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U.S. SECURITIES AND EXCHANGE COMMISSION
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WASHINGTON, D. C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the fiscal year ended DECEMBER 31, 2005
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or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ___________________ to ____________________
Commission File Number 0-26366
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
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(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2812193
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(State of other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
732 MONTGOMERY AVENUE, NARBERTH, PENNSYLVANIA 19072
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(Address of principal executive offices) (Zip Code)
(610) 668-4700
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(Issuer's telephone number, including area code)
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(Former name, former address and former year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: CLASS A COMMON STOCK ($2.00 PAR VALUE)
CLASS B COMMON STOCK ($.10 PAR VALUE)
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act.
[ ] Yes [X] No
Indicate by check mark if the registrant is required to file reports pursuant to
Section 13 or 15(d) of the Exchange Act.
[ ] Yes [X]
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 of 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 contended, 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]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes [X] No [ ]
The aggregate market value of Registrant's Common Stock held by non-affiliates
is $96,871,266, based on the June 30, 2005 closing price of the Registrant's
Common Stock of $22.96 per share (restated for stock dividend).
1
As of February 28, 2006, the Registrant had 10,700,513 and 1,992,156 shares
outstanding of Class A and Class B common stock, respectively.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the following documents are incorporated by reference: the
definitive Proxy Statement of the Registrant relating to Registrant's Annual
meeting of Shareholders to be held on May 17, 2006--Part III.
PART I
ITEM 1. BUSINESS
ROYAL BANCSHARES
Royal Bancshares of Pennsylvania, Inc. ("Royal Bancshares"), is a
Pennsylvania business corporation and a bank holding company registered under
the Federal Bank Holding Company Act of 1956, as amended (the "Holding Company
Act"). Royal Bancshares is supervised by the Board of Governors of the Federal
Reserve System (Federal Reserve Board). Its legal headquarters is located at 732
Montgomery Avenue, Narberth, PA. On June 29, 1995, pursuant to the plan of
reorganization approved by the shareholders of Royal Bank America, formerly
Royal Bank of Pennsylvania ("Royal Bank"), all of the outstanding shares of
common stock of Royal Bank were acquired by Royal Bancshares and were exchanged
on a one-for-one basis for common stock of Royal Bancshares. The principal
activities of Royal Bancshares is owning and supervising Royal Bank, which
engages in a general banking business principally in Montgomery, Philadelphia
and Berks counties in Pennsylvania and in Northern and Southern New Jersey.
Royal Bancshares also has a wholly owned non-bank subsidiary, Royal Investments
of Delaware, Inc., which is engaged in investment activities. During 2005, Royal
Bancshares received permission to offer Mezzanine loans by the Federal Reserve
Board. At December 31, 2005, Royal Bancshares had consolidated total assets of
approximately $1.3 billion, total deposits of approximately $697 million and
shareholders' equity of approximately $156 million. Royal Bancshares two
Delaware trusts, Royal Bancshares Capital Trust I and Royal Bancshares Capital
Trust II, are not consolidated per requirements under FIN 46(R).
From time to time, Royal Bancshares may include forward-looking
statements relating to such matters as anticipated financial performance,
business prospects, technological developments, new products, research and
development activities and similar matters in this and other filings with the
Securities and Exchange Commission. The Private Securities Litigation Reform Act
of 1995 provides a safe harbor for forward-looking statements. When we use words
such as "believes", "expects," "anticipates" or similar expressions, we are
making forward-looking statements. In order to comply with the terms of the safe
harbor, Royal Bancshares notes that a variety of factors could cause Royal
Bancshares' actual results and experience to differ materially from the
anticipated results or other expectations expressed in Royal Bancshares
forward-looking statements. The risks and uncertainties that may affect the
operations, performance development and results of Royal Bancshares' business
include the following: general economic conditions, including their impact on
capital expenditures; interest rate fluctuations: business conditions in the
banking industry; the regulatory environment; rapidly changing technology and
evolving banking industry standards; competitive factors, including increased
competition with community, regional and national financial institutions; new
service and product offerings by competitors and price pressures and similar
items.
Royal Bancshares has three reportable operating segments, Community
Banking, Tax Liens, and Equity Investments which resulted from the adoption of
FIN46(R) as described in Note B of the Notes to Consolidated Financial
Statements included in this Report. The segment reporting information in Note B
is incorporated by reference into this Item 1.
ROYAL BANK AMERICA
Royal Bank was incorporated in the Commonwealth of Pennsylvania on July
30, 1963, was chartered by the Commonwealth of Pennsylvania Department of
Banking and commenced operation as a Pennsylvania state-chartered bank on
October 22, 1963. Royal Bank is the successor of the Bank of King of Prussia,
the principal ownership of which was acquired by The Tabas Family in 1980. Royal
Bank is an insured bank by the Federal Deposit Insurance Corporation (the
"FDIC").
During the third quarter of 2005 the Bank formed a subsidiary called
Royal Bank America Leasing LP to originate small business product leases. The
Bank owns 60% of the subsidiary.
2
During 2004, Royal Bank started a banking division called Royal Asian
Bank ("Royal Asian") which operates three branches in Pennsylvania and one
branch in Fort Lee, New Jersey. During the second quarter of 2006 Royal
Bancshares anticipates that Royal Asian will begin operating under a separate
bank charter under the laws of the Commonwealth of Pennsylvania. This will
result in Royal Bancshares becoming a two bank holding company.
Royal Bank derives its income principally from interest charged on
loans, investment securities, and fees received in connection with the
origination of loans and other services. Royal Bank's principal expenses are
interest expense on deposits and operating expenses. Operating revenues, deposit
growth, investment maturities, loan sales and the repayment of outstanding loans
provide the majority funds for activities.
Service Area. Royal Bank's primary service area includes Montgomery,
Chester, Bucks, Delaware, Berks and Philadelphia counties, New Jersey and the
State of Delaware. This area includes residential areas and industrial and
commercial businesses of the type usually found within a major metropolitan
area. Royal Bank serves this area from twenty branches located throughout
Montgomery, Philadelphia and Berks counties and New Jersey. Royal Bank also
considers the states of Pennsylvania, New Jersey, New York, Florida, Washington
DC, Maryland, Northern Virginia and Delaware as a part of its service area for
certain products and services. Frequently, Royal Bank will do business with
clients located outside of its service area. Royal Bank has loans in twenty-four
states via participations with other lenders who have broad experience in those
respective markets. Royal Bank's legal headquarters are located at 732
Montgomery Avenue, Narberth, PA.
Royal Bank conducts business operations as a commercial bank offering
checking accounts, savings and time deposits, and loans, including residential
mortgages, home equity and SBA loans. Royal Bank also offers safe deposit boxes,
collections, internet banking and bill payment along with other customary bank
services (excluding trust) to its customers. Drive-up, ATM, and night depository
facilities are available. Services may be added or deleted from time to time.
The services offered and the business of Royal Bank is not subject to
significant seasonal fluctuations. Royal Bank is a member of the Federal Reserve
Fedline Wire Transfer System.
Competition. The financial services industry in our service area is
extremely competitive. Competitors within our service area include banks and
bank holding companies with greater resources. Many competitors have
substantially higher legal lending limits.
In addition, savings banks, savings and loan associations, credit
unions, money market and other mutual funds, mortgage companies, leasing
companies, finance companies and other financial services companies offer
products and services similar to those offered by Royal Bank, on competitive
terms.
Many bank holding companies have elected to become financial holding
companies under the Gramm-Leach-Bliley Act of 1999, which give a broader range
of products with which Royal Bank must compete. Although the long-range effects
of this development cannot be predicted, it will likely further narrow the
differences and intensify competition among commercial banks, investment banks,
insurance firms and other financial services companies.
Employees. Royal Bancshares employed approximately 169 persons on a
full-time equivalent basis as of December 31, 2005.
Deposits. At December 31, 2005, total deposits of Royal Bank were
distributed among demand deposits (11%), money market deposit accounts, savings
and Super Now (43%) and time deposits (46%). At year-end 2005, deposits
decreased $45 million from year-end 2004, or 6%, primarily due to an increased
use of overnight borrowings at lower interest rates paid compared to offering
higher rates to the Money Market accounts which caused a reduction in the
average balance during the year.
Lending. At December 31, 2005, Royal Bancshares had a total loan
portfolio of $550 million, representing 42% of total assets. The loan portfolio
is categorized into commercial demand, commercial mortgages, residential
mortgages (including home equity lines of credit), construction, real estate tax
liens and installment loans. At year-end 2005, loans increased $81 million from
year end 2004, or 17% primarily due to the addition of the Royal Asian division
and increasing the size of the lending staff along with offering additional loan
products and more competitive rates.
Current market and regulatory trends in banking are changing the basic
nature of the banking industry. Royal Bank intends to keep pace with the banking
industry by being competitive with respect to interest rates and new types or
classes of deposits insofar as it is practical to do so consistent with Royal
Bank's size, objective of profit maintenance and stable capital structure.
3
NON-BANK SUBSIDIARIES
On June 30, 1995, Royal Bancshares established a special purpose
Delaware investment company, Royal Investment of Delaware ("RID"), as a wholly
owned subsidiary. Its legal headquarters is at 103 Springer Building, 3411
Silverside Road, Wilmington, DE. RID buys, holds and sells investment
securities. At December 31, 2005, total assets of RID were $20.9 million, of
which $1.2 million was held in cash and cash equivalents and $19.1 million was
held in investment securities.
Royal Bancshares, through its wholly owned subsidiary Royal Bank holds
a 60% ownership interest in Crusader Servicing Corporation ("CSC"). Its legal
headquarters is at 732 Montgomery Avenue, Narberth, PA. CSC acquires, through
auction, delinquent property tax liens in various jurisdictions, assuming a lien
position that is generally superior to any mortgage liens on the property, and
obtaining certain foreclosure rights as defined by local statute. At December
31, 2005, total assets of CSC were $52.2 million.
On June 23, 2003, Royal Bancshares, through its wholly owned subsidiary
Royal Bank, established Royal Investments of Pennsylvania, LLC ("RIP") as a
wholly owned subsidiary. Its legal headquarters is at 732 Montgomery Avenue,
Narberth, Pennsylvania. RIP was formed to invest in equity real estate ventures
subject to limitations imposed by regulation. At December 31, 2005, total assets
of RIP prior to consolidation under FIN 46(R) were $13.8 million. During the
early part of 2005, RIP changed its name to Royal Investments America, LLC.
On October 27, 2004, Royal Bancshares formed two Delaware trust
affiliates, Royal Bancshares Capital Trust I and Royal Bancshares Capital Trust
II from the completion of an aggregate of $25.0 million of a private placement
of trust preferred securities.
On July 25, 2005, Royal Bancshares through its wholly owned subsidiary
Royal Bank formed Royal Bank America Leasing, LP ("Royal Leasing"). Royal Bank
holds a 60% ownership interest in Royal Leasing. Its legal headquarters is 550
Township Line Road, Blue Bell, Pennsylvania. Royal Leasing was formed to
originate small business leases. At December 31, 2005, total assets of Royal
Leasing were $3 million.
WEBSITE ACCESS TO COMPANY REPORTS
We post publicly available reports required to be filed with the SEC on
our website, www.royalbankamerica.com, as soon as reasonably practicable after
filing such reports with the SEC. The required reports are available free of
charge through our website.
PRODUCTS AND SERVICES WITH REPUTATION RISK
Royal Bancshares offers a diverse range of financial and banking
products and services. In the event one or more customers and/or governmental
agencies become dissatisfied or object to any product or service offered by
Royal Bancshares or any of its subsidiaries, whether legally justified or not,
negative publicity with respect to any such product or service could have a
negative impact on Royal Bancshares's reputation. The discontinuance of any
product or service, whether or not any customer or governmental agency has
challenged any such product or service, could have a negative impact on Royal
Bancshares' reputation.
FUTURE ACQUISITIONS
Royal Bancshares' acquisition strategy consists of identifying
financial institutions, insurance agencies and other financial companies with
business philosophies that are similar to our business philosophies, which
operate in strong markets that are geographically compatible with our
operations, and which can be acquired at an acceptable cost. In evaluating
acquisition opportunities, we generally consider potential revenue enhancements
and operating efficiencies, asset quality, interest rate risk, and management
capabilities. Royal Bancshares currently has no formal commitments with respect
to future acquisitions although discussions with acquisition candidates take
place occasionally.
CONCENTRATIONS, SEASONALITY
Royal Bancshares does not have any portion of its business dependent on
a single or limited number of customers, the loss of which would have a material
adverse effect on its business. No substantial portion of loans or investments
is concentrated within a single industry or group of related industries, except
a significant majority of loans are secured by real estate much of which is
located in southeastern Pennsylvania. The business of Royal Bancshares and its
subsidiaries is not seasonal in nature.
4
ENVIRONMENT COMPLIANCE
Royal Bancshares and its subsidiaries' compliance with federal, state
and local environment protection laws had no material effect on capital
expenditures, earnings or their competitive position in 2005, and is not
expected to have a material effect on such expenditures, earnings or competitive
position in 2006.
SUPERVISION AND REGULATION
Bank holding companies and banks operate in a highly regulated
environment and are regularly examined by federal and state regulatory
authorities.
The following discussion concerns various federal and state laws and
regulations and the potential impact of such laws and regulation on Royal
Bancshares and its subsidiaries.
To the extent that the following information describes statutory or
regulatory provisions, it is qualified in its entirety by reference to the
particular statutory or regulatory provisions themselves. Proposals to change
laws and regulations are frequently introduced in Congress, the state
legislatures, and before the various bank regulatory agencies. Royal Bancshares
cannot determine the likelihood or timing of any such proposals or legislations
or the impact they may have on Royal Bancshares and its subsidiaries. A change
in law, regulations or regulatory policy may have a material effect on Royal
Bancshares' business.
Holding Company. Royal Bancshares, as a Pennsylvania business
corporation, is subject to the jurisdiction of the Securities and Exchange
Commission (the "SEC") and of state securities commissions for matters relating
to the offering and sale of its securities. Accordingly, if Royal Bancshares
wishes to issue additional shares of its Common Stock, in order, for example, to
raise capital or to grant stock options, Royal Bancshares will have to comply
with the registration requirements of the Securities Act of 1933 as amended, or
find an applicable exemption from registration.
Royal Bancshares is subject to the provisions of the Holding Company
Act, and to supervision, regulation and examination by the Federal Reserve
Board. The Holding Company Act requires Royal Bancshares to secure the prior
approval of the Federal Reserve Board before it owns or controls, directly or
indirectly, more than 5% of the voting shares of any corporation, including
another bank. In addition, the Holding Company Act prohibits Royal Bancshares
from acquiring more than 5% of the voting shares of, or interest in, or all or
substantially all of the assets of, any bank located outside Pennsylvania,
unless such an acquisition is specifically authorized by laws of the state in
which such bank is located.
A bank holding company also is prohibited from engaging in or acquiring
direct or indirect control of more than 5% of the voting shares of any such
company engaged in non-banking activities unless the Federal Reserve Board, by
order or regulation, has found such activities to be closely related to banking
or managing or controlling banks as to be a proper incident thereto. In making
this determination, the Federal Reserve Board considers whether the performance
of these activities by a bank holding company would offer benefits to the public
that outweigh possible adverse effects.
As a bank holding company, Royal Bancshares is required to file an
annual report with the Federal Reserve Board and any additional information that
the Federal Reserve Board may require pursuant to the Holding Company Act. The
Federal Reserve Board may also make examinations of the holding company and any
or all of subsidiaries. Further, under the Holding Company Act and the Federal
Reserve Board's regulations, a bank holding company and its subsidiaries are
prohibited from engaging in certain tying arrangements in connection with any
extension of credit or provision of credit of any property or services. The so
called "anti-tying" provisions state generally that a bank may not extend
credit, lease, sell property or furnish any service to a customer on the
condition that the customer obtain additional credit or service from Royal Bank,
its bank holding company or any other subsidiary of its bank holding company, or
on the condition that the customer not obtain other credit or services from a
competitor of Royal Bank, its bank holding company or any subsidiary of its bank
holding company.
Subsidiary banks of a bank holding company are subject to certain
restrictions imposed by the Federal Reserve Act and by state banking laws on any
extensions of credit to the bank holding company or any of the holding company's
subsidiaries, on investments in the stock or other securities of the bank
holding company and on taking of such stock or securities as collateral for
loans to any borrower.
5
Under the Pennsylvania Banking Code of 1965, as amended, the ("Code"),
Royal Bancshares is permitted to control an unlimited number of banks. However,
Royal Bancshares would be required under the Holding Company Act to obtain the
prior approval of the Federal Reserve Board before it could acquire all or
substantially all of the assets of any bank, or acquiring ownership or control
of any voting shares of any bank other than Royal Bank, if, after such
acquisition, the registrant would own or control more than 5% of the voting
shares of such bank. The Holding Company Act has been amended by the Riegle-Neal
Interstate Banking and Branching Act of 1994, which authorizes bank holding
companies, subject to certain limitations and restrictions, to acquire banks
located in any state.
In 1995, the Code was amended to harmonize Pennsylvania law with the
Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 to enable
Pennsylvania institutions to participate fully in interstate banking and to
remove obstacles to the choice by banks from other states engaged in interstate
banking to select Pennsylvania as a head office location.
A bank holding company located in Pennsylvania, another state, the
District of Columbia or a territory or possession of the United States may
control one or more banks, bank and trust companies, national banks, interstate
banks and, with the prior written approval of the Pennsylvania Department of
Banking, may acquire control of a bank and trust company or a national bank
located in Pennsylvania. A Pennsylvania-chartered institution may maintain a
bank, branches in any other state, the District of Columbia, or a territory or
possession of the United States upon the written approval of the Pennsylvania
Department of Banking.
Federal law also prohibits the acquisition of control of a bank holding
company without prior notice to certain federal bank regulators. Control is
defined for this purpose as the power, directly or indirectly, to direct the
management or policies of a bank or bank holding company or to vote 25% or more
of any class of voting securities of a bank or bank holding company.
Royal Bank. The deposits of Royal Bank are insured by the FDIC. Royal
Bank is subject to supervision, regulation and examination by the Pennsylvania
Department of Banking and by the FDIC. In addition, Royal Bank is subject to a
variety of local, state and federal laws that affect its operation.
The Pennsylvania Department of Banking and the FDIC routinely examine
Pennsylvania state-chartered, non-member banks such as Royal Bank in areas such
as reserves, loans, investments, management practices and other aspects of
operations. These examinations are designed for the protection of depositors
rather that Royal Bancshares' shareholders.
Federal and state banking laws and regulations govern, among other
things, the scope of a bank's business, the investments a bank may make, the
reserves against deposits a bank must maintain, the types and terms of loans a
bank may make and the collateral it may take, the activities of banks with
respect to mergers and consolidations, and the establishment of branches.
Pennsylvania law permits statewide branching.
Under the Federal Deposit Insurance Act ("FDIC Act"), the FDIC
possesses the power to prohibit institutions regulated by it (such as Royal
Bank) from engaging in any activity that would be an unsafe and unsound banking
practice or in violation of applicable law. Moreover, the FDIC Act: (i) empowers
the FDIC to issue cease-and-desist or civil money penalty orders against Royal
Bank or its executive officers, directors and/or principal shareholders based on
violations of law or unsafe and unsound banking practices; (ii) authorizes the
FDIC to remove executive officers who have participated in such violations or
unsound practices; (iii) restricts lending by Royal Bank to its executive
officers, directors, principal shareholders or related interests thereof; and
(iv) restricts management personnel of a bank from serving as directors or in
other management positions with certain depository institutions whose assets
exceed a specified amount or which have an office within a specified geographic
area. Additionally, the FDIC Act provides that no person may acquire control of
Royal Bank unless the FDIC has been given 60-days prior written notice and
within that time has not disapproved the acquisition or extended the period for
disapproval.
Under the Community Reinvestment Act ("CRA"), the FDIC uses a
five-point rating scale to assign a numerical score for a bank's performance in
each of three areas: lending, service and investment. Under the CRA, the FDIC is
required to: (i) assess the records of all financial institutions regulated by
it to determine if these institutions are meeting the credit needs of the
community (including low-and moderate-income neighborhoods) which they serve,
and (ii) take this record into account in its evaluation of any application made
by any such institutions for, among other things, approval of a branch or other
deposit facility, office relocation, a merger or an acquisition of another bank.
The CRA also requires the federal banking agencies to make public disclosures of
their evaluation of each bank's record of meeting the credit needs of its entire
community, including low-and moderate-income neighborhoods. This evaluation will
include a descriptive rate ("outstanding," "satisfactory," "needs to improve" or
"substantial noncompliance") and a statement describing the basis for the
rating. After its most recent examination of Royal Bank under CRA, the FDIC gave
Royal Bank a CRA rating of satisfactory.
6
A subsidiary bank of a holding company is subject to certain
restrictions imposed by the Federal Reserve Act, as amended, on any extensions
of credit to the bank holding company or its subsidiaries, on investments in the
stock or other securities of the bank holding company or its subsidiaries, and
on taking such stock or securities as collateral for loans. The Federal Reserve
Act, as amended, and Federal Reserve Board regulations also place certain
limitations and reporting requirements on extensions of credit by a bank to
principal shareholders of its parent holding company, among others, and to
related interests of such principal shareholders. In addition, such legislation
and regulations may affect the terms upon which any person who becomes a
principal shareholder of a holding company may obtain credit from banks with
which the subsidiary bank maintains a correspondent relationship.
From time to time, various types of federal and state legislation have
been proposed that could result in additional regulation of, and restrictions
on, the business of Royal Bank. It cannot be predicted whether any such
legislation will be adopted or how such legislation would affect the business of
Royal Bank. As a consequence of the extensive regulation of commercial banking
activities in the United States, Royal Bank's business is particularly
susceptible to being affected by federal legislation and regulations that may
increase the costs of doing business.
Under Bank Secrecy Act ("BSA"), banks and other financial institutions
are required to report to the Internal Revenue Service currency transactions of
more than $10,000 or multiple transactions in any one day of which Royal Bank is
aware that exceed $10,000 in the aggregate. Civil and criminal penalties are
provided under the BSA for failure to file a required report, for failure to
supply information required by the BSA or for filing a false or fraudulent
report.
FEDERAL DEPOSIT INSURANCE CORPORATION IMPROVEMENT ACT OF 1991
GENERAL. The Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDIC Improvement Act") includes several provisions that have a direct
impact on Royal Bank. The most significant of these provisions are discussed
below.
The FDIC is required to conduct periodic full-scope, on-site
examinations of Royal Bank. In order to minimize losses to the deposit insurance
funds, the FDIC Improvement Act establishes a format to monitor FDIC-insured
institutions and to enable "prompt corrective action" by the appropriate federal
supervisory agency if an institution begins to experience any difficulty. The
FDIC Improvement Act establishes five "capital" categories. They are: (1) well
capitalized, (2) adequately capitalized, (3) undercapitalized, (4) significantly
undercapitalized, and (5) critically undercapitalized. The overall goal of these
capital measures is to impose scrutiny and operational restrictions on banks as
they descend the capital categories from well capitalized to critically
undercapitalized.
Under current regulations, a "well-capitalized" institution is one that
has at least a 10% total risk-based capital ratio, a 6% Tier 1 risk-based
capital ratio, a 5% Tier 1 Leverage Ratio, and is not subject to any written
order or final directive by the FDIC to meet and maintain a specific capital
level. Royal Bank is presently categorized as a "well-capitalized" institution.
An "adequately capitalized" institution is one that meets the required
minimum capital levels, but does not meet the definition of a "well-capitalized"
institution. The existing capital rules generally require banks to maintain a
Tier 1 Leverage Ratio of at least 4% and an 8% total risk-based capital ratio.
Since the risk-based capital requirement is measured in the form of Tier 1
capital, this also will mean that a bank would need to maintain at least 4% Tier
1 risk-based capital ratio. An institution must meet each of the required
minimum capital levels in order to be deemed "adequately capitalized."
An "undercapitalized" institution is one that fails to meet one or more
of the required minimum capital levels for an "adequately capitalized"
institution. Under the FDIC Improvement Act, an "undercapitalized" institution
must file a capital restoration plan and is automatically subject to
restrictions on dividends, management fees and asset growth. In addition, the
institution is prohibited from making acquisitions, opening new branches or
engaging in new lines of business without the prior approval of its primary
federal regulator. A number of other restrictions may be imposed.
A "critically undercapitalized" institution is one that has a tangible
equity (Tier 1 capital) ratio of 2% or less. In addition to the same
restrictions and prohibitions that apply to "undercapitalized" and
"significantly undercapitalized" institutions, any institution that becomes
"critically undercapitalized" is prohibited from taking the following actions
without the prior written approval of its primary federal supervisory agency:
engaging in any material transactions other than in the usual course of
business; extending credit for highly leveraged transactions; amending its
charter or bylaws; making any material changes in accounting methods; engaging
in certain transactions with affiliates; paying excessive compensation or
bonuses; and paying interest on liabilities exceeding the prevailing rates in
the institution's market area. In addition, a "critically undercapitalized"
institution is prohibited from paying interest or principal on its subordinated
debt and is subject to being placed in conservatorship or receivership if its
tangible equity capital level is not increased within certain mandated time
frames.
7
REAL ESTATE LENDING GUIDELINES. Pursuant to the FDIC Improvement Act,
the FDIC has issued real estate lending guidelines that establish loan-to-value
("LTV") ratios for different types of real estate loans. A LTV ratio is
generally defined as the total loan amount divided by the appraised value of the
property at the time the loan is originated. If a bank does not hold a first
lien position, the total loan amount would be combined with the amount of all
senior liens when calculating the ratio. In addition to establishing the LTV
ratios, the FDIC's real estate guidelines require all real estate loans to be
based upon proper loan documentation and a recent independent appraisal of the
property.
The FDIC's guidelines establish the following limits for LTV ratios:
Loan Category LTV Limit
------------- ---------
Raw Land 65%
Land Development
Construction:
Commercial, Multifamily (includes
condos and co-ops), and other
Nonresidential 80%
Improved Property 85%
Owner occupied 1-4 Family and Home Equity
(without credit enhancements) 90%
The guidelines provide exceptions to the LTV ratios for
government-backed loans; loans facilitating the sale of real estate acquired by
the lending institution in the normal course of business; loans where Royal
Bank's decision to lend is not based on the offer of real estate as collateral
and such collateral is taken only out of an abundance of caution; and loans
renewed, refinanced, or restructured by the original lender to the same
borrower, without the advancement of new money. The regulation also allows
institutions to make a limited amount of real estate loans that do not conform
to the proposed LTV ratios. Under this exception, Royal Bank would be allowed to
make real estate loans that do not conform to the LTV ratio limits, up to an
amount not to exceed 100% of Royal Bank's total capital.
TRUTH IN SAVINGS ACT. The FDIC Improvement Act also contains the Truth
in Savings Act. The purpose of this Act is to require the clear and uniform
disclosure of the rates of interest that are payable on deposit accounts by
Royal Bank and the fees that are assessable against deposit accounts, so that
consumers can make a meaningful comparison between the competing claims of banks
with regard to deposit accounts and products. This Act requires Royal Bank to
include, in a clear and conspicuous manner, the following information with each
periodic statement of a deposit account: (1) the annual percentage yield earned,
(2) the amount of interest earned, (3) the amount of any fees and charges
imposed and (4) the number of days in the reporting period. This Act allows for
civil lawsuits to be initiated by customers if Royal Bank violates any provision
or regulation under this Act.
GRAMM-LEACH-BLILEY ACT OF 1999. On November 12, 1999, President Clinton signed
the Gramm-Leach-Bliley Act of 1999, also known as the Financial Services
Modernization Act. The Financial Services Modernization Act repeals the two
anti-affiliation provisions of the Glass-Steagall Act:
o Section 20, which restricted the affiliation of Federal Reserve
Member Banks with firms "engaged principally" in specified
securities activities; and
o Section 32, which restricts officer, director, or employee
interlocks between a member bank and any company or person
"primarily engaged" in specified securities activities.
In addition, the Financial Services Modernization Act contains provisions
that expressly preempt any state insurance law. The law establishes a
comprehensive framework to permit affiliations among commercial banks, insurance
companies, securities firms, and other financial service providers. It revises
and expands the framework of the Holding Company Act to permit a holding company
to engage in a full range of financial activities through a new entity known as
a Financial Holding Company. "Financial activities" is broadly defined to
include not only banking, insurance and securities activities, but also merchant
banking and additional activities that the Federal Reserve Board, in
consultation with the Secretary of the Treasury, determines to be financial in
nature, incidental to such financial activities, or complementary activities
that do not pose a substantial risk to the safety and soundness of depository
institutions or the financial system generally.
8
In general, the Financial Services Modernization Act:
o Repeals historical restrictions on, and eliminates many federal
and state law barriers to, affiliations among banks, securities
firms, insurance companies, and other financial service providers;
o Provides a uniform framework for the functional regulation of the
activities of banks, savings institutions and their holding
companies;
o Broadens the activities that may be conducted by national banks,
banking subsidiaries of bank holding companies, and their
financial subsidiaries;
o Provides an enhanced framework for protecting the privacy of
consumer information;
o Adopts a number of provisions related to the capitalization,
membership, corporate governance, and other measures designed to
modernize the Federal Home Loan Bank system;
o Modifies the laws governing the implementation of the CRA; and
o Addresses a variety of other legal and regulatory issues affecting
both day-to-day operations and long-term activities of financial
institutions.
In order for Royal Bancshares to take advantage of the ability to
affiliate with other financial service providers, Royal Bancshares must become a
"Financial Holding Company." To become a Financial Holding Company, a company
must file a declaration with the Federal Reserve, electing to engage in
activities permissible for Financial Holding Companies and certifying that it is
eligible to do so because all of its insured depository institution subsidiaries
are well-capitalized and well-managed. In addition, the Federal Reserve Board
must determine that each insured depository institution subsidiary of Royal
Bancshares has at least a "satisfactory" CRA rating. Royal Bancshares currently
meets the requirements to make an election to become a Financial Holding
Company. Royal Bancshares' management has not determined at this time whether it
will seek an election to become a Financial Holding Company. Royal Bancshares
continues to examine its strategic business plan to determine whether, based,
among other factors, on market conditions, the relative financial conditions of
Royal Bancshares and its subsidiaries, regulatory capital requirements and
general economic conditions, Royal Bancshares desires to utilize any of the
expanded powers provided in the Financial Service Modernization Act.
The Financial Services Modernization Act also includes a new section of
the FDIC Act governing subsidiaries of state banks that engage in "activities as
principal that would only be permissible" for a national bank to conduct in a
financial subsidiary. It expressly preserves the ability of a state bank to
retain all existing subsidiaries. Because Pennsylvania permits commercial banks
chartered by the state to engage in any activity permissible for national banks,
Royal Bank will be permitted to form subsidiaries to engage in the activities
authorized by the Financial Services Modernization Act, to the same extent as a
national bank. In order to form a financial subsidiary, Royal Bank must be
well-capitalized, and Royal Bank would be subject to the same capital deduction,
risk management and affiliate transaction rules as applicable to national banks.
Although the long-range effect of the Financial Services Modernization
Act cannot be predicted, Royal Bancshares and Royal Bank do not believe that the
Financial Services Modernization Act will have a material adverse effect on its
operations in the near-term. However, to the extent that it permits banks,
securities firms, and insurance companies to affiliate, the financial services
industry may experience further consolidation. The Financial Services
Modernization Act is intended to grant to community banks certain powers as a
matter of right that larger institutions have accumulated on an ad hoc basis.
Nevertheless, this act may have the result of increasing the amount of
competition that Royal Bancshares and Royal Bank face from larger institutions
and other types of companies offering financial products, many of which may have
substantially more financial resources than Royal Bancshares and Royal Bank.
USA PATRIOT ACT OF 2001. In October 2001, the USA Patriot Act of 2001
was enacted in response to the terrorist attacks in New York, Pennsylvania and
Washington D.C., which occurred on September 11, 2001. The Patriot Act is
intended to strengthen U.S. law enforcements' and the intelligence communities'
abilities to work cohesively to combat terrorism on a variety of fronts. The
potential impact of the Patriot Act on financial institutions of all kinds is
significant and wide ranging. The Patriot Act contains sweeping anti-money
laundering and financial transparency laws and imposes various regulations,
including standards for verifying client identification at account opening, and
rules to promote cooperation among financial institutions, regulators and law
enforcement entities in identifying parties that may be involved in terrorism or
money laundering.
9
SARBANES-OXLEY ACT OF 2002. On July 30, 2002, the Sarbanes-Oxley Act of
2002 was enacted ("SOX"). The stated goals of the SOX are to increase corporate
responsibility, to provide for enhanced penalties for accounting and auditing
improprieties at publicly traded companies and to protect investors by improving
the accuracy and reliability of corporate disclosures pursuant to the securities
laws.
SOX is the most far-reaching U.S. securities legislation enacted in
some time. SOX generally applies to all companies, both U.S. and non-U.S., that
file or are required to file periodic reports with the SEC under the Securities
Exchange Act of 1934, or the Exchange Act. Given the extensive SEC role in
implementing rules relating to many of SOX's new requirements, the final scope
of the requirements remains to be determined.
The SOX addresses, among other matters:
- New requirements for audit committees of reporting companies,
including independence, expertise, and responsibilities;
- Certification of financial statements by the chief executive
officer and chief financial officer;
- The forfeiture of bonuses or other incentive-based compensation
and profits from the sale of an issuer's securities by directors
and senior officers in the twelve month period following initial
publication of any financial statements that later require
restatement;
- Increased disclosure and reporting obligations for the reporting
company and their directors and executive officers with other
banks regulatory requirements;
- Disclosure of off-balance sheet transactions;
- A prohibition on personal loans to directors and officers, except
certain loans made by insured financial institutions on
non-preferential terms and in compliance with other bank
regulatory requirements;
- Disclosure of a code of ethics and filing a Form 8-K for a change
or waiver of such code;
- "Real time" filing of periodic reports;
- The formation of an independent public accounting oversight board;
- New standards for auditors and regulation of audits, including
independence provisions that restrict non-audit services that
accountants may provide to their audit clients; and
- Various increased civil and criminal penalties for fraud and other
violations of securities laws.
Section 404 of SOX requires Royal Bancshares to include in its Annual
Report on Form 10-K for fiscal years ending after November 15, 2004, a report by
its management and an attestation report by its independent registered public
accounting firm on the adequacy of Royal Bancshares' internal control over
financial reporting. Management's internal control report must, among other
things, set forth management's assessment of the effectiveness of Royal
Bancshares' internal control over financial reporting as of the end of its most
recent fiscal year, including a statement as to whether or not internal control
over financial reporting is effective. See Item 9A of this Report.
REGULATION W. Transactions between a bank and its "affiliates" are
quantitatively and qualitatively restricted under the Sections 23A and 23B of
Federal Reserve Act. The FDIC Act applies Sections 23A and 23B to insured
nonmember banks in the same manner and to the same extent as if they were
members of the Federal Reserve System. The Federal Reserve Board has also
recently issued Regulation W, which codifies prior regulations under Sections
23A and 23B of the Federal Reserve Act and interpretative guidance with respect
to affiliate transactions. Regulation W incorporates the exemption from the
affiliate transaction rules but expands the exemption to cover the purchase of
any type of loan or extension of credit from an affiliate. Affiliates of a bank
include, among other entities, the bank's holding company and companies that are
under common control with the bank. Royal Bancshares is considered to be an
affiliate of Royal Bank. In general, subject to certain specified exemptions, a
bank or its subsidiaries are limited in their ability to engage in "covered
transactions" with affiliates:
10
- To an amount equal to 10% of Royal Bank's capital and surplus, in
the case of covered transactions with any one affiliate; and
- To an amount equal to 20% of Royal Bank's capital and surplus, in
the case of covered transactions with all affiliates.
In addition, a bank and its subsidiaries may engage in covered
transactions and other specified transactions only on terms and under
circumstances that are substantially the same, or at least as favorable to the
bank or its subsidiary, as those prevailing at the time for comparable
transactions with nonaffiliated companies. A "covered transaction" includes:
- A loan or extension of credit to an affiliate;
- A purchase of, or an investment in, securities issued by an
affiliate;
- A purchase of assets from an affiliate, with some exceptions;
- The acceptance of securities issued by an affiliate as collateral
for a loan or extension of credit to any party; and
- This issuance of a guarantee, acceptance or letter of credit on
behalf of an affiliate.
In addition, under Regulation W:
- A bank and its subsidiaries may not purchase a low-quality asset
from an affiliate;
- Covered transactions and other specified transactions between a
bank or its subsidiaries and an affiliate must be on terms and
conditions that are consistent with safe and sound banking
practices; and
- With some exceptions, each loan or extension of credit by a bank
to an affiliate must be secured by collateral with a market value
ranging from 100% to 130%, depending on the type of collateral, of
the amount of the loan or extension of credit.
Regulation W generally excludes all non-bank and non-savings
association subsidiaries of banks from treatment as affiliates, except to the
extent that the Federal Reserve Board decides to treat these subsidiaries as
affiliates.
Concurrently with the adoption of Regulation W, the Federal Reserve
Board has proposed a regulation which would further limit the amount of loans
that could be purchased by a bank from an affiliate to not more than 100% of
Royal Bank's capital and surplus.
MONETARY POLICY
The earnings of Royal Bank are affected by the policies of regulatory
authorities including the Federal Reserve Board. An important function of the
Federal Reserve System is to influence the money supply and interest rates.
Among the instruments used to implement those objectives are open market
operations in United States government securities, changes in reserve
requirements against member bank deposits and limitations on interest rates that
member banks may pay on time and savings deposits. These instruments are used in
varying combinations to influence overall growth and distribution of bank loans
and investments and deposits. Their use may also affect rates charged on loans
or paid for deposits.
The policies and regulations of the Federal Reserve Board have had and
will probably continue to have a significant effect on its reserve requirements,
deposits, loans and investment growth, as well as the rate of interest earned
and paid, and are expected to affect Royal Bank's operations in the future. The
effect of such policies and regulations upon the future business and earnings of
Royal Bank cannot be predicted.
11
EFFECTS OF INFLATION
Inflation has some impact on Royal Bancshares' operating costs. Unlike
many industrial companies, however, substantially all of Royal Bancshares'
assets and liabilities are monetary in nature. As a result, interest rates have
a more significant impact on Royal Bancshares' performance than the general
level of inflation. Over short periods of time, interest rates may not
necessarily move in the same direction or in the same magnitude as prices of
goods and services.
CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES
The accounting and reporting policies of Royal Bancshares conform to
accounting principles generally accepted in the United States of America and
general practices within the financial services industry. Critical accounting
policies, judgments and estimates relate to loans, the allowance for loan losses
and deferred tax assets. The policies which significantly affect the
determination of Royal Bancshares' financial position, results of operations and
cash flows are summarized in Note A "Summary of Significant Accounting Polices"
of the Notes to Consolidated Financial Statements and are discussed in the
section captioned "Recent Accounting Pronouncements" of Management's Discussion
and Analysis of Financial Condition and Results of Operations, included in Items
7 and 8 of this Report, each of which is incorporated herein by reference.
Royal Bancshares considers that the determination of the allowance for
loan losses involves a higher degree of judgment and complexity than its other
significant accounting policies. The allowance for loan losses is calculated
with the objective of maintaining a reserve level believed by management to be
sufficient to absorb estimated credit losses. Management's determination of the
adequacy of the allowance is based on periodic evaluations of the loan portfolio
and other relevant factors. However, this evaluation is inherently subjective as
it requires material estimates, including, among others, expected default
probabilities, loss given default, expected commitment usage, the amounts of
timing of expected future cash flows on impaired loans, mortgages, and general
amounts for historical loss experience. The process also considers economic
conditions, uncertainties in estimating losses and inherent risks in the loan
portfolio. All of these factors may be susceptible to significant change. To the
extent actual outcomes differ from management estimates, additional provisions
for loan losses may be required that would adversely impact earnings in future
periods.
Royal Bancshares recognizes deferred tax assets and liabilities for the
future tax effects of temporary differences, net operating loss carry forwards
and tax credits. Deferred tax assets are subject to management's judgment based
upon available evidence that future realization is more likely than not. If
management determines that Royal Bancshares may be unable to realize all or part
of net deferred tax assets in the future, a direct charge to income tax expense
may be required to reduce the recorded value of the net deferred tax asset to
the expected realizable amount.
AVAILABLE INFORMATION
Upon a shareholder's written request, a copy of Royal Bancshares'
Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports
on Form 8-K, as required to be filed with the SEC pursuant to Exchange Act Rule
13a-1, may be obtained without charge on our website www.royalbankamerica.com or
from Jeffrey T. Hanuscin, Chief Financial Officer, Royal Bank America, 732
Montgomery Avenue, Narberth, PA 19072.
(The remainder of this page intentionally left blank)
12
ITEM 1A. RISK FACTORS.
An investment in our common stock involves risks. Before making an
investment decision, investors should carefully consider the risks described
below in conjunction with the other information in this report, including our
consolidated financial statements and related notes. If any of the following
risks or other risks, which have not been identified or which we may believe are
immaterial or unlikely, actually occur, our business, financial condition and
results of operations could be harmed. In such a case, the trading price of our
common stock could decline, and investors may lose all or part of their
investment.
RISKS RELATED TO OUR BUSINESS
OUR RECENT OPERATING RESULTS MAY NOT BE INDICATIVE OF FUTURE OPERATING RESULTS.
Royal Bancshares may not be able to sustain its growth. Various factors
(discussed below) such as increased size, economic conditions, regulatory and
legislative considerations, competition and the ability to find and retain
people that can make Royal Bancshares' community-focused operating model
successful, may impede its ability to expand its market presence. If we
experience a significant decrease in our growth rate, our results of operations
and financial condition may be adversely affected.
OUR BUSINESS IS SUBJECT TO THE SUCCESS OF THE LOCAL ECONOMIES AND REAL ESTATE
MARKETS IN WHICH WE OPERATE.
Our success significantly depends on the growth in population, income
levels, loans and deposits and on the continued stability in real estate values
in our markets. If the communities in which we operate do not grow or if
prevailing economic conditions locally or nationally are unfavorable, our
business may be adversely affected. Adverse economic conditions in our specific
market areas, specifically decreases in real estate property values due to the
nature of our loan portfolio, over 94% of which is secured by real estate, could
reduce our growth rate, affect the ability of customers to repay their loans and
generally affect our financial condition and results of operations. Royal
Bancshares is less able than a larger institution to spread the risks of
unfavorable local economic conditions across a large number of more diverse
economies.
OUR CONCENTRATION OF COMMERCIAL AND CONSTRUCTION LOANS IS SUBJECT TO UNIQUE
RISKS THAT COULD ADVERSELY AFFECT OUR EARNINGS.
Our commercial and construction loan portfolio was $505 million at
December 31, 2005, comprising 92% of total loans. Commercial and construction
loans are often riskier than home equity loans or residential mortgage loans to
individuals. In the event of a general economic slowdown, they would represent
higher risk due to slower sales and reduced cash flow that could impact the
borrowers' ability to repay on a timely basis.
OUR ABILITY TO PAY DIVIDENDS DEPENDS PRIMARILY ON DIVIDENDS FROM OUR BANKING
SUBSIDIARY, WHICH ARE SUBJECT TO REGULATORY LIMITS.
We are a bank holding company and our operations are conducted by
direct and indirect subsidiaries, each of which is a separate and distinct legal
entity. Substantially all of our assets are held by our direct and indirect
subsidiaries.
Our ability to pay dividends depends on our receipt of dividends from
our direct and indirect subsidiaries. Our banking subsidiary, Royal Bank,
including the Royal Asian Bank division, is our primary source of dividends.
Dividend payments from our banking subsidiary are subject to legal and
regulatory limitations, generally based on net profits and retained earnings,
imposed by the various banking regulatory agencies. The ability of Royal Bank to
pay dividends is also subject to its profitability, financial condition, capital
expenditures and other cash flow requirements. At December 31, 2005,
approximately $30 million was available without the need for regulatory approval
for the payment of dividends to us from our banking subsidiary. There is no
assurance that our subsidiaries will be able to pay dividends in the future or
that we will generate adequate cash flow to pay dividends in the future. Failure
to pay dividends on our common stock could have a material adverse effect on the
market price of our common stock.
13
COMPETITION FROM OTHER FINANCIAL INSTITUTIONS MAY ADVERSELY AFFECT OUR
PROFITABILITY.
We face substantial competition in originating loans, both commercial
and consumer. This competition comes principally from other banks, savings
institutions, mortgage banking companies and other lenders. Many of our
competitors enjoy advantages, including greater financial resources and higher
lending limits, a wider geographic presence, more accessible branch office
locations, the ability to offer a wider array of services or more favorable
pricing alternatives, as well as lower origination and operating costs. This
competition could reduce our net income by decreasing the number and size of
loans that we originate and the interest rates we may charge on these loans.
In attracting business and consumer deposits, Royal Bank faces
substantial competition from other insured depository institutions such as
banks, savings institutions and credit unions, as well as institutions offering
uninsured investment alternatives, including money market funds. Many of our
competitors enjoy advantages, including greater financial resources, more
aggressive marketing campaigns, better brand recognition and more branch
locations. These competitors may offer higher interest rates than we do, which
could decrease the deposits that we attract or require us to increase our rates
to retain existing deposits or attract new deposits. Increased deposit
competition could adversely affect our ability to generate the funds necessary
for lending operations. As a result, we may need to seek other sources of funds
that may be more expensive to obtain and could increase our cost of funds.
Royal Bancshares' banking and non-banking subsidiaries also compete
with non-bank providers of financial services, such as brokerage firms, consumer
finance companies, credit unions, insurance agencies and governmental
organizations which may offer more favorable terms. Some of our non-bank
competitors are not subject to the same extensive regulations that govern our
banking operations. As a result, such non-bank competitors may have advantages
over Royal Bancshares' banking and non-banking subsidiaries in providing certain
products and services. This competition may reduce or limit our margins on
banking and non-banking services, reduce our market share and adversely affect
our earnings and financial condition.
OUR ALLOWANCE FOR LOAN LOSSES MAY NOT BE ADEQUATE TO COVER ACTUAL LOSSES.
Like all financial institutions, we maintain an allowance for loan
losses to provide for loan defaults and non-performance. Our allowance for loan
losses is based on our historical loss experience as well as an evaluation of
the risks associated with our loan portfolio, including the size and composition
of the loan portfolio, current economic conditions and geographic concentrations
within the portfolio. Our allowance for loan losses may not be adequate to cover
actual loan losses, and future provisions for loan losses could materially and
adversely affect our financial results.
WE MAY SUFFER LOSSES IN OUR LOAN PORTFOLIO DESPITE OUR UNDERWRITING PRACTICES.
Royal Bancshares seeks to mitigate the risks inherent in its loan
portfolio by adhering to specific underwriting practices. These practices often
include: analysis of a borrower's credit history, financial statements, tax
returns and cash flow projections; valuation of collateral based on reports of
independent appraisers; and verification of liquid assets. Although we believe
that our underwriting criteria are appropriate for the various kinds of loans we
make, Royal Bancshares may incur losses on loans that meet these criteria.
NEGATIVE PUBLICITY COULD DAMAGE OUR REPUTATION AND ADVERSELY IMPACT OUR BUSINESS
AND FINANCIAL RESULTS.
Reputation risk, or the risk to Royal Bancshares' earnings and capital
from negative publicity, is inherent in our business. Negative publicity can
result from Royal Bancshares' actual or alleged conduct in any number of
activities, including lending practices, corporate governance and acquisitions,
and actions taken by government regulators and community organizations in
response to those activities. Negative publicity can adversely affect our
ability to keep and attract customers and can expose Royal Bancshares to
litigation and regulatory action. Although Royal Bancshares takes steps to
minimize reputation risk in dealing with customers and other constituencies,
Royal Bancshares, as a larger diversified financial services company with a high
industry profile, is inherently exposed to this risk.
14
RISKS RELATED TO OUR INDUSTRY
OUR BUSINESS IS SUBJECT TO INTEREST RATE RISK AND VARIATIONS IN INTEREST RATES
MAY NEGATIVELY AFFECT OUR FINANCIAL PERFORMANCE.
Changes in the interest rate environment may reduce profits. The
primary source of our income for is the differential or "spread" between the
interest earned on loans, securities and other interest-earning assets, and
interest paid on deposits, borrowings and other interest-bearing liabilities. As
prevailing interest rates change, net interest spreads are affected by the
difference between the maturities and re-pricing characteristics of
interest-earning assets and interest-bearing liabilities. In addition, loan
volume and yields are affected by market interest rates on loans, and rising
interest rates generally are associated with a lower volume of loan
originations. An increase in the general level of interest rates may also
adversely affect the ability of certain borrowers to pay the interest on and
principal of their obligations. Accordingly, changes in levels of market
interest rates could materially adversely affect our net interest spread, asset
quality, loan origination volume and overall profitability.
FUTURE GOVERNMENTAL REGULATION AND LEGISLATION COULD LIMIT OUR FUTURE GROWTH.
Royal Bancshares and our subsidiaries are subject to extensive state
and federal regulation, supervision and legislation that govern almost all
aspects of the operations of Royal Bancshares and our subsidiaries. These laws
may change from time to time and are primarily intended for the protection of
consumers, depositors and the deposit insurance funds. Any changes to these laws
may negatively affect our ability to expand our services and to increase the
value of our business. While we cannot predict what effect any presently
contemplated or future changes in the laws or regulations or their
interpretations would have on Royal Bancshares, these changes could be
materially adverse to Royal Bancshares' shareholders.
CHANGES IN CONSUMER USE OF BANKS AND CHANGES IN CONSUMER SPENDING AND SAVING
HABITS COULD ADVERSELY AFFECT THE COMPANY'S FINANCIAL RESULTS.
Technology and other changes now allow many consumers to complete
financial transactions without using banks. For example, consumers can pay bills
and transfer funds directly without going through a bank. This
"disintermediation" could result in the loss of fee income, as well as the loss
of customer deposits and income generated from those deposits. In addition,
changes in consumer spending and saving habits could adversely affect our
operations, and Royal Bancshares may be unable to timely develop competitive new
products and services in response to these changes that are accepted by new and
existing customers.
ACTS OR THREATS OF TERRORISM AND POLITICAL OR MILITARY ACTIONS TAKEN BY THE
UNITED STATES OR OTHER GOVERNMENTS COULD ADVERSELY AFFECT GENERAL ECONOMIC OR
INDUSTRY CONDITIONS.
Geopolitical conditions may also affect our earnings. Acts or threats
or terrorism and political or military actions taken by the United States or
other governments in response to terrorism, or similar activity, could adversely
affect general economic or industry conditions.
OTHER RISKS.
OUR DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL SHAREHOLDERS OWN A SIGNIFICANT
PORTION OF OUR COMMON STOCK AND CAN INFLUENCE SHAREHOLDER DECISIONS.
Our directors, executive officers and principal shareholders, as a group,
beneficially owned approximately 65% of our fully diluted outstanding common
stock as of February 28, 2006. As a result of their ownership, the directors,
executive officers and principal shareholders will have the ability, by voting
their shares in concert, to influence the outcome of any matter submitted to our
shareholders for approval, including the election of directors. The directors
and executive officers may vote to cause Royal Bancshares to take actions with
which the other shareholders do not agree or that are not beneficial to all
shareholders.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
There have been no written comments from the Securities and Exchange
Commission staff regarding Royal Bancshares' periodic or current reports under
the Exchange Act that Royal Bancshares believes are material, were issued more
than 180 days before December 31, 2005, and remain unresolved as of the date of
filing of this Annual Report on Form 10-K.
15
ITEM 2. PROPERTIES
Royal Bank has twenty-one banking offices, which are located in
Pennsylvania and New Jersey.
ROYAL BANK AMERICA
Narberth Office (1) Villanova Office King of Prussia Office (1)
- ------------------- ---------------- --------------------------
732 Montgomery Avenue 801 East Lancaster Avenue Rt. 202 at Wilson Road
Narberth, PA 19072 Villanova, PA 19085 King of Prussia, PA 19406
Walnut Street Office Shillington Office Bridgeport Office (1)
- -------------------- ------------------ ---------------------
1230 Walnut Street 516 East Lancaster Avenue 105 W. 4th Street
Philadelphia, PA 19107 Shillington, PA 19607 Bridgeport, PA 19406
Fairmont Office (1) Trooper Office (1) Henderson Road Office
- ------------------- ------------------ ---------------------
401 Fairmont Avenue Trooper and Egypt Roads Bielder and Henderson Roads
Philadelphia, PA 19123 Trooper, PA 19401 King of Prussia, PA 19406
Castor Office (1) Reading Office Phoenixville Office (1)
- ----------------- -------------- -----------------------
6331 Castor Avenue 501 Washington Avenue 808 Valley Forge Road
Philadelphia, PA 19149 Reading, PA 19601 Phoenixville, PA 19460
15th Street Office Jenkintown Office (1) Turnersville Office
- ------------------ --------------------- -------------------
30 South Street 600 Old York Road 3501 Black Horse Pike
Philadelphia, PA 19102 Jenkintown, PA 19046 Turnersville, NJ 08012
Grant Avenue Office (1) Narberth Training Center (1)(2) Storage Facility (1)
- ----------------------- ------------------------------- --------------------
1650 Grant Avenue 814 Montgomery Avenue 3836 Spring Garden Street
Philadelphia, PA 19115 Narberth, PA 19072 Philadelphia, PA 19104
Main Street Office
- ------------------
213 Main Street
Fort Lee, NJ 07024
ROYAL ASIAN BANK DIVISION
Northeast Office Cheltenham Office Upper Darby Office
- ---------------- ----------------- ------------------
6526 Castor Avenue 418 Oak Lane 7001 West Chester Pike
Philadelphia, PA 19149 Philadelphia, PA 19126 Upper Darby, PA 19082
Fort Lee Office
- ---------------
1550 Lemoine Avenue
Fort Lee, NJ 07024
(1) Owned
(2) Used for employee training
Royal Bank owns eleven of the above properties, one property is subject
to a mortgage. The remaining twelve properties are leased with expiration dates
between 2006 and 2012. During 2005, Royal Bank made aggregate lease payments of
approximately $716,000. Royal Bank believes that all of its properties are
attractive, adequately insured, and well maintained and are adequate for Royal
Bank's purposes. Royal Bank also owns a property located at 144 Narberth Avenue,
Narberth, PA, which may serve as a site for future expansion.
ITEM 3. LEGAL PROCEEDINGS
Management, after consulting with Royal Bancshares' legal counsel, is
not aware of any litigation that would have a material adverse effect on the
consolidated financial position of Royal Bancshares. There are no proceedings
pending other than routine litigation incident to the business of Royal
Bancshares. In addition, no material proceedings are known to be contemplated by
governmental authorities against Royal Bancshares.
16
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Royal Bancshares' shareholders
during the fourth calendar quarter of 2005.
PART II
ITEM 5. MARKET FOR ROYAL BANCSHARES' COMMON STOCK AND RELATED SECURITY
HOLDER MATTERS
On September 6, 1988, Royal Bancshares' Class A Common Stock commenced
trading on the NASDAQ National Market System (NASDAQ/NMS). Royal Bancshares'
NASDAQ Symbol is RBPAA and is included in the NASDAQ National Market Stock
Table, which is published in most major newspapers. There is no market for Royal
Bancshares' Class B Common Stock, as such is prohibited by the terms of the
Class B Common Stock. The following table shows the range of high, low-end and
closing bid prices for Royal Bancshares' stock as reported by NASDAQ.
BID PRICES
2005 HIGH LOW CLOSE
- ---- ---- --- -----
First Quarter ............................... $27.431 $21.422 $22.265
Second Quarter .............................. 24.020 21.569 23.284
Third Quarter ............................... 24.353 21.578 21.902
Fourth Quarter .............................. 24.020 21.853 22.706
2004 HIGH LOW CLOSE
- ---- ---- --- -----
First Quarter ............................... $25.952 $23.453 $24.510
Second Quarter .............................. 25.087 20.521 23.837
Third Quarter ............................... 24.404 21.194 23.328
Fourth Quarter .............................. 28.729 22.982 25.971
(Source: This summary reflects information supplied by YAHOO)
The bid information shown above is derived from statistical reports of
the NASDAQ Stock Market and reflects inter-dealer prices without retail mark-up,
mark-down or commissions and may not necessarily represent actual transactions.
The bid prices reflect the 2% stock dividends that were declared on December 18,
2005, . The NASDAQ Stock Market, Inc., is a wholly-owned subsidiary of National
Association of Securities Dealers, Inc.
The approximate number of recorded holders of Royal Bancshares' Class A
and Class B Common Stock, as of February 28, 2006, is shown below:
TITLE OF CLASS NUMBER OF RECORD HOLDERS
-------------------- ------------------------
Class A Common Stock 357
Class B Common Stock 147
Because substantially all of the holders of Class B Common Stock are
also holders of Class A Common stock the number of record holders of the two
classes on a combined basis was approximately 420 as of February 28, 2006.
17
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following two tables disclose the number of outstanding options,
warrants and rights granted by Royal Bancshares to participants in equity
compensation plans, as well as the number of securities remaining available for
future issuance under the plans. The tables provide this information separately
for equity compensation plans that have and have not been approved by security
holders.
(c)
Number of securities
(a) remaining available for
Number of securities to (b) future issuance under
be issued upon Weighted-average equity compensation
exercise of outstanding exercise price of plans (excluding
options, warrants and outstanding options, securities reflected in
rights warrants and rights column (a))
----------------------------------------------------------------------------
OUTSIDE DIRECTORS STOCK OPTION PLAN
- -----------------------------------
Equity compensation plan approved
by stockholders 91,068 $18.53 48,632
Equity compensation plan not
approved by stockholders -- -- --
----------------- ---------------
91,068 $18.53 48,632
(c)
Number of securities
(a) remaining available for
Number of securities to (b) future issuance under
be issued upon Weighted-average equity compensation
exercise of outstanding exercise price of plans (excluding
options, warrants and outstanding options, securities reflected in
rights warrants and rights column (a))
----------------------------------------------------------------------------
EMPLOYEES STOCK OPTION PLAN
- ---------------------------
Equity compensation plan approved
by stockholders 737,170 $19.61 44,941
Equity compensation plan not
approved by stockholders -- -- --
----------------- ---------------
Total 737,170 $19.61 44,941
DIVIDENDS
Subject to certain limitations imposed by law, the Board of Directors
of Royal Bancshares may declare a dividend on shares of common stock.
Stock dividends. On January 17, 2001, the Board of Directors of Royal
Bancshares declared a 5% stock dividend on both its Class A Common Stock and
Class B Common Stock shares payable on February 12, 2001, to shareholders of
record on January 29, 2001. The stock dividend resulted in the issuance of
408,197 additional shares of Class A Common Stock and 86,614 additional shares
of Class B Common Stock.
On January 16, 2002, the Board of Directors of Royal Bancshares
declared a 6% stock dividend on both its Class A Common Stock and Class B Common
Stock shares payable on February 8, 2002, to shareholders of record on January
28, 2002. The stock dividend resulted in the issuance of 517,635 additional
shares of Class A common stock and 108,282 additional shares of Class B common
stock.
On January 15, 2003, the Board of Directors of Royal Bancshares
declared a 3% stock dividend on both its Class A Common Stock and Class B Common
Stock shares payable on February 12, 2003, to shareholders of record on January
29, 2003. The stock dividend resulted in the issuance of 281,196 additional
shares of Class A common stock and 55,820 additional shares of Class B common
stock.
18
On January 21, 2004, the Board of Directors of Royal Bancshares
declared a 2% stock dividend on both its Class A Common Stock and Class B Common
Stock shares payable on February 18, 2004, to shareholders of record on February
4, 2004. The stock dividend resulted in the issuance of 195,861 additional
shares of Class A common stock and 38,216 additional shares of Class B common
stock.
On December 15, 2004, the Board of Directors of Royal Bancshares
declared a 2% stock dividend on both its Class A Common Stock and Class B Common
Stock shares payable on January 12, 2005, to shareholders of record on December
29, 2004. The stock dividend resulted in the issuance of 200,814 additional
shares of Class A common stock and 38,865 additional shares of Class B common
stock.
On December 18, 2005, the Board of Directors of Royal Bancshares
declared a 2% stock dividend on both its Class A Common Stock and Class B Common
Stock shares payable on January 17, 2006, to shareholders of record on January
4, 2006. The stock dividend resulted in the issuance of 205,120 additional
shares of Class A common stock and 19,426 additional shares of Class B common
stock. There were 20,117 Class B shares deferred (agreed to by the Tabas Family
Trust) until the Annual Shareholders Meeting where Management will request the
company's shareholders to approve amending the Company's Articles of
Incorporation to increase the number of Class B shares authorized. Future stock
dividends, if any, will be at the discretion of the Board of Directors and will
be dependent on the level of earnings and compliance with regulatory
requirements.
Cash Dividends. Royal Bancshares paid cash dividends in each quarter of
2005 and 2004 for holders of Class A Common Stock and for holders of Class B
Common Stock. This resulted in a charge to retained earnings of approximately
$12.9 million and $12.2 million for 2005 and 2004, respectively. The following
table sets forth on a quarterly basis dividends paid to holders of each Class A
and Class B Common Stock for 2005 and 2004, adjusted to give effect to the stock
dividends paid.
CASH DIVIDENDS PER SHARE
------------------------
2005 CLASS A CLASS B
- ---- ------- -------
First Quarter .................................. $.2500 $.2875
Second Quarter ................................. $.2500 $.2875
Third Quarter .................................. $.2750 $.31625
Fourth Quarter ................................. $.2750 $.31625
CASH DIVIDENDS PER SHARE
------------------------
2004 CLASS A CLASS B
- ---- ------- -------
First Quarter................................... $.2500 $.2875
Second Quarter.................................. $.2500 $.2875
Third Quarter................................... $.2500 $.2875
Fourth Quarter.................................. $.2500 $.2875
Future dividends must necessarily depend upon net income, capital
requirements, and appropriate legal restrictions and other factors relevant at
the time the Board of Directors of Royal Bancshares considers dividend policy.
Cash necessary to fund dividends available for dividend distributions to the
shareholders of Royal Bancshares must initially come from dividends paid by
Royal Bank to Royal Bancshares. Therefore, the restrictions on Royal Bank's
dividend payments are directly applicable to Royal Bancshares. Under the
Pennsylvania Banking Code of 1965, as amended, Royal Bank places a restriction
on the availability of capital surplus for payment of dividends.
Under the Pennsylvania Business Corporation Law of 1988, as amended,
Royal Bancshares may pay dividends only if after payment Royal Bancshares would
be able to pay its debts as they become due in the usual course of business and
the total assets are greater than the sum of its total liabilities plus the
amount that would be needed if Royal Bancshares were to be dissolved at the time
of the dividend to satisfy the preferential rights upon dissolution of
shareholders whose preferential rights are superior to those receiving the
dividend. See Regulatory Matters Note to the Consolidated Financial Statements
in Item 8 of this report.
19
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial and operating information
for Royal Bancshares should be read in conjunction with Item 7, Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the consolidated financial statements and accompanying notes in Item 8:
YEARS ENDED DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)
---------------------------------------------------------
2005 2004 2003 2002 2001
---- ---- ---- ---- ----
INCOME STATEMENT DATA (IN THOUSANDS)
Interest income $76,460 $67,541 $72,320 $77,104 $69,224
Interest expense 31,796 27,301 29,941 36,491 31,808
---------------------------------------------------------
Net interest income 44,664 40,240 42,379 40,613 37,416
Provision for loan losses 1 6 674 250 --
---------------------------------------------------------
Net interest income after loan losses 44,663 40,234 41,705 40,363 37,416
Gains on sale of loans 508 480 637 767 372
Gains on sale of real estate 2,494 2,102 568 455 188
Gains (losses) on investment securities 227 810 719 790 60
Income related to equity investments ("VIE") 19,418 7,133 -- -- --
Other income 2,179 2,635 1,780 1,188 1,118
---------------------------------------------------------
Total other income 24,826 13,160 3,704 3,200 1,738
Income before other expenses & income taxes 69,489 53,394 45,410 43,563 39,154
Non-interest expense
Salaries and benefits 13,488 10,767 9,959 9,440 10,479
Expenses related to equity investments ("VIE") 262 4,780 -- -- --
Other 11,049 9,900 8,929 9,481 7,124
---------------------------------------------------------
Total operating expenses 24,799 25,447 18,888 18,921 17,603
---------------------------------------------------------
Income before taxes 44,690 27,947 26,522 24,642 21,551
Incomes taxes 12,637 7,914 7,996 7,237 5,797
---------------------------------------------------------
Net income $32,053 $20,033 $18,526 $17,405 $15,754
=========================================================
Basic earnings per share (1) $ 2.50 $ 1.57 $ 1.47 $ 1.38 $ 1.27
------- ------- ------- ------- -------
Diluted earnings per share (1) $ 2.49 $ 1.56 $ 1.46 $ 1.36 $ 1.25
------- ------- ------- ------- -------
(1) Earnings per share has the weighted average number of shares used in the
calculation adjusted to reflect a 2% stock dividend in December 2005, a 2%
stock dividend in December 2004, a 2% stock dividend in January 2004, a 3%
stock dividend in 2003, a 6% stock dividend in 2002, and a 5% stock dividend
in 2001.
AS OF DECEMBER 31,
------------------------------------------------------------------
BALANCE SHEET DATA (IN THOUSANDS) 2005 2004 2003 2002 2001
- --------------------------------- ---- ---- ---- ---- ----
Total assets $1,301,019 $1,205,274 $1,154,410 $1,088,484 $930,980
Total average assets 1,258,137 1,194,008 1,160,354 1,048,875 788,419
Loans, net 539,360 454,775 500,131 564,264 634,347
Total deposits 697,409 742,382 791,059 820,840 701,860
Total borrowings 354,000 222,000 212,000 124,500 70,225
Total stockholders equity 155,508 140,876 134,833 121,331 108,449
Total average stockholders equity 145,601 137,622 127,728 114,655 105,072
Return on average assets 2.5% 1.7% 1.6% 1.7% 2.0%
Return on average equity 22.0% 14.6% 14.5% 15.2% 15.0%
Average equity to average assets 11.6% 11.5% 11.0% 10.9% 13.3%
Cash dividend payout ratio 40.1% 60.9% 61.1% 60.8% 56.9%
(The remainder of this page is intentionally left blank)
20
ITEM 7. MANAGEMENT'S DISCUSSIONS AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion and analysis of financial condition and
results of operations should be read in conjunction with the Consolidated
Financial Statements of Royal Bancshares and related notes (see Item 8).
FINANCIAL CONDITION
Total assets increased $96 million, or 8%, to $1.3 billion at December
31, 2005 from $1.21 billion at year-end 2004.
Cash and Cash Equivalents. Cash and cash equivalents are comprised of
cash on hand, and cash in interest bearing and non-interest bearing accounts in
banks, in addition to federal funds sold. Cash and cash equivalents increased
$3.8 million, to $30.9 million at December 31, 2005. The average balance of cash
and cash equivalents was approximately $16.3 million for 2005 versus $53.1
million for 2004. The majority of this average balance is held in
non-interest-bearing accounts with the Federal Reserve Bank as collateral for
deposit processing and operating cash held at the branches. The excess cash is
invested daily in overnight fed funds. The average balance of these funds that
earn interest was $3.9 million in 2005. The increase in the balance of cash and
cash equivalents at year end was primarily due to larger balances maintained
with the Federal Reserve Bank along with pending funding needs.
Investment Securities Held to Maturity. Held to maturity ("HTM")
investment securities represents approximately 21.5% of average earning assets
during 2005 and are comprised of primarily government agency bonds and corporate
debt securities of investment grade quality, at the time of purchase. During
2005, HTM investment securities increased by $43.2 million to $255.4 million at
December 31, 2005, from $212.2 million at December 31, 2004. The increase was
primarily due to the purchase of $50 million of investments funded by brokered
deposits as part of a leverage strategy.
Investment Securities Available for Sale. AFS investment securities
represent 32.1% of average earning assets during 2005 and are primarily
comprised of government secured agency bonds and government secured
mortgaged-backed securities, capital trust security issues of regional banks,
domestic corporate debt and U.S. denominated foreign corporate debt. At December
31, 2005, AFS investment securities were $326.2 million as compared to $360.9
million at December 31, 2004, a decrease of $34.7 million. This decrease was
primarily due to maturities and principal payments from mortgage backed
securities from the existing portfolio.
Loans. Royal Bancshares' primary earning assets are loans, representing
approximately 46.1% of average earning assets during 2005. The loan portfolio is
comprised primarily of business demand loans and commercial mortgages secured by
real estate and to a significantly lesser extent, residential loans comprised of
one to four family residential and home equity loans. During 2005, total loans
increased $82.3 million to $549.6 million at December 31, 2005 from $467.3
million at December 31, 2004 primarily due to an increased lending staff and
products along with the addition of the Royal Asian Bank Division.
Allowance for loan losses. The Company considers that the determination
of the allowance for loan losses involves a higher degree of judgment and
complexity than its other significant accounting policies. Management determines
the allowance for loan losses with the objective of maintaining a reserve level
sufficient to absorb estimated probable credit losses. Management has determined
the Company's balance in the allowance for loan losses based on management's
detailed analysis and review of loan portfolio. Management considers all known
relevant internal and external factors that may affect loan collectibility. The
periodic analysis and review includes an evaluation of the loan portfolio in
relation to historical loss experience, the size and composition of the
portfolio, current economic events and conditions, and other pertinent factors,
including Management's assumptions as to future delinquencies, recoveries and
losses. Management's evaluation is inherently subjective and all of these
factors may be susceptible to significant change. To the extent actual outcomes
differ from management's the Company may be required to make additional
provisions for loan losses that could adversely impact earnings in future
periods.
During 2005, the allowance for loan loss decreased $2.2 million to
$10.3 million at December 31, 2005 from $12.5 million at December 31, 2004. The
$2.2 million charge to allowance was attributed to a loan the Company had in
Texas. The level of allowance for loan loss reserve represents approximately
1.8% of total loans at December 31, 2005 versus 2.7% at December 31, 2004. As of
December 31, 2005 the Company had four loans in the amount of $5.6 million that
are considered to be potential problem loans with a specific reserve of $1.3
million. The decrease in the percentage in the allowance was related to the $2.2
million charge off as well as an increase in the balance of outstanding loans of
approximately $82 million. Management believes that, based on information
currently available, including the potential problem loans, the allowance for
loan loss is sufficient to cover losses inherent in the Company's loan portfolio
at this time, no assurances can be given that the level of allowance will be
sufficient to cover future loan losses or that future adjustments to the
allowance will be sufficient to cover future loan losses or that future
adjustments to the allowance will not be necessary if economic and/or other
conditions differ substantially from the economic and other conditions
considered by management in evaluating the adequacy of the current level of the
allowance.
21
Analysis of the Allowance for Loan losses by loan type
December 31, 2005 December 31, 2004
Reserve Percent of loans Reserve Percent of loans
Amount in each Amount in each
(in category to (in category to
thousands) total loans thousands) total loans
Domestic
Construction loans $ 3,397 31.43% $ 1,718 22.59%
Single family residents $ 925 7.74% $ 1,163 10.19%
Tax certificates - 6.44% -- 7.31%
Real estate - non-residential $ 5,132 43.19% $ 7,112 47.48%
Real estate - multi-family $ 277 4.51% $ 99 3.24%
Commercial and industrial $ 494 5.45% $ 964 8.53%
Installment loans to individual $ 41 0.70% $ 63 .66%
Lease financing $ 75 0.54% -- 00%
Foreign -- 00% -- 00%
Unallocated ($65) N/A $ 1,400 N/A
------- ------- ------- -------
$10,276 100.00% $12,519 100.00%
======= ======= ======= =======
An unallocated component is maintained to cover uncertainties that
could affect management's estimate of probable losses. The unallocated component
of the allowance reflects the margin of imprecision inherent in the underlying
assumptions used in the methodologies for estimating specific and general losses
in the portfolio.
Deposits. Royal Bancshares' deposits are an important source of
funding. Total deposits decreased $45.0 million, or 6.1%, from $742.4 million at
December 31, 2004 to $697.4 million at December 31, 2005. This decrease in
deposits is primarily due to a financial benefit from allowing money market
accounts to be replaced by overnight borrowings. At December 31, 2005, brokered
deposits were $152.0 million as compared to $65.3 million at December 31, 2004.
Certificate of deposit accounts increased $119.4 million, or 59.0% from $202.5
million at December 31, 2004 to $321.9 million at December 31, 2005. The
increase in brokered deposits and certificates of deposits was primarily due to
the $50 million investment strategy and use of these deposits to fund increased
loan demand. Other deposit categories comprised of demand, NOW, money markets
and savings deposits decreased $164.4 million during 2005 over their levels at
December 31, 2004. The decrease in all savings categories is primarily due to a
reduction in interest rates offered.
FHLB Borrowings. Borrowings are comprised of long-term borrowings
(advances) and short-term borrowings (overnight borrowings, advances). Long-term
FHLB borrowings increased $45.0 million to $249.5 million at December 31, 2005
from $204.5 million at December 31, 2004 due to converting overnight borrowings
to long-tern borrowings which allowed Royal Bancshares to take advantage of the
flat yield curve by locking in interest rates. At December 31, 2005 short term
FHLB borrowings were $104.5 million. The average balance of borrowings during
2005 was $312.8 million versus $221.7 million for 2004.
Other Borrowings. Royal Bancshares previous completed a private
placement of trust preferred securities in the aggregate amount of $25 million
for a term of 30 years with a call feature of 5 years. In addition, as result of
the adoption of FIN 46(R) Royal Bancshares consolidated into its statement of
condition $47.4 million of debt related to real estate equity investment of
which $0 is guaranteed by Royal Bancshares.
Other Liabilities. During 2005, Royal Bancshares increased its
unfunded pension obligation by $930 thousand as a result to modification the
pension plan, increased it profit sharing obligation by $760, and $676 third
quarter posting to from its posting an expense for the fair value of
derivatives.
22
Shareholders' Equity. Shareholders' equity increased $14.6 million or
10.4% in 2005 to $155.5 million primarily due to net income of $32.1 million
partially offset by $12.9 million in cash dividends paid in 2005. Additionally,
shareholders' equity was affected by the decrease in market value of AFS
investment securities during 2005, which resulted in a downward adjustment of
$4.8 million.
RESULTS OF OPERATIONS
General. Royal Bancshares' results of operations depend primarily on
net interest income, which is the difference between interest income on interest
earning assets and interest expense on interest bearing liabilities. Interest
earning assets consist principally of loans and investment securities, while
interest bearing liabilities consist primarily of deposits. Net income is also
affected by the provision for loan losses and the level of non-interest income
as well as by non-interest expenses, including salary and employee benefits,
occupancy expenses and other operating expenses.
Net Income. Net income in 2005 was $32.1 million as compared to $20.0
million in 2004 and $18.5 million in 2003. Basic earnings per share were $2.50,
$1.57 and $1.47 for 2005, 2004, and 2003, respectively. The $12.1 million
increase in net income for 2005 represents a 60% increase over 2004, and is
primarily attributable to the sale of two apartment complex which Royal
Bancshares held an equity ownership in. This transaction was disclosed through a
Form 8-K filing on October 20, 2005. The $1.5 million increase in net income for
2004 represents an 8% increase over 2003 and was primarily due to an increase in
non-interest income specifically with income from Bank Owned Life Insurance and
gains from the disposition of Other Real Estate Owned.
Net Interest Income. Net interest income is Royal Bancshares' primary
source of income. Its level is a function of the average balance of
interest-earning assets, the average balance of interest-bearing liabilities,
and the spread between the yield on assets and liabilities. In turn, these
factors are influenced by the pricing and mix of Royal Bancshares'
interest-earning assets and funding sources. Additionally, net interest income
is affected by market and economic conditions, which influence rates on loan and
deposit growth.
Net interest income was $44.7 million in 2005 as compared to $40.2
million in 2004. The increase in net interest income in 2005 of $4.5 million was
primarily due an increase in both the average balance and yield on earning
assets along with a one time exit fee in the amount of $1.3 million collected
during the second quarter of 2005.
The decrease in 2004 from 2003 of net interest income of $2.2 million
is primarily due to the reduction of the yield on earning assets along with a
decline in the spread of earning assets as compared to costing liabilities in
2004.
LOANS AND MORTGAGES
2005 2004 2003
---- ---- ----
Average loan outstandings $510,349,000 $471,526,000 $562,765,000
Interest and fees on loans $46,995,000 $40,044,000 $46,609,000
Average Yield 9.21% 8.49% 8.28%
Royal Bancshares continues to originate both fixed rate and variable
rate loans. At December 31, 2005 variable rate loans represented 53% of total
loans. Together with some match funding of fixed rate deposits to fixed rate
loans, variable rate loans have helped Royal Bancshares manage interest rate
risk.
In 2005, the average balance of loans increased $38.8 million to $510.3
million in 2005, primarily due an increase in the lending staff, offering
additional lending products and the addition of the Royal Asian Division. The
average yield on loans increased by 72 basis points in 2005 primarily due to the
increases in the prime rate and the $1.3 million exit fee collected in the
second quarter in 2005.
In 2004, the average balance of loans decreased $91.2 million to $471.5
million primarily due a large amount of loans being paid off as interest rates
remained at historically low levels. The average yield on loans increased by 21
basis points in 2004 primarily due to the average loan run off being at a lower
yield than the 2003 average yield , along with the Federal Reserve increasing
the short term rates in the second half of 2004.
23
HTM INVESTMENT SECURITIES
2005 2004 2003
---- ---- ----
Average HTM investment
securities $237,701,000 $141,799,000 $46,302,000
Interest income $10,122,000 $6,365,000 $3,087,000
Average yield 4.26% 4.49% 6.67%
HTM investment securities are comprised primarily of taxable corporate
debt issues and US government agencies. The corporate debt issues are investment
grade at the time of purchase. It is Royal Bancshares' expressed intention to
hold these securities to maturity.
In 2005, the yield on HTM investment securities decreased 23 basis
points to 4.26% from 4.49% in 2004. This decrease was primarily due to the
increase in the average balance of U.S. government agency bonds held during the
year. The government bonds were purchased with lower yields.
In 2004, the yield on HTM investment securities decreased 218 basis
points to 4.49% from 6.67% in 2003. This decrease was primarily due to the
purchasing of low credit risk government agency bonds that were yielding 3.0% to
4.5%. The government agency bonds at December 31, 2004 have step up and/or call
features.
AFS INVESTMENT SECURITIES
2005 2004 2003
---- ---- ----
Average AFS investment
securities $355,005,000 $399,361,000 $446,210,000
Interest and dividend income $19,229,000 $20,621,000 $22,007,000
Average yield 5.42% 5.16% 4.93%
AFS investment securities are comprised primarily of government secured
mortgage-backed securities, government agency bonds, non-rated and rated capital
trust security issues of regional banks, rated domestic and US denominated
foreign corporate debt securities and to a lesser extent preferred and common
stock.
In 2005, the average balance of AFS investment securities decreased
$44.4 million to $355.0 million primarily due to maturities and the repayment of
principal from the existing mortgaged backed securities. The 26 basis point
increase in average yield is primarily due to the lower yield on the principal
repayments.
In 2004, the average balance of AFS investment securities decreased
$46.8 million to $399.4 million primarily due to classifying new purchases from
investment runoff as held to maturity. The 23 basis point increase in average
yield is primarily due to higher yields earned on mortgage back securities
resulting from slower principal repayments speeds.
INTEREST EXPENSE ON NOW AND MONEY MARKET DEPOSITS
2005 2004 2003
---- ---- ----
Average NOW & Money Market
deposits $355,387,000 $461,076,000 $475,383,000
Interest expense $7,457,000 $7,965,000 $10,000,000
Average cost of funds 2.10% 1.73% 2.10%
In 2005, the average cost of funds on NOW and money market deposits
increased 36 basis points to 2.09% from 1.73% in 2004 primarily due to
increasing rates as a result of Federal Reserve increasing the overnight rates
during the year.
In 2004, the average cost of funds on NOW and money market deposits
decreased 37 basis points to 1.73% from 2.10% in 2003 primarily due to a decline
in the interest rate paid on these deposits.
24
INTEREST EXPENSE ON TIME DEPOSITS
2005 2004 2003
---- ---- ----
Average time deposits $254,031,000 $218,756,000 $269,293,000
Interest expense $9,965,000 $8,577,000 $12,011,000
Average cost of funds 3.92% 3.92% 4.46%
In 2005, the average balance of time deposits increased $35.3 million
to $254.0 million. The increase in average time deposits is primarily due to the
$50 million brokered deposit used in investment strategy. In 2004, the average
balance of time deposits decreased $50.5 million to $218.8 million. This
decrease in average time deposits is primarily due to the maturity of higher
yielding brokered deposits.
Although short term rates in general continued to move upward in 2005,
the long term rates continued to remain flat causing the yield on term deposits
to remain the same. At December 31, 2005, 63% of time deposits were comprised of
certificates of deposits accounts with balances of $100,000 or more, while in
2004, 45% of time deposits were comprised of certificates of deposit accounts
with balances of $100,000 or more. These types of deposit have traditionally
been considered more rate volatile than other types of deposits, however Royal
Bank's penalty for early redemption somewhat mitigates this volatility.
PROVISION FOR POSSIBLE LOAN LOSSES
The provision for loan losses is an amount charged to expense to
provide for future losses on existing loans. In order to determine the amount of
the provision for loan loss, Royal Bank conducts a quarterly review of the loan
portfolio to evaluate overall credit quality. This evaluation consists of an
analysis of individual loans and overall risk characteristics and size of the
loan, and takes into consideration current economic and market conditions,
changes in non-performing loans, the capability of specific borrowers to repay
loan obligations as well as current collateral values.
During 2005, a provision for loan losses was recorded for $1 thousand,
as compared to the $6 thousand in 2004. Both provisions were due to charge offs
relating to delinquent tax liens held by Crusader Servicing Corporation.
Management determined that no additional provision was needed based on its
analysis of the reserve for possible loan losses according to documentation
required under SAB 102. Net charge-offs were $2.2 million in 2005 as compared to
net recoveries $87 thousand in 2004.
In 2004, a provision for loan losses was recorded for $6 thousand, as
compared to $674 thousand in 2003 due to charges off's relating to delinquent
tax liens. During 2004 senior management determined that loan loss reserve was
adequate and no additional provision was required for the period. Net recoveries
were $87 thousand in 2004 as compared to net charge-offs of $718 thousand in
2003.
NON-INTEREST INCOME
Non-interest income includes service charges on depositors' accounts,
safe deposit rentals and various services such as cashing checks, issuing money
orders and traveler's checks, and similar activities. In addition, other forms
of non-interest income are derived from changes in the cash value of BOLI, fees
collected on the sale of residential mortgages in the secondary market and
income relating to the VIE's which Royal Bank has an investment. Most components
of non-interest income are a modest and stable source of income, with exceptions
of one-time gains and losses from the sale of investments securities and other
real estate owned, from period to period these sources of income may vary
considerably. Service charges on depositors' accounts, safe deposit rentals and
other fees are periodically reviewed by management to remain competitive with
other local banks.
In 2005, total non-interest income increased $11.7 million to $24.8 to
million at December 31, 2005. This increase is primarily due the sale of two
apartment complexes resulting in a pretax gain of $16.7 million from Royal
Bancshares' investment in VIE's. This was partially offset by a reduction of
$6.4 million due to the deconsolidation of the VIE's in which Royal Bancshares'
interest was sold.
In 2004, total non-interest income increased $9.5 million to $13.2
million at December 31, 2004. This increase is primarily due income earned on
the purchase of BOLI, income related to the consolidation of the VIEs and the
sale of other real estate owned.
25
NON-INTEREST EXPENSE
Non-interest expense includes compensation and employee benefits,
occupancy, advertising, FDIC insurance, state taxes, depreciation, and other
expenses such as auditing, automatic teller machines (ATMs), data processing,
legal, outside service charges, postage, printing and other expenses relating to
other real estate owned. Effective 2004, Royal Bancshares through the adoption
of FIN46(R) consolidates the expenses related to equity investments.
Non-interest expenses decreased $648 thousand to $24.8 million in 2005,
from $25.4 million in 2004. Salaries and benefits increased $2.7 million
primarily due to the increased in the lending staff and Royal Asian Division, an
increase to the Company's Profit Sharing Plan due to the results for the year,
and a one time charge of approximately $1 million related to modifications to
the company's pension plan. Expenses related to equity investments decreased
$4.5 million during 2005. This was primarily due to the deconsolidation of three
VIE's during the second and fourth quarters. During 2005, the Company has taken
some one time charges; $675 thousand for the decline in the fair value of
interest rate swaps and $424 thousand for an asset write-down.
Non-interest expense increased $6.5 million to $25.4 million in 2004,
from $18.9 million in 2003. Salaries and employee benefits increased $809
thousand to $10.8 million in 2004, from $10.0 million in 2003. This was
primarily due to annual salary increases and the addition of the Royal Asian
Bank, a division of Royal Bank. Occupancy expense increased $179 thousand to
$1.5 million in 2004 primarily due to the addition Royal Asian Bank. Other
operating expenses increased $792 thousand to $8.4 million in 2004. As a result
of consolidation of the "VIE" non-interest expense increased $4.8 million during
2004.
ACCOUNTING FOR INCOME TAXES
The provision for federal income taxes was $12.6 million in 2005 as
compared to $7.9 million for 2004, and $8.0 million for 2003 representing an
effective tax rate of 28%, 28% and 30%, respectively. During 2005, a $1.7
million reduction in tax expense was recorded as a result of the completion of
an IRS audit, with respect to a valuation allowance against a deferred tax asset
derived from net operating loss carryovers.
ACCOUNTING FOR DEBT AND EQUITY SECURITIES
Royal Bancshares accounts for investment securities in accordance with
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." This standard requires investments in securities to be classified
in one of three categories; held to maturity, trading or available for sale.
Debt securities that Royal Bancshares has the positive intent and ability to
hold to maturity are classified as held to maturity and are reported at
amortized cost. As Royal Bancshares does not engage in security trading, the
balance of its debt securities and any equity securities are classified as
available for sale. Net unrealized gains and losses for such securities, net of
tax effect, are required to be recognized as a separate component of
shareholders' equity and excluded from the determination of net income.
ASSET LIABILITY MANAGEMENT
The primary functions of asset-liability management are to assure
adequate liquidity and maintain an appropriate balance between interest earning
assets and interest bearing liabilities. This process is overseen by the
Asset-Liability Committee ("ALCO") which monitors and controls, among other
variables, the liquidity, balance sheet structure and interest rate risk of the
consolidated company within policy parameters established and outlined in the
ALCO Policy which are reviewed by the Board of Directors at least annually.
Additionally, the ALCO committee meets periodically and reports on liquidity,
interest rate sensitivity and projects financial performance in various interest
rate scenarios.
Liquidity. Liquidity is the ability of the financial institution to
ensure that adequate funds will be available to meet its financial commitments
as they become due. In managing its liquidity position, the financial
institution evaluates all sources of funds, the largest of which is deposits.
Also taken into consideration is the repayment of loans. These sources provide
the financial institution with alternatives to meet its short-term liquidity
needs. Longer-term liquidity needs may be met by issuing longer-term deposits
and by raising additional capital.
Royal Bancshares generally maintains a liquidity ratio equal to or greater
than 25% of total deposits and short-term liabilities. Liquidity is specifically
defined as the ratio of net cash, short term and marketable assets to net
deposits and short-term liabilities. The liquidity ratio for the years ended
December 31, 2005, 2004 and 2003 was 32%, 39% and 60%, respectively. Management
believes that Royal Bancshares' liquidity position continues to be adequate,
continues to be in excess of its peer group level and meets or exceeds the
liquidity target set forth in the Asset/Liability Management Policy. Management
believes that due to its financial position, it will be able to raise deposits
as needed to meet liquidity demands. However, any financial institution could
have unmet liquidity demands at any time.
26
Contractual Obligations and Other Commitments. The following table sets
forth contractual obligations and other commitments representing required and
potential cash outflows as of December 31, 2005.
Less than More than 5
(in thousands) Total 1 year 1-3 years 4-5 years years
-----------------------------------------------------------------
FHLB Advances $354,000 $104,500 $ 0 $162,500 $ 87,000
Operating leases 2,924 661 1,317 781 165
Interest rate swaps 1,281 36 -- 1,034 211
Commitments to extend credit 176,415 176,415 -- -- --
Standby letters of credit 3,228 2,750 478 -- --
Subordinated debt 25,774 -- -- -- 25,774
Time deposits 321,944 120,677 116,096 81,813 3,358
-------- -------- -------- -------- --------
Total $885,566 $405,039 $117,891 $246,128 $116,508
======== ======== ======== ======== ========
Interest-Rate Sensitivity. Interest rate sensitivity is a function of
the repricing characteristics of the financial institution's assets and
liabilities. These include the volume of assets and liabilities repricing, the
timing of repricing, and the relative levels of repricing. Attempting to
minimize the interest rate sensitivity gaps is a continual challenge in a
changing rate environment. The interest sensitivity report examines the
positioning of the interest rate risk exposure in a changing interest rate
environment. Ideally the rate sensitive assets and liabilities will be
maintained in a matched position to minimize interest rate risk.
The interest rate sensitivity analysis is an important management tool,
however, it does have some inherent shortcomings. It is a "static" analysis.
Although certain assets and liabilities may have similar maturities or
repricing, they may react in different degrees to changes in market interest
rates. Additionally, repricing characteristics of certain assets and liabilities
may vary substantially within a given period.
The following table summarizes repricing intervals for interest earning
assets and interest bearing liabilities as of December 31, 2005, and the
difference or "gap" between them on an actual and cumulative basis for the
periods indicated. A gap is considered positive when the amount of interest rate
sensitive assets exceeds the amount of interest rate sensitive liabilities.
During a period of falling interest rates, a positive gap would tend to
adversely affect net interest income, while a negative gap would tend to result
in an increase in net interest income. During a period of rising interest rates,
a positive gap would tend to result in an increase in net interest income while
a negative gap would tend to affect net interest income adversely. At December
31, 2005, Royal Bancshares is in an asset sensitive positive of $301.9 million,
which indicates assets will reprice somewhat faster than liabilities within one
year.
(This remainder of this page was intentionally left blank)
27
INTEREST RATE SENSITIVITY
(IN MILLIONS)
DAYS
---------------------- 1 TO 5 OVER 5 NON-RATE
ASSETS (1) 0 - 90 91 - 365 YEARS YEARS SENSITIVE TOTAL
----------------------------------------------------------------------------
Interest-bearing deposits in banks $ 7.2 $ -- $ -- $ -- $ 9.9 $ 17.1
Federal funds sold 13.8 -- -- -- -- 13.8
Investment securities:
Available for sale 14.5 21.4 192.3 98.5 (0.5) 326.2
Held to maturity 0.9 50.1 204.6 -- -- 255.6
----------------------------------------------------------------------------
Total investment securities 15.4 71.5 396.9 98.5 (0.5) 581.8
Loans:(2)
Fixed rate 21.5 39.6 159.8 13.6 -- 234.5
Variable rate 197.4 99.6 12.9 6.5 (11.5) 304.9
----------------------------------------------------------------------------
Total loans 218.9 139.2 172.7 20.1 (11.5) 539.4
Other assets 38.2 -- -- -- 110.7 148.9
----------------------------------------------------------------------------
Total Assets $ 293.5 $ 210.7 $ 569.6 $ 118.6 $ 108.6 $ 1,301.0
============================================================================
LIABILITIES & CAPITAL
Deposits:
Non interest bearing deposits $ -- $ -- $ -- $ -- $ 76.8 $ 76.8
Interest bearing deposits 18.7 56.2 223.8 -- -- 298.7
Certificate of deposits 5.4 10.5 287.7 18.3 -- 321.9
----------------------------------------------------------------------------
Total deposits 24.1 66.7 511.5 18.3 76.8 697.4
Borrowings 81.5 30.0 238.3 30.0 47.4 427.2
Other liabilities -- -- 0.3 -- 20.6 20.9
Capital -- -- -- -- 155.5 155.5
----------------------------------------------------------------------------
Total liabilities & capital $ 105.6 $ 96.7 $ 750.1 $ 48.3 $ 300.3 $ 1,301.0
============================================================================
Net interest rate GAP $ 187.9 $ 114.0 $ (180.5) $ 70.3 $ (191.7)
==============================================================
Cumulative interest rate GAP $ 187.9 $ 301.9 $ 121.4 $ 191.7 $ --
==============================================================
GAP to total assets 14% 9%
======================
GAP to total equity 121% 73%
======================
Cumulative GAP to total assets 14% 23%
======================
Cumulative GAP to total equity 121% 194%
======================
(1) Interest earning assets are included in the period in which the balances are
expected to be repaid and/or repriced as a result of anticipated
prepayments, scheduled rate adjustments, and contractual maturities.
(2) Reflects principal maturing within the specified periods for fixed and
repricing for variable rate loans; includes nonperforming loans.
The method of analysis of interest rate sensitivity in the table above
has a number of limitations. Certain assets and liabilities may react
differently to changes in interest rates even though they reprice or mature in
the same time periods. The interest rates on certain assets and liabilities may
change at different times than changes in market interest rates, with some
changing in advance of changes in market rates and some lagging behind changes
in market rates. Also, certain assets have provisions, which limit changes in
interest rates each time the interest rate changes and for the entire term of
the loan. Additionally, prepayments and withdrawals experienced in the event of
a change in interest rates may deviate significantly from those assumed in the
interest rate sensitivity table. Additionally, the ability of some borrowers to
service their debt may decrease in the event of an interest rate increase.
28
CAPITAL ADEQUACY
The table shown below sets forth Royal Bancshares' consolidated capital
level and performance ratios:
REGULATORY
2005 2004 2003 MINIMUM
--------- --------- -------- ------------
CAPITAL LEVEL
Leverage ratio 14.2% 13.9% 11.1% 3.0%
Risk based capital ratio:
Tier 1 18.8% 19.2% 15.3% 4.0%
Total 19.8% 20.4% 16.5% 8.0%
CAPITAL PERFORMANCE
Return on average assets 2.5% 1.7% 1.6% -
Return on average equity 22.0% 14.6% 14.5% -
Royal Bancshares' sources of capital have been derived from the
issuance of stock as well as retained earnings. While Royal Bancshares has not
had a stock offering since 1986, total shareholders' equity has increased
primarily due to steady increases in retained earnings. At December 31, 2005,
Royal Bancshares had an average equity to average asset ratio of 11.6%. Royal
Bancshares has no current plans to raise capital through new stock offerings and
indeed, seeks ways to leverage its existing capital.
The capital ratios set forth above compare favorably to the minimum
required amounts of Tier 1 and total capital to risk-weighted assets and the
minimum Tier 1 leverage ratio, as defined by the banking regulators. At December
31, 2005, Royal Bancshares was required to have minimum Tier 1 and total capital
ratios of 4.0% and 8.0%, respectively, and a minimum Tier 1 leverage ratio of
4.0%. In order for Royal Bancshares to be considered well capitalized, as
defined by the banking regulators, Royal Bancshares must have Tier 1 and total
capital ratios of 6.0% and 10.0%, respectively, and a minimum Tier 1 leverage
ratio of 5.0%. At December 31, 2005, Royal Bancshares met the criteria for a
well capitalized institution, and management believes that, under current
regulations, Royal Bancshares will continue to meet its minimum capital
requirements in the foreseeable future.
MANAGEMENT OPTIONS TO PURCHASE SECURITIES
In May 2001, the directors of the Royal Bancshares approved the amended
Royal Bancshares of Pennsylvania Non-qualified Stock Option and Appreciation
Right Plan (the Plan). The shareholders in connection with the formation of the
holding company reapproved the Plan. The Plan is an incentive program under
which Bank officers and other key employees may be awarded additional
compensation in the form of options to purchase up to 1,500,000 shares of the
Royal Bancshares' Class A common stock (but not in excess of 15% of outstanding
shares). In May 2005, the shareholders approved to increase the options to
purchase to 1,650,000. At the time a stock option is granted, a stock
appreciation right for an identical number of shares may also be granted. The
option price is equal to the fair market value at the date of the grant. At
December 31, 2005, 737,170 options have been granted which are exercisable at
20% per year. At December 31, 2005, options covering 292,317 shares were
exercisable by 95 employees.
In May 2001, the directors of the Royal Bancshares approved an amended
non-qualified Outside Directors Stock Option Plan. The shareholders in
connection with the formation of the holding company reapproved this Plan. Under
the terms of the plan, 250,000 shares of Class A stock are authorized for
grants. Each director is entitled to a grant of an option to purchase 1,500
shares of stock annually, which is exercisable one year from the grant date. The
options were granted at the fair market value at the date of the grant. At
December 31, 2005, 91,068 options were outstanding and options covering 74,238
shares were exercisable.
29
AVERAGE BALANCES
The following table represents the average daily balances of assets,
liabilities and shareholders' equity and the respective interest paid on
interest bearing assets and interest bearing liabilities, as well as average
rates for the periods indicated:
2005 2004 2003
------------------------------ ------------------------------- --------------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
ASSETS (In thousands) BALANCE INTEREST RATE BALANCE INTEREST RATE BALANCE INTEREST RATE
- --------------------- ------- -------- ------ -------- -------- ------ ------- -------- ------
Interest bearing deposits $ 1,789 $ 56 3.13% $ 34,702 $ 409 1.18% $ 40,856 $ 475 1.16%
Federal funds 2,079 58 2.79% 8,644 102 1.18% 13,598 142 1.04%
Investment securities
Held to maturity 237,701 10,122 4.26% 141,799 6,365 4.49% 46,302 3,087 6.67%
Available for sale 355,005 19,229 5.42% 399,361 20,621 5.16% 446,210 22,007 4.93%
------------------------------ ------------------------------- --------------------------------
Total investment securities 592,706 29,351 4.95% 541,160 26,986 4.99% 492,512 25,094 5.10%
Loans
Commercial demand loans 259,216 20,605 7.95% 199,645 14,241 7.13% 225,224 15,812 7.02%
Real estate secured 247,762 26,181 10.57% 267,757 25,504 9.53% 333,168 30,532 9.16%
Other loans 3,371 209 6.20% 4,124 299 7.25% 4,373 265 6.06%
------------------------------ ------------------------------- --------------------------------
Total loans 510,349 46,995 9.21% 471,526 40,044 8.49% 562,765 46,609 8.28%
------------------------------ ------------------------------- --------------------------------
Total interest earnings assets 1,106,923 76,460 6.91% 1,056,032 67,541 6.40% 1,109,731 72,320 6.52%
Non interest earnings assets
Cash & due from banks 12,470 9,720 8,348
Other assets 151,738 142,455 56,780
Allowance for loan loss (11,165) (12,503) (12,472)
Unearned discount (1,829) (1,696) (2,033)
---------- ---------- ----------
Total non-interest earning assets 151,214 137,976 50,623
---------- ---------- ----------
Total assets $1,258,137 $1,194,008 $1,160,354
========== ========== ==========
LIABILITIES & SHAREHOLDERS' EQUITY
- ----------------------------------
Deposits:
Savings $ 21,814 $ 127 0.58% $ 24,278 $ 152 0.63% $ 23,714 $ 182 0.77%
Now 33,732 307 0.91% 34,181 244 0.71% 32,510 339 1.04%
Money market 321,655 7,150 2.22% 426,895 7,721 1.81% 442,873 9,661 2.18%
Time deposits 254,031 9,965 3.92% 218,756 8,577 3.92% 269,293 12,011 4.46%
------------------------------ ------------------------------- --------------------------------
Total interest bearing deposits 631,232 17,549 2.78% 704,110 16,694 2.37% 768,390 22,193 2.89%
Federal funds -- -- -- -- -- -- -- -- --
Borrowings 312,952 12,225 3.91% 221,741 8,744 3.94% 183,339 7,748 4.23%
Obligation through VIE equity
investments 11,936 557 4.67% 55,558 1,639 2.95% -- -- --
Subordinate debt 25,000 1,465 5.86% 4,448 224 5.06% -- -- --
------------------------------ ------------------------------- --------------------------------
Total interest bearing liabilities 981,120 31,796 3.24% 985,857 27,301 2.77% 951,729 29,941 3.15%
------------------------------ ------------------------------- --------------------------------
Non interest bearing deposits 68,308 57,789 56,814
Other liabilities 63,108 12,740 24,083
---------- ---------- ----------
Total liabilities 1,112,536 1,056,386 1,032,626
Shareholders' equity 145,601 137,622 127,728
---------- ---------- ----------
Total liabilities and
Shareholders' equity $1,258,137 $1,194,008 $1,160,354
========== ========== ==========
Net interest income $44,664 $40,240 $42,379
======= ======= =======
Net interest margin 4.03% 3.81% 3.82%
===== ===== =====
(1) Nonaccruing loans have been included in the appropriate average loan balance
category, but interest on these loans has not been included.
(The remainder of the page is intentionally left blank)
30
The following table sets forth a rate/volume analysis, which segregates
in detail the major factors contributing to the change in net interest income
for the years ended December 31, 2005 and 2004, as compared to respective
previous periods, into amounts attributable to both rate and volume variances.
2005 VS 2004 2004 VS 2003
CHANGES DUE TO: CHANGES DUE TO:
---------------------------- ---------------------------
INTEREST INCOME VOLUME RATE TOTAL VOLUME RATE TOTAL
- --------------- ------ ------ ----- ------ ------ -----
(IN THOUSANDS)
Interest bearing deposits in banks ($622) $269 ($353) ($73) $7 ($66)
Federal funds sold (115) 71 (44) (57) 17 (40)
Investments securities
Held to maturity 4,101 (344) 3,757 4,573 (1,295) 2,278
Available for sale (2,368) 976 (1,392) (2,384) 998 (1,386)
---------------------------- -----------------------------
Total investment securities 1,733 632 2,365 2,189 (297) 1,892
Loans
Commercial demand loans 4,600 1,764 6,364 (1,820) (249) (1,571)
Mortgages secured by real estate (1,990) 2,667 677 (6,192) 1,164 (5,028)
Other loans (50) (40) (90) (16) 50 34
---------------------------- -----------------------------
Total loans 2,560 4,391 6,951 (8,028) 1,463 (6,565)
---------------------------- -----------------------------
Total increase (decrease) in interest income 3,556 5,363 8,919 (5,969) 1,190 (4,779)
INTEREST EXPENSE
- ----------------
Deposits
Savings ($17) ($8) ($25) ($4) ($34) ($30)
Now and Money Market (1,400) 892 (508) (959) (1,076) (2,035)
Time deposits 1,387 1 1,388 (2,106) (1,328) (3,434)
---------------------------- -----------------------------
Total deposits (30) 885 855 (3,061) (2,438) (5,499)
Borrowings 1,999 1,084 3,083 3,200 (341) 2,859
---------------------------- -----------------------------
Total increase(decrease) in interest expense 1,969 1,969 3,938 139 (2,779) (2,640)
Total increase(decrease) in net interest income $1,587 $3,394 $4,981 ($6,108) $3,969 ($2,139)
============================ =============================
LOANS
The following table reflects the composition of the loan portfolio of
Royal Bank and the percent of gross outstanding represented by each category at
the dates indicated.
AS OF DECEMBER 31,
(IN THOUSANDS)
--------------------------------------------------------------------------------------
2005 2004 2003 2002 2001
---------------- --------------- ----------------- --------------- ---------------
LOANS
Comm'l and Industrial $ 30,075 5% $ 37,468 8% $ 18,343 4% $ 6,963 1% $ 8,544 1%
Const & land development 177,102 32% 109,129 23% 107,463 21% 82,736 14% 64,551 10%
Single family residential 42,703 8% 48,020 10% 60,366 12% 119,667 21% 151,020 23%
Other real estate secured 296,051 53% 273,306 58% 326,718 63% 354,875 61% 411,219 64%
Leases -net of unearned 2,623 1% -- -- -- -- -- -- -- --
income
Other 3,868 1% 3,322 1% 4,512 1% 14,613 3% 14,101 2%
--------------------------------------------------------------------------------------
Total gross loans 552,422 100% 471,245 100% 517,202 100% 578,854 100% 649,435 100%
Unearned income (1,983) (1,540) (1,203) (1,082) (1,056)
Discount on loans purchased -- -- (290) (1,038) (2,144)
-------- ------- --------- -------- --------
550,439 469,498 515,714 576,734 646,235
Allowance for loan loss (10,276) (12,519) (12,426) (12,470) (11,888)
-------- ------- --------- -------- --------
Total net loans $540,163 $456,979 $ 503,288 $564,264 $634,347
======== ======== ========= ======== ========
31
ANALYSIS OF ALLOWANCE FOR LOAN LOSS
YEAR ENDING DECEMBER 31,
(IN THOUSANDS)
---------------------------------------------------------
2005 2004 2003 2002 2001
--------- --------- --------- --------- ---------
Total Loans $ 550,439 $ 469,498 $ 515,714 $ 576,734 $ 646,235
========= ========= ========= ========= =========
Daily average loan balance $ 510,349 $ 471,526 $ 562,765 $ 617,156 $ 543,854
========= ========= ========= ========= =========
Allowance for loan loss:
Balance at the beginning of the year $ 12,519 $ 12,426 $ 12,470 $ 11,888 $ 11,973
Charge offs by loan type:
Single family residential 142 197 444 775 402
Other real estate secured 2,162 1 -- 103 33
Tax certificates 1 6 74 -- --
Commercial and industrial 28 -- 22 47 54
Other loans 2 -- 271 -- 28
--------- --------- --------- --------- ---------
Total charge offs 2,335 204 811 925 517
Recoveries by loan type:
Single family residential 68 249 49 100 149
Other real estate secured 7 1 3 167 23
Tax certificates -- -- -- -- --
Commercial and industrial 12 37 26 19 162
Other loans 4 4 15 971 98
--------- --------- --------- --------- ---------
Total recoveries 91 291 93 1,257 432
--------- --------- --------- --------- ---------
(Loan charge off's) recoveries (2,244) 87 (718) 332 (85)
Provision for loan loss 1 6 674 250 --
--------- --------- --------- --------- ---------
Balance at end of year $ 10,276 $ 12,519 $ 12,426 $ 12,470 $ 11,888
========= ========= ========= ========= =========
Net charge offs to average loans (0.44%) 0.02% (0.13%) 0.05% (0.02%)
========= ========= ========= ========= =========
Allowance to total loans at year-end 1.87% 2.67% 2.41% 2.16% 1.84%
========= ========= ========= ========= =========
Royal Bancshares considers that the determination of the allowance for
loan losses involves a higher degree of judgment and complexity than its other
significant accounting policies. Management determines the allowance for loan
losses with the objective of maintaining a reserve level sufficient to absorb
estimated probable credit losses inherent within the loan portfolio. Management
has determined the Company's balance in the allowance for loan losses based on
management's detailed analysis and review of the loan portfolio. Management
considers all known relevant internal and external factors that may affect loan
collectibility. The periodic analysis and review includes an evaluation of the
loan portfolio in relation to past loss experience, the size and composition of
the portfolio, current economic events and conditions, and other pertinent
factors, including Management's assumptions as to future economic conditions,
recoveries and losses. Management's evaluation is inherently subjective and all
of these factors may be susceptible to significant change. To the extent actual
outcomes differ from management's the Company may be required to make additional
provisions for loan losses that could adversely impact earnings in future
periods.
Royal Bancshares uses the reserve method of accounting for loans
losses. The balance in the allowance for loan and lease losses is determined
based on management's review and evaluation of the loan portfolio in relation to
past loss experience, the size and composition of the portfolio, current
economics events and conditions, and other pertinent factors, including
management's assumptions related to future delinquencies, recoveries and losses.
Increases to the allowance for loans and leases losses are made by charges to
the provision for loan losses. Credit exposures deemed to be uncollectible are
charged against the allowance for loans losses. Recoveries of amounts previously
charged-off are credited to the allowance for loan losses.
While Royal Bank believes that it has established an adequate allowance
for loan losses, there can be no assurance that the regulators, in reviewing
Royal Bank's loan portfolio, will not request Royal Bancshares to materially
increase its allowances for loan losses. Although management believes that
adequate specific and general loan loss allowances have been established, actual
losses are dependant upon future events and, as such, further additions to the
level of specific and general loss allowances could become necessary.
32
LOANS AND LEASE FINANCING RECEIVABLES
The following table summarizes the loan portfolio by loan category and
amount that corresponds to the appropriate regulatory definitions.
AS OF DECEMBER 31,
(IN THOUSANDS)
2005 2004 2003
--------- --------- ---------
Loans secured by real estate
Construction and land development $ 177,102 $ 109,129 $ 107,463
Secured by 1-4 family residential properties:
Revolving, open-end loans secured by 1-4 family residential
properties and extended under lines of credit 10,070 7,369 5,854
All other loans secured by 1-4 family residential properties:
Secured by first liens 28,327 36,136 50,716
Secured by junior liens 4,306 4,515 3,796
Secured by multi family (5 or more) residential properties 24,804 15,256 21,728
Secured by nonfarm nonresidential properties 271,247 257,843 304,794
Commercial and industrial loans to US addresses 30,075 37,468 18,343
Loans to individuals for household, family, and other personal
expenditures 1,061 1,346 1,182
Obligations of state and political subdivisions in the US 1,268 1,769 3,134
Lease financing receivables (net of unearned income) 2,623 -- --
All other loans 1,539 207 196
Less: Any unearned income on loans listed above 1,983 1,540 1,492
-------- -------- --------
Total loans and leases, net of unearned income $ 550,439 $ 469,498 $ 515,714
======== ======== ========
CREDIT QUALITY
The following table presents the principal amounts of nonaccruing loans
and other real estate.
AS OF DECEMBER 31,
(IN THOUSANDS)
---------------------------------------------------------------
2005 2004 2003 2002 2001
---------- ----------- ---------- ---------- ----------
Non-accruing loans (1)(2) $ 4,371 $ 4,526 $ 11,328 $ 11,908 $ 10,794
Other real estate 3,834 5,424 4,371 1,444 884
---------- ----------- ---------- ---------- ----------
Total nonperforming assets $ 8,205 $ 9,950 $ 15,699 $ 13,352 $ 11,678
========== =========== ========== ========== ==========
Nonperforming assets to total assets 0.63% 0.83% 1.36% 1.23% 1.25%
========== =========== ========== ========== ==========
Nonperforming loans to total loans 0.79% 0.96% 2.20% 2.06% 1.67%
========== =========== ========== ========== ==========
Allowance for loan loss to nonperforming loans 235.09% 276.54% 109.69% 104.72% 110.14%
========== =========== ========== ========== ==========
(1) Generally, a loan is placed on nonaccruing status when it has been
delinquent for a period of 90 days or more unless the loan is both well
secured and in the process of collection.
(2) If interest had been accrued on these nonaccruing loans, such income would
have approximated $506,000 for 2005, $209,000 for 2004, $401,000 for 2003,
$473,000 for 2002 and $526,000 for 2001.
33
INVESTMENT SECURITIES
The contractual maturity distribution and weighted average rate of
Royal Bancshares' investments held to maturity and available for sale portfolios
at December 31, 2005 are presented in the following table. Weighted average
rates on tax-exempt obligations have been computed on a fully taxable equivalent
basis assuming a tax rate of 35%.
AS OF DECEMBER 31, 2005
(IN THOUSANDS)
-------------------------------------------------------------------------------------------------
AFTER 1 YEAR BUT AFTER 5 YEARS, BUT
WITHIN 1 YEAR WITHIN 5 YEARS WITHIN 10 YEARS AFTER 10 YEARS TOTAL
--------------- ----------------- ------------------- ------------------- ----------------
AMOUNT RATE AMOUNT RATE AMOUNT RATE AMOUNT RATE AMOUNT RATE
------ ---- ------ ---- ------ ---- ------ ---- ------ ----
SECURITIES HELD TO MATURITY
- ---------------------------
Mortgage backed
securities $ 6 7.5% $ 16 10.5% $ -- --% $ 145 4.4% $ 167 5.1%
Agencies -- --% 145,000 3.7% 50,000 4.0% -- --% 195,000 3.8%
Other securities -- --% 60,300 6.6% -- --% -- --% 60,300 6.6%
------- ---- -------- ----- ------- ---- -------- ---- -------- ----
Total $ 6 7.5% $205,316 4.6% $50,000 4.0% $ 145 4.4% $255,467 4.4%
======= ==== ======== ===== ======= ==== ======== ==== ======== ====
AVAILABLE FOR SALE
- ------------------
Mortgage backed
securities $ -- --% $ 10 7.5% $ 42 6.1% $ 32,436 4.8% $ 32,488 4.8%
CMO'S -- --% -- --% -- --% 23,481 5.0% 23,481 5.0%
Agencies -- --% 38,325 3.7% 29,068 4.3% 34,305 4.9% 101,698 4.3%
Foreign 3,015 7.2% -- --% -- --% -- --% 3,015 7.2%
Trust Preferred -- --% -- --% -- --% 39,733 9.8% 39,733 9.8%
Other securities 24,255 4.8% 95,236 6.2% 3,729 6.4% 2,554 4.2% 125,774 5.9%
------- ---- -------- ----- ------- ---- -------- ---- -------- ----
Total $27,270 5.1% $133,571 5.5% $32,839 4.5% $132,509 6.3% $326,189 5.7%
======= ==== ======== ===== ======= ==== ======== ==== ======== ====
The following table represents the consolidated book values and
approximate fair value at December 31, 2005, 2004 and 2003, respectively, for
each major category of Royal Bancshares' investment securities portfolio for
held to maturity securities and available for sale securities.
(The remainder of this page is intentionally left blank)
34
AS OF DECEMBER 31,
(IN THOUSANDS)
2005 2004 2003
----------------------- ------------------------ -----------------------
AMORTIZED FAIR AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE COST VALUE
SECURITIES HELD TO MATURITY
- ---------------------------
Mortgage backed securities $ 167 $ 167 $ 232 $ 232 $ 340 $ 340
US agencies 195,000 190,829 185,000 184,267 91,630 91,333
Other securities 60,300 62,202 26,995 27,366 21,121 22,602
---------- ---------- ----------- ---------- ---------- ----------
Total $ 255,467 $ 253,198 $ 212,227 $ 211,865 $ 113,091 $ 114,275
========== ========== =========== =========== ========== ==========
SECURITIES AVAILABLE FOR SALE
- -----------------------------
Mortgage backed securities $ 56,628 $ 55,892 $ 81,303 $ 81,669 $ 110,596 $ 111,875
US agencies 104,979 101,698 94,997 93,305 122,785 121,112
Trust preferred securities 36,174 39,733 37,196 39,562 36,251 37,139
Other securities 129,854 128,866 141,679 146,398 161,488 170,713
---------- ---------- ----------- ---------- ---------- ----------
Total $ 327,635 $ 326,189 $ 355,175 $ 360,934 $ 431,120 $ 440,839
========== ========== =========== =========== ========== ==========
DEPOSITS
The average balance of Royal Bank's deposits by major classifications
for each of the last three years is presented in the following table.
AS OF DECEMBER 31,
(IN THOUSANDS)
2005 2004 2003
----------------------- ------------------------ -----------------------
AVERAGE AVERAGE AVERAGE
BALANCE RATE BALANCE RATE BALANCE RATE
---------- ---------- ----------- ---------- ---------- ----------
Demand deposits:
Non interest bearing $ 68,308 --% $ 57,789 --% $ 56,814 --%
Interest bearing (NOW) 33,732 0.91% 34,181 0.71% 32,510 1.04%
Money market deposits 321,655 2.22% 426,895 1.81% 442,873 2.18%
Savings deposits 21,814 0.58% 24,278 0.63% 23,714 0.77%
Certificate of deposit 254,031 3.92% 218,756 3.92% 269,293 4.46%
---------- ----------- ----------
Total deposits $ 699,540 $ 761,899 $ 825,204
========== =========== ==========
35
The remaining maturity of Certificates of Deposit of $100,000 or
greater:
AS OF DECEMBER 31,
(IN THOUSANDS)
MATURITY 2005 2004
- -------- ---------- ----------
Three months or less $ 8,523 $ 13,309
Over three months through twelve months 41,534 27,426
Over twelve months through five years 152,566 48,590
Over five years 988 1,271
---------- ----------
Total $ 203,611 $ 90,596
========== ==========
SHORT AND LONG TERM BORROWINGS
YEAR ENDING DECEMBER 31,
(IN THOUSANDS)
---------------------------------------------------------------
2005 2004 2003 2002 2001
---------- ----------- ---------- ---------- ----------
Short term borrowings $ 104,500 $ 17,500 $ -- $ 3,000 $ 30,000
Long term borrowings:
Other borrowings -- -- -- -- 2,725
Obligations through VIE equity investments (1) 47,356 56,249 -- --
Subordinated debt 25,774 25,774 -- -- --
FHLB advances 249,500 204,500 212,000 124,500 67,500
---------- ----------- ---------- ---------- ----------
Total borrowings $ 427,130 $ 304,023 $ 212,000 $ 127,500 $ 100,225
========== =========== ========== ========== ==========
(1) This obligation is consolidated from requirements under FIN (46)R of which
$0 is guaranteed by the Company.
(The remainder of the page was intentionally left blank)
36
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
A simulation model is used to estimate the impact of various changes, both
upward and downward, in market interest rates and volumes of assets and
liabilities on the net income. This model produces an interest rate exposure
report that forecast changes in the market value of portfolio equity under
alternative interest rate environment. The market value of portfolio is defined
as the present value of existing assets and liabilities. The calculated
estimates of changes in the market value of portfolio value are as follows:
As of December 31, 2005 (Dollars in Thousands)
Market Value of Percent of
Changes in Rates Portfolio Equity Change
---------------- ---------------- ----------
+ 200 basis points 162,005 -6.3%
+ 100 basis points 168,719 -2.4%
Flat rate 172,904 0%
- 100 basis points 168,155 -2.7%
- 200 basis points 156,574 -9.4%
The assumptions used in evaluating the vulnerability of earnings and
capital to changes in interest rates are based on management's considerations of
past experience, current position and anticipated future economic conditions.
The interest rate sensitivity of assets and liabilities as well as the estimated
effect of changes in interest rates on the market value of portfolio equity
could vary substantially if different assumptions are used or actual experience
differs from what the calculations may be based.
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the FASB's Emerging Issues Task Force (EITF) issued
EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investors" ("EITF 03-1"), and in March 2004, the EITF
issued an update. EITF 03-1 addresses the meaning of other-than-temporary
impairment and its application to certain debt and equity securities. EITF 03-1
aids in the determination of impairment of an investment and gives guidance as
to the measurement of impairment loss and the recognition and disclosures of
other-than-temporary investments. EITF 03-1 also provides a model to determine
other-than-temporary impairment using evidence-based judgment about the recovery
of the fair value up to the cost of the investment by considering the severity
and duration of the impairment in relation to the forecasted recovery of the
fair value. In July 2005, FASB adopted the recommendation of its staff to
nullify key parts of EITF 03-1. The staff's recommendations were to nullify the
guidance on the determination of whether an investment is impaired as set forth
in paragraphs 10-18 of Issue 03-1 and not to provide additional guidance on the
meaning of other-than-temporary impairment. Instead, the staff recommends
entities recognize other-than-temporary impairments by applying existing
accounting literature such as paragraph 16 of SFAS 115. Royal Bancshares
believes the FSP on FAS 115-1 and FAS 124-1 will not have a material impact on
the company's financial condition, results of operations or cash flows.
In June 2005, the EITF reached a consensus on Issue No. 05-6,
"Determining the Amortization Period for Leasehold Improvements Purchased after
Lease Inception or Acquired in a Business Combination" ("EITF 05-6"). This
guidance requires that leasehold improvements acquired in a business combination
or purchased subsequent to the inception of a lease be amortized over the
shorter of the useful life of the assets or a term that includes required lease
periods and renewals that are reasonably assured at the date of the business
combination or purchase. This guidance is applicable only to leasehold
improvements that are purchased or acquired in reporting periods beginning after
June 29, 2005. Royal Bancshares is evaluating the impact, if any, of EITF 05-6
on its consolidated financial statements.
In October 2005, the FASB issued FASB Staff Position FAS13-1 ("FSP
13-1"), which requires companies to expense rental costs associated with ground
or building operating leases that are incurred during a construction period. As
a result, companies that are currently capitalizing these rental costs are
required to expense them beginning in its first reporting period beginning after
December 15, 2005. FSP FAS 13-1 is effective for our Company as of the first
quarter of fiscal 2006. Management has evaluated the provisions of FSP FAS 13-1
and do not believe that its adoption will have a material impact of Royal
Bancshares' financial condition or results of operations.
37
In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement No. 123(R), "Share-Based Payment." Statement No. 123(R) replaces
Statement No. 123, "Accounting for Stock-Based Compensation," and supersedes APB
Opinion No. 25, "Accounting for Stock Issued to Employees." Statement No. 123(R)
requires compensation costs related to share-based payment transactions to be
recognized in the financial statements over the period that an employee provides
service in exchange for the award. Public companies are required to adopt the
new standard using a modified prospective method and may elect to restate prior
periods using the modified retrospective method. Under the modified prospective
method, companies are required to record compensation cost for new and modified
awards over the related vesting period of such awards prospectively and record
compensation cost prospectively for the unvested portion, at the date of
adoption, of previously issued and outstanding awards over the remaining vesting
period of such awards. No change to prior periods presented is permitted under
the modified prospective method. Under the modified retrospective method,
companies record compensation costs for prior periods retroactively through
restatement of such periods using the exact pro forma amounts disclosed in the
companies' footnotes. Also, in the period of adoption and after, companies
record compensation cost based on the modified prospective method. Royal
Bancshares estimates its compensation expense will increase $762,000 during
2006.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107 ("SAB
No. 107"), "Share-Based Payment," providing guidance on option valuation
methods, the accounting for income tax effects of share-based payment
arrangements upon adoption of SFAS No. 123(R), and the disclosures in MD&A
subsequent to the adoption. Royal Bancshares will provide SAB No. 107 required
disclosures upon adoption of SFAS No. 123(R) on January 1, 2006.
On April 14, 2005, the Securities and Exchange Commission ("SEC")
adopted a new rule that amends the compliance dates for FASB's Statement of
Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment"
("SFAS No. 123R"). Under the new rule, the Company is required to adopt SFAS No.
123R in the first annual period beginning after June 15, 2005. The Company has
not yet determined the method of adoption or the effect of adopting SFAS No.
123R, and it has not determined whether the adoption will result in amounts that
are similar to the current pro forma disclosures under SFAS No. 123.
In March 2005, the FASB issued Interpretation No. 47, "Accounting for
Conditional Asset Retirement Obligations--an interpretation of SFAS No. 143,"
("FIN 47"). This Interpretation provides clarification with respect to the
timing of liability recognition for legal obligations associated with the
retirement of tangible long-lived assets when the timing and/or method of
settlement of the obligation are conditional on a future event. FIN 47 is
effective for all fiscal years ending after December 15, 2005 (December 31,
2005, for calendar-year companies). Retrospective application for interim
financial information is permitted but is not required. Early adoption of this
Interpretation is encouraged. We do not expect the adoption of FIN 47 to
materially impact our consolidated financial statements.
In May 2005, FASB issued SFAS 154, "Accounting Changes and Error
Corrections." The Statement requires retroactive application of a voluntary
change in accounting principle to prior period financial statements unless it is
impracticable. SFAS 154 also requires that a change in method of depreciation,
amortization, or depletion for long-lived, non-financial assets be accounted for
as a change in accounting estimate that is affected by a change in accounting
principle. SFAS 154 replaces APB Opinion 20, "Accounting Changes," and SFAS 3,
"Reporting Accounting Changes in Interim Financial Statements." SFAS 154 will be
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. Management currently believes that adoption
of the provisions of SFAS 154 will not have a material impact on Royal
Bancshares' consolidated financial statements.
38
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL STATEMENTS AND REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
DECEMBER 31, 2005 AND 2004
39
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Royal Bancshares of Pennsylvania, Inc.
Narberth, Pennsylvania
We have audited the accompanying consolidated balance sheets of Royal
Bancshares of Pennsylvania, Inc. and subsidiaries as of December 31, 2005 and
2004, and the related consolidated statements of income, changes in
stockholders' equity and cash flows for each of the years in the two-year period
ended December 31, 2005. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits. The consolidated
statements of income, changes in stockholders' equity and cash flows of Royal
Bancshares of Pennsylvania, Inc. for the year ended December 31, 2003 were
audited by other auditors, whose report dated January 22, 2004, expressed an
unqualified opinion on those statements.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
As discussed on Note A to the consolidated financial statements, Royal
Bancshares of Pennsylvania, Inc. adopted the provisions of Financial Accounting
Standards Board Interpretation No. 46, "Consolidation of Variable Interest
Entities," on March 31, 2004.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Royal Bancshares of Pennsylvania, Inc. and its subsidiaries as of December 31,
2005 and 2004, and the consolidated results of their operations and their
consolidated cash flows for each of the years in the two-year period ended
December 31, 2005 in conformity with accounting principles generally accepted in
the United States of America.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness of Royal
Bancshares of Pennsylvania, Inc. internal control over financial reporting as of
December 31, 2005, based on the criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO), and our report dated March 14, 2006 expressed an
unqualified opinion on management's assessment of internal control over
financial reporting and an unqualified opinion on the effectiveness of internal
control over financial reporting.
/s/ Beard Miller Company LLP
Beard Miller Company LLP
Reading, Pennsylvania
March 14, 2006
40
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31,
------------------------------------
ASSETS 2005 2004
--------------- ---------------
(In thousands, except share data)
Cash and due from banks $ 17,095 $ 26,109
Federal funds sold 13,800 1,000
-------------- --------------
Total cash and cash equivalents 30,895 27,109
Investment securities held to maturity (fair value of $253,198 and
$211,865 in 2005 and 2004, respectively) 255,467 212,227
Investment securities available for sale - at fair value 326,189 360,934
Federal Home Loan Bank stock, at cost 17,073 11,100
Loans held for sale 803 2,204
Loans 549,636 467,294
Less allowance for loan losses 10,276 12,519
-------------- --------------
Net loans 539,360 454,775
Premises and equipment, net 8,373 8,780
Real estate owned via equity investments 58,209 63,653
Accrued interest receivable 14,843 15,634
Bank owned life insurance 22,059 21,214
Other assets 27,748 27,644
-------------- --------------
Total assets $ 1,301,019 $ 1,205,274
============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Deposits
Non-interest bearing $ 75,754 $ 64,371
Interest bearing 621,655 678,011
-------------- --------------
Total deposits 697,409 742,382
Accrued interest payable 6,606 5,602
Other liabilities 11,879 8,736
Borrowings 354,000 222,000
Obligations related to equity investments in real estate 47,356 56,249
Subordinated debentures 25,774 25,774
-------------- --------------
Total liabilities 1,143,024 1,060,743
Minority interests 2,487 3,655
Stockholders' equity
Common stock
Class A, par value $2.00 per share; authorized, 18,000,000 shares;
issued, 10,699,592 and 10,276,672 shares in 2005 and 2004, respectively 21,400 20,553
Class B, par value $0.10 per share; authorized, 2,000,000 shares;
issued, 1,992,957 and 1,939,490 shares in 2005 and 2004, respectively 199 194
Undistributed Class B shares 2 --
Additional paid in capital 104,285 92,037
Retained earnings 32,827 26,558
Accumulated other comprehensive (loss) income (940) 3,799
-------------- --------------
157,773 143,141
Treasury stock - at cost, 215,388 Class A shares in 2005 and 2004 (2,265) (2,265)
-------------- --------------
Total stockholders' equity 155,508 140,876
-------------- --------------
Total liabilities and stockholders' equity $ 1,301,019 $ 1,205,274
============== ==============
The accompanying notes are an integral part of these statements.
41
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Years ended December 31,
------------------------------------------------------
2005 2004 2003
-------------- -------------- --------------
(In thousands, except per share data)
Interest income
Loans, including fees $ 46,995 $ 40,044 $ 46,609
Investment securities held to maturity 10,122 6,365 3,087
Investment securities available for sale 19,229 20,621 22,007
Deposits in banks 56 409 475
Federal funds sold 58 102 142
-------------- -------------- --------------
TOTAL INTEREST INCOME 76,460 67,541 72,320
-------------- -------------- --------------
Interest expense
Deposits 17,549 16,918 22,193
Borrowings 13,690 8,744 7,748
Obligations related to equity investments in real estate 557 1,639 -
-------------- -------------- --------------
TOTAL INTEREST EXPENSE 31,796 27,301 29,941
-------------- -------------- --------------
NET INTEREST INCOME 44,664 40,240 42,379
Provision for loan losses 1 6 674
-------------- -------------- --------------
NET INTEREST INCOME AFTER PROVISION FOR
LOAN LOSSES 44,663 40,234 41,705
-------------- -------------- --------------
Other income
Service charges and fees 1,293 1,496 1,125
Gains on sale of investment securities available for sale 227 810 719
Income related to equity investments in real estate 19,418 7,133 --
Income from bank owned life insurance 845 966 248
Gains on sale of other real estate 2,494 2,102 568
Gains on sale of loans 508 480 637
Other income 41 173 407
-------------- -------------- --------------
24,826 13,160 3,704
-------------- -------------- --------------
Other expenses
Salaries and employee benefits 13,488 10,767 9,958
Occupancy and equipment 1,611 1,509 1,330
Expenses related to equity investments 262 4,780 -
Other operating expenses 9,438 8,391 7,599
-------------- -------------- --------------
24,799 25,447 18,887
-------------- -------------- --------------
INCOME BEFORE INCOME TAXES 44,690 27,947 26,522
Income taxes 12,637 7,914 7,996
-------------- -------------- --------------
NET INCOME $ 32,053 $ 20,033 $ 18,526
============== ============== ==============
Per share data
Net income - basic $ 2.50 $ 1.57 $ 1.47
============== ============== ==============
Net income - diluted $ 2.49 $ 1.56 $ 1.46
============== ============== ==============
The accompanying notes are an integral part of these statements.
42
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
Years ended December 31, 2005, 2004 and 2003
(In thousands, except per share data)
Class A common stock Class B common stock Additional
-------------------------- -------------------------- paid in Retained
Shares Amount Shares Amount capital earnings
------------ ------------ ------------ ------------ ----------- -----------
Balance, December 31, 2002 9,595 $ 19,190 1,861 $ 186 $ 76,984 $ 24,819
Net income for the year ended
December 31, 2003 - - - - - 18,526
Conversion of Class B common stock
to Class A common stock 8 16 (7) (1) - (15)
3% stock dividends declared 281 562 55 6 6,443 (7,011)
Cash in lieu of fractional shares - - - - - (8)
Stock options exercised 143 286 - - 2,021 -
Cash dividends on common stock
(Class A $0.96, Class B $1.11) - - - - - (11,321)
Other comprehensive income, net of
reclassifications and taxes - - - - - -
------------ ------------ ------------ ------------ ----------- -----------
Comprehensive income
Balance, December 31, 2003 10,027 20,054 1,909 191 85,448 24,990
Net income for the year ended
December 31, 2004 - - - - - 20,033
Conversion of Class B common stock
to Class A common stock 10 20 (1) (1) - (19)
2% stock dividends declared 196 392 31 3 5,842 (6,236)
Cash in lieu of fractional shares - - - - - (11)
Stock options exercised 44 87 - - 747 -
Cash dividends on common stock
(Class A $1.00, Class B $1.15) - - - - - (12,199)
Other comprehensive loss, net of
reclassifications and taxes - - - - - -
------------ ------------ ------------ ------------ ----------- -----------
Comprehensive income
Balance, December 31, 2004 10,277 20,553 1,939 194 92,037 26,558
Accumulated
other
comprehensive Treasury Comprehensive
income (loss) stock income
--------------- -------------- --------------
Balance, December 31, 2002 $ 2,415 $ (2,265)
Net income for the year ended
December 31, 2003 - - $ 18,526
Conversion of Class B common stock
to Class A common stock - - -
3% stock dividends declared - - -
Cash in lieu of fractional shares - - -
Stock options exercised - - -
Cash dividends on common stock
(Class A $0.96, Class B $1.11) - - -
Other comprehensive income, net of
reclassifications and taxes 4,000 - 4,000
--------------- -------------- --------------
Comprehensive income $ 22,526
==============
Balance, December 31, 2003 6,415 (2,265)
Net income for the year ended $
December 31, 2004 - - 20,033
Conversion of Class B common stock
to Class A common stock - - -
2% stock dividends declared - - -
Cash in lieu of fractional shares - - -
Stock options exercised - - -
Cash dividends on common stock
(Class A $1.00, Class B $1.15) - - -
Other comprehensive loss, net of
reclassifications and taxes (2,616) - (2,616)
--------------- -------------- --------------
Comprehensive income $ 17,417
==============
Balance, December 31, 2004 3,799 (2,265)
(Continued)
43
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity - Continued
Years ended December 31, 2005, 2004 and 2003
(In thousands, except per share data)
Class A common stock Class B common stock Un- Additional
-------------------------- -------------------------- Distributed paid in Retained
Shares Amount Shares Amount B-shares capital earnings
------------ ------------ ------------ ------------ ----------- ---------- --------
Balance, December 31, 2004 10,277 $ 20,553 1,939 $ 194 $ - $ 92,037 $ 26,558
Net income for the year ended
December 31, 2005 - - - - - - 32,053
Conversion of Class B common stock
to Class A common stock 6 11 (4) (1) - - (11)
2% stock dividends declared (January) 201 402 39 3 - 6,481 (6,887)
2% stock dividends declared (December) 206 412 19 3 2 5,599 (6,015)
Cash in lieu of fractional shares - - - - - - (12)
Stock options exercised 10 22 - - - 168 -
Cash dividends on common stock
(Class A $1.03, Class B $1.18) - - - - - - (12,859)
Other comprehensive loss, net of
reclassifications and taxes - - - - - - -
----------- ----------- ----------- ------------ --------- ---------- ---------
Comprehensive income
Balance, December 31, 2005 10,700 $ 21,400 1,993 $ 199 $ 2 $ 104,285 $ 32,827
=========== ============ =========== ============ ========= ========== =========
Accumulated
other
comprehensive Treasury Comprehensive
income (loss) stock income
--------------- -------------- --------------
Balance, December 31, 2004 $ 3,799 $ (2,265)
Net income for the year ended
December 31, 2005 - - $ 32,053
Conversion of Class B common stock
to Class A common stock - -
2% stock dividends declared (January) - - -
2% stock dividends declared (December)
Cash in lieu of fractional shares - - -
Stock options exercised - - -
Cash dividends on common stock
(Class A $1.03, Class B $1.18) - - -
Other comprehensive loss, net of
reclassifications and taxes (4,739) - (4,739)
------------ --------- ---------
Comprehensive income $ 27,314
=========
Balance, December 31, 2005 (940) (2,265)
============ =========
The accompanying notes are an integral part of this statement.
44
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Year ended December 31,
2005 2004 2003
-------------- -------------- --------------
(In thousands)
Cash flows from operating activities
Net income $ 32,053 $ 20,033 $ 18,526
Adjustments to reconcile net income to net cash
provided by (used in) operating activities
Depreciation and amortization 1,307 2,633 1,035
Provision for loan losses 1 6 674
Amortization of premiums and discounts on loans,
mortgage-backed securities and investments 14 7,577 289
Income tax benefit on stock options 53 331 --
(Benefit)provision for deferred income taxes (2,493) (1,442) 2,078
Gains on sale other real estate (2,494) (2,102) (568)
Gains on sale of loans (508) (480) (637)
Gains on sales of investment securities available
for sale (227) (810) (719)
Increase (decrease) in accrued interest receivable 791 719 (2,575)
Decrease (increase) in other assets 1,545 (9,191) (26,021)
Increase (decrease) in accrued interest payable 1,004 (2,131) (3,673)
Increase in other liabilities 1,975 3,666 1,238
-------------- -------------- --------------
Net cash provided by (used in) operating activities 33,021 18,809 (10,353)
-------------- -------------- --------------
Cash flows from investing activities
Proceeds from calls and maturities of investment securities
held to maturity 46,685 153,714 9,982
Purchases of investment securities held to maturity (90,025) (255,150) (89,310)
Proceeds from calls and maturities of investment securities
available for sale 33,729 60,836 201,341
Proceeds from sales of investment securities available for sale 15,600 27,860 91,339
Purchase (redemption) of Federal Home Loan Bank stock (5,973) 307 (3,532)
Purchases of investment securities available for sale (25,137) (13,812) (321,451)
Net (increased) decrease in loans (73,996) 46,256 61,647
Purchases of premises and equipment (900) (596) (513)
Deconsolidation of premises and equipment VIE 57,966 -- --
Purchases of premises and equipment through VIE (52,522) (66,990) --
-------------- -------------- --------------
Net cash used in investing activities (94,573) (47,575) (50,497)
-------------- -------------- --------------
(Continued)
45
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows - Continued
Year ended December 31,
2005 2004 2003
-------------- -------------- --------------
(In thousands, except per share data)
Cash flows from financing activities
Increase (decrease) in non-interest bearing and interest
bearing demand deposits and savings accounts $ (164,396) $ (14,295) $ 63,511
Increase (decrease) in time deposits 119,424 (34,382) (93,292)
Principal payments on mortgage (63) (60) (62)
Obligations through equity investments (8,893) 56,249 -
Proceeds from subordinated debentures, net -- 25,000 -
Cash dividends in lieu of fractional shares (12) (11) (8)
Proceeds from borrowings, net of repayments 132,000 10,000 84,500
Issuance of common stock under stock option plans 137 503 2,021
Cash dividends paid (12,859) (12,199) (11,321)
-------------- -------------- --------------
Net cash provided by financing activities 65,338 30,805 45,349
-------------- -------------- --------------
Net increase (decrease) in cash and cash equivalents 3,786 2,039 (15,501)
Cash and cash equivalents at beginning of year 27,109 25,070 40,571
-------------- -------------- --------------
Cash and cash equivalents at end of year $ 30,895 $ 27,109 $ 25,070
============== ============== ==============
Supplemental disclosure of cash flow information
Cash paid during the year for
Interest $ 30,792 $ 29,432 $ 33,615
============== ============== ==============
Income taxes $ 13,450 $ 8,705 $ 7,000
============== ============== ==============
The accompanying notes are an integral part of these statements.
46
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Royal Bancshares of Pennsylvania, Inc. (Royal Bancshares), through its
subsidiary Royal Bank America (Royal Bank), offers a full range of banking
services to individual and corporate customers located in Pennsylvania, New
Jersey and Delaware. Royal Bank competes with other banking and financial
institutions in certain markets, including financial institutions with
resources substantially greater than its own. Commercial banks, savings
banks, savings and loan associations, credit unions and money market funds
actively compete for savings and time deposits and for various types of
loans. Such institutions, as well as consumer finance and insurance
companies, may be considered competitors of Royal Bank with respect to one
or more of the services it renders.
1. Basis of Financial Statement Presentation
The accompanying consolidated financial statements include the accounts of
Royal Bancshares and its wholly-owned subsidiaries, Royal Investments of
Delaware, Inc. and Royal Bank, including Royal Bank's subsidiaries, Royal
Real Estate of Pennsylvania, Inc., Royal Investment America, LLC, and Royal
Bank America Leasing, LP, and Crusader Servicing Corporation which both are
60% owned by Royal Bank America. Both Royal Bancshares' Trusts' are not
consolidated as further discussed in Note A-17. During 2004, Royal
Bancshares through Royal Bank started a banking division called Royal Asian
Bank which operates three branches in Pennsylvania and one branch in
Northern New Jersey. All significant inter-company transactions and balances
have been eliminated.
In preparing the consolidated financial statements, management is required
to make estimates and assumptions that affect the reported amounts of assets
and liabilities as of the date of the balance sheet and revenues and
expenditures for the period. Therefore, actual results could differ
significantly from those estimates.
The principal estimates that are particularly susceptible to significant
change in the near term relate to the allowance for loan losses and the
valuation of deferred tax assets. In connection with the allowance for loan
losses estimate, when circumstances warrant, management obtains independent
appraisals for significant properties. However, future changes in real
estate market conditions and the economy could affect Royal Bancshares'
allowance for loan losses.
In addition to being subject to competition from other financial
institutions, Royal Bancshares is subject to regulations of certain federal
agencies and, accordingly, it is periodically examined by those regulatory
authorities.
(Continued)
47
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46). In general, a variable interest entity
is a corporation, partnership, trust or any other legal structures used for
business purposes that either (a) does not have equity investors with voting
rights or (b) has equity investors that do not provide sufficient financial
resources for the entity to support its activities. FIN 46 requires certain
variable interest entities to be consolidated by the primary beneficiary if
the investors do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance
its activities without additional subordinated financial support from other
parties. The consolidation requirements of FIN 46 applied immediately to
interest entities created after January 31, 2003. In December 2003, the FASB
issued FIN 46(R) with respect to variable interest entities created before
January 31, 2003, which among other things revised the implementation date
to the first fiscal year or interim period ended after March 15, 2004, with
the exception of Special Purpose Entities (SPE). Royal Bancshares currently
has no SPEs. Royal Bancshares adopted the provisions of FIN 46 effective for
the period ended March 31, 2004, which required Royal Bancshares to
consolidate its investments in real estate partnerships and deconsolidate
its investment un two trusts. Prior to FIN 46 and 46(R), Royal Bancshares
accounted for its investments in the real estate partnerships under the
equity method of accounting.
Royal Bancshares' investments in real estate partnerships and trusts are
further discussed in Note A -17.
In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement 123(R), "Share-Based Payment," an Amendment of SFAS No. 123 and
APB No. 95. The Statement addresses the accounting for share-based payment
transactions in which an enterprise receives employee services in exchange
for (a) equity instruments of the enterprise or (b) liabilities that are
based on the fair value of the enterprise's equity instruments or that may
be settled by the issuance of such equity instruments. Statement 123(R)
requires that all forms of share-based payments to employees, including
employee stock options, would be treated the same as other forms of
compensation by recognizing the related cost in the income statement. The
expense of the award would generally be measured at fair value at the grant
date. Current accounting guidance requires that the expense relating to
fixed plan employee stock options only be disclosed in the footnotes to the
financial statements. The Statement eliminates the ability to account for
share-based compensation transactions using APB Opinion No. 25, "Accounting
for Stock Issued to Employees." This statement is effective for all
share-based payment transactions entered into for fiscal years beginning
after June 15, 2005 and to any awards modified, repurchased, or cancelled
after that date. Royal Bancshares estimates its compensation expense
relating to stock options will be $762,000 during 2006.
(Continued)
48
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
2. Investment Securities
Investment securities are classified in one of three categories: held to
maturity, available for sale or trading. Debt securities that Royal
Bancshares has the positive intent and ability to hold to maturity are
classified as held to maturity and are reported at amortized cost. As Royal
Bancshares does not engage in security trading, the balance of its debt
securities and any equity securities are classified as available for sale.
Net unrealized gains and losses for such investment securities available for
sale, net of tax effect, are required to be recognized as a separate
component of stockholders' equity and excluded from the determination of net
income. Gains or losses on disposition are computed by the specific
identification method.
Purchase premiums and discounts are recognized in interest income using the
interest method over the terms of the securities. Declines in the fair value
of held to maturity and available for sale securities below their cost that
are deemed to be other than temporary are reflected in earnings as realized
losses. In estimating other-than-temporary impairment losses, management
considers (1) the length of time and the extent to which the fair value has
been less than cost, (2) the financial condition and near- term prospects of
the issuer, and (3) the intent and ability of Royal Bancshares to retain its
investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value.
3. Loans held for sale
Residential mortgage loans are only originated for sale to the secondary
mortgage loans market. These loans have a prior sales commitment on a best
efforts basis in place prior to the loan closing. These loans are classified
as loans held for sale and are carried at the lower of cost or estimated
fair value. Fair value is determined by the purchase price quoted in the
sales agreement.
Royal Bancshares accounts for the transfer of financial assets in accordance
with SFAS No. 140 "Accounting for Transfers and Servicing of Assets and
Extinguishments of Liabilities." The standard is based on consistent
application of a financial-components approach that recognizes the financial
and servicing assets it controls and the liabilities it has incurred,
derecognizes financial assets when control has been surrendered and
derecognizes liabilities when extinguished. The standard provides consistent
guidelines for distinguishing transfers of financial assets from transfers
that are secured borrowings.
4. Loans and Allowance for Loan Losses
Loans that management has the intent and ability to hold for the foreseeable
future or until maturity or payoff are stated at the amount of unpaid
principal, reduced by unearned income and an allowance for loan and lease
losses. The allowance for loan losses is maintained at a level believed
adequate by management to absorb potential losses in the loan portfolio.
Management's determination of the adequacy of the allowance is based on an
evaluation of the portfolio, past loan loss experience, current economic
conditions, volume, growth, and composition of the loan portfolio, and other
relevant factors. The allowance is increased by provisions for loan losses
charged against income. Decreases in the allowance result from management's
determination that the
(Continued)
49
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
allowance for loan losses exceeds their estimates of potential loan loss.
This evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes available.
Royal Bancshares accounts for its impaired loans in accordance with SFAS No.
114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS
No. 118, "Accounting by Creditors for Impairment of a Loan - Income
Recognition and Disclosure," which requires that a creditor measure
impairment based on the present value of expected future cash flows
discounted at the loan's effective interest rate, except that as a practical
expedient, a creditor may measure impairment based on a loan's observable
market price, or the fair value of the collateral if the loan is
collateral-dependent. Regardless of the measurement method, a creditor must
measure impairment based on the fair value of the collateral when the
creditor determines that foreclosure is probable.
Large groups of smaller balance homogeneous loans are collectively evaluated
for impairment. Accordingly, Royal Bancshares does not separately identify
individual consumer and residential loans for impairment disclosures, unless
such loans are the subject of a restructuring agreement.
Interest on loans is accrued and credited to operations based upon the
principal amount outstanding. Accretion of unearned discounts on loans has
been added to the related interest income. Accrual of interest is
discontinued on a loan when management believes that the borrower's
financial condition is such that collection of interest is doubtful and
generally when a loan becomes 90 days past due as to principal or interest.
When interest accruals are discontinued, interest credited to income in the
current year is reversed and interest accrued in the prior year is charged
to the allowance for loan losses.
Royal Bancshares accounts for guarantees in accordance with FIN 45
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
including Indirect Guarantees of Indebtedness of Others". FIN 45 requires a
guarantor entity, at the inception of a guarantee covered by the measurement
provisions of the interpretation, to record a liability for the fair value
of the obligation undertaken in issuing the guarantee. Royal Bancshares has
financial and performance letters of credit. Financial letters of credit
require a company to make a payment if the customer's condition
deteriorates, as defined in agreements. Performance letters of credits
require Royal Bancshares to make payments if the customer fails to perform
certain non-financial contractual obligations.
5. Other Real Estate
Royal Bancshares carries other real estate at the fair market value less
estimated costs for the disposition of the property. Management will monitor
cases in which the property value exceeds the book value. Costs relating to
holding the property are expensed when incurred. Other real estate owned of
approximately $3,834,000 and $5,424,000 at December 31, 2005 and 2004,
respectively, is included in other assets on the consolidated balance
sheets.
(Continued)
50
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
6. Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation,
which is computed principally on accelerated methods over the estimated
useful lives of the assets. Leasehold improvements are amortized on the
accelerated methods over the shorter of the estimated useful lives of the
improvements or the terms of the related leases.
7. Bank-Owned Life Insurance
Royal Bank has purchased life insurance policies on certain executives.
These policies are recorded in other assets at their cash surrender value,
or the amount that can be realized. Income from these policies and changes
in the cash surrender value are recorded in other income.
8. Income Taxes
Under the liability method, deferred tax assets and liabilities are
determined based on the difference between the financial statement and tax
bases of assets and liabilities as measured by the enacted tax rates which
will be in effect when these differences reverse. Deferred tax expense is
the result of changes in deferred tax assets and liabilities. The principal
types of differences between assets and liabilities for financial statement
and tax return purposes are the allowance for loan losses, deferred
compensation plans, asset valuation reserves and net operating loss
carryovers.
(Continued)
51
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
9. Per Share Information
Basic per share data excludes dilution and is computed by dividing income
available to common shareholders by the weighted average common shares
outstanding during the period. Diluted per share data takes into account the
potential dilution that could occur if securities or other contracts to
issue common stock were exercised and converted into common stock, using the
treasury stock method.
The Class B shares of Royal Bancshares may be converted to Class A shares at
the rate of 1.15 to 1.
10. Stock Option Plans
SFAS No. 123, "Accounting for Stock-Based Compensation," as Amended by SFAS
No.148, contains a fair value-based method for valuing stock-based
compensation that entities may use to measure compensation cost at the grant
date based on the fair value of the award. Compensation is recognized over
the service period, which is usually the vesting period. Alternatively, SFAS
No. 123 permits entities to continue accounting for employee stock options
and similar equity instruments under Accounting Principles Board (APB)
Opinion 25, "Accounting for Stock Issued to Employees." Entities that
continue to account for stock options using APB Opinion 25 are required to
make a pro forma disclosure of net income and earnings per share, as if the
fair value-based method of accounting defined in SFAS No. 123 had been
applied. Effective January 1, 2006, Royal Bancshares will apply SFAS No.
123(R).
At December 31, 2005, Royal Bancshares had both a director and employee
stock-based compensation plan, which are more fully described in Note L.
Royal Bancshares accounts for these plans under the recognition and
measurement principles of APB Opinion No. 25 and related interpretations.
Stock-based employee compensation costs are not reflected in net income, as
all options granted under the plan had an exercise price equal to the market
value under the underlying common stock of the date of the grant. The
following table illustrates the effect on net income and earnings per share
if Royal Bancshares had applied the fair value recognition provisions of
SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based
employee compensation.
2005 2004 2003
-------------- --------------- ---------------
Net income, as reported $32,053 $20,033 $18,526
Less: Stock-based compensation costs under
fair value based method for all awards,
net of tax (682) (490) (425)
------- ------- -------
Pro forma net income 31,371 19,543 18,101
======= ======= =======
Earnings per share -Basic As Reported $2.50 $1.57 $1.47
Pro forma 2.45 1.53 1.43
Earnings per share -Diluted As Reported 2.49 1.56 1.46
Pro forma 2.43 1.52 1.43
(Continued)
52
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
11. Benefit Plans
Royal Bancshares has a noncontributory nonqualified, defined benefit pension
plan covering certain eligible employees. Net pension expense consists of
service costs, interest costs, return on pension assets and amortization of
unrecognized initial net assets. Royal Bancshares accrues pension costs as
incurred.
12. Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash
on hand, amounts due from banks, short-term investments and federal funds
sold. Generally, federal funds are purchased and sold for one-day periods.
13. Financial Instruments
SFAS No. 107, "Disclosures About Fair Value of Financial Instruments,"
requires all entities to disclose the estimated fair value of their assets
and liabilities considered to be financial instruments. Financial
instruments consist primarily of investment securities, loans, deposits and
borrowings.
14. Advertising Costs
Royal Bancshares' expensed advertising costs of $360,000, $289,000 and
$314,000 for 2005, 2004 and 2003, respectively.
15. Comprehensive Income
Royal Bancshares reports comprehensive income which includes net income as
well as certain other items, which result in a change to equity during the
period.
The income tax effects allocated to comprehensive loss is as follows (in
thousands):
December 31, 2005
------------------------------------------------
Before Tax Net of
tax (benefit) tax
amount expense amount
-------------- --------------- -----------
Unrealized losses on securities
Unrealized holding losses arising during period $ (6,978) $ (2,387) $ (4,591)
Less reclassification adjustment for gains
realized in net income 227 79 148
---------- --------- ---------
Other comprehensive loss, net
$ (7,205) $ (2,466) $ (4,739)
========== ========= =========
(Continued)
53
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
December 31, 2004
------------------------------------------------
Before Tax Net of
tax (benefit) tax
amount expense amount
--------------- --------------- -----------
Unrealized losses on securities
Unrealized holding gains arising during period $ (3,150) $ (1,069) $ (2,081)
Less reclassification adjustment for gains
realized in net income 810 275 535
--------- --------- ---------
Other comprehensive loss, net $ (3,960) $ (1,344) $ (2,616)
========= ========= =========
December 31, 2003
------------------------------------------------
Before Tax Net of
tax (benefit) tax
amount expense amount
--------------- --------------- -----------
Unrealized gains on securities
Unrealized holding gains arising during period $ 6,791 $ 2,316 $ 4,475
Less reclassification adjustment for gains
realized in net income 719 244 475
--------- --------- ---------
Other comprehensive income, net $ 6,072 $ 2,072 $ 4,000
========= ========= =========
16. Reclassifications
Certain reclassifications of prior year amounts have been made to conform to
the current year presentation.
17. Variable Interest Entities (VIE)
Real estate owned via equity investments
Royal Bancshares, together with a real estate development company, formed
Brook View Investors, L.L.C. ("Brook View") in May 2001. Brook View was
formed to construct 13 apartment buildings with a total of 116 units in a
gated apartment community. The development company is the general partner of
the project. Royal Bancshares invested 60% of initial capital contributions
with the development company holding the remaining equity interest. Upon the
repayment of the initial capital contributions and a preferred return,
distributions will convert to 50% for Royal Bancshares and 50% for the
development company. On October 19, 2005 the Company sold its ownership in
Brook View which resulted an after tax gain of approximately $3.3 million.
As a result of the sale, the company discontinued consolidating the
financial statements of Brook View during the fourth quarter 2005.
(Continued)
54
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Royal Bancshares, together with a real estate development company, formed
Burrough's Mill Apartment, L.L.C. ("Burrough's Mill") in December 2001.
Burrough's Mill was formed to construct 32 apartment buildings with a total
of 308 units in a gated apartment community. The development company is the
general partner of the project. Royal Bancshares invested 60% of initial
capital contributions with the development company holding the remaining
equity interest. Upon the repayment of the initial capital contributions and
a preferred return, distributions will convert to 50% for Royal Bancshares
and 50% for the development company. On October 19, 2005, the Company sold
its ownership in Burrough's Mill which resulted an after tax gain of
approximately $7.6 million. As a result of the sale the Company discontinued
consolidating the financial statements of Burrough's Mill during the fourth
quarter 2005.
Royal Bancshares, together with a real estate development company, formed
Main Street West Associates, L.P. ("Main Street") in February 2002. Main
Street was formed to acquire, maintain, improve, and operate office space
located in Norristown, Pennsylvania. The development company is the general
partner of the project. Royal Bancshares invested 93% of initial capital
contributions with the development company holding the remaining equity
interest. Upon the repayment of the initial capital contributions and a
preferred return, distributions will convert to 50% for Royal Bancshares and
50% for the development company. On June 30, 2005, Main Street sold the
property and paid back the Company's original investment plus the accrued
preferred return in full. As a result of the return of capital the Company
discontinued consolidating the financial statements of Main Street during
the second quarter 2005.
Royal Bancshares, together with a real estate investment company, formed 212
C Associates, L.P. ("212 C") in May 2002. 212 C was formed to acquire, hold,
improve, and operate office space located in Lansdale, Pennsylvania. The
investment company is the general partner of the project. Royal Bancshares
invested 90% of initial capital contributions with the investment company
holding the remaining equity interest. Upon the repayment of the initial
capital contributions and a preferred return, distributions will convert to
50% for Royal Bancshares and 50% for the investment company. On June 7,
2005, 212 C made a distribution to the Company of approximately $4.0 million
which paid back the Company's original investment and accrued preferred
return. In addition, the Company received a profit of $1.8 million as result
of this distribution. As a result of the transaction, the Company no longer
qualifies as the primary beneficiary and discontinued consolidating this VIE
during the second quarter 2005.
Royal Bancshares, together with a real estate development company, formed
Royal Scully Associates, G.P. ("Royal Scully") in September 2005. Royal
Scully was formed to convert an apartment complex into condominiums in Blue
Bell, Pennsylvania. The development company is the general partner of the
project. Royal Bancshares invested 66% of initial capital contributions, or
$2.5 million, with the development company holding the remaining equity
interest. In addition the Company holds two notes totaling $9.2 million with
a competitive term and interest rate. Upon the repayment of the initial
capital contributions and a preferred return, distributions will convert to
50% for Royal Bancshares and 50% for the development company. Royal Scully
has total assets of $61.0 million and total borrowings of $47.4 million, of
which $-0- is guaranteed by Royal Bancshares. Royal Bancshares has
determined that Royal Scully is a VIE and it is the primary beneficiary.
Royal Bancshares' exposure to loss due to its investment in and receivables
due from Royal Scully is $11.7 million at December 31, 2005.
(Continued)
55
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued
Trust Preferred Securities
Management has determined that Royal Capital Trust I/II (the Trusts) qualify
as VIE's under FASB Interpretation 46 (FIN 46), "Consolidation of Variable
Interest Entities," as revised. The Trusts issued mandatory redeemable
preferred stock to investors and loaned the proceeds to Royal Bancshares.
Royal Bancshares adopted the provisions under the revised interpretation,
FIN 46(R), in the first quarter of 2004. Accordingly, Royal Bancshares does
not consolidate the Trusts. FIN 46(R) precludes consideration of the call
option embedded in the preferred stock when determining if Royal Bancshares
has the right to a majority of the Trusts' expected residual returns. The
deconsolidation resulted in the investment in the common stock of the Trusts
to be included in other assets as of December 31, 2005 and the corresponding
increase in outstanding debt of $774,000. In addition, the income received
on Royal Bancshares' common stock investment is included in other income.
18. Interest Rate Swaps
For asset/liability management purposes, Royal Bancshares uses interest rate
swap agreements to hedge various exposures or to modify interest rate
characteristics of various balance sheet accounts. Such derivatives are used
as part of the asset/liability management process, are linked to specific
liabilities, and have a high correlation between the contract and the
underlying item being hedged, both at inception and throughout the hedge
period.
The Company currently utilizes interest rate swap agreements to convert a
portion of its fixed rate time deposits to a variable rate (fair value
hedge) to fund variable rate loans and investments. Interest rate swap
contracts in which a series of interest flows are exchanged over a
prescribed period. The notional amount of $60 million on which interest
payments are based is not exchanged. During the third quarter ended
September 30, 2005 the Company recorded an expense in the amount of $676,000
in other operating expenses which reflects the fair value of the interest
rate swaps resulting from the Company not meeting the upfront documentation
and the effectiveness assessment requirements of SFAS 133. As of October 1,
2005 and December 31, 2005, the Company had completed documentation
determining the effectiveness of each hedge using the Volatility Reduction
Measure ("VRM"). It was determined that these swaps are to be effective and
should be treated as a fair value hedge.
At December 31, 2005 and 2004, the information pertaining to outstanding
interest rate swap agreement used to hedge fixed rate loans and investments
is as follows:
December 31,
(in thousands) 2005 2004
------- -------
Notional Amount $60,000 $25,000
Weighted average pay rate 4.40% 2.33%
Weighted average receive rate 3.87% 2.50%
Weighted average maturity (years) 4.5 1.72
Unrealized loss relating to interest rate swaps ($1,281) ($135)
The change in the fair value of the swaps from 2004 to 2005 is related to
$50 million of new contracts during 2005 along with $15 million of the swaps
which were in existence at the end of 2004 maturing during 2005.
56
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE B - SEGMENT INFORMATION
SFAS No. 131, "Segment Reporting," established standards for public business
enterprises to report information about operating segments in their annual
financial statements and requires that those enterprises report selected
information about operating segments in subsequent interim financial reports
issued to shareholders. It also established standards for related disclosure
about products and services, geographic areas, and major customers.
Operating segments are components of an enterprise, which are evaluated
regularly by the chief operating decision maker in deciding how to allocate
and assess resources and performance. Royal Bancshares' chief operating
decision maker is the President and Chief Executive Officer. Royal
Bancshares has identified its reportable operating segment as "Community
Banking."
Royal Bancshares' community banking segment consists of commercial and
retail banking. The community banking business segment is managed as a
single strategic unit which generates revenue from a variety of products and
services provided by Royal Bank. For example, commercial lending is
dependent upon the ability of Royal Bank to fund itself with retail deposits
and other borrowings and to manage interest rate and credit risk. This
situation is also similar for consumer and residential mortgage lending.
Royal Bancshares' tax lien operation does not meet the quantitative
thresholds for requiring disclosure, but has different characteristics than
the community banking operation. Royal Bancshares' tax lien operation
consists of purchasing delinquent tax certificates from local municipalities
at auction. The tax lien segment is managed as a single strategic unit which
generates revenue from a nominal interest rate achieved at the individual
auctions along with periodic penalties imposed.
As a result of FIN 46(R), as of December 31, 2005 Royal Bancshares is
reporting on a consolidated basis its interest in one equity investment as a
VIE which has different characteristics than the community banking segment.
Royal Bancshares has an investment in an apartment complex that is being
converted into condominiums.
As of December 31, 2004, Royal Bancshares reported on a consolidated basis
its interest in four equity investments as VIE's which have different
characteristics that the community banking segment. Royal Bancshares had
investments in two apartment complexes and two buildings leased as a
commercial office space.
The accounting policies used in this disclosure of business segments are the
same as those described in the summary of significant accounting policies.
(Continued)
57
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE B - SEGMENT INFORMATION - Continued
Selected segment information and reconciliations to consolidated financial
information is as follows:
Community Tax Lien Equity
(in thousands) Bank Operation Investments Consolidated
--------------- ---------- ----------- ---------------
DECEMBER 31, 2005
Total assets $ 1,187,825 $ 52,162 $ 61,032 $ 1,301,019
=========== ========= ========= ===========
Total deposits 697,409 - - 697,409
=========== ========= ========= ===========
Net interest income (losses) 43,356 1,865 (557) 44,664
Provision for loan losses - 1 - 1
Total non-interest income 3,827 1,581 19,418 24,826
Total non-interest expense 21,751 2,786 262 24,799
Income taxes $ 5,830 297 6,510 12,637
----------- --------- --------- -----------
Net Income $ 19,602 $ 362 $ 12,089 $ 32,053
=========== ========= ========= ===========
DECEMBER 31, 2004
Total assets $ 1,088,031 $ 50,196 $ 67,047 $ 1,205,274
=========== ========= ========= ===========
Total deposits 742,382 - - 742,382
=========== ========= ========= ===========
Net interest income 38,846 3,024 (1,630) 40,240
Provision for loan loss - 6 - 6
Total non-interest income 4,800 1,227 7,133 13,160
Total non-interest expense 17,295 3,372 4,780 25,447
Income taxes 7,272 389 253 7,914
----------- --------- --------- -----------
Net Income $ 19,079 $ 484 $ 470 $ 20,033
=========== ========= ========= ===========
DECEMBER 31, 2003
Total assets $ 1,103,619 $ 50,791 $ - $ 1,154,410
=========== ========= ========= ===========
Total deposits 791,059 - - 791,059
=========== ========= ========= ===========
Net interest income 38,773 3,606 - 42,379
Provision for loan loss 500 174 - 674
Total non-interest income 3,196 508 - 3,704
Total non-interest expense 16,023 2,864 - 18,887
Income taxes $ 7,528 $ 468 - $ 7,996
----------- --------- --------- -----------
Net Income $ 17,918 $ 608 $ - $ 18,526
=========== ========= ========= ===========
Interest paid to the Community Bank segment by the Tax Lien Operation was
approximately $2,862,000, $1,896,000 and $1,879,000 for the years ended
December 31, 2005, 2004 and 2003, respectively.
(Continued)
58
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES
The amortized cost, gross unrealized gains and losses, and fair value of
Royal Bancshares' investment securities held to maturity and available for
sale are summarized as follows (in thousands):
2005
----------------------------------------------------------------
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
------------ ---------- ----------- ---------
Investment securities held to maturity
Corporate securities $ 60,300 $ 1,902 $ - $ 62,202
U.S. government agencies 195,000 - (4,171) 190,829
Mortgage backed securities 167 - - 167
------------ ---------- ----------- ---------
$ 255,467 $ 1,902 $ (4,171) $ 253,198
============ ========== ========== =========
2005
----------------------------------------------------------------
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
------------ ---------- ----------- ---------
Investment securities available for sale
Preferred and common stock $ 5,129 $ 88 $ - $ 5,217
Corporate bonds 109,564 670 (1,700) 108,534
U.S. government agencies 104,979 - (3,281) 101,698
Trust preferred securities 36,174 3,559 -- 39,733
Foreign bonds 2,995 20 -- 3,015
Mortgage backed securities 56,628 126 (862) 55,892
Other securities 12,166 81 (147) 12,100
------------ ---------- ---------- ----------
$ 327,635 $ 4,564 $ (6,010) $ 326,189
============ ========== ========== ==========
(Continued)
59
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
2004
--------------------------------------------------------------------
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
------------- -------------- --------------- ---------------
Investment securities held to maturity
Corporate securities $ 26,995 $ 371 $ - $ 27,366
U.S. government agencies 185,000 9 (742) 184,267
Mortgage backed securities 232 - - 232
----------- ------------ ----------- ------------
$ 212,227 $ 380 $ (742) $ 211,865
=========== ============ ========== ===========
2004
-----------------------------------------------------------------
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
------------- -------------- ------------- ------------
Investment securities available for sale
Preferred and common stock $ 5,113 $ 250 $ - $ 5,363
Corporate bonds 125,750 4,104 (48) 129,806
U.S. government agencies 94,977 -- (1,672) 93,305
Trust preferred securities 37,196 2,754 (388) 39,562
Foreign bonds 9,212 293 - 9,505
Mortgage backed securities 81,303 496 (130) 81,669
Other securities 1,624 100 -- 1,724
----------- ------------ ----------- ------------
$ 355,175 $ 7,997 $ (2,238) $ 360,934
=========== ============ ========== ===========
(Continued)
60
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
The amortized cost and estimated fair value of investment securities at
December 31, 2005, by contractual maturity, are shown below (in thousands).
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.
2005
---------------------------------------------------------------
Held to maturity Available for sale
--------------------------------- ---------------------------
Amortized Fair Amortized Fair
cost value cost value
---------- --------- --------- ----------
Within 1 year $ 6 $ 6 $ 21,961 $ 22,053
After 1 but within 5 years 205,316 203,703 136,362 133,571
After 5 but within 10 years 50,000 49,344 33,841 32,839
After 10 years 145 145 130,316 132,509
No contractual maturity - - 5,155 5,217
---------- --------- --------- ----------
$ 255,467 $ 253,198 $ 327,635 $ 326,189
========== ========= ========= ==========
Proceeds from the sale of investment securities available for sale during
2005, 2004 and 2003 were $15,370,000, $68,576,000 and $91,339,000,
respectively, resulting in gross realized gains (losses) of $300,000
($73,000), $900,000 ($90,000) and $1,016,000 ($297,000) and during 2005,
2004 and 2003, respectively. Royal Bancshares recorded a tax expense
equivalent to 35% of the gains which resulted in a tax expense of $79,000,
$284,000 and $252,000 during 2005, 2004, and 2003, respectively.
As of December 31, 2005, investment securities with a book value of
$10,000,000 were pledged as collateral to secure public deposits and for
other purposes required or permitted by law.
The table below indicates the length of time individual securities have been
in a continuous unrealized loss position at December 31, 2005:
DESCRIPTION OF SECURITIES LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
Fair Unrealized Fair Unrealized Fair Unrealized
value losses value losses value losses
------------- ------------ ------------- ------------ ------------ -----------
HELD TO MATURITY
-----------------
US government agencies $108,426 $(1,574) $82,403 $(2,597) $190,829 $(4,171)
--------- ------- ------- ------- -------- -------
Total held to maturity $ 108,426 $(1,574) $82,403 $(2,597) $190,829 $(4,171)
AVAILABLE FOR SALE
------------------
US government agencies $9,886 $(114) $91,812 $(3,167) $101,698 $(3,281)
Mortgage backed securities 22,387 (381) 17,992 (481) 40,379 (862)
Corporate bonds 51,312 (1,700) -- -- 51,312 (1,700)
Other bonds 10,121 (167) -- -- 10,121 (167)
--------- ------- ------- ------- -------- -------
Total available for sale $ 93,706 $(2,362) $109,804 $ (3,648) 203,510 $(6,010)
--------- ------- ------- ------- -------- -------
Total temporarily
impaired securities $ 202,132 $(3,936) $192,207 $ (6,245) $394,339 $(10,181)
========= ======= ======== ======== ======== ========
(Continued)
61
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE C - INVESTMENT SECURITIES - Continued
In management's opinion the unrealized losses reflect changes in interest
rates subsequent to the purchase of specific securities. At December 31,
2005, there were 26 securities in the less than twelve month category and 11
in the twelve or more month category and of the $394 million fair value of
investments, $333 million consisted of government bonds and government
secured mortgage backed securities which maintain a AAA rating. Royal
Bancshares has the ability to hold these securities until maturity or market
price recovery. Management believes that the unrealized losses represent
temporary impairments of the securities.
The table below indicates the length of time individual securities have been
in a continuous unrealized loss position at December 31, 2004:
DESCRIPTION OF SECURITIES LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
Fair Unrealized Fair Unrealized Fair Unrealized
value losses value losses value losses
------ ---------- ------ ---------- ------- ----------
HELD TO MATURITY
US government agencies $ 84,258 $ (742) $ -- $ (--) $ 84,258 $ (742)
-------- ------- ------ ------- -------- -------
Total held to maturity 84,258 (742) -- (--) 84,258 (742)
AVAILABLE FOR SALE
US government agencies $14,941 $(36) $78,364 $(1,636) $93,305 $(1,672)
Mortgage backed securities 401 (2) 23,217 (128) 23,618 (130)
Trust preferred 10,000 (385) 4,330 (3) 14,330 (388)
Corporate bonds 6,149 (48) -- -- 6,149 (48)
-------- ------- ------ ------- -------- -------
Total available for sale 31,491 (471) 105,911 (1,767) 137,402 (2,238)
-------- ------- ------ ------- -------- -------
Total temporarily
impaired securities $115,749 $(1,213) $105,911 $(1,767) $221,660 $(2,980)
======== ======= ======== ======= ======== =======
62
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE D - LOANS
Major classifications of loans are as follows (in thousands):
2005 2004
---------- ----------
Commercial and industrial $ 30,075 $ 37,468
Construction and land development 177,102 109,129
Single family and residential 41,900 45,816
Other real estate secured 296,051 273,099
Leases (net of unearned income) 2,623 --
Other 3,868 3,322
---------- ----------
551,619 468,834
Less
Unearned income (1,983) (1,540)
---------- ----------
Total loans $ 549,636 $ 467,294
========== ==========
Loans on which the accrual of interest has been discontinued or reduced
amounted to approximately $4,371,000 and $4,526,000 at December 31, 2005 and
2004, respectively. If interest had been accrued, such income would have
been approximately $506,000, $209,000 and $401,000 for the years ended
December 31, 2005, 2004 and 2003, respectively. Management believes it has
adequate collateral to limit its credit risk with these loans.
Royal Bancshares granted loans to the officers and directors of Royal
Bancshares and to their associates. In accordance with Regulation O related
party loans are made on substantially the same terms, including interest
rates and collateral, as those prevailing at the time for comparable
transactions with unrelated persons and do not involve more than normal risk
of collectibility. The aggregate dollar amount of these loans was
$13,338,000 and $5,163,000 at December 31, 2005 and 2004, respectively.
During 2005, three new loans totaling $8,658,000 were made and repayments
totaled $483,000.
Impaired loans which include the loans on which the accrual of interest has
been discontinued, was approximately $10,003,000 and $14,087,000 at December
31, 2005 and 2004, respectively. Royal Bancshares has identified a loan as
impaired when it is probable that interest and principal will not be
collected according to the contractual terms of the loan agreements. The
income recognized on impaired loans during 2005 and 2004 was $-0- and $-0-,
respectively. During 2005, the average balance of impaired loans was
$13,471,000. At December 31, 2005 there was $1,473,000 of the allowance for
possible loan loss reserved specifically for impaired loans.
Total cash collected on impaired loans during 2005 was $3,001,000 of which
$3,001,000 was credited to the principal balance outstanding on such loans.
Royal Bancshares' policy for interest income recognition on impaired loans
is to recognize income on currently performing restructured loans under the
accrual method. Royal Bancshares recognizes income on non-accrual loans
under the cash basis when the principal payments on the loans become current
and the collateral on the loan is sufficient to cover the outstanding
obligation to Royal Bancshares. If these factors do not exist, Royal
Bancshares does not recognize income.
63
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE D - LOANS -Continued
Royal Bancshares primarily grants commercial and real estate loans in the
greater Philadelphia metropolitan area. Royal Bancshares has concentrations
of credit risk in real estate development loans at December 31, 2005. A
substantial portion of its debtors' ability to honor these contracts is
dependent upon the economic sector.
Changes in the allowance for loan losses were as follows (in thousands):
2005 2004 2003
-------------- --------------- -----------
Balance at beginning of year $ 12,519 $ 12,426 $ 12,470
Charge-offs (2,335) (204) (811)
Recoveries 91 291 93
---------- ----------- ----------
Net (charge-offs) recoveries (2,244) 87 (718)
Provision for loan losses 1 6 674
---------- ----------- ----------
Balance at end of year $ 10,276 $ 12,519 $ 12,426
========== =========== ==========
NOTE E - PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows (in thousands):
Estimated
Useful
Lives 2005 2004
------------------ ----------- -----------
Land - $ 2,396 $ 2,396
Buildings and leasehold improvements 7 - 31.5 years 7,764 8,178
Furniture, fixtures and equipment 3 - 7 years 5,225 6,812
----------- ----------
15,385 17,386
Less accumulated depreciation and amortization 7,012 8,606
----------- ----------
$ 8,373 $ 8,780
=========== ==========
(Continued)
64
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE E - PREMISES AND EQUIPMENT-Continued
Depreciation and amortization in expense, related to premises and equipment,
was approximately $1,300,000, $977,000 and $944,000 for the years ended
2005, 2004 and 2003, respectively.
NOTE F - DEPOSITS
Deposits are summarized as follows (in thousands):
2005 2004
--------------- ---------------
Demand $ 75,754 $ 64,371
NOW and money market 279,602 451,671
Savings 20,109 23,820
Time, $100,000 and over 203,611 90,596
Other time 118,333 111,924
--------------- ---------------
$ 697,409 $ 742,382
=============== ===============
Maturities of time deposits for the next five years and thereafter are as
follows (in thousands):
2006 $ 120,676
2007 41,920
2008 74,177
2009 7,630
2010 74,183
Thereafter 3,358
---------------
$ 321,944
===============
NOTE G - BORROWINGS
1. Advances from the Federal Home Loan Bank
At December 31, 2005, advances from the Federal Home Loan Bank (FHLB)
totaling $354,000,000 will mature within one to eight years. The advances
are collateralized by FHLB stock and certain first mortgage loans, and
mortgage-backed securities. These advances had a weighted average interest
rate of 4.20%. Royal Bancshares available borrowing capacity is based on
qualified collateral as of December 31, 2005.
(Continued)
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE G - BORROWINGS - Continued
Outstanding borrowings mature as follows with its corresponding weighted
average rate (in thousands):
2006 3.69% $ 104,500
2007 -- --
2008 -- --
2009 5.58% 15,000
2010 4.92% 147,500
Thereafter 3.33% 87,000
-----------
$ 354,000
===========
2. Subordinated Debentures
On October 27, 2004, Royal Bancshares completed a private placement of an
aggregate of $25.0 million of Trust Preferred Securities through two
newly-formed Delaware trust affiliates, Royal Bancshares Capital Trust I
("Trust I") and Royal Bancshares Capital Trust II ("Trust II")
(collectively, the "Trusts"). As part of this transaction, Royal Bancshares
issued an aggregate principal amount of $12,887,000 of floating rate junior
subordinate debt securities to Trust I, which debt securities bear an
interest rate of 6.64% at December 31, 2005, and reset quarterly at 3-month
LIBOR plus 2.15%, and an aggregate principal amount of $12,887,000 of
fixed/floating rate junior subordinated deferrable interest to Trust II,
which debt securities bear an initial interest rate of 5.80% until December
2009 and then which will reset quarterly at 3-month LIBOR plus 2.15%.
Each of Trust I and Trust II issued an aggregate principal amount of
$12,500,000 of capital securities bearing fixed and/or fixed/floating
interest rates corresponding to the debt securities held by each trust to an
unaffiliated investment vehicle and an aggregate principal amount of
$387,000 of common securities bearing fixed and/or fixed/floating interest
rates corresponding to the debt securities held by each trust to Royal
Bancshares. Royal Bancshares has fully and unconditionally guaranteed all of
the obligations of the Trusts, including any distributions and payments on
liquidation or redemption of the capital securities.
The Federal Reserve has issued final guidance on the regulatory capital
treatment for trust preferred securities issued by Trust as a result of the
adoption of FIN 46(R). The rule would retain current maximum percentage of
total capital permitted for Trust Preferred Securities at 25%, but would
enact other changes to the rules governing Trust Preferred Securities that
affect their use as a part of the collection of entities known as
"restricted core capital elements." The rule would take effect March 31,
2009; however, a five year transition period starting March 31, 2004 and
leading up to that date would allow bank holding companies to continue to
count Trust Preferred Securities as Tier 1 Capital after applying FIN 46(R).
Management has evaluated the effects of the rule and does not anticipate a
material impact on its capital ratios.
(Continued)
66
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE H - LEASE COMMITMENTS
Royal Bancshares leases various premises under non-cancelable operating
lease agreements, which expire through 2012 and require minimum annual
rentals. The approximate minimum rental commitments under the leases are as
follows for the year ended December 31,
2006 $ 661,000
2007 664,000
2008 654,000
2009 475,000
2010 305,000
Thereafter 165,000
-------------
$ 2,924,000
=============
Rental expense for all leases was approximately $716,000, $664,000 and
$612,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE I - COMMON STOCK
Each holder of Class A and Class B common stock is entitled to one vote for
each Class A share and ten votes for each Class B share held. Holders of
either class of common stock are entitled to conversion equivalent per share
dividends when declared.
The Class B shares may not be transferred in any manner except to the
holder's immediate family. Class B shares may be converted to Class A shares
at the rate of 1.15 to 1.
Per share information and weighted average shares outstanding have been
restated to reflect the 2% stock dividend of December 2005 and the 2% stock
dividend of January 2005.
NOTE J - INCOME TAXES
The components of the income tax expense included in the consolidated
statements of income are as follows (in thousands):
2005 2004 2003
----------- ----------- -----------
Income tax expense (benefit)
Current $ 15,130 $ 9,356 $ 9,221
Deferred federal tax (2,493) (1,442) (1,225)
----------- ---------- -----------
$ 12,637 $ 7,914 $ 7,996
============ ========== ===========
(Continued)
67
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE J - INCOME TAXES - Continued
The difference between the applicable income tax expense and the amount
computed by applying the statutory federal income tax rate of 35% in 2005
and 2004, and 34% in 2003 is as follows (in thousands):
2005 2004 2003
-------------- --------------- ---------------
Computed tax expense at statutory rate $ 15,642 $ 9,781 $ 9,286
Tax-exempt income (361) (466) (263)
Low-income housing tax credit (545) (545) (545)
Reduction of valuation allowance (1,761) -- --
Other, net (338) (619) (482)
Effect of 35% rate bracket -- (237) --
--------------- -------------- --------------
Applicable income tax expense $ 12,637 $ 7,914 $ 7,996
=============== ============== ==============
Deferred tax assets and liabilities consist of the following (in thousands):
2005 2004
--------------- ---------------
Deferred tax assets
Allowance for loan losses $ 3,597 $ 5,366
Asset valuation reserves 431 836
Goodwill from Knoblauch State Bank 539 808
Accrued pension liability 1,806 1,156
Net operating loss carryovers from Knoblauch State Bank 1,761 7,140
Unrealized losses on investment securities available for sale 506 --
Other -- 46
------------- -------------
8,640 15,352
Less valuation allowance -- (7,140)
------------- -------------
8,640 8,212
------------- -------------
Deferred tax liabilities
Unrealized gains on investment securities available for sale -- 1,957
Penalties on delinquent tax certificates 182 243
Deferred tax related to VIE's 662 --
Other 321 720
------------- -------------
1,165 2,920
------------- -------------
Net deferred tax asset, included in other assets $ 7,475 $ 5,292
============= =============
Royal Bancshares has approximately $21,000,000 of net operating loss
carryovers from the acquisition of Knoblauch State Bank (KSB). These losses
will fully expire in 2009. The utilization of these losses is subject to
limitation under Section 382 of the Internal Revenue Code. As a result, a
valuation allowance existed at December 31, 2004 to eliminate the deferred
tax asset attributable to these net operating losses.
(Continued)
68
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE J - INCOME TAXES - Continued
During 2005 the Company recorded an approximate $1.7 million decrease in tax
expense, resulting from the completion of an IRS audit, with respect to a
valuation allowance against the deferred tax asset derived from these net
operating loss carryovers.
In addition, Royal Bancshares has approximately $15,700,000 of tax goodwill
from the acquisition of KSB. The ability to deduct this goodwill for tax
purposes will expire in 2015. The utilization of this goodwill for tax
purposes was subject to the limitations under Section 382 of the Internal
Revenue Code. For 2005, 2004 and 2003 approximately $1,353,000 has been
utilized for tax purposes.
NOTE K - EARNINGS PER SHARE
Basic and diluted EPS are calculated as follows (in thousands, except per
share data):
2005
--------------------------------------------------
Average
Income shares Per share
(numerator) (denominator) amount
-------------- --------------- ---------------
Basic EPS
Income available to common shareholders $ 32,053 12,797 $2.50
Effect of dilutive securities
Stock options - 95 (0.01)
----------- ----------- ----------
Diluted EPS
Income available to common shareholders plus
assumed exercise of options $ 32,053 12,892 $2.49
=========== ============ ==========
All options to purchase shares of common stock were included in the
computation of 2005 diluted EPS because the exercise price was less than the
average market price of the common stock.
(Continued)
69
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE K - EARNINGS PER SHARE - Continued
2004
--------------------------------------------------
Average
Income shares Per share
(numerator) (denominator) Amount
-------------- --------------- ---------------
Basic EPS
Income available to common shareholders $ 20,033 12,755 $ 1.57
Effect of dilutive securities
Stock options - 104 (0.01)
------------- ------------ ------------
Diluted EPS
Income available to common shareholders plus
assumed exercise of options $ 20,033 12,859 $ 1.56
============= ============ ============
All options to purchase shares of common stock were included in the
computation of 2004 diluted EPS because the exercise price was less than the
average market price of the common stock.
2003
--------------------------------------------------
Average
Income shares Per share
(numerator) (denominator) Amount
-------------- --------------- ---------------
Basic EPS
Income available to common shareholders $ 18,526 12,640 $ 1.47
Effect of dilutive securities
Stock options - 54 (0.01)
------------- ------------ ------------
Diluted EPS
Income available to common shareholders plus
assumed exercise of options $ 18,526 12,694 $ 1.46
============= ============ ============
All options to purchase shares of common stock were included in the
computation of 2003 diluted EPS because the exercise price was less than the
average market price of the common stock.
(Continued)
70
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE L - STOCK OPTION PLANS
Royal Bancshares has two stock-based compensation plans, which are described
below. Royal Bancshares accounts for these plans under APB Opinion No. 25.
1. Outside Directors' Stock Option Plan
Royal Bancshares adopted a non-qualified outside Directors' Stock Option
Plan (the Director's Plan). Under the terms of the Director's Plan, 250,000
shares of Class A stock are authorized for grants. Each director is entitled
to a grant of an option to purchase 1,500 shares of stock annually, which
are exercisable one year after the grant date. The options were granted at
the fair market value at the date of the grant.
Stock option transactions consist of the following:
2005 2004 2003
--------------------------- -------------------------- -----------------------
Weighted Weighted Weighted
average average average
exercise exercise exercise
Shares price Shares price Shares price
----------- ------------ ----------- ----------- ----------- -----------
Outstanding at beginning
of year 80,485 $16.95 72,751 $14.62 81,897 $13.84
Granted 16,830 22.79 17,167 23.50 17,017 19.57
Exercised (6,247) 10.28 (9,433) 11.31 (26,163) 11.79
Cancelled - - - - - -
-------- ---------- --------
Outstanding at end of year 91,068 $18.53 80,485 $16.95 72,751 $14.62
========= ========== ========
Weighted average fair
value of options
granted during the
year $4.48 $5.15 $ 3.55
The following table summarizes information about options outstanding and
exercisable at December 31, 2005:
Options outstanding Options exercisable
---------------------------------------------- -------------------------
Weighted
average Weighted Weighted
remaining average average
Range of Number contractual exercise Number exercise
exercise prices outstanding life (years) price exercisable price
--------------------------- -------------- ------------- ----------- ----------- -----------
$9.40 2,151 1.2 $ 9.40 2,194 $ 9.40
$10.89 - 18.81 54,927 5.5 15.65 60,788 15.65
$22.53 - 23.05 33,990 8.7 22.79 17,503 23.05
------------- -----------
91,068 80,485
============= ===========
(Continued)
71
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE L - STOCK OPTION PLANS - Continued
2. Employee Stock Option and Appreciation Right Plan
Royal Bancshares adopted a Stock Option and Appreciation Right Plan (the
Plan). The Plan is an incentive program under which Company officers and
other key employees may be awarded additional compensation in the form of
options to purchase up to 1,650,000 shares of Royal Bancshares' Class A
common stock (but not in excess of 15% of outstanding shares). At the time a
stock option is granted, a stock appreciation right for an identical number
of shares may also be granted. The option price is equal to the fair market
value at the date of the grant. The options are exercisable at 20% per year
beginning one year after the date of grant and must be exercised within ten
years of the grant.
Stock option transactions consist of the following:
2005 2004 2003
--------------------------- -------------------------- -------------------------
Weighted Weighted Weighted
average average average
exercise exercise exercise
Shares price Shares price Shares price
----------- ------------ ----------- ----------- ----------- -----------
Outstanding at beginning
of year 605,409 $18.80 437,001 $15.45 508,779 $13.84
Granted 153,000 22.53 260,493 23.50 160,569 19.57
Exercised (5,398) 14.52 (35,336) 11.31 (122,921) 11.21
Cancelled (15,841) 22.80 (56,749) 20.11 (109,426) 16.82
----------- ----------- ---------
Outstanding at end of year 737,170 19.61 605,409 18.80 437,001 $15.45
=========== =========== ==========
Weighted average fair
value of options
granted during the
year $ 4.48 $ 5.15 $ 3.55
The following table summarizes information about options outstanding and
exercisable at December 31, 2005:
Options outstanding Options exercisable
---------------------------------------------- -------------------------
Weighted
average Weighted Weighted
remaining average average
Range of Number contractual exercise Number exercise
exercise prices Outstanding life (years) price exercisable price
--------------------------- -------------- ------------- ----------- ----------- -----------
$9.39 17,643 1.2 $ 9.39 17,643 $ 9.39
$10.89 - 18.81 347,596 5.7 15.72 233,855 14.77
$22.53 - 23.04 371,931 8.6 22.83 46,666 23.04
--------- ---------
737,170 298,164
========= =========
72
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE M - PENSION PLANS
Royal Bancshares has a noncontributory nonqualified defined benefit pension
plan covering certain eligible employees. Royal Bancshares-sponsored pension
plan provides retirement benefits under pension trust agreements and under
contracts with insurance companies. The benefits are based on years of
service and the employee's compensation during the highest three consecutive
years during the last 10 years of employment. Royal Bancshares' policy is to
fund pension costs allowable for income tax purposes. The following table
sets forth the plan's funded status and amounts recognized in Royal
Bancshares consolidated balance sheets (in thousands):
2005 2004
------------ ------------
Change in benefit obligation
Benefit obligation at beginning of year $ 4,303 $ 3,591
Service cost 1,725 722
Interest cost 248 205
Other changes (32) (215)
------------ ------------
Benefits obligation at end of year $ 6,244 $ 4,303
============ ============
Weighted-average assumptions used to determine benefit obligations, end of year
December 31
----------------------
2005 2004
--------- --------
Discount rate 6.00% 6.00%
Rate of compensation increase 4.00% 4.00%
The asset allocation for Royal Bancshares pension plans and the end of 2005
and 2004 consists of insurance policies under Royal Bancshares Owned Life
Insurance program. The cash surrender value for these policies was
approximately $1,462,000 and $1,203,000 for the years ended December 31,
2005 and 2004, respectively.
Net pension cost included the following components (in thousands):
2005 2004 2003
----------- ----------- ------------
Service cost $ 1,477 $ 570 $ 410
Interest cost 248 205 214
------------ --------- ----------
Net periodic benefit cost $ 1,725 $ 775 $ 624
============ ========= ==========
(Continued)
73
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE M - PENSION PLANS-Continued
Royal Bancshares has a capital accumulation and salary reduction plan under
Section 401(k) of the Internal Revenue Code of 1986, as amended. Under the
plan, all employees are eligible to contribute up to the maximum allowed by
IRS regulation, with Royal Bancshares matching 100% of any contribution
between 1% and 5% subject to a $2,500 per employee annual limit. Matching
contributions to the plan were approximately $155,000, $162,000 and $199,000
for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS
OF CREDIT RISK
Royal Bancshares is a party to financial instruments with off-balance-sheet
risk in the normal course of business to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These financial instruments include commitments to extend credit and standby
letters of credit. Such financial instruments are recorded in the financial
statements when they become payable. Those instruments involve, to varying
degrees, elements of credit and interest rate risk in excess of the amount
recognized in the consolidated balance sheets. The contract amounts of those
instruments reflect the extent of involvement Royal Bancshares has in
particular classes of financial instruments.
Royal Bancshares's exposure to credit loss in the event of non-performance
by the other party to commitments to extend credit and standby letters of
credit is represented by the contractual amount of those instruments. Royal
Bancshares uses the same credit policies in making commitments and
conditional obligations as it does for on-balance-sheet instruments.
The contract amounts are as follows (in thousands):
December 31.
---------------------------------
2005 2004
--------------- ---------------
Financial instruments whose contract amounts represent credit risk
Commitments to extend credit $ 176,415 $ 119,458
Standby letters of credit and financial guarantees written 3,228 1,797
Financial Instruments whose notional amount exceed the amount the amount
of credit risk.
Interest rate swap agreements $ 60,000 $ 25,000
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 or other termination
clauses and may require payment of a fee. Since many of the commitments are
expected to expire without being drawn upon, and others are for staged
construction, the total commitment amounts do not necessarily represent
immediate cash requirements.
(Continued)
74
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE N - FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATIONS
OF CREDIT RISK - Continued
Royal Bancshares evaluates each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary
by Royal Bancshares upon extension of credit, is based on management's
credit evaluation. Collateral held varies but may include personal or
commercial real estate, accounts receivable, inventory and equipment.
Standby letters of credit are conditional commitments issued by Royal
Bancshares to guarantee the performance of a customer to a third party.
Those guarantees are primarily issued to support public and private
borrowing arrangements, including commercial paper, bond financing and
similar transactions. Most guarantees extend for one year and expire in
decreasing amounts through 2006. The credit risk involved in issuing letters
of credit is essentially the same as that involved in extending loan
facilities to customers. Royal Bancshares holds personal or commercial real
estate, accounts receivable, inventory and equipment as collateral
supporting those commitments for which collateral is deemed necessary. The
extent of collateral held for those commitments is approximately 80%.
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107 requires disclosure of the estimated fair value of an entity's
assets and liabilities considered to be financial instruments. For Royal
Bancshares, as for most financial institutions, the majority of its assets
and liabilities are considered financial instruments as defined in SFAS No.
107. However, many of such instruments lack an available trading market, as
characterized by a willing buyer and seller engaging in an exchange
transaction. Also, it is Royal Bancshares's general practice and intent to
hold its financial instruments to maturity and not to engage in trading or
sales activities. Therefore, Royal Bancshares had to use significant
estimations and present value calculations to prepare this disclosure.
Changes in the assumptions or methodologies used to estimate fair value may
materially affect the estimated amounts. Also, management is concerned that
there may not be reasonable comparability between institutions due to the
wide range of permitted assumptions and methodologies in the absence of
active markets. This lack of uniformity gives rise to a high degree of
subjectivity in estimating financial instrument fair value.
Fair values have been estimated using data which management considered the
best available and estimation methodologies deemed suitable for the
pertinent category of financial instrument. The estimation methodologies,
resulting fair values and recorded carrying amounts at December 31, 2005 and
2004 were as follows:
(Continued)
75
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
Fair value of financial instruments actively traded in a secondary market
has been estimated using quoted market prices as follows (in thousands):
2005 2004
--------------------------------- --------------------------------
Estimated Carrying Estimated Carrying
fair value amount fair value amount
-------------- --------------- --------------- ---------------
Cash and cash equivalents $ 30,895 $ 30,895 $ 27,109 $ 27,109
Investment securities held to maturity 253,198 255,467 211,865 212,227
Investment securities available for sale 326,189 326,189 360,934 360,934
Fair value of financial instruments with stated maturities has been
estimated using present value cash flow, discounted at a rate approximating
current market for similar assets and liabilities, as follows (in
thousands):
2005 2004
--------------------------------- --------------------------------
Estimated Carrying Estimated Carrying
fair value amount fair value amount
-------------- --------------- --------------- ---------------
Deposits with stated maturities $327,879 $ 321,944 $ 208,198 $ 202,520
Borrowings 355,547 354,000 224,437 222,000
Subordinated debt 25,774 25,774 25,774 25,774
Obligations from equity investments 47,356 47,356 56,249 56,249
The fair value of commitments to extend credit is estimated based on the
amount of unamortized deferred loan commitment fees. The fair value of
letters of credit is based on the amount of unearned fees plus the estimated
cost to terminate the letters of credit. Fair values of unrecognized
financial instruments including commitments to extend credit and the fair
value of letters of credit are considered immaterial.
2005 2004
--------------------------------- --------------------------------
Estimated Carrying Estimated Carrying
fair value amount fair value amount
-------------- --------------- --------------- ---------------
Commitments to extend credit -- -- -- --
Standby letters of credit -- -- -- --
Fair value of the net loan portfolio has been estimated using present value
cash flow, discounted at the treasury rate adjusted for non-interest
operating costs and giving consideration to estimated prepayment risk and
credit loss factors, as follows (in thousands):
(Continued)
76
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE O - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued
2005 2004
--------------------------------- --------------------------------
Estimated Carrying Estimated Carrying
fair value amount fair value amount
-------------- --------------- --------------- ---------------
Loans held for sale $ 803 $ 803 $ 2,221 $ 2,204
Loans, net 538,804 539,360 454,882 454,775
The fair value of accrued interest receivable and payable approximates
carrying amounts.
The fair value of interest rate swaps are based on upon the estimated amount
Royal Bank would receive or pay to terminate the contract or agreements,
taking into account current interest rates and, when appropriate, the
current creditworthiness of the counterparties. The fair value of the
interest rate swaps as of December 31, 2005 was a negative $1.3 million on a
notional amount $60 million. The fair value of the interest rate swaps as of
December 31, 2004 was a negative $135 thousand on a notional amount $25
million.
Royal Bancshares' remaining assets and liabilities are not considered
financial instruments. No disclosure of the relationship value of Royal
Bancshares's deposits is required by SFAS No. 107.
NOTE P - REGULATORY MATTERS
1. Payment of Dividends
Under the Pennsylvania Business Corporation Law, Royal Bancshares may pay
dividends only if it is solvent and would not be rendered insolvent by the
dividend payment. There are also restrictions set forth in the Pennsylvania
Banking Code of 1965 (the Code) and in the Federal Deposit Insurance Act
(FDIA) concerning the payment of dividends by Royal Bancshares. Under the
Code, no dividends may be paid except from "accumulated net earnings"
(generally retained earnings). Under the FDIA, no dividend may be paid if a
bank is in arrears in the payment of any insurance assessment due to the
Federal Deposit Insurance Corporation (FDIC).
In addition, dividends paid by Royal Bank to Royal Bancshares would be
prohibited if the effect thereof would cause Royal Bank's capital to be
reduced below applicable minimum capital requirements.
2. Capital Ratios
Royal Bancshares and Royal Bank are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory--and possible
additional discretionary actions by regulators that, if undertaken, could
have a direct material effect on Royal Bancshares' financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, Royal Bancshares must meet specific capital guidelines
that involve quantitative measures of Royal Bancshares' assets, liabilities
and certain off-balance-sheet items as calculated under regulatory
accounting practices. Royal Bancshares and Royal Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators
about components, risk weightings and other factors.
Quantitative measures established by regulations to ensure capital adequacy
require Royal Bancshares and Royal Bank to maintain minimum amounts and
ratios (set forth in the table below) of total and Tier I capital (as
defined
(Continued)
77
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE P - REGULATORY MATTERS - Continued
in the regulations) to risk-weighted assets (as defined), and of Tier I
capital (as defined) to average assets (as defined). As of December 31,
2005, management believes that Royal Bank meets all capital adequacy
requirements to which it is subject.
As of December 31, 2005, Royal Bank met all regulatory requirements for
classification as well capitalized under the regulatory framework for prompt
corrective action. To be categorized as well capitalized, Royal Bank must
maintain minimum total risk-based, Tier I risk-based and Tier I leverage
ratios as set forth in the table. There are no conditions or events since
that notification that management believes have changed Royal Bank's
category.
Royal Bancshares' and Royal Bank's actual capital amounts and ratios are
also presented in the table (in thousands).
2005
-------------------------------------------------------------------------------------
To be well
capitalized under
For capital prompt corrective
Actual adequacy purposes action provisions
-------------------------- --------------------------- -------------------------
Amount Ratio Amount Ratio Amount Ratio
----------- ----------- ------------ ----------- ----------- -----------
Total capital (to risk-
weighted assets)
Company (consolidated) $193,125 19.80% $78,021 8.00% N/A N/A
Bank 141,673 14.86% 76,247 8.00% $ 95,309 10.00%
Tier I capital (to risk-
weighted assets)
Company (consolidated) 182,849 18.75% 39,010 4.00% N/A N/A
Bank 131,397 13.79% 38,123 4.00% 57,185 6.00%
Tier I capital(to average
assets, leverage)
Company (consolidated) 182,849 14.24% 38,528 3.00% N/A N/A
Bank 131,397 10.43% 37,790 3.00% 62,983 5.00%
(Continued)
78
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE P - REGULATORY MATTERS - Continued
2004
-------------------------------------------------------------------------------------
To be well
capitalized under
For capital prompt corrective
Actual adequacy purposes action provisions
-------------------------- --------------------------- -------------------------
Amount Ratio Amount Ratio Amount Ratio
----------- ----------- ------------ ----------- ----------- -----------
Total capital (to risk-
weighted assets)
Company (consolidated) $176,557 20.43% $69,149 8.00% N/A N/A
Bank 124,847 14.55% 68,663 8.00% $85,829 10.00%
Tier I capital (to risk-
weighted assets)
Company (consolidated) 165,731 19.17% 34,574 4.00% N/A N/A
Bank 114,096 13.29% 34,332 4.00% 51,497 6.00%
Tier I capital(to average
assets, leverage)
Company (consolidated) 165,731 13.93% 35,692 3.00% N/A N/A
Bank 114,096 9.59% 35,692 3.00% 59,487 5.00%
NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY
Condensed financial information for the parent company only follows (in
thousands).
CONDENSED BALANCE SHEETS
December 31,
---------------------------------
2005 2004
--------------- ---------------
Assets
Cash $ 24,119 $ 30,326
Investment in Royal Investments of Delaware, Inc. - at equity 19,699 21,178
Investment in Royal Bank America - at equity 130,009 114,109
Loans, net 4,682 --
Other assets 2,773 1,037
----------- -----------
$ 181,282 $ 166,650
=========== ===========
Subordinated debentures $ 25,774 $ 25,774
Stockholders' equity 155,508 140,876
----------- -----------
$ 181,282 $ 166,650
=========== ===========
(Continued)
79
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE Q - CONDENSED FINANCIAL INFORMATION - PARENT COMPANY ONLY - Continued
CONDENSED STATEMENTS OF INCOME
Year ended December 31,
--------------------------------------------------
2005 2004 2003
-------------- --------------- ---------------
Income
Equity in undistributed net earnings of subsidiaries $ 19,160 $ 7,888 $ 7,241
Dividends from subsidiary bank 12,859 12,199 11,321
Other income 173 - 25
-------- -------- --------
Total income 32,192 20,087 18,587
-------- -------- --------
Expenses
Other expenses 121 83 81
Income tax expense (benefit) 18 (29) (20)
-------- -------- --------
Total expenses 139 54 61
-------- -------- --------
Net income $ 32,053 $ 20,033 $ 18,526
======== ======== ========
(Continued)
80
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE R - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
CONDENSED STATEMENTS OF CASH FLOWS
Year ended December 31,
-------------------------------------------------
2005 2004 2003
------------- --------------- ---------------
Cash flows from operating activities
Net income $ 32,053 $ 20,033 $ 18,526
Adjustments to reconcile net income to net cash
provided by operating activities
Undistributed earnings from subsidiaries (19,160) (7,888) (7,241)
Operating expenses 121 83 81
Rental income - - (25)
Non-cash income tax (benefit) expense 18 (29) (20)
------------- ------------ -----------
Net cash provided by operating activities 13,032 12,199 11,321
------------- ------------ -----------
Cash flows from financing activities
Loan funding (4,695) -- --
Cash dividends paid (12,859) (12,199) (11,321)
Proceeds from subordinated debentures -- 25,000 -
Other, net (1,685) 551 2,248
------------- ------------ -----------
Net cash provided by (used in) financing
activities 19,239 13,352 (9,073)
------------- ------------ -----------
Net increase (decrease) in cash (6,207) 25,551 2,248
Cash at beginning of year 30,326 4,775 2,527
------------- ------------ -----------
Cash at end of year $ 24,119 $ 30,326 $ 4,775
============= ============ ===========
(Continued)
81
ROYAL BANCSHARES OF PENNSYLVANIA, INC. AND SUBSIDIARIES
Notes To Consolidated Financial Statements - Continued
NOTE R - SUMMARY OF QUARTERLY RESULTS (UNAUDITED)
The following summarizes the consolidated results of operations during 2005
and 2004, on a quarterly basis, for Royal Bancshares (in thousands except
per share data):
2005
------------------------------------------------------------------
Fourth Third Second First
Quarter Quarter Quarter Quarter
------------ ------------ ------------ ------------
Interest income $ 20,281 $ 19,645 $ 19,330 $ 17,204
Net interest income 12,297 10,894 11,635 9,838
Provision for loan losses - - - 1
------------ ------------ ----------- ------------
Net interest income after provision 12,297 10,894 11,635 9,837
Non interest income 15,039 3,294 3,880 2,613
Non interest expenses 3,345 7,526 7,569 6,359
Income before income taxes 23,991 6,662 7,946 6,091
------------ ------------ ----------- ------------
Net income $ 15,587 $ 4,903 $ 7,242 $ 4,321
============ ============ =========== ============
Net income per share
Basic $ 1.22 $ 0.38 $ 0.57 $ 0.33
Diluted $ 1.21 $ 0.38 $ 0.57 $ 0.33
2004
------------------------------------------------------------------
Fourth Third Second First
Quarter Quarter Quarter Quarter
------------ ------------ ------------ ------------
Interest income $ 16,990 $ 16,515 $ 16,508 $ 17,528
Net interest income 10,181 9,722 9,539 10,798
Provision for loan losses - 1 4 1
------------ ------------ ----------- ------------
Net interest income after provision 10,181 9,721 9,535 10,797
Non interest income 2,691 3,822 3,464 3,183
Non interest expense 5,864 6,225 6,782 6,576
Income before income taxes 7,008 7,318 6,217 7,404
------------ ------------ ----------- ------------
Net income $ 5,363 $ 5,112 $ 4,394 $ 5,164
============ ============ =========== ============
Net income per share
Basic $ 0.42 $ 0.40 $ 0.34 $ 0.41
Diluted $ 0.42 $ 0.40 $ 0.34 $ 0.40
82
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
As reported on its Report on Form 8-K filed with the SEC on October 21,
2004, on October 18, 2004, Royal Bancshares dismissed its then independent
accountants, Grant Thornton, LLP and appointed Beard Miller Company LLP as its
new independent accountants, each effective immediately. The decisions to
dismiss Grant Thornton and to engage Beard Miller were approved by Royal
Bancshares' Audit Committee. The Audit Committee's decision was based upon a
response to a competitive bid requested by Royal Bancshares. The reports on
Royal Bancshares' financial statements from Grant Thornton for 2003 or any
period prior to that period, have not contained an adverse opinion or disclaimer
of opinion, nor were qualified or modified as to any uncertainty, audit scope,
or accounting principles. There have been no disagreements with Grant Thornton
on any matter of accounting principles or practices, financial statement
disclosures, or auditing scope of procedure during the two most recent fiscal
years, or any subsequent interim period through the date of dismissal or in any
of the years prior to that period, which, if not resolved to the satisfaction of
Grant Thornton, would have caused Grant Thornton to make reference to the
subject matter of the disagreement in connection with its report.
During the two most recent fiscal years, or any subsequent interim
period through the date of dismissal of Grant Thornton, there were no
disagreements with Grant Thornton on any of the kinds of events listed in Item
304 (a)(1)(v)(A) through (D) of Regulation S-K.
During the years ended December 31, 2003 and the subsequent interim
period through the date of engaging Beard Miller, neither Royal Bancshares nor
anyone on its behalf consulted Beard Miller on any of the matters or reportable
events listed in Item 304 (a) (2) (i) and (ii) of Regulation S-K.
ITEM 9A. CONTROLS AND PROCEDURES
EFFECTIVENESS OF DISCLOSURE CONTROLS AND PROCEDURES
We maintain a system of controls and procedures designed to provide reasonable
assurance to the reliability of the financial statements and other disclosures
included in this report, as well as to safeguard assets from unauthorized use or
disposition. We evaluated the effectiveness of the design and operation of our
disclosure controls and procedures under the supervision and with the
participation of management, including our Chief Executive Officer and Chief
Financial Officer, within 90 days prior to the filing date of this report. Based
upon that evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that the Company's disclosure controls and procedures are effective.
During the quarter ended December 31, 2005, there have been no changes in our
internal controls over financial reporting that has materially affected, or are
reasonably likely to material affect, these controls.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of the Company is responsible for establishing and
maintaining adequate internal control over financial reporting, as defined in
Rule 13a - 15(f) under the Securities Exchange Act of 1934. The Company's
internal control over financial reporting is a process designed under the
supervision of the Company's Chief Executive Officer and Chief Financial Officer
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of the Company's financial statements for external reporting
purposes in accordance with U.S. generally accepted accounting principles.
As of December 31, 2005, management assessed the effectiveness of the
Company's internal control over financial reporting based on the framework
established in "Internal Control - Integrated Framework" issued by the Committee
of Sponsoring Organizations of the Treadway Commission (COSO). Based on this
evaluation, management has determined that the Company's internal control over
financial reporting was effective as of December 31, 2005 based on the criteria
specified.
83
Beard Miller Company LLP, the independent registered public accounting
firm that audited the consolidated financial statements of the Company included
in this Annual Report on Form 10-K, has issued an attestation report on
management's assessment of the effectiveness of the Company's internal control
over financial reporting as of December 31, 2005.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Royal Bancshares of Pennsylvania, Inc.
Narberth, Pennsylvania
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that Royal
Bancshares of Pennsylvania, Inc. maintained effective internal control over
financial reporting as of December 31, 2005, based on criteria established in
Internal Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO). Royal Bancshares of
Pennsylvania, Inc.'s management is responsible for maintaining effective
internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting. Our responsibility
is to express an opinion on management's assessment and an opinion on the
effectiveness of the Company's internal control over financial reporting based
on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal
control over financial reporting, evaluating management's assessment, testing
and evaluating the design and operating effectiveness of internal control and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis for our
opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles. A company's internal
control over financial reporting includes those policies and procedures that (1)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the asses of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and the receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Royal Bancshares of
Pennsylvania, Inc. maintained effective internal control over financial
reporting as of December 31, 2005, is fairly stated, in all material respects,
based on criteria established in Internal Control - Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Also, in our opinion, Royal Bancshares of Pennsylvania, Inc. maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2005 based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO).
84
We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated balance
sheets of Royal Bancshares of Pennsylvania, Inc. and subsidiaries as of December
31, 2005 and the related statements of income, stockholders' equity and cash
flows for each of the years in the two-year period ended December 31, 2005 and
our report dated March 14, 2006 expressed an unqualified opinion.
/s/ Beard Miller Company LLP
Beard Miller Company LLP
Reading, Pennsylvania
March 14, 2006
85
PART III.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
The information required in this Item, relating to directors, executive
officers, and control persons is set forth in Royal Bancshares' Proxy Statement
to be used in connection with the 2006 Annual Meeting of Shareholders under the
heading "Remuneration of Directors and Officers and Other Transactions", which
pages are incorporated herein by reference.
AUDIT COMMITTEE. Royal Bancshares has a separately-designated standing
Audit Committee established in accordance with Section 3(a)(58)(A) of the
Exchange Act. The members of the Audit Committee are Gregory T. Reardon
(Chairman), Jack R. Loew, Anthony J. Micale and Edward B. Tepper as an advisor
each of whom is independent as that term is used in Item 7(d)(3)(iv) of Schedule
14A under the Exchange Act.
AUDIT COMMITTEE FINANCIAL EXPERT. Royal Bancshares' Board of Directors
has determined that Gregory T. Reardon, the Audit Committee Chairman, is an
audit committee financial expert as defined in Item 401(h) of Regulation S-K of
the Exchange Act and is independent as that term is used in Item 7(d)(3)(iv) of
Schedule 14A under the Exchange Act.
BENEFICIAL OWNERSHIP - COMPLIANCE. Section 16(a) of the Securities
Exchange Act of 1934, as amended, requires Royal Bancshares' officers and
directors, and persons who own more than 10 percent of the registered class of
Royal Bancshares' equity securities, to file reports of ownership and changes in
ownership with the SEC. Officers, directors and greater than 10 percent
shareholders are required by SEC regulation to furnish the Corporation copies of
all Section 16(a) forms they file.
Based solely on its review of forms that were received from certain
reporting persons, Royal Bancshares believes that during the period January 1,
2005 through December 31, 2005, its officers and directors were in compliance
with all filing requirements applicable to them.
86
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item, relating to executive
compensation, is set forth in the Royal Bancshares' Proxy Statement to be used
in connection with the 2006 Annual Meeting of Shareholders, under the heading
"Renumeration of Directors and Officers and Other Transactions", which pages are
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item, relating to beneficial ownership
of the Registrant's Common Stock, is set forth in Royal Bancshares' Proxy
Statement to be used in connection with the 2006 Annual Meeting of Shareholders,
under the heading "Information About Nominees, Continuing Directors and
Executive Officers", which pages are incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item, relating to transactions with
management and others, certain business relationships and indebtedness of
management, is set forth in Royal Bancshares' Proxy Statement to be used in
connection with the 2006 Annual Meeting of Shareholders, under the heading
"Interest of Management and Others in Certain Transactions", which pages are
incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item appears under the heading "AUDIT
FEES" of the Proxy Statement to be used in connection with the 2006 Annual
Meeting of Shareholders, which pages are incorporated herein by reference.
87
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
a. 1. Financial Statements
The following financial statements are included by reference in
Part II, Item 8 hereof.
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets.
Consolidated Statements of Income.
Consolidated Statements of Changes in Stockholders' Equity.
Consolidated Statement of Cash Flows.
Notes to Consolidated Financial Statements.
2. Financial Statement Schedules
Financial Statement Schedules are omitted because the required
information is either not applicable, not required or is shown in
the respective financial statements or in the notes thereto.
3. The following Exhibits are filed herewith or incorporated by
reference as a part of this Annual Report.
2 Purchase and Assumption Agreement, dated as of March
12, 2001, among Royal Bank of Pennsylvania, Crusader
Holding Corporation, Crusader Savings Bank, F.S.B.
and Asset Investment Corporation. (Incorporated by
reference to Exhibit 2 to Registrant's Report on Form
8-K, filed with the Commission on March 15, 2001.)
3(i) Articles of Incorporation. (Incorporated by reference
to Exhibit 3(i) to Registrant's Registration
Statement No. 0-26366 on Form S-4.)
3(ii) By-laws. (Incorporated by reference to Exhibit 99 to
Registrant's Current Report on Form 8-K, filed with
the Commission on March 13, 2001.)
4.1 Junior Subordinated Debt Security Due 2034 issued by
Royal Bancshares of Pennsylvania, Inc. to JPMorgan
Chase Bank, as Institutional Trustee, dated October
27, 2004. (Incorporated by reference to Exhibit 4.1
to Registrant's Current Report on Form 8-K (included
as Exhibit A to Exhibit 10.1) filed with the
Commission on November 1, 2004.))
4.2 Junior Subordinated Debt Security Due 2034 issued by
Royal Bancshares of Pennsylvania, Inc. to JPMorgan
Chase Bank, as Institutional Trustee, dated October
27, 2004. (Incorporated by reference to Exhibit 4.2
to Registrant's Current Report on Form 8-K (included
as Exhibit A to Exhibit 10.2) filed with the
Commission on November 1, 2004.))
4.3 Indenture by and between Royal Bancshares of
Pennsylvania, Inc. and JPMorgan Chase Bank, as
Trustee, dated October 27, 2004. (Incorporated by
reference to Exhibit 10.1 to Registrant's Current
Report on Form 8-K filed with the Commission on
November 1, 2004.)
4.4 Indenture by and between Royal Bancshares of
Pennsylvania, Inc. and JPMorgan Chase Bank, as
Trustee, dated October 27, 2004. (Incorporated by
reference to Exhibit 10.2 to Registrant's Current
Report on Form 8-K filed with the Commission on
November 1, 2004.)
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4.5 Guarantee Agreement by and between Royal Bancshares
of Pennsylvania, Inc. and JPMorgan Chase Bank, as
Guarantee Trustee, dated October 27, 2004.
(Incorporated by reference to Exhibit 10.3 to
Registrant's Current Report on Form 8-K filed with
the Commission on November 1, 2004.)
4.6 Guarantee Agreement by and between Royal Bancshares
of Pennsylvania, Inc. and JPMorgan Chase Bank, as
Guarantee Trustee, October 27, 2004. (Incorporated by
reference to Exhibit 10.4 to Registrant's Current
Report on Form 8-K filed with the Commission on
November 1, 2004.)
10.1 Stock Option and Appreciation Right Plan. As amended
on May 16, 2005 (Incorporated by reference to the
Registrant's Registration Statement N0. 333-25855, on
form S-8 filed with the Commission on November 22,
2005).
10.2 Outside Directors' Stock Option Plan. (Incorporated
by reference to the Registrant's Registration
Statement N0. 333-25855, on form S-8 filed with the
Commission on April 5, 1997).
10.3 Employment agreement between Royal Bancshares of
Pennsylvania, Inc. and Joseph P. Campbell, President
and Chief Executive Officer, entered into on April
23, 2004. (Incorporated by reference to Exhibit 10.1
to Registrant's Quarterly Report on Form 10- Q filed
with the Commission on November 9, 2004.)
10.4 Employment agreement between Royal Bancshares of
Pennsylvania, Inc. and James J. McSwiggan, Executive
Vice President, entered into on April 23, 2004.
(Incorporated by reference to Exhibit 10.3 to
Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
10.5 Employment agreement between Royal Bank America and
Robert R. Tabas, entered into on April 23, 2004.
(Incorporated by reference to Exhibit 10.6 to
Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
10.6 Employment agreement between Royal Bancshares of
Pennsylvania, Inc. and Murray Stempel, Senior Vice
President, entered into on April 23, 2004.
(Incorporated by reference to Exhibit 10.4 to
Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
10.7 Employment agreement between Royal Bancshares of
Pennsylvania, Inc. and John Decker, Senior Vice
President, entered into on April 23, 2004.
(Incorporated by reference to Exhibit 10.2 to
Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
10.8 Employment agreement between Royal Bank America and
Edward Shin, entered into on April 23, 2004.
(Incorporated by reference to Exhibit 10.5 to
Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
11. Statement Re: Computation of Earnings Per Share.
Included at Item 8, hereof, Note K, "Per Share
Information".
12. Statement re: Computation of Ratios. (Included at
Item 8 here of, Note P, "Regulatory Matters.")
14. Royal Bancshares of Pennsylvania, Inc. Code of
Ethics.
21. Subsidiaries of Registrant.
89
23.1 Consent of Independent Accountants from Beard Miller
Company LLP.
23.2 Consent of Independent Accountants from Grant
Thornton LLP.
31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief
Executive Officer
31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief
Financial Officer
32.1 Section 1350 Certification of Chief Executive
Officer.
32.2 Section 1350 Certification of Chief Financial
Officer.
99.1 Opinion letter of Independent Accounts Grant Thornton
LLP.
(b) Reports on Form 8-K filed by the Registrant during the fourth quarter
and through this Form 10K filing are as follows:
Royal Bancshares filed a repot on Form 8-K with the Securities and
Exchange Commission as of October 20, 2005, announcing the sale of two
equity positions held in Royal Investments America, LLC.
Royal Bancshares filed a repot on Form 8-K with the Securities and
Exchange Commission as of October 25, 2005, reporting its third quarter
earnings and the declaration of its 42nd consecutive cash dividend.
Royal Bancshares filed a repot on Form 8-K with the Securities and
Exchange Commission as of December 22, 2005, announcing the declaration
of a 2% stock dividend on both Class A and Class B shares.
Royal Bancshares filed a repot on Form 8-K with the Securities and
Exchange Commission as of January 23, 2006, reporting its fourth
quarter earnings and the declaration of its 43rd consecutive cash
dividend.
Royal Bancshares filed a repot on Form 8-K with the Securities and
Exchange Commission as of February 22, 2006, announcing the appointment
of Patrick J. McCormick to the Boards of Directors of Royal Bancshares
and Royal Bank.
(c) The exhibits required to be filed by this Item are listed under Item
14(a)3 above.
(d) Not applicable.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
/s/ Joseph P. Campbell
- -------------------------------------
Joseph P. Campbell
Chief Executive Officer
March 14, 2006.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
SINATURES
By: /s/ Joseph P. Campbell March 15, 2006
- ---------------------------------------
Joseph P. Campbell
CEO/ President/Director
By: /s/ Jeffrey T. Hanuscin March 15, 2006
- ---------------------------------------
Jeffrey T. Hanuscin
Chief Financial Officer
By: /s/ James J. McSwiggan March 15, 2006
- ---------------------------------------
James J. McSwiggan
Chief Operating Officer/ Director
By: /s/ Robert R. Tabas March 15, 2006
- ---------------------------------------
Robert R. Tabas
Chairman of the Board
By:/s/ Albert Ominsky March 15, 2006
- ---------------------------------------
Albert Ominsky
Director
91
By: /s/ Anthony Micale March 15, 2006
- ---------------------------------------
Anthony Micale
Director
By: /s/ Gregory Reardon March 15, 2006
- ---------------------------------------
Gregory Reardon
Director
By: /s/ Murray Stempel, III March 15, 2006
- ---------------------------------------
Murray Stempel, III
Chief Lending Officer/Director
By: /s/ John M. Decker March 15, 2006
- ---------------------------------------
John M. Decker
Executive Vice President
By:/s/ Carl M. Cousins March 15, 2006
- ---------------------------------------
Carl M. Cousins
Director
By: /s/ Lee E. Tabas March 15, 2006
- ---------------------------------------
Lee E. Tabas
Director
By: /s/ Jack R. Loew March 15, 2006
- ---------------------------------------
Jack R. Loew
Director
By: /s/ Howard Wurzak March 15, 2006
- ---------------------------------------
Howard Wurzak
Director
92
By: /s/ Evelyn R. Tabas March 15, 2006
- ---------------------------------------
Evelyn R. Tabas
Director
By: /s/ Mitchell L. Morgan March 15, 2006
- ---------------------------------------
Mitchell L. Morgan
Director
By: /s/ Edward B. Tepper March 15, 2006
- ---------------------------------------
Edward B. Tepper
Director
By: /s/ Linda Tabas Stempel March 15, 2006
- ---------------------------------------
Linda Tabas Stempel
Director
By:/s/ Patrick McCormick March 15, 2006
- ---------------------------------------
Patrick McCormick
Director
93
ROYAL BANCSHARES OF PENNSYLVANIA, INC.
ANNUAL REPORT ON FORM 10-K
EXHIBIT INDEX
2. Purchase and Assumption Agreement, dated as of March 12, 2001,
among Royal Bank of Pennsylvania, Crusader Holding
Corporation, Crusader Savings Bank, F.S.B. and Asset
Investment Corporation. (Incorporated by reference to Exhibit
2 to Registrant's Report on Form 8-K, filed with the
Commission on March 15, 2001.)
3(i) Articles of Incorporation. (Incorporated by reference to
Exhibit 3(i) to Registrant's Registration Statement No.
0-26366 on Form S-4.)
3(ii) By-laws. (Incorporated by reference to Exhibit 99 to
Registrant's Current Report on Form 8-K, filed with the
Commission on March 13, 2001.)
4.1 Junior Subordinated Debt Security Due 2034 issued by Royal
Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as
Institutional Trustee, dated October 27, 2004. (Incorporated
by reference to Exhibit 4.1 to Registrant's Current Report on
Form 8-K (included as Exhibit A to Exhibit 10.1) filed with
the Commission on November 1, 2004.))
4.2 Junior Subordinated Debt Security Due 2034 issued by Royal
Bancshares of Pennsylvania, Inc. to JPMorgan Chase Bank, as
Institutional Trustee, dated October 27, 2004. (Incorporated
by reference to Exhibit 4.2 to Registrant's Current Report on
Form 8-K (included as Exhibit A to Exhibit 10.2) filed with
the Commission on November 1, 2004.))
4.3 Indenture by and between Royal Bancshares of Pennsylvania,
Inc. and JPMorgan Chase Bank, as Trustee, dated October 27,
2004. (Incorporated by reference to Exhibit 10.1 to
Registrant's Current Report on Form 8-K filed with the
Commission on November 1, 2004.)
4.4 Indenture by and between Royal Bancshares of Pennsylvania,
Inc. and JPMorgan Chase Bank, as Trustee, dated October 27,
2004. (Incorporated by reference to Exhibit 10.2 to
Registrant's Current Report on Form 8-K filed with the
Commission on November 1, 2004.)
4.5 Guarantee Agreement by and between Royal Bancshares of
Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee
Trustee, dated October 27, 2004. (Incorporated by reference to
Exhibit 10.3 to Registrant's Current Report on Form 8-K filed
with the Commission on November 1, 2004.)
4.6 Guarantee Agreement by and between Royal Bancshares of
Pennsylvania, Inc. and JPMorgan Chase Bank, as Guarantee
Trustee, October 27, 2004. (Incorporated by reference to
Exhibit 10.4 to Registrant's Current Report on Form 8-K filed
with the Commission on November 1, 2004.)
10.1 Stock Option and Appreciation Right Plan. (Incorporated by
reference to the Registrant's Registration Statement N0.
333-25855, on form S-8 filed with the Commission on April 5,
1997).
10.2 Outside Directors' Stock Option Plan. (Incorporated by
reference to the Registrant's Registration Statement N0.
333-25855, on form S-8 filed with the Commission on April 5,
1997).
10.3 Employment agreement between Royal Bancshares of Pennsylvania,
Inc. and Joseph P. Campbell, President and Chief Executive
Officer, entered into on April 23, 2004. (Incorporated by
reference to Exhibit 10.1 to Registrant's Quarterly Report on
Form 10-Q filed with the Commission on November 9, 2004.)
94
10.4 Employment agreement between Royal Bancshares of Pennsylvania,
Inc. and James J. McSwiggan, Executive Vice President, entered
into on April 23, 2004. (Incorporated by reference to Exhibit
10.3 to Registrant's Quarterly Report on Form 10-Q filed with
the Commission on November 9, 2004.)
10.5 Employment agreement between Royal Bank America and Robert R.
Tabas, entered into on April 23, 2004. (Incorporated by
reference to Exhibit 10.6 to Registrant's Quarterly Report on
Form 10-Q filed with the Commission on November 9, 2004.)
10.6 Employment agreement between Royal Bancshares of Pennsylvania,
Inc. and Murray Stempel, Senior Vice President, entered into
on April 23, 2004. (Incorporated by reference to Exhibit 10.4
to Registrant's Quarterly Report on Form 10-Q filed with the
Commission on November 9, 2004.)
10.7 Employment agreement between Royal Bancshares of Pennsylvania,
Inc. and John Decker, Senior Vice President, entered into on
April 23, 2004. (Incorporated by reference to Exhibit 10.2 to
Registrant's Quarterly Report on Form 10-Q filed with the
Commission on November 9, 2004.)
10.8 Employment agreement between Royal Bank America and Edward
Shin, entered into on April 23, 2004. (Incorporated by
reference to Exhibit 10.5 to Registrant's Quarterly Report on
Form 10-Q filed with the Commission on November 9, 2004.)
11. Statement Re: Computation of Earnings Per Share. (Included at
Item 8, hereof, Note K, "Per Share Information".)
12. Statements re: Computation of Ratios. (Included at Item 8 here
of, Note P, "Regulatory Matters.")
14. Royal Bancshares of Pennsylvania, Inc. Code of Ethics.
21. Subsidiaries of Registrant.
23.1 Consent of Independent Accountants from Beard Miller Company
LLP.
23.2 Consent of Independent Accountants Grant Thornton LLP.
31.1 Rule 13a-14(a)/15-d-14(a) Certification of Chief Executive
Officer
31.2 Rule 13a-14(a)/15-d-14(a) Certification of Chief Financial
Officer
32.1 Section 1350 Certification of Chief Executive Officer.
32.2 Section 1350 Certification of Chief Financial Officer.
99.1 Opinion letter of Independent Accounts Grant Thornton LLP.
95