SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 FORM 10-K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended: December 31, 1997 or [ ] TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission File Number: 0-13528 PACIFIC CAPITAL BANCORP - -------------------------------------------------------------------------------- (Exact Name of registrant as specified in its charter) California 77-0003875 - -------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 307 Main Street, Salinas, California 93901 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) Registrant's telephone number, including area code: (408) 757-4900 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, No Par Value -------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO _____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ X ] Aggregate market value of common stock held by nonaffiliates of Pacific Capital Bancorp at March 1, 1998: $138,921,000 Number of shares of Common Stock outstanding at March 1, 1998: 4,310,155 Documents Incorporated by Reference: Location in Form 10-K - ------------------------------------ --------------------- 1997 Annual Report to Shareholders Part I, Items 1 and 2 Proxy Statement for 1998 Annual Part III, Items 10, 11, 12 and 13 Meeting of Shareholders THIS REPORT INCLUDES A TOTAL OF 142 PAGES EXHIBIT INDEX IS ON PAGE 70 TABLE OF CONTENTS Page - --------------------------------------------------------------------------------------------------------------------- Form 10-K Annual Report Proxy (1) Statement (2) -------------------- ----------------- ---------------- Part I Item 1 Business 1 Selected Statistical Information 4 Distribution of Average Assets, Liabilities, Shareholders' Equity; Interest Rates and Interest Differential 5 27-29 Investment Portfolio 5 12-13, 35-36 Loan and Lease Portfolio 5 8, 14-15, 31-32 Summary of Loan Loss Experience 6 33 Deposits 6 10-11 Financial Ratios 6 2 Competition 6-7 Supervision and Regulation 8-9 Capital Standards 9-11 40-41 Item 2 Properties 12 Item 3 Legal Proceedings 13 Item 4 Submission of Matters to a Vote of Securities Holders 13 Part II Item 5 Market for Registrant's Common Stock and Related Stockholder Matters 13 45 Item 6 Selected Financial Data 13 1 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations 13 22-45 Item 7a Quantitative and Qualitative Disclosures About Market Risk 13-14 Item 8 Financial Statements and Supplementary Data 14 2-26 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 14 Part III Item 10 Directors and Executive Officers of the Registrant 15 4-9 Item 11 Executive Compensation 15 9-13 Item 12 Security Ownership of Certain Beneficial Owners and Management 15 4-5 Item 13 Certain Relationships and Related Transactions 15 15, 23 13 Part IV Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K 16 1-26 <FN> (1) The 1997 Annual Report to Shareholders, portions of which are incorporated by reference into this Form 10-K. (2) The Proxy Statement dated for the Annual Meeting of Shareholders, portions of which are incorporated by reference into this Form 10-K. </FN> ii PART I ITEM 1 BUSINESS GENERAL Pacific Capital Bancorp (the "Company") is a California bank holding company headquartered in Salinas, California and incorporated on January 26, 1983. Its principal wholly-owned subsidiaries, First National Bank of Central California (formerly First National Bank of Monterey County) ("First National") commenced operations on April 2, 1984, and South Valley National Bank ("South Valley") commenced operations on April 21, 1982. On November 20, 1996, the Company acquired South Valley Bancorporation ("SVB") and its banking subsidiary, South Valley, headquartered in Morgan Hill, California. Each share of SVB common stock outstanding on November 20, 1996, was converted into 0.92 shares of the Company's common stock. The consolidated financial statements of the Company give effect to the merger, which has been accounted for as a pooling-of-interests. Accordingly, the accounts of SVB have been combined with those of the Company for all periods presented. First National and South Valley are collectively referred to herein as the "Subsidiary Banks." First National is a full service commercial bank serving Monterey, Salinas, Carmel, Watsonville, and surrounding areas in Monterey and Santa Cruz Counties in California. South Valley is a full service commercial bank serving Morgan Hill, Gilroy, Hollister, San Juan Bautista, and surrounding areas in Santa Clara and San Benito Counties in California. The Company itself does not engage in any business activities other than the ownership of the Subsidiary Banks and the ownership of one other wholly-owned subsidiary, Pacific Capital Services Corporation, an inactive subsidiary. General Banking Services The Subsidiary Banks provides a wide range of commercial banking services to individuals, professionals, and small- and medium-sized businesses. The services provided include those typically offered by commercial banks, such as: checking, interest checking and savings accounts, travelers checks, safe deposit boxes, collection services, night depository facilities and wire and telephone transfers. In addition to the above deposit services, the Subsidiary Banks also provide a full array of loan products including commercial, real estate and consumer loans as well as a variety of government assisted loan programs such as SBA or Rural Economic Community Development Service guaranteed loans. Professional firms, individuals and businesses form the core of the Subsidiary Banks customer and deposit bases. 1 The Subsidiary Banks maintain lobby hours between 9:00 a.m. and 5:00 p.m., Monday through Thursday and between 9:00 a.m. and 6:00 p.m. on Friday. South Valley's Gilroy and Hollister offices are also open from 9:00 a.m. to 12:00 p.m. on Saturday. In addition to a broad range of retail products and services, the Subsidiary Banks offer courier pick-up service, nationwide ATM access available through the Star(R) system, Cirrus(R), Plus(R) Explore(R) and Ca$h24(R), and point of sale transactions through Explore(R), Maestro(R) and Discover/Novus(R), merchant bank card support with electronic ticket capture, self directed IRA, discount brokerage services and consumer and business credit cards. First National also offers offsite ATM access at the Prunetree Shopping Center, Prunedale, California and at the Monterey Pennisula College, Monterey, Calififornia. The Subsidiary Banks do not offer trust services. Most of the Subsidiary Banks deposits are obtained from individuals, professionals and small- and medium-sized businesses. As of December 31, 1997 the Subsidiary Banks had a total of 34,524 accounts representing 18,940 interest bearing and non-interest bearing checking accounts with an average balance of approximately $11,410 each; 11,434 savings and money market accounts with an average balance of approximately $14,421 each; and 4,150 other time deposits with an average balance of approximately $40,046 each. The Subsidiary Banks are members of the Federal Deposit Insurance Corporation (the "FDIC") and the deposits of each depositor of the Subsidiary Banks are insured up to $100,000. The Subsidiary Banks engage in a full complement of lending activities, including commercial, consumer/installment and short-term real estate loans, with a particular emphasis on short- and medium-term commercial obligations. Commercial lending activities are directed principally toward small- to medium-sized businesses, such as professional firms, retail, light industry and manufacturing to which the Subsidiary Banks make (a) loans for working capital, (b) loans secured by receivable and inventory, (c) term loans for equipment; and (d) real estate development loans. In addition to conventional commercial lending, the Subsidiary Banks also offer an array of government assisted loan products including SBA guaranteed loans, SBA 504 loans (primarily for commercial real estate transactions), Rural Economic Community Development Services guaranteed loans and loans guaranteed under the State of California guarantee program. The Subsidiary Banks also work to meet the needs of the local municipalities by providing lease financing for a wide variety of equipment purchases including energy retrofit, fire trucks, police cars, portable classrooms, etc. Consumer lending is oriented primarily to the needs of the Subsidiary Banks customers, with an emphasis on automobile financing and real estate loans. Real estate loans include home loans and equity advance loans. In addition, the Subsidiary Banks offer construction loans, generally for single-family residences and multi-unit projects. Real estate and construction loans are typically secured by first deeds of trust and guarantees from principals of the borrower. The economic viability of the project and the borrower's credit worthiness are primary considerations in the loan underwriting decision. The Subsidiary Banks use independent local appraisers, conservative loan-to-value ratios and close monitoring of the projects during construction phases, and in the absence of rapid declines in real estate values, ultimate collectibilty of these secured loans is considered by the Subsidiary Banks management to be better than the average mix of commercial loans. The Subsidiary Banks do not make long-term fixed rate real estate loans and, therefore, material sustained increases or decreases in general interest rate levels have only a short-term effect on the Subsidiary Banks net yield on real estate loans. 2 The Subsidiary Banks concentrate their lending activities in the following areas: real estate loans, commercial loans, consumer loans to individuals, and other loans. As of December 31, 1997, these four categories accounted for approximately 64.2%, 26.4%, 5.9%, and 3.5% respectively, of the Company's loan portfolio. As of December 31, 1997, the Company had total loans outstanding of $419,293,000. No material portion of the Subsidiary Bank's loan portfolio is concentrated within a single industry or group of related industries. The interest rates charged for the various loans made by the Subsidiary Banks vary with the degree of risk, size, and maturity of the loans involved and are generally affected by competition, governmental regulation and by current money market rates. The Company's consolidated financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on the loan portfolio. The Subsidiary Banks follow the policy of non-accrual of interest on a loan when principal or interest is 90 days or more past due unless the loan is well secured and in the process of collection. Interest income from non-accrual loans is not accrued on the books, but rather is recorded only when and if received. When a loan is placed on a non-accrual basis, any previously accrued but unpaid interest is reversed and charged against current income unless there is adequate collateral to assure recovery of the accrued interest. Correspondent Banks The Subsidiary Banks have correspondent relationships with Wells Fargo Bank, N.A., Union Bank of California., Bank of America, N.T.& S.A., City National Bank and the Federal Reserve Bank of San Francisco. These relationships are a result of the Subsidiary Banks efforts to obtain a wide range of services for the Subsidiary Banks and its customers and, as net sellers of federal funds (overnight interbank loans), to minimize the risk of an undue concentration of its resources with a few entities. The Subsidiary Banks do not currently serve, nor do they have plans to serve, as a correspondent to other banks. The correspondent banks perform the following services for the Subsidiary Banks: arrange loan participations; purchase and sell federal funds; obtain lines for letters of credit; buy and sell investment securities; safekeep the Subsidiary Banks investment securities; send and receive foreign wire transactions and data processing services. Existing Locations First National currently operates six branch offices: the Monterey branch located at 495 Washington Street, Monterey; the Salinas branch located at 1001 South Main Street, Salinas; the Oldtown office located at 307 Main Street, Salinas; the Carmel branch located in the Carmel Rancho Shopping Center, Carmel; the Watsonville branch located at 655 Main Street, Watsonville: and the Soledad branch located at 695 Front Street, Soledad. First National offers offsite 24-hour ATM services and night depository facilities at the Prunetree Shopping Center located in Prunedale, and ATM services located at the Monterey Peninsula College, Monterey, California. The Company's loan administration department is located at 517 S. Main Street, Salinas. In addition to a banking office, the Oldtown office 3 located at 307 Main Street, Salinas houses all of the Company's administrative functions as well as the Data Processing/Operations department and a Community/Board room. South Valley currently operates four branch offices: the Morgan Hill branch located at 500 Tennant Station in Morgan Hill; the Gilroy branch located at 8000 Santa Teresa Boulevard, Gilroy; the Hollister branch located at 1730 Airline Highway, Hollister; and the San Juan Bautista branch located at 301 Third Street, San Juan Bautista. As of December 31, 1997, the Company and the Subsidiary Banks employed 280 full-time equivalent employees. Other Information Concerning the Company and the Subsidiary Banks The Company and its Subsidiary Banks hold no material patents, trademarks, licenses, franchises or concessions except for the written approvals issued by the Office of the Comptroller of the Currency (the "OCC") for the Subsidiary Banks' banking offices. No material expenditures were made by the Company or its Subsidiary Banks during the last three fiscal years on research and development activities relating to the development of services or the improvement of existing services. Based upon present business activities, compliance with federal, state and local provisions regulating discharge of materials into the environment will have no material effect upon the capital expenditures, earnings and competitive position of the Company or its Subsidiary Banks. Pacific Capital Services Corporation PCSC, a wholly-owned inactive subsidiary of the Company, was incorporated on April 22, 1985, to arrange and broker residential, commercial and construction loans and other extensions of credit. SELECTED STATISTICAL INFORMATION Consolidated statistical information concerning the business of the Company and the Subsidiary Banks is set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations ("Management's Discussion and Analysis") on pages 22 through 45 the Company's Annual Report to Shareholders for the fiscal year ended December 31, 1997, (the "Annual Report") and in Notes 1-14 to the Consolidated Financial Statements on pages 1 through 21 of the Annual Report, which pages of the Annual Report are incorporated herein by reference. This information should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included in the Annual Report which have been incorporated herein by reference. 4 Distribution of Average Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential The Company's average consolidated balance sheet and an analysis of net interest earnings for the years ended December 31, 1997, 1996 and 1995 is set forth in Management's Discussion and Analysis on page 27 of the Annual Report. A table setting forth the changes in interest income and interest expense in 1997 and 1996 resulting from changes in volume and changes in rates is set forth in Management's Discussion and Analysis on page 28 of the Annual Report. Investment Portfolio The amortized cost and estimated fair values of each category of investment securities at December 31, 1997, and 1996 and the maturities of investment securities at December 31, 1997, are set forth in Note 5 of the Notes to Consolidated Financial Statements on pages 12 and 13 of the Annual Report. At December 31, 1997, investment securities from the following issuers each totaled over ten percent (10%) of shareholder's equity of the Company: Amortized Estimated Cost Fair value Available-for-sale securities: U.S. Treasury and Agencies $ 87,591,000 $ 88,247,000 Agency Mortgage-Backed Securities $ 121,769,000 $ 123,095,000 Loan and Lease Portfolio The composition of the loan and lease portfolio for the five years ended at December 31, 1997, is set forth in Management's Discussion and Analysis on page 32 of the Annual Report. Maturities and sensitivity to changes in interest rates in the loan and lease portfolio, including real estate-mortgage and consumer loans, as of December 31, 1997, are summarized in Management's Discussion and Analysis on page 33 of the Annual Report. The composition of nonaccrual, past due and restructured loans and leases for the five years ended December 31, 1997, and a discussion of the Company's policy for placing loans on nonaccrual status is set forth in Management's Discussion and Analysis on page 37 of the Annual Report. 5 Summary of Loan Loss Experience An analysis of loan loss experience for the five years ended December 31, 1997 and a description of the factors which influenced management's judgment in determining the amount of the additions to the allowance charged to operating expenses in each fiscal period, as well as a discussion of the risk elements in the loan portfolio, are set forth in Management's Discussion and Analysis on page 35of the Annual Report. Deposits The average amount of and the average rate paid on major deposit categories for the years ended December 31, 1997, 1996 and 1995 is set forth in Management's Discussion and Analysis on page 39 of the Annual Report. The maturity of time certificates of deposit of $100,000 or more and other time deposits of $100,000 or more at December 31, 1997, is set forth in Management's Discussion and Analysis on page 39 of the Annual Report. Financial Ratios Certain ratios of profitability, liquidity and capital for the years ended December 31, 1997, and 1996 are summarized in the Selected Financial Data on page 1 of the Annual Report. COMPETITION In California and in the Subsidiary Banks primary service areas, major banks dominate the commercial banking industry. Among the advantages which these banks have over the Subsidiary Banks are their ability to finance wide-ranging advertising campaigns and to allocate their investment assets, including loans, to regions of higher yield and demand. By virtue of their larger amounts of capital, such institutions have substantially greater lending limits than the Subsidiary Banks and perform certain functions, including trust services and international banking, which are not offered directly by the Subsidiary Banks but are offered indirectly through its correspondent institutions. First National's primary service area consists of Monterey County and Southern Santa Cruz County and encompasses the cities of Monterey, Carmel, Pacific Grove, Seaside, Marina, Sand City, Del Rey Oaks, Salinas, Prunedale, Watsonville, Soledad, Gonzales, Greenfield, King City, and the unincorporated communities of Pebble Beach, Carmel Valley and North Monterey County. Based on data as of the most recent practicable date, June 30, 1997, there were 99 financial institutions with $4,184.2 million in deposits serving this area. First National's market share at June 30, 1997 was as follows 1: 6 First National Total Deposits Deposits First National Service Area (in thousands) (in thousands) Market Share - -------------------------------------------------------------------------------------------------------------------------- Monterey $1,380,394 $140,859 10.2% Salinas 1,446,156 167,983 11.6% Carmel 522,268 58,848 11.3% Watsonville 616,842 57,291 9.3% Soledad 218,494 30,681 14.0% - -------------------------------------------------------------------------------------------------------------------------- Total $4,184,154 $455,662 10.9% ========================================================================================================================== South Valley's primary service area is Southern Santa Clara County and San Benito County, which includes the cities of Morgan Hill, Gilroy, Hollister and San Juan Bautista. Based upon data as of the most recent practicable date, June 30, 1997, there were 29 financial institutions with $1,062.2 million in deposits serving this area. South Valley's market share at June 30, 1997 was as follows 1: South Valley Total Deposits Deposits South Valley Service Area (in thousands) (in thousands) Market Share - -------------------------------------------------------------------------------------------------------------------------- Morgan Hill $336,742 $69,757 20.7% Gilroy 343,493 74,941 21.8% Hollister 365,930 26,840 7.3% San Juan Bautista 16,015 11,521 71.9% ========================================================================================================================== Total $1,062,180 $183,059 17.2% ========================================================================================================================== <FN> 1 Sheshunoff(TM)Information Services Branches of California and Hawaii, June 1997 Data. </FN> Other entities, both governmental and in private industry, seeking to raise capital through the issuance and sale of debt securities, as well as other depository institutions such as thrift and loan companies and credit unions, also provide competition for the Subsidiary Banks in the acquisition of deposits. The Subsidiary Banks also compete with money market funds and other money market instruments which are not subject to interest rate ceilings. From time to time, legislation is proposed or enacted which has the effect of increasing the cost of doing business, limiting permissible activities or affecting the competitive balance between banks and other financial institutions. It is impossible to predict the competitive impact these and other changes in legislation will have on commercial banking in general or on the business of the Subsidiary Banks in particular. 7 SUPERVISION AND REGULATION The Effect of Governmental Policy on Banking The earnings and growth of the Company and the Subsidiary Banks are affected not only by local market area factors and general economic conditions, but also by government monetary and fiscal policies. For example, the Board of Governors of the Federal Reserve System (the "FRB") influences the supply of money through its open market operations in U.S. Government securities, and adjustments to the discount rates applicable to borrowings by depository institutions and others. Such actions influence the growth of loans, investments and deposits and also effect interest rates charged on loans and paid on deposits. The nature and impact of future changes in such policies on the business and earnings of the Company and the Subsidiary Banks cannot be predicted. As a consequence of the extensive regulation of commercial banking activities in the United States, the business of the Company is particularly susceptible to federal and state legislation which may have the effect of increasing or decreasing the cost of doing business, modifying permissible activities, or enhancing the competitive position of other financial institutions. Any change in applicable laws or regulations may have a material adverse effect on the business and prospects of the Company. Regulation and Supervision of Bank Holding Companies The Company is a bank holding company subject to the Bank Holding Company Act of 1956, as amended ("BHCA"). The Company reports to, registers with, and may be examined by the FRB. The FRB also has the authority to examine the Company's subsidiaries. The FRB requires the Company to maintain certain levels of capital. See "Capital Standards" herein. The FRB also has the authority to take enforcement action against any bank holding company that commits any unsafe or unsound practice, or violates certain laws, regulations, or conditions imposed in writing by the FRB. Under the BHCA, a company generally must obtain the prior approval of the FRB before it exercises a controlling influence over, or acquires directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any bank or bank holding company. Thus, the Company is required to obtain the prior approval of the FRB before it acquires, merges or consolidates with any bank or bank holding company. Any company seeking to acquire, merge or consolidate with the Company also would be required to obtain the FRB's approval. The Company is generally prohibited under the BHCA from acquiring ownership or control of more than 5% of the voting shares of any company that is not a bank or bank holding company and from engaging directly or indirectly in activities other than banking, managing banks, or providing services to affiliates of the holding company. A bank holding company, with the approval of the FRB, may engage, or acquire the voting shares of companies engaged, in activities that the FRB has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. A bank holding company must demonstrate that the benefits to the public of the proposed activity will outweigh the possible adverse effects associated with such activity. 8 Legislation is pending in Congress that would repeal the current statutory restrictions on affiliations between commercial banks and securities firms. Under the proposed legislation, bank holding companies would be allowed to control both a commercial bank and a securities affiliate, which could engage in the full range of investment banking activities, including corporate underwriting. The likelihood of such legislative changes and the impact of such changes might have on the Company and the Subsidiary Banks are impossible to predict. The FRB generally prohibits a bank holding company from declaring or paying a cash dividend which would impose undue pressure on the capital of the Subsidiary Banks or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company's financial position. The FRB's policy is that a bank holding company should not continue its existing rate of cash dividends on its common stock unless its net income is sufficient to fully fund each dividend and its prospective rate of earnings retention appears consistent with its capital needs, asset quality and overall financial condition. Transactions between the Company and the Subsidiary Banks and any future subsidiaries are subject to a number of other restrictions. FRB policies forbid the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered (or, if no market exists, actual costs plus a reasonable profit). Additionally, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit, sale or lease of property, or furnishing of services. Subject to certain limitations, depository institution subsidiaries of bank holding companies may extend credit to, invest in the securities of, purchase assets from, or issue a guarantee, acceptance, or letter of credit on behalf of, an affiliate, provided that the aggregate of such transactions with affiliates may not exceed 10% of the capital stock and surplus of the institution, and the aggregate of such transactions with all affiliates may not exceed 20% of the capital stock and surplus of such institution. The Company may only borrow from depository institution subsidiaries if the loan is secured by marketable obligations with a value of a designated amount in excess of the loan. Further, the Company may not sell a low-quality asset to a depository institution subsidiary. Bank Regulation and Supervision As national banks, the Subsidiary Banks are regulated, supervised and regularly examined by the OCC. Deposit accounts at the Subsidiary Banks are insured by the Bank Insurance Fund ("BIF"), as administered by the FDIC, to the maximum amount permitted by law. The Subsidiary Banks are also subject to applicable provisions of California law, insofar as such provisions are not in conflict with or preempted by federal banking law. Capital Standards The OCC and other federal banking agencies have risk-based capital adequacy guidelines intended to provide a measure of capital adequacy that reflects the degree of risk associated with a banking organization's operations for both transactions reported on the balance sheet as assets and transactions, such as letters of credit and recourse arrangements, which are reported as off-balance sheet items. Under these guidelines, nominal dollar amounts of assets and credit equivalent amounts of off balance sheet 9 items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. government securities, to 100% for assets with relatively higher credit risk, such as business loans. A banking organization's risk-based capital ratios are obtained by dividing its qualifying capital by its total risk adjusted assets and off-balance sheet items. The federal banking agencies measure risk-adjusted assets and off-balance sheet items against both total qualifying capital (the sum of Tier 1 capital and limited amounts of Tier 2 capital) and Tier 1 capital. Tier 1 capital consists of common stock, retained earnings, noncumulative perpetual preferred stock and minority interests in certain subsidiaries, less most other intangible assets. Tier 2 capital may consist of a limited amount of the allowance for possible loan and lease losses and certain other instruments with some characteristics of equity. The inclusion of elements of Tier 2 capital are subject to certain other requirements and limitations of the federal banking agencies. Since December 31, 1992, the federal banking agencies have required a minimum ratio of qualifying total capital to risk-adjusted assets and off-balance sheet items of 8%, and a minimum ratio of Tier 1 capital to risk-adjusted assets and off-balance sheet items of 4%. In addition to the risk-based guidelines, federal banking agencies require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio. For a banking organization rated in the highest of the five categories used by regulators to rate banking organizations, the minimum leverage ratio of Tier 1 capital to total assets is 3%. It is improbable, however, that an institution with a 3% leverage ratio would receive the highest rating since a strong capital position is a significant part of the rating. For all banking organizations not rated in the highest category, the minimum leverage ratio is at least 100 to 200 basis points above the 3% minimum. Thus, the effective minimum leverage ratio, for all practical purposes, is at least 4% to 5%. In addition to these uniform risk-based capital guidelines and leverage ratios that apply across the industry, the federal banking agencies have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios. The following tables present the capital ratios for the Company and the Subsidiary Banks as of December 31, 1997. The Company South Valley First National Amount Ratio Amount Ratio Amount Ratio - ------------------------------- -------------- --------------- --------------- --------------- -------------- -------------- (000's) (000's) (000's) Risk-Based Capital Ratio: Tier 1 Capital $68,925 13.58% $17,592 11.71% $44,601 12.81% Minimum Requirement 20,295 4.00% 6,009 4.00% 13,929 4.00% Excess 48,630 9.58% 11,583 7.71% 30,672 8.81% ====== ===== ====== ===== ====== ===== Total Capital 73,191 14.43% 19,337 12.87% 47,116 13.53% Minimum Requirement 40,589 8.00% 12,017 8.00% 27,858 8.00% Excess 32,602 6.43% 7,320 4.87% 19,258 5.53% ====== ===== ===== ===== ====== ===== Risk-Adjusted Assets $507,363 $150,216 $348,220 10 The Company South Valley First National Amount Ratio Amount Ratio Amount Ratio - ----------------------------------- --------------- -------------- --------------- --------------- --------------- --------------- (000's) (000's) (000's) Leverage Ratio: Tier 1 Capital $68,925 9.17% $17,592 8.03% $44,601 8.49% Minimum Requirement 30,058 4.00% 8,767 4.00% 21,014 4.00% Excess 38,867 5.17% 8,825 4.03% 23,587 4.49% ====== ===== ===== ===== ====== ===== Total Average Quarterly Assets $751,439 $219,168 $525,357 Restrictions on Dividends and Other Distributions The power of the board of directors of an insured depository institution to declare a cash dividend or other distribution with respect to capital is subject to statutory and regulatory restrictions which limit the amount available for such distribution depending upon the earnings, financial condition and cash needs of the institution, as well as general business conditions. Federal law prohibits insured depository institutions from paying management fees to any controlling persons or, with certain limited exceptions, making capital distributions, including dividends, if, after such transaction, the institution would be undercapitalized. The payment of dividends by a national bank is further restricted by additional provisions of federal law, which prohibits a national bank from declaring a dividend on its shares of common stock unless its surplus fund exceeds the amount of its common capital (total outstanding common shares times the par value per share). Additionally, if losses have at any time been sustained equal to or exceeding a bank's undivided profits then on hand, no dividend can be paid. Moreover, even if a bank's surplus exceeds its common capital and its undivided profits exceed its losses, the approval of the OCC is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. A national bank must consider other business factors in determining the payment of dividends. The payment of dividends by the Bank is governed by the Bank's ability to maintain minimum required capital levels and an adequate allowance for loan losses. The federal banking agencies also have the authority to prohibit a depository institution from engaging in business practices, which are considered to be unsafe or unsound, possibly including payments of dividends or other payments under certain circumstances even if such payments are not expressly prohibited by statute. The Company has paid a stock dividend every year since 1986 and cash dividends were paid in 1993, 1994, 1995, 1996 and 1997. 11 Premiums for Deposit Insurance and Assessments for Examinations As an insured depository institution, the Company is required to pay premiums for FDIC deposit insurance. The FDIC has adopted a risk-based assessment system for deposit insurance premiums. Under this system, depository institutions were charged anywhere from 23 cents to 31 cents for every $100 in insured deposits based on that institution's capital levels and supervisory subgroup assignment. In May 1995, the BIF achieved its target goal of bringing the ratio of insurance fund reserves to $1.25 for each $100 of insured deposits. Based on this reserve level, the FDIC in November 1995 reduced the range of insurance assessment rates from $0.04 to $0.31 to $0 to $0.31 per $100 in insured deposits. Due to these changes in assessment rates, the Company's FDIC assessment expense decreased for 1995 by $316,000 or 94.6%. During 1996, a special one-time assessment was paid by BIF-insured financial institutions to the FDIC for the purpose of assisting in the recapitalization of the Savings Association Insurance Fund (the "SAIF"). The SAIF is the insurance fund reserve for savings institutions. In November 1996, the Subsidiary Banks paid $71,000 for this special assessment. During 1997, the FDIC assessment expense for the Subsidiary Banks was $68,000. Interstate Banking and Branching The Riegle-Neal Interstate Banking and Branching Efficiency Act (the "Act"), which was enacted in 1994, codifies the authority of banks to provide specified interstate banking services on an agency basis to customers of affiliate banks as of September 1995. Also, under the Act, as of September 1995, bank holding companies may acquire banks in other states, subject to certain deposit concentration limitations. Beginning June 1, 1997, and subject to certain deposit concentration and other limitations, banks may merge with other banks in states that do not "opt out" of the interstate legislation prior to June 1, 1997. Interstate mergers may be conducted prior to June 1, 1997 in states that specifically permit such mergers. In addition, prior to June 1, 1997, certain consolidations are possible using the "30-mile rule," which allows national banks to relocate their headquarters up to 30 miles away, including across state lines. Currently, several states have already "opted in" to the interstate legislation. Effective October 2, 1996, California opted in early to interstate branching by permitting other state's banks to acquire an entire California bank by merger or purchase and thereby establish one or more California branch offices, provided the acquired bank has been in existence at least five years. The effect of these laws on the Company and the Subsidiary Banks cannot be determined. ITEM 2 PROPERTIES On December 31, 1997, the Company had 11 offices, of which 4 were owned and 7 were leased by the Company or its Subsidiary Banks. All of these offices are considered by management to be well maintained and adequate for the purpose intended. See page 23 of the Annual Report incorporated herein by reference for further information on leases. 12 ITEM 3 LEGAL PROCEEDINGS Neither the Company nor its Subsidiary Banks is a party to, nor is any of their property the subject of, any material pending legal proceedings other than ordinary routine litigation incidental to their respective businesses. ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote by the Shareholders of the Company's Common Stock during the fourth quarter of 1997. PART II ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS For information concerning the Company's common stock and related security holder matters, see "Pacific Capital Bancorp Stock Activity" at Page 45 of the Annual Report, which is incorporated herein by reference. For information regarding dividends, see "Restrictions on Dividends and other Distributions" under Part I, Item 1 of this Form 10-K on page 13. As of March 31, 1997, there were 1,874 holders of record of the Company's common stock. ITEM 6 SELECTED FINANCIAL DATA For selected financial data concerning the Company, see "Selected Financial Information and Comparative Per Share Data" at Page 1 of the Annual Report, which is incorporated herein by reference. ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For management's discussion and analysis of financial condition and results of operations, see "Management's Discussion and Analysis" at Pages 22 through 45 of the Annual Report, which pages of the Annual Report are incorporated herein by reference. ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Company's net interest income to adverse movements in interest rates. Although the Company manages other risks, as in credit and liquidity risk, in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company's financial condition. The primary objective of the asset/liability management process is to measure the effect of changing interest rates on net interest income and market value and adjust the balance sheet (if necessary) to minimize the inherent risk and maximize income. The Company's exposure to market risk is reviewed on a regular basis by the 13 Asset/Liability Committee. Tools used by management include a modified GAP report and an asset/liability simulation model. Management believes that the Company's market risk and interest rate risk profiles are within reasonable tolerances at this time. A derivative financial instrument includes futures, forward contracts, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Company currently does not enter into futures, forwards, swaps, or options. The Company is however, party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These instruments include commitments to extend credit and standby letters of credit. These instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statement of condition. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Company. Standby letters of credit are conditional commitments issued by the Subsidiary Banks to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded on the Company's consolidated balance sheet until the instrument is exercised. The following table represents the change in the Company's Market Value of Portfolio Equity (MVPE) at December 31, 1997 in the event of a sudden and sustained change in interest rates as presented. MVPE is defined as the fair value of assets less the fair value of liabilities on the Company's consolidated balance sheet. (Dollars in thousands) Market Value of Change in interest rates Portfolio Equity $ Change % Change - -------------------------------------------------------------------------------- 200 Basis points rise $90,811 $755 0.84% 100 Basis points rise 90,434 378 0.42% Base scenario 90,056 - 0.00% 100 Basis points decline 88,950 (1,107) (1.23%) 200 Basis points decline 87,873 (2,213) (2.46%) ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA For financial statements of the Company, see Pages 2 through 26 of the Annual Report and the "Independent Auditors" Report thereon at Page 49 which pages of the Annual Report are incorporated herein by reference. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. 14 PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information Concerning Directors and Executive Officers For information concerning directors and executive officers of the Company, see "ELECTION OF DIRECTORS OF THE COMPANY" in the definitive Proxy Statement for the Company's 1997 Annual Meeting of Shareholders (the "Proxy Statement"), which is incorporated herein by reference. Compliance With Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires the Company's officers and directors, and any persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Officers, directors and greater than ten-percent shareholders are required by SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. To the best knowledge of the Company, there are no persons who own more than ten-percent of the Company's Common Stock. Based solely on its review of the copies of such forms received by it, or written representations from certain reporting persons that no Forms 5 were required for those persons, the Company believes that, for the fiscal year ended December 31, 1997, all filing requirements applicable to its officers and directors have been satisfied. ITEM 11 EXECUTIVE COMPENSATION For information concerning executive compensation, see "EXECUTIVE COMPENSATION" in the Proxy Statement, which is incorporated herein by reference. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information concerning security ownership of certain beneficial owners and management, see "PRINCIPAL SHAREHOLDERS" and "ELECTION OF DIRECTORS OF THE COMPANY" in the Proxy Statement, which is incorporated herein by reference. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For information concerning certain relationships and related transactions, see "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS" and "INDEBTEDNESS OF MANAGEMENT" in the Proxy Statement, which is incorporated herein by reference. 15 PART IV ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements. The consolidated financial statements of Pacific Capital Bancorp and subsidiaries, other financial information and the Independent Auditors' Report on Consolidated Financial Statements appearing at the indicated location in the Annual Report are incorporated by reference into this report. 2. Financial Statement Schedules. In accordance with Regulation S-X, the financial statement schedules have been omitted because (a) they are not applicable to or required of the Company; or (b) the information required is included in the consolidated financial statements or notes thereto. With the exception of such information in the 1997 Annual Report incorporated herein by reference, the 1997 Annual Report is not deemed "filed" as part of this report. 3. Exhibits. See Index to Exhibits at pages 69 - 73 of this Form 10-K. (b) Reports on Form 8-K. None 16 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Consolidated Financial Statements December 31, 1997, 1996, and 1995 (With Independent Auditors' Report Thereon) 17 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES SELECTED FINANCIAL INFORMATION AND COMPARATIVE PER SHARE DATA - ------------------------------------------------------------------------------------------------------------------------- (Dollars in thousands, except per share amounts) 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------------------- RESULTS OF OPERATIONS: Interest income $ 53,215 $ 43,958 $ 38,678 $ 33,030 $ 29,346 Interest expense 17,385 13,319 10,971 8,074 7,763 Net interest income 35,830 30,639 27,707 24,956 21,583 Provision for possible loan losses 1,520 685 527 479 1,278 - ------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for possible loan losses 34,310 29,954 27,180 24,477 20,305 Other income 3,345 3,206 3,056 2,888 2,911 Other expense 20,884 22,727 19,352 17,345 16,445 Net gain (loss) on securities transactions 11 (46) (73) (17) 120 - ------------------------------------------------------------------------------------------------------------------------- Income before income taxes 16,782 10,387 10,811 10,003 6,891 Income taxes 6,635 4,348 4,200 3,778 2,426 - ------------------------------------------------------------------------------------------------------------------------- Income before cumulative effect of Accounting change 10,147 6,039 6,611 6,225 4,465 Cumulative effect of accounting change -- -- -- -- 549 - ------------------------------------------------------------------------------------------------------------------------- Net income $ 10,147 $ 6,039 $ 6,611 $ 6,225 $ 5,014 - ------------------------------------------------------------------------------------------------------------------------- PER SHARE DATA Income before cumulative effect of Accounting change - diluted $ 2.28 $ 1.36 $ 1.50 $ 1.44 $ 1.03 Net income - diluted 2.28 1.36 1.50 1.44 1.15 Cash dividends 0.66 0.60 0.53 0.40 0.30 Book value 16.90 15.59 15.54 14.60 13.83 BALANCES AT YEAR END Total assets 764,719 619,439 530,852 487,749 436,958 Total loans 419,293 388,728 300,895 290,352 265,903 Total deposits 683,398 547,182 465,508 427,870 382,475 Total shareholders' equity 72,558 63,646 60,533 55,002 50,039 AVERAGE DAILY BALANCES Total assets 677,491 568,686 496,007 459,695 433,558 Total loans 411,546 332,421 290,265 277,263 259,131 Total deposits 604,953 501,833 431,975 404,047 382,183 Total shareholders' equity 68,353 63,106 58,183 52,719 48,205 PERFORMANCE AND CAPITAL RATIOS Return on average assets 1.50% 1.06% 1.33% 1.35% 1.16% Return on average shareholders' equity 14.84% 9.57% 11.36% 11.81% 10.40% Average shareholders' equity to average assets 10.09% 11.10% 11.73% 11.47% 11.12% - ------------------------------------------------------------------------------------------------------------------------- 18 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, - --------------------------------------------------------------------------------------------------- (In thousands, except share amounts) 1997 1996 - --------------------------------------------------------------------------------------------------- Assets Cash and due from banks $ 49,982 $ 48,126 Federal funds sold 26,405 14,910 Money market funds 2,132 13,209 - --------------------------------------------------------------------------------------------------- Cash and cash equivalents 78,519 76,245 Investment securities: Held-to-maturity, at amortized cost (fair value of $7,347 and $9,741, respectively) 7,347 9,680 Available-for-sale, at fair value 220,984 116,528 - --------------------------------------------------------------------------------------------------- Total investment securities 228,331 126,208 Loans available for sale 10,523 5,821 Loans, net of unearned income 419,293 388,728 Less allowance for possible loan losses 4,266 3,672 - --------------------------------------------------------------------------------------------------- Net loans 415,027 385,056 Premises and equipment, net 15,331 15,300 Accrued interest receivable and other assets 16,988 10,809 - --------------------------------------------------------------------------------------------------- Total assets $ 764,719 $ 619,439 =================================================================================================== Liabilities and Shareholders' Equity Deposits: Demand, noninterest bearing $ 174,649 $ 131,332 Demand, interest bearing 97,322 84,770 Savings and money market 173,151 164,890 Time certificates 238,276 166,190 - --------------------------------------------------------------------------------------------------- Total deposits 683,398 547,182 Accrued interest payable and other liabilities 8,763 8,611 - --------------------------------------------------------------------------------------------------- Total liabilities 692,161 555,793 - --------------------------------------------------------------------------------------------------- Shareholders' equity: Preferred stock; no par value, 20,000,000 shares authorized and unissued -- -- Common stock; no par value, 20,000,000 shares authorized: 4,294,403 and 4,083,363 shares issued and outstanding in 1997 and 1996, respectively 58,434 49,388 Retained earnings 12,852 14,423 Net unrealized gain (loss) on available-for-sale securities 1,272 (165) - --------------------------------------------------------------------------------------------------- Total shareholders' equity 72,558 63,646 Commitments and contingencies -- -- - --------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 764,719 $ 619,439 =================================================================================================== <FN> See accompanying notes to consolidated financial statements. </FN> 19 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years ended December 31, - -------------------------------------------------------------------------------------------------------------- (In thousands, except per share amounts) 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------- Interest income: Interest and fees on loans $ 40,843 $ 33,845 $ 30,490 Interest on federal funds sold 2,482 1,806 1,870 Interest on investment securities: Taxable 9,239 7,557 5,415 Non-taxable 651 750 903 - -------------------------------------------------------------------------------------------------------------- Total interest income 53,215 43,958 38,678 - -------------------------------------------------------------------------------------------------------------- Interest expense: Interest on deposits 17,356 13,292 10,922 Other interest expense 29 27 49 - -------------------------------------------------------------------------------------------------------------- Total interest expense 17,385 13,319 10,971 - -------------------------------------------------------------------------------------------------------------- Net interest income 35,830 30,639 27,707 Provision for possible loan losses 1,520 685 527 - -------------------------------------------------------------------------------------------------------------- Net interest income after provision for possible loan losses 34,310 29,954 27,180 - -------------------------------------------------------------------------------------------------------------- Other income: Service charges 2,619 2,432 2,399 Gain on sale of loans 22 27 91 Net gains (losses) on securities transactions 11 (46) (73) Other 704 747 566 - -------------------------------------------------------------------------------------------------------------- Total other income 3,356 3,160 2,983 - -------------------------------------------------------------------------------------------------------------- Other expenses: Salaries and benefits 11,315 11,864 9,989 Occupancy 2,326 2,111 1,959 Equipment 1,755 2,577 1,943 Advertising and promotion 864 710 659 Stationery and supplies 767 563 508 Legal and professional fees 1,185 1,946 823 Regulatory assessments 222 147 572 Other 2,450 2,809 2,899 - -------------------------------------------------------------------------------------------------------------- Total other expenses 20,884 22,727 19,352 - -------------------------------------------------------------------------------------------------------------- Income before income taxes 16,782 10,387 10,811 Income taxes 6,635 4,348 4,200 - -------------------------------------------------------------------------------------------------------------- Net income $ 10,147 $ 6,039 $ 6,611 ============================================================================================================== Earnings per share $ 2.36 $ 1.41 $ 1.55 ============================================================================================================== Diluted earnings per share $ 2.28 $ 1.36 $ 1.50 ============================================================================================================== Weighted average shares outstanding 4,297,832 4,297,017 4,271,445 Dilutive effect of stock options 149,456 154,581 130,467 - -------------------------------------------------------------------------------------------------------------- Total weighted average diluted shares outstanding 4,447,288 4,451,598 4,401,912 ============================================================================================================== <FN> See accompanying notes to consolidated financial statements </FN> 20 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY - --------------------------------------------------------------------------------------------------------- December 31, 1997, 1996, and 1995 - --------------------------------------------------------------------------------------------------------- Net unrealized gain (loss) on Total Common Stock Retained available-for- shareholders' (In thousands, except share amounts) Shares Amount earnings sale securities Equity - --------------------------------------------------------------------------------------------------------- Balances, December 31, 1994 3,767,702 $ 41,182 $ 14,026 $ (206) $ 55,002 Net income for the year -- -- 6,611 -- 6,611 Purchase and retirement of shares (5,606) (111) -- -- (111) Exercise of stock options 9,590 158 -- -- 158 5% stock dividend, including payment of fractional shares 123,338 3,132 (3,147) -- (15) Cash dividends declared -- -- (1,684) -- (1,684) Net unrealized gain on available-for-sale securities -- -- -- 572 572 - --------------------------------------------------------------------------------------------------------- Balances, December 31, 1995 3,895,024 44,361 15,806 366 60,533 Net income for the year -- -- 6,039 -- 6,039 Purchase and retirement of shares (23,646) (605) -- (605) - --------------------------------------------------------------------------------------------------------- Exercise of stock options 17,981 295 -- -- 295 5% stock dividend, including payment of fractional shares 194,455 5,348 (5,372) -- (24) Cash dividends declared -- -- (2,050) -- (2,050) Repurchase of dissenter shares (451) (11) -- -- (11) Net unrealized loss on available-for-sale securities -- -- (531) (531) - --------------------------------------------------------------------------------------------------------- Balances, December 31, 1996 4,083,363 49,388 14,423 (165) 63,646 Net income for the year -- -- 10,147 -- 10,147 Purchase and retirement of shares (10,000) (410) -- -- (410) Exercise of stock options 17,436 456 -- -- 456 5% stock dividend, including Payment of fractional shares 203,404 9,000 (9,040) -- (40) Cash dividend declared -- -- (2,678) -- (2,678) Net unrealized gain on available-for-sale securities -- -- -- 1,437 1,437 - --------------------------------------------------------------------------------------------------------- Balances, December 31, 1997 4,294,203 $ 58,434 $ 12,852 $ 1,272 $ 72,558 ========================================================================================================= <FN> See accompanying notes to consolidated financial statements </FN> 21 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, - --------------------------------------------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 - --------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 10,147 $ 6,039 $ 6,611 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,478 1,074 1,260 Provision for possible loan losses 1,520 685 527 (Gain) loss on investment securities transactions (11) 46 73 Net originations of loans available for sale (4,702) (1,945) (2,891) Proceeds from sale of loans -- -- 924 Gain on sale of loans (22) (27) (91) Deferral of loan origination fees 150 (64) 40 Change in accrued interest receivable and other assets (4,742) (118) (837) Change in accrued interest payable and other liabilities 185 3,813 93 - --------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 4,003 9,503 5,709 - --------------------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Net change in loans (31,858) (88,839) (11,003) Recoveries on loans 217 347 264 Maturities of investment securities 27,146 20,445 40,818 Purchases of investment securities (129,269) (82,606) (95,070) Proceeds from sale of available-for-sale securities -- 61,735 42,089 Capital expenditures, net (1,509) (2,867) (1,536) - --------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (135,273) (91,785) (24,438) - --------------------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Net increase in deposits 111,522 81,677 21,471 Cash received in connection with branch acquisition 24,694 -- 16,167 Cash paid for retirement of stock (410) (605) (111) Proceeds from exercise of stock options 456 295 158 Cash paid in lieu of fractional shares (40) (24) (15) Cash paid for dividends (2,678) (2,050) (1,684) - --------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 133,544 79,293 35,986 - --------------------------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 2,274 (2,989) 17,257 Cash and cash equivalents at beginning of year 76,245 79,234 61,977 - --------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 78,519 $ 76,245 $ 79,234 ===================================================================================================================== Supplemental disclosures of cash flow information: Cash paid during the period: Interest $ 18,188 $ 14,379 $ 11,827 Income taxes 6,040 4,834 4,107 ===================================================================================================================== Noncash investing and financing activities: Transfer from retained earnings to common stock due to Stock dividends $ 9,000 $ 5,348 $ 3,132 Transfer of securities from held-to-maturity to available-for-sale -- -- 38,660 Transfer from loans to other real estate owned -- 352 1,940 ===================================================================================================================== <FN> See accompanying notes to consolidated financial statements </FN> 22 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1997 (1) Summary of Significant Accounting Policies The accounting policies of Pacific Capital Bancorp and subsidiaries (the Company) are in accordance with generally accepted accounting principles and conform to general practices within the banking industry. The Company - Pacific Capital Bancorp is a California corporation and a multi-bank holding company, which was incorporated on January 26, 1983. The Company's subsidiaries, First National Bank of Central California (First National), and South Valley National Bank (South Valley), collectively (Subsidiary Banks), commenced operations in 1984 and 1983, respectively. First National is a full service commercial bank serving Monterey, Salinas, Carmel, Watsonville, Prunedale and surrounding areas in Monterey and Santa Cruz Counties. South Valley is a full service commercial bank serving Morgan Hill, Gilroy, Hollister, San Juan Bautista and surrounding areas in Santa Clara and San Benito Counties. Consolidation - The accompanying consolidated financial statements include the effect of the fourth quarter 1996 acquisition of South Valley Bancorporation which was accounted for as a pooling-of-interests. These financial statements include the accounts of Pacific Capital Bancorp and its subsidiaries, First National Bank of Central California and South Valley National Bank. Accordingly, the financial information included in the consolidated financial statements and notes thereto, present the combined results of operations of Pacific Capital Bancorp and South Valley Bancorporation as if the merger had been in effect for all periods presented. All significant intercompany balances and transactions have been eliminated. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents - Cash and cash equivalents as reported in the consolidated statements of cash flows includes cash on hand, cash balances due from banks, federal 23 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements funds sold, and money market mutual funds. The cash equivalents are readily convertible to known cash within 90 days. Investment Securities - The Company has classified its securities for which it has the positive intent and ability to hold to maturity as held-to-maturity securities. Such securities are reported at amortized cost. The Company has classified certain securities for which it does not have the intent to hold to maturity and which are not held principally for the purpose of selling them in the near term as available-for-sale securities. Such securities are reported at fair value, with unrealized gains and losses, net of income taxes, reported in a separate component of shareholders' equity. The Company does not engage in trading activities. Amortization of premiums and accretion of discounts arising at acquisition of investment securities are included in income using methods that approximate the level yield method. Gains or losses on the sale of securities are determined based on the specific identification method. In November 1995, the Financial Accounting Standards Board (FASB) issued a special report, A Guide to Implementation of Statement No. 115, on Accounting for Certain Investments in Debt and Equity Securities Questions and Answers, (the Special Report). The Special Report allowed companies to reassess the appropriateness of the classifications of all securities held and account for any resulting reclassifications at fair value. Reclassifications from this one-time reassessment will not call into question the intent of an enterprise to hold other debt securities to maturity in the future, provided that reclassification was performed by December 31, 1995. The Company adopted the reclassification provision in the Special Report during 1995 and transferred $38,660,000 of held-to-maturity securities into available-for-sale. Loans - Loans are stated at the principal amount outstanding. Interest on loans is credited to income on a simple interest basis. Loan origination fees and direct origination costs are deferred and amortized to income by a method approximating the level yield interest method over the estimated lives of the underlying loans. Loans contractually past due over 90 days or considered impaired are placed on nonaccrual status, unless they are well-secured by underlying collateral and are in the process of collection. When a loan is placed on nonaccrual status, the accrued interest is reversed against interest income and the loan is accounted for on the cash or cost recovery method thereafter until qualifying for return to accrual status. Generally, a loan will be returned to accrual status when all delinquent principal and interest become current in accordance with the terms of the loan agreement and full collection of the principal appears probable. 24 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The allowance for possible loan losses is a valuation allowance that is maintained at a level estimated to be adequate to provide for future loan losses through charges to current operating expense. The allowance is based upon a continuing review of loans by management which includes consideration of changes in the character of the loan portfolio, current and anticipated economic conditions, past lending experience, loan loss experience, and such other factors which, in management's judgment, deserve recognition in estimating potential loan losses. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for possible loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination. Loans Available for Sale - The Subsidiary Banks originate loans that are guaranteed in part by the Small Business Administration (SBA). The guaranteed portion of such loans may be sold without recourse. The Subsidiary Banks retain the servicing and credit risk in the remaining unguaranteed portion. Loans available for sale are valued at lower of cost or estimated market value and are comprised of the portion of loans originated for sale, which are guaranteed by the SBA. When participating interests in loans are sold without recourse, gains are recognized at the time of the sale which are equal to the premium received less estimated future loan servicing costs and profits. Any discounts related to loan interests retained are amortized using methods that approximate the level yield interest method over the remaining life of the loan. In 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities based on consistent application of a financial-components approach that focuses on control. It distinguishes transfers of financial assets that are sales from transfers that are secured borrowings. Under this approach, after a transfer of financial assets, an entity recognizes all financial and servicing assets it controls and liabilities it has incurred and derecognizes financial assets it no longer controls and liabilities that have been extinguished. Upon adoption, there was not a material impact to the Company's consolidated financial statements. Premises and Equipment - Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are charged to expense over the estimated useful lives of the assets or the lease term on a straight-line basis as follows: 25 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements - -------------------------------------------------------------------------------- Buildings 40 years Furniture and equipment 2-5 years Leasehold improvements 5 years Property under capital lease 5 years - -------------------------------------------------------------------------------- Other Real Estate Owned - Real estate and other assets acquired in satisfaction of indebtedness are recorded at the lower of the recorded loan amount or the estimated fair market value net of anticipated selling costs, and any difference between this and the loan amount is treated as a loan loss. Costs of maintaining other real estate owned, subsequent declines in fair value, if any, and gains or losses on sale are reflected in current earnings. Income Taxes - Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. To the extent that current available evidence about the future raises doubt about the realization of a deferred tax asset, a valuation allowance is established to reduce that deferred tax asset if it is more likely than not that the related tax benefits will not be realized. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years which those differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Net Income Per Share - In February 1997, the FASB issued SFAS No. 128, Earnings Per Share. SFAS No. 128 supersedes APB Opinion No. 15 Earnings Per Share, and specifies the computation, presentation, and disclosure requirements for earnings per share (EPS) for entities with publicly held common stock or potential common stock. SFAS No. 128 replaces Primary EPS and Fully Diluted EPS with Basic EPS and Diluted EPS, respectively. Upon adoption, it also requires dual presentation of Basic EPS and Diluted EPS on the face of the Statement of Income for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the Basic EPS computation to the numerator of the Diluted EPS computation. Basic EPS is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year plus shares issuable assuming exercise of all employee stock options, except where antidilutive. Weighted average shares outstanding and all per share 26 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements amounts included in the accompanying consolidated financial statements and notes thereto have given effect to all stock dividends. In February 1997, the FASB issued SFAS No. 129, Disclosures of Information about Capital Structure which establishes standards for disclosing information about an entity's capital structure for those entities deemed to have complex capital structures. This statement did not have a material impact on the Company's consolidated financial statements. Dividends - In 1997 the Company paid four cash dividends of $0.165 per share to shareholders of record on March 14, June 16, September 15, and November 17, payable on March 31, June 30, September 30, and December 1, 1997, respectively. The Company also paid a five percent (5%) stock dividend payable to shareholders of record as of December 1, 1997. Recent Accounting Pronouncements - In June 1997, the FASB issued SFAS No. 130, Reporting of Comprehensive Income. This statement establishes standards for reporting and displaying comprehensive income and its components in the consolidated financial statements. It does not, however, require a specific format for the statement, but requires the Company to display an amount representing total comprehensive income for the period in that financial statement. The Company will adopt the statement in 1998 but has not decided as to the presentation format. In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The Statement establishes standards for the way the public business enterprises are to report information about operating segments in annual financial statements and requires those enterprises to report selected information about operating segments in interim financial reports issued to shareholders. This statement is effective for fiscal years beginning after December 15, 1997. (2) Merger On November 20, 1996, the Company acquired South Valley Bancorporation (SVB) and its banking subsidiary, South Valley National Bank, headquartered in Morgan Hill, California. The consolidated financial statements of the Company give effect to the merger, which has been accounted for as a pooling-of-interests. Accordingly, the accounts of SVB have been combined with those of the Company for all prior periods presented. 27 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (3) Cash and Due from Banks Cash and due from banks includes approximately $3,845,000 and $5,659,000 as of December 31, 1997 and 1996, respectively, held by the Federal Reserve Bank of San Francisco to meet required reserve balances. (4) Quarterly Income Statement The consolidated statements of income for 1997 and 1996 by quarter is as follows: (Unaudited) 1997 - ----------------------------------------------------------------------------------------------------------------- (In thousands, except per share amounts) 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter - ----------------------------------------------------------------------------------------------------------------- Interest income $14,547 $13,633 $13,049 $11,986 Interest expense 4,867 4,513 4,143 3,862 - ----------------------------------------------------------------------------------------------------------------- Net interest income 9,680 9,120 8,906 8,124 Provision for possible loan losses 610 340 285 285 - ----------------------------------------------------------------------------------------------------------------- Net interest income after provision for possible loan losses 9,070 8,780 8,621 7,839 Other income 939 813 799 805 Other expense 5,927 5,033 4,964 4,960 - ----------------------------------------------------------------------------------------------------------------- Earnings before income taxes 4,082 4,560 4,456 3,684 Income taxes 1,607 1,811 1,775 1,442 - ----------------------------------------------------------------------------------------------------------------- Net income $ 2,475 $ 2,749 $ 2,681 $ 2,242 ================================================================================================================= Net income per share - basic $ 0.58 $ 0.64 $ 0.62 $ 0.52 ================================================================================================================= Net income per share - diluted $ 0.55 $ 0.62 $ 0.60 $ 0.50 ================================================================================================================= (Unaudited) 1996 - ----------------------------------------------------------------------------------------------------------------- (In thousands, except per share amounts) 4th Quarter 3rd Quarter 2nd Quarter 1st Quarter - ----------------------------------------------------------------------------------------------------------------- Interest income $11,843 $11,201 $10,626 $10,288 Interest expense 3,654 3,406 3,158 3,101 - ----------------------------------------------------------------------------------------------------------------- Net interest income 8,189 7,795 7,468 7,187 Provision for loan loss 500 6 74 105 - ----------------------------------------------------------------------------------------------------------------- Net interest income after provision for possible loan losses 7,689 7,789 7,394 7,082 Other income 781 780 817 782 Other expense 7,270 5,584 4,962 4,911 - ----------------------------------------------------------------------------------------------------------------- Earnings before income taxes 1,200 2,985 3,249 2,953 Income taxes 733 1,207 1,256 1,152 - ----------------------------------------------------------------------------------------------------------------- Net income $ 467 $ 1,778 $ 1,993 $ 1,801 ================================================================================================================= Net income per share - basic $ 0.11 $ 0.41 $ 0.46 $ 0.42 ================================================================================================================= Net income per share - diluted $ 0.10 $ 0.39 $ 0.45 $ 0.41 ================================================================================================================= 28 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (5) Investment Securities The amortized cost and estimated fair values of investment securities as of December 31 are as follows: - ---------------------------------------------------------------------------------------------------------------- Estimated Amortized Unrealized Unrealized fair (In thousands) cost gain loss value - ---------------------------------------------------------------------------------------------------------------- 1997 - ---------------------------------------------------------------------------------------------------------------- Available-for-sale securities: U.S. Treasury and agency $ 87,591 $ 698 $ 42 $ 88,247 State and municipal 9,529 115 2 9,642 Mortgage-backed securities 121,769 1,363 37 123,095 - ---------------------------------------------------------------------------------------------------------------- $218,889 $ 2,176 $ 81 $220,984 ================================================================================================================ Held-to-maturity securities: State and municipal $ 4,985 $ 32 $ 70 $ 4,947 Mortgage-backed securities And other 2,362 43 5 2,400 - ---------------------------------------------------------------------------------------------------------------- $ 7,347 $ 75 $ 75 $ 7,347 ================================================================================================================ 1996 - ---------------------------------------------------------------------------------------------------------------- Available-for-sale securities: U.S. Treasury and agency $ 64,109 $ 159 $ 187 $ 64,081 State and municipal 7,233 59 21 7,271 Mortgage-backed securities 45,470 9 303 45,176 - ---------------------------------------------------------------------------------------------------------------- $116,812 $ 227 $ 511 $116,528 ================================================================================================================ Held-to-maturity securities: State and municipal $ 6,449 $ 55 $ 42 $ 6,462 Mortgage-backed securities and other 3,231 59 11 3,279 - ---------------------------------------------------------------------------------------------------------------- $ 9,680 $ 114 $ 53 $ 9,741 ================================================================================================================ 29 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The amortized cost and estimated fair values of investment securities as of December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Available-for-sale Held-to-maturity securities securities ---------- ---------- Estimated Estimated Amortized fair Amortized fair (In thousands) cost value cost value - ----------------------------------------------------------------------------------------------------------------- Due within one year $ 18,847 $ 18,869 $1,733 $1,736 Due after one through five years 75,983 76,691 2,793 2,828 Due after five through ten years 17,323 18,284 529 529 Due after ten years 106,736 107,140 1,632 1,594 - ----------------------------------------------------------------------------------------------------------------- 218,889 220,984 6,687 6,687 Federal Reserve Bank Stock - - 660 660 - ----------------------------------------------------------------------------------------------------------------- $218,889 $220,984 $7,347 $7,347 ================================================================================================================= As of December 31, 1997 and 1996, securities with carrying values of approximately $34,660,000 and $26,638,000, respectively, were pledged as collateral for such items as deposits of public funds, Federal Reserve Bank borrowings, bankruptcy court accounts, and U.S. Treasury, tax, and loan deposits. 30 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (6) Loans A summary of loans as of December 31 is as follows: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 - -------------------------------------------------------------------------------- Commercial $110,595 $113,428 Consumer 24,677 22,509 Real estate - mortgage 227,367 195,417 Real estate - construction 41,863 38,014 Other 15,595 20,349 - -------------------------------------------------------------------------------- 420,097 389,717 Less deferred loan fees 804 989 - -------------------------------------------------------------------------------- $419,293 $388,728 ================================================================================ The following is an analysis of the allowance for possible loan losses for the years ended December 31: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 - -------------------------------------------------------------------------------- Balance, beginning of year $3,672 $3,710 $3,769 Provision charged to expense 1,520 685 527 Loans charged off (1,143) (1,070) (850) Recoveries on loans previously charged off 217 347 264 - -------------------------------------------------------------------------------- Balance, end of year $4,266 $3,672 $3,710 ================================================================================ Loans for which interest is no longer being accrued totaled $2,150,000, $1,564,000, and $2,481,000 as of December 31, 1997, 1996, and 1995, respectively. Interest that would have been recognized on nonaccrual loans was $125,000, $149,000, and $379,000 during 1997, 1996, and 1995, respectively. The recorded investment in impaired loans was $2,150,000 and $1,564,000 at December 31, 1997 and 1996, respectively. The average balance of impaired loans during 1997 and 1996 was $1,891,000 and $2,126,000. The Company did not recognize any interest income on impaired loans during 1997 and 1996. 31 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The Subsidiary Banks operate in a geographic region comprising Monterey, San Benito, Santa Clara, and Santa Cruz Counties. The Bank's credit risk is therefore dependent in part to the economic condition of this region. Loans are made on the basis of a secure repayment source, namely the cash flows generated by the borrowing entity, collateral is generally a secondary source for loan qualification. It is the Bank's policy to maintain the loan to value ratio on secured loans below 75%. Management believes this practice tends to mitigate risks caused by the local economy. The Subsidiary Banks make loans to executive officers, directors, and their affiliates in the ordinary course of business. Following is an analysis of activity with respect to such loans for the years ended December 31, 1997, and 1996: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 - -------------------------------------------------------------------------------- Balance, beginning of year $ 5,711 $ 5,002 New loans funded 5,190 4,394 Repayments of loans (2,714) (3,685) - -------------------------------------------------------------------------------- Balance, end of year $ 8,187 $ 5,711 ================================================================================ (7) Premises and Equipment Premises and equipment as of December 31 are summarized as follows: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 - -------------------------------------------------------------------------------- Land $2,888 $2,752 Buildings 10,244 9,867 Furniture and equipment 9,796 8,929 Leasehold improvements 1,529 1,421 - -------------------------------------------------------------------------------- 24,457 22,969 Less accumulated depreciation and amortization 9,126 7,669 - -------------------------------------------------------------------------------- Premises and equipment, net $15,331 $15,300 ================================================================================ (8) Time Deposits As of December 31, 1997 and 1996, the Company had liabilities of $117,409,000 and $80,952,000, respectively, for time deposits in denominations of $100,000 or more. Interest expense for these deposits was $6,243,000 and $4,036,000 in 1997 and 1996, respectively. 32 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (9) Income Taxes Components of income tax expense for the years ended December 31, 1997, 1996, and 1995 are as follows: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 - -------------------------------------------------------------------------------- Current: Federal $5,295 $3,696 $3,053 State 2,003 1,457 1,240 - -------------------------------------------------------------------------------- 7,298 5,153 4,293 - -------------------------------------------------------------------------------- Deferred: Federal (535) (649) (66) State (128) (156) (27) - -------------------------------------------------------------------------------- (663) (805) (93) - -------------------------------------------------------------------------------- Total $6,635 $4,348 $4,200 ================================================================================ The temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities that give rise to significant components of the deferred tax asset and liability amounts relate to the following as of December 31: - -------------------------------------------------------------------------------- (In thousands) 1997 1996 - -------------------------------------------------------------------------------- Deferred tax assets: Book provision for loan losses in excess of tax provision $1,492 $1,096 State franchise taxes 466 222 Accrued interest on nonaccrual loans recognized for tax 239 182 Expenses accrued for books not currently deductible 417 355 Unrealized loss on securities available-for-sale - 118 Loan fees and other, net 363 344 - -------------------------------------------------------------------------------- Total deferred tax assets 2,977 2,317 - -------------------------------------------------------------------------------- Deferred tax liabilities: Tax depreciation in excess of book 196 86 Amortization related to sale/leaseback of building 126 34 Difference in recognition of organization costs and other 11 11 Unrealized gain on available-for-sale securities 941 - - -------------------------------------------------------------------------------- Total deferred tax liabilities 1,274 131 - -------------------------------------------------------------------------------- Net deferred tax asset $1,703 $2,186 ================================================================================ 33 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The net deferred tax asset represents recoverable taxes and is included in other assets in the accompanying consolidated balance sheets. The Company believes that the net deferred tax asset is realizable through sufficient taxable income within the carryback period and the current year taxable income. Actual income tax expense differs from the "expected" tax expense (computed by applying the U.S. federal corporate income tax rate of 34% to earnings before income taxes) for the years ended December 31, as follows: - ------------------------------------------------------------------------------------------------------------------ (In thousands) 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------------ Computed "expected" tax expense $5,706 $3,531 $3,702 Increase (reduction) in income taxes resulting from: Franchise taxes, net of federal income tax benefit 1,270 858 802 Tax exempt income (371) (368) (335) Merger related costs - 325 - Other, net 30 2 31 - ------------------------------------------------------------------------------------------------------------------ $6,635 $4,348 $4,200 ================================================================================================================== (10) Benefit Plans Stock Option Plans - The Company's 1984 Stock Option Plan (the 1984 Plan) under which incentive stock options or nonqualified stock options were granted to certain key employees or directors to purchase an aggregate of 53,364 shares of authorized, but unissued, common stock of the Company. Unexercised options were granted and outstanding as of December 31, 1997, for an aggregate of 53,364 shares. Options have been granted at an exercise price not less than the fair market value of such stock at the date of grant. All stock options become exercisable at the rate determined by the Company's Board of Directors and expire no later than 10 years after the date of grant. The Company's 1994 Stock Option Plan (the 1994 Plan) which was a successor to the 1984 Plan, provides for incentive stock options or nonqualified stock options for key employees or directors to purchase an aggregate of 592,915 shares of authorized, but unissued, common stock of the Company. Unexercised options were granted and outstanding as of December 31, 1997, for an aggregate of 417,474 shares with an exercise price equal to the fair market value of the Company's common stock at the date of grant. The 1994 Plan provides that options granted thereunder begin to vest 6 months after the date of grant ratably over 4 years and expire no later than 10 years after the date of grant. 34 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The Company has a Directors Stock Option Plan (the 1991 Plan) under which, nonqualified options may be granted to non-employee directors of the Company and its subsidiaries to purchase an aggregate of 202,776 shares of authorized, but unissued, common stock of the Company according to a formula set forth in the 1991 Plan. Unexercised options were granted and outstanding as of December 31, 1997, for an aggregate of 83,116 shares with an exercise price equal to the fair market value of the Company's common stock at the date of grant. The 1991 Plan provides that options granted thereunder begin to vest 6 months after the date of grant and expire no later than 10 years after the date of grant. In October 1995, the FASB issued SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 established financial accounting and reporting standards for stock-based employee compensation plans. This statement defines a fair value based method of accounting for an employee stock option or similar equity instrument. Under this method, compensation costs are measured at the grant date based on the value of the award and are recognized over the service period, which is the vesting period. As allowed under SFAS No. 123, the Company applies APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock option plans. Had compensation costs for the Company's three stock option plans been determined consistent with SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below: December 31, - ---------------------------------------------------------------------------------------------------------------- (In thousands, except per share) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------------- Net income As reported $10,147 $6,039 $6,611 Pro forma $9,836 $5,883 $6,605 Basic earnings per share As reported $2.36 $1.41 $1.55 Pro forma $2.29 $1.37 $1.55 Diluted earnings per share As reported $2.28 $1.36 $1.50 Pro forma $2.21 $1.32 $1.50 The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants in 1997, 1996 and 1995, respectively: dividend yield of 2.1%, 2.5% and 2.1%, expected volatility of 18% for all years, risk-free interest rates of 5.86%, 5.64% and 5.39%, and expected lives of 6.9, 6.1 and 5.5 years, respectively. 35 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements Below is a summary of stock option activity under all plans during 1997, 1996 and 1995: 1997 1996 1995 - -------------------------------------------------------------------------------------------------------------------- Weighted Weighted Weighted average average average exercise exercise exercise Shares price Shares price Shares price - -------------------------------------------------------------------------------------------------------------------- Outstanding at beginning of year 388,895 $15.59 433,474 $14.57 400,967 $14.33 Granted 197,270 35.93 157,153 19.13 62,321 15.00 Exercised (17,436) 10.74 (200,106) 14.69 (22,811) 11.73 Forfeited (16,525) 13.32 (1,626) 11.32 (7,003) 13.74 - -------------------------------------------------------------------------------------------------------------------- Outstanding at end of year 552,204 $22.36 388,895 $16.37 433,474 $14.57 Options exercisable at end of 489,046 333,753 366,350 year Weighted average fair value of options granted during the year $9.40 $4.12 $3.12 - -------------------------------------------------------------------------------------------------------------------- The following table summarizes information about stock options outstanding at December 31, 1997: Options Outstanding Options Exercisable - --------------------------------------------------------------------------------------------------------------------- Weighted average Weighted Weighted Number contractual average Number average Exercise Prices outstanding life exercise price outstanding exercise price - -------------------------------------------------------------------------------------------------------------------- $6.83 to $15.00 293,066 5.61 $13.97 292,315 $13.97 $15.01 to $20.00 15,229 5.63 16.14 12,046 16.05 $20.01 to $30.00 66,609 8.88 24.47 16,685 24.43 $30.01 to $43.50 177,300 9.87 35.96 168,000 35.60 - -------------------------------------------------------------------------------------------------------------------- $6.83 to $43.50 552,204 7.37 $22.36 489,046 $21.81 - -------------------------------------------------------------------------------------------------------------------- Employee Stock Ownership Plan - In 1986, the Company adopted an Employee Stock Ownership Plan (ESOP) covering substantially all employees. The Company may make annual contributions to the ESOP in an amount determined by the Board of Directors. Contributions are not intended to exceed an amount estimated to be an allowable deduction for tax purposes. The Company made contributions to the ESOP of $400,000, $275,000, and $292,000 in 1997, 1996, and 1995, respectively. 401(k) Plan - The Company also has a tax deferred profit sharing plan and thrift plan covering all eligible employees. The Company's contributions amounted to $70,000, $71,000, and $70,000 for the years ended December 31, 1997, 1996, and 1995. 36 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (11) Fair Value of Financial Instruments The carrying amounts and estimated fair values of the Company's financial instruments are as follows: - --------------------------------------------------------------------------------------------------------------------- December 31, 1997 December 31, 1996 ------------------- ------------------ Carrying Estimated Carrying Estimated (In thousands) amounts fair value amounts fair value - --------------------------------------------------------------------------------------------------------------------- Assets: Cash and cash equivalents $78,519 $78,519 $76,245 $76,245 Investment securities 228,331 228,331 126,208 126,269 Net loans 430,620 430,582 395,538 395,796 - --------------------------------------------------------------------------------------------------------------------- Liabilities: Demand deposits, noninterest bearing $174,649 $174,649 $131,332 $131,332 Demand deposits, interest bearing 97,322 97,322 84,770 84,770 Savings and money market 173,151 173,151 164,890 164,890 Time certificates 238,276 238,465 166,190 166,632 - --------------------------------------------------------------------------------------------------------------------- The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value. Cash and Cash Equivalents - The carrying amount approximates fair value because of the short maturities of these instruments. Investment Securities - The fair value of investments and mortgage-backed securities, except certain state and municipal securities, is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers. The fair value of certain state and municipal securities is not readily available through market sources other than dealer quotations, so fair value estimates are based on quoted market prices of similar instruments, adjusted for differences between the quoted instruments and the instruments being valued. Loans - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, and consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. 37 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements The fair value of performing fixed rate loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of maturity is based on the Company's historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The fair value of performing variable rate loans is judged to approximate book value for those loans whose rates reprice in less than 90 days. Rate floors and rate ceilings are not considered for fair value purposes as the number of loans with such limitations is not significant. Fair value for significant nonperforming loans is based on recent external appraisals. If appraisals are not available, estimated cash flows are discounted using a rate commensurate with the risk associated with the estimated cash flows. Assumptions regarding credit risk, cash flows, and discount rates are judgmentally determined using available market information and specific borrower information. Deposit Liabilities - The fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings and NOW accounts, and money market and checking accounts, approximates the amount payable on demand. The fair value of certificates of deposit is judged to approximate book value for those certificates whose remaining maturities are less than 90 days. For all other certificates, estimated cash flows are discounted using rates currently offered for deposits of similar remaining maturities. Limitations - Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. 38 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in many of the estimates. (12) Commitments and Contingencies Future minimum rental payments for Company premises under noncancelable operating leases as of December 31, 1997 are as follows: - ------------------------------------------------------------------------------ Minimum lease payments Year ending December 31, (In thousands) - ------------------------------------------------------------------------------ 1998 $931 1999 683 2000 461 2001 213 2002 213 Thereafter 913 - ------------------------------------------------------------------------------ 3,414 Minimum rentals receivable under noncancelable subleases (868) - ------------------------------------------------------------------------------ $2,546 ============================================================================== Rent expense under operating leases totaled $802,000, $796,000, and $781,000 for the years ended December 31, 1997, 1996, and 1995, respectively. Related sublease rental income totaled $137,000, $131,000, and $82,000, respectively. In December 1988, the Company entered into an operating lease with a member of its Board of Directors for rental of its administrative headquarters. This lease required payments totaling approximately $199,000, $192,000, and $188,000 for the years ended December 31, 1997, 1996, and 1995, respectively. The lease expires on April 30, 1999. In the normal course of business, there are outstanding commitments, such as commitments to extend credit, which are not reflected in the accompanying consolidated financial statements. These commitments involve elements of credit and interest rate risk. Management does not anticipate any loss will result from such commitments. 39 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements As of December 31, 1997, amounts committed to extend credit under normal lending agreements aggregated approximately $134,638,000. Management reviews the risk associated with these credits in evaluating the overall adequacy of the allowance for possible loan losses. Additionally, there are approximately $4,193,000 in outstanding standby letters of credit which, in effect, are guarantees of obligations of customers. The Company, through the Subsidiary Banks, has borrowing lines of approximately $51,000,000 with primary correspondent banks. There were no borrowings outstanding under these lines as of December 31, 1997 and 1996. (13) Regulatory Capital The Federal Reserve Board and the Comptroller have established a minimum leverage ratio of 3% Tier 1 capital to total assets for bank holding companies and national banks that have received the highest composite regulatory rating and are not anticipating or experiencing any significant growth. All other institutions will be required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum. Following are the Company's and the Subsidiary Banks' risk-based and leverage capital ratios as of December 31, 1997: - ------------------------------------------------------------------------------------------------------------------- Risk Based Capital Ratio As of December 31, 1997 - ------------------------------------------------------------------------------------------------------------------- Company South Valley First National (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------- Tier 1 capital $68,925 13.58% $17,592 11.71% $44,601 12.81% Tier 1 capital minimum requirement 20,295 4.00% 6,009 4.00% 13,929 4.00% - ------------------------------------------------------------------------------------------------------------------- Excess 48,630 9.58% 11,583 7.71% 30,672 8.81% =================================================================================================================== Total capital 73,191 14.43% 19,337 12.87% 47,116 13.53% Total capital minimum requirement 40,589 8.00% 12,017 8.00% 27,858 8.00% - ------------------------------------------------------------------------------------------------------------------- Excess 32,602 6.43% 7,320 4.87% 19,258 5.53% =================================================================================================================== Risk-adjusted assets $507,363 $150,216 $348,220 =================================================================================================================== 40 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 1996 - ------------------------------------------------------------------------------------------------------------------- Company South Valley First National (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------- Tier 1 capital $63,469 13.91% $16,096 11.63% $42,034 13.40% Tier 1 capital minimum requirement 18,254 4.00% 5,534 4.00% 12,546 4.00% - ------------------------------------------------------------------------------------------------------------------- Excess 45,215 9.91% 10,562 7.63% 29,488 9.40% =================================================================================================================== Total capital 67,141 14.71% 17,409 12.58% 44,258 14.11% Total capital minimum requirement 36,508 8.00% 11,069 8.00% 25,092 8.00% - ------------------------------------------------------------------------------------------------------------------- Excess 30,633 6.71% 6,340 4.58% 19,166 6.11% =================================================================================================================== Risk-adjusted assets $456,356 $138,362 $313,644 =================================================================================================================== As indicated in the table above, the Company's capital ratios significantly exceeded the minimum capital levels required by current federal regulations. Management believes that the Company and the Subsidiary Banks will continue to meet their respective minimum capital requirements in the foreseeable future. - -------------------------------------------------------------------------------------------------------------------- Leverage Capital Ratio December 31, 1997 Company South Valley First National - -------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------------------------------- Tier 1 capital to quarterly average Total assets (Leverage Ratio) $68,925 9.17% $17,592 8.03% $44,601 8.49% Minimum leverage requirement 22,543 to 3.00% to 6,575 to 3.00% to 15,761 to 3.00% to 37,572 5.00% 10,958 5.00% 26,268 5.00% - -------------------------------------------------------------------------------------------------------------------- Excess 31,353 to 4.17% to 6,634 to 3.03% to 18,333 to 3.49% to 46,382 6.17% 11,017 5.03% 28,840 5.49% ==================================================================================================================== Total quarterly average assets $751,439 $219,168 $525,357 ==================================================================================================================== December 31, 1996 Company South Valley First National - -------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------------------------------- Tier 1 capital to quarterly average Total assets (Leverage Ratio) $63,469 10.55% $16,096 8.61% $42,034 10.29% Minimum leverage requirement 18,045 to 3.00% to 5,611 to 3.00% to 12,255 to 3.00% to 30,075 5.00% 9,351 5.00% 20,425 5.00% - -------------------------------------------------------------------------------------------------------------------- Excess 33,394 to 5.55% to 6,745 to 3.61% to 21,609 to 5.29% to 45,424 7.55% 10,485 5.61% 29,779 7.29% ==================================================================================================================== Total quarterly average assets $601,496 $187,024 $408,502 ==================================================================================================================== 41 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (14) Pacific Capital Bancorp (Parent Company Only) The following are the financial statements of Pacific Capital Bancorp: - -------------------------------------------------------------------------------- BALANCE SHEETS Years ended December 31, - -------------------------------------------------------------------------------- (In thousands) 1997 1996 - -------------------------------------------------------------------------------- Assets Cash and cash equivalents $538 $937 Loans - 1,042 Premises and equipment, net 3,500 3,022 Investment in subsidiaries 65,826 58,178 Other assets 5,360 910 - -------------------------------------------------------------------------------- Total Assets $75,224 $64,089 ================================================================================ Liabilities and Shareholders' Equity Liabilities $2,666 $443 Shareholders' equity 72,558 63,646 - -------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $75,224 $64,089 ================================================================================ - -------------------------------------------------------------------------------- STATEMENTS OF INCOME Years ended December 31, - -------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 - -------------------------------------------------------------------------------- Equity in undistributed income of subsidiaries $6,211 $3,061 $6,010 Cash dividends received from bank subsidiaries 4,799 3,993 882 Interest income and fees on loans 36 136 214 Other expenses (899) (1,151) (495) - -------------------------------------------------------------------------------- Net income $10,147 $6,039 $6,611 ================================================================================ 42 PACIFIC CAPITAL BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements STATEMENTS OF CASH FLOWS Years ended December 31, - ---------------------------------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $ 10,147 $ 6,039 $ 6,611 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of subsidiaries (11,010) (7,054) (6,892) Dividends received from subsidiaries 4,799 3,993 882 Increase in other assets (4,450) (341) (68) Increase (decrease) in other liabilities 2,223 140 (34) - ---------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 1,709 2,777 499 - ---------------------------------------------------------------------------------------------------------- Cash flows from investing activities: Net change in loans 1,042 107 1,931 Capital expenditures (386) (1,157) (493) - ---------------------------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities 656 (1,050) 1,438 - ---------------------------------------------------------------------------------------------------------- Cash flows from financing activities: Repurchase and retirement of stock (456) (605) (111) Proceeds from stock options exercised 410 284 158 Cash paid for fractional shares (40) (21) (15) Cash paid for dividends (2,678) (2,053) (1,684) - ---------------------------------------------------------------------------------------------------------- Net cash used in financing activities (2,764) (2,395) (1,652) - ---------------------------------------------------------------------------------------------------------- Net (decrease) increase in cash and cash equivalents (399) (668) 285 Cash and cash equivalents at beginning of year 937 1,605 1,320 - ---------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of year $ 538 $ 937 $ 1,605 ========================================================================================================== Supplemental disclosures: Noncash investment and financing activities: Transfer from retained earnings to common stock due to stock dividend $ 9,000 $ 5,348 $ 3,132 ========================================================================================================== The ability of the Company to pay dividends will largely depend upon the dividends paid to it by the Subsidiary Banks. There are legal limitations on the ability of the Subsidiary Banks to provide funds to the Company in the form of loans, advances, or dividends. Under the National Bank Act, the Subsidiary Banks may not declare dividends in any calendar year that exceeds certain legal limitations. The approximate amount of restricted equity of the Subsidiary Banks as of December 31, 1997 was $47,826,000. 43 PACIFIC CAPITAL BANCORP Management's Discussion and Analysis 1997 This document may contain forward-looking statements that are subject to risks and uncertainties, including, but not limited to the local economy, the real estate market in California, and other factors beyond the Company's control. Such risks and uncertainties could cause actual results to differ materially from those indicated. For a discussion of factors that could cause actual results to differ, please see the discussion contained herein. Readers should not place undue reliance on forward-looking statements, which reflect management's view only as of the date hereof. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances. Readers are also encouraged to review the Company's publicly available filings with the Securities and Exchange Commission. The Company Pacific Capital Bancorp (the "Company") through its wholly owned subsidiaries, First National Bank of Central California ("First National"), and South Valley National Bank ("South Valley") engages in a broad range of financial service activities. First National and South Valley are collectively referred to herein as "Subsidiary Banks," and references to the Company include the Subsidiary Banks. On November 20, 1996, the Company acquired South Valley Bancorporation (SVB) in a transaction accounted for as a pooling-of-interests. Accordingly, these consolidated financial statements were restated on a combined basis for all periods presented. The following sections set forth a discussion of the significant operating changes, business trends, financial condition, earnings, capital position, and liquidity that have occurred in the three-year period ended December 31, 1997, together with an assessment, when considered appropriate, of external factors that may affect the Company in the future. This discussion should be read in conjunction with the Company's consolidated financial statements and notes on pages _____ of this annual report. Summary of Financial Results Net income for 1997 was $10,147,000 or $2.28 per share, an increase of $4,108,000 or $0.92 per share from 1996. This increase in net income is due to an increase in net interest income of $5,191,000 or 16.9% over 1996. In addition, results from the year ended December 31, 1996 contained merger-related expenses incurred relating to the merger with South Valley Bancorporation. Net income for 1996 excluding the one-time merger-related expenses was $7,540,000 or $1.69 per share and represented an increase of $929,000 or $0.19 per share over results for 1995. 44 In 1997 the Company paid four cash dividends of $0.165 in March, June, September, and December. In 1996, the Company distributed three $0.15 cash dividends in March, June, September and December. In addition, the Company distributed a 5% stock dividend in each of the years in the three year period ended December 31, 1997. Earnings per share amounts have been retroactively restated to reflect these stock dividends. The return on average shareholders' equity was 14.8% in 1997, compared to 9.6% in 1996 and 11.4% in 1995. The Company believes that the economies in which it operates, Monterey, Santa Cruz, Santa Clara, and San Benito Counties, have experienced strong growth and favorable economic activity in the past three years. Signs of the strength in these local economies include sustained quality loan demand and strong deposit growth. On a national scale, the Company is forecasting a relatively flat interest rate environment due to minimal inflation prospects and very modest growth. Certain information concerning the Company's average balances, yields and rates on average interest-earning assets and interest-bearing liabilities is set forth in the following table. Interest yields and amounts earned include net loan fees of $1,312,000, $1,211,000, and $1,152,000 in 1997, 1996, and 1995, respectively. 45 AVERAGE BALANCE SHEETS - --------------------------------------------------------------------------------------------------------------------- 1997 1996 1995 Average Yield/ Interest Average Yield/ Interest Average Yield/ Interest (Dollars in thousands) Balance Rate Amount Balance Rate Amount Balance Rate Amount - --------------------------------------------------------------------------------------------------------------------- Assets Earning assets Investment securities: Taxable $144,331 6.4% $9,239 $124,709 6.1% $7,645 $95,408 5.7% $5,455 Non-taxable 13,247 4.9% 651 14,966 5.0% 750 17,529 5.2% 903 Federal funds sold 46,211 5.4% 2,482 34,267 5.3% 1,805 35,564 5.3% 1,871 - --------------------------------------------------------------------------------------------------------------------- Total investment securities 203,789 6.1% 12,372 173,942 5.9% 10,200 148,501 5.5% 8,229 Loans 411,546 9.9% 40,843 332,421 10.2% 33,758 290,265 10.5% 30,449 - --------------------------------------------------------------------------------------------------------------------- Total earning assets 615,335 8.6% 53,215 506,363 8.7% 43,958 438,760 8.8% 38,678 Non-earning assets Premises and equipment 15,270 14,769 13,201 Other 46,886 47,554 44,040 - --------------------------------------------------------------------------------------------------------------------- Total non-earning assets 62,156 62,323 57,241 - --------------------------------------------------------------------------------------------------------------------- Total assets $677,491 $568,686 $496,007 ===================================================================================================================== Liabilities and Shareholders' Equity Interest-bearing deposits: Demand $85,769 1.0% $846 $77,306 1.1% $846 $87,916 1.7% $1,502 Savings and money market 169,577 2.9% 4,844 168,553 2.8% 4,664 140,209 2.8% 3,913 Time certificates 214,664 5.4% 11,666 146,359 5.3% 7,782 108,026 5.1% 5,507 Other interest-bearing 522 5.6% 29 716 3.8% 27 1,030 4.8% 49 liabilities - --------------------------------------------------------------------------------------------------------------------- Total 470,532 3.7% 17,385 392,934 3.4% 13,319 337,181 3.3% 10,971 Non interest-bearing deposits And other liabilities: Demand, non 134,943 109,615 95,824 interest-bearing Other liabilities 3,663 3,031 4,819 Shareholder's equity 68,353 63,106 58,183 - --------------------------------------------------------------------------------------------------------------------- Total 206,959 175,752 158,826 - --------------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $677,491 $568,686 $496,007 ===================================================================================================================== NET INTEREST INCOME $35,830 $30,639 $27,707 NET INTEREST MARGIN 5.8% 6.1% 6.3% - --------------------------------------------------------------------------------------------------------------------- The net interest margin is expressed as the percentage of net interest income to average total earning assets. The average balance on non-accrual loans is immaterial as a percentage of total loans and as such has been included in total loans. Non-taxable securities and leases have not been calculated on a tax equivalent basis. Net Interest Income Net interest income, the difference between interest earned on loans and investments and the interest paid on deposits and other sources of funds, is the principal component of the Company's earnings. The preceding table shows the composition of average earning assets and average interest-bearing liabilities, average yields and rates, and the net interest margin for 1995 through 1997. Interest income increased $9,257,000 or 21.1% from $43,958,000 in 1996 to $53,215,000 in 1997, after increasing $5,280,000 or 13.7% from 1995 to 1996. The increases in 1997 and 1996 are the result of higher average loan and investment volumes partially offset by a slightly 46 lower yield on the loan portfolio. Total interest and fees produced a 8.6% yield on average earning assets in 1997, compared to 8.7% and 8.8% yields on average earning assets in 1996 and 1995, respectively. Total interest expense for 1997 was $17,385,000, an increase of $4,066,000 or 30.5% over 1996, compared to an increase of $2,348,000 or 21.4% from 1995 to 1996. The Company's cost of funds experienced an increase of 0.3% from 1996 to 1997 and an increase of 0.1% from 1995 to 1996. The cost of funds increase in 1997 was due primarily to a change in the mix of deposits. The increase in 1996 over 1995 was due to the prevailing rising interest rate environment. The Company's net yield on interest-earning assets is affected by changes in the rates earned and paid and the volume of interest-earning assets and interest-bearing liabilities. The impact of changes in volume and rate on net interest income in 1997 and 1996 is shown in the following table. Changes attributable to both volume and rate have been allocated to rate. - --------------------------------------------------------------------------------------------------------------------- 1997 Compared to 1996 1996 Compared to 1995 (In thousands) Volume Rate Total Volume Rate Total - --------------------------------------------------------------------------------------------------------------------- Investment securities Taxable $1,203 $391 $1,594 $1,675 $515 $2,190 Non-taxable (86) (13) (99) (132) (21) (153) Federal funds sold 629 48 677 (68) 2 (66) Loans 8,035 (950) 7,085 4,708 (1,399) 3,309 - --------------------------------------------------------------------------------------------------------------------- Total 9,781 (524) 9,257 6,183 (903) 5,280 - --------------------------------------------------------------------------------------------------------------------- Demand, interest bearing 93 (93) - (181) (475) (656) Savings 28 152 180 791 (40) 751 Time certificates 3,632 252 3,884 1,954 321 2,275 Fed funds purchased (7) 9 2 (15) (7) (22) - --------------------------------------------------------------------------------------------------------------------- Total 3,746 320 4,066 2,549 (201) 2,348 - --------------------------------------------------------------------------------------------------------------------- Increase in net interest income $6,035 $(844) $5,191 $3,634 $(702) $2,932 ===================================================================================================================== Earning Assets Outstanding total loans averaged $411,546,000 in 1997 compared to $332,421,000 during 1996. This represents an increase of $79,125,000 or 23.8%, compared to an increase of $42,156,000 or 14.5% from 1995 to 1996. The increase in total loans outstanding during 1997 is due to increased loan demand from qualified borrowers and is reflective of the strength of the economy in most of the primary markets which the Company serves. The table on the following page summarizes the composition of the loan portfolio as of December 31: 47 - --------------------------------------------------------------------------------------------------------------- (In thousands) 1997 1996 1995 1994 1993 - --------------------------------------------------------------------------------------------------------------- Commercial $110,595 $113,428 $82,583 $77,402 $63,926 Real Estate - construction 41,863 38,014 32,409 39,352 26,799 Real Estate - mortgage 227,367 195,417 154,572 144,687 146,675 Consumer 24,677 22,509 25,604 22,907 22,185 Other 14,791 19,360 5,727 6,004 6,318 - --------------------------------------------------------------------------------------------------------------- Total $419,293 $388,728 $300,895 $290,352 $265,903 =============================================================================================================== The Company lends primarily to small- and medium-sized businesses within its markets, which is comprised principally of Monterey, Santa Cruz, Santa Clara, and San Benito Counties. A majority of the Company's loan portfolio consists of loans secured by commercial, industrial, and residential real estate. As of December 31, 1997, real estate mortgage and construction loans represented $269,230,000 or 64.2% of total loans, compared to $233,431,000 or 60.0% of total loans at December 31, 1996. Real estate mortgage loans included commercial real estate loans of approximately $175,684,000, one-to-four family home loans of approximately $25,374,000, equity lines of credit of approximately $19,462,000, multifamily dwelling loans of approximately $4,334,000 and farm land loans of approximately $2,513,000. Construction loans totaled $41,863,000 or 10.0% of the loan portfolio as of December 31, 1997, which represents an increase of $3,849,000 or 10.1% from December 31, 1996. Management believes that the Bank does not have any significant loss exposure with respect to such loans, due to the Bank's collateral position. In general, advances do not exceed 70% of appraised value on commercial real estate loans and 75% on residential mortgages. Continued emphasis is placed on this policy and, accordingly, appraisals are periodically updated as conditions change. The Company finances the construction of residential and commercial real estate properties. These loans are all at variable rates, are secured by first deeds of trust on the underlying properties, and generally have maturities of less than 24 months. Repayment is based on a pre-qualification analysis of the borrower's ability to obtain take-out financing. The Company's construction lending has been in areas which management believes to have favorable market conditions. Advances on residential and commercial projects are limited in general to the lower of approximately 75% and 70%, respectively, of cost or appraised value. Commercial loans not secured by real estate totaled $110,595,000 or 26.4% of the total loan portfolio at December 31, 1997 compared to $113,428,000, or 29.2% of total loans as of December 31, 1996. Consumer loans increased $2,168,000 or 9.6% during 1997. Consumer loans, as of December 31, 1997, represent 5.9% of the total loan portfolio, compared to 5.8% of the 1996 loan portfolio. The Company had undisbursed loans totaling $134,638,000 as of December 31, 1997, primarily representing available lines of credit and the unfunded portion of construction loan commitments. 48 The following table sets forth the maturity distribution of the loan portfolio as of December 31, 1997: - ---------------------------------------------------------------------------------------------------------- After one In one year year through After five (In thousands) or less five years years Total - ---------------------------------------------------------------------------------------------------------- Commercial $ 93,317 $14,276 $ 3,002 $110,595 Real Estate - construction 41,101 484 278 41,863 Real Estate - mortgage 108,888 63,205 55,274 227,367 Consumer 11,901 10,398 2,378 24,677 Other 3,067 4,962 6,762 14,791 - ---------------------------------------------------------------------------------------------------------- Gross loans $258,274 $93,325 $67,694 $419,293 ========================================================================================================== The fixed rate loan categories discussed above mature as follows: $14,072,000 in 1998, $9,201,000 in 1999, $10,212,000 in 2000, $20,566,000 in 2001, and $16,738,000 in 2002, with the remaining $67,694,000 maturing thereafter. The variable loan rate categories discussed above mature as follows: $244,287,000 in 1998, $15,198,000 in 1999, $5,780,000 in 2000, $8,107,000 in 2001, and $7,438,000 maturing in 2002. 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 liabilities than assets reprice in a given period (a liability sensitive position), market interest rate changes will be reflected more quickly in liability rates. If interest rates decline, a liability sensitive position will benefit net income. Alternatively, where assets reprice more quickly than liabilities in a given period (an asset sensitive position) a decline in market rates will have an adverse effect on net interest income. The table on the following page presents the interest rate sensitivity of the Company as of December 31, 1997. For any given period, the structure is matched when an equal amount of assets and liabilities reprice. Any excess of assets or liabilities over these matched items results in the gap, or mismatch, shown at the foot of the table. A negative gap indicates liability sensitivity and a positive gap indicates asset sensitivity. 49 - ----------------------------------------------------------------------------------------------------------- Interest Rate Sensitivity as of December 31, 1997 - ----------------------------------------------------------------------------------------------------------- Repricing Opportunity 0 - 90 91 - 180 181 - 365 Over (In thousands) Days Days Days One Year Total - ----------------------------------------------------------------------------------------------------------- Federal funds sold $26,405 $- $- $- $26,405 Loans 216,404 20,202 30,662 163,352 430,620 Taxable investments 14,501 5,281 18,404 177,650 215,836 Non-taxable investments 552 228 1,988 11,859 14,627 - ----------------------------------------------------------------------------------------------------------- Total Earning Assets 257,862 25,711 52,054 352,861 687,488 - ----------------------------------------------------------------------------------------------------------- Interest bearing demand 97,322 - - - 97,322 Savings deposits 161,195 - 6,082 5,874 173,151 Time certificates 88,242 63,784 82,329 3,921 238,276 - ----------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 346,759 63,784 88,411 9,795 508,749 - ----------------------------------------------------------------------------------------------------------- Gap $(88,897) $(38,073) $(37,357) $343,066 $178,739 Cumulative gap (88,897) (126,970) (164,627) 178,739 =========================================================================================================== The Company has remained flexible in determining the point at which to reprice deposits. This flexibility mitigates the Company's liability sensitive position in the under one year category. Quality of Loans The Company had net loan charge-offs of $926,000, $723,000 and $586,000 in 1997, 1996 and 1995, respectively. Net charge-offs as a percent of average loans has remained relatively constant over the last three years at 0.23%, 0.22%, and 0.20% for the years ended December 31, 1997, 1996, and 1995, respectively. Over the last five years, the low amount of net charge-offs to average loans is indicative of the continued emphasis placed on credit quality standards in the loan approval process as well as close monitoring of the loan portfolio. The Company's net charge-offs as a percent of average loans have been below most industry averages in each year reflected in the following table. Management anticipates the Company's charge-off experience in 1998 to be consistent with that experienced in 1997 primarily due to the strength and growth in the local economic areas in which the Company serves. This factor continues to be of importance in assessing the adequacy of the allowance for possible loan losses. The table on the following page summarizes the actual loan losses and provision for possible loan losses during the last five fiscal years by loan category: 50 - -------------------------------------------------------------------------------------------- Summary of Loan Loss Activity (In thousands) 1997 1996 1995 1994 1993 - -------------------------------------------------------------------------------------------- Total loans outstanding, end of year $419,293 $388,728 $300,895 $290,352 $265,903 Average loans during the year 411,546 332,421 290,265 277,263 259,131 Allowance for possible loan losses: Balance, beginning of year 3,672 3,710 3,769 3,753 3,479 Charge-off by loan category Commercial 873 761 480 331 491 Consumer 59 188 129 148 327 Real estate 211 121 241 186 364 - -------------------------------------------------------------------------------------------- Total 1,143 1,070 850 665 1,182 - -------------------------------------------------------------------------------------------- Recoveries by loan category Commercial 120 239 98 144 62 Consumer 24 91 42 37 54 Real estate 73 17 124 21 62 - -------------------------------------------------------------------------------------------- Total 217 347 264 202 178 - -------------------------------------------------------------------------------------------- Net charge-offs 926 723 586 463 1,004 Provision charged to expense 1,520 685 527 479 1,278 - -------------------------------------------------------------------------------------------- Balance, end of year $4,266 $3,672 $3,710 $3,769 $3,753 ============================================================================================ Ratios: Net charge-offs to average loans 0.23% 0.22% 0.20% 0.17% 0.39% Allowance to loans at end of year 1.02% 0.94% 1.23% 1.30% 1.41% - -------------------------------------------------------------------------------------------- Inherent in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan extended and the creditworthiness of the borrower. To reflect the estimated risks of loss associated with its loan portfolio, provisions are made to the Company's allowance for possible loan losses. As an integral part of this process, the allowance for possible loan losses is subject to review and possible adjustment as a result of regulatory examinations conducted by governmental agencies and through management's assessment of risk. The Company's entire allowance is a valuation allocation; that is, it has been created by direct charges against earnings through the provision for possible loan losses. The Company evaluates the allowance for possible loan losses based upon an individual analysis of specific categories of loans. The adequacy of the allowance can be determined only on an approximate basis, since estimates as to the magnitude and timing of loan losses are not predictable because of the impact of external events. In addition, the Company has for the last several years contracted with an independent loan review consulting firm to evaluate overall credit quality on an ongoing basis. Management then considers the adequacy of the allowance for possible loan losses in relation to the total loan portfolio. The provision for possible loan losses charged against earnings is based upon an analysis of the actual migration of loans to losses plus an amount for other factors which, in management's judgment, deserve recognition in estimating possible loan losses. These factors include: specific loan conditions as determined by management; the historical relationship between charge-offs and the level of the allowance; the estimated future loss in all significant loans; known deterioration in 51 concentrations of credit, certain classes of loans or pledged collateral; historical loss experience based on volume and types of loans; the results of any independent review or evaluation of the loan portfolio quality conducted by or at the direction of Company management or by bank regulatory agencies; trends in portfolio volume, maturity, and composition; off-balance sheet credit risk; volume and trends in delinquencies and nonaccruals; lending policies and procedures including those for charge-off, collection, and recovery; national and local economic conditions and downturns in specific local industries; and the experience, ability, and depth of lending management and staff. The Company evaluates the adequacy of its allowance for possible loan losses on a quarterly basis. While these factors cannot be reduced to a mathematical formula, it is management's view that the allowance for possible loan losses of $4,266,000 or 1.02% of total loans as of December 31, 1997, was adequate. This allowance is compared to $3,672,000 or 0.94% in 1996 and $3,710,000 or 1.23% in 1995. The increase in the allowance for loan losses as a percentage of total loans from 1996 to 1997 was due to the increased provision for loan losses charged to expense in 1997. This increase in the provision was due to the substantial growth in total loans during 1996 and 1997. Management believes that the quality of the loan growth coupled with the decrease in nonperforming loans during this same period warrants the decrease in the level of the allowance relative to the loan portfolio. There are, however, no assurances that in any given period the Company will not sustain charge-offs which are substantial in relation to the size of the allowance. Loans are charged to the allowance for possible loan losses when the loans are deemed uncollectible. It is the policy of management to make additions to the allowance so that it remains adequate to cover anticipated losses inherent in the Company's loan portfolio. Any allocation or breakdown in the allowance lends an appearance of an exactness which does not exist. Thus, the allocation below should not be interpreted as an indication of expected amounts or categories where charge-offs will occur. The allocation of the allowance for possible loan losses as of the end of the last five fiscal years is summarized in the table below: - ------------------------------------------------------------------------------------------------------------ Allocation of Allowance 1997 1996 1995 1994 1993 - ------------------------------------------------------------------------------------------------------------ Percent of Percent of Percent of Percent of Percent of loans in loans in loans in loans in loans in each each each each each category category category category category (Dollars in to total to total to total to total to total thousands) $ loans $ loans $ loans $ loans $ loans - ------------------------------------------------------------------------------------------------------------ Balance applicable to: Commercial $1,996 26.38% $1,507 29.18% $1,395 27.45% $1,607 26.66% $1,441 24.99% Real estate - construction 302 9.98% 218 9.78% 306 10.77% 590 13.55% 229 4.16% Real estate - mortgage 1,716 54.22% 1,516 50.27% 1,708 51.37% 1,216 49.83% 1,785 57.82% Consumer 249 5.89% 286 5.79% 272 8.51% 333 7.89% 269 7.40% Other 3 3.53% 145 4.98% 29 1.90% 26 2.07% 28 2.88% - ------------------------------------------------------------------------------------------------------------ Total $4,266 100.0% $3,672 100.0% $3,710 100.0% $3,769 100.0% $3,753 100.0% ============================================================================================================ Nonperforming Loans Interest income on the loan portfolio is recorded on the accrual basis. However, the Company follows the policy of discontinuing the accrual of interest income and 52 reversing any accrued and unpaid interest when the payment of principal or interest is 90 days past due unless the loan is both well secured and in the process of collection. The Company's Lending Policy provides for strict requirements for exempting loans from nonaccrual status. The composition of nonperforming loans as of the end of the last three fiscal years is summarized in the following table: - -------------------------------------------------------------------------------------- Nonperforming Loans (In thousands) 1997 1996 1995 - -------------------------------------------------------------------------------------- Loans accounted for on a nonaccrual basis $2,150 $1,564 $2,481 Other loans contractually past due 90 days or more 43 17 261 Restructured loans 174 279 513 - -------------------------------------------------------------------------------------- Total $2,367 $1,860 $3,255 ====================================================================================== Loans accounted for on a nonaccrual basis increased in 1997 due to an Agriculture-related commercial loan of $779,000 which was placed on non-accrual status in 1997. Management continues to focus on overall loan quality as well as to resolve significantly past due loans. The overall coverage of the allowance as a percent of nonperforming loans is 180.2%. The Company's ratio of nonperforming loans to average loans has been below most industry averages in each year reflected in the table above. The Company does not expect to sustain losses in excess of that provided for in the allowance for possible loan losses. At December 31, 1997, the Company had $174,000 in loans which were troubled debt restructurings and which were not either nonaccrual loans or loans past due 90 days or more and still accruing interest. At December 31, 1997, the Company did not have any loans other than those disclosed as nonaccrual loans, loans past due 90 days or more and still accruing interest and troubled debt restructurings where known information about possible credit problems of the borrowers cause management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms. Investments The average balance of Federal Funds Sold (overnight investments with other banks) and other short-term investments (primarily money market mutual funds) was $58,359,000 in 1997, $43,823,000 in 1996, and $42,617,000 in 1995. These investments are maintained primarily for the short-term liquidity needs of the Company. The major factors influencing the levels of required liquidity are loan demand of the Company's customers and fluctuations in the Company's level of deposits. The Company's loan to deposit ratio averaged 68.0% in 1997, compared to 66.2% in 1996, and 67.2% in 1995. 53 Average total investment securities were $145,430,000 in 1997, an increase of $15,311,000 over the 1996 average. This increase was the result of the growth in average deposits which exceeded the growth in average loans by $23,995,000. As of December 31, 1997, the aggregate market value of the investment portfolio exceeded the book value by $2,097,000. At December 31, 1996, the book value exceeded the market value by $223,000. This increase in the market value of the portfolio was the result of increasing prices in the bond market during the course of 1997. It is the Company's policy not to engage in securities trading transactions. There are no investments in the portfolio deemed to be permanently or temporarily impaired. - -------------------------------------------------------------------------------- Estimated Amortized Unrealized Unrealized fair (In thousands) cost gain loss value - -------------------------------------------------------------------------------- 1997 - -------------------------------------------------------------------------------- Available-for-sale securities: U.S. Treasury and agency $87,591 $698 $42 $88,247 State and municipal 9,529 115 2 9,642 Mortgage-backed securities 121,769 1,363 37 123,095 - -------------------------------------------------------------------------------- $218,889 $2,176 $81 $220,984 ================================================================================ Held-to-maturity securities: State and municipal $4,985 $32 $70 $4,947 Mortgage-backed securities and other 2,362 43 5 2,400 - -------------------------------------------------------------------------------- $7,347 $75 $75 $7,347 ================================================================================ 1996 - -------------------------------------------------------------------------------- Available-for-sale securities: U.S. Treasury and agencies $64,109 $159 $187 $64,081 State and municipal 7,233 59 21 7,271 Mortgage-backed securities 45,470 9 303 45,176 - -------------------------------------------------------------------------------- $116,812 $227 $511 $116,528 ================================================================================ Held-to-maturity securities: State and municipal $6,449 $55 $42 $6,462 Mortgage-backed securities and other 3,231 59 11 3,279 - -------------------------------------------------------------------------------- $9,680 $114 $53 $9,741 ================================================================================ Funding Average total deposits increased $103,120,000 or 20.5% during 1997, compared to an increase of $69,858,000 or 16.2% during 1996 and an increase of $27,928,000 or 6.9% in 1995. Average non-interest bearing deposits increased in 1997 by $25,328,000 or 23.1% compared to an increase of $13,791,000 or 14.4% in 1996, and an increase of $8,908,000 or 10.3% in 1995. Average interest-bearing deposits increased $77,792,000 or 19.8% in 1997, compared with increases of $56,067,000 or 16.7% in 1996 and $19,020,000 or 6.0% during 1995. Total deposit growth in 1998 is expected to continue but may not increase at the same rate or in the same categories. The Company is able to attract deposits by providing interest rates and services competitive with other institutions located in its market area. The Company does not have any brokered deposits or large concentrations with any one customer. 54 - ------------------------------------------------------------------------------- Average Deposits 1997 1996 1995 - ------------------------------------------------------------------------------- Average Average Average (Dollars in thousands) balance Rate balance Rate balance Rate - ------------------------------------------------------------------------------- Demand, noninterest-bearing $134,943 - $109,615 - $95,824 - Demand, interest-bearing 85,769 0.99% 77,306 1.09% 87,916 1.71% Savings and money market 169,577 2.86% 168,553 2.77% 140,209 2.79% Time certificates 214,664 5.43% 146,359 5.32% 108,026 5.10% - ------------------------------------------------------------------------------- The table above sets forth information for the last three fiscal years regarding the Company's average deposits and the average rates paid on each of the deposit categories. The remaining maturities of the Company's certificates of deposit, including public funds, in amounts of $100,000 or more as of December 31, 1997, are indicated in the table below. Interest expense on these certificates of deposit totaled $6,244,000 in 1997. - ------------------------------------------------------------------------------ (In thousands) 1997 - ------------------------------------------------------------------------------ Three month or less $49,733 Over three through six months 32,375 Over six through twelve months 33,432 Over twelve months 1,869 - ------------------------------------------------------------------------------ Total $117,409 ============================================================================== Branch Purchase On November 20, 1997, First National Bank purchased certain assets and assumed certain liabilities of the Soledad branch of Bank of America, NT & SA. As a result of this transaction, First National assumed $24,694,000 in deposit liabilities and received $21,449,000 of cash and tangible assets of $1,144,000. The transaction resulted in an intangible asset of $2,076,000, representing the excess of liabilities assumed over the fair value of tangible assets acquired. Noninterest Income Total noninterest income increased in 1997 to $3,356,000 from $3,160,000 in 1996. The increase was primarily due to a $187,000 increase in service charges and an increase in gains on sales of securities of $57,000 partially offset by a decrease in other income of $43,000. Noninterest income also increased in 1996 by $177,000 as a result of an increase in other income of $181,000 partially offset by a decrease in gains on sales of loans of $64,000. 55 Noninterest Expense In 1997, total other operating expenses decreased 8.1% to $20,884,000, after an increase of $3,375,000 or 17.4% in 1996. Of the $3,375,000 increase in 1996, $1,972,000 was attributable to merger-related expenses. These costs were primarily within the categories of salaries and benefits, equipment expense, and legal and professional expenses. Salaries and benefits expense in 1997 decreased $549,000 or 4.6% compared to an increase of $1,875,000 or 18.8% in 1996. The decrease in salaries and benefits during 1997 was mainly the result of consolidation of all back-office operations following the merger with South Valley Bancorporation in 1996. The increase in 1996 over 1995 was primarily due to the severance costs related to the merger as well as normal salary increases. As a percentage of average earning assets, salaries and benefits were 1.8% in 1997 compared to 2.3% for 1996 and 1995. The Company employed 285 full-time equivalent employees at year-end 1997. Occupancy expense increased $215,000 or 10.2% in 1997 compared to an increase of $152,000 or 7.8% in 1996. The increases in 1997 and 1996 were due primarily to the expansion of the Salinas office of First National Bank in 1996, the leasing of additional space to house the Loan Administration center in 1997, and normal rental rate increases. All other operating expenses totaled $7,243,000 in 1997 compared to $8,752,000 in 1996, a decrease of $1,509,000 or 17.2%. This decrease was mainly due to merger-related expenses for data processing and legal and professional fees which were incurred in 1996. In 1996, other operating expense increased by $1,348,000 or 18.2% over 1995, again, the result of merger-related costs in 1996. The major components of other expenses in dollars and as a percentage of average earning assets are as indicated in the table below. - ------------------------------------------------------------------------------------------------------------- Other Expenses 1997 1996 1995 - ------------------------------------------------------------------------------------------------------------- Percentage Percentage Percentage of average of average of average (Dollars in thousands) Amount earning assets Amount earning assets Amount earning assets - ------------------------------------------------------------------------------------------------------------- Salaries and benefits $11,315 1.83% $11,864 2.34% $9,989 2.29% Occupancy 2,326 0.38% 2,111 0.42% 1,959 0.45% Equipment 1,755 0.29% 2,577 0.51% 1,943 0.45% Advertising and promotion 864 0.14% 710 0.14% 659 0.15% Forms and supplies 767 0.12% 563 0.11% 508 0.12% Legal and professional fees 1,185 0.19% 1,946 0.38% 823 0.19% Assessments 222 0.04% 147 0.03% 572 0.13% Other 2,450 0.40% 2,809 0.56% 2,899 0.65% - ------------------------------------------------------------------------------------------------------------- Total $20,884 3.39% $22,727 4.49% $19,352 4.43% ============================================================================================================= Year 2000 During 1997, the Company began the implementation of its Year 2000 Plan. The Year 2000 problem, also known as the "Millenium Bug" was created when software engineers, in an attempt to save processing speed and hard disk storage, decided to create a two-digit year field within a date field instead of four. This was done to save on disk space and to maximize processing speed. The two-digit year does not allow the software to determine if '00' is the year 1900 or 2000. The year 2000 issue is very pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the date from 1999 to 2000. 56 The Company is using both internal and external resources to identify, correct or reprogram and test the systems for year 2000 compliance. It is anticipated that all reprogramming efforts or system changes will be complete by December 31, 1998, allowing adequate time for testing. To date, confirmations have been received from the Company's primary processing vendors that their systems are year 2000 compliant. Based on a preliminary study, the Company expects to spend approximately $150,000 over the next two years to modify and test its computer systems to allow for transactions in the year 2000 and beyond. The amount expensed in 1997 was not significant. Income Taxes The provision for income taxes was $6,635,000 in 1997, compared to $4,348,000 in 1996 and $4,200,000 in 1995. The Company's effective tax rate for 1997 was 39.5%, compared with 41.9% for 1996, and 38.9% for 1995. The increased effective tax rate in 1996 was due to the fact that a majority of the merger-related costs were not tax-deductible. Capital Shareholders' equity increased $8,912,000 or 14.0% in 1997. The increase was primarily a result of retention of the Company's 1997 net income and the exercise of stock options, offset in part by a repurchase of outstanding shares and a total cash dividend of $0.66 per share paid during 1997. The Company regularly assesses future capital needs so that it will remain in compliance with the capital adequacy guidelines issued by the Federal Reserve Board for bank holding companies and by the Office of the Comptroller of the Currency (the "OCC") for national banks. The Company's operating plan for 1998 contemplates continued growth in shareholders' equity through the retention of net income. The Company and the Subsidiary Banks are subject to the guidelines and regulations of the Federal Reserve Board and the Comptroller, respectively, governing capital adequacy. The Federal Reserve Board has established final risk-based and leverage capital guidelines for bank holding companies which are the same as the Comptroller's capital regulations for national banks. 57 The Federal Reserve Board capital guidelines for bank holding companies and the OCC's regulations for national banks set total capital requirements and define capital in terms of "core capital elements" (comprising Tier 1 capital) and "supplemental capital elements" (comprising Tier 2 capital). Tier 1 capital is generally defined as the sum of the core capital elements less goodwill. The following items are defined as core capital elements: common stockholders' equity, qualifying noncumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries. Supplementary capital elements include: allowance for loan and lease losses (which cannot exceed 1.25% of an institution's risk weighted assets), perpetual preferred stock not qualifying as core capital, hybrid capital instruments and mandatory convertible debt instruments, and term subordinated debt and intermediate-term preferred stock. The maximum amount of supplemental capital elements which qualifies as Tier 2 capital is limited to 100% of Tier 1 capital, net of goodwill. Risk-based capital ratios are calculated with reference to risk-weighted assets, including both on and off-balance sheet exposures, which are multiplied by certain risk weights assigned by the Federal Reserve Board or the OCC to those assets. Both bank holding companies and national banks are required to maintain a minimum ratio of qualifying total capital to risk-weighted assets of 8%, at least one-half of which must be in the form of Tier 1 capital. There are presently four risk-weight categories: 0% for cash and unconditionally guaranteed government securities; 20% for conditionally guaranteed government securities; 50% for performing residential real estate loans secured by first liens; and 100% for commercial loans. The federal banking agencies have issued a joint advance notice of proposed rulemaking to solicit comments on a framework for revising their risk-based capital guidelines to take account of interest rate risk. As required by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), the notice seeks comment on a proposed method of incorporating an interest rate risk component into the current risk-based capital guidelines, with the goal of ensuring that institutions with high levels of interest rate risk have sufficient capital to cover their exposures. Interest rate risk is a measure of the relationship between a change in market interest rates and the resultant change in net interest income due to the repricing and/or maturity characteristics of the assets and liabilities of the Company. As financial intermediaries, depository institutions accept interest rate risk as a normal part of their business. They assume this risk whenever the interest rate sensitivity of their assets does not match the sensitivity of their liabilities or off balance sheet positions. Thus, when interest-sensitive assets and liabilities reprice at mismatched intervals, an increase or decrease in interest rates will affect net interest income. Under the proposal, interest rate risk exposures would be quantified by weighing assets, liabilities and off-balance sheet items by risk factors which approximate sensitivity to interest rate fluctuations. Institutions identified as having an interest rate risk exposure greater than a defined threshold would be required to allocate additional capital to support this higher risk. The capital to be allocated would be a dollar amount equal to the percentage by which the risk exceeds the defined threshold multiplied by the institution's total assets. Higher individual capital allocations could be required by the bank regulators based on supervisory concerns. Federal banking agencies have solicited comments on this proposal but have not yet proposed regulations to implement any interest rate risk component into the risk-based capital guidelines. 58 Accordingly, the ultimate impact on the Subsidiary Banks and the Company of a final regulation in this area cannot be predicted at this time. Leverage Capital Guidelines The Federal Reserve Board and the OCC have established a minimum leverage ratio of 3% Tier 1 capital to total assets for bank holding companies and national banks that have received the highest composite regulatory rating and are not anticipating or experiencing any significant growth. All other institutions will be required to maintain a leverage ratio of at least 100 to 200 basis points above the 3% minimum. Set forth below are the Company's and the Subsidiary Banks' risk-based and leverage capital ratios as of December 31, 1997: - --------------------------------------------------------------------------------------------------- Risk Based Capital Ratio As of December 31, 1997 - --------------------------------------------------------------------------------------------------- Company South Valley First National (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------- ------------- Tier 1 capital $68,925 13.58% $17,592 11.71% $44,601 12.81% Tier 1 capital minimum requirement 20,295 4.00% 6,009 4.00% 13,929 4.00% - --------------------------------------------------------------------------------------------------- Excess 48,630 9.58% 11,583 7.71% 30,672 8.81% ===================================================================================== ============= Total capital 73,191 14.43% 19,337 12.87% 47,116 13.53% Total capital minimum requirement 40,589 8.00% 12,017 8.00% 27,858 8.00% - ------------------------------------------------------------------------------------- ------------- Excess 32,602 6.43% 7,320 4.87% 19,258 5.53% ===================================================================================== ============= Risk-adjusted assets $507,363 $150,216 $348,220 ===================================================================================== ============= As indicated in the table on the previous page, the Company's capital ratios significantly exceeded the minimum capital levels required by current federal regulations. Management believes that the Company and the Subsidiary Banks will continue to meet their respective minimum capital requirements in the foreseeable future. - ---------------------------------------------------------------------------------------------------------- Leverage Capital Ratio As of December 31, 1997 - ---------------------------------------------------------------------------------------------------------- Company South Valley First National (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - ---------------------------------------------------------------------------------------------------------- Tier 1 capital to quarterly average total assets (leverage ratio) $68,925 9.17% $17,592 8.03% $44,601 8.49% Minimum leverage requirement 22,543 to 3.00% to 6,575 to 3.00% to 15,761 to 3.00% to 37,572 5.00% 10,958 5.00% 26,268 5.00% - ---------------------------------------------------------------------------------------------------------- Excess 31,353 to 4.17% to 6,634 to 3.03% to 18,333 to 3.49% to 46,382 6.17% 11,017 5.03% 28,840 5.49% ========================================================================================================== Total quarterly average assets $751,439 $219,168 $525,357 ========================================================================================================== 59 Federal banking laws impose restrictions upon the amount of dividends the Subsidiary Banks may declare to the Holding Company (see Note 14 to the accompanying consolidated financial statements). Federal laws also impose restrictions upon the amount of loans or advances that the Subsidiary Banks may extend to the Holding Company. In management's opinion, these do not affect the ability of the Company to meet its cash obligations. Liquidity Liquidity represents the ability of the Company to meet the requirements of customer borrowing needs as well as fluctuations in deposit flows. The Company's principal sources of asset liquidity are cash and due from banks, time deposits with other financial institutions, federal funds sold, short-term investments, and marketable investment securities. As of December 31, 1997 these sources represented $306,850,000 or 44.9% of total deposits, compared to 37.0% in 1996 and 44.1% in 1995. The decrease in 1996 reflects the growth within the loan portfolio of which a small portion was funded by maturities in the investment portfolio. Other sources of asset liquidity are maturing loans and borrowing lines of approximately $51,000,000 with primary correspondent banks. There were no borrowings outstanding under these lines as of December 31, 1997. The Company guarantees the obligations or performance of its customers by issuing standby letters of credit to a third party. These standby letters of credit are frequently issued in support of third-party obligations, such as retail company transactions and travel agency issuances. The risk involved in issuing standby letters of credit is essentially the same as the credit risk in extending loans to customers, and they are subject to the same credit origination, maintenance, and management procedures in effect to monitor other credit products. As of December 31, 1997 and 1996, outstanding standby letters of credit totaled $4,193,000 and $4,994,000, respectively. The Company does not offer or engage in any other off-balance sheet products such as commitments to purchase and sell foreign exchange, interest rate or currency swaps, or financial futures and options. In the opinion of management, there are sufficient resources to meet the liquidity needs of the Company at present and projected future levels. 60 Effects of Changing Prices The most direct effect of inflation is higher interest rates. However, the Company's earnings are not necessarily dependent on the absolute level of interest rates. Instead, earnings are affected by the spread between the yield on loans and investments and the cost of deposits and borrowing money. Another effect of inflation is upward pressure of the Company's operating expenses. It is management's opinion that the effects of inflation on the consolidated financial statements have not been material. Quantitative and Qualitative Disclosures about Market Risk The Company's success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Company's net interest income to adverse movements in interest rates. Although the Company manages other risks, as in credit and liquidity risk, in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company's financial condition. The primary objective of the asset/liability management process is to measure the effect of changing interest rates on net interest income and market value and adjust the balance sheet (if necessary) to minimize the inherent risk and maximize income. The Company's exposure to market risk and interest rate risk is reviewed on a regular basis by the Asset/Liability Committee. Tools used by management include a modified GAP report and an asset/liability simulation model. Management believes that the Company's market risk and interest rate risk profiles are within reasonable tolerances at this time. A derivative financial instrument includes futures, forward contracts, interest rate swaps, option contracts, and other financial instruments with similar characteristics. The Company currently does not enter into futures, forwards, swaps, or options. The Company is however, party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These instruments include commitments to extend credit and standby letters of credit. These instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statement of condition. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates and may require collateral from the borrower if deemed necessary by the Company. Standby letters of credit are conditional commitments issued by the Subsidiary Banks to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded on the Company's consolidated balance sheet until the instrument is exercised. The table on the following page represents the change in the Company's Market Value of Portfolio Equity (MVPE) at December 31, 1997 in the event of a sudden and sustained change in interest rates as presented. MVPE is defined as the fair value of assets less the fair value of liabilities on the Company's consolidated balance sheet. 61 (Dollars in thousands) Market value of Change in interest rates portfolio equity $ Change % Change - --------------------------------------------------------------------------- 200 Basis points rise $90,811 $755 0.84% 100 Basis points rise 90,434 378 0.42% Base scenario 90,056 - 0.00% 100 Basis points decline 88,950 (1,107) (1.23%) 200 Basis points decline 87,873 (2,213) (2.46%) 62 PACIFIC CAPITAL BANCORP STOCK ACTIVITY The common stock of the Company is listed on the NASDAQ National Market under the symbol PABN. This listing became effective on November 20, 1996. Prior to that date, the Company's common stock was listed on the OTC Bulletin Board. The high and low prices listed below reflect actual trades which occurred in the specified time frames listed. Three brokerage firms effect transactions in the Company's stock: Van Kasper & Co., Sandler O'Neill Partners, L.P.; and Hoefer & Arnett, Inc. According to the Company's records, there were 2,063 shareholders as of September 10, 1996. In 1997 the Company paid four cash dividends of $0.165 per share to holders of record on March 14, June 16, September 15, and November 17, payable on March 31, June 30, September 30, and December 1, 1996, respectively. The Company also paid a five percent (5%) stock dividend payable to shareholders of record as of December 1, 1997. For information regarding restrictions on the payment of dividends see Note 14 to the accompanying consolidated financial Statements. - -------------------------------------------------------------------------------- Ranges of Common Stock Prices - -------------------------------------------------------------------------------- 1997 - -------------------------------------------------------------------------------- Quarter Low High - ------------------------------------------------------------------------------- First $23.10 $27.62 Second 27.02 33.93 Third 30.60 33.10 Fourth 32.74 44.25 - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 1996 - -------------------------------------------------------------------------------- Quarter Low High - ------------------------------------------------------------------------------- First $24.05 $28.09 Second 25.47 27.63 Third 24.77 26.67 Fourth 25.38 27.63 - ------------------------------------------------------------------------------- 63 The Corporation The Company is a California corporation and bank holding company that was incorporated on January 26, 1983. First National and South Valley, wholly owned subsidiaries of the Company, commenced operations in 1984 and 1983, respectively. First National and South Valley are nationally chartered commercial banks serving Monterey, Santa Cruz, Santa Clara and San Benito Counties and surrounding areas in California. Registrar & Transfer Agent Form 10-K First National Bank of South Valley -------------------------- ---------------------------- Central California National Bank ChaseMellon Shareholder A Copy of the Company's Banking Offices Banking Offices Services Form 10-K as filed with the - ----------------------------- ----------------------------- Overpeck Centre Securities and Exchange 1001 South Main Street 500 Tennant Station 85 Challenger Road Commission is available, Salinas, California Morgan Hill, California Ridgefield Park, NJ without charge, upon 93902-1786 95037 07660 written request. (408) 757-4900 (408) 778-1510 Please direct requests to: 495 Washington Street 8000 Santa Teresa Blvd. Market Makers Dennis A. DeCius Monterey, California Gilroy, California Hoefer & Arnett, Inc. Executive Vice President 93942-2718 95020 353 Sacramento Street Chief Financial Officer (408) 373-4900 (408) 848-2161 Tenth Floor Pacific Capital Bancorp San Francisco, California P.O. Box 1786 307 Main Street 1730 Airline Highway 94111 Salinas, California Salinas, California Hollister, California 93902-1786 93902-1786 95023 Sandler O'Neill Partners, (408) 757-4900 (408) 636-5581 LP 2 World Trade Center Corporate Counsel 104th Floor Preston, Gates & Ellis LLP 655 Main Street 301 Third Street New York, New York One Maritime Plaza Watsonville, California San Juan Bautista, Ca. 10048 Suite 2400 95077-1540 95045 San Francisco, California (408) 728-2265 (408) 623-4590 Van Kasper & Co. 94111 600 California Street 26380 Carmel Rancho Lane Suite 1700 Certified Public Carmel, California San Francisco, California Accountants 93922-2017 94108 KPMG Peat Marwick LLP (408) 626-2900 500 East Middlefield Road Mountain View, California 695 Front Street 94043 Soledad, California 93960 (408) 678-2609 64 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant had duly caused this report to be signed on its behalf of the undersigned, thereunto duly authorized. Date: March 25, 1998 PACIFIC CAPITAL BANCORP ------------------------------------- By: /S/ Clayton C. Larson CLAYTON C. LARSON President /S/ Charles E. Bancroft Date: March 25, 1998 - -------------------------------------------- Charles E. Bancroft, Director /S/ Dennis A. DeCius Date: March 25, 1998 - -------------------------------------------- Dennis A. DeCius Executive Vice President and Chief Financial Officer (principal financial officer and principal accounting officer) /S/ Gene DiCicco Date: March 25, 1998 - -------------------------------------------- Gene DiCicco, Director /S/ Lewis L. Fenton Date: March 25, 1998 - -------------------------------------------- Lewis L. Fenton, Director 65 /S/ James L. Gattis Date: March 25, 1998 - -------------------------------------------- James L. Gattis, Director and Secretary /S/ Hubert W. Hudson Date: March 25, 1998 - -------------------------------------------- Hubert W. Hudson, Director /S/ William H. Pope Date: March 25, 1998 - -------------------------------------------- William H. Pope, Director /S/ William J. Keller Date: March 25, 1998 - -------------------------------------------- William J. Keller, Director /S/ Eugene R.Guglielmo Date: March 25, 1998 ------------------------------------------- Eugene R. Guglielmo, Director /S/ Roger C. Knopf Date: March 25, 1998 - -------------------------------------------- Roger C. Knopf, Director /S/ Clayton C. Larson Date: March 25, 1998 - -------------------------------------------- Clayton C. Larson, President and Director /S/ William S. McAfee Date: March 25, 1998 - -------------------------------------------- William S. McAfee, Director 66 /S/ Robert B. Sheppard Date: March 25, 1998 - -------------------------------------------- Robert B. Sheppard, Director /S/ Mary Lou Rawitser Date: March 25, 1998 - -------------------------------------------- Mary Lou Rawitser, Director 67 INDEX TO EXHIBITS Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 3.1 Articles of incorporation of the Company as amended. 1/ (*) 3.2 Bylaws of Company as amended. 2/ (*) 10.1 Lease -- 601 Abrego Street, Monterey, Premises. 3/ (*) 10.2 Lease for 1001 South Main Street, Salinas, Banking office. 2/ (*) 10.3 Lease dated December 15, 1988 by and between the Bank (*) and James L. Gattis for 307 Main Street, Salinas Old Town Office. 2/ 10.4 Lease dated May 1, 1985 by and between the Bank (*) and Pacific Capital Bancorp. 4/ 10.5 Pacific Capital Bancorp Employee Stock Ownership (*) Plan and Trust Agreement. 5/ 10.6 Master Equipment Lease Agreement between Bank and (*) Parker North American Corporation. 5/ 10.7 Lease dated September 22, 1986 between (*) Bank and The Saunders Company. 5/ */ Not Applicable. - --------------------------------------------------------------------------- 1/ Filed as Exhibits 3.1, 10.21 and 10.32, respectively, to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1988, which are incorporated by reference. 2/ Filed as Exhibits 3.2 and 10.17, respectively, to the Company's Annual Report on Form 10-K (File No. 2-87513) for the fiscal year ended December 31, 1984, which are incorporated by reference. 3/ Filed as Exhibit to the Company's Registration Statement on Form S-18 (Registration No. 2-87513), which is incorporated by reference. 4/ Filed as Exhibit 10.20 to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1985, which is incorporated by reference. 5/ Filed as Exhibits 10.24 through 10.26, respectively, to Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1986, which are incorporated by reference. 68 Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 10.8 Matrix Funding Corporation Master Lease Agreement. 1/ (*) 10.9 Lease dated January 24, 1989 by and between First (*) National Bank of Monterey County and Stanley R. Haynes. 6/ 10.13 Amendment No. One to Pacific Capital Bancorp (*) Employee Stock Ownership Plan. 2/ 10.14 Amendment No. Two to Pacific Capital Bancorp (*) Employee Stock Ownership Plan. 7/ 10.15 Amendment No. Three to Pacific Capital Bancorp (*) Employee Stock Ownership Plan. 7/ 10.16 Lease dated August 10, 1990 by and between the (*) Trustees of the Stanley Family Trust and Pacific Capital Bancorp for Carmel Office. 7/ 10.17 Assignment of Lease dated November 1, 1990 by and (*) between Pacific Capital Bancorp and First National Bank of Monterey-County for Carmel Office. 7/ 10.18 Lease dated November 12, 1990 by and between (*) First National Bank of Monterey County and Carmel Monterey Travel for Premises located at 601 Abrego Street, Monterey, California. 7/ 10.19 Prunetree Shopping Center Lease dated June 28, 1988 (*) by and between Dennis R. Keith and Pajaro Valley Bancorporation. 7/ - ------------- 6/ Filed as Exhibits 10.20 through 10.24, respectively, to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1989, which are incorporated by reference. 7/ Filed as Exhibits 10.25 through 10.32 to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1990, which are incorporated by reference. 69 Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 10.20 Lease dated June 21, 1990 by and between Saucito (*) Land Co. and First National Bank of Monterey County. 7/ 10.22 Amendment No. Four to Pacific Capital Bancorp (*) Employee Stock Ownership Plan. 8/ 10.23 Amendment dated May 20, 1991 to Lease dated (*) December 15, 1988 by and between the Bank and James L. Gattis for 307 Main Street, Salinas Old Town Office. 8/ 10.24 Pacific Capital Bancorp Directors' Stock Option Plan (*) and Form of Stock Option Agreement. 8/ 10.26 Pacific Capital Bancorp 1984 Stock Option Plan (*) and Forms of Agreements as amended to date. 8/ 10.30 Business Recovery Services Agreement dated (*) September 30, 1991 by and between Bank and J.D.B. & Associates, Inc. 8/ 10.31 Consolidated Agreement dated December 17, 1991 by and (*) between Bank and Unisys with Equipment Sale Agreement, Software License Agreement and Product License Agreement by and between Bank and information Technology, Inc. 8/ 10.32 Fidelity and Deposit Company of Maryland Directors and (*) Officers Liability Insurance Policy including Bank Reimbursement. 8/ 10.33 Fidelity and Deposit Company of Maryland (*) Financial Institution Bond. 8/ 10.34 Lease dated January 28, 1993 by and between J.W. (*) and R.W. McClellan, Partners, and First National Bank of Central California. 9/ 10.35 Exercise of Lease Option as of September 19, 1992 (*) by and between First National Bank of Central California and James L. Gattis. 9/ - ------------------- 8/ Filed as Exhibits 10.23 through 10.34 to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1991, which are incorporated by reference. 9/ Filed as exhibits to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1993, which are incorporated by reference. 70 Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 10.37 Lease dated November 18, 1993 by and between (*) Hazel Graven and Vines Stewart and First National Bank of Central California. 10/ 10.38 Software License Agreement for Platform (*) Transfer Module and Interface dated September 15, 1993 by and between First National Bank of Central California and Information Technology, Inc. 10/ 10.39 Equipment Sale Agreement dated December 16, 1993 by and (*) between First National Bank of Central California and Information Technology, Inc. 10/ 10.40 Asset/Liability Management Software Agreement dated (*) December 31, 1993 by and between First National Bank of Central California and Profitstar, Inc. 10/ 10.41 Applications dated December 28, 1993 by First (*) National Bank of Central California to become a member of the California Bankers Clearing House Association. 10/ 10.42 Consolidated Agreement for the purchase of computer (*) hardware dated December 20, 1993 by and between First National Bank of Central California and Unisys Corporation. 10/ 10.46 Amended Pacific Capital Bancorp 1994 Stock Option Plan (*) and Form of Incentive and Non-Qualified Stock Option Agreements. 9/ 10.47 Amendment No. Five to Pacific Capital Bancorp Employee (*) Stock Ownership Plan and Trust. 10/ 10.48 Pacific Capital Bancorp 401(k) Profit Sharing Plan. 10/ (*) 10.49 Equipment Sale Agreement dated March 22, 1995, by and (*) between First National Bank of Central California and Information Technology, Inc. 11/ 10.50 Equipment Sale Agreement dated February 2, 1996, by and (*) between First National Bank of Central California and Information Technology, Inc. 11/ - -------------- 9/ Filed as Exhibits to the Company's Registration Statement on Form S-8 (File No. 33-83848) as filed on September 8, 1994, and Amendment No. 1 to Form S-8 as filed on November 15, 1994. 10/ Filed as exhibits to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1994, which are incorporated by reference. 11/ Filed as exhibits to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1995, which are incorporated by reference. 71 Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 10.51 Standard Form of Agreement between Owner (Pacific (*) Capital Bancorp) and Contractor (Daniels & House Construction Co.) for the renovation of existing building and construction of new addition for First National Bank of Central California at 1001 S. Main Street, Salinas, CA, 93901, dated June 15, 1995. 11/ 10.52 Employee Welfare Benefit Plan Agreement dated (*) January 1, 1995, between Pacific Capital Bancorp and Great-West Life & Annuity Insurance Co. 11/ 10.53 Lease Agreement dated October 29, 1996 by and between (*) James L. Gattis and Pacific Capital Bancorp for property located at 517 S. Main Street, Salinas 12/ 10.57 Employment Agreement dated November 20, 1996 between South (*) Valley National Bank and Brad L. Smith 12/ 10.58 Employment Agreement dated August 26, 1997 between Pacific (*) Capital Bancorp and Clayton C. Larson 13/ 10.59 Employment Agreement dated August 26, 1997 between Pacific (*) Capital Bancorp and D. Vernon Horton 13/ 10.60 Employment Agreement dated August 26, 1997 between Pacific (*) Capital Bancorp and Dennis A. DeCius 13/ 10.61 Employment Agreement dated August 26, 1997 between Pacific (*) Capital Bancorp and Dale R. Diederick 13/ - -------------- 11/ Filed as exhibits to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1995, which are incorporated by reference. 12/ Filed as exhibits to the Company's Annual Report on Form 10-K (File No. 0-13528) for the fiscal year ended December 31, 1996, which are incorporated by reference. 13/ Filed as exhibits to the Company's Quarterly Report on Form 10-Q (File No. 0-13528) for the period ended September 30, 1997 which are incorporated by reference. 72 Exhibit Sequentially Number Exhibit Numbered Page - ------ ------- ------------- 10.62 Amended and Restated Executive Salary Continuation Agreement (*) dated September 23, 1997 between Pacific Capital Bancorp and Clayton C. Larson 13/ 10.63 Amended and Restated Executive Salary Continuation Agreement (*) dated September 23, 1997 between Pacific Capital Bancorp and D. Vernon Horton 13/ 10.64 Amended and Restated Executive Salary Continuation Agreement (*) dated September 23, 1997 between Pacific Capital Bancorp and Dennis A. DeCius 13/ 10.65 Amended and Restated Executive Salary Continuation Agreement (*) dated September 23, 1997 between Pacific Capital Bancorp and Dale R. Diederick 13/ 10.66 Purchase and Assumption dated September 18, 1997 between First 76 National Bank of Central California and Bank of America, NT & SA 13. Pacific Capital Bancorp 1997 Annual Report to Shareholders --- (parts not incorporated by reference are furnished for informational purposes only and are not filed herewith). 21. Subsidiaries of the Company 141 23. Opinion of KPMG Peat Marwick LLP 65 24. Consent of KPMG Peat Marwick LLP 66 27. Financial Data Schedule 142 - ----------- 13/ Filed as exhibits to the Company's Quarterly Report on Form 10-Q (File No. 0-13528) for the period ended September 30, 1997 which are incorporated by reference. 73