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 September 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 November 2, 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 38 pages of which this is page one. REGENCY BANCORP TABLE OF CONTENTS PAGE PART I. FINANCIAL INFORMATION Item 1. Financial Statements (unaudited) Consolidated Balance Sheets September 30, 1998, and December 31, 1997 . . . . . . . . . 3 Consolidated Statements of Operations and Comprehensive Income/(Loss) Three Months and Nine Months Ended September 30, 1998 and 1997 . . . . . . . . . . . . . . . . 4 Consolidated Statements of Shareholders' Equity Nine Months Ended September 30, 1998 and 1997 . . . . . . . 5 Consolidated Statements of Cash Flows Nine Months Ended September 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 . . . . . . . . . . . . 10 PART II. OTHER INFORMATION Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . 32 Item 2. Changes in Securities . . . . . . . . . . . . . . . . . . . 32 Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . 32 Item 4. Submission of Matters to a Vote of Security Holders . . . . 32 Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . 32 Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . 32 2 REGENCY BANCORP AND SUBSIDIARIES PART I ITEM 1. FINANCIAL INFORMATION CONSOLIDATED BALANCE SHEETS (UNAUDITED) - ------------------------------------------------------------------------------------------- (In thousands, except share data) September 30, 1998 December 31, 1997 - ------------------------------------------------------------------------------------------- ASSETS Cash and due from banks $ 9,076 $ 16,893 Federal funds sold 15,250 3,000 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Cash and Equivalents 24,326 19,893 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Other short term investments 3,868 232 Securities available-for-sale 44,121 36,986 Non-marketable equity securities (FRB & FHLB stock) 1,170 - - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Loans 144,305 129,635 Allowance for credit losses (2,689) (2,219) Deferred loan fees & discounts (951) (986) - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Net Loans 140,665 126,430 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Investments in real estate - 4,338 Other real estate owned 684 503 Cash surrender value of life insurance 3,143 3,038 Premises and equipment, net 1,566 1,751 Accrued interest receivable and other assets 4,275 5,070 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Assets $223,818 $198,241 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest bearing transaction accounts $ 43,580 $ 46,744 Interest bearing transaction accounts 49,974 48,616 Savings accounts 55,680 36,498 Time deposits $100,000 or over 33,208 28,643 Other time deposits 16,283 15,778 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Deposits 198,725 176,279 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Short term borrowings - - Notes payable 538 509 Other liabilities 3,446 2,719 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Liabilities $202,709 $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 issued and outstanding in 1998 and 1997, respectively 15,229 15,203 Retained earnings 5,553 3,327 Net unrealized gain (loss) on available-for-sale securities, net of taxes of $237 in 1998 and $148 in 1997 327 204 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Shareholders' Equity 21,109 18,734 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $223,818 $198,241 - ------------------------------------------------------------------------------------------- - ------------------------------------------------------------------------------------------- See notes to consolidated financial statements 3 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME/(LOSS) (UNAUDITED) - --------------------------------------------------------------------------------------------------------------- For the three months For the nine months (In thousands, except for per common and equivalent share data) ended September 30, ended September 30, - --------------------------------------------------------------------------------------------------------------- 1998 1997 1998 1997 - --------------------------------------------------------------------------------------------------------------- INTEREST INCOME Loans (including fees) $ 4,098 $ 3,330 $ 11,752 $ 9,034 Investment securities: Taxable 524 557 1,431 1,651 Tax exempt 90 45 241 99 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Total Investment Interest Income 614 602 1,672 1,750 Other 149 99 255 354 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Total Interest Income 4,861 4,031 13,679 11,138 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE Interest on deposits 1,388 1,331 3,922 3,900 Other 21 20 83 60 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Total Interest Expense 1,409 1,351 4,005 3,960 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Net interest income 3,452 2,680 9,674 7,178 Provision for credit losses 100 460 375 1,295 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Net interest income after provision for credit losses 3,352 2,220 9,299 5,883 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- NONINTEREST INCOME Gain-on-sale of loans 55 26 277 512 Depositor service charges 126 101 356 295 Income from investment management services 242 198 687 600 Gain (loss) on sale of securities - - 5 (34) Gain-on-sale of assets 4 248 4 252 Servicing fees on loans sold - 83 79 250 Other 344 68 526 249 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Total Noninterest Income 771 724 1,934 2,124 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- NONINTEREST EXPENSE Loss (gain) from investments in real estate partnerships (93) (21) 121 3,569 Salaries and related benefits 1,311 1,216 3,752 3,613 Occupancy 382 399 1,121 1,213 FDIC insurance and regulatory assessments 79 47 307 91 Marketing 97 102 367 334 Professional services 213 56 544 334 Director's fees and expenses 50 44 149 220 Management fees for real estate projects - 9 - 121 Supplies, telephone & postage 73 78 237 241 Other 148 490 781 1,035 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Total Noninterest Expense 2,260 2,420 7,379 10,771 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Income before income taxes (benefit) 1,863 524 3,854 (2,764) Provision (benefit) for income taxes 785 223 1,628 (1,158) - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Net Income/ (loss) $ 1,078 $ 301 $ 2,226 $ (1,606) Other comprehensive income, net of tax: Unrealized gain on securities 113 99 123 173 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- Comprehensive income/(loss) $ 1,191 $ 400 $ 2,349 $ (1,433) Earnings (loss) per common share Basic $ .41 $ .16 $ .85 $ (.87) Diluted $ .38 $ .16 $ .80 $ (.87) Shares on which earnings per common share were based Basic 2,624,000 1,871,000 2,623,000 1,854,000 Diluted 2,804,000 1,926,000 2,799,000 1,854,000 - --------------------------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------------------------- See notes to consolidated financial statements 4 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997 - ---------------------------------------------------------------------------------------------------- Common Common Net Stock Number Stock Retained Unrealized (In thousands) 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 - - - 173 173 taxes of $126,000) Net Income (loss) - - (1,606) - (1,606) - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- Balance, September 30, 1997 1,818 $9,276 $ 2,995 $ 174 $12,445 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------- Common Common Net Stock Number Stock Retained Unrealized (In thousands) of Shares Amount Earnings Gain (Loss) Total - ----------------------------------------------------------------------------------------------------- Balance, December 31, 1997 2,621 $15,203 $3,327 $204 $18,734 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- Issuance of common stock to employee stock ownership plan 3 26 - - 26 Net change in unrealized gain (loss) on available-for-sale securities (net of taxes of $72,000) - - - 123 123 Net Income - - 2,226 - 2,226 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- Balance, September 30, 1998 2,624 $15,229 $5,553 $327 $21,109 - ----------------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------------- See notes to consolidated financial statements 5 REGENCY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) - ----------------------------------------------------------------------------------- (In thousands) For the nine months ended September 30, 1998 1997 - ----------------------------------------------------------------------------------- OPERATING ACTIVITIES: Increase (decrease) in cash equivalents: Net income/(loss) $ 2,226 $ (1,606) Adjustments: Provision for credit losses 375 1,295 Provision for losses on real estate - 364 Provision for OREO losses 131 80 Depreciation and amortization 383 467 Deferred income taxes 701 (171) (Increase) decrease in interest receivable and other assets 5 1,641 Increase in surrender value of life insurance (105) (99) Distributions of income from real estate partnerships 213 7 Equity in loss of real estate partnerships 38 397 Decrease in real estate held-for-sale 4,087 6,110 Increase (decrease) in other liabilities 756 (1,285) Gain on sale of loans held-for-sale (277) (512) Proceeds from sale of loans held-for-sale 15,229 14,475 Additions to loans held-for-sale (16,023) (14,065) (Gain)/loss on sale of premises and equipment and OREO (2) (7) (Gain)/loss on sale of investment securities (5) 34 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- Net cash provided by operating activities $ 7,732 $ 7,125 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- INVESTING ACTIVITIES: Purchase of available-for-sale securities (24,768) (15,612) Proceeds from sales of available-for-sale securities 5 4,341 Proceeds from maturities of available-for-sale securities 17,783 7,303 Purchases of non-marketable equity securities (1,170) - Net increase in loans (14,351) (18,355) Net decrease (increase) in other short-term investments (3,636) 98 Cash received through acquisition of partnerships - 224 Proceeds from sale of OREO 501 700 Capital contributions to real estate partnerships - (89) Purchases of premises and equipment (146) 34 Proceeds from sale of premises and equipment 11 - - ----------------------------------------------------------------------------------- Net cash (used in) investing activities $(25,771) $(21,356) - ----------------------------------------------------------------------------------- FINANCING ACTIVITIES: Net increase in time deposits accounts 5,070 (5,018) Net increase (decrease) in other deposits 17,376 20,194 Payments on notes payable - (7,155) 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 financing activities 22,472 10,608 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4,433 (3,623) - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 19,893 19,833 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD 24,326 $ 16,210 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- CASH PAID DURING THE PERIOD Interest 4,272 3,039 Income taxes 28 - SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITES Transfer of loans to other real estate owned 813 364 - ----------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------- 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 nine months ended September 30, 1998 and 1997. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for an enterprise's 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. Adoption of this Statement will not impact the Company's consolidated financial position, results of operations or cash flows. 7 NOTE 3. - INVESTMENT SECURITIES During the period between December 31, 1997 and September 30, 1998, the Company recorded a net increase in the value of its available-for-sale portfolio of $123,000 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 September 30, 1998 December 31, 1997 - ------------------------------------------------------------------------------------------------------------------------------ Amortized Fair Amortized Fair (In thousands) Cost Value Cost Value - ------------------------------------------------------------------------------------------------------------------------------ U.S. Treasuries $ 1,004 $ 1,009 $ 2,007 $ 2,012 U.S. Government Agencies 17,836 17,969 17,431 17,489 Mortgage-backed securities 16,581 16,700 11,541 11,647 State and Political Subdivisions 7,893 8,200 5,441 5,624 Equity Securities 243 243 214 214 - ------------------------------------------------------------------------------------------------------------------------------ Total $43,557 $44,121 $36,634 $36,986 - ------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------ In addition to the available-for-sale securities listed above the Company held $1,170,000 in nonmarketable equity securities at September 30, 1998. These securities are made up of Federal Reserve Bank and Federal Home Loan Bank stock which is not traded on a recognized exchange. In order to maintain membership in these banks an equity investment is required. The Company can resell its investment to either the Federal Reserve or the Federal Home Loan Bank should it choose to relinquish membership. At September 30, 1998 no impairment reserve was deemed necessary. The Company held no nonmarketable equity securities at December 31, 1997. At September 30, 1998 and December 31, 1997, the Company held no securities classified as held-to-maturity. 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) September 30, 1998 December 31, 1997 - ------------------------------------------------------------------------------------------------------------------------------ Percent of Percent of Amount Total Loans Amount Total Loans - ------------------------------------------------------------------------------------------------------------------------------ Commercial $ 95,594 66.2% $ 75,487 58.3% Real estate mortgage 18,219 12.6% 14,900 11.5% Real estate construction 20,886 14.5% 30,128 23.2% Consumer and other 9,606 6.7% 9,120 7.0% - ------------------------------------------------------------------------------------------------------------------------------ Subtotal $144,305 100.0% $129,635 100.0% - ------------------------------------------------------------------------------------------------------------------------------ Less: Unearned discount 468 623 Deferred loan fees 483 363 Allowances for credit losses 2,689 2,219 - ------------------------------------------------------------------------------------------------------------------------------ Total loans, net $140,665 $126,430 - ------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------ 8 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 nine month period ended September 30, 1997, because the effect of potentially dilutive securities under the stock option plans were antidilutive. 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 nine month periods ended September 30, 1998 and 1997: - ------------------------------------------------------------------------------------------------------------------------------ For the three months For the nine months (In thousands, except per share data) ended September 30, ended September 30, - ------------------------------------------------------------------------------------------------------------------------------ 1998 1997 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------ Basic EPS Computation: Net income (loss) $1,078 $ 301 $2,226 $(1,606) Average common shares outstanding 2,624,000 1,871,000 2,623,000 1,854,000 - ------------------------------------------------------------------------------------------------------------------------------ Basic EPS $ .41 $ .16 $ .85 $ (.87) - ------------------------------------------------------------------------------------------------------------------------------ Diluted EPS Computation: Net income (loss) $1,078 $ 301 $2,226 $(1,606) Average common shares outstanding 2,624,000 1,871,000 2,623,000 1,854,000 Stock options and warrants 180,000 55,000 176,000 - - ------------------------------------------------------------------------------------------------------------------------------ 2,804,000 1,926,000 2,799,000 1,854,000 - ------------------------------------------------------------------------------------------------------------------------------ Diluted EPS $ .38 $ .16 $ .80 $ (.87) - ------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------ Options to purchase 48,500 and 60,000 shares of common stock at various prices per share were outstanding at September 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. 9 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 It took a year, but the seeds planted in mid-year 1997 have begun to produce a bountiful harvest as reflected in our 1998 third quarter performance. Among the highlights for the quarter ended September 30, 1998 were record net income of $1,078,000; return on assets of 2.02%; return on equity of 20.87%; record assets of $223,818,000; record loans of $144,305,000; record deposits of $198,725,000; the removal (i) by the Federal Deposit Insurance Corporation, effective as of September 3, 1998 of the cease and desist order issued on November 14, 1997 and (ii) by the California Department of Financial Institutions effective as of September 15, 1998 of the order issued on November 14, 1997; and the Bank was accepted as a Federal Reserve member bank. While not every quarter will be equally as monumental, we are excited about the future and look forward with optimism. Net income reached $2,226,000 for the first nine months of 1998, an increase of $3,832,000 from a loss of $1,606,000 for the first nine months of 1997. The increase in income was the result of significantly higher levels of earning assets producing interest income, as well as, a dramatic reduction of losses related to RSC's real estate investments. For the quarter ended September 30, 1998, net income reached $1,078,000, an increase of $777,000 or 258% from $301,000 for the same period in 1997. In addition to the improvements mentioned above, the Company recovered approximately $335,000 in previously charged off assets related to RSC. These recoveries had the effect of increasing after-tax income by $195,000. 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 $144,305,000 at September 30, 1998, up 11.3% from $129,635,000 at year-end and up 20.4% in the last twelve months. During the last twelve months ending September 30, 1998, interest-earning assets have increased by $48,719,000, and now account for more than 92% of the Company's total assets. The growth in loans and other earning assets have allowed the Company to improve its interest income and subsequently its net income. Earnings/(loss) per weighted average common share were $.41 for the third quarter of 1998 and $.85 for the first nine months of 1998, compared to earnings of $.16 per share in the third quarter of 1997 and a loss of $(.87) per share for the nine month period ended September 30, 1997. The Company paid no cash dividends in the third quarter of 1998 or 1997. The Company's return on average assets improved to 2.02% for the third quarter of 1998, compared to .63% for the comparable period in 1997. For the first nine months of 1998 return 10 on average assets was 1.49% compared to (1.17)% for the first nine months of 1997. Return on average common equity for the three and nine months ended September 30, 1998, was 20.87% and 15.08% respectively, compared to 9.58% and (16.04)% for the comparable periods in 1997. In addition to improving the revenue side of the income statement, management and staff have focused attention on expenses with a goal of continually improving 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, improved to 4.23% for the quarter ended September 30, 1998 and 4.93% for the first nine months of 1998 from 5.09% and 7.84% for the comparable periods in 1997. The Company's efficiency ratio improved to 53.5% for the quarter ended September 30, 1998 compared to 71.1% for the third quarter of 1997. At September 30, 1998, the Company's total risk-based capital ratio was 15.67% while the leverage ratio was 9.21%. Both ratios are well in excess of minimum capital standards. 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 was a "cease-and-desist order" for the purposes of Section 8 of the Federal Deposit Insurance Act. Additionally, the Bank stipulated to the issuance of a State Order by the CDFI, the State Order was a final order pursuant to Section 1913 of the California Financial Code. During the third quarter ended September 30, 1998, the Bank received written notice from the FDIC and CDFI that both orders had been "terminated", i.e. they have been cancelled and removed in their entirety. 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 tables present, 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 tables also set forth the net interest income and the net earning balance for the periods indicated. 11 CONSOLIDATED AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND INTEREST RATES - ------------------------------------------------------------------------------------------------------------------------------ (In thousands, except for percentages) For the three months ended September 30, 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------ Average Yield/ Average Yield/ Balance Rate Interest Balance Rate Interest - ------------------------------------------------------------------------------------------------------------------------------ ASSETS Interest-earning assets: Loans (1) $143,979 11.29% $4,098 $115,239 11.46% $3,330 Investment securities (2) 38,866 6.26% 614 37,003 6.45% 602 Federal funds sold & other 9,864 5.95% 149 7,250 5.42% 99 - ------------------------------------------------------------------------------------------------------------------------------ Total Interest-earning Assets $192,709 10.01% $4,861 $159,492 10.03% $4,031 - ------------------------------------------------------------------------------------------------------------------------------ Noninterest -earning assets: Allowance for credit losses (2,646) (1,912) Cash and due from banks 11,949 10,220 Real estate investments - 10,582 OREO 635 530 Premises and equivalent, net 1,617 1,965 Cash surrender value of life insurance 3,121 2,979 Accrued interest receivable and other 4,555 4,450 assets - ------------------------------------------------------------------------------------------------------------------------------ Total Average Assets $211,940 $188,306 - ------------------------------------------------------------------------------------------------------------------------------ LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities: Transaction accounts $ 50,300 2.35% $ 298 $ 51,613 2.47% $ 321 Savings accounts 42,730 3.93% 424 35,491 4.09% 366 Time deposits 49,113 5.38% 666 46,183 5.53% 644 Federal funds purchased, notes payable and other 531 16.01% 21 1,956 4.06% 20 - ------------------------------------------------------------------------------------------------------------------------------ Total Interest-bearing Liabilities $142,674 3.92% $1,409 $135,243 3.96% $1,351 - ------------------------------------------------------------------------------------------------------------------------------ Noninterest -bearing liabilities: Transaction accounts 45,619 38,807 Other liabilities 3,149 1,787 - ------------------------------------------------------------------------------------------------------------------------------ Total Liabilities $191,442 $175,837 - ------------------------------------------------------------------------------------------------------------------------------ Shareholders' Equity: Common stock 15,230 9,274 Retained earnings 5,058 3,061 Unrealized gain / (loss) on investment securities 210 134 - ------------------------------------------------------------------------------------------------------------------------------ Total Shareholders' Equity 20,498 12,469 - ------------------------------------------------------------------------------------------------------------------------------ Total average liabilities and shareholders' equity $211,940 $188,306 - ------------------------------------------------------------------------------------------------------------------------------ Net Interest Income $3,452 $2,680 - ------------------------------------------------------------------------------------------------------------------------------ Interest income as a percentage of average interest-earning assets 10.01% 10.03% Interest expense as a percentage of average interest-earning assets (2.90%) (3.36%) - ------------------------------------------------------------------------------------------------------------------------------ Net Interest Margin 7.11% 6.67% - ------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------ (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 $360,000 and $344,000 for the three months ended September 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. 12 CONSOLIDATED AVERAGE BALANCE SHEETS, NET INTEREST INCOME AND INTEREST RATES - ------------------------------------------------------------------------------------------------------------------------------ (In thousands, except for percentages) For the nine months ended September 30, 1998 1997 - ------------------------------------------------------------------------------------------------------------------------------ Average Yield/ Average Yield/ Balance Rate Interest Balance Rate Interest - ------------------------------------------------------------------------------------------------------------------------------ ASSETS Interest-earning assets: Loans (1) $137,568 11.42% $11,752 $107,893 11.19% $ 9,034 Investment securities (2) 36,220 6.17% 1,672 35,736 6.55% 1,750 Federal funds sold & other 5,942 5.74% 255 8,763 5.40% 354 - ------------------------------------------------------------------------------------------------------------------------------ Total Interest-earning Assets $179,730 10.18% $13,679 $152,392 9.77% $ 11,138 - ------------------------------------------------------------------------------------------------------------------------------ Noninterest -earning assets: Allowance for credit losses (2,439) (1,755) Cash and due from banks 11,354 9,301 Real estate investments 1,301 14,457 OREO 670 Premises and equivalent, net 1,681 2,118 Cash surrender value of life insurance 3,086 2,948 Accrued interest receivable and other 4,796 4,324 assets - ------------------------------------------------------------------------------------------------------------------------------ Total Average Assets $200,179 $183,785 - ------------------------------------------------------------------------------------------------------------------------------ LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing liabilities: Transaction accounts $ 48,866 2.35% $ 859 $ 49,217 2.52% $ 928 Savings accounts 39,069 4.01% 1,171 32,764 4.08% 1,000 Time deposits 47,005 5.38% 1,892 47,845 5.51% 1,972 Federal funds purchased, notes payable and other 985 11.27% 83 3,483 2.30% 60 - ------------------------------------------------------------------------------------------------------------------------------ Total Interest-bearing Liabilities $135,925 3.94% $ 4,005 $133,309 3.97% $ 3,960 - ------------------------------------------------------------------------------------------------------------------------------ Noninterest -bearing liabilities: Transaction accounts 41,695 34,971 Other liabilities 2,820 2,121 - ------------------------------------------------------------------------------------------------------------------------------ Total Liabilities $180,440 $170,401 - ------------------------------------------------------------------------------------------------------------------------------ Shareholders' Equity: Common stock 15,221 9,156 Retained earnings 4,300 4,224 Unrealized gain / (loss) on investment securities 218 4 - ------------------------------------------------------------------------------------------------------------------------------ Total Shareholders' Equity 19,739 13,384 - ------------------------------------------------------------------------------------------------------------------------------ Total average liabilities and shareholders' equity $200,179 $183,785 - ------------------------------------------------------------------------------------------------------------------------------ Net Interest Income $ 9,674 $ 7,178 - ------------------------------------------------------------------------------------------------------------------------------ Interest income as a percentage of average interest-earning assets 10.18% 9.77% Interest expense as a percentage of average interest-earning assets (2.98%) (3.47%) - ------------------------------------------------------------------------------------------------------------------------------ Net Interest Margin 7.20% 6.30% - ------------------------------------------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------------------------------------------ (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 $936,000 and $950,000 for the nine months ended September 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. 13 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 table presents 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 September 30, 1998 compared to 1997 Volume(1) Rate(1) Total - --------------------------------------------------------------------------------------------- Net Interest Earnings Variance Analysis Increase (decrease) in interest income: Loans 817 (49) 768 Investment securities(2) 28 (16) 12 Federal funds sold and other 38 12 50 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Total 883 (53) 830 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Increase (decrease) in interest expense: Transaction accounts (8) (15) (23) Savings accounts 71 (13) 58 Time deposits 39 (17) 22 Federal funds purchased and other - 1 1 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Total 102 (44) 58 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Increase (decrease) in net interest income 781 (9) 772 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- (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 $3,452,000 for the third quarter of 1998 as compared to $2,680,000 for the comparable period of 1997, an increase of $772,000 or 28.8%. The net interest margin for the third quarter ended September 30, 1998 was 7.11% compared to 6.67% 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, primarily in the loan portfolio. This increase in loans was the result of the Bank holding new production Small Business Administration ("SBA") and Business and Industry ("B&I") loans rather than selling these loans on the secondary market. The Company's earning asset yield declined slightly to 10.01% during the third quarter of 1998, compared to 10.03% in the third 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, however, lower interest rates in general caused a slight decline in the overall net yield on earning assets. The recovery of nonaccrued interest on RSC loans during 1998's third quarter had the effect of increasing the net interest margin approximately 8 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 through the use of cash liberated from the sale of RSC's real estate investments, as well as, lower interest rates in general. Average interest-earning assets for the third quarter ended September 30, 1998 increased to $192,709,000 from $159,492,000 for the comparable period in 1997 an increase of $33,217,000 or 20.8%. Average loans increased by $28,740,000 to $143,979,000 representing 74.7% of average interest-earning assets for the third quarter of 1998, compared to $115,239,000 or 72.3 % for the third quarter of 1997. The yield on average loans declined slightly to 11.29% for the third quarter of 1998, from 11.46% for the comparable period in 1997, primarily due to lower market interest rates caused by aggressive competition from major banks. 14 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 6.26% for the third quarter ended September 30, 1998, from 6.45% in the comparable period in 1997. On a fully tax equivalent basis the yield on investments was 6.79% for the third quarter ended September 30, 1998 compared to 6.75% for the third quarter ended September 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. Excess liquidity is invested in federal funds sold on an overnight basis. During the third quarter of 1998, the Bank increased the amount of funds invested in overnight federal funds. This increase was a result of the Bank's efforts to take advantage of an inverted yield curve for short term investments with the federal funds rate being higher than other short and medium term investments. The yield on federal funds sold and other short term investments was 5.95% in the third quarter of 1998 compared to 5.42% in the comparable period in 1997. Average interest-bearing liabilities for the third quarter ended September 30, 1998 increased to $142,674,000 from $135,243,000 for the comparable period in 1997, an increase of $7,431,000 or 5.5%. For the third quarter ended September 30, 1998, the average interest rate paid on interest-bearing liabilities decreased slightly to 3.92% from an average rate of 3.96% paid during the third quarter of 1997. - --------------------------------------------------------------------------------------------- (In thousands) For the nine months ended September 30, 1998 compared to 1997 Volume(1) Rate(1) Total - --------------------------------------------------------------------------------------------- Net Interest Earnings Variance Analysis Increase (decrease) in interest income: Loans 2,532 186 2,718 Investment securities(2) 24 (102) (78) Federal funds sold and other (123) 24 (99) - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Total 2,433 108 2,541 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Increase (decrease) in interest expense: Transaction accounts (7) (62) (69) Savings accounts 189 (18) 171 Certificates of deposit (34) (46) (80) Federal funds purchased and other (5) 28 23 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Total 143 (98) 45 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- Increase (decrease) in net interest income 2,290 206 2,496 - --------------------------------------------------------------------------------------------- - --------------------------------------------------------------------------------------------- (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. 15 Net interest income before the provision for credit losses was $9,674,000 for the first nine months of 1998 as compared to $7,178,000 for the first nine months of 1997, an increase of $2,496,000 or 34.8%. 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 10.18% during the first nine months of 1998, compared to 9.77% for the first nine months of 1997. The net interest margin for the nine months ended September 30, 1998 was 7.20% compared to 6.30% 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 the first nine months of 1998 had the effect of increasing the net interest margin approximately 72 basis points on average. Average interest-earning assets for the nine months ended September 30, 1998 increased to $179,730,000 from $152,392,000 for the comparable period in 1997, an increase of $27,338 or 17.9%. Average loans increased by $29,675 to $137,568,000 representing 76.5% of average interest-earning assets for the first nine months of 1998, compared to $107,893,000 or 70.8% for the first nine months of 1997. The yield on average loans increased to 11.42% for the first nine months of 1998, from 11.19% 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 6.17% for the nine month period ended September 30, 1998, from 6.55% in the comparable period in 1997. On a fully tax equivalent basis the yield on investments was 6.61% for the nine months ended September 30, 1998, compared to 6.74% for the nine months ended September 30, 1997. The primary cause of the decline in investment yield was lower interest rates in the bond market. 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. The yield on federal funds sold and other investments for the first nine months of 1998 and 1997 was 5.74% and 5.40%, respectively. Average interest-bearing liabilities for the nine months ended September 30, 1998 grew marginally to $135,925,000 from $133,309,000 for the comparable period in 1997, an increase of $2,616,000 or 2.0%. For the first nine months ended September 30, 1998, the average interest rate paid on interest-bearing liabilities decreased to 3.94% from an average rate of 3.97% paid during the first nine months of 1997. 16 NONINTEREST INCOME The Company receives a significant portion of its income from noninterest sources related both to activities conducted by the Bank (loan originations and servicing, depositor service charges), as well as, the Company's investment advisory firm, RIA. The following table sets forth, for the periods indicated, the principal categories of noninterest income received by the Company. - ------------------------------------------------------------------------------------------ For the three months For the nine months (In thousands) ended September 30, ended September 30, - ------------------------------------------------------------------------------------------ 1998 1997 1998 1997 - ------------------------------------------------------------------------------------------ Other noninterest income: Gain-on-sale of loans $ 55 $ 26 $ 277 $ 512 Depositor service charges 126 101 356 295 Income from investment management services 242 198 687 600 Gain/(loss) on sale of securities - - 5 (34) Gain-on-sale of assets 4 248 4 252 Servicing fees on loans sold - 83 79 250 Other 344 68 526 249 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ Total $771 $724 $1,934 $2,124 - ------------------------------------------------------------------------------------------ - ------------------------------------------------------------------------------------------ During the third quarter of 1998, the Company recognized noninterest income of $771,000, compared to $724,000 for the same period in 1997, an increase of $47,000 or 6.5%. For the first nine months of 1998, noninterest income was $1,934,000, compared to $2,124,000 for the first nine months of 1997, a decrease of $190,000 or 9.0%. The decline for the first nine 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 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 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 the Bank's 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 their economic value. During the quarter ended September 30, 1998, the Bank did not sell SBA or B&I loans, but actively sold newly originated home mortgages. Net income from loans sold in the third quarter of 1998 was $55,000 compared to $26,000 in the third quarter of 1997. For the nine months ended September 30, 1998, gains on the sale of loans were $277,000 compared to $512,000 during the first nine months of 1997, a decrease of $235,000. The primary cause of the decline in income from the sale of loans for the first nine months of 1998 compared to the first nine months of 1997 was the decision to hold a larger portfolio of B&I and SBA guaranteed loans in the Bank's portfolio. 17 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 third quarter ended September 30, 1998, servicing income totaled $0, compared to servicing income of $83,000 during the quarter ended September 30, 1997. Under generally accepted accounting principles, when loans are sold a portion of the gain is deferred and accreted into income over the expected life of the loan. Additionally, the projected servicing income is calculated whereby a servicing asset is established and a portion of this projected future servicing income is recognized as income at the time of sale and a portion of the projected future income is deferred and accreted to servicing income over the projected life of the loan. Due to early payoffs on a number of older SBA loans, the reduction in servicing income as a result of the elimination of the future serving asset was equal to the gain from sale and servicing income for the period, thereby resulting in net servicing fee income of $0 for the quarter. For the nine months ended September 30, 1998, servicing income totaled $79,000, a decrease of $171,000 compared to $250,000 during the first nine 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 accretion 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, 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. As of September 30, 1998, RSC had only four units remaining compared to 66 units remaining at December 31, 1997 and 220 units remaining at September 30, 1997. When viewed on a stand-alone basis, RSC's activities combined to produce net income of $342,000 for the first nine months of 1998. During the most recent quarter, RSC was able to recover refundable deposits previously charged-off on numerous projects of $220,000, as well as, interest from loans previously on nonaccrual and principal from previously charged-off loans. The recovery of principal increased the Company's and RSC's reserve for credit losses by $142,000. Management expects that RSC's performance for the remainder of 1998 will be similar to the first nine months of 1998 and that any losses recorded on the sale of properties will be 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." 18 REGENCY INVESTMENT ADVISORS, INC. The Company's other wholly-owned subsidiary, Regency Investment Advisors, 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 third quarter of 1998 increased to $242,000 from $198,000 in the same period of 1997, an increase of $44,000 or 22.2%. 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 third quarter of 1998 compared to after-tax income of $29,000 in the third quarter of 1997. For the nine months ended September 30, 1998, revenue from RIA increased to $687,000 from $600,000 for the same period in 1997, an increase of $87,000 or 14.5%. On a stand alone basis, RIA's activities, (income from investment management activities less operating expenses), provided the Company with after-tax income of $106,000 for the nine months ended September 30, 1998, compared to after tax income of $77,000 for the same period in 1997, and increase of 37.6%. 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 September 30, 1998, RIA had $100,700,000 in assets under management, an increase of $14,500,000, or 16.8% compared to $86,200,000 as of September 30, 1997. Assets in client accounts managed by RIA are not reflected in the consolidated assets of the Company. 19 THIRD 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 September 30, 1998 1997 - ------------------------------------------------------------------------------------------------------------------ Percent of Percent of Amount Average Assets Amount Average Assets - ------------------------------------------------------------------------------------------------------------------ Noninterest Expense: Loss (gain) from investments in real estate partnerships $ (93) (0.17%) $ (21) (0.04%) Salaries and related benefits 1,311 2.45% 1,216 2.56% Occupancy 382 0.71% 399 0.84% FDIC insurance and regulatory assessments 79 0.15% 47 0.10% Marketing 97 0.18% 102 0.21% Professional services 213 0.40% 56 0.12% Director's fees and expenses 50 0.09% 44 0.09% Management fees for real estate projects - 0.00% 9 0.02% Supplies, telephone & postage 73 0.14% 78 0.16% Other 148 0.28% 490 1.03% - ------------------------------------------------------------------------------------------------------------------ Total $2,260 4.23% $2,420 5.09% - ------------------------------------------------------------------------------------------------------------------ Noninterest expense decreased by $160,000 or 6.6% to $2,260,000 for the three months ended September 30, 1998, compared to $2,420,000 during the same period of 1997. The decline in noninterest expense between the third quarter of 1997 and 1998 was due primarily to significantly lower expenses related to RSC's activities. When compared to average assets for the respective periods, noninterest expense decreased to 4.23% in the third quarter of 1998 compared to 5.09% 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 68.1% or $32,000, to $79,000 for the quarter ended September 30, 1998, compared to only $47,000 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 FDIC insurance premium to be $0 beginning in the first quarter of 1999. Additionally, management has petitioned the FDIC for a rebate of a portion of the Bank's deposit insurance premiums for quarters three and four of 1998. During the third quarter of 1998, professional expenses increased to $213,000 from $56,000 during the third quarter of 1997. The increase was primarily related to one time consulting expense related to the Company's year 2000 project, as well as, general legal expenses. Salaries and related benefits, occupancy and most other expense categories were similar in both the third quarters of 1998 and 1997. The other category of noninterest expense decreased to $148,000, for the third quarter of 1998, a decline of $342,000, or 69.8% from $490,000 in the comparable period of 1997. Other expense in 1997 was higher than normal due to OREO writedowns and RSC expenses. 20 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 2.56% in the third quarter of 1997 to 2.45% in the third 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 12.6%. NONINTEREST EXPENSE YEAR-TO-DATE - ------------------------------------------------------------------------------------------------------------------ (In thousands, except percentages) For the nine months ended September 30, 1998 1997 - ------------------------------------------------------------------------------------------------------------------ Percent of Percent of Amount Average Assets Amount Average Assets - ------------------------------------------------------------------------------------------------------------------ Other Expense: Loss (gain) from investments in real estate $ 121 0.08% $ 3,569 2.60% Salaries and related benefits 3,752 2.51% 3,613 2.63% Occupancy 1,121 0.75% 1,213 0.88% FDIC insurance and regulatory assessments 307 0.20% 91 0.07% Marketing 367 0.25% 334 0.24% Professional services 544 0.36% 334 0.24% Director's fees and expenses 149 0.10% 220 0.16% Management fees for real estate projects - 0.00% 121 0.09% Supplies, telephone & postage 237 0.16% 241 0.18% Other 781 0.52% 1,035 0.75% - ------------------------------------------------------------------------------------------------------------------ Total $7,379 4.93% $10,771 7.84% - ------------------------------------------------------------------------------------------------------------------ For the nine months ended 1998, year-to-date noninterest expense decreased substantially to $7,379,000 a decline of $3,392,000 or 31.5%, from $10,771,000 in the first nine months of 1997. The decline in expense was primarily the result of lower losses from investments in real estate. For the first nine months of 1998, RSC's losses on the sale of real estate were $121,000, a decline of $3,448,000 or 96.6% from $3,569,000 in the first nine 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 237% or $216,000 to $307,000 for the first nine months of 1998, compared to $91,000 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. Professional services and marketing grew modestly in the nine months ended September 30, 1998 compared to 1997 respectively. Professional services include legal expense, audit and consulting services. Legal expense was higher during the first nine months of 1998 due to expenses associated with the Company's registration of stock issued in December 1997 as well as its listing on Nasdaq. Consulting fees increased as a result of the Company's year 2000 data processing project. Salaries and related benefits, occupancy, director's fees, supplies and other expense all declined as a percentage of average assets and were very similar in dollar terms. The other category of noninterest expense declined to $781,000 for the first nine months of 1998 from $1,035,000 in the comparable period in 1997. The reduction in other expense relates primarily to lower RSC expenses. Overall, the Company's non-interest expense to average assets for the first nine months of 1998 declined to 4.93% compared to 7.84% for the comparable period of 1997. 21 BALANCE SHEET ANALYSIS Total assets at September 30, 1998 were $223,818,000 an increase of 12.9% or $25,577 from $198,241,000 at December 31, 1997. At September 30, 1998, the Company's loan portfolio grew to $144,305,000 an increase of $14,670,000 or 11.3% 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 $198,725,000 at September 30, 1998, up $22,446,000 or 12.7% from $176,279,000 at December 31, 1997. At September 30, 1998, the Company's net investment in real estate was $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 66.2% of the Bank's loan portfolio at September 30, 1998, compared to 58.3% at December 31, 1997 and 56.1% at September 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 14.5% of the Company's loan portfolio at September 30, 1998, compared to 23.2% of the Bank's loan portfolio at December 31, 1997, and 23.5% at September 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 12.6% of the loan portfolio at September 30, 1998, compared to 11.5% at December 31, 1997, and 12.9% of the loan portfolio at September 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 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 22 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 September 30, 1998, comprising 6.7% of the loan portfolio compared to 7.0% of total loans at December 31, 1997 and 7.5% at September 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 and the Bank'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 September 30, 1998, nonperforming loans amounted to $1,456,000 or 1.01% of total loans compared to $1,736,000 or 1.34% at December 31, 1997, and $2,013,000 or 1.68% at September 30, 1997. Other real estate owned was $684,000 at September 30, 1998, compared to $503,000 at December 31, 1997. Total nonperforming loans at September 30, 1998, compared to December 31, 1997, declined by $280,000. Of the total nonperforming loans, $231,000 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. These loans have dropped dramatically during 1998 and management expects they will be paid off prior to year end. Without the non-accrual loans made by RSC, the Bank's loan portfolio at September 30, 1998 had $1,225,000 in non-accrual loans or .85%, 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 September 30, 1998, $900,000 represented the portion of SBA loans that are guaranteed by the SBA. Beginning in 1997, the SBA changed the requirements for origination of SBA loans which are subsequently sold in the secondary market. Under the new requirement, if a 23 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. 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. An 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. The following table presents information concerning the nonperforming loans for the periods ending September 30, 1998 and December 31, 1997, respectively. - ---------------------------------------------------------------------------------------------------------- (In thousands, except percentages) September 30, 1998 December 31, 1997 - ---------------------------------------------------------------------------------------------------------- Nonperforming Assets: Nonaccrual RSC loans $ 231 $ 1,138 Nonaccrual bank loans 1,225 598 - ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Nonperforming loans 1,456 1,736 Other real estate owned 684 503 - ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Total nonperforming assets 2,140 2,239 - ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Accruing loans 90 days past due 102 48 - ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Total loans before allowance for credit losses $144,305 $129,635 Total assets 223,818 198,241 Allowance for possible credit losses (2,689) (2,219) - ---------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------- Ratios: Nonperforming loans to total loans 1.01% 1.34% Nonperforming loans to total loans (excluding RSC loans) .85% .46% Nonperforming assets to: Total loans 1.48% 1.73% Total loans and OREO 1.48% 1.72% Total assets .96% 1.13% Allowance for possible credit losses to total nonperforming assets 125.69% 99.11% Allowance for possible credit losses to loans 1.86% 1.71% - ---------------------------------------------------------------------------------------------------------- At September 30, 1998 and December 31, 1997, the Company's recorded investments in loans for which an impairment had been recognized totaled $1,544,000 and $1,410,000, respectively. These amounts were evaluated for impairment using the fair value of collateral. At September 30, 1998, the related SFAS No. 114 allowance for credit losses considered impaired was $121,000. The Company uses the cash basis method of income recognition for impaired loans. For the nine months ended September 30, 1998 and 1997, the Company did not recognize any income on such loans. 24 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 $2,689,000 or 1.86% of total loans at September 30, 1998, compared to $2,219,000 or 1.71% at December 31, 1997. The increase in allowance for credit losses is the result of additional provisions for credit losses of $375,000 in the nine months ended September 30, 1998, along with net recoveries of previously charged off loans of $219,000 less charge-offs of $124,000. Charge-offs as a percentage of average loans were .12% on an annualized basis through the first nine months of 1998. Of the Company's $144,300,000 in total loans, approximately $32,000,000 are guaranteed by the SBA or are guaranteed under the Department of Agriculture's' B&I program. If the guaranteed portion of these loans were subtracted from the Company's gross loan portfolio the allowance for credit losses to non-guaranteed loans was 2.41% at September 30, 1998. 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 allowance for credit losses for the period between December 31, 1997 and September 30, 1998. - ----------------------------------------------------------------------- (In thousands) - ----------------------------------------------------------------------- - ----------------------------------------------------------------------- BALANCE, DECEMBER 31, 1997 $2,219 - ----------------------------------------------------------------------- - ----------------------------------------------------------------------- Provision charged to expense 375 Loans charged-off (124) Recoveries 219 - ----------------------------------------------------------------------- - ----------------------------------------------------------------------- BALANCE, SEPTEMBER 30, 1998 $2,689 - ----------------------------------------------------------------------- 25 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 a limited partner in two projects with a total of four model homes remaining for sale. During the nine months ended September 30, 1998, RSC reduced its net investment in real estate to $0, from $4,067,000 at December 31, 1997 and $8,636,000 at September 30, 1997. The following table represents the condensed financial information relative to RSC for the periods ended September 30, 1998 and December 31, 1997, respectively. - ----------------------------------------------------------------------------------------- (In thousands) September 30, 1998 December 31, 1997 - ----------------------------------------------------------------------------------------- Financial Position: Investments in real estate Real estate held-for-sale $ - $ 4,420 Equity in partnerships 450 702 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Investment in real estate before allowance 450 5,122 Allowance for real estate losses (450) (1,055) - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Investment in real estate $ - $ 4,067 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Loans to real estate partnerships and projects 545 1,768 Allowance for loan losses (507) (364) - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Net Loans 38 1,404 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Other Assets 1,956 2,524 - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Liabilities (201) (144) - ----------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------- Bank's investment in RSC $1,793 $ 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 September 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 September 30, 1998 and December 31, 1997, respectively. - --------------------------------------------------------------------------------------------------- (In thousands) September 30, 1998 December 31, 1997 - --------------------------------------------------------------------------------------------------- Percent of Percent of Amount Total Deposits Amount Total Deposits - -------------------------------------------------------------------------------------------------- Noninterest-bearing transaction accounts $ 43,580 21.9% $ 46,744 26.5% Now and MMI 49,974 25.2% 48,616 27.6% Savings 55,680 28.0% 36,498 20.7% Time under $100,000 16,283 8.2% 15,778 9.0% Time $100,000 and over 33,208 16.7% 28,643 16.2% - -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- Total Interest-bearing Deposits 155,145 78.1% 129,535 73.5% - -------------------------------------------------------------------------------------------------- - -------------------------------------------------------------------------------------------------- Total Deposits $198,725 100.0% $176,279 100.0% - -------------------------------------------------------------------------------------------------- 26 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 generally maintains a 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. - ---------------------------------------------------------------------------------------------------------------- After Three After (In thousands, except percentages) Within Months But One Year But After As of September 30, 1998 Three Months Within 12 Months Within Five Years Five Years Total - ---------------------------------------------------------------------------------------------------------------- Interest Rate Sensitivity Gap: Loans (1) $103,362 $18,658 $12,722 $ 8,106 $142,848 Investment securities and other 13,963 8,400 6,338 20,458 49,159 Federal funds sold 15,250 - - - 15,250 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- Total Earning Assets $132,575 $27,058 $19,060 $ 28,564 $207,257 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- Interest-bearing transaction accounts 50,891 - - - 50,891 Savings accounts 55,680 2,907 1,646 - 60,233 Time deposits 17,393 20,485 6,664 - 44,542 Federal funds purchased - - - - - - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- Total Interest-Bearing Liabilities $123,964 $23,392 $ 8,310 $ - $155,666 - ---------------------------------------------------------------------------------------------------------------- - ---------------------------------------------------------------------------------------------------------------- Interest rate sensitivity gap 8,611 3,666 10,750 28,564 Cumulative gap 8,611 12,277 23,027 51,591 Cumulative gap percentage to interest earning assets 4.15% 5.92% 11.11% 24.89% - ---------------------------------------------------------------------------------------------------------------- (1) Amounts exclude nonaccrual loans of $1,457,000. 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 27 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, principle 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 other 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. Effective October 1, 1998 the Board of Governors and other federal bank regulatory agencies approved including Tier 2 capital up to 45% of the pretax net unrealized gains on certain available-for-sale equity securities having readily determinable fair values (i.e. the excess, if any, of fair market value over the book value or historical cost of the investment security). The federal regulatory agencies reserve the right to exclude all or a portion of the unrealized gains upon a determination that the equity securities are not prudently valued. Unrealized gains and losses on other types of assets, such as bank premises and available-for-sale debt securities, are not included in Tier 2 capital, but may be taken into account in the evaluation of overall capital adequacy and net unrealized losses on available-for-sale equity securities will continue to be deducted from Tier 1 capital as a cushion against risk. The Board of Governors and other federal agencies have adopted a revised minimum leverage ratio for bank holding companies as a supplement to the risk-weighted capital guidelines. The old rule established a 3% minimum leverage standard for well-run banking organizations (bank holding companies and banks) with diversified risk profiles. Banking organizations which did not exhibit such characteristics or had greater risk due to significant growth, among other factors, were required to maintain a minimum leverage ratio 1% to 2% higher. The old rule did not take into account the implementation of the market risk capital measure set forth in the federal regulatory agency capital adequacy guidelines. The revised leverage ratio establishes a minimum Tier 1 ratio of 3% (Tier 1 capital to total assets) for the highest rated bank holding companies or those that have implemented the risk-based capital market risk measure. All other bank holding companies must maintain a 28 minimum Tier 1 leverage ratio of 4% higher leverage capital ratios required for bank holding companies that have significant financial and/or operational weaknesses, a high risk profile, or are undergoing or anticipating rapid growth. The old rule remains in effect for banks, however, the federal regulatory agencies are currently continuing work on a revised leverage rule for banks. 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%. 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. As a condition of the administrative orders issued by the FDIC and CDFI in 1997, the Company and Bank's Board of Directors, agreed that the Bank would 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%. With the termination of the orders in September 1998, these additional capital conditions were removed. 29 The Company and Bank's actual capital amounts (in thousands) and ratios, as of September 30, 1998, are also presented in the following table: To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions - ---------------------------------------------------------------------------------------------------------------- As of September 30, 1998 Amount Ratio Amount Ratio Amount Ratio - ---------------------------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets:) Company $21,090 15.67% >=$10,766 >=8.00% N/A Regency Bank $18,235 13.55% >=$10,769 >=8.00% >=$13,462 >=10.00% Tier 1 Capital (to Risk Weighted Assets): Company $19,395 14.41% >=$ 5,383 >=4.00% N/A Regency Bank $16,540 12.29% >=$ 5,385 >=4.00% >=$ 8,077 >= 6.00% Tier 1 Capital (to Average Assets): Company $19,395 9.21% >=$ 8,424 >=4.00% N/A Regency Bank $16,540 7.87% >=$ 8,410 >=4.00% >=$10,512 >= 5.00% - ---------------------------------------------------------------------------------------------------------------- SELECTED RATIOS 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 Nine Months Ended September 30, Ended September 30, - ----------------------------------------------------------------------------------------------- 1998 1997 1998 1997 - ----------------------------------------------------------------------------------------------- Return on average assets 2.02% .63% 1.49% (1.17%) - ----------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------- Return on average shareholders' equity 20.87% 9.58% 15.08% (16.04%) - ----------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------- Average shareholders' equity to average assets 9.67% 6.62% 9.87% 7.28% - ----------------------------------------------------------------------------------------------- - ----------------------------------------------------------------------------------------------- Dividend payout ratio - - - - - ----------------------------------------------------------------------------------------------- YEAR 2000 READINESS DISCLOSURE 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 that 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." As a part of this process the Company has segregated its various systems and classified them either as mission critical or non-mission critical. 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 30 bank operations or in the premises from which the Company operates. The first priority is to make sure all mission critical systems are Y2K ready and that adequate testing and contingency plans are in place. The Company utilizes both internal and external resources to implement its year 2000 project and 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. Through September 30, 1998. The Company has incurred approximately $50,000 in expense related to its Y2K efforts and expects to expend approximately $50,000 in additional expense to complete the project. These expenses have been primarily for consulting services. The majority of costs associated with new software or upgraded hardware would have been incurred in the normal course of operations regardless of the year 2000 issue. During the quarter ended September 30, 1998, the Company continued to certify various systems as year 2000 ready. Testing of most mission critical systems has either been completed or is substantially complete including the Bank's main customer and accounting software the "Fiserv CBS System". The Fiserv software has been thoroughly tested by Fiserv and has been certified by Fiserv as Y2K ready. The Company has completed additional testing of all components of the software through April 2000 and has detected no Y2K problems. The Company anticipates completion of testing and the installation of upgraded software for several ancillary PC based systems by year-end 1998. Most of these ancillary PC based systems are related to new account or loan production and could be performed manually using existing forms in a worst case scenario. In addition to internal systems, 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. Borrowers or large deposit customers have been categorized based upon risk and are monitored on a regular basis. If a borrowing customer is determined to have significant Y2K exposure that may impair the quality or collectability of its loan, reserves for potential losses resulting from such Y2K exposures are established accordingly. Despite the Company's best efforts, 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. For these reasons the Company has developed and will continue to refine contingency plans for all mission critical systems. While the Company fully expects its main customer and accounting systems to be Y2K ready, external problems such as a major electrical or telecommunications failure could result in a disruption of business for the Company and its customers as part of its contingency plans. The Company has established backup facilities in other geographic regions as well as various levels of electronic and manual processes and procedures to continue operation in the event of Y2K problems. Based upon the relative small size and low volume of transactions processed by the Company, complete manual operation is, while a last resort, a realistic option that is available to the Company. 31 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 None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits (3.1) Articles of Incorporation dated June 9, 1994, incorporated by reference from exhibit 3.1 of registrant's Annual Report on Form 10-K for the year ended December 31, 1994, filed with the Commission on February 27, 1995. (3.2) Bylaws, as amended, incorporated by reference from exhibit 3.2 of registrant's Annual Report on Form 10-K for the year ended December 31, 1994, filed with the Commission on February 27, 1995. (4.1) Specimen form of Regency Bancorp stock certificate incorporated by reference from exhibit 4.1 of registrant's Annual Report on Form 10-K for the year ended December 31, 1994, filed with the Commission on February 27, 1995. *(10.1) 401(k) Pension and Profit Sharing Plan, incorporated by reference from exhibit 10.3 of registration statement number 33-82150 on Form S-4, filed with the Commission on July 27, 1994. *(10.2) Employee Stock Ownership Plan, incorporated by reference from exhibit 10.4 of registration statement number 33-82150 on Form S-4, filed with the Commission on July 27, 1994. *(10.3) Directors Deferred Fee Plan, incorporated by reference from exhibit 10.5 of registration statement number 33-82150 on Form S-4, filed with the Commission on July 27, 1994. 32 *(10.4) Form of Directors Deferred Fees Agreement for Regency Bank, incorporated by reference from exhibit 10.6 of registration statement number 33-82150 on Form S-4, filed with the Commission on July 27, 1994. *(10.11) Form of Indemnification Agreement, incorporated by reference from exhibit 10.3 of registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1996, filed with the Commission on August 2, 1996. *(10.13) Employment Agreement made and entered into as of August 22, 1996 between Regency Bank, a California Corporation, and Steven F. Hertel, President/Chief Executive Officer, incorporated by reference from exhibit 10.2 of registrant's Quarterly Report on Form 10-Q/A-1 for the quarter ended September 30, 1996, filed with the Commission on November 16, 1996. *(10.14) Employment Agreement made and entered into as of August 22, 1996 between Regency Bank, a California Corporation, and Steven R. Canfield, Executive Vice President/Chief Financial Officer incorporated by reference from exhibit 10.3 of registrant's Quarterly Report on Form 10-Q/A- 1 for the quarter ended September 30, 1996, filed with the Commission on November 16, 1996. *(10.15) Employment Agreement made and entered into as of August 22, 1996 between Regency Bank, a California Corporation, and Robert J. Longatti, Executive Vice President/Chief Credit Officer incorporated by reference from exhibit 10.4 of registrant's Quarterly Report on Form 10-Q/A-1 for the quarter ended September 30, 1996, filed with the Commission on November 16, 1996. *(10.16) Employment Agreement made and entered into as of August 22, 1996 between Regency Bank, a California Corporation, and Regency Investment Advisors Incorporated, a California Corporation, and Alan R. Graas, President,incorporated by reference from exhibit 10.5 of registrant's Quarterly Report on Form 10-Q/A-1 for the quarter ended September 30, 1996, filed with the Commission on November 16, 1996. *(10.17) Regency Bancorp 1990 Stock Option Plan, as amended, and Form of Nonstatatory Stock Option Agreement, Form of Incentive Stock Option Agreement and Form of Nonstatutory Stock Option Agreement for Outside Directors, under the Regency Bancorp 1990 Stock Option Plan, as amended, incorporated by reference on registration statement number 33-3848 on Form S-8, filed with the Commission on April 19, 1996. *(10.18) Incentive Stock Option Agreement entered into with Steven F. Hertel, dated December 16, 1996 incorporated by reference from exhibit 10.29 of registrant's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31, 1997. 33 *(10.19) Incentive Stock Option Agreement entered into with Steven R. Canfield, dated December 16, 1996 incorporated by reference from exhibit 10.30 of registrant's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31, 1997. *(10.20) Incentive Stock Option Agreement entered into with Robert J. Longatti, dated December 16, 1996 incorporated by reference from exhibit 10.31 of registrant's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31, 1997. *(10.21) Form of Director Deferred Fees Agreement for Regency Bancorp incorporated by reference from exhibit 10.32 of registrant's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31, 1997. *(10.22) Form of Director Deferred Fees Agreement for Regency Service Corporation incorporated by reference from exhibit 10.33 of registrant's Annual Report on Form 10-K for the year ended December 31, 1996, filed with the Commission on March 31,1997. *(10.24) Amended and Restated Executive Salary Continuation Agreement dated September 23, 1997, made by and between Regency Bank and Steven F. Hertel, incorporated by reference from exhibit 99.1 of registrant's current report on Form 8-K, filed with the Commission on October 9, 1997. *(10.25) Amended and Restated Executive Salary Continuation Agreement dated September 26, 1997, made by and between Regency Bank and Robert J. Longatti, incorporated by reference from exhibit 99.2 of the Form 8-K, filed with the Commission on October 9, 1997. *(10.26) Amended and Restated Executive Salary Continuation Agreement dated September 30, 1997, made by and between Regency Bank and Steven R. Canfield, incorporated by reference from exhibit 99.3 of the Form 8-K, filed with the Commission on October 9, 1997. (27.1) Financial Data Schedule * Denotes management contracts, compensatory plans or arrangements 34 (b) Reports on Form 8-K The Company filed a Form 8-K dated July 9, 1998, in which it reported its record mid-year earnings, which stated earnings of $1.15 million or $0.44 per share in the first six months of 1998. The Company filed a Form 8-K dated July 27, 1998, in which it reported that the Federal Reserve Bank of San Francisco approved the application of Regency Bank to become a member of the Federal Reserve Bank of San Francisco. Additionally, the registrant reported that it engaged Belle Plaine Financial LLC to act as exclusive financial advisor to Regency Bancorp and its various entities in connection with its efforts to acquire, invest in, or sell depository institutions and/or other businesses. The Company filed a Form 8-K dated August 1, 1998, in which it reported a change in the registrant's certifying accountant. The registrant's board of directors approved the dismissal of Deloitte & Touche LLP as the registrant's independent accountant effective August 1, 1998. Additionally, the registrant reported that it has engaged KPMG Peat Marwick LLP as principal accountant to audit the registrant's financial statements effective August 1, 1998. The Company filed a Form 8-K dated September 23, 1998, in which it announced its intention to repurchase stock and the completion of real estate investment divestiture. 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: 11/2/98 By: /s/ Steven F. Hertel --------------------------- ---------------------------- Steven F. Hertel President and Chief Executive Officer (Principal Executive Officer) Date: 11/2/98 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 27.1 Financial Data Schedule 38 37