UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 . --------------------------------------- [ ] 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 000-23815 ------------ REGENCY BANCORP --------------- (Exact name of registrant as specified in its charter) CALIFORNIA 77-0378956 ---------- ---------- (State or other jurisdiction of (I.R.S. Employer Incorporation or organizations) Identification No.) 7060 N. FRESNO STREET, FRESNO, CALIFORNIA 93720 ----------------------------------------- ----- (Address of principal executive offices) (Zip code) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (209) 438-2600. ---------------- None ---- (Former name, former address and fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for the 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 . ---- ---- As of July 28,1998, the registrant had 2,624,374 shares of Common Stock outstanding. The Exhibit Index is located on page 37. This report contains a total of 47 pages of which this is page one. REGENCY BANCORP TABLE OF CONTENTS PART I. FINANCIAL INFORMATION PAGE Item 1. Financial Statements (unaudited) Consolidated Balance Sheets June 30, 1998, and December 31, 1997. . . . . . . . . . . . . . . . . . 3 Consolidated Statements of Income and Comprehensive Income Three Months Ended and Six Months Ended June 30, 1998 and 1997 . . . . 4 Consolidated Statements of Shareholders' Equity Six Months Ended June 30, 1998 and 1997 . . . . . . . . . . . . . . . . 5 Consolidated Statements of Cash Flows Six Months Ended June 30, 1998 and 1997 . . . . . . . . . . . . . . . . 6 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . 11 PART II. OTHER INFORMATION Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Item 2. Changes in Securities . . . . . . . . . . . . . . . . . . . . . . . . 34 Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . . . . 34 Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . 34 Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Item 6. Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . . . 35 2 REGENCY BANCORP AND SUBSIDIARIES PART I ITEM 1. FINANCIAL INFORMATION CONSOLIDATED BALANCE SHEETS (UNAUDITED) (IN THOUSANDS, EXCEPT SHARE DATA) JUNE 30, 1998 DECEMBER 31, 1997 - ---------------------------------------------------------------------------------------------------- ASSETS Cash and due from banks $ 13,608 $ 16,893 Federal funds sold 3,500 3,000 - ---------------------------------------------------------------------------------------------------- Total Cash and Equivalents 17,108 19,893 - ---------------------------------------------------------------------------------------------------- Interest bearing deposits in other banks 76 232 Securities available-for-sale 37,098 36,986 Loans 142,381 129,635 Allowance for credit losses (2,614) (2,219) Deferred loan fees & discounts (979) (986) - ---------------------------------------------------------------------------------------------------- Net Loans 138,788 126,430 - ---------------------------------------------------------------------------------------------------- Investments in real estate - 4,338 Other real estate owned 572 503 Cash surrender value of life insurance 3,108 3,038 Premises and equipment, net 1,639 1,751 Accrued interest receivable and other assets 7,243 5,070 - ---------------------------------------------------------------------------------------------------- Total Assets $ 205,632 $ 198,241 - ---------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest bearing transaction accounts $ 44,448 $ 46,744 Interest bearing transaction accounts 51,731 48,616 Savings accounts 38,546 36,498 Time Deposits $100,000 and over 31,524 28,643 Other time deposits 16,069 15,778 - ---------------------------------------------------------------------------------------------------- Total Deposits 182,318 176,279 Short term borrowings - - Notes Payable and capital lease obligation 528 509 Other liabilities 2,868 2,719 - ---------------------------------------------------------------------------------------------------- Total Liabilities $ 185,714 $ 179,507 - ---------------------------------------------------------------------------------------------------- Commitments and contingent liabilities (Note 6) Shareholders' Equity: Preferred stock, no par value; 1,000,000 shares authorized; no shares issued or outstanding Common stock, no par value; 5,000,000 shares authorized, 2,624,374 and 2,621,125 shares 15,229 15,203 issued and outstanding in 1998 and 1997, respectively 4,475 3,327 Retained earnings 214 204 Net unrealized gain on available-for-sale securities, net of taxes of $155 in 1998 and $148 in 1997 - ---------------------------------------------------------------------------------------------------- Total Shareholders' Equity 19,918 18,734 - ---------------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $ 205,632 $ 198,241 - ---------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------- See notes to consolidated financial statements 3 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (UNAUDITED) - ------------------------------------------------------------------------------------------------------------------ (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) FOR THE THREE MONTHS FOR THE SIX MONTHS - ------------------------------------------------------------------------------------------------------------------ ENDED JUNE 30, ENDED JUNE 30, - ------------------------------------------------------------------------------------------------------------------ 1998 1997 1998 1997 - ------------------------------------------------------------------------------------------------------------------ INTEREST INCOME Loans (including fees) $ 4,111 $ 2,904 $ 7,654 $ 5,704 Investment securities: Taxable 431 580 907 1,094 Tax exempt 80 34 151 54 - ------------------------------------------------------------------------------------------------------------------ Total Investment Interest Income 511 614 1,058 1,148 Other 72 141 106 255 - ------------------------------------------------------------------------------------------------------------------ Total Interest Income 4,694 3,659 8,818 7,107 - ------------------------------------------------------------------------------------------------------------------ INTEREST EXPENSE Interest on deposits 1,292 1,310 2,534 2,569 Other 21 20 62 40 - ------------------------------------------------------------------------------------------------------------------ Total Interest Expense 1,313 1,330 2,596 2,609 - ------------------------------------------------------------------------------------------------------------------ Net interest income 3,381 2,329 6,222 4,498 Provision for credit losses 150 835 275 835 - ------------------------------------------------------------------------------------------------------------------ Net interest income after provision for credit losses 3,231 1,494 5,947 3,663 - ------------------------------------------------------------------------------------------------------------------ NONINTEREST INCOME Gain-on-sale of loans 207 216 222 486 Depositor service charges 118 96 230 194 Income from investment management services 229 188 445 402 Gain (loss) on-sale of securities - (36) 5 (34) Gain-on-sale of assets - - - 4 Servicing fees on loans sold 10 81 79 167 Other 112 74 182 181 - ------------------------------------------------------------------------------------------------------------------ Total Noninterest Income 676 619 1,163 1,400 - ------------------------------------------------------------------------------------------------------------------ NONINTEREST EXPENSE Loss from investments in real estate 221 3,350 214 3,590 Salaries and related benefits 1,245 1,233 2,441 2,397 Occupancy 379 411 739 814 FDIC insurance and regulatory assessments 115 22 228 44 Marketing 144 142 270 232 Professional services 159 157 331 278 Director's fees and expenses 46 80 99 176 Management fees for real estate projects - 4 - 112 Supplies, telephone & postage 83 84 164 163 Other 423 323 633 545 - ------------------------------------------------------------------------------------------------------------------ Total Noninterest Expense 2,815 5,806 5,119 8,351 - ------------------------------------------------------------------------------------------------------------------ Income before income taxes (benefit) 1,092 (3,693) 1,991 (3,288) Provision (benefit) for income taxes 463 (1,551) 843 (1,381) - ------------------------------------------------------------------------------------------------------------------ Net Income/(loss) 629 (2,142) 1,148 (1,907) Other comprehensive income, net of tax: Unrealized gain on securities 5 215 10 74 - ------------------------------------------------------------------------------------------------------------------ Comprehensive income/(loss) $ 634 $ (1,927) $ 1,158 $ (1,833) Earnings (loss) per common share $ .24 $ (1.15) $ .44 $ (1.03) Basic $ .22 $ (1.15) $ .41 $ (1.03) Diluted Shares on which earnings per common share were based 2,624,000 1,859,000 2,623,000 1,845,000 Basic 2,807,000 1,859,000 2,796,000 1,845,000 Diluted - ------------------------------------------------------------------------------------------------------------------ See notes to consolidated financial statements 4 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED) - -------------------------------------------------------------------------------------------------------------------------- FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997 - -------------------------------------------------------------------------------------------------------------------------- Common Common Net Stock Stock Retained Unrealized (In thousands) Number of Shares Amount Earnings Gain (Loss) Total - -------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1996 1,818 $ 8,868 $ 4,601 $ 1 $ 13,470 - -------------------------------------------------------------------------------------------------------------------------- Issuance of common stock to employee stock ownership plan 36 333 - - 333 Issuance of common stock under stock option plan 17 75 - - 75 Net change in unrealized gain on available-for-sale securities net of taxes of $53,000 - - - 74 74 Net (loss) - - (1,907) - (1,907) - -------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 1997 1,871 $ 9,276 $ 2,694 $ 75 $ 12,045 - -------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------- Common Common Net Stock Number of Stock Retained Unrealized (In thousands) Shares Amount Earnings Gain (Loss) Total - -------------------------------------------------------------------------------------------------------------------------- Balance, December 31, 1997 2,621 $ 15,203 $ 3,327 $ 204 $ 18,734 - -------------------------------------------------------------------------------------------------------------------------- Issuance of common stock under stock option plan 3 26 - - 26 Net change in unrealized gain on available-for-sale securities net of taxes of $7,000 - - - 10 10 Net Income - - 1,148 - 1,148 - -------------------------------------------------------------------------------------------------------------------------- Balance, June 30, 1998 2,624 $ 15,229 $ 4,475 $ 214 $ 19,918 - -------------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------------- See notes to consolidated financial statements 5 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - ---------------------------------------------------------------------------------------------------- (IN THOUSANDS) FOR THE SIX MONTHS ENDED JUNE 30, 1998 1997 - ---------------------------------------------------------------------------------------------------- OPERATING ACTIVITIES: Increase (decrease) in cash equivalents: Net income/(loss) $ 1,148 $ (1,907) Adjustments: Provision for credit losses 275 835 Provision for losses on real estate - 635 Provision for OREO losses 131 29 Depreciation and amortization 263 315 Deferred income taxes 359 (286) (Increase) decrease in interest receivable and other assets (188) 1,096 Increase in surrender value of life insurance (70) (65) Distributions of income from real estate partnerships 213 7 Equity in loss of real estate partnerships 38 218 Decrease in real estate held for sale 4,087 4,169 Increase (decrease) in other liabilities 168 (1,392) Gain on sale of loans held-for-sale (221) (227) Proceeds from sale of loans held-for-sale 7,481 5,587 Additions to loans held-for-sale (10,202) (3,884) Gain on sale of premises and equipment and OREO - (6) Loss on sale of furniture and equipment - 16 (Gain)/loss on sale of investment securities (5) 36 - ---------------------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities 3,477 5,176 - ---------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES: Purchase of available-for-sale securities (12,422) (12,820) Proceeds from sales of available-for-sale securities 5 2,102 Proceeds from maturities of available-for-sale securities 12,283 6,848 Net increase in loans (12,686) (12,159) Net decrease (increase) in other short-term investments 156 98 Proceeds from sale of OREO 444 203 Capital distributions from real estate partnerships - 200 Purchases of premises and equipment (107) (82) Proceeds from sale of premises and equipment - 34 - ---------------------------------------------------------------------------------------------------- Net cash provided by (used in) investing activities (12,327) (15,576) - ---------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES: Net increase in time deposits accounts 3,171 13,875 Net increase (decrease) in other deposits 2,868 (2,815) Payments on notes payable - (4,610) Proceeds from notes payable - 2,179 Proceeds from the issuance of common stock under employee stock option plan 26 75 Proceeds from the issuance of common stock to employee stock ownership plan - 333 - ---------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 6,065 9,037 - ---------------------------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (2,785) (1,363) - ---------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 19,893 19,833 - ---------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD 17,108 $ 18,470 - ---------------------------------------------------------------------------------------------------- CASH PAID DURING THE PERIOD: Interest $ 2,875 $ 1,762 Income taxes 28 - SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Transfer of loans held-for-sale to accounts receivable 2,350 - Transfer of loans to other real estate owned 644 233 - ---------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------- See notes to consolidated financial statements 6 REGENCY BANCORP AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. - BASIS OF PRESENTATION The accompanying consolidated financial statements include the accounts of Regency Bancorp and its wholly-owned subsidiaries (the "Company"). Regency Bancorp is a California corporation organized to act as the holding company for Regency Bank (the "Bank") and Regency Investment Advisors, Inc. ("RIA"). RIA provides investment management and consulting services. The Bank has one wholly-owned subsidiary, Regency Service Corporation, a California corporation ("RSC"), that has engaged in the business of real estate development primarily in the Fresno/Clovis area. All significant intercompany balances and transactions have been eliminated in consolidation. These unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles on a basis consistent with the accounting policies reflected in the audited consolidated financial statements of the Company included in the Annual Report on Form 10-K for the year ended December 31, 1997. They do not, however, include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments (all of which are of a normal, recurring nature) necessary for a fair presentation of the results for the interim periods presented. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for any other interim period or for the year as a whole. NOTE 2. - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting of Comprehensive Income." This Statement requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. This Statement also requires that an entity classify items of other comprehensive earnings by their nature in an annual financial statement. Accordingly, the Company included unrealized gains and losses on available-for-sale securities in comprehensive earnings in the accompanying statement of operations for the three and six months ended June 30, 1998 and 1997. In June 1997, the FASB adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for an enterprises business segments and related disclosures about its products, services, geographic areas and major customers. This Statement is effective for fiscal years after December 15, 1997. In the initial year of adoption, the Statement applies to annual financial statements only and does not apply to interim financial statements. In the year subsequent to adoption, interim financial statements will be required to include segment information. Adoption 7 of this Statement will not impact the Company's consolidated financial position, results of operations or cash flows. NOTE 3. - Investment Securities During the period between December 31, 1997, and June 30, 1998, the Company recorded a net increase in the value of its available-for-sale portfolio of $10,000 net of applicable taxes. This change is reflected as a change in shareholders' equity in the Consolidated Statement of Shareholders' Equity. Following is a comparison of the amortized cost and approximate fair value of securities available-for-sale: - -------------------------------------------------------------------------------- AVAILABLE-FOR-SALE SECURITIES JUNE 30, 1998 DECEMBER 31, 1997 - -------------------------------------------------------------------------------- Amortized Fair Amortized Fair (In thousands) Cost Value Cost Value - -------------------------------------------------------------------------------- U.S. Treasuries $ 2,000 $ 2,002 $ 2,007 $ 2,012 U.S. Government Agencies 16,449 16,520 17,431 17,489 Mortgage-backed securities 11,157 7,104 11,541 11,647 State and Political Subdivisions 6,909 11,258 5,441 5,624 Equity Securities 214 214 214 214 - -------------------------------------------------------------------------------- Total $ 36,729 $ 37,098 $ 36,634 $ 36,986 - -------------------------------------------------------------------------------- At June 30, 1998 and December 31, 1997, the Company held no securities classified as held-to-maturity. 8 NOTE 4. - LOANS The following table presents a breakdown of the Company's loan portfolio in both dollars outstanding, as well as, a percentage of total loans. Further discussion of the Company's loan portfolio can be found in "Item No. 2 - -Management's Discussion and Analysis of Financial Condition and Results of Operations - Balance Sheet Analysis". - --------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT PERCENTAGES) JUNE 30, 1998 DECEMBER 31, 1997 - --------------------------------------------------------------------------------------------- Percent of Percent of Amount Total Loans Amount Total Loans - --------------------------------------------------------------------------------------------- Commercial $ 92,438 64.9% $ 75,487 58.3% Real estate mortgage 17,181 12.1% 14,900 11.5% Real estate construction 22,972 16.1% 30,128 23.2% Consumer and other 9,790 6.9% 9,120 7.0% Subtotal $142,381 100.0% $ 129,635 100.0% - --------------------------------------------------------------------------------------------- Less: Unearned discount 547 623 Deferred loan fees 432 363 Allowances for credit losses 2,614 2,219 - --------------------------------------------------------------------------------------------- Total loans, net $138,788 $ 126,430 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- NOTE 5. - EARNINGS PER SHARE Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted average common shares outstanding during the period plus potential common shares outstanding. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. Diluted loss per common share is equal to basic loss per common share for the three and six month periods ended June 30, 1997 because the effect of potentially dilutive securities under the stock option plans were antidilutive. 9 The following table provides a reconciliation of the numerator and denominator of the basic EPS computation with the numerator and denominator of the diluted EPS computation for the three and six month periods ended June 30, 1998 and 1997: - --------------------------------------------------------------------------------------------------------------- FOR THE THREE MONTHS FOR THE SIX MONTHS (IN THOUSANDS, EXCEPT PER SHARE DATA) ENDED JUNE 30, ENDED JUNE 30, - ------------------------------------------------- ----------------------- ---------------------- 1998 1997 1998 1997 - ------------------------------------------------- ---------- --------- --------- --------- Basic EPS Computation: Net income (loss) $ 629 $ (2,142) $ 1,148 $ (1,907) Average common shares outstanding 2,624,000 1,859,000 2,623,000 1,845,000 - ------------------------------------------------- ---------- --------- --------- --------- Basic EPS $ .24 $ (1.15) $ .44 $ (1.03) - ------------------------------------------------- ---------- --------- --------- --------- Diluted EPS Computation: Net income (loss) $ 629 $ (2,142) $ 1,148 $ (1,907) Average common shares outstanding 2,624,000 1,859,000 2,623,000 1,845,000 Stock options and warrants 183,000 - 173,000 - - ------------------------------------------------- ---------- --------- --------- --------- 2,807,000 1,859,000 2,796,000 1,845,000 - ------------------------------------------------- ---------- --------- --------- --------- Diluted EPS $ .22 $ (1.15) $.41 $ (1.03) - ------------------------------------------------- ---------- --------- --------- --------- - ------------------------------------------------- ---------- --------- --------- --------- Options to purchase 40,000 and 70,000 shares of common stock at various prices per share were outstanding at June 30, 1998 and 1997, respectively, but were not included in diluted EPS because the options exercise price was greater than the average market price of the common shares for the periods then ended. NOTE 6. - COMMITMENTS AND CONTINGENT LIABILITIES As a result of an examination of the Bank as of June 30, 1997, the FDIC determined that the Company required special supervisory attention. The Bank consented to an FDIC Order on October 28, 1997. The FDIC Order is a "cease-and-desist order" for the purposes of Section 8 of the Federal Deposit Insurance Act, and violation of the FDIC Order by the Bank can give rise to enforcement proceedings under Section 8 of the Federal Deposit Insurance Act. In addition, as a result of an examination of the Bank as of June 30, 1997, the California Department of Financial Institutions ("CDFI") and the Bank have stipulated to the issuance of the State Order by the Department of Financial Institutions which State Order is a final order pursuant to Section 1913 of the California Financial Code. These orders, their specific conditions, and the Banks actions to comply are discussed in greater detail under the heading "Administrative Orders" on pages 12 and 13, below. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain matters discussed in this Report on Form 10-Q are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties include, but are not limited to, those described in Management's Discussion and Analysis of Financial Condition and Results of Operations. Changes to such risks and uncertainties, which could impact future financial performance, include, among other things, (1) competitive pressures in the banking industry; (2) changes in the interest rate environment; (3) general economic conditions, either nationally or regionally; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; and (6) changes in security markets. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company and the Bank. FINANCIAL SUMMARY The first six months of 1998 were marked by substantially improved earnings, record asset levels, record loan levels, and the reduction of RSC's real estate investment assets from $11 million at June 30, 1997 to a net balance of $0 at June 30, 1998. Additionally, RIA's client assets under management topped $100 million for the first time, the Bank took steps to become both a Federal Reserve and Federal Home Loan Bank member, and Regency Bancorp stock began trading on the Nasdaq national market system. At June 30, 1997, RSC held 260 single family real estate units for sale representing assets of $11,000,000. During the last twelve months, RSC has sold 255 of these homes and lots leaving five units remaining at June 30, 1998. More importantly the carrying value of the five units remaining has been reduced to $0 on the Company's books. This is the first time since the end of 1984, thirteen and a half years ago, that the Company has not carried real estate investment assets on its balance sheet. The reduction of RSC's holdings has allowed the Company to increase its earning assets, most significantly in the loan portfolio. Total loans increased to $142,381,000 at June 30, 1998, up 9.9% from year-end and up 26.6% in the last twelve months. During the last twelve months ending June 30, 1998, interest earning assets have increased by $27,200,000, while the Company's total assets have grown by $18,700,000 reaching a record $205,632,000 at quarter end. The tremendous growth in loans and other earning assets has allowed the Company to improve its interest margin and subsequently its bottom line income. For the first six months ending June 30, 1998, consolidated net income totaled $1,148,000 compared to a net loss of $(1,907,000) for the period ended June 30, 1997, an increase of $3,052,000. Net income for the second quarter of 1998 increased to $629,000 as compared to a net loss of $(2,142,000) in the second quarter of 1997. Earnings/(loss) per weighted average common share were $.24 for the second quarter of 1998 and $.44 for the first six months of 1998, compared to a $(1.15) per share loss in the second quarter of 1997 and $(1.03) for the six month period ended 11 June 30, 1997. The Company paid no cash dividends in either the second quarter of 1998 or 1997. The Company's return on average assets improved to 1.19% for the first six months of 1998 compared to (2.12)% for the first six months of 1997. Return on average common equity for the first six months of 1998 was 12.0% compared to (27.8)% for the same period in 1997. In addition to improving the revenue side of the income statement, management and staff have focused attention on expenses with the goal to continually improve efficiency by controlling operating expense as the Company grows. Over the past year, operating efficiency has shown steady improvement. Noninterest expense to average assets, one measurement of efficiency, has dropped from 9.28% for the first six months of 1997 to 5.31% for the first six months of 1998. Detail for the various expense items that make up total noninterest expense can be found on pages 23 and 24. At June 30, 1998, the Company's total risk-based capital ratio was 14.90% while the leverage ratio was 9.20%. During the second quarter of 1998, the Bank filed an application to become a member of the Federal Reserve System. In May 1998, the Federal Reserve Bank ("FRB") conducted a pre-membership examination and concurrently the California Department of Financial Institutions ("CDFI") conducted their regularly scheduled exam as well. Based upon the comments made at the conclusion of the examination, the Bank anticipates becoming a member of the Federal Reserve System during the third quarter of 1998. Additionally, management anticipates that the administrative orders, described below, will be removed prior to year end 1998. ADMINISTRATIVE ORDERS As a result of an examination of the Bank as of June 30, 1997, the FDIC determined that the Company required special supervisory attention. The Bank consented to an FDIC Order on October 28, 1997. The FDIC Order is a "cease-and-desist order" for the purposes of Section 8 of the Federal Deposit Insurance Act, and violation of the FDIC Order by the Bank can give rise to enforcement proceedings under Section 8 of the Federal Deposit Insurance Act. The FDIC Order provides that the Bank must: (a) retain qualified management; (b) increase on or before December 31, 1997, and thereafter maintain Tier 1 capital equal to the greater of $14,000,000 or the equivalent of a Tier 1 capital to average assets ratio of at least 7.0%; (c) eliminate from its books classified assets not previously collected or charged off; (d) not extend additional credit to borrowers with previous classified or charged off credits which are uncollected; (e) not engage in any activities not permissible for a national bank subsidiary, except that the Bank and RSC may continue real estate activities as permitted by the FDIC's letter of November 29, 1996, to the Bank requiring, among other things, that RSC divest all properties held by it not later than December 31, 1998; (f) review the adequacy of the Bank's allowance for loan and lease losses and establish a comprehensive policy for determining its adequacy on a quarterly basis; (g) develop a plan to control overhead and other expenses and restore the Bank to profitability; (h) prepare a business/strategic plan for the operation of the Bank acceptable to the FDIC; (i) not pay cash dividends in any amount except with the prior written consent of the FDIC and the CDFI; and (j) furnish quarterly written progress reports to 12 the FDIC and the CDFI detailing the form and manner of any actions taken to comply with the Administrative Orders. As a result of an examination of the Bank as of June 30, 1997, the CDFI and the Bank have stipulated to the issuance of the State Order by the Department of Financial Institutions which State Order is a final order pursuant to Section 1913 of the California Financial Code. The State Order provides that the Bank must: (a) retain management and maintain a Board of Directors for the Bank and RSC acceptable to the CDFI and FDIC; (b) increase and maintain tangible shareholders' equity (shareholders' equity less intangible assets) to an amount not less than the greater of (i) 7% of its tangible assets (total assets less intangible assets) or (ii) $14,000,000; (c) maintain an adequate allowance for loan and lease losses; (d) cause RSC to maintain an adequate reserve for losses on its real estate investments; (e) cause RSC to reduce the assets classified as substandard so that the amount of such assets shall not exceed $10,115,000 by December 31, 1997, $8,750,000 by March 31, 1998, $7,100,000 by June 30, 1998 and $4,900,000 by September 30, 1998; (f) develop, adopt and implement a plan acceptable to the CDFI for divestiture of RSC and all of RSC's real estate investments by not later than December 31, 1998; (g) not make any distribution to shareholders except with the prior written approval of the CDFI; and (h) furnish written progress reports within thirty (30) days after the end of each quarter to the CDFI and the FDIC describing actions to comply with the State Order. As of the date of this Form 10-Q, the Company and the Bank have taken certain actions to comply with the Administrative Orders, which included raising capital through a private offering, which closed in the fourth quarter of 1997. Based upon comments made at the conclusion of the FRB/CDFI joint examination in the second quarter of 1998, management believes the Bank is in full compliance with the orders and anticipates the orders being removed prior to year-end 1998. NET INTEREST INCOME The Company's operating results depend primarily on net interest income (the difference between the interest earned on loans and investments less interest expense on deposit accounts and borrowings). A primary factor affecting the level of net interest income is the Company's interest rate margin, the difference between the yield earned on interest earning assets and the rate paid on interest bearing liabilities, as well as the difference between the relative amounts of average interest earning assets and interest bearing liabilities. The following table presents, for the periods indicated, the Company's total dollar amount of interest income from average interest earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities and the resultant cost, expressed both in dollars and rates. The table also sets forth the net interest income and the net earning balance for the periods indicated. 13 CONSOLIDATED AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND INTEREST RATES - --------------------------------------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT FOR PERCENTAGES) FOR THE THREE MONTHS ENDED JUNE 30, 1998 1997 - --------------------------------------------------------------------------------------------------------------------------- Average Yield/ Average Yield/ Balance Rate Interest Balance Rate Interest - --------------------------------------------------------------------------------------------------------------------------- ASSETS Interest-earning assets: Loans (1) $ 137,823 11.96% $ 4,111 $ 105,732 11.02% $ 2,904 Investment securities (2) 34,140 6.01% 511 37,381 6.59% 614 Federal funds sold & other 5,315 5.49% 72 10,274 5.50% 141 - --------------------------------------------------------------------------------------------------------------------------- Total Interest-earning assets $ 177,278 10.62% $ 4,694 $ 153,387 9.57% $ 3,659 - --------------------------------------------------------------------------------------------------------------------------- Noninterest-earning assets: Allowance for credit losses (2,386) (1,677) Cash and due from banks 11,486 9,000 Real estate investments 1,118 15,453 OREO 872 409 Premises and equivalent, net 1,678 2,143 Cash surrender value of life insurance 3,086 2,949 Accrued interest receivable and other assets 4,967 4,570 - --------------------------------------------------------------------------------------------------------------------------- Total Average Assets $ 198,099 $ 186,234 - --------------------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities: Transaction accounts $ 48,977 2.35% $ 286 $ 48,913 2.50% $ 305 Savings accounts 37,849 4.04% 381 33,552 4.04% 338 Time deposits 46,532 5.38% 625 48,590 5.51% 667 Federal funds purchased , notes payable and other 522 16.48% 21 3,864 2.08% 20 - --------------------------------------------------------------------------------------------------------------------------- Total Interest-bearing liabilities $ 133,880 3.94% $ 1,313 $ 134,919 3.95% $ 1,330 - --------------------------------------------------------------------------------------------------------------------------- Noninterest-bearing liabilities: Transaction accounts 41,416 35,042 Other liabilities 3,140 2,257 - --------------------------------------------------------------------------------------------------------------------------- Total liabilities 178,436 172,218 Shareholders' Equity: Common stock 15,230 9,208 Retained earnings 4,243 4,922 Unrealized gain / (loss) on investment securities 190 (114) - --------------------------------------------------------------------------------------------------------------------------- Total Shareholders Equity 19,663 $ 14,016 - --------------------------------------------------------------------------------------------------------------------------- Total average liabilities and shareholders' equity $ 198,099 $ 186,234 - --------------------------------------------------------------------------------------------------------------------------- Net Interest Income $ 3,381 $ 2,329 - --------------------------------------------------------------------------------------------------------------------------- Interest income as a percentage of average interest-earning assets 10.62% 9.57% Interest expense as a percentage of average interest-earning assets (2.97%) (3.48%) - --------------------------------------------------------------------------------------------------------------------------- Net Interest Margin 7.65% 6.09% - --------------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------------- (1) Loan amounts include nonaccrual loans, but the related interest income has been included only for the period prior to the loan being placed on a nonaccrual basis. Loan interest income includes loan fees of approximately $298,000 and $320,000 for the three months ended June 30, 1998 and 1997, respectively. (2) Applicable nontaxable securities yields have not been calculated on a taxable-equivalent basis because they are not material to the Company's results of operations. 14 CONSOLIDATED AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND INTEREST RATES - --------------------------------------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT FOR PERCENTAGES) FOR THE THREE MONTHS ENDED JUNE 30, 1998 1997 - --------------------------------------------------------------------------------------------------------------------------- Average Yield/ Average Yield/ Balance Rate Interest Balance Rate Interest - --------------------------------------------------------------------------------------------------------------------------- ASSETS Interest-earning assets: Loans (1) $ 134,362 11.49% $7,654 $ 104,159 11.04% $ 5,704 Investment securities (2) 34,881 6.12% 1,058 35,092 6.60% 1,148 Federal funds sold & other 3,969 5.39% 106 9,532 5.39% 255 - --------------------------------------------------------------------------------------------------------------------------- Total Interest-earning assets $ 173,212 10.26% $ 8,818 $ 148,783 9.63% $ 7,107 - --------------------------------------------------------------------------------------------------------------------------- Noninterest-earning assets: Allowance for credit losses (2,335) (1,675) Cash and due from banks 11,056 8,834 Real estate investments 1,952 15,744 OREO 686 413 Premises and equivalent, net 1,714 2,196 Cash surrender value of life insurance 3,068 2,932 Accrued interest receivable and other assets 4,917 4,260 - --------------------------------------------------------------------------------------------------------------------------- Total Average Assets 194,270 $ 181,487 - --------------------------------------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities: Transaction accounts $ 48,146 2.35% $ 561 $ 47,999 2.55% $ 607 Savings accounts 37,220 4.05% 748 31,378 4.07% 634 Time deposits 45,950 5.38% 1,225 48,690 5.50% 1,328 Federal funds purchased, notes payable and other 1,212 10.67% 62 4,259 1.89% 40 - --------------------------------------------------------------------------------------------------------------------------- Total Interest-bearing liabilities $ 132,528 3.95% $ 2,596 $ 132,326 3.98% $ 2,609 - --------------------------------------------------------------------------------------------------------------------------- Noninterest-bearing liabilities: Transaction accounts 39,733 33,021 Other liabilities 2,652 2,291 - --------------------------------------------------------------------------------------------------------------------------- Total liabilities 174,913 167,638 Shareholders' Equity: Common stock 15,217 9,096 Retained earnings 3,919 4,815 Unrealized gain / (loss) on investment securities 221 (62) - --------------------------------------------------------------------------------------------------------------------------- Total Shareholders Equity $ 19,357 $ 13,849 - --------------------------------------------------------------------------------------------------------------------------- Total average liabilities and shareholders' equity $ 194,270 $ 181,487 - --------------------------------------------------------------------------------------------------------------------------- Net Interest Income $ 6,222 $ 4,498 - --------------------------------------------------------------------------------------------------------------------------- Interest income as a percentage of average interest-earning assets 10.26% 9.63% Interest expense as a percentage of average interest-earning assets (3.02%) (3.54%) - --------------------------------------------------------------------------------------------------------------------------- Net Interest Margin 7.24% 6.09% - --------------------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------------------- (1) Loan amounts include nonaccrual loans, but the related interest income has been included only for the period prior to the loan being placed on a nonaccrual basis. Loan interest income includes loan fees of approximately $576,000 and $606,000 for the six months ended June 30, 1998, and 1997, respectively. (2) Applicable nontaxable securities yields have not been calculated on a taxable-equivalent basis because they are not material to the Company's results of operations. 15 Changes in the interest margin can be attributed to changes in the yield on interest earning assets, the rate paid on interest bearing liabilities, as well as, changes in the volume of interest earning assets and interest bearing liabilities. The following tables present the dollar amount of certain changes in interest income and expense for each major component of interest earning assets and interest bearing liabilities and the difference attributable to changes in average rates and volumes for the periods indicated. VOLUME/RATE ANALYSIS - ----------------------------------------------------------------------------------------------------- (IN THOUSANDS) FOR THE THREE MONTHS ENDED JUNE 30, 1998 COMPARED TO 1997 VOLUME (1) RATE (1) TOTAL - ----------------------------------------------------------------------------------------------------- Net Interest Earnings Variance Analysis Increase (decrease) in interest income: Loans $ 940 $ 267 $ 1,207 Investment securities (2) (51) (52) (103) Federal funds sold and other (67) (2) (69) - ----------------------------------------------------------------------------------------------------- Total 822 213 1,035 - ----------------------------------------------------------------------------------------------------- Increase (decrease) in interest expense: Transaction accounts - (19) (19) Savings accounts 43 - 43 Certificates of deposit (28) (14) (42) Federal funds purchased and other - 1 1 - ----------------------------------------------------------------------------------------------------- Total 15 (32) (17) - ----------------------------------------------------------------------------------------------------- Increase (decrease) in net interest income $ 807 $ 245 $ 1,052 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- (1) A change due to both volume and rate has been allocated to the change in volume and rate in proportion to the relationship of the dollar amount of the change in each. (2) Changes calculated on nontaxable securities have not considered tax equivalent effects. Net interest income before the provision for credit losses was $3,381,000 for the second quarter of 1998 as compared to $2,329,000 for the comparable period of 1997, an increase of $1,052,000 or 45.2%. The net interest margin for the second quarter ended June 30, 1998 was 7.65% compared to 6.09% during the comparable period in 1997. The increase in net interest income and net interest margin was primarily attributable to a larger earning asset base, as well as, a significant increase in the net interest margin. The increase in earning assets, primarily in the loan portfolio, was the result of the Bank holding new production SBA and B&I loans rather than selling these loans on the secondary market. This shift to a greater proportion of loans compared to lower yielding investments and federal funds sold resulted in the Company's earning asset yield rising to 10.62% during the second quarter of 1998, compared to 9.57% in the second quarter of 1997. The yield on earning assets was also augmented by a lower number of nonaccrual loans and the recovery of a significant amount of interest on RSC loans that had previously been on nonaccrual. This recovery of interest during 1998's second quarter had the effect of increasing the net interest margin approximately 67 basis points on average. In addition to the increase in earning assets and earning asset yield, the Company was able to lower its cost of funds primarily through the use of cash liberated from the sale of RSC's real estate investments. 16 Average interest-earning assets for the second quarter ended June 30, 1998 increased to $177,278,000 from $153,387,000 for the comparable period in 1997 an increase of $23,891,000 or 15.6%. Average loans increased by $32,091,000 to $137,823,000 representing 77.7% of average interest-earning assets for the second quarter of 1998, compared to $105,732,000 or 68.9% for the second quarter of 1997. The yield on average loans increased to 11.96% for the second quarter of 1998, from 11.02% for the comparable period in 1997, primarily due to recoveries of nonaccrued interest on RSC loans. Other interest-earning assets consist of investment securities, overnight federal funds sold and other short-term investments. These investments are maintained to meet the liquidity requirements of the Company, as well as, pledging requirements on certain deposits and typically have a lower yield than loans. The yield on investments decreased to 6.01% for the second quarter ended June 30, 1998, from 6.59% in the comparable period in 1997. On a fully tax equivalent basis the yield on investments was 6.55% for the second quarter ended June 30, 1998 compared to 6.74% for the second quarter ended June 30, 1997. The primary causes of the decline in investment yield were older, higher yielding bonds maturing and being replaced by lower yielding investments due to lower interest rates in the bond market and a flat yield curve. Excess liquidity is invested in federal funds sold on an overnight basis. During 1998, lower balances were maintained in federal funds sold in an effort to maximize the net interest margin. The yield on federal funds sold was 5.49% in the second quarter of 1998 compared to 5.50% in the comparable period in 1997. Average interest-bearing liabilities for the second quarter ended June 30, 1998 decreased to $133,880,000 from $134,919,000 for the comparable period in 1997, a decline of $1,039,000 or 0.8%. For the second quarter ended June 30, 1998, the average interest rate paid on interest-bearing liabilities decreased slightly to 3.94% from an average rate of 3.95% paid during the second quarter of 1997. - -------------------------------------------------------------------------------------------------------- (IN THOUSANDS) FOR THE SIX MONTHS ENDED JUNE 30, 1998 COMPARED TO 1997 VOLUME (1) RATE (1) TOTAL - -------------------------------------------------------------------------------------------------------- Net Interest Earnings Variance Analysis Increase (decrease) in interest income: Loans $ 1,712 $ 238 $ 1,950 Investment securities (2) (7) (83) (90) Federal funds sold and other (149) - (149) - -------------------------------------------------------------------------------------------------------- Total 1,556 155 1,711 - -------------------------------------------------------------------------------------------------------- Increase (decrease) in interest expense: Transaction accounts 2 (48) (46) Savings accounts 117 (3) 114 Certificates of deposit (74) (29) (103) Federal funds purchased and other (4) 26 22 - -------------------------------------------------------------------------------------------------------- Total 41 (54) (13) - -------------------------------------------------------------------------------------------------------- Increase (decrease) in net interest income $ 1,515 $ 209 $ 1,724 - -------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------- (1) A change due to both volume and rate has been allocated to the change in volume and rate in proportion to the relationship of the dollar amount of the change in each. (2) Changes calculated on nontaxable securities have not considered tax equivalent effects. 17 Net interest income before the provision for credit losses was $6,222,000 for the first six months of 1998 as compared to $4,498,000 for the first six months of 1997, an increase of $1,724,000 or 38.3%. The increase was primarily attributable to a larger earning asset base, as well as, an increase in the net interest margin. The increase in earning assets, primarily in the loan portfolio, was the result of the Bank retaining SBA and B&I loans rather than selling these loans on the secondary market. This shift of assets into a larger loan portfolio resulted in the Company's earning asset yield rising to 10.26% during the first six months of 1998, compared to 9.63% for the first six months of 1997. The net interest margin for the six months ended June 30, 1998 was 7.24% compared to 6.09% during the comparable period in 1997. The increased yield on earning assets and net interest margin was augmented by a lower number of nonaccrual loans and the recovery of interest that had previously been on nonaccrual. This recovery of interest during 1998's second quarter had the effect of increasing the net interest margin approximately 34 basis points on average for the first six months of 1998 Average interest-earning assets for the six months ended June 30, 1998 increased to $173,212,000 from $148,783,000 for the comparable period in 1997, an increase of $24,429,000 or 16.4%. Average loans increased by $30,203,000 to $134,362,000 representing 77.6% of average interest-earning assets for the first six months of 1998, compared to $104,159,000 or 70.0% for the first six months of 1997. The yield on average loans increased to 11.49% for the first six months of 1998, from 11.04% for the comparable period in 1997, primarily due to recoveries of nonaccrued interest on RSC loans. Other interest-earning assets consist of investment securities, overnight federal funds sold and other short-term investments. These investments are maintained to meet the liquidity requirements of the Company, as well as, pledging requirements on certain deposits and typically have a lower yield than loans. The yield on investments decreased to 6.12% for the six-month period ended June 30, 1998, from 6.60% in the comparable period in 1997. On a fully tax equivalent basis the yield on investments was 6.57% for the six months ended June 30, 1998, compared to 6.76% for the six months ended June 30, 1997. The primary cause of the decline in investment yield was lower interest rates in the bond market and a flat yield curve. Additionally, the Company increased the percentage of tax free municipal bonds held in its investment portfolio. These bonds typically carry lower coupons, however the interest earned is exempt from federal tax. Excess liquidity is invested in federal funds sold on an overnight basis. During 1998, lower balances were maintained in federal funds sold in an effort to maximize the net interest margin. The yield on federal funds sold for the first six months of 1998 and 1997 was identical at 5.39%. Average interest-bearing liabilities for the six months ended June 30, 1998 grew very little to $132,528,000 from $132,326,000 for the comparable period in 1997, an increase of $202,000 or 0.2%. For the first six months ended June 30, 1998, the average interest rate paid on interest-bearing liabilities decreased to 3.95% from an average rate of 3.98% paid during the first six months of 1997. 18 NONINTEREST INCOME The Company receives a significant portion of its income from noninterest sources related both to activities conducted by the Bank (SBA loan originations and servicing and depositor service charges), as well as, from the Company's investment advisory firm, RIA. - ------------------------------------------------------------------------------------------------------------------ FOR THE THREE MONTHS FOR THE SIX MONTHS (IN THOUSANDS) ENDED JUNE 30, ENDED JUNE 30, - --------------------------------------------------- --------- ------------ ------------ ------------- 1998 1997 1998 1997 - --------------------------------------------------- --------- ------------ ------------ ------------- Other Noninterest Income: Gain-on-sale of loans $ 207 $ 216 $ 222 $ 486 Depositor service charges 118 96 230 194 Income from investment management services 229 188 445 402 Gain/(loss)-on-sale of securities - (36) 5 (34) Gain-on-sale of assets - - - 4 Servicing fees on loans sold 10 81 79 167 Other 112 74 182 181 - --------------------------------------------------- --------- ------------ ------------ ------------- Total $ 676 $ 619 $ 1,163 $ 1,400 - --------------------------------------------------- --------- ------------ ------------ ------------- - --------------------------------------------------- --------- ------------ ------------ ------------- During the second quarter of 1998, the Company recognized noninterest income of $676,000, compared to $619,000 for the same period in 1997, an increase of $57,000 or 9.2%. For the first six months of 1998, noninterest income was $1,163,000, compared to $1,400,000 for the first six months of 1997, a decrease of $237,000 or 16.9%. The decline for the first six months was primarily attributable to lower gains on the sale of loans due to the decision to retain a larger portfolio of these loans in the Bank's loan portfolio, as well as, a decline in income from servicing fees on the loans sold. LOAN ORIGINATION & SALES The Bank originates various types of loans that may be sold on active secondary markets. Types of loans originated that are saleable include: loans made under the U.S. Small Business Administration ("SBA") program that generally provide for SBA guarantees of 70% to 90% of each loan; loans made under the U.S. Department of Agriculture's Business and Industry ("B & I") loan program; and conventional real estate mortgage loans. Historically, the majority of the Bank's gain on sale of loans has come from SBA loan sales. During 1997, the Company decided to hold the majority of SBA and B&I loans originated to more rapidly build its loan portfolio and increase interest income. From time to time the Bank evaluates the valuations available on various groups of loans and may sell groups of loans in an effort to maximize value. During the quarter ended June 30, 1998, the Bank sold one pool of SBA loans totaling approximately $2,300,000, in addition to its mortgage origination activity. Net income from loans sold in the second quarter of 1998 was $207,000 compared to $216,000 in the second quarter of 1997. For the six months ended June 30, 1998, gains on the sale of loans was $222,000 compared to $486,000 during the first six months of 1997, a decrease of $264,000. The primary cause of the decline in income from the sale of loans for the first six months of 1998 compared to the first six months of 1997 was the decision to hold a larger portfolio of SBA guaranteed loans in the Bank's portfolio. 19 An additional source of income related to the Bank's SBA loan origination activities is reflected in income from the ongoing servicing of loans sold. During the second quarter ended June 30, 1998, servicing income totaled $10,000, compared to servicing income of $81,000 during the quarter ended June 30, 1997. For the six months ended June 30, 1998, servicing income totaled $79,000, a decrease of $88,000 compared to $167,000 during the first six months of 1997. The decline in servicing income in 1998 compared to 1997 was the result of a smaller portfolio of loans serviced during 1998 and the amortization of capitalized servicing fees on previously sold loans that have pre-paid at an accelerated rate. REGENCY SERVICE CORPORATION The Bank's wholly owned subsidiary, Regency Service Corporation ("RSC"), has engaged in real estate development activities since 1986. Under FDIC regulations, banks were required to divest their real estate development investments as quickly as prudently possible but in no event later than December 19, 1996, and submit a plan to the FDIC regarding divestiture of such investments. In December 1995, the Bank and RSC submitted a request to extend the mandatory time period in which it must divest its real estate development interests. In December 1996, the FDIC, responding to the Bank's request, granted the Bank and RSC a two-year extension, until December 31, 1998, to continue its divestiture activities. During the second quarter of 1998, RSC continued its effort toward total divestiture of its real estate holdings with the sale of 14 additional homes and lots. As of June 30, 1998, RSC had only five units remaining compared to 66 units remaining at December 31, 1997 and 260 units remaining at June 30, 1997. In the quarter ended June 30, 1998, RSC recorded a loss from the sale of the 14 properties of $221,000 compared to a loss of $3,350,000 in the second quarter of 1997. When viewed on a stand-alone basis, RSC's activities (losses from the sale of properties plus operating expenses plus income) combined to produce a net loss at RSC of only $8,000 for the first six months of 1998. During the most recent quarter RSC was able to recover interest from loans previously on nonaccrual as well as $125,000 of principal from previously charged-off loans. The recovery of principal increased the Company and RSC's reserve for credit losses. Management expects that RSC's performance for the remainder of 1998 will be similar to the first six months and that any losses recorded on the sale of properties will be generally offset by income or previously established reserves. Additional discussion of loans made by RSC to facilitate the sale of its properties and, in general, of the Company's investment in RSC, is contained in this report under the headings, "Nonperforming Loans" and "Investments in Real Estate." 20 REGENCY INVESTMENT ADVISORS The Company's other wholly-owned subsidiary, Regency Investment Advisors ("RIA"), was formed in August 1993 through the acquisition by the Bank of the assets, including the client list, of a fee-only investment management and consulting firm. RIA provides investment management and consulting services, including comprehensive financial and retirement planning and investment advice to individuals and corporate clients for an annual fee that varies depending upon the size of a client account. Revenue from RIA for the second quarter of 1998 increased to $229,000 from $188,000 in the same period of 1997, an increase of $41,000 or 21.8%. On a stand alone basis, RIA's activities, (income from investment management activities less operating expenses), provided the Company with after-tax income of $37,000 in the second quarter of 1998 compared to after-tax income of $21,000 in the second quarter of 1997. For the six months ended June 30, 1998, revenue from RIA increased to $445,000 from $402,000 for the same period in 1997, an increase of $43,000 or 10.7%. On a stand alone basis, RIA's activities, (income from investment management activities less operating expenses), provided the Company with after-tax income of $69,000 for the six months ended June 30, 1998, compared to after tax income of $48,000 for the same period in 1997, and increase of 43.8%. RIA's operating expenses have been consolidated with similar operating expenses in the Company's consolidated statement of income. RIA's ability to generate and increase income comes, in large part, from the volume of assets under management. As of June 30, 1998, RIA had $100,200,000 in assets under management, an increase of $19,900,000, or 24.8% compared to $80,300,000 as of June 30, 1997. Assets in client accounts managed by RIA are not reflected in the consolidated assets of the Company. 21 SECOND QUARTER NONINTEREST EXPENSE Noninterest expense reflects the costs of products and services, systems, facilities and personnel for the Company. The major components of other operating expenses stated both as dollars and as a percentage of average assets are as follows: - ---------------------------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT PERCENTAGES) FOR THE THREE MONTHS ENDED JUNE 30, 1998 1997 - ---------------------------------------------------------------------------------------------------------------- Percent of Percent of Average Average Amount Assets Amount Assets - ---------------------------------------------------------------------------------------------------------------- Noninterest Expense: Loss from investments in real estate $ 221 .45% $ 3,350 7.21% Salaries and related benefits 1,245 2.51% 1,233 2.65% Occupancy 379 .77% 411 0.88% FDIC insurance and regulatory assessments 115 .23% 22 0.05% Marketing 144 .29% 142 0.31% Professional services 159 .32% 157 0.34% Director's fees and expenses 46 .09% 80 0.17% Management fees for real estate projects - - 4 0.01% Supplies, telephone & postage 83 .17% 84 0.18% Other 423 .86% 323 0.70% - ---------------------------------------------------------------------------------------------------------------- TOTAL $ 2,815 5.69% $ 5,806 12.50% - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- Noninterest expense decreased substantially by $2,991,000 or 51.5% to $2,815,000 for the three months ended June 30, 1998, compared to $5,806,000 during the same period of 1997. The large drop in noninterest expense between the second quarter of 1997 and 1998 was due to significantly lower losses on RSC's investment in real estate between the two periods. The loss in 1997 on investments in real estate resulted from expense for additional reserves as well as the direct writedown of properties to facilitate the rapid disposition of RSC's remaining assets. When compared to average assets for the respective periods, noninterest expense decreased to 5.69% in the second quarter of 1998 compared to 12.50% in the comparable period in 1997. The reduction of noninterest expense as a percentage of average assets is a central part of the Company's overall plan to increase earnings through improved efficiency. As a percentage of average assets, most expense categories decreased over the past twelve months. However, certain categories showed an increase; FDIC insurance and regulatory assessments increased by more than 400% or $93,000 to $115,000 for the quarter ended June 30, 1998, compared to only $22,000 during the comparable quarter in 1997. This substantial increase is the direct result of the FDIC and CDFI administrative orders, as well as, the Bank's average capital level during the third and fourth quarters of 1997. Management expects the Bank's insurance premiums to decrease during the second half of 1998 due to higher capital levels and progress made related to the disposal of RSC assets. The other category of noninterest expense increased to $423,000, for the second quarter of 1998, an increase of $100,000, or 31% from $323,000 in the comparable period of 1997. The primary cause of this increase was related to costs associated with the Bank's OREO properties which were $103,000 higher in the second quarter of 1998 compared to the same period in 1997. 22 All other noninterest expense categories declined as a percentage of average assets with salaries and related benefits, the Company's largest noninterest expense category, declining from 2.66% in the second quarter of 1997 to 2.53% in the second quarter of 1998. The Company has been able to maintain the number of full time equivalent employees at or near levels of a year ago while average assets have grown by 6.4%. NONINTEREST EXPENSE YEAR-TO-DATE - ------------------------------------------------------------------------------------------------------------------ (IN THOUSANDS, EXCEPT PERCENTAGES) FOR THE Six MONTHS ENDED JUNE 30, 1998 1997 - ------------------------------------------------------------------------------------------------------------------ Percent of Percent of Average Average Amount Assets Amount Assets - ------------------------------------------------------------------------------------------------------------------ Other Expense: Loss from investments in real estate $ 214 .22% $ 3,590 3.99% Salaries and related benefits 2,441 2.53% 2,397 2.66% Occupancy 739 .77% 814 0.90% FDIC insurance and regulatory assessments 228 .24% 44 0.05% Marketing 270 .28% 232 0.26% Professional services 331 .34% 278 0.31% Director's fees and expenses 99 .10% 176 0.20% Management fees for real estate projects - - 112 0.12% Supplies, telephone & postage 164 .17% 163 0.18% Other 633 .66% 545 0.61% - ------------------------------------------------------------------------------------------------------------------ TOTAL $ 5,119 5.31% $ 8,351 9.28% - ------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------ As with the second quarter, 1998's year-to-date noninterest expense decreased substantially primarily as a result of lower losses from investments in real estate. For the first six months of 1998, RSC's losses on real estate were $214,000, a decline of $3,376,000 or 94% from $3,590,000 in the first six months of 1997. The large losses in 1997 resulted from expense for reserves and the writedown of properties to facilitate the rapid disposition of RSC's remaining assets. FDIC insurance and regulatory assessments increased by more than 400% or $184,000 to $228,000 for the first six months of 1998, compared to $44,000 during the comparable period in 1997. This substantial increase is the direct result of the FDIC and CDFI administrative orders, as well as, the Bank's average capital level during the third and fourth quarters of 1997. Salaries and related benefits, professional services and marketing grew modestly in the six months ended June 30, 1998 compared to 1997 respectively, however, as a percentage of average assets they declined by a cumulative .08%. The Other noninterest expense category increased to $633,000, for the first six months of 1998, an increase of $88,000 compared to the first six months of 1997, as a result of higher expenses related to the sale of Bank OREO properties. Occupancy expense, director fees and expense, and management fees for real estate projects all declined. Overall, the Company's non-interest expense to average assets for the first six months of 1998 declined to 5.31% compared to 9.28% for the comparable period of 1997. 23 BALANCE SHEET ANALYSIS Total assets at June 30, 1998 were $205,632,000 an increase of 4.0% or $7,391,000 from $198,241,000 at December 31, 1997. At June 30, 1998, the Company's loan portfolio grew to $142,381,000, an increase of $12,746,000 or 9.8% since December 31, 1997. Loan growth was substantially a result of the decision to hold the majority of newly originated SBA and B&I loans, rather than sell them on the secondary market, in an effort to increase higher yielding assets and interest income. Total deposits were $182,318,000 at June 30, 1998, up $6,039,000 or 3.4% from $176,279,000 at December 31, 1997. At June 30, 1998, the Company's net investment in real estate was reduced to $0 from $4,338,000 at December 31, 1997. LOANS The three areas in which the Bank has directed virtually all of its lending activities are: (a) commercial loans; (b) real estate loans (including residential construction and mortgage loans); and (c) consumer loans. The Company's loans are primarily made within its defined market area of Fresno and Madera counties. The Bank also maintains a loan production office in Modesto, California. Commercial loans, including SBA and B&I loans, comprised approximately 64.9% of the Company's loan portfolio at June 30, 1998, compared to 58.3% at December 31, 1997 and 58.2% at June 30, 1997. These loans are generally made to small and mid-size businesses and professionals. Commercial loans are diversified as to industries and types of business with no material industry concentrations. Most of these loans have floating rates based upon underwriting analysis. The primary source of repayment on most commercial loans is cash flow from the primary business. Additional collateral in the form of real estate, cash, accounts receivable, inventory or other financial instruments is often obtained as a secondary source of repayment. Real estate construction lending comprised 16.1% of the Company's loan portfolio at June 30, 1998, compared to 23.2% of the Company's loan portfolio at December 31, 1997, and 21.4% at June 30, 1997. These loans are primarily made for the construction of single family residential housing. Loans in this category may be made to the home buyer or to the developer. Construction loans are secured by deeds of trust on the primary property. The majority of construction loans have floating rates based upon underwriting analysis. A significant portion of the borrowers' ability to repay these loans is dependent upon the sale of the property which is affected by, among other factors, the residential real estate market. In this regard, the Company's potential risks include a general decline in the value of the underlying property, as well as, cost overruns or delays in the sale or completion of a property. Real estate mortgage loans comprised 12.1% of the loan portfolio at June 30, 1998, compared to 11.5% at December 31, 1997, and 12.4% of the loan portfolio at June 30, 1997. Real estate mortgage loans are made up of approximately 75% non-residential properties and 25% single-family, residential mortgages. The non-residential loans generally are "mini-perm" (medium-term) commercial real estate mortgages with maturities under seven years. The residential mortgages are secured by first trust deeds and have varying maturities. Both types of loans may 24 have either fixed or floating rates, of which, the majority are floating. Risks associated with non-residential loans include the decline in value of commercial property values; economic conditions surrounding commercial real estate properties; and vacancy rates. The repayment of single-family residential mortgage loans is generally dependent upon the income of the borrower from other sources, however, declines in the underlying property value may create risk in these loans. Consumer loans represented the remainder of the loan portfolio at June 30, 1998, comprising 6.9% of the loan portfolio compared to 7.0% of total loans at December 31, 1997 and 8.0% at June 30, 1997. This category includes traditional consumer loans, home equity lines of credit, and Visa card loans. Consumer loans are generally secured by third trust deeds on single-family residences or personal property, while Visa cards are unsecured. RISK ELEMENTS The Company assesses and manages credit risk on an ongoing basis through stringent credit review and approval policies, extensive internal monitoring, and established formal lending policies. Additionally, the Bank contracts with an outside loan review consultant to periodically grade new loans and to review the existing loan portfolio. Management believes its ability to identify and assess risk and return characteristics of the Company's loan portfolio is critical for profitability and growth. Management strives to continue the historically low level of credit losses by continuing its emphasis on credit quality in the loan approval process, active credit administration, and regular monitoring. With this in mind, management has designed and implemented a comprehensive loan review and grading system that functions to continually assess the credit risk inherent in the loan portfolio. Additionally, management believes its ability to manage portfolio credit risk is enhanced by knowledge of the Bank's service area by the Bank's lending personnel and Board of Directors. NONPERFORMING LOANS The Company's current policy is to cease accruing interest when a loan becomes 90-days past due as to principal or interest; when the full, timely collection of interest or principal becomes uncertain; or when a portion of the principal balance has been charged off, unless the loan is well secured and in the process of collection. When a loan is placed on nonaccrual status, the accrued and uncollected interest receivable is reversed and the loan is accounted for on the cash or cost recovery method thereafter, until qualifying for return to accrual status. Generally, a loan may be returned to accrual status when all delinquent interest and principal become current in accordance with the terms of the loan agreement or when the loan is both well secured and in process of collection. At June 30, 1998, nonperforming loans amounted to $1,752,000 or 1.23% of total loans compared to $1,736,000 or 1.34% at December 31, 1997, and $2,496,000 or 2.22% at June 30, 1997. Other real estate owned was $572,000 at June 30, 1998, compared to $503,000 at December 31, 1997. Total nonperforming loans at June 30, 1998, compared to December 31, 1997, were little changed in terms of dollars outstanding, however, as a percentage of total loans, nonperformings dropped slightly as a result of growth in the loan portfolio. Of the total nonperforming loans, 25 $1,012,000 represented loans RSC made to facilitate the sale of former partnership properties that have loan to value ratios higher than would normally be made by the Bank. Without the non-accrual loans made by RSC, the Bank's loan portfolio at June 30, 1998 had $740,000 in non-accrual loans or 0.52%, compared to $598,000 in non-accrual loans or 0.46% at December 31, 1997. Of the Bank's non-accrual loans (excluding RSC loans) at June 30, 1998, $431,000 represented the portion of SBA loans that are guaranteed by the SBA. Beginning in 1997, the SBA changed the requirements for Bank's originating SBA loans which are subsequently sold in the secondary market. Under the new requirement, if a borrower defaults on an SBA guaranteed loan, the originating bank is required to buy the guaranteed portion back and hold it in its portfolio until collection efforts are exhausted. While this guaranteed portion is backed by the full faith and credit of the U.S. government and poses little risk of loss to the originating bank, the originating bank does incur loss of the use of the funds while awaiting payoff from the SBA or other loan collateral. Expense from the loss of use of the funds is expected to be minimal; however, due to this new requirement, it is expected that SBA non-accrual loan levels will be slightly higher. Following is a table presenting the nonperforming loans for the periods ending June 30, 1998 and December 31, 1997, respectively. - --------------------------------------------------------------------------------------------------------------- (IN THOUSANDS, EXCEPT PERCENTAGES) JUNE 30, 1998 DECEMBER 31, 1997 - --------------------------------------------------------------------------------------------------------------- Nonperforming Assets: Nonaccrual RSC loans $ 1,012 $ 1,138 Nonaccrual bank loans 740 598 - --------------------------------------------------------------------------------------------------------------- Nonperforming loans 1,752 1,736 Other real estate owned 572 503 - --------------------------------------------------------------------------------------------------------------- Total nonperforming assets 2,324 2,239 - --------------------------------------------------------------------------------------------------------------- Accruing loans 90 days past due 141 48 - --------------------------------------------------------------------------------------------------------------- Total loans before allowance for credit losses $ 142,381 $ 129,635 Total assets 205,632 198,241 Allowance for possible credit losses (2,614) (2,219) - --------------------------------------------------------------------------------------------------------------- Ratios: Nonperforming loans to total loans 1.23% 1.34% Nonperforming loans to total loans (excluding RSC loans) .52% .46% Nonperforming assets to: Total loans 1.63% 1.73% Total loans and OREO 1.62% 1.72% Total assets 1.13% 1.13% Allowance for possible credit losses to total nonperforming 112.47% 99.11% assets Allowance for possible credit losses to loans 1.84% 1.71% - --------------------------------------------------------------------------------------------------------------- At June 30, 1998 and December 31, 1997, the Company's recorded investments in loans for which an impairment had been recognized totaled $1,498,000 and $1,410,000, respectively. These amounts were evaluated for impairment using the fair value of collateral. At June 30, 1998, the related SFAS No. 114 allowance for credit losses considered impaired was $320,000. The Company uses the cash basis method of income recognition for impaired loans. For the six months ended June 30, 1998 and 1997, the Company did not recognize any income on such loans. 26 ALLOWANCE FOR CREDIT LOSSES The allowance for credit losses reflects management's judgment as to the level which is considered adequate to absorb potential losses inherent in the loan portfolio. This allowance is increased by provisions charged to expense and reduced by loan charge-offs net of recoveries. Management determines an appropriate provision based on information currently available to analyze credit loss potential, including: (a) the loan portfolio growth in the period, (b) a comprehensive grading and review of new and existing loans outstanding, (c) actual previous charge-offs, and (d) changes in economic conditions. The allowance for credit losses totaled $2,614,000 or 1.84% of total loans at June 30, 1998, compared to $2,219,000 or 1.71% at December 31, 1997. This increase is the result of additional provisions for credit losses of $275,000 in the six months ended June 30, 1998, along with net recoveries of previously charged off loans of $120,000. During the second quarter of 1998, RSC recovered $125,000 that had been charged off in prior years. It is the policy of management to maintain the allowance for credit losses at a level adequate for known and future risks inherent in the loan portfolio. Based on information currently available to analyze credit loss potential, including economic factors, overall credit quality, historical delinquency and a history of actual charge-offs, management believes that the credit loss provision and allowance is adequate. However, no prediction of the ultimate level of loans charged-off in future years can be made with any certainty. Following is a table presenting the activity within the Company's provision for credit losses for the period between December 31, 1997 and June 30, 1998. - ------------------------------------------------------------ (In thousands) - ------------------------------------------------------------ Balance, December 31, 1997 $ 2,219 - ------------------------------------------------------------ Provision charged to expense 275 Loans charged off (67) Recoveries 187 - ------------------------------------------------------------ Balance, June 30, 1998 2,614 - ------------------------------------------------------------ - ------------------------------------------------------------ INVESTMENTS IN REAL ESTATE The Company's investment in real estate consists of the Bank's investment of capital and retained earnings in RSC. RSC is currently the sole owner of one residential lot and is a limited partner in two projects with a total of four model homes remaining for sale. The number of units remaining for sale declined to five at June 30, 1998, from 66 at December 31, 1997, and 260 units one year ago. During the six month period ended June 30, 1998, RSC reduced its net investment in real estate to $0, from $4,067,000 at December 31, 1997 and from $10,989,000 at June 30, 1997. 27 The following table represents the condensed financial information relative to RSC for the period ending June 30, 1998 and December 31, 1997, respectively. - ------------------------------------------------------------------------------------- (IN THOUSANDS) JUNE 30, 1998 DECEMBER 31, 1997 - ------------------------------------------------------------------------------------- Financial Position: Investments in real estate Real estate held-for-sale $ 147 $ 4,420 Equity in partnerships 450 702 - ------------------------------------------------------------------------------------- Investment in real estate before allowance 597 5,122 Allowance for real estate losses (597) (1,055) - ------------------------------------------------------------------------------------- Investment in real estate $ 0 $ 4,067 - ------------------------------------------------------------------------------------- Loans to real estate partnerships and projects 1,329 1,768 Allowance for loan losses (490) (364) - ------------------------------------------------------------------------------------- Net Loans 839 1,404 - ------------------------------------------------------------------------------------- Other Assets 1,242 2,524 - ------------------------------------------------------------------------------------- Liabilities (147) (144) - ------------------------------------------------------------------------------------- Bank's investment in RSC $1,934 $ 7,851 - ------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------- FUNDING SOURCES Deposits represent the Bank's principal source of funds for investment. Deposits are primarily core deposits in that they are demand, savings, and time deposits generated from local businesses and individuals. These sources are considered to be relatively more stable, long-term deposit relationships thereby enhancing steady growth of the deposit base without major fluctuations in overall deposit balances. In order to assist in meeting its funding needs, the Bank maintains federal funds lines with correspondent banks in addition to using its investment portfolio to raise funds through repurchase agreements. In addition, the Bank may, from time to time, obtain additional deposits through the use of brokered time deposits. As of June 30, 1998, the Bank held no brokered time deposits and had no borrowings from correspondent banks against its federal funds lines. The following table presents the composition of the deposit mix for the period ending June 30, 1998 and December 31, 1997, respectively. - -------------------------------------------------------------------------------------------------------------- (IN THOUSANDS) JUNE 30, 1998 DECEMBER 31, 1997 - -------------------------------------------------------------------------------------------------------------- Percent of Percent of Amount Total Deposits Amount Total Deposits - -------------------------------------------------------------------------------------------------------------- Noninterest-bearing transaction accounts $ 44,448 24.4% $ 46,744 26.5% Now and MMI 51,731 28.3% 48,616 27.6% Savings 38,546 21.2% 36,498 20.7% Time under $100,000 16,069 8.8% 15,778 9.0% Time $100,000 and over 31,524 17.3% 28,643 16.2% - -------------------------------------------------------------------------------------------------------------- Total Interest-bearing Deposits 137,870 75.6% 129,535 73.5% - -------------------------------------------------------------------------------------------------------------- Total Deposits $182,318 100.0% $ 176,279 100.0% - -------------------------------------------------------------------------------------------------------------- 28 LIQUIDITY Liquidity management refers to the Bank's ability to provide funds on an ongoing basis to meet fluctuations in deposit levels as well as the credit needs and requirements of its clients. Both assets and liabilities contribute to the Bank's liquidity position. Federal funds lines, short-term investments and securities, and loan repayments contribute to liquidity, along with deposit increases, while loan funding and deposit withdrawals decrease liquidity. The Bank assesses the likelihood of projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual client funding needs. The Bank maintains a line of credit with a correspondent bank for up to $5,000,000 available on a short-term basis and has applied for membership to the Federal Home Loan Bank ("FHLB") which will provide additional borrowing capacity in the future. Additionally, the Bank maintains a substantial portfolio of SBA loans either available for sale or in its portfolio that could be sold should additional liquidity be required. INTEREST RATE SENSITIVITY Interest rate sensitivity is a measure of the exposure to fluctuations in the Bank's future earnings caused by fluctuations in interest rates. Generally, if assets and liabilities do not reprice simultaneously and in equal volumes, the potential for such exposure exists. It is management's objective to maintain stability in the net interest margin in times of fluctuating interest rates by maintaining an appropriate mix of interest sensitive assets and liabilities. To achieve this goal, the Bank prices the majority of its interest-bearing liabilities at variable rates. At the same time, the majority of its interest-earning assets are also priced at variable rates, the majority of which float with the Prime Rate. This pricing structure tends to stabilize the net interest margin percentage earned by the Bank. The following table sets forth the interest rate sensitivity and repricing schedule of the Company's interest-earning assets and interest-bearing liabilities, the interest rate sensitivity gap, the cumulative interest rate sensitivity gap, and the cumulative interest rate sensitivity gap ratio. - ----------------------------------------------------------------------------------------------------------------------------------- NEXT DAY AFTER THREE AFTER BUT WITHIN MONTHS ONE YEAR (IN THOUSANDS, EXCEPT PERCENTAGES) THREE BUT WITHIN BUT WITHIN AFTER AS OF JUNE 30, 1998 IMMEDIATELY MONTHS 12 MONTHS FIVE YEARS FIVE YEARS TOTAL - ----------------------------------------------------------------------------------------------------------------------------------- Interest Rate Sensitivity Gap: Loans (1) $ 52,194 $ 51,181 $ 8,617 $ 23,362 $ 5,275 $ 140,629 Investment securities and other 214 13,063 10,411 6,679 6,362 36,729 - ----------------------------------------------------------------------------------------------------------------------------------- Total Earning Assets $ 52,408 $ 64,244 $ 19,028 $ 30,041 $ 11,637 $ 177,358 - ----------------------------------------------------------------------------------------------------------------------------------- Interest-bearing transaction accounts 51,732 - - - - 51,732 Savings accounts 35,460 3,086 - - - 38,546 Time deposits - 17,045 20,331 9,297 919 47,592 Federal funds purchased - - - - - - - ----------------------------------------------------------------------------------------------------------------------------------- Total Interest-Bearing Liabilities $ 87,192 $ 20,131 $ 20,331 $ 9,297 $ 919 $ 137,870 - ----------------------------------------------------------------------------------------------------------------------------------- Interest rate sensitivity gap (34,784) 44,113 (1,303) 20,744 10,718 Cumulative gap (34,784) 9,329 8,026 28,770 39,488 Cumulative gap percentage to interest earning assets (19.61%) 5.26% 4.53% 16.22% 22.26% - ----------------------------------------------------------------------------------------------------------------------------------- (1) Amounts exclude nonaccrual loans of $1,752,000. 29 The above table indicates the time periods in which interest-earning assets and interest-bearing liabilities will mature or reprice in accordance with their contractual terms. The table does not necessarily indicate the impact of general interest rate movements on the net interest margin since the repricing of various categories of assets and liabilities is subject to competitive pressures. Additionally, this table does not take into consideration changing balances in forward periods as a result of normal amortization, principal paydowns, changes in deposit mix or other such movements of funds as a result of changing interest rate environments. CAPITAL RESOURCES The Board of Governors of the Federal Reserve System and the FDIC have adopted risk-based capital guidelines for evaluating the capital adequacy of bank holding companies and banks. The guidelines are designed to make capital requirements sensitive to differences in risk profiles among banking organizations, to take into account off-balance sheet exposures, and to aid in making the definition of bank capital uniform internationally. Under the guidelines, the Company and the Bank are required to maintain capital equal to at least 8.0% of its assets and commitments to extend credit, weighted by risk, of which at least 4.0%, must consist primarily of common equity (including retained earnings) and the remainder may consist of subordinated debt, cumulative preferred stock, or a limited amount of loan loss reserves. Assets, commitments to extend credit, and off-balance sheet items are categorized according to risk and certain assets considered to present less risk than others permit maintenance of capital at less than the 8% ratio. The guidelines establish two categories of qualifying capital: Tier 1 capital comprising core capital elements and Tier 2 comprising supplementary capital requirements. At least one-half of the required capital must be maintained in the form of Tier 1 capital. Tier 1 capital includes common shareholder's equity and qualifying perpetual preferred stock less intangible assets and certain other adjustments. However, no more than 25% of the Company's total Tier 1 capital may consist of perpetual preferred stock. The definition of Tier 1 capital for the Bank is the same, except that perpetual preferred stock may be included only if it is noncumulative. Tier 2 capital includes, among other items, limited life (and in the case of banks, cumulative) preferred stock, mandatory convertible securities, subordinated debt, and a limited amount of reserves for credit losses. The Board of Governors also adopted a 3.0% minimum leverage ratio for banking organizations as a supplement to the risk-weighted capital guidelines. The leverage ratio is generally calculated using Tier 1 capital (as defined under risk-based capital guidelines) divided by quarterly average net total assets (excluding intangible assets and certain other adjustments). The Board of Governors emphasized that the leverage ratio constitutes a minimum requirement for well-run banking organizations having diversified risk. Banking organizations experiencing or anticipating significant growth, as well as those organizations which do not exhibit the characteristics of a strong, well-run banking organization above, will be required to maintain minimum capital ranging generally from 100 to 200 basis points in excess of the leverage ratio. The FDIC adopted a substantially similar leverage ratio for state non-member banks. 30 On December 19, 1991, the President signed the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). The FDICIA, among other matters, substantially revised banking regulations and established a framework for determination of capital adequacy of financial institutions. Under the FDICIA, financial institutions are placed into one of five capital adequacy categories as follows: (1) "Well capitalized" - consisting of institutions with a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, and a leverage ratio of 5% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive; (2) "Adequately capitalized" - consisting of institutions with a total risk-based capital ratio of 8% or greater, a Tier 1 risk-based capital ratio of 4% or greater and a leverage ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution; (3) "Undercapitalized" - consisting of institutions with a total risk-based capital ratio less than 8%, a Tier 1 risk-based capital ratio of less than 4%, or a leverage ratio of less than 4%; (4) "Significantly undercapitalized" - consisting of institutions with a total risk-based capital ratio of less than 6%, a Tier 1 risk-based capital ratio of less than 3%, or a leverage ratio of less than 3%; (5) "Critically undercapitalized" - consisting of an institution with a ratio of tangible equity to total assets that is equal to or less than 2%. 31 Financial institutions classified as undercapitalized or below are subject to various limitations including, among other matters, certain supervisory actions by bank regulatory authorities and restrictions related to (a) growth of assets, (b) payment of interest on subordinated indebtedness, (c) payment of dividends or other capital distributions, and (d) payment of management fees to a parent holding company. The FDICIA requires the bank regulatory authorities to initiate corrective action regarding financial institutions which fail to meet minimum capital requirements. Such action may be taken in order to, among other matters, augment capital and reduce total assets. Critically undercapitalized financial institutions may also be subject to appointment of a receiver or conservator unless the financial institution submits an adequate capitalization plan. In addition to the capital guidelines described above, the Company and Bank's Board of Directors, in consenting to administrative orders issued by the FDIC and CDFI, have agreed that the Bank will maintain Tier 1 capital equal to the greater of $14,000,000 or the equivalent of a Tier 1 capital to average assets ratio of at least 7.0%. The Company and Bank's actual capital amounts (in thousands) and ratios, as of June 30, 1998, are also presented in the following table: TO BE WELL CAPITALIZED UNDER FOR CAPITAL ADEQUACY PROMPT CORRECTIVE PURPOSES ACTION PROVISIONS - ------------------------------------------------------------------------------------------------------------------------------ AS OF JUNE 30, 1998 AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO - ------------------------------------------------------------------------------------------------------------------------------ Total Capital (to Risk Weighted Assets:) Company $19,750 14.90% >=$10,603 >=8.00% N/A Regency Bank $16,919 12.76% >=$10,608 >=8.00% >=$ 13,260 >=10.00% Tier 1 Capital (to Risk Weighted Assets): Company $18,081 13.64% >=$ 5,302 >=4.00% N/A Regency Bank $15,250 11.50% >=$ 5,304 >=4.00% >=$ 7,956 >=6.00% Tier 1 Capital (to Average Assets): Company $18,081 9.20% >=$ 7,859 >=4.00% N/A Regency Bank $15,250 7.78% >=$ 7,843 >=4.00% >=$ 9,804 >=5.00% - ------------------------------------------------------------------------------------------------------------------------------ 32 RETURN ON EQUITY AND ASSETS The following table sets forth the ratios of net income to average assets and average shareholders' equity, and average shareholders' equity to average assets. Also indicated is the Company's dividend payout ratio. (For purposes of calculating average shareholders' equity as used in these ratios, unrealized losses on the Company's available-for-sale securities portfolio have been included and the percentages shown have been annualized). - -------------------------------------------------------------------------------------------------------------------- FOR THE THREE MONTHS FOR THE SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, - -------------------------------------------------------------------------------------------------------------------- 1998 1997 1998 1997 - -------------------------------------------------------------------------------------------------------------------- Return on average assets 1.27% (4.61)% 1.19% (2.12)% - -------------------------------------------------------------------------------------------------------------------- Return on average shareholders' equity 12.82% (61.30)% 11.96% (27.77)% - -------------------------------------------------------------------------------------------------------------------- Average shareholders' equity to average assets 9.93% 7.53% 9.96% 7.63% - -------------------------------------------------------------------------------------------------------------------- Dividend payout ratio - - - - - -------------------------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------------------------- YEAR 2000 COMPLIANCE The inability of most computers, software, and other equipment utilizing microprocessors to distinguish the year 1900 from the year 2000 poses substantial risks to all financial institutions including the Company. The year 2000 problem is pervasive and complex. Virtually every financial institution, service provider, and vendor will have its computing operations affected in some way by the rollover of the two-digit year value to 00 if action is not taken to fix the problem before the year 2000 arrives. The Company is currently engaged in a five-phase management program which includes awareness, assessment, renovation, validation, and implementation. The Company has identified all major applications and systems that may require modification to ensure "Year 2000 Compliance." The scope of the project covers all computer systems including PC and network hardware and software, and mainframe and mainframe software. It also covers all equipment and other systems utilized in bank operations or in the premises from which the Company operates. In addition, the Company has communicated with its large borrowers, corporate customers, and major vendors upon which it relies to determine the extent to which the Company is vulnerable to those third parties if they fail to resolve their Year 2000 issues. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be converted on time, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a materially adverse effect on the Company. The Company will utilize both internal and external resources to implement its Year 2000 Project. The Company expects to complete the majority of its efforts by the end of 1998, leaving adequate time to assess and correct any significant issues that may materialize. Purchased hardware and software will be capitalized in accordance with normal policy. Personnel and all other costs related to the project are being expensed as incurred. The majority of these costs are expected to be incurred during 1998, and are not expected to have a material impact on the Company's cash flows, results of operations, or financial condition. 33 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTER TO VOTE OF SECURITY HOLDERS (a) The 1998 Annual Meeting of Shareholders (the "Annual Meeting") was held on May 12, 1998. (b) The following nine directors, all of whom are incumbent directors, and Mr. Steve Freeland (the employee director nominee) were elected at the Annual Meeting by the following vote: VOTES AGAINST VOTES FOR OR WITHHELD --------- -------------- William J. Alessini 1,655,727 2,100 Joseph L, Castanos 1,655,727 2,100 Steve D. Freeland 1,655,727 2,100 Steven F. Hertel 1,655,727 2,100 Roy Jura 1,655,727 2,100 Barbara Palmquist 1,655,727 2,100 David N. Price 1,655,727 2,100 William J. Ruh 1,655,727 2,100 Daniel R. Suchy 1,655,727 2,100 Waymon E. Watts 1,655,727 2,100 (c) The appointment of Deloitte & Touche LLP as the Company's independent public accountants for the 1998 fiscal year was ratified by the following vote: Votes for - 1,656,677 Votes against or withheld - 1,150 ITEM 5. OTHER INFORMATION None 34 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (10.1) Agreement between Regency Bancorp and Belle Plaine Financial, LLC, to act as the exclusive financial advisor to Regency Bancorp and its various entities in connection with its efforts to acquire, invest in, or sell depository and/or other businesses. William J. Ruh, a director of Regency Bancorp is also a principal in Belle Plaine Financial, LLC. (27.1) Financial Data Schedule (b) Reports on Form 8-K The Company filed a Form 8-K dated May 8, 1998, in which it reported that the Registrant received approval from NASDAQ to begin trading on the NASDAQ national market system effective May 8, 1998. 35 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. REGENCY BANCORP Date: July 28, 1998 By: /s/ STEVEN F. HERTEL -------------------------------------- Steven F. Hertel President and Chief Executive Officer (Principal Executive Officer) Date: July 28, 1998 By: /s/ STEVEN R. CANFIELD -------------------------------------- Steven R. Canfield Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 36 EXHIBIT INDEX EXHIBIT SEQUENTIAL NUMBER DESCRIPTION PAGE NUMBER 10.1 Agreement between Regency Bancorp and Belle Plaine 38 Financial, LLC 27.1 Financial Data Schedule 47 37