Exhibit 13
Farmers & Merchants
Bancorp
2002
Annual
Report
1
To Our Shareholders:
Farmers & Merchants Bancorp's record 2002 financial results are a testament to
the skill and commitment of our employees, the patronage of our valued
customers, the vitality of the Central Valley economy, and the dedication of our
shareholders. Throughout our 86-year history, these advantages have enabled the
Company to prosper financially and at the same time, maintain a strong community
focus. During 2002, our established growth trend continued resulting in the
Company surpassing a key milestone of $1 billion in total assets. At the same
time, we continued to upgrade our product delivery and technological
capabilities in preparation for additional expansion.
We are pleased to present to you Farmers & Merchants Bancorp's consolidated
annual financial reports for fiscal year 2002; the most profitable and
successful year in our history. Net income after taxes totaled $13,419,203 or
$18.18 per share of common stock, up 11.5% over the prior year. The growth in
earnings per share occurred because of a 16% increase in total loans
outstanding, a 7% rise in total deposits net of time certificates, and a 30%
jump in non-interest income less non-recurring items. Return on assets
strengthened to 1.41% from 1.35% the prior year and return on equity improved 37
basis points to 13.51% in 2002 compared to 13.14% in 2001. In conjunction with
these strong results, the Company completed over $2,000,000 in capital
improvements and increased the allowance for future loan losses to $16,684,487,
a $3,975,308 increase over the prior year, to provide a larger level of
protection against the financial impact of future economic downturns.
Last April, for the 28th consecutive year, the Board of Directors unanimously
approved a 5% stock dividend. In addition, cash dividends declared in 2002
totaled $4,403,582 or $6.00 per share of common stock, a 12.3% increase over the
prior year. The Board of Directors is currently evaluating the merits of
transitioning to a more uniform quarterly cash dividend payment. Their analysis
is taking into consideration a variety of factors including the best interests
of the shareholders, the Company's financial condition and capacity, and
regulatory requirements.
Several important initiatives were rolled out this past year including the
exciting new image campaign designed to build the F&M Bank brand name. For
years, your Company has been affectionately referred to as "F&M Bank". To appeal
to a broader customer base, we have updated our image and will more consistently
make use of the simpler name, F&M Bank. We have designed a new logo and adopted
the catchy slogan "Where Banking is Easy!" to support our strategy of creating
new growth opportunities for the Company.
Other key initiatives in 2002 included the installation of the new Southwest
Bell/Cisco telecommunications system and the opening of our first branch office
in over a decade at the prestigious Lincoln Center in Stockton. The new branch
was an instant success achieving first year growth targets in just four months.
As part of the effort to build our brand name and modernize the Bank's image, we
have also completed the model architectural design for future F&M Bank branch
offices. Our new Vintage Faire office, scheduled to open this Summer, will be
the first branch to use the new model bank design. The design work was also
completed for updated F&M Bank signage with installation beginning in 2003. In
addition, we upgraded our personal computer network hardware and software and
converted to the next generation of check/document imaging technology.
Looking to the future, the downward trend of market interest rates will continue
to exert pressure on the banking industry's net interest margin creating a
challenging earnings environment. The Board of Directors and Management Team at
Farmers & Merchants Bancorp will address these challenges by seeking greater
operating efficiency, expanding our market penetration, and strengthening
capital management and asset/liability discipline. Efforts to enhance our
product distribution capabilities will be ongoing. We believe our geographic
market offers growth opportunities and are confident the scope, functionality
and value of our products and customer solutions will differentiate Farmers &
Merchants Bancorp from the competition. These ingredients, in the hands of our
talented team of employees, have the potential to build meaningful value for our
shareholders.
A special thank you is extended to our employees for their hard work and
enormous contributions in 2002. Acknowledgement is owed as well to the Board of
Directors for their dedication and extraordinary efforts in representing the
shareholders' best interests. Furthermore, their guidance and support were of
great value to the management team. We also thank our many outstanding
customers. We immensely value your business and feel privileged to be able to
serve your banking needs.
This great financial institution has stood strong for over 86 years. We look
back with tremendous pride and forward with great enthusiasm and excitement. Our
shareholders have always been a source of strength for the Bank. Your continued
confidence and satisfaction with your investment in Farmers & Merchants Bancorp
remains of the utmost importance to us. We extend our best wishes to you for a
healthy and prosperous 2003.
/s/ Kent A. Steinwert /s/ Ole R. Mettler
Kent A. Steinwert Ole R. Mettler
President & Chief Executive Officer Chairman of the Board
2
FARMERS & MERCHANTS BANCORP
Mission Statement
To become "THE PREMIER" community bank serving the financial needs of
communities throughout California's Great Central Valley. To successfully
accomplish this mission, the Company will:
|X| Consistently provide shareholders with a competitive return on investment.
|X| Strengthen and discipline capital management.
|X| Be staffed by highly skilled and motivated employees, properly supported by
continuing education, advanced technology and quality products.
|X| Carefully target and successfully penetrate desired market segments.
|X| Deliver an extraordinary level of personalized service backed by value
added financial products.
|X| Conservatively manage all risks.
|X| Be exemplary in community development, reinvestment and service.
|X| Develop and foster local ownership in order to maintain independence.
3
FARMERS & MERCHANTS BANCORP
Operating Philosophy
Farmers & Merchants Bancorp was founded, and exists today, for the purpose of
generating a competitive return for it's shareholders through the delivery of
financial services to the communities it serves. In order to accomplish this
purpose, we will strive to benefit four distinct constituents: shareholders,
customers, employees and the communities we serve. Although the short-term
interests of these groups may occasionally differ, in the long run we believe
them to be complimentary. We are convinced that our purpose can only be achieved
through diligent attention to all four. Building the Company's financial
strength by delivering a reliable stream of earnings is fundamental to the
interest of each group. The Company's economic viability has positive
implications for all concerned. We are committed to maintaining the Company's
independence in order to accomplish our purpose of pro-actively benefiting each
constituent.
The Board of Directors and Executive Management Team recognizes that each
constituent has different needs and aspirations, and are committed to the
following goals:
|X| Shareholders, our owners, can expect a competitive return on their
investment, taking into consideration the maintenance of capital adequacy
and capital expenditure requirements. We strive to build their pride of
ownership in an organization respected for it's accomplishments, and
recognized for community leadership.
|X| Customers, whose patronage allows us to function and prosper, are entitled
to financial services of the highest quality, delivered by knowledgeable
and caring employees. Our customers must be assured of a reasonable return
on the deposits entrusted to us, and fair terms on borrowed funds. We
acknowledge that the protection of their deposits, as well as their
personal privacy, are absolute priorities. We will always strive to deliver
a level of service that is "beyond their expectations." Making banking easy
for the customer is a core strategy.
|X| Employees, who are skilled and dedicated, are fundamental to our success.
They can anticipate fair compensation, respect, acknowledgment of superior
performance, a productive and healthy work environment, equal employment
opportunity, and an employer in whom they can take great pride.
|X| The communities we serve can expect a commitment to reinvestment,
leadership in pursuing economic vitality, and an ongoing effort to improve
the overall quality of life. We will be diligent in aiding community based
service organizations through both financial and volunteer support.
4
Report of Management
The management of Farmers & Merchants Bancorp (the Company) and its subsidiary
has the responsibility for the preparation, integrity and reliability of the
consolidated financial statements and related financial information contained in
this annual report. The financial statements were prepared in accordance with
generally accepted accounting principles and prevailing practices of the banking
industry. Where amounts must be based on estimates and judgments, they represent
the best estimates and judgments of management.
Management has established and is responsible for maintaining an adequate
internal control structure designed to provide reasonable, but not absolute,
assurance as to the integrity and reliability of the financial statements,
safeguarding of assets against loss from unauthorized use or disposition and the
prevention and detection of fraudulent financial reporting. The internal control
structure includes: an effective financial accounting environment; a
comprehensive internal audit function; an independent audit committee of the
Board of Directors; and extensive financial and operating policies and
procedures. Management also recognizes its responsibility for fostering a strong
ethical climate which is supported by a code of conduct, appropriate levels of
management authority and responsibility, an effective corporate organizational
structure and appropriate selection and training of personnel.
The Board of Directors, primarily through its audit committee, oversees the
adequacy of the Company's internal control structure. The audit committee, whose
members are neither officers nor employees of the Company, meet periodically
with management, internal auditors and internal credit examiners to review the
functioning of each and to ensure that each is properly discharging its
responsibilities. In addition, PricewaterhouseCoopers LLP, independent auditors,
are engaged to audit the Company's financial statements.
PricewaterhouseCoopers LLP, obtains and maintains an understanding of the
Company's accounting and financial controls and conducts its audit in accordance
with generally accepted auditing standards which includes such audit procedures
as it considers necessary to express the opinion in the report that follows.
Management recognizes that there are inherent limitations in the effectiveness
of any internal control structure. However, management has assessed and believes
that, as of December 31, 2002, the Company's internal control structure, as
described above, provides reasonable assurance as to the integrity and
reliability of the financial statements and related financial information.
Management also is responsible for compliance with federal and state laws and
regulations concerning loans to insiders and dividend restrictions designated by
the FDIC as safety and soundness laws and regulations.
Management assessed its compliance with the designated laws and regulations
relating to safety and soundness. Based on this assessment, Management believes
that the Bank complied with the designated laws and regulations relating to
safety and soundness for the year ended December 31, 2002.
/s/ Kent A. Steinwert /s/ John R. Olson
Kent A. Steinwert John R. Olson
President & Executive Vice President &
Chief Executive Officer Chief Financial Officer
5
Report of Independent Accountants
To the Board of Directors and
Shareholders of Farmers & Merchants Bancorp:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of changes in shareholders' equity, of
comprehensive income and of cash flows present fairly, in all material respects,
the financial position of Farmers & Merchants Bancorp and its subsidiaries at
December 31, 2002 and 2001, and the results of their operations and their cash
flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
February 18, 2003
6
Consolidated Statements of Income
- ---------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
Year Ended December 31,
2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------------
Interest Income
Interest and Fees on Loans $41,911 $43,956 $44,171
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 555 1,922 1,300
Interest on Investment Securities:
Taxable 9,400 15,112 17,574
Tax-Exempt 2,372 2,540 3,082
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest Income 54,238 63,530 66,127
- ---------------------------------------------------------------------------------------------------------------------------
Interest Expense
Interest on Deposits 11,369 21,038 21,845
Interest on Borrowed Funds 2,227 2,242 2,912
- ---------------------------------------------------------------------------------------------------------------------------
Total Interest Expense 13,596 23,280 24,757
- ---------------------------------------------------------------------------------------------------------------------------
Net Interest Income 40,642 40,250 41,370
Provision for Loan Losses 4,926 1,000 2,800
- ---------------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision for Loan Losses 35,716 39,250 38,570
- ---------------------------------------------------------------------------------------------------------------------------
Non-Interest Income
Service Charges on Deposit Accounts 4,760 4,179 3,464
Net Gain (Loss) on Sale of Investment Securities 276 88 (120)
Credit Card Merchant Fees 1,415 1,207 976
Gain on Sale of Assets 2,800 - -
Increase in Cash Surrender Value of Life Insurance 1,433 - -
Other 3,182 2,900 2,328
- ---------------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 13,866 8,374 6,648
- ---------------------------------------------------------------------------------------------------------------------------
Non-Interest Expense
Salaries and Employee Benefits 17,796 16,986 16,235
Occupancy Expense 1,709 1,680 1,730
Equipment Expense 2,146 2,026 1,916
Other 7,458 6,794 7,667
- ---------------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expense 29,109 27,486 27,548
- ---------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 20,473 20,138 17,670
Provision for Income Taxes 7,054 7,821 6,650
- ---------------------------------------------------------------------------------------------------------------------------
Net Income $13,419 $12,317 $11,020
===========================================================================================================================
Earnings Per Share $ 18.18 $ 16.31 $ 14.54
===========================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
7
Consolidated Balance Sheets
- ----------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
December 31,
Assets 2002 2001
- ----------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due from Banks $ 45,389 $ 32,406
Federal Funds Sold and Securities Purchased Under Agreements to Resell 8,185 31,100
- ----------------------------------------------------------------------------------------------------------------------------
Total Cash and Cash Equivalents 53,574 63,506
- ----------------------------------------------------------------------------------------------------------------------------
Investment Securities:
Available-for-Sale 206,063 242,852
Held-to-Maturity 27,870 32,698
- ----------------------------------------------------------------------------------------------------------------------------
Total Investment Securities 233,933 275,550
- ----------------------------------------------------------------------------------------------------------------------------
Loans: 696,675 602,169
Less: Allowance for Loan Losses 16,684 12,709
- ----------------------------------------------------------------------------------------------------------------------------
Loans, Net 679,991 589,460
- ----------------------------------------------------------------------------------------------------------------------------
Premises and Equipment, Net 11,342 11,432
Interest Receivable and Other Assets 43,067 30,935
- ----------------------------------------------------------------------------------------------------------------------------
Total Assets $1,021,907 $970,883
============================================================================================================================
Liabilities
Deposits:
Demand $ 205,997 $198,316
Interest-Bearing Transaction Accounts 93,646 100,574
Savings 231,964 198,651
Time 318,618 322,170
- ----------------------------------------------------------------------------------------------------------------------------
Total Deposits 850,225 819,711
- ----------------------------------------------------------------------------------------------------------------------------
Federal Funds Purchased 16,997 -
Federal Home Loan Bank Advances 40,965 41,000
Interest Payable and Other Liabilities 10,155 9,436
- ----------------------------------------------------------------------------------------------------------------------------
Total Liabilities 918,342 870,147
- ----------------------------------------------------------------------------------------------------------------------------
Shareholders' Equity
Preferred Stock: No Par Value. 1,000,000 Authorized, None Issued or Outstanding - -
Common Stock: Par Value $0.01, 2,000,000 Shares Authorized, 733,021 and
719,269 Issued and Outstanding at December 31, 2002 and 2001, Respectively 7 7
Additional Paid-In Capital 64,979 61,360
Retained Earnings 36,749 36,499
Accumulated Other Comprehensive Income 1,830 2,870
- ----------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 103,565 100,736
- ----------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $1,021,907 $970,883
============================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
8
Consolidated Statements of Changes in Shareholders' Equity
- ---------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income(Loss) Equity
- ---------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 660,989 $ 7 $47,993 $36,040 $(3,839) $80,201
- ---------------------------------------------------------------------------------------------------------------------------
Net Income 11,020 11,020
Cash Dividends Declared on
Common Stock (3,609) (3,609)
5% Stock Dividend 32,496 6,824 (6,824)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (100) (100)
Redemption of Stock (5,994) (1,258) (1,258)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale 4,629 4,629
- ---------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 687,491 $ 7 $53,559 $36,527 $ 790 $90,883
- ---------------------------------------------------------------------------------------------------------------------------
Net Income 12,317 12,317
Cash Dividends Declared on
Common Stock (3,923) (3,923)
5% Stock Dividend 33,831 8,289 (8,289)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (133) (133)
Redemption of Stock (2,053) (488) (488)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale 2,080 2,080
- ---------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 719,269 $ 7 $61,360 $36,499 $ 2,870 $100,736
- ---------------------------------------------------------------------------------------------------------------------------
Net Income 13,419 13,419
Cash Dividends Declared on
Common Stock (4,404) (4,404)
5% Stock Dividend 34,501 8,625 (8,625)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (140) (140)
Redemption of Stock (20,749) (5,006) (5,006)
Unrealized Gains on Derivative Instruments 117 117
Minimum Pension Plan Liability Adjustment (731) (731)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale (426) (426)
- ---------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2002 733,021 $ 7 $64,979 $36,749 $ 1,830 $103,565
===========================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
9
Consolidated Statements of Cash Flows
- ----------------------------------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net Income $ 13,419 $ 12,317 $ 11,020
Adjustments to Reconcile Net Income to Net Cash Provided
by Operating Activities:
Provision for Loan Losses 4,926 1,000 2,800
Depreciation and Amortization 1,584 1,592 1,760
Provision for Deferred Income Taxes (836) (38) (730)
Net Amortization of Investment Security Premium & Discounts 10 (314) (435)
Net (Gain) Loss on Sale of Investment Securities (276) (88) 120
Net (Increase) Decrease in Interest Receivable and Other Assets (10,945) (18,307) (1,325)
Net Increase in Interest Payable and Other Liabilities (12) 479 (4,516)
- ----------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Operating Activities 7,870 (3,359) 8,694
- ----------------------------------------------------------------------------------------------------------------------------
Investing Activities
Securities Available-for-Sale:
Purchased (113,687) (26,704) (42,873)
Sold or Matured 150,026 66,548 69,161
Securities Held-to-Maturity:
Purchased (329) (6,460) (398)
Matured 5,214 15,142 8,493
Net Increase in Loans (95,792) (105,526) (84,916)
Principal Collected on Loans Previously Charged Off 335 587 217
Net Additions to Premises and Equipment (1,495) (1,468) (609)
- ----------------------------------------------------------------------------------------------------------------------------
Net Cash Used for Investing Activities (55,728) (57,881) (50,925)
- ----------------------------------------------------------------------------------------------------------------------------
Financing Activities
Net Increase in Demand, Interest-Bearing Transaction,
and Savings Accounts 34,066 57,351 10,735
Net (Decrease) in Time Deposits (3,552) (2,318) 68,800
Net Increase in Federal Funds Purchased 16,997 - -
Net (Decrease) in Federal Home Loan Bank Advances (35) (33) (31)
Stock Redemption (5,006) (488) (1,258)
Cash Dividends (4,544) (4,056) (3,709)
- ----------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 37,926 50,456 74,537
- ----------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents (9,932) (10,784) 32,306
Cash and Cash Equivalents at Beginning of Year 63,506 74,290 41,984
- ----------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $53,574 $63,506 $74,290
============================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
10
Consolidated Statements of Comprehensive Income
- --------------------------------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
2002 2001 2000
- --------------------------------------------------------------------------------------------------------------------------
Net Income $13,419 $12,317 $11,020
Other Comprehensive Income (Loss)
Unrealized Gains on Derivative Instruments:
Unrealized holding gains arising during the period, net
of income tax effects of $85 for the year ended December 31, 2002 117 - -
Unrealized (Loss) on Minimum Pension Plan Liability Adjustment:
Unrealized (loss) arising during the period, net of income
tax effects of $(531) for the year ended December 31, 2002 (731) - -
Unrealized Gains (Losses) on Securities:
Unrealized holding gains (losses) arising during the period, net
of income tax effects of $(117), $1,492 and $3,188 for the
years ended December 31, 2002, 2001 and 2000,
respectively. (266) 2,131 4,558
Less: Reclassification adjustment for realized (gains) losses
included in net income, net of related income tax effects
of $(116), $(37) and $49 for the years ended December 31,
2002, 2001 and 2000, respectively. (160) (51) 71
- --------------------------------------------------------------------------------------------------------------------------
Total Other Comprehensive Income (Loss) (1,040) 2,080 4,629
- --------------------------------------------------------------------------------------------------------------------------
Comprehensive Income $12,379 $14,397 $15,649
==========================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
11
Notes to Consolidated Financial Statements
1. Significant Accounting Policies
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Its'
primary operations are related to traditional banking activities through its
subsidiary Farmers & Merchants Bank of Central California (the Bank). The
consolidated financial statements of the Company and its subsidiary, the Bank,
are prepared in conformity with generally accepted accounting principles and
prevailing practices within the banking industry. In preparing the financial
statements, management is required to make estimates and assumptions that affect
reported amounts as of the date of the balance sheet and revenues and expenses
for the period. These estimates are based on information available as of the
date of the financial statements. Therefore, actual results could differ from
those estimates. The following is a summary of the significant accounting and
reporting policies used in preparing the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F&M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. The investment in the Bank is
carried at the Company's equity in the underlying net assets. Significant
intercompany transactions have been eliminated in consolidation. F&M Bancorp,
Inc. was created in March 2002 to protect the name F&M Bank, Farmers &
Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants
Corp. acts as trustee on deeds of trust originated by the Bank.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
Information in this report dated prior to March 10, 1999 is for Farmers &
Merchants Bank of Central California.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks and Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Bank has the ability to hold the securities
until maturity. These securities are carried at cost, adjusted for amortization
of premium and accretion of discount using a methodology which approximates a
level yield of interest over the estimated remaining period until maturity.
Losses, reflecting a decline in value judged by the Bank to be other than
temporary, are recognized in the period in which they become known.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. Securities classified as available-for-sale include securities which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes. Fair values are based on quoted market prices or broker/dealer price
quotations on a specific identification basis. Gains or losses on the sale of
these securities are computed using the specific identification method.
Unrealized losses on these securities, reflecting a decline in value judged by
the Company to be other than temporary, are recognized in the period in which
they become known.
12
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the remaining principal and interest can be reasonably assured.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that can be reasonably anticipated. The allowance is
increased by provisions charged to operating expense and reduced by net
charge-offs. Management employs a systematic methodology for determining the
allowance for loan losses. On a quarterly basis, management reviews the credit
quality of the loan portfolio and considers problem loans, delinquencies,
internal credit reviews, current economic conditions, loan loss experience and
other factors in determining the adequacy of the allowance balance.
The conditions evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, credit quality trends, collateral values, loan volumes and
concentration, seasoning of the loan portfolio, specific industry conditions,
recent loss experience, duration of the current business cycle, bank regulatory
examination results and findings of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known.
13
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are recorded at fair value less estimated selling costs upon
acquisition. Revised estimates to the fair value less cost to sell are reported
as adjustments to the carrying amount of the asset, provided that such adjusted
value is not in excess of the carrying amount at acquisition. Initial losses on
properties acquired through full or partial satisfaction of debt are treated as
credit losses and charged to the Allowance for Loan Losses at the time of
acquisition. Subsequent declines in value from the recorded amounts, routine
holding costs, and gains or losses upon disposition, if any, are included in
non-interest income or expense as incurred.
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
Earnings Per Share
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding for the period. Prior years have
been restated for the 5% stock dividend paid in each of the years presented.
Segment Reporting
The Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" requires that public
companies report certain information about operating segments. It also requires
that public companies report certain information about their products and
services, the geographic areas in which they operate, and their major customers.
The Company is a community bank which offers a wide array of products and
services to its customers. Pursuant to its banking strategy, emphasis is placed
on building relationships with its customers, as opposed to building specific
lines of business. As a result, the Company is not organized around discernable
lines of business and prefers to work as an integrated unit to customize
solutions for its customers, with business line emphasis and product offerings
changing over time as needs and demands change. Thus, all necessary requirements
of SFAS No. 131 have been met by the Company as of December 31, 2002.
14
Derivative Instruments and Hedging Activities
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in the fair value of
those derivatives are accounted for depending on the intended use of the
derivative and the resulting designation under specified criteria. If the
derivative is designated as a fair value hedge, the changes in the fair value of
the derivative and of the hedged item attributable to the hedged risk are
recognized in earnings. If the derivative is designated as a cash flow hedge,
designed to minimize interest rate risk, the effective portions of the change in
the fair value of the derivative are recorded in other comprehensive income.
Ineffective portions of changes in the fair value of cash flow hedges are
recognized in earnings. As required, SFAS No. 133 was adopted by the Company
effective January 1, 2001.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income.
Comprehensive Income
The Statement of Financial Accounting Standards, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income includes net
income (loss) and changes in fair value of its available-for-sale investment
securities, pension plan liability adjustments and cash flow hedges.
2. Securities Purchased Under Agreements to Resell
The Company enters into purchases and sales of securities under agreements to
resell substantially identical securities. These types of security transactions
are generally for one day periods and are primarily whole loan securities rated
AA or better. During 2002 and 2001, the underlying securities purchased under
resale agreements were delivered into the Bank's account at a third-party
custodian that recognizes the Company's rights and interest in these securities.
3. Investment Securities
The amortized cost, fair values and unrealized gains and losses of the
securities available-for-sale are as follows:
(in thousands)
Amortized Gross Unrealized Fair/Book
----------------------
December 31, 2002 Cost Gains Losses Value
----------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 26,584 $ 400 $ - $ 26,984
Obligations of States and Political Subdivisions 33,372 1,023 43 34,352
Mortgage-Backed Securities 114,878 2,457 - 117,335
Corporate Bonds 17,579 124 - 17,703
Other 9,432 257 - 9,689
- ------------------------------------------------------------------------------------------------------
Total $201,845 $4,261 $ 43 $206,063
======================================================================================================
December 31, 2001
----------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 12,588 $ 183 $ - $ 12,771
Obligations of States and Political Subdivisions 23,906 238 68 24,076
Mortgage-Backed Securities 191,994 4,423 33 196,384
Other 9,487 140 6 9,621
- ------------------------------------------------------------------------------------------------------
Total $237,975 $4,984 $ 107 $242,852
======================================================================================================
15
The book values, estimated fair values and unrealized gains and losses of
investments classified as held-to-maturity are as follows: (in thousands)
Book Gross Unrealized Fair
----------------------
December 31, 2002 Value Gains Losses Value
------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $27,351 $1,230 $ 2 $28,579
Other 519 13 - 532
------------------------------------------------------------------------------------------------------
Total $27,870 $1,243 $ 2 $29,111
======================================================================================================
December 31, 2001
------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $32,137 $ 825 $ 13 $32,949
Other 561 36 - 597
------------------------------------------------------------------------------------------------------
Total $32,698 $ 861 $ 13 $33,546
======================================================================================================
Fair values are based on quoted market prices or dealer quotes. If a quoted
market price is not available, fair value is estimated using quoted market
prices for similar securities.
The remaining principal maturities of debt securities as of December 31, 2002
and 2001 are shown below. Expected maturities may differ from contractual
maturities as borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 2002 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ - $ 26,984 $ - $ - $26,984
Obligations of States and Political Subdivisions 2,088 26,654 4,638 972 34,352
Mortgage-Backed Securities 64,047 43,030 10,257 - 117,334
Corporate Bonds 8,163 9,541 - - 17,704
Other 4,596 5,093 - - 9,689
------------------------------------------------------------------------------------------------------------------
Total $78,894 $111,302 $14,895 $ 972 $206,063
==================================================================================================================
2001 Totals $78,495 $154,805 $ 8,567 $ 985 $242,852
==================================================================================================================
After 1 After 5 Total
Securities Held-to-Maturity Within but but Over Book
December 31, 2001 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 7,234 $16,144 $ 1,699 $2,274 $27,351
Other - - - 519 519
------------------------------------------------------------------------------------------------------------------
Total $ 7,234 $16,144 $ 1,699 $2,793 $27,870
==================================================================================================================
2001 Totals $ 4,510 $20,566 $ 3,365 $4,257 $32,698
==================================================================================================================
Proceeds from sales of securities available-for-sale were as follows:
(in thousands) Gross Gross Gross
Proceeds Gains Losses
- --------------------------------------------------------------------------------------------------------------------
2002 $24,862 $276 $ -
2001 5,206 88 -
2000 $21,744 $506 $199
As of December 31, 2002, securities carried at $105,949,000 were pledged to
secure public and other deposits as required by law.
16
4. Loans and Allowance for Loan Losses
Loans as of December 31, consisted of the following:
(in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Real Estate $367,224 $304,451
Real Estate Construction 66,467 49,692
Agricultural 109,130 110,707
Commercial 135,877 117,202
Consumer 19,995 21,133
- -------------------------------------------------------------------------------------------------------------------
698,693 603,185
Less: Unearned Income on Loans (2,018) (1,016)
- -------------------------------------------------------------------------------------------------------------------
Total Loans $696,675 $602,169
===================================================================================================================
Non-Accrual Loans $ 2,897 $ 2,353
===================================================================================================================
Changes in the allowance for loan losses consisted of the following:
(in thousands)
2002 2001 2000
- -------------------------------------------------------------------------------------------------------------------
Balance, January 1 $12,709 $11,876 $ 9,787
Provision Charged to Operating Expense 4,926 1,000 2,800
Recoveries of Loans Previously Charged Off 335 587 218
Loans Charged Off (1,286) (754) (929)
- -------------------------------------------------------------------------------------------------------------------
Balance, December 31 $16,684 $12,709 $11,876
===================================================================================================================
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. All impaired loans
have been assigned a related allowance for credit losses. As of December 31,
2002 and 2001, the total recorded investment in impaired loans was $2,897,000
and $2,353,000, respectively. The related allowance for impaired loans was
$1,289,000 and $190,000 for the years ended 2002 and 2001, respectively. For
income reporting purposes, impaired loans are placed on a non-accrual status and
are more fully discussed in Note 1. Cash payments are first applied as a
reduction of the loan's principal balance until collection of the remaining
principal and interest can be reasonably assured. Thereafter, interest income is
recognized as it is collected in cash. The average balance of impaired loans was
$4.7 million, $1.1 million and $2.3 million for the years ended 2002, 2001 and
2000, respectively. There was no interest income reported on impaired loans in
2002, 2001 and 2000. Interest income forgone on loans placed on nonaccrual
status was $331,000, $26,000 and $71,000 for the years ended December 31, 2002,
2001 and 2000, respectively.
5. Premises and Equipment
Premises and equipment as of December 31, consisted of the following:
(in thousands) 2002 2001
- -----------------------------------------------------------------------------------------------------------------
Land and Buildings $16,023 $15,830
Furniture, Fixtures and Equipment 15,464 14,429
Leasehold Improvements 1,062 835
- -----------------------------------------------------------------------------------------------------------------
32,549 31,094
Less: Accumulated Depreciation and Amortization 21,207 19,662
- -----------------------------------------------------------------------------------------------------------------
Total $11,342 $11,432
=================================================================================================================
17
Depreciation and amortization on premises and equipment included in occupancy
and equipment expense amounted to $1,585,000, $1,592,000 and $1,760,000 for the
years ended December 31, 2002, 2001 and 2000, respectively. Total rental expense
for premises were $248,000, $212,000 and $270,000 for the years ended December
31, 2002, 2001 and 2000, respectively. Rental income was $73,000, $70,000 and
$81,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
6. Other Real Estate
The Bank reported no other real estate at December 31, 2002 and 2001. Other real
estate includes property no longer utilized for business operations and property
acquired through foreclosure proceedings. These properties are carried at the
lower of cost or estimated net realizable value determined at the date acquired.
Losses arising from the acquisition of these properties are charged against the
allowance for loan losses. Subsequent declines in value, routine holding costs
and net gains or losses on disposition are included in other operating expense
as incurred.
7. Time Deposits
Time Deposits of $100,000 or more were as follows:
(in thousands)
December 31,
2002 2001
- ------------------------------------------------------------------------------------------------------------------
Balance $148,005 $146,432
==================================================================================================================
At December 31, 2002, the scheduled maturities of time deposits were as follows:
Scheduled
(in thousands) Maturities
- -------------------------------------------------------------------------------------------------------------------
2003 $272,784
2004 23,778
2005 12,071
2006 9,985
2007 and thereafter -
- -------------------------------------------------------------------------------------------------------------------
Total $318,618
===================================================================================================================
8. Income Taxes
Current and deferred income tax expense (benefit) provided for the years ended
December 31, consisted of the following:
(in thousands) 2002 2001 2000
-----------------------------------------------------------------------------------------------------------------
Current
Federal $5,506 $5,673 $5,229
State 2,384 2,186 2,151
- -----------------------------------------------------------------------------------------------------------------
Total Current 7,890 7,859 7,380
- -----------------------------------------------------------------------------------------------------------------
Deferred
Federal (503) (33) (493)
State (333) (5) (237)
- -----------------------------------------------------------------------------------------------------------------
Total Deferred (836) (38) (730)
- -----------------------------------------------------------------------------------------------------------------
Total Provision for Taxes $7,054 $7,821 $6,650
=================================================================================================================
18
The total provision for income taxes differs from the federal statutory rate as
follows:
(in thousands)
2002 2001 2000
Amount Rate Amount Rate Amount Rate
- -------------------------------------------------------------------------------------------------------------------
Tax Provision at Federal Statutory Rate $7,165 35.0 % $7,048 35.0 % $6,185 35.0 %
Interest on Obligations of States
and Political Subdivisions
Exempt from Federal Taxation (806) (3.9)% (658) (3.3)% (740) (4.2)%
State and Local Income Taxes,
Net of Federal Income Tax Benefit 1,333 6.5 % 1,418 7.0 % 1,263 7.2 %
Bank Owned Life Insurance (523) (2.6)%
Other, Net (115) (0.6)% 13 0.1 % (58) (0.4)%
- -------------------------------------------------------------------------------------------------------------------
Total Provision for Taxes $7,054 34.4 % $7,821 38.8 % $6,650 37.6 %
===================================================================================================================
The components of the net deferred tax assets as of December 31 are as follows:
(in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Deferred Tax Assets
Allowance for Loan Losses $7,015 $5,084
Accrued Liabilities 507 892
Deferred Compensation 1,160 999
Other Real Estate - 309
State Franchise Tax 834 765
Interest on Non-Accrual Loans 80 11
- -------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Assets 9,596 8,060
- -------------------------------------------------------------------------------------------------------------------
Deferred Tax Liabilities
Depreciation (214) (229)
Unrealized Gain on Securities Available-for-Sale (1,774) (2,051)
Securities Accretion (933) (1,039)
Pension (1,079) (269)
Other 278 (156)
- -------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Liabilities (3,722) (3,744)
- -------------------------------------------------------------------------------------------------------------------
Net Deferred Tax Assets $5,874 $4,316
===================================================================================================================
The net deferred tax assets are reported in Interest Receivable and Other Assets
on the Company's Consolidated Balance Sheets. Prior year amounts have been
restated to conform with the tax return as filed.
9. Short Term Borrowings
As of December 31, 2002 and 2001, the Company had unused lines of credit
available for short term liquidity purposes of $284 million and $136 million,
respectively. Federal Funds purchased and advances from the Federal Reserve Bank
are generally issued on an overnight basis.
19
10. Federal Home Loan Bank Advances
The Company's advances from the Federal Home Loan Bank of San Francisco consist
of the following as of December 31,
(in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
5.35% note payable due February 4, 2008 with interest due quarterly, callable February 2, $25,000 $25,000
2003 and quarterly thereafter.
5.38% note payable due August 12, 2008 with interest due quarterly, callable August 12, 15,000 15,000
2003 and quarterly thereafter.
5.60% amortizing note, interest and principal payable monthly with final maturity of
September 25, 2018. 965 1,000
- -------------------------------------------------------------------------------------------------------------------
Total $40,965 $41,000
===================================================================================================================
In accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the company and by agency
and mortgage-backed securities, classified as available-for-sale, with carrying
values of $39,097,000.
11. Shareholders' Equity
Beginning in 1975 and continuing through 2002, the Company has issued an annual
5% stock dividend. Earnings per share amounts have been restated for each year
presented to reflect the stock dividend.
Dividends from the Bank constitute the principal source of cash to the Company.
The Company is a legal entity separate and distinct from the Bank. Under
regulations controlling California state chartered banks, the Bank is, to some
extent, limited in the amount of dividends that can be paid to shareholders
without prior approval of the State Department of Financial Institutions. These
regulations require approval if total dividends declared by a state chartered
bank in any calendar year exceed the bank's net profits for that year combined
with its retained net profits for the preceding two calendar years. As of
December 31, 2002, the Bank could declare dividends of $14,489,000 without
approval of the California State Banking Department. These regulations apply to
all California state chartered banks.
The Accumulated Other Comprehensive Income is the result of the accounting
standard, Reporting Comprehensive Income. This accounting principle requires
securities classified as available-for-sale be reported at their fair values.
Unrealized gains and losses are reported on a net-of-tax basis as a component of
Shareholders' Equity.
The Company and the Bank are subject to various regulatory capital requirements
administered by the Federal Reserve Bank of San Francisco and the Federal
Deposit Insurance Corporation. These guidelines are designed to make capital
requirements more sensitive to differences in risk related assets among banking
organizations, to take into account off-balance sheet exposures and aid in
making the definition of banking capital uniform. Bank assets and off-balance
sheet items are categorized by risk. The results of these regulations are that
assets with a higher degree of risk require a larger amount of capital; assets,
such as cash, with a low degree of risk have little or no capital requirements.
Failure to meet these minimum capital requirements can initiate certain
disciplinary actions by regulators. As of December 31, 2002 and 2001, the
Company and the Bank meet all capital adequacy requirements to which they are
subject. The following table illustrates the relationship between the Bank's
regulatory capital requirements and the Bank's capital position.
20
Well Capitalized
Regulatory Capital Under Prompt
(in thousands) Actual Requirements Corrective Action
December 31, 2002 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $108,191 11.73% $73,766 8.0% $92,208 10.0%
Total Consolidated Capital to Risk Weighted Assets $113,370 12.25% $74,058 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $ 96,602 10.48% $36,883 4.0% $55,325 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $101,735 10.99% $37,029 4.0% N/A N/A
Tier I Bank Capital to Average Assets $ 96,602 9.84% $39,259 4.0% $49,074 5.0%
Tier I Consolidated Capital to Average Assets $101,735 10.32% $39,439 4.0% N/A N/A
December 31, 2001 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $100,842 12.93% $62,391 8.0% $77,988 10.0%
Total Consolidated Capital to Risk Weighted Assets $107,591 13.76% $62,543 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $ 91,104 11.68% $31,195 4.0% $46,793 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $ 97,829 12.51% $31,271 4.0% N/A N/A
Tier I Bank Capital to Average Assets $ 91,104 9.57% $38,077 4.0% $47,596 5.0%
Tier I Consolidated Capital to Average Assets $ 97,829 10.25% $38,159 4.0% N/A N/A
12. Employee Benefit Plans
The Company, through the Bank, sponsors a defined benefit pension plan (the
Plan) that covers employees of Farmers & Merchants Bank of Central California.
Effective June 9, 2001 the Plan was amended to freeze the benefit accruals in
the Plan. With the exception of employees who have reached age 55 and who have
accumulated 10 years of Plan service, the effect of the amendment will be to
freeze the participants' monthly pension benefit. Employees who have reached age
55 and have accumulated 10 years of Plan service as of December 31, 2000 will
continue to accrue benefits under the Plan.
The Plan provides benefits up to a maximum stated in the plan, based on each
covered employee's years of service and highest five-year average compensation
earned while a participant in the Plan. Plan benefits are fully vested after
five years of Plan service.
The Company's funding policy is to contribute annually an amount that is not
less than the ERISA minimum funding requirement and not in excess of the maximum
tax-deductible contribution as developed in accordance with the aggregate cost
method.
The following schedule states the change in benefit obligations for the years
ended December 31:
(in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Benefit Obligation at Beginning of Year $3,502 $6,033
Service Cost 33 247
Reduction due to Census Gain 233 (597)
Reduction due to Curtailment - (1,749)
Interest Cost 222 285
Benefits Paid (695) (717)
Actuarial Loss 246 -
- -------------------------------------------------------------------------------------------------------------------
Total Benefit Obligation at End of Year $3,541 $3,502
===================================================================================================================
The Change in Plan Assets are as follows: (in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at Beginning of Year $4,444 $5,346
Employer Contribution - 40
Benefits Paid (695) (717)
Actual Return on Plan Assets (645) (225)
- -------------------------------------------------------------------------------------------------------------------
Total Fair Value of Plan Assets at End of Year $3,104 $4,444
===================================================================================================================
21
The following table sets forth the Plan's funded status along with amounts
recognized and not recognized in the Bank's Consolidated Balance Sheets for the
years ended December 31:
(in thousands) 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Benefit Obligation $3,541 $3,502
Fair Value of Plan Assets 3,104 4,444
- -------------------------------------------------------------------------------------------------------------------
Funded Status (437) 942
Unrecognized Net Asset at Transition - -
Unrecognized Prior Service Cost - (2)
Unrecognized Net Loss 1,348 20
Adjustment Required to Recognize Minimum Liability (1,262) -
- -------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $ (351) $ 960
===================================================================================================================
Amounts Recognized: (in thousands)
- -------------------------------------------------------------------------------------------------------------------
Prepaid Benefit Cost $ - $ 960
Accrued Benefit Liability (351) -
Intangible Asset - -
- -------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $ (351) $ 960
===================================================================================================================
The components of the net periodic benefit costs are as follows:
(in thousands) 2002 2001 2000
- -------------------------------------------------------------------------------------------------------------------
Service Cost $ 33 $ 247 $ 572
Interest Cost 222 284 404
Expected Return on Plan Assets (217) (414) (473)
Amortization of
Unrecognized Net Asset at Transition - (11) (28)
Unrecognized Prior Service Cost ( 1) ( 3) ( 7)
Unrecognized Net Loss 13 23 57
- -------------------------------------------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $ 50 $ 126 $ 525
===================================================================================================================
Adjustment Required to Recognize Minimum Liability $1,262 - -
===================================================================================================================
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 6.75% 7.25% 7.25%
Rate of Increase in Salary Levels 4.00% 4.00% 4.00%
Expected Return on Assets 6.00% 9.00% 9.00%
===================================================================================================================
Substantially all full-time employees of the Bank with one or more years of
service also participate in a defined contribution profit sharing plan and a
money purchase plan. Contributions to the profit sharing plan are made at the
discretion of the Board of Directors and the Board can terminate the plan at any
time. The Bank contributed $625,000, $545,000 and $515,000 for the years ended
December 31, 2002, 2001 and 2000, respectively. The employees are permitted,
within limitations imposed by tax law, to make pretax contributions to the
401(k) feature of the profit sharing plan. The Bank does not match employee
contributions within the 401(k) feature of the profit sharing plan.
The money purchase plan was established January 1, 2001 to replace the defined
benefit pension plan that was frozen effective June 9, 2001. Substantially all
full-time employees of the Bank participate in the money purchase plan, with the
exception of employees who have reached age 55 and who have accumulated 10 years
of service and are continuing to accrue benefits in the defined benefit pension
plan.
22
Contributions to the money purchase plan are made according to a predetermined
set of criteria. The Board can terminate the plan at any time. The Bank
contributed $522,000 and $491,000, for the years ended December 31, 2002 and
2001, respectively.
The Bank sponsors a Deferred Bonus Plan for certain employees. Deferred bonuses
are granted and benefits accumulate based on the cumulative profits during the
employee's participation period. The Bank contributed $222,000, $175,000 and
$132,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
13. Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, "Disclosure about Fair
Value of Financial Instruments." The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. The use of assumptions and various valuation
techniques, as well as the absence of secondary markets for certain financial
instruments, will likely reduce the comparability of fair value disclosures
between financial institutions. In some cases, book value is a reasonable
estimate of fair value due to the relatively short period of time between
origination of the instrument and its expected realization. The following table
summarized the book value and estimated fair value of financial instruments as
of December 31:
2002 2001
Carrying Estimated Carrying Estimated
ASSETS: (in thousands) Amount Fair Value Amount Fair Value
- ------------------------------------------------------------- ------------- ------------- ------------ -------------
Cash and Cash Equivalents $ 53,574 $ 53,574 $ 63,506 $ 63,506
Investment Securities Held-to-Maturity 27,870 29,111 32,698 33,546
Investment Securities Available-for-Sale 206,063 206,063 242,852 242,852
Loans, Net of Unearned Income 696,675 697,351 602,169 598,817
Less: Allowance for Loan Losses 16,684 16,684 12,709 12,709
Loans, Net of Allowance 679,991 680,667 589,460 586,109
LIABILITIES:
Deposits:
Noninterest-bearing 205,997 205,997 198,316 198,316
Interest-bearing 644,228 647,291 621,395 597,098
Federal Home Loan Bank Advances 40,965 45,671 41,000 41,241
The methods and assumptions used to estimate the fair value of each class of
financial instrument listed in the table above are explained below.
Cash and cash equivalents: The carrying amounts reported in the balance sheet
for cash and due from bank and federal funds sold are a reasonable estimate of
fair value.
Investment securities: Fair values for investment securities are based on quoted
market prices, where available. If quoted market prices are not available, fair
values are based on quoted market prices of comparable instruments.
Loans: For variable-rate loans that reprice frequently and with no significant
change in credit risk, fair values are based on carrying values. The fair values
for fixed-rate loans are estimated using discounted cash flow analyses, using
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality.
Commitments to extend credit and standby letters of credit: The fair value of
commitments is estimated using the fees currently charged to enter into similar
agreements, taking into account the remaining terms of the agreements and the
present creditworthiness of the counterparties. For fixed-rate loan commitments,
fair value also considers the difference between current levels of interest
rates and the committed rates. The fair value of letters of credit is based on
fees currently charged for similar agreements or on the estimated cost to
terminate them or otherwise settle the obligations with the counterparties at
the reporting date.
23
Deposit liabilities: The fair value of demand deposits, interest bearing
transaction accounts and savings accounts is the amount payable on demand as of
December 31, 2002 and 2001. The fair value of fixed-maturity certificates of
deposit is estimated by discounting expected future cash flows utilizing
interest rates currently being offered for deposits of similar remaining
maturities.
Borrowings: The fair value of federal funds purchased and other short-term
borrowings is approximated by the book value. The fair value for Federal Home
Loan Bank borrowings is determined using discounted future cash flows.
Limitations: Fair value estimates presented herein are based on pertinent
information available to management as of December 31, 2002 and 2001. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been comprehensively
revalued for purposes of these financial statements since that date, and
therefore, current estimates of fair value may differ significantly from the
amounts presented above.
14. Derivative Instruments and Hedging Activities
The Company uses derivative instruments to limit its exposure to declining
interest rates. The Company's current program relative to interest rate
protection primarily contemplates fixing the rates on variable rate loans. To do
this, the Company has developed a Hedging Policy to provide guidelines that
address instruments to be used, authority limits, implementation guidelines,
guidelines for evaluating hedge alternatives, reporting requirements, and the
credit worthiness of the instruments counterparty.
The Company reviews compliance with these guidelines annually with the ALCO
Committee and the Board of Directors. The guidelines may change as the Company's
business needs dictate.
As of November 6, 2002 the Company entered into a no cost collar with a maturity
date of November 8, 2004: one interest rate floor with a notional amount of $40
million and an interest rate cap with a notional amount of $40 million. Every
month actual prime rate is reviewed and the collar has the following impact on
the Company for the notional amount:
|X| For the floor, if prime is less than 4.75%, the Company receives the
difference between the current prime and 4.75%, calculated on a daily basis
and paid monthly.
|X| For the cap, if prime is greater than 5.26%, the Company pays the
difference between the current prime and 5.26%, calculated on a daily basis
and paid monthly.
As required, the Company records in the balance sheet the cap and floor at fair
value. Because the transaction meets the criteria for a cash-flow hedge, changes
in fair value are reported in other comprehensive income. In the event that a
portion of the hedge becomes ineffective, the ineffective portion of the
derivative's change in fair value will be immediately recognized in earnings.
24
15. Commitments and Contingencies
In the normal course of business, the Company is a party to financial
instruments with off-balance sheet risk to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These instruments include commitments to extend credit, letters of credit and
financial guarantees that are not reflected in the Consolidated Balance Sheets.
The Company's exposure to credit loss in the event of nonperformance by the
other party with regard to standby letters of credit, undisbursed loan
commitments and financial guarantees is represented by the contractual notional
amount of those instruments. Commitments to extend credit are agreements to lend
to a customer as long as there is no violation of any condition established in
the contract. The Company uses the same credit policies in making commitments
and conditional obligations as it does for recorded balance sheet items. The
Company may or may not require collateral or other security to support financial
instruments with credit risk. Evaluations of each customer's creditworthiness
are performed on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to
guarantee performance of or payment for a customer to a third party. The Company
had standby letters of credit outstanding of $15,635,000 at December 31, 2002,
and $6,163,000 at December 31, 2001. Outstanding standby letters of credit had
original terms ranging from 4 to 108 months with final expiration in 2004.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition contained in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Undisbursed loan commitments totaled $269,211,000 and
$245,699,000 as of December 31, 2002 and 2001, respectively. Since many of these
commitments are expected to expire without fully being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. The
Company does not anticipate any loss as a result of these transactions.
The Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 2002 were
$151,000, $148,000, $148,000, $111,000, and $45,000 for the years 2003 to 2007
and $98,000 thereafter.
In the ordinary course of business, the Company becomes involved in litigation
arising out of its normal business activities. Management, after consultation
with legal counsel, is of the opinion that the ultimate liability, if any,
resulting from the disposition of such claims would not be material in relation
to the financial position of the Company.
The Company may be required to maintain average reserves on deposit with the
Federal Reserve Bank primarily based on deposits outstanding. There were no
reserve requirements during 2002 or at December 31, 2002 and 2001.
16. Transactions with Related Parties
The Company, in the ordinary course of business, has had, and expects to have in
the future, deposit and loan transactions with Directors, executive officers and
their affiliated companies. These transactions were on substantially the same
terms, including interest rates, as those prevailing at the time for comparable
transactions with unaffiliated parties and do not involve more than normal
credit risk or other unfavorable features.
25
Loan transactions with Directors, executive officers and their affiliated
companies during the year ended December 31, 2002, were as follows:
(in thousands)
- -----------------------------------------------------
Loan Balances December 31, 2001 $2,033
Disbursements During 2002 2,943
Loan Reductions During 2002 2,561
- -----------------------------------------------------
Loan Balances December 31, 2002 $2,415
=====================================================
17. Future Impact of Accounting Standards Not Yet Adopted
In June 2001, the FASB issued Statement No. 143, Accounting for Asset Retirement
Obligations. This Statement addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. This Statement requires that the fair value
of a liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made. The
associated asset retirement costs are capitalized as part of the carrying amount
of the long-lived asset.
This Statement is effective for financial statements issued for fiscal years
beginning after June 15, 2002. The Company does not expect adoption of Statement
No. 143 to have a material impact on the financial condition or operating
results of the Company.
26
18. Parent Company Financial Information
The financial information below is presented as of December 31, 2002 and
December 31, 2001.
Farmers & Merchants Bancorp
Balance Sheet
(in thousands) 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Cash $ 1,597 $ 1,925
Investment in Farmers and Merchants Bank of Central California 96,601 94,011
Investment Securities 3,104 4,380
Loans
- 87
Other Assets 491 368
- --------------------------------------------------------------------------------------------------------------------
Total Assets $101,793 $100,771
====================================================================================================================
Liabilities $ - $ 35
Shareholders' Equity 101,793 100,736
- --------------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders Equity $101,793 $100,771
====================================================================================================================
Farmers & Merchants Bancorp
Income Statement
for the period ending December 31,
2002 2001 2000
- --------------------------------------------------------------------------------------------------------------------
Equity Earnings in Farmers and Merchants Bank of Central California $ 13,561 $ 12,538 $11,178
Interest Income 167 42 -
Other Expenses, Net (309) (263) (158)
- --------------------------------------------------------------------------------------------------------------------
Net Income $ 13,419 $ 12,317 $11,020
====================================================================================================================
Farmers & Merchants Bancorp
Statement of Cash Flows
for the period ending December 31,
2002 2001 2000
- --------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net Income $13,419 $12,317 $11,020
Adjustments to Reconcile Net Income to Net Cash Used in Operating Activities:
Equity in Undistributed Net Earnings from Subsidiary (5,460) (2,938) (5,374)
Net Increase in Interest Receivable and Other Assets (200) (161) (122)
- --------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 7,759 9,218 5,524
- --------------------------------------------------------------------------------------------------------------------
Investing Activities:
Securities Purchased (47) (4,291) (308)
Securities Sold or Matured 1,423 254 -
Net Loans Originated 87 27 (114)
- --------------------------------------------------------------------------------------------------------------------
Net Cash Used in Investing Activities 1,463 (4,010) (422)
- --------------------------------------------------------------------------------------------------------------------
Financing Activities:
Stock Redemption (5,006) (488) (1,258)
Cash Dividends (4,544) (4,056) (3,709)
- --------------------------------------------------------------------------------------------------------------------
Net Cash Used in Financing Activities (9,550) (4,544) (4,967)
- --------------------------------------------------------------------------------------------------------------------
Increase in Cash and Cash Equivalents (328) 664 135
Cash and Cash Equivalents at Beginning of Year 1,925 1,261 1,126
- --------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 1,597 $ 1,925 $ 1,261
====================================================================================================================
27
Five Year Financial Summary of Operations
(in thousands, except per share data)
2002 2001 2000 1999 1998
- --------------------------------------------------------------------------------------------------------------------
Total Interest Income $54,238 $63,530 $66,127 $56,055 $51,194
Total Interest Expense 13,596 23,280 24,757 18,862 17,428
------------------------------------------------------------------------------------------------------------------
Net Interest Income 40,642 40,250 41,370 37,193 33,766
Provision for Loan Losses 4,926 1,000 2,800 1,700 1,400
------------------------------------------------------------------------------------------------------------------
Net Interest income After
Provision for Loan Losses 35,716 39,250 38,570 35,493 32,366
Total Non-Interest Income 13,866 8,374 6,648 5,658 5,819
Total Non-Interest Expense 29,109 27,486 27,548 27,021 26,095
------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 20,473 20,138 17,670 14,130 12,090
Provision for Income Taxes 7,054 7,821 6,650 4,914 4,030
------------------------------------------------------------------------------------------------------------------
Net Income $13,419 $12,317 $11,020 $ 9,216 $ 8,060
==================================================================================================================
Balance Sheet Data
Total Assets $1,021,907 $970,883 $905,551 $819,881 $758,799
Loans 696,675 602,169 497,397 413,409 329,178
Allowance for Loan Losses 16,684 12,709 11,876 9,787 8,589
Investment Securities 233,933 275,550 320,654 346,855 374,170
Deposits 850,225 819,711 764,678 685,143 627,387
Federal Home Loan Bank Advances 40,965 41,000 41,033 41,064 41,093
Shareholders' Equity 103,565 100,736 90,883 80,201 79,405
Selected Ratios
Return on Average Assets 1.41% 1.35% 1.29% 1.19% 1.17%
Return on Average Equity - Net of Accumulated 13.51% 13.14% 12.38% 10.95% 10.31%
Other Comprehensive Income
Dividend Payout Ratio 33.86% 32.93% 33.66% 36.30% 38.91%
Average Loan to Average Deposits 79.71% 68.37% 59.96% 52.93% 48.93%
Average Equity - Net of Accumulated Other 10.43% 10.25% 10.40% 10.86% 11.33%
Comprehensive Income - to Average Assets
Period-end Shareholders' Equity to Total Assets 10.13% 10.38% 10.04% 9.78% 10.46%
Per Share Data (1)
Net Income $18.18 $16.31 $14.54 $12.08 $10.53
Cash Dividends Declared $6.00 $5.45 $5.00 $4.50 $4.20
(1) Net Income per share is based on the weighted average number of shares
outstanding of 738,081, 755,140, 757,974, 763,096 and 765,437 for the years
ended December 31, 2002, 2001, 2000, 1999 and 1998, respectively. Prior years'
per share data has been restated for the 5% stock dividend issued in each of the
above years.
28
Quarterly Financial Data
(in thousands, except for per share data)
First Second Third Fourth
2002 Quarter Quarter Quarter Quarter Total
-----------------------------------------------------------------------------------------------------------------
Total Interest Income $13,685 $13,554 $13,564 $13,435 $54,238
Total Interest Expense 3,884 3,423 3,218 3,071 13,596
------------------------------------------------------------------------------------------------------------------
Net Interest Income 9,801 10,131 10,346 10,364 40,642
Provision for Loan Losses 200 300 500 3,926 4,926
------------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 9,601 9,831 9,846 6,438 35,716
Total Non-Interest Income 2,204 2,951 2,731 5,980 13,866
Total Non-Interest Expense 6,946 7,559 7,152 7,452 29,109
------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 4,859 5,223 5,425 4,966 20,473
Provision for Income Taxes 1,797 1,903 1,980 1,374 7,054
------------------------------------------------------------------------------------------------------------------
Net Income $ 3,062 $ 3,320 $ 3,445 $ 3,592 $13,419
==================================================================================================================
Earnings Per Share (1) $ 4.10 $ 4.51 $ 4.68 $ 4.89 $ 18.18
==================================================================================================================
2001
------------------------------------------------------------------------------------------------------------------
Total Interest Income $16,590 $16,539 $15,788 $14,613 $63,530
Total Interest Expense 6,395 6,005 5,851 5,029 23,280
------------------------------------------------------------------------------------------------------------------
Net Interest Income 10,195 10,534 9,937 9,584 40,250
Provision for Loan Losses 300 300 150 250 1,000
------------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 9,895 10,234 9,787 9,334 39,250
Total Non-Interest Income 1,773 2,033 2,335 2,233 8,374
Total Non-Interest Expense 6,720 7,074 6,951 6,741 27,486
------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 4,948 5,193 5,171 4,826 20,138
Provision for Income Taxes 1,908 2,032 2,009 1,872 7,821
------------------------------------------------------------------------------------------------------------------
Net Income $ 3,040 $ 3,161 $ 3,162 $ 2,954 $12,317
==================================================================================================================
Earnings Per Share (1) $ 4.02 $ 4.18 $ 4.19 $ 3.92 $ 16.31
==================================================================================================================
Farmers & Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Dividends
declared semiannually during the past three years were for the following
amounts: June 2002, 2001 and 2000, $2.00, $1.95 and $1.85 per share,
respectively, and for December 2002, 2001, and 2000, $4.00, $3.50 and $3.40 per
share, respectively. Based on information from shareholders and from Company
stock transfer records, the prices paid in 2002, 2001 and 2000 ranged from
$320.00 to $150.00 per share.
(1) Prior years' per share data has been restated for the 5% stock dividend
issued in each of the above years.
29
Management's Discussion and Analysis
Forward -Looking Statements
This annual report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, real estate, consumer and
other lending activities; (iv) changes in federal and state banking regulations;
(v) other external developments which could materially impact the Company's
operational and financial performance. Readers are cautioned not to place undue
reliance on these forward-looking statements which speak only as of the date
hereof. The Company undertakes no obligation to update any forward-looking
statements to reflect events or circumstances arising after the date on which
they are made.
Introduction
The following discussion and analysis is intended to provide a better
understanding of Farmers & Merchants Bancorp and subsidiaries' performance
during 2002 and 2001, the material changes in financial condition, operating
income and expense of the Company and its subsidiaries as shown in the
accompanying financial statements.
Farmers & Merchants Bancorp is a bank holding company formed March 10, 1999. Its
subsidiary, Farmers & Merchants Bank of Central California is a state-chartered
bank with 17 offices located in Sacramento, San Joaquin and Stanislaus Counties.
Virtually all of the Company's business activities are conducted within its
market area.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report. Per share amounts for 2001 and 2000 have been restated
to reflect the 5% stock dividend declared during 2002.
Overview
At the completion of our 86th year, management is pleased to present the highest
reported income in the Company's history. As of December 31, 2002, Farmers &
Merchants Bancorp reported net income of $13,419,000, earnings per share of
$18.18, return on average assets of 1.41% and return on average equity of 13.51%
(net of accumulated other comprehensive income). For the year 2001, net income
totaled $12,317,000, earnings per share was $16.31, return on average assets was
1.35% and return on average equity was 13.14% (net of accumulated other
comprehensive income). For the year 2000, net income totaled $11,020,000,
earnings per share was $14.54 for the year, return on average assets was 1.29%,
and the return on average shareholders' equity totaled 12.38% (net of
accumulated other comprehensive income).
As of December 31, 2002, consolidated assets were $1.0 billion, gross loans were
$696.7 million and deposits were $850.2 million. Total consolidated assets
increased $51.4 million, gross loans increased $94.5 million and deposits grew
$30.5 million.
The Company's improved financial performance in 2002 was due to a combination of
a change in asset mix, focus on credit quality, improvement in non-interest
income and the control of non-interest expense.
30
The following is a summary of the financial accomplishments achieved during
2002:
|X| Net interest income was $40,642,000 compared to $40,250,000 reported during
2001.
|X| The provision for loan losses was $4,926,000 during 2002 compared to
$1,000,000 in 2001.
|X| Non-interest income (net of securities transactions) increased 64.0% during
2002, when compared to 2001.
|X| Non-interest expense increased by $2.6 million during 2002 compared to a
decrease of $62 thousand in 2001.
|X| The Company's effective tax rate was reduced to 34.6% compared to 38.8% in
2001.
|X| Total assets increased 5.3% to $1,021,907,000.
|X| Total loans increased 15.7% to $696,675,000.
|X| Non-accrual loans were $3,021,000 which was 0.43% of total loans at
December 31, 2002.
|X| Total investment securities were reduced to $233,933,000 from $275,550,000
in 2001.
|X| Total Shareholders' Equity increased to $104,296,000 from $100,736,000 in
2001.
Net Interest Income
The principal component of the Company's earnings is net interest income which
is the amount by which the interest and fees on loans and interest earned on
earning assets exceeds the interest paid on interest bearing sources of funds.
The net interest spread is the yield on average earning assets minus the cost of
average interest-bearing liabilities. For the purpose of analysis, the interest
earned on tax-exempt investments and municipal loans is adjusted to an amount
comparable to interest subject to normal income taxes. This adjustment is
referred to as "taxable equivalent" and is noted wherever applicable. The
Company's net interest income, interest spread and net interest margin are
affected by general economic conditions. These conditions include interest
rates, inflation, monetary supply and strength of the economy in the Company's
service area. The Company manages net interest income through affecting changes
in the volume and mix of average interest earning assets and average interest
bearing liabilities, as well as the growth of earning assets. Therefore,
increases or decreases in net interest income are analyzed as changes in volume,
changes in rate and changes in the mix of assets and liabilities.
Net interest income increased 1.0% to $40.6 million during 2002. During 2001,
net interest income was $40.3 million, representing a decrease of 2.7% from
2000. On a fully taxable equivalent basis, net interest income increased 1.0%
and totaled $42.0 million during 2002, compared to $41.6 million for 2001. In
2000, on a taxable equivalent basis, net interest income increased 10.1% or $3.9
million from that of 1999. Net interest income on a taxable equivalent basis,
expressed as a percentage of average total earning assets, is referred to as the
net interest margin, which represents the average net effective yield on earning
assets. For 2002, the net interest margin was 4.76% compared to 4.78% in 2001.
The decrease in the net interest margin during 2002 was due to a decline in
interest rates, the change in the earning asset mix and a change in the
liability mix. The decline in net interest margin in 2001, was the result of the
unprecedented decline in interest rates and competitive deposit rate climate in
the Bank's market area.
31
It is difficult to attribute the changes in net interest income to any one
factor. However, the banking and financial services businesses in the Company's
market area are highly competitive. This competition has an influence on the
strategies the Company employs.
The predominant reasons for the increase in net interest income during 2002 was
the Company's change in the asset and liability mix of the balance sheet. In
addition, interest rates continued to decline throughout 2002, which also had an
impact on the year. Average earning assets increased 1.4%, earnings on those
assets decreased by $9.3 million. Average interest bearing liabilities grew by
2.8% and interest paid on those liabilities decreased by $9.7 million. The
Bank's earning assets reprice more quickly than the deposit products causing a
temporary decline in net interest income. If interest rates stabilize, and as
deposit products continue to reprice, the net interest margin is expected to
improve during 2003.
Loans, the Company's highest earning asset, increased $94.5 million as of
December 31, 2002 compared to 2001. On an average balance basis, loans increased
by $112.7 million during the year, which, considering the decline in interest
rates, helped minimize the decrease in interest and fees on loans of $2.0
million. The average yield on the loan portfolio declined 180 basis points to
6.6% in 2002 compared to 8.4% in 2001.
The investment portfolio represents a significant portion of the Company's
earning assets. The Company's investment policy is conservative. The Company
primarily invests in mortgage-backed securities, U.S. Treasuries, U.S.
Government Agencies, high-grade municipals and high-grade corporate bonds. Since
the risk factor for these types of investments is significantly lower than that
of loans, the yield earned on investments is substantially less than that of
loans.
Interest income from investment securities declined $5.9 million due to a
reduction in average investment securities of $81.9 million during 2002. The
reduction in investment securities was used to partially fund the growth in
loans. The average yield, on a taxable equivalent basis, in the investment
portfolio was 6.2% for 2002 and 6.5% for both 2001 and 2000. Net interest income
on a taxable equivalent basis is higher than net interest income on the
Consolidated Statements of Income because it reflects adjustments that relate to
income on certain securities that are exempt from federal income taxes.
As a result of the decline in interest rates, interest expense on deposits
decreased 45.9% or $9.7 million in 2002. In spite of the decline in market rates
during 2002, the Bank was able to grow average interest bearing deposits by
$17.9 million. The increase was primarily in savings deposits, which grew $34.7
million, as higher cost time deposits were reduced by $25.6 million. Total
interest expense on deposit accounts for 2002 was $11.4 million. In 2001,
interest expense on deposits was $21.0 million. The average rate paid on
interest-bearing deposits was 1.8% in 2002 and 3.5% in 2001. The percentage
decline in interest expense did not match the decline in loan yields due to the
fact that deposit products do not reprice as quickly as loan rates.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix.
Provision and Allowance for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, the Company anticipates that credit losses will be
experienced in the normal course of business. The provision for loan losses
represents the current period credit cost of maintaining an appropriate
allowance for loan losses. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. In determining the adequacy of the allowance for loan
losses, management takes into consideration examinations of bank supervisory
authorities, results of internal credit reviews, financial condition of
borrowers, loan concentrations, prior loan loss experience, and general economic
conditions. The allowance is based on estimates and ultimate losses may vary
from the current estimates. Management reviews these estimates periodically and,
when adjustments are necessary, they are reported in the period in which they
become known.
32
The provision for loan losses totaled $4.9 million in 2002, compared to $1.0
million in 2001. The increase in the provision was the result of management's
evaluation of the credit quality of the loan portfolio, loan growth, current
loan losses, the prevailing economic climate, and its effect on borrowers'
ability to repay loans in accordance with the terms of the notes.
As of December 31, 2002, the allowance for loan losses was $16.7 million, which
represented 2.4% of the total loan balance. At December 31, 2001 the allowance
for loan losses was $12.7 million or 2.1% of the total loan balance.
Non-Interest Income
Non-interest income for the Company includes income derived from services
offered by the Bank, such as merchant card, investment services and other
miscellaneous business services; it also includes service charges and fees from
deposit accounts and net gains and losses from the sale of investment
securities, the increase in the cash surrender value of bank owned life
insurance, the sale of assets and other real estate owned.
Before securities transactions, non-interest income totaled $13.6 million for
2002. This represents an increase of $5.3 million, or 64.0%, from non-interest
income of $8.3 million for 2001. During 2001, non-interest income increased $1.5
million or 22.4% over non-interest income of $6.8 million for 2000.
Service charges on deposit accounts totaled $4.8 million in 2002. This
represented an increase of $581 thousand or 13.9% over service charges on
deposit accounts of $4.2 million in 2001. Service charges of demand deposit
accounts for business customers are generally charged based on an analysis of
their activity. The activity charges for a given month may be offset by an
earnings credit. The lower interest rate environment resulted in a lower account
earnings credit thus increasing service charges on business deposit accounts.
Service charges in 2001 increased $715 thousand or 20.6% over service charges on
deposit accounts of $3.5 in 2000.
The Bank provides merchant bankcard services to business customers in its
service area. Fees of $1.4 million were generated in 2002. This represents an
increase of $208 thousand or 17.2% over fees generated of $1.2 million in 2001.
Fees of $976 thousand were generated in 2000.
During 2002 the Bank purchased life insurance on its key executives. The
increase in the cash surrender value for 2002 was $1.4 million and is reported
as a separate line item on the consolidated statements of income.
During the fourth quarter of 2002, the Bank recorded a gain of $2.8 million from
the sale of preferred stock previously acquired through a troubled debt
restructuring.
Other non-interest income increased $282 thousand in 2002 or 9.8%. In 2001,
other non-interest income totaled $2.9 million compared to the $2.3 million of
non-interest income recorded in 2000. Fees from these services include ATM fees,
wire transfer fees, gain on sale of mortgage loans and other miscellaneous
charges
33
Non-Interest Expense
Non-interest expense for the Company includes expenses for salaries and
benefits, occupancy, equipment, supplies, professional services, data
processing, marketing, deposit insurance, other real estate, credit card
operations, and other miscellaneous expenses. Non interest expense totaled $30.1
million during 2002. For both 2001 and 2000, non-interest expense totaled $27.5
million.
Salaries and employee benefits, the largest component of non-interest expense,
increased $1.8 million in 2002, representing an increase of 10.3% over that of
2001. During 2001, the increase was $751 thousand or 4.6% over 2000. The
increase was primarily the net result of merit increases for Company employees
along with incentive bonuses. At the end of 2002, the Company had 292.0 full
time equivalent employees compared to 304.0 at the end of 2001 and 296.2 at the
end of 2000.
Occupancy and equipment expenses represent the cost of operating and maintaining
branch and administrative facilities, including the purchase and maintenance of
furniture, fixtures, office and equipment and data processing equipment.
Occupancy expense increased 1.7% during 2002. Equipment expense increased $120
thousand or 5.9% and totaled $2.1 million during 2002. During 2001, equipment
expense increased 5.7% or $110 thousand over the previous year.
Other operating expense totaled $7.5 million, a 9.8% increase from the prior
year. This increase in other operating expense was due to an increase in
marketing and promotional efforts during 2002. During 2001, other operating
expense was $6.8 million compared to $7.7 million in 2000.
The Company, through the Bank, sponsors a defined benefit pension plan (the
Plan) covering Bank employees. In June 2001, the Plan was amended to freeze
benefit accruals, except for employees aged 55 with 10 years of service. The
Company's recorded liability for Plan benefits is based on a number of
assumptions, including life expectancies, retirement rates, long-term interest
rates, long-term rates of return on investments and future compensation levels.
These assumptions are periodically reviewed by the Company and revised when
appropriate. Changes in one or more of these assumptions could affect the amount
of the Company's recorded pension expense for Plan benefits. If the actual
experience differs from expectations, the Company's results of operations in
future periods could be affected. As part of its most recent review, the Company
in 2002, reduced its expected long-term rate of return on plan assets to 6.0%
from 9.0% to reflect revised expectations for long-term investment returns. It
also reduced its discount rate for pensions to 6.75% from 7.25%. The Company
presently expects pension expense to increase in future periods. In January of
2003, the Company made a Plan contribution of approximately $1.9 million in
respect of its 2002 Plan funding requirements. This contribution will affect the
Company's balance sheet, but will not directly impact earnings. The Company's
future Plan funding obligation depends on a number of factors and cannot be
reasonably estimated at the present time. For additional information, see Note
12 of Notes to Consolidated Financial Statements.
Income Taxes
The provision for income taxes decreased 9.8% during 2002 as a result of the
purchase of bank owned life insurance in which the increase in cash surrender
value is tax exempt. The provision for income taxes increased 17.6% in 2001 due
to improved earnings and an increase in the effective tax rate over that of
2000. The effective tax rate in 2002 was 34.5% compared to 38.8% in 2001 and
37.6% in 2000.
Current tax law causes the Company's current taxes payable to approximate or
exceed the current provision for taxes on the income statement. Two provisions
have had a significant effect on the Company's current income tax liability; the
restrictions on the deductibility of loan losses and the mandatory use of
accrual accounting for taxes rather than the cash basis method of accounting.
34
Balance Sheet Analysis
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. As of December
31, the Company classified securities as either held-to-maturity or
available-for-sale. Trading securities are securities acquired for short-term
appreciation and are carried at fair value, with unrealized gains and losses
recorded in non-interest income. As of December 31, there were no securities in
the trading portfolio.
Securities are classified as held-to-maturity and accounted for at amortized
cost when the Company has the positive intent and ability to hold the securities
to maturity.
Securities for which the Company does not have the intent to hold to maturity
are classified as available-for-sale. This portion of the investment portfolio
provides the Company with liquidity that may be required to meet the needs of
Company borrowers and satisfy depositor's withdrawals.
The investment portfolio provides the Company with an income alternative to
loans. The Company's total investment portfolio represented 22.9% of the
Company's total assets during 2002 and 28.4% of the Company's total assets
during 2001. Not included in the investment portfolio are overnight investments
in Federal Funds Sold. In 2002, average Federal Funds Sold on a year to date
basis was $33.0 million compared to $51.9 million in 2001.
The Company's investment portfolio at the end of 2002 was $233.9 million a
reduction of $41.6 million from 2001. The proceeds from the investment portfolio
were used to fund the Company's loan growth during 2002. On an average balance
basis, the Company's investments in non-taxable obligations of states and
political subdivisions were $51.0 million in 2002, and $54.5 million for 2001.
The Company generally replaces maturities of municipal securities, to the point
of a maximum tax benefit, with "qualified issues." Qualified issues are
municipal obligations that are considered "small issues" and meet Internal
Revenue Service requirements. By meeting these requirements, the interest earned
from qualified issues is exempt from federal income taxes.
Note 3 in the Notes to Consolidated Financial Statements displays the
classifications of the Company's investment portfolio, the market value of the
Company's investment portfolio and the maturity distribution.
Loans
The Company's written lending policies, along with applicable laws and
regulations governing the extension of credit, require risk analysis as well as
ongoing portfolio and credit management through loan product diversification,
lending limits, ongoing credit reviews and approval policies prior to funding of
any loan. The Company manages and controls credit risk through diversification,
dollar limits on loans to one borrower and by primarily restricting loans made
to its principal market area. Loans that are performing but have shown some
signs of weakness are subjected to more stringent reporting and oversight.
Fixed-rate real estate loans are comprised primarily of loans with maturities of
five years or less. Long-term residential loans are originated by the Company
and sold in the secondary market.
As of December 31, 2002, loans totaled $696.7 million, a 15.7% increase over
that of 2001. On an average balance basis the Company's loan portfolio increased
$112.7 million over the average balance in 2001. In 2001, average balances
increased from the prior year by 14.8% or $67.7 million. This increase was due
to strong loan demand in the Company's market area along with an aggressive
calling program.
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Non-Performing Loans
The Company's policy is to place loans on non-accrual status when, for any
reason, principal or interest is past due for ninety days or more unless it is
both well secured and in the process of collection. Any interest accrued, but
unpaid, is reversed against current income. Thereafter, interest is recognized
as income only as it is collected in cash.
As a result of events beyond the Company's control, problem loans can and do
occur. As of December 31, 2002, non-accrual loans were $3.0 million compared to
$2.4 million at the end of 2001. Managing problem loans continues to be an
important Company objective. The Company reported no foreclosed loans as other
real estate in 2002 and in 2001. Interest forgone on loans placed on a
non-accrual status totaled $331 thousand at December 31, 2002. Non-accrual loans
to total loans for the year ended 2002 was 0.4%. For the year ended 2001 the
percentage was 0.4%.
Although management believes that non-performing loans are generally well
secured and that potential losses are provided for in the Company's allowance
for loan losses, there can be no assurance that future deterioration in economic
conditions or collateral values will not result in future credit losses.
Deposits
At December 31, 2002, deposits totaled $850.2 million. This represents an
increase of $30.5 million or 3.7% from the deposit totals of $819.7 million
reported in 2001. The increase was concentrated in demand and savings deposits,
which increased $7.7 million and $33.3 million, respectively. The Company
increased its marketing efforts for deposits during 2002 and ran several
successful deposit campaigns contributing to the growth in deposit balances. The
change in the mix of deposits occurs as interest rates change. The expectations
our customers have of future interest rates, dictates their maturity and account
selections. As rates decreased during 2002, some customers moved from time
deposits to demand and savings accounts because they anticipated rates would
rise and were unwilling to commit their deposits to long term investments at the
current rates.
The most volatile deposits in any financial institution are certificates of
deposit over $100,000. The Company has not found its certificates of deposit
over $100,000 to be as volatile as some other financial institutions as it does
not solicit these types of deposits from brokers nor does it offer interest rate
premiums. It has been the Company's experience that large depositors have placed
their funds with the Company due to its strong reputation for safety, security
and liquidity.
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank are used to match fund long-term real
estate loans and, as opportunities exist, the Bank borrows funds and invests the
proceeds at a positive spread through the investment portfolio. These activities
contribute to the Bank and Company's earnings as well as help offset the Bank's
interest rate risk. The average rate paid for other borrowed funds was 5.4% in
2002 compared to 5.5% in 2001.
Capital
The Company relies on capital generated through the retention of earnings to
satisfy its capital requirements. The Company engages in an ongoing assessment
of its capital needs in order to support business growth and to insure depositor
protection. Shareholders' Equity totaled $104.3 million at December 31, 2002 and
$100.7 million at the end of 2001.
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The Board of Governors of the Federal Reserve System and the Federal Deposit
Insurance Corporation have adopted risk-based capital guidelines. The guidelines
are designed to make capital requirements more sensitive to differences in risk
related assets among banking organizations, to take into account off-balance
sheet exposures and to aid in making the definition of bank capital uniform.
Company assets and off-balance sheet items are categorized by risk. The results
of these regulations are that assets with a higher degree of risk require a
larger amount of capital; assets, such as cash, with a low degree of risk have
little or no capital requirements. Under these guidelines the Company is
currently required to maintain regulatory risk based capital equal to at least
8.0%. As of December 31, 2002, the Company's risk based capital was 11.73%; well
above regulatory risk based capital guidelines.
In 1998, the Shareholders approved a stock repurchase program. During 2002, the
company repurchased 20,749 shares at an average share price of $241 per share.
In 2001, the Company repurchased 2,053 shares at an average share price of $238.
Risk Management
The Company has adopted a Risk Management Plan to ensure the proper control and
management of all risk factors inherent in the operation of the Company and the
Bank. Specifically, credit risk, interest rate risk, liquidity risk, compliance
risk, strategic risk, reputation risk and price risk can all affect the market
risk of the Company. These specific risk factors are not mutually exclusive. It
is recognized that any product or service offered by the Company may expose the
Company and Bank to one or more of these risk factors.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer,
or borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Bank's policy statements. In addition,
certain securities carry insurance to enhance credit quality of the bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are provided with
information to appropriately identify, measure, control and monitor the credit
risk of the Bank.
The Company's methodology for assessing the appropriateness of the allowance is
conducted on a regular basis and considers all loans. The systemic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan -- Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectable in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will insure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
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Based on the risk rating system specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies". In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element in the Company's methodology for assessing the
appropriateness of the allowance consists of management's considerations of all
known relevant internal and external factors that may affect a loan's
collectibility. This includes management's estimates of the amounts necessary
for concentrations, economic uncertainties, the volatility of the market value
of collateral and other relevant factors. The relationship of the two major
elements of the allowance to the total allowance may fluctuate from period to
period.
In the second major element of the analysis which considers all known relevant
internal and external factors that may affect a loan's collectibility is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
|X| then-existing general economic and business conditions affecting the key
lending areas of the Company;
|X| credit quality trends (including trends in
|X| non-performing loans expected to result from existing conditions);
|X| collateral values;
|X| loan volumes and concentrations;
|X| seasoning of the loan portfolio;
|X| specific industry conditions within portfolio segments;
|X| recent loss experience in particular segments of the portfolio;
|X| duration of the current business cycle;
|X| bank regulatory examination results and
|X| findings of the Company's internal credit examiners.
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Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio along with unused commitments to provide financing
including commitments under commercial and standby letters of credit.
Management believes that the allowance for loan losses at December 31, 2002 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan chargeoffs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Market Risk - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. Farmers & Merchants Bancorp's primary
objective in managing interest rate risk is to minimize the potential for
significant loss as a result of changes in interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products to relatively short periods which reduces the market
volatility of those instruments.
The gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
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The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 100 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
December 31, 2002, the Company's estimated net interest income sensitivity to
changes in interest rates, as a percent of net interest income was an increase
in net interest income of 3.8% if rates increase by 200 basis points and a
decrease in net interest income of 0.2% if rates decline 100 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change. See Note 13 of the Notes to the Consolidated Financial Statements.
Liquidity
Liquidity risk is the risk to earnings or capital resulting from the Bank's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Bank's ability to liquidate assets or acquire funds
quickly and with minimum loss of value. The Company endeavors to maintain a cash
flow adequate to fund operations, handle fluctuations in deposit levels, respond
to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as, interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Fed
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Fed Funds as a cushion
for temporary liquidity needs. During 2002, Federal Funds averaged $33.0
million. The Company maintains Federal Fund credit lines of $61.0 million with
major banks subject to the customary terms and conditions for such arrangements
and $150 million in repurchase lines with major brokers. In addition the Company
has additional borrowing capacity of $ 88.0 million from the Federal Home Loan
Bank.
At December 31, 2002, the Company had available liquid assets, which included
cash and cash equivalents and unpledged investment securities of approximately
$171,697,000, which represents 16.8% of total assets.
Controls and Procedures
The Company maintains controls and procedures designed to ensure that
information is recorded and reported in all filings of financial reports. Such
information is reported to the Company's management, including its Chief
Executive Officer and its Chief Financial Officer to allow timely and accurate
disclosure based on the definition of "disclosure controls and procedures" in
Rule 13a-14(c). In designing these controls and procedures, management
recognizes that they can only provide reasonable assurance of achieving the
desired control objectives. Management also evaluated the cost-benefit
relationship of possible controls and procedures.
40
Within 90 days prior to the date of this report, the Company carried out an
evaluation of the effectiveness of Company's controls and disclosure procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. Based on
the foregoing, the Company's Chief Executive Officer and the Chief Financial
Officer concluded that the Company's disclosure controls and procedures were
effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
Available Information
Company reports filed with the Securities and Exchange Commission (the
"Commission") including the annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statements and other information
can be accessed through the F&M Bank website. The Company web address is
http://www.fmbonline.com. The link to the Securities & Exchange Commission is on
the About F&M Bank page.
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