10-K 1 fcbc_10k-123112.htm FORM 10-K fcbc_10k-123112.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2012
or

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 000-14412

 
Farmers Capital Bank Corporation
 
 
(Exact name of registrant as specified in its charter)
 

Kentucky
 
61-1017851
(State or other jurisdiction of
 incorporation or organization)
 
(I.R.S. Employer
Identification Number)

P.O. Box 309, 202 West Main St.
   
Frankfort, Kentucky
 
40601
(Address of principal executive offices)
 
(Zip Code)

Registrant's telephone number, including area code: (502) 227-1600

Securities registered pursuant to Section 12(b) of the Act:

Common Stock - $.125 per share Par Value
 
The NASDAQ Global Select Market
(Title of each class)
 
(Name of each exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act:

 
None
 
 
(Title of Class)
 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  o
 
No  x

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  x

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  x
 
No  o

 
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Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  x
 
No  o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) 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. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o
 
Accelerated filer o
Non-accelerated filer x
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act)

Yes  o
 
No  x

The aggregate market value of the registrant’s outstanding voting stock held by non-affiliates on June 30, 2012 (the last business day of the registrant’s most recently completed second fiscal quarter) was $44.8 million based on the closing price per share of the registrant’s common stock reported on the NASDAQ.

As of March 1, 2013 there were 7,469,813 shares of common stock outstanding.

Documents incorporated by reference:

Portions of the Registrant’s Proxy Statement relating to the Registrant’s 2013 Annual Meeting of Shareholders are incorporated by reference into Part III.

An index of exhibits filed with this Form 10-K can be found on page 138.
 
 
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FARMERS CAPITAL BANK CORPORATION
FORM 10-K
INDEX

   
Page
 
Part I
 
     
Item 1.
Business
4
Item 1A.
Risk Factors
24
Item 1B.
Unresolved Staff Comments
35
Item 2.
Properties
35
Item 3.
Legal Proceedings
37
Item 4.
Mine Safety Disclosures
37
     
 
Part II
 
     
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
37
Item 6.
Selected Financial Data
40
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
41
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
79
Item 8.
Financial Statements and Supplementary Data
80
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
131
Item 9A.
Controls and Procedures
132
Item 9B.
Other Information
133
     
 
Part III
 
     
Item 10.
Directors, Executive Officers and Corporate Governance
133
Item 11.
Executive Compensation
134
Item 12.
Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters
134
Item 13.
Certain Relationships and Related Transactions, and Director Independence
134
Item 14.
Principal Accounting Fees and Services
134
     
 
Part IV
 
     
Item 15.
Exhibits, Financial Statement Schedules
134
     
Signatures
137
Index of Exhibits
138
 
 
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PART I

Item 1. Business

The disclosures set forth in this item are qualified by Item 1A (“Risk Factors”) beginning on page 24 and the section captioned “Forward-Looking Statements” in Item 7 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations”) beginning on page 42 of this report and other cautionary statements contained elsewhere in this report.

Organization
Farmers Capital Bank Corporation (the “Registrant,” “Company,” “we,” “us,” or “Parent Company”) is a bank holding company with four wholly-owned bank subsidiaries.  The Registrant was originally formed as a bank holding company under the Bank Holding Company Act of 1956, as amended, on October 28, 1982 under the laws of the Commonwealth of Kentucky (“Commonwealth”).  During 2000, the Federal Reserve Board (“Federal Reserve” or “FRB”) granted the Company financial holding company status. The Company withdrew its financial holding company election subsequent to the sale of KHL Holdings, LLC (“KHL Holdings”) during the third quarter of 2009. The Company’s subsidiaries provide a wide range of banking and bank-related services to customers throughout Central and Northern Kentucky.  The Company’s four bank subsidiaries include Farmers Bank & Capital Trust Company ("Farmers Bank"), Frankfort, Kentucky; United Bank & Trust Company ("United Bank"), Versailles, Kentucky; First Citizens Bank (“First Citizens”), Elizabethtown, Kentucky; and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”), Newport, Kentucky. The Lawrenceburg Bank and Trust Company ("Lawrenceburg Bank"), Lawrenceburg, Kentucky, which previously was a separate bank subsidiary of the Parent Company, was merged into Farmers Bank during the second quarter of 2010.

The Company also owns FCB Services, Inc., ("FCB Services"), a nonbank data processing subsidiary located in Frankfort, Kentucky; FFKT Insurance Services, Inc., (“FFKT Insurance”), a captive property and casualty insurance company in Frankfort, Kentucky; EKT Properties, Inc., established during 2008 to manage and liquidate certain real estate properties repossessed by the Company; and Farmers Capital Bank Trust I (“Trust I”), Farmers Capital Bank Trust II (“Trust II”), and Farmers Capital Bank Trust III (“Trust III”), which are unconsolidated trusts established to complete the private offering of trust preferred securities. In the case of Trust I and Trust II, the proceeds of the offerings were used to finance the cash portion of the acquisition in 2005 of Citizens Bancorp Inc. (“Citizens Bancorp”), the former parent company of Citizens Northern. For Trust III, the proceeds of the offering were used to finance the cost of acquiring Company shares under a share repurchase program during 2007.

Kentucky General Holdings, LLC, (“Kentucky General”), in Frankfort, Kentucky, was a nonbank subsidiary of the Parent Company until it was dissolved during the third quarter of 2010. During 2009 Kentucky General sold its entire interest in KHL Holdings, the parent company of Kentucky Home Life Insurance Company (“KHL Insurance”).

The Company provides a broad range of financial services at its 36 locations in 23 communities throughout Central and Northern Kentucky to individual, business, agriculture, government, and educational customers. Its primary deposit products are checking, savings, and term certificate accounts.  Its primary lending products are residential mortgage, commercial lending, and consumer installment loans. Substantially all loans and leases are secured by specific items of collateral including business assets, consumer assets, and commercial and residential real estate. Commercial loans and leases are expected to be repaid from cash flow from operations of businesses. Other services provided by the Company include, but are not limited to, cash management services, issuing letters of credit, safe deposit box rental, and providing funds transfer services.  Other financial instruments, which potentially represent concentrations of credit risk, include deposit accounts in other financial institutions and federal funds sold.

While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis.   Operating segments are aggregated into one as operating results for all segments are similar. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.  As of December 31, 2012, the Company had $1.8 billion in consolidated assets.
 
 
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Organization Chart
Subsidiaries of Farmers Capital Bank Corporation at December 31, 2012 are indicated in the table that follows. Percentages reflect the ownership interest held by the parent company of each of the subsidiaries. Tier 2 subsidiaries are direct subsidiaries of Farmers Capital Bank Corporation. Tier 3 subsidiaries are direct subsidiaries of the Tier 2 subsidiary listed immediately above them. Tier 4 subsidiaries are direct subsidiaries of the Tier 3 subsidiary listed immediately above them. Tier 5 subsidiaries are direct subsidiaries of the Tier 4 subsidiary listed immediately above them.

Tier
Entity
1
Farmers Capital Bank Corporation, Frankfort, KY (Parent Company)
     
2
 
United Bank & Trust Company, Versailles, KY 100%
3
   
EGT Properties, Inc., Georgetown, KY 100%
4
     
WCO, LLC, Versailles, KY 6.6%
4
     
NUBT Properties, LLC, Georgetown, KY 83%
5
     
Flowing Creek Realty, LLC, Bloomfield, IN 67%
     
2
 
Farmers Bank & Capital Trust Company, Frankfort, KY 100%
3
   
Farmers Bank Realty Co., Frankfort, KY 100%
3
   
Leasing One Corporation, Frankfort, KY 100%
3
   
EG Properties, Inc., Frankfort, KY 100%
4
     
WCO, LLC, Versailles, KY 93.4%
3
   
FORE Realty, LLC, Frankfort, KY 100%
3
   
Austin Park Apartments, LTD, Frankfort, KY 99%
3
   
Frankfort Apartments II, LTD, Frankfort, KY 99.9%
3
   
St. Clair Properties, LLC, Frankfort, KY 95%
3
   
Farmers Capital Insurance Corporation, Frankfort, KY 100%
4
     
Farmers Fidelity Insurance Agency, LLP, Lexington, KY 50%
         
2
 
First Citizens Bank, Elizabethtown, KY 100%
3
   
HBJ Properties, LLC, Elizabethtown, KY 100%
       
2
 
Citizens Bank of Northern Kentucky, Inc., Newport, KY 100%
3
   
ENKY Properties, Inc., Newport, KY 100%
4
     
NUBT Properties, LLC, Georgetown, KY 17%
5
     
Flowing Creek Realty, LLC, Bloomfield, IN 67%
       
2
 
FCB Services, Inc., Frankfort, KY 100%
     
2
 
FFKT Insurance Services, Inc., Frankfort, KY 100%
       
2
 
Farmers Capital Bank Trust I, Frankfort, KY 100%
     
2
 
Farmers Capital Bank Trust II, Frankfort, KY 100%
     
2
 
Farmers Capital Bank Trust III, Frankfort, KY 100%
     
2
 
EKT Properties, Inc. Frankfort, KY 100%
 
 
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Farmers Bank
Farmers Bank, originally organized in 1850, is a state chartered bank engaged in a wide range of commercial and personal banking activities, which include accepting savings, time and demand deposits; making secured and unsecured loans to corporations, individuals and others; providing cash management services to corporate and individual customers; issuing letters of credit; renting safe deposit boxes; and providing funds transfer services.  The bank's lending activities include making commercial, construction, mortgage, and personal loans and lines of credit.  The bank serves as an agent in providing credit card loans.  It acts as trustee of personal trusts, as executor of estates, as trustee for employee benefit trusts and as registrar, transfer agent and paying agent for bond issues.

Until mid-2011, Farmers Bank had served as the general depository for the Commonwealth for more than 70 years. The Company learned in the first quarter of 2011 that the Commonwealth awarded its general depository services contract to a large multi-national bank. Farmers Bank held the previous contract which had an original termination date of June 30, 2011, but was extended through December 2011 in order for the Company to continue providing service and assistance during the transition process. An additional extension to June 2012 was made between the two parties during the fourth quarter of 2011. Transaction volumes have decreased significantly since the expiration of the original contract on June 30, 2011. The impact of not retaining the general depository services contract of the Commonwealth did not have a material effect on the Company’s consolidated results of operations, overall liquidity, or net cash flows, although gross cash flows such as for cash on hand, deposits outstanding, and short-term borrowings have decreased. Farmers Bank continues to provide investment and other services to the Commonwealth.

Farmers Bank is the largest bank operating in Franklin County based on total bank deposits in the county.  It conducts business at its principal office and four branches in Frankfort, the capital of Kentucky, as well as two branches in Anderson County, Kentucky, and one branch each in Mercer County, Kentucky and Boyle County, Kentucky.  The market served by Farmers Bank is diverse, and includes government, commerce, finance, industry, medicine, education, and agriculture.  The bank serves many individuals and corporations throughout Central Kentucky.  On December 31, 2012, it had total consolidated assets of $699 million, including loans net of unearned income of $338 million.  On the same date, total deposits were $559 million and shareholders' equity totaled $73.4 million.

On October 23, 2009, the Company announced that it was in the preliminary stages of merging Lawrenceburg Bank into Farmers Bank.  The Company applied for regulatory approval for the merger in the first quarter of 2010 and the merger was effective during the second quarter of 2010.

Farmers Bank had eight active direct subsidiaries at year-end 2012:  Farmers Bank Realty Co. ("Farmers Realty"), Leasing One Corporation ("Leasing One"), Farmers Capital Insurance Corporation (“Farmers Insurance”), EG Properties, Inc. (“EG Properties”), FORE Realty, LLC (“FORE Realty”), St. Clair Properties, LLC (“St. Clair Properties”), Austin Park Apartments, LTD (“Austin Park”), and Frankfort Apartments II, LTD (“Frankfort Apartments”).

Farmers Realty was incorporated in 1978 for the purpose of owning certain real estate used by the Company and Farmers Bank in the ordinary course of business.  Farmers Realty had total assets of $3.7 million on December 31, 2012.

Leasing One was incorporated in August 1993 to operate as a commercial equipment leasing company. At year-end 2012, it had total assets of $7.4 million, including leases net of unearned income of $1.5 million. During 2010, the board of directors of Leasing One reduced the staff and curtailed new lending.  Servicing existing leases and terming out residuals are the extent of its ongoing activity at the present time.

Farmers Insurance was organized in 1988 to engage in insurance activities permitted to the Company under federal and state law.  Farmers Bank capitalized this corporation in December 1998.   Farmers Insurance acts as an agent for Stewart Title Guaranty Company.  At year-end 2012, it had total assets of $565 thousand.  Farmers Insurance holds a 50% interest in Farmers Fidelity Insurance Agency, LLP (“Farmers Fidelity”).  The Creech & Stafford Insurance Agency, Inc., an otherwise unrelated party to the Company, also holds a 50% interest in Farmers Fidelity. Farmers Fidelity is a direct writer of property and casualty coverage, both individual and commercial.

In November 2002, Farmers Bank incorporated EG Properties.  EG Properties is involved in real estate management and liquidation for certain properties repossessed by Farmers Bank.  EG Properties holds a 93.4% interest in WCO, LLC
 
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(“WCO”), which was formed during 2012 to hold certain real estate that has been repossessed by Farmers Bank and United Bank. EG Properties had total assets of $19.5 million at year-end 2012.
 
In July 2008, Farmers Bank incorporated FA Properties which, prior to its dissolution during the fourth quarter of 2011, owned automobiles that were used by the Company and Farmers Bank in the ordinary course of business. FORE Realty and LORE Realty were organized in December 2009 and February 2010, respectively, for the purpose of managing and liquidating certain other properties repossessed by Farmers Bank. At year-end 2012, FORE Realty had total assets of $600 thousand; LORE Realty was dissolved effective January 1, 2011.

Farmers Bank is a limited partner in Austin Park and Frankfort Apartments, two low income housing tax credit partnerships located in Frankfort, Kentucky.  These investments provide for federal income tax credits to the Company.  In December 2009, Farmers Bank became a limited partner in St. Clair Properties. The objective of St. Clair Properties is to restore and preserve certain qualifying historic structures in Frankfort for which the Company receives federal and state tax credits. Farmers Bank’s cumulative share of losses from the three partnerships at year-end 2012 has exceeded the amount invested by an aggregate amount of $54 thousand.

Lawrenceburg Bank
On June 28, 1985, the Company acquired Lawrenceburg Bank, a state chartered bank originally organized in 1885 in Anderson County. As mentioned above, Lawrenceburg Bank was merged into Farmers Bank during the second quarter of 2010. Based on deposits at its Anderson County locations, Farmers Bank has the largest market presence in Anderson County.

United Bank
On February 15, 1985, the Company acquired United Bank, a state chartered bank originally organized in 1880.  It is engaged in a general banking business providing full service banking to individuals, businesses and governmental customers.  On November 1, 2008, the Company merged Farmers Bank & Trust Company (“Farmers Georgetown”) and Citizens Bank of Jessamine County (“Citizens Jessamine”) into United Bank. Each of these three banks was previously a wholly-owned subsidiary of the Company. United Bank conducts business in its principal office and two branches in Woodford County, Kentucky, four branches in Scott County, Kentucky, two branches in Fayette County, Kentucky, and four branches in Jessamine County, Kentucky.  Based on total bank deposits in Woodford County, United Bank is the largest bank operating in Woodford County. On December 31, 2012, United Bank had total consolidated assets of $540 million, including loans net of unearned income of $296 million. On the same date, total deposits were $405 million and shareholders’ equity was $60.4 million.

United Bank had one direct subsidiary during 2012, EGT Properties, Inc. (“EGT Properties”). EGT Properties was created in March 2008 and is involved in real estate management and liquidation for certain repossessed properties of United Bank.  In addition, EGT Properties holds an 83% interest in NUBT Properties, LLC (“NUBT”), the parent company of Flowing Creek Realty, LLC (“Flowing Creek”). Flowing Creek holds certain real estate that has been repossessed by United Bank and Citizens Northern along with parties unrelated to the Company. NUBT holds a 67% interest in Flowing Creek and unrelated financial institutions hold the remaining 33% interest. EGT Properties had total assets of $31.0 million at year-end 2012.

Farmers Georgetown
On June 30, 1986, the Company acquired Farmers Georgetown, a state chartered bank originally organized in 1850 located in Scott County, Kentucky. On November 1, 2008, the Company merged Farmers Georgetown into United Bank. Based on deposits at its Scott County locations, United Bank has the largest market presence in Scott County.

Citizens Jessamine
On October 1, 2006, the Company acquired Citizens National Bancshares (“Citizens Bancshares”), the former one-bank holding company of Citizens Jessamine. Citizens Bancshares was subsequently merged into the Company, leaving Citizens Jessamine as a direct subsidiary of the Company. Citizens Jessamine, organized in 1996 as a national charter bank located in Jessamine County, Kentucky, was merged into United Bank on November 1, 2008.  Based on deposits at its Jessamine County locations, United Bank has the second largest market presence in Jessamine County.

 
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First Citizens
On March 31, 1986, the Company acquired First Citizens, a state chartered bank originally organized in 1964.  It is engaged in a general banking business providing full service banking to individuals, businesses and governmental customers. It conducts business at its main office and three branches in Hardin County, Kentucky along with two branch offices in Bullitt County, Kentucky. First Citizens incorporated HBJ Properties, LLC (“HBJ Properties”) during 2012 to hold, manage, and liquidate certain properties repossessed by First Citizens. HBJ Properties had total assets of $4.4 million at year-end 2012.

On October 8, 2004, First Citizens acquired Financial National Electronic Transfer, Inc. (“FiNET”), a data processing company that specializes in the processing of federal benefit payments and military allotments, headquartered in Radcliff, Kentucky.  Effective January 1, 2005 FiNET was merged into First Citizens. These services are now operated using the name of FirstNet.

On November 2, 2006, First Citizens announced the signing of a definitive agreement to acquire the military allotment operation of PNC Bank, National Association based in Elizabethtown, Kentucky. The operation specializes in the processing of data associated with military allotments and federal benefit payments. The transaction was completed on January 12, 2007 and merged into First Citizens and its FirstNet operations.

Based on total bank deposits in Hardin County, First Citizens ranks fourth in size compared to all banks operating in Hardin County.  On December 31, 2012, First Citizens had total consolidated assets of $310 million, including loans net of unearned income of $203 million. On the same date, total deposits were $268 million and shareholders’ equity was $30.1 million.

Citizens Northern
On December 6, 2005, the Company acquired Citizens Bancorp in Newport, Kentucky.  Citizens Bancorp was subsequently merged into Citizens Acquisition, a former bank holding company subsidiary of the Company. During January 2007, Citizens Acquisition was merged into the Company, leaving Citizens Northern as a direct subsidiary of the Company. Citizens Northern is a state chartered bank organized in 1993 and is engaged in a general banking business providing full service banking to individuals, businesses, and governmental customers.  It conducts business in its principal office in Newport and four branches in Campbell County, Kentucky, one branch in Boone County, Kentucky and two branches in Kenton County, Kentucky. Based on total bank deposits in Campbell County, Citizens Northern ranks fourth in size compared to all banks operating in Campbell County.  At year-end 2012, Citizens Northern had total consolidated assets of $251 million, including loans net of unearned income of $168 million. On the same date, total deposits were $251 million and shareholders’ equity was $24.6 million.

In March 2008, Citizens Northern incorporated ENKY Properties, Inc. (“ENKY”). ENKY was established to manage and liquidate certain real estate properties repossessed by Citizens Northern. ENKY also holds a 17% interest in NUBT, the parent company of Flowing Creek. Flowing Creek holds real estate that has been repossessed by Citizens Northern and United Bank along with parties unrelated to the Company. NUBT holds a 67% interest in Flowing Creek and unrelated financial institutions hold the remaining 33% interest. ENKY had total assets of $5.0 million at year-end 2012.

Nonbank Subsidiaries
FCB Services, organized in 1992, provides data processing services and support for the Company and its subsidiaries.  It is located in Frankfort, Kentucky. It also performs data processing services for nonaffiliated entities.  FCB Services had total assets of $4.2 million at December 31, 2012.

Kentucky General was incorporated in November 2004 and previously held a 50% voting interest in KHL Holdings prior to its sale during the third quarter of 2009.  KHL Holdings owned a 100% interest in KHL Insurance that it acquired in 2005. KHL Insurance was a writer of credit life and health insurance in Kentucky. Kentucky General was dissolved during 2010.

EKT was created in September 2008 to manage and liquidate certain real estate properties repossessed by the Company’s subsidiary banks. On December 31, 2012, EKT had total assets of $3.2 million.
 
 
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Kentucky General Life Insurance Company was incorporated during 2000 to engage in insurance activities permitted by federal and state law.  This corporation has remained inactive since its inception and was dissolved during 2010.

Trust I, Trust II, and Trust III are each separate Delaware statutory business trusts sponsored by the Company.  The Company completed two private offerings of trust preferred securities during 2005 through Trust I and Trust II totaling $25.0 million. During 2007, the Company completed a private offering of trust preferred securities totaling $22.5 million. The Company owns all of the common securities of each of the Trusts. The Company does not consolidate the Trusts into its financial statements consistent with applicable accounting standards.

FFKT Insurance was incorporated during 2005. It is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. FFKT Insurance had total assets of $2.9 million at December 31, 2012.

Lending Summary
A significant part of the Company’s operating activities include originating loans, approximately 89% of which are secured by real estate at December 31, 2012.  Real estate lending primarily includes loans secured by owner and non-owner occupied one-to-four family residential properties as well as commercial real estate mortgage loans to developers and owners of other commercial real estate.  Real estate lending primarily includes both variable and adjustable rate products.  Loan rates on variable rate loans generally adjust upward or downward immediately based on changes in the loan’s index, normally prime rate as published by the Wall Street Journal.  Rates on adjustable rate loans move upward or downward after an initial fixed term of normally one, three, or five years. Rate adjustments on adjustable rate loans are made annually after the initial fixed term expires and are indexed mainly to shorter-term Treasury indexes.  Generally, variable and adjustable rate loans contain provisions that cap the amount of interest rate increases of up to 600 basis points and rate decreases of up to 100 basis points over the life of the loan. Over the past year, it has been increasingly common for the Company to set the floor equal to the initial rate without further downward adjustments. In addition to the lifetime caps and floors on rate adjustments, loans secured by residential real estate typically contain provisions that limit annual increases at a maximum of 100 basis points. There is typically no annual limit applied to loans secured by commercial real estate.

The Company also makes fixed rate commercial real estate loans to a lesser extent with repayment periods generally ranging from three to five years.  The Company’s subsidiary banks make first and second residential mortgage loans secured by real estate not to exceed 90% loan to value without seeking third party guarantees.  Commercial real estate loans are made primarily to small and mid-sized businesses, secured by real estate not exceeding 80% loan to value.  Other commercial loans are asset based loans secured by equipment and lines of credit secured by receivables and include lending across a diverse range of business types.

Commercial lending and real estate construction lending, including commercial leasing, generally includes a higher degree of credit risk than other loans, such as residential mortgage loans.  Commercial loans, like other loans, are evaluated at the time of approval to determine the adequacy of repayment sources and collateral requirements.  Collateral requirements vary to some degree among borrowers and depend on the borrower’s financial strength, the terms and amount of the loan, and collateral available to secure the loan.  Credit risk results from the decreased ability or willingness to pay by a borrower.  Credit risk also results when a liquidation of collateral occurs and there is a shortfall in collateral value as compared to a loan’s outstanding balance.  For construction loans, inaccurate initial estimates of a project’s costs or the property’s completed value could weaken the Company’s position and lead to the property having a value that is insufficient to satisfy full payment of the amount of funds advanced for the property.  Secured and unsecured direct consumer lending generally is made for automobiles, boats, and other motor vehicles.  The Company does not presently engage in indirect consumer lending. Credit card lending is limited to one affiliate and is considered nominal risk exposure due to extremely low volume. In most cases loans are restricted to the subsidiaries' general market area.

Loan Policy
The Company has a company-wide lending policy in place that is amended and approved from time to time as needed to reflect current economic conditions, law and regulatory changes, and product offerings in its markets.  The policy has established minimum standards that each of its bank subsidiaries must adopt. Additionally, the policy is subject to amendment based on positive and negative trends observed within the lending portfolio as a whole.  As an example, the loan to value limits and amortization terms contained within the policy were reduced during 2009 due to the declining
 
9

 

economy and related real estate market decline.  While new appraisals now reflect that decline, appraisal reviews and downward adjustments are a continuing area of focus to reduce credit risk.  The lending policy is evaluated for underwriting criteria by the Company’s internal audit department in its loan review capacity as well as by the Company’s Chief Credit Officer and its regulatory authorities.  Suggested revisions from these groups are taken into account, analyzed, and implemented by management where improvements are warranted.
 
The Company’s subsidiary banks may amend their lending policy so long as the amendment is no less stringent than the company-wide lending policy. These amendments are done within the control structure and oversight of the parent company.  The Company’s board of directors approved a recommendation from management during 2009 to create the position of Chief Credit Officer.  This position oversees all lending at affiliate institutions where the size and risk of individual credits are deemed significant to the Company.  The Chief Credit Officer also monitors trends in asset quality, portfolio composition, concentrations of credit, reports of examinations, internal audit reports, work-out strategies for large credits, and other responsibilities as matters evolve.

The Company’s Chief Credit Officer analyzes all loans in excess of $2.5 million prior to it being presented to the board of directors of the originating affiliate bank. All new loans, regardless of the amount, to an existing credit relationship in excess of $2.5 million are also analyzed by the Chief Credit Officer prior to being presented to the board of directors of the affiliate for consideration. The Chief Credit Officer reviews all loans to insiders for adherence to underwriting standards and regulatory compliance as well as credits identified as substandard.

Procedures
The lending policy lists the products and credit services offered by each of the Company’s subsidiary banks.   Each product and service has an established written procedure to adhere to when transacting business with a customer.   The lending policy also establishes pre-determined lending authorities for loan officers commensurate with their abilities and experience.  Further, the policy establishes committees to review and approve or deny credit requests at various lending amounts.  This includes subcommittees of the bank boards of directors and, at certain lending levels, the entire bank board.

Generally, for loans in excess of $2.5 million, the subsidiaries bank’s full board of directors will be presented with the loan request. This only occurs when the potential credit has first been recommended by the loan officer and chief credit officer of the subsidiary bank, and then by the directors’ loan committee and the Chief Credit Officer.  When loan requests are within policy guidelines and the amount requested is within their lending authority, lenders are permitted to approve and close the transaction.  A review of the loan file and documentation takes place within 30 days to ensure policy and procedures are being followed.  Approval authorities are under regular review for adjustment by affiliate management and the Parent Company.  Loan requests outside of standard policy may be made on a case by case basis when justified, documented, and approved by either the board of directors of the subsidiary bank, committee, or other authorized person as determined by the size of the transaction. Procedures are in place that requires ongoing monitoring subsequent to loan approval. For example, updated financial statements are required periodically for certain types of credits and risk ratings are re-evaluated at least annually for credit relationships in excess of $500 thousand, which includes analyzing updated cash flows and loan to value ratios.

Underwriting
Underwriting criteria for all types of loans are prescribed within the lending policy.

Residential Real Estate
Residential real estate mortgage lending made up 37% of the loan portfolio at year-end 2012.  Underwriting criteria and procedures for residential real estate mortgage loans include:

 
·
Monthly debt payments of the borrower to gross monthly income should not exceed 45% with stable employment;
 
·
Interest rate shocks are applied for variable rate loans to determine repayment capabilities at elevated rates;
 
·
Loan to value limits of up to 90%. Loan to value ratios exceeding 90% require additional third party guarantees;
 
·
A thorough credit investigation using the three nationally available credit repositories;
 
·
Incomes and employment is verified;
 
 
10

 
 
 
·
Insurance is required in an amount to fully replace the improvements with the lending bank named as loss payee/mortgagee;
 
·
Flood certifications are procured to ensure the improvements are not in a flood plain or are insured if they are within the flood plain boundaries;
 
·
Collateral is investigated using current appraisals and is supplemented by the loan officer’s knowledge of the locale and salient factors of the local market.  Only appraisers which are state certified or licensed and on the banks’ approved list are utilized to perform this service;
 
·
Title attorneys and closing agents are required to maintain malpractice liability insurance and be on the banks approved list;
 
·
Secondary market mortgages must meet the underwriting criteria of the purchasers, which is generally the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation;
 
·
Adjustable rate owner occupied home loans are tied to market based rates such as are published by the Federal Reserve, commonly the one year constant maturity Treasury bill is used; and
 
·
Residential real estate mortgage loans are made for terms not to exceed 30 years.

Commercial Real Estate
Commercial real estate lending made up 42% of the loan portfolio at year-end 2012. Commercial real estate lending underwriting criteria is documented in the lending policy and includes loans secured by office buildings, retail stores, warehouses, hotels, and other commercial properties. Underwriting criteria and procedures for commercial real estate loans include:

 
·
Procurement of Federal income tax returns and financial statements for the past 3 years and related supplemental information deemed relevant;
 
·
Detailed financial and credit analysis is performed and presented to various committees;
 
·
Cash investment from the applicant in an amount equal to 20% of cost (loan to value ratio not to exceed 80%).  Additional collateral may be taken in lieu of a full 20% investment in limited circumstances;
 
·
Cash flows from the project financed and global cash flow of the principals and their entities must produce a minimum debt coverage ratio of 1.25:1;
 
·
Past experience of the customer with the bank;
 
·
Experience of the investor in commercial real estate;
 
·
Tangible net worth analysis;
 
·
Interest rate shocks for variable rate loans;
 
·
General and local commercial real estate conditions;
 
·
Alternative uses of the security in the event of a default;
 
·
Thorough analysis of appraisals;
 
·
References and resumes are procured for background knowledge of the principals/guarantors;
 
·
Credit enhancements are utilized when necessary and/or desirable such as assignments of life insurance and the use of guarantors and firm take-out commitments;
 
·
Frequent financial reporting is required for income generating real estate such as:  rent rolls, tenant listings, average daily rates and occupancy rates for hotels;
 
·
Commercial real estate loans are made with amortization terms not to exceed 20 years; and
 
·
For lending arrangements determined to be more complex, loan agreements with financial and collateral representations and warranties are employed to ensure the ongoing viability of the borrower.

Real Estate Construction
The Company’s real estate construction lending has declined over the last several years due to recent economic conditions. Where the Company’s markets continue to demonstrate demand, construction lending continues with close monitoring of the borrower and the local economy. At year-end 2012, real estate construction lending comprised approximately 10% of the total loan portfolio.
 
Real estate construction lending underwriting criteria is documented in the lending policy and includes loans to individuals for home construction, loans to businesses primarily for the construction of owner-occupied commercial real estate, and for land development activities. Underwriting criteria and procedures for such lending include:
 
 
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·
20% capital injection from the applicant (loan to value ratio not to exceed 80%);
 
·
25% capital injection for land acquisition for development (loan to value ratio not to exceed 75%);
 
·
Pre-sell, pre-lease, and take-out commitments are procured and evaluated/verified;
 
·
Draw requests require documentation of expenses;
 
·
On site progress inspections are completed to protect the lending bank affiliate;
 
·
Control procedures are in place to minimize risk on construction projects such as conducting lien searches and requiring affidavits;
 
·
Lender on site visits and periodic financial discussions with owners/operators; and
 
·
Real estate construction loans are made for terms not to exceed 12 months and 18 months for residential and commercial purposes, respectively.

Commercial, Financial, and Agriculture
Commercial, financial, and agriculture lending underwriting criteria is documented in the lending policy and includes loans to small and medium sized businesses secured by business assets, loans to financial institutions, and loans to farmers and for the production of agriculture. At year-end 2012, these loans made up approximately 9% of the total loan portfolio Underwriting criteria and procedures for such loans are detailed below.

For commercial loans secured by business assets, the following loan to value ratios and debt coverage are required by policy:

 
·
Inventory 50%;
 
·
Accounts receivable less than 90 days past due 75%;
 
·
Furniture, fixtures, and equipment 60%;
 
·
Borrowing-base certificates are required for monitoring asset based loans;
 
·
Stocks, bonds, and mutual funds are often pledged by business owners. Marketability and volatility is taken into account when valuing these types of collateral and lending is generally limited to 60% of their value;
 
·
Debt coverage ratios from cash flows must meet the policy minimum of 1.25:1.  This coverage applies to global cash flow and guarantors, if any; and
 
·
Commercial loans secured by business assets are made for terms to match the economic useful lives of the asset securing the loan. Loans secured by furniture, fixtures, and equipment are made for terms not to exceed seven years. Lien searches are performed to ensure lien priority for credits exceeding certain thresholds.

Loans to financial institutions are generally secured by the capital stock of the financial institution with a loan to value ratio not to exceed 60% and repayment terms not exceeding 10 years. Capital stock values of non-public companies are determined by common metrics such as a multiple of tangible book value or by obtaining third party estimates. Financial covenants are also obtained that require the borrower to maintain certain levels of asset quality, capital adequacy, liquidity, profitability, and regulatory compliance. At year-end 2012, loans to financial institutions were $12.9 million.

Agricultural lending, such as for tobacco or corn, is limited to 75% of expected sales proceeds while lending for cattle and farm equipment is capped at 80% loan to value.

Interest Only Loans
Interest only loans are limited to construction lending and properties recently completed and undergoing an occupancy stabilization period.  These loans are short-term in nature, usually with maturities of less than one year.

Installment Loans
Installment lending is a small component of the Company’s portfolio mix, reflecting less than 2% of outstanding loans at year-end 2012. These loans predominantly are direct loans to established bank customers and primarily include the financing of automobiles, boats, and other consumer goods. The character, capacity, collateral, and conditions are evaluated using policy restraints. Installment loans are made for terms of up to 5 years.

 
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Installment lending underwriting criteria and procedures for such financing include:

 
·
Required financial statement of the applicant for loans in excess of $20,000;
 
·
Past experience of the customer with the bank and other creditors of the applicant;
 
·
Monthly debt payments of the borrower to gross monthly income should not exceed 45% with stable employment;
 
·
Secured and unsecured loans are made with a definite repayment plan which coincides with the purpose of the loan;
 
·
Borrower’s unsecured debt must not exceed 25% of the borrower’s net worth; and
 
·
Verification of borrower’s credit and income.

Lease Financing
Lease financing is a small component of the Company’s portfolio, representing less than 1% of outstanding loans at year-end 2012.  Lease receivables are generally obtained through indirect sources such as equipment brokers and dealers.  The board of directors of the Company’s Leasing One subsidiary has reduced the staff and curtailed new leasing transactions for the foreseeable future.  Servicing existing leases and terming out residuals are the extent of its ongoing activity at the present time.

Lease financing underwriting criteria is documented by policy. Underwriting criteria and procedures for such financing include:

 
·
Lessee must be a commercial entity;
 
·
Lessee must be in business for a minimum of two years;
 
·
Leased equipment must be of essential use to lessee’s business;
 
·
Residual positions taken will not exceed 20% of original equipment cost;
 
·
Leasing terms generally not to exceed five years; used equipment and computers not to exceed three years;
 
·
Personal and/or corporate financial statements or tax returns required for all financing requests. Submission of updated financial statements annually;
 
·
Credit reports must be clear of judgments and bankruptcies and chronic delinquency paying habits; and
 
·
Bank and trade references must report satisfactory references.

Hybrid Loans
The Company and its subsidiary banks have a policy of not underwriting, originating, selling or holding hybrid loans.  The Company does not currently hold hybrid loans.  Hybrid loans include payment option adjustable rate mortgages (ARM’s), negative amortization loans, and stated income/stated asset loans.

Appraisals
The values of real estate in the Company’s markets are beginning to stabilize, but overall levels have generally declined during the economic downturn which accelerated in 2008. Net loan charge-offs have been negatively impacted in recent years by slower sales and excess inventory related to loans secured by real estate. The slower sales and excess inventory has decreased the cash flow and financial prospects of many borrowers, particularly those in the real estate development and related industries, and reduced the estimated fair value of the collateral securing these loans.

The Company uses independent third party state certified or licensed appraisers. These appraisers take into account local market conditions when preparing their estimate of a properties fair value. The Company evaluates appraisals it receives from independent third parties subsequent to the appraisal date by monitoring transactions in its markets and comparing them to its other projects that are similar in nature. The Company’s internal audit department reviews appraisals on a test basis to determine that assumptions used in appraisals remain valid and are not stale. New appraisals are obtained if market conditions significantly impact collateral values for those loans that are identified as impaired. Internal audit reviews appraisals related to all of the Company’s impaired loans and repossessed properties at least annually.

The Company considers appraisals it receives on one property as a means to extrapolate the estimated value for other collateral of similar characteristics if that property may not otherwise have a need for an appraisal. Should a borrower’s financial condition continue to deteriorate, an updated appraisal on that specific collateral will be obtained.
 
 
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Appraisals obtained for construction and development lending purposes are performed by state licensed or state certified appraisers who are credentialed and on the Company’s approved list.  Plans and specifications are provided to the appraiser by bank personnel not directly involved in the credit approval process.  The appraisals conform to the standards of appraisal practices established by the Appraisal Standards Board in effect at the time of the appraisal. This includes net present value accounting for construction and development loans on an “as completed” and “as is” basis.

Appraisal reviews are conducted internally by bank personnel familiar with the local market and who are not directly involved in the credit approval process and externally by state licensed and certified appraisers.  Bank personnel do not increase the valuation from the appraisal but may, in some instances, make a reduction. Upon completion, a follow up site visit by the appraiser is completed to verify the property was improved in accordance with the original plans and specifications and recertify, if appropriate, the original estimate of “as completed” market value.  Circumstances where management may make adjustments to appraisals include the following:

As discussed above, construction and development appraisals are on an “as completed” basis.  If work remains to be completed on a financed project, management will reduce the estimated value in the appraisal by the estimated cost to complete the work and, if required by the loan balance, establish reserves allocated to the loan or write down the loan based on the need to complete such work.

If an appraisal for given collateral is still valid (e.g. less than one year old, etc.), but due to market conditions and the bank’s familiarity with comparable property sales in the market the appraised value appears high, management may adjust downward from the last appraisal its estimate of the value of the collateral and, in turn, establish reserves allocated to the loan or write down the loan to reflect this downward adjustment.

Certain appraisals such as for subdivision development and for other projects expected to take over one year to liquidate, are required to include estimated costs to sell. For others, management adjusts the appraised value by the estimated selling costs when they are either absent or not required. Additional reserves or direct write downs are made to the loan to reflect these adjustments.

Loan to value ratios are typically well under 100% at inception, which gives the Company a cushion as collateral values fall.  However, when updated appraisals reveal collateral exposure (i.e. the value of the collateral for a nonperforming loan is less than originally estimated and no longer supports the outstanding loan amount), negotiations ensue with the borrower aimed at providing additional collateral support for the credit.  This may be in many forms as determined by the financial holdings of the borrower.  If not available, third party support for the credit is pursued (e.g., guarantors or equity investors).  If negotiations fail to provide additional adequate collateral support, reserves are allocated to the loan or the loan is written down to the fair value of the collateral less the estimated costs to sell.

When a construction loan or development loan is downgraded, a new appraisal is ordered contemporaneously with the downgrade.  The appraisers are instructed to give a fair value based upon both an “as is” basis and an “as completed” basis.  The twofold purpose is to facilitate management’s decision making process in determining the cost benefits of completing a project compared with marketing the project as is.

The carrying value of a downgraded loan or nonperforming asset wherein the underlying collateral is an incomplete project is based on an updated appraisal at the “as is” value.  The current appraisal is a compilation of the most recent sales available and therefore includes the risk premium established by market conditions.  When the comparable sales are not deemed to be reliable or the adjustments are not satisfactory, management will make appropriate adjustments to the fair value which includes a risk premium (discount) deducted using the discounted cash flow framework.  The reserve or write down is expended upon completion of the appraisal and other relevant information assessment.

Interest Reserves
Interest reserves represent funds loaned to a borrower for the payment of interest during the development phase on certain construction and development loans. Interest reserves were a common industry practice when banks were more actively lending in their markets and the predictability of a sale or stabilization of the project had a high probability.  The interest reserve is a component of the loan proceeds which is determined at the loan’s inception after a full evaluation of the
 
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sources and uses of funds for the project, and is intended to match the project’s debt service requirements with its expected cash flows. In all construction lending projects, the Company monitors the project to determine if it is being completed as planned and if sales/stabilization projections are being met.
 
As a result of the overall decline in the real estate market during the last several years, the Company has been less active in construction and development lending and the use of the interest reserves. For present and future construction and development loan requests, borrowers must show sufficient cash reserves and significant excess cash flow from all sources in addition to other underwriting criteria measures.  The projects viability is a major consideration as well, along with the probability of its stabilization and/or sale. Due to the general lack of risk appropriate opportunities currently in our markets combined with our low desire for this segment of the lending portfolio, interest reserves are not commonplace.

Supervision and Regulation
The Company and its subsidiaries are subject to comprehensive supervision and regulation that affect virtually all aspects of their operations. These laws and regulations are primarily intended for the protection of depositors, borrowers, and federal deposit insurance funds, and, to a lesser extent, for the protection of stockholders and creditors. Changes in applicable laws, regulations, or in the policies of banking and other government regulators may have a material adverse effect on our current or future business. The following summarizes certain of the more important aspects of the relevant statutory and regulatory provisions.
 
Supervisory Authorities
The Company is a bank holding company, registered with and regulated by the Federal Reserve. All four of its subsidiary banks are Kentucky state-chartered banks. Two of the Company’s subsidiary banks are members of their regional Federal Reserve Bank. The Company and its subsidiary banks are subject to supervision, regulation and examination by the Federal Reserve, Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The regulatory authorities routinely examine the Company and its subsidiary banks to monitor their compliance with laws and regulations, financial condition, adequacy of capital and reserves, quality and documentation of loans, payment of dividends, adequacy of systems and controls, credit underwriting and asset liability management, and the establishment of branches. The Company and its subsidiary banks are required to file regular reports with the FRB, the FDIC and the KDFI, as applicable.
 
Capital
The FRB, the FDIC, and the KDFI require the Company and its subsidiary banks to meet certain ratios of capital to assets in order to conduct their activities. To be well-capitalized, the institutions must generally maintain a Total Risk-based Capital ratio of 10% or greater, a Tier 1 Risk-based Capital ratio of 6% or greater, and a Tier 1 Leverage ratio of 5% or more. For the purposes of these tests, Tier 1 Capital consists of common equity and related surplus, retained earnings, and a limited amount of qualifying preferred stock, less goodwill (net of certain deferred tax liabilities) and certain core deposit intangibles. Tier 2 Capital consists of non-qualifying preferred stock, certain types of debt and a limited amount of other items. Total Capital is the sum of Tier 1 and Tier 2 Capital.
 
In measuring the adequacy of capital, assets are generally weighted for risk. Certain assets, such as cash and U.S. government securities, have a zero risk weighting. Others, such as commercial and consumer loans, have a 100% risk weighting. Risk weightings are also assigned for off-balance sheet items such as loan commitments. The various items are multiplied by the appropriate risk-weighting to determine risk-adjusted assets for the capital calculations. For the leverage ratio mentioned above, average quarterly assets (as defined) are used and are not risk-weighted.
 
If the institution fails to remain well-capitalized, it will be subject to a series of restrictions that increase as the capital condition worsens. For instance, federal law generally prohibits a depository institution from making any capital distribution, including the payment of a dividend or paying any management fee to its holding company, if the depository institution would be undercapitalized as a result. Undercapitalized depository institutions may not accept brokered deposits absent a waiver from the FDIC, are subject to growth limitations, and are required to submit a capital restoration plan for approval, which must be guaranteed by the institution’s parent holding company. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits
 
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from correspondent banks. Critically undercapitalized institutions are subject to the appointment of a receiver or conservator.
 
In December 2010, the Basel Committee on Banking Supervision issued final rules related to global regulatory standards on bank capital adequacy and liquidity (commonly referred to as “Basel III”) previously agreed on by the Group of Governors and Heads of Supervision (the oversight body of the Basel Committee).  The new rules present details of the Basel III framework, which includes increased capital requirements and limits the types of instruments that can be included in Tier 1 capital. U.S. federal banking agencies issued proposed rules during 2012 seeking to implement Basel III standards effective January 1, 2013. Due to the nature and volume of comments received on the proposed rules, the federal banking agencies announced that the proposed rules would not become effective on the date proposed. There has been no indication of an alternative effective date by the agencies. As such, the dates and phase-in periods of the Basel III framework discussed below will change. Final rules could change significantly from the proposed rules.

Basel III includes the following provisions: (i) that the minimum ratio of common equity to risk-weighted assets be increased to 4.5% from the current level of 2%, to be fully phased in by January 1, 2015, and (ii) that the minimum requirement for the Tier 1 Risk-based capital ratio will be increased from 4% to 6%, to be fully phased in by January 1, 2015. The new minimums were initially set to be phased in starting January 1, 2013.

Basel III also includes a “capital conservation buffer” requiring banking organizations to maintain an additional 2.5% of Tier 1 common equity to total risk-weighted assets in addition to the minimum requirement. This requirement was initially set to be phased in between January 1, 2016 and January 1, 2019. The capital conservation buffer is designed to absorb losses in periods of financial and economic distress and, while banks are allowed to draw on the buffer during periods of stress, if a bank’s regulatory capital ratios approach the minimum requirement, the bank will be subject to more stringent constraints on dividends and bonuses. In addition, Basel III includes a countercyclical buffer of up to 2.5%, which could be imposed by countries to address economies that appear to be building excessive system-wide risks due to rapid growth.

To constrain the build-up of excess leverage in the banking system, Basel III introduces a new non-risk-based leverage ratio. A minimum Tier 1 Leverage ratio of 3% was initially to be tested during a parallel run period between January 1, 2013 and January 1, 2017 with any final adjustments carried out in the first half of 2017 based on the results of the parallel run.

As discussed above, regulatory agencies in the U.S. have yet to adopt final rules for implementing Basel III. Further regulations and guidelines issued by banking regulators may significantly differ from current proposals. The regulatory agencies’ current proposal, if adopted, could have a material negative impact on the Company’s level of capital. In addition to the overall higher levels of required capital, the proposed rules would phase out the inclusion of trust preferred securities from the Company’s regulatory capital base. Unrealized holding gains and losses related to available for sale securities would be included as a component of capital under the current proposal, which could lead to high degree of volatility in regulatory capital calculations. Other significant requirements included in the proposal relate to higher risk-weighting of assets, particularly of loans, which would result in lower capital ratios.

Basel III also includes two separate standards for supervising liquidity risks which include: (i) a “liquidity coverage ratio” designed to ensure that banks have a sufficient amount of high-quality liquid assets to survive a significant liquidity stress scenario over a 30-day period, (ii) a “net stable funding ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon. The liquidity coverage ratio was initially set to become effective on January 1, 2015. The revised net stable funding ratio was to become effective January 1, 2018.

Expansion and Activity Limitations
With prior regulatory approval, the Company may acquire other banks or bank holding companies and its subsidiaries may merge with other banks. Acquisitions of banks located in other states may be subject to certain deposit-percentage, age or other restrictions. During the third quarter of 2009, the Company withdrew its financial holding company election upon the sale of its KHL subsidiary. Financial holding companies and their subsidiaries are permitted to engage in expanded activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, broad insurance agency activities, merchant banking, and other nonbanking activities that the FRB determines to be financial in nature or complementary to these activities. The FRB normally requires some form of notice or application to
 
16

 
 
engage in or acquire companies engaged in such activities. Under the Bank Holding Company Act, the Company is generally prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in activities that are deemed not closely related to banking.
 
Limitations on Acquisitions of Bank Holding Companies
In general, other companies seeking to acquire control of a bank holding company such as the Company would require the approval of the FRB under the Bank Holding Company Act. In addition, individuals or groups of individuals seeking to acquire control of a bank holding company such as the Company would need to file a prior notice with the FRB (which the FRB may disapprove under certain circumstances) under the Change in Bank Control Act. Control is conclusively presumed to exist if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Control may exist under the Change in Bank Control Act if the individual or company acquires 10% or more of any class of voting securities of the bank holding company and no shareholder holds a larger percentage of the subject class of voting securities.
 
Deposit Insurance
Each of the Company’s subsidiary banks are members of the FDIC, and their deposits are insured by the FDIC’s Deposit Insurance Fund (“DIF”) up to the amount permitted by law. The Company’s subsidiary banks are thus subject to quarterly FDIC deposit insurance assessments. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating.

In February 2009, the FDIC adopted a long-term DIF restoration plan as well as an additional emergency assessment for 2009. The restoration plan increased base assessment rates for banks in all risk categories with the goal of raising the DIF reserve ratio from its then-current .40% to its statutorily mandated minimum of 1.15% within eight years (as amended). Beginning April 1, 2009, the FDIC established a bank’s initial base assessment rate ranging between 12 and 45 basis points, depending on the banks risk category. The initial base assessment rate was then adjusted higher or lower to obtain the total base assessment rate. Adjustments to the initial base assessment rate were based on a bank’s level of unsecured debt, secured liabilities, and brokered deposits. The total base assessment rate ranged between 7 and 77.5 basis points and applied to a bank’s assessable deposits when computing the FDIC insurance assessment amount.

The FDIC adopted an emergency special assessment in 2009 which superseded its interim rule that would have imposed a 20 basis point assessment with an option for an additional 10 basis point assessment. Under the final rule adopted, the FDIC imposed a special assessment of 5 basis points on a bank’s total assets minus Tier 1 capital as of June 30, 2009 and collected September 30, 2009. The Company paid $1.1 million related to the 2009 special assessment. The final rule also authorized the FDIC to impose up to two additional 5 basis points assessments if needed while capping each assessment at 10 basis points of the banks assessment base.

In addition to the FDIC’s special assessment for 2009, the FDIC in November 2009 approved a final rule requiring banks to prepay their estimated quarterly assessments for the fourth quarter of 2009 as well as all of 2010, 2011, and 2012 on December 30, 2009. The prepayment was adopted by the FDIC in lieu of an additional special assessment as summarized in the preceding paragraph. The assessment rate used for all periods covered in the prepayment plan was the bank’s assessment rate in effect as of September 30, 2009, increased by 3 basis points for all of 2011 and 2012. The prepayment was based on a bank’s regular assessment base (total domestic deposits) as of September 30, 2009, with a quarterly increase of an estimated 5% annual growth rate through the end of 2012. The prepaid assessment is applied against actual future quarterly assessments until exhausted.  Any funds remaining after June 30, 2013 will be returned to the institution.  Requiring this prepaid assessment does not limit the FDIC from changing assessment rates or from further revising the risk-based assessment system. The Company paid $8.2 million on December 30, 2009 related to this assessment. Prepaid FDIC insurance assessments were $2.6 million on December 31, 2012 and included in other assets on the Company’s balance sheet.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) required changes to a number of components of the FDIC insurance assessment that was effective April 1, 2011. The Dodd-Frank Act required the FDIC to adopt a new DIF restoration plan to ensure that the reserve ratio increases to 1.35% from 1.15% of insured deposits by 2020. Under the restoration plan, the FDIC dropped the uniform three-basis point increase in initial assessment rates that was scheduled to take place on January 1, 2011 and adopted new regulations that redefined the assessment base as average consolidated assets less average tangible equity during the assessment period.  Since the new assessment base
 
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resulted in a larger overall base when compared to the domestic deposits base methodology, overall assessments rates have been lowered and the secured liability adjustment has been eliminated from the rate calculation in an attempt to make the new assessments revenue neutral. The new regulations retain the risk category system for depository institutions with less than $10 billion in assets. Under this system, each institution is assigned to one of four risk categories based upon the institution’s capital and supervisory evaluation. At least semi-annually, the FDIC will update its loss and income projections for the DIF and, if needed, increase or decrease assessment rates. In establishing assessments, the FDIC is required to offset the effect of the higher reserve ratio against insured depository institutions with total consolidated assets of less than $10 billion.
 
In addition to deposit insurance assessments, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 possessing assessment powers in addition to the FDIC. The FDIC acts as a collection agent for FICO, whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation. FICO assessment rates are determined quarterly and will continue until the FICO bonds mature in 2017.

During the fourth quarter of 2010, the FDIC issued a final rule implementing provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for noninterest-bearing transaction accounts, which became effective on December 31, 2010 and expired on December 31, 2012. The Dodd-Frank Act also permanently increased the maximum deposit insurance amount available for depositors from $100 thousand to $250 thousand. This coverage is in addition to, and separate from, the temporary unlimited coverage for noninterest-bearing transaction accounts that expired at year-end 2012.

Other Statutes and Regulations
The Company and its subsidiary banks are subject to numerous other statutes and regulations affecting their activities. Some of the more important are:
 
Anti-Money Laundering. Financial institutions are required to establish anti-money laundering programs that must include the development of internal policies, procedures, and controls; the designation of a compliance officer; an ongoing employee training program; and an independent audit function to test the performance of the programs. The Company and its subsidiary banks are also subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers.  Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships in order to guard against money laundering and to report any suspicious transactions. Recent laws provide law enforcement authorities with increased access to financial information maintained by banks.
 
Sections 23A and 23B of the Federal Reserve Act. The Company’s subsidiary banks are limited in their ability to lend funds or engage in transactions with the Company or other nonbank affiliates of the Company, and all transactions must be on an arm’s-length basis and on terms at least as favorable to the subsidiary bank as prevailing at the time for transactions with unaffiliated companies.
 
Dividends. The Parent Company’s principal source of cash flow, including cash flow to pay dividends to its shareholders, is the dividends that it receives from its subsidiary banks. Statutory and regulatory limitations apply to the subsidiary banks’ payments of dividends to the Parent Company as well as to the Parent Company’s payment of dividends to its shareholders. A depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. The federal banking agencies may prevent the payment of a dividend if they determine that the payment would be an unsafe and unsound banking practice. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings. The Parent Company and certain of its bank subsidiaries are currently under regulatory orders that restrict the payment of dividends. For further information please refer to the caption “Recent Regulatory Events and Increased Capital Requirements” below.

The Company’s outstanding Series A preferred stock was issued under the Capital Purchase Program (“CPP”) during the first quarter of 2009 and includes restrictions on the Company’s ability to pay dividends to its common shareholders. The
 
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Company is unable to declare dividend payments on shares of its common stock if it is in arrears on the dividends on its Series A preferred stock.
 
Community Reinvestment Act. The Company’s subsidiary banks are subject to the provisions of the Community Reinvestment Act of 1977 (“CRA”), as amended, and the federal banking agencies’ related regulations, stating that all banks have a continuing and affirmative obligation, consistent with safe and sound operations, to help meet the credit needs for their entire communities, including low and moderate-income neighborhoods. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution or its evaluation of certain regulatory applications, to evaluate the institution’s record in assessing and meeting the credit needs of the community served by that institution, including low and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public.

Insurance Regulation.  The Company’s subsidiaries that may underwrite or sell insurance products are subject to regulation by the Kentucky Department of Insurance.
 
Consumer Regulation.  The activities of the Company and its bank subsidiaries are subject to a variety of statutes and regulations designed to protect consumers. These laws and regulations:
 
 
·
limit the interest and other charges collected or contracted for by all of the Company’s subsidiary banks;
 
·
govern disclosures of credit terms to consumer borrowers;
 
·
require financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
 
·
prohibit discrimination on the basis of race, creed, or other prohibited factors in extending credit;
 
·
require all of the Company’s subsidiary banks to safeguard the personal non-public information of its customers, provide annual notices to consumers regarding the usage and sharing of such information and limit disclosure of such information to third parties except under specific circumstances; and
 
·
govern the manner in which consumer debts may be collected by collection agencies.
 
The deposit operations of the Company’s subsidiary banks are also subject to laws and regulations that:
 
 
·
require disclosure of the interest rate and other terms of consumer deposit accounts;
 
·
impose a duty to maintain the confidentiality of consumer financial records and prescribe procedures for complying with administrative subpoenas of financial records; and
 
·
govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.

Emergency Economic Stabilization Act of 2008 (“EESA”). EESA was signed into law on October 3, 2008 as a measure to stabilize and provide liquidity to the U.S. financial markets. Under EESA, the Troubled Asset Relief Program (“TARP”) was created. TARP granted the U.S. Treasury (“Treasury”) authority to, among other things, invest in financial institutions and purchase troubled assets in an aggregate amount up to $700 billion.

In connection with TARP, the CPP was launched on October 14, 2008. Under the CPP, the Treasury announced a plan to use up to $250 billion of TARP funds to purchase equity stakes in certain eligible financial institutions, including the Company. The Company received $30.0 million of equity capital under the CPP in January 2009. In the transaction, the Company issued 30 thousand shares of fixed-rate cumulative perpetual preferred stock to the Treasury. The Company must pay a 5% cumulative dividend during the first five years the preferred shares are outstanding, resetting to 9% thereafter if not redeemed, and includes certain restrictions on dividend payments of lower ranking equity.
 
During June 2012, the Treasury conducted an auction as part of ongoing efforts to wind down and recover its remaining CPP investments. The auction included preferred stock positions held by the Treasury of seven banks participating in the CPP, including the $30.0 million investment in the Company’s Series A preferred stock. The Treasury was successful in selling all of its investment in the Company’s Series A preferred stock to private investors through a registered public
 
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offering. The Company received no proceeds as part of the transaction. Since the Treasury no longer owns the preferred stock, the executive compensation and other restrictions put in place by the Treasury no longer apply. The Company continues to view the outstanding preferred stock as an important component of its capital structure.
 
As required by the CPP, the Company also issued a warrant to the Treasury to purchase common shares equal to 15% of the value of the preferred stock, with the number of shares underlying the warrant and exercise price determined based on the 20-day average closing price of the common shares ending on the day prior to preliminary approval. The warrant allowed the Treasury to purchase 223,992 shares of Company common stock at an exercise price of $20.09 per share.  In July 2012, the Company repurchased the warrant from the Treasury at a mutually agreed upon price of $75 thousand. The repurchase of the warrant had no impact on the Company’s results of operations, although cash and shareholders’ equity declined by the amount of the purchase price. Upon settlement of the warrant repurchase, the Treasury has no remaining equity stake in the Company.

Temporary Liquidity Guarantee Program (“TLGP”). The TLGP consists of two separate programs implemented by the FDIC in October 2008. This includes the Debt Guarantee Program (“DGP”) and the Transaction Account Guarantee Program (“TAGP”). These programs were initially provided at no cost to participants during the first 30 days. Eligible institutions that do not “opt out” of either of these programs become participants by default and will incur the fees assessed for taking part.

Under the DGP, as amended, eligible participating entities were permitted to issue senior unsecured debt guaranteed by the FDIC through October 31, 2009. The guarantee by the FDIC would expire on the earlier of the maturity date of the debt or December 31, 2012. During October 2009, the FDIC adopted final rules to phase out the DGP. The DGP expired October 31, 2009; however, the FDIC established a six month emergency guarantee facility effective upon the expiration of the DGP. Subject to its prior approval, the FDIC will provide guarantees of senior debt issued after October 31, 2009 through April 30, 2010 with the guarantee expiring on the earlier of the maturity date of the debt or December 31, 2012. The Company chose to opt out of the DGP.

Under the TAGP, which was terminated at year-end 2012, the FDIC guaranteed 100% of certain noninterest bearing transaction accounts up to any amount to participating FDIC insured institutions. The unlimited coverage, set to initially expire on December 31, 2009, was extended by the FDIC in August 2009 with an expiration date of June 30, 2010. In April 2010, the FDIC further extended the TAGP to December 31, 2010 and adopted rules that allowed extending the program an additional twelve months without further rulemaking. However, amendments related to the enactment of the Dodd-Frank Act provided full deposit insurance coverage for noninterest bearing deposit transaction accounts beginning December 31, 2010 for an additional two year period, which ended December 31, 2012. No opt-out options were permitted and there was no separate assessment applicable to the covered accounts.

The Company opted to participate in the TAGP, including the extension period. All participating institutions initially paid an additional 10 basis point quarterly-assessed fee on certain noninterest bearing transaction accounts that exceed the existing $250 thousand deposit insurance limit. The Company incurred the additional 10 basis point annual fee through the program’s original expiration date of December 31, 2009. For coverage after December 31, 2009, the program included an increase in the annualized assessment based on an institutions risk category. Institutions in risk category one and two were subject to a 15 basis point and 20 basis point fee assessment, respectively. Institutions in risk category three and four were subject to a 25 basis point fee assessment.

Dodd-Frank Act. On July 21, 2010, the Dodd-Frank Act was signed into law by President Obama. The Dodd-Frank Act implements far-reaching changes to the regulation of the financial services industry, including provisions that:
 
 
·
Centralize responsibility for consumer financial protection by creating the Consumer Financial Protection Bureau, a new agency responsible for implementing, examining, and enforcing compliance with federal consumer financial laws;
 
·
Apply the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies;
 
·
Require the federal banking regulators to seek to make their capital requirements countercyclical, so that capital requirements increase in times of economic expansion and decreases in times of economic contraction;
 
 
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·
Change the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;
 
·
Provide for new disclosure and other requirements relating to executive compensation and corporate governance;
 
·
Make permanent the $250 thousand limit for federal deposit insurance;
 
·
Repeal the federal prohibitions on the payment of interest on commercial demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts;
 
·
Increase the authority of the Federal Reserve to examine non-bank subsidiaries; and
 
·
Codify and expand the “source of strength” doctrine as a statutory requirement. The source of strength doctrine represents the long held policy view by the Federal Reserve that a bank holding company should serve as a source of financial strength for its subsidiary banks. The Parent Company, under this requirement, is expected to commit resources to support a distressed subsidiary bank.

Many aspects of the Dodd-Frank Act are subject to further rulemaking which will take effect over several years, making it difficult to anticipate the overall financial impact on the Company, its customers or the financial industry more generally. Provisions in the legislation that affect deposit insurance assessments and payment of interest on commercial demand deposits could increase the costs associated with deposits as well as place limitations on certain revenues those deposits may generate.

References under the caption “Supervision and Regulation” to applicable statutes and regulations are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference thereto.

Recent Regulatory Events and Increased Capital Requirements
The Company’s subsidiary banks are subject to capital-based regulatory requirements.  The Company has historically managed its banks’ capital levels with the goal of meeting the criteria established by its regulators for each bank subsidiaries to be “well-capitalized.” Historically, to be well-capitalized, a depository institution needed to have a Tier 1 Leverage ratio of at least 5% and a Total Risk-based Capital ratio of 10%.  As of December 31, 2012, each of the Company’s four subsidiary banks satisfied these capital ratios.

Although each of the Company’s subsidiary banks met the definition of well-capitalized as of December 31, 2012, some of their capital levels have decreased in recent years as a result of the economic downturn that began in late 2007.  Because of the turmoil in the banking markets and continued difficulty many banks are experiencing with their loan portfolios, bank regulatory agencies are increasingly requiring banks to maintain higher capital reserves as a cushion for dealing with any further deterioration in their loan portfolios in order to maintain well-capitalized status.  Primarily as a result of examinations that took place starting in 2009, the Company’s banking regulators have required higher minimum capital ratios that have resulted in capital infusions by the Parent Company at certain of the its banking subsidiaries. The capital requirements and other supervisory actions resulting from the regulatory examinations are summarized below. For a more complete discussion, please refer to the section captioned “Capital Resources” under Item 7 “Management’s Discussion and Analysis of Financial Condition and Result of Operations” part of this Form 10-K.

Parent Company. Primarily due to the regulatory actions and capital requirements at three of the Company’s subsidiary banks as further discussed below, the Federal Reserve Bank of St. Louis (“FRB St. Louis”) and KDFI proposed the Company enter into a Memorandum of Understanding (“Memorandum”).  The Company’s board approved entry into the Memorandum at a regular board meeting during the fourth quarter of 2009.  Pursuant to the Memorandum, the Company agreed that it would develop an acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as summarized below.

The Company also agreed to reduce its common stock dividend in the fourth quarter of 2009 from $.25 per share down to $.10 per share and not make interest payments on the Company’s trust preferred securities or dividends on its common or preferred stock without prior approval from the FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both
 
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regulatory agencies have granted approval of all subsequent quarterly Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted. 
 
Other components in the regulatory order for the parent company include requesting and receiving regulatory approval for the payment of new salaries/bonuses or other compensation to insiders; assisting its subsidiary banks in addressing weaknesses identified in their reports of examinations; providing periodic reports detailing how it will meet its debt service obligations; and providing progress reports with its compliance with the regulatory Memorandum.

Farmers Bank.  In November of 2009, the KDFI and FRB St. Louis entered into a Memorandum with Farmers Bank.  The Memorandum requires that Farmers Bank obtain written consent prior to declaring or paying the Parent Company a cash dividend and to achieve and maintain a Tier 1 Leverage ratio of 8.0% by June 30, 2010.  The Parent Company injected from its reserves $11.0 million in capital into Farmers Bank subsequent to the Memorandum and an additional $200 thousand during 2010. During the third quarter of 2012, Farmers Bank paid dividends in the amount of $4.0 million to the Parent Company after receiving approval from its regulators. At December 31, 2012, Farmers Bank had a Tier 1 Leverage ratio of 9.68% and a Total Risk-based Capital ratio of 19.20%.

Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, developing and implementing a written profit plan and strategic plans, and evaluating policies and procedures for monitoring construction loans and use of interest reserves. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.

The Company received written notification in January 2013 that the FRB St. Louis and the KDFI terminated the Memorandum that was entered into with Farmers Bank effective immediately. The termination followed a joint examination of Farmers Bank by the FRB St. Louis and the KDFI, which found satisfactory compliance with the terms of the Memorandum and overall improvement in financial condition.

United Bank.  In November of 2009, the FDIC and United Bank entered into a Cease and Desist Order (“C&D”) primarily as a result of its level of nonperforming assets.  The C&D was terminated in December 2011 coincident with the issuance of a Consent Order (“Consent Order”) entered into between the parties. The Consent Order is substantially the same as the C&D, with the primary exception being that United Bank must achieve and maintain a Tier 1 Leverage ratio of 9.0% and a Total Risk-based Capital ratio of 13.0% no later than March 31, 2012.   During the first quarter of 2012, the Parent Company injected from its reserves $2.5 million in capital into United Bank in order for it to comply with the Consent Order. At December 31, 2012, United Bank had a Tier 1 Leverage ratio of 9.45% and a Total Risk-based Capital ratio of 16.69%. The Parent Company has injected from its reserves $18.9 million of capital into United Bank since the fourth quarter of 2009.

Other components in the regulatory order include stricter oversight and reporting to its regulators in terms of complying with the Consent Order. It also includes an increase in the level of reporting by management to its board of directors of its financial results, budgeting, and liquidity analysis, as well as restricting the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination. There is also a requirement to obtain written consent prior to declaring or paying a dividend and to develop a written contingency plan if the bank is unable to meet the capital levels established in the Consent Order.

Citizens Northern.  The KDFI and the FDIC entered into a Memorandum with Citizens Northern in September of 2010.  The Memorandum requires that Citizens Northern obtain written consent prior to declaring or paying a dividend and to increase Tier 1 Leverage ratio to equal or exceed 7.5% prior to September 30, 2010 and to achieve and maintain Tier 1 Leverage ratio to equal or exceed 8.0% prior to December 31, 2010.  In December 2010, the Parent Company injected $250 thousand of capital into Citizens Northern to bring its Tier 1 Leverage ratio up to 8.04% as of year-end
 
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2010.  At December 31, 2012, Citizens Northern had a Tier 1 Leverage ratio of 9.36% and a Total Risk-based Capital ratio of 14.22%.
 
Other parts of the regulatory order include the development and documentation of plans for reducing problem loans, providing progress reports on compliance with the Memorandum, and for the development and implementation of a written profit plan and strategic plans. It also restricts the bank from extending additional credit to borrowers with credits classified as substandard, doubtful or special mention in the report of examination.

Regulators continue to monitor the Company’s progress and compliance with the regulatory agreements through periodic on-site examinations, regular communications, and quarterly data analysis. At the Parent Company and at each of its bank subsidiaries, the Company believes it is adequately addressing all issues of the regulatory agreements to which it is subject. However, only the respective regulatory agencies can determine if compliance with the applicable regulatory agreements have been met. The Company believes that it and its subsidiary banks are in compliance with the requirements identified in the regulatory agreements as of December 31, 2012.

The Parent Company maintains cash available to fund a certain amount of additional injections of capital to its bank subsidiaries as determined by management or if required by its regulators. If needed, further amounts in excess of available cash may be funded by future public or private sales of securities, although the Parent Company is under no directive by its regulators to raise any additional capital.

Competition
The Company and its subsidiaries face vigorous competition for banking services from various types of businesses other than commercial banks and savings and loan associations.  These include, but are not limited to, credit unions, mortgage lenders, finance companies, insurance companies, stock and bond brokers, financial planning firms, and department stores which compete for one or more lines of banking business.  The Company also competes for commercial and retail business not only with banks in Central and Northern Kentucky, but with banking organizations from Ohio, Indiana, Tennessee, Pennsylvania, and North Carolina which have banking subsidiaries located in Kentucky.  These competing businesses may possess greater resources and offer a greater number of branch locations, higher lending limits, and may offer other services not provided by the Company. In addition, the Company’s competitors that are not depository institutions are generally not subject to the extensive regulations that apply to the Company and its subsidiary banks. The Company has attempted to offset some of the advantages of its competitors by arranging participations with other banks for loans above its legal lending limits, expanding into additional markets and product lines, and entering into third party arrangements to better compete for its targeted customer base. Competition from other providers of financial services may reduce or limit the Company’s profitability and market share.

The Company competes primarily on the basis of quality of services, interest rates and fees charged on loans, and the rates of interest paid on deposit funds. The business of the Company is not dependent upon any one customer or on a few customers, and the loss of any one or a few customers would not have a material adverse effect on the Company.

No material portion of the business of the Company is seasonal. No material portion of the business of the Company is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government, though certain contracts are subject to such renegotiation or termination.

The Company is not engaged in operations in foreign countries.

Employees
As of December 31, 2012, the Company had 518 full-time equivalent employees. Employees are offered a variety of benefits. A salary savings plan, group life insurance, hospitalization, dental, and major medical insurance along with postretirement health insurance benefits are available to eligible personnel.  Employees are not represented by a union. Management and employee relations are considered good.

The Company maintains a Stock Option Plan (“Plan”) that grants certain eligible employees the option to purchase a limited number of the Company’s common stock. The Plan specifies the conditions and terms that the grantee must meet in order to exercise the options. No options have been granted under the Plan since 2004.
 
 
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In 2004, the Company’s Board of Directors adopted an Employee Stock Purchase Plan (“ESPP”). The ESPP was subsequently approved by the Company’s shareholders and became effective July 1, 2004. Under the ESPP, at the discretion of the Board of Directors, employees of the Company and its subsidiaries can purchase Company common stock at a discounted price and without payment of brokerage costs or other fees and in the process benefit from the favorable tax treatment afforded such plans pursuant to Section 423 of the Internal Revenue Code.

Available Information
The Company makes available free of charge through its website (www.farmerscapital.com) its Code of Ethics and other filings with the Securities and Exchange Commission (“SEC”), including its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after electronically filing such material with the SEC.

Item 1A. Risk Factors

Investing in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.
 
If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Company’s common stock could decline significantly, and shareholders could lose all or part of their investment.

The Company operates in a highly regulated environment and may be adversely affected by changes in federal and state laws and regulations.

The Company is subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or laws could have a substantial adverse impact on the Company and its operations.  Additional legislation and regulations that could significantly affect the Company’s powers, authority and operations may be enacted or adopted in the future, which could have a material adverse effect on the Company’s results of operations and financial condition.  Further, in the performance of their supervisory duties and enforcement powers, the Company’s banking regulators have significant discretion and authority to prevent or remedy practices they deem as unsafe or unsound or violations of law. The exercise of regulatory authority may have a negative impact on the Company’s operations, which may be material to its results of operations and financial condition.

The Company presently is subject to, and in the future may become subject to, additional supervisory actions and/or enhanced regulation that could have a material negative effect on its business, operating flexibility, financial condition and the value of its common stock.

Under federal and state laws and regulations pertaining to the safety and soundness of insured depository institutions, the KDFI (for state-chartered banks), the Federal Reserve (for bank holding companies), and the FDIC as the insurer of bank deposits, have the authority to compel or restrict certain actions on the Company’s part if they determine that the Company has insufficient capital or is otherwise operating in a manner that may be deemed to be inconsistent with safe and sound banking practices. Under this authority, bank regulators can require the Company to enter into informal or formal enforcement orders, including board resolutions, memoranda of understanding, written agreements and consent or cease and desist orders, pursuant to which the Company would be required to take identified corrective actions to address cited concerns and to refrain from taking certain actions.
 
Primarily as a result of increased levels of nonperforming assets which led to deteriorating earnings and capital positions, the Parent Company, Farmers Bank, United Bank, and Citizens Northern have entered into separate agreements with their respective regulators. In the aggregate, these agreements, among other things, require (1) the Company to develop an
 
 
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acceptable capital plan to ensure that the consolidated organization remains well-capitalized and each of its subsidiary banks meet the capital requirements imposed by their regulator as further described elsewhere in this report, (2) the maintenance of minimum regulatory capital ratios at these three banks, (3) these three banks refrain from paying dividends to the Parent Company unless approved in advance by the regulators and (4) the Company not make future interest payments on its trust preferred securities or dividends on its common or preferred stock without seeking prior approval from the FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  While both regulatory agencies have granted approval of all Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position and earnings trends, yield the conclusion that the payment of a common stock dividend is warranted. 

If the Company is unable to comply with the terms of its current regulatory orders, or is unable to comply with the terms of any future regulatory orders to which it may become subject, then it could become subject to additional, heightened supervisory actions and orders, possibly including cease and desist orders, prompt corrective actions and/or other regulatory enforcement actions. If the Company’s regulators were to take such additional supervisory actions, then we could, among other things, become subject to significant restrictions on our ability to develop any new business, as well as restrictions on our existing business, and we could be required to raise additional capital, dispose of certain assets and liabilities within a prescribed period of time, or both. If one or more of the Company’s banks were unable to comply with regulatory requirements, such banks could ultimately face failure.  The terms of any such supervisory action could have a material negative effect on our business, operating flexibility, financial condition and the value of our common stock.

Our nonperforming assets adversely affect our results of operations and financial condition and take significant management time to resolve.

The Company’s level of nonperforming assets (which include performing restructured loans), although improving, remain high. Nonperforming assets adversely affect the Company’s net income in various ways.  The Company does not record interest income on nonaccrual loans or other real estate owned, thereby adversely affecting interest income.  When the Company takes collateral in foreclosures and similar proceedings, it is required to mark the property to its fair value less estimated selling costs, which decreases net income.

Nonperforming loans and other real estate owned also increase our risk profile and the amount of capital the Company’s regulators believe is appropriate in light of such risks.  While the Company seeks to reduce its problem loans through workouts, restructurings and otherwise, decreases in the value of these assets, the underlying collateral or our borrowers’ performance or financial conditions have adversely affected, and may continue to adversely affect, the Company’s results of operations and financial condition.  Moreover, the resolution of nonperforming assets requires significant time commitments from management of our banks, which can be detrimental to the performance of their other responsibilities. There can be no assurance that the Company will not experience further increases in nonperforming loans in the future. If economic conditions do not improve or worsen in our markets, the Company could continue to incur additional losses relating to an increase in nonperforming assets.

Losses from loan defaults may exceed the allowance established for that purpose, which will have an adverse effect on the Company’s financial condition.

Volatility and deterioration in the broader economy increases the Company’s risk of credit losses, which could have a material adverse effect on its operating results.  If a significant number of loans in the Company’s portfolio are not repaid, it would have an adverse effect on its earnings and overall financial condition.  Like all banks, the Company’s subsidiaries maintain an allowance for loan losses to provide for losses inherent in the loan portfolio.  The allowance for loan losses reflects management of each subsidiary’s best estimate of probable incurred credit losses in their loan portfolio at the relevant balance sheet date.  This evaluation is primarily based upon a review of the bank’s and the banking industry’s historical loan loss experience, known risks contained in the bank’s loan portfolio, composition and growth of the bank’s
 
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loan portfolio and economic factors.  Additionally, a bank’s regulators may require additional provision for the loan portfolio in connection with regulatory examinations, agreements or orders.  The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions.  As a result, the Company’s allowance for loan losses may be inadequate to cover actual losses in its loan portfolio.  Consequently, the Company risks having additional future provision for loan losses that may materially affect its earnings.
 
If the Company’s local markets experience a prolonged recession or economic downturn, it may be required to make further increases in its allowance for loan losses and to charge off additional loans, which would adversely affect its results of operations and capital.

Substantially all of the Company’s loans are to businesses and individuals located in Kentucky.  A continuing or prolonged decline in the Central and Northern Kentucky economies could negatively impact demand for the Company’s products and services, the ability of customers to repay their loans, collateral values securing loans, and the stability of funding sources. This could result in a material adverse effect on the Company’s financial condition, results of operations and prospects. Further, all of the Company’s investments in municipal bonds are issued by political subdivisions or agencies located in Kentucky.

Generally, the Company’s nonperforming loans and assets reflect operating difficulties of individual borrowers; however, more recently the prolonged decline of the overall economy has become a significant contributing factor to the increased levels of delinquencies and nonperforming loans.  Sluggish sales and excess inventory in the residential housing market continue to exist and has been the primary cause of elevated delinquencies and foreclosures for residential construction and land development loans.  If negative trends in the housing and real estate markets continue or worsen, the Company expects that it will continue to experience high levels of delinquencies and credit losses.  As a result, the Company may be required to make further increases to its provision for loan losses and charge off additional loans in the future, which could adversely affect the Company’s financial condition and results of operations, perhaps materially.  If such additional provisions and charge-offs cause the Company to experience losses, it may be required to contribute additional capital to its bank subsidiaries to maintain capital ratios required by regulators.

The Company’s exposure to credit risk is increased by its real estate development lending.

Real estate development lending has historically been considered to be higher credit risk than that of other types of lending, such as for single-family residential properties. At year-end 2012, 23% of the outstanding balance of real estate development loans was classified as impaired. Such loans typically involve larger loan balances to a single borrower or related borrowers. These loans can be affected by adverse conditions in real estate markets or the economy in general because commercial real estate borrowers’ ability to repay their loans depends on successful development and, in most cases, sale of the underlying property. These loans also involve greater risk because they generally are not fully amortized over the loan period, but have a balloon payment due at maturity of the loan. A borrower’s ability to make a balloon payment typically will depend on being able to either refinance the loan or timely sell the underlying property. In the current economic environment, the ability of borrowers to refinance or sell newly developed property or vacant land has greatly diminished.  If the real estate markets were to worsen or not improve, the Company would likely experience increased credit losses and require additional provisions to our allowance for loan losses, which would adversely impact the Company’s earnings and financial condition.

The Company’s investment securities portfolio is comparatively larger than other community banks and it is more dependent on its investment portfolio to generate net income.

The Company relies more heavily on its investment securities portfolio as a source of interest income than many other community banks because it has a comparatively small loan portfolio.  If the Company is not able to successfully manage the interest rate spread on the investment portfolio, its net interest income will decrease, which would adversely affect its results of operations and negatively impact net income.  Investment securities tend to have a lower risk than loans, and as such, generally provide a lower yield. For 2012, average investment securities made up 33.4% of the Company’s average total assets. Interest income on investment securities accounted for 21.2% of total interest income for 2012.
 
 
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During 2012, the Company sold and realized net gains on investment securities.  The Company may not have the same level of net gains (and may have net realized losses) in future periods on the sale of investment securities, which would reduce earnings.  Moreover, due to the current interest rate environment, proceeds from recent sales may be reinvested in investment securities with lower yields which may reduce earnings from investment securities.

The Company continually monitors its investment securities portfolio for deteriorating values and for other-than-temporary impairment.  Any material other-than-temporary impairment charges would likewise have an adverse effect on the Company’s results of operations and could lead to additional losses.

The Company cannot accurately predict the effect of the current economy on its future results of operations or the market price of its stock.

The national economy and the financial services sector in particular continue to face challenges stemming from the economic recession occurring between 2007 and 2009. The Company cannot accurately predict the severity or duration of the current economic slowdown, which has adversely impacted its performance and the markets it serves.  Any further deterioration in the economies of the nation as a whole or in the Company’s local markets would have an adverse effect, which could be material, on the Company’s financial condition, results of operations and prospects, and could also cause the market price of the Company’s stock to decline.  While it is impossible to predict how long these conditions may exist, the economic slowdown could continue to present risks for some time for our industry and the Company.

Interest rate volatility could significantly harm the Company’s results of operations.

The Company’s results of operations are affected by the monetary and fiscal policies of the federal government, the policies of the Company’s regulators, and the prevailing interest rates in the United States and the Company’s markets.  In addition, it is increasingly common for the Company’s competitors, who may be aggressively seeking to attract deposits as a result of liquidity concerns arising from changing economic or other conditions, to pay rates on deposits that are much higher than normal market rates.  A significant component of the Company’s earnings is the net interest income of its subsidiary banks, which is the difference between the income from interest earning assets, such as loans, and the expense on interest bearing liabilities, such as deposits.  A change in market interest rates could adversely affect the Company’s earnings if market interest rates change such that the interest it pays on deposits and borrowings increases faster than the interest it collects on loans and investments; or, alternatively, if interest rates earned on earning assets decline faster than those rates paid on interest paying liabilities.  Consequently, as with most financial institutions, the Company is sensitive to interest rate fluctuations.

The FDIC periodically amends its deposit insurance rate assessment structure, which can increase costs to the Company.

Under the Federal Deposit Insurance Act, as amended by the Dodd-Frank Act, the FDIC must establish and implement a plan to restore the deposit insurance fund’s designated reserve ratio to 1.35% of insured deposits by 2020. The Dodd-Frank Act removed the previously established upper limit reserve ratio of 1.15%. The FDIC must continue to assess and consider the appropriate level of the reserve ratio annually by considering each of the following: risk of loss to the insurance fund; economic conditions affecting the banking industry; the prevention of sharp swings in the assessment rates; and any other factors the FDIC deems important. In December 2010, the FDIC announced that it had established the long-term reserve ratio at 2.0%.

The FDIC previously implemented a restoration plan that changed both its risk-based assessment system and its base assessment rates. As part of this plan, during the second quarter of 2009, it increased deposit insurance assessment rates generally and imposed a special assessment of five basis points on each insured institution’s total assets less Tier 1 capital.  The special assessment in 2009, which was in addition to the regular quarterly risk-based assessment, totaled approximately $1.1 million for the Company.

In the wake of a rapid depletion of the FDIC’s Deposit Insurance Fund resulting from a high number of bank failures, the FDIC required that all (with limited exceptions) insured institutions pay in the fourth quarter of 2009 its following estimated three years’ quarterly deposit assessments in advance.  This resulted in an aggregate payment by the Company’s bank subsidiaries totaling $8.2 million in the fourth quarter of 2009.  The three years’ advance payment was recorded as a
 
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prepaid asset that is being expensed in approximately equal amounts over the prepayment period and, thus, only impacts earnings in the normal course. At December 31, 2012, the prepaid FDIC insurance assessment included on the Company’s balance sheet was $2.6 million.
 
As discussed previously under the heading “Deposit Insurance” in Item 1, the Dodd-Frank Act required changes to a number of components of the FDIC insurance assessment that was effective April 1, 2011. While these changes have resulted in a lower amount of deposit insurance assessments for the Company, future changes in assessment rates or methodology could adversely impact the Company’s future earnings and liquidity in a material amount.

The recent repeal of federal prohibitions on the payment of interest on demand deposits of business customers could increase the Company’s interest expense.

Federal prohibitions against financial institutions paying interest on demand deposit accounts of business customers were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could offer to pay interest on commercial demand deposits to compete for customers. The Company expects that its interest expense would increase and its net interest margin to decrease should it begin to pay interest on commercial demand deposits to attract additional customers or to keep current customers. This could result in a material adverse impact on the Company’s financial condition and results of operations. As of December 31, 2012, the Company does not offer interest bearing demand deposits to its business customers.

Any future losses may require the Company to raise additional capital; however, such capital may not be available to us on favorable terms or at all.

The Company is required by federal and state regulatory authorities to maintain levels of capital to support its operations.  Furthermore, in the wake of recent regularly scheduled examinations of three of its subsidiaries, the Company’s regulators have required these three banks to raise their capital to levels significantly above the well-capitalized benchmark.  The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on the Company’s future financial condition and performance.  Accordingly, the Company cannot make assurances with respect to its ability to raise additional capital on favorable terms, or at all.  If the Company cannot raise additional capital when needed, its ability to further expand its operations through internal growth and acquisitions could be materially impaired and its financial condition and liquidity could be materially and adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.

The tightening of available liquidity could limit the Company’s ability to replace deposits and fund loan demand, which could adversely affect its earnings and capital levels.

A tightening of the credit and liquidity markets and the Company’s inability to obtain adequate funding to replace deposits may negatively affect its earnings and capital levels.  In addition to deposit growth, maturity of investment securities and loan payments from borrowers, the Company relies from time to time on advances from the Federal Home Loan Bank and other wholesale funding sources to fund loans and replace deposits.  In the event of a further downturn in the economy, these additional funding sources could be negatively affected which could limit the funds available to the Company.  The Company’s liquidity position could be significantly constrained if it were unable to access funds from the Federal Home Loan Bank or other wholesale funding sources.

The Company’s financial condition and outlook may be adversely affected by damage to its reputation.

The Company’s financial condition and outlook is highly dependent upon perceptions of its business practices and reputation. Its ability to attract and retain customers and employees could be adversely affected to the extent its reputation is damaged. Negative public opinion could result from its actual or alleged conduct in any number of activities, including regulatory actions taken against the Company, lending practices, corporate governance, regulatory compliance, mergers of its subsidiaries, or sharing or inadequate protection of customer information.  Damage to the Company’s reputation could give rise to loss of customers and legal risks, which could have an adverse impact on its financial condition.

 
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The Company faces strong competition from financial services companies and other companies that offer banking services.

The Company conducts most of its operations in Central and Northern Kentucky. The banking and financial services businesses in these areas are highly competitive and increased competition in its primary market areas may adversely impact the level of its loans and deposits. Ultimately, the Company may not be able to compete successfully against current and future competitors. These competitors include national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including savings and loan associations, finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Company’s competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous locations and mount extensive promotional and advertising campaigns. Areas of competition include interest rates for loans and deposits, efforts to obtain loan and deposit customers and a range in quality of products and services provided, including new technology-driven products and services. If the Company is unable to attract and retain banking customers, it may be unable to increase its loans and level of deposits.

The Company’s financial results could be adversely affected by changes in accounting standards or tax laws and regulations.

The Financial Accounting Standards Board and the SEC frequently change the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. In addition, from time to time, federal and state taxing authorities will change the tax laws, regulations, and their related interpretations. These changes and their effects can be difficult to predict and can materially and adversely impact how the Company records and reports its financial condition and results of operations.

The short term and long term impact of changes to banking capital standards could negatively impact the Company’s regulatory capital and liquidity.

In December 2010, the Basel Committee on Banking Supervision issued final rules related to global regulatory standards on bank capital adequacy and liquidity. The new rules present details of the Basel III framework, which includes increased capital requirements and limits the types of instruments that can be included in Tier 1 capital. U.S. federal banking agencies issued proposed rules during 2012 seeking to implement Basel III standards effective January 1, 2013. Due to the nature and volume of comments received on the proposed rules, the federal banking agencies announced that the proposed rules would not become effective on the date proposed. There has been no indication of an alternative effective date by the agencies. As such, the dates and phase-in periods of the Basel III framework discussed below will change. Final rules could change significantly from the proposed rules.

Basel III includes the following provisions: (i) that the minimum ratio of common equity to risk-weighted assets be increased to 4.5% from the current level of 2%, to be fully phased in by January 1, 2015, and (ii) that the minimum requirement for the Tier 1 Risk-based capital ratio will be increased from 4% to 6%, to be fully phased in by January 1, 2015. The new minimums were initially set to be phased in starting January 1, 2013.

Basel III also includes a “capital conservation buffer” requiring banking organizations to maintain an additional 2.5% of Tier 1 common equity to total risk-weighted assets in addition to the minimum requirement. This requirement was initially set to be phased in between January 1, 2016 and January 1, 2019. The capital conservation buffer is designed to absorb losses in periods of financial and economic distress and, while banks are allowed to draw on the buffer during periods of stress, if a bank’s regulatory capital ratios approach the minimum requirement, the bank will be subject to more stringent constraints on dividends and bonuses. In addition, Basel III includes a countercyclical buffer of up to 2.5%, which could be imposed by countries to address economies that appear to be building excessive system-wide risks due to rapid growth.

To constrain the build-up of excess leverage in the banking system, Basel III introduces a new non-risk-based leverage ratio. A minimum Tier 1 Leverage ratio of 3% was initially set to be tested during a parallel run period between January 1, 2013 and January 1, 2017 with any final adjustments carried out in the first half of 2017 based on the results of the parallel run.
 
 
29

 

Regulatory agencies in the U.S. have yet to adopt final rules for implementing Basel III. Further regulations and guidelines issued by banking regulators may significantly differ from current proposals. The regulatory agencies’ current proposal, if adopted, could have a material negative impact on the Company’s level of capital. In addition to the overall higher levels of required capital, the proposed rules would phase out the inclusion of trust preferred securities from the Company’s capital base. Unrealized holding gains and losses related to available for sale securities would be included as a component of capital under the current proposal, which could lead to high degree of volatility in regulatory capital calculations. Other significant requirements included in the proposal relate to higher risk-weighting of assets, particularly of loans, which would result in lower capital ratios.

Basel III also includes two separate standards for supervising liquidity risks which include: (i) a “liquidity coverage ratio” designed to ensure that banks have a sufficient amount of high-quality liquid assets to survive a significant liquidity stress scenario over a 30-day period, (ii) a “net stable funding ratio” designed to promote more medium and long-term funding of the assets and activities of banks over a one-year time horizon. The liquidity coverage ratio was initially set to become effective on January 1, 2015. The revised net stable funding ratio was to become effective January 1, 2018.

The Company cannot predict at this time the precise content of capital and liquidity guidelines or regulations that may be adopted by regulatory agencies having authority over us and our subsidiaries. The new standards, however, will generally require the Company and our banking subsidiaries to maintain more capital (with common equity as a more predominant component) and manage the configuration of our assets and liabilities in order to comply with new liquidity requirements, which could significantly impact our return on equity, financial condition, operations, capital position, and ability to pursue business opportunities.

The price of the Company’s common stock may fluctuate significantly, and this may make it difficult to resell it when you want or at prices you find attractive.

The Company cannot predict how its common stock will trade in the future.  The market value of its common stock will likely continue to fluctuate in response to a number of factors including the following, most of which are beyond our control, as well as the other factors described in this “Risk Factors” section:

 
·
general economic conditions and conditions in the financial markets;
 
·
changes in global financial markets, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility and other geopolitical events;
 
·
conditions in our local and national credit, mortgage and housing markets;
 
·
developments with respect to financial institutions generally, including government regulation;
 
·
our dividend practice; and
 
·
actual and anticipated quarterly fluctuations in our operating results and earnings.
 
The market value of the Company’s common stock may also be affected by conditions affecting the financial markets in general, including price and trading fluctuations. These conditions may result in: (1) volatility in the level of, and fluctuations in, the market prices of stocks generally and, in turn, the Company’s common stock and (2) sales of substantial amounts of the Company’s common stock in the market, in each case that could be unrelated or disproportionate to changes in the Company’s operating performance. These broad market fluctuations may adversely affect the market value of the Company’s common stock.

There may be future sales of additional common stock or other dilution of the Company’s equity, which may adversely affect the market price of the Company’s common stock.

The Company is not restricted from issuing additional common or preferred stock, including any securities that are convertible into or exchangeable for, or that represent the right to receive, common stock or preferred stock or any substantially similar securities. The market price of the Company’s common stock could decline as a result of sales by the Company of a large number of shares of common stock or preferred stock or similar securities in the market or from the perception that such sales could occur.
 
 
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The Company’s board of directors is authorized generally to cause it to issue additional common and preferred stock without any action on the part of the Company’s shareholders, except as may be required under the listing requirements of the NASDAQ Stock Market. In addition, the board has the power, without shareholder approval, to set the terms of any series of preferred stock that may be issued, including voting rights, dividend rights, preferences and other terms.  This could include preferences over the common stock with respect to dividends or upon liquidation.  If the Company issues preferred stock in the future that has a preference over the common stock with respect to the payment of dividends or upon liquidation, or if the Company issues preferred stock with voting rights that dilute the voting power of the common stock, the rights of holders of the common stock or the market price of the common stock could be adversely affected. The Parent Company is currently under no directive by its regulators to raise any additional capital.

You may not receive dividends on the Company’s common stock.

Holders of the Company’s common stock are entitled to receive dividends only when, as, and if its board of directors declares them and as permitted by its regulators.  Although the Company has (up through 2009) historically declared quarterly cash dividends on its common stock, it is not required to do so.  The Company’s board of directors reduced its quarterly common stock dividend in January 2009 from $.33 per share to $.25 per share and again in October 2009 to $.10 per share. The Company also agreed to not make interest payments on its trust preferred securities or dividends on its common or preferred stock without prior approval from the FRB St. Louis and KDFI.  Representatives of the FRB St. Louis and KDFI have indicated that any such approval for the payment of dividends will be predicated on a demonstration of adequate, normalized earnings on the part of the Company’s subsidiaries sufficient to support quarterly payments on the Company’s trust preferred securities and quarterly dividends on the Company’s common and preferred stock.  However, there can be no assurance the Company’s regulators will provide such approvals in the future.

While both regulatory agencies have granted approval of all Company requests to make interest payments on its trust preferred securities and dividends on its preferred stock, the Company has not (based on the assessment by Company management of both the Company’s capital position and the earnings of its subsidiaries) sought regulatory approval for the payment of common stock dividends since the fourth quarter of 2009.  Moreover, the Company will not pay any such dividends on its common stock in any subsequent quarter until the regulator’s assessment of the earnings of the Company’s subsidiaries, and the Company’s assessment of its capital position, both yield the conclusion that the payment of a Company common stock dividend is warranted. 

Dividends declared and discount accretion on the Company’s Series A preferred stock reduce the net income available to common stockholders and reduce earnings per common share.  Moreover, under the terms of the Company’s articles of incorporation, it is unable to declare dividend payments on shares of its common stock if it is in arrears on the dividends on the Series A preferred stock.

If the Company is in arrears on interest payments on its trust preferred securities, it may not pay dividends on its common stock until such interest obligations are brought current.

The Company’s ability to pay dividends depends upon the results of operations of its subsidiary banks and certain regulatory considerations.
 
The Parent Company is a bank holding company that conducts substantially all of its operations through its subsidiary banks. As a result, the Company’s ability to make dividend payments on its common stock depends primarily on certain federal and state regulatory considerations and the receipt of dividends and other distributions from its bank subsidiaries. There are various regulatory restrictions on the ability of three of our subsidiary banks to pay dividends or make other payments to the Parent Company and its ability to make payments to its shareholders, including certain regulatory approvals of dividends or distributions. There can be no assurance that the Company will receive such approval or that it will resume paying dividends to shareholders.

The trading volume in the Company’s common stock is less than that of many other similar companies.

The Company’s common stock is listed for trading on the NASDAQ Global Select Stock Market.  As of December 31, 2012, the 50-day average trading volume of the Company’s common stock on NASDAQ was 15,907 shares or .21% of the total common shares outstanding of 7,469,813.  An efficient public trading market is dependent upon the existence in
 
31

 
 
the marketplace of willing buyers and willing sellers of a stock at any given time. The Company has no control over such individual decisions of investors and general economic and market conditions. Given the lower trading volume of the Company’s common stock, larger sales volumes of its common stock could cause the value of its common stock to decrease.  Moreover, due to its lower trading volume it may take longer to liquidate your position in the Company’s common stock.

There can be no assurance when the Company’s Series A preferred stock can be redeemed.

Subject to consultation with banking regulators, the Company intends to repurchase the Series A preferred stock it issued when it believes the credit metrics in its loan portfolio have improved for the long-term and the overall economy has rebounded. However, there can be no assurance when the Series A preferred stock can be repurchased, if at all. Until such time as the Series A preferred stock is repurchased, the Company will remain subject to the terms and conditions of the instrument, which, among other things, limit the Company’s ability to repurchase or redeem common stock.

Holders of the Company’s Series A preferred stock have rights that are senior to those of the Company’s common stockholders.

The Series A preferred stock that the Company issued to the Treasury is senior to the Company’s shares of common stock, and holders of the Series A preferred stock have certain rights and preferences that are senior to holders of the Company’s common stock. The restrictions on the Company’s ability to declare and pay dividends to common stockholders are discussed above. In addition, the Company and its subsidiaries may not purchase, redeem or otherwise acquire for consideration any shares of the Company’s common stock unless the Company has paid in full all accrued dividends on the Series A preferred stock for all prior dividend periods, other than in certain circumstances. Furthermore, the Series A preferred stock is entitled to a liquidation preference over shares of the Company’s common stock in the event of liquidation, dissolution or winding up.

Holders of the Company’s Series A preferred stock have limited voting rights.

Except (1) in connection with the election of two directors to the Company’s board of directors if its dividends on the Series A preferred stock are in arrears and we have missed six quarterly dividends and (2) as otherwise required by law, holders of the Company’s Series A preferred stock have limited voting rights. In addition to any other vote or consent of shareholders required by law or the Company’s articles of incorporation, the vote or consent of holders owning at least 66 2/3% of the shares of Series A preferred stock outstanding is required for (1) any authorization or issuance of shares ranking senior to the Series A preferred stock; (2) any amendment to the rights of the Series A preferred stock that adversely affects the rights, preferences, privileges or voting power of the Series A preferred stock; or (3) consummation of any merger, share exchange or similar transaction unless the shares of Series A preferred stock remain outstanding or are converted into or exchanged for preference securities of the surviving entity other than the Company and have such rights, preferences, privileges and voting power as are not materially less favorable than those of the holders of the Series A preferred stock.

The Company’s common stock constitutes equity and is subordinate to its existing and future indebtedness and its Series A preferred stock, and effectively subordinated to all the indebtedness and other non-common equity claims against its subsidiaries.

Shares of the Company’s common stock represent equity interests in our holding company and do not constitute indebtedness. Accordingly, the shares of the Company’s common stock rank junior to all of its indebtedness and to other non-equity claims on Farmers Capital Bank Corporation with respect to assets available to satisfy such claims. Additionally, dividends to holders of the Company’s common stock are subject to the prior dividend and liquidation rights of the holders of the Company’s Series A preferred stock and any additional preferred stock we may issue. The Series A preferred stock has an aggregate liquidation preference of $30 million, plus any accrued and unpaid dividends.

The Company’s right to participate in any distribution of assets of any of its subsidiaries upon the subsidiary’s liquidation or otherwise, and thus the ability of the Company’s common stock to benefit indirectly from such distribution, will be subject to the prior claims of creditors of that subsidiary.  As a result, holders of the Company’s common stock will be
 
32

 
 
effectively subordinated to all existing and future liabilities and obligations of its subsidiaries, including claims of depositors.  As of December 31, 2012, our subsidiaries’ total deposits and borrowings were approximately $1.6 billion.

If the Company is unable to redeem its Series A preferred stock after an initial five-year period, the cost of this capital will increase substantially.

If the Company is unable to redeem its Series A preferred stock prior to February 15, 2014, the cost of this capital to us will increase from approximately $1.5 million annually (5.0% per annum of the Series A preferred stock liquidation value) to $2.7 million annually (9.0% per annum of the Series A preferred stock liquidation value).  This increase in the annual dividend rate on the Series A preferred stock would have a material negative effect on the earnings the Company can retain for growth and to pay dividends on its common stock.

The current economic environment exposes the Company to higher credit losses and expenses and may result in lower earnings or increase the likelihood of losses.

Although the Company remains well-capitalized, it continues to operate in a very challenging and uncertain economic environment. Financial institutions, including the Company, continue to being adversely effected by difficult economic conditions that have impacted not only local markets, but on a national and global scale. Substantial deterioration in real estate and other financial markets in recent years have and may continue to adversely impact the Company’s financial performance. Declines in real estate values and home sales volumes, along with high levels of unemployment and other economic stresses can decrease the value of collateral securing loans extended to borrowers, particularly that of real estate loans. Lower values of real estate securing loans may make it more difficult for the Company to recover amounts it is owed in the event of default by a borrower.

The current economic conditions may result in a higher degree of financial stress on the Company’s borrowers and their customers which could impair the Company’s ability to collect payments on loans, potentially increasing loan delinquencies, nonperforming assets, foreclosures, and higher losses. Current market forces have and may in the future cause the value of investment securities or other assets held by the Company to deteriorate, resulting in impairment charges, higher losses, and lower regulatory capital levels.

Market volatility could adversely impact the Company’s results of operations, liquidity position, and access to additional capital.

The capital and credit markets experienced heavy volatility and disruptions during the recent economic downturn, with unprecedented levels of volatility and disruptions that took place beginning in the last few months of 2008. In many cases, this led to downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If market disruptions and volatility continue or worsen, the Company may experience a material adverse effect on its results of operations and liquidity position or on its ability to access additional capital.

Risks associated with unpredictable economic and political conditions may be amplified as a result of limited market area.

Commercial banks and other financial institutions, including the Company, are affected by economic and political conditions, both domestic and international, and by governmental monetary policies. Conditions such as inflation, value of the dollar, recession, high unemployment rates, high interest rates, prolonged periods of low interest rates, short money supply, scarce natural resources, international turmoil, terrorism and other factors beyond the Company’s control may adversely affect profitability. In addition, almost all of the Company’s primary business area is located in Central and Northern Kentucky. Significant downturns in this economic region may result in, among other things, deterioration in the Company’s credit quality or a reduced demand for credit and may harm the financial stability of the Company’s customers. Due to the Company’s regional market area, these negative conditions may have a more noticeable effect on the Company than would be experienced by an institution with a larger, more diverse market area.

 
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The Company’s results of operations are significantly affected by the ability of its borrowers to repay their loans.

Lending money is an essential part of the banking business. However, borrowers do not always repay their loans. The risk of non-payment is affected by:

 
·
unanticipated declines in borrower income or cash flow;
 
·
changes in economic and industry conditions;
 
·
the duration of the loan; and
 
·
in the case of a collateralized loan, uncertainties as to the future value of the collateral.

Due to the fact that the outstanding principal balances can be larger for commercial loans than other types of loans, such loans present a greater risk to the Company than other types of loans when non-payment by a borrower occurs.

Consumer loans typically have shorter terms and lower balances with higher yields compared to real estate mortgage loans, but generally carry higher risks of frequency of default than real estate mortgage and commercial loans. Consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount that can be recovered on these loans.

Inability to hire or retain certain key professionals, management and staff could adversely affect the Company’s revenues and net income.

The Company relies on key personnel to manage and operate its business, including major revenue generating functions such as its loan and deposit portfolios. The loss of key staff may adversely affect the Company’s ability to maintain and manage these portfolios effectively, which could negatively affect our revenues. In addition, loss of key personnel could result in increased recruiting and hiring expenses, which could cause a decrease in our net income.

The Company’s controls and procedures may fail or be circumvented.

The Company’s management regularly reviews and updates its internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well-designed and operated, can provide only reasonable, not absolute, assurances that the objectives of the system of controls are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material and adverse effect on the Company’s business, results of operations, and financial condition.

The Company offers online banking services and both sends and receives confidential customer information electronically. This activity is vulnerable to security breaches and computer viruses which could expose the Company to litigation and adversely affect our reputation and overall operations.

The secure transmission of confidential information over the Internet is a significant element of online banking. The Company’s computer network or those of its customers could be vulnerable to unauthorized access, computer viruses, phishing schemes and other security problems. The Company could be required to commit additional resources to protect against the threat of security breaches and computer viruses, or to remedy problems caused by security breaches or viruses. To the extent that the Company’s activities or the activities of its customers involve the storage and transmission of confidential information, security breaches and viruses could expose the Company to litigation and other possible liabilities. The inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in the Company’s systems and could adversely affect its reputation and overall operations.

The Company’s operations rely on certain external vendors.

The Company utilizes certain external vendors to provide products and services necessary to maintain its day-to-day operations. The Company is exposed to the risk that such vendors fail to perform under these arrangements. This could result in disruption to the Company’s business and have a material adverse impact on the Company’s results of operations
 
34

 
 
and financial condition. There can be no assurance that the Company’s policies and procedures designed to monitor and mitigate vendor risks will be effective in preventing or limiting the effect of vendor non-performance.

The Company is subject to claims and litigation pertaining to fiduciary responsibility.

The Company’s customers or others may make claims and take legal action against us related to fiduciary responsibilities. If claims and legal action against the Company are not resolved in a favorable manner to the Company, it could result in a material financial liability or damage to our reputation.

The Dodd-Frank Act may increase the Company’s costs of operations which could adversely impact the Company's results of operations, financial condition or liquidity.

On July 21, 2010, the Dodd-Frank Act was signed into law by President Obama. The goals of the new legislation include restoring public confidence in the financial system that resulted from the recent financial and credit crises, preventing another financial crisis, and allowing regulators to identify failings in the system before another crisis can occur.  As part of the reform, the Dodd-Frank Act created the Financial Stability Oversight Council, with oversight authority for monitoring and regulating systemic risk, and the Bureau of Consumer Financial Protection, which has broad regulatory and enforcement powers over consumer financial products and services.  The Dodd-Frank Act also changes the responsibilities of the current federal banking regulators, imposes additional corporate governance and disclosure requirements in areas such as executive compensation and proxy access, and limits or prohibits proprietary trading and hedge fund and private equity activities of banks. It also impacts areas such as deposit insurance, mortgage lending, capital requirements, securitizations, and insurance.

The scope of the Dodd-Frank Act impacts many aspects of the financial services industry and requires the development and adoption of numerous implementing regulations, many of which have yet to be proposed. Consequently, the effects of the Dodd-Frank Act on the financial services industry and the Company will depend, in large part, upon the extent to which regulators exercise the authority granted to them and the approaches taken to implement the regulations.  The Company continues to assess the impact of the Dodd-Frank Act on its business and operations and believes that compliance with these new laws and regulations will likely result in additional costs, but the probable impact cannot be measured with a high degree of certainty. Compliance with the new laws and regulations could adversely impact the Company’s results of operations, financial condition or liquidity, any of which may impact the market price of the Company’s common stock.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The Company owns or leases buildings that are used in the normal course of its business. The corporate headquarters is located at 202 W. Main Street, Frankfort, Kentucky, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. See the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statement and Supplementary Data,” of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.
 
 
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Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2012.

Corporate Headquarters
202 – 208 W. Main Street, Frankfort, KY

Banking Offices
 
Farmers Bank:
 
125 W. Main Street, Frankfort, KY
 
555 Versailles Road, Frankfort, KY
 
1401 Louisville Road, Frankfort, KY
 
154 Versailles Road, Frankfort, KY
 
1301 US 127 South, Frankfort, KY (leased)
 
128 S. Main Street, Lawrenceburg, KY
 
201 West Park Shopping Center, Lawrenceburg, KY
 
838 N. College Street, Harrodsburg, KY
 
1035 Ben Ali Drive, Danville, KY
 
United Bank:
 
100 United Drive, Versailles, KY
 
146 N. Locust Street, Versailles, KY
 
206 N. Gratz, Midway, KY
 
200 E. Main Street, Georgetown, KY
 
100 Farmers Bank Drive, Georgetown, KY (leased)
 
100 N. Bradford Lane, Georgetown, KY
 
3285 Main Street, Stamping Ground, KY
 
2509 Sir Barton Way, Lexington, KY
 
3098 Harrodsburg Road, Lexington, KY (leased)
 
201 N. Main Street, Nicholasville, KY
 
995 S. Main Street (Kroger Store), Nicholasville, KY (leased)
 
986 N. Main Street, Nicholasville, KY
 
106 S. Lexington Avenue, Wilmore, KY
 
First Citizens:
 
425 W. Dixie Avenue, Elizabethtown, KY
 
3030 Ring Road, Elizabethtown, KY
 
111 Towne Drive (Kroger Store), Elizabethtown, KY (leased)
 
645 S. Dixie Blvd., Radcliff, KY
 
4810 N. Preston Highway, Shepherdsville, KY
 
157 Eastbrooke Court, Mt. Washington, KY
 
Citizens Northern:
 
103 Churchill Drive, Newport, KY
 
7300 Alexandria Pike, Alexandria, KY
 
164 Fairfield Avenue, Bellevue, KY
 
8730 US Highway 42, Florence, KY
 
34 N. Ft. Thomas Avenue, Ft. Thomas, KY
 
2911 Alexandria Pike, Highland Heights, KY
 
2006 Patriot Way, Independence, KY
 
2774 Town Center Blvd., Crestview Hills, KY (leased)
 

Data Processing Center
102 Bypass Plaza, Frankfort, KY

Other
201 W. Main Street, Frankfort, KY
 
 
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The Company considers its properties to be suitable and adequate based on its present needs.

Item 3. Legal Proceedings

As of December 31, 2012, there were various pending legal actions and proceedings against the Company arising from the normal course of business and in which claims for damages are asserted.  It is the opinion of management, after discussion with legal counsel, that the disposition or ultimate resolution of such claims and legal actions will not have a material effect upon the consolidated financial statements of the Company.

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

At various times, the Company’s Board of Directors has authorized the purchase of shares of the Company’s outstanding common stock.  No stated expiration dates have been established under any of the previous authorizations. There were no shares of common stock repurchased by the Company during the quarter ended December 31, 2012. The maximum number of shares that may still be purchased under previously announced repurchase plans is 84,971.

On January 9, 2009, the Company issued 30 thousand shares of Series A, no par value cumulative perpetual preferred stock to the Treasury for $30.0 million pursuant to a Letter Agreement and Securities Purchase Agreement. The Company also issued a warrant to the Treasury allowing it to purchase 224 thousand shares of the Company’s common stock at an exercise price of $20.09. The Series A preferred stock and warrant were issued in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. During June 2012, the Treasury sold its entire investment in the Company’s Series A preferred stock to private investors through a registered public offering. On July 18, 2012, the Company repurchased the warrant from the Treasury at a mutually agreed upon amount of $75 thousand. The Treasury has no remaining equity stake in the Company.

Performance Graph
The following graph sets forth a comparison of the five-year cumulative total returns among the shares of Company Common Stock, the NASDAQ Composite Index ("broad market index") and Southeastern Banks Under 1 Billion Market-Capitalization ("peer group index"). Cumulative shareholder return is computed by dividing the sum of the cumulative amount of dividends for the measurement period and the difference between the share price at the end and the beginning of the measurement period by the share price at the beginning of the measurement period.

The broad market index includes over 3,000 domestic and international based common shares listed on The NASDAQ Stock Market. The peer group index consists of 40 banking companies in the Southeastern United States. The Company is included among those in the peer group index.
 
 
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2007
   
2008
   
2009
   
2010
   
2011
   
2012
 
                                     
Farmers Capital Bank Corporation
  $ 100.00     $ 95.22     $ 41.99     $ 20.05     $ 18.45     $ 50.33  
NASDAQ Composite
    100.00       59.03       82.25       97.32       98.63       110.78  
Southeastern Banks Under 1 Billion Market-Capitalization
    100.00       95.06       69.82       82.29       84.15       96.61  
 
Corporate Address
The headquarters of Farmers Capital Bank Corporation is located at:
202 West Main Street
Frankfort, Kentucky 40601

Direct correspondence to:
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone: (502) 227-1668
www.farmerscapital.com

Annual Meeting
The annual meeting of shareholders of Farmers Capital Bank Corporation will be held Tuesday, May 14, 2013 at 11:00 a.m. at the main office of Farmers Bank & Capital Trust Company, Frankfort, Kentucky.
 
 
38

 

Form 10-K
For a free copy of Farmers Capital Bank Corporation's Annual Report on Form 10-K filed with the Securities and Exchange Commission, please write:

C. Douglas Carpenter, Executive Vice President, Secretary, and Chief Financial Officer
Farmers Capital Bank Corporation
P.O. Box 309
Frankfort, Kentucky 40602-0309
Phone:  (502) 227-1668

Web Site Access to Filings
All reports filed electronically by the Company to the United States Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports, are available at no cost on the Company’s Web site at www.farmerscapital.com.

NASDAQ Market Makers
 
J.J.B. Hilliard, W.L. Lyons, LLC
Morgan, Keegan & Company, Inc.
(502) 588-8400
(800) 260-0280
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UBS Securities, LLC
Raymond James & Associates, Inc.
(859) 269-6900
(800) 248-8863
(502) 589-4000
 

The Transfer Agent and Registrar for Farmers Capital Bank Corporation is American Stock Transfer & Trust Company, LLC.

American Stock Transfer & Trust Company, LLC
Shareholder Relations
59 Maiden Lane - Plaza Level
New York, NY 10038
PH: (800) 937-5449
Fax: (718) 236-2641
Email: Info@amstock.com
Website: www.amstock.com

Additional information is set forth under the captions “Shareholder Information” and “Common Stock Price” on page 78 under Part II, Item 7 and Note 17 “Regulatory Matters” in the notes to the Company's 2012 audited consolidated financial statements on pages 118 to 121 of this Form 10-K and is hereby incorporated by reference.

 
39

 

Item 6. Selected Financial Data

Selected Financial Highlights
                             
December 31,
(In thousands, except per share data)
 
2012
   
2011
   
2010
   
2009
   
2008
 
Results of Operations
                             
Interest income
  $ 71,222     $ 78,349     $ 89,751     $ 100,910     $ 113,920  
Interest expense
    18,258       24,670       34,948       47,065       55,130  
Net interest income
    52,964       53,679       54,803       53,845       58,790  
Provision for loan losses
    2,772       13,487       17,233       20,768       5,321  
Noninterest income
    24,654       24,391       34,110       28,169       9,810  
Noninterest expense
    59,787       62,492       62,711       115,141       60,098  
Net income (loss)
    12,149       2,738       6,932       (44,742 )     4,395  
Dividends and accretion on preferred shares
    1,922       1,896       1,871       1,802       -  
Net income (loss) available to common shareholders
    10,227       842       5,061       (46,544 )     4,395  
Per Common Share Data
                                       
Basic and diluted net income (loss)
  $ 1.37     $ .11     $ .68     $ (6.32 )   $ .60  
Cash dividends declared
    -       -       -       .85       1.32  
Book value
    18.54       17.18       16.35       16.11       22.87  
Tangible book value1
    18.35       16.86       15.87       15.44       14.81  
Selected Ratios
                                       
Percentage of net income (loss) to:
                                       
Average shareholders’ equity (ROE)
    7.38 %     1.77 %     4.55 %     (22.68 )%     2.62 %
Average total assets (ROA)
    .65       .14       .33       (1.99 )     .21  
Percentage of common dividends declared to net income
    -       -       -       N/M       220.96  
Percentage of average shareholders’ equity to average total assets
    8.85       8.05       7.32       8.76       7.88  
Total shareholders’ equity
  $ 168,021     $ 157,057     $ 149,896     $ 147,227     $ 168,296  
Total assets
    1,807,232       1,883,590       1,935,693       2,171,562       2,202,167  
Long term borrowings
    178,267       239,664       252,209       316,932       335,661  
Senior perpetual preferred stock
    29,537       29,115       28,719       28,348       -  
Weighted average common shares outstanding -  basic and diluted
    7,457       7,424       7,390       7,365       7,357  

1Represents total common equity less intangible assets divided by the number of common shares outstanding at the end of the period.
N/M-Not meaningful.
 
 
40

 
 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Glossary of Financial Terms
Allowance for loan losses
A valuation allowance to offset credit losses specifically identified in the loan portfolio, as well as management’s best estimate of probable incurred losses in the remainder of the portfolio at the balance sheet date.  Management estimates the allowance balance required using past loan loss experience, an assessment of the financial condition of individual borrowers, a determination of the value and adequacy of underlying collateral, the condition of the local economy, an analysis of the levels and trends of the loan portfolio, and a review of delinquent and classified loans. Actual losses could differ significantly from the amounts estimated by management.

Dividend payout
Cash dividends paid on common shares, divided by net income.

Basis points
Each basis point is equal to one hundredth of one percent.  Basis points are calculated by multiplying percentage points times 100. For example:  3.7 percentage points equals 370 basis points.

Interest rate sensitivity
The relationship between interest sensitive earning assets and interest bearing liabilities.

Net charge-offs
The amount of total loans charged off net of recoveries of loans that have been previously charged off.

Net interest income
Total interest income less total interest expense.

Net interest margin
Taxable equivalent net interest income expressed as a percentage of average earning assets.

Net interest spread
The difference between the taxable equivalent yield on earning assets and the rate paid on interest bearing funds.

Other real estate owned
Real estate not used for banking purposes. For example, real estate acquired through foreclosure.

Provision for loan losses
The charge against current income needed to maintain an adequate allowance for loan losses.

Return on average assets (ROA)
Net income (loss) divided by average total assets. Measures the relative profitability of the resources utilized by the Company.

Return on average equity (ROE)
Net income (loss) divided by average shareholders’ equity. Measures the relative profitability of the shareholders' investment in the Company.

Tax equivalent basis (TE)
Income from tax-exempt loans and investment securities has been increased by an amount equivalent to the taxes that would have been paid if this income were taxable at statutory rates. In order to provide comparisons of yields and margins for all earning assets, the interest income earned on tax-exempt assets is increased to make them fully equivalent to other taxable interest income investments.

Weighted average number of common shares outstanding
The number of shares determined by relating (a) the portion of time within a reporting period that common shares have been outstanding to (b) the total time in that period.
 
 
41

 
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following pages present management’s discussion and analysis of the consolidated financial condition and results of operations of Farmers Capital Bank Corporation (the “Company” or “Parent Company”), a bank holding company, and its bank and nonbank subsidiaries. Bank subsidiaries include Farmers Bank & Capital Trust Company (“Farmers Bank”) in Frankfort, KY, United Bank & Trust Company (“United Bank”) in Versailles, KY, First Citizens Bank (“First Citizens”) in Elizabethtown, KY, and Citizens Bank of Northern Kentucky, Inc. (“Citizens Northern”) in Newport, KY.

At year-end 2012, Farmers Bank had three primary subsidiaries, which include EG Properties, Inc., Leasing One Corporation (“Leasing One”), and Farmers Capital Insurance Corporation (“Farmers Insurance”). EG Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of Farmers Bank. Leasing One is a commercial leasing company in Frankfort, KY and Farmers Insurance is an insurance agency in Frankfort, KY. United Bank had one direct subsidiary at year-end 2012, EGT Properties, Inc. EGT Properties, Inc. is involved in real estate management and liquidation for certain repossessed properties of United Bank. First Citizens had one subsidiary at year-end 2012, HBJ Properties, LLC. HBJ Properties, LLC is involved in real estate management and liquidation for certain repossessed properties of First Citizens. Citizens Northern had one direct subsidiary at year-end 2012, ENKY Properties, Inc., which is involved in real estate management and liquidation for certain repossessed properties of Citizens Northern.

The Company has three active nonbank subsidiaries, FCB Services, Inc. (“FCB Services”), FFKT Insurance Services, Inc. (“FFKT Insurance”), and EKT Properties, Inc. (“EKT”). FCB Services is a data processing subsidiary located in Frankfort, KY that provides services to the Company’s banks as well as unaffiliated entities. FFKT Insurance is a captive property and casualty insurance company insuring primarily deductible exposures and uncovered liability related to properties of the Company. EKT was formed to manage and liquidate certain real estate properties repossessed by the Company. In addition, the Company has three subsidiaries organized as Delaware statutory trusts that are not consolidated into its financial statements. These trusts were formed for the purpose of issuing trust preferred securities. All significant intercompany transactions and balances are eliminated in consolidation.

For a complete list of the Company’s subsidiaries, please refer to the discussion under the heading “Organization” included in Part 1, Item 1 of this Form 10-K. The following discussion should be read in conjunction with the audited consolidated financial statements and related footnotes that follow.

Forward-Looking Statements
This report contains forward-looking statements with the meaning of 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”), under the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties.  Statements in this report that are not statements of historical fact are forward-looking statements. In general, forward-looking statements relate to a discussion of future financial results or projections, future economic performance, future operational plans and objectives, and statements regarding the underlying assumptions of such statements.  Although the Company believes that the assumptions underlying the forward-looking statements contained herein are reasonable, any of the assumptions could be inaccurate, and therefore, there can be no assurance that the forward-looking statements included herein will prove to be accurate.

Various risks and uncertainties may cause actual results to differ materially from those indicated by the Company’s forward-looking statements. In addition to the risks described under Part 1, Item 1A “Risk Factors” in this report, factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to: economic conditions (both generally and more specifically in the markets in which the Company and its subsidiaries operate) and lower interest margins; competition for the Company’s customers from other providers of financial services; deposit outflows or reduced demand for financial services and loan products; government legislation, regulation, and changes in monetary and fiscal policies (which changes from time to time and over which the Company has no control); changes in interest rates; changes in prepayment speeds of loans or investment securities; inflation; material unforeseen changes in the liquidity, results of operations, or financial condition of the Company’s customers; changes in the level of non-performing assets and charge-offs; changes in the number of common shares outstanding; the capability of the Company to successfully enter into a definitive agreement for and close anticipated transactions; unexpected claims or litigation against the Company; technological or operational difficulties; the impact of new accounting pronouncements and changes in policies and practices that may be adopted by regulatory agencies; acts of war
 
42

 

or terrorism; the ability of the parent company to receive dividends from its subsidiaries; the impact of larger or similar financial institutions encountering difficulties, which may adversely affect the banking industry or the Company; the Company or its subsidiary banks’ ability to maintain required capital levels and adequate funding sources and liquidity; and other risks or uncertainties detailed in the Company’s filings with the Securities and Exchange Commission, all of which are difficult to predict and many of which are beyond the control of the Company.
 
The Company’s forward-looking statements are based on information available at the time such statements are made. The Company expressly disclaims any intent or obligation to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events, or other changes.

Application of Critical Accounting Policies
The Company’s audited consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices applicable to the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility from period to period. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management primarily through the use of internal cash flow modeling techniques.

The most significant accounting policies followed by the Company are presented in Note 1 of the Company’s 2012 audited consolidated financial statements. These policies, along with the disclosures presented in other financial statement notes and in this management’s discussion and analysis of financial condition and results of operations, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and fair value measurements to be the accounting areas that requires the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.

Allowance for Loan Losses
The allowance for loan losses represents credit losses specifically identified in the loan portfolio, as well as management's estimate of probable incurred credit losses in the loan portfolio at the balance sheet date. Determining the amount of the allowance for loan losses and the related provision for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant changes. The loan portfolio also represents the largest asset group on the consolidated balance sheets. Additional information related to the allowance for loan losses that describes the methodology and risk factors can be found under the captions “Asset Quality” and “Nonperforming Assets” in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations, as well as Notes 1 and 3 of the Company’s 2012 audited consolidated financial statements.

Fair Value Measurements
The carrying value of certain financial assets and liabilities of the Company is impacted by the application of fair value measurements, either directly or indirectly.  Fair value is the price that would be received to sell an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as investment securities classified as available for sale.  In other cases,
 
43

 

management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established.  
 
The Company estimates the fair value of a financial instrument using a variety of valuation methods. Where financial instruments are actively traded and have quoted market prices, quoted market prices are used for fair value. The Company characterizes active markets as those where transaction volumes are sufficient to provide objective pricing information, with reasonably narrow bid/ask spreads, and where received quoted prices do not vary widely. When the financial instruments are not actively traded, other observable market inputs such as quoted prices of securities with similar characteristics may be used, if available, to determine fair value. Inactive markets are characterized by low transaction volumes, price quotations that vary substantially among market participants, or in which minimal information is released publicly.

When observable market prices do not exist, the Company estimates fair value primarily by using cash flow and other financial modeling methods. The valuation methods may also consider factors such as liquidity and concentration concerns. Other factors such as model assumptions, market dislocations, and unexpected correlations can affect estimates of fair value. Changes in these underlying factors, assumptions, or estimates in any of these areas could materially impact the amount of revenue or loss recorded.
 
Additional information regarding fair value measurements can be found in Notes 1 and 18 of the Company’s 2012 audited consolidated financial statements.  The following is a summary of the Company’s more significant assets that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by the Company:

Available For Sale Investment Securities
Investment securities classified as available for sale are measured and reported at fair value on a recurring basis. Available for sale investment securities are valued primarily by independent third party pricing services under the market valuation approach that include, but are not limited to, the following inputs:

 
·
U.S. Treasury (“Treasury”) securities are priced using dealer quotes from active market makers and real-time trading systems;
 
·
Mutual funds and marketable equity securities are priced utilizing real-time data feeds from active market exchanges for identical securities; and
 
·
Government-sponsored agency debt securities, obligations of states and political subdivisions, mortgage-backed securities, corporate bonds, and other similar investment securities are priced with available market information through processes using benchmark yields, matrix pricing, prepayment speeds, cash flows, live trading data, and market spreads sourced from new issues, dealer quotes, and trade prices, among others sources.

At December 31, 2012, all of the Company’s available for sale investment securities were measured using observable market data.
 
Other Real Estate Owned
Other real estate owned (“OREO”) includes properties acquired by the Company through, or in lieu of, actual loan foreclosures and is initially carried at fair value less estimated costs to sell. Fair value of assets is generally based on third party appraisals of the property that includes comparable sales data. If the carrying amount exceeds fair value less estimated costs to sell, an impairment loss is recorded through expense. OREO is subsequently accounted for at the lower of carrying amount or fair value less estimated costs to sell. At December 31, 2012, OREO was $52.6 million compared to $38.2 million at year-end 2011.

Impaired Loans
Loans are considered impaired when it is probable that the Company will be unable to collect all amounts due under the contractual terms of the loan agreement. Impaired loans are measured at the present value of expected future cash flows, discounted at the loan’s effective interest rate, at the loan’s observable market price, or at the fair value of the collateral based on recent appraisals if the loan is collateral dependent. If the value of an impaired loan is less than the unpaid
 
44

 

balance, the difference is credited to the allowance for loan losses with a corresponding charge to provision for loan losses. Loan losses are charged against the allowance for loan losses when management believes the uncollectibility of a loan is confirmed.
 
Appraisals used in connection with valuing collateral dependent loans may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraisers take absorption rates into consideration and adjustments are routinely made in the appraisal process to identify differences between the comparable sales and income data available. Such adjustments consist primarily of estimated costs to sell that are not included in certain appraisals or to update appraised collateral values as a result of market declines of similar properties for which a newer appraisal is available. These adjustments can be significant. Impaired loans were $63.9 million and $138 million at year-end 2012 and 2011, respectively.

EXECUTIVE LEVEL OVERVIEW

The Company offers a variety of financial products and services at its 36 banking locations in 23 communities throughout Central and Northern Kentucky. The Company has four separately chartered commercial banks that operate under a community banking philosophy. This philosophy is focused primarily on understanding the banking needs and providing competitively priced products and a high level of personalized service to those in the local communities and surrounding areas in which the Company operates. The most significant products and services the Company offers include consumer and business lending, checking, savings, and other deposit accounts, automated teller machines, electronic bill payments, and providing trust services among other traditional banking products and services. The primary goals of the Company are to continually improve profitability and shareholder value, increase and maintain a strong capital position, provide excellent service to our customers through our community banking structure, and to provide a challenging and rewarding work environment for our employees.

The Company generates a significant amount of its revenue, cash flows, and net income from interest income and net interest income. The ability to properly manage net interest income under changing market environments is crucial to the success of the Company. Managing credit risk also significantly influences the operating results of the Company. The overall weak economy of the last several years, which has contributed to higher credit losses and lower earnings, showed modest improvement during 2012. However, high unemployment rates and weak economic growth continue to hinder a more robust recovery. Despite the economic challenges, the Company made notable improvement in the credit quality of its loan portfolio during 2012.

Significant issues and events impacting the Company’s operations during 2012 and those likely to impact future operations are summarized below.

 
·
The level of nonperforming assets continues to be the most important issue facing the Company. Although nonperforming assets have declined to their lowest point since the third quarter of 2009, they remain elevated at $106 million or 5.9% of total assets. Nonperforming assets negatively impact the Company’s earnings primarily through lower interest income, recording related provisions for loans losses, and asset impairment charges for repossessed loan collateral.
 
·
The Parent Company and its three subsidiary banks that are subject to agreements entered into with their banking regulators in prior years remained in compliance with the terms of those agreements. In the third quarter, Farmers Bank obtained regulatory approval for the payment of $4.0 million in dividends to the Parent Company, the first dividend payment by Farmers Bank since 2008. During the first quarter of 2013, the Company announced that it received notification that, as a result of a regulatory examination, the Memorandum of Understanding at Farmers Bank had been terminated effectively immediately. The Company continues to focus on continual improvement and the eventual removal of the other existing regulatory agreements within the Company.
 
·
The overall interest rate environment during 2012, as measured by the Treasury yield curve, continued near historical low levels. Shorter-term yields for three and six-month maturities were relatively unchanged at .04% and .11%, respectively, at year-end 2012 compared to year-end 2011. For longer-term maturities, the three, five, and ten year maturity periods each declined, and ended the year at .35%, .72%, and 1.76%, respectively. The thirty year maturity period increased 6 basis points to 2.95%. The Federal Reserve Board has reiterated its objective of holding short-term interest rates at exceptionally low levels for at least as long as the unemployment
 
 
45

 
 
 
rate remains above 6.5% and inflation remains within policy goals. The near historical low rate environment makes managing the Company’s net interest margin very challenging. The Company has implemented a strategy to lower its cost of funds mainly by allowing higher-rate time deposits to roll off or reprice at significantly lower interest rates.
 
·
During 2012, the Treasury conducted numerous auctions of as part of its ongoing efforts to wind down and recover investments it made under the Capital Purchase Program (“CPP”). One such auction during the second quarter included selling to private investors all of the Treasury’s $30.0 million investment it held in the Company’s Series A preferred stock. The Company received no proceeds as part of the transaction. During the third quarter, the Company repurchased the warrant it issued to the Treasury as part of the CPP at a mutually agreed upon price of $75 thousand. The Treasury no longer has an equity stake in the Company.
 
·
The Company’s outstanding preferred stock currently pay a cumulative cash dividend quarterly at 5.0% per annum, resetting to 9.0% during the first quarter of 2014 if not redeemed. The Company’s goal is to repurchase the preferred shares either in whole or in part prior to the dividend rate increasing to 9.0%, using internally generated cash flows for any potential repurchase.
 
·
The size of the balance sheet declined over the course of 2012. The individual components, however, represent an overall stronger financial position compared to a year ago. Total shareholders’ equity increased $11.0 million during 2012. Loan balances decreased as high quality demand continues to be soft. Investment securities declined and the Company used part of the proceeds from maturities and other securities transactions to build sufficient liquidity to repay maturing long-term borrowings. Higher-priced time deposits decreased $107 million or 16.5% which, combined with a lower average rate paid, led to an increase in net interest margin. The allowance for loan losses as a percentage of outstanding loans (net of unearned income) was 2.43% at year-end 2012. Regulatory capital ratios have improved on a consolidated basis as well as at each individual bank subsidiary and are well above regulatory minimums.
 
·
Although the Parent Company periodically evaluates potential capital raising scenarios, there is currently no directive by regulators to raise any additional capital and no determination has been made as to if or when a capital raise will be completed. Net proceeds from a possible sale of securities could be used for any corporate purpose determined by the Company’s board of directors.

 
46

 

RESULTS OF OPERATIONS

The Company reported net income of $12.1 million or $1.37 per common share for 2012 compared to $2.7 million or $.11 per common share for 2011. This represents an increase of $9.4 million or $1.26 per common share. Selected income statement amounts and related information is presented in the table below.

(In thousands except per share data)
           
Twelve Months Ended December 31,
 
2012
   
2011
   
Increase
(Decrease)
 
Interest income
  $ 71,222     $ 78,349     $ (7,127 )
Interest expense
    18,258       24,670       (6,412 )
Net interest income
    52,964       53,679       (715 )
Provision for loan losses
    2,772       13,487       (10,715 )
Net interest income after provision for loan losses
    50,192       40,192       10,000  
Noninterest income
    24,654       24,391       263  
Noninterest expenses
    59,787       62,492       (2,705 )
Income before income taxes
    15,059       2,091       12,968  
Income tax expense (benefit)
    2,910       (647 )     3,557  
Net income
  $ 12,149     $ 2,738     $ 9,411  
Less preferred stock dividends and discount accretion
    1,922       1,896       26  
Net income available to common shareholders
  $ 10,227     $ 842     $ 9,385  
                         
Basic and diluted net income per common share
  $ 1.37     $ .11     $ 1.26  
                         
Weighted average common shares outstanding – basic and diluted
    7,457       7,424       33  
Return on average assets
    .65 %     .14 %     51  bp
Return on average equity
    7.38 %     1.77 %     561  bp
bp = basis points.

The increase in net income for 2012 compared to the 2011 is primarily the result of a lower provision for loan losses in the amount of $10.7 million or 79.4% and a decrease in expenses related to repossessed real estate of $2.1 million or 28.9%. The decrease in the provision for loan losses is attributed to an overall improvement in the credit quality of the loan portfolio and a decrease in loan balances outstanding. Nonperforming loans, loans past due 30-89 days, and watch list loans all decreased in the annual comparison. Historical loss rates have also improved, mainly as higher charge-off activity from the early periods of the recent economic decline have rolled out of the Company’s three-year look-back period used when evaluating the allowance for loan losses. Collateral values have begun to stabilize. Expenses related to repossessed properties decreased primarily due to lower impairment charges of $1.7 million. Impairment charges for the prior year include $2.8 million attributed to a single real estate development credit that was written down to its fair value consistent with an updated appraisal.

The more significant components related to the Company’s results of operations are included below.

Interest Income
Interest income results from interest earned on earning assets, which primarily includes loans and investment securities. Interest income is affected by volume (average balance), the composition of earning assets, and the related rates earned on those assets. Total interest income for 2012 was $71.2 million, a decrease of $7.1 million or 9.1% compared to $78.3 million for 2011. With the exception of nontaxable investment securities, interest income decreased across all major earning asset categories. The decrease in interest income is mainly related to lower interest on loans, which decreased primarily as a result of lower volumes. Interest on investment securities decreased due to lower average rates earned, offsetting the impact of higher volumes. Rate declines continue to be driven by a slow-growth economy and the overall strategy by the Company of being more selective in pricing both its loans and deposits. Actions taken by the Federal Reserve Board has also kept the level of interest rates near historic lows throughout 2012, with the objective of holding short-term interest rates at exceptionally low levels until unemployment levels decline to a target of 6.5%. In general, the Company’s variable and floating rate assets and liabilities that have reset since the prior year, as well as activity related to
 
47

 
 
new earning assets and funding sources, have repriced downward to reflect the overall lower interest rate environment. The Company’s tax equivalent yield on earning assets was 4.2% for 2012, a decrease of 22 basis points compared to 4.5% for 2011.
 
Interest Expense
Interest expense results from incurring interest on interest bearing liabilities, which are made up of interest bearing deposits, federal funds purchased, securities sold under agreements to repurchase, and other borrowed funds. Interest expense is affected by volume, composition of interest bearing liabilities, and the related rates paid on those liabilities. Total interest expense was $18.3 million for 2012, a decrease of $6.4 million or 26.0% compared to $24.7 million for 2011. Interest expense decreased mainly as a result of a lower average rate paid on deposits in an overall lower interest rate environment. Volume reductions, primarily on time deposits and long-term borrowings, also contributed to the decrease in interest expense. For deposits, the Company has more aggressively repriced higher-rate maturing time deposits downward or allowed them to mature without renewal. Long-term borrowings outstanding declined in 2012 as a result of scheduled principal payments related to the Company’s 2007 balance sheet leverage transaction and outstanding Federal Home Loan Bank (“FHLB”) borrowings. The average rate paid on interest bearing liabilities was 1.3% for 2012, a decrease of 34 basis points compared to 1.6% for 2011.

The decrease in interest income for 2012 exceeded the reduction in interest expense due to the repricing structure of the Company’s earning assets and rate paying liabilities. The very low interest rate environment that currently exists makes it increasingly difficult to reprice already low interest paying liabilities further downward. The short-term targeted federal funds rate has remained at near zero percent since the end of 2008.

Net Interest Income
Net interest income is the most significant component of the Company’s operating earnings. Net interest income is the excess of the interest income earned on earning assets over the interest paid for funds to support those assets. The two most common metrics used to analyze net interest income are net interest spread and net interest margin.  Net interest spread represents the difference between the taxable equivalent yields on earning assets and the rates paid on interest bearing liabilities.  Net interest margin represents the percentage of taxable equivalent net interest income to average earning assets.  Net interest margin will exceed net interest spread because of the existence of noninterest bearing sources of funds, principally demand deposits and shareholders’ equity, which are also available to fund earning assets.  Changes in net interest income and margin result from the interaction between the volume and composition of earning assets, their related yields, and the associated cost and composition of the interest bearing liabilities. Accordingly, portfolio size, composition, and the related yields earned and the average rates paid have a significant impact on net interest spread and margin. The table following this discussion represents the major components of interest earning assets and interest bearing liabilities on a tax equivalent basis.  To compare the tax-exempt asset yields to taxable yields, amounts in the table are adjusted to pretax equivalents based on the marginal corporate Federal tax rate of 35%.

Tax equivalent net interest income was $54.7 million for 2012, a decrease of $715 thousand or 1.3% compared to $55.4 million for 2011. Net interest margin was 3.18%, an increase of 9 basis points from 3.09% for the prior year. The increase in net interest margin was driven by a 12 basis point increase in the net interest spread, which was 2.96% for 2012 compared to 2.84% for 2011.

The Company actively monitors and proactively manages the rate sensitive components of both its assets and liabilities in a continuously changing and difficult market environment. Competition in the Company’s market areas continues to be intense, and the overall interest rate environment remains low by historical measures. The Federal Reserve has kept its short-term federal funds target rate at near zero percent since mid-December 2008 and has indicated that it expects to maintain that rate at an exceptionally low level while unemployment rates remain above 6.5%. Yields on Treasury securities of medium and longer-term maturity structures are relatively unchanged or slightly lower at year-end 2012 than a year earlier. The two and 10-year notes decreased 1 basis point and 12 basis points, respectively in the comparison while the 30-year bond increased 6 basis points.

Similar to the short-term federal funds target rate, the prime interest rate has not changed since December 2008. The Company uses the prime interest rate as part of its pricing model primarily on variable rate commercial real estate loans. The prime interest rate can have a significant impact on the Company’s interest income on loans that reprice based on changes to this rate. The Company’s variable interest rate loans contain provisions that limit the amount of increase or
 
48

 

decrease in the interest rate during the life of a loan. This will limit the increase or decrease in interest income on loans that have interest rates tied to the prime interest rate. For 2012, the average yield earned on loans was 5.5%, which exceeded the prime interest rate of 3.25% at year-end 2012. Predicting the movement of future interest rates is uncertain.
 
During 2012, the average rates for two of the most significant components of net interest income for the Company, loans and time deposits, both declined. The average rate earned on the Company’s loan portfolio for 2012 edged downward 7 basis points to 5.5% and the average rate paid on time deposits decreased 46 basis points to 1.4% compared to 2011. The Company expects its net interest margin to trend upward in the near term according to internal modeling using expectations about future market interest rates, the maturity structure of the Company’s earning assets and liabilities, and other factors. In particular, the Company’s cost of funds is expected to decrease in the near term primarily from the maturity of $50.0 million of 3.98% fixed rate borrowings combined with $23.2 million of 6.60% fixed rate borrowings that repriced downward to a floating interest rate of three-month LIBOR plus 132 basis points. Each of these events occurred during the fourth quarter of 2012. Future results, however, could be significantly different than expectations.
 
 
49

 
 
Distribution of Assets, Liabilities and Shareholders’ Equity: Interest Rates and Interest Differential
 
Years Ended December 31,
 
2012
   
2011
   
2010
 
   
Average
         
Average
   
Average
         
Average
   
Average
         
Average
 
(In thousands)
 
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Earning Assets
                                                     
Investment securities
                                                     
Taxable
  $ 532,197     $ 12,872       2.42 %   $ 494,341     $ 14,387       2.91 %   $ 441,635     $ 16,565       3.75 %
Nontaxable1
    88,369       3,313       3.75       63,837       2,848       4.46       82,327       4,149       5.04  
Interest bearing deposits with banks, federal funds sold and securities purchased under agreements to resell
    66,757       160       .24       106,037       241       .23       133,586       280       .21  
Loans 1,2,3
    1,035,959       56,639       5.47       1,130,273       62,635       5.54       1,236,202       70,946       5.74  
Total earning assets
    1,723,282     $ 72,984       4.24 %     1,794,488     $ 80,111       4.46 %     1,893,750     $ 91,940       4.85 %
Allowance for loan losses
    (26,772 )                     (29,856 )                     (25,467 )                
Total earning assets, net of allowance for loan losses
    1,696,510                       1,764,632                       1,868,283                  
Nonearning Assets
                                                                       
Cash and due from banks
    25,165                       19,349                       64,216                  
Premises and equipment, net
    37,612                       39,319                       39,541                  
Other assets
    100,659                       95,785                       106,347                  
Total assets
  $ 1,859,946                     $ 1,919,085                     $ 2,078,387                  
Interest Bearing Liabilities
                                                                 
Deposits
                                                                       
Interest bearing demand
  $ 281,076     $ 240       .09 %   $ 258,244     $ 355       .14 %   $ 258,674     $ 453       .18 %
Savings
    311,724       626       .20       293,526       1,204       .41       272,080       1,663       .61  
Time
    588,544       8,373       1.42       687,517       12,929       1.88       807,730       20,257       2.51  
Federal funds purchased and other short-term borrowings
    26,134       96       .37       38,043       191       .50       46,755       324       .69  
Securities sold under agreements to repurchase and other long-term borrowings
    223,722       8,923       3.99       246,153       9,991       4.06       304,356       12,251       4.03  
Total interest bearing liabilities
    1,431,200     $ 18,258       1.28 %     1,523,483     $ 24,670       1.62 %     1,689,595     $ 34,948       2.07 %
Noninterest Bearing Liabilities
                                                                       
Demand deposits
    238,443                       217,357                       210,367                  
Other liabilities
    25,697                       23,685                       26,219                  
Total liabilities
    1,695,340                       1,764,525                       1,926,181                  
Shareholders’ equity
    164,606                       154,560                       152,206                  
Total liabilities and shareholders’ equity
  $ 1,859,946                     $ 1,919,085                     $ 2,078,387                  
Net interest income
            54,726                       55,441                       56,992          
TE basis adjustment
            (1,762 )                     (1,762 )                     (2,189 )        
Net interest income
          $ 52,964                     $ 53,679                     $ 54,803          
Net interest spread
                    2.96 %                     2.84 %                     2.78 %
Impact of noninterest bearing sources of funds
                    .22                       .25                       .22  
Net interest margin
                    3.18 %                     3.09 %                     3.00 %
 
1
Income and yield stated at a fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.
2
Loan balances include principal balances on nonaccrual loans.
3
Loan fees included in interest income amounted to $1.1 million, $912 thousand, and $1.4 million for 2012, 2011, and 2010, respectively.
 
 
50

 
 
The following table is an analysis of the change in net interest income.

Analysis of Changes in Net Interest Income (tax equivalent basis)
 
   
Variance
   
Variance Attributed to
   
Variance
   
Variance Attributed to
 
(In thousands)
    2012/20111    
Volume
   
Rate
      2011/20101    
Volume
   
Rate
 
Interest Income
                                       
Taxable investment securities
  $ (1,515 )   $ 1,041     $ (2,556 )   $ (2,178 )   $ 1,822     $ (4,000 )
Nontaxable investment securities2
    465       970       (505 )     (1,301 )     (861 )     (440 )
Interest bearing deposits with banks, federal funds sold and securities purchased under agreements to resell
    (81 )     (92 )     11       (39 )     (63 )     24  
Loans2
    (5,996 )     (5,208 )     (788 )     (8,311 )     (5,909 )     (2,402 )
Total interest income
    (7,127 )     (3,289 )     (3,838 )     (11,829 )     (5,011 )     (6,818 )
Interest Expense
                                               
Interest bearing demand deposits
    (115 )     28       (143 )     (98 )     (1 )     (97 )
Savings deposits
    (578 )     71       (649 )     (459 )     122       (581 )
Time deposits
    (4,556 )     (1,688 )     (2,868 )     (7,328 )     (2,727 )     (4,601 )
Federal funds purchased and other short-term borrowings
    (95 )     (52 )     (43 )     (133 )     (54 )     (79 )
Securities sold under agreements to repurchase and other long-term borrowings
    (1,068 )     (898 )     (170 )     (2,260 )     (2,351 )     91  
Total interest expense
    (6,412 )     (2,539 )     (3,873 )     (10,278 )     (5,011 )     (5,267 )
Net interest income
  $ (715 )   $ (750 )   $ 35     $ (1,551 )   $ -     $ (1,551 )
Percentage change
    100.0 %     104.9 %     (4.9 )%     100.0 %     - %     100.0 %
 
1
The changes which are not solely due to rate or volume are allocated on a percentage basis using the absolute values of rate and volume variances as a basis for allocation.
2
Income stated at fully tax equivalent basis using the marginal corporate Federal tax rate of 35%.

Noninterest Income

The components of noninterest income are as follows for the periods indicated:

Years Ended December 31, (In thousands)
 
2012
   
2011
   
Increase
(Decrease
)
Service charges and fees on deposits
  $ 8,124     $ 8,617     $ (493 )
Allotment processing fees
    5,215       5,346       (131 )
Other service charges, commissions, and fees
    4,478       4,248       230  
Data processing income
    242       792       (550 )
Trust income
    1,909       2,085       (176 )
Investment securities gains, net
    1,209       1,355       (146 )
Gain on sale of mortgage loans, net
    1,918       982       936  
Income from company-owned life insurance
    1,524       939       585  
Other
    35       27       8  
Total noninterest income
  $ 24,654     $ 24,391     $ 263  
 
The more significant items impacting noninterest income are included below.

 
·
The $493 thousand or 5.7% decrease in service charges and fees on deposits was driven by lower fees from overdraft/insufficient funds of $682 thousand or 12.5% related to lower transaction volume. Transaction volume has declined similar to trends experienced by the banking industry as a whole, mainly as a result of increased consumer compliance regulations and changes in customer behavior that have evolved over the last several years. Dormant fees related to customer allotment accounts increased $222 thousand or 11.1%.
 
 
51

 
 
 
·
The decrease in allotment processing fees of $131 thousand or 2.5% is primarily due to lower transaction volumes. Transaction volumes have declined primarily as a result of the Company terminating its relationship with two of its larger-volume corporate clients during 2010.
 
·
The $230 thousand or 5.4% increase from other service charges, commissions, and fees is attributed to numerous smaller-balance increases included within this line item. Interchange fees increased $84 thousand or 3.7% related to increased debit card transaction volumes, followed by an increase from loan servicing fees of $56 thousand or 17.0% related to a larger mortgage loan servicing portfolio.
 
·
The decrease in data processing income of $550 thousand or 69.4% is driven by a $397 thousand or 73.9% decline in fees related to the winding down of the depository services contract with the Commonwealth of Kentucky (“Commonwealth”). These fee reductions have been partially offset by decreases in noninterest expenses spread over multiple line items categories. Data processing fees have also declined $154 thousand or 95.7% related to the lower processing volumes from the Commonwealth’s Women, Infants, and Children supplemental nutrition program. The program has changed its method of processing from a manual process to a paperless system that is now served by an unrelated third party. The Company expects to continue processing only a small number of transactions subject to manual processing.
 
·
The $176 thousand or 8.4% decrease in trust income is due mainly to accrual refinements during the prior-year second quarter that resulted in a one-time increase in the amount of $165 thousand.
 
·
The $146 thousand or 10.8% decrease in the net gain on the sale of investment securities is attributed to the volume, timing, and market value of the individual securities sold. Sales of investment securities take place at irregular intervals and amounts based on current asset and liability management strategies and market conditions. The Company periodically sells investment securities to lock in gains, increase yield, restructure expected future cash flows, and/or enhance its capital position as opportunities occur.
 
·
Net gains on the sale of mortgage loans increased $936 thousand or 95.3% as the volume of loans sold increased $43.6 million or 106%. The increase in loans sold has been fueled by a very favorable low interest rate environment. The interest rate environment during 2012 declined beyond the already low levels that existed during 2011, which led to a spike in home refinancing and purchasing activity for the current year.
 
·
The $585 thousand or 62.3% increase in income from company-owned life insurance is mainly the result of a $529 thousand gain related to death benefit proceeds received during 2012. There was no similar transaction in 2011.

Noninterest Expense

The components of noninterest expense are as follows for the periods indicated:

Years Ended December 31, (In thousands)
 
2012
   
2011
   
Increase
(Decrease)
 
Salaries and employee benefits
  $ 28,190     $ 26,986     $ 1,204  
Occupancy expenses, net
    4,757       4,846       (89 )
Equipment expenses
    2,364       2,503       (139 )
Data processing and communication expense
    4,271       4,636       (365 )
Bank franchise tax
    2,381       2,572       (191 )
Amortization of intangibles
    1,014