10-K 1 a10-kfy2013.htm 10-K 10-K FY2013

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, 2013
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 24, 2014, there were issued and outstanding 353,897,001 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, 2013, as reported by The NASDAQ Stock Market LLC, was approximately $3,534,226,180.

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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 2014 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, 2013, we had $37.6 billion of assets, $26.7 billion of deposits and $5.0 billion of stockholders’ equity.
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,” and Part II, Item 8, "Financial Statements and Supplementary Data," Note 2, "Acquisitions," for further information about the HSBC Branch 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, the structure of the instrument, the credit risk we take, 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 actions and policies of the federal government and its regulatory agencies, including the Federal Reserve. While the prolonged low interest rate and weak economic environment has pressured our net interest income and margin in recent years, more recently, competition from banks and non-banks has intensified both from a pricing and structural perspective, which has also put pressure on our fee income. Absent an improvement in the competitive environment, net interest income will be challenged until we see an increase in short term interest rates. We manage our interest rate risk as described in "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”.  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 announced it would 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

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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 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.
These actions had the cumulative impact of flattening the yield curve, keeping short-term interest rates low and therefore reducing the yields on our earning assets. Additionally, we have been replacing higher yielding, fixed rate, longer duration loans that prepaid or refinanced away with lower yielding, shorter duration, and variable rate products. Such yield differential has and will continue to weigh on net interest income in subsequent periods.
In December of 2013, the Fed announced it would begin tapering its monthly purchases of Treasury and agency mortgage-backed securities by $10 billion. Most recently, in January 2014, the Fed announced that it would continue tapering its monthly purchases of Treasury and agency mortgage-backed securities by an additional $10 billion, thereby reducing its current level of purchases to $65 billion per month.
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 New York, Western and Eastern 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, 2013, the Bank consolidated with its subsidiaries had $37.6 billion of assets, $26.7 billion of deposits, and $5.2 billion of stockholder’s equity, employed over 5,800 people, and operated through 421 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. First Niagara Funding, Inc. and First Niagara Business Trust, each a real estate investment trust (“REIT”) which primarily originate and hold some of our commercial real estate and business loans, certain residential mortgages, and home equity loans; First Niagara Realty, Inc., which holds commercial other real estate owned; 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.

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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.
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;
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;
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 New York, Western and Eastern 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

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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, as well as 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.
More recently, competition for loans, particularly commercial loans, has intensified given the weak economic activity within our markets and nationally. This increased competition from banks and non-banks has resulted in accelerated loan prepayments, particularly in our investor owned commercial real estate portfolio as borrowers gravitate towards financial institutions that are more willing to compete on price, loan structures or tenor. This competition is most notable in Eastern Pennsylvania and New England.
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, 2013, we operated 421 bank branches, including 199 in New York primarily located near Buffalo, Rochester, Syracuse and Albany; 127 branches in Pennsylvania primarily located near Philadelphia, Pittsburgh, Erie, and Warren; 84 branches in Connecticut primarily located near New Haven and Hartford; and 11 in Western Massachusetts primarily located near Springfield.
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 talent. 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 more recently, our 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.

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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 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 multi-family residential, office, retail, and industrial 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 among these property types.
Commercial and multi-family real estate loans that we originate generally feature a term of 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 almost exclusively indexed to LIBOR. 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

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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 individuals, groups of related borrowers, industries, and property types. 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 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. During 2013, we originated and held $260 million of fixed rate, 30 year jumbo loans and intend to continue to originate and hold these types of loans in 2014. We intend to continue to hold the majority of 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 resets 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 from the initial interest rate 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 loan 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.
We have made all necessary systematic, procedural and underwriting changes, both manual and automated, including elimination and modification of certain product offerings to adhere to Qualified Mortgage ("QM") guidance under the Mortgage Reform and Anti-Predatory Lending Act of the Dodd Frank Wall Street Reform and Consumer Protection Act which is described more fully in "Supervision and Regulation."  While early in the implementation process, testing has gone well with successful implementation.  Training has been rolled out to all impacted employees.  Compliance to QM will be more onerous on business practices and will have a negative impact on efficiencies.  Any additional required changes that arise will be implemented, even if manual processes are required.

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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.
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. We may also finance certain products as part of a motor vehicle loan, including credit life, accident and health insurance, Guaranteed Auto Protection ("GAP") insurance, service contracts, mechanical breakdown protection insurance, theft deterrent products, and maintenance agreements. The maximum term for any motor vehicle loan is 84 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. Most 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. 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.
Other 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 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 and lines of credit 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.
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

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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 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 credit allowances. We regularly review our loan portfolio to ensure that loans are correctly graded and classified in accordance with our policy or applicable regulations.
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 third party mutual funds and annuities as well as other investment products using appropriately licensed financial consultants.
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 management 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 investment 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 Licensed Financial Advisors and 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

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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 objectives of our clients.
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 a diversified portfolio of investment securities. Residential mortgage backed securities and collateralized mortgage obligations ("CMOs") issued and guaranteed by the FNMA, FHLMC, Government National Mortgage Association (“GNMA”) comprise the largest part of our portfolio. Our debt securities are primarily comprised of corporate debt, municipal bonds, and debt issued by U.S. government sponsored enterprises. We also invest in other investments which carry higher yields given their credit risk profile, including collateralized loan obligations (“CLOs”) backed by corporate loans and other types of structured financing, commercial mortgage backed securities ("CMBS") collateralized by commercial mortgages, and asset-backed securities (“ABS”) collateralized auto loans, student loans, credit cards, or other consumer financial assets.
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, 2013, 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. Purchases made will generally be re-deployed into the same investment component, keeping the mix of the portfolio relatively unchanged.

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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
Our strategy is to acquire and retain core checking households through a diversified product offering led by our Pinnacle family of products. We seek to deepen these relationships with competitive savings and money market deposit rates in addition to a variety of certificate of deposits.  Our commercial checking offerings include competitive small business and commercial analyzed accounts including an array of treasury management services such as account reconciliation, remote deposit capture, ACH payments, and cash vault services. In addition we offer business savings and money market products and also accept municipal deposits. In order to further diversify liquidity sources, we have 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 are also 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 our 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 and 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

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any event, acquire 5% or more of the voting stock or substantially all of the assets of any bank or bank holding company without prior Federal Reserve approval.
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”) and, with respect to Federal consumer protection laws, the Consumer Financial Protection Bureau (the “CFPB”). National banks, including the Bank, are subject to extensive regulation of many aspects of their business. These regulations relate to, among other things: (i) capital and liquidity requirements; (ii) the nature and amount of loans that may be made by the Bank and the rates of interest that may be charged; (iii) types and amounts of other investments; (iv) branching; (v) permissible activities; (vi) reserve requirements; and (vii) dealings with officers, directors and affiliates.
Dodd-Frank Wall Street Reform and Consumer Protection Act
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 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 how market practices and structures change in response to the requirements of the Dodd-Frank Act.
We will continue to assess our businesses and risk management and compliance practices to conform to developments in the regulatory environment.
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. The CFPB is focusing 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;
non-depository companies that offer one or more consumer financial products or services; and
with respect to the indirect auto business, holding lenders accountable for discriminatory dealer mark-ups.
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.
Qualified Mortgage Rules
Pursuant to the Dodd-Frank Act, the CFPB has adopted amendments, which became effective January 10, 2014, to the regulations that implement the Truth in Lending Act. These amendments address mortgage origination practices by certain creditors, including the Bank. The amendments generally require creditors to make a reasonable, good faith determination of a consumer’s ability to repay a mortgage (the “ability-to-repay

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requirement”), a violation of which can subject the creditor to enforcement actions and liability for amounts including previously paid finance charges, offsets in foreclosure for such finance charges and actual damages. The amendments provide that mortgages deemed to be qualified mortgages (“QMs”) that are “higher priced” are entitled to a rebuttable presumption that the creditor making the loan satisfied the ability-to-repay requirements and those mortgages deemed to be QMs that are not “higher priced” are entitled to a safe harbor from the ability-to-repay requirements.
Pursuant to the ability-to-repay requirement, creditors must consider eight minimum underwriting factors related to the terms of the mortgage and the income, employment, debt and credit history of the borrower. To be deemed a qualified mortgage, a mortgage cannot include certain features, such as a term exceeding 30 years, negative amortization, an interest-only period, or a balloon payment and must have been originated in compliance with certain underwriting criteria, in particular, a 43% debt-to-income cap. A QM cannot have points and fees that exceed 3% of the total loan amount, with different caps for mortgages under $100 thousand.
The amendments also provide for a temporary category of qualified mortgage that will phase out over time. The underwriting requirements for such mortgages have more flexible underwriting requirements-in particular, they are not required to meet the 43% debt-to-income cap so long as they satisfy the general product feature prerequisites for a qualified mortgage and also satisfy the underwriting requirements of, and are therefore, eligible to be purchased, guaranteed or insured by, the GSEs (Fannie Mae or Freddie Mac) while they operate under Federal conservatorship or receivership, the Department of Housing and Urban Development (i.e., the Federal Housing Administration), the Department of Veteran Affairs, the Department of Agriculture or Rural Housing Services. The vast majority of our loans fall into the temporary qualified mortgage definition, with a small percentage identified as qualified mortgages and an even smaller percentage as “Non-QMs” (loans that follow the ability-to-repay requirements but cannot be sold to the agencies and do not meet one or more QM requirements). Although the Bank has determined that we will continue to originate Non-QMs, with enhanced guidelines, we also made some changes to our existing products in order to ensure compliance with the new regulations and mitigate risk:
We eliminated interest-only loans from the products we offer.
We discontinued non-refundable borrower paid single premium mortgage insurance and introduced refundable mortgage insurance. We will also offer lender-paid mortgage insurance in the future.
We reduced the maximum initial interest rate change on our 5/1 adjustable rate mortgages from 5% to 2%.
We are shifting our pricing structure by incorporating certain of the GSEs’ risk-based pass-through fees into the interest rate as opposed to charging them directly as origination fees.
We have enhanced underwriting guidelines to comply with the ability-to-repay standards.
We have created several new products designed to qualify as QMs, as well as updated our existing products to identify them with QM/Non-QM designations.
We have been actively engaged with our vendors, especially our loan origination system ("LOS") vendors, to ensure we implement proper system enhancements. This process will ensure that our LOS will calculate the parameters and determine an appropriate designation (QM, Temp QM or Non-QM) for each loan.
The borrower has the ability to assert a defense against us in the event of a foreclosure proceeding that we did not comply with the ability-to-repay requirements. If the court finds in the borrower's favor, we could lose our ability to foreclose on the collateral property.
The CFPB has adopted a number of additional requirements and issued additional guidance, including with respect to indirect auto lending and mortgage disclosures, appraisals, escrow accounts and servicing, each of which will entail increased compliance costs. We will continue to monitor these developments and analyze the expected impacts on our business.

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Durbin Amendment
In July 2013, the U.S. District Court for the District of Columbia (the "District Court") issued an order granting summary judgment to the plaintiffs in a case challenging certain provisions of the Federal Reserve's rule concerning electronic debit card transaction fees and network exclusivity arrangements (i.e., routing for PIN and signature debit card transactions) (the “Current Rule”) that were adopted to implement Section 1075 of the Dodd-Frank Act (the “Durbin Amendment”). The District Court held that, in adopting the Current Rule, the Federal Reserve violated the Durbin Amendment's provisions concerning which costs are allowed to be taken into account for purposes of setting fees that are reasonable and proportional to the costs incurred by the issuer and therefore the Current Rule's maximum permissible fees of 21 cents per transaction were too high. In addition, the District Court held that Current Rule's network non-exclusivity provisions concerning unaffiliated payment networks for debit cards also violated the Durbin Amendment. In September 2013, the District Court agreed to stay its ruling pending the Federal Reserve's expedited appeal to the District of Columbia Circuit Court of Appeals (“D.C. Circuit”). In January 2014, following receipt of appellate and amicus briefs in the case, a three-judge panel for the D.C. Circuit heard oral arguments in this case. Although it is unknown when an opinion will be issued by the court, a decision is expected before the end of the D.C. Circuit’s current term which ends in late summer.   We are currently evaluating the impact of the ruling on our business, and will continue to monitor future developments. We recorded $27 million and $22 million of debit card interchange revenues in 2013 and 2012, respectively.
Capital Requirements
General Risk-Based Capital Rules
    
As a bank holding company, we are 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 1988 capital accord of the Basel Committee on Banking Supervision (the "Basel Committee"), 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 loan commitments and 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, certain accumulated other comprehensive income items 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 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).
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. Basel II also sets

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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") which does not include either the Company or the Bank.
Basel III and the Capital Rules
In July 2013, the Federal Reserve and the OCC published final rules (the “New Capital Rules”) establishing a new comprehensive capital framework for U.S. banking organizations. The rules implement the Basel Committee's December 2010 capital framework known as “Basel III” for strengthening international capital standards as well as certain provisions of the Dodd-Frank Act. The New Capital Rules substantially revise the risk-based capital requirements applicable to bank holding companies and depository institutions, including the Company and the Bank, compared to the current U.S. risk-based capital rules. The New Capital Rules define the components of capital and address other issues affecting the numerator in banking institutions' regulatory capital ratios. The New Capital Rules also address risk weights and other issues affecting the denominator in banking institutions' regulatory capital ratios and replace the existing risk-weighting approach, which was derived from Basel I capital accords of the Basel Committee, with a more risk-sensitive approach based, in part, on the standardized approach in the Basel Committee's 2004 “Basel II” capital accords. The New Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the Federal banking agencies' rules. The New Capital Rules are effective for the Company and the Bank on January 1, 2015 (subject to phase-in periods for certain of their components).
The New Capital Rules, among other things, (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 deductions/adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expand the scope of the deductions from and adjustments to capital as compared to existing regulations. The New Capital Rules, like the current capital rules, specify that Total capital consists of Tier 1 capital and Tier 2 capital. For most banking organizations, the most common form of Additional Tier 1 capital is non-cumulative perpetual preferred stock, and the most common form of Tier 2 capital is subordinated notes and a portion of the allocation for loan and lease losses, in each case subject to the New Capital Rules' specific requirements.
Under the New Capital Rules, the minimum capital ratios as of January 1, 2015 will be as follows:
4.5% CET1 to risk-weighted assets.
6.0% Tier 1 capital to risk-weighted assets.
8.0% Total capital to risk-weighted assets.
4% Tier 1 capital to average consolidated assets as reported on consolidated financial statements (known as the “leverage ratio”).
When fully phased in on January 1, 2019, the New Capital Rules will require the Company and the Bank to maintain a 2.5% “capital conservation buffer”, composed entirely of CET1, on top of the minimum risk-weighted asset ratios, effectively resulting in minimum ratios of (i) CET1 to risk-weighted assets of at least 7%, (ii) Tier 1 capital to risk-weighted assets of at least 8.5%, and (iii) Total capital (that is Tier I plus Tier 2) to risk-weighted assets of at least 10.5%.
The capital conservation buffer 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 capital conservation buffer will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
The New Capital Rules 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. Under current capital rules, the effects of accumulated other comprehensive income or loss items included in

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shareholders' equity (for example, marks-to-market of securities held in the available for sale portfolio) are reversed for the purposes of determining regulatory capital ratios. Under the New Capital Rules, the effects of certain accumulated other comprehensive items are not excluded; however, non-advanced approaches banks, including the Company and the Bank, may make a one-time permanent election to continue to exclude these items. The New Capital Rules state that certain hybrid securities, such as trust preferred securities, including the outstanding trust preferred securities issued by the Company or companies it acquired, may be included in bank holding companies' Tier 1 capital, subject to certain provisions. Trust preferred securities excluded from Tier 1 capital may nonetheless be included as a component of Tier 2 capital. As we were below $15 billion in assets as of December 31, 2009, based on Federal Reserve Bank interpretations of our acquisitions, the trust preferred securities classified as long term debt on our balance sheet will be included as Tier 1 capital while they are outstanding, unless we complete an acquisition of a depository institution holding company after January 1, 2014, at which time they would be subject to the stated phase-out requirements of the New Capital Rules and would be included as Tier 2 capital.
Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2015 and will be phased-in over a 4-year period (beginning at 40% on January 1, 2015 and an additional 20% per year thereafter). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).
With respect to the Bank, the New Capital Rules also revise the “prompt corrective action” regulations pursuant to Section 38 of the Federal Deposit Insurance Act, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 capital ratio for well-capitalized status being 8% (as compared to the current 6%); and (iii) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3% leverage ratio and still be adequately capitalized. The New Capital Rules do not change the total risk-based capital requirement for any “prompt corrective action” category.
The New Capital Rules prescribe a new standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. In addition, the New Capital Rules provide more advantageous risk weights for derivatives and repurchase-style transactions cleared through a qualifying central counterparty and increase the scope of eligible guarantors and eligible collateral for purposes of credit risk mitigation.
Based on our preliminary interpretation of the rules and our planned reduction of $275 million of asset-backed securities and collateralized loan obligations that will be subject to significant risk weighting increases under Basel III, we estimate that our reported Tier 1 common ratio at December 31, 2013 of 7.86% would be five to ten basis points lower under the New Capital Rules. We are confident in our ability to meet the minimum capital ratios plus the capital conservation buffer upon implementation of the revised requirements, as finalized.
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 Capital Ratio
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

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minimum leverage ratio of 4.0%, unless a different minimum is specified by the relevant Federal banking agency. Under the New Capital Rules, 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 New Capital Rules apply the Basel III leverage ratio (referred to in the New Capital Rules as the “supplemental leverage ratio”) only to advanced approaches banks.
Liquidity Requirements
Historically, regulation and monitoring of bank and bank holding company liquidity have 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 bank maintains an adequate level of unencumbered high quality liquid assets equal to the bank'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 banks over a one year time horizon. These requirements will incent banks 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.
In October 2013, the Federal banking agencies proposed rules implementing the LCR for advanced approaches banks and a modified version of the LCR for bank holding companies with at least $50 billion in total consolidated assets that are not advanced approach banks, neither of which would apply to us. The Federal banking agencies have not yet proposed rules to implement the NSFR.
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 rules 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 base and stress scenarios provided by the agencies. We are in the process of conducting our company run stress test to meet the first submission date of March 31, 2014 using data as of September 30, 2013 and the scenarios released by the regulators in November 2013. We fully expect to meet the regulatory thresholds. 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 to be disclosed in June 2015.
Enhanced Prudential Standards for SIFIs
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.

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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.

In February 2014, the Federal Reserve adopted rules, which we refer to as the “SIFI rules,” to implement certain of these enhanced prudential standards. Beginning in 2015, the rules require bank holding companies with $10 billion or more in total consolidated assets to establish risk committees and require bank holding companies with $50 billion or more in total consolidated assets to comply with enhanced liquidity and overall risk management standards, including a buffer of highly liquid assets based on projected funding needs for 30 days. The liquidity buffer is in addition to the Federal banking agencies’ proposal on minimum liquidity standards discussed above and described by the Federal Reserve as being “complementary” to those liquidity standards. Rules implementing the single-counterparty credit limits and early remediation requirements are still under consideration by the Federal Reserve. We are monitoring developments with respect to the SIFI Rules because of their application to us if our total consolidated assets reach $50 billion or more.
Volcker Rule
The so-called “Volcker Rule” provisions of the Dodd-Frank Act restrict the ability of affiliates of insured depository institutions to sponsor or invest in private funds or to engage in certain types of proprietary trading. The Federal Reserve adopted final rules implementing the Volcker Rule on December 10, 2013. Although we are continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder, we do not expect them to have a material impact on our business. The final Volcker Rule may restrict our ability to hold certain securities. See the Volcker Rule discussion in Item 1A. "Risk Factors." Although the Volcker Rule became effective on July 21, 2012 and the final rules become effective April 1, 2014, in connection with the adoption of the final rules on December 10, 2013 by the responsible agencies, the Federal Reserve issued an order extending the period during which institutions have to conform their activities and investments to the requirements of the Volcker Rule to July 21, 2015.
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' New Capital Rules, discussed above under “Capital Requirements,” 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, 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.”

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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.
In addition, under the National Bank Act 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 discussed under "Stress Test Rules," above, 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

21


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.
Deposit Insurance
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. A depository institution’s DIF assessment is calculated by multiplying its assessment rate by the assessment base, which is defined as the average consolidated total assets less the average tangible equity of the depository institution. The initial base assessment rate is based on its capital level and supervisory ratings (its “CAMELS ratings”), certain financial measures to assess an institution's ability to withstand asset related stress and funding related stress and, in some cases, additional discretionary adjustments by the FDIC to reflect additional risk factors. 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 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, an institution must pay a premium equal to 50 basis points on every dollar of long-term, unsecured debt held by the depository institution to the extent that such debt exceeds 3% of an institution's Tier 1 capital held by that depository institution if such debt was issued by another insured depository institution (excluding debt guaranteed under the Temporary Liquidity Guarantee Program).
The FDIC’s current DIF restoration plan is designed 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.
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.
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.

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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
Our compensation practices are subject to oversight by the Federal Reserve and the OCC. In June 2010, the Federal banking agencies 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.
Dodd-Frank requires the Federal banking agencies to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities having at least $1 billion in total consolidated 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, the agencies must establish regulations or guidelines

23


requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The initial version of these regulations was proposed by agencies 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.
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 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, regulations and regulatory policies that are designed to protect the interests of consumers in their credit transactions and other transactions with banks and financial service providers. 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”). We are also subject to laws, regulations and policies designed to protect our customers’ privacy and requiring us to adopt an information security program. A violation of the consumer protection and privacy 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, 2013, we were in compliance with this requirement. While we are not a member of FHLB of Boston, we acquired FHLB Boston common stock in connection with our merger with NewAlliance.
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 regulations under the Patriot Act that impose obligations on financial institutions such as the Bank to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of

24


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 administers 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.
 
 
 
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 in our footprint may increase our exposure to credit risk
At December 31, 2013, our portfolio of commercial real estate loans totaled $7.8 billion, or 36% of total loans. While our concentration of commercial real estate loans in New York has steadily decreased over the past three

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years, from 68% at December 31, 2010 to 48% at December 31, 2013, a large portion of this portfolio remains concentrated in this geographical area.

At December 31, 2013, our portfolio of residential real estate loans (including home equity loans) totaled $6.2 billion, or 29% of total loans. While our concentration in these loans in New York has steadily decreased over the past three years, from 67% at December 31, 2010 to 42% at December 31, 2013, a large portion of this portfolio remains concentrated in this geographical area.
A significant weakening in economic conditions in 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 New York could lower the value of the collateral securing our residential real estate loans, leading to higher credit losses.
Commercial real estate and business loans increase our exposure to credit risks
At December 31, 2013, our portfolio of commercial real estate and business loans totaled $13.1 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 New York, Western and Eastern 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, 2013, 21% 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, 13% in collateralized loan obligations and 8% in asset-backed securities
Approximately one-third of our assets have been invested in securities, currently with over 16% in commercial mortgage-backed securities, 13% in collateralized loan obligations and 8% 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

26


that we recognize. Additionally, given the structural complexities inherent in these types of securities, there could be cash flow provisions that we may not fully understand.
The Volcker Rule collateralized loan obligation provisions could result in adverse consequences for us, including lower earnings, lower tangible capital and/or lower regulatory capital
The so-called “Volcker Rule” provisions of the Dodd-Frank Act restrict the ability of affiliates of insured depository institutions, such as the Bank, to sponsor or invest in private funds or to engage in certain types of proprietary trading. The Federal Reserve adopted final rules implementing the Volcker Rule in December, 2013. We are continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder. We own $1.4 billion of collateralized loan obligation ("CLO") securities with a weighted average yield of 3.2% that are subject to the Volcker Rule. If we decide to sell or are required to sell these securities, our future net interest income could be adversely impacted if our alternative use for these funds yields a lower rate. A 100 basis point reduction in yield upon reinvestment into similar duration securities would result in reduced net interest income of $14 million, or three cents per diluted common share.
While there is a potential for additional regulatory guidance or a legislative ruling that would enable banks to continue to hold CLO securities under the Volcker Rule, to the extent this does not materialize nor do the regulators accept any structural solutions put forth by the financial services industry, we are currently subject to potentially significant price movements in these securities which could adversely impact our tangible capital. For instance, a hypothetical 10% reduction in current CLO market prices would result in a $140 million loss to our current CLO securities valuation. Since these securities are currently held as available for sale, the resulting change in Other Comprehensive Income ("OCI"), after tax, would be approximately $90 million. Further, if we decide to sell these securities or if it is more likely than not that we will be required to sell such securities before recovery, we may recognize losses that could adversely impact our regulatory capital ratios. An after tax loss of $90 million would lower regulatory capital by 34 basis points.
Our provision for credit losses may be insufficient
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.
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, 2013, we had $23.0 billion of deposit liabilities that have no maturity and, therefore, may be 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

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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.  A loss of interest earning assets could 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 using historic data and such scenarios result in an increase in our net interest income, our interest-bearing liabilities may reprice or mature more quickly than modeled, thus 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 adverse 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.
A reduction in our credit rating to below investment grade could adversely impact us or the holders of our securities
We are regularly evaluated by ratings agencies. Their ratings are based on a number of factors, including our financial strength and factors outside of our control such as conditions affecting the financial services industry and the broader economy. In light of the difficulties facing the financial services industry, there can be no assurances that we will maintain our current ratings. In December 2013, Moody's placed First Niagara Financial Group, Inc.'s long-term issuer rating of Baa2 (two notches above investment grade) on review for downgrade. While this credit action had no impact on our ability to continue serving our customers, a future downgrade to below investment grade could have adverse consequences for us. In addition to a negative perception by our customers, a downgrade of our debt securities to below investment grade could result in adverse price movements of such securities and higher borrowing costs on any debt securities we issue in the future. A downgrade of our holding company below investment grade triggers a breach of covenant on our holding company line of credit, resulting in a possibility of limiting our access to that credit line. While this line of credit could potentially be renegotiated to cure the breach, it could result in higher interest and non-usage rates as well as additional fees.
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-

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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.
Our total consolidated assets were $37.6 billion at December 31, 2013. 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 and will incur higher levels of expense to comply with these standards.
See “Supervision and Regulation” for more information about the regulations to which we are subject.
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. As of January 2014, just over 50% of the regulatory rules (implementation or changes) have been issued for the Dodd-Frank Act, which illustrates the continued and on-going need requirement of focus for financial institutions.
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. For example, since the establishment of the Consumer Finance Protection Bureau (CFPB), which has been focused on numerous consumer-based regulations, the exam focus of our regulators has evolved to include greater scrutiny and annual examinations of previously less reviewed regulations, such as the Servicemember's Civil Relief Act and the Flood Disaster Protection Act. 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 regulations 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

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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 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,
balance sheet composition,
amount of unsecured debt, including subordinated debt and debt issues by another depository institution, and
amount of brokered deposits.
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. The Company's ability to pay dividends to our stockholders is substantially dependent upon the Bank's ability to pay dividends to the Company. Subject to the Bank meeting or exceeding regulatory capital requirements, the prior approval of the OCC is required if the total of all dividends declared by the 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. Federal law also prohibits the Bank from paying dividends that would be greater than its undivided profits after deducting statutory bad debt in excess of its allowance for loan losses. The Bank paid dividends of $175 million and $45 million to the Company during 2013 and 2012, respectively. Under the foregoing dividend restrictions, the Bank could pay additional dividends of approximately $464 million to the Company without obtaining regulatory approvals, however, this amount would be limited to $261 million to maintain its "well-capitalized" status.
If the Bank is unable to make dividend payments to us, due to a large loss or other event that would eliminate the dividend availability, 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.
Our goodwill could become impaired in the future. If our goodwill were to become impaired, it could limit the ability of our bank to pay dividends to our holding company, adversely impacting the holding company’s liquidity and ability to pay dividends or repay debt.
The most significant assumptions affecting our goodwill impairment evaluation are variables including the market price of our common stock, projections of earnings, and the control premium above our current stock price that an acquirer would pay to obtain control of the Company. We are required to test our goodwill for impairment on an annual basis, or between annual impairment tests if a triggering event occurs. If an impairment determination is made in a future reporting period, our earnings and the book value of goodwill will be reduced by the amount of

30


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. At December 31, 2013, the book value of our goodwill was $2.4 billion.
At February 24, 2014, the market value of a share of our common stock was $8.82, representing a decline from the $11.05 market value of our common stock at November 1, 2013 (the most recent time we have evaluated our goodwill balances for impairment). When we performed our annual goodwill impairment assessment as of November 1, 2013, we concluded that our goodwill balance was not impaired. The market value of a share of our common stock could be an indicator that an event has occurred which could be indicative of goodwill impairment, which may require us to reevaluate goodwill for impairment prior to the next annual test.
A goodwill impairment charge could impact the Bank’s ability to pay dividends to the Company. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations–Liquidity Risk” and Part II, Item 8, “Financial Statements and Supplementary Data–Note 11. Capital” for further details.
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.

We may not be able to successfully realize the benefits from our technology transformation strategy, which could adversely affect our business operations and profitability

We have decided to upgrade our information technology infrastructure to increase revenue and operating leverage and decrease our overall technology operating expenses.  We are in the early stages of planning for such

31


initiatives, and estimate the total investment to be $200 million to $250 million over a three to four year period. Our Board of Directors and Executive Management will maintain ongoing monitoring of these projects.

There is risk related to our time line and cost estimates.  We may not be able to successfully implement and integrate the technology needed within our estimated time line and cost estimate, which could adversely impact the ability to increase revenue or to implement new technology solutions in an efficient manner.  While we have instituted a governance and tollgate process at the both the Board of Directors and Executive Management that will continue to monitor cost and benefit estimates throughout the implementation process, there can be no assurances that we will realize the expected benefits in a cost efficient manner.
We rely on third-party relationships to conduct our business, which subjects us to strategic, reputation, compliance and transaction (operational) risk
We rely on third party service providers to leverage subject matter expertise and industry best practice, provide enhanced products and services, and reduce costs. Although there are benefits in entering into third party relationships with vendors, there are risks associated with such activities. When entering a third party relationship, the risks associated with that activity are not passed to the third party but remain our responsibility. Management and the Board of Directors are ultimately responsible for the activities conducted by vendors. To that end, Management is accountable for the review and evaluation of all new and existing vendor relationships. Management is responsible for ensuring that adequate controls are in place at First Niagara and our vendors to protect the bank and its customers from the risks associated with vendor relationships.
Increased risk most often arises from poor planning, oversight, and control on the part of the bank and inferior performance or service on the part of the third party, and may result in legal costs or loss of business. While we have implemented a vendor management program to actively manage the risks associated with the use of third party service providers, any problems caused by third party service providers could adversely affect our ability to deliver products and services to our customers and to conduct our business. Replacing third party vendors could also take a long period of time and result in increased expenses.

We are exposed to fraud in many aspects of the services and products that we provide.
We offer debit cards and credit cards to our banking customers and plan to expand our online banking and online account opening capabilities in 2014.  Historically, we have experienced operational losses from fraud committed by third parties that steal credentials from our customers or merchants utilized by our customers.  We have little ability to manage how merchants or our banking customers protect the credentials that our customers have to transact with us.  When customers and merchants do not adequately protect customer account credentials, our risks and potential costs increase.  As (a) our sales of these services and products expand, (b) those who are committing fraud become more sophisticated and more determined, and (c) our banking services and product offerings expand, our operational losses could increase.
There are risks resulting from the complex models we utilize as part of our planning and decision making processes
Like most banks, we use models for a broad range of activities, including but not limited to: evaluating credit exposures; investment securities; measuring risk; deposit behavior to changing rates; and determining capital and reserve adequacy. We have implemented a model risk governance framework commensurate with business activities, and the extent and complexity of the models used considering the materiality of model risk at an individual model level and in the aggregate. While models can improve business decisions, they can also increase our risk profile due to the potential for adverse consequences from decisions based on models that are either incorrect or misinterpreted. Such adverse consequences include poor decision making leading to lower revenues, higher expenses (including provisions for loan losses) and inaccurate financial reporting.

32


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.

33


Although management has established business continuity and 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. 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 161,000 square feet of space. At December 31, 2013, we conducted our business through 199 full-service branches located across New York, 127 full-service branches in Western and Eastern Pennsylvania, 84 branches in Connecticut, and 11 branches in Western Massachusetts, including several financial services offices. One hundred forty-seven of our branches are owned and 274 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 37 leased offices and 16 buildings which we own with a total occupancy of approximately 1,568,000 square feet, including our administrative center in Lockport, New York which has 76,000 square feet. At December 31, 2013, our premises and equipment had a net book value of $418 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.

34


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, 2013, we had approximately 25,000 stockholders of record. During 2013, the high sales price of our common stock was $11.34 and the low sales price of our common stock was $7.68. We paid dividends of $0.32 per common share during 2013. See additional information regarding the market price and dividends paid in Item 6, “Selected Financial Data.”
We did not repurchase any shares of our common stock during 2013 and 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.

35


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, 2008 as reported by the NASDAQ Global Select Market, through December 31, 2013, (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
12/31/2008

12/31/2009

12/31/2010

12/31/2011

12/31/2012

12/31/2013

First Niagara Financial Group, Inc.
$
100.00

$
89.76

$
94.31

$
61.49

$
58.66

$
81.23

NASDAQ Composite Index
100.00

145.36

171.74

170.38

200.63

281.22

KBW Regional Bank Index
100.00

77.87

93.75

88.93

100.86

148.09



36


ITEM 6.
 
Selected Financial Data
At or for the year ended December 31,
2013
2012(1)
2011(2)
2010(3)
2009(4)
 
(In millions, except per share amounts)
Selected financial condition data:
 
 
 
 
 
Total assets
$
37,628

$
36,806

$
32,811

$
21,084

$
14,585

Loans and leases, net
21,230

19,547

16,352

10,388

7,209

Investment securities:
 
 
 
 
 
Available for sale
7,423

10,994

9,348

7,289

4,422

Held to maturity
4,042

1,300

2,670

1,026

1,094

Goodwill and other intangibles
2,543

2,618

1,803

1,114

935

Deposits
26,665

27,677

19,405

13,149

9,730

Borrowings
5,556

3,716

8,127

4,893

2,302

Stockholders’ equity
$
4,993

$
4,927

$
4,798

$
2,765

$
2,374

Common shares outstanding
354

353

352

209

188

Selected operations data:
 
 
 
 
 
Interest income
$
1,210

$
1,176

$
1,065

$
746

$
491

Interest expense
117

153

184

148

126

Net interest income
1,093

1,023

881

598

364

Provision for credit losses
105

92

58

49

44

Net interest income after provision for credit losses
988

931

823

549

321

Noninterest income(5)
366

360

245

187

126

Merger and acquisition integration expenses

178

98

50

36

Restructuring charges

6

43



Noninterest expense
931

867

666

473

290

Income before income tax
423

239

262

212

120

Income taxes
128

71

88

72

41

Net income
295

168

174

140

79

Preferred stock dividend and discount accretion(6)
30

28



12

Net income available to common stockholders
$
265

$
141

$
174

$
140

$
67

Common stock and related per share data:
 
 
 
 
 
Earnings per common share:
 
 
 
 
 
Basic
$
0.75

$
0.40

$
0.64

$
0.70

$
0.46

Diluted
0.75

0.40

0.64

0.70

0.46

Cash dividends
0.32

0.32

0.64

0.57

0.56

Book value (7)
13.31

13.15

12.79

13.42

12.84

Tangible book value per common share(7)(8)
6.04

5.65

7.62

8.01

7.78

Market Price (NASDAQ: FNFG):
 
 
 
 
 
High
11.34

10.35

15.10

14.88

16.32

Low
7.68

7.08

8.22

11.23

9.48

Close
$
10.62

$
7.93

$
8.63

$
13.98

$
13.91

(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 National City Bank branches acquired on September 4, 2009.
(5) 
Includes $21 million gain on sale of mortgage-backed securities from the 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) 
This is a Non-GAAP measure that we believe is useful in understanding our financial performance and condition. Refer to the GAAP to Non-GAAP Reconciliation for further information.

37


At or for the year ended December 31,
2013
2012(1)
2011(2)
2010(3)
2009(4)
 
(Dollars in millions)
Selected financial ratios and other data:
 
 
 
 
 
Performance ratios(5):
 
 
 
 
 
Return on average assets
0.80
%
0.48
%
0.62
%
0.74
%
0.69
%
Common equity:
 
 
 
 
 
Return on average common equity
5.73

3.09

4.71

5.23

3.47

Return on average tangible common equity(6)
12.86

6.30

8.40

8.67

6.06

Total equity:
 
 
 
 
 
Return on average equity
5.95

3.45

4.68

5.23

3.95

Return on average tangible equity(6)
12.31

6.55

8.33

8.67

6.71

Earnings to fixed charges:
 
 
 
 
 
Including interest on deposits
2.84

2.48

2.34

2.38

1.93

Excluding interest on deposits
3.63

3.51

3.34

3.57

3.18

Net interest rate spread
3.31

3.24

3.46

3.48

3.40

Net interest rate margin
3.39

3.34

3.58

3.64

3.65

Efficiency ratio(7)
63.82

76.02

71.58

66.72

66.62

Operating expenses as a percent of average loans and deposits(8)
1.96

2.47

2.52

2.40

2.32

Effective tax rate
30.2

29.6

33.7

33.9

33.9

Dividend payout ratio
42.67

80.00

100.00

81.43

121.74

Capital ratios:
 
 
 
 
 
First Niagara Financial Group, Inc.
 
 
 
 
 
Total risk-based capital
11.53

11.23

17.84

14.35

18.51

Tier 1 risk-based capital
9.56

9.29

15.60

13.54

17.41

Tier 1 risk-based common capital(6)
7.86

7.45

13.23

12.76

17.26

Leverage ratio(9)
7.26

6.75

9.97

8.14


Tangible capital(6)(9)




10.34

Ratio of stockholders’ equity to total assets
13.27

13.39

14.62

13.11

16.27

Ratio of tangible common stockholders’ equity to tangible assets
6.02

5.77

8.57

8.27

10.54

Risk-weighted assets
$
26,412

$
24,379

$
18,971

$
11,809

$
8,066

First Niagara Bank:
 
 
 
 
 
Total risk-based capital
10.99
%
10.66
%
16.47
%
11.86
%
13.73
%
Tier 1 risk-based capital
10.15

9.94

14.66

11.06

12.63

Leverage ratio(9)
7.70

7.23

9.38

6.64


Tangible capital(9)




7.48

Risk-weighted assets
$
26,365

$
24,379

$
18,997

$
11,828

$
7,997

Other data:
 
 
 
 
 
Number of full service branches
421

430

333

257

171

Full time equivalent employees
5,807

5,927

4,827

3,791

2,816

(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 National City Bank branches acquired on September 4, 2009.
(5) 
Computed using daily averages.
(6) 
This is a Non-GAAP measure that we believe is useful in understanding our financial performance and condition. Refer to the GAAP to Non-GAAP Reconciliation for further information.
(7) 
Computed by dividing noninterest expense by the sum of net interest income and noninterest income.
(8) 
Computed by dividing noninterest expense by the sum of average total loans and deposits
(9) 
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.



38


GAAP to Non-GAAP Reconciliation
At or for the year ended December 31,
2013
2012
2011
2010
2009
 
(in millions)
Reconciliation of noninterest income on operating basis to reported noninterest income:
 
 
 
 
 
Total noninterest income on operating basis (Non-GAAP)
$
366

$
338

$
245

$
187

$
126

Gain on securities portfolio repositioning

21




Total reported noninterest income (GAAP)
$
366

$
360

$
245

$
187

$
126

 
 
 
 
 
 
Computation of ending tangible common equity:
 
 
 
 
 
Total stockholders' equity
$
4,993

$
4,927

$
4,798

$
2,765

$
2,374

Less: goodwill and other intangibles
(2,543
)
(2,618
)
(1,803
)
(1,114
)
(935
)
Less: preferred stockholders' equity
(338
)
(338
)
(338
)


Tangible common equity
$
2,113

$
1,971

$
2,657

$
1,651

$
1,438

 
 
 
 
 
 
Computation of average tangible equity:
 
 
 
 
 
Total stockholders' equity
$
4,966

$
4,887

$
3,713

$
2,683

$
2,011

Less: goodwill and other intangibles
(2,567
)
(2,315
)
(1,625
)
(1,064
)
(829
)
Tangible Equity
$
2,399

$
2,572

$
2,088

$
1,620

$
1,182

 
 
 
 
 
 
Computation of average tangible common equity:
 
 
 
 
 
Total stockholders' equity
$
4,966

$
4,887

$
3,713

$
2,683

$
2,011

Less: goodwill and other intangibles
(2,567
)
(2,315
)
(1,625
)
(1,064
)
(829
)
Less: preferred stockholders' equity
(338
)
(338
)
(17
)


Tangible common equity
$
2,061

$
2,234

$
2,072

$
1,620

$
1,182

 
 
 
 
 
 
Computation of Tier 1 common capital:
 
 
 
 
 
Tier 1 capital
$
2,526

$
2,265

$
2,962

$
1,602

$
1,404

Less: qualifying restricted core capital elements
(113
)
(112
)
(112
)
(93
)
(12
)
Less: perpetual non-cumulative preferred stock
(338
)
(338
)
(338
)


Tier 1 common capital (Non-GAAP)
$
2,075

$
1,815

$
2,512

$
1,509

$
1,392

 
 
 
 
 
 


39


 
2013
 
2012
Selected Quarterly Data
Fourth
quarter
Third
quarter
Second
quarter
First
quarter
 
Fourth
quarter
Third
quarter
Second
quarter
First
quarter
 
(In millions, except per share amounts)
Interest income
$
310

$
307

$
298

$
296

 
$
284

$
302

$
300

$
291

Interest expense
30

29

29

29

 
31

32

41

48

Net interest income
280

278

269

266

 
252

270

259

242

Provision for credit losses
32

28

25

20

 
22

22

28

20

Net interest income after provision for credit losses
248

250

244

246

 
230

247

231

222

Noninterest income
89

91

96

89

 
92

102

96

70

Merger and acquisition integration expenses




 
4

29

131

13

Restructuring charges




 


4

3

Noninterest expense
227

231

235

238

 
235

237

210

185

Income before income tax
110

110

105

98

 
83

83

(19
)
92

Income taxes
33

31

33

30

 
22

25

(8
)
32

Net income
78

79

71

67

 
61

58

(11
)
60

Preferred stock dividend
8

8

8

8

 
8

8

8

5

Net income available to common stockholders
$
70

$
72

$
64

$
60

 
$
54

$
51

$
(18
)
$
55

Earnings per common share:
 
 
 
 
 
 
 
 
 
Basic
$
0.20

$
0.20

$
0.18

$
0.17

 
$
0.15

$
0.15

$
(0.05
)
$
0.16

Diluted
0.20

0.20

0.18

0.17

 
0.15

0.14

(0.05
)
0.16

Market Price (NASDAQ: FNFG):
 
 
 
 
 
 
 
 
 
High
11.34

11.02

10.17

8.94

 
8.52

8.50

9.87

10.35

Low
7.68

9.78

8.79

7.68

 
7.08

7.14

7.49

8.71

Close
10.62

10.37

10.07

8.86

 
7.93

8.07

7.65

9.84

Cash dividends
$
0.08

$
0.08

$
0.08

$
0.08

 
$
0.08

$
0.08

$
0.08

$
0.08


40


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 New York, Western and Eastern Pennsylvania, Connecticut, and Western Massachusetts with $37.6 billion of assets, $26.7 billion of deposits, and 421 branch locations as of December 31, 2013.
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 New York; our September 2009 acquisition of 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 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 and financial services and risk management (insurance). These include commercial real estate loans, commercial business loans and leases, residential real estate, home equity, indirect auto, credit cards, and other consumer loans, as well as retail and commercial deposit products and insurance services. We also provide wealth management products and services. The markets we compete in exhibit attractive characteristics of economic growth and stability. Over the next five year period, the household income in our markets weighted by the deposits we hold in each market is expected to increase at an 18% rate, outpacing the national average. Within our markets, the strong economy particularly in our Western and Eastern Pennsylvania and New England markets provides us compelling opportunities to organically grow our commercial loan portfolio in areas such as healthcare and manufacturing. The strong and stable low cost deposit base in our Western and Eastern Pennsylvania and New York markets provides a strong funding base to finance such loan growth.

In 2013, we selectively invested in key opportunities within the franchise. Beginning in 2014, we announced a pivot in our strategic imperatives by choosing to accelerate investments in specific revenue generation and efficiency opportunities as well as our “common rails” technology effort. At the end of our planned three to four year investment period, we expect to be positioned to i) deliver greater fee generation and revenue capabilities by improving our value proposition to our retail and commercial clients, ii) improve operating leverage by lowering integration costs and our overall cost to serve, iii) address growing industrywide regulatory concerns such as cybersecurity, and iv) improve our overall financial returns. The total cash spend for these investments is estimated at between $200 million and $250 million. Our common rails initiative is aimed at leveraging the significant innovations in the technologies for infrastructure for product integration and product application, data analytics, as well as improving our core processing capabilities. We believe these investments will facilitate the integration of new products or technology platforms in a more cost efficient manner, reduce risk and increase our speed to market. While the expenses associated with implementing this strategy, future operating costs, and capitalization of these investments will weigh on near-term earnings over the investment period, we expect the incremental revenues and associated efficiencies from these investments will improve our financial metrics such as return on assets ("ROA"), improve our efficiency ratio and our fee income contribution to revenues.
Based on the execution of our accelerated investment strategy, we expect a 10 to 15 basis point increase in our ROA at the end of the investment period.

41


Including the benefit of normalized rates and our investments, we expect ROA to range between 1.15% and 1.20% after the investment period. (Federal Funds Target rate of approximately 4%.)
FINANCIAL OVERVIEW
Despite challenges presented by the macro-economic, regulatory and competitive environment during 2013, we achieved strong organic loan growth in our markets and positive operating leverage through disciplined cost management and by leveraging our proven ability to acquire and deepen profitable customer relationships. We balanced our ongoing investments in the franchise for the longer term with a short-term earnings priority. We self funded these investments by reducing costs in the retail platform through branch consolidations and restructurings and lowered overall headcount while delivering strong loan growth across all our markets.
The following table summarizes our results of operations for the periods indicated on a GAAP basis and on an operating (non-GAAP) basis for the periods indicated. Our results for 2013 reflect the full year impact of our May 2012 HSBC Branch Acquisition and a $6 million pre-tax charge, or $0.01 per share, related to two executive departures. Our results for 2012 reflect the partial year impact of our HSBC Branch Acquisition.
Our operating results exclude certain nonoperating income and expense items as detailed below. 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. 
 
Year ended December 31,
(in millions, except per share amounts)
2013
2012
2011
Operating results (Non-GAAP):
 
 
 
Net interest income
$
1,093

$
1,048

$
881

Provision for credit losses
105

92

58

Noninterest income
366

338

245

Noninterest expense
931

867

666

Income tax expense
128

135

136

Net operating income (Non-GAAP)
$
295

$
292

$
267

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

$
0.75

$
0.98

Reconciliation of net operating income to net income
$
295

$
292

$
267

Nonoperating income and expenses, net of tax at effective tax rate:
 
 
 
Retroactive premium amortization on securities portfolio ($25 pre-tax)

(17
)

Gain on securities portfolio repositioning ($21 pre-tax)

14


Merger and acquisition integration expenses ($178 and $98 pre-tax in 2012 and 2011, respectively)

(116
)
(64
)
Restructuring charges ($6 and $43 pre-tax in 2012 and 2011, respectively)

(4
)
(28
)
Total nonoperating expenses, net of tax

(123
)
(93
)
Net income (GAAP)
$
295

$
168

$
174

Earnings per diluted share (GAAP)
$
0.75

$
0.40

$
0.64

2013 compared to 2012
Our tax equivalent net interest margin increased five basis points to 3.39% for 2013 from 3.34% for 2012. During 2013, yields on commercial loans dropped 46 basis points compared to 2012, reflecting the cumulative impact of replacing higher yielding, fixed rate, longer duration loans that prepaid with new originations that were lower yielding, shorter duration, variable rate products. Consumer loan yields dropped 17 basis points during 2013, driven primarily by a 53 basis points decline in indirect auto yields driven by the impact of normal amortization

42


and prepayments of balances as well as our business decision to lend to customers with higher FICO scores. These adverse impacts were partially offset by benefits derived from the acquisition of low-cost deposits through our May 2012 HSBC branch transaction as the cost of our interest bearing deposits declined nine basis points in 2013 from 2012. Net interest income increased $70 million, or 7%, for 2013 compared to 2012.
Our provision for credit losses for 2013 was $105 million, an increase of $13 million from 2012. Our provision for loan losses increased to $103 million for 2013 from $91 million for 2012. The provision for loan losses on originated loans increased to $96 million for 2013 from $84 million for 2012. Net charge-offs decreased to 34 basis points of average originated loans for 2013 from 35 basis points of average originated loans for 2012. The provision for loan losses on acquired loans was unchanged for 2013 from 2012 at $7 million. Net charge-offs decreased to nine basis points of average acquired loans for 2013 from 12 basis points of average acquired loans for 2012. For the years ended 2013 and 2012, we recognized provision for credit losses related to our unfunded loan commitments of $2 million and $1 million, respectively.
Period end balances in our commercial loan portfolio grew $1.0 billion, or 8%, to $13.1 billion and our indirect auto loan portfolio more than doubled in 2013 to $1.5 billion at December 31, 2013 from $601 million at December 31, 2012. The decrease in our residential real estate loans reflected industry wide prepayment levels.
The growth in commercial loans was tempered by an intensifying competitive landscape which continues to drive an escalating degradation of pricing and loan structures. More recently, competition for loans, particularly commercial loans, has intensified given the weak economic activity within our markets and nationally. This increased competition from banks and non-banks has resulted in accelerated loan prepayments, particularly in our investor owned commercial real estate portfolio as borrowers gravitate towards financial institutions that are more willing to compete on price or loan structures. This competition is most notable in our Eastern Pennsylvania and New England regions.
Our ability to gain market share and generate adequate loan volumes in 2013 together with pricing actions on our deposits has enabled us to mitigate some of the net interest income pressures to date.
There is evidence that spreads for the types of loans we originate are and will continue to be under pressure. While we will compete to an extent on price, weakly structured loans offered by some participants continue to be a concerning trend across the industry as we will not make loans with such structural concessions. As we continue to maintain our credit discipline, we have not and may not be able to continue to grow our loan portfolio sufficiently to mitigate the impact on net interest income.
The $828 million decrease in our available for sale and held to maturity investment securities portfolio reflects the balance sheet rotation strategy we executed during 2013 whereby we used cash flows received on our residential mortgage-backed investment securities portfolio and investment security sales to fund loan growth. We expect to maintain the investment book at current levels until loan growth rebounds.
Transactional deposit balances increased $515 million, reflecting our continued efforts to grow our customer base, reposition our account mix, and increase our lower cost deposits. Short-term borrowings increased $1.8 billion from December 31, 2012 as we used short-term borrowings to fund asset growth due to the planned run off of our money market deposit accounts and certificates of deposit.
The increase in our noninterest income for 2013 from 2012 was driven by increases in deposit service charges, merchant and card fees, and wealth management services, which reflect the full year impact of our HSBC Branch Acquisition. These increases were offset by decreases in mortgage banking revenues and capital markets income.
We expect deposit service charges to remain relatively flat in the near term; over the longer-term, our investments in and the delivery of Treasury Management and Digital solutions to our commercial and retail consumers will drive our fee income higher. Mortgage application and refinance volumes have dropped throughout 2013 as industry gain-on-sale margins have normalized resulting in significant contraction in mortgage banking revenues. Our focus in mortgage remains on market share gains, particularly in the purchase market. Consistent with our experience in 2013, increased competition and the impact of Dodd-Frank Act’s definition of Eligible Market

43


Participants for derivative swap transactions has and will continue to challenge capital markets revenues. Competition in the insurance industry continues to be strong as the market remains soft, limiting the potential to raise rates. 
Total GAAP noninterest expenses were $931 million for 2013, down approximately $120 million from 2012. Excluding merger and acquisition integration expenses and restructuring charges in 2012, our noninterest expenses increased $64 million. In 2013, we have been diligent about managing our costs to reduce inefficiency out of our cost structure.
The ongoing investments required to support future revenue growth as well as our common rails effort will drive 2014 operating expenses greater than full year 2013 levels. Over the next few years, our continued investment in revenue generating enhancements, such as our Digital and Treasury Management platforms, coupled with other investments to position us competitively, will increase operating costs in the short term but drive revenue growth in the long term.
2012 compared to 2011
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 points 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 provision for loan losses increased to $91 million for 2012 from $54 million for 2011. The provision for loan losses on originated loans increased to $84 million for 2012 from $51 million for 2011. Net charge-offs increased to 35 basis points of average originated loans in for 2012 from 32 basis points of average originated loans for 2011. The provision for loan losses on acquired loans increased to $7 million for 2012 from $3 million for 2011. Net charge-offs increased to 12 basis points of average acquired loans in 2012 from two basis points of average acquired loans for 2011.
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.

44


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 those which require our most subjective and complex judgments. Accordingly, our accounting estimates relating to the valuation of our investment securities, prepayment assumptions on our collateralized mortgage obligations and mortgage-backed securities, 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, 2013, our available for sale and held to maturity investment securities totaled $11.5 billion, or 30% 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 monthly 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, 2013 or 2012. 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 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 which 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.
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 as warranted.
In order to compute the constant effective yield for these securities, we estimate pooled level cash flows for each security based on a variety of factors, including historical and projected prepayment speeds, current and future interest rates, yield curve assumptions, security issuer and the current political environment. These cash flows are then translated into security level cash flows based on the tranche we own and the unique structure and status of each security. At December 31, 2013, the par value of our portfolio of residential mortgage-backed securities totaled $5.5 billion, which included $4.9 billion of collateralized mortgage obligations. In the determination of our constant effective yield, we estimate that we will receive $0.9 billion of principal cash flows on our collateralized mortgage obligations over the next 12 months.
Acquired Loans
Loans that we acquired in acquisitions subsequent to January 1, 2009 were recorded at fair value with no carryover of the related allowance for loan losses at the time of acquisition. Determining the fair value of the loans involved 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.

45


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.
Individual acquired loans determined to have evidence of deterioration in credit quality are accounted for individually in accordance with ASC 310-30. 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).
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.
Acquired loans accounted for under ASC 310-30
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 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 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

46


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 consists of commercial loans and consumer loans. Our commercial loan portfolio includes both business and commercial real estate loans. Our consumer loan portfolio includes residential real estate, home equity, indirect auto, credit card and other consumer loans. We further segregate these portfolios 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 included 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. The level of the allowance for loan losses is 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.
For our originated loans, our allowance for loan losses consists of the following elements: (i) 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; and (ii) specific valuation allowances based on probable losses on specifically identified impaired loans.

Impaired loans
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 troubled debt restructuring ("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 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
We estimate the allowance for our commercial loan portfolio by applying 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.”

47


Consumer loan portfolio
We estimate the allowance for loan losses for our consumer loan portfolio by estimating the amount of loans that will eventually default based on their current 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, 2013, our goodwill totaled $2.4 billion. Of this, 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 the market price of our common stock, 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, including a control premium, 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 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

48


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.
While bank stocks, in general, performed well in 2013, the banking industry continues to be challenged by numerous factors, including, but not limited to, actions by the Federal Reserve intended to keep long term interest rates low, continued loan refinancings and prepayments, increased competition for loans, regulatory actions emanating from Dodd-Frank and, in our case, investments in infrastructure and new products. 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 future expected 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 at that point in time, 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 2013. 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. An 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 6% was then applied in determining the terminal value. These cash flows were discounted at a 12% 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 13.4x and was based on our stock price at the assessment date of $11.05 per share, and was applied to our projected 2014 and 2015 earnings. The tangible book value multiple used was 1.9x 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. The fair value of our Banking unit exceeded its carrying value by approximately $655 million (15%). Changes to the significant estimates used in computing fair value of our Banking unit could have a significant adverse impact on its value. A 10% reduction to the price of our common stock utilized in the impairment test decreases the fair value of our banking unit by $285 million. A reduction in the control premium assumption from 50% to 45% decreases the overall fair value of our Banking unit by approximately $95 million, while an increase in the control premium from 50% to 60% increases the overall fair value by $190 million. A 100 basis point increase in the discount rate decreases the fair value of the Banking unit by approximately $125 million. In each of these indicative stress scenarios, we would pass Step 1 of the goodwill impairment review. A combination of two or more adverse scenarios may have an additive effect on the decline in fair value and may result in us failing Step 1 of the goodwill impairment review.

49


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 35%. A control premium analysis indicated that the “implied premium” was within range of the overall purchase price premiums observed in market acquisition transactions.
NET INTEREST INCOME
2013 compared to 2012
Our net interest income increased 6.9% to $1.1 billion in 2013 from $1.0 billion in 2012. The year over year increase primarily reflected our $1.6 billion increase in average interest earning assets to $32.8 billion, which was largely attributable to the full year impact of the HSBC Branch Acquisition and continued organic growth in our commercial and indirect auto loan portfolios offset in large part due to lower asset yields. The increase in average interest earning assets outpaced the growth in average interest bearing liabilities, which increased $1.0 billion year over year, resulting in a $518 million increase in net earning assets to $5.9 billion in 2013. The increase, on a taxable equivalent basis, in net interest income due to the increase in our average net earning assets was approximately $102 million. In addition, our net interest income benefited from approximately $19 million in accretable yield attributable to better than expected credit performance of certain acquired loans.
During 2013, the yield curve steepened appreciably driven by increased anticipation that the Federal Reserve would begin tapering its Quantitative Easing Bond-Buying program.  The steepening of the yield curve resulted from an increase in the mid-to-long end of the curve which had the positive impact of increasing reinvestment rates on certain securities purchases and mitigating premium amortization due to lower prepayment activity driven by higher mortgage rates. However, these benefits to net interest income were more than offset by continued prepayments and/or refinancing of higher-yielding loans and new loan growth at lower market rates. An intensifying competitive landscape, particularly for commercial and commercial real estate loans may drive spread compression in the future, which will likely impact net interest income. Improvement in net interest income will require increases to short-term interest rate indices such as the prime rate or 90 day LIBOR.
Our average balance of investment securities decreased year over year by approximately $752 million as we executed our balance sheet rotation strategy of using repayments on our securities portfolio to fund loan growth. The decrease in average balance was offset by an increase in yield of 18 basis points during 2013. The increase in yield was primarily due to lower premium amortization on residential mortgage-backed securities in the current year partially offset by reinvestment in lower yielding assets.
As of December 31, 2013, the amount of net premiums on our residential mortgage-backed securities to be recognized in future periods amounted to approximately $71 million, which equates to a weighted average premium above par of approximately 1.3%. Subsequent changes to the interest rate environment will continue to impact our yield earned on these securities. Cash flows from collateralized mortgage obligations ("CMOs") in the current year were almost $600 million lower than the approximately $1.9 billion in cash flows expected at the beginning of the year. Such slower prepayments delay and elongate the period over which the premium is amortized. Also contributing to the increase in yields was the prepayment of CLOs that were purchased at a discount. During 2013, we recognized $3 million of interest income related to these prepayments. While such

50


income from CLO payoffs benefit the quarter in which they are recognized, the long-term implication is that these assets had above market interest rates that are being replaced with other lower yielding assets.
Overall, average loans increased 13%, or $2.4 billion, in 2013. Commercial loans increased 14%, or $1.6 billion, as our pipeline remained strong throughout the year. Indirect auto remained a source of growth contributing approximately one-third of the average net loan growth this year. Our average indirect auto portfolio increased $849 million, as we originated $1.3 billion in new loans during 2013. These increases were partially offset by a slight decrease in our residential real estate loans. Loan yields declined 36 basis points as commercial loan yields decreased by 46 basis points and our total consumer loan portfolio yields decreased by 17 basis points.
Commercial loan yields declined as a result of (i) new loan production being booked in a lower interest rate environment, and (ii) a shorter duration of our commercial loan portfolio.  The shorter duration resulted as a higher percentage of our new originations were variable rate, which was partially attributable to our customer derivatives capacity, which permits us to offer our customers seeking a longer term rate the flexibility to swap their variable loan obligation to a fixed rate. These variable rate originations replaced the repayment of fixed rate loans with higher rates. Commercial real estate loan yields benefited three basis points from other favorable loan adjustments not expected to continue in the normal course of business, primarily comprised of the payoff of acquired loans that we were carrying at a discount.
Our average balances of interest bearing deposits increased by $2.0 billion reflecting the full year impact of the HSBC Branch Acquisition offset by current year declines in money market deposits and certificates of deposit. Our average rate paid declined by nine basis points due to our previous deposit pricing actions and competitive rate pressure. Demand for longer term certificates of deposit remains weak.
Our average borrowings decreased year over year by approximately $1.0 billion as a result of paying down borrowings upon closing of the HSBC Branch Acquisition, partially offset by our decision to fund our balance sheet growth and rotation through low cost short-term borrowings. This funding strategy has also decreased the rate paid on borrowings by 16 basis points.
2012 compared to 2011
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 $256 million.
Our net interest income, on a taxable equivalent basis, decreased $119 million due to a 24 basis points reduction in our net interest margin. This was due to the impact of deposit pricing initiatives we implemented throughout the year, partially offset by lower yielding assets and higher investment security premium amortization.
In the second quarter of 2012, we executed our securities portfolio repositioning transaction. 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 in 2012. 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%.

51


The following table presents our condensed average balance sheet and taxable equivalent interest income and yields. Yields earned on interest-earning assets, rates paid on interest-bearing liabilities and average balances are based on average daily balances:
 
2013
 
2012
 
2011
(dollars in millions)
Average outstanding balance
Interest earned/paid(1)
Yield/rate(1)
 
Average outstanding balance
Interest earned/paid(1)
Yield/rate(1)
 
Average outstanding balance
Interest earned/paid(1)
Yield/rate(1)
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
Loans and leases(2)
 
 
 
 
 
 
 
 
 
 
 
Commercial:
 
 
 
 
 
 
 
 
 
 
 
Real estate
$
7,446

$
314

4.16
%
 
$
6,625

$
318

4.72
%
 
$
5,651

$
306

5.33
%
Business
5,134

190

3.66

 
4,402

176

3.94

 
3,209

138

4.23

Total commercial lending
12,580

504

3.95

 
11,027

494

4.41

 
8,860

443

4.93

Residential real estate
3,569

141

3.94

 
3,922

161

4.11

 
3,474

158

4.54

Home equity
2,681

113

4.21

 
2,476

109

4.39

 
1,973

90

4.54

Indirect auto
1,077

34

3.12

 
228

8

3.65

 



Credit cards
307

34

11.20

 
202

22

10.88

 



Other consumer
315

27

8.43

 
296

24

8.25

 
274

19

6.98

Total consumer loans
7,949

348

4.38

 
7,124

325

4.55

 
5,721

266

4.66

Total loans
20,529

853

4.15

 
18,151

819

4.51

 
14,582

710

4.87

Residential mortgage-backed securities(3)(4)
5,500

146

2.66

 
7,230

177

2.45

 
8,191

284

3.47

Commercial mortgage-backed securities(3)
1,844

68

3.69

 
1,855

73

3.91

 
626

25

4.03

Other investment securities(3)
4,694

158

3.36

 
3,704

123

3.32

 
1,681

67

3.97

Total investment securities(4)
12,038

372

3.09

 
12,790

372

2.91

 
10,497

376

3.59

Money market and other investments
189

3

1.65

 
257

3

1.13

 
132

2

1.33

Total interest-earning assets(4)
32,756

$
1,228

3.75
%
 
31,198

$
1,194

3.83
%
 
25,211

$
1,088

4.31
%
Noninterest-earning assets(5)(6)
4,311

 
 
 
4,119

 
 
 
3,049

 
 
Total assets
$
37,067

 
 
 
$
35,317

 
 
 
$
28,260

 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
Deposits
 
 
 
 
 
 
 
 
 
 
 
Savings deposits
$
3,813

$
4

0.10
%
 
$
3,451

$
5

0.15
%
 
$
2,287

$
5

0.20
%
Checking accounts
4,524

2

0.04

 
3,347

2

0.07

 
1,958

2

0.12

Money market deposits
10,167

21

0.21

 
9,507

26

0.28

 
6,504

36

0.56

Certificates of deposit
3,875

26

0.68

 
4,048

33

0.81

 
4,057

40

0.98

Total interest-bearing deposits
22,379

53

0.24

 
20,352

67

0.33

 
14,806

83

0.56

Borrowings
 
 
 
 
 
 
 
 
 
 
 
Short-term borrowings
3,744

15

0.41

 
3,163

17

0.53

 
1,638

6

0.40

Long-term borrowings
732

48

6.61

 
2,299

69

3.02

 
5,124

94

1.84

Total borrowings
4,476

64

1.42

 
5,462

86

1.58

 
6,762

101

1.49

Total interest-bearing liabilities
26,855

$
117

0.44
%
 
25,814

$
153

0.59
%
 
21,568

$
184

0.85
%
Noninterest-bearing deposits
4,712

 
 
 
4,041

 
 
 
2,595

 
 
Other noninterest-bearing liabilities
534

 
 
 
575

 
 
 
385

 
 
Total liabilities
32,101

 
 
 
30,430

 
 
 
24,547

 
 
Stockholders’ equity(5)
4,966

 
 
 
4,887

 
 
 
3,713

 
 
Total liabilities and stockholders’ equity
$
37,067

 
 
 
$
35,317

 
 
 
$
28,260

 
 
Net interest income
 
$
1,111

 
 
 
$
1,041

 
 
 
$
904

 
Net interest rate spread
 
 
3.31
%
 
 
 
3.24
%
 
 
 
3.46
%
Net earning assets
$
5,902

 
 
 
$
5,383

 
 
 
$
3,643

 
 
Net interest rate margin
 
 
3.39
%
 
 
 
3.34
%
 
 
 
3.58
%
Ratio of average interest-earning assets to average interest-bearing liabilities
122
%
 
 
 
121
%
 
 
 
117
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 

52


(1) 
We use a taxable equivalent basis based on a 35% tax rate in order to provide the most comparative yields among all types of interest-earning assets.
(2) 
Average outstanding balances are net of deferred costs and unearned discounts and include nonperforming loans.
(3) 
Average outstanding balances are at amortized cost.
(4) 
Our operating (non-GAAP) results for 2012 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 investment securities
3.11

Total interest-earning assets
3.91

Net interest rate spread
3.32

Net interest rate margin
3.42

(5) 
Average outstanding balances include unrealized gains/losses on securities available for sale.
(6) 
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:
 
2013 vs. 2012
 
2012 vs. 2011
 
Increase/(decrease)
due to
Total
increase
 
Increase/(decrease)
due to
Total
increase
(in millions)
Volume
Rate
(decrease)
 
Volume
Rate
(decrease)
Interest income on:
 
 
 
 
 
 
 
Real estate
$
36

$
(40
)
$
(4
)
 
$
49

$
(37
)
$
12

Business
27

(13
)
14

 
49

(10
)
39

Total commercial lending