1 - --------------------------------------------------------------------------- U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-QSB [X]QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1996 [ ]TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 0-12231 BAY COMMERCIAL SERVICES (Exact name of small business issuer as specified in its charter) California 94-2760444 (State or other jurisdiction of (I.R.S.Employer incorporation or organization) Identification No.) 1495 East 14th Street San Leandro, California 94577 (Address of principal executive offices) (510) 357-2265 (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 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 State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. Class Outstanding at October 31, 1996 Common stock, no par value 1,076,720 shares Transitional Small Business Disclosure Format YES NO X This report contains a total of 19 pages 2 FINANCIAL STATEMENTS BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED BALANCE SHEETS September 30, December 31, 1996 1995 (unaudited) -------- --------- (000'S OMITTED) ASSETS Cash and due from banks............................... $ 8,176 $ 5,057 Federal funds sold.and securities purchased under repurchase agreements............................... 5,000 6,700 ------- ------- Cash and cash equivalents........................... 13,176 11,757 ------- ------- Securities available for sale, stated at market value (amortized cost of $11,393 for 1996; $13,045 for 1995) 11,346 13,199 Securities held to maturity (market values of $6,549 for 1996; $7,339 for 1995).......................... 6,557 7,211 Loans held for sale................................... 2,673 4,984 Loans................................................. 63,088 53,168 Allowance for loan losses........................... (964) (982) ------- ------- Net loans........................................... 64,797 57,170 ------- ------- Premises and equipment, net........................... 1,979 2,139 Interest and fees receivable.......................... 727 600 Other real estate owned............................... 41 359 Other assets.......................................... 505 384 ------- ------- Total assets........................................ $99,128 $92,819 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand.......................... $25,598 $26,841 Savings and interest-bearing demand................. 27,224 24,516 Time................................................ 28,505 23,773 Certificates of deposit, $100,000 and over.......... 5,307 5,123 ------- ------- Total deposits...................................... 86,634 80,253 ------- ------- Securities sold under agreements to repurchase........ 2,167 2,203 Interest payable and other liabilities................ 820 1,596 ------- ------- Total liabilities................................... 89,621 84,052 ------- ------- Commitments and contingent liabilities................ 0 0 Shareholders' equity: Common stock - no par value: authorized 20,000,000 shares; issued & outstanding 1,076,720 shares in 1996 and 1995 ........................................ 3,662 3,662 Retained earnings................................... 5,873 5,011 Net unrealized gain(loss) on securities available for sale................................ (28) 94 ------- ------- Total shareholders' equity.......................... 9,507 8,767 ------- ------- Total liabilities and shareholders' equity.......... $99,128 $92,819 ======= ======= See accompanying notes to consolidated condensed financial statements. 3 BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED STATEMENTS OF INCOME (unaudited) Nine Months Ended Three Months Ended September 30, September 30, 1996 1995 1996 1995 ------ ------ ------ ------ (000'S OMITTED) Interest income: Loans, including fees................. $4,736 $4,249 $1,641 $1,445 Federal funds sold and securities purchased under repurchase agreements 209 290 94 113 Investment securities Taxable.............................. 740 924 231 330 Nontaxable........................... 122 77 46 20 ------ ------ ------ ------ Total interest income............... 5,807 5,540 2,012 1,908 ------ ------ ------ ------ Interest expense: Deposits: Savings & interest-bearing demand... 497 559 177 191 Time................................ 1,041 917 374 316 Certificates of deposit, $100,000 and over................. 212 216 73 76 Other borrowed funds.................. 77 34 26 13 ------ ------ ------ ------ Total interest expense.............. 1,827 1,726 650 596 ------ ------ ------ ------ Net interest income................. 3,980 3,814 1,362 1,312 Benefit for loan losses................. 0 130 0 80 ------ ------ ------ ------ Net interest income after benefit for loan losses........... 3,980 3,944 1,362 1,392 ------ ------ ------ ------ Noninterest income: Service charges and fees.............. 192 175 67 62 Bankcard income....................... 186 150 66 50 Gain on sale of loans................. 174 7 66 0 Loan servicing........................ 99 137 34 46 Net gain(loss) on sale of OREO....... 111 77 111 (4) Securities losses..................... 0 (35) 0 0 Other................................. 128 51 54 24 ------ ------ ------ ------ Total noninterest income............ 890 562 398 178 ------ ------ ------ ------ Noninterest expenses: Salaries and employee benefits........ 1,831 1,765 623 579 Occupancy............................. 446 442 149 146 Professional services................. 190 146 86 48 Data processing....................... 213 208 69 69 Bankcard expenses..................... 149 117 58 40 FDIC insurance........................ 2 81 1 (5) Other................................. 610 509 156 171 ------ ------ ------ ------ Total noninterest expenses.......... 3,441 3,268 1,142 1,048 ------ ------ ------ ------ Income before income tax expense.... 1,429 1,238 618 522 Income tax expense...................... 567 483 251 207 ------ ------ ------ ------ Net income.......................... $ 862 $ 755 $ 367 $ 315 ====== ====== ====== ====== Net income per common and equivalent share $0.71 $0.65 $0.30 $0.26 ====== ====== ====== ====== See accompanying notes to consolidated condensed financial statements. 4 BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (unaudited) Nine Months Ended September 30, 1996 1995 ------- ------- (000'S OMITTED) Cash flows from operating activities: Net income................................................$ 862 $ 755 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization......................... 181 105 Loan loss benefit..................................... 0 (130) Unamortized deferred loan fees, net................... (60) 126 Securities losses..................................... 0 35 Originations of SBA loans held for resale............. (810) (1,090) Proceeds from sale of SBA loans held for resale....... 3,106 188 Net income related to OREO............................ (111) (77) Change in interest and fees receivable and other assets........................................ (230) (139) Change in interest payable and other liabilities...... (393) 431 ------- ------- Net cash provided by operating activities............... 2,545 204 ------- ------- Cash flows from investing activities: Proceeds from sale of securities available for sale....... 0 965 Proceeds from maturities of securities available for sale. 1,655 19,215 Proceeds from maturities of securities held to maturity... 1,661 2,494 Purchase of securities available for sale................. 0 (12,891) Purchase of securities held to maturity................... (1,028) (6,032) Net change in loans....................................... (9,685) (485) Proceeds from sale of OREO................................ 251 77 Purchases of premises and equipment....................... (50) (92) Sales of premises and equipment........................... 48 2 ------- ------- Net cash provided by (used in) investing activities..... (7,148) 3,253 ------- ------- Cash flows from financing activities: Net change in noninterest-bearing demand deposits......... (1,243) 3,582 Net change in savings and interest-bearing demand deposits 2,708 (2,164) Net change in time deposits............................... 4,732 2,632 Net change in certificates of deposit, $100,000 and over.. 184 (165) Net change in securities sold under agreements to repurchase........................................... (36) 1,042 Exercise of stock option.................................. 0 1 Cash dividends paid....................................... (323) (216) ------- ------- Net cash provided by financing activities............... 6,022 4,712 ------- ------- Net change in cash and cash equivalents................. 1,419 8,169 Cash and cash equivalents at beginning of period............ 11,757 8,006 ------- ------- Cash and cash equivalents at end of period..................$13,176 $16,175 ======= ======= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest..............................................$ 1,817 $ 1,719 Income taxes.......................................... 854 129 Noncash investing activities during the period: Loan made in connection with sale of OREO.............$ 178 $ 794 Repossession of loan collateral....................... 0 319 See accompanying notes to consolidated condensed financial statements. 5 BAY COMMERCIAL SERVICES AND SUBSIDIARY NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (unaudited) 1) All adjustments (consisting only of normal recurring accruals) which, in the opinion of Management, are necessary for a fair presentation of the Company's financial position at September 30, 1996 and December 31, 1995 and the results of its operations and its cash flows for the three month and nine month periods ended September 30, 1996 and 1995 have been included. The results of operations and cash flows for the periods presented are not necessarily indicative of the results for a full year. 2) The accompanying unaudited financial statements have been prepared on a basis consistent with the accounting principles and policies reflected in the Company's annual report for the year ended December 31, 1995. 3) Net income per share for the three and nine month periods ended September 30, 1996 and 1995 was computed by dividing net income by the weighted average number of shares of common stock outstanding during the periods, including the dilutive effects of stock options, if material. The weighted average number of common and equivalent shares outstanding for the nine month periods ended September 30, 1996 and 1995 was 1,214,788 and 1,167,389, respectively. The weighted average number of common and equivalent shares outstanding for the third quarters of 1996 and 1995 was 1,220,296 and 1,197,193, respectively. 4) The provision for income taxes for the periods presented is based on a projected tax rate for the entire year. The Company's effective tax rate was 40% and 39% for the nine month periods ended September 30, 1996 and 1995, respectively. The Company's effective tax rate was 41% and 40% for the third quarters of 1996 and 1995, respectively. 6 BAY COMMERCIAL SERVICES AND SUBSIDIARY THE TABLE BELOW ILLUSTRATES CHANGES IN MAJOR CATEGORIES OF THE AVERAGE BALANCE SHEETS AND STATEMENTS OF INCOME AND IN CERTAIN PERFORMANCE RATIOS Nine Months Ended Increase September 30, (Decrease) 1996 1995 $ % ------- ------- ------ ------ (000'S OMITTED) Average Balances: Assets *............................. $94,425 $90,857 $ 3,568 3.9% Securities - taxable*................ 15,934 20,839 (4,905) (23.5) Securities - nontaxable.............. 3,113 2,053 1,060 51.6 Total loans.......................... 61,218 51,937 9,281 17.9 Nonaccrual loans..................... 194 271 (77) (28.4) Other real estate owned.............. 336 454 (118) (26.0) Deposits............................. 82,134 80,549 1,585 2.0 Shareholders' equity *............... 9,112 8,458 654 7.7 Interest-earning assets.............. 85,530 81,300 4,230 5.2 Interest-bearing liabilities......... 59,609 57,400 2,209 3.8 Income Statements: Interest income (1).................. $5,864 $5,576 $ 288 5.2% Interest expense..................... 1,827 1,726 101 5.9 ------- ------ ------ ------ Net interest income (1)............ 4,037 3,850 187 4.9 Taxable equivalent adjustment........ 57 36 21 58.3 Net interest income................ 3,980 3,814 166 4.4 Benefit for loan losses.............. 0 130 (130) (100.0) ------- ------- ------ ------ Net interest income after benefit for loan losses.................. 3,980 3,944 36 0.9 ------- ------- ------ ------ Noninterest income................... 890 562 328 58.4 Noninterest expenses................. 3,441 3,268 173 5.3 Income tax expense................... 567 483 84 17.4 ------- ------- ------ ------ Net income......................... $ 862 $ 755 $ 107 14.2% ======= ======= ====== ====== * Before unrealized gain (loss) on securities available for sale Change ------ Performance Ratios: (2) Yield on average earning assets...... 9.07% 9.11% (0.04)% Yield on average earning assets (1).. 9.16% 9.17% (0.01)% Interest rate on average interest- bearing liabilities................ 4.09% 4.02% 0.07 % Interest expense as a percent of average earning assets............. 2.85% 2.84% 0.01 % Net yield on average earning assets.. 6.22% 6.27% (0.05)% Net yield on average earning assets (1) 6.31% 6.33% (0.02)% (1) Federal taxable equivalent basis. (2) Ratios have been annualized and are not necessarily indicative of results for a full year. 7 BAY COMMERCIAL SERVICES AND SUBSIDIARY THE TABLE BELOW ILLUSTRATES CHANGES IN MAJOR CATEGORIES OF THE AVERAGE BALANCE SHEETS AND STATEMENTS OF INCOME AND IN CERTAIN PERFORMANCE RATIOS Three Months Ended Increase September 30, (Decrease) 1996 1995 $ % ------- ------- ------ ------ (000'S OMITTED) Average Balances: Assets *............................. $98,334 $93,016 $ 5,318 5.7% Securities - taxable*................ 15,078 21,690 (6,612) (30.5) Securities - nontaxable.............. 3,134 2,317 817 35.3 Total loans.......................... 64,316 51,774 12,542 24.2 Nonaccrual loans..................... 299 3 296 9,866.7 Other real estate owned.............. 291 378 (87) (23.0) Deposits............................. 85,906 82,231 3,675 4.5 Shareholders' equity *............... 9,393 8,712 681 7.8 Interest-earning assets.............. 89,463 83,692 5,771 6.9 Interest-bearing liabilities......... 62,699 58,191 4,508 7.7 Income Statements: Interest income (1).................. $2,034 $1,917 $117 6.1% Interest expense..................... 650 596 54 9.1 ------- ------- ------ ------ Net interest income (1)............ 1,384 1,321 63 4.8 Taxable equivalent adjustment........ 22 9 13 144.4 ------- ------- ------ ------ Net interest income................ 1,362 1,312 50 3.8 Benefit for loan losses.............. 0 80 (80) (100.0) ------- ------- ------ ------ Net interest income after benefit for loan losses.................. 1,362 1,392 (30) (2.2) ------- ------- ------ ------ Noninterest income................... 398 178 220 123.6 Noninterest expenses................. 1,142 1,048 94 9.0 Income tax expense................... 251 207 44 21.3 ------- ------- ------ ------ Net income......................... $ 367 $ 315 $ 52 16.5% ======= ======= ====== ====== * Before unrealized gain (loss) on securities available for sale Change ------ Performance Ratios: (2) Yield on average earning assets...... 8.95% 9.04% (0.09)% Yield on average earning assets (1).. 9.04% 9.09% (0.05)% Interest rate on average interest- bearing liabilities................ 4.12% 4.06% 0.06 % Interest expense as a percent of average earning assets............. 2.89% 2.83% 0.06 % Net yield on average earning assets.. 6.06% 6.21% (0.15)% Net yield on average earning assets (1) 6.15% 6.26% (0.11)% (1) Federal taxable equivalent basis. (2) Ratios have been annualized and are not necessarily indicative of results for a full year. 8 BAY COMMERCIAL SERVICES AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION NINE MONTHS ENDED SEPTEMBER 30, 1996 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1995 OVERVIEW Net income of Bay Commercial Services (the "Company") was $862,000 for the first nine months of 1996 compared to $755,000 for the first nine months of 1995. Net income per share was $0.71 for the 1996 period compared to $0.65 for the 1995 period. Annualized return on average assets was 1.2% and 1.1% for the 1996 and 1995 periods, respectively. Annualized return on average shareholders' equity was 12.6% and 11.9% for the 1996 and 1995 periods, respectively. These annualized ratios are not necessarily indicative of results for a full year. Strong loan growth during the 1996 period was a significant factor in the $107,000 or 14.2% increase in net income compared to the 1995 period. Net interest income increased $166,000 or 4.4%, principally due to a $9,358,000 or 18.1% growth in average earning loans during the first nine months of 1996 compared to the first nine months of 1995. Noninterest income also increased during the 1996 period, up $328,000 or 58.4% over the 1995 period, with the largest contribution from a $167,000 increase in gain on sale of loans. These increases in income were partially offset by a $173,000 or 5.3% increase in noninterest expenses, a $130,000 credit to the provision for loan losses during the 1995 period which was not repeated in the 1996 period, and an $84,000 or 17.4% increase in income tax expense. The increase in noninterest expenses was largely attributable to the settlement of a litigation matter during the 1996 period. Total assets were $99,128,000 at September 30, 1996, representing a $6,309,000 or 6.8% increase over December 31, 1995. The increase in assets reflected the use of funds generated principally from deposit growth of $6,381,000 or 8.0% and an increase of $740,000 or 8.4% in total shareholders' equity during the period. The asset mix shifted during the 1996 period as total securities declined $2,507,000 or 12.3% while total loans increased $7,627,000 or 13.3% and cash and cash equivalents increased $1,419,000 or 12.1%. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income, the principal source of the Company's earnings, is the amount by which interest and fees generated by interest-earning assets, loans and investments, exceed the interest cost of deposits and other interest- bearing liabilities. Net interest income is affected by changes in interest rates as well as the composition and volume of interest-earning assets and interest-bearing liabilities. 9 Net interest income of $3,980,000 for the first nine months of 1996 increased $166,000 or 4.4% compared to the first nine months of 1995. The increase principally reflected a $4,230,000 or 5.2% growth in average earning assets. The net interest margin remained relatively unchanged at 6.31% and 6.33% for the 1996 and 1995 periods, respectively. The growth in average interest-earning assets between the 1996 and 1995 periods was principally due to growth of $9,358,000 or 18.1% in average earning loans. Average total securities and average overnight funds (federal funds sold and securities purchased under repurchase agreements) declined $3,845,000 or 16.8% and $1,283,000 or 19.0%, respectively. The yield on average earning assets remained relatively unchanged at 9.07% compared to 9.11% during the 1995 period. The positive effects of an increase in the proportion of earning assets invested in higher yielding loans, 71.4% for the 1996 period compared to 63.6% for the 1995 period, were offset by the lower overall lending and money market rates during the 1996 period. Average interest-bearing liabilities increased $2,209,000 or 3.9% between the 1996 and 1995 periods. The average rate paid for interest-bearing liabilities remained relatively unchanged at 4.09% for the 1996 period compared to 4.02% for the 1995 period. Although the average rates paid by individual deposit categories declined during the 1996 period in response to overall lower market rates compared to the 1995 period, the composition of the portfolio shifted to a larger proportion of higher cost time deposits. Average time deposits as a percentage of average interest-bearing liabilities increased to 53.5% for the 1996 period from 48.5% for the 1995 period. INTEREST RATE SENSITIVITY Interest rate sensitivity is the relationship between market interest rates and net interest income due to the repricing characteristics of assets and liabilities. If more assets than liabilities reprice in a given period (an asset sensitive position), market interest rate changes will be reflected more quickly in asset rates. If interest rates decline, an asset sensitive position could adversely affect net interest income. Alternatively, where liabilities reprice more quickly than assets in a given period (a liability sensitive position) a decline in market rates could benefit net interest income. The results would reverse if market rates were to increase. The following table presents the Company's interest rate sensitivity gap position at September 30, 1996. For any given period, the repricing is matched when an equal amount of assets and liabilities reprice. The repricing of a fixed rate asset or liability is considered to occur at its contractual maturity or, for those assets which are available for sale, within the time period during which sale may reasonably be expected to be accomplished. Floating rate assets or liabilities are considered to reprice in the period during which the rate can contractually change. Any excess of either assets or liabilities in a period results in a gap, or mismatch, shown in the table. A positive gap indicates asset sensitivity and a negative gap indicates liability sensitivity. 10 INTEREST SENSITIVITY PERIOD ------------------------------------- (000'S OMITTED) 3 Over 3 Over 1 months months to year to Over 5 or less 1 year 5 years years Total ------- ------- ------- ------- ------- Interest rate sensitive assets: Loans (net of nonaccrual)........$42,346 $ 1,566 $10,621 $11,609 $66,142 Securities (before unrealized gain or loss on securities available for sale)............ 2,000 373 10,378 5,198 17,949 Federal funds sold and securities purchased under repurchase agreements..................... 5,000 0 0 0 5,000 ------- ------- ------- ------- ------- Total.......................... 49,346 1,939 20,999 16,807 89,091 ------- ------- ------- ------- ------- Interest rate sensitive liabilities: Interest-bearing transaction accounts......... 6,241 0 0 0 6,241 Savings deposits................. 20,983 0 0 0 20,983 Time deposits >$100,000.......... 14,972 2,532 603 0 18,107 Other time deposits.............. 10,356 4,160 1,189 0 15,705 Other borrowed funds............. 2,167 0 0 0 2,167 ------- ------- ------- ------ ------- Total.......................... 54,719 6,692 1,792 0 63,203 ------- ------- ------- ------ ------- Interest rate sensitivity gap......$(5,373) $(4,753) $19,207 $16,807 $25,888 ------- ------- ------- ------- ------- Cumulative interest rate sensitivity gap...................$(5,373)$(10,126) $ 9,081 $25,888 $25,888 ------- ------- ------- ------- Cumulative interest rate sensitivity gap to total assets... (5.4)% (10.2)% 9.2% 26.1% This table presents a static gap, which is a position at a point in time. It does not address the interest rate sensitivity of assets or liabilities which would be added through growth, nor does it anticipate the future interest rate sensitivity of assets and liabilities once they have repriced, and it assumes equivalent elasticity of assets and liabilities. The interest rate sensitivity analysis at September 30, 1996, indicates that the Company, on a cumulative gap basis, is liability sensitive over the 3 months or less period and the over 3 months to 1 year period and asset sensitive over the remaining periods. PROVISION AND ALLOWANCE FOR LOAN LOSSES The Company provides for potential loan losses by a charge to operating income based upon the current composition of the loan portfolio, past loan loss experience, current and projected economic conditions, an evaluation of the risk elements in the loan portfolio and other factors that, in Management's judgment, deserve recognition in estimating loan losses. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to make additions to the allowance based on their evaluations of information available to them at the time of their examination. Management will charge off loans to the allowance when it determines there has been a permanent impairment of the related carrying values. The allowance for loan losses reflects an amount sufficient to cover estimated loan losses and is maintained at a level which, in Management's opinion, is adequate to absorb potential credit losses inherent in loans, outstanding loan commitments and standby letters of credit. 11 As of September 30, 1996, the allowance for loan losses was $964,000 compared to $982,000 at December 31, 1995. The reduced allowance reflected net loan chargeoffs of $18,000 during the first nine months of 1996. The ratio of the allowance for loan losses to total loans was 1.5% at September 30, 1996, and 1.7% at December 31, 1995. While Management uses available information to provide for losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. Based upon information currently available, Management believes that the allowance for loan losses at September 30, 1996, is adequate to absorb future possible losses. However, no assurance can be given that the Company may not sustain charge-offs which are in excess of the size of the allowance in any given period. Due to the level of the allowance in relation to both nonperforming and total outstanding loans, no provision for loan losses was made during the first nine months of either 1996 or 1995, and the reserve was decreased by a $130,000 credit to the provision for loan losses during the second and third quarters of 1995. Information on nonperforming loans for the nine month periods ended September 30, 1996 and 1995 and the year ended December 31, 1995 is summarized in the following table. <Caption September 30, December 31, September 30, 1996 1995 1995 ------------ ----------- ------------ (000's OMITTED) Net loan (charge-offs) recoveries during period......... $(18) $381 $340 Ratio of net loan (charge-offs) recoveries to average loans...... (0.1%) 0.7% 0.7% Nonperforming loans: Nonaccrual loans................. $171 $ 0 $ 0 Accruing loans past due 90 days or more................ 267 99 0 ---- ---- ---- Total nonperforming loans...... $438 $ 99 $ 0 ===== ==== ==== Ratio of nonperforming loans to total loans................... 0.7% 0.2% 0% Ratio of allowance for loan losses to nonperforming loans.... 220% 992% 0% Other real estate owned............ $41 $359 $378 Total nonperforming loans increased to $438,000 at September 30, 1996 compared to $99,000 at December 31, 1995. There were no nonperforming loans at September 30, 1995. The current ratio of nonperforming loans to total loans at 0.7% remains well below industry averages. The loans in this category are generally well secured and Management believes they represent a relatively low risk of loss. 12 OTHER REAL ESTATE OWNED Other real estate owned (OREO) of $41,000 at September 30, 1996, consisted of one property. OREO balances declined $318,000 or 88.6% compared to December 31, 1995, due to the sale of two OREO properties during the first and third quarters of 1996. OREO consists of real estate acquired as a result of legal foreclosure or through receipt of a deed in lieu of foreclosure. OREO amounts are carried at the lower of cost or fair value less estimated disposal costs. When the property is acquired, any excess of the loan balance over fair value of the property is charged to the allowance for loan losses. Subsequent write-downs, if any, and disposition gains and losses are included in noninterest income or noninterest expense. OREO assets are not being depreciated and any rental income is applied against current expenses or the recorded balance of the asset. NONINTEREST INCOME Total noninterest income of $890,000 for the first nine months of 1996 increased $328,000 or 58.4% compared to the first nine months of 1995. The greatest change was a $167,000 increase in gain on sale of loans, reflecting a larger sale of loans guaranteed by the Small Business Administration ("SBA loans") during the first nine months of 1996 compared to the first nine months of 1995. Other noninterest income increased $77,000 or 151% between the periods, principally due to the 1996 recovery of prior years' expenses related to charged-off loans. Increases also occurred in bankcard income and in gain on sale of OREO, up $36,000 or 24.0% and $34,000 or 44.2%, respectively, over 1995 figures. These increases were partially offset by a decrease during the 1996 period of $38,000 or 27.7% in loan servicing income, principally due to SBA loan payoffs. The Bank experienced increased payoffs of SBA loans during the first nine months of 1996 as some borrowers refinanced with aggressively priced fixed-rate (non-SBA) loans offered by other lenders. These payoffs caused the Bank's serviced portfolio and, thereby, servicing income to decline. The serviced portfolio may experience additional reductions if payoffs continue at a rate in excess of SBA loan sales. NONINTEREST EXPENSE Total noninterest expenses of $3,441,000 for the first nine months of 1996 increased $173,000 or 5.3% compared to the same period in 1995. The largest factor contributing to the increase in noninterest expenses was a $101,000 or 19.8% increase in other noninterest expense, principally attributable to the settlement of a litigation matter. Salaries and employee benefits increased $66,000 or 3.7%, reflecting higher accruals for bonuses and the addition of staff in preparation for the opening of a new branch of the Bank during the fourth quarter of 1996. Professional fees increased $44,000 or 30.1% principally due to increased legal fees. Bankcard expense increased $32,000 or 27.4% due to increased merchant bankcard activity. These increases were partially offset by a $79,000 or 97.5% decrease in assessment fees paid to the Federal Deposit Insurance Corporation (FDIC) resulting from a reduction in deposit insurance rates for the Bank Insurance Fund. 13 PROVISION FOR INCOME TAXES The provision for income tax expense was $567,000 for the first nine months of 1996 compared to $483,000 for the first nine months of 1995. The increased income tax expense reflected higher taxable income during the 1996 period. The effective income tax rates was 40% and 39% for the 1996 and 1995 periods, respectively. THREE MONTHS ENDED SEPTEMBER 30, 1996 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1995 OVERVIEW Net income for the Company for the third quarter of 1996 was $367,000 compared to $315,000 for the third quarter of 1995. Net income per share was $0.30 for the 1996 quarter compared to $0.26 for the 1995 quarter. Annualized return on average assets was 1.5% and 1.3% for the 1996 and 1995 quarters, respectively. Annualized return on average shareholders' equity was 15.5% and 14.3% for the 1996 and 1995 quarters, respectively. These annualized ratios are not necessarily indicative of results for a full year. The $52,000 or 16.5% increase in net income for the 1996 quarter compared to the 1995 quarter was principally due to an increase of $220,000 or 123.6% in noninterest income and a $50,000 or 3.8% increase in net interest income, which were partially offset by an increase of $94,000 or 9.0% in noninterest expense, a nonrecurring $80,000 credit to the provision for loan losses during the 1995 quarter, and a $44,000 or 21.3% increase in income tax expense. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income of $1,362,000 for the third quarter of 1996 increased $50,000 or 3.8% compared to the third quarter of 1995. The increase reflected a $5,771,000 or 6.9% growth in average earning assets which was partially offset by a decline in the net interest margin to 6.15% for the 1996 quarter from 6.26% for the 1995 quarter. The growth in average interest-earning assets between the 1996 and 1995 quarters was due to growth of $12,246,000 or 23.7% in average earning loans. Average earning loans as a percentage of average earning assets climbed to 71.6% for the 1996 quarter compared to 61.9% for the 1995 quarter. The yield on average earning assets declined to 8.95% for the 1996 quarter compared to 9.04% for the 1995 quarter, however, largely due to a 0.5% decline in the Bank's prime (reference) rate between the periods. Average interest-bearing liabilities increased $4,508,000 or 7.7% between the 1996 and 1995 quarters. The average rate paid for interest-bearing liabilities increased to 4.12% for the 1996 quarter compared to 4.06% for the 1995 quarter. The higher average rate paid during the 1996 14 quarter reflected a shift in the deposit mix. The proportion of total interest-bearing liabilities that were higher cost time deposits increased to 53.8% for the 1996 quarter compared to 48.8% for the 1995 quarter. The average rate paid for each deposit category declined during the 1996 quarter in response to overall lower market rates compared to the 1995 quarter. PROVISION AND ALLOWANCE FOR LOAN LOSSES Due to reductions in nonperforming loans and recoveries on loans previously written off, in addition to the level of the allowance in relation to both nonperforming and total outstanding loans, no provision for loan losses was made during the third quarter of 1996 and the reserve was decreased by an $80,000 credit to the provision for loan losses during the third quarter of 1995. NONINTEREST INCOME Total noninterest income of $398,000 for the third quarter of 1996 was $220,000 or 123.6% higher than for the third quarter of 1995. The most significant factors in the increase were a $66,000 increase in gain on sale of loans and a $115,000 increase in net gain on sale of OREO. NONINTEREST EXPENSE Total noninterest expenses of $1,142,000 for the third quarter of 1996 increased $94,000 or 9.0% compared to the same quarter in 1995. The most significant changes included a $44,000 or 7.6% increase in salaries and employee benefits related to increased accruals for bonuses and additions to staff. Other significant changes included a $38,000 or 79.2% increase in professional services, specifically legal fees, and an $18,000 or 45.0% increase in bankcard expense, reflecting the increase in merchant bankcard activity. PROVISION FOR INCOME TAXES The provision for income tax expense was $251,000 for the third quarter of 1996 compared to $207,000 for the third quarter of 1995. The increased income tax expense reflected higher taxable income during the 1996 quarter. The effective income tax rates were 41% and 40% for the 1996 and 1995 quarters, respectively. FINANCIAL CONDITION LOANS AND INVESTMENTS Total loans of $65,761,000 at September 30, 1996 increased $7,609,000 or 13.1% from December 31, 1995. Total securities declined $2,507,000 or 12.3% and cash and cash equivalents increased $1,419,000 or 12.1% compared to December 31, 1995. The loan growth during the 1996 period was principally in fixed rate commercial loans, reflecting both the Bank's competitive lending environment and Management's intention to diversify the loan portfolio and reduce the Bank's asset sensitive position. 15 DEPOSITS AND OTHER BORROWED FUNDS Total deposits of $86,634,000 at September 30, 1996 increased $6,381,000 or 8.0% compared to December 31, 1995. The greatest growth was experienced in time deposits, up $4,916,000 or 17%, and savings and interest-bearing demand, which increased $2,708,000 or 11.1% compared to year-end 1995. Securities sold under agreements to repurchase remained relative unchanged at $2,167,000 at September 30, 1996 compared to $2,203,000 at December 31, 1995. OTHER ASSETS AND OTHER LIABILITIES As previously discussed, OREO assets of $41,000 at September 30, 1996, declined $318,000 or 88.6% from December 31, 1995. Interest and fees receivable increased $127,000 or 21.2% during the first nine months of 1996, reflecting the increased volume of earning assets. Interest payable and other liabilities at September 30, 1996, declined $776,000 or 48.6% from year-end 1995 due to the payment in 1996 of a cash dividend and income taxes payable. LIQUIDITY Liquidity is defined as the ability of the Company to meet present and future obligations either through the sale or maturity of existing assets, or by the acquisition of funds through liability management. The Company manages its liquidity to provide adequate funds to support both the borrowing needs of its customers and fluctuations in deposit flows. The Company defines liquid assets to include cash and noninterest-bearing deposit balances, federal funds sold, all marketable securities less liabilities that are secured by any of the securities, and loans held for sale, less any reserve requirements being met by any of the above. Net deposits and short-term liabilities include all deposits, federal funds purchased, repurchase agreements and other borrowings and debt due in one year or less. The liquidity ratio is calculated by dividing total liquid assets by net deposits and short term liabilities. The Company's liquidity ratio by this measure was 33% at September 30, 1996, and 41% at December 31, 1995. It is the opinion of Management that the Company's and the Bank's liquidity positions are sufficient to meet their respective needs. In addition, the Bank has informal, non-binding, federal funds borrowing arrangements totaling $4,000,000 with two correspondent banks and a $3,000,000 repurchase facility to meet unforeseen outflows. As of September 30, 1996, no borrowed funds were outstanding on these credit agreements. As of September 30, 1996, the Bank did not carry any brokered deposit balances. CAPITAL The Company and the Bank are subject to Federal Reserve Board guidelines and regulations of the FDIC governing capital adequacy. The Federal Reserve Board's risk-based and leverage capital guidelines for bank holding companies are substantially the same as the FDIC's capital regulations for nonmember banks. 16 The Federal Reserve Board capital guidelines for bank holding companies and the FDIC's regulations for nonmember banks set total capital requirements and define capital in terms of "core capital elements" (comprising Tier 1 capital) and "supplemental capital elements" (comprising Tier 2 capital). Tier 1 capital is generally defined as the sum of the core capital elements less goodwill, with core capital elements including (i) common stockholders' equity; (ii) qualifying noncumulative perpetual preferred stock; and (iii) Supplementary capital elements include: (i) allowance for loan and lease losses (which cannot exceed 1.25% of risk weighted assets); (ii) perpetual preferred stock not qualifying as core capital; (iii) hybrid capital instruments and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock. The maximum amount of supplemental capital elements which qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill. Risk-based capital ratios are calculated with reference to risk-weighted assets, including both on and off-balance sheet exposures, which are multiplied by certain risk weights assigned by the Federal Reserve Board to those assets. Both bank holding companies and nonmember banks are required to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, at least one-half of which must be in the form of Tier 1 capital. The Federal Reserve Board and the FDIC also have established a minimum leverage ratio of 3% of Tier 1 capital to total assets for bank holding companies and nonmember banks that have received the highest composite regulatory rating and are not anticipating or experiencing any significant growth. All other institutions are required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum. The following tables present the Company's and the Bank's regulatory capital positions at September 30, 1996, and average assets over the nine month period ended September 30, 1996: RISK BASED CAPITAL RATIO (000's OMITTED) Company Bank Amount Ratio Amount Ratio ------ ----- ------ ----- Tier 1 Capital..........................$ 9,535 13.0% $ 9,280 12.7% Tier 1 Capital minimum requirement 2,930 4.0 2,924 4.0 ------- ----- ------- ----- Excess..................................$ 6,605 9.0% $ 6,356 8.7% Total Capital...........................$10,451 14.3% $10,194 13.9% Total capital minimum requirement....... 5,860 8.0 5,849 8.0 ------- ----- ------- ----- Excess..................................$ 4,591 6.3% $ 4,345 5.9% ------- ----- ------- ----- Risk weighted assets.................... $73,246 $73,108 ======= ======= 17 LEVERAGE RATIO (000's OMITTED) Company Bank Amount Ratio Amount Ratio ------ ----- ------ ----- Tier 1 Capital to average total assets..$ 9,535 10.1% $ 9,280 9.8% Range of minimum leverage............... 2,833- 3.0- 2,829- 3.0- requirement........................... 4,721 5.0% 4,714 5.0% ------- ----- ------- ---- Range of excess.........................$ 4,814- 5.1- $ 4,566- 4.8- 6,702 7.1% 6,451 6.8% ------- ----- ------- ---- Average total assets.................... $94,425 $94,284 ======= ======= The Company currently does not have any material commitments for capital expenditures, and in the opinion of Management, the Company's and the Bank's capital positions are sufficient to meet their respective needs. INFLATION It is Management's opinion that the effects of inflation on the consolidated financial statements for the periods ended September 30, 1996 and 1995 have not been material. 18 PART II - OTHER INFORMATION Item 5. Other Information: None Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits: None. (b) Reports on Form 8-K: No reports on Form 8-K were filed by the Company for the quarter ended September 30, 1996. 19> SIGNATURES Pursuant to the requirements 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. BAY COMMERCIAL SERVICES (Registrant) Date: November 12, 1996 /s/ R. M. Kahler ---------------------------- R. M. Kahler President and Chief Executive Officer (Principal Executive Officer) Date: November 12, 1996 /s/ R. D. Greenfield ---------------------------- R. D. Greenfield Chief Financial Officer (Principal Accounting Officer)