these factors are influenced by the pricing and mix of Royal Bancshares' interest-earning assets and funding sources. Additionally, net interest income is affected by market and economic conditions, which influence rates on loan and deposit growth. Net interest income was $40.2 million in 2004 as compared to $42.4 million in 2003. The decrease in net interest income in 2004 of $2.2 million was primarily due to the reduction of the yield on earning assets along with a decline in the spread of earning assets as compared to costing liabilities in 2004. The increase in 2003 of net interest income of $1.8 million is primarily due to the reduction of interest paid on deposits and borrowings. Interest paid on interest bearing liabilities decreased $6.6 million from $36.5 million in 2002, to $29.9 million in 2003. The reduction is primarily due the reduction of rates offered during 2003. 27 LOANS AND MORTGAGES
2004 2003 2002 -------------- -------------- -------------- Average loan outstandings $ 471,525,000 $ 562,765,000 $ 617,156,000 Interest and fees on loans $ 40,044,000 $ 46,609,000 $ 53,314,000 Average Yield 8.49% 8.28% 8.64%
Royal Bancshares continues to originate both fixed rate and variable rate loans. At December 31, 2004 variable rate loans represented 45% of total loans. Together with some match funding of fixed rate deposits to fixed rate loans, variable rate loans have helped Royal Bank manage interest rate risk. In 2004, the average balance of loans decreased $91.2 million to $471.5 million primarily due a large amount of loans being paid off as interest rates remained at historically low levels. The average yield on loans increased by 21 basis points in 2004 primarily due to the average loan run off being at a lower yield than the 2003 average yield , along with the Federal Reserve increasing the short term rates in the second half of 2004. In 2003, the average balance of loans decreased $54.3 million to $562.8 million primarily due a large amount of loans being paid off as interest rates remained at historically low levels. The average yield on loans decreased 36 basis points in 2003 primarily due to interest rates re-pricing at lower levels on variable rate loans. HTM INVESTMENT SECURITIES
2004 2003 2002 -------------- -------------- -------------- Average HTM investment securities $ 141,799,000 $ 46,302,000 $ 53,226,000 Interest income $ 6,365,000 $ 3,087,000 $ 4,019,000 Average yield 4.49% 6.67% 7.55%
HTM investment securities are comprised primarily of taxable corporate debt issues and US government agencies. The corporate debt issues are investment grade at the time of purchase. It is Royal Bancshares' expressed intention to hold these securities to maturity. In 2004, the yield on HTM investment securities decreased 218 basis points to 4.49% from 6.67% in 2003. This decrease was primarily due to the purchasing of low credit risk government agency bonds that are yielding 3.0% to 4.5 %. The government agencies at December 31, 2004 have step up and/or call features. In 2003, the yield on HTM investment securities decreased 88 basis points to 6.67% from 7.55% in 2002. This decrease was primarily due to higher yielding investments that have maturing and being replaced with lower yielding investments as a result of current market conditions. AFS INVESTMENT SECURITIES
2004 2003 2002 -------------- -------------- -------------- Average AFS investment securities $ 399,361,000 $ 446,210,000 $ 297,457,000 Interest and dividend income $ 20,621,000 $ 22,007,000 $ 18,817,000 Average yield 5.16% 4.93% 6.33%
28 AFS investment securities are comprised primarily of government secured mortgage-backed securities, government agencies, non-rated and rated capital trust security issues of regional banks, rated domestic and US denominated foreign corporate debt securities and to a lesser extent preferred and common stock. In 2004, the average balance of AFS investment securities decreased $46.8 million to $399.4 million primarily due classifying new purchases from investment runoff as held to maturity. The 23 basis point increase in average yield is primarily due to higher yields earned on mortgage back securities resulting from slower principal repayments speeds. In 2003, the average balance of AFS investment securities increased $148.8 million to $446.2 million primarily due to the redeployment of excess cash on hand to achieve a higher rate of return than overnight funds. The 140 basis point decrease in average yield is primarily due to the lower yields on the new investment purchases. INTEREST EXPENSE ON NOW AND MONEY MARKET DEPOSITS
2004 2003 2002 -------------- -------------- -------------- Average NOW & Money Market deposits $ 461,076,000 $ 475,383,000 $ 305,320,000 Interest expense $ 7,965,000 $ 10,000,000 $ 9,188,000 Average cost of funds 1.73% 2.10% 3.01%
In 2004 the average cost of funds on NOW and money market deposits decreased 37 basis points to 1.73% from 2.10% in 2003 primarily due to a decline in the interest rate paid on these deposits. In 2003 the average cost of funds on NOW and money market deposits decreased 91 basis points to 2.10% from 3.01% in 2002 primarily due to a decline in the interest rate paid on these deposits. INTEREST EXPENSE ON TIME DEPOSITS
2004 2003 2002 -------------- -------------- -------------- Average time deposits $ 218,756,000 $ 269,293,000 $ 385,370,000 Interest expense $ 8,577,000 $ 12,011,000 $ 19,358,000 Average cost of funds 3.92% 4.46% 5.02%
In 2004, the average balance of time deposits decreased $50.5 million to $218.8 million. This decrease in average time deposits is primarily due to the maturity of higher yielding brokered deposits that were not renewed. In 2003, the average balance of time deposits decreased $116.1 million to $269.3 million. This decrease in average time deposits is primarily due to the maturity of higher yielding brokered deposits. Although rates in general continued to move upward in 2004, the reaction of deposits to rate changes (both increases and decreases) is slower than the change in the prime rate because these time deposits must mature before a rate adjustment would become effective. At December 31, 2004, 45% of time deposits were comprised of certificates of deposits accounts with balances of $100,000 or more, while in 2003, 44% of time deposits were comprised of certificates of deposit accounts with balances of $100,000 or more. These types of deposit have traditionally been considered more rate volatile than other types of deposits, however Royal Bank's penalty for early redemption somewhat mitigates this volatility. PROVISION FOR POSSIBLE LOAN LOSSES The provision for loan losses is an amount charged to expense to provide for future losses on existing loans. In order to determine the amount of the provision for loan loss, Royal Bank conducts a quarterly review of the loan portfolio to evaluate overall credit quality. This evaluation consists of an analysis of individual loans and overall risk characteristics and size of the loan, and takes into consideration current economic and market conditions, changes in non-performing loans, the capability of specific borrowers to repay loan obligations as well as current collateral values. In 2004, a provision for loan losses was recorded at $6 thousand, as compared to $674 thousand in 2003 due to charges off's relating to delinquent tax liens held by Crusader Servicing Corporation. During 2004 senior management 29 determined that loan loss reserve was adequate and no additional provision was required for the period. Net recoveries were $87 thousand in 2004 as compared to net charge-offs of $718 thousand in 2003. In 2003, a provision for loan losses was recorded at $674 thousand, as compared to $250 thousand in 2002 due to senior management assessment that the level of loan loss reserve was not adequate. Net charge-offs were $718 thousand in 2003 as compared to net recoveries of $332 thousand for 2002. The allowance for possible loan loss at December 31, 2004 was $12.5 million, or 2.67% of net loans as compared to $12.4 million at December 31, 2003 or 2.41% of net loans, and $12.5 million at December 31, 2002, or 2.16% of net loans. NON-INTEREST INCOME Non-interest income includes service charges on depositors' accounts, safe deposit rentals and various services such as cashing checks, issuing money orders and traveler's checks, and similar activities. In addition, other forms of non-interest income is derived from changes in the cash value of BOLI, fees collected on the sale of residential mortgages in the secondary market and income relating to the VIE's which Royal Bancshares has an investment. Most components of non-interest income are a modest and stable source of income, with exceptions of one-time gains and losses from the sale of investments securities and other real estate owned, from period to period these sources of income may vary considerably. Service charges on depositors' accounts, safe deposit rentals and other fees are periodically reviewed by management to remain competitive with other local banks. In 2004, total non-interest income increased $9.5 million to $13.2 million at December 31, 2004. This increase is primarily due income earned on the purchase of BOLI, income related to the consolidation of the VIEs and the sale of other real estate owned. In 2003, total non-interest income increased $0.5 million primarily due income earned on the purchase of Bank Owned Life Insurance ("BOLI") and the sale of insurance products through an affiliation with the MONY Group. NON-INTEREST EXPENSE Non-interest expense includes compensation and employee benefits, occupancy, advertising, FDIC insurance, state taxes, depreciation, and other expenses such as auditing, automatic teller machines (ATMs), data processing, legal, outside service charges, postage, printing and other expenses relating to other real estate owned. Effective 2004, Royal Bancshares through the adoption of FIN46(R) consolidates the expenses related to equity investments. Non-interest expense increased $6.5 million to $25.4 million in 2004, from $18.9 million in 2003. Salaries and employee benefits increased $809 thousand to $10.8 million in 2004, from $10.0 million in 2003. This was primarily due to annual salary increases and the addition of the Royal Asian Bank, a division of Royal Bank. Occupancy expense increased $179 thousand to $1.5 million in 2004 primarily due to the addition Royal Asian Bank. Other operating expenses increased $792 thousand to $8.4 million in 2004. As a result of consolidation of the "VIE" non-interest expense increased $4.8 million during 2004. Non-interest expense decreased $34 thousand to $18.9 million in 2003, from $18.9 million in 2002. Salaries and employee benefits increased $519 thousand to $10.0 million in 2003, from $9.4 million in 2002. This was primarily due to annual salary increases and an increase in pension cost. Occupancy expense increased $151 thousand to $1.3 million in 2003 primarily due the addition of our Turnersville Branch. Other operating expenses decreased $704 thousand to $7.6 million in 2003. ACCOUNTING FOR INCOME TAXES The provision for federal income taxes was $7.9 million in 2004 as compared to $8.0 million for 2003, and $7.2 million for 2002 representing an effective tax rate of 28%, 30% and 29%, respectively. The reduction in effective tax rate in 2004 was primarily due to the addition of BOLI and increased level of earnings offset by the use of tax goodwill related to the acquisition of Knoblauch State Bank in 1995. 30 ACCOUNTING FOR DEBT AND EQUITY SECURITIES Royal Bancshares accounts for investment securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This standard requires investments in securities to be classified in one of three categories; held to maturity, trading or available for sale. Debt securities that Royal Bank has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. As Royal Bank does not engage in security trading, the balance of its debt securities and any equity securities are classified as available for sale. Net unrealized gains and losses for such securities, net of tax effect, are required to be recognized as a separate component of shareholders' equity and excluded from the determination of net income. ASSET LIABILITY MANAGEMENT The primary functions of asset-liability management are to assure adequate liquidity and maintain an appropriate balance between interest earning assets and interest bearing liabilities. This process is overseen by the Asset-Liability Committee ("ALCO") which monitors and controls, among other variables, the liquidity, balance sheet structure and interest rate risk of the consolidated company within policy parameters established and outlined in the Funds, Cash Flow and Liquidity Policies and Procedures which are reviewed by the Board of Directors at least annually. Additionally, the ALCO committee meets periodically and reports on liquidity, interest rate sensitivity and projects financial performance in various interest rate scenarios. Liquidity. Liquidity is the ability of the financial institution to ensure that adequate funds will be available to meet its financial commitments as they become due. In managing its liquidity position, the financial institution evaluates all sources of funds, the largest of which is deposits. Also taken into consideration is the repayment of loans. These sources provide the financial institution with alternatives to meet its short-term liquidity needs. Longer-term liquidity needs may be met by issuing longer-term deposits and by raising additional capital. Royal Bancshares generally maintains a liquidity ratio equal to or greater than 25% of total deposits and short-term liabilities. Liquidity is specifically defined as the ratio of net cash, short term and marketable assets to net deposits and short-term liabilities. The liquidity ratio for the years ended December 31, 2004, 2003 and 2002 was 39%, 60% and 42%, respectively. Management believes that Royal Bancshares' liquidity position continues to be adequate, continues to be in excess of its peer group level and meets or exceeds the liquidity target set forth in the Asset/Liability Management Policy. Management believes that due to its financial position, it will be able to raise deposits as needed to meet liquidity demands. However, any financial institution could have unmet liquidity demands at any time. Contractual Obligations and Other Commitments. The following table sets forth contractual obligations and other commitments representing required and potential cash outflows as of December 31, 2004.
Less than More than 5 (in thousands) Total 1 year 1-3 years 4-5 years years ------------------------- --------- --------- --------- --------- ----------- FHLB Advances $ 222,000 $ 17,500 $ 30,000 $ 15,000 $ 159,500 Operating leases 2,541 648 937 702 254 Standby letters of credit 1,797 1,637 160 -- -- Time deposits 202,520 86,566 58,255 53,130 4,569 --------- --------- --------- --------- ----------- Total $ 428,858 $ 106,351 $ 89,352 $ 68,832 $ 164,323 ========= ========= ========= ========= ===========
Interest-Rate Sensitivity. Interest rate sensitivity is a function of the repricing characteristics of the financial institution's assets and liabilities. These include the volume of assets and liabilities repricing, the timing of repricing, and the relative levels of repricing. Attempting to minimize the interest rate sensitivity gaps is a continual challenge in a changing rate environment. The interest sensitivity report examines the positioning of the interest rate risk exposure in a changing interest rate environment. Ideally the rate sensitive assets and liabilities will be maintained in a matched position to minimize interest rate risk. The interest rate sensitivity analysis is an important management tool, however, it does have some inherent shortcomings. It is a "static" analysis. Although certain assets and liabilities may have similar maturities or repricing, 31 they may react in different degrees to changes in market interest rates. Additionally, repricing characteristics of certain assets and liabilities may vary substantially within a given period. The following table summarizes repricing intervals for interest earning assets and interest bearing liabilities as of December 31, 2004, and the difference or "gap" between them on an actual and cumulative basis for the periods indicated. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. During a period of falling interest rates, a positive gap would tend to adversely affect net interest income, while a negative gap would tend to result in an increase in net interest income. During a period of rising interest rates, a positive gap would tend to result in an increase in net interest income while a negative gap would tend to affect net interest income adversely. At December 31, 2004, Royal Bancshares is in an asset sensitive positive of $191.4 million, which indicates assets will reprice somewhat faster than liabilities within one year. INTEREST RATE SENSITIVITY (IN MILLIONS)
DAYS ---------------------- 1 TO 5 OVER 5 NON-RATE 0 - 90 91 - 365 YEARS YEARS SENSITIVE TOTAL --------- --------- --------- --------- --------- --------- ASSETS (1) Interest-bearing deposits in banks $ 13.3 $ -- $ -- $ -- $ 12.8 $ 26.1 Federal funds sold 1.0 -- -- -- -- 1.0 Investment securities: Available for sale 5.6 38.0 237.3 80.0 -- 360.9 Held to maturity 32.8 34.1 145.3 -- -- 212.2 --------- --------- --------- --------- --------- --------- Total investment securities 38.4 72.1 382.6 80.0 -- 573.1 Loans:(2) Fixed rate 52.9 40.6 146.0 18.8 -- 258.3 Variable rate 187.9 21.1 -- -- (12.5) 196.5 --------- --------- --------- --------- --------- --------- Total loans 240.8 61.7 146.0 18.8 (12.5) 454.8 Other assets -- -- -- -- 150.3 150.3 --------- --------- --------- --------- --------- --------- Total Assets $ 293.5 $ 133.8 $ 528.6 $ 98.8 $ 150.6 $ 1,205.3 ========= ========= ========= ========= ========= ========= LIABILITIES & CAPITAL Deposits: Non interest bearing deposits $ -- $ -- $ -- $ -- $ 64.4 $ 64.4 Interest bearing deposits 29.8 89.4 356.3 -- -- 475.5 Certificate of deposits 29.1 27.4 141.4 4.6 -- 202.5 --------- --------- --------- --------- --------- --------- Total deposits 58.9 116.8 497.7 4.6 64.4 742.4 Borrowings 22.7 37.5 107.3 79.5 57.0 304.0 Other liabilities -- -- -- .3 17.7 18.0 Capital -- -- -- -- 140.9 140.9 --------- --------- --------- --------- --------- --------- Total liabilities & capital $ 81.6 $ 154.3 $ 605.3 $ 84.1 $ 280.0 $ 1,205.3 ========= ========= ========= ========= ========= ========= Net interest rate GAP $ 211.9 $ (20.5) $ (76.7) $ 14.7 $ (129.4) ========= ========= ========= ========= ========= Cumulative interest rate GAP $ 211.9 $ 191.4 $ 114.7 $ 129.4 $ -- ========= ========= ========= ========= ========= GAP to total assets 18% -2% ========= ========= GAP to total equity 150% -15% ========= ========= Cumulative GAP to total assets 18% 16% ========= ========= Cumulative GAP to total equity 150% 136% ========= =========
(1) Interest earning assets are included in the period in which the balances are expected to be repaid and/or repriced as a result of anticipated prepayments, scheduled rate adjustments, and contractual maturities. (2) Reflects principal maturing within the specified periods for fixed and repricing for variable rate loans; includes nonperforming loans. 32 The method of analysis of interest rate sensitivity in the table above has a number of limitations. Certain assets and liabilities may react differently to changes in interest rates even though they reprice or mature in the same time periods. The interest rates on certain assets and liabilities may change at different times than changes in market interest rates, with some changing in advance of changes in market rates and some lagging behind changes in market rates. Also, certain assets have provisions, which limit changes in interest rates each time the interest rate changes and for the entire term of the loan. Additionally, prepayments and withdrawals experienced in the event of a change in interest rates may deviate significantly from those assumed in the interest rate sensitivity table. Additionally, the ability of some borrowers to service their debt may decrease in the event of an interest rate increase. CAPITAL ADEQUACY The table shown below sets forth Royal Bancshares' consolidated capital level and performance ratios: REGULATORY 2004 2003 2002 MINIMUM ---- ---- ---- ---------- CAPITAL LEVEL Leverage ratio 13.9% 11.1% 11.4% 3.0% Risk based capital ratio: Tier 1 19.2% 15.3% 14.6% 4.0% Total 20.4% 16.5% 15.9% 8.0% CAPITAL PERFORMANCE Return on average assets 1.7% 1.6% 1.7% - Return on average equity 14.6% 14.5% 15.2% - Royal Bancshares' sources of capital have been derived from the issuance of stock as well as retained earnings. While Royal Bancshares has not had a stock offering since 1986, total shareholders' equity has increased primarily due to steady increases in retained earnings. At December 31, 2004, Royal Bancshares had an average equity to average asset ratio of 11.5%. Royal Bancshares has no current plans to raise capital through new stock offerings and indeed, seeks ways to leverage its existing capital. The capital ratios set forth above compare favorably to the minimum required amounts of Tier 1 and total capital to risk-weighted assets and the minimum Tier 1 leverage ratio, as defined by the banking regulators. At December 31, 2004, Royal Bancshares was required to have minimum Tier 1 and total capital ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of 4.0%. In order for Royal Bancshares to be considered well capitalized, as defined by the banking regulators, Royal Bancshares must have Tier 1 and total capital ratios of 6.0% and 10.0%, respectively, and a minimum Tier 1 leverage ratio of 5.0%. At December 31, 2004, Royal Bancshares met the criteria for a well capitalized institution, and management believes that, under current regulations, Royal Bancshares will continue to meet its minimum capital requirements in the foreseeable future. MANAGEMENT OPTIONS TO PURCHASE SECURITIES In May 2001, the directors of the Royal Bancshares approved the amended Royal Bancshares of Pennsylvania Non-qualified Stock Option and Appreciation Right Plan (the Plan). The shareholders in connection with the formation of the holding company reapproved the Plan. The Plan is an incentive program under which Bank officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1,500,000 shares of the Royal Bancshares' Class A common stock (but not in excess of 15% of outstanding shares). At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. At December 31, 2004, 593,539 options have been granted which are exercisable at 20% per year. At December 31, 2004, options covering 186,112 shares were exercisable by 94 employees. In May 2001, the directors of the Royal Bancshares approved an amended non-qualified Outside Directors Stock Option Plan. The shareholders in connection with the formation of the holding company reapproved this Plan. Under the terms of the plan, 250,000 shares of Class A stock are authorized for grants. Each director is entitled to a grant of an option to purchase 1,500 shares of stock annually, which is exercisable one year from the grant date. The options were granted at the fair market value at the date of the grant. At December 31, 2004, 79,044 options were outstanding and options covering 62,214 shares were exercisable. 33 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK A simulation model is used to estimate the impact of various changes, both upward and downward, in market interest rates and volumes of assets and liabilities on the net income. This model produces an interest rate exposure report that forecast changes in the market value of portfolio equity under alternative interest rate environment. The market value of portfolio is defined as the present value of existing assets and liabilities. The calculated estimates of changes in the market value of portfolio value are as follows: As of December 31, 2004 (Dollars in Thousands) Market Value of Percent of Changes in Rates Portfolio Equity Change ------------------ ---------------- ---------- + 200 basis points 153,256 -4.9% + 100 basis points 160,427 -0.5% Flat rate 161,202 0% - 100 basis points 153,474 -4.8% - 200 basis points 135,774 -15.8% The assumptions used in evaluating the vulnerability of earnings and capital to changes in interest rates are based on management's considerations of past experience, current position and anticipated future economic conditions. The interest rate sensitivity of assets and liabilities as well as the estimated effect of changes in interest rates on the market value of portfolio equity could vary substantially if different assumptions are used or actual experience differs from what the calculations may be based. RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46). In general, a variable interest entity is a corporation, partnership, trust or any other legal structures used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary if the 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. The consolidation requirements of FIN 46 apply immediately to interest entities created after January 31, 2003. In December 2003, the FASB issued FIN 46(R) with respect to variable interest entities created before January 31, 2003, which among other things revised the implementation date to the first fiscal year or interim period ended after March 15, 2004, with the exception of Special Purpose Entities (SPE). Royal Bancshares currently has no SPEs. Royal Bancshares adopted the provisions of FIN 46 effective for the period ending March 31, 2004, which required Royal Bancshares to consolidate its investment in real estate partnerships. Prior to FIN 46 and 46(R), Royal Bancshares accounted for its investment in the real estate partnerships under the equity method of accounting. The SEC recently released Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments. SAB 105 provides guidance about the measurements of loan commitments recognized at fair value under FASB Statement No. 133, Accountings for Derivative Instruments and Hedging Activities. SAB 105 also requires companies to disclose their accounting policy for those loan commitments including methods and assumptions used to estimate fair value and associated hedging strategies. SAB 105 is effective for all loan commitments accounted for as derivatives that are entered into after March 31, 2004. The adoption of SAB 105 is not expected to have a material effect on our consolidated financial statements. 34 In December 2004, the Financial Accounting Standards Board (FASB) issued Statement 123(R), "Share-Based Payment," an Amendment of FASB Statements No. 123 and APB No. 95. The Statement addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires that all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees." Royal Bancshares is currently evaluating this Statement and its effects on its results of operations. 35 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES DECEMBER 31, 2004 AND 2003 36 Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Royal Bancshares of Pennsylvania, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Royal Bancshares of Pennsylvania, Inc. and Subsidiaries as of December 31, 2004, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the year then ended. These financial statements are the responsibility of Royal Bancshares's management. Our responsibility is to express an opinion on these financial statements based on our audit. The consolidated financial statements of Royal Bancshares of Pennsylvania, Inc. for the years ended December 31, 2003 and 2002 were audited by other auditors, whose report dated January 22, 2004, expressed an unqualified opinion on those statements. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As discussed in Note A to the consolidated financial statements, Royal Bancshares of Pennsylvania, Inc. adopted the provisions of Financial Accounting Standards Board Interpretation No. 46, "Consolidation of Variable Interest Entities," on March 31, 2004. In our opinion, the 2004 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Royal Bancshares of Pennsylvania, Inc. and Subsidiaries as of December 31, 2004, and the consolidated results of their operations and their consolidated cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Royal Bancshares of Pennsylvania, Inc. and Subsidiaries internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2005 expressed an unqualified opinion on management's assessment of internal control over financial reporting and an adverse opinion on the effectiveness of internal control over financial reporting because of the effects of a material weakness identified in management's assessment process. /s/ Beard Miller Company LLP Reading, Pennsylvania March 14, 2005 37 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Balance Sheets
December 31, --------------------------------- 2004 2003 --------------- --------------- (In thousands, except share data) ASSETS Cash and due from banks $ 26,109 $ 17,470 Federal funds sold 1,000 7,600 --------------- --------------- Total cash and cash equivalents 27,109 25,070 Investment securities held to maturity (fair value of $211,865 and $114,275 in 2004 and 2003, respectively) 212,227 113,091 Investment securities available for sale - at fair value 360,934 440,839 Federal Home Loan Bank stock, at cost 11,100 11,407 Loans held for sale 2,204 3,157 Loans 467,294 512,557 Less allowance for loan losses 12,519 12,426 --------------- --------------- Net loans 454,775 500,131 Premises and equipment, net 8,780 7,480 Real estate owned via equity investments 63,653 - Accrued interest receivable 15,634 16,353 Bank owned life insurance 21,214 20,248 Other assets 27,644 16,634 --------------- --------------- Total assets $ 1,205,274 $ 1,154,410 =============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Deposits Non-interest bearing $ 64,371 $ 58,942 Interest bearing 678,011 732,117 --------------- --------------- Total deposits 742,382 791,059 Accrued interest payable 5,602 7,733 Other liabilities 8,736 7,920 Borrowings 222,000 212,000 Obligations related to equity investments 56,249 - Subordinated debentures 25,774 - --------------- --------------- Total liabilities 1,060,743 1,018,712 Minority interests 3,655 865 Stockholders' equity Common stock Class A, par value $2.00 per share; authorized, 18,000,000 shares; issued, 10,276,672 and 10,027,284 shares in 2004 and 2003, respectively 20,553 20,054 Class B, par value $0.10 per share; authorized, 2,000,000 shares; issued, 1,939,490 and 1,909,742 shares in 2004 and 2003, respectively 194 191 Additional paid in capital 92,037 85,448 Retained earnings 26,558 24,990 Accumulated other comprehensive income 3,799 6,415 --------------- --------------- 143,141 137,098 Treasury stock - at cost, 215,388 Class A shares in 2004 and 2003 (2,265) (2,265) --------------- --------------- Total stockholders' equity 140,876 134,833 --------------- --------------- Total liabilities and stockholders' equity $ 1,205,274 $ 1,154,410 =============== ===============
The accompanying notes are an integral part of these statements. 38 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Statements of Income
Years ended December 31, ------------------------------------------------ 2004 2003 2002 -------------- -------------- -------------- (In thousands, except per share data) Interest income Loans, including fees $ 40,044 $ 46,609 $ 53,314 Investment securities held to maturity 6,365 3,087 4,019 Investment securities available for sale 20,621 22,007 18,817 Deposits in banks 409 475 682 Federal funds sold 102 142 272 -------------- -------------- -------------- TOTAL INTEREST INCOME 67,541 72,320 77,104 -------------- -------------- -------------- Interest expense Deposits 16,918 22,193 28,916 Borrowings 8,744 7,748 7,575 Obligations related to equity investments 1,639 - - -------------- -------------- -------------- TOTAL INTEREST EXPENSE 27,301 29,941 36,491 -------------- -------------- -------------- NET INTEREST INCOME 40,240 42,379 40,613 Provision for loan losses 6 674 250 -------------- -------------- -------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 40,234 41,705 40,363 -------------- -------------- -------------- Other income Service charges and fees 1,496 1,125 1,124 Gains on sale of investment securities available for sale 810 719 790 Income related to equity investments 7,133 - - Income from bank owned life insurance 966 248 - Gains on sale of other real estate 2,102 568 457 Gains on sale of loans 480 637 767 Other income 173 407 62 -------------- -------------- -------------- 13,160 3,704 3,200 -------------- -------------- -------------- Other expenses Salaries and employee benefits 10,767 9,958 9,440 Occupancy and equipment 1,509 1,330 1,180 Expenses related to equity investments 4,780 - - Other operating expenses 8,391 7,599 8,301 -------------- -------------- -------------- 25,447 18,887 18,921 -------------- -------------- -------------- INCOME BEFORE INCOME TAXES 27,947 26,522 24,642 Income taxes 7,914 7,996 7,237 -------------- -------------- -------------- NET INCOME $ 20,033 $ 18,526 $ 17,405 ============== ============== ============== Per share data Net income - basic $ 1.60 $ 1.49 $ 1.41 ============== ============== ============== Net income - diluted $ 1.59 $ 1.49 $ 1.38 ============== ============== ==============
The accompanying notes are an integral part of these statements. 39 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Statement of Changes in Stockholders' Equity Years ended December 31, 2004, 2003 and 2002 (In thousands, except per share data)
Class A common stock Class B common stock Additional ----------------------------- ------------------------------ paid in Shares Amount Shares Amount capital ------------- ------------- ------------- ------------- ------------- Balance, December 31, 2001 8,849 $ 17,698 1,805 $ 180 $ 65,011 Net income for the year ended December 31, 2002 - - - - - Conversion of Class B common stock to Class A common stock 60 120 (52) (5) - 6% stock dividends declared 518 1,036 108 11 11,285 Cash in lieu of fractional shares - - - - - Stock options exercised 168 336 - - 688 Cash dividends on common stock (Class A $0.93, Class B $1.07) - - - - - Other comprehensive income, net of reclassifications and taxes - - - - - ------------- ------------- ------------- ------------- ------------- Comprehensive income Balance, December 31, 2002 9,595 19,190 1,861 186 76,984 Net income for the year ended December 31, 2003 - - - - - Conversion of Class B common stock to Class A common stock 8 16 (7) (1) - 3% stock dividends declared 281 562 55 6 6,443 Cash in lieu of fractional shares - - - - - Stock options exercised 143 286 - - 2,021 Cash dividends on common stock (Class A $0.96, Class B $1.11) - - - - - Other comprehensive income, net of reclassifications and taxes - - - - - ------------- ------------- ------------- ------------- ------------- Comprehensive income Balance, December 31, 2003 10,027 20,054 1,909 191 85,448 Accumulated other Retained comprehensive Treasury Comprehensive earnings income (loss) stock income ------------- ------------- ------------- ------------- Balance, December 31, 2001 $ 30,457 $ (2,632) $ (2,265) Net income for the year ended December 31, 2002 17,405 - - $ 17,405 Conversion of Class B common stock to Class A common stock (115) - - - 6% stock dividends declared (12,331) - - - Cash in lieu of fractional shares (7) - - - Stock options exercised - - - - Cash dividends on common stock (Class A $0.93, Class B $1.07) (10,590) - - - Other comprehensive income, net of reclassifications and taxes - 5,047 - 5,047 ------------- ------------- ------------- ------------- Comprehensive income $ 22,452 ============= Balance, December 31, 2002 24,819 2,415 (2,265) Net income for the year ended December 31, 2003 18,526 - - $ 18,526 Conversion of Class B common stock to Class A common stock (15) - - - 3% stock dividends declared (7,011) - - - Cash in lieu of fractional shares (8) - - - Stock options exercised - - - - Cash dividends on common stock (Class A $0.96, Class B $1.11) (11,321) - - - Other comprehensive income, net of reclassifications and taxes - 4,000 - 4,000 ------------- ------------- ------------- ------------- Comprehensive income $ 22,526 ============= Balance, December 31, 2003 24,990 6,415 (2,265)
(Continued) 40 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Statement of Changes in Stockholders' Equity - Continued Years ended December 31, 2004, 2003 and 2002 (In thousands, except per share data)
Class A common stock Class B common stock Additional ----------------------------- ------------------------------ paid in Shares Amount Shares Amount capital ------------- ------------- ------------- ------------- ------------- Balance, December 31, 2003 10,027 $ 20,054 1,909 $ 191 $ 85,448 Net income for the year ended December 31, 2004 - - - - - Conversion of Class B common stock to Class A common stock 10 20 (1) - - 2% stock dividends declared 196 392 31 3 5,842 Cash in lieu of fractional shares - - - - - Stock options exercised 44 87 - - 747 Cash dividends on common stock (Class A $1.00, Class B $1.15) - - - - - Other comprehensive income, net of reclassifications and taxes - - - - - ------------- ------------- ------------- ------------- ------------- Comprehensive income Balance, December 31, 2004 10,277 $ 20,553 1,939 $ 194 $ 92,037 ============= ============= ============= ============= ============= Accumulated other Retained comprehensive Treasury Comprehensive earnings income (loss) stock income ------------- ------------- ------------- ------------- Balance, December 31, 2003 $ 24,990 $ 6,415 $ (2,265) Net income for the year ended December 31, 2004 20,033 - - $ 20,033 Conversion of Class B common stock to Class A common stock (19) - - - 2% stock dividends declared (6,236) - - - Cash in lieu of fractional shares (11) - - - Stock options exercised - - - - Cash dividends on common stock (Class A $1.00, Class B $1.15) (12,199) - - - Other comprehensive income, net of reclassifications and taxes - (2,616) - (2,616) ------------- ------------- ------------- ------------- Comprehensive income $ 17,417 ============= Balance, December 31, 2004 $ 26,558 $ 3,799 $ (2,265) ============= ============= =============
The accompanying notes are an integral part of this statement. 41 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Year ended December 31,
2004 2003 2002 -------------- -------------- -------------- (In thousands) Cash flows from operating activities Net income $ 20,033 $ 18,526 $ 17,405 Adjustments to reconcile net income to net cash provided by (used in) operating activities Depreciation and amortization 2,633 1,035 1,297 Provision for loan losses 6 674 250 Amortization of premiums and discounts on loans, mortgage-backed securities and investments 7,577 289 (1,495) Income tax benefit on stock options 331 -- -- Provision (benefit) for deferred income taxes (1,442) 2,078 (32) Gains on sale other real estate (2,102) (568) (457) Gains on sale of loans (480) (637) (767) Gains on sales of investment securities available for sale (810) (719) (790) (Increase) decrease in accrued interest receivable 719 (2,575) (2,082) Decrease (increase) in other assets (9,191) (26,021) 842 Decrease in accrued interest payable (2,131) (3,673) (228) Increase (decrease) in other liabilities 3,666 1,238 (1,452) -------------- -------------- -------------- Net cash provided by (used in) operating activities 18,809 (10,353) 12,491 -------------- -------------- -------------- Cash flows from investing activities Proceeds from calls and maturities of investment securities held to maturity 153,714 9,982 60,563 Purchases of investment securities held to maturity (255,150) (89,310) - Proceeds from calls and maturities of investment securities available for sale 60,836 201,341 309,710 Proceeds from sales of investment securities available for sale 27,860 91,339 115,250 Redemption (purchase) of Federal Home Loan Bank stock 307 (3,532) (4,074) Purchases of investment securities available for sale (13,812) (321,451) (699,480) Net decrease in loans 46,256 61,647 70,581 Purchases of premises and equipment (67,586) (513) (787) -------------- -------------- -------------- Net cash used in investing activities (47,575) (50,497) (148,237) -------------- -------------- --------------
(Continued) 42 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows - Continued Year ended December 31,
2004 2003 2002 -------------- -------------- -------------- (In thousands, except per share data) Cash flows from financing activities Increase (decrease) in non-interest bearing and interest bearing $ (14,295) $ 63,511 $ 253,560 demand deposits and savings accounts Decrease in certificates of deposit (34,382) (93,292) (134,579) Principal payments on mortgage (60) (62) (49) Obligations through equity investments 56,249 - - Proceeds from subordinated debentures, net 25,000 - - Cash dividends in lieu of fractional shares (11) (8) (7) Proceeds from borrowings, net of repayments 10,000 84,500 27,275 Issuance of common stock under stock option plans 503 2,021 688 Cash dividends paid (12,199) (11,321) (10,589) -------------- -------------- -------------- Net cash provided by financing activities 30,805 45,349 136,299 -------------- -------------- -------------- Net increase (decrease) in cash and cash equivalents 2,039 (15,501) 553 Cash and cash equivalents at beginning of year 25,070 40,571 40,018 -------------- -------------- -------------- Cash and cash equivalents at end of year $ 27,109 $ 25,070 $ 40,571 ============== ============== ============== Supplemental disclosure of cash flow information Cash paid during the year for Interest $ 29,432 $ 33,615 $ 36,719 ============== ============== ============== Income taxes $ 8,705 $ 7,000 $ 5,650 ============== ============== ==============
The accompanying notes are an integral part of these statements. 43 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Royal Bancshares of Pennsylvania, Inc. (Royal Bancshares), through its subsidiary Royal Bank America, Inc. (Royal Bank), offers a full range of banking services to individual and corporate customers located in Pennsylvania, New Jersey and Delaware. Royal Bank competes with other banking and financial institutions in certain markets, including financial institutions with resources substantially greater than its own. Commercial banks, savings banks, savings and loan associations, credit unions and money market funds actively compete for savings and time deposits and for various types of loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors of Royal Bank with respect to one or more of the services it renders. 1. Basis of Financial Statement Presentation The accompanying consolidated financial statements include the accounts of Royal Bancshares and its wholly-owned subsidiaries, Royal Investments of Delaware, Inc. and Royal Bank, including Royal Bank's subsidiaries, Royal Real Estate of Pennsylvania, Inc., Royal Investment America, LLC, and Crusader Servicing Corporation. Both Royal Bancshares' Trusts' are not consolidated as further discussed in Note A17. During 2004, Royal Bancshares through Royal Bank started a banking division called Royal Asian Bank which operates three branches in Pennsylvania and anticipates opening two branches in Northern New Jersey during the first quarter of 2005. All significant inter-company transactions and balances have been eliminated. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenditures for the period. Therefore, actual results could differ significantly from those estimates. The principal estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses and the valuation of deferred tax assets. In connection with the allowance for loan losses estimate, when circumstances warrant, management obtains independent appraisals for significant properties. However, future changes in real estate market conditions and the economy could affect Royal Bancshares' allowance for loan losses. In addition to being subject to competition from other financial institutions, Royal Bancshares is subject to regulations of certain federal agencies and, accordingly, it is periodically examined by those regulatory authorities. (Continued) 44 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). In general, a variable interest entity is a corporation, partnership, trust or any other legal structures used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary if the 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. The consolidation requirements of FIN 46 applied immediately to interest entities created after January 31, 2003. In December 2003, the FASB issued FIN 46(R) with respect to variable interest entities created before January 31, 2003, which among other things revised the implementation date to the first fiscal year or interim period ended after March 15, 2004, with the exception of Special Purpose Entities (SPE). Royal Bancshares currently has no SPEs. Royal Bancshares adopted the provisions of FIN 46 effective for the period ended March 31, 2004, which required Royal Bancshares to consolidate its investments in real estate partnerships. Prior to FIN 46 and 46(R), Royal Bancshares accounted for its investments in the real estate partnerships under the equity method of accounting. Royal Bancshares' investments in real estate partnerships is further discussed in Note A -17. The SEC recently released Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments." SAB 105 provides guidance about the measurements of loan commitments recognized at fair value under FASB Statement No. 133, "Accountings for Derivative Instruments and Hedging Activities." SAB 105 also requires companies to disclose their accounting policy for those loan commitments including methods and assumptions used to estimate fair value and associated hedging strategies. SAB 105 is effective for all loan commitments accounted for as derivatives that are entered into after March 31, 2004. The adoption of SAB 105 did not have a material effect on Royal Bancshares consolidated financial statements. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement 123(R), "Share-Based Payment," an Amendment of SFAS No. 123 and APB No. 95. The Statement addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. Statement 123(R) requires that all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, "Accounting for Stock Issued to Employees." This statement is effective for all share-based payment transactions entered into after June 15, 2005 and to any awards modified, repurchased, or cancelled after that date. Royal Bancshares is currently evaluating this Statement and its effects on its results of operations. (Continued) 45 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued 2. Investment Securities Investment securities are classified in one of three categories: held to maturity, available for sale or trading. Debt securities that Royal Bancshares has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. As Royal Bancshares does not engage in security trading, the balance of its debt securities and any equity securities are classified as available for sale. Net unrealized gains and losses for such investment securities available for sale, net of tax effect, are required to be recognized as a separate component of stockholders' equity and excluded from the determination of net income. Gains or losses on disposition are computed by the specific identification method. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near- term prospects of the issuer, and (3) the intent and ability of Royal Bancshares to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. 3. Loans held for sale Residential mortgage loans are only originated for sale to the secondary mortgage loans market. These loans have a prior sales commitment on a best efforts basis in place prior to the loan closing. These loans are classified as loans held for sale and are carried at the lower of cost or estimated fair value. Fair value is determined by the purchase price quoted in the sales agreement. Royal Bancshares accounts for the transfer of financial assets in accordance with SFAS No. 140 "Accounting for Transfers and Servicing of Assets and Extinguishments of Liabilities." The standard is based on consistent application of a financial-components approach that recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered and derecognizes liabilities when extinguished. The standard provides consistent guidelines for distinguishing transfers of financial assets from transfers that are secured borrowings. 4. Loans and Allowance for Loan Losses Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are stated at the amount of unpaid principal, reduced by unearned income and an allowance for loan and lease losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses in the loan portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loan loss experience, current economic conditions, volume, growth, and composition of the loan portfolio, and other relevant factors. The allowance is increased by provisions for loan losses charged against income. Decreases in the allowance result from management's determination that the (Continued) 46 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued allowance for loan losses exceeds their estimates of potential loan loss. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Royal Bancshares generally accounts for its impaired loans in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosure," which requires that a creditor measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral-dependent. Regardless of the measurement method, a creditor must measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, Royal Bancshares does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement. Interest on loans is accrued and credited to operations based upon the principal amount outstanding. Accretion of unearned discounts on loans has been added to the related interest income. Accrual of interest is discontinued on a loan when management believes that the borrower's financial condition is such that collection of interest is doubtful and generally when a loan becomes 90 days past due as to principal or interest. When interest accruals are discontinued, interest credited to income in the current year is reversed and interest accrued in the prior year is charged to the allowance for loan losses. On July 6, 2001, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 102 "Selected Loan Loss Allowance Methodology and Documentation Issues." SAB No. 102 provides guidance on the development, documentation, and application of a systematic methodology for determining the allowance for loans and leases in accordance with US GAAP and is effective upon issuance. The adoption of SAB No. 102 did not have a material impact on Royal Bancshares's financial position or results of operations. In October 2003, the AICPA issued Statement of Position (SOP) 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer. This statement addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer as a result of credit quality deterioration. The statement requires recognition of the excess of all cash flows expected at acquisition over the investor's initial investment in the loan as interest income on a level-yield basis over the life of the loan as the accretable yield. The loan's contractual required payments receivable in excess of the amount of its cash flows expected at acquisition (nonaccretable difference) should not be recognized as an adjustment to yield, a loss accrual or a valuation allowance for credit risk. This statement is effective for loans acquired in fiscal years beginning after December 31, 2004. Early adoption is permitted. The adoptions of SOP 03-3 is not expected to have a material impact on the Company's financial position or results of operations. (Continued) 47 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Royal Bancshares adopted FIN 45 "Guarantor's Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others" on January 1, 2003 ("FIN 45"). FIN 45 requires a guarantor entity, at the inception of a guarantee covered by the measurement provisions of the interpretation, to record a liability for the fair value of the obligation undertaken in issuing the guarantee. Royal Bancshares has financial and performance letters of credit. Financial letters of credit require a company to make a payment if the customer's condition deteriorates, as defined in agreements. Performance letters of credits require Royal Bancshares to make payments if the customer fails to perform certain non-financial contractual obligation. Royal Bancshares previously did not record a liability when guaranteeing obligations unless it became probable that Royal Bancshares would have to perform under the guarantee. 5. Other Real Estate The adjusted fair market value is determined by reducing the fair market value by estimated costs for the disposition of the property. Costs relating to holding the property are expensed when incurred. Other real estate owned of approximately $5,424,000 and $4,371,000 at December 31, 2004 and 2003, respectively, is included in other assets on the consolidated balance sheets. 6. Premises and Equipment Premises and equipment are stated at cost less accumulated depreciation, which is computed principally on accelerated methods over the estimated useful lives of the assets. Leasehold improvements are amortized on the accelerated methods over the shorter of the estimated useful lives of the improvements or the terms of the related leases. 7. Bank-Owned Life Insurance Royal Bank has purchased life insurance policies on certain executives. These policies are recorded in other assets at their cash surrender value, or the amount that can be realized. Income from these policies and changes in the cash surrender value are recorded in other income. 8. Income Taxes Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense is the result of changes in deferred tax assets and liabilities. The principal types of differences between assets and liabilities for financial statement and tax return purposes are the allowance for loan losses, deferred compensation plans, asset valuation reserves and net operating loss carryovers. (Continued) 48 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued 9. Per Share Information Basic per share data excludes dilution and is computed by dividing income available to common shareholders by the weighted average common shares outstanding during the period. Diluted per share data takes into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock, using the treasury stock method. 10. Stock Option Plans Royal Bancshares currently accounts for stock options under SFAS No. 123, "Accounting for Stock-Based Compensation," as Amended by SFAS No.148, which contains a fair value-based method for valuing stock-based compensation that entities may use to measure compensation cost at the grant date based on the fair value of the award. Compensation is recognized over the service period, which is usually the vesting period. Alternatively, SFAS No. 123 permits entities to continue accounting for employee stock options and similar equity instruments under Accounting Principles Board (APB) Opinion 25, "Accounting for Stock Issued to Employees." Entities that continue to account for stock options using APB Opinion 25 are required to make a pro forma disclosure of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been applied. Effective June 15, 2005, Royal Bancshares will apply SFAS No. 123(R). At December 31, 2004, Royal Bancshares had both a director and employee stock-based compensation plan, which is more fully described in Note L. Royal Bancshares accounts for that plan under the recognition and measurement principles of APB Opinion No.25 and related interpretations. Stock-based employee compensation costs are not reflected in net income, as all options granted under the plan had an exercise price equal to the market value under the underlying common stock of the date of the grant. The following table illustrates the effect on net loss and loss per share if Royal Bancshares had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation.
2004 2003 2002 ---------- ---------- ---------- Net income, as reported $ 20,033 $ 18,526 $ 17,405 Less: Stock-based compensation costs under fair value based method for all awards, net of tax (490) (425) (435) ---------- ---------- ---------- Pro forma net income (loss) $ 19,543 18,101 16,970 Earnings per share -Basic As Reported $ 1.60 $ 1.49 $ 1.41 Pro forma 1.56 1.46 1.37 Earnings per share -Diluted As Reported 1.59 1.49 1.38 Pro forma 1.56 1.46 1.37
(Continued) 49 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued 11. Benefit Plans Royal Bancshares has a noncontributory nonqualified, defined benefit pension plan covering certain eligible employees. Net pension expense consists of service costs, interest costs, return on pension assets and amortization of unrecognized initial net assets. Royal Bancshares accrues pension costs as incurred. 12. Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, short-term investments and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. 13. Financial Instruments SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," requires all entities to disclose the estimated fair value of their assets and liabilities considered to be financial instruments. Financial instruments consist primarily of investment securities, loans, deposits and borrowings. 14. Advertising Costs Royal Bancshares and Royal Bank expense advertising costs as incurred. 15. Comprehensive Income Royal Bancshares reports comprehensive income which includes net income as well as certain other items, which result in a change to equity during the period. The income tax effects allocated to comprehensive income is as follows (in thousands):
December 31, 2004 -------------------------------------- Tax Net of Before tax (benefit) tax amount expense amount ---------- ---------- ---------- Unrealized losses on securities Unrealized holding losses arising during period $ (3,150) $ (1,069) $ (2,081) Less reclassification adjustment for gains realized in net income 810 275 535 ---------- ---------- ---------- Other comprehensive income, net $ (3,960) $ (1,344) $ (2,616) ========== ========== ==========
(Continued) 50 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
December 31, 2003 ------------------------------------ Tax Net of Before tax (benefit) tax amount expense amount ---------- ---------- ---------- Unrealized gains on securities Unrealized holding gains arising during period $ 6,791 $ 2,316 $ 4,475 Less reclassification adjustment for gains realized in net income 719 244 475 ---------- ---------- ---------- Other comprehensive income, net $ 6,072 $ 2,072 $ 4,000 ========== ========== ==========
December 31, 2002 ------------------------------------ Tax Net of Before tax (benefit) tax amount expense amount ---------- ---------- ---------- Unrealized gains on securities Unrealized holding gains arising during period $ 8,436 $ 2,868 $ 5,568 Less reclassification adjustment for gains realized in net income 790 269 521 ---------- ---------- ---------- Other comprehensive income, net $ 7,646 $ 2,599 $ 5,047 ========== ========== ==========
16. Reclassifications Certain reclassifications of prior year amounts have been made to conform to the current year presentation. 17. Variable Interest Entities (VIE) Real estate owned via equity investments Royal Bancshares, together with a real estate development company, formed Brook View Investors, L.L.C. ("Brook View") in May 2001. Brook View was formed to construct 13 apartment buildings with a total of 116 units in a gated apartment community. The development company is the general partner of the project. Royal Bancshares invested 60% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. Brook View has total assets of $13.1 million and total borrowings of $12.8 million of which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has determined that Brook View is a VIE and it is the primary beneficiary. Royal Bancshares' exposure to loss due to its investment in and receivables due from Brook View is $187,000. Royal Bancshares, together with a real estate development company, formed Burrough's Mill Apartment, L.L.C. ("Burrough's Mill") in December 2001. Burrough's Mill was formed to construct 32 apartment buildings with a 51 total of 308 units in a gated apartment community. The development company is the general partner of the project. Royal Bancshares invested 60% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. Burrough's Mill has total assets of $36.1 million and total borrowings of $28.6 million of which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has determined that Burrough's Mill is a VIE and it is the primary beneficiary. Royal Bancshares' exposure to loss due to its investment in and receivables due from Burrough's Mill is $4.2 million. Royal Bancshares, together with a real estate development company, formed Main Street West Associates, L.P. ("Main Street") in February 2002. Main Street was formed to acquire, maintain, improve, and operate office space located in Norristown, Pennsylvania. The development company is the general partner of the project. Royal Bancshares invested 93% of initial capital contributions with the development company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the development company. Main Street has total assets of $4.1 million and total borrowings at $2.9 million of which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has determined that Main Street is a VIE and it is the primary beneficiary. Royal Bancshares' exposure to loss due to its investment in and receivables due from Main Street is $729,000. (Continued) 52 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Royal Bancshares, together with a real estate investment company, formed 212 C Associates, L.P. ("212 C") in May 2002. 212 C was formed to acquire, hold, improve, and operate office space located in Lansdale, Pennsylvania. The investment company is the general partner of the project. Royal Bancshares invested 90% of initial capital contributions with the investment company holding the remaining equity interest. Upon the repayment of the initial capital contributions and a preferred return, distributions will convert to 50% for Royal Bancshares and 50% for the investment company. 212 C has total assets of $13.8 million and total borrowings of $11.9 million, of which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has determined that 212 C is a VIE and it is the primary beneficiary. Royal Bancshares' exposure to loss due to its investment in and receivables due from 212 C is $1.6 million. Trust Preferred Securities Management has determined that Royal Capital Trust I/II (the Trusts) qualify as VIE's under FASB Interpretation 46 (FIN 46), "Consolidation of Variable Interest Entities," as revised. The Trusts issued mandatory redeemable preferred stock to investors and loaned the proceeds to Royal Bancshares. Royal Bancshares adopted the provision under the revised interpretation, FIN 46(R), in the first quarter of 2004. Accordingly, Royal Bancshares does not consolidate the Trusts. FIN 46(R) precludes consideration of the call option embedded in the preferred stock when determining if Royal Bancshares has the right to a majority of the Trusts' expected residual returns. The deconsolidation resulted in the investment in the common stock of the Trusts to be included in other assets as of December 31, 2004 and the corresponding increase in outstanding debt of $774,000. In addition, the income received on Royal Bancshares' common stock investment is included in other income. 18. Interest Rate Swaps For asset/liability management purposes, Royal Bancshares uses interest rate swap agreements to hedge various exposures or to modify interest rate characteristics of various balance sheet accounts. Such derivatives are used as part of the asset/liability management process and linked to specific liabilities and have a high correlation between the contract and the underlying item being hedged, both at inception and throughout the hedge period. Royal Bancshares currently utilizes interest rate swap agreements to convert a portion of its fixed rate time deposits to a variable rate (fair value hedge) to fund variable rate loans. Interest rate swaps are contracts in which a series of interest flows are exchanged over a prescribed period. The notional amount ($25 million) on which interest payments are based is not exchanged. NOTE B - SEGMENT INFORMATION SFAS No. 131, "Segment Reporting," established standards for public business enterprises to report information about operating segments in their annual financial statements and requires that those enterprises report selected information about operating segments in subsequent interim financial reports issued to shareholders. It also established standards for related disclosure about products and services, geographic areas, and major customers. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision maker in deciding how to allocate and assess resources and performance. Royal Bancshares' chief operating decision maker is the President and Chief Executive Officer. Royal Bancshares has identified its reportable operating segment as "Community Banking." 53 Royal Bancshares' community banking segment consists of commercial and retail banking. The community banking business segment is managed as a single strategic unit which generates revenue from a variety of products and services provided by Royal Bank. For example, commercial lending is dependent upon the ability of Royal Bank to fund itself with retail deposits and other borrowings and to manage interest rate and credit risk. This situation is also similar for consumer and residential mortgage lending. Royal Bancshares' tax lien operation does not meet the quantitative thresholds for requiring disclosure, but has different characteristics than the community banking operation. Royal Bancshares' tax lien operation consists of purchasing delinquent tax certificates from local municipalities at auction. The tax lien segment is managed as a single strategic unit which generates revenue from a nominal interest rate achieved at the individual auctions along with periodic penalties imposed. As a result of the adoption of FIN 46(R), Royal Bancshares is reporting on a consolidated basis its interest in four equity investments as VIE's which have different characteristics than the community banking segment. Royal Bancshares has investments in two apartment complexes and two buildings leased as commercial office space. The accounting policies used in this disclosure of business segments are the same as those described in the summary of significant accounting policies. (Continued) 54 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE B - SEGMENT INFORMATION - Continued Selected segment information and reconciliations to consolidated financial information is as follows:
Community Tax Lien Equity (in thousands) Bank Operation Investments Consolidated --------------------------------- ------------ ------------ ------------ ------------ DECEMBER 31, 2004 Total assets $ 1,088,031 $ 50,196 $ 67,047 $ 1,205,274 ============ ============ ============ ============ Total deposits 742,382 - - 742,382 ============ ============ ============ ============ Net interest income (losses) 38,846 3,024 (1,630) 40,240 Provision for loan losses - 6 - 6 Total non-interest income 4,800 1,227 7,133 13,160 Total non-interest expense 17,295 3,372 4,780 25,447 Income taxes 7,525 389 - 7,914 ------------ ------------ ------------ ------------ Net Income $ 18,826 $ 484 $ 723 $ 20,033 ============ ============ ============ ============ DECEMBER 31, 2003 Total assets $ 1,103,619 $ 50,791 $ - $ 1,154,410 ============ ============ ============ ============ Total deposits 791,059 - - 791,059 ============ ============ ============ ============ Net interest income 38,773 3,606 - 42,379 Provision for loan loss 500 174 - 674 Total non-interest income 3,196 508 - 3,704 Total non-interest expense 16,023 2,864 - 18,887 Income taxes 7,528 468 - 7,996 ------------ ------------ ------------ ------------ Net Income $ 17,918 $ 608 $ - $ 18,526 ============ ============ ============ ============
Interest paid to the Community Bank segment by the Tax Lien Operation was approximately $1,896,000 and $1,879,000 for the years ending December 31, 2004 and 2003, respectively. (Continued) 55 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE C - INVESTMENT SECURITIES The amortized cost, gross unrealized gains and losses, and fair value of Royal Bancshares's investment securities held to maturity and available for sale are summarized as follows (in thousands):
2004 ---------------------------------------------------------- Gross Gross Amortized unrealized unrealized Fair cost gains losses value ------------ ------------ ------------ ------------ Investment securities held to maturity Corporate securities $ 26,995 $ 371 $ - $ 27,366 U.S. government agencies 185,000 9 (742) 184,267 Mortgage backed securities 232 - - 232 ------------ ------------ ------------ ------------ $ 212,227 $ 380 $ (742) $ 211,865 ============ ============ ============ ============
2004 ---------------------------------------------------------- Gross Gross Amortized unrealized unrealized Fair cost gains losses value ------------ ------------ ------------ ------------ Investment securities available for sale Preferred and common stock $ 5,113 $ 250 $ - $ 5,363 Corporate bonds 125,750 4,104 (48) 129,806 U.S. government agencies 94,977 - (1,672) 93,305 Trust preferred securities 37,196 2,754 (388) 39,562 Foreign bonds 9,212 293 - 9,505 Mortgage backed securities 81,303 496 (130) 81,669 Other securities 1,624 100 - 1,724 ------------ ------------ ------------ ------------ $ 355,175 $ 7,997 $ (2,238) $ 360,934 ============ ============ ============ ============
(Continued) 56 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE C - INVESTMENT SECURITIES - Continued
2003 ---------------------------------------------------------- Gross Gross Amortized unrealized unrealized Fair cost gains losses value ------------ ------------ ------------ ------------ Investment securities held to maturity Corporate securities $ 21,121 $ 1,481 $ - $ 22,602 U.S. government agencies 91,630 168 (465) 91,333 Mortgage backed securities 340 - - 340 ------------ ------------ ------------ ------------ $ 113,091 $ 1,649 $ (465) $ 114,275 ============ ============ ============ ============
2003 ---------------------------------------------------------- Gross Gross Amortized unrealized unrealized Fair cost gains losses value ------------ ------------ ------------ ------------ Investment securities available for sale Preferred and common stock $ 40 $ 15 $ - $ 55 Corporate bonds 148,487 8,474 (12) 156,949 U.S. government agencies 122,785 139 (1,812) 121,112 Trust preferred securities 36,251 3,049 (2,161) 37,139 Foreign bonds 11,363 803 - 12,166 Mortgage backed securities 110,596 1,345 (66) 111,875 Other securities 1,598 - (55) 1,543 ------------ ------------ ------------ ------------ $ 431,120 $ 13,825 $ (4,106) $ 440,839 ============ ============ ============ ============
(Continued) 57 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE C - INVESTMENT SECURITIES - Continued The amortized cost and estimated fair value of investment securities at December 31, 2004, by contractual maturity, are shown below (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
2004 ---------------------------------------------------------- Held to maturity Available for sale --------------------------- --------------------------- Amortized Fair Amortized Fair cost value cost value ------------ ------------ ------------ ------------ Within 1 year $ 16,695 $ 17,066 $ 21,944 $ 22,217 After 1 but within 5 years 135,352 134,710 113,630 117,728 After 5 but within 10 years 60,000 59,909 69,800 68,664 After 10 years 180 180 144,661 146,935 Preferred and common stock - - 5,140 5,390 ------------ ------------ ------------ ------------ $ 212,227 $ 211,865 $ 355,175 $ 360,934 ============ ============ ============ ============
Proceeds from the sale of investment securities available for sale during 2004, 2003 and 2002 were $68,576,000, $91,339,000 and $115,250,000, respectively, resulting in gross realized gain (loss) of $900,000 ($90,000), $1,016,000 ($297,000), and $881,000 ($91,000) and during 2004, 2003 and 2002, respectively. As of December 31, 2004 and 2003, investment securities with a book value of $130,184,000 and $11,185,000, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law. The table below indicates the length of time individual securities have been in a continuous unrealized loss position at December 31, 2004:
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL ----------------------- ------------------------ ----------------------- Fair Unrealized Fair Unrealized Fair Unrealized DESCRIPTION OF SECURITIES value losses value losses value losses --------------------------- ---------- ---------- ---------- ---------- ---------- ---------- US government agencies $ 99,199 $ (778) $ 78,364 $ (1,636) $ 177,563 $ (2,414) Mortgage backed securities 401 (2) 23,217 (128) 23,618 (130) Trust preferred 10,000 (385) 4,330 (3) 14,330 (388) Corporate bonds 6,149 (48) -- -- 6,149 (48) ---------- ---------- ---------- ---------- ---------- ---------- Total temporarily impaired securities $ 115,749 $ (1,213) $ 105,911 $ (1,767) $ 221,660 $ (2,980) ========== ========== ========== ========== ========== ==========
(Continued) 58 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE C - INVESTMENT SECURITIES - Continued In management's opinion the unrealized losses reflect changes in interest rates subsequent to the purchase of specific securities. There were 22 securities in the less than twelve month category and 7 in the twelve or more month category and of the $222 million fair value of investments, $201 million consisted of government bonds and government secured mortgage backed securities. Royal Bancshares has the ability to hold these securities until maturity or market price recovery. Management believes that the unrealized losses represent temporary impairments of the securities. NOTE D - LOANS Major classifications of loans are as follows (in thousands): 2004 2003 ---------- ---------- Commercial and Industrial $ 208,204 $ 225,268 Commercial mortgages 193,611 204,396 Residential 28,513 41,590 Tax liens 34,419 37,855 Other 4,090 4,941 ---------- ---------- 468,834 514,050 Less Unearned income (1,540) (1,203) Unamortized discount on purchased loans - (290) ---------- ---------- Total loans $ 467,294 $ 512,557 ========== ========== Loans on which the accrual of interest has been discontinued or reduced amounted to approximately $4,526,000 and $11,328,000 at December 31, 2004 and 2003, respectively. If interest had been accrued, such income would have been approximately $209,000, $401,000 and $473,000 for the years ended December 31, 2004, 2003 and 2002, respectively. Management believes it has adequate collateral to limit its credit risk with these loans. Royal Bancshares granted loans to the officers and directors of Royal Bancshares and to their associates. Related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The aggregate dollar amount of these loans was $4,723,000 and $4,667,000 at December 31, 2004 and 2003, respectively. During 2004, one new loan in the amount of $85,000 was made and repayments totaled $179,000. (Continued) 59 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE D - LOANS - Continued Impaired loans, which include the loans on which the accrual of interest has been discontinued, was approximately $4,526,000 and $11,328,000 at December 31, 2004 and 2003, respectively. Royal Bancshares has identified a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreements. The income recognized on impaired loans during 2004 and 2003 was $-0- and $1,000, respectively. Total cash collected on impaired loans during 2004 was $919,000 of which $919,000 was credited to the principal balance outstanding on such loans. Royal Bancshares' policy for interest income recognition on impaired loans is to recognize income on currently performing restructured loans under the accrual method. Royal Bancshares recognizes income on non-accrual loans under the cash basis when the principal payments on the loans become current and the collateral on the loan is sufficient to cover the outstanding obligation to Royal Bancshares. If these factors do not exist, Royal Bancshares does not recognize income. Royal Bancshares primarily grants commercial and real estate loans in the greater Philadelphia metropolitan area. Royal Bancshares has concentrations of credit risk in real estate development loans at December 31, 2004. A substantial portion of its debtors' ability to honor these contracts is dependent upon the economic sector. Changes in the allowance for loan losses were as follows (in thousands):
2004 2003 2002 ---------- ---------- ---------- Balance at beginning of year $ 12,426 $ 12,470 $ 11,888 Charge-offs (204) (811) (925) Recoveries 291 93 1,257 ---------- ---------- ---------- Net (charge-offs) recoveries 87 (718) 332 Provision for loan losses 6 674 250 ---------- ---------- ---------- Balance at end of year $ 12,519 $ 12,426 $ 12,470 ========== ========== ==========
NOTE E - PREMISES AND EQUIPMENT Premises and equipment are summarized as follows (in thousands):
Estimated Useful Lives 2004 2003 -------------- ---------- ---------- Land - $ 2,396 $ 2,396 Buildings and leasehold improvements 7 - 31.5 years 8,178 6,989 Furniture and fixtures 3 - 7 years 6,812 5,605 ---------- ---------- 17,386 14,990 Less accumulated depreciation and amortization 8,606 7,510 ---------- ---------- $ 8,780 $ 7,480 ========== ==========
Depreciation and amortization in expense, related to premises and equipment, was approximately $977,000, $944,000 and $1,297,000 for the years ended 2004, 2003 and 2002, respectively. (Continued) 60 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE F - DEPOSITS Deposits are summarized as follows (in thousands): 2004 2003 ------------- ------------- Demand $ 64,371 $ 58,942 NOW and money market 451,671 471,140 Savings 23,820 24,075 Time, $100,000 and over 90,596 104,123 Other time 111,924 132,779 ------------- ------------- $ 742,382 $ 791,059 ============= ============= Maturities of certificates of deposit for the next five years and thereafter are as follows (in thousands): 2005 $ 86,566 2006 40,053 2007 18,202 2008 41,282 2009 11,848 Thereafter 4,569 ------------- $ 202,520 ============= NOTE G - BORROWINGS 1. Advances from the Federal Home Loan Bank At December 31, 2004, advances from the Federal Home Loan Bank (FHLB) totaling $222,000,000 will mature within one to ten years. The advances are collateralized by FHLB stock and certain first mortgage loans, and mortgage-backed securities. These advances had a weighted average interest rate of 3.88%. Outstanding borrowings mature as follows (in thousands): 2005 $ 17,500 2006 30,000 2007 - 2008 - 2009 15,000 Thereafter 159,500 ------------- $ 222,000 ============= (Continued) 61 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE G - BORROWINGS - Continued 2. Subordinated Debentures On October 27, 2004, Royal Bancshares completed a private placement of an aggregate of $25.0 million of Trust Preferred Securities through two newly-formed Delaware trust affiliates, Royal Bancshares Capital Trust I ("Trust I") and Royal Bancshares Capital Trust II ("Trust II") (collectively, the "Trusts"). As part of this transaction, Royal Bancshares issued an aggregate principal amount of $12,887,000 of floating rate junior subordinate debt securities to Trust I, which debt securities bear an initial interest rate of 4.26% until December 2004, and after that which will be reset quarterly at 3-month LIBOR plus 2.15%, and an aggregate principal amount of $12,887,000 of fixed/floating rate junior subordinated deferrable interest to Trust II, which debt securities bear an initial interest rate of 5.80% until December 2009 and then which will reset quarterly at 3-month LIBOR plus 2.15%. Each of Trust I and Trust II issued an aggregate principal amount of $12,500,000 of capital securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to an unaffiliated investment vehicle and an aggregate principal amount of $387,000 of common securities bearing fixed and/or fixed/floating interest rates corresponding to the debt securities held by each trust to Royal Bancshares. Royal Bancshares has fully and unconditionally guaranteed all of the obligations of the Trusts, including any distributions and payments on liquidation or redemption of the capital securities. The Federal Reserve has issued final guidance on the regulatory capital treatment for trust preferred securities issued by Trust as a result of the adoption of FIN 46(R). The proposed rule would retain current maximum percentage of total capital permitted for Trust Preferred Securities at 25%, but would enact other changes to the rules governing Trust Preferred Securities that affect their use as a part of the collection of entities known as "restricted core capital elements." The rule would take effect March 31, 2009; however, a five year transition period starting March 31, 2004 and leading up to that date would allow bank holding companies to continue to count Trust Preferred Securities as Tier 1 Capital after applying FIN 46(R). Management has evaluated the effects of the proposed rule and does not anticipate a material impact on its capital ratios when the proposed rule is finalized. (Continued) 62 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE H - LEASE COMMITMENTS Royal Bancshares leases various premises under non-cancelable agreements, which expire through 2012 and require minimum annual rentals. The approximate minimum rental commitments under the leases are as follows for the year ended December 31, (in thousands): 2005 $ 648,000 2006 481,000 2007 456,000 2008 442,000 2009 260,000 Thereafter 254,000 ------------- $ 2,541,000 ============= Rental expense for all leases was approximately $664,000, $612,000 and $614,000 for the years ended December 31, 2004, 2003 and 2002, respectively. NOTE I - COMMON STOCK Each holder of Class A and Class B common stock is entitled to one vote for each Class A share and ten votes for each Class B share held. Holders of either class of common stock are entitled to equal per share dividends when declared. The Class B shares may not be transferred in any manner except to the holder's immediate family. Class B shares may be converted to Class A shares at the rate of 1.15 to 1. Per share information and weighted average shares outstanding have been restated to reflect the 2% stock dividend of December 2004, the 2% stock dividend of January 2004, the 3% stock dividend of January 2003, and the 6% stock dividend of January 2002. NOTE J - INCOME TAXES The components of the income tax expense included in the consolidated statements of income are as follows (in thousands): 2004 2003 2002 ---------- ---------- ---------- Income tax expense (benefit) Current $ 9,356 $ 9,221 $ 7,269 Deferred federal tax (1,442) (1,225) (32) ---------- ---------- ---------- $ 7,914 $ 7,996 $ 7,237 ========== ========== ========== The difference between the applicable income tax expense and the amount computed by applying the statutory federal income tax rate of 35% in 2004, and 34% in 2003 and 2002 is as follows (in thousands): 63
2004 2003 2002 ---------- ---------- ---------- Computed tax expense at statutory rate $ 9,781 $ 9,286 $ 8,620 Tax-exempt income (466) (263) (101) Low-income housing tax credit (545) (545) (545) Other, net (619) (482) (737) Effect of 35% rate bracket (237) - - ---------- ---------- ---------- Applicable income tax expense $ 7,914 $ 7,996 $ 7,237 ========== ========== ==========
(Continued) 64 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE J - INCOME TAXES - Continued Deferred tax assets and liabilities consist of the following (in thousands):
2004 2003 ---------- ---------- Deferred tax assets Allowance for loan losses $ 5,366 $ 4,153 Asset valuation reserves 836 812 Goodwill from Knoblauch State Bank 808 785 Accrued pension liability 1,156 886 Net operating loss carryovers from Knoblauch State Bank 7,140 7,449 Other 46 149 ---------- ---------- 15,352 14,234 Less valuation allowance (7,140) (7,449) ---------- ---------- 8,212 6,785 ---------- ---------- Deferred tax liabilities Unrealized gains on investment securities available for sale 1,957 3,304 Penalties on delinquent tax certificates 243 283 Other 720 692 ---------- ---------- 2,920 4,279 ---------- ---------- Net deferred tax asset, included in other assets $ 5,292 $ 2,506 ========== ==========
Royal Bancshares has approximately $21,000,000 of net operating loss carryovers from the acquisition of Knoblauch State Bank (KSB). These losses will fully expire in 2009. The utilization of these losses is subject to limitation under Section 382 of the Internal Revenue Code. As a result, a valuation allowance has been established to eliminate the deferred tax asset attributable to these net operating losses. During 2004, 2003 and 2002, Royal Bancshares realized a tax benefit related to the net operating loss carryovers from the acquisition of KSB. The deferred tax asset associated with those loss carryovers is fully offset by a valuation allowance. Accordingly, the realized tax benefit is reflected as a reduction of the goodwill associated with the acquisition and a corresponding reduction of deferred income tax benefit for the year. In addition, Royal Bancshares has approximately $15,700,000 of tax goodwill from the acquisition of KSB. The ability to deduct this goodwill for tax purposes will expire in 2015. The utilization of this goodwill for tax purposes was subject to the limitations under Section 382 of the Internal Revenue Code. For 2004, 2003 and 2002 approximately $1,353,000 has been utilized for tax purposes. (Continued) 65 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE J - INCOME TAXES - Continued During 2004, the Internal Revenue Service ("IRS") commenced an examination of Royal Bancshares's tax treatment relating to tax goodwill acquired in Royal's 1995 purchase of Knoblauch State Bank. A final determination has not been made. Upon completion of the examination, management will address the financial statement implications of the IRS examination findings, if any. NOTE K - EARNINGS PER SHARE Basic and diluted EPS are calculated as follows (in thousands, except per share data):
2004 ---------------------------------------- Average Income shares Per share (numerator) (denominator) amount ----------- ------------- --------- Basic EPS Income available to common shareholders $ 20,033 12,505 $ 1.60 Effect of dilutive securities Stock options - 102 (0.01) ----------- ------------- --------- Diluted EPS Income available to common shareholders plus assumed exercise of options $ 20,033 12,607 $ 1.59 =========== ============= =========
All options to purchase shares of common stock were included in the computation of 2004 diluted EPS because the exercise price was less than the average market price of the common stock.
2003 ---------------------------------------- Average Income shares Per share (numerator) (denominator) amount ----------- ------------- --------- Basic EPS Income available to common shareholders $ 18,526 12,392 $ 1.49 Effect of dilutive securities Stock options - 53 - ----------- ------------- --------- Diluted EPS Income available to common shareholders plus assumed exercise of options $ 18,526 12,445 $ 1.49 =========== ============= =========
(Continued) 66 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE K - EARNINGS PER SHARE - Continued All options to purchase shares of common stock were included in the computation of 2003 diluted EPS because the exercise price was less than the average market price of the common stock.
2002 ---------------------------------------- Average Income shares Per share (numerator) (denominator) amount ----------- ------------- --------- Basic EPS Income available to common shareholders $ 17,405 12,324 $ 1.41 Effect of dilutive securities Stock options - 258 (0.03) ----------- ------------- --------- Diluted EPS Income available to common shareholders plus assumed exercise of options $ 17,405 12,582 $ 1.38 =========== ============= =========
All options to purchase shares of common stock were included in the computation of 2002 diluted EPS because the exercise price was less than the average market price of the common stock. NOTE L - STOCK OPTION PLANS Royal Bancshares has two stock-based compensation plans, which are described below. Royal Bancshares accounts for these plans under APB Opinion No. 25. 1. Outside Directors' Stock Option Plan Royal Bancshares adopted a non-qualified outside Directors' Stock Option Plan (the Director's Plan). Under the terms of the Director's Plan, 250,000 shares of Class A stock are authorized for grants. Each director is entitled to a grant of an option to purchase 1,500 shares of stock annually, which are exercisable one year after the grant date. The options were granted at the fair market value at the date of the grant. (Continued) 67 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE L - STOCK OPTION PLANS - Continued Stock option transactions consist of the following:
2004 2003 2002 ----------------------- ----------------------- ----------------------- Weighted Weighted Weighted average average average exercise exercise exercise Shares price Shares price Shares price ---------- ---------- ---------- ---------- ---------- ---------- Outstanding at beginning of year 71,462 $ 14.91 80,291 $ 14.12 75,296 $ 11.47 Granted 16,830 23.97 16,683 19.96 16,037 19.56 Exercised (9,248) 11.54 (25,512) 12.03 (11,043) 9.66 Cancelled - - - - - - ---------- ---------- ---------- Outstanding at end of year 79,044 $ 17.29 71,462 $ 14.91 80,290 $ 14.12 ========== ========== ========== Weighted average fair value of options granted during the year $ 5.25 $ 3.62 $ 8.70
The following table summarizes information about options outstanding and exercisable at December 31, 2004:
Options outstanding Options exercisable ----------------------------------------- --------------------------- Weighted average Weighted Weighted remaining average average Range of Number contractual exercise Number exercise exercise prices outstanding life (years) price exercisable price -------------------------- ----------- ------------ ------------ ------------ ------------ $7.11 - 9.78 6,327 1.8 $ 8.89 6,327 $ 8.89 $11.34 - 14.75 27,439 4.9 12.93 27,439 12.93 $19.19 - 23.97 45,278 8.3 21.10 28,448 19.40 ----------- ------------ 79,044 62,214 =========== ============
(Continued) 68 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE L - STOCK OPTION PLANS - Continued 2. Employee Stock Option and Appreciation Right Plan Royal Bancshares adopted a Stock Option and Appreciation Right Plan (the Plan). The Plan is an incentive program under which Company officers and other key employees may be awarded additional compensation in the form of options to purchase up to 1,500,000 shares of Royal Bancshares' Class A common stock (but not in excess of 15% of outstanding shares). At the time a stock option is granted, a stock appreciation right for an identical number of shares may also be granted. The option price is equal to the fair market value at the date of the grant. The options are exercisable at 20% per year beginning one year after the date of grant and must be exercised within ten years of the grant. Stock option transactions consist of the following:
2004 2003 2002 ----------------------- ----------------------- ----------------------- Weighted Weighted Weighted average average average exercise exercise exercise Shares price Shares price Shares price ---------- ---------- ---------- ---------- ---------- ---------- Outstanding at beginning of year 428,433 $ 15.76 498,803 $ 14.12 512,410 $ 10.24 Granted 255,385 23.97 157,421 19.96 163,543 19.56 Exercised (34,643) 11.54 (120,511) 11.43 (160,775) 5.72 Cancelled (55,636) 20.51 (107,280) 17.16 (16,374) 17.27 ---------- ---------- ---------- Outstanding at end of year 593,539 19.18 428,433 $ 15.76 498,803 $ 14.12 ========== ========== ========== Weighted average fair value of options granted during the year $ 5.25 $ 3.62 $ 8.70
The following table summarizes information about options outstanding and exercisable at December 31, 2004:
Options outstanding Options exercisable ------------------------------------------ --------------------------- Weighted average Weighted Weighted remaining average average Range of Number contractual exercise Number exercise exercise prices outstanding life (years) price exercisable price ------------------------- ------------ ------------ ------------ ------------ ------------ $9.80 - 12.76 157,853 5.3 $ 12.22 116,102 $ 12.03 $14.78 - 19.57 200,427 7.3 19.04 70,010 18.35 $23.97 235,259 9.2 23.97 -- -- ------------ ------------ 593,539 186,112 ============ ============
69 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE M - PENSION PLAN Royal Bancshares has a noncontributory nonqualified defined benefit pension plan covering certain eligible employees. Royal Bancshares-sponsored pension plan provides retirement benefits under pension trust agreements and under contracts with insurance companies. The benefits are based on years of service and the employee's compensation during the highest five consecutive years during the last 10 years of employment. Royal Bancshares's policy is to fund pension costs allowable for income tax purposes. The following table sets forth the plan's funded status and amounts recognized in Royal Bancshares's consolidated balance sheets (in thousands): 2004 2003 ------------- ------------- Change in benefit obligation Benefit obligation at beginning of year $ 3,591 $ 3,048 Service cost 722 317 Interest cost 205 214 Other changes (215) 12 ------------- ------------- Benefits obligation at end of year $ 4,303 $ 3,591 ============= ============= Weighted-average assumptions used to determine benefit obligations, end of year December 31 ------------------- 2004 2003 -------- -------- Discount rate 6.00% 7.00% Rate of compensation increase 4.00% 4.00% The asset allocation for Royal Bancshares's pension plans and the end of 2004 and 2003 consists of insurance policies under Royal Bancshares Owned Life Insurance program. The cash surrender value for these policies was approximately $1,203,000 and $993,000 for the years ended December 31, 2004 and 2003, respectively. Net pension cost included the following components (in thousands): 2004 2003 2002 ---------- ---------- ---------- Service cost $ 570 $ 410 $ 208 Interest cost 205 214 191 ---------- ---------- ---------- Net periodic benefit cost $ 775 $ 624 $ 399 ========== ========== ========== (Continued) 70 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE M - PENSION PLAN-Continued Royal Bancshares has a capital accumulation and salary reduction plan under Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the plan, all employees are eligible to contribute from 1% to a maximum of 15% of their annual salary, with Royal Bancshares matching 100% of any contribution between 1% and 5% subject to a $2,500 per employee annual limit. Matching contributions to the plan were approximately $162,000, $199,000 and $187,000 for the years ended December 31, 2004, 2003 and 2002, respectively. NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK Royal Bancshares is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement Royal Bancshares has in particular classes of financial instruments. Royal Bancshares' exposure to credit loss in the event of non-performance by the other party to commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. Royal Bancshares uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The contract amounts are as follows (in thousands):
December 31, ----------------------------- 2004 2003 ------------- ------------- Financial instruments whose contract amounts represent credit risk Commitments to extend credit $ 119,458 $ 59,829 Standby letters of credit and financial guarantees written 1,797 5,099 Financial Instruments whose notional amount exceed the amount the amount of credit risk. Interest rate swap agreements $ 25,000 $ 20,000
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, and others are for staged construction, the total commitment amounts do not necessarily represent immediate cash requirements. (Continued) 71 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS OF CREDIT RISK - Continued Royal Bancshares evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by Royal Bancshares upon extension of credit, is based on management's credit evaluation. Collateral held varies but may include personal or commercial real estate, accounts receivable, inventory and equipment. Standby letters of credit are conditional commitments issued by Royal Bancshares to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Most guarantees extend for one year and expire in decreasing amounts through 2005. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Royal Bancshares holds personal or commercial real estate, accounts receivable, inventory and equipment as collateral supporting those commitments for which collateral is deemed necessary. The extent of collateral held for those commitments is approximately 80%. NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 requires disclosure of the estimated fair value of an entity's assets and liabilities considered to be financial instruments. For Royal Bancshares, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in SFAS No. 107. However, many of such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is Royal Bancshares's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities. Therefore, Royal Bancshares had to use significant estimations and present value calculations to prepare this disclosure. Changes in the assumptions or methodologies used to estimate fair value may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair value. Fair values have been estimated using data which management considered the best available and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimation methodologies, resulting fair values and recorded carrying amounts at December 31, 2004 and 2003 were as follows: (Continued) 72 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued Fair value of financial instruments actively traded in a secondary market has been estimated using quoted market prices as follows (in thousands):
2004 2003 ----------------------- ----------------------- Estimated Carrying Estimated Carrying fair value amount fair value amount ---------- ---------- ---------- ---------- Cash and cash equivalents $ 27,109 $ 27,109 $ 25,070 $ 25,070 Investment securities held to maturity 211,865 212,227 114,275 113,091 Investment securities available for sale 360,934 360,934 452,246 452,246
Fair value of financial instruments with stated maturities has been estimated using present value cash flow, discounted at a rate approximating current market for similar assets and liabilities, as follows (in thousands):
2004 2003 ----------------------- ----------------------- Estimated Carrying Estimated Carrying fair value amount fair value amount ---------- ---------- ---------- ---------- Deposits with stated maturities $ 208,198 $ 202,520 $ 245,409 $ 236,902 Borrowings 224,437 222,000 217,319 212,000 Subordinated debt 25,774 25,774 -- -- Obligations from equity investments 56,249 56,249 -- --
Fair value of financial instrument liabilities with no stated maturities has been estimated to equal the carrying amount (the amount payable on demand), totaling approximately $539,862,000 and $554,157,000 at December 31, 2004 and 2003, respectively. Fair value of the net loan portfolio has been estimated using present value cash flow, discounted at the treasury rate adjusted for non-interest operating costs and giving consideration to estimated prepayment risk and credit loss factors, as follows (in thousands):
2004 2003 ----------------------- ----------------------- Estimated Carrying Estimated Carrying fair value amount fair value amount ---------- ---------- ---------- ---------- Loans held for sale $ 2,221 $ 2,204 $ 3,181 $ 3,157 Net loans 467,401 467,294 513,479 512,557
The fair value of accrued interest receivable and payable approximates carrying amounts. (Continued) 73 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued The fair value of commitments to extend credit is estimated based on the amount of unamortized deferred loan commitment fees. The fair value of letters of credit is based on the amount of unearned fees plus the estimated cost to terminate the letters of credit. Fair values of unrecognized financial instruments including commitments to extend credit and the fair value of letters of credit are considered immaterial. The fair value of interest rate swaps are based on upon the estimated amount Royal Bank would receive or pay to terminate the contract or agreements, taking into account current interest rates and, when appropriate, the current creditworthiness of the counterparties. The fair value of the interest rate swaps agreements are considered immaterial. Royal Bancshares' remaining assets and liabilities are not considered financial instruments. No disclosure of the relationship value of Royal Bancshares's deposits is required by SFAS No. 107. NOTE P - REGULATORY MATTERS 1. Payment of Dividends Under the Pennsylvania Business Corporation Law, Royal Bancshares may pay dividends only if it is solvent and would not be rendered insolvent by the dividend payment. There are also restrictions set forth in the Pennsylvania Banking Code of 1965 (the Code) and in the Federal Deposit Insurance Act (FDIA) concerning the payment of dividends by Royal Bancshares. Under the Code, no dividends may be paid except from "accumulated net earnings" (generally retained earnings). Under the FDIA, no dividend may be paid if a bank is in arrears in the payment of any insurance assessment due to the Federal Deposit Insurance Corporation (FDIC). In addition, dividends paid by Royal Bank to Royal Bancshares would be prohibited if the effect thereof would cause Royal Bank's capital to be reduced below applicable minimum capital requirements. 2. Capital Ratios Royal Bancshares and Royal Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possible additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on Royal Bancshares' financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Royal Bancshares must meet specific capital guidelines that involve quantitative measures of Royal Bancshares' assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Royal Bancshares and Royal Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulations to ensure capital adequacy require Royal Bancshares and Royal Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). As of December 31, 2004, management believes that Royal Bank meets all capital adequacy requirements to which it is subject. (Continued) 74 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE P - REGULATORY MATTERS - Continued As of December 31, 2004, Royal Bank met all regulatory requirements for classification as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, Royal Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed Royal Bank's category. Royal Bancshares' and Royal Bank's actual capital amounts and ratios are also presented in the table (in thousands).
2004 --------------------------------------------------------------------------- To be well capitalized under For capital prompt corrective Actual adequacy purposes action provisions ----------------------- ----------------------- ----------------------- Amount Ratio Amount Ratio Amount Ratio ---------- ---------- ---------- ---------- ---------- ---------- Total capital (to risk- weighted assets) Company (consolidated) $ 176,557 20.43% $ 69,149 8.00% N/A N/A Bank 124,847 14.55% 68,663 8.00% $ 85,829 10.00% Tier I capital (to risk- weighted assets) Company (consolidated) 165,731 19.17% 34,574 4.00% N/A N/A Bank 114,096 13.29% 34,332 4.00% 51,497 6.00% Tier I capital(to average assets, leverage) Company (consolidated) 165,731 13.93% 35,692 3.00% N/A N/A Bank 114,096 9.59% 35,692 3.00% 59,487 5.00%
(Continued) 75 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE P - REGULATORY MATTERS - Continued
2003 --------------------------------------------------------------------------- To be well capitalized under For capital prompt corrective Actual adequacy purposes action provisions ----------------------- ----------------------- ----------------------- Amount Ratio Amount Ratio Amount Ratio ---------- ---------- ---------- ---------- ---------- ---------- Total capital (to risk- weighted assets) Company (consolidated) $ 139,876 16.50% $ 67,792 8.00% N/A N/A Bank 113,922 13.73% 66,371 8.00% $ 82,964 10.00% Tier I capital (to risk- weighted assets) Company (consolidated) 129,283 15.30% 33,896 4.00% N/A N/A Bank 103,523 12.47% 33,186 4.00% 49,778 6.00% Tier I capital(to average assets, leverage) Company (consolidated) 129,283 11.10% 34,811 3.00% N/A N/A Bank 103,523 8.99% 34,556 3.00% 57,593 5.00%
NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY Condensed financial information for the parent company only follows (in thousands). CONDENSED BALANCE SHEETS
December 31, ----------------------------- 2004 2003 ------------- ------------- Assets Cash $ 30,326 $ 4,775 Investment in Royal Investments of Delaware, Inc. - at equity 21,178 20,995 Investment in Royal Bank America - at equity 114,109 109,063 Other assets 1,037 - ------------- ------------- $ 166,650 $ 134,833 ============= ============= Subordinated debentures $ 25,774 $ - Stockholders' equity 140,876 134,833 ------------- ------------- $ 166,650 $ 134,833 ============= =============
(Continued) 76 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY - Continued CONDENSED STATEMENTS OF INCOME
Year ended December 31, -------------------------------------- 2004 2003 2002 ---------- ---------- ---------- Income Equity in undistributed net earnings of subsidiaries $ 7,888 $ 7,241 $ 6,840 Dividends from subsidiary bank 12,199 11,321 10,589 Other income - 25 49 ---------- ---------- ---------- Total income 20,087 18,587 17,478 ---------- ---------- ---------- Expenses Other expenses 83 81 85 Income tax benefit (29) (20) (12) ---------- ---------- ---------- Total expenses 54 61 73 ---------- ---------- ---------- Net income $ 20,033 $ 18,526 $ 17,405 ========== ========== ==========
CONDENSED STATEMENTS OF CASH FLOWS
Year ended December 31, -------------------------------------- 2004 2003 2002 ---------- ---------- ---------- Cash flows from operating activities Net income $ 20,033 $ 18,526 $ 17,405 Adjustments to reconcile net income to net cash provided by operating activities Undistributed earnings from subsidiaries (7,888) (7,241) (6,840) Operating expenses 83 81 85 Rental income - (25) (49) Non-cash income tax benefit (29) (20) (12) ---------- ---------- ---------- Net cash provided by operating activities 12,199 11,321 10,589 ---------- ---------- ---------- Cash flows from financing activities Cash dividends paid (12,199) (11,321) (10,589) Proceeds from subordinated debentures 25,000 - - Other, net 551 2,248 1,083 ---------- ---------- ---------- Net cash provided by (used in) financing activities 13,352 (9,073) (9,506) ---------- ---------- ---------- Net increase in cash 25,551 2,248 1,083 ---------- ---------- ---------- Cash at beginning of year 4,775 2,527 1,444 ---------- ---------- ---------- Cash at end of year $ 30,326 $ 4,775 $ 2,527 ========== ========== ==========
(Continued) 77 ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES Notes To Consolidated Financial Statements - Continued NOTE R - SUMMARY OF QUARTERLY RESULTS (UNAUDITED) The following summarizes the consolidated results of operations during 2004 and 2003, on a quarterly basis, for Royal Bancshares (in thousands except per share data):
2004 ----------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ----------- ----------- ----------- ----------- Interest income $ 16,990 $ 16,515 $ 16,508 $ 17,528 Net interest income 10,181 9,722 9,539 10,798 Provision for loan losses - 1 4 1 Income before income taxes 7,008 7,318 6,217 7,404 Net income 5,363 5,112 4,394 5,164 Net income per share Basic $ 0.43 $ 0.41 $ 0.35 $ 0.41 Diluted $ 0.42 $ 0.41 $ 0.35 $ 0.41
2003 ----------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ----------- ----------- ----------- ----------- Interest income $ 17,939 $ 18,197 $ 17,753 $ 18,431 Net interest income 10,885 10,967 10,123 10,404 Provision for loan losses 160 197 167 150 Income before income taxes 7,325 6,984 5,879 6,334 Net income 5,383 4,763 3,980 4,400 Net income per share Basic $ 0.43 $ 0.39 $ 0.32 $ 0.35 Diluted $ 0.43 $ 0.39 $ 0.32 $ 0.35
78 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE As reported on its Report on Form 8-K filed with the SEC on October 21, 2004, on October 18, 2004, Royal Bancshares dismissed its then independent accountants, Grant Thornton, LLP and appointed Beard Miller Company LLP as its new independent accountants, each effective immediately. The decisions to dismiss Grant Thornton and to engage Beard Miller were approved by Royal Bancshares' Audit Committee. The Audit Committee's decision was based upon a response to a competitive bid requested by Royal Bancshares. The reports on Royal Bancshares' financial statements from Grant Thornton for the past two fiscal years, or any period prior to that period, have not contained an adverse opinion or disclaimer of opinion, nor were qualified or modified as to any uncertainty, audit scope, or accounting principles. There have been no disagreements with Grant Thornton on any matter of accounting principles or practices, financial statement disclosures, or auditing scope of procedure during the two most recent fiscal years, or any subsequent interim period through the date of dismissal or in any of the years prior to that period, which, if not resolved to the satisfaction of Grant Thornton, would have caused Grant Thornton to make reference to the subject matter of the disagreement in connection with its report. During the two most recent fiscal years, or any subsequent interim period through the date of dismissal of Grant Thornton, there were no disagreements with Grant Thornton on any of the kinds of events listed in Item 304 (a)(1)(v)(A) through (D) of Regulation S-K. During the years ended December 31, 2003 and 2002 and the subsequent interim period through the date of engaging Beard Miller, neither Royal Bancshares nor anyone on its behalf consulted Beard Miller on any of the matters or reportable events listed in Item 304 (a) (2) (i) and (ii) of Regulation S-K. ITEM 9A. CONTROLS AND PROCEDURES EFFECTIVENESS OF DISCLOSURE CONTROLS AND PROCEDURES We maintain a system of controls and procedures designed to provide reasonable assurance to the reliability of the financial statements and other disclosures included in this report, as well as to safeguard assets from unauthorized use or disposition. We evaluated the effectiveness of the design and operation of our disclosure controls and procedures under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, within 90 days prior to the filing date of this report. Based upon that evaluation, we discovered a weakness within our residential mortgage originations department regarding procedures and policy manuals. This weakness has been corrected as of December 31, 2004. MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of Royal Bancshares is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of, Royal Bancshares' principal executives and principal financial officers and effected by the Royal Bancshares' Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: o Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of Royal Bancshares; o Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of 79 Royal Bancshares are being made only in accordance with authorizations of management and directors of Royal Bancshares; and o Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of Royal Bancshares' assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a significant deficiency (as defined in Public Company Accounting Oversight Board Auditing Standard No. 2), or a combination of significant deficiencies, that results in there being more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis by management or employees in the normal course of performing their assigned functions. Management assessed the effectiveness of Royal Bancshares' internal control over financial reporting as of December 31, 2004. Management's assessment identified the following material weakness in Royal Bancshares' internal control over financial reporting. o Royal Bancshares' analysis of the allowance for loan losses for impaired loans is based on classifications of loans into various categories and loss percentages that are commonly used for regulatory purposes. For non-classified loans, the estimated reserve is based on what Royal Bancshares deems to be appropriate. This estimate is not supported by documentation discussed in the FFIEC's July 2001 policy statement and SAB No. 102, which include trends in loan categories, such as delinquencies, restructurings, concentrations and volume, and actual charge-off and recovery histories to the net charge-off estimates. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Management is required by the Securities and Exchange Commission to report, as of December 31, 2004, that Royal Bancshares' internal control over financial reporting was not effective based on its maintaining the allowance for loan loss according to regulatory requirements, but not putting in place the documentation required under SAB No. 102. POST YEAR-END REMEDIATION TO ADDRESS THE MATERIAL WEAKNESS IS AS FOLLOWS: o Management is in the process of developing procedures and analytical worksheets to ensure compliance and which will be reviewed by senior management on a quarterly basis. Royal Bancshares Independent Registered Public Accounting Firm has issued an audit report on management's assessment of the Corporation's internal control over financial reporting. Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders Royal Bancshares of Pennsylvania, Inc. We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Royal Bancshares of Pennsylvania, Inc. (the Company) did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of a material weakness identified in management's assessment, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 80 The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidation financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of consolidated financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the consolidated financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected. The following material weakness has been identified and included in management's assessment. Management has identified, as a material weakness, its documentation for the allowance for loan losses as required under Staff Accounting Bulletin (SAB) No. 102 not being in place. The Company's analysis of the allowance for loan losses for impaired loans is based on classifications of loans into various categories and loss percentages that are commonly used for regulatory purposes. For non-classified loans, the estimated reserve is based on what the Company deems to be appropriate. This estimate is not supported by documentation discussed in the Federal Financial Institutions Examination Council July 2001 policy statement and SAB No. 102, which include trends in loan categories, such as delinquencies, restructurings, concentrations and volume, and actual charge-off and recovery histories to the net charge-off estimates. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2004 consolidated financial statements, and this report does not affect our report dated March 14, 2005 on those consolidated financial statements. In our opinion, management's assessment that Royal Bancshares of Pennsylvania, Inc. did not maintain effective internal control over financial reporting as of December 31, 2004, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, is fairly stated, in all material respects, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, Royal Bancshares of Pennsylvania, Inc. has not maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). We do not express an opinion or any other form of assurance on management's statement referring to post year-end remediation to address the material weakness. 81 Reading, Pennsylvania March 14, 2005 PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT The information required in this Item, relating to directors, executive officers, and control persons is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2005 Annual Meeting of Shareholders under the heading "Remuneration of Directors and Officers and Other Transactions", which pages are incorporated herein by reference. AUDIT COMMITTEE. Royal Bancshares has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. The members of the Audit Committee are Gregory T. Reardon (Chairman), Jack R. Loew, Anthony J. Micale and Edward B. Tepper as an advisor each of whom is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act. AUDIT COMMITTEE FINANCIAL EXPERT. Royal Bancshares' Board of Directors has determined that Gregory T. Reardon, the Audit Committee Chairman, is an audit committee financial expert as defined in Item 401(h) of Regulation S-K of the Exchange Act and is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act. BENEFICIAL OWNERSHIP - COMPLIANCE. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires Royal Bancshares' officers and directors, and persons who own more than 10 percent of the registered class of Royal Bancshares' equity securities, to file reports of ownership and changes in ownership with the SEC. Officers, directors and greater than 10 percent shareholders are required by SEC regulation to furnish the Corporation copies of all Section 16(a) forms they file. Based solely on its review of forms that were received from certain reporting persons, Royal Bancshares believes that during the period January 1, 2004 through December 31, 2004, its officers and directors were in compliance with all filing requirements applicable to them. 82 ITEM 11. EXECUTIVE COMPENSATION The information required by this Item, relating to executive compensation, is set forth in the Royal Bancshares' Proxy Statement to be used in connection with the 2005 Annual Meeting of Shareholders, under the heading "Renumeration of Directors and Officers and Other Transactions", which pages are incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item, relating to beneficial ownership of the Registrant's Common Stock, is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2005 Annual Meeting of Shareholders, under the heading "Information About Nominees, Continuing Directors and Executive Officers", which pages are incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item, relating to transactions with management and others, certain business relationships and indebtedness of management, is set forth in Royal Bancshares' Proxy Statement to be used in connection with the 2005 Annual Meeting of Shareholders, under the heading "Interest of Management and Others in Certain Transactions", which pages are incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item appears under the heading "AUDIT FEES" of the Proxy Statement to be used in connection with the 2005 Annual Meeting of Shareholders, which pages are incorporated herein by reference. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a. 1. Financial Statements The following financial statements are included by reference in Part II, Item 8 hereof. Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets. Consolidated Statements of Income. Consolidated Statements of Changes in Stockholders' Equity. Consolidated Statement of Cash Flows. Notes to Consolidated Financial Statements. 2. Financial Statement Schedules Financial Statement Schedules are omitted because the required information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto. 3. The following Exhibits are files herewith or incorporated by reference as a part of this Annual Report. 2 Purchase and Assumption Agreement, dated as of March 12, 2001, among Royal Bank of Pennsylvania, Crusader Holding Corporation, Crusader Savings Bank, F.S.B. and Asset Investment Corporation. (Incorporated by reference to Exhibit 2 to Registrant's Report on Form 8-K, filed with the Commission on March 15, 2001.) 83 3(i) Articles of Incorporation. (Incorporated by reference to Exhibit 3(i) to Registrant's Registration Statement No. 0-26366 on Form S-4.) 3(ii) By-laws. (Incorporated by reference to Exhibit 99 to Registrant's Current Report on Form 8-K, filed with the Commission on March 13, 2001.) 4.1 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.1 to Registrant's Current Report 8-K (included as Exhibit A to Exhibit 10.1) filed with the Commission on November 1, 2004.)) 4.2 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.2 to Registrant's Current Report 8-K (included as Exhibit A to Exhibit 10.2) filed with the Commission on November 1, 2004.)) 4.3 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.4 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.5 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.6 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, October 27, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 10.1 Stock Option and Appreciation Right Plan. (Incorporated by reference to the Registrant's Registration Statement No. 333-25855, on form S-8 filed with the Commission on April 5, 1997). 10.2 Outside Directors' Stock Option Plan. (Incorporated by reference to the Registrant's Registration Statement No. 333-25855, on form S-8 filed with the Commission on April 5, 1997). 10.3 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Joseph P. Campbell, President and Chief Executive Officer, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10- Q filed with the Commission on November 9, 2004.) 10.4 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and James J. McSwiggan, Executive Vice President, entered into on April 23, 2004. (Incorporated by 84 reference to Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.5 Employment agreement between Royal Bank America and Robert R. Tabas, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.6 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Murray Stempel, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.7 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and John Decker, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.8 Employment agreement between Royal Bank America and Edward Shin, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 11. Statement Re: Computation of Earnings Per Share. Included at Item 8, hereof, Note K, "Per Share Information". 12. Statement re: Computation of Ratios. (Included at Item 8 here of, Note P, "Regulatory Matters.") 14. Royal Bancshares of Pennsylvania, Inc. Code of Ethics. 21. Subsidiaries of Registrant. 23a. Consent of Independent Accountants from Beard Miller Company LLP. 23b. Consent of Independent Accountants from Grant Thornton LLP. 31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certification of Chief Executive Officer. 32.2 Section 1350 Certification of Chief Financial Officer. 99.1 Opinion letter of Independent Accounts Grant Thornton LLP. (b) Reports on Form 8-K filed by the Registrant during the fourth quarter and through this Form 10K filing are as follows: Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of October 18, 2004 announcing the dismissal of independent accounts from Grant Thornton LLP and appointed Beard Miller Company LLP. Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of October 25, 2004, reporting its third quarter earnings and the declaration of its 38th consecutive cash dividend. Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of October 27, 2004, reporting the completion of private placement of an aggregate $25 million of trust preferred securities and the formations of two Delaware Trust affiliates. 85 Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of December 16, 2004, announcing the declaration of 2% stock dividend on both Class A and Class B shares. Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of January 20, 2005, reporting its forth quarter earnings and the declaration of its 39th consecutive cash dividend. Royal Bancshares filed a report on Form 8-K with the Securities and Exchange Commission as of January 25, 2005, announcing the promotions of senior management. (c) The exhibits required to be filed by this Item are listed under Item 14(a)3 above. (d) Not applicable. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. 86 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. ROYAL BANCSHARES OF PENNSYLVANIA, INC. /s/ Joseph P. Campbell ----------------------- Joseph P. Campbell Chief Executive Officer March 14, 2005. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURES By: /s/ Joseph P. Campbell March 14, 2005. ---------------------------------- Joseph P. Campbell CEO/President/Director By: /s/ Jeffrey T. Hanuscin March 14, 2005. ---------------------------------- Jeffrey T. Hanuscin Chief Financial Officer By:/s/ James J. McSwiggan March 14, 2005. ---------------------------------- James J. McSwiggan Director/Chief Operating Officer By:/s/Robert R. Tabas March 14, 2005. ---------------------------------- Robert R. Tabas Chairman of the Board By:/s/ Albert Ominsky March 14, 2005. ---------------------------------- Albert Ominsky Director By:/s/ Anthony J. Micale March 14, 2005. ---------------------------------- Anthony J. Micale Director By:/s/ Gregory T. Reardon March 14, 2005. ---------------------------------- Gregory T. Reardon Director By:/s/ Murray Stempel,III March 14, 2005. ---------------------------------- Murray Stempel, III Director/ Senior Vice President By:/s/ John M. Decker March 14, 2005. ---------------------------------- John M. Decker Director/ Senior Vice President 87 By:/s/ Carl M. Cousins March 14, 2005. ---------------------------------- Carl M. Cousins Director By:/s/ Lee E. Tabas March 14, 2005. ---------------------------------- Lee E. Tabas Director By:/s/ Jack R. Loew March 14, 2005. ---------------------------------- Jack R. Loew Director By:/s/ Howard Wurzak March 14, 2005. ---------------------------------- Howard Wurzak Director By:/s/ Evelyn Rome Tabas March 14, 2005. ---------------------------------- Evelyn Rome Tabas Director By:/s/ Mitchell L. Morgan March 14, 2005. ---------------------------------- Mitchell L. Morgan Director By:/s/ Edward B. Tepper March 14, 2005. ---------------------------------- Edward B. Tepper Director By:/s/ Linda Tabas Stempel March 14, 2005. ---------------------------------- Linda Tabas Stempel Director 88 ROYAL BANCSHARES OF PENNSYLVANIA, INC. ANNUAL REPORT ON FORM 10-K EXHIBIT INDEX 2. Purchase and Assumption Agreement, dated as of March 12, 2001, among Royal Bank of Pennsylvania, Crusader Holding Corporation, Crusader Savings Bank, F.S.B. and Asset Investment Corporation. (Incorporated by reference to Exhibit 2 to Registrant's Report on Form 8-K, filed with the Commission on March 15, 2001.) 3(i) Articles of Incorporation. (Incorporated by reference to Exhibit 3(i) to Registrant's Registration Statement No. 0-26366 on Form S-4.) 3(ii) By-laws. (Incorporated by reference to Exhibit 99 to Registrant's Current Report on Form 8-K, filed with the Commission on March 13, 2001.) 4.1 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.1 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.1) filed with the Commission on November 1, 2004.)) 4.2 Junior Subordinated Debt Security Due 2034 issued by Royal Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as Institutional Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 4.2 to Registrant's Current Report on Form 8-K (included as Exhibit A to Exhibit 10.2) filed with the Commission on November 1, 2004.)) 4.3 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.4 Indenture by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.5 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, dated October 27, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 4.6 Guarantee Agreement by and between Royal Bancshares of Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee Trustee, October 27, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Current Report on Form 8-K filed with the Commission on November 1, 2004.) 10.1 Stock Option and Appreciation Right Plan. (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on April 5, 1997). 10.2 Outside Directors' Stock Option Plan. (Incorporated by reference to the Registrant's Registration Statement N0. 333-25855, on form S-8 filed with the Commission on April 5, 1997). 10.3 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Joseph P. Campbell, President and Chief Executive Officer, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.1 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 89 10.4 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and James J. McSwiggan, Executive Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.3 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.5 Employment agreement between Royal Bank America and Robert R. Tabas, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.6 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.6 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and Murray Stempel, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.4 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.7 Employment agreement between Royal Bancshares of Pennsylvania, Inc. and John Decker, Senior Vice President, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.2 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 10.8 Employment agreement between Royal Bank America and Edward Shin, entered into on April 23, 2004. (Incorporated by reference to Exhibit 10.5 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on November 9, 2004.) 11. Statement Re: Computation of Earnings Per Share. (Included at Item 8, hereof, Note K, "Per Share Information".) 12. Statements re: Computation of Ratios. (Included at Item 8 here of, Note P, "Regulatory Matters.") 14. Royal Bancshares of Pennsylvania, Inc. Code of Ethics. 21. Subsidiaries of Registrant. 23.1 Consent of Independent Accountants from Beard Miller Company LLP. 23.2 Consent of Independent Accountants Grant Thornton LLP. 31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief Financial Officer 32.1 Section 1350 Certification of Chief Executive Officer. 32.2 Section 1350 Certification of Chief Financial Officer. 99.1 Opinion letter of Independent Accounts Grant Thornton LLP. 90