10-K 1 fnfg10-kfy2012.htm 10-K FNFG 10-K FY2012

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
þ
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
For the Fiscal Year Ended December 31, 2012
OR
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     
Commission File No. 001-35390
FIRST NIAGARA FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)
 
 
 
Delaware
 
42-1556195
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
 
 
 
726 Exchange Street, Suite 618, Buffalo, NY
 
14210
(Address of Principal Executive Offices)
 
(Zip Code)
(716) 819-5500
(Registrant’s telephone number)
Securities Registered Pursuant to Section 12(b) of the Act:
 
 
 
Title of Class
 
Name of Exchange on which Registered
 
 
Common Stock, par value $0.01 per share
 
The NASDAQ Stock Market LLC
Fixed-to-Floating Rate Perpetual Non-Cumulative
 
New York Stock Exchange
Preferred Stock, Series B, par value $0.01 per share
 
 
Securities Registered Pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES þ NO o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o NO þ
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such requirements for the past 90 days. YES þ NO o
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES þ NO o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Large accelerated filer þ
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ
As of February 22, 2013, there were issued and outstanding 352,593,632 shares of the Registrant’s Common Stock. The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the last sale price on June 30, 2012, as reported by The NASDAQ Stock Market LLC, was approximately $2,678,004,640.




DOCUMENTS INCORPORATED
BY REFERENCE
The following documents, in whole or in part, are specifically incorporated by reference in the indicated part of our Proxy Statement:
 
 
 
Document
 
Part
Proxy Statement for the 2013 Annual Meeting of Stockholders
 
Part III, Item 10
 
“Directors, Executive Officers, and Corporate Governance”
 
 
 
 
 
Part III, Item 11
 
 
“Executive Compensation”
 
 
 
 
 
Part III, Item 12
 
 
“Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters”
 
 
 
 
 
Part III, Item 13
 
 
“Certain Relationships and Related Transactions, and Director Independence”
 
 
 
 
 
Part III, Item 14
 
 
“Principal Accountant Fees and Services”

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TABLE OF CONTENTS
ITEM
 
PAGE
NUMBER
 
NUMBER
 
 
 
 
PART I
 
 
 
 
1
1A
1B
2
3
4
 
 
 
 
PART II
 
 
 
 
5
6
7
7A
8
9
9A
9B
 
 
 
 
PART III
 
 
 
 
10
11
12
13
14
 
 
 
 
PART IV
 
 
 
 
15
 

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Unless the context otherwise requires, the terms “we”, “us”, and “our” refer to First Niagara Financial Group, Inc. and its subsidiaries on a consolidated basis.
PART I
 
 
 
ITEM 1.
 
Business

GENERAL
First Niagara Financial Group, Inc.
First Niagara Financial Group, Inc. (the “Company”), a Delaware corporation whose principal executive offices are located at 726 Exchange Street, Suite 618, Buffalo, New York, provides a wide range of retail and commercial banking as well as other financial services through its wholly-owned bank subsidiary, First Niagara Bank, N.A. (the “Bank”). The Company is a bank holding company subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). At December 31, 2012, we had $36.8 billion of assets, $27.7 billion of deposits and $4.9 billion of stockholders’ equity.
Since 1998, we deployed the proceeds from several stock offerings by making multiple whole-bank and nonbank financial services company acquisitions, acquiring branches, and by opening de novo branches in target markets across Upstate New York and Pennsylvania. This strategy, coupled with our organic growth initiatives, which includes an emphasis on expanding our commercial banking operations and financial services businesses, has resulted in our successful transition from a traditional thrift to a commercial bank.
In April 2011, we acquired all of the outstanding common shares of NewAlliance Bancshares, Inc. (“NewAlliance”), the parent company of NewAlliance Bank, for total consideration of $1.5 billion, and thereby acquired all of NewAlliance Bank’s 88 branch locations in Connecticut and Western Massachusetts. Under the terms of the merger agreement, each outstanding share of NewAlliance stock was converted into the right to receive either 1.10 shares of common stock of the Company, or $14.28 in cash, or a combination thereof. As a result, NewAlliance stockholders received 94 million shares of Company common stock, valued at $1.3 billion, and cash consideration of $199 million.
On May 18, 2012, the Bank acquired 137 full-service branches from HSBC Bank USA, National Association (“HSBC”) and its affiliates (the “HSBC Branch Acquisition”) in the Buffalo, Rochester, Syracuse, Albany, Downstate New York and Connecticut banking markets, and paid a net deposit premium of $772 million.
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” for further information about the HSBC Acquisition.
Our profitability is primarily dependent on the difference between the interest we receive on loans and investment securities, and the interest we pay on deposits and borrowings. The rates we earn on our assets and the rates we pay on our liabilities are a function of the general level of interest rates and competition within our markets. These rates are also highly sensitive to conditions that are beyond our control, such as inflation, economic growth, and unemployment, as well as policies of the federal government and its regulatory agencies, including the Federal Reserve. We manage our interest rate risk as described in "Interest Rate and Market Risk" in this report, Part II Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
The Federal Reserve implements national monetary policies (with objectives such as curbing inflation and combating recession) through its open-market operations in U.S. Government securities, by adjusting depository institutions reserve requirements, by varying the target federal funds and discount rates and by varying the supply of money. The actions of the Federal Reserve in these areas influence the growth of our loans, investments, and deposits, and also affect interest rates that we earn on interest-earning assets and that we pay on interest-bearing liabilities.

During the third quarter of 2011, the Federal Reserve announced that it intended to keep interest rates low through mid-2013, and take certain actions designed to lower longer-term interest rates, referred to “Operation Twist”.  This action had the impact of flattening the yield curve and reducing the yields on earning assets that are (a) adjustable rate and directly tied to longer term rates, such as certain commercial real estate loan products that we offer, and (b) fixed rate where the rate is based on longer-term rates, such as certain of our residential real estate loan products. In January 2012, the Federal Reserve modified its position to keep low interest rates and extended the time horizon through at least late 2014. The Federal Reserve also

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announced it will continue its “Operation Twist” initiative by continuing to extend the average maturity of its securities portfolio. In September 2012, the Federal Open Market Committee (“FOMC”) stated its intention to maintain the exceptionally low levels for federal funds rate at least through mid-2015. Such an accommodative stance of monetary policy was designed to continue support to the labor markets and overall economy. The FOMC also announced additional purchases of long-dated agency mortgage-backed securities at the pace of $40 billion each month for an indefinite period which was designed to move longer-term interest rates lower. Additionally, the FOMC decided to continue its program known as “Operation Twist” through the end of the year.
In December 2012, the Federal Open Market Committee (“FOMC”) stated they anticipate that the current exceptionally low federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than 0.5% above the FOMC's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the FOMC will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the FOMC decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%. The FOMC also announced it would continue purchasing additional agency mortgage-backed securities at the pace of $40 billion each month and longer-term Treasury securities initially at a pace of $45 billion per month. Additionally, the FOMC stated it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and, in January, will resume rolling over maturing Treasury securities at auction.
In January 2013, the FOMC met and stated that economic activity has paused in recent months as weather related disruptions offset improvement in household spending and the housing sector. No further actions were taken. These actions will continue to maintain downward pressure on longer-term interest rates, and thus, on the industry net interest margin by; (i) continuing to reduce the yields on earning assets relative to the cost of funding; (ii) causing borrowers to repay their higher-yielding fixed rate loans at a faster rate; and (iii) reducing the rates at which cash flows from these repayments could be reinvested.
First Niagara Bank, N.A.
First Niagara Bank, N.A. was organized in 1870, and is a nationally chartered regional bank providing financial services to individuals, families and businesses. In November 2002, the Bank was converted from a New York State chartered savings bank to a federal charter and in April 2010, the Bank became a national bank subject to supervision and regulation by the Office of the Comptroller of the Currency (the “OCC”).
The Bank is positioned as a leading regional bank, with its footprint reaching across Upstate New York, Pennsylvania, Connecticut and Western Massachusetts, providing our retail consumer and business customers with banking services including residential and commercial real estate loans, commercial business loans, consumer loans, wealth management products, as well as retail and commercial deposit products. Additionally, we offer insurance services through a wholly-owned subsidiary of the Bank. As of December 31, 2012, the Bank and all of its subsidiaries had $36.8 billion of assets, $27.7 billion of deposits, and $5.2 billion of stockholder’s equity, employed over 6,200 people, and operated through 430 branches and several financial services subsidiaries.
The Bank’s subsidiaries provide a range of financial services to individuals and companies in our market and service areas. These subsidiaries include: First Niagara Funding, Inc., our real estate investment trust (“REIT”) which primarily originates and holds some of our commercial real estate and business loans; First Niagara Servicing Company, which owns and partially services loans that are collateralized by property in Connecticut; and First Niagara Risk Management, Inc. (“FNRM”), our full service insurance agency, which sells insurance products, including business and personal insurance, surety bonds, life, disability and long-term care coverage. FNRM also provides risk management advisory services such as alternative risk and self-insurance, claims investigation and adjusting services, and third-party administration of self-insured workers’ compensation plans.
OTHER INFORMATION
We maintain a website at www.firstniagara.com. Our annual reports on Form 10-K, proxy statements, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are made available, free of charge, on the Investor Relations page on our website, as soon as reasonably practicable after we electronically file them or furnish them to the Securities and Exchange Commission (“SEC”). You may also obtain copies, without charge, by writing to our Investor Relations Department, 726 Exchange Street, Suite 618, Buffalo, New York 14210.

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We have adopted a Code of Ethics that is applicable to our senior financial officers, including our Chief Executive Officer, Chief Financial Officer and Corporate Controller, among others. The Code of Ethics is available on the Investor Relations page of our website along with any amendments to or waivers from that policy. Additionally, we have adopted a general Code of Conduct that sets forth standards of ethical business conduct for all of our directors, officers and employees. This Code of Conduct is also available on our website.
FORWARD LOOKING STATEMENTS
Certain statements we make in this document may be considered “forward-looking statements” as that term is defined in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve substantial risks and uncertainties. You can identify these forward-looking statements by our use of such words as estimate, project, believe, intend, anticipate, plan, seek, expect, and other similar expressions. These forward-looking statements include: statements of our goals, intentions, and expectations; statements regarding our business plans, prospects, growth, and operating strategies; statements regarding the asset quality of our loan and investment portfolios; and estimates of our risks and future costs and benefits.
Forward-looking statements are subject to significant risks, assumptions, and uncertainties, including, among other things, the following important factors that could affect the actual outcome of future events:
General economic conditions, either nationally or in our market or service areas, that are worse than expected;
Significantly increased competition among depository and other financial institutions;
Inflation and changes in the interest rate environment that reduce our margins or fair value of financial instruments;
Changes in laws or government regulations affecting financial institutions, including changes in regulatory fees and capital requirements;
Our ability to enter new markets successfully and capitalize on growth opportunities;
Our ability to successfully integrate acquired entities;
Changes in consumer spending, borrowing, and savings habits;
Changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, taxing authorities and the Financial Accounting Standards Board; and
Changes in our organization, compensation, and benefit plans.
Because of these and other uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.
MARKET AREAS AND COMPETITION
Our business operations are concentrated in our primary market areas of Upstate New York, Pennsylvania, Connecticut, and Western Massachusetts. Therefore, our financial results are affected by economic conditions in these geographic areas. If economic conditions in our markets deteriorate or if we are unable to sustain our competitive posture, our ability to expand our business and the quality of our loan portfolio could materially impact our financial results.
Our primary lending and deposit gathering areas are generally concentrated in the same areas as our branches. We face significant competition in both making loans and attracting deposits in our markets as they have a high density of financial institutions, some of which are significantly larger than we are and have greater financial resources. Our competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies, and other financial services companies. Our most direct competition for deposits has historically come from commercial banks, savings banks, and credit unions. We face additional competition for deposits from the mutual fund industry, internet banks, securities and brokerage firms, and insurance companies, as well as nontraditional competitors such as large retailers offering bank-like products. In addition to the traditional sources of competition for loans and deposits, payment processors and other companies exploring direct peer to peer banking provide additional competition for our products and services. In these marketplaces, opportunities to grow and expand are primarily a function of how we are able to differentiate our product offerings and customer experience from our competitors.
We offer a variety of financial services to meet the needs of the communities that we serve, functioning under a philosophy that includes a commitment to customer service and the community. As of December 31, 2012 we operated 430 bank branches, including 205 in Upstate New York primarily located near Buffalo, Rochester, Syracuse and Albany; 129 branches in Pennsylvania primarily located near Philadelphia, Pittsburgh, Erie, and Warren; 85 branches in Connecticut primarily located near New Haven and Hartford; and 11 in Western Massachusetts primarily located near Springfield.

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LENDING ACTIVITIES
Our principal lending activity has been the origination of commercial business and real estate loans, and residential mortgage loans to commercial and retail customers generally located within our primary market and service areas.
Our Commercial business is positioned for continuing success with best-in-class service. Our footprint provides ample opportunity for growth and our strategy seeks to capitalize on our commercial business scale by driving organic growth, investing in infrastructure, and expanding our product set. We are focused on providing a full range of services to our commercial banking clients through a regional, decentralized approach with plans to invest further in healthcare capabilities, use asset based lending opportunities for access to broader markets and industries, enhance our leasing capability, lead more syndicated transactions, and leverage our risk management products to further increase fee income.
Our Retail business is focused on acquiring core deposit relationships from consumer and small business customers. These core deposit relationships provide a low cost of funds and are the cornerstone of household profitability. Our Retail business is also focused on consumer finance, offering an array of products including residential mortgage loans, home equity loans, and our recent expansion of credit card and indirect auto loan products.
Winning, expanding and retaining core relationship customers is driven by a clear value proposition:
Doing business with us will be simple, easy and fast for our customers.
We will deliver a friendly, helpful and proactive customer experience.
We will take a personal interest in helping our customers earn more, pay less and borrow wisely.
We are committed to delivering a superior and differentiated customer experience driven by our engaged employee culture, a convenient and efficient multi-channel customer experience and the strength of a dense and efficient branch network. Product development efforts are focused on meeting the banking, investment and insurance needs of our clients and our products are designed to be simple and easy to use while creating a fair value exchange for our customers and shareholders. Through a targeted and multi-channel marketing effort we deliver relevant offers to our customers and prospects and efficiently drive the sales and service experience.
Commercial Business Loans
Our commercial business loan portfolio includes business term loans and lines of credit issued to companies in our market and service areas, some of which are secured in part by additional owner occupied real estate. Additionally, we make secured and unsecured commercial loans and extend lines of credit for the purpose of financing equipment purchases, inventory, business expansion, working capital, and for other general purposes. The terms of these loans generally range from less than one year to seven years with either a fixed interest rate or a variable interest rate indexed to a London Inter-Bank Offered Rate (“LIBOR”) or our prime rate. Our lines of credit typically carry a variable interest rate indexed to either LIBOR or our prime rate.
As part of our strategic initiatives to fully service our larger corporate clients generally located within our primary market and service areas, we look to strengthen our commercial business relationships by offering not only larger loans, but more and better solutions. This includes products and services such as standby letters of credit, cash management, foreign exchange, remote deposit capture, merchant services, wire transfers, lock-box, business credit and debit cards, and online banking.
We also make commercial business and real estate loans which are 50% to 90% government guaranteed through the Small Business Administration. Based on the additional guarantee, terms of these loans range from one to 20 years and generally carry a variable rate of interest indexed to the prime rate. This insured loan product allows us to better meet the needs of our small business customers without subjecting us to undue credit risk.
In addition to loans to commercial clients, we also provide financing to commercial clients in the form of equipment finance agreements and capital leases. Our primary focus is middle market transactions with bank customers and prospects, municipal and healthcare tax exempt leases, and upper middle market/investment grade transactions purchased from quality independent leasing companies and other bank owned equipment finance subsidiaries located in the Northeast region of the United States, in amounts ranging from $250 thousand to $20 million.
Commercial Real Estate and Multi-family Lending
We originate commercial real estate loans secured predominantly by first liens on apartment buildings, office buildings, shopping centers, and industrial and warehouse properties. Our current policy with regard to these loans is to minimize our risk by emphasizing geographic distribution within our primary market and service areas and diversification of these property types.

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Commercial and multi-family real estate loans that we originate are generally limited to three, five, or seven year adjustable-rate products which we initially price at prevailing market interest rates. These interest rates, which may be subject to interest rate floors, subsequently reset annually after completion of the initial adjustment period at new market rates that generally range at a spread over the current applicable market index such as Federal Home Loan Bank (“FHLB”) Advance Rates. The maximum term that we offer for commercial real estate loans is generally not more than 10 years, with a payment schedule based on not more than a 30 year amortization schedule for multi-family loans, and 20 years for commercial real estate loans.
We also offer the availability of commercial real estate and multi-family construction loans to our better relationship borrowers. Most of our construction loans provide for disbursement of loan funds during the construction period and conversion to a permanent loan when the construction is complete, and either tenant lease-up provisions or prescribed debt service coverage ratios are met. We make the construction phase of the loan on a short-term basis, usually not exceeding two years, with floating interest rates that are indexed to either a LIBOR or our prime rate. The construction loan application process includes the same criteria which are required for our permanent commercial mortgage loans, as well as a submission of completed plans, specifications, and cost estimates related to the proposed construction. We use these items as an additional basis to determine the expected appraised value of the subject property upon its completion. The appraisal is an important component because construction loans involve additional risks related to advancing loan funds upon the security of the project under construction, which is of uncertain value prior to the completion of construction and subsequent lease-up.
We continue to emphasize commercial real estate and multi-family lending because of the higher interest rates, relative to expected losses, associated with this asset class. Commercial real estate and multi-family loans, however, carry more risk as compared to residential mortgage lending, because they typically involve larger loan balances concentrated with a single borrower or groups of related borrowers. Additionally, the payment experience on loans that are secured by income producing properties is typically dependent on the successful operation of the related real estate project and thus, may subject us to adverse conditions in the real estate market or to the general economy. To help manage this risk, we have put in place concentration limits based upon property types and maximum amounts that we lend to an individual or group of borrowers. In addition, our policy for commercial lending generally requires a loan-to-value (“LTV”) ratio of 75% or lower on purchases of existing commercial real estate and 80% or lower on purchases of existing multi-family real estate. For construction loans, the maximum LTV ratio varies depending on the project, however it generally does not exceed the lesser of 75% to 80% LTV based on property type or 80% of cost.

Residential Real Estate Lending
We originate mortgage loans to enable our customers to finance residential real estate, both owner occupied and non-owner occupied, in our primary market and service areas. We offer traditional fixed-rate and adjustable-rate mortgage (“ARM”) products that have maturities up to 30 years, and maximum loan amounts determined by market generally up to $2.5 million.
We generally have sold newly originated conventional 15 to 30 year fixed-rate loans as well as FHA insured and VA guaranteed loans in the secondary market to government sponsored enterprises such as Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”) or to wholesale lenders. We intend to continue to hold the majority our newly originated ARMs in our portfolio, but will occasionally sell these loans to FNMA, FHLMC, or wholesale lenders. Our LTV requirements for residential real estate loans vary depending on the loan program as well as the secondary market investor. Loans with LTVs in excess of 80% are required to carry mortgage insurance. We generally originate loans that meet accepted secondary market underwriting standards.
We offer ARM products secured by residential properties. These ARMs have terms generally up to 30 years, with rates that generally adjust annually after three, five, or seven years. After that initial fixed rate period of time, the interest rate on these loans is reset based upon a spread or margin above a specified index (e.g., LIBOR). Our ARM loans are generally subject to limitations on interest rate increases and decreases of up to 2% per adjustment period and a total adjustment of up to 6% over the life of the loan. These loans generally require that any payment adjustment resulting from a change in the interest rate be sufficient to result in full amortization of the loan by the end of the term, and thus, do not permit any of the increased payment to be added to the principal amount of the loan, commonly referred to as negative amortization.
ARMs generally pose higher credit risks relative to fixed-rate loans primarily because, as interest rates rise, the payment amounts due from the borrowers rise, thereby increasing the potential for default. In order to manage this risk, we generally do not originate adjustable-rate loans with less than an initial fixed term of three years. Adjustable rate loans with less than a five year fixed term are subject to more stringent underwriting standards. Additionally, we do not offer ARM loans with initial teaser rates.


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Home Equity Lending
We offer fixed-rate, fixed-term, monthly and bi-weekly payment home equity loans ("HELOANs"), and prime-based variable rate home equity lines of credit (“HELOCs”) within our market footprint. These products typically allow customers to borrow up to 85% of the appraised value of the collateral property (including the first mortgage) with a maximum loan amount generally no greater than $500 thousand. Our fixed-rate home equity loans generally have repayment terms up to 30 years. Our “Ultraflex” home equity line of credit product allows borrowers a 10 year draw period with a 20 year repayment period to follow. During the draw period, customers may elect a five year interest only payment option followed by a five year principal and interest period or pay principal and interest for all 10 years. Additionally, this product offers an option allowing customers to convert portions or all of their variable rate line balances to a fixed rate loan. Customers may have up to three fixed rate loans within their line of credit at one time.

Consumer Loans
We offer a variety of consumer loans ranging from fixed-rate installment loans to variable rate lines of credit, including personal secured and unsecured loans, automobile loans, and overdraft lines of credit. Terms of these loans range from six months to 72 months and typically do not exceed $50 thousand. Secured loans are generally collateralized by vehicles, savings accounts, or other non real estate assets. Unsecured loans, lines of credit, and credit cards are generally only granted to our most creditworthy customers. Consumer loans can generally entail greater risk of loss than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that tend to depreciate rapidly.

Indirect Automobile Lending

We purchase motor vehicle retail installment sales contracts relating to new or used automobiles and light and medium-duty trucks from dealers who regularly originate these third party installment sales contracts. The contracts are sold and assigned to us pursuant to the terms of an approved dealer agreement. When a customer purchases a vehicle from a dealer, the customer and the dealer determine the contract amount, loan term, payment terms, and interest rate to be charged subject to our current program limits. We pay the dealer proceeds as determined by the itemization of the amount financed once all required disclosures and stipulations have been met by the dealer.

Each applicant for a motor vehicle loan request is evaluated based on our underwriting standards, which are intended to assess the applicant's ability and willingness to repay, along with the adequacy of the financed vehicle as collateral. Depending on the applicant's credit bureau score, the amount advanced under any motor vehicle loan generally will not exceed 80% to 115% of either the vehicle's Manufacturer's Suggested Retail Price for new vehicles or the vehicle's retail value stated in the most recently published National Automobile Dealers Association Official Used Car Guide for used vehicles, plus taxes, title and license fees on the financed vehicle. In addition, we may also finance certain products as part of a motor vehicle loan, including credit life, accident and health insurance, GAP insurance, service contracts, mechanical breakdown protection insurance, theft deterrent products, and maintenance agreements. The maximum term for any motor vehicle loan is 75 months, depending on the applicant's credit bureau score and age of the financed vehicle.

Credit Cards

We originate a variety of different credit card products to provide our customers flexible and accommodating borrowing options. A large portion of our credit card customers were acquired as part of the HSBC Branch Acquisition and were not underwritten by us at origination. All credit card products are open-ended lines of credit with variable interest rates and line sizes generally ranging from $500 to $50 thousand. Certain products offer rewards associated with usage that can be redeemed for a variety of pre-determined products and services. These lines of credit are unsecured (except for our Secured product offering) and are generally granted to our more creditworthy customers.


Asset Quality Review
We review loans on a regular basis. Consistent with regulatory guidelines, we provide for the classification of loans which are considered to be of lesser quality as special mention, substandard, doubtful, or loss. We consider a loan substandard if it is inadequately protected by the current net worth and paying capacity of the borrower or of the collateral pledged, if any. Substandard loans have a well defined weakness that jeopardizes liquidation of the loan. Substandard loans include those loans where there is the distinct possibility that we will sustain some loss of principal if the deficiencies are not corrected. Loans that we classify as doubtful have all of the weaknesses inherent in those loans that are classified as substandard but also have the

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added characteristic that the weaknesses presented make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, improbable. Loans that we classify as loss are those considered uncollectible and of such little value that their continuance as an asset is not appropriate and the uncollectible amounts are charged off. Loans that do not expose us to risk sufficient to warrant classification in one of the aforementioned categories, but which possess some weaknesses, are designated special mention. A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risks to warrant classification. Any loan not rated special mention, substandard, doubtful, or loss is considered pass rated. Beginning in the fourth quarter of 2011, we established a watch-list for loans that are performing and are considered pass, but warrant greater attention than those loans in other pass grades. While the loans warrant more attention than other pass grades, they do not exhibit characteristics of a special mention loan.
When we classify problem loans greater than $200 thousand as either substandard or doubtful, we evaluate them individually for impairment. When we classify problem loans as a loss, we charge-off the amount of impairment against the allowance for loan losses. Our determination as to the classification of our loans and the amount of our allowance is subject to ongoing review by regulatory agencies, which can require us to establish additional general or specific loss allowances. We regularly review our loan portfolio to ensure that they are correctly graded and classified in accordance with our policy or applicable regulations.
Allowance for Loan Losses
We establish our allowance for loan losses through a provision for credit losses based on our evaluation of the credit quality of our loan portfolio. We determine our allowance for loan losses by portfolio segment, which consists of commercial loans and consumer loans. We further segregate these segments between our originated loans and acquired loans. Our commercial loan portfolio segment includes both business and commercial real estate loans. Our consumer portfolio segment includes residential real estate, home equity, and other consumer loans. A detailed description of our methodology for calculating our allowance for loan losses is included in “Critical Accounting Policies and Estimates” filed herewith in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

WEALTH MANAGEMENT
We offer wealth management services through two delivery channels, Private Client Services (“PCS”) and First Niagara Investment Services (“FNIS”). PCS provides holistic wealth management solutions using investment, fiduciary and banking services. FNIS is the Bank’s branch based investment brokerage platform that offers mutual funds and annuities as well as other investment products using financial consultants and appropriately licensed employees.
Private Client Services
Our PCS Group utilizes a comprehensive approach to wealth management incorporating wealth planning, investment management, fiduciary, risk management, credit and banking services for our customers. Revenue from PCS is primarily comprised of investment fees, estate settlement fees and credit and banking revenue paid by our clients. Investment fees are based on the current market value of assets under management, the amount of which is impacted by fluctuations in stock and bond market prices. Estate settlement fees are based on the total market value of real and personal property settled. Credit and banking revenue is primarily generated from interest income earned on commercial and consumer loans. PCS offers wealth management services to manage client funds utilizing various third party investment vehicles including separately managed accounts, bonds, exchange traded funds and mutual funds.
First Niagara Investment Services
FNIS offers wealth management, retirement planning, education funding and wealth protection products and services to our mass, mass affluent and small business clients. Through a third party broker dealer relationship we offer vehicles including stocks, bonds, mutual funds, annuities, life insurance, long term care insurance, and advisory products. The planning services and products we offer are distributed through our branch network using Financial Advisors and Licensed Sales Professionals.
Revenue from investment and insurance products consists of commissions and fee income paid by our clients, investment managers, and third party product providers. New business activity and the corresponding income that is earned can be affected by fluctuations in stock and bond market prices, the development of new products, interest rate fluctuations, commodity prices, regulatory changes, the relative attractiveness of investment products offered under current market conditions, and changes in the investment patterns of our clients.

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FINANCIAL SERVICES
To complement our traditional core banking business, we offer a wide range of insurance products and consulting services to help both our retail and commercial customers achieve their financial goals. These products and services are delivered through FNRM, our financial services business, which includes risk management (insurance) consulting services.
Through FNRM, we offer a wide range of commercial and personal insurance products and services including our claims investigation and adjusting services, third party administration of self insured workers compensation plans, alternative risk management services, as well as self insurance consulting services. FNRM also provides industry specific insurance programs related to healthcare, moving and storage, construction/surety, non-profits, ice rinks, and municipalities.
The revenue attributable to FNRM consists primarily of fees paid by our clients as well as commissions, fees, and contingent profit sharing paid by insurance carriers. Commission rates that we earn vary based on the type of insurance product, the carrier being represented, and the services that our agency provides.

INVESTMENT ACTIVITIES
Our investment policy provides that investment decisions will be made based on the ability of an investment to generate earnings consistent with factors of quality, maturity, marketability, and risk diversification.
We invest in U.S. Government and agency securities, municipal bonds, corporate debt obligations, asset-backed securities (“ABS”) collateralized by consumer and commercial loans such as student loans, credit cards, floor plan, and auto leases or loans, collateralized loan obligations (“CLOs”) backed by corporate loans and other types of structured financing, small business administration pooled loans, mortgage-backed securities and collateralized mortgage obligations (“CMOs”) issued and guaranteed by the FNMA, FHLMC, Government National Mortgage Association (“GNMA”), or non-agency issued and backed by residential conventional “whole loans” or commercial real estate loans.
Our investment strategy generally utilizes a risk management approach of diversified investing to optimize investment yields while managing our overall credit risk, interest rate risk, and liquidity position. To accomplish these objectives, we focus on investments in mortgage related securities, including CMOs, and other structured products. We attempt to maintain a high degree of liquidity in our investment securities and generally do not invest in debt securities with expected average lives at purchase in excess of seven years.
Consistent with our investment strategy laid out at the time of our HSBC Branch Acquisition announcement, we began purchasing ABS and CLOs in the fourth quarter of 2011 and increased our portfolio allocation to Commercial Mortgage Backed Securities. The strategy represented the commercial and consumer types of credits that normally would be included in an acquisition but were not included with the HSBC branches. From that point we have allocated investment portfolio cash flows in the same portfolio allocation percentages.
As of December 31, 2012, our investment portfolio's largest component is residential mortgage-backed securities. In addition, we have diversified the portfolio with commercial mortgage-backed securities, asset-backed securities, collateralized loan obligations and corporate bonds. A portion of the cash flow received from securities is used to fund loan growth rotating the balance sheet to fewer securities and more loans. Purchases made will generally be re-deployed into the same investment component, keeping the mix of the portfolio relatively unchanged.

SOURCES OF FUNDS
Deposits and borrowed funds, primarily FHLB advances and repurchase agreements, are the primary sources of funds we use in lending, investing, and other general purposes. In addition, we receive repayments on and proceeds from our sales of loans and securities, and cash flows from our operations. We have available lines of credit with the FHLB of New York, Federal Reserve Bank (“FRB”), and commercial banks, which can provide us liquidity if the above funding sources are not sufficient to meet our short-term liquidity needs.
Deposits
We offer a variety of deposit products with a range of interest rates and terms. Our retail deposit accounts consist of savings, negotiable order of withdrawal (“NOW”), checking, money market, and certificate of deposit accounts. Our commercial account offerings include business savings and checking, money market, cash management accounts, and a totally free

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checking product. We also accept municipal deposits. In order to further diversify liquidity sources, the Bank has obtained certificates of deposit and money market deposit accounts through brokers.
Borrowed Funds
We utilize borrowings to manage the overall maturity of our liabilities and to leverage our capital for the purpose of improving our return on equity. These borrowings primarily consist of advances and repurchase agreements with the FHLB, nationally recognized securities brokerage firms, and with our commercial and municipal customers. Our strategy is to use wholesale borrowings as a funding source based upon levels of our loans, investments, and deposits. Wholesale borrowings may also be used as an alternative to higher acquisition cost money market deposit accounts.

SEGMENT INFORMATION
Information about our business segments is included in Note 18 of “Notes to Consolidated Financial Statements” filed herewith in Part II, Item 8, “Financial Statements and Supplementary Data.” We have identified two business segments: banking and financial services. Our financial services activities consist predominantly of insurance sales. All of our other activities are considered banking.

SUPERVISION AND REGULATION
General
The banking industry is highly regulated. Statutory and regulatory controls are designed primarily for the protection of depositors and the financial system, and not for the purpose of protecting shareholders. The following discussion is not intended to be a complete list of all the activities regulated by the banking laws or of the impact of such laws and regulations on us and the Bank. Changes in applicable law or regulation, and in their interpretation and application by regulatory agencies, cannot be predicted but may have a material effect on our business and results.
We are registered as a bank holding company under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). We have not elected to become a financial holding company and thus are not entitled to the broader powers granted to those entities under the BHC Act. As a bank holding company, we are subject to inspection, examination and supervision by the Federal Reserve. In general, the BHC Act limits the business of bank holding companies that are not financial holding companies to banking, managing or controlling banks, performing servicing activities for subsidiaries, and engaging in activities that the Federal Reserve has determined, by order or regulation, are so closely related to banking as to be a proper incident thereto under the BHC Act. Under the BHC Act a bank holding company that is not a financial holding company may not acquire 5% or more of the voting stock of any company engaged in activities other than these activities, and a bank holding company may not in any event, without prior Federal Reserve approval, acquire 5% or more of the voting stock or substantially all of the assets of any bank or bank holding company.
We are also subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the Securities and Exchange Commission (“SEC”). Our common stock is listed on the NASDAQ Global Select Market (“NASDAQ”) under the trading symbol “FNFG” and is subject to NASDAQ rules for listed companies. Our fixed-to-floating rate perpetual non-cumulative preferred stock, series B is listed on the New York Stock Exchange (“NYSE”) under the trading symbol “FNFG PRB” and is subject to NYSE rules for listed companies.
The Bank is a national banking association organized under the National Bank Act. As a national bank, the Bank is subject to regulation and examination by the OCC and the Federal Deposit Insurance Corporation (the “FDIC”). Insured banks, including the Bank, are subject to extensive regulation of many aspects of their business. These regulations relate to, among other things: (i) the nature and amount of loans that may be made by the Bank and the rates of interest that may be charged; (ii) types and amounts of other investments; (iii) branching; (iv) permissible activities; (v) reserve requirements; and (vi) dealings with officers, directors and affiliates. In addition, the Bank is subject to regulation by the Consumer Financial Protection Bureau (the “CFPB”). The CFBP has responsibility for implementing, examining, and enforcing compliance with Federal consumer protection laws.
Regulatory Reforms
The events of the past several years have led to numerous new laws in the United States and internationally for financial institutions. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”), which was enacted in July 2010, significantly restructured the financial regulatory regime in the United States. While several

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rules under the Dodd-Frank Act have been implemented, the full implication of the Dodd-Frank Act for our businesses will depend to a large extent on the manner in which all rules adopted pursuant to the Dodd-Frank Act are implemented by the primary U.S. financial regulatory agencies as well as potential changes in market practices and structures in response to the requirements of the Dodd-Frank Act. We continue to monitor the rule-writing activity of the regulatory agencies and to analyze the impact of rules adopted under Dodd-Frank on our businesses. However, the full impact will not be known until the rules, and other regulatory initiatives that overlap with the rules, are finalized and their combined impacts can be understood.

Similar and other reforms have been considered by other regulators and policy makers worldwide. Particularly important are reforms to regulation of capital and liquidity initiated through the Basel Committee on Banking Supervision (the “Basel Committee”), discussed further below. We will continue to assess our businesses and risk management and compliance practices to conform to developments in the regulatory environment.
Capital Requirements
General Risk-Based Capital Rules
    
As a bank holding company, the Company is subject to consolidated regulatory capital requirements administered by the Federal Reserve. The Bank is subject to similar capital requirements administered by the OCC. The Federal banking agencies' risk-based capital rules applicable to all bank holding companies and banks, which they refer to as their “general risk-based capital rules”, are based upon the Basel Committee's 1988 capital accord, referred to as “Basel I”. These rules are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet obligations. Under these rules, bank holding companies and banks, which together we are referring to as “banking organizations”, are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization's assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A banking organization's capital, in turn, is classified in one of two tiers, depending on type:
Tier 1 (or Core) Capital. Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, minority interests in equity accounts of consolidated subsidiaries (and, under existing standards, a limited amount of qualifying trust preferred securities and qualifying cumulative perpetual preferred stock at the holding company level), less goodwill, most intangible assets and certain other assets.
Tier 2 (or Supplementary) Capital. Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for possible loan and lease losses, subject to limitations.
Under the general risk-based capital rules, banking organizations are currently required to maintain Tier 1 capital and “Total capital” (the sum of Tier 1 and Tier 2 capital) equal to at least 4.0% and 8.0%, respectively, of total risk-weighted assets (including various off-balance-sheet items, such as letters of credit).
The Dodd-Frank Act requires that the risk-based capital requirements and leverage requirements (discussed below) that apply to insured depository institutions act as a minimum, or “floor”, for capital required of bank holding companies such as the Company. Among other things, going forward this will preclude us from including in Tier 1 capital trust preferred securities or cumulative preferred stock, if any, issued on or after May 19, 2010. We have not issued any trust preferred securities since that date and have no outstanding cumulative preferred stock under Dodd-Frank. Our existing trust preferred securities are grandfathered as Tier 1 capital as our consolidated assets were less than $15 billion on December 31, 2009.
Advanced Approaches Risk-Based Capital Rules
In 2004, the Basel Committee published a new capital framework, referred to as “Basel II”, to replace Basel I. Basel II provides three approaches for setting capital standards for credit risk - “foundation” and “advanced” internal ratings-based approaches tailored to individual institutions' circumstances and a standardized approach that bases risk weightings on external credit assessments to a much greater extent than provided in Basel I or in the Federal banking agencies' general risk-based capital rules. Basel II also sets capital requirements for operational risk and refines the existing capital requirements for market risk exposures. The Federal banking agencies only adopted Basel II's advanced approaches, and only for banking organizations having $250 billion or more in total consolidated assets or $10 billion or more of foreign exposures (“advanced approaches- banks"). They refer to their Basel II based rules as their “advanced approaches risk-based capital rules”. Basel II currently does not apply either to the Company or the Bank.

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The NPRs - Basel III and the New Standardized Approach
In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as “Basel III”. In June 2012, the Federal banking agencies issued three notice of proposed rulemakings (“NPRs”) that would substantially revise the agencies' existing capital rules (both general and advanced approaches). The three NPRs would (i) implement the Basel III capital framework for U.S. bank holding companies and banks with total consolidated assets of $500 million or more (including by redefining the components of capital and establishing higher minimum percentages for applicable capital ratios), (ii) substantially revise the agencies' general risk-based capital rules for all banking organizations with a new “standardized approach” to make them more risk sensitive, and (iii) enhance the risk sensitivity of risk-based capital rules for advanced approaches banks. As we have less than $250 billion in assets and less than $10 billion in foreign exposures, we are not subject to the requirements of advanced approach banks. As proposed by the NPRs, the five year phase-in periods for the new ratios and the components of capital would have become effective January 1, 2013 with the standardized approach rules set to become effective on January 1, 2015. In November 2012, the agencies stated that any of the proposed rules for new ratios and components of capital that would have become effective on January 1, 2013 had been delayed, but did not specify the effectiveness date that would apply for the new ratios and components of capital or the impact of the delay on the effectiveness date of the changes to the calculation of risk weighted assets. If these rules preserve the Basel III implementation schedule, they would be fully phased-in by January 1, 2019.
The NPRs would implement Basel III for U.S. banking organizations largely as proposed by the Basel Committee as an international standard. Among other things, they would (i) introduce a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) define CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital, and (iv) expands the scope of the adjustments as compared to existing regulations.
The NPRs also implement changes to thresholds for the federal banking agencies' prompt corrective action rules. In addition to the changes for the thresholds, bank organizations will be required to hold levels exceeding the well capitalized levels to avoid constraints on dividends, equity repurchases and compensation. When fully phased in, the NPRs will require banks to maintain:
as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation);
a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation); and
a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation).
The capital conservation buffer is applicable to banks following the standardized approach as well as advanced approaches banks and is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
The NPRs, like Basel III, also provide for a “countercyclical capital buffer” applicable to advanced approaches banks, generally to be imposed when bank regulatory agencies determine that excess aggregate credit growth has become associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5% for advanced approaches banks). As we are not an advanced approach bank, we are not subject to the countercyclical capital buffer.
The NPRs, like Basel III, provide for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. In addition, the NPRs provide for full deduction of trust preferred securities from Tier 1 capital, including those previously grandfathered by the Dodd-Frank Act.
The NPRs' provisions relating to the standardized approach would amend the agencies' general risk-based capital rules and replace the risk-weighting categories currently used to calculate risk-weighted assets in the denominator of capital ratios with a broader range of risk-weighting categories that are intended to be more risk sensitive. The new risk weights for the standardized approach generally range from 0% to 600% as compared to the risk weights of 0% to 100% in the agencies'

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existing general risk-based capital rules. Higher risk weights would apply to a variety of exposures, including certain securitization exposures, residential mortgages, and equity exposures. Compared with the general risk-based capital rules, the risk weighting changes likely to have most significance for the Company and the Bank are the increased risk-weights for home equity loans.
Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company's net income and return on equity. The current requirements and the Company's actual capital levels are detailed in Note 11 of “Notes to Consolidated Financial Statements” filed in Part II, Item 8, “Financial Statements and Supplementary Data.”
Leverage
Bank holding companies and banks are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization's Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes). The existing rules require a minimum leverage ratio of 3.0% for banking organizations that either have the highest supervisory rating or have implemented the relevant Federal banking agency's risk-adjusted measure for market risk. All other banking organizations are required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by the relevant Federal banking agency. Under the Federal banking agency's capital NPRs, all banking organizations would be required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by a relevant regulatory authority. Although Basel III includes as a new international standard a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures, the NPRs apply the Basel III leverage ratio only to advanced approaches banks.
Liquidity Requirements
Historically, regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III liquidity framework requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high quality liquid assets equal to the entity's expected net cash outflow for a 30 day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. In January 2013, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee, approved amendments to the LCR to expand the range of eligible assets and refine assumed inflow and outflow rates to reflect actual experience in times of stress. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one year time horizon. These requirements will incent banking organizations to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source.
The Basel III liquidity framework contemplates that the LCR will be subject to an observation period continuing through mid-2013 and, subject to any revisions resulting from the analyses conducted and data collected during the observation period, with a minimum LCR of 60% required by 2015 gradually increasing to 100% by 2019. Similarly, it contemplates that the NSFR will be subject to an observation period through mid-2016 and, subject to any revisions resulting from the analyses conducted and data collected during the observation period, implemented as a minimum standard by January 1, 2018.
These new standards are subject to further rulemaking (including determinations as to which banking organizations will be subject to them) and their terms may well change before implementation. Although the Federal banking agencies' capital NPRs propose rules to implement the Basel III capital framework for U.S. banking organizations (discussed above under “Capital Requirements”), the agencies have not yet proposed rules to implement Basel III's liquidity framework.
Stress Test Rules
In October 2012, the Federal Reserve and OCC announced publication of their final rules regarding company run stress testing of capital as required by Dodd-Frank.  The stress test rules are the only component of the Proposed SIFI Rules (described below under “Proposed SIFI Rules”) that have been finalized to date. The rules will require covered institutions with average total consolidated assets greater than $10 billion, including the Company and the Bank, to conduct an annual company run stress test of capital, consolidated earnings and losses under one base and stress scenarios provided by the agencies. The first date on which institutions with total consolidated assets between $10 billion and $50 billion are required to submit to the agencies their company-run stress tests is March 31, 2014 using data as of September 30, 2013 and scenarios released by the

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agencies in November 2013. Public disclosure of our results is required beginning with our company-run stress tests using data as of September 30, 2014. A summary of those stress test results will be required in June 2015.
Proposed SIFI Rules

Dodd-Frank directed the Federal Reserve to enact enhanced prudential standards applicable to bank holding companies with total consolidated assets of $50 billion or more and non-bank covered companies designated as systemically important by the Financial Stability Oversight Council. A banking organization is deemed to have met the $50 billion asset criterion based on the average of the company's total consolidated assets as reported on its four most recent quarterly reports to the Federal banking agencies. We refer to such entities as “systemically important financial institutions”. Dodd-Frank mandates that certain regulatory requirements applicable to systemically important financial institutions be more stringent than those applicable to other financial institutions. In December 2011, the Federal Reserve issued for public comment a notice of proposed rulemaking, which we refer to as the “Proposed SIFI Rules,” establishing enhanced prudential standards responsive to these provisions for:

risk-based capital requirements and leverage limits;
stress testing of capital;
liquidity requirements;
overall risk management requirement; and
single counterparty credit exposure limits.

Although the Proposed SIFI Rules generally apply to bank holding companies with total consolidated assets of $50 billion or more as stated above, two of their provisions - stress testing of capital and certain risk management requirements - apply to bank holding companies as well as banks with $10 billion or more but less than $50 billion of total consolidated assets, including the Company and the Bank. As discussed above under “Stress Test Rules”, the stress test rules are the only component of the Proposed SIFI Rules that have been adopted. Upon performance of the stress testing of capital required under the Dodd-Frank Act, banking organizations are expected to maintain capital above each minimum regulatory capital ratio and above a tier 1 common ratio of five percent. We are monitoring developments with respect to the remaining Proposed SIFI Rules because of their potential application to us if our total consolidated assets reach $50 billion or more.
Prompt Corrective Action Regulations
The Federal Deposit Insurance Act, as amended (“FDIA”), requires the Federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet specified capital requirements. The FDIA establishes five capital categories for FDIC-insured banks: well capitalized, adequately capitalized, under-capitalized, significantly under-capitalized and critically under-capitalized. Under existing rules, a depository institution is deemed to be “well-capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. The FDIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category in which an institution is classified. The U.S. banking agencies' capital NPRs, discussed above under “Capital Requirements”, would amend the prompt corrective action requirements in certain respects, including adding a CET1 risk-based capital ratio as one of the metrics (with a minimum 6.5% ratio for well-capitalized status) and increasing the Tier 1 risk-based capital ratio required for each of the five capital categories for FDIC-insured banks, including an increase from 6.0% to 8.0% to be well-capitalized).
The current requirements and the actual levels for the Bank are detailed in Note 11 of “Notes to Consolidated Financial Statements” filed herewith in Part II, Item 8, “Financial Statements and Supplementary Data.”
Source of Strength Doctrine
Federal Reserve policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement. Under this requirement, the Company is expected to commit resources to support the Bank, including at times when we may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a Federal banking agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

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In addition, under the National Bank Act, which applies to national banks, if the capital stock of the Bank is impaired by losses or otherwise, the OCC is authorized to require us to pay the deficiency through an assessment. If the assessment is not paid within three months, the OCC could order us to sell our holdings of the Bank's stock to make good the deficiency.
Payment of Dividends
The principal source of the Company's liquidity is dividends from the Bank. If the total of all dividends declared by a national bank in any calendar year would exceed the sum of the bank's net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus, the prior approval of the OCC is required. Federal law also prohibits national banks, such as the Bank, from paying dividends that would be greater than the bank's undivided profits after deducting statutory bad debt in excess of the bank's allowance for loan losses.
In addition, we and the Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimum capital levels. The appropriate Federal banking agency is authorized to determine under certain circumstances relating to the financial condition of a banking organization that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The Federal banking agencies have stated that paying dividends that deplete a banking organization's capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings. In addition, in the current financial and economic environment, the Federal Reserve has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
Under rules adopted by the Federal Reserve in November 2011, known as the Comprehensive Capital Analysis and Review (“CCAR”) Rules, bank holding companies with $50 billion or more of total consolidated assets are required to submit annual capital plans to the Federal Reserve and generally may pay dividends and repurchase stock only under a capital plan as to which the Federal Reserve has not objected. The CCAR rules will not apply to us for so long as our total consolidated assets remain below $50 billion. However, we anticipate that our capital ratios reflected in the stress test calculations required of us under the stress test rules of the Proposed SIFI Rules will be an important factor considered by the Federal Reserve in evaluating whether proposed payments of dividends or stock repurchases may be an unsafe or unsound practice.
Transactions with Affiliates
Federal laws strictly limit the ability of banks to engage in transactions with their affiliates, including their bank holding companies. Regulations promulgated by the Federal Reserve limit the types and amounts of these transactions (including loans due and extensions of credit from their U.S. bank subsidiaries) that may take place and generally require those transactions to be on an arm's-length basis. In general, these regulations require that “covered transactions” between a subsidiary bank and its parent company or the nonbank subsidiaries of the bank holding company are limited to 10% of the bank subsidiary's capital and surplus and, with respect to such parent company and all such nonbank subsidiaries, to an aggregate of 20% of the bank subsidiary's capital and surplus. Further, loans and extensions of credit to affiliates generally are required to be secured by eligible collateral in specified amounts. The Dodd-Frank Act significantly expands the coverage and scope of the limitations on affiliate transactions within a banking organization. For example, commencing in July 2011, the Dodd-Frank Act required that the 10% of capital limit on these transactions applies to financial subsidiaries as well. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve) from the affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
Federal law also limits a bank's authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such extensions of credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the bank's capital.

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Consumer Financial Protection Bureau Supervision
Dodd-Frank centralized responsibility for consumer financial protection by creating a new agency, the CFPB, and giving it responsibility for implementing, examining and enforcing compliance with federal consumer protection laws. In July 2011, consistent with its mandate under Dodd-Frank to supervise depository institutions with more than $10 billion in assets, the CFPB notified the Bank that it will be supervised by the CFPB for certain consumer protection purposes. The CFPB will focus on:
risks to consumers and compliance with the Federal consumer financial laws, when it evaluates the policies and practices of a financial institution;
the markets in which firms operate and risks to consumers posed by activities in those markets;
depository institutions that offer a wide variety of consumer financial products and services;
depository institutions with a more specialized focus; and
non-depository companies that offer one or more consumer financial products or services.
Deposit Insurance
Substantially all of the deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund ("DIF") and are subject to deposit insurance assessments to maintain the DIF. On April 1, 2011, the deposit insurance assessment base changed from total domestic deposits to the average consolidated total assets minus the average tangible equity of the depository institution, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Act. Additionally, the deposit insurance assessment system was revised to create a two scorecard system, one for most large institutions, including the Bank, that have more than $10 billion in assets and another for “highly complex” institutions that have over $50 billion in assets and are fully owned by a parent with over $500 billion in assets. Each scorecard has a performance score and a loss severity score that is combined to produce a total score, which is translated into an initial assessment rate. In calculating these scores, the FDIC has continued to utilize a bank's capital level and supervisory ratings (its “CAMELS ratings”), has introduced certain new financial measures to assess an institution's ability to withstand asset related stress and funding related stress, and has eliminated the use of risk categories and long-term debt issuer ratings. The FDIC also has the ability to make discretionary adjustments to the total score, up or down, by a maximum of 15 points, based upon significant risk factors that are not adequately captured by the scorecard. The total score translates to an initial base assessment rate on a non-linear, sharply increasing scale.
For large institutions, including the Bank, the initial base assessment rate ranges from five to 35 basis points on an annualized basis (basis points representing cents per $100 of assessable assets). After the effect of potential base-rate adjustments, the total base assessment rate could range from 2.5 to 45 basis points on an annualized basis. The potential adjustments to an institution's initial base assessment rate include (i) a potential decrease of up to five basis points for certain long-term unsecured debt and, except for well-capitalized institutions with a CAMELS rating of 1 or 2, and (ii) a potential increase of up to 10 basis points for brokered deposits in excess of 10% of domestic deposits. As the DIF reserve ratio grows, the rate schedule will be adjusted downward. Additionally, the rule includes a new adjustment for depository institution debt whereby an institution must pay an additional premium equal to 50 basis points on every dollar (above 3% of an institution's Tier 1 capital) of long-term, unsecured debt held that was issued by another insured depository institution (excluding debt guaranteed under the Temporary Liquidity Guarantee Program). The FDIC's new definitions for higher risk commercial and industrial loans and securities, higher risk securitizations and higher risk consumer loans will go into effect in the second quarter of 2013.
In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.
In November 2010, the FDIC issued a final rule to implement provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for noninterest-bearing transaction accounts. The separate coverage for noninterest-bearing transaction accounts became effective on December 31, 2010 and terminated on December 31, 2012.
Under the FDIA, if the FDIC finds that an institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC, the FDIC may determine that such violation or unsafe or unsound practice or condition requires the termination of deposit insurance.

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Insolvency of an Insured Depository Institution
If the FDIC is appointed the conservator or receiver of an insured depository institution, upon its insolvency or in certain other events, the FDIC has the power:
to transfer any of the depository institution's assets and liabilities to a new obligor without the approval of the depository institution's creditors;
to enforce the terms of the depository institution's contracts pursuant to their terms; or
to repudiate or disaffirm any contract or lease to which the depository institution is a party, the performance of which is determined by the FDIC to be burdensome and the disaffirmance or repudiation of which is determined by the FDIC to promote the orderly administration of the depository institution.
In addition, under Federal law, the claims of holders of deposit liabilities and certain claims for administrative expenses against an insured depository institution would be afforded priority over other general unsecured claims against such an institution, including claims of debt holders of the institution in the liquidation or other resolution of such an institution by any receiver. As a result, whether or not the FDIC ever sought to repudiate any debt obligations of the Bank, the debt holders would be treated differently from, and could receive, if anything, substantially less than the Bank's depositors.
Depositor Preference
The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC standing in for insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States, and the parent bank holding company with respect to any extensions of credit it has made to such insured depository institution.
Safety and Soundness Standards
The FDIA requires the Federal banking agencies to prescribe standards, through regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the Federal banking agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of the FDIA. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Incentive Compensation
In June 2010, the Federal Reserve, OCC and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization's incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization's ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization's board of directors. These three principles are incorporated into the proposed joint compensation regulations under Dodd-Frank, discussed above.
Dodd-Frank requires the U.S. financial regulators, including the Federal Reserve, to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities having at least $1 billion in total consolidated

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assets (which would include the Company and the Bank) that encourage inappropriate risks by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The initial version of these regulations was proposed by the U.S. financial regulators in early 2011 but the regulations have not yet been finalized. The proposed regulations include the three key principles from the June 2010 regulatory guidance discussed above. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which we may structure compensation for our executives.
The Federal Reserve will review, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization's supervisory ratings, which can affect the organization's ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
Community Reinvestment Act and Fair Lending Laws
The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low and moderate income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. The Federal banking agencies take into account CRA ratings when considering approval of proposed acquisition transactions. The Bank received a “Satisfactory” CRA rating on its most recent Federal examination.
The Fair Housing Act (“FHA”) and Equal Credit Opportunity Act (“ECOA”) are commonly known as the Fair Lending Laws. The FHA is a civil rights law that makes discrimination in housing lending illegal. The ECOA is a customer protection law prohibiting discrimination in all types of credit-both consumer and commercial-and requiring that certain notifications be given to loan applicants. The Americans with Disabilities Act (“ADA”) also bears on lending activities. Banks are obligated to reasonably accommodate individuals with disabilities when they apply for loans as well as during the entire lending process. Depository institutions are periodically examined for compliance with the Fair Lending Laws. Regulators are required to refer matters to the U.S. Department of Justice whenever the regulator has reason to believe that a creditor has engaged in a pattern or practice of discouraging or denying applications for credit in violation of ECOA.
Other Consumer Protection Laws
There are a number of consumer protection laws and implementing regulations that are designed to protect the interests of consumers in their credit transactions and other transactions with banks and financial service providers. More recently, the Dodd-Frank Act amended an existing consumer protection law to expand its scope so that it now covers deceptive acts or practices, and to provide examination and enforcement authority over the CFPB. Under Dodd-Frank it is unlawful for any provider of consumer financial products or services to engage in any unfair, deceptive or abusive act or practice (“UDAAP”). A violation of the consumer protection laws, and in particular UDAAP, could have serious legal, financial and reputational consequences.
Federal Home Loan Bank System
We are a member of the Federal Home Loan Bank System (“FHLB System”), which consists of 12 regional Federal Home Loan Banks (each a “FHLB”). The FHLB System provides a central credit facility primarily for member banks. As a member of the FHLB of New York, we are required to acquire and hold shares of capital stock in the FHLB in an amount equal to 0.2% of the total principal amount of our unpaid residential real estate loans, commercial real estate loans, home equity loans, CMOs, and other similar obligations at the beginning of each year, and 4.5% of our borrowings from the FHLB. As of December 31, 2012, we were in compliance with this requirement. While we are not a member of FHLB of Pittsburgh or Boston, we acquired FHLB of Pittsburgh and Boston common stock in connection with our mergers with Harleysville National Corporation ("Harleysville") and NewAlliance, respectively.
Financial Privacy
Federal regulations require the Company to disclose its privacy policy, including identifying with whom we share “nonpublic personal information,” to our customers at the time the customer establishes a relationship with the Company and annually

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thereafter. In addition, we are required to provide our customers with the ability to “opt-out” of having the Company share their nonpublic personal information with nonaffiliated third parties before we can disclose that information, subject to certain exceptions.
The Federal banking agencies adopted guidelines establishing standards for safeguarding our customer information. The guidelines describe the agencies' expectation that we create, implement, and maintain an information security program, which would include administrative, technical, and physical safeguards appropriate to our size and complexity and the nature and scope of our activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of our customer records and information, protect against any anticipated threats or hazards to the security or integrity of our customer records, and protect against unauthorized access to records or information that could result in substantial harm or inconvenience to our customers. Additionally, the guidance states that banks, such as the Bank, should develop and implement a response program to address security breaches involving customer information, including customer notification procedures. We have developed such a program.
Anti-Money Laundering and the USA PATRIOT Act
A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department (the “Treasury”) has issued and, in some cases, proposed a number of regulations that apply various requirements of the Patriot Act to financial institutions such as the Bank. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal, financial, and reputational consequences for the institution.
Office of Foreign Assets Control Regulation
The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the Treasury's Office of Foreign Assets Control (“OFAC”). The OFAC administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal, financial, and reputational consequences.
Sarbanes-Oxley Act
The stated goals of the Sarbanes-Oxley Act of 2002 (“SOX”) are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.
SOX addresses, among other matters, audit committees; certification of financial statements and internal controls by the Chief Executive Officer and Chief Financial Officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan blackout periods; disclosure of off-balance sheet transactions; a prohibition on certain loans to directors and officers; expedited filing requirements for Forms 4; disclosure of a code of ethics and filing a Form 8-K for significant changes or waivers of such code; “real time” filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws. The SEC has enacted rules to implement various provisions of SOX.

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The Fair and Accurate Credit Transactions Act of 2003
The Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”) includes many provisions concerning national credit reporting standards, and permits consumers, including our customers, to opt out of information sharing among affiliated companies for marketing purposes. The FACT Act also requires the Company to notify its customers if it reports negative information about them to credit bureaus or if the credit that we grant to them is on less favorable terms than are generally available. We also must comply with guidelines established by our Federal banking regulators to help detect identity theft.
 
 
 
ITEM 1A.
 
Risk Factors
Making or continuing an investment in securities issued by the Company, including our common stock, involves certain risks that you should carefully consider. The following are the key risk factors that affect us. If any of the following risks actually occur, our business, financial condition or results of operations could be negatively affected, the market price for your securities could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company.
Economic Conditions May Adversely Affect Our Liquidity and Financial Condition
From December 2007 through June 2009, the U.S. economy was in recession with weaker than expected recovery to date. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have improved, certain sectors, such as real estate, remain weak and unemployment remains high. Recovery by many businesses has been impaired by lower consumer spending. A return to prolonged or deteriorating economic conditions could have one or more of the following adverse effects on our business:
A decrease in the demand for loans and other products and services that we offer;
A decrease in net interest income derived from our lending and deposit gathering activities;
A decrease in the value of our investment securities;
A decrease in the value of our loans held for sale or other assets secured by consumer or commercial real estate;
An impairment of certain intangible assets, such as goodwill; and
An increase in the number of customers and counterparties who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us. An increase in the number of delinquencies, bankruptcies or defaults could result in a higher level of nonperforming assets, net charge-offs, provision for loan losses and valuation adjustments on loans held for sale.

Concentration in Real Estate Loans, Particularly in Upstate New York, May Increase Our Exposure to Credit Risk

At December 31, 2012, our portfolio of commercial real estate loans totaled $7.1 billion, or 36% of total loans. While our concentration of commercial real estate loans in Upstate New York has steadily decreased over the past three years, from 90% at December 31, 2009 to 50% at December 31, 2012, a large portion of this portfolio remains concentrated in this geographical area.

At December 31, 2012, our portfolio of residential real estate loans (including home equity loans) totaled $6.4 billion, or 33% of total loans. While our concentration in these loans in Upstate New York has steadily decreased over the past three years, from 99% at December 31, 2010 to 41% at December 31, 2012, a large portion of this portfolio remains concentrated in this geographical area.

A significant weakening in economic conditions in Upstate New York, such as unemployment or other factors beyond our control, could reduce our ability to generate new loans and increase default rates on these loans and otherwise negatively affect our financial results. Moreover, while home prices in Upstate New York have not seen the declines that other parts of the country have experienced over the past four to six years, a decline in real estate valuations in Upstate New York could lower the value of the collateral securing our residential real estate loans, leading to higher credit losses.

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Commercial Real Estate and Business Loans Increase Our Exposure to Credit Risks
At December 31, 2012, our portfolio of commercial real estate and business loans totaled $12.0 billion, or 61% of total loans. We plan to continue to emphasize the origination of these types of loans, which generally expose us to a greater risk of nonpayment and loss than residential real estate loans because repayment of such loans often depends on the successful operations and income stream of the borrowers. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential real estate loans. Also, many of our borrowers have more than one commercial loan outstanding. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a residential real estate loan.
Concentration of Loans in Our Primary Market Area May Increase Risk
Our success is impacted by the general economic conditions in the geographic areas in which we operate, primarily Upstate New York, Pennsylvania, Connecticut, and Western Massachusetts. Accordingly, the local economic conditions in these markets have a significant impact on the ability of borrowers to repay loans. As such, a decline in real estate valuations in these markets would lower the value of the collateral securing those loans. In addition, a significant weakening in general economic conditions such as inflation, recession, unemployment, or other factors beyond our control could reduce our ability to generate new loans and increase default rates on those loans and otherwise negatively affect our financial results.

A Large Portion of our Loan Portfolio Is Acquired and Was Not Underwritten by Us at Origination

At December 31, 2012, 32% of our loan portfolio was acquired and was not underwritten by us at origination, and therefore is not necessarily reflective of our historical credit risk experience. We performed extensive credit due diligence prior to each acquisition and marked the loans to fair value upon acquisition, with such fair valuation considering expected credit losses that existed at the time of acquisition. Additionally, we evaluate the expected cash flows of these loans on a quarterly basis. However, there is a risk that credit losses could be larger than currently anticipated, thus adversely affecting our earnings.

One-Third of Our Assets are Invested in Securities, With Over 16% in Commercial Mortgage-Backed Securities, Ten Percent in Collateralized Loan Obligations and Over Seven Percent in Asset-Backed Securities

Approximately one-third of our assets have been invested in securities, currently with over 16% in commercial mortgage-backed securities, over ten percent in collateralized loan obligations and over seven percent in asset backed securities. These securities are structured investments with complex formulas to determine the amount of cash flows that get paid to holders of each security type within the various structures. Changes in expected cash flows due to factors such as changing credit experience of the underlying collateral, changes in interest rates or changes in prepayment speeds could affect the amount of interest and principal cash flows we receive and the amount of interest income that we recognize.
Increases to the Provision for Credit Losses May Cause Our Earnings to Decrease
Our customers might not repay their loans according to the original terms, and the collateral securing the payment of those loans might be insufficient to pay any remaining loan balance. Hence, we may experience significant loan losses, which could have a materially adverse effect on our operating results. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. In determining the amount of the allowance for loan losses, we rely on loan quality reviews, past loss experience, and an evaluation of economic conditions, among other factors. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in additions to the allowance. Material additions to the allowance would materially decrease our net income.
Our emphasis on the origination of commercial real estate and business loans is one of the more significant factors in evaluating our allowance for loan losses. As we continue to increase the amount of these loans, additional or increased provisions for credit losses may be necessary and as a result would decrease our earnings.
Bank regulators periodically review our allowance for loan losses and may require us to increase our provision for credit losses or loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities could have a materially adverse effect on our results of operations and/or financial condition.


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We Accept Deposits That Do Not Have a Fixed Term and Which May Be Withdrawn by the Customer at Any Time For Any Reason

At December 31, 2012, we had $23.6 billion of deposit liabilities that have no maturity and, therefore, maybe withdrawn by the depositor at any time.  These deposit liabilities include our checking, savings, and money market deposit accounts.  The withdrawal of more deposits than we anticipate could have an adverse impact on our profitability as this source of funding, if not replaced by similar deposit funding, would need to be replaced with wholesale funding, the sale of interest earning assets, or a combination of these two actions.  The replacement of deposit funding with wholesale funding could cause our overall cost of funding to increase, which would reduce our net interest income.  The loss of interest earning assets would also reduce our net interest income.
Changes in Interest Rates Could Adversely Affect Our Results of Operations and Financial Condition
Our results of operations and financial condition could be significantly affected by changes in interest rates. Our financial results depend substantially on net interest income, which is the difference between the interest income that we earn on interest-earning assets and the interest expense we pay on interest-bearing liabilities. While we have modeled rising interest rate scenarios and such scenarios result in an increase in our net interest income, our interest-bearing liabilities reprice or mature more quickly than our interest-earning assets, resulting in a decrease in our net interest income.
Changes in interest rates also affect the value of our interest-earning assets and in particular our investment securities. Generally, the value of our investment securities fluctuates inversely with changes in interest rates. Decreases in the fair value of our investment securities, therefore, could have an adverse effect on our stockholders’ equity or our earnings if the decrease in fair value is deemed to be other than temporary.
Changes in interest rates may also affect the average life of our loans and mortgage related securities. Decreases in interest rates resulting from actions taken by the Federal Reserve has caused an increase in prepayments of our loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. As prepayment speeds on mortgage related securities increase, the premium amortization increases prospectively, and additionally there would be an adjustment required under the application of the interest method of income recognition, and will therefore result in lower net interest income. We recorded two such adjustments to our mortgage related securities in 2012 totaling $25 million. Under these circumstances, we are also subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on our existing loans and securities. Additionally, increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable rate loans.
If We Continue to Grow and Our Total Consolidated Assets Reach $50 Billion, We Will Become Subject to Stricter Prudential Standards Required by the Dodd-Frank Act for Large Bank Holding Companies.
In December 2011, the Federal Reserve, pursuant to the requirements of the Dodd-Frank Act, proposed rules applying stricter prudential standards to, among others, bank holding companies having $50 billion or more in total consolidated assets. The stricter prudential standards include risk-based capital and leverage requirements, liquidity requirements, risk-management requirements, stress testing of capital, credit limits and early remediation regimes. Only the stress testing of capital rules have been adopted in final form. The Federal Reserve is also required by the Dodd-Frank Act to adopt rules regarding credit exposure reporting by these institutions. The Dodd-Frank Act permits, but does not require, the Federal Reserve to apply to these institutions heightened prudential standards in a number of other areas, including short-term debt limits and enhanced public disclosure.
We completed four acquisitions during the last several years that have contributed substantially to our growth — our acquisition of certain assets and assumption of certain liabilities related to 137 branches of HSBC (in 2012) and NewAlliance (in 2011), discussed in Note 2 to our consolidated financial statements included in this Annual Report on Form 10-K and under “Management’s Discussion and Analysis of Financial Condition and Results of Operation — Overview” in this report, and Harleysville (in 2010), and 57 branches of National City Bank in Western Pennsylvania (2009), addressed in prior filings under the Exchange Act. At December 31, 2008, our total consolidated assets were $9.3 billion, as compared to $36.8 billion at December 31, 2012. If our assets reach the $50 billion threshold, whether driven by organic growth or future acquisitions, we will become subject to the stricter prudential standards required by the Dodd-Frank Act.
Growing By Acquisition Entails Certain Risks
As indicated above, we have grown substantially due to acquisitions in the last several years. Growth by acquisition involves risks. The success of our acquisitions may depend on, among other things, our ability to realize anticipated cost savings and to combine the businesses of the acquired company with our businesses in a manner that does not result in decreased revenues

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resulting from any disruption of existing customer relationships of the acquired company. If we are not able to achieve these objectives, the anticipated benefits of an acquisition may not be realized fully or at all or may take longer to realize than planned. Further, the asset quality or other financial characteristics of a company we may acquire may deteriorate after the acquisition agreement is signed or after the acquisition closes.
We May Incur Restructuring Charges That May Reduce Our Earnings
We continually evaluate the efficiency of our operations. From time to time, we may engage in certain cost-cutting measures to improve efficiency. Charges related to such efforts could adversely affect earnings in the period in which the charges are incurred.
Strong Competition May Limit Our Growth and Profitability
Competition in the banking and financial services industry is intense. We compete with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors (whether regional or national institutions) have substantially greater resources and lending limits than us and may offer certain services that we do not or cannot provide. Our profitability depends upon our ability to successfully compete in our market areas.
We May Not Be Able to Attract or Retain Skilled People
Our success depends, in large part, on our ability to attract new employees, retain and motivate our existing employees, and continue to compensate employees competitively amid intense public and regulatory scrutiny on the compensation practices of financial institutions. Our compensation plans are an important element in the attraction and retention of key employees. Competition for the best people in most activities engaged in by us can be intense and we may not be able to hire these people or to retain them.
We Are Subject to Extensive Government Regulation and Supervision
We are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the financial system as a whole, not security holders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Other changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in civil or criminal sanctions by state and federal agencies, the loss of FDIC insurance, the revocation of our banking charter, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations. See “Supervision and Regulation” for more information about the regulation to which we are subject.
Any Future FDIC Insurance Premium Increases May Adversely Affect our Earnings
The amount that is assessed by the FDIC for deposit insurance is set by the FDIC based on a variety of factors. These include the DIF’s reserve ratio, the Bank’s assessment base, which is equal to average consolidated total assets minus average tangible equity, and various inputs into the FDIC’s assessment rate calculation, including the Bank’s:
CAMELS rating,
criticized and classified assets,
capital levels, including the Tier 1 leverage ratio,
higher-risk assets, defined as construction and development loans, leveraged loans and securities, nontraditional mortgages and subprime consumer loans and, after April 1, 2013, higher risk securitizations,
ratio of core earnings to average assets,
ratio of core deposits to total liabilities,
liquidity ratio (as defined by the FDIC),
our projected shortfall (in event of failure) between projected insured deposits and the projected assets available to pay off projected insured deposits as a percentage of current domestic deposits,
amount of unsecured debt, including subordinated debt and debt issues by another depository institution, and
amount of brokered deposits.

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If there are additional financial institution failures we may be required to pay even higher FDIC premiums than the recently increased levels. Such increases or required prepayments of FDIC insurance premiums may adversely impact our earnings. See “Supervision and Regulation—Deposit Insurance” for more information about FDIC insurance premiums.
We Are a Holding Company and Depend on Our Subsidiaries for Dividends, Distributions and Other Payments
We are a legal entity separate and distinct from our banking and other subsidiaries. Our principal source of cash flow, including cash flow to pay dividends to our stockholders and principal and interest on our outstanding debt, is dividends from the Bank. There are statutory and regulatory limitations on the payment of dividends by the Bank to us, as well as by us to our stockholders. Regulations of the OCC affect the ability of the Bank to pay dividends and other distributions to us and to make loans to us. If the Bank is unable to make dividend payments to us and sufficient capital is not otherwise available, we may not be able to make dividend payments to our common stockholders or principal and interest payments on our outstanding debt. See “Payment of Dividends” above under “Supervision and Regulation.”
In addition, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.
We Hold Certain Intangible Assets that Could Be Classified as Impaired in The Future. If These Assets Are Considered to Be Either Partially or Fully Impaired in the Future, Earnings Could Decrease
We are required to test our goodwill and core deposit intangible assets for impairment on a periodic basis. The impairment testing process considers a variety of factors, including the current market price of our common shares, the estimated net present value of our assets and liabilities, and information concerning the terminal valuation of similarly situated insured depository institutions. If an impairment determination is made in a future reporting period, our earnings and the book value of these intangible assets will be reduced by the amount of the impairment. If an impairment loss is recorded, it will have little or no impact on the tangible book value of our common shares or our regulatory capital levels, but such an impairment loss could significantly restrict the Bank’s ability to make dividend payments to us without prior regulatory approval.
We Are Subject to a Variety of Operational Risks, Including Reputational Risk, Legal and Compliance Risk, the Risk of Fraud or Theft by Employees or Outsiders, Which May Adversely Affect Our Business and Results of Operations
We are exposed to many types of operational risks, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees, or operational errors, including clerical or record keeping errors or those resulting from faulty or disabled computer or telecommunications systems or disclosure of confidential proprietary information of our customers. Negative public opinion can result from our actual or alleged conduct in any number of activities, including lending practices, sales practices, customer treatment, corporate governance and acquisitions and from actions taken by government regulators and community organizations in response to those activities. Negative public opinion can adversely affect our ability to attract and keep customers and can expose us to litigation and regulatory action. Actual or alleged conduct by the Company can result in negative public opinion about our other business.
If personal, nonpublic, confidential, or proprietary information of customers in our possession were to be mishandled or misused, we could suffer significant regulatory consequences, reputational damage, and financial loss. Such mishandling or misuse could include, for example, if such information were erroneously provided to parties who are not permitted to have the information, either by fault of our systems, employees or counterparties, or where such information is intercepted or otherwise inappropriately taken by third parties.
Because the nature of the financial services business involves a high volume of transactions, certain errors may be repeated or compounded before they are discovered and successfully rectified. Our necessary dependence upon automated systems to record and process transactions and the large transaction volumes may further increase the risk that technical flaws or employee tampering or manipulation of those systems will result in losses that are difficult to detect. We also may be subject to disruptions of our operating systems arising from events that are wholly or partially beyond our control (for example, computer viruses or electrical or telecommunications outages), which may give rise to disruption of service to customers and to financial loss or liability. We are further exposed to the risk that our external vendors may be unable to fulfill their contractual obligations (or will be subject to the same risk of fraud or operational errors by their respective employees as we are) and to the risk that we (or our vendors’) business continuity and data security systems prove to be inadequate. The occurrence of any of these risks could result in a diminished ability to operate our business, potential liability to clients, reputational damage, and regulatory intervention, which could adversely affect our business, financial condition, and results of operations, perhaps materially.

26


We May Be Adversely Affected By The Soundness Of Other Financial Institutions
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and routinely execute transactions with counterparties in the financial services industry. Many of these transactions expose us to credit risk in the event of a default by a counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to us. Any such losses could have a material adverse effect on our financial condition and results of operations.
Our Information Systems May Experience an Interruption or Security Breach

We rely heavily on communications and information systems to conduct our business. Any failure or interruption of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the possible failure or interruption of our information systems, there can be no assurance that any such failure or interruption will not occur or, if they do occur, that they will be adequately addressed. A breach in security of our systems, including a breach resulting from our newer online capabilities such as mobile banking, increases the potential for fraud losses. The occurrence of any failure, interruption or security breach of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny or expose us to civil litigation and possible financial liability.
Anti-takeover Laws and Certain Agreements and Charter Provisions May Adversely Affect Share Value
Certain provisions of our certificate of incorporation and state and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire control of the Company without our board of directors' approval. Under federal law, subject to certain exemptions, a person, entity or group must notify the Federal Reserve before acquiring control of a bank holding company. Acquisition of 10% or more of any class of voting stock of a bank holding company, including shares of our common stock or shares of our preferred stock were those shares to become entitled to vote upon the election of two directors because of missed dividends, creates a rebuttable presumption that the acquirer “controls” the bank holding company. Also, a bank holding company must obtain the prior approval of the Federal Reserve before, among other things, acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any bank, including the Bank. There also are provisions in our certificate of incorporation that may be used to delay or block a takeover attempt. Taken as a whole, these statutory provisions and provisions in our certificate of incorporation could result in the Company being less attractive to a potential acquirer and thus could adversely affect the market price of our common stock.

Financial Services Companies Depend On The Accuracy and Completeness Of Information About Customers And Counterparties

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. We may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on our business and, in turn, our financial condition and results of operations.

Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events Could Significantly Impact Our Business

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. In addition, such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause us to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event in the future could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

We Are Exposed to Risk of Environmental Liability When We Take Title to Property.

In the course of our business, we may foreclose on and take title to real estate. As a result, we could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property.

27


The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. If we become subject to significant environmental liabilities, our business, financial condition or results of operations could be adversely affected.

 
 
 
ITEM 1B.
 
Unresolved Staff Comments
None.
 
 
 
ITEM 2.
 
Properties
Our headquarters are located in our Buffalo regional market center at 726 Exchange Street, Suite 618, Buffalo, New York where we lease 115,000 square feet of space. At December 31, 2012, we conducted our business through 205 full-service branches located across Upstate New York, 129 full-service branches in Pennsylvania, 85 branches in Connecticut, and 11 branches in Western Massachusetts, including several financial services offices. One hundred fifty-two of our branches are owned and 278 are leased.
In addition to our branch network and Buffalo regional market center, we occupy office space in our six other regional market centers located in Rochester, Albany, and Syracuse, New York and Pittsburgh and Philadelphia, Pennsylvania and New Haven, Connecticut where we provide financial services and perform certain back office operations. We also lease or own other facilities which are used as training centers and storage. Some of our facilities contain tenant leases that are subleases. These properties include 38 leased offices and 21 buildings which we own with a total occupancy of approximately 1,556,000 square feet, including our administrative center in Lockport, New York which has 76,000 square feet. At December 31, 2012, our premises and equipment had a net book value of $411 million. See Note 5 of the “Notes to Consolidated Financial Statements” filed herewith in Part II, Item 8, “Financial Statements and Supplementary Data” for further detail on our premises and equipment. All of these properties are generally in good condition and are appropriate for their intended use.
 
 
 
ITEM 3.
 
Legal Proceedings
In the ordinary course of business, we are involved in various threatened and pending legal proceedings. We believe that we are not a party to any pending legal, arbitration, or regulatory proceedings that would have a material adverse impact on our financial results or liquidity.
 
 
 
ITEM 4.
 
Mine Safety Disclosures
Not applicable.
PART II
 
 
 
ITEM 5.
 
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is traded under the symbol ‘FNFG’ on the NASDAQ Global Select Market. At December 31, 2012, we had approximately 26,000 stockholders of record. During 2012, the high sales price of our common stock was $10.35 and the low sales price of our common stock was $7.08. We paid dividends of $0.32 per common share during 2012. See additional information regarding the market price and dividends paid in Item 6, “Selected Financial Data.”
During 2011, we repurchased 9 million shares of our common stock, but we did not repurchase any shares of our common stock during 2012. Under the current stock repurchase plan, approved by our Board of Directors on July 27, 2010, we are authorized to repurchase up to an additional 12 million shares of our common stock. This plan does not have an expiration date.

28


Stock Performance Graph
Below is a stock performance graph comparing (i) the cumulative total return on our common stock for the period beginning December 31, 2007 as reported by the NASDAQ Global Select Market, through December 31, 2012, (ii) the cumulative total return on stocks included in the NASDAQ Composite Index over the same period, and (iii) the cumulative total return of publicly traded regional banks and thrifts over the same period. Cumulative return assumes the reinvestment of dividends, and is expressed in dollars based on an assumed investment of $100.
FIRST NIAGARA FINANCIAL GROUP, INC.
 
Period Ended
Index
12/31/2007

12/31/2008

12/31/2009

12/31/2010

12/31/2011

12/31/2012

First Niagara Financial Group, Inc.
$
100.00

$
139.76

$
125.46

$
131.81

$
85.94

$
81.99

NASDAQ Composite Index
100.00

60.02

87.24

103.08

102.26

120.42

KBW Regional Bank Index
100.00

81.42

63.41

76.34

72.41

82.12




29


 
 
 
ITEM 6.
 
Selected Financial Data
At or for the year ended December 31,
2012(1)
2011(2)
2010(3)
2009(4)
2008
 
(In thousands, except per share amounts)
Selected financial condition data:
 
 
 
 
 
Total assets
$
36,806,232

$
32,810,615

$
21,083,853

$
14,584,833

$
9,331,372

Loans and leases, net
19,547,490

16,352,483

10,388,060

7,208,883

6,384,284

Investment securities:
 
 
 
 
 
Available for sale
10,993,605

9,348,296

7,289,455

4,421,678

1,573,101

Held to maturity
1,299,806

2,669,630

1,025,724

1,093,552


Goodwill and other intangibles
2,617,810

1,803,240

1,114,144

935,384

784,549

Deposits
27,676,531

19,405,115

13,148,844

9,729,524

5,943,613

Borrowings
3,716,143

8,127,121

4,893,474

2,302,280

1,540,227

Stockholders’ equity
$
4,926,558

$
4,798,178

$
2,765,070

$
2,373,661

$
1,727,263

Common shares outstanding
352,621

351,834

209,112

188,215

118,562

Selected operations data:
 
 
 
 
 
Interest income
$
1,176,088

$
1,065,307

$
745,588

$
490,758

$
441,138

Interest expense
152,813

184,060

147,834

126,358

172,561

Net interest income
1,023,275

881,247

597,754

364,400

268,577

Provision for credit losses
92,300

58,107

48,631

43,650

22,500

Net interest income after provision for credit losses
930,975

823,140

549,123

320,750

246,077

Noninterest income(5)
359,530

245,309

186,615

125,975

115,735

Merger and acquisition integration expenses
177,512

98,161

49,890

36,467

2,186

Restructuring charges
6,453

42,534




Noninterest expense
867,178

665,638

473,438

290,205

226,224

Income before income tax
239,362

262,116

212,410

120,053

133,402

Income tax expense
70,940

88,206

72,057

40,676

44,964

Net income
168,422

173,910

140,353

79,377

88,438

Preferred stock dividend and discount accretion(6)
27,756



12,046

1,184

Net income available to common stockholders
$
140,666

$
173,910

$
140,353

$
67,331

$
87,254

Stock and related per share data:
 
 
 
 
 
Earnings per common share:
 
 
 
 
 
Basic
$
0.40

$
0.64

$
0.70

$
0.46

$
0.81

Diluted
0.40

0.64

0.70

0.46

0.81

Cash dividends
0.32

0.64

0.57

0.56

0.56

Book value (7)
13.15

12.79

13.42

12.84

15.02

Tangible book value per common share(7)(8)
5.65

7.62

8.01

7.78

8.20

Market Price (NASDAQ: FNFG):
 
 
 
 
 
High
10.35

15.10

14.88

16.32

22.38

Low
7.08

8.22

11.23

9.48

9.98

Close
$
7.93

$
8.63

$
13.98

$
13.91

$
16.17

(1) 
Includes the impact of the HSBC Branch Acquisition on May 18, 2012.
(2) 
Includes the impact of the merger with NewAlliance Bancshares, Inc. on April 15, 2011.
(3) 
Includes the impact of the merger with Harleysville National Corporation on April 9, 2010.
(4) 
Includes the impact of the acquisition of 57 National City Bank branch locations on September 4, 2009.
(5) 
Includes $21 million gain on sale of mortgage-backed securities portfolio repositioning in 2012.
(6) 
Includes $8 million of discount accretion related to the redemption of preferred stock issued as part of the Troubled Asset Relief Program in 2009.
(7) 
Excludes unallocated employee stock ownership plan shares and unvested restricted stock shares.
(8) 
Tangible common equity is used to calculate tangible book value per common share and excludes goodwill and other intangibles of $2.6 billion, $1.8 billion, $1.1 billion, $935 million, and $785 million at December 31, 2012, 2011, 2010, 2009, and 2008, respectively. Tangible common equity also excludes preferred stock of $338 million at December 31, 2012 and 2011 and $177 million at December 31, 2008. This is a non-GAAP financial measure that we believe provides management and investors with information that is useful in understanding our financial performance and condition.

30


At or for the year ended December 31,
2012(1)
2011(2)
2010(3)
2009(4)
2008
 
(Dollars in thousands)
Selected financial ratios and other data:
 
 
 
 
 
Performance ratios(5):
 
 
 
 
 
Return on average assets
0.48
%
0.62
%
0.74
%
0.69
%
0.99
%
Common equity:
 
 
 
 
 
Return on average common equity
3.09

4.71

5.23

3.47

5.99

Return on average tangible common equity(6)
6.30

8.40

8.67

6.06

13.19

Total equity:
 
 
 
 
 
Return on average equity
3.45

4.68

5.23

3.95

5.99

Return on average tangible equity(7)
6.55

8.33

8.67

6.71

12.98

Earnings to fixed charges:
 
 
 
 
 
Including interest on deposits
2.48

2.34

2.38

1.93

1.76

Excluding interest on deposits
3.51

3.34

3.57

3.18

3.38

Net interest rate spread
3.24

3.46

3.48

3.40

3.19

Net interest rate margin
3.34

3.58

3.64

3.65

3.55

Efficiency ratio(8)
76.02

71.58

66.72

66.62

59.43

Dividend payout ratio
80.00
%
100.00
%
81.43
%
121.74
%
69.14
%
Capital ratios:
 
 
 
 
 
First Niagara Financial Group, Inc.
 
 
 
 
 
Total risk-based capital
11.23

17.84

14.35

18.51

16.28

Tier 1 risk-based capital
9.29

15.60

13.54

17.41

15.04

Tier 1 risk-based common capital(9)
7.45

13.23

12.76

17.26

11.96

Leverage ratio(10)
6.75

9.97

8.14



Tangible capital(10)(11)



10.34

11.08

Ratio of stockholders’ equity to total assets
13.39

14.62

13.11

16.27

18.51

Ratio of tangible common stockholders’ equity to tangible assets(11)
5.77
%
8.57
%
8.27
%
10.54
%
8.96
%
First Niagara Bank:
 
 
 
 
 
Total risk-based capital
10.66

16.47

11.86

13.73

12.72

Tier 1 risk-based capital
9.94

14.66

11.06

12.63

11.48

Leverage ratio(10)
7.23

9.38

6.64



Tangible capital(10)



7.48

8.47

Asset quality:
 
 
 
 
 
Total nonaccruing loans
$
172,724

$
89,798

$
89,323

$
68,561

$
46,417

Other nonperforming assets
10,114

4,482

8,647

7,057

2,001

Total classified loans(12)
708,468

748,375

481,074

280,391

139,009

Total criticized loans(13)
1,002,659

1,144,222

942,941

485,036

263,643

Allowance for credit losses
162,522

120,100

95,354

88,303

77,793

Net loan charge-offs
$
48,099

$
29,625

$
41,580

$
33,140

$
17,844

Net charge-offs to average loans
0.26
%
0.20
%
0.44
%
0.50
%
0.28
%
Provision to average loans
0.50

0.37

0.52

0.65

0.36

Total nonaccruing loans to total loans
0.88

0.55

0.85

0.94

0.72

Total nonperforming assets to total assets
0.50

0.29

0.46

0.52

0.52

Allowance for loan losses to total loans
0.82

0.73

0.91

1.20

1.20

Allowance for loan losses to nonaccruing loans
94.1

133.7

106.8

128.8

167.6

Texas ratio(14)
16.60
%
8.55
%
8.94
%
4.95
%
4.74
%
Asset quality—Originated loans(15):
 
 
 
 
 
Net charge-offs of originated loans to average originated loans
0.35
%
0.32
%
0.58
%
0.51
%
0.28
%
Provision for originated loans to average originated loans
0.73

0.58

0.68

0.67

0.36

Total nonaccruing originated loans to total originated loans
1.07

0.91

1.14

1.03

0.72

Allowance for originated loan losses to originated loans
1.20

1.20

1.22

1.33

1.20

Other data:
 
 
 
 
 
Number of full service branches
430

333

257

171

114

Full time equivalent employees
5,927

4,827

3,791

2,816

1,909

Effective tax rate
29.6
%
33.7
%
33.9
%
33.9
%
33.7
%
(1) 
Includes the impact of the HSBC Branch Acquisition on May 18, 2012.
(2) 
Includes the impact of the merger with NewAlliance Bancshares, Inc. on April 15, 2011.

31


(3) 
Includes the impact of the merger with Harleysville National Corporation on April 9, 2010.
(4) 
Includes the impact of the acquisition of 57 National City Bank branch locations on September 4, 2009.
(5) 
Computed using daily averages.
(6) 
Average tangible common equity excludes average goodwill, other intangibles, and preferred stock of $2.7 billion, $1.6 billion, $1.1 billion, $900 million, and $815 million for 2012, 2011, 2010, 2009, and 2008, respectively. This is a non-GAAP financial measure that we believe provides management and investors with information that is useful in understanding our financial performance and condition.
(7) 
Average tangible equity excludes average goodwill and other intangibles of $2.3 billion, $1.6 billion, $1.1 billion, $829 million, and $795 million for 2012, 2011, 2010, 2009, and 2008, respectively. This is a non-GAAP financial measure that we believe provides management and investors with information that is useful in understanding our financial performance and condition.
(8) 
Computed by dividing noninterest expense by the sum of net interest income and noninterest income.
(9) 
Computed by subtracting the sum of preferred stock and the junior subordinated debentures associated with trust preferred securities from Tier 1 capital, divided by risk weighted assets. This is a non-GAAP financial measure that we believe provides management and investors with information that is useful in understanding our financial performance and position.
(10) 
Tangible capital ratio presented for periods ended prior to First Niagara Bank’s conversion to a national bank regulated by the OCC. Leverage ratio disclosed for periods ended subsequent to such conversion.
(11) 
Tangible common equity and tangible assets exclude goodwill and other intangibles of $2.6 billion, $1.8 billion, $1.1 billion, $935 million, and $785 million at December 31, 2012, 2011, 2010, 2009, and 2008, respectively. Tangible common equity also excludes preferred stock of $338 million at December 31, 2012 and 2011 and $177 million at December 31, 2008. This is a non-GAAP financial measure that we believe provides management and investors with information that is useful in understanding our financial performance and condition.
(12) 
Includes consumer loans, which are considered classified when they are 90 days or more past due. Classified loans include substandard, doubtful, and loss, which are consistent with regulatory definitions, and as described in Item 1, “Business”, under the heading “Asset Quality Review”.
(13) 
Beginning in 2011, criticized loans include consumer loans when they are 90 days or more past due. Prior to 2011, criticized loans include consumer loans when they are 60 days or more past due. Criticized loans include special mention, substandard, doubtful, and loss.
(14) 
The Texas ratio is computed by dividing the sum of nonperforming assets and loans 90 days past due still accruing by the sum of tangible equity and the allowance for loan losses. This is a non-GAAP measure that we believe provides management and investors with information that is useful in understanding our financial performance and position.
(15) 
Originated loans represent total loans excluding acquired loans.
 
2012
 
2011
 
Fourth
quarter
Third
quarter
Second
quarter
First
quarter
 
Fourth
quarter
Third
quarter
Second
quarter
First
quarter
 
(In thousands, except per share amounts)
Selected Quarterly Data:
 
 
 
 
 
 
 
 
 
Interest income
$
283,599

$
301,868

$
299,841

$
290,780

 
$
291,906

$
287,147

$
277,370

$
208,884

Interest expense
31,313

32,263

40,828

48,409

 
49,393

51,718

46,933

36,016

Net Interest income
252,286

269,605

259,013

242,371

 
242,513

235,429

230,437

172,868

Provision for credit losses
22,000

22,200

28,100

20,000

 
13,400

14,500

17,307

12,900

Net interest income after provision for credit losses
230,286

247,405

230,913

222,371

 
229,113

220,929

213,130

159,968

Noninterest income
91,821

102,203

95,598

69,908

 
63,685

68,655

60,895

52,074

Merger and acquisition integration expenses
3,678

29,404

131,460

12,970

 
6,149

9,008

76,828

6,176

Restructuring charges


3,750

2,703

 
13,496

16,326

11,656

1,056

Other noninterest expense
235,106

237,138

210,429

184,505

 
182,526

178,537

166,657

137,918

Income (loss) before income taxes
83,323

83,066

(19,128
)
92,101

 
90,627

85,713

18,884

66,892

Income taxes (benefit)
22,226

24,682

(8,204
)
32,236

 
32,166

28,732

5,334

21,974

Net income (loss)
61,097

58,384

(10,924
)
59,865

 
58,461

56,981

13,550

44,918

Preferred stock dividend
7,547

7,547

7,547

5,115

 




Net income (loss) available to common stockholders
$
53,550

$
50,837

$
(18,471
)
$
54,750

 
$
58,461

$
56,981

$
13,550

$
44,918

Earnings (loss) per share:
 
 
 
 
 
 
 
 
 
Basic
$
0.15

$
0.15

$
(0.05
)
$
0.16

 
$
0.19

$
0.19

$
0.05

$
0.22

Diluted
0.15

0.14

(0.05
)
0.16

 
0.19

0.19

0.05

0.22

Market price (NASDAQ: FNFG):
 
 
 
 
 
 
 
 
 
High
8.52

8.50

9.87

10.35

 
9.99

13.59

14.54

15.10

Low
7.08

7.14

7.49

8.71

 
8.22

9.15

13.02

13.54

Close
7.93

8.07

7.65

9.84

 
8.63

9.15

13.20

13.58

Cash dividends
$
0.08

$
0.08

$
0.08

$
0.08

 
$
0.16

$
0.16

$
0.16

$
0.16


32



 
 
 
ITEM 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is an analysis of our financial condition and results of operations. You should read this item in conjunction with our Consolidated Financial Statements and related notes filed with this report in Part II, Item 8, “Financial Statements and Supplementary Data” and the description of our business filed here within Part I, Item I, “Business.”
OVERVIEW
First Niagara Financial Group, Inc. is a Delaware corporation and a bank holding company, subject to supervision and regulation by the Federal Reserve, serving both retail and commercial customers through our bank subsidiary, First Niagara Bank, N.A., a national bank subject to supervision and regulation by the OCC. We are a multi-faceted regional bank, with a community banking model, in Upstate New York, Pennsylvania, Connecticut, and Western Massachusetts with $36.8 billion of assets, $27.7 billion of deposits, and 430 branch locations as of December 31, 2012.
We were organized in April 1998 in connection with the conversion of First Niagara Bank, N.A. from a mutual savings bank to a stock savings bank. Since that time we have strategically deployed capital through the acquisition of community banks and financial services companies throughout Upstate New York, and most recently through our September 2009 acquisition of 57 National City Bank branch locations in Western Pennsylvania; our April 2010 merger with Harleysville in Eastern Pennsylvania; our April 2011 merger with NewAlliance, which allowed us to further build our organization by adding operations in Connecticut and Western Massachusetts; and our May 18, 2012 acquisition of 137 full-service branches from HSBC in the Buffalo, Rochester, Syracuse, Albany, Downstate New York and Connecticut banking markets. We provide our customers with a full range of products and services delivered through our customer focused operations, which include retail and commercial banking; financial services and risk management (insurance); and commercial business services. These include commercial real estate loans, commercial business loans and leases, residential real estate, home equity and other consumer loans, as well as retail and commercial deposit products and insurance services. We also provide wealth management products and services.
Our goal is to organically grow both loans and deposits, as these relationships are the primary drivers of our financial success. We have continued to open de novo branch locations, albeit at a slower pace, especially in areas where acquisition opportunities have been more limited. We have also significantly expanded our commercial lending and business services to include a full complement of cash management and merchant banking services. Over the past three year period, we supplemented our organic growth strategy with the opportunistic acquisitions of whole banks, bank branches, and financial services organizations.

Following the acquisition of four franchises over the past three year period, our strategy today has evolved to an “Operate Operate Operate” strategy from the prior “Aggregate, Integrate, Operate” strategy. We fully expect to leverage our expanded market presence, improved competencies, our capacity in newer and existing markets, and our enhanced products and services to continue the acquisition of core deposit and lending relationships with current and prospective customers within our footprint. In our retail banking unit, we expect to further enhance our Simple Fast Easy value proposition through the addition of features and functionalities including an enhanced digital platform, remote deposit capture, and our recently launched mobile banking application as well as cross-selling products and services such as credit cards, mortgage, and automobile loans offered by our Consumer Finance division.
On May 18, 2012, the Bank acquired 137 full-service branches from HSBC in the Buffalo, Rochester, Syracuse, Albany, Downstate New York and Connecticut banking markets and paid a net deposit premium of $772 million. The Bank acquired cash of $7.4 billion, performing loans with a fair value of approximately $1.6 billion, core deposit and other intangibles of $85 million, and deposits with a fair value of approximately $9.9 billion (shortly after acquisition, we allowed $0.5 billion in municipal deposits to one large customer run-off), resulting in goodwill of $780 million. The cash received was used to pay down wholesale borrowings, including those used to purchase securities in advance of the HSBC Branch Acquisition. In addition, we acquired certain wealth management relationships and approximately $2.5 billion of assets under management of such relationships. At closing, the Bank did not receive any loans greater than 60 days delinquent. Concurrent with the HSBC Branch Acquisition, we consolidated 15 existing First Niagara branches into acquired HSBC branches and in the third quarter of 2012, we consolidated 19 of the HSBC branches into First Niagara branches, resulting in 103 net new full-service branches from the HSBC Branch Acquisition.

We incurred $183 million in pre-tax merger and acquisition expenses related to the HSBC Branch Acquisition since we entered into the Purchase and Assumption Agreement on July 30, 2011. These expenses include $65 million in prepayment penalties

33


on borrowings and swap termination fees; redundant facilities and employee severance costs; technology costs related to system conversions; and professional fees.

In connection with the regulatory process for the HSBC Branch Acquisition, we agreed with the DOJ to assign our purchase rights related to 26 HSBC branches in the Buffalo area. In January 2012, we entered into an agreement with Key Bank ("Key") assigning our right to purchase the 26 HSBC Buffalo branches as well as 11 additional HSBC branches in the Rochester area. On July 13, 2012, Key acquired these 37 branches with a total of $2.0 billion in deposits and approximately $256.5 million in loans, and paid us a deposit premium of $91.5 million.

In January 2012, we also entered into separate agreements with Five Star Bank ("Five Star") and Community Bank System, Inc. ("Community Bank") for them to purchase seven First Niagara branches and 20 HSBC branches, for which we had assigned our purchase rights. On June 22, 2012, Five Star acquired four First Niagara branches with $58.6 million in loans, assumed approximately $129.3 million in deposits, and paid us a deposit premium of $5.3 million. On August 17, 2012, Five Star acquired four of the HSBC branches, assumed approximately $18 million in loans, $157.2 million in deposits, and paid us a deposit premium of $6.5 million. On July 20, 2012, Community Bank acquired 16 HSBC branches, with a total of $107.0 million in loans, $696.6 million in deposits, and paid us a deposit premium of $23.8 million. On September 7, 2012, Community Bank acquired three First Niagara branches, assumed approximately $55.4 million in loans, $100.8 million in deposits, and paid us a deposit premium of $3.1 million.
The HSBC Branch Acquisition represented a unique opportunity to acquire low cost deposits and valuable customer relationships. We believe that the HSBC Branch Acquisition will result in earnings growth and strengthen our franchise. The size of the HSBC Branch Acquisition, in terms of loans acquired, deposit liabilities assumed, and the number of banking offices acquired, presents us with an attractive opportunity to significantly enhance our position in the Albany, Buffalo, Rochester and Syracuse, New York banking markets as well as in the New York—New Jersey—Connecticut banking market. Furthermore, the HSBC Branch Acquisition provides us with the opportunity to grow our share of the consumer banking, business banking and wealth management businesses in Upstate New York.

In the second quarter of 2012, we sold mortgage-backed securities in our available for sale portfolio with a total carrying value of $3.1 billion and recognized a $21 million pre-tax gain. The securities sold were selected based on an assessment of their potential prepayment risk at that time and the proceeds were used to pay down short-term borrowings. The sale of the securities served to reduce future volatility in our net interest margin by reducing the impact of prepayments on the mortgage-backed securities portfolio yield. In addition, the sale of these securities with the greatest levels of prepayment risk coupled with the pay down of short-term borrowings improves our asset sensitivity, allowing us to be better positioned to benefit when interest rates rise while at the same time managing the near term volatility created by the current sustained low interest rate environment.

As a result of the substantial prepayments received after June and the expected levels of cash flows to be received for the foreseeable future, we recognized a pre-tax retroactive adjustment of $16 million, or $0.03 per share, to accelerate premium amortization on our remaining CMO portfolio in the fourth quarter of 2012. The adjustment reduces the amount of unamortized premium on our CMO portfolio to reflect the impacts of the substantial level of prepayments received in recent months, particularly in the fourth quarter, and the expected elevated levels of cash flows to be received for the foreseeable future.

FINANCIAL OVERVIEW

Our 2012 results reflect the benefits of our HSBC Branch Acquisition, our strong core business fundamentals, and core customer acquisition across our regional banking footprint. Our performance was driven by sustained market share gains through new customer acquisition as well as deepening relationships with existing customers.
Our GAAP net income for 2012 was $168 million compared to $174 million for 2011 and diluted earnings per share in 2012 was $0.40, compared to $0.64 in 2011, reflecting:
Our May 2012 HSBC Branch Acquisition as reflected in the merger and acquisition integration expenses and higher average net interest-earning assets and interest-bearing liabilities.
The $21 million gain resulting from the sale of investment securities partially offset by the forgone interest income on these securities.
$25 million in retroactive premium amortization on our CMO portfolio, including $16 million in the fourth quarter of 2012 as a result of the substantial level of prepayments in recent months and those expected to continue for the foreseeable future.
Continued pressure on asset pricing from the low interest rate environment.

34


The full year impact of our April 2011 acquisition of NewAlliance and 94 million shares issued to its stockholders.
Our December 2011 issuance of 57 million common shares.
$28 million in dividends on the 14 million preferred shares we issued in December 2011.
Our operating (non-GAAP) net income amounted to $292 million, or $0.75 per diluted share, for 2012, compared to $267 million, or $0.98 per diluted share, for 2011. Our operating results for 2012 exclude the $25 million retroactive premium amortization on our CMO portfolio, $21 million gain on securities portfolio repositioning, $178 million in merger and acquisition integration expenses, and $6 million in restructuring charges. Our operating results for 2011 exclude $98 million in merger and acquisition integration expenses and $43 million in restructuring charges. Operating income is a non-GAAP financial measure which we believe provides a meaningful comparison of our underlying operational performance and facilitates management's and investors’ assessments of business and performance trends in comparison to others in the financial services industry and period over period analysis of our fundamental results. In addition, we believe the exclusion of the nonoperating items from our performance enables management and investors to perform a more effective evaluation and comparison of our results and to assess performance in relation to our ongoing operations.
Net interest income increased to $1.0 billion in 2012, from $881 million in 2011. This increase was driven by a number of factors, including higher interest-earning assets resulting from our May 2012 HSBC Branch Acquisition, the full year impact of our NewAlliance merger, and double digit commercial loan growth. However, our taxable equivalent net interest margin decreased from 3.58% for 2011 to 3.34% in 2012 as the accelerated premium amortization on our investment securities portfolio and downward repricing pressure on our interest earning assets negatively impacted our yields. Compression of loan yields from prepayments and lower spreads were partially offset by a 26 basis point decline in the cost of interest-bearing liabilities. Noninterest income increased $114 million due primarily to the partial year impact of the HSBC Branch Acquisition, the gain on securities portfolio restructuring, and full year impact of our April 2011 merger with NewAlliance. Mortgage banking revenues benefited from higher purchase and refinance volumes as well as higher margins on sold loans. Growth in derivatives sales to existing and new commercial customers continued to push our capital markets revenues higher.
Our HSBC Branch Acquisition resulted in higher loan and deposit balances. In addition, our commercial loan portfolio, which comprised 61% of total loans at December 31, 2012, increased 17%, excluding loans acquired from HSBC, due to sustained growth driven by our focus on our commercial lending efforts. Our investment securities balances increased $338 million as the purchases we made in anticipation of asset needs related to the HSBC Branch Acquisition were offset by our sale of $3.1 billion in mortgage-backed securities at the end of the second quarter of 2012. We used the proceeds from the sale to pay down short-term borrowings, improving our funding profile and capital ratios. Excluding deposits acquired from HSBC, our total deposit balances decreased, driven by our pricing initiatives to reduce higher cost certificates of deposit and money market accounts, which pay a higher interest rate and have higher acquisition costs. However, our strategic focus on customer acquisition and increasing consumer and business checking deposit balances resulted in higher interest-bearing checking account balances.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
We evaluate those accounting policies and estimates that we judge to be critical: those most important to the presentation of our financial condition and results of operations, and that require our most subjective and complex judgments. Accordingly, our accounting estimates relating to the investment securities accounting (valuation, other than temporary impairment analysis, and prepayment assumptions on our CMOs and MBS), the accounting treatment and valuation of our acquired loans, adequacy of our allowance for loan losses, and the analysis of the carrying value of goodwill for impairment are deemed to be critical, as our judgments could have a material effect on our results of operations.
Investment Securities
As of December 31, 2012, our available for sale and held to maturity investment securities totaled $12.3 billion, or 33% of our total assets. We use third party pricing services to value our investment securities portfolio, which is comprised almost entirely of Level 2 fair value measured securities. Fair value of our investment securities is based upon quoted market prices of identical securities, where available. If such quoted prices are not available, fair value is determined using valuation models that consider cash flow, security structure, and other observable information. For the vast majority of the portfolio, we validate the prices received from these third parties, on a quarterly basis, by comparing them to prices provided by a different independent pricing service. For the remaining securities that are priced by these third parties where we are unable to obtain a secondary independent price, we review material price changes for reasonableness based upon changes in interest rates, credit outlook based upon spreads for similar securities, and the weighted average life of the debt securities. We have also reviewed detailed valuation methodologies provided to us by our pricing services. We did not adjust any of the prices provided to us by the independent pricing services at December 31, 2012 or 2011. Where sufficient information is not available from the pricing services to produce a reliable valuation, we estimate fair value based on broker quotes, which are reviewed using the same

35


process that is applied to our securities priced by pricing services where we are unable to obtain a secondary independent price, or based on internally developed models consider estimated prepayment speeds, losses, recoveries, default rates that are implied by the underlying performance of collateral in the structure or similar structures, and discount rates that are implied by market prices for similar securities and collateral structure types.
We conduct a quarterly review and evaluation of our investment securities portfolio to determine if any declines in fair value below amortized cost are other than temporary. In making this determination, we consider some or all of the following factors: the period of time the securities have been in an unrealized loss position, the percentage decline in fair value in comparison to the securities’ amortized cost, credit rating, the financial condition of the issuer and guarantor, where applicable, the delinquency or default rates of underlying collateral, credit enhancement, projected losses, level of credit loss, and projected cash flows. If we intend to sell a security with a fair value below amortized cost or if it is more likely than not that we will be required to sell such a security, we would record an other than temporary impairment charge through current period earnings for the full decline in fair value below amortized cost. For debt securities that we do not intend to sell or it is more likely than not that we will not be required to sell before recovery, we would record an other than temporary impairment charge through current period earnings for the amount of the valuation decline below amortized cost that is attributable to credit losses. The remaining difference between the debt security’s fair value and amortized cost (i.e. decline in fair value not attributable to credit losses) is recognized in other comprehensive income.
Our investment securities portfolio includes residential mortgage backed securities and collateralized mortgage obligations. As the underlying collateral of each of these securities is comprised of a large number of similar residential mortgage loans for which prepayments are probable and the timing and amount of such prepayments can be reasonably estimated, we estimate future principal prepayments of the underlying residential mortgage loans to determine a constant effective yield used to apply the interest method, with retroactive adjustments made as warranted.
Acquired Loans
Loans that we acquire in acquisitions subsequent to January 1, 2009 are recorded at fair value with no carryover of the related allowance for loan losses. Determining the fair value of the loans involves estimating the amount and timing of principal and interest cash flows expected to be collected on the loans and discounting those cash flows at a market rate of interest.
We have acquired loans in four separate acquisitions after January 1, 2009. For each acquisition, we reviewed all loans greater than $1 million and considered the following factors as indicators that such an acquired loan had evidence of deterioration in credit quality and was therefore in the scope of Accounting Standards Codification (“ASC”) 310-30 (Loans and Debt Securities Acquired with Deteriorated Credit Quality):
Loans that were 90 days or more past due;
Loans that had an internal risk rating of substandard or worse. Substandard is consistent with regulatory definitions and is defined as having a well defined weakness that jeopardizes liquidation of the loan;
Loans that were classified as nonaccrual by the acquired bank at the time of acquisition; or
Loans that had been previously modified in a troubled debt restructuring.

Any acquired loans that were not individually in the scope of ASC 310-30 because they did not meet the criteria above were either (i) pooled into groups of similar loans based on the borrower type, loan purpose, and collateral type and accounted for under ASC 310-30 by analogy or (ii) accounted for under ASC 310-20 (Nonrefundable Fees and Other Costs.)
Acquired loans accounted for under ASC 310-30 by analogy
We performed a fair valuation of each of the pools and each pool was recorded at a discount. We determined that at least part of the discount on the acquired pools of loans was attributable to credit quality by reference to the valuation model used to estimate the fair value of these pools of loans. The valuation model incorporated lifetime expected credit losses into the loans’ fair valuation in consideration of factors such as evidence of credit deterioration since origination and the amounts of contractually required principal and interest that we did not expect to collect as of the acquisition date. Based on the guidance included in the December 18, 2009 letter from the AICPA Depository Institutions Panel to the Office of the Chief Accountant of the SEC, we have made an accounting policy election to apply ASC 310-30 by analogy to qualifying acquired pools of loans that (i) were acquired in a business combination or asset purchase, (ii) resulted in recognition of a discount attributable, at least in part, to credit quality; and (iii) were not subsequently accounted for at fair value.
The excess of expected cash flows from acquired loans over the estimated fair value of acquired loans at acquisition is referred to as the accretable discount and is recognized into interest income over the remaining life of the acquired loans using the interest method. The difference between contractually required payments at acquisition and the cash flows expected to be collected at acquisition is referred to as the nonaccretable discount. The nonaccretable discount represents estimated future

36


credit losses expected to be incurred over the life of the acquired loans. Subsequent decreases to the expected cash flows require us to evaluate the need for an addition to the allowance for loan losses. Subsequent improvements in expected cash flows result in the reversal of a corresponding amount of the nonaccretable discount which we then reclassify as accretable discount that is recognized into interest income over the remaining life of the loan using the interest method. Our evaluation of the amount of future cash flows that we expect to collect takes into account actual credit performance of the acquired loans to date and our best estimates for the expected lifetime credit performance of the loans using currently available information. Charge-offs of the principal amount on acquired loans would be first applied to the nonaccretable discount portion of the fair value adjustment. To the extent that we experience a deterioration in credit quality in our expected cash flows subsequent to the acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans.

In accordance with ASC 310-30, recognition of income is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected.  We perform such an evaluation on a quarterly basis on both our acquired loans individually accounted for under ASC 310-30 and those in pools accounted for under ASC 310-30 by analogy. 

Cash flows for acquired loans individually accounted for under ASC 310-30 are estimated on a quarterly basis.  Based on this evaluation, a determination is made as to whether or not we have a reasonable expectation about the timing and amount of cash flows.  Such an expectation includes cash flows from normal customer repayment, foreclosure or other collection efforts.  Cash flows for acquired loans accounted for on a pooled basis under ASC 310-30 by analogy are also estimated on a quarterly basis.  For residential real estate, home equity and other consumer loans, cash flow loss estimates are calculated by a vintage and FICO based model which incorporates a projected forward loss curve.  For commercial loans, lifetime loss rates are assigned to each pool with consideration given for pool make-up, including risk rating profile.  Lifetime loss rates are developed from internally generated loss data and are applied to each pool. 

To the extent that we cannot reasonably estimate cash flows, interest income recognition is discontinued.  The unit of account for loans in pools accounted for under ASC 310-30 by analogy is the pool of loans.  Accordingly, as long as we can reasonably estimate cash flows for the pool as a whole, accretable yield on the pool is recognized and all individual loans within the pool - even those more than 90 days past due - would be considered to be accruing interest in our financial statement disclosures, regardless of whether or not we expected to collect any principal or interest cash flows on an individual loan 90 days or more past due.
Allowance for Loan Losses
We determined our allowance for loan losses by portfolio segment, which consist of commercial loans and consumer loans. Our commercial loan portfolio segment includes both business and commercial real estate loans. Our consumer portfolio segment includes residential real estate, home equity, and other consumer loans. We further segregate these segments between loans which are accounted for under the amortized cost method (referred to as “originated” loans) and loans acquired (referred to as “acquired” loans), as acquired loans were originally recorded at fair value, which includes an estimate of lifetime credit losses, resulting in no carryover of the related allowance for loan losses.
Originated loans
We establish our allowance for loan losses through a provision for credit losses based on our evaluation of the credit quality of our loan portfolio. This evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers, among other matters, the estimated fair value of the underlying collateral, economic conditions, historical net loan loss experience, and other factors that warrant recognition in determining our allowance for loan losses. We continue to monitor and modify the level of our allowance for loan losses to ensure it is adequate to cover losses inherent in our loan portfolio. In addition, regulatory agencies, as an integral part of their examination process, review our allowance for loan losses.
For our originated loans, our allowance for loan losses consists of the following elements: (i) specific valuation allowances based on probable losses on specifically identified impaired loans; and (ii) valuation allowances based on net historical loan loss experience for similar loans with similar inherent risk characteristics and performance trends, adjusted, as appropriate, for qualitative risk factors specific to respective loan types.
For our originated loans, when current information and events indicate that it is probable that we will be unable to collect all amounts of principal and interest due under the original terms of a business or commercial real estate loan greater than $200 thousand, such loan will be classified as impaired. Additionally, all loans modified in a TDR are considered impaired. The need for specific valuation allowances are determined for impaired loans and recorded as necessary. For impaired loans, we consider the fair value of the underlying collateral, less estimated costs to sell, if the loan is collateral dependent, or we use the present value of estimated future cash flows in determining the estimates of impairment and any related allowance for loan losses for

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these loans. Confirmed losses are charged off immediately. Prior to a loan becoming impaired, we typically would obtain an appraisal through our internal loan grading process to use as the basis for the fair value of the underlying collateral.

Commercial loan portfolio segment
We estimate the allowance for our commercial loan portfolio segment by considering their type and loan grade. We first apply a historic loss rate to loans based on their type and loan grade. This amount is then adjusted, as necessary, for qualitative considerations to reflect changes in underwriting, market or industry conditions, or based on changes in trends in the composition of the portfolio, including risk composition, seasoning, and underlying collateral. Our loan grading system is described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Credit Risk.”
Consumer loan portfolio segment
We estimate the allowance for loan losses for our consumer loan portfolio segment by first estimating the amount of loans that will eventually default based on delinquency severity. We then apply a loss rate to the amount of loans that we predict will default based on our historical net loss experience. This amount is then adjusted, as necessary, for qualitative considerations to reflect changes in underwriting, market or industry conditions or based on changes in trends in the composition of the portfolio, including risk composition, seasoning, and underlying collateral. We obtain and review refreshed FICO scores on a quarterly basis, and trends are evaluated for consideration as a qualitative adjustment to the allowance. Other qualitative considerations include, but are not limited to, the evaluation of trends in property values, building permits and unemployment.
Acquired Loans
Acquired loans accounted for under ASC 310-30 (including those accounted for under ASC 310-30 by analogy)
For our acquired loans accounted for under ASC 310-30, our allowance for loan losses is estimated based upon our expected cash flows for these loans. To the extent that we experience a deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to the acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans.
Acquired loans accounted for under ASC 310-20
We establish our allowance for loan losses through a provision for credit losses based upon an evaluation process that is similar to our evaluation process used for originated loans. This evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers, among other matters, the estimated fair value of the underlying collateral, economic conditions, historical net loan loss experience, carrying value of the loans, which includes the remaining net purchase discount or premium, and other factors that warrant recognition in determining our allowance for loan losses.
Goodwill
We record the excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired less the fair value of liabilities assumed as goodwill. We do not amortize goodwill and we review it for impairment at our reporting unit level on an annual basis, and when events or changes in circumstances indicate that the carrying amounts may be impaired. We define a reporting unit as a distinct, separately identifiable component of one of our operating segments for which complete, discrete financial information is available and reviewed regularly by that segment's management. We have two reporting units: Banking and Financial Services. At December 31, 2012, our goodwill totaled $2.5 billion. Of this $2.5 billion, $2.4 billion, or 97%, was allocated to our Banking unit.
Under Step 1 of the goodwill impairment review, we compare each reporting unit's fair value to carrying value to identify potential impairment. If the estimated fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered impaired. Determining the fair value of a reporting unit as part of the Step 1 analysis involves significant judgment. Inputs and assumptions, such as future cash flows and earnings, discount rates, the assessment of relevant market transactions for comparability and the resulting control premium assumption, and multiples of relevant financial statement metrics, such as tangible book value and estimated earnings are all estimates involving significant judgment. We are also required to assess the reasonableness of the overall combined fair value of our reporting units by reference to our market capitalization over time.
If the carrying amount of the reporting unit were to exceed its estimated fair value, a second step (Step 2) would be performed that would compare the implied fair value of the reporting unit's goodwill with the carrying amount of the goodwill for the reporting unit. The implied fair value of goodwill is determined in the same manner as goodwill that is recognized in a business combination. Significant judgment and estimates are also involved in estimating the fair value of the assets and liabilities of the reporting units, and therefore the implied fair value of goodwill, as part of this Step 2 analysis. The most significant

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estimates involved related to our Banking unit would be the fair valuation of our loans and core deposit intangible asset. We would determine fair value of our loan portfolio by reference to market observable transactions for loan portfolios with similar characteristics, while we would estimate the value of the core deposit intangible asset using a discounted cash flow approach and market comparable transactions. Both of these estimates are highly subjective and involve many estimates.
During 2012, the banking industry has been challenged by numerous factors, including actions by the Federal Reserve intended to keep long term interest rates low, uncertainty surrounding the resolution of the "fiscal cliff", and regulatory actions emanating from Dodd-Frank. These factors have put negative pressure on our profitability and market capitalization. Further declines in overall interest rates, increased regulatory costs or resulting lost revenue, or worsening credit losses as a result of adverse economic conditions could reduce the profitability of one or both of our reporting units and therefore result in us having a lower stock price and market capitalization, both of which are important elements of the overall evaluation of goodwill impairment, and therefore could also lead to a goodwill impairment charge. A substantial goodwill impairment charge would not have a significant impact on our regulatory capital ratios, but could have an adverse impact on our results of operations and financial condition. However, such a charge would not be expected to decrease our level of income producing assets such as loans or investments. Due to regulatory restrictions, our banking subsidiary could be restricted from distributing available cash to the bank holding company, thus adversely affecting the liquidity of the bank holding company.
We perform our annual impairment review of goodwill on November 1 of each year utilizing valuation methods we believe appropriate, given the availability and applicability of market-based inputs for those methods. After giving appropriate consideration to all available information, we determined that the fair value of each reporting unit exceeded its carrying value (Step 1) and, therefore, there was no impairment of goodwill in 2012. As both of our reporting units' fair values exceeded their carrying amount, we were not required to perform Step 2 of the goodwill impairment review. For Step 1, we used both an income approach and a market approach to determine the fair values of our reporting units.
For our banking reporting unit, our application of the income approach was based upon assumptions of both balance sheet and income statement activity. A long-term internal forecast was developed through consideration of current year financial performance and near term expectations regarding key business drivers such as anticipated loan and deposit growth. A long-term growth rate of 5% was then applied in determining the terminal value. These cash flows were discounted at an 11% discount rate based upon consideration of the risk free rate, leverage factors, equity risk premium, and Company specific risk factors.
In our application of the market approach for our banking reporting unit, we utilized a 50% control premium assumption based on our review of transactions observable in the market place that we determined were comparable and applied market based multiples to the tangible book value and projected earnings of our banking reporting unit. The projected earnings multiple used was 10.9x and was based on our stock price at the assessment date and consensus analyst earnings, and was applied to our projected 2013 earnings. The tangible book value multiple used was 1.5x and was based on our stock price and tangible book value at the assessment date.
The market and income approaches were weighted equally. Both approaches have their inherent strengths and weaknesses; we use both and weight each equally as we believe that the approaches are complimentary. Additionally, the results of each approach were congruent with the other approach. The fair value of our Banking unit exceeded its carrying value by approximately $300 million (7%). Adverse changes to the significant estimates used in computing fair value of our Banking unit could have a significant adverse impact on its value. A reduction in the control premium assumption from 50% to 45% decreases the overall fair value of our Banking unit by approximately $80 million. A 100 basis point increase in the discount rate decreases the fair value of the Banking unit by approximately $160 million. In both of these stress scenarios, we would pass Step 1 of the goodwill impairment review.
For our financial services reporting unit, our income approach was based upon assumptions of income statement activity. An internal forecast was developed through consideration of current year financial performance and near term expectations regarding key business drivers. Long-term growth rates of 3% were then applied in determining the terminal value. A discount rate of 14% was used based upon consideration of the risk free rate, leverage factors, equity risk premium, and Company specific risk factors. In our market approach for our financial services reporting unit, we utilized a 30% control premium assumption based on our review of transactions observable in the market place that we determined were comparable to earnings for our financial services reporting unit. The market and income approaches were weighted equally.
The aggregate fair values of both of our reporting units (Banking and Financial Services) were compared to market capitalization as an assessment of the appropriateness of the fair value measurements. The comparison between the aggregate fair values and market capitalization indicated an implied control premium of 57%. A control premium analysis indicated that the implied premium was within range of the overall premiums observed in the market place.

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RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2012 AND DECEMBER 31, 2011
The following table summarizes our results of operations for the periods indicated on a GAAP basis and on an operating (non-GAAP) basis. Our results for 2012 reflect the partial year impact of our May 2012 HSBC Branch Acquisition, the full year impact of our merger with NewAlliance in April 2011, and the full year impact of our December 2011 common stock and preferred stock issuances. Our results for 2011 reflect the full year impact of our April 2010 merger with Harleysville, partial year impact of our merger with NewAlliance, and partial year impact of our common stock issuance.
Our operating (non-GAAP) results exclude the retroactive premium amortization on investment securities portfolio, gain on securities portfolio restructuring, merger and acquisition integration expenses, and restructuring charges. We believe this non-GAAP measure provides a meaningful comparison of our underlying operational performance and facilitates management’s and investors’ assessments of business and performance trends in comparison to others in the financial services industry and period over period analysis of our fundamental results. In addition, we believe the exclusion of the nonoperating items from our performance enables management and investors to perform a more effective evaluation and comparison of our results and to assess performance in relation to our ongoing operations (amounts in thousands).
 
Year ended
December 31,
 
2012
2011
Operating results (Non-GAAP):
 
 
Net interest income
$
1,047,913

$
881,247

Provision for credit losses
92,300

58,107

Noninterest income
338,298

245,309

Noninterest expense
867,178

665,638

Income tax expense
135,107

136,093

Net operating income (Non-GAAP)
$
291,626

$
266,718

Operating earnings per diluted share (Non-GAAP)
$
0.75

$
0.98

Reconciliation of net operating income to net income
$
291,626

$
266,718

Nonoperating income and expenses, net of tax at effective tax rate:
 
 
Retroactive premium amortization on securities portfolio ($24,638 pre-tax)
(17,191
)

Gain on securities portfolio repositioning ($21,232 pre-tax)
13,800


Merger and acquisition integration expenses ($177,512 and $98,161 pre-tax in 2012 and 2011, respectively)
(115,619
)
(64,420
)
Restructuring charges ($6,453 and $42,534 pre-tax in 2012 and 2011, respectively)
(4,194
)
(28,388
)
Total nonoperating income and expenses, net of tax
(123,204
)
(92,808
)
Net income (GAAP)
$
168,422

$
173,910

Earnings per diluted share (GAAP)
$
0.40

$
0.64

Net Interest Income
Our net interest income increased 16% to $1.0 billion in 2012 from $881 million in 2011. The year over year increase primarily reflected our $6.0 billion increase in average interest earning assets to $31.2 billion, which was largely attributable to the HSBC Branch Acquisition and full year impact of the NewAlliance merger. The increase in average interest earning assets outpaced the growth in average interest bearing liabilities, which increased $4.2 billion year over year, resulting in a $1.7 billion increase in net earning assets to $5.4 billion in 2012. The increase, on a taxable equivalent basis, in net interest income due to the increase in our average net earning assets was approximately $133 million.
As previously discussed, the Federal Reserve implements national monetary policies through its open-market operations. The FOMC has taken actions to grow the economy through maximum employment and price stability, through programs such as "Operation Twist" and purchasing of agency mortgage-backed securities. We expect these actions to further exacerbate longer-term pressures on the industry net interest margin by (i) continuing to reduce the yields on earning assets relative to the cost of funding; (ii) causing borrowers to repay their higher-yielding fixed rate loans at a faster rate; and (iii) reducing the rates at which cash flows from these repayments could be reinvested.
Despite a 24 basis points reduction in our net interest margin, our net interest income, on a taxable equivalent basis, increased $4 million due to interest rates. This was due to the impact of deposit pricing initiatives implemented by the Company throughout the year, partially offset by lower yielding assets and higher investment security premium amortization.

40


In light of the interest rate environment in 2012, we took targeted measures that partially mitigated this impact. Deposit pricing actions taken in the third and fourth quarter, focused primarily on our money market and online savings accounts, lowered funding costs with minimal impact to core balances. The actions related to money market deposit accounts contributed to an increase in our net interest income of $131 million. In addition, our net interest income benefited from approximately $11 million in accretable yield attributable to better than expected credit performance of certain loans acquired from Harleysville and NewAlliance.
In the second quarter of 2012, we executed our securities portfolio repositioning transaction. Since then, as a result of the substantial prepayments received and the expected levels of cash flows to be received for the foreseeable future, we recognized a pre-tax retroactive adjustment of $25 million during 2012 to accelerate premium amortization on our CMO portfolio. Including these retroactive premium adjustments, we recognized $100 million of premium amortization related to our residential mortgage-backed securities portfolio. As of December 31, 2012, the amount of net premiums on our residential mortgage-backed securities to be recognized in future periods amounted to approximately $96 million, which equates to a weighted average premium above par of approximately 1.7%. Subsequent changes to the interest rate environment will continue to impact our yield earned on these securities.

Our average balance of investment securities increased year over year by approximately $2.3 billion due to the investment of the proceeds received from the HSBC Branch Acquisition, partially offset by the securities portfolio repositioning discussed above. The increase in average balance was offset by a decrease in yield of 68 basis points during 2012. The decrease in yield was primarily due to increased premium amortization on residential mortgage-backed securities and lower yielding assets.

Our average balance of loans increased by $3.6 billion, of which $1.0 billion was attributable to the impact of loans acquired from HSBC. The remaining increase was attributable to organic growth in our commercial loans portfolio and $228 million in our indirect auto portfolio, offset by a decrease in our residential loan category. Loan yields declined 36 basis points as commercial loan yields decreased by 52 basis points, while our total consumer loan portfolio decreased by 11 basis points.

Excluding the HSBC Branch Acquisition impact, our average balances of interest bearing deposits increased by $306 million and our average rate paid declined by two basis points due to our deposit pricing actions. The increase in our average balances was driven by the full year impact of the NewAlliance acquisition being offset by our interest rate and treasury management strategies as we continue to move down deposit pricing.

Our average borrowings decreased year over year by approximately $1.3 billion as a result of paying down borrowings upon closing of the HSBC Branch Acquisition. This also increased the rate paid on borrowings by 9 basis points as the pay down of wholesale borrowings resulted in a higher concentration of our borrowings in longer term corporate debt.


41


The following table presents our condensed average balance sheet as well as taxable-equivalent interest income and yields. We use a taxable equivalent basis in order to provide the most comparative yields among all types of interest-earning assets. Yields earned on interest-earning assets, rates paid on interest-bearing liabilities and average balances are based on average daily balances (amounts in thousands):
 
2012
 
2011
 
2010
Average balance sheet
Average outstanding balance
Interest earned/paid
Yield/rate
 
Average outstanding balance
Interest earned/paid
Yield/rate
 
Average outstanding balance
Interest earned/paid
Yield/rate
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Loans and leases(1)
 
 
 
 
 
 
 
 
 
 
 
Commercial:
 
 
 
 
 
 
 
 
 
 
 
Real estate
$
6,624,814

$
317,894

4.72
%
 
$
5,650,972

$
305,645

5.33
%
 
$
3,960,268

$
227,966

5.75
%
Business
4,401,712

176,484

3.94

 
3,209,358

137,662

4.23

 
2,114,500

103,210

4.88

Total commercial lending
11,026,526

494,378

4.41

 
8,860,330

443,307

4.93

 
6,074,768

331,176

5.45

Residential real estate
3,922,455

161,214

4.11

 
3,474,282

157,730

4.54

 
1,790,873

91,191

5.09

Home equity
2,476,061

108,631

4.39

 
1,973,363

89,510

4.54

 
1,263,407

58,844

4.66

Indirect auto
228,165

8,333

3.65

 



 



Credit cards
201,629

21,937

10.88

 



 



Other consumer
295,883

24,422

8.25

 
273,824

19,109

6.98

 
247,222

18,305

7.40

Total consumer loans
7,124,193

324,537

4.55

 
5,721,469

266,349

4.66

 
3,301,502

168,340

5.10

Total loans
18,150,719

818,915

4.51

 
14,581,799

709,656

4.87

 
9,376,270

499,516

5.32

Residential mortgage-backed securities(2)(3)
7,230,117

177,092

2.45

 
8,191,305

284,496

3.47

 
6,358,817

221,467

3.48

Commercial mortgage-backed securities(2)
1,855,232

72,533

3.91

 
625,575

25,235

4.03

 



Other investment securities(2)
3,704,062

122,837

3.32

 
1,680,520

66,688

3.97

 
945,987

35,456

3.75

Money market and other investments
257,439

2,918

1.13

 
131,970

1,751

1.33

 
60,530

350

0.58

Total interest-earning assets(3)
31,197,569

$
1,194,295

3.83
%
 
25,211,169

$
1,087,826

4.31
%
 
16,741,604

$
756,789

4.52
%
Noninterest-earning assets(4)(5)
4,119,498

 
 
 
3,049,157

 
 
 
2,120,690

 
 
Total assets
$
35,317,067

 
 
 
$
28,260,326

 
 
 
$
18,862,294

 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
 
 
 
 
 
 
 
 
 
 
Savings deposits
$
3,450,767

$
5,147

0.15
%
 
$
2,287,084

$
4,680

0.20
%
 
$
1,164,416

$
1,587

0.14
%
Checking accounts
3,346,586

2,445

0.07

 
1,957,783

2,379

0.12

 
1,541,259

2,951

0.19

Money market deposits
9,507,453

26,195

0.28

 
6,503,873

36,493

0.56

 
4,576,958

27,676

0.60

Certificates of deposit
4,047,629

32,863

0.81

 
4,057,139

39,686

0.98

 
3,526,389

38,936

1.10

Total interest-bearing deposits
20,352,435

66,650

0.33

 
14,805,879

83,238

0.56

 
10,809,022

71,150

0.66

Borrowings
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
3,162,513

16,748

0.53

 
1,637,786

6,477

0.40

 
1,451,952

30,922

2.13

Long-term borrowings
2,299,346

69,416

3.02

 
5,124,090

94,345

1.84

 
1,978,263

45,762

2.31

Total borrowings
5,461,859

86,164

1.58

 
6,761,876

100,822

1.49

 
3,430,215

76,684

2.23

Total interest-bearing liabilities
25,814,294

$
152,814

0.59
%
 
21,567,755

$
184,060

0.85
%
 
14,239,237

$
147,834

1.04
%
Noninterest-bearing deposits
4,040,960

 
 
 
2,595,066

 
 
 
1,667,760

 
 
Other noninterest-bearing liabilities
574,742

 
 
 
384,578

 
 
 
271,918

 
 
Total liabilities
30,429,996

 
 
 
24,547,399

 
 
 
16,178,915

 
 
Stockholders’ equity(4)
4,887,071

 
 
 
3,712,927

 
 
 
2,683,379

 
 
Total liabilities and stockholders’ equity
$
35,317,067

 
 
 
$
28,260,326

 
 
 
$
18,862,294

 
 
Net interest income
 
$
1,041,481

 
 
 
$
903,766

 
 
 
$
608,955

 
Net interest rate spread
 
 
3.24
%
 
 
 
3.46
%
 
 
 
3.48
%
Net earning assets
$
5,383,275

 
 
 
$
3,643,414

 
 
 
$
2,502,367

 
 
Net interest rate margin
 
 
3.34
%
 
 
 
3.58
%
 
 
 
3.64
%
Ratio of average interest-earning assets to average interest-bearing liabilities
121
%
 
 
 
117
%
 
 
 
118
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(1) 
Average outstanding balances are net of deferred costs and unearned discounts and include nonperforming loans and for 2010, loans held for sale.

42


(2) 
Average outstanding balances are at amortized cost.
(3) 
Our operating (non-GAAP) results excluded $25 million of accelerated CMO adjustments from our net interest income. Had these adjustments been excluded from the table above, our yields for the year ended December 31, 2012 would have been:
Average balance sheet
2012 Rate
Residential mortgage-backed securities
2.79
%
Total interest-earning assets
3.91

Net interest rate spread
3.32

Net interest rate margin
3.42

(4) 
Average outstanding balances include unrealized gains/losses on securities available for sale.
(5) 
Average outstanding balances include allowance for loan losses and bank-owned life insurance, earnings from which are reflected in noninterest income.
Rate/Volume Analysis
The following table presents (on a taxable-equivalent basis) the extent to which changes in interest rates and changes in the volume of our interest-earning assets and interest-bearing liabilities have affected our net interest income during the years indicated. We have provided information in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate for the years ended December 31 (in thousands):
 
2012 vs. 2011
 
2011 vs. 2010
 
Increase/(decrease)
due to
Total
increase
 
Increase/(decrease)
due to
Total
increase
 
Volume
Rate
(decrease)
 
Volume
Rate
(decrease)
Interest income on:
 
 
 
 
 
 
 
Loans
$
155,969

$
(46,710
)
$
109,259

 
$
248,236

$
(38,096
)
$
210,140

Residential mortgage-backed securities
(36,155
)
(71,249
)
(107,404
)
 
60,920

2,109

63,029

Commercial mortgage-backed securities
48,026

(728
)
47,298

 
25,235


25,235

Other investment securities
64,985

(8,836
)
56,149

 
23,253

4,041

27,294

Money market and other investments
1,373

(206
)
1,167

 
5,931

(592
)
5,339

Total interest-earning assets
234,198

(127,729
)
106,469

 
363,575

(32,538
)
331,037

Interest expense of:
 
 
 
 
 
 
 
Savings deposits
984

(517
)
467

 
2,091

1,002

3,093

Checking accounts
164

(98
)
66

 
1,714

(2,286
)
(572
)
Money market deposits
120,834

(131,132
)
(10,298
)
 
10,411

(1,594
)
8,817

Certificates of deposit
(92
)
(6,731
)
(6,823
)
 
2,835

(2,085
)
750

Borrowings
(21,185
)
6,527

(14,658
)
 
36,622

(12,484
)
24,138

Total interest-bearing liabilities
100,705

(131,951
)
(31,246
)
 
53,673

(17,447
)
36,226

Net interest income
$
133,493

$
4,222

$
137,715

 
$
309,902

$
(15,091
)
$
294,811

Provision for Credit Losses
Our provision for credit losses is comprised of three components: consideration of the adequacy of our allowance for originated loan losses; needs for allowance for acquired loan losses due to deterioration in credit quality subsequent to acquisition; and probable losses associated with our unfunded loan commitments. Our provision for credit losses related to our originated loans is based upon the inherent risk of our loans and considers such interrelated factors as the composition and other credit risk factors of our loan portfolio, growth in our loan portfolio, trends in asset quality including loan concentrations, and the level of our delinquent loans. Consideration is also given to collateral value, government guarantees, and regional and global economic considerations. Our provision for credit losses related to our acquired loans is based upon a deterioration in expected cash flows subsequent to the acquisition of the loans. These acquired loans were originally recorded at fair value on the date of acquisition. As the fair value at time of acquisition incorporated lifetime expected credit losses, there was no carryover of the related allowance for loan losses.

43


The following table details the composition of our provision for credit losses for the periods indicated (in thousands):
 
Year ended December 31,
 
2012
2011
2010
Provision for originated loans
$
83,661

$
51,142

$
48,631

Provision for acquired loans
7,367

3,229


Provision for unfunded commitments
1,272

3,736


Total
$
92,300

$
58,107

$
48,631

The provision for credit losses was $92.3 million in 2012, reflecting continued growth in our commercial lending portfolios, offset by credit quality improvements in our commercial real estate portfolio and, to a lesser extent, in our home equity portfolio. We also recorded a $1.3 million provision for unfunded loan commitments in 2012 as a result of the organic growth in our unfunded commitments and the associated liability. Our total unfunded commitments at December 31, 2012 were $8.7 billion, which included $3.0 billion of unfunded commitments acquired in the HSBC Branch Acquisition. The liability for unfunded commitments is included in Other Liabilities in our Consolidated Statements of Condition and amounted to $12 million and $7 million at December 31, 2012 and December 31, 2011, respectively. The remaining increase of $4 million was established to recognize probable losses inherent in the commitments assumed in the HSBC Branch Acquisition.
Our provision for loan losses related to our originated loans is based upon the inherent risk of our loans and considers such interrelated factors as the composition and other credit risk factors of our loan portfolio, trends in asset quality including loan concentrations, and the level of our delinquent loans. Consideration is also given to collateral value, government guarantees, and regional and global economic considerations. The provision for credit losses related to originated loans amounted to $83.7 million, or 0.73% of average originated loans, for 2012, compared to $51 million, or 0.58% of average originated loans, for 2011. This provision included approximately $43.3 million to support sequential originated loan growth of $3.5 billion and $40.4 million to cover net charge-offs.
Our provision for loan losses related to our acquired loans is based upon a deterioration in expected cash flows subsequent to the acquisition of the loans. These acquired loans were originally recorded at fair value on the date of acquisition. As the fair value at time of acquisition incorporated lifetime expected credit losses, there was no carryover of the related allowance for loan losses. Subsequent to acquisition, we periodically reforecast the expected cash flows for our acquired loans and compare this to our original estimates to evaluate the need for a loan loss provision. In 2012, we recorded $7.4 million of provision related to our acquired loans primarily due to the charge-off of several commercial loans acquired in the Harleysville acquisition. Due to a decrease in expected cash flows in 2011 related to a portfolio of other consumer loans acquired from Harleysville with an outstanding principal balance of approximately $59 million as of December 31, 2011, we recorded a provision for credit losses related to acquired other consumer loans for $2 million in 2011, representing our expected credit losses over the remaining life of the loans. In addition, we recognized $1 million in provision during 2011 related to commercial business and commercial real estate loans acquired from Harleysville due to a deterioration in credit performance.
Noninterest Income
The following table presents our noninterest income for the years ended December 31 (amounts in thousands):
 
Year ended December 31,
 
 
2012
2011
Increase
Deposit service charges
$
91,237

$
66,144

$
25,093

Insurance commissions
68,166

65,125

3,041

Merchant and card fees
38,758

29,253

9,505

Wealth management services
41,315

30,729

10,586

Mortgage banking
31,857

15,182

16,675

Capital markets income
26,849

8,349

18,500

Lending and leasing
14,837

11,425

3,412

Bank owned life insurance
13,705

11,129

2,576

Gain on securities portfolio repositioning
21,232


21,232

Other
11,574

7,973

3,601

Total noninterest income
$
359,530

$
245,309

$
114,221

Noninterest income as a percentage of net revenue
26.0
%
21.8
%
 

44


Noninterest income increased $114 million for the year ended December 31, 2012, compared to the year ended December 31, 2011. The increase is primarily attributable to the partial year impact of the HSBC Branch Acquisition, gain on securities portfolio repositioning, and the full year impact of our April 2011 merger with NewAlliance. However, other factors contributing to changes in noninterest income are described below:
Revenues from deposit service charges benefited not only from the HSBC Branch Acquisition but also from an increase in checking account openings and our ongoing fee income initiatives.
Wealth management services revenues increased primarily due to the impact of acquiring wealth management relationships from HSBC. However, the increase is also a reflection of greater cross-selling of securities and insurance products through our branch network and the growth strategy of our Private Client Services group as we opened offices in Buffalo, Rochester and Pittsburgh in 2011 to add to offices we acquired in Philadelphia in 2010 and Connecticut in 2011. In addition, alternative investment products have become more marketable in the current low rate environment.

Capital markets revenues more than doubled, reflecting growth in derivatives sales to commercial customers whereby we act as an interest rate swap counterparty.

Mortgage banking revenues benefited from higher refinance volumes as well as higher margins on sold loans through the first three quarters of 2012 but we were negatively impacted late in the fourth quarter by lower application volumes and margins. We opened our third mortgage processing center in the fourth quarter of 2012. As the mortgage business is a strategic focus for us, we are building capacity to meet long-term strategic goals of growing this business, including a greater emphasis on retail origination and new purchase volumes.

Excluding the gain on the investment securities portfolio sale and premium acceleration on our CMO portfolio, noninterest income as a percentage of net revenue (the sum of net interest income and noninterest income) increased from 21.8%