FORM 10-QSB U.S. Securities and Exchange Commission Washington, D.C. 20549 (Mark One) [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 EXCHANGE ACT For the transition period from ________ to________ Commission file number: 33-76832 MCB FINANCIAL CORPORATION (exact name of small business issuer) California 68-0300300 (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.) 1248 Fifth Avenue, San Rafael, California 94901 (Address of principal executive offices) (415) 459-2265 (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: November 13, 1996 Class Common stock, no par value 898,324 PART I - FINANCIAL INFORMATION Item 1. Financial Statements: MCB FINANCIAL CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS September 30, December 31, 1996 1995 ASSETS (Unaudited) Cash and due from banks $ 7,227,325 $ 7,706,117 Federal funds sold 2,320,000 4,860,000 Total cash and cash equivalents 9,547,325 12,566,117 Interest-bearing deposits with banks 384,000 1,269,000 Investment securities (market value of $35,719,718 and $39,332,581) 36,200,762 39,232,892 Mortgage loans sold pending settlement 862,400 3,515,620 Loans held for investment (net of allowance for possible credit losses of $945,545 in 1996 and $752,358 in 1995) 77,993,446 58,612,151 Premises and equipment - net 2,359,627 2,550,871 Accrued interest receivable 866,655 983,158 Deferred income taxes 110,788 1,483,758 Other assets 1,411,336 2,102,508 Total assets $ 129,736,339 $ 122,316,075 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits: Noninterest-bearing $ 24,383,082 $ 21,758,760 Interest-bearing: Transaction accounts 73,275,836 64,160,115 Time certificates, $100,000 and over 9,170,401 9,106,755 Savings and other time deposits 11,327,431 15,237,740 Total interest-bearing deposits 93,773,668 88,504,610 Total deposits 118,156,750 110,263,370 Other borrowings 750,500 213,378 Accrued interest payable and other liabilities 997,107 3,568,592 Total liabilities 119,904,357 114,045,340 Commitments and contingencies SHAREHOLDERS' EQUITY Preferred stock, no par value: authorized 20,000,000 shares; none issued or outstanding Common stock, no par value: authorized 20,000,000 shares; issued and outstanding 898,324 shares in 1996 and 1995 8,908,876 8,908,876 Unrealized (loss) gain on investment securities available for sale - net (78,312) 9,691 Retained earnings (accumulated deficit) 1,001,418 (647,832) Total shareholders' equity 9,831,982 8,270,735 Total liabilities and shareholders' equity $ 129,736,339 $ 122,316,075 See notes to condensed consolidated financial statements. MCB FINANCIAL CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS Three Months Ended For the Nine Months September 30, Ended September 30, 1996 1995 1996 1995 (Unaudited) (Unaudited) INTEREST INCOME: Loans, including fees $2,095,254 $1,656,866 $5,589,186 $4,547,093 Federal funds sold 32,487 160,622 190,665 346,140 Investment securities 609,622 538,111 1,857,321 1,435,825 Total 2,737,363 2,355,599 7,637,172 6,329,058 INTEREST EXPENSE: Interest-bearing transaction, savings and other time deposits 879,456 888,525 2,614,568 2,385,538 Time certificates, $100,000 and over 122,819 133,701 368,705 357,927 Other interest 9,088 8,588 23,747 61,235 Total 1,011,363 1,030,814 3,007,020 2,804,700 NET INTEREST INCOME 1,726,000 1,324,785 4,630,152 3,524,358 PROVISION FOR POSSIBLE CREDIT LOSSES 35,000 175,000 40,000 NET INTEREST INCOME AFTER PROVISION FOR POSSIBLE CREDIT LOSSES 1,691,000 1,324,785 4,455,152 3,484,358 OTHER INCOME: Gain on sale of loans 88,994 133,089 347,607 328,244 Service fees on deposit accounts 96,645 63,342 286,058 179,370 Loan servicing fees 6,083 17,453 4,207 Recovery of litigation expenses 1,824,689 451,640 Other 29,857 24,044 104,980 70,559 Total 221,579 220,475 2,580,787 1,034,020 OTHER EXPENSES: Salaries and employee benefits 720,889 692,792 2,449,634 2,296,505 Occupancy expense 180,828 172,927 529,594 543,416 Furniture and equipment expense 96,386 96,273 292,692 262,032 Professional services 75,946 129,483 137,808 384,617 Supplies 52,971 49,858 172,734 196,209 Promotional expenses 67,105 45,724 157,515 232,983 Data processing fees 69,004 62,865 200,935 167,740 Regulatory assessments 11,516 7,285 34,143 109,901 Provision for legal settlement 2,800,000 Other 86,392 53,687 252,108 315,137 Total 1,361,037 1,310,894 4,227,163 7,308,540 INCOME (LOSS) BEFORE INCOME TAXES 551,542 234,366 2,808,776 (2,790,162) INCOME TAXES (BENEFIT) 224,888 86,785 1,159,526 (1,067,415) NET INCOME (LOSS) $326,654 $147,581 $1,649,250 ($ 1,722,747) NET INCOME (LOSS) PER COMMON SHARE: Primary and fully diluted $ 0.36 $ 0.16 $ 1.83 ($ 1.91) See notes to condensed consolidated financial statements. MCB FINANCIAL CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS For the Nine Months Ended September 30, 1996 1995 OPERATING ACTIVITIES: (Unaudited) Net income $1,649,250 $(1,722,747) Adjustments to reconcile net income to net cash provided by operating activities: Originations of loans for sale (26,407,000) (31,963,000) Settlement of mortgage loans sold 29,060,220 34,156,050 Provision for possible credit losses 175,000 40,000 Depreciation and amortization 400,063 204,136 Loss on sale of other real estate owned 9,972 Provision for legal settlement 2,800,000 Loss on sale of investment securities 56,243 Recovery of litigation expenses (1,800,000) Change in deferred income taxes 1,435,503 (643,830) Decrease (increase) in accrued interest receivable 116,503 (230,061) Decrease (increase) in other assets 1,915,664 (187,227) (Decrease) increase in accrued interest payable and other liabilities (1,992,765) 116,110 Net cash provided by operating activities 4,552,438 2,635,646 INVESTING ACTIVITIES: Held to maturity securities: Maturities 9,000,000 6,100,000 Purchases (16,238,750) (23,800,615) Available for sale securities: Sales 1,731,520 Maturities 10,998,591 620,305 Purchases (1,000,481) (933,469) Decrease (increase) in interest-bearing deposits with banks 885,000 (585,000) Proceeds from sale of other real estate owned 286,090 Net increase in loans held for investment (19,556,295) (9,979,834) Purchases of premises and equipment (89,797) (373,921) Net cash used by investing activities (16,001,732) (26,934,924) FINANCING ACTIVITIES: Net increase in noninterest-bearing demand deposits 2,624,322 4,296,496 Net increase in interest-bearing transaction, savings and other time deposits 5,269,058 27,121,667 Net increase (decrease) in other borrowings 537,122 (3,769,412) Purchases of common stock (104,970) Net cash provided by financing activities 8,430,502 27,543,781 NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (3,018,792) 3,244,503 CASH AND CASH EQUIVALENTS: Beginning of period 12,566,117 7,062,896 End of period $9,547,325 $10,307,399 CASH PAID DURING THE PERIOD FOR: Interest on deposits and other borrowings $3,155,374 $2,716,081 Income taxes 1,600 See notes to condensed consolidated financial statements. MCB FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1996 Item 1. Financial Statements Introduction and Basis of Presentation The unaudited consolidated financial information included herein has been prepared in conformity with the accounting principles and practices in MCB Financial Corporation's ("the Company") consolidated financial statements included in the Annual Report for the year ended December 31, 1995. The accompanying interim consolidated financial statements contained herein are unaudited. However, in the opinion of the Company, all adjustments, consisting of normal recurring items necessary for a fair presentation of the operating results for the periods shown, have been made. The results of operations for the nine months ended September 30, 1996 may not be indicative of operating results for the year ended December 31, 1996. Certain prior year and prior quarter amounts have been reclassified to conform to current classifications. Cash and cash equivalents consists of cash, due from banks, and federal funds sold. Legal In September 1992, Chino Valley Bank filed a lawsuit against Metro Commerce alleging that Metro Commerce and its Chief Executive Officer, John Cavallucci, had engaged in unfair competition with Chino Valley Bank. In June 1995, a jury rendered a verdict in favor of Chino Valley Bank and against Metro Commerce and Mr. Cavallucci in the amount of $795,000. Subsequently during 1995 Metro Commerce established a legal contingency reserve of $2.8 million, based on the amount of the jury verdict, the legal costs expected to be incurred by Metro Commerce, and the possibility of an award of attorneys' fees to the plaintiff. In addition, Metro Commerce agreed to indemnify Mr. Cavallucci for the amount of his personal liability to Chino Valley Bank, and Metro Commerce and Mr. Cavallucci reached an agreement with Metro Commerce's directors and officers liability insurance carrier pursuant to which the carrier agreed to pay $1.2 million of the amounts awarded to Chino Valley Bank. In February 1996, the trial court awarded Chino Valley Bank costs and attorneys' fees in the amount of $1,327,438. Subsequently, in March 1996 Metro Commerce and Mr. Cavallucci entered into a settlement agreement with Chino Valley Bank pursuant to which the parties agreed to settle all claims upon the payment of $2,100,000 to Chino Valley Bank. As a result of the settlement agreement with Chino Valley Bank and the separate settlement with Metro Commerce's insurance carrier, Metro Commerce recovered and reversed approximately $1.8 million from the legal contingency reserve during the first quarter of 1996. This recovery reflects the final settlement of this matter. Recently Issued Accounting Pronouncements On January 1, 1996, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options, restricted stock and stock appreciation rights. The Statement defines a "fair value-based method" of accounting for employee stock options and encourages all entities to adopt that method of accounting for all of their employee stock compensation plans. However, it also allows an entity to continue to measure compensation for those plans using the "intrinsic value- based method" under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (Opinion No. 25). All of the Company's stock options have no intrinsic value at grant date, and under Opinion No. 25, no compensation cost is recognized for them. SFAS No. 123 requires that an employer's financial statements include certain disclosures about stock- based compensation arrangements regardless of the method used to account for them. An employer that continues to apply the accounting provisions of Opinion No. 25 will disclose pro forma amounts that reflect the difference between compensation cost, if any, included in net income and the related cost measured by the fair value-based method, including tax effects, that would have been recognized in the income statement if the fair value-based method had been used. The Company will continue to apply Opinion No. 25 in accounting for stock-based compensation plans. In June of 1996, SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" was issued. This statement establishes standards for when transfers of financial assets, including those with continuing involvement by the transferor, should be considered a sale. SFAS No. 125 also establishes standards for when a liability should be considered extinguished. This statement is effective for transfers of assets and extinguishments of liabilities after December 31, 1996, applied prospectively. Earlier adoption or retroactive application of this statement is not permitted. Management will be reviewing this statement during the remainder of 1996 to determine its effect on the Company's financial statements. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion presents information pertaining to the financial condition and results of operation of MCB Financial Corporation ("Company") and should be read in conjunction with the financial statements and notes thereto presented in this 10- QSB. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances. OVERVIEW Earnings Summary. The Company reported net income of $326,654, or $0.36 per share, for the third quarter of 1996. This compares to net income of $147,581 or $0.16 per share, for the same period in 1995. Improvement in net interest income, due to the recent rise in commercial loan activity, continued to positively impact the net interest margin. In addition, the Company's efficiency ratio (noninterest expense divided by operating income) improved to 69.9% from 84.8% in the third quarter of 1995. For the nine months ended September 30, 1996, the Company reported net income of $1,649,250, or $1.83 per share. This compares to a net operating loss of $1,722,747, or $1.91 per share, for the same period of 1995. During the first quarter of 1996, the Company recovered approximately $1.8 million from its litigation contingency reserve in conjunction with the settlement of its outstanding litigation. Return on average assets and return on average equity for the third quarter of 1996 were 1.02% and 13.45%, respectively, as compared to 0.50% and 7.44%, respectively, for the same period of 1995. Return on average assets and return on average equity for the nine months ended September 30, 1996 were 1.76% and 23.98%, respectively, as compared to (2.19%) and (25.50%), respectively, for the same period of 1995. FINANCIAL CONDITION Summary. Total assets of the Company increased by $7.4 million, or 6.1%, from the end of 1995 to reach $129.7 million at September 30, 1996. This increase resulted from growth in existing operations. Investment Securities. Investment securities totaled $36.2 million at September 30, 1996. This represented a $3.0 million, or 7.7%, decrease from the December 31, 1995 balance of $39.2 million. Investments decreased as proceeds from maturities were used to fund commercial loans during the period. Loans Held for Investment. Net loans held for investment increased by $19.4 million, or 33.1%, during the first nine months of 1996. Most of the growth came from an increase in commercial real estate refinancings due to lower interest rates and a 10-year commercial real estate financing program the Company offered to small businesses from March to August. The following table sets forth the amount of total loans outstanding by category as of the dates indicated: Total Loans September 30, December 31, (dollar amounts in thousands) 1996 1995 Commercial $19,789 $16,145 Real estate: Commercial 45,183 32,161 Construction 6,759 4,388 Land 1,951 1,882 Home equity 2,830 2,903 Loans to consumers and individuals 2,464 1,960 Total 78,976 59,439 Deferred loan fees (37) (75) Allowance for possible credit losses (946) (752) Total net loans $77,993 $58,612 In the normal practice of extending credit, the Company accepts real estate collateral on loans which have primary sources of repayment from commercial operations. The total amount of loans secured by real estate equaled $62.1 million, or 78.6% of the total portfolio as of September 30, 1996. Due to the Company's limited marketing area, its real estate collateral is concentrated primarily in Northern California. The Company believes that its prudent underwriting standards for real estate secured loans provides an adequate safeguard against decreasing real estate prices. The Company focuses its portfolio lending on commercial, commercial real estate, and construction loans. These loans generally carry a higher level of risk than conventional real estate loans, accordingly, yields on these loans are typically higher than those of other loans. The performance of commercial and construction loans is generally dependent upon future cash flows from business operations (including the sale of products, merchandise and services) and the successful completion or operation of large real estate projects. Risks attributable to such loans can be significantly increased, often to a greater extent than other loans, by regional economic factors, real estate prices, the demand for commercial and retail office space, and the demand for products and services of industries which are concentrated within the Company's loan portfolio. As of September 30, 1996, the two largest industry concentrations within the loan portfolio were real estate and related services at 21.8% and the business/personal service industry at 18.5% of the portfolio. Because credit concentrations increase portfolio risk, the Company places significant emphasis on the purpose of each loan and the related sources of repayment. The Company generally limits unsecured commercial loans to maturities of three years and secured commercial loans to maturities of five years. Mortgage Loans. Mortgage loans sold pending settlement totaled $0.9 million at September 30, 1996, as compared to $3.5 million at December 31, 1995. The outstanding aggregate amount of mortgage loans is dependent upon the volume of mortgage originations, loan delivery schedules, and sale transaction settlement dates. During the third quarter of 1996, the Company's mortgage origination volume was $6.2 million as compared to $12.6 million during the same period of 1995. Higher interest rates and the lack of real estate transaction activity have severely impacted the mortgage market since the second quarter of 1994. Nonperforming Assets. The Company carefully monitors the quality of its loan portfolio and the factors that effect it including regional economic conditions, employment stability, and real estate values. It is the Company's policy to transfer loans which become 90 days or more past due, from either delinquent principal or interest payments, to "nonaccrual" status. No additional interest income is recognized once a loan is classified as nonaccrual. If previously accrued interest is deemed uncollectable, it is reversed from interest income. As of September 30, 1996, the Company had one nonperforming loan in the amount of $78,731. Had this loan performed under its contractual terms $6,508 in additional interest income would have been recognized during 1996. The following table sets forth the balance of nonperforming assets as of the dates indicated. Nonperforming Assets September 30, December 31, (dollar amounts in thousands) 1996 1995 Nonaccrual loans $ 79 $ Loans 90 days or more past due and still accruing Other real estate owned $ 79 $ As a percent of total loans 0.10% 0.00% As a percent of total assets 0.06% 0.00% At September 30, 1996, the Company had one loan identified as impaired in accordance with Statement of Financial Accounting Standards ("SFAS") No. 114, Accounting by Creditors for Impairment of a Loan and SFAS No. 118 (an amendment to SFAS No. 114), in the amount of $78,731. The Company provided no allowance for possible credit losses at September 30, 1996 for this impaired loan. Allowance for Possible Credit Losses. The Company maintains an allowance for possible credit losses ("APCL") which is reduced by credit losses and increased by credit recoveries and provisions to the APCL charged against operations. Provisions to the APCL and the total of the APCL are based, among other factors, upon the Company's credit loss experience, current and projected economic conditions, the performance of loans within the portfolio, evaluation of loan collateral value, and the prospects or worth of respective borrowers and guarantors. In determining the adequacy of its APCL and after carefully analyzing each loan individually, the Company segments its loan portfolio into pools of homogeneous loans that share similar risk factors. Each pool is given a risk assessment factor which largely reflects the expected future losses from each category. These risk assessment factors change as economic conditions shift and actual loan losses are recorded. As of September 30, 1996, the APCL of $945,545, or 1.19% of total loans was determined to be adequate against foreseeable future losses. The following table summarizes, for the periods indicated, loan balances at the end of each period and average balances during the period, changes in the APCL arising from credit losses, recoveries of credit losses previously incurred, additions to the APCL charged to operating expense, and certain ratios relating to the APCL (dollar amounts in thousands): September 30, December 31, 1996 1995 Balances: Average loans during period (includes mortgage loans held for sale) $69,299 $56,589 Loans at end of period (includes mortgage loans held for sale) 79,801 62,880 Allowance for Possible Credit Losses: Balance at beginning of period 752 906 Actual credit losses: Commercial loans 242 Loans to consumers and individuals 21 Total 263 Actual credit recoveries: Commercial loans 16 9 Loans to consumers and individuals 3 Total 19 9 Net credit losses (19) 254 Provision charged to operating expenses 175 100 Balance at end of period $ 946 $ 752 Ratios: Net credit losses to average loans -0.03% 0.45% Allowance for possible credit losses to loans at end of period 1.19% 1.20% Net credit losses to beginning of period allowance for credit losses -2.53% 28.04% As a prudent measure, based upon recent growth in the loan portfolio, the Company provided $35,000 to the allowance for possible credit losses during the third quarter of 1996. No loan loss provision was recorded during the third quarter of 1995. For the nine months ended September 30, 1996, based upon growth in the loan portfolio, the Company provided $175,000 to the allowance for possible credit losses as compared to $40,000 during the same period of 1995. Net credit losses in 1995 resulted from the write-off of substandard loans acquired when the Company purchased the Bank of Hayward in 1994. These loans were reflected in the allowance for possible credit losses acquired from the Bank of Hayward. The following table sets forth the allocation of the APCL as of the dates indicated (dollar amounts in thousands): September 30, December 31, 1996 1995 % of % of Category Category to Total to Total APCL Loans APCL Loans Commercial loans $611 45.18% $324 46.21% Real estate loans 187 47.65% 248 45.11% Consumer loans 50 7.18% 46 8.68% Not allocated 98 N/A 134 N/A Total $946 100.00% $752 100.00% The allowance is available to absorb losses from all loans, although allocations have been made for certain loans and loan categories. The allocation of the allowance as shown above should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. In addition to the most recent analysis of individual loans and pools of loans, management's methodology also places emphasis on historical loss data, delinquency and nonaccrual trends by loan classification category and expected loan maturity. This analysis, management believes, identifies potential losses within the loan portfolio and therefore results in allocation of a large portion of the allowance to specific loan categories. Deposits/Other Borrowings. Total consolidated deposits increased by $7.9 million, or 7.2%, during the nine months ended September 30, 1996. This increase was primarily the result of growth in existing operations. Lower interest rates and growth in noninterest-bearing demand deposits during the nine months ended September 30, 1996 caused the cost of funds to decrease to 3.51% from 3.89% during 1995. The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated (dollar amounts in thousands): Nine Months Ended Year Ended September 30, 1996 December 31, 1995 Average Average Average Average Balance Rate Balance Rate Noninterest-bearing demand deposits $ 21,897 $ 16,691 Interest-bearing demand deposits (includes money market deposit accounts) 69,724 4.12% 55,927 4.46% Savings deposits 2,494 1.97% 2,430 2.22% Time deposits, $100,000 and over 8,911 5.52% 8,541 5.78% Other time deposits 10,411 5.46% 13,357 5.50% Total interest-bearing 91,540 4.34% 80,255 4.70% Total deposits $ 113,437 3.51% $ 96,946 3.89% The following table sets forth the time remaining to maturity of the Company's time deposits in amounts of $100,000 or more (dollar amounts in thousands): September 30, December 31, Time remaining to maturity 1996 1995 Three months or less $ 3,259 $ 3,637 After three months to six months 2,545 2,182 After six months to one year 2,111 2,148 After twelve months 1,255 1,140 Total $ 9,170 $ 9,107 RESULTS OF OPERATIONS Net Interest Income/Net Interest Margin. Net interest income for the quarter ended September 30, 1996 was $1,726,000, an increase of 30.3% over the net interest income of $1,324,785 during the same period of 1995. Net interest income for the nine months ended September 30, 1996 was $4,630,152, an increase of 31.4% over the net interest income of $3,524,358 during the same period of 1995. The increases in both periods were primarily due to the growth in commercial lending. The following table sets forth average assets, liabilities, and shareholders' equity; the amount of interest income or interest expense; and the average yield or rate for each category of interest-bearing assets and interest-bearing liabilities and the net interest margin (net interest income divided by average earning assets) for the periods indicated (dollar amounts in thousands): For the quarter ended September 30, 1996 1995 Average Average Balance Interest Rate Balance Interest Rate ASSETS Federal funds sold $ 2,531 $ 32 5.06% $ 11,109 $ 161 5.80% Interest-bearing deposits with banks 467 7 6.00% 1,049 18 6.86% Investment securities 38,247 603 6.32% 35,496 520 5.87% Mortgage loans held for sale 964 21 8.71% 1,940 37 7.63% Loans 74,472 2,074 11.14% 55,885 1,620 11.60% Total earning assets 116,681 2,737 9.39% 105,479 2,356 8.94% Total non-earning assets 11,238 10,809 Total assets $ 127,919 $ 116,288 LIABILITIES & SHAREHOLDERS' EQUITY Demand deposits $ 23,734 $ 17,762 Interest-bearing transaction accounts 71,962 746 4.15% 61,982 678 4.38% Time deposits, $100,000 or more 9,105 123 5.40% 8,746 134 6.13% Savings and other time 11,580 133 4.59% 16,055 210 5.23% Total interest-bearing deposits 92,647 1,002 4.33% 86,783 1,022 4.71% Other borrowings 799 9 4.51% 655 9 5.50% Total interest-bearing liabilities 93,446 1,011 4.33% 87,438 1,031 4.72% Other liabilities 1,026 3,219 Shareholders' equity 9,713 7,869 Total liabilities and shareholders' equity $ 127,919 $ 116,288 Net interest income $ 1,726 $ 1,325 Net interest margin 5.92% 5.03% For the nine months ended September 30, 1996 1995 Average Average Balance Interest Rate Balance Interest Rate ASSETS Federal funds sold $ 4,878 $ 191 5.22% $ 7,926 $ 346 5.82% Interest-bearing deposits with banks 747 35 6.25% 849 42 6.59% Investment securities 39,287 1,822 6.19% 32,759 1,394 5.75% Mortgage loans held for sale 1,660 103 8.27% 2,211 130 7.84% Loans 66,783 5,486 10.95% 51,801 4,417 11.37% Total earning assets 113,355 7,637 8.99% 95,546 6,329 8.86% Total non-earning assets 11,856 9,845 Total assets $ 125,211 $ 105,391 LIABILITIES & SHAREHOLDERS' EQUITY Demand deposits $ 21,897 $ 15,752 Interest-bearing transaction accounts 69,724 2,152 4.12% 53,465 1,804 4.50% Time deposits, $100,000 or more 8,911 369 5.52% 8,394 358 5.69% Savings and other time 12,905 462 4.77% 15,800 582 4.91% Total interest-bearing deposits 91,540 2,983 4.34% 77,659 2,744 4.71% Other borrowings 690 24 4.64% 1,392 61 5.84% Total interest-bearing liabilities 92,230 3,007 4.35% 79,051 2,805 4.73% Other liabilities 1,915 1,554 Shareholders' equity 9,169 9,034 Total liabilities and shareholders' equity $ 125,211 $ 105,391 Net interest income $ 4,630 $ 3,524 Net interest margin 5.45% 4.94% The net interest margin increased to 5.92% during the third quarter of 1996 from 5.03% in the same quarter of 1995. For the nine months ended September 30, 1996, the net interest margin increased to 5.45% from 4.94% for the same period of 1995. The increase in both periods was primarily attributable to an increase in commercial loan activity and noninterest bearing deposits. The following table presents the dollar amount of changes in interest earned and interest paid for each major category of interest-earning asset and interest-bearing liability and the amount of change attributable to average balances (volume) fluctuations and average rate fluctuations. The variance attributable to both balance and rate fluctuations is allocated to a combined rate/volume variance (dollar amounts in thousands). Quarter Ended September 30, 1996 Nine Months Ended September 30, 1996 Compared to Compared to Quarter Ended September 30, 1995 Nine Months Ended September 30, 1995 Change in Change in Rate/ Rate/ Volume Rate Volume Total Volume Rate Volume Total Interest Income: Federal funds sold ($124) ($21) $16 ($129) ($133) ($36) $14 ($155) Interest-bearing deposits with banks (10) (2) 1 (11) (5) (2) 0 (7) Investment securities 40 40 3 83 282 108 38 428 Mortgage loans held for sale (18) 5 (3) (16) (32) 7 (2) (27) Loans 539 (64) (21) 454 1,279 (163) (47) 1,069 Total Interest Income 427 (42) (4) 381 1,391 (86) 3 1,308 Interest Expense: Interest-bearing transaction accounts 110 (36) (6) 68 546 (152) (46) 348 Time deposits, $100,000 or more 6 (16) (1) (11) 23 (11) (1) 11 Savings and other time (58) (26) 7 (77) (106) (17) 3 (120) Other borrowings 2 (2) 0 0 (30) (13) 6 (37) Total Interest Expense 60 (80) 0 (20) 433 (193) (38) 202 Net Interest Income $367 $38 ($4) $401 $958 $107 $41 $1,106 Noninterest Income. The following table summarizes noninterest income for periods indicated and expresses the amounts as a percentage of average assets (dollar amounts in thousands). Quarter Ended Nine Months Ended September 30, September 30, Components of Noninterest Income 1996 1995 1996 1995 Gain on sale of loans $ 89 $ 133 $ 348 $ 328 Service fees on deposit accounts 97 63 286 179 Loan servicing fees 6 17 4 Recovery of litigation expenses 1,825 452 Other 30 24 105 71 Total $ 222 $ 220 $ 2,581 $ 1,034 As a Percentage of Average Assets (Annualized) Gain on sale of loans 0.28% 0.46% 0.37% 0.41% Service fees on deposit accounts 0.30% 0.22% 0.30% 0.23% Loan servicing fees 0.02% 0.00% 0.02% 0.01% Recovery of litigation expenses 0.00% 0.00% 1.94% 0.57% Other 0.09% 0.08% 0.11% 0.09% Total 0.69% 0.76% 2.74% 1.30% During the first quarter of 1996, the Company recovered $1.8 million from its litigation contingency reserve. The recovery resulted from the settlement agreement reached in conjunction with the Company's outstanding litigation. During the nine months ended September 30, 1995, the Company received reimbursements totaling $452,000 from its primary liability insurers for litigation expenses incurred in prior periods. Noninterest Expenses. The following table summarizes noninterest expenses and the associated ratios to average assets for the periods indicated (dollar amounts in thousands). Quarter Ended Nine Months Ended September 30, September 30, Components of Noninterest Expense 1996 1995 1996 1995 Salaries and employee benefits $ 721 $ 693 $ 2,450 $ 2,297 Occupancy expense 181 173 530 543 Furniture and equipment expense 96 96 292 262 Professional services 76 129 138 385 Supplies 53 50 173 196 Promotional expenses 67 46 157 233 Data processing fees 69 63 201 168 Regulatory assessments 12 7 34 110 Provision for legal settlement 2,800 Other 86 54 252 315 Total $ 1,361 $ 1,311 $ 4,227 $ 7,309 Average full-time equivalent employees 50 46 50 52 As a Percentage of Average Assets (Annualized) Salaries and employee benefits 2.25% 2.38% 2.61% 2.91% Occupancy expense 0.57% 0.60% 0.56% 0.69% Furniture and equipment expense 0.30% 0.33% 0.31% 0.33% Professional services 0.24% 0.44% 0.15% 0.49% Supplies 0.17% 0.17% 0.18% 0.25% Promotional expenses 0.21% 0.16% 0.17% 0.29% Data processing fees 0.22% 0.22% 0.21% 0.21% Regulatory assessments 0.04% 0.02% 0.04% 0.14% Provision for legal settlement 0.00% 0.00% 0.00% 3.54% Other 0.27% 0.19% 0.27% 0.40% Total 4.26% 4.51% 4.50% 9.25% For the nine months ended September 30, 1996, noninterest expense decreased to $4.2 million from $7.3 million during the same period of the prior year. The principal reason for the decline was the creation of the legal contingency reserve of $2.8 million in the second quarter of 1995. Income Taxes. The Company's effective tax rate for the quarter ended September 30, 1996 was 40.8% as compared to 37.0% in the same period of the prior year. For the nine months ended September 30, 1996, the effective tax rate was 41.3% as compared to a 38.3% benefit in the same period of the prior year. The benefit recorded in 1995 was principally attributable to the recording of the $2.8 million legal reserve and the Company's ability to recover federal taxes paid in prior years and the expected use of net operating losses to offset future taxable income. Liquidity and Asset/Liability Management. Liquidity is the Company's ability to absorb fluctuations in deposits while simultaneously providing for the credit needs of its borrowers. The objective in liquidity management is to balance the sources and uses of funds. Primary sources of liquidity for the Company include payments of principal and interest on loans and investments, proceeds from the sale or maturity of loans and investments, growth in deposits, and other borrowings. The Company, at times, holds overnight federal funds as a cushion for temporary liquidity needs. During the nine months ended September 30, 1996, federal funds sold averaged $4.9 million, or 3.9% of total assets. In addition to its federal funds, the Company maintains various lines of credit with correspondent banks, the Federal Reserve Bank, and the Federal Home Loan Bank. At September 30, 1996, the Company had cash, time deposits with banks, federal funds sold, and unpledged investment securities of approximately $43.6 million, or 33.6% of total assets. This represented all available liquid assets, excluding mortgage loans held for sale and other assets. Several methods are used to measure liquidity. One method is to measure the balance between loans and deposits (gross loans divided by total deposits). In general, the closer this ratio is to 100%, the more reliant an institution becomes on its illiquid loan portfolio to absorb temporary fluctuations in deposit levels. At September 30, 1996, the loan-to-deposit ratio was 66.8% as compared to 53.8% at December 31, 1995. Another frequently used method is the relationship between short-term liquid assets (federal funds sold and investments maturing within one year) and short-term liabilities (total deposits and other borrowings) as measured by the liquidity ratio. The Company targets a minimum ratio of 5%. At September 30, 1996, this ratio was 6.94% as compared to 20.0% at December 31, 1995. As of September 30, 1996, the Company had no material commitments that were expected to adversely impact liquidity. Net interest income and the net interest margin are largely dependent on the Company's ability to closely match interest- earning assets with interest-bearing liabilities. As interest rates change, the Company must constantly balance maturing and repricing liabilities with maturing and repricing assets. This process is called asset/liability management and is commonly measured by the maturity/repricing gap. The maturity/repricing gap is the dollar difference between maturing or repricing assets and maturing or repricing liabilities at different intervals of time. The following tables sets forth rate sensitive interest- earning assets and interest-bearing liabilities as of September 30, 1996, the interest rate sensitivity gap (i.e. interest sensitive assets minus interest sensitive liabilities), the cumulative interest rate sensitivity gap, the interest rate sensitivity gap ratio (interest sensitive assets divided by interest sensitive liabilities) and the cumulative interest rate sensitivity gap ratio. For the purposes of the following table, an asset or liability is considered rate sensitive within a specified period when it matures or can be repriced within that period pursuant to its original contractual terms (dollar amounts in thousands): September 30, 1996 Over 90 Over 180 After One After 90 days days to days to Year to Five or less 180 days 365 days Five Years Years Total Earning Assets (Rate Sensitive): Federal funds sold $2,320 $2,320 Interest-bearing deposits with other banks 196 $98 $90 384 Investment securities 2,154 $1,158 2,326 22,200 $8,497 36,335 Mortgage loans held for sale 862 862 Loans, gross of allowance for possible losses 38,955 1,265 3,078 19,085 16,593 78,976 Total 44,487 2,423 5,502 41,375 25,090 118,877 Interest-Bearing Liabilities (Rate Sensitive): Interest-bearing transaction deposits 9,494 31,891 31,891 73,276 Time deposits, $100,000 or more 3,259 2,545 2,111 1,255 9,170 Savings and other time deposits 2,106 2,778 3,519 2,924 11,327 Other borrowings 751 751 Total 15,610 5,323 37,521 36,070 $94,524 Period GAP $28,877 $(2,900) $(32,019) $5,305 $25,090 Cumulative GAP $28,877 $25,977 $(6,042) $(737)$24,353 Interest Sensitivity GAP Ratio 64.91% (119.69%) (581.95%) 12.82% 100.00% Cumulative Interest Sensitivity 64.91% 55.38% (11.53%) (0.79%) 20.49% The Company classifies its money market accounts and savings accounts into the over 180 days to 365 days time period as well as the after one year to five years time period. This is done to adjust for the insensitivity of these accounts to changes in interest rates. Although rates on these accounts can contractually be reset at the Company's discretion, historically these accounts have not demonstrated strong correlation to changes in the prime rate. Generally, a positive gap at one year indicates that net interest income and the net interest margin will increase if interest rates rise in the future. The Company neither currently utilizes financial derivatives to hedge its asset/liability position nor has any plans to employ such strategies in the near future. Capital Resources. The principal source of capital for the Company is and will continue to be the retention of operating profits. The ratios of average equity to average assets for the periods indicated are set forth below. Nine Months Ended Year Ended September 30, 1996 December 31, 1995 7.32% 8.06% Regulatory authorities have issued guidelines to implement risk-based capital requirements. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Capital is classified into two components: tier 1 (primarily shareholder's equity) and tier 2 (supplementary capital including allowance for possible credit losses, certain preferred stock, eligible subordinated debt, and other qualifying instruments). The guidelines require that qualifying capital be 8% of risk-based assets, of which at least 4% must be tier 1 capital. As of September 30, 1996, the Company's qualifying capital was 11.51%, 10.47% of which was tier 1 capital. In addition, the Company, under the guidelines established for adequately capitalized institutions, must also maintain a minimum leverage ratio (tier 1 capital divided by total assets) of 4%. As of September 30, 1996, the Company's leverage ratio was 7.42%. PART II - OTHER INFORMATION Item 1. Legal Proceedings In September 1992, Chino Valley Bank filed a lawsuit against Metro Commerce alleging that Metro Commerce and its Chief Executive Officer, John Cavallucci, had engaged in unfair competition with Chino Valley Bank. In June 1995, a jury rendered a verdict in favor of Chino Valley Bank and against Metro Commerce and Mr. Cavallucci in the amount of $795,000. Subsequently during 1995 Metro Commerce established a legal contingency reserve of $2.8 million, based on the amount of the jury verdict, the legal costs expected to be incurred by Metro Commerce, and the possibility of an award of attorneys' fees to the plaintiff. In addition, Metro Commerce agreed to indemnify Mr. Cavallucci for the amount of his personal liability to Chino Valley Bank, and Metro Commerce and Mr. Cavallucci reached an agreement with Metro Commerce's directors and officers liability insurance carrier pursuant to which the carrier agreed to pay $1.2 million of the amounts awarded to Chino Valley Bank. In February 1996, the trial court awarded Chino Valley Bank costs and attorneys' fees in the amount of $1,327,438. Subsequently, in March 1996 Metro Commerce and Mr. Cavallucci entered into a settlement agreement with Chino Valley Bank pursuant to which the parties agreed to settle all claims upon the payment of $2,100,000 to Chino Valley Bank. As a result of the settlement agreement with Chino Valley Bank and the separate settlement with Metro Commerce's insurance carrier, Metro Commerce recovered and reversed approximately $1.8 million from the legal contingency reserve during the first quarter of 1996. This recovery reflects the final settlement of this matter. Item 2. Changes in Securities Not applicable. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Item 5. Other Information Not applicable. Item 6. Exhibits and Reports on Form 8-K. (a) List of Exhibits: (3)(a) -- Articles of incorporation (incorporated by reference to the registrant's registration statement on Form S-4 (File No. 33-76832). (3)(b) -- By-laws (incorporated by reference to the registrant's registration statement on Form S-4 (File No. 33-76832). (10)(a)(1) -- Stock Option Plan (incorporated by reference to the registrant's registration statement on Form S-4 (File No. 33-76832). (10)(a)(2) -- Deferred Compensation Plan for Executives (incorporated by reference to Exhibit (10)(a)(2) to the registrant's Annual Report on Form 10-KSB for its fiscal year ended December 31, 1994). (10)(b) -- Leases (10)(b)(1) -- San Rafael Office Lease (incorporated by reference to Exhibit (10)(b)(1) to the registrant's Annual Report on Form 10-KSB for its fiscal year ended December 31,1994). (10)(b)(2) -- South San Francisco Office Lease (incorporated by reference to Exhibit (10)(b)(2) to the registrant's Annual Report on Form 10-KSB for its fiscal year ended December 31, 1994). (10)(b)(3) -- Hayward Office Lease (incorporated by reference to Exhibit (10)(b)(3) to the registrant's Annual Report on Form 10-KSB for its fiscal year ended December 31,1994). (10)(b)(4) -- Upland Office Lease (incorporated by reference to Exhibit (10)(b)(4) to the registrant's Annual Report on Form 10-KSB for its fiscal year ended December 31, 1994). (27) -- Financial Data Schedule (b) Reports on Form 8-K None. SIGNATURES In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MCB FINANCIAL CORPORATION (Registrant) Date: November 13, 1996 By:/s/ Brian M. Riley Chief Financial Officer (Principal Accounting Officer)