Exhibit 13.1 from 2003 Annual Report
Asset/Liability Management
The primary component of Bancorp’s earnings is net interest income of the Bank. The Bank’s asset/liability management strategy is to maximize net interest income over time by reducing the impact of fluctuating interest rates. This is accomplished by matching the mix and maturities of its assets and liabilities. At the same time the Bank’s asset/liability strategies for managing interest rate risk must also accommodate customer demands for particular types of deposit and loan products. The Bank uses asset/liability management techniques in an attempt to maintain a profitable mix of financial assets and liabilities, provide deposit and loan products that meet the needs of its market area, and maintain control over interest rate risk resulting from changes in interest rates.
Net interest income, the primary component of the Bank’s net income, is derived from the difference or “spread” between the yield on interest-earning assets and the cost of interest-bearing liabilities. The Bank has sought to reduce its exposure to changes in interest rates by matching more closely the effective maturities and repricings of its interest-sensitive assets and liabilities. At the same time, the Bank’s asset/liability management strategies must also accommodate customer demands for particular types of deposit and loan products.
While much of the Bank’s asset/liability management efforts involve strategies that increase the rate sensitivity of its loans and investments, such as the sale of long-term fixed rate loans, originations of adjustable rate loans and purchases of adjustable rate mortgage-backed securities or relatively short average life fixed-rate investments, it also uses techniques to reduce the rate sensitivity of its deposits and borrowed money. Those techniques include attracting longer-term certificates of deposit when the market will permit, emphasizing core deposits, which are less sensitive to changes in interest rates, and borrowing through long-term FHLB advances. The Bank’s asset/liability management strategy will change when market rates change.
The Bank measures its exposure to interest rate fluctuations primarily by using a computer modeling system designed for savings institutions such as the Bank. The model uses assumptions which management believes are reasonable for the analysis. These assumptions include (but are not limited to) prepayment and decay rates based on nine interest rate scenarios. These assumptions are based on national statistics and may not reflect the Bank’s own experience. It allows the Bank to adjust its asset-liability mix based on the interest rate risk identified. The analysis estimates the changes in the market value of the Bank’s equity using interest rate change scenarios ranging from +4% to –4%, in 1% increments from current market rates. At December 31, 2003, the following table illustrates the interest rate sensitivity of the Bancorp’s consolidated equity to changes in market interest rates.
| (in Thousands of Dollars) | ||||
| Book value of stockholders’ equity | $ | 29,158 | ||
| 4% increase in market rates | 45,548 | |||
| 3% increase in market rates | 48,063 | |||
| 2% increase in market rates | 47,651 | |||
| 1% increase in market rates | 47,691 | |||
| No change (current market value of equity) | 46,697 | |||
| 1% decrease in market rates | 44,752 | |||
| 2% decrease in market rates | 42,160 | |||
| 3% decrease in market rates | 39,051 | |||
| 4% decrease in market rates | 34,762 |
As the table shows, Bancorp’s book value of equity is less than estimated market value in all of the scenarios. That indicates that Bancorp is able to withstand fluctuations in market interest rates without posting a significant threat to either Bancorp’s stockholders’ equity or the federal deposit insurance system, and therefore, Bancorp can be deliberate in its actions to adjust the asset-liability mix. Bancorp would meet the regulatory minimum capital requirements in all of the interest-rate scenarios.
The Bank has an Asset-Liability Management Committee (ALCO) that meets as needed. The purpose of this Committee is to communicate, coordinate, and monitor asset-liability management procedures. The Committee establishes and monitors the volume and mix of both assets and funding sources. The objective is to manage assets and funding sources to produce results consistent with Bancorp’s liquidity requirements, capital adequacy, growth, and profitability goals. To accomplish this objective, the ALCO uses internal budget variance reports, forecasts for changes in interest rates and consumer deposit activity, as well as forecasts of loan demand in each of the Bank’s loan types, investment maturities and new investment alternatives, and various other internal and external reports.
Static Gap Analysis: The management of interest rate sensitivity includes monitoring the maturities and repricing opportunities of interest-earning assets and interest-bearing liabilities. The following table summarizes the Bancorp’s consolidated interest rate repricing gaps for selected maturity periods as of December 31, 2003:
| (In Thousands) | ||||||||||||||||||||||||||||||||
| 1 Mo. | 2-3 Mos. | 4-6 Mos. | 7-9 Mos. | 10-12 Mos. | >1-5 Yrs. | >5 Yrs. | Total | |||||||||||||||||||||||||
| Non-loan interest-earning assets | $ | 8,668 | $ | 5,910 | $ | 4,573 | $ | 1,283 | $ | 7,671 | $ | 12,074 | $ | 2,117 | $ | 42,296 | ||||||||||||||||
| Loans | 83,910 | 12,090 | 17,490 | 17,216 | 18,192 | 61,679 | 4,000 | 214,577 | ||||||||||||||||||||||||
| Total interest-earning assets | $ | 92,578 | $ | 18,000 | $ | 22,063 | $ | 18,499 | $ | 25,863 | $ | 73,753 | $ | 6,117 | $ | 256,873 | ||||||||||||||||
| Savings accounts | $ | 1,323 | $ | 2,646 | $ | 4,120 | $ | 4,120 | $ | 4,120 | $ | 21,566 | $ | 5,710 | $ | 43,605 | ||||||||||||||||
| Checking accounts | 1,772 | 3,556 | 5,613 | 5,613 | 5,613 | 27,997 | 7,371 | 57,535 | ||||||||||||||||||||||||
| Certificates & Term IRA’s | 2,887 | 6,137 | 8,886 | 4,222 | 6,428 | 52,840 | 5,098 | 86,498 | ||||||||||||||||||||||||
| Other IB liabilities (FHLB advances) | 5,876 | 3,026 | 0 | 0 | 0 | 15,903 | 31,000 | 55,805 | ||||||||||||||||||||||||
| Total interest-bearing liabilities | $ | 11,858 | $ | 15,365 | $ | 18,619 | $ | 13,955 | $ | 16,161 | $ | 118,306 | $ | 49,179 | $ | 243,443 | ||||||||||||||||
| Asset (liability) gap | $ | 80,720 | $ | 2,635 | $ | 3,444 | $ | 4,544 | $ | 9,702 | -$ | 44,553 | -$ | 43,062 | $ | 13,430 | ||||||||||||||||
| Cumulative asset gap | 80,720 | 83,355 | 86,799 | 91,343 | 101,045 | 55,492 | 13,430 | |||||||||||||||||||||||||
| Cumulative gap as a percentage of cumulative earning assets | 87.2 | % | 75.4 | % | 65.4 | % | 60.4 | % | 57.1 | % | 22.5 | % | 5.2 | % | ||||||||||||||||||
Total interest-earning assets exceeded interest-bearing liabilities by $13.4 million at December 31, 2003. This difference was funded mainly through non-interest-bearing liabilities. The above table shows that total assets maturing or repricing within one year exceed liabilities maturing or repricing within one year by $101.0 million. This indicates the Bancorp’s net interest income would increase with rising interest rates, because more of its assets than liabilities would reprice at the higher rates in the next year. However, the repricing and cash flows of certain categories of assets and liabilities are subject to competitive and other influences that are beyond the control of the Bancorp. As a result, certain assets and liabilities indicated as maturing or repricing within a stated period may, in fact, mature or reprice in other periods or at different volumes.
Simulation: Bancorp recognizes the limitations of static gap analysis as a tool for managing its interest rate risk. Bancorp also uses a computer-based earnings simulation model to estimate the effects of various interest rate environments on the balance sheet structure and net interest income. These simulation techniques involve changes in interest rate relationships, asset and liability mixes, and prepayment options inherent in financial instruments, as
well as interest rate levels in order to quantify risk. Bancorp’s sensitivity is estimated by first forecasting the next twelve months of net interest income under an assumed environment of constant market interest rates. Next, immediate parallel interest rate shocks are constructed in the model. The rate shocks reflect changes of equal magnitude to all market interest forecast under each of the rate shock scenarios. The resulting change in net interest income is an indication of the sensitivity change in net earnings to directional changes in market interest rates. This model is based solely on parallel changes in market rates and does not reflect the levels of interest rate risk that may arise from other factors such as changes in the spreads between key market rates or in the shape of the Treasury yield curve. The net interest income simulation model includes on-balance sheet loan, investment, deposit, and debt instruments as well as off-balance sheet interest rate swaps.
Bancorp’s Board of Directors compares net interest income sensitivity to established tolerance limits for fluctuation. Throughout 2003, the forecasted exposure was within the Bancorp’s established policy limits, except in falling rate change scenarios. Management recognizes the “out of policy” condition in the falling rate environment and has reported this condition to the Board quarterly. The Bancorp’s Board of Directors and Management consider further significant rate decreases from December 31, 2003 unlikely and have not changed the Bank policy’s tolerance limits to conform to the existing rate environment.
Net Interest Income Sensitivity: Change in Projected Results vs. Constant Rates
Year-End 2003 12 Month Projection
| Rate Shock Amount | ||||||||||||||||||||
| (2.00%) | (1.00%) | 0.00% | 1.00% | 2.00% | ||||||||||||||||
| Percent Change in net interest income vs. constant rates | (9.68 | %) | (4.15 | %) | 0.00 | % | 1.27 | % | 2.03 | % | ||||||||||
| ALCO Policy Limit | (6.00 | %) | (3.00 | %) | 0.00 | % | (4.00 | %) | (8.00 | %) | ||||||||||
Effect of Interest Rate Fluctuations
Bancorp’s consolidated results of operations depend to a large extent on the Bank’s level of net interest income, which is the difference between interest income earned on its loan and investment portfolios versus the interest paid on deposits and borrowed funds. If the cost of funds increases faster than the yield on its interest-earning assets, net interest income will be reduced.
Bancorp measures its interest rate risk primarily using simulation analysis. This analysis is prepared by the Chief Financial Officer and reviewed
by the ALCO. ALCO is comprised of the Chief Executive Officer, Chief Financial Officer, Executive Vice President and Senior Officers of the Bank. Bancorp’s Board of Directors review quarterly reports that estimate Bancorp’s sensitivity to changes in interest rates. Sensitivity is estimated for net interest income and market value of portfolio equity.
While Bancorp uses various tools to monitor interest rate risk, it is unable to predict future fluctuations in interest rates or the specific impact thereof. The market value of most of Bancorp’s financial assets is sensitive to fluctuations in market interest rates. Fixed-rate investments and mortgage loans decline in value as interest rates rise. Adjustable-rate investments and loans generally have less market value volatility than fixed-rate assets.
