U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 FORM 10-QSB (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1999 [ ] 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 April 30, 1999 Common stock, no par value 1,322,110 shares Transitional Small Business Disclosure Format YES NO __X_ This report contains a total of 29 pages. BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED BALANCE SHEETS MARCH 31, DECEMBER 31, 1999 1998 (DOLLARS IN THOUSANDS): (UNAUDITED) ---------------------------------------------------------------------------------------- Cash and due from banks $ 8,262 $ 9,077 Federal funds sold and reverse repurchase agreements 5,000 --- ---------------------------------------------------------------------------------------- Cash and cash equivalents 13,262 9,077 ---------------------------------------------------------------------------------------- Securities available for sale, stated at fair value (amortized cost of $27,669 for 1999; $31,969 for 1998) 27,589 32,033 Securities held to maturity (fair values of $7,669 for 1999; $7,748 for 1998) 7,483 7,509 Federal Home Loan Bank stock 364 359 Loans held for sale 661 939 Loans held for investment 94,288 92,190 Allowance for loan losses (1,020) (980) ---------------------------------------------------------------------------------------- Net loans 93,929 92,149 ---------------------------------------------------------------------------------------- Premises and equipment, net 1,905 1,949 Interest and fees receivable 630 635 Other assets 760 491 ---------------------------------------------------------------------------------------- TOTAL ASSETS $145,922 $144,202 ======================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand $ 38,163 $ 33,904 Savings and interest-bearing demand 42,328 37,571 Time 30,404 30,309 Certificates of deposit, $100 and over 22,256 21,611 ---------------------------------------------------------------------------------------- Total deposits 133,151 123,395 ---------------------------------------------------------------------------------------- Securities sold under agreements to repurchase 100 1,344 Other short-term borrowing --- 7,000 Interest payable and other liabilities 714 1,068 ---------------------------------------------------------------------------------------- Total liabilities 133,965 132,807 ---------------------------------------------------------------------------------------- Commitments and contingent liabilities --- --- Shareholders' equity: Common stock - no par value: authorized 20,000,000 shares; issued and outstanding 1,194,435 in 1999; 1,080,670 in 1998 4,121 3,622 Retained earnings 7,885 7,734 Accumulated other comprehensive income (loss), net of tax (49) 39 ---------------------------------------------------------------------------------------- Total shareholders' equity 11,957 11,395 ---------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $145,922 $144,202 ======================================================================================== SEE ACCOMPANYING NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS. BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED STATEMENTS OF INCOME (UNAUDITED) THREE MONTHS ENDED MARCH 31, (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS): 1999 1998 ---------------------------------------------------------------------------- Interest income: Loans, including fees $2,118 $1,935 Federal funds sold and reverse repurchase agreements 26 55 Securities: Taxable 380 279 Tax exempt 77 60 ---------------------------------------------------------------------------- Total interest income 2,601 2,329 ---------------------------------------------------------------------------- Interest expense: Deposits: Savings and interest-bearing demand 275 204 Time 342 386 Certificates of deposit, $100 and over 249 184 Other borrowed funds 17 18 ---------------------------------------------------------------------------- Total interest expense 883 792 ---------------------------------------------------------------------------- Net interest income 1,718 1,537 Provision for loan losses 41 10 ---------------------------------------------------------------------------- Net interest income after provision for loan losses 1,677 1,527 ---------------------------------------------------------------------------- Noninterest income: Bankcard income 108 96 Service charges and fees 78 68 Gain on sale of loans 24 33 Loan servicing 22 24 Other 10 27 ---------------------------------------------------------------------------- Total noninterest income 242 248 ---------------------------------------------------------------------------- Noninterest expenses: Salaries and employee benefits 828 793 Occupancy 174 170 Data processing 100 85 Bankcard processing expense 89 79 Professional services 50 28 Other 242 232 ---------------------------------------------------------------------------- Total noninterest expenses 1,483 1,387 ---------------------------------------------------------------------------- Income before income tax expense 436 388 Income tax expense 152 134 ---------------------------------------------------------------------------- NET INCOME $ 284 $ 254 ============================================================================ NET INCOME PER COMMON SHARE - BASIC $0.24 $0.24 Weighted average common shares - basic 1,182,427 1,079,653 NET INCOME PER COMMON SHARE - DILUTED $0.22 $0.20 Weighted average common shares - diluted 1,292,516 1,279,707 ============================================================================ SEE ACCOMPANYING NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS. BAY COMMERCIAL SERVICES AND SUBSIDIARY CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (UNAUDITED) THREE MONTHS ENDED MARCH 31, (DOLLARS IN THOUSANDS): 1999 1998 - --------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 284 $ 254 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization (124) (4) Provision for loan losses 41 10 Unamortized deferred loan fees, net (7) (62) Originations of SBA loans held for sale (458) (158) Proceeds from the sale of SBA loans held for sale 622 734 Change in interest and fees receivable and other assets (52) (48) Change in interest payable and other liabilities (159) (37) - ---------------------------------------------------------------------------------------- Net cash provided by operating activities 147 689 - --------------------------------------------------------------------------------------- Cash flows from investing activities: Proceeds from maturities of securities available for sale 40,920 17,244 Proceeds from maturities of securities held to maturity 30 71 Purchase of securities available for sale (36,433) (3,975) Purchase of securities held to maturity --- (144) Purchase of Federal Home Loan Bank stock (5) --- Net change in loans (1,984) (6,113) Purchases of premises and equipment (23) (24) - ---------------------------------------------------------------------------------------- Net cash provided by investing activities 2,505 7,059 - --------------------------------------------------------------------------------------- Cash flows from financing activities: Net change in deposits 9,756 10,167 Net change in securities sold under agreements to repurchase (1,244) (98) Net change in other short-term borrowing (7,000) (2,500) Exercise of stock options 499 9 Cash dividends paid (478) (324) - ---------------------------------------------------------------------------------------- Net cash provided by financing activities 1,533 7,254 - --------------------------------------------------------------------------------------- Net change in cash and cash equivalents 4,185 15,002 Cash and cash equivalents at beginning of period 9,077 7,548 - --------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 13,262 $ 22,550 ======================================================================================= Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $864 $676 Income taxes 76 --- Noncash investing and financing activities during the period: Tax benefit from exercise of nonqualified stock options $345 --- SEE ACCOMPANYING NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS. BAY COMMERCIAL SERVICES AND SUBSIDIARY NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (UNAUDITED) AS OF MARCH 31, 1999 AND DECEMBER 31, 1998 AND FOR THE MONTHS ENDED MARCH 31, 1999 AND 1998 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 March 31, 1999 and December 31, 1998 and the results of its operations and its cash flows for the three month periods ended March 31, 1999 and 1998 have been included. The results of operations and cash flows for the periods presented are not necessarily indicative of the results that may be expected for a full year. These unaudited consolidated condensed financial statements should be read in conjunction with the consolidated financial statements, and notes thereto, included in the Company's Annual Report on SEC Form 10KSB for the year ended December 31, 1998. 2) Net income per common share - basic for the three month periods ended March 31, 1999 and 1998 was computed by dividing net income by the weighted average number of outstanding common shares. Net income per common share - diluted for the three month periods ended March 31, 1999 and 1998 is computed by dividing net income by the weighted average number of outstanding common shares including the dilutive effect of stock options. The weighted average number of outstanding common shares for the three month periods ended March 31, 1999 and 1998 was 1,182,427 and 1,079,653, respectively. The weighted average number of outstanding common shares including the dilutive effect of stock options for the three months periods ended March 31, 1999 and 1998 was 1,292,516 and 1,279,707, respectively. 3) 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 35% for the three month periods ended March 31, 1999 and 1998. 4) Comprehensive income includes net income and other comprehensive income. The Company's only source of other comprehensive income is derived from unrealized gains and losses on investment securities available for sale. Reclassification adjustments resulting from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose are excluded from comprehensive income of the current period. The Company's total comprehensive income was $196,000 and $268,000 for the three months ended March 31, 1999 and 1998, respectively. 5) Subsequent Event. On April 30, 1999, the Company entered into an Agreement and Plan of Reorganization ("Agreement") with Greater Bay Bancorp ("GBB"). Under the terms of the Agreement, GBB will acquire all the outstanding common stock of the Company in exchange for 0.7134 shares of GBB common stock for each share of common stock of the Company, subject to adjustment as provided in the Agreement. The merger, which is expected to close in the third quarter of 1999, is subject to the approval of the Company's shareholders, various regulatory agencies and certain other conditions. 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 (Unaudited) THREE MONTHS ENDED INCREASE MARCH 31, (DECREASE) (DOLLARS IN THOUSANDS): 1999 1998 $ % - --------------------------------------------------------------------------------------------- Average Balances: Assets (1) $139,119 $114,300 $24,819 21.7 % Securities - taxable (1) 27,852 18,359 9,493 51.7 Securities - tax exempt 6,125 4,671 1,454 31.1 Federal funds sold and reverse repurchase agreements 2,203 4,013 (1,810) (45.1) Total loans 92,967 77,355 15,612 20.2 Nonaccrual loans 29 433 (404) (93.3) Deposits 124,876 101,547 23,329 23.0 Shareholders' equity (1) 11,683 10,340 1,343 13.0 Interest-earning assets (1) 129,118 103,965 25,153 24.2 Interest-bearing liabilities 91,349 74,057 17,292 23.3 Income Statements: Interest income (2) $2,637 $2,357 $280 11.9 % Interest expense 883 792 91 11.5 - --------------------------------------------------------------------------------------------- Net interest income (2) 1,754 1,565 189 12.1 Taxable equivalent adjustment 36 28 8 28.6 - --------------------------------------------------------------------------------------------- Net interest income 1,718 1,537 181 11.8 Provision for loan losses 41 10 31 310.0 - --------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 1,677 1,527 150 9.8 - --------------------------------------------------------------------------------------------- Noninterest income 242 248 (6) (2.4) Noninterest expenses 1,483 1,387 96 6.9 Income tax expense 152 134 18 13.4 - --------------------------------------------------------------------------------------------- NET INCOME $284 $254 $ 30 11.8 % ============================================================================================= Performance Ratios: (3) Change ------ Yield on average interest-earning assets 8.17% 9.09% (0.92)% Yield on average interest-earning assets (2) 8.28% 9.19% (0.91)% Interest rate on average interest-bearing liabilities 3.92% 4.34% (0.42)% Interest expense as a percent of average interest-earning assets 2.77% 3.09% (0.32)% Net yield on average interest-earning assets 5.40% 6.00% (0.60)% Net yield on average interest-earning assets (2) 5.51% 6.10% (0.59)% (1) Before unrealized gain or loss on securities available for sale (2) Federal taxable equivalent basis. (3) Ratios have been annualized and are not necessarily indicative of results that may be expected for a full year. -19- BAY COMMERCIAL SERVICES AND SUBSIDIARY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 1999 COMPARED TO THREE MONTHS ENDED MARCH 31, 1998 OVERVIEW Certain matters discussed in this Management's Discussion and Analysis are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, among others, (1) significant increases in competitive pressure in the banking industry; (2) changes in the interest rate environment which could reduce margins; (3) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in securities markets. Therefore, the information set forth in such forward-looking statements should be carefully considered when evaluating the business prospects of Bay Commercial Services (the "Company") and Bay Bank of Commerce (the "Bank"). Net income of the Company was $284,000 for the first quarter of 1999 compared to $254,000 for the first quarter of 1998. Net income per common share - basic was $0.24 for the first quarter of 1999 and 1998. Net income per common share - diluted was $0.22 and $0.20 for the first quarter of 1999 and 1998, respectively. The $30,000 or 12% growth in net income for the first quarter of 1999 compared to the first quarter of 1998 reflected higher net interest income for the 1999 quarter, which was partially offset by increases in noninterest expenses, income tax expense and the provision for loan losses as well as reduced noninterest income compared to the 1998 quarter. Net interest income for the 1999 quarter increased $181,000 or 12% compared to the 1998 quarter due to strong growth in average interest-earning assets which more than offset a drop in the net yield on average interest-earning assets. A $96,000 or 7% increase in noninterest expenses in the 1999 quarter largely reflected higher salaries and employee expenses and increased consulting expenses related to Year 2000 compliance. Income tax expense increased $18,000 or 13% and the provision for loan losses increased $31,000 or 310% in the 1999 quarter. Noninterest income declined $6,000 or 2% in the 1999 quarter as increases in bankcard income and services charges and fees were more than offset by decreases in gain on sale of loans guaranteed by the Small Business Administration ("SBA loans") and other noninterest income. Total assets were $145,922,000 at March 31, 1999, representing a $1,720,000 or 1% increase from December 31, 1998. Total deposits of $133,151,000 at March 31, 1999 grew $9,756,000 or 8% from year-end 1998 while securities sold under agreements to repurchase declined $1,244,000 or 93% and other short-term borrowing decreased $7,000,000 or 100%. Funds from the deposit growth net of the reductions in repurchase agreements and short-term borrowing combined with the $4,470,000 received in cash as securities matured during the quarter were principally invested in federal funds sold and repurchase agreements and in loans. Cash and cash equivalents increased $4,185,000 or 46% and loans increased $1,820,000 or 2% during the first quarter of 1999. 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. Net interest income of $1,718,000 for the first quarter of 1999 increased $181,000 or 12% compared to the first quarter of 1998. The increase reflected a $25,153,000 or 24% growth in average interest-earning assets. The net yield on average earning assets declined to 5.40% for the 1999 quarter from 6.00% for the 1998 quarter. The increase in average interest-earning assets between the 1999 and 1998 quarters was principally due to growth of $16,016,000 or 21% in average earning loans and $10,947,000 or 48% in average total securities. The average yield on interest-earning assets for the first quarter of 1999 declined to 8.17% compared to 9.09% for the 1998 quarter reflecting the lower level of money market and lending rates in the first quarter of 1999 compared to the first quarter of 1998 as well as an increase in the percentage of the earning asset portfolio invested in lower yielding short-term securities. The average yield on earning loans for the 1999 quarter declined to 9.24% from 10.20% for the 1998 quarter and the ratio of loans to interest-earning assets for the 1999 quarter dropped to 72% from 74% for the 1998 quarter. Average interest-bearing liabilities increased $17,292,000 or 23% between the 1999 and 1998 quarters. The average rate paid for interest-bearing liabilities declined to 3.92% for the 1999 quarter compared to 4.34% for the 1998 quarter, reflecting a decrease in overall money market and deposit rates between the quarters and a shift in the deposit portfolio. The ratio of time deposits to average total interest-bearing liabilities fell to 56% for the 1999 quarter compared to 59% for the 1998 quarter. 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), interest rate changes will have a greater effect on earning assets. If interest rates decline, an asset sensitive position could adversely affect net interest income. Alternatively, when more liabilities than assets reprice in a given period (a liability sensitive position) a decline in interest rates could benefit net interest income. The results would reverse if interest rates were to increase. The following table presents the Company's interest rate sensitivity gap position at March 31, 1999. 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 held 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. INTEREST SENSITIVITY PERIOD 3 OVER OVER 1 AS OF MARCH 31, 1999: MONTHS 3 MONTHS YEAR TO OVER 5 (DOLLARS IN THOUSANDS) OR LESS TO 1 YEAR 5 YEARS YEARS TOTAL - ------------------------------------------------------------------------- ------------------- Interest rate sensitive assets: Loans (excluding nonaccrual and deferred fees) $59,060 $ 7,395 $14,155 $14,829 $95,439 Securities (before unrealized loss on securities available for sale) 16,265 665 10,849 7,373 35,152 Federal funds sold and reverse repurchase agreements 5,000 --- --- --- 5,000 - ------------------------------------------------------------------------- ------------------- Total 80,325 8,060 25,004 22,202 135,591 - ------------------------------------------------------------------------- ------------------- Interest rate sensitive liabilities: Interest-bearing transaction accounts 35,016 --- --- --- 35,016 Savings deposits 7,312 --- --- --- 7,312 Time deposits, $100 and over 27,816 4,712 1,137 --- 33,665 Other time deposits 12,213 5,512 1,269 1 18,995 Other borrowed funds 100 --- --- --- 100 - ------------------------------------------------------------------------- ------------------- Total 82,457 10,224 2,406 1 95,088 - ------------------------------------------------------------------------- ------------------- Interest rate sensitivity gap (2,132) (2,164) 22,598 22,201 $40,503 - ------------------------------------------------------------------------- ------------------- Cumulative interest rate sensitivity gap $(2,132) $(4,296) $18,302 $40,503 - ------------------------------------------------------------------------- ------------------- Cumulative interest rate sensitivity gap to total assets (1.5)% (3.0)% 12.5% 27.8% 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 March 31, 1999, indicates that the Company, on a cumulative gap basis, is liability sensitive in the periods "3 months or less" and "Over 3 months to 1 year" and asset sensitive over the remaining time periods. PROVISION AND ALLOWANCE FOR LOAN LOSSES The Bank provides for possible loan losses by a charge to operating income based upon the composition of the loan portfolio, past loan loss experience, current economic conditions and other factors which, in management's judgment, deserve recognition in estimating loan losses. Management will charge off loans when it determines there has been a permanent impairment of the related carrying values. The allowance for loan losses is reviewed by management monthly and approved by the Board of Directors at least quarterly. Management attributes general reserves to different types of loans using percentages which are based upon perceived risk associated with the portfolio and underlying collateral, historical loss experience, and vulnerability to changing economic conditions which may affect the collectibility of the loans. Specific allowances are allocated for impaired loans, for loans which have experienced a decline in internal loan grading, and when management believes additional loss exposure exists. Although the allowance for loan losses is allocated to various portfolio segments, it is general in nature and is available for the loan portfolio in its entirety. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance based on their analysis of information available to them at the time of their examination. The Senior Loan Officer assesses the loan portfolio monthly to determine which loans are specifically identifiable problem credits in order to update the Bank's internal watch list, which tracks all such credits. The Bank's internal Loan Review Examiner grades all new commercial loans and all credits where the total liability equals or exceeds certain thresholds established by management. If either the Senior Loan Officer or the Loan Review Examiner identifies a serious deficiency, the loan is placed on the next quarterly watch list. Management provides a specific reserve allowance for the effects of the problem applicable to each watchlisted credit. When management identifies a generalized risk not evidenced by a specially identifiable loan or portfolio segment as of the evaluation date, management's evaluation of the probable loss exposure concerning this condition will be provided for by adjusting the level of general reserve for this exposure. The provision for loan losses reflects an amount necessary to adjust the allowance for loan losses to 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. As of March 31, 1999, the allowance for loan losses was $1,020,000 compared to $980,000 at December 31, 1998. The increased allowance is a result of the $41,000 provision for loan losses. The provision for loan losses was $10,000 in the first quarter of 1998. Although nonperforming loans dropped slightly from March 31, 1998, additional credit risk inherent in the strong loan growth was reflected in the provision. The ratio of the allowance for loan losses to total loans was 1.1% at March 31, 1999 and at December 31, 1998. Based upon information currently available, management believes that the allowance for loan losses at March 31, 1999, 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. At March 31, 1999 and December 31, 1998, the Bank also held California Capital Access Program ("CalCAP") deposits of $208,000 and $203,000, respectively, which CalCAP has pledged to offset any losses on any loans in the Bank's CalCAP portfolio. The Bank had a total of $1,486,000 and $1,584,000 in CalCAP loans as of March 31, 1999 and December 31, 1998, respectively. CalCAP is a program authorized by the California Legislature to encourage California financial institutions to make loans to small businesses whose operations affect the state's environment and which may not meet the normal underwriting standards of the financial institution. Information on nonperforming loans for the quarters ended March 31, 1999 and 1998 and the year ended December 31, 1998 is summarized in the following table. MARCH 31, DECEMBER 31, MARCH 31, (DOLLARS IN THOUSANDS) 1999 1998 1998 - --------------------------------------------------------------------------------------------- Net loan charge-offs $(1) $(154) $(5) Ratio of net loan charge-offs to average loans --- (0.2)% --- Nonperforming loans: Nonaccrual $ 27 $ 30 $ 395 Accruing loans past due 90 days or more --- 299 Restructured 469 469 469 - -------------------------------------------------------------------------------------------- Total nonperforming loans $496 $499 $1,163 - -------------------------------------------------------------------------------------------- Ratio of nonperforming loans to total loans 0.5% 0.5% 1.5% Ratio of allowance for loan losses to nonperforming loans 205.6% 196.4% 86% The nonaccrual balance represents one loan which is guaranteed by the Small Business Administration. The restructured balance represents one loan which is paying as agreed according to the terms of the renegotiated loan agreement. NONINTEREST INCOME Comparing the first quarters of 1999 and 1998, noninterest income was nearly unchanged. Reductions of $17,000 or 63% in other noninterest income, $9,000 or 27% in gain on sale of SBA loans and $2,000 or 8% in loan servicing income were slightly in excess of increases of $12,000 or 13% in bankcard income and $10,000 or 15% in servicing charges and fees. The increases in bankcard income and servicing charges and fees reflected increased merchant activity and deposit growth. The decline in other noninterest income was attributable to the recovery during the 1998 quarter of income and expenses related to previously charged-off or paid-off loans, which was not repeated in the first quarter of 1999. NONINTEREST EXPENSES Total noninterest expenses of $1,483,000 for the first quarter of 1999 increased $96,000 or 7% compared to the first quarter of 1998. Salaries and employee benefits rose $35,000 or 4%, principally due to salary increases and higher bonuses associated with loan growth. Professional services expense for the first quarter of 1999 were $22,000 or 79% above the 1998 quarter, reflecting increased accounting firm fees and legal services expense. Data processing expense increased $15,000 or 18% principally due to asset growth and costs associated with Year 2000 remediation. PROVISION FOR INCOME TAXES The provision for income tax expense was $152,000 for the first quarter of 1999 compared to $134,000 for the first quarter of 1998. The $18,000 or 13% increase in income tax expense reflected higher taxable income for the 1999 quarter. The effective income tax rate was 35% for both the 1999 and 1998 quarters. FINANCIAL CONDITION CASH AND CASH EQUIVALENTS, INVESTMENTS AND LOANS Cash and cash equivalents of $13,262,000 at March 31, 1999 increased $4,185,000 or 46% from year-end 1998, reflecting both the deposit growth and a $4,470,000 or 11% decline in securities outstanding as of March 31, 1999. Total loans of $94,949,000 at March 31, 1999 increased $1,820,000 or 2% from December 31, 1998. DEPOSITS AND OTHER BORROWED FUNDS Reflecting a continuation of the Bank's strong growth trend, total deposits of $133,151,000 at March 31, 1999 increased $9,756,000 or 8% compared to December 31, 1998. Noninterest-bearing demand deposits grew $4,259,000 or 13% and savings and interest-bearing demand increased $4,757,000 or 13% from December 31, 1998. Part of the deposit growth was used to reduce by $7,000,000 other short-term borrowing as of March 31, 1999. Securities sold under agreements to repurchase declined $1,244,000 or 93% during the first three months of 1999. OTHER ASSETS AND OTHER LIABILITIES While interest and fees receivable at March 31, 1999 were relatively unchanged from year-end 1998, other assets increased $269,000 or 55%. The increase in other assets was principally due to the exercise during the first quarter of 1999 of nonqualified stock options, resulting in a $186,000 increase in deferred tax assets, and an increase of approximately $100,000 in prepaid expenses. Interest payable and other liabilities at March 31, 1999, declined $354,000 or 33% from year-end 1998 principally due to the payment of income taxes and $159,000 in tax benefits related to the exercise of nonqualified stock options during the first quarter of 1999. 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 cash equivalents, all marketable securities with maturities of one year or less, securities available for sale with maturities beyond one year, 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 30% at March 31, 1999 and December 31, 1998. 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, to meet unforeseen outflows, the Bank has informal, non-binding borrowing arrangements with two correspondent banks, which include federal funds borrowing lines totaling $8,500,000 and a repurchase facility, as well as access to a collaterized credit line with an available borrowing capacity of approximately $12,000,000 with the Federal Home Loan Bank of San Francisco. As of March 31, 1999, no borrowed funds were outstanding from these credit facilities. CAPITAL The following tables present the Company's and the Bank's regulatory capital positions and risk-weighted assets at March 31, 1999, and average assets over the three month period ended March 31, 1999: RISK BASED CAPITAL RATIO COMPANY BANK (DOLLARS IN THOUSANDS) AMOUNT RATIO AMOUNT RATIO - --------------------------------------------------------------------------------------------- Tier 1 Capital $12,006 9.6% $11,774 9.5% Tier 1 Capital regulatory minimum requirement 4,988 4.0 4,983 4.0 - --------------------------------------------------------------------------------------------- Capital held in excess of regulatory minimum $7,018 5.6% $6,791 5.5% Total Capital $13,026 10.4% $12,794 10.3% Total Capital regulatory minimum requirement 9,976 8.0 9,966 8.0 - --------------------------------------------------------------------------------------------- Capital held in excess of regulatory minimum $ 3,050 2.4% $ 2,828 2.3% Risk weighted assets $124,702 $124,580 LEVERAGE RATIO COMPANY BANK (DOLLARS IN THOUSANDS) AMOUNT RATIO AMOUNT RATIO - --------------------------------------------------------------------------------------------- Tier 1 Capital to average total assets $12,006 8.6% $11,774 8.5% Range of regulatory minimum leverage 4,174- 3.0- 4,170- 3.0- requirement 6,956 5.0% 6,950 5.0% - ----------------------------------------------------------------- ---------- ---------------- Range of regulatory excess 5,050- 3.6- 4,824- 3.5- $ 7,832 5.6% $ 7,604 5.5% Average total assets for first quarter* $139,119 $139,005 (* Average total assets do not include unrealized gains/losses on securities available for sale.) 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 March 31, 1999 and 1998 have not been material. YEAR 2000 READINESS DISCLOSURE The following discussion of the implications of the Year 2000 problem for the Company contains numerous forward-looking statements based on inherently uncertain information. The cost of the project and the date on which the Company plans to complete the internal Year 2000 modifications are based on management's best estimates, which were derived utilizing a number of assumptions of future events including the continued availability of internal and external resources, third party modifications and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ. Moreover, although management believes it will be able to make the necessary modifications in advance, there can be no guarantee that failure to modify the systems would not have a material adverse affect on the Company. In addition, the Company places a high degree of reliance on computer systems of third parties, such as customers, suppliers, and other financial and governmental institutions. Although the Company continues to assess the readiness of these third parties and is preparing contingency plans, there can be no guarantees that the failure of any one of these third parties to modify their systems in advance of December 31, 1999 would not have a material adverse affect on the Company. Many computer hardware systems and software programs in use today were developed using a two digit date code to specify the year. As a result many systems and programs that are date sensitive will treat "00" as the year 1900, and not properly recognize the date transition at the year 2000. An additional issue is that 1900 was not a leap year, whereas the year 2000 is. Therefore, some programs may not properly provide for February 29, 2000. The Company initiated its Year 2000 planning in 1997 and has prepared a comprehensive written plan which addresses both internal and external Year 2000 exposure and includes the following phases - Inventory and Assessment, Renovation, Testing and Implementation, and Contingency Planning. INVENTORY & ASSESSMENT The Company completed its inventory and assessment phase during 1997. During this process the Company made a physical inventory of information technology ("IT") systems and non-IT systems at each office location. Additionally, all vendor supplied services were reviewed to identify IT and non-IT Year 2000 issues. The systems examined included hardware and software platforms associated with customer account processing, computer networks and workstations, and telecommunications systems. Although the assessment determined that there was no significant reliance on non-IT technology (that is, equipment with embedded microprocessor controls such as elevators, climate control systems, etc.), it did identify mission critical IT systems, both internal and external that were not Year 2000 compliant. These noncompliant systems included data processing applications provided by third party suppliers, the teller platform at two branch offices of the Bank, and some of the hardware and software elements of the Bank's Wide Area Network ("WAN") computer network. The WAN is a centralized, server based, system that interconnects employees' desktop PC workstations at each location. One additional element of Year 2000 concern has been the Bank's customers. The Bank is reliant on its customers to make the necessary preparations for the Year 2000 so that their business operations will not be interrupted, thus threatening their ability to honor financial commitments. In an ongoing effort to ensure that its customer base is aware of the Year 2000 issue, during the second quarter of 1998 the Bank mailed to each commercial account, and included in each commercial account loan and deposit account statement, a letter addressing Year 2000 issues and encouraging the assessment of Year 2000 risk. Year 2000 reference resources for businesses were also provided. As part of its customer Year 2000 assessment, the Bank identified all commercial account borrowing relationships in excess of $100,000. These represented over 200 relationships and approximately 95% of the total borrowings outstanding as of June 30, 1998. Each of these business relationships was analyzed as to its potential for Year 2000 risk and approximately 20% were selected to receive a detailed Year 2000 questionnaire. The questionnaire, requesting additional information on Year 2000 status, was delivered to these selected customers during the third quarter of 1998. The completed questionnaires were analyzed for risk and each borrower was assigned a Year 2000 risk rating. As a result of this analysis, the Bank modified its credit review process and its underwriting criteria to include consideration of Year 2000 issues. RENOVATION, TESTING & IMPLEMENTATION The correction and testing phase of the Company's Year 2000 Plan includes the renovation and/or replacement of all mission critical IT hardware, software and equipment identified as not compliant with the Year 2000. The majority of the internal mission critical renovation centered around the upgrade to the Bank's WAN and teller systems. The installation of the Year 2000 compliant teller system was completed by December 31, 1998. To ensure Year 2000 compliance of its WAN and reduce the administrative overhead of its IT systems, management determined that a complete renovation of the WAN would provide the most cost effective solution. Most of the elements of the Bank's WAN upgrade were completed by December 31, 1998. Due to the overall complexity of this project, however, only a few of the desktop workstations were operational on the new system at that time. Current projections are for all users to be converted over to the new Year 2000 compliant system during the second quarter of 1999. The Bank relies on two primary off-site data processing vendors for the mission critical processing of the Bank's customer accounting system and general ledger applications. These vendors identified certain Year 2000 compliance issues and the renovations to these systems were completed by December 31, 1998. Testing of these systems was completed during the first quarter of 1999. Although no vendors were identified where the inability to be Year 2000 compliant would cause the Company to seek alternative suppliers, the Company has no viable alternatives for some vendors, such as power distribution and local telephone companies. The Year 2000 efforts of these companies continue to be monitored and are part of the Company's contingency plan. As with all financial institutions, the Company places a high degree of reliance on systems of other institutions, including governmental agencies, to settle transactions. In compliance with FFIEC guidelines, the Company has met all testing requirements at or prior to the time such requirements were required to have been met and the present schedule reflects completion of all remaining testing by June 30, 1999. The remaining scheduled testing includes only non-critical applications or is a result of software upgrades. The Company will perform additional testing through the remainder of 1999 when appropriate or when changes are made in hardware or software, however, few changes are anticipated. COSTS The majority of the costs associated with the Company's Year 2000 project are for the installation and testing of the components to upgrade the Bank's teller systems and WAN. Included in this project were improved communication connections between offices, higher capacity computer file servers, and operating system upgrades for the entire network. While these investments were not specifically accelerated due to the Company's Year 2000 project, these costs have been included. The Company invested approximately $78,000 in the first quarter of 1999 for capital improvements to the WAN. As of March 31, 1999, total investment in this project was $ 153,000 with an estimated additional $82,000 remaining to be incurred.. The capital cost to upgrade the Bank's teller system for Year 2000 compliance, which was completed in the first quarter of 1999, was $60,000 of which $42,000 was paid in the first quarter of 1999. Other costs incurred by the Company as of March 31, 1999 include staff time devoted to the issue at a cost of approximately $6,000 and outside consulting of $28,000 for the first quarter of 1999. Costs to-date at March 31, 1999 for staff time and outside consulting were $21,000 and $35,000, respectively. Current estimates of additional costs for staff and outside consultants in 1999 and the year 2000 are $29,000. While management believes it has identified and planned for the resolution of the mission critical issues relevant to the Year 2000, no assurance can be given that the Company may not be required to expend significant additional amounts related to the Year 2000 issue. RISKS The principal risks associated with the Year 2000 problem primarily fall into three categories. The first risk is that the Company is unable to successfully renovate and/or migrate to Year 2000 compliant systems. The second risk is the disruption of operations due to the failure of third parties. The third is the risk of business interruption among fund providers and fund users which affects their ability to contractually perform. The only risk largely under the Company's control for the Year 2000 project is the identification, renovation and implementation of its internal operations. The Company, like other financial institutions, is heavily dependent upon its computer systems. Reliance on readily available PC-based systems and technology for WAN and desktop workstations has simplified this process to some extent, and management believes it will be able to make the necessary renovations of its internal systems for Year 2000 compliance. Because of the reliance on outside vendors for processing mission critical customer accounting systems, a computer failure of a third party may jeopardize Company operations. How serious this would be depends on the nature and duration of such failures. Because of the complexity, integration and dependence of these outside systems to the Company's operations, switching to another vendor on short notice does not represent a viable option. At this time, management believes that the necessary renovations to these third party systems will be completed on schedule. Another serious impact to Company operations would occur if basic services such as telecommunications, electric power supplies and services provided by other governmental agencies were disrupted. To date definitive public disclosure of the state of readiness among basic infrastructure suppliers has not been generally available. Although inquiries continue, the Company does not yet have the information to estimate the likelihood of significant disruptions among these suppliers. CONTINGENCY PLANNING The Company has developed contingency plans for the Year 2000 in the event that remediation is not completed in time, or if systems fail for reasons that are not presently foreseen. In the event of a failure, these plans outline the steps that will be taken to deal with the situation to minimize the effect on customers and losses to the Company. As the Company's identified Year 2000 risks are largely concentrated with the ability of third parties to provide services after the year 2000, contingency plans being developed will primarily concentrate on the inability of these suppliers to complete their Year 2000 projects. Based upon currently known information, management believes that its primary vendors have the resources to complete their Year 2000 projects successfully and on time. Apart from the Company's Year 2000 project, federal banking regulators are conducting special examinations of FDIC-insured financial institutions and third party data processors, including suppliers to the Company, to determine whether they are taking necessary steps to prepare for the Year 2000. They are closely monitoring the progress made by these institutions in completing key steps required by their individual Year 2000 plans. The Company's disclosure and announcement herein concerning its Year 2000 planning and programs are intended to constitute "year 2000 readiness disclosures" as defined in the recently-enacted Year 2000 Information and Readiness Disclosure Act (the "Act"). The Act provided certain protection from liability for certain public and private statements concerning an entity's Year 2000 readiness and the Year 2000 readiness of its products and services. PART II - OTHER INFORMATION Item 5. Other Information: None Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits: Exhibit 10.2.1 Amendment to Employee Stock Ownership Plan, dated January 22, 1997; Exhibit 10.9.1 Amendments to 401(k) Profit Sharing Plan, dated December 12, 1994, and December 30, 1993. (b) Reports on Form 8-K: No reports on Form 8-K were filed by the Company for the quarter ended March 31, 1999. 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: May 13, 1999 /s/ R. M. Kahler -------------------- R. M. Kahler President and Chief Executive Officer (Principal Executive Officer) Date: May 13, 1999 /s/ R. D. Greenfield --------------------- R. D. Greenfield Chief Financial Officer (Principal Accounting Officer)