10-K 1 v369445_10k.htm ANNUAL REPORT
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
(Mark One)
 
  x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the Fiscal Year Ended December 31, 2013
 
OR
 
  ¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the transition period from ______________ to ___________________.
 
Commission File Number: 001-34214
 
 
THE BANK OF KENTUCKY FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
 
Kentucky
 
61-1256535
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 
111 Lookout Farm Drive, Crestview Hills, Kentucky 41017
(Address of principal executive offices) (Zip Code)
 
Registrant’s telephone number, including area code: (859) 371-2340
 
Securities registered pursuant to Section 12(b) of the Exchange Act:
 
Common Stock, without par value
 
The Nasdaq Stock Market LLC
(Title of each class)
 
(Name of each exchange on which registered)
   
Securities registered pursuant to Section 12(g) of the Exchange Act:
 
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨     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 ¨     No x
 
Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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   ¨
 
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 ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (Check one):
 
Large accelerated filer  ¨     Accelerated filer x     Non-accelerated filer  ¨   Smaller reporting company     ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨     No x
 
The aggregate market value of the voting Common Stock held by non-affiliates of the registrant as of June 28, 2013 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $192,283,000. 
At March 4, 2014, there were 7,647,093 shares of the registrant’s Common Stock issued and outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Part III of this Form 10-K incorporates by reference certain information from the Registrant’s definitive Proxy Statement for the 2014 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission.
 
 
 
TABLE OF CONTENTS
 
PART I
 
 
2
Item 1.
Business
 
2
Item 1A.
Risk Factors
 
24
Item 1B.
Unresolved Staff Comments
 
30
Item 2.
Properties
 
30
Item 3.
Legal Proceedings
 
30
Item 4.
Mine Safety Disclosures
 
30
 
 
 
 
PART II.
 
 
31
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
31
Item 6.
Selected Financial Data
 
33
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operation
 
34
Item 7A.
Quantitative and Qualitative Disclosure about Market Risk
 
52
Item 8.
Financial Statements and Supplementary Data
 
53
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
117
Item 9A.
Controls and Procedures
 
117
Item 9B.
Other Information
 
117
 
 
 
 
PART III
 
 
117
Item 10.
Directors, Executive Officers and Corporate Governance
 
117
Item 11.
Executive Compensation
 
117
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
117
Item 13.
Certain Relationships and Related Transactions, and Director Independence
 
117
Item 14.
Principal Accountant Fees and Services
 
117
 
 
 
PART IV
 
 
118
Item 15.
Exhibits and Financial Statement Schedules
 
118
 
 
 
 
SIGNATURES
 
 
119
 
 
 
INDEX TO EXHIBITS
 
120 
 
 
 
PART I
Item 1.   Business
 
General
 
The Bank of Kentucky Financial Corporation (“BKFC”) is a bank holding company that was incorporated as a Kentucky corporation in 1993 and engaged in no business activities until 1995, when BKFC acquired all of the issued and outstanding shares of common stock of The Bank of Kentucky, Inc. (the “Bank”), a bank incorporated under the laws of the Commonwealth of Kentucky (formerly named The Bank of Boone County, Inc.), and Burnett Federal Savings Bank (“Burnett”), a federal savings bank that was later merged into the Bank.  BKFC, through the Bank, is engaged in the banking business in northern Kentucky and Hamilton county, Ohio. 
 
Formed in 1990, the Bank provides financial services and other financial solutions through 32 offices located in northern Kentucky, which includes Boone, Kenton and Campbell counties and parts of Grant, Pendleton and Gallatin counties in northern Kentucky, and Hamilton county in Ohio.  The principal products produced and services rendered by the Bank are as follows:
 
· Commercial Banking – The Bank provides a full range of commercial banking services to corporations and other business clients.  Loans are provided for a variety of general corporate purposes, including financing for commercial and industrial projects, income producing commercial real estate, owner-occupied real estate and construction and land development.  The Bank also provides a wide range of deposit services, including checking, lockbox services and other treasury management services.
 
· Consumer Banking – The Bank provides banking services to consumers, including checking, savings and money market accounts as well as certificates of deposits and individual retirement accounts.  The Bank also provides consumers with electronic banking products like internet banking, debit cards and 56 ATMs.  In addition, the Bank provides consumer clients with installment and real estate loans and home equity lines of credit.
 
· Trust Services – The Bank offers specialized services and expertise in the areas of fiduciary services and wealth management.  The fiduciary services include administration of personal trusts and estates.  Wealth management services include investment management of accounts for individuals, institutions and not-for-profit entities.  Also, brokerage and insurance products are offered through the Bank’s broker-dealer relationship with Cetera, Inc.
 
The majority of the Bank’s loan portfolio, approximately 77%, consists of loans secured with or by real estate.  Loans secured with real estate are further broken down by loan type and borrower.  Included in loans secured with or by real estate as of December 31, 2013 are:
 
· Residential real estate loans - $283 million or 23% of loans.   These loans are secured by residential properties, where the repayment comes from the borrower’s personal cash flows and liquidity, and collateral values are a function of residential real estate values in the markets we serve.
 
· Commercial real estate loans - $372 million or 30% of loans.  This loan type includes non-owner-occupied commercial real estate loans and construction and land development loans. These loans are made to borrowers where the primary source of repayment is derived from the cash flows generated by the real estate collateral.  These loans are secured by property such as apartment complexes, retail centers and land which is being developed and sold.
 
· Owner-occupied commercial real estate loans - $302 million or 24% of loans.  These are loans secured by real estate where the operating business is the source of repayment.  These properties serving as collateral are characterized as industrial, warehouse or office.
 
BKFC’s senior management monitors and evaluates financial performance on a company-wide basis.  All of BKFC’s financial service operations are similar, and considered by management to be aggregated into one reportable operating segment for purposes of generally accepted accounting principles, although certain management responsibilities are assigned by business line.  Accordingly, all of BKFC’s operations are aggregated in one reportable operating segment in this Annual Report on Form 10-K (this “Annual Report”).  Revenue, net income and total assets for the years ended December 31, 2013, 2012 and 2011 are presented below:
 
 
2

 
 
 
For the year ended December 31,
 
 
 
2013
 
2012
 
2011
 
 
 
(Dollars in thousands)
 
Revenue:
 
 
 
 
 
 
 
 
 
 
Net Interest Income
 
$
55,254
 
$
56,185
 
$
55,538
 
Non-interest Income
 
 
24,011
 
 
22,421
 
 
20,724
 
Total Revenue
 
 
79,265
 
 
78,606
 
 
76,262
 
Net Income available to common shareholders
 
$
19,765
 
$
18,145
 
$
15,517
 
Total Assets
 
$
1,857,492
 
$
1,844,104
 
$
1,744,724
 
 
As described in more detail in this Annual Report, the recent economic recession and ongoing economic recovery have had a substantial effect on the operations of BKFC and the Bank.  In an effort to stabilize and strengthen the financial markets and the banking industry, the United States Congress and various federal agencies have taken a number of significant actions over the past several years, including the passage of legislation and the implementation of a number of programs.  The most recent of these actions was the passage into law, on July 21, 2010, of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  See below under “Regulation and Supervision” for further discussion of the Dodd-Frank Act. 
 
BKFC and the Bank participated in two government programs enacted in response to the recession.  First, in October 2008 the Bank participated in the transaction account guarantee component of the Federal Deposit Insurance Corporation’s (the “FDIC”) Temporary Liquidity Guarantee Program (the “TLGP”), whereby the FDIC would temporarily guarantee all depositor funds in qualifying non-interest-bearing transaction accounts.  Second, in February 2009 BKFC participated in the Capital Purchase Program (“CPP”) as part of the Troubled Asset Relief Program (“TARP”) sponsored by the United States Department of the Treasury (the “Treasury Department”), in order to enhance BKFC’s liquidity and capital position.  BKFC received $34.0 million under the CPP in exchange for issuing 34,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the “Series A Preferred Stock”), and a warrant (the “Warrant”) to purchase approximately 274,784 shares of BKFC common stock (“Common Stock”).  The Treasury Department’s authority to make new investments under the CPP expired in October 2010.  On December 22, 2010, BKFC effected the repurchase of one-half of the outstanding $34 million of Series A Preferred Stock held by the Treasury Department.  On November 23, 2011, BKFC effected the repurchase of the final $17 million of Series A Preferred Stock held by the Treasury Department.  In the second quarter of 2013, the Company completed the repurchase of the Warrant for an aggregate repurchase price of $2,150,649. Prior to the repurchase transaction, the Warrant permitted the Treasury Department to purchase 276,078.12 shares of the Company’s common stock at an exercise price of $18.473 per share. Neither BKFC nor the Bank has actively participated in any of the other wide-ranging programs that were instituted by the federal government in response to the economic recession.  For a discussion of the impact of the current economic conditions on the financial condition and results of operations of BKFC and its subsidiaries, see below under “The Current Economic Environment,” as well as “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report.
 
As a bank incorporated under the laws of the Commonwealth of Kentucky, the Bank is subject to regulation, supervision and examination by the Department of Financial Institutions of the Commonwealth of Kentucky (the “Department”) and the FDIC.  The Bank is also a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”).
 
Acquisition Activities
 
On June 14, 2000, BKFC consummated the acquisition of the Fort Thomas Financial Corporation (“FTFC”) and its wholly owned subsidiary, the Fort Thomas Savings Bank (“FTSB”).  FTFC was merged with and into BKFC and FTSB was merged with and into the Bank.  Upon consummation of this acquisition, 865,592 shares of Common Stock were issued for substantially all of the outstanding shares of FTFC.  The combination was accounted for as a pooling of interests and the historical financial position and results of operations of the two companies have been combined for financial reporting purposes.
 
 
3

 
On November 22, 2002, BKFC consummated the acquisition of certain assets and assumption of certain liabilities of Peoples Bank of Northern Kentucky (“PBNK”).  This acquisition was accounted for under the purchase method of accounting and, accordingly, the tangible and identifiable intangible assets and liabilities of the purchase were recorded at estimated fair values.  The excess of the purchase price over the net tangible and identifiable intangible assets was recorded as goodwill.  The adjustments necessary to record tangible and identifiable intangible assets and liabilities at fair value are amortized to income and expensed over the estimated remaining lives of the related assets and liabilities.
 
On May 18, 2007, BKFC consummated the acquisition of FNB Bancorporation, Inc. and its subsidiary, First Bank of Northern Kentucky, Inc. (“First Bank”).  This acquisition was accounted for under the purchase method of accounting and, accordingly, the tangible and identifiable intangible assets and liabilities of the purchase were recorded at estimated fair values.  The excess of the purchase price over the net tangible and identifiable intangible assets was recorded as goodwill.  The adjustments necessary to record tangible and identifiable intangible assets and liabilities at fair value are amortized to income and expensed over the estimated remaining lives of the related assets and liabilities.
 
On December 11, 2009, the Bank completed the purchase of three banking offices of Integra Bank Corporation’s wholly-owned bank subsidiary, Integra Bank N.A. (“Integra Bank”), located in Crittenden, Dry Ridge and Warsaw, Kentucky and a portfolio of selected commercial loans originated by Integra Bank’s Covington, Kentucky loan production office.  This transaction also included the deposits of two additional branches in northern Kentucky where the banking offices were excluded.  This transaction added $76 million in deposits and $51 million in loans.  The deposits were purchased at a premium of 6.50%, while the loans were purchased at an approximate 1% discount.  The acquisition included a core deposit intangible asset of $1.579 million and goodwill of $5.31 million.  In a separate transaction, the Bank also bought an additional $49 million in loans from Integra Bank in the third quarter and $7 million in the fourth quarter of 2009 at an approximate 1% discount.   None of these purchased loans had shown evidence of credit deterioration since origination
 
On December 31, 2009, the Bank completed the purchase of Tapke Asset Management, LLC (“TAM”). TAM was an independent investment advisory firm, headquartered in Fort Wright, Kentucky, and one of northern Kentucky’s largest independent investment advisory firms.  As a result of this transaction, the Bank’s client assets increased to over $650 million at December 31, 2009.  TAM was purchased for $3 million, consisting of $2 million in cash and $1 million in Common Stock, with an additional $500,000 in contingent consideration payable in three years based on revenue retention, which had a fair value of $395,000 and was paid out in 2012.  The acquisition included a customer relationship intangible of $1,525,000, a non-compete agreement intangible of $320,000, a trade name intangible of $165,000 and goodwill of $1,370,000.
 
On October 28, 2011, the Bank completed the purchase of one banking office of the United Kentucky Bank of Pendleton County, Inc. (“United Kentucky Bank”), located in Falmouth, Kentucky and a portfolio of selected loans.  This acquisition was consistent with the Bank’s strategy to strengthen and expand its northern Kentucky market share.  This transaction added $28 million in deposits and $14 million in loans.  The deposits were purchased at a $300,000 premium, while the loans were purchased at an approximate 1.58% discount.  The acquisition included a core deposit intangible asset of $511,000 and goodwill of $134,000.  The results of operations for this acquisition have been included since the transaction date of October 28, 2011.
 
The Current Economic Environment
 
During 2013, the nation continued to experience a slow economic recovery. While the recovery remains fragile and is still threatened by slow jobs growth, the economic outlook in the markets in which we operate continue to show signs of weaker asset quality levels in the residential and commercial mortgage markets, household and business uncertainty as well as tight credit conditions.  The Bank anticipates that the effects of the financial crisis and recession are expected to continue for the near future, especially as the magnitude of economic distress facing local markets places continued pressure on asset quality and earnings, with the potential for undermining the stability of the banking organizations that serve these markets.
 
Although the Bank has experienced an increase in defaults and foreclosures during the last five years, such levels have been significantly less than other regions of the United States. This is due, in part, to the fact that the Bank’s markets in northern Kentucky and Cincinnati, Ohio have not experienced as dramatic a reduction in real estate values from previous years compared with markets like Florida and California.
 
 
4

 
As a result of management concerns over the current economic environment, individual lending authorities remain at reduced levels and the loan committee structure established in 2009 remains in place, which added the Bank’s Chief Executive Officer to the Bank’s loan committee to further scrutinize credit decisions. Additionally, the Bank previously established a problem asset workout group in 2009. This group’s primary task is to reduce risk by accelerating the exit from troubled credits. The problem asset workout group does this employing a number of strategies.  In addition, this group provides advice and support for the Bank’s lending professionals with respect to those relationships that are showing signs of stress but have not elevated to the point of transfer to workout.  In addition to these monitoring and management processes, BKFC also conducts quarterly reviews and evaluations of all criticized loans.  These comprehensive reviews, which pre-date the recent economic recession, include the formulation of action plans and updates on recent developments on all criticized loans. Proactive management of problem loans remains a high priority of the Bank’s senior management.
 
BKFC has not experienced the stress or deterioration in its residential real estate portfolio that other financial institutions may be experiencing, as residential real estate loans represent a small portion of the Bank’s overall loan portfolio. The Bank has not created or marketed any sub-prime loan products to its customers and does not service mortgages on behalf of other institutions. The Bank follows a strategy of selling a majority of its originated residential loans in the secondary market. In the majority of situations, the Bank follows the underwriting guidelines of the various government agencies on residential real estate loans the Bank seeks to portfolio. For the year ended December 31, 2013, the Bank’s residential real estate loan production was $135.5 million. Of this, sold loans totaled $105.8 million, while portfolio and construction loans totaled $12.3 million and $17.4 million, respectively. Residential real estate net charge-offs in this portfolio in 2013 and 2012 were $2.5 million and $2.2 million respectively. Other residential real estate delinquencies has been moderate, and non-accruals were $4.74 million as of December 31, 2013. The foregoing measures are a reflection of the Bank’s underwriting and collection practices. The Bank also added full time equivalent resources to its collections department, allowing the Bank to make more frequent and earlier collection calls, resulting in better working relationships with those borrowers who may have difficulty in making timely payments.
 
The economic recession and current recovery has also affected the operations of BKFC and the Bank. During the fourth quarter of 2008 and first quarter of 2009, BKFC and the Bank each participated in two government programs, which had the effect of enabling it to enhance liquidity and to augment its strong capital position and otherwise facilitate its response to the economic crisis. First, in October 2008 the Bank participated in the transaction account guarantee component of the FDIC’s TLGP program. Second, in February 2009 BKFC participated in the CPP, receiving $34,000,000, in exchange for issuing 34,000 shares of Series A Preferred Stock and a Warrant to purchase approximately 274,784 shares of Common Stock.   As of December 31, 2013, all of the TARP Series A Preferred Stock has been repurchased by BKFC and in the second quarter of 2013, the Company completed the repurchase of the Warrant.  As a result of the final repurchase, limitations on increasing dividends, executive compensation and other regulatory requirements are no longer applicable to BKFC.  Neither BKFC nor the Bank actively participates in any of the other federal government programs that have been instituted in response to the current economic recession.
 
For additional discussion of the impact of the current economic recession on the financial condition and results of operations of BKFC and its subsidiaries, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report.
 
Available Information
 
BKFC maintains an internet website at the following internet address: www.bankofky.com. BKFC makes available free of charge through its website, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as soon as reasonably practicable after such material was electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”).  Materials that BKFC files with the SEC may be read and copied at the SEC Public Reference Room at 100 F Street, N.E., Washington, DC 20549.  This information may also be obtained by calling the SEC at 1-800-SEC-0330.  The SEC also maintains an internet website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at the SEC’s website, www.sec.gov.  BKFC will provide a copy of any of the foregoing documents to shareholders free of charge upon request.
 
 
5

 
Lending Activities
 
General.  As a commercial bank, the Bank offers a wide variety of loans.  Among the Bank’s various lending activities are the origination of loans secured by first mortgages on nonresidential real estate; loans secured by first mortgages on one- to four-family residences; unsecured commercial loans and commercial loans secured by various assets of the borrower; unsecured consumer loans and consumer loans secured by automobiles, boats and recreational vehicles; and construction and land development loans secured by mortgages on the underlying property.
 
The following table sets forth the composition of the Bank’s loan portfolio by type of loan at the dates indicated:
 
 
 
As of December 31,
 
 
 
2013
 
 
2012
 
 
2011
 
 
2010
 
 
2009
 
 
 
Amount
 
%
 
 
Amount
 
%
 
 
Amount
 
%
 
 
Amount
 
%
 
 
Amount
 
%
 
 
 
(Dollars in thousands)  (Dollars in thousands)  (In thousands)
Type of Loan:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nonresidential real estate
   loans
 
$
571,221
 
45.6
%
 
$
573,101
 
47.9
%
 
$
523,485
 
46.2
%
 
$
482,173
 
43.5
%
 
$
476,089
 
41.2
%
Residential real estate
   loans
 
 
283,356
 
22.7
 
 
 
278,286
 
23.3
 
 
 
266,268
 
23.5
 
 
 
260,625
 
23.5
 
 
 
267,857
 
23.2
 
Commercial loans
 
 
241,794
 
19.3
 
 
 
201,384
 
16.8
 
 
 
193,176
 
17.1
 
 
 
216,660
 
19.6
 
 
 
223,404
 
19.3
 
Consumer loans
 
 
15,806
 
1.3
 
 
 
16,447
 
1.4
 
 
 
16,618
 
1.5
 
 
 
16,546
 
1.5
 
 
 
20,750
 
1.8
 
Construction and land
   development loans
 
 
103,019
 
8.2
 
 
 
104,498
 
8.7
 
 
 
104,788
 
9.3
 
 
 
107,611
 
9.8
 
 
 
148,288
 
12.8
 
Municipal obligations
 
 
36,058
 
2.9
 
 
 
23,128
 
1.9
 
 
 
27,066
 
2.4
 
 
 
23,573
 
2.1
 
 
 
20,232
 
1.7
 
Total loans
 
$
1,251,254
 
100.0
%
 
$
1,196,844
 
100.0
%
 
$
1,131,401
 
100.0
%
 
$
1,107,188
 
100.0
%
 
$
1,156,620
 
100.0
%
Less:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deferred loan fees
 
 
1,609
 
 
 
 
 
1,435
 
 
 
 
 
1,447
 
 
 
 
 
1,179
 
 
 
 
 
1,636
 
 
 
Allowance for loan losses
 
 
16,306
 
 
 
 
 
16,568
 
 
 
 
 
18,288
 
 
 
 
 
17,368
 
 
 
 
 
15,153
 
 
 
Net loans
 
$
1,233,339
 
 
 
 
$
1,178,841
 
 
 
 
$
1,111,666
 
 
 
 
$
1,088,641
 
 
 
 
$
1,139,831
 
 
 
 
 
6

 
Loan Maturity Schedule.  The following table sets forth certain information, as of December 31, 2013, regarding the dollar amount of certain loans maturing in the Bank’s portfolio based on their contractual terms to maturity and the dollar amount of such loans that have fixed or variable rates within certain maturity ranges ending after 2013:
 
 
 
 
 
 
Due after 1
year to 5
 
 
Due after 5
 
 
 
 
 
 
Due within one year
 
years
 
years
 
Total
 
 
 
(Dollars in thousands)
 
Commercial loans
 
$
116,795
 
$
115,749
 
$
9,250
 
$
241,794
 
Construction and land development
   loans
 
 
103,019
 
 
-
 
 
-
 
 
103,019
 
Total
 
$
219,814
 
$
115,749
 
$
9,250
 
$
344,813
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest sensitivity:
 
 
 
 
 
 
 
 
 
 
 
 
 
With fixed rates
 
 
 
 
$
45,127
 
$
4,723
 
 
 
 
With variable rates
 
 
 
 
 
70,622
 
 
4,527
 
 
 
 
Total
 
 
 
 
$
115,749
 
$
9,250
 
 
 
 
 
Nonresidential Real Estate Loans.  The Bank makes loans secured by first mortgages on nonresidential real estate, including retail stores, office buildings, warehouses, apartment buildings and recreational facilities.  Such mortgage loans generally have maturities between 5 and 10 years with amortization periods of 10 to 20 years and are made with adjustable interest rates tied to a spread over LIBOR or a comparable U.S. Treasury index (“ARMs”).  Interest rates on LIBOR based loans typically adjust every 30 days, while the ARMs adjust every one-, three- or five-years based upon the interest rates of the applicable one-, three- or five- year U.S. Treasury security then offered. 
 
The Bank limits the amount of each loan in relationship, in accordance with the Bank’s policy, to the appraised value of the real estate and improvements at the time of origination of a nonresidential real estate loan.  In accordance with regulations, the maximum loan-to-value ratio (the “LTV”) on nonresidential real estate loans made by the Bank ranges from 65% to 85%, depending on property type.
 
Nonresidential real estate lending is generally considered to involve a higher degree of risk than residential lending.  Such risk is due primarily to the dependence of the borrower on the cash flow from the property to service the loan.  If the cash flow from the property is reduced due to a downturn in the economy, for example, or due to any other reason, the borrower’s ability to repay the loan may be impaired.  To reduce such risk, the decision to underwrite a nonresidential real estate loan is based primarily on the quality and characteristics of the income stream generated by the property and/or the business of the borrower and any other applicable credit enhancement, such as global cash flow analysis.  In addition, the Bank generally obtains the personal guarantees of one or more of the principals of the borrower and carefully evaluates the location of the real estate, the quality of the management operating the property, the debt service ratio and appraisals supporting the property’s valuation. 
 
At December 31, 2013, the Bank had a total of $571 million in nonresidential real estate loans, the vast majority of which were secured by property located in the northern Kentucky and the Greater Cincinnati metropolitan area.  Owner-occupied nonresidential real estate was $302 million of the total nonresidential real estate loans.  Total nonresidential real estate loans comprised approximately 46% of the Bank’s total loans at such date, $9.16 million of which were classified as non-performing.
 
Residential Real Estate Loans.  The Bank originates permanent conventional loans secured by first mortgages on single-family and 1-4 family residential properties located in the northern Kentucky area.  The Bank also originates  loans for the construction of residential properties and home equity loans secured by second mortgages on residential real estate.  Each such loans is secured by a mortgage on the underlying real estate and any improvements thereon. 
 
The residential real estate loans originated for the Bank’s loan portfolio are either one- or three-year ARMs.  Such loans typically have adjustment period caps of 2% and lifetime caps of 6%.  The maximum amortization period of such loans is 30 years.  The Bank does not engage in the practice of deeply discounting the initial rates on such loans, nor does the Bank engage in the practice of putting payment caps on loans that could lead to negative amortization.  Historically, the Bank has not made fixed-rate residential mortgage loans for its portfolio.  In order to meet consumer demand for fixed-rate loans, however, the Bank has originated and sold loans to other lenders willing to accept the interest rate and credit risk.
 
 
7

 
While in a rising interest rate environment the delinquency and foreclosure rates associated with interest rate resets on residential real estate loans could increase, this risk is somewhat mitigated by the 2% period cap and the 6% lifetime cap on the typical loan in the Bank’s residential real estate portfolio.  Furthermore, the aggregate amount of residential real estate loans held by the Bank does not represent a significant portion of the Bank’s overall loan portfolio.  Accordingly, the risks associated with a material increase in delinquencies and foreclosures resulting upon the occurrence of any interest rate reset are minimal.
 
BKFC does not have higher risk loans such as subprime loans, “alt A” loans, no or little documentation loans, interest-only or option adjustable rate mortgage products in its portfolio.  The majority of the Bank’s residential portfolio would be considered conforming loans in accordance with standards of governmental agencies.
 
The Bank requires private mortgage insurance for the amount of any such loan with an LTV in excess of 90%.
 
The aggregate amount of the Bank’s residential real estate loans equaled approximately $283 million at December 31, 2013 and represented 23% of total loans at such date.  At December 31, 2013, the Bank had $5.36 million of non-performing loans of this type.
 
Loans Held for Sale.  The Bank originates residential real estate loans to be sold, service released, subject to commitment to purchase in the secondary market.  These loans are fixed rate with terms ranging from fifteen to thirty years.  At December 31, 2013, these loans totaled $3.2 million.
 
Commercial Loans.  The Bank offers commercial loans to individuals and businesses located throughout northern Kentucky and the Greater Cincinnati metropolitan area.  The typical commercial borrower is a small to mid-sized company with annual sales under $20 million.  The majority of commercial loans are made with adjustable rates of interest tied to the Bank’s prime interest rate.  Commercial loans typically have terms of one to five years.  In general, commercial lending entails significant risks.  Such loans are subject to greater risk of default during periods of adverse economic conditions.  Because such loans are secured by equipment, inventory, accounts receivable and other non-real estate assets, the collateral may not be sufficient to ensure full payment of the loan in the event of a default.  To reduce such risk, the Bank generally obtains personal guarantees from one or more of the principals backing the borrower.  At December 31, 2013, the Bank had $242 million, or 19% of total loans, in commercial loans, $385,000 of which were classified as non-performing.
 
Consumer Loans.  The Bank makes a variety of consumer loans, including automobile loans, recreational vehicle loans and personal loans.  Such loans generally have fixed rates with terms from three to five years.  Consumer loans involve a higher risk of default than residential real estate loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets, such as automobiles.  Repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation, and the remaining deficiency may not warrant further substantial collection efforts against the borrower.  In addition, consumer loan collections depend on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, illness or personal bankruptcy.  Various federal and state laws, including federal and state bankruptcy and insolvency laws, may also limit the amount that can be recovered on such loans.  At December 31, 2013, the Bank had $16 million, or 1% of total loans, in consumer loans, $27,000 of which were classified as non-performing.
 
Construction and Land Development Loans.  The Bank makes loans for the construction of residential and nonresidential real estate and land development purposes.  Most of these loans are structured with adjustable rates of interest tied to changes in the Bank’s prime interest rate for the period of construction.  A general contractor is used with the majority of the construction loans originated by the Bank to owner-occupants for the construction of single-family homes.  Other loans are made to builders and developers for various projects, including the construction of homes and other buildings that may have not been pre-sold or to finance the preparation of land for site and project development.
 
Construction and land development loans involve greater underwriting and default risks than do loans secured by mortgages on improved and developed properties, due to the effects of general economic conditions on real estate developments, developers, managers and builders.  In addition, such loans are more challenging to evaluate and monitor.  Loan funds are advanced upon the security of the project under construction, which is more challenging to value before the completion of construction.  Moreover, because of the uncertainties inherent in estimating construction costs, it is challenging to evaluate accurately the value upon completion and the total loan funds required to complete a project.  In the event a default on a construction or land development loan, it may be necessary for the Bank to take control of the project and attempt either to arrange for completion of construction or dispose of the unfinished project.  At December 31, 2013, a total of $103 million, or approximately 8% of the Bank’s total loans, consisted of construction and land development loans, $510,000 of which were classified as non-performing.
 
 
8

 
Municipal Obligations.  The Bank makes loans to various Kentucky municipalities for various purposes, including the construction of municipal buildings and equipment purchases.  Loans made to municipalities are usually secured by mortgages on the properties or financed by a lien on equipment purchased or by the general taxing authority of the municipality and provide certain tax benefits for the Bank.  At December 31, 2013, the Bank had $36 million, or 3% of total loans, invested in municipal obligation loans, none of which were classified as non-performing.
 
Loan Solicitation and Processing.  The Bank’s loan originations are developed from a number of sources, including its existing customer base, periodic newspaper and radio advertisements, solicitations by the Bank’s lending staff, walk-in customers, director referrals and an officer call program.  For nonresidential real estate loans, the Bank obtains information with respect to the credit, business and financial history of the borrower and its current and prior real estate projects.  Personal guarantees of one or more principals of the borrower are generally obtained.  For loans that meet or exceed a certain dollar threshold, an environmental study of such real estate is normally conducted.  Upon the completion of the appraisal of the nonresidential real estate and the receipt of information on the borrower, the loan package is submitted to the Bank’s Loan Committee if the amount and/or relationship exceed the officer’s lending authority for approval or rejection.  If, however, the loan relationship is in excess of $2.50 million, the loan will be submitted to the Bank’s Executive Loan Committee for approval or rejection. 
 
In connection with residential real estate loans, the Bank obtains a credit report, verification of employment and other documentation concerning the creditworthiness of the borrower.  An appraisal of the fair market value of the real estate on which the Bank will be granted a mortgage to secure the loan is prepared by an independent fee appraiser approved by the Bank’s Board of Directors.  An environmental study of such real estate is conducted only if the appraiser or Bank has reason to believe that an environmental problem may exist. 
 
When a residential real estate loan application is approved, title insurance is normally obtained in respect of the real estate, which will secure the loan.  At the time a nonresidential real estate loan is closed, title insurance is customarily obtained on the title to the real estate, which will secure the mortgage loan.  All borrowers are required to carry satisfactory fire and casualty insurance and flood insurance, if applicable, and name the Bank as an insured mortgagee. 
 
Commercial loans are underwritten primarily on the basis of the stability of the income and cash flows generated by the business and/or property.  For most commercial loans, however, the personal guarantees of one or more principals of the borrowers are generally obtained.  Consumer loans are underwritten on the basis of the borrower’s credit history and an analysis of the borrower’s income and expenses, ability to repay the loan and the value of any collateral.  The procedure for approval of construction loans is the same as for permanent mortgage loans, except that an appraiser evaluates the building plans, construction specifications and estimates of construction costs.  The Bank also evaluates the feasibility of the proposed construction project and the experience and record of the builder. 
 
Loan Origination and Other Fees.  The Bank realizes loan origination fees and other fee income from its lending activities and also realizes income from late payment charges, application fees and fees for other miscellaneous services.  Loan origination fees and other fees are a volatile source of income, varying with the volume of lending, loan repayments and general economic conditions.  Nonrefundable loan origination fees and certain direct loan origination costs are deferred and recognized as an adjustment to yield over the life of the related loan.
 
Delinquent Loans, Non-Performing Assets, Classified Assets and Troubled Debt Restructurings (TDRs).  When a borrower fails to make a required payment on a loan, the Bank attempts to cause the deficiency to be cured by contacting the borrower.  In most cases, deficiencies are cured promptly as a result of these collection efforts.
 
Loans that are 90 days past due or more that are not considered well secured and in the process of collection are placed on non-accrual status.  Under-collateralized loans that are 90 days past due or more in which the Bank does not expect to be repaid by the borrower’s or guarantor’s financial wherewithal after an extensive collection effort, shall be reviewed for full or partial charge-off.  The amount charged-off will be charged against the allowance for loan losses.
 
The Bank utilizes a risk-rating system to quantify and monitor loan quality.  The system assigns a risk rating from one to nine for each loan.  Classified commercial loans are those with risk ratings of seven or higher.  Each loan rating is determined by analyzing the borrowers’ management, financial ability, sales trends, operating results, financial conditions, asset protection, contingencies, payment history, financial flexibility, credit enhancements and other relevant factors.  Loans that fall into the classified categories are monitored on a regular basis and proper action is taken to minimize the Bank’s loss exposure.  Losses or partial losses are recognized when loans are deemed uncollectible.
 
 
9

 
The Bank’s risk rating system was developed in a manner that is consistent with the regulatory guidance.  Problem assets are classified as “special mention” (risk rating 6), “substandard” (risk rating 7), “substandard non-accrual” (risk rating 8), or “doubtful” (risk rating 9).  “Substandard” assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected.  “Doubtful” assets have the same weaknesses as “substandard” assets, with the additional characteristics that (i) the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable and (ii) there is a high possibility of loss.  The regulations also contain a “special mention” or also known as “criticized assets” category, consisting of assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but which possess credit deficiencies or potential weaknesses deserving management’s close attention. 
 
The aggregate amounts of the Bank’s classified assets at December 31, 2013 and 2012 were as follows:
 
 
 
12/31/13
 
12/31/12
 
 
 
(Dollars in thousands)
 
Special mention (risk rating 6)
 
$
27,590
 
$
34,723
 
Substandard (risk rating 7 & 8)
 
 
56,027
 
 
53,542
 
Doubtful (risk rating 9)
 
 
0
 
 
0
 
 
 
 
 
 
 
 
 
Total classified assets
 
$
83,617
 
$
88,265
 
 
The following table reflects the amount of loans that are in delinquent status of 30 to 89 days as of December 31, 2013 and 2012.  Loans that are delinquent 90 days or more are included in the non-accrual loans noted below.
 
 
 
12/31/13
 
 
12/31/12
 
 
 
(Dollars in thousands)
Loans delinquent
 
 
 
 
 
 
 
 
30 to 59 days
 
$
4,271
 
 
$
11,036
 
60 to 89 days
 
 
1,543
 
 
 
4,095
 
 
 
 
 
 
 
 
 
 
Total delinquent loans
 
$
5,814
 
 
$
15,131
 
 
 
 
 
 
 
 
 
 
Ratio of total delinquent loans 30 to 89
     days to total loans
 
 
0.46
%
 
 
1.26
%
 
The following table sets forth information with respect to the Bank’s non-performing assets for the periods indicated.  In addition, the Bank evaluates loans to identify those that are “impaired.”  Impaired loans are those for which management has determined that it is probable that the customer will be unable to comply with the contractual terms of the loan.  Loans so identified are reduced (i) to the fair value of the collateral securing the loan, (ii) to the present value of expected future cash flows, or (iii) to the market price of the loan based upon readily available information for that type of loan, by the allocation of a portion of the allowance for loan losses to the loan.  As of December 31, 2013, the Bank had designated $29 million as impaired loans, and a portion of these loans were included in the non-accrual and 90 days past due and troubled debt restructurings totals below. Management evaluates for impairment all loans selected for specific review during its quarterly allowance for loan losses analysis.  Generally, the impairment analysis does not address smaller balance consumer credits. 
 
 
10

 
 
 
At December 31,
 
 
2013
 
 
2012
 
 
2011
 
 
2010
 
 
2009
 
 
 
(Dollars in thousands)
Loans accounted for on a non-accrual
    basis:(1)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nonresidential real estate
 
$
9,156
 
 
$
12,138
 
 
$
6,628
 
 
$
6,311
 
 
$
8,588
 
Residential real estate
 
 
5,360
 
 
 
5,243
 
 
 
5,325
 
 
 
4,208
 
 
 
5,113
 
Construction
 
 
510
 
 
 
1,075
 
 
 
1,897
 
 
 
5,329
 
 
 
7,302
 
Commercial
 
 
385
 
 
 
740
 
 
 
1,175
 
 
 
4,749
 
 
 
2,712
 
Consumer and other
 
 
6
 
 
 
48
 
 
 
626
 
 
 
51
 
 
 
111
 
Total
 
 
15,417
 
 
 
19,244
 
 
 
15,651
 
 
 
20,648
 
 
 
23,826
 
Accruing loans which are contractually
       past due 90 days or more:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Nonresidential real estate
 
$
0
 
 
$
0
 
 
$
0
 
 
$
68
 
 
$
220
 
Residential real estate
 
 
0
 
 
 
17
 
 
 
112
 
 
 
263
 
 
 
758
 
Construction
 
 
0
 
 
 
0
 
 
 
0
 
 
 
0
 
 
 
682
 
Commercial
 
 
0
 
 
 
0
 
 
 
74
 
 
 
0
 
 
 
34
 
Consumer and other loans
 
 
21
 
 
 
22
 
 
 
33
 
 
 
83
 
 
 
42
 
Total
 
 
21
 
 
 
39
 
 
 
219
 
 
 
414
 
 
 
1,736
 
Total non-performing loans
 
$
15,438
 
 
$
19,283
 
 
$
15,870
 
 
$
21,062
 
 
$
25,562
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Percentage of total loans
 
 
1.24
%
 
 
1.61
%
 
 
1.40
%
 
 
1.90
%
 
 
2.21
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Other real estate owned(2)
 
$
5,305
 
 
$
5,396
 
 
$
5,844
 
 
$
795
 
 
$
1,381
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Troubled debt restructured (TDR) loans:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Performing troubled debt restructured (TDR) loans(3)
 
$
8,816
 
 
$
6,046
 
 
$
13,306
 
 
$
6,135
 
 
$
3,568
 
Nonperforming trouble debt restructured (TDR) loans (included in nonaccrual loans)
 
$
8,246
 
 
$
11,095
 
 
$
1,923
 
 
$
2,186
 
 
$
3,831
 
Total troubled debt restructured loans
 
$
17,062
 
 
$
17,141
 
 
$
15,229
 
 
$
8,321
 
 
$
7,399
 
 
(1) A loan is generally placed on non-accrual status if: (i) the loan becomes 90 days or more past due or (ii) payment in full of both principal and interest for the loan cannot be reasonably expected.  Payments received on a non-accrual loan are applied to principal, until qualifying for return to accrual method.
 
(2) Consists of real estate acquired through foreclosure, which is carried at fair value less estimated selling expenses.
 
(3)  Consists of accruing TDR loans to borrowers experiencing financial difficulties where the Bank made certain concessionary modifications to the loan’s contractual terms such as interest rate reductions, principal forgiveness and other actions intended to minimize or eliminate the economic loss and to avoid foreclosure or repossession of collateral.  TDRs accrue interest as long as the borrower complies with the modified terms.
 
The amount of gross interest income that would have been recorded for nonaccrual loans in 2013 if loans had been current in accordance with their original terms was $789,000 and $640,000 for 2012.
 
The credit quality table detailing loans by grade, the non-performing loan table and the aging of past due table include measurements which management believes are the best indicators of potential problem loans and there were no other known potential problem loans beyond what is disclosed in these tables at December 31, 2013.
 
Allowance for Loan Losses.  While management believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments, and net earnings could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination.  At December 31, 2013, the Bank’s allowance for loan losses totaled $16.3 million. 
 
On at least a quarterly basis, a formal analysis of the adequacy of the allowance is prepared and reviewed by senior management and the Bank’s Board of Directors.  This analysis serves as a point in time assessment of the level of the allowance and serves as a basis for provisions for loan losses.  The loan quality monitoring process includes assigning loan grades and the use of a watch list to identify loans of concern. 
 
The analysis of the allowance for loan losses includes the allocation of specific amounts of the allowance to individual problem loans, generally based on an analysis of the collateral securing those loans.  Portions of the allowance are also allocated to loans based on their risk rating with the higher the risk rating, the higher the allowance allocated to that loan.  These components are added together and compared to the balance of our allowance at the evaluation date.
 
 
11

 
The following table provides an allocation of the Bank’s allowance for loan losses as of each of the following dates:
 
 
 
At December 31,
 
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
Loan type:
 
Amount
 
Percentage
of Loans in
each
Category to
Total
Loans
 
Amount
 
Percentage
 of Loans in
each
Category to
Total
Loans
 
Amount
 
Percentage
of Loans in
each
Category to
Total
Loans
 
Amount
 
Percentage
of Loans in
each
Category to
Total
Loans
 
Amount
 
Percentage
of Loans in
each
Category to
Total
Loans
 
 
 
(Dollars in thousands)
 
Commercial
 
$
3,247
 
19
%
$
2,716
 
17
%
$
3,207
 
17
%
$
3,440
 
20
%
$
3,001
 
19
%
Residential real estate
 
 
4,554
 
23
 
 
4,272
 
23
 
 
2,591
 
24
 
 
2,431
 
23
 
 
2,121
 
23
 
Nonresidential real
     estate
 
 
6,502
 
46
 
 
6,991
 
48
 
 
7,614
 
46
 
 
8,126
 
44
 
 
7,090
 
41
 
Construction
 
 
1,538
 
8
 
 
1,964
 
9
 
 
4,701
 
9
 
 
3,150
 
10
 
 
2,748
 
13
 
Consumer
 
 
373
 
1
 
 
584
 
1
 
 
162
 
2
 
 
166
 
1
 
 
145
 
2
 
Municipal obligations
 
 
92
 
3
 
 
41
 
2
 
 
13
 
2
 
 
55
 
2
 
 
48
 
2
 
Total allowance for loan
     losses
 
$
16,306
 
100
%
$
16,568
 
100
%
$
18,288
 
100
%
$
17,368
 
100
%
$
15,153
 
100
%
 
The Bank’s allowance for loan losses decreased from $16.6 million at December 31, 2012, to $16.3 million at December 31, 2013.  Because the loan loss allowance is based on estimates, it is monitored on an ongoing basis and adjusted as necessary to provide an adequate allowance.  For further discussion on the allowance for loan losses see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report.
 
Investment Activities
 
The investment policy of the Bank is both to manage the utilization of excess funds and to provide for the liquidity needs of the Bank as loan demand and daily operations dictate.  The Bank’s federal income tax position is also a consideration in its investment decisions.  Investments in tax-exempt securities with maturities of less than 10 years are considered when the net yield exceeds that of taxable securities and the Bank’s effective tax rate warrants such investments.
 
The following table sets forth the composition of the Bank’s securities portfolio, at the dates indicated:
 
 
 
At December 31,
 
 
 
2013
 
2012
 
2011
 
 
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
Amortized
Cost
 
Fair
Value
 
 
 
(Dollars in thousands)
 
Held-to-maturity securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Municipal and other obligations
 
$
77,010
 
$
76,457
 
$
66,843
 
$
68,504
 
$
48,975
 
$
50,643
 
Total held-to-maturity securities
 
$
77,010
 
$
76,457
 
$
66,843
 
$
68,504
 
$
48,975
 
$
50,643
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available-for-sale securities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government, Federal Agency and Government Sponsored Enterprises
 
$
122,905
 
$
120,139
 
$
127,416
 
$
128,477
 
$
168,104
 
$
169,460
 
U.S. Government Mortgage-Backed
 
 
219,986
 
 
220,059
 
 
180,019
 
 
184,907
 
 
148,329
 
 
151,992
 
Corporate obligations
 
 
925
 
 
925
 
 
1,060
 
 
1,060
 
 
1,060
 
 
1,060
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total available-for-sale securities
 
$
343,816
 
$
341,123
 
$
308,495
 
$
314,444
 
$
317,493
 
$
322,512
 
 
 
12

 
 
The following table sets forth the amortized cost of the Bank’s securities portfolio at December 31, 2013 by contractual or expected maturity.  Securities with call features are presented at call date if management expects that option to be exercised.
 
 
 
Maturing within
one year
 
Maturing after one
and within five years
 
Maturing after five
and within ten years
 
Maturing after
ten years
 
Total
 
 
 
Amortized
Cost
 
Average
Yield
 
Amortized
Cost
 
Average
Yield
 
Amortized
Cost
 
Average
Yield
 
Amortized
Cost
 
Average
Yield
 
Amortized
Cost
 
Average
Yield
 
 
 
  (Dollars in thousands)
 
Held-to-maturity:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Municipal and other obligations (1)
 
$
4,080
 
2.31
%
$
32,507
 
2.98
%
$
40,423
 
2.54
%
$
-
 
-
%
$
77,010
 
2.71
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Available- for- sale:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate obligations
 
 
-
 
0.00
%
 
-
 
0.00
%
 
925
 
0.35
%
 
-
 
-
 
 
925
 
0.35
%
U.S. Government, Federal Agency and Government Sponsored
 
 
14,083
 
1.48
%
 
67,216
 
1.28
%
 
41,606
 
0.00
%
 
-
 
-
 
 
122,905
 
0.87
%
Enterprises
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
U.S. Government Mortgage-Backed
 
 
43,491
 
2.20
%
 
102,161
 
2.38
%
 
74,334
 
2.40
%
 
-
 
-
 
 
219,986
 
2.35
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Totals
 
$
61,654
 
2.04
%
$
201,884
 
2.11
%
$
157,288
 
1.79
%
$
-
 
-
%
$
420,826
 
1.98
%
 
_________________________
 
(1)  Yield stated on a tax-equivalent basis using a 35% effective rate.
 
Deposits and Borrowings
 
General.  Deposits have traditionally been the primary source of the Bank’s funds for use in lending and other investment activities.  In addition to deposits, the Bank derives funds from interest payments and principal repayments on loans and income on earning assets.  Loan payments are a relatively stable source of funds, while deposit inflows and outflows fluctuate more in response to economic conditions and interest rates.  The Bank has lines of credit established at its major correspondent banks to purchase federal funds to meet liquidity needs.  The Bank may also borrow funds from the FHLB in the form of advances.
 
The Bank also uses retail repurchase agreements as a source of funds.  These agreements essentially represent borrowings by the Bank from customers with maturities of three months or less.  Certain securities are pledged as collateral for these agreements.  At December 31, 2013, the Bank had $27.6 million in retail repurchase agreements.
 
The Bank also entered into a capital lease obligation for a branch in 1997 with a term of 20 years and a monthly payment of $4,000.
 
Deposits.  Deposits are attracted principally from within the Bank’s designated lending area through the offering of numerous deposit instruments, including regular passbook savings accounts, negotiable order of withdrawal (“NOW”) accounts, money market deposit accounts, term certificate accounts and individual retirement accounts (“IRAs”).  Interest rates paid, maturity terms, service fees and withdrawal penalties for the various types of accounts are established periodically by the Bank’s Board of Directors based on the Bank’s liquidity requirements, growth goals and market trends.  The Bank may on occasion use brokers to attract deposits.  The Bank did not have brokered deposits as of December 31, 2013. 
 
The following table presents the amount of the Bank’s jumbo certificates of deposit with principal balances greater than $100,000 by the time remaining until maturity as of December 31, 2013:
 
Maturity
 
At December 31, 2013
 
 
 
(In thousands)
 
 
 
 
 
 
Three months or less
 
$
25,976
 
Over 3 months to 6 months
 
 
25,433
 
Over 6 months to 12 months
 
 
32,126
 
Over 12 months
 
 
28,992
 
 
 
 
 
 
Total
 
$
112,527
 
 
 
13

 
The following table presents the average daily deposits for the years ended December 31, 2013, 2012 and 2011, and the average rates paid on those deposits are summarized in the following table:
 
 
 
At December 31,
 
 
 
2013
 
 
2012
 
 
2011
 
 
 
Average
Balance
 
Average
Rate paid
 
 
Average
Balance
 
Average
Rate paid
 
 
Average
Balance
 
Average
Rate paid
 
 
 
(Dollars in thousands)
 
Demand deposits
 
$
328,998
 
0.00
%
 
$
290,654
 
0.00
%
 
$
251,033
 
0.00
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Savings and transaction accounts:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Savings
 
 
386,995
 
0.15
%
 
 
372,201
 
0.20
%
 
 
350,755
 
0.33
%
Interest bearing checking
 
 
496,530
 
0.18
%
 
 
447,714
 
0.22
%
 
 
385,568
 
0.32
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Time deposits:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Deposits of $100,000 or more
 
 
120,763
 
0.63
%
 
 
135,055
 
0.86
%
 
 
137,210
 
1.30
%
Other time deposits
 
 
205,664
 
0.71
%
 
 
243,056
 
0.98
%
 
 
282,816
 
1.43
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total deposits
 
$
1,538,950
 
0.24
%
 
$
1,488,680
 
0.35
%
 
$
1,407,382
 
0.59
%
 
Short-Term Borrowings.  In addition to repurchase agreements, the Bank has agreements with correspondent banks to purchase federal funds on an as needed basis to meet liquidity needs.
 
The following table sets forth the maximum month-end balance amount of the Bank’s outstanding short-term borrowings during the years ended December 31, 2013, 2012 and 2011, along with the average aggregate balances of the Bank’s outstanding short-term borrowings for such periods:
 
 
During year ended December 31,
 
 
2013
 
2012
 
2011
 
 
(Dollars in thousands)
 
Maximum balance at any month-end during
     the period
$
32,514
 
$
41,408
 
$
29,300
 
 
 
 
 
 
 
 
 
 
 
Average balance
 
27,947
 
 
26,060
 
 
25,378
 
 
 
 
 
 
 
 
 
 
 
Weighted average interest rate
 
0.22
%
 
0.30
%
 
0.41
%
 
The following table sets forth certain information as to short-term borrowings at the dates indicated:
 
 
December 31,
 
 
2013
 
2012
 
2011
 
Short-term borrowings outstanding
$
27,643
 
$
41,408
 
$
29,300
 
Weighted average interest rate
 
0.20
%
 
0.26
%
 
0.31
%
 
 
Long-Term Borrowings. Long-term consist of $5 million in advances from the Federal Home Loan Bank, $18.6 in trust preferred securities, $20 million in subordinate debentures issued by US Bank and a $1.9 note payable from US Bank. Further details of these borrowings can be found in note 8 of the accompanying financial statements.
 
Asset/Liability Management.  The Bank’s earnings depend primarily upon its net interest income, which is the difference between its interest income on its interest-earning assets, such as mortgage loans and investment securities, and its interest expense paid on its interest-bearing liabilities, consisting of deposits and borrowings.  As market interest rates change, asset yields and liability costs do not change simultaneously.  Due to maturity, re-pricing and timing differences of interest-earning assets and interest-bearing liabilities, earnings will be affected differently under various interest rate scenarios.  The Bank has sought to limit these net income fluctuations and manage interest rate risk by originating adjustable-rate loans and purchasing relatively short-term and variable-rate investments and securities.
 
 
14

 
The Bank’s interest rate spread is the principal determinant of the Bank’s net interest income.  The interest rate spread can vary considerably over time because asset and liability re-pricing do not coincide.  Moreover, the long-term and cumulative effect of interest rate changes can be substantial.  Interest rate risk is defined as the sensitivity of an institution’s earnings and net asset values to changes in interest rates. 
 
The ability to maximize net interest income is largely dependent upon sustaining a positive interest rate spread during fluctuations in the prevailing level of interest rates.  Interest rate sensitivity is a measure of the difference between amounts of interest-earning assets and interest-bearing liabilities, which either re-price or mature within a given period of time. The difference, or the interest rate re-pricing “gap,” provides an indication of the extent to which a financial institution’s interest rate spread will be affected by changes in interest rates.  A positive gap occurs when interest-earning assets exceed interest-bearing liabilities re-pricing during a designated time frame.  Conversely, a negative gap occurs when interest-bearing liabilities exceed interest-earning assets re-pricing within a designated time frame.  Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income, while a positive gap would result in an increase in net interest income, and during a period of falling interest rates, a negative gap would result in an increase in net interest income, while a positive gap would have the opposite effect.
 
In recognition of the foregoing factors, the management and the Board of Directors of the Bank have implemented an asset and liability management strategy directed toward maintaining a reasonable degree of interest rate sensitivity.  The principal elements of such strategy include: (i) meeting the consumer preference for fixed-rate loans by establishing a correspondent lending program that has enabled the Bank to originate and sell fixed-rate mortgage loans; (ii) maintaining relatively short weighted-average terms to maturity in the securities portfolio as a hedge against rising interest rates; (iii) emphasizing the origination and retention of adjustable-rate loans; and (iv) utilizing longer term certificates of deposit as funding sources when available.  Management and the Board of Directors monitor the Bank’s exposure to interest rate risk on a monthly basis to ensure the interest rate risk is maintained within an acceptable range.  For more information on the Bank’s interest rate risk see the “Asset/Liability Management and Market Risk” section of “Item 7A. Quantitative and Qualitative Disclosure about Market Risk”.
 
The following table sets forth the amounts of the Bank’s interest-earning assets and interest-bearing liabilities outstanding at December 31, 2013, which are scheduled to re-price or mature in each of the time periods shown.  The amounts of assets and liabilities shown which re-price or mature in a given period were determined in accordance with the contractual terms of the asset or liability.  The table shows that the maturity or re-pricing of the Bank’s liabilities exceed the contractual terms to maturity or re-pricing of the Bank’s earning assets in a twelve-month period by $266 million. 
 
 
 
Within 3 months
 
 
4 - 12 months
 
 
1 through 5 years
 
 
Over 5 years
 
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
(Dollars in thousands)
 
Interest-earning assets:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Federal funds sold
 
$
23,016
 
 
$
-
 
 
$
-
 
 
$
-
 
 
$
23,016
 
Interest bearing deposits with banks
 
 
252
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
252
 
Securities
 
 
19,043
 
 
 
47,458
 
 
 
201,733
 
 
 
154,998
 
 
 
423,232
 
Loans receivable (1)
 
 
686,741
 
 
 
175,111
 
 
 
358,684
 
 
 
33,559
 
 
 
1,254,095
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total interest-earning assets
 
 
729,052
 
 
 
222,569
 
 
 
560,417
 
 
 
188,557
 
 
 
1,700,595
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing liabilities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Savings deposits
 
 
151,920
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
151,920
 
Money market deposit accounts
 
 
215,245
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
215,245
 
NOW accounts
 
 
560,369
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
560,369
 
Certificates of deposit
 
 
50,898
 
 
 
128,766
 
 
 
65,911
 
 
 
50
 
 
 
245,625
 
IRAs
 
 
15,161
 
 
 
22,981
 
 
 
17,069
 
 
 
16
 
 
 
55,227
 
Repurchase agreements
 
 
27,643
 
 
 
-
 
 
 
-
 
 
 
-
 
 
 
27,643
 
Notes payable
 
 
39,889
 
 
 
5,000
 
 
 
-
 
 
 
688
 
 
 
45,577
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total interest-bearing liabilities
 
 
1,061,125
 
 
 
156,747
 
 
 
82,980
 
 
 
754
 
 
 
1,301,606
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-earning assets less
      interest-bearing liabilities
 
$
(332,073)
 
 
$
65,822
 
 
$
477,437
 
 
$
187,803
 
 
$
398,989
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cumulative interest-rate sensitivity gap
 
$
(332,073)
 
 
$
(266,251)
 
 
$
211,186
 
 
$
398,989
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cumulative interest-rate gap as a
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
percentage of total interest earning
assets
 
 
(19.53)
%
 
 
(15.66)
%
 
 
12.42
%
 
 
23.46
%
 
 
 
 
 
(1) Excludes the allowance for loan losses, in process accounts and purchase accounting adjustments.
 
 
15

 
Competition
 
There is significant competition within the banking and financial services industry in northern Kentucky, which is the primary market in which the Bank operates.  Changes in regulation, technology and product delivery systems have resulted in an increasingly competitive environment.  The Bank expects to continue to face increasing competition from online and traditional financial institutions seeking to attract customers by providing access to similar services and products.
 
Some of the institutions which compete with the Bank are among the largest financial institutions in the United States.  Any actual intervention or assistance to these competitors made by the U.S. federal government, as well as the perception that such assistance would be forthcoming if needed, could have the effect of eroding any competitive advantages of the Bank in the markets in which it operates.  Within the northern Kentucky and greater Cincinnati, Ohio markets, the Bank competes with approximately six financial institutions with over $50 billion in total assets, as well as numerous state chartered banking institutions of comparable or larger size and resources and smaller community banking organizations.  The Bank also has numerous local, regional and national nonbank competitors, including savings and loan associations, credit unions, mortgage companies, insurance companies, finance companies, financial service operations of major retailers, investment brokerage and financial advisory firms and mutual fund companies.  Because nonbank financial institutions are not subject to the same regulatory restrictions as banks and bank holding companies, they can often operate with greater flexibility and lower cost structures.  Currently, the Bank does not face meaningful competition from international banks in its market, although that could change in the future.
 
The Bank competes for deposits primarily with other commercial banks, savings associations and credit unions and with the issuers of commercial paper and other securities, such as shares in money market mutual funds. The primary factors in competing for deposits are interest rates and convenience of office locations.  The Bank competes for making loans primarily with other banks, savings associations, consumer finance companies, credit unions, leasing companies and other nonbank competitors. The Bank competes for loan originations primarily through the interest rates and loan fees it charges and through the efficiency and quality of services it provides to borrowers. Competition for loans is affected by, among other things, the general availability of lendable funds, general and local economic conditions, current interest rate levels and other factors that are not readily predictable.
 
Due to the Bank’s size relative to the many other financial institutions in its market, management believes that the Bank does not have a substantial share of the deposit and loan markets. The table below presents FDIC deposit data regarding the Bank’s deposit market share.  The June 2013 data set forth below are the most current data available from the FDIC at this time and represents those counties in which the Bank has reported market share for deposits.
 
Bank Deposit Market Share
($ in thousands)
 
Market (1)
 
June 2013 Deposits
 
Deposit Market Share
 
Boone County, Kentucky
 
$
524,740
 
24.39
%
Campbell County, Kentucky
 
 
179,326
 
13.61
%
Gallatin County, Kentucky
 
 
26,526
 
59.97
%
Grant County, Kentucky
 
 
59,664
 
23.84
%
Kenton County, Kentucky
 
 
670,397
 
29.52
%
Pendleton County, Kentucky
 
 
23,959
 
17.35
%
Hamilton County Ohio
 
 
23,485
 
0.04
%
 
 
 
(1) Source:  FDIC
 
Services provided by the Bank’s trust division face competition from many national, regional and local financial institutions.  Companies that offer broad services similar to those provided by the Bank, such as other banks, trust companies and full service brokerage firms, as well as companies that specialize in particular services offered by the Bank, such as investment advisors and mutual fund providers, all compete with the Bank’s trust division.
 
 
16

 
The Bank’s ability to compete effectively is a result of being able to provide customers with desired products and services in a convenient and cost effective manner.  Customers for commercial, consumer and mortgage banking as well as trust services are influenced by convenience, quality of service, personal contacts, availability of products and services and related pricing.  The Bank continually reviews its products, locations, alternative delivery channels and pricing strategies to maintain and enhance its competitive position.  Management believes it can compete effectively as a result of local market knowledge and awareness of, and attention to, customer needs.
 
Employees
 
As of December 31, 2013, the Bank had 301 full-time employees and 70 part-time employees.  The Bank believes that relations with its employees are good.  None of the employees of the Bank are represented by a labor union or subject to a collective bargaining agreement.
 
Regulation and Supervision
 
The following discussion describes elements of an extensive regulatory framework applicable to bank holding companies and banks and specific information about BKFC.  Federal and state regulation of banks and their holding companies is intended primarily for the protection of depositors and the Deposit Insurance Fund (“DIF”), rather than for the protection of shareholders and creditors.  A change in statutes, regulations or policies could have a material impact on the business of BKFC and its subsidiaries, including changes resulting from the passage of the Dodd-Frank Act in 2010 and the implementation of rulemaking under the Dodd-Frank Act that has continued through 2013, as described in more detail below.  BKFC and its subsidiaries may also be affected by future legislation and rulemaking that can change banking statutes in substantial and unexpected ways and by the actions of the Board of Governors of the Federal Reserve System (the “FRB”) as it attempts to control the money supply and credit availability in order to influence the economy.
 
Regulation of BKFC.  BKFC is a bank holding company subject to regulation by the FRB under the Bank Holding Company Act of 1956, as amended (“BHCA”).  As a bank holding company, BKFC is required to file periodic reports with, and is subject to the regulation, supervision and examination by, the FRB.  Such examination by the FRB determines whether BKFC is operating in accordance with various regulatory requirements and in a safe and sound manner.  The FRB may initiate enforcement proceedings against BKFC for violations of laws or regulations or for engaging in unsafe and unsound practices, particularly if such conduct could or does adversely impact the Bank.  BKFC is also subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC.
 
Under the BHCA, the FRB’s prior approval is required in any case in which BKFC proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company.  The BHCA also prohibits, with certain exceptions, BKFC from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any non-banking company.  Under the BHCA, BKFC may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of non-banking companies unless the FRB determines such businesses and services to be closely related to banking.  When reviewing bank acquisition applications for approval, the FRB considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (the “CRA”).  The Bank has a current CRA rating of “satisfactory.”  In addition, the FRB could require that BKFC terminate any activity, if the FRB deems the activity to constitute a serious risk to the financial soundness of the Bank.
 
It is the policy of the FRB that a bank holding company be ready and able to use its resources to provide capital to its subsidiary banks during periods of financial stress or adversity.  The FRB could require BKFC to provide such support at times when BKFC lacks the resources to do so.  See “Regulatory Capital Requirements” and “Dividend Restrictions” regarding minimum capital levels to which BKFC is subject and regulatory limits on BKFC’s ability to pay dividends to shareholders.  As a bank holding company, BKFC must notify the FRB if, during any one-year period, it seeks to redeem shares of stock in an amount such that total redemptions during the year, net of sales of shares, would be greater than 10% of BKFC’s net worth.
 
Regulation of the Bank.  The Bank is a Kentucky-chartered bank with FDIC deposit insurance.  The Bank is subject to numerous federal and state statutes and regulations regarding the conduct of its business, including, among other things, maintenance of reserves against deposits; capital adequacy; restrictions on the nature and amount of loans which may be made and the interest which may be charged thereon; restrictions on the terms of loans to officers, directors, large shareholders and their affiliates; restrictions relating to investments and other activities; and requirements regarding mergers and branching activities.
 
 
17

 
The Bank is subject to the regulation, supervision and examination by the Department and the FDIC.  Both the Department and the FDIC have the authority to issue cease-and-desist orders if either determines that the activities of the Bank represent unsafe and unsound banking practices.  If the grounds provided by law exist, the Department or the FDIC may appoint a conservator or receiver for the Bank.
 
State-chartered banks, like the Bank, are subject to regulatory oversight under various consumer protection and fair lending laws.  These laws govern, among other things, truth-in-lending disclosure, equal credit opportunity, fair credit reporting and community reinvestment.  Failure to abide by federal laws and regulations governing community reinvestment could limit the ability of a state-chartered bank to open a new branch or engage in a merger transaction.
 
The Bank is subject to the guidance on sound risk management practices for concentrations in commercial real estate lending set forth by the Office of the Comptroller of the Currency, the FRB and the FDIC.  The guidance is intended to help ensure that institutions pursuing a significant commercial real estate lending strategy remain healthy and profitable while continuing to serve the credit needs of their communities.  Also, this guidance directs institutions in developing risk management practices and levels of capital that are commensurate with the level and nature of their commercial real estate concentrations.
 
Kentucky law limits loans or other extensions of credit to any borrower to 20% of the Bank’s paid-in capital and actual surplus.  Such limit is increased to 30% if the borrower provides good collateral security or executes to it a mortgage upon real or personal property with a cash value exceeding the amount of the loan.  Loans or extensions of credit to certain borrowers are aggregated, and loans secured by certain government obligations are exempt from these limits.  At December 31, 2013, the maximum the Bank could lend to any one borrower generally equaled $23 million and equaled $34 million if the borrower provided collateral with a cash value in excess of the amount of the loan.  Federal banking laws and regulations also limit the transfer of funds or other items of value, including pursuant to the provision of loans, from banks to their affiliates.
 
Generally, the Bank’s permissible activities and investments are prescribed by Kentucky law.  However, state-chartered banks, including the Bank, may not, directly or through a subsidiary, engage in activities or make any investments as principal not permitted for a national bank, a bank holding company or a subsidiary of a nonmember bank, unless they obtain FDIC approval.
 
The Dodd-Frank Act.  The Dodd-Frank Act represents a significant overhaul of many aspects of the regulation of the financial-services industry.  The Dodd-Frank Act implements numerous and far-reaching changes that affect financial companies, including banks and bank holding companies such as BKFC by, among other things:
 
· centralizing responsibility for consumer financial protection by creating a new independent agency, the Consumer Financial Protection Bureau, with responsibility for implementing, enforcing and examining for compliance with federal consumer financial laws;
 
· applying the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies;
 
· requiring the FDIC to seek to make its capital requirements for banks countercyclical so that the amount of capital required to be maintained increases in times of economic expansion and decreases in times of economic contraction;
 
· changing the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital;
 
· implementing corporate governance revisions, including with regard to executive compensation and proxy access by shareholders, that apply to all public companies, not just financial institutions;
 
·
making permanent the $250,000 limit for federal deposit insurance and increasing the cash limit of Securities Investor Protection Corporation protection from $100,000 to $250,000; and
 
· repealing the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.
 
 
18

 
The majority of the provisions in the Dodd-Frank Act are aimed at financial institutions that are significantly larger than BKFC or the Bank.  Nonetheless, there are provisions with which we will have to comply now that the Dodd-Frank Act is signed into law. Many aspects of the Dodd-Frank Act are subject to further rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on BKFC and the Bank.  However, compliance with this law and its implementing regulations has resulted, and will continue to result, in additional operating costs that could have a material adverse effect on our future financial condition and results of operations.
 
Emergency Economic Stabilization Act of 2008.  The Emergency Economic Stabilization Act of 2008 (the “EESA”) was enacted on October 3, 2008.  The EESA authorized the Secretary of the Treasury Department (the “Secretary”) to purchase or guarantee up to $700 billion in troubled assets from financial institutions under TARP.  Pursuant to authority granted under the EESA, the Secretary created the TARP CPP under which the Treasury Department was authorized to invest up to $250 billion in senior preferred stock of U.S. banks and savings associations or their holding companies.  The Treasury Department’s authority to make new investments under the CPP expired in October 2010. 
 
CPP Participation.  On February 13, 2009, BKFC issued 34,000 shares of Series A Preferred Stock for a total price of $34 million pursuant to a Letter Agreement with the Treasury Department (the “Purchase Agreement”).  On November 23, 2011, BKFC repurchased the final $17 million outstanding Series A Preferred Stock held by the Treasury Department.  Accordingly, BKFC no longer is subject to the restrictions applicable to CPP participants. 
 
As part of its purchase of the Series A Preferred Stock, the Treasury Department received the Warrant to purchase 274,784 shares of Common Stock at an initial per share exercise price of $18.56, which was repurchased in the second quarter of 2013.
 
Both the Series A Preferred Stock and the Warrant were accounted for as components of Tier 1 capital.
 
Regulatory Capital Requirements.  The FRB has adopted risk-based capital guidelines for bank holding companies.  Such companies must maintain adequate consolidated capital to meet the minimum ratio of total capital to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) (the “Total Risk-Based Ratio”) of 8%.  At least half of the minimum-required total capital of 8% must be composed of Tier 1 Capital, which consists of common shareholders’ equity, minority interests in the equity of consolidated subsidiaries and a limited amount of perpetual preferred stock, less goodwill and certain other intangibles (“Tier 1 Risk-Based Ratio”).  The remainder of total capital may consist of subordinated and qualifying convertible debt, other preferred stock and a limited amount of loan and lease loss allowances.
 
The FRB also has established minimum leverage ratio guidelines for bank holding companies.  The guidelines provide for a minimum ratio of Tier 1 Capital to average total assets (excluding the loan and lease loss allowance, goodwill and certain other intangibles, and portions of certain nonfinancial equity investments) (the “Leverage Ratio”) of 3% for bank holding companies that meet specified criteria, including having the highest regulatory rating.  All other bank holding companies must maintain a Leverage Ratio of 4% to 5%.  The guidelines further provide that bank holding companies making acquisitions are expected to maintain strong capital positions substantially above the minimum supervisory levels.
 
The Bank is subject to similar capital requirements, and such capital requirements are imposed and enforced by the FDIC.
 
As part of the Dodd-Frank Act, provisions were added that require federal banking agencies to develop capital requirements that address systemically risky activities.  The effect of these capital rules are such that trust preferred securities issued by a company, such as BKFC, with total consolidated assets of less than $15 billion before May 19, 2010 and treated as regulatory capital are grandfathered, but any such securities issued later are not eligible as regulatory capital.  The banking regulators must develop regulations setting minimum risk-based and leverage capital requirements for holding companies and banks on a consolidated basis that are no less stringent than the generally applicable requirements in effect for depository institutions under the prompt corrective action regulations discussed below.  The banking regulators also must seek to make capital standards countercyclical so that the required levels of capital increase in times of economic expansion and decrease in times of economic contraction.
 
 
19

 
Basel III.   In 2010, the Group of Governors and Heads of Supervisors of the Basel Committee on Banking Supervision, the oversight body of the Basel Committee, published its “calibrated” capital standards for major banking institutions (“Basel III”). Under these standards, when fully phased in, banking institutions will be required to maintain heightened Tier 1 common equity, Tier 1 capital and total capital ratios, as well as maintaining a “capital conservation buffer.” As proposed, Basel III provides for the Tier 1 common equity and Tier 1 capital ratio requirements to be phased in incrementally between January 1, 2013 and January 1, 2015; the deductions from common equity made in calculating Tier 1 common equity (for example, for mortgage servicing assets, deferred tax assets and investments in unconsolidated financial institutions) to be phased in incrementally over a four-year period commencing on January 1, 2014; and the capital conservation buffer to be phased in incrementally between January 1, 2016 and January 1, 2019.  The Basel Committee also announced that a “countercyclical buffer” of 0% to 2.5% of common equity or other fully loss-absorbing capital “will be implemented according to national circumstances” as an “extension” of the conservation buffer.  The final package of Basel III reforms was approved by the G20 leaders in November 2010 and is subject to individual adoption by member nations.  While Basel III is intended to be implemented on a global basis beginning January 1, 2013, it was not until July 2, 2013, that the United States, through the FRB and the OCC, adopted final rules for U.S. Banking organizations implementing Basel III requirements (the “Final Rules”).
 
U.S. Implementation of Basel III.  The Final Rules establish a comprehensive capital framework and will implement the Basel III reforms and certain changes required by the Dodd-Frank Act. Under the Final Rules, minimum requirements will increase for both the quantity and quality of capital held by banking organizations. Consistent with the international Basel III framework, the Final Rules include a new minimum ratio of common equity tier 1 capital (Tier 1 Common) to risk-weighted assets and a Tier 1 Common capital conservation buffer of 2.5% of risk-weighted assets that will apply to all supervised financial institutions. The Final Rules also raise the minimum ratio of tier 1 capital to risk-weighted assets and includes a minimum leverage ratio of 4% for all banking organizations. These new minimum capital ratios will become effective for us on January 1, 2015, and will be fully phased-in on January 1, 2019.
 
Following are the Basel III regulatory capital levels that we must satisfy to avoid limitations on capital distributions and discretionary bonus payments during the applicable transition period, from January 1, 2015 until January 1, 2019:
 
 
 
January 1, 2015
 
 
January 1, 2016
 
 
January 1, 2017
 
 
January 1, 2018
 
 
January 1, 2019
 
Tier 1 Common
 
4.5
%
 
5.125
%
 
5.75
%
 
6.375
%
 
7.0
%
Tier 1 risk-based capital ratio
 
6.0
%
 
6.625
%
 
7.25
%
 
7.875
%
 
8.5
%
Total risk-based capital ratio
 
8.0
%
 
8.625
%
 
9.25
%
 
9.875
%
 
10.5
%
 
The Final Rules emphasize Tier 1 Common capital, the most loss absorbing form of capital, and implements strict eligibility criteria for regulatory capital instruments. The Final Rules also improve the methodology for calculating risk weighted assets to enhance risk sensitivity. Banks and regulators use risk weighting to assign different levels of risk to different classes of assets.
 
The following table sets forth the Tier 1 Risk-Based Ratio, Total Risk-Based Ratio and Leverage Ratio for BKFC and the Bank at December 31, 2013:
 
 
 
At December 31, 2013
 
 
 
BKFC
 
 
Bank
 
 
 
Amount
 
Percent
 
 
Amount
 
Percent
 
 
 
(Dollars in thousands)
Tier 1 risk-based
 
$
174,214
 
11.28
%
 
$
174,160
 
11.28
%
Requirement
 
 
61,786
 
4.00
 
 
 
61,761
 
4.00
 
Excess
 
$
112,428
 
7.28
%
 
$
112,399
 
7.28
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Total risk-based
 
$
206,520
 
13.37
%
 
$
206,466
 
13.37
%
Requirement
 
 
123,573
 
8.00
 
 
 
123,523
 
8.00
 
Excess
 
$
82,947
 
5.37
%
 
$
82,943
 
5.37
%
 
 
 
 
 
 
 
 
 
 
 
 
 
Leverage ratio
 
$
174,214
 
9.61
%
 
$
174,160
 
9.66
%
Requirement
 
 
72,506
 
4.00
 
 
 
72,150
 
4.00
 
Excess
 
$
101,708
 
5.61