10-K 1 v337115_10k.htm FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the fiscal year ended December 31, 2012. Commission File Number 000-27894

 

COMMERCIAL BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

 

OHIO 34-1787239
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

 

118 S. Sandusky Avenue, Upper Sandusky, Ohio 43351

(Address of principal executive offices including zip code)

Registrant’s telephone number, including area code: (419) 294-5781

 

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

 

Title of Each Class

None

 

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

 

Title of Each Class

Common Shares, no par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes £ No þ

 

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

 

Large accelerated filer  ¨ Accelerated filer  ¨
Non-Accelerated filer ¨ Smaller reporting company  þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ

 

Based on the closing price of the registrant’s common shares as of June 30, 2012, the aggregate value of the voting common shares held by non-affiliates was $23,659,467.

 

At March 26, 2013, there were issued and outstanding 1,186,638 of the registrant’s Common Shares.

 

 
 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s 2012 Annual Report to Shareholders are incorporated by reference into Parts I and II of this Form 10-K. Portions of the registrant’s Proxy Statement dated April 3, 2013 for the May 16, 2013 Annual Meeting of Shareholders are incorporated by reference into Part III of the Form 10-K.

  

 
 

 

INDEX

FORM 10-K

 

    Page
PART I    
Item 1. Description of Business 4
     
Item 1A. Risk Factors 12
     
Item 1B. Unresolved Staff Comments 15
     
Item 2. Properties 16
     
Item 3. Legal Proceedings 16
     
PART II    
Item 4. Mine Safety Disclosures 17
     
Item 5. Market for Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities 17
     
Item 6. Selected Financial Data 17
     
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation 17
     
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 18
     
Item 8. Financial Statements and Supplementary Data 18
     
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 18
     
Item 9A. Controls and Procedures 18
     
Item 9B. Other Information 18
     
PART III    
Item 10. Directors and Executive Officers of the Registrant 18
     
Item 11. Executive Compensation 19
     
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 19
     
Item 13. Certain Relationships and Related Transactions 20
     
Item 14. Principal Accountant Fees and Services 20
     
PART IV    
Item 15. Exhibits and Financial Statement Schedules 20
     
Signatures   23

 

3.
 

 

PART I

 

ITEM 1 - DESCRIPTION OF BUSINESS

 

General

 

In February 1995, Commercial Bancshares, Inc. (the “Corporation”) received approval from the Board of Governors of the Federal Reserve System to become a bank holding company by acquiring all the voting shares of common stock of The Commercial Savings Bank (the “Bank”). The principal business of the Corporation presently is to operate the Bank, which is a wholly-owned subsidiary, and its principal asset. The Corporation and the main office of the Bank are located at 118 South Sandusky Avenue, Upper Sandusky, Ohio 43351. On December 23, 2003, Articles of Incorporation were filed for Commercial Financial and Insurance Agency, LTD (“Commercial Financial”), an Ohio limited liability company. This company, a subsidiary of the Corporation, was formed to enable the Corporation to expand the products and services available to current customers and others to include the sales of non-deposit investment products and other selected financial and insurance products and services.

 

Although wholly owned by the Corporation, the Bank functions as an independent community bank. The Bank was organized on April 20, 1920 as a state-chartered Bank and incorporated as “The Lewis Bank & Trust Corporation” under the laws and statutes of the State of Ohio. An amendment to the articles of incorporation on February 8, 1929 changed the name of the Bank to its present name. The Bank provides customary retail and commercial banking services to its customers, including acceptance of deposits for demand, savings and time accounts, individual retirement accounts (IRAs) and servicing of such accounts; commercial, consumer and real estate lending, including installment loans, and safe deposit and night depository facilities. The Bank is a nonmember of the Federal Reserve System, is insured by the Federal Deposit Insurance Corporation (FDIC) and is regulated by the Ohio Division of the Financial Institutions and the FDIC.

 

The Bank grants residential, installment and commercial loans to customers located primarily in the Ohio counties of Wyandot, Marion and Hancock and the surrounding area. Commercial loans are primarily variable rate and include operating lines of credit and term loans made to small businesses primarily based on the ability to repay the loan from the cash flow of the business. Such loans are typically secured by business assets such as equipment and inventory, and occasionally by the business owner’s personal residence. When the borrower is not an individual, the Bank generally obtains the personal guarantee of the business owner. Commercial real estate loans are primarily secured by borrower-occupied business real estate, and are dependent on the ability of the related business to generate adequate cash flow to service the debt. Such loans predominantly carry adjustable interest rates. Residential real estate loans are made with primarily variable rates and are secured by the borrower’s residence. Such loans are made based on the borrower’s ability to make repayment from employment and other income. The Bank generally makes these loans in amounts of 80% or less of the value of collateral. An appraisal is obtained from a qualified real estate appraiser for substantially all loans secured by real estate. Construction loans are secured by residential and business real estate that primarily will be borrower-occupied upon completion. The Bank usually does not make the permanent loan at the end of the construction phase, unless the customer accepts a variable rate mortgage. Installment loans to individuals include loans secured by automobiles and other consumer assets, including second mortgages on personal residences. Loans secured by automobiles are generated both by direct application from the customer and from the Bank’s purchase of indirect retail installment contracts from the dealers. The Bank entered into a business relationship during 2000 whereby the Bank obtained an ownership interest in Beck Title Agency, Ltd. of Carey, Ohio (“Beck Title”). This joint venture provides an additional source of fee income for title research activity on new home loan originations in the local market.

 

As with other financial institutions, the earnings of the Corporation are affected by general economic conditions and by the monetary policies of the Federal Reserve Board. Continued weakness in employment and real estate markets and the general uncertainty as to the state of the economic recovery made for a challenging year. During 2012, management increased efforts to manage non-performing assets and work with borrowers to mitigate and protect against risk of loss. Considerable time and effort was taken to understand, prepare for and implement rapidly increasing regulatory requirements with the expectation of additional rules and regulations to follow from bodies such as the Financial Accounting Standards Board (“FASB”), the Securities and Exchange Commission (the “SEC”), and newly created bodies writing new rules and regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Generally, the Dodd-Frank Act imposes more stringent regulatory capital requirements on financial institutions. The Act requires that the Council make recommendations to the Federal Reserve regarding the establishment of heightened prudential standards for risk-based capital, leverage, liquidity and contingent capital. Although the future impact of these mandatory and discretionary rulemakings by federal regulatory agencies cannot be accurately predicted, it will expose the banking industry to more extensive regulations and heavier compliance burdens.

 

4.
 

 

The general economic conditions in the Corporation’s market area have generally been consistent with the state as a whole. The Corporation is not aware of any exposure to material costs associated with environmental hazardous waste cleanup. The Bank’s loan procedures require that where such potential risk is considered likely to exist, before approving any commercial real estate loan, management must obtain state and federal environmental regulatory studies.

 

Competition in Financial Services

 

The Bank, Commercial Financial and Beck Title compete for business primarily in the Ohio counties of Wyandot, Hancock and Marion. The Corporation’s competitors for business come from two primary sources: large regional firms and independent community banks and thrifts. As of June 30, 2012 (the most recent date for which the FDIC provides market share information), there were approximately 19 depository institutions (excluding credit unions) competing in these markets. As of that date, the Corporation ranked 3rd in total market share, with aggregate deposits of approximately $265 million.

 

The Bank also competes, particularly for deposit dollars, with insurance companies, brokerage firms and investment companies. Competition with independent community banks is enhanced by creating product niches so as not to resort solely to pricing as a means to attract business.

 

Employees

 

Currently the Corporation has 79 full-time employees and 23 part-time employees.

 

Supervision and Regulation

 

General

Commercial Bancshares, Inc. is a corporation organized under the laws of the State of Ohio. The business in which the Corporation and its subsidiary are engaged is subject to extensive supervision, regulation and examination by various bank regulatory authorities. The supervision, regulation and examination to which the Corporation and its subsidiaries are subject are intended primarily for the protection of depositors and the deposit insurance funds that insure the deposits of banks, rather than for the protection of shareholders.

 

Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Corporation and the Bank are subject are discussed below. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Corporation and the Bank.

 

Regulatory Agencies

The Corporation is a registered financial holding company and is subject to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) pursuant to the Bank Holding Company Act of 1956, as amended.

 

The Bank is an Ohio chartered commercial bank. It is subject to regulation and examination by both the Ohio Division of Financial Institutions (the “ODFI”) and the Federal Deposit Insurance Corporation (the “FDIC”).

 

The Holding Company

As a holding company incorporated and doing business within the State of Ohio, the Corporation is subject to regulation and supervision under the Bank Holding Act of 1956, as amended (the “Act”). The Corporation is required to file with the Federal Reserve Board, on a quarterly basis, information pursuant to the Act. The Federal Reserve Board may conduct examinations or inspections of the Corporation and the Bank.

 

5.
 

 

The Corporation is required to obtain prior approval from the Federal Reserve Board for the acquisition of more than five percent of the voting shares or substantially all of the assets of any bank or bank holding company. In addition, the Corporation is generally prohibited by the Act from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank or bank holding company and from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiaries. The Corporation may, however, subject to certain prior approval requirements of the Federal Reserve Board, engage in, or acquire shares of companies engaged in activities which are deemed by the Federal Reserve Board by order or by regulation to be financial in nature or closely related to banking.

 

On November 12, 1999, the Gramm-Leach Bliley Act (the “GLB Act”) was enacted into law. The GLB Act made sweeping changes with respect to the permissible financial services which various types of financial institutions may now provide. The Glass-Steagall Act, which had generally prevented banks from affiliation with securities and insurance firms, was repealed. Pursuant to the GLB Act, bank holding companies may elect to become a “financial holding company,” provided that all of the depository institution subsidiaries of the bank holding company are “well capitalized” and “well managed” under applicable regulatory standards.

 

Under the GLB Act, a bank holding company that has elected to become a financial holding company may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. Activities that are “financial in nature” include securities underwriting, dealing and market-making, sponsoring mutual funds and investment companies, insurance underwriting and agency, merchant banking and activities that the Federal Reserve Board has determined to be closely related to banking. No Federal Reserve Board approval is required for the Corporation to acquire a company, other than a bank holding company, bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. Prior Federal Reserve Board approval is required before the Corporation may acquire the beneficial ownership or control of more than five percent of the voting shares, or substantially all of the assets, of a bank holding company, bank or savings association. If any subsidiary bank of the Corporation ceases to be “well capitalized” or “well managed” under applicable regulatory standards, the Federal Reserve Board may, among other actions, order the Corporation to divest the subsidiary bank. Alternatively, the Corporation may elect to conform its activities to those permissible for a bank holding company that is not also a financial holding company. If any subsidiary bank of the Corporation receives a rating under the Community Reinvestment Act of 1977 of less than satisfactory, the Corporation will be prohibited from engaging in new activities or acquiring companies other than bank holding companies, banks or savings associations.

 

The Bank

 

General.

The Bank is an Ohio-chartered bank that is not a member of the Federal Reserve System and is therefore regulated by the ODFI as well as the FDIC. The regulatory agencies have the authority to regularly examine the Bank, which is subject to all applicable rules and regulations promulgated by its supervisory agencies. In addition, the Bank’s deposits are insured by the FDIC to the fullest extent permitted by law.

 

Deposit Insurance.

As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system under which each depository institution is assigned to a risk category based on capital and supervisory measures. In 2009, the FDIC revised the method for calculating the assessment rate for depository institutions by introducing several adjustments to an institution’s initial base assessment rate. A depository institution is assessed premiums by the FDIC based on its risk category and its average total assets. Higher levels of bank failures have dramatically increased FDIC resolution costs and depleted the deposit insurance fund.

 

In light of the increased stress on the deposit insurance fund caused by these developments, and in order to maintain a strong funding position and restore the reserve ratios of the deposit insurance fund, the FDIC (a) imposed a special assessment in June 2009, (b) has increased assessment rates of insured institutions generally, and (c) required insured institutions to prepay on December 30, 2009 the premiums that were expected to become due for 2010, 2011 and 2012. In addition, the Dodd-Frank Act alters the assessment base for deposit insurance assessments from a deposit to an asset base, and seeks to fund part of the cost of the Dodd-Frank Act by increasing the deposit insurance reserve fund to 1.35 percent of estimated insured deposits. The Dodd-Frank Act also requires that FDIC assessments be set in a manner that offsets the cost of the assessment increases for institutions with consolidated assets of less than $10 billion. This provision effectively places the increased assessment costs on larger financial institutions.

 

6.
 

 

Additionally, the Dodd-Frank Act permanently increased deposit insurance coverage from $100,000 per account ownership type to $250,000, and extended the unlimited insurance of noninterest-bearing transaction accounts under the FDIC Transaction Account Guaranty program to December 31, 2012. This program was not extended beyond that date and deposit insurance is now limited to $250,000 on all noninterest-bearing transaction accounts.

 

The FDIC may terminate the deposit insurance of any insured depository institution if the FDIC determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, order, or any condition imposed in writing by, or written agreement with, the FDIC. The FDIC may also suspend deposit insurance temporarily during the hearing process for a permanent termination of insurance if the institution has no tangible capital. The Corporation’s management is not aware of any activity or condition that could result in termination of the Bank’s FDIC deposit insurance.

 

Capital Requirements.

The Federal Reserve Board, ODFI and FDIC require banks and holding companies to maintain minimum capital ratios. The “risk-adjusted” capital guidelines for the Bank and the Corporation involve a mathematical process of assigning various risk weights to different classes of assets, then evaluating the sum of the risk-weighted balance sheet structure against the Bank’s and the Corporation’s capital base. The rules set the minimum guidelines for the ratio of capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) at 8%. Tier 1 capital is comprised of common equity, retained earnings, and a limited amount of perpetual preferred stock less certain intangible items. At least half of the total capital is to be Tier 1 Capital. The remainder may consist of a limited amount of subordinated debt, other preferred stock, and a portion of the loan loss reserves (not to exceed 1.25% of risk-weighted assets). The Bank anticipates maintaining capital at a level sufficient to be classified as “well capitalized” pursuant to the Federal Reserve guidelines.

 

In addition, the federal banking regulatory agencies have adopted leverage capital guidelines for banks and bank holding companies. Under these guidelines, banks and bank holding companies must maintain a minimum ratio of three percent (3%) Tier 1 Capital to total assets. However, most banking organizations are expected to maintain capital ratios well in excess of the minimum level and generally must keep their Tier 1 ratio at or above 5%. The Bank intends to maintain capital well above the regulatory minimum.

 

The capital requirements described above are minimum requirements. Higher capital levels will be required if warranted by the particular circumstances or risk profiles of individual institutions. For example, the regulations provide that additional capital may be required to take adequate account of, among other things, interest rate risk or the risks posed by concentrations of credit, nontraditional activities or securities trading activities. As of December 31, 2012, the Bank exceeded its minimum regulatory capital requirements with a total risk-based capital ratio of 12.5%, a Tier 1 risk-based capital ratio of 11.3% and a Tier 1 leverage ratio of 9.4%.

 

In addition to the minimum regulatory capital requirements discussed above, provisions contained in the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”) expressly provide for certain supervisory actions which are directly keyed to the capital levels of an insured depository institution. These “prompt corrective action” provisions impose progressively more restrictive constraints on operations, management and capital distributions of a particular institution as its regulatory capital decreases. Using Tier 1 risk-based, total risk-based, and Tier 1 leverage capital ratios as the relevant measures, FDIC insured depository institutions are grouped into one of the following five prompt corrective action capital categories: well capitalized, adequately capitalized; undercapitalized; significantly undercapitalized; and critically undercapitalized. An institution is considered well capitalized if it has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6% and a Tier 1 leverage capital ratio of at least 5%, provided, however, such institution is not subject to a written advisement, order or capital directive to meet and maintain a specific capital level for any particular capital measure. An adequately capitalized institution must have a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a Tier 1 leverage capital ratio of at least 4% (3% if the institution has achieved the highest composite rating in its most recent examination). At December 31, 2012, the Bank satisfied all requirements for inclusion in the “well capitalized” category.

 

7.
 

 

Dividends.

Ohio law prohibits the Bank, without the prior approval of the ODFI, from paying dividends in an amount greater than the lesser of its undivided profits or the total of its net income for that year, combined with its retained net income from the preceding two years. The payment of dividends by any financial institution or its holding company is also affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be under-capitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines as of December 31, 2012.

 

Branching Authority

Ohio chartered banks have the authority under Ohio law to establish branches anywhere in the State of Ohio, subject to receipt of all required regulatory approvals. Additionally, in May 1997 Ohio adopted legislation “opting in” to the provisions of Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Act”) which allows banks to establish interstate branch networks through acquisitions of other banks, subject to certain conditions, including certain limitations on the aggregate amount of deposits that may be held by the surviving bank and all of its insured depository institution affiliates. The establishment of de novo interstate branches or the acquisition of individual branches of a bank in another state (rather than the acquisition of an out-of-state bank in its entirety) is also allowed by the Riegle-Neal Act and authorized by Ohio law.

 

Affiliate Transactions.

Various governmental requirements, including Sections 23A and 23B of the Federal Reserve Act, limit borrowings by holding companies and non-bank subsidiaries from affiliated insured depository institutions, and also limit various other transactions between holding companies and their non-bank subsidiaries, on the one hand, and their affiliated insured depository institutions on the other. Section 23A of the Federal Reserve Act also generally requires that an insured depository institution’s loan to its non-bank affiliates be secured, and Section 23B of the Federal Reserve Act generally requires that an insured depository institution’s transactions with its non-bank affiliates be on arms-length terms.

 

Depositor Preference.

The Federal Deposit Insurance Act provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors and shareholders of the institution.

 

Privacy Provisions of Gramm-Leach-Bliley Act.

Under the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to non-affiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to non-affiliated third parties. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside venders.

 

Anti-Money Laundering Provisions of the USA Patriot Act of 2001.

On October 26, 2001, the USA Patriot Act of 2001 (the “Patriot Act”) was signed into law. The Patriot Act is intended to strengthen U.S. law enforcement’s and intelligence community’s ability to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Patriot Act on financial institutions of all kinds is significant and wide-ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including: (a) due diligence requirements for financial institutions that administer, maintain, or manage private bank accounts or correspondent accounts for non-U.S. persons; (b) standards for verifying customer identification at account opening; and (c) rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

 

8.
 

 

Fiscal and Monetary Policies.

The Bank’s business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. The Bank is particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the Federal Reserve are (a) conducting open market operations in United States government securities, (b) changing the discount rates of borrowings of depository institutions, (c) imposing or changing reserve requirements against depository institutions’ deposits, and (d) imposing or changing reserve requirements against certain borrowing by banks and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the Federal Reserve Board have a material effect on the earnings of the Bank.

 

Additional and Pending Regulation.

The Bank is also subject to federal regulation as to such matters as the maintenance of required reserves against deposits, limitations in connection with affiliate transactions, limitations as to the nature and amount of its loans and investments, regulatory approval of any merger or consolidation, issuance or retirement by the Bank of its own securities and other aspects of banking operations. In addition, the activities and operations of the Bank are subject to a number of additional detailed, complex and sometimes overlapping laws and regulations. These include state usury and consumer credit laws, state laws relating to fiduciaries, the Federal Truth-in-Lending Act and Regulation Z, the Federal Equal Credit Opportunity Act and Regulation B, the Fair Credit Reporting Act, the Truth in Savings Act, the Community Reinvestment Act, anti-redlining legislation and antitrust laws.

 

Congress regularly considers legislation that may have an impact upon the operations of the Corporation and the Bank. At this time, the Corporation is unable to predict whether any proposed legislation will be enacted and, therefore, is unable to predict the impact such legislation may have on the operations of the Corporation.

 

Regulatory Reform

 

Overview.

Congress, the U.S. Department of the Treasury (“Treasury”), and the federal banking regulators, including the FDIC, have taken broad action since early September 2008 to address volatility in the U.S. banking system and financial markets. Beginning in late 2008, the U.S. and global financial markets experienced deterioration of the worldwide credit markets, which created significant challenges for financial institutions both in the United States and around the world. Dramatic declines in the housing market during the past year, marked by falling home prices and increasing levels of mortgage foreclosures, have resulted in significant write downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. In addition, many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including other financial institutions, as a result of concern about the stability of the financial markets and the strength of counterparties.

 

In response to the financial market crisis and continuing economic uncertainty, the United States government, specifically the Treasury, the Federal Reserve Board and the FDIC working in cooperation with foreign governments and other central banks, took a variety of extraordinary measures designed to restore confidence in the financial markets and to strengthen financial institutions, including measures available under the Emergency Economic Stabilization Act of 2008 (“EESA”), as amended by the American Recovery and Reinvestment Act of 2009 (“ARRA”), which included the Troubled Asset Relief Program (“TARP”).The stated purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. As part of TARP, Treasury purchased debt or equity securities from participating financial institutions through the Treasury’s Capital Purchase Plan (“CPP”). Participants in the CPP are subject to various restrictions regarding dividends, stock repurchases, corporate governance and executive compensation. The Company elected not to participate in the program and, therefore, it is not subject to the restrictions imposed on CPP participants.

 

9.
 

 

EESA also temporarily increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase became permanent at the end of 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). Following a systemic risk determination, on October 14, 2008, the FDIC established a Temporary Liquidity Guarantee Program (“TLGP”). Under the Transaction Account Guarantee Program of the TLGP, the FDIC temporarily provides a 100% guarantee of the deposits in noninterest-bearing transaction deposit accounts in participating financial institutions. The Bank participated in this program. Consequently, all funds held in noninterest-bearing transaction accounts (demand deposit accounts), Interest on Lawyers Trust Accounts (IOLTAs), and low-interest NOW accounts (defined as NOW accounts with interest rates no higher than 0.50%) with the Bank were covered under this program. The Dodd-Frank Act extended unlimited FDIC insurance coverage on noninterest-bearing transaction accounts through December 31, 2012. Under the Dodd-Frank Act, low-interest NOW accounts are excluded from the definition of noninterest-bearing transaction accounts.

 

The Dodd-Frank Act is aimed, in part, at accountability and transparency in the financial system and includes numerous provisions that apply to and/or could impact the Corporation and its banking subsidiary. The Dodd-Frank Act implements changes that, among other things, affect the oversight and supervision of financial institutions, provide for a new resolution procedure for large financial companies, create a new agency responsible for implementing and enforcing compliance with consumer financial laws, introduce more stringent regulatory capital requirements, effect significant changes in the regulation of over the counter derivatives, reform the regulation of credit rating agencies, implement changes to corporate governance and executive compensation practices, incorporate requirements on proprietary trading and investing in certain funds by financial institutions (known as the "Volcker Rule"), require registration of advisers to certain private funds, and effect significant changes in the securitization market. In order to fully implement many provisions of the Dodd-Frank Act, various government agencies, in particular banking and other financial services agencies are required to promulgate regulations. Set forth below is a discussion of some of the major sections the Dodd-Frank Act and implementing regulations that have or could have a substantial impact on the Corporation and its banking subsidiary. Due to the volume of regulations required by the Dodd-Frank Act, not all proposed or final regulations that may have an impact on the Corporation or its banking subsidiary are necessarily discussed.

 

Consumer Issues.

The Dodd-Frank Act creates the new Consumer Financial Protection Bureau (the “CFPB”), which has the authority to implement regulations pursuant to numerous consumer protection laws and has supervisory authority, including the power to conduct examination and take enforcement actions, with respect to depository institutions with more than $10 billion in consolidated assets. The CFPB also has authority, with respect to consumer financial services to, among other things, restrict unfair, deceptive or abusive acts or practices, enforce laws that prohibit discrimination and unfair treatment and to require certain consumer disclosures.

 

Deposit Insurance Assessments.

All of the Bank’s deposits are insured under the Federal Deposit Insurance Act by the FDIC to the fullest extent permitted by law. As an FDIC-insured institution, the Bank is required to pay deposit insurance premium assessments to the FDIC. The FDIC has adopted a risk-based assessment system whereby FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to the regulators. The FDIC recently raised assessment rates to increase funding for the Deposit Insurance Fund (the “DIF”), which is currently underfunded.

 

The Dodd-Frank Act changes the deposit insurance assessment framework, primarily by basing assessments on an institution’s average total consolidated assets less average tangible equity (subject to risk-based adjustments that would further reduce the assessment base for custodial banks) rather than on the amount of an institution’s domestic deposits, which is how the assessment had previously been calculated. This change is expected to shift a greater portion of the aggregate assessments to large banks, as described in detail below. The Dodd-Frank Act also eliminates the upper limit for the reserve ratio designated by the FDIC each year, increases the minimum designated reserve ratio of the DIF from 1.15% to 1.35% of the estimated amount of total insured deposits by September 30, 2020, and eliminates the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. On December 20, 2010, the FDIC raised the minimum designated reserve ratio of DIF to 2%. The ratio is higher than the minimum reserve ratio of 1.35% as set by the Dodd-Frank Act. Under the Dodd-Frank Act, the FDIC is required to offset the effect of the higher reserve ratio on small insured depository institutions, defined as those with consolidated assets of less than $10 billion.

 

10.
 

 

On February 7, 2011, the FDIC approved a final rule implementing the changes in the deposit insurance assessment framework mandated by the Dodd-Frank Act. Because the new assessment base under the Dodd-Frank Act results in a larger amount than the previous assessment base, the final rule’s assessment rates are lower than the current rates, which achieves the FDIC’s goal of not significantly altering the total amount of revenue collected from the industry. In addition, the final rule adopts a “scorecard” assessment scheme for larger banks and suspends dividend payments if the DIF reserve ratio exceeds 1.5% but provides for decreasing assessment rates when the DIF reserve ratio reaches certain thresholds. The final rule also determines how the effect of the higher reserve ratio will be offset for institutions with less than $10 billion of consolidated assets.

 

Executive Compensation and Corporate Governance.

The Dodd-Frank Act clarifies that the SEC may, but is not required to promulgate rules that would require that a company's proxy materials include a nominee for the board of directors submitted by a shareholder. Although the SEC promulgated rules to accomplish this, these rules were invalidated by a federal appeals court decision. The SEC has said that it will not challenge the ruling, but has not ruled out the possibility that new rules could be proposed under the authority of Dodd-Frank.

 

The Dodd-Frank Act also adds disclosure and voting requirements for golden parachute compensation that is payable to named executive officers in connection with sale transactions. In addition, the Dodd-Frank Act requires the SEC to issue rules directing the stock exchanges to prohibit listing classes of equity securities if a company's compensation committee members are not independent. The Dodd-Frank Act also provides that a company's compensation committee may only select a compensation consultant, legal counsel or other advisor after taking into consideration factors to be identified by the SEC that affect the independence of a compensation consultant, legal counsel or other advisor.

 

The SEC is required under the Dodd-Frank Act to issue rules obligating companies to disclose in proxy materials for annual meetings of shareholders information that shows the relationship between executive compensation actually paid to their named executive officers and their financial performance, taking into account any change in the value of the shares of a company's stock and dividends or distributions.

 

The Corporation is presently a “smaller reporting company” as defined by SEC regulations and is therefore exempt presently from some of the provisions noted above regarding compensation disclosures. As a smaller reporting company, the Corporation is required to comply with say on pay and say on frequency shareholder proposal requirements beginning with its 2013 Annual Meeting of Shareholders.

 

Statistical Disclosures

 

The following statistical information for 2012, 2011, and 2010, included in the Annual Report is incorporated herein by reference.

 

  Annual
  Report
  Page
Return on Equity and Assets 2
Volume / Rate Analysis 5
Distribution of Assets, Liabilities and Shareholders’ Equity 6
Loan Portfolio 10-11
Summary of Loan Loss Experience 11-15
Investment Portfolio 15-16
Deposits 17-18

 

The Corporation files annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy solicitation materials, as applicable, under Commission Regulation 14A. The public may read and copy any materials the Corporation files with the Commission at the SEC’s Public Reference Room at 100 F. Street, NE, Washington, DC 20549, on official business days during the hours of 10:00 am to 3:00 pm. The public may obtain information on the operation of the Public Reference Room by calling the Commission at 1-800-SEC-0330. The Commission maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the Commission at http://www.sec.gov. The Corporation’s internet website is at www.csbanking.com.

 

11.
 

 

ITEM 1A – RISK FACTORS

 

There are risks inherent to the Corporation’s business. The material risks and uncertainties that management believes affect the Corporation are described below. The risks and uncertainties described below are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, the Corporation’s financial condition and results of operations could be materially and adversely affected.

 

The Corporation is Subject to Interest Rate Risk

 

The Corporation’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, (ii) the fair value of the Corporation’s financial assets and liabilities, and (iii) the average duration of the Corporation’s mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Corporation’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall at a faster pace than the interest rates paid on deposits and other borrowings.

 

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the Corporation’s results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on the Corporation’s financial condition and results of operations. See the sections captioned “Results of Operations – Net Interest Income” and “Quantitative and Qualitative Disclosures about Market Risk” set forth in the Corporation’s 2012 Annual Report to Shareholders incorporated herein by reference.

 

The Corporation is Subject to Lending Risk

 

There are inherent risks associated with the Corporation’s lending activities. These risks include, but are not limited to, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates as well as those across the State of Ohio, as well as the entire United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with the applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil monetary penalties against the Corporation.

 

As of December 31, 2012, approximately 78.3% of the Corporation’s loan and lease portfolio consisted of commercial, construction and commercial real estate loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Loans” set forth in the Corporation’s 2012 Annual Report to Shareholders and incorporated herein by reference.

 

12.
 

 

The Corporation’s Allowance For Loan and Lease Losses May Be Insufficient

 

The Corporation maintains an allowance for loan and lease losses, which is an allowance established through a provision for loan and lease losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans and leases. The allowance, in the judgment of management, is necessary to reserve for estimated loan and lease losses and risks inherent in the loan and lease portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan and lease portfolio quality, current economic conditions, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan and lease losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation’s control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for loan and lease losses, the Corporation will need additional provisions to increase the allowance for loan and lease losses. These increases in the allowance for loan and lease losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Allowance for Loan Losses” set forth in the Corporation’s 2012 Annual Report to Shareholders incorporated herein by reference for further discussion related to the Corporation’s process for determining the appropriate level of the allowance for loan and losses.

 

The Corporation’s Profitability Depends Significantly on Economic Conditions in North Central Ohio

 

The Corporation’s success depends primarily on the general economic conditions of North Central Ohio and the specific local markets in which the Corporation operates. Unlike larger national or other regional banks that are more geographically diversified, the Corporation provides banking and financial services to customers primarily in the North Central Ohio counties of Wyandot, Marion and Hancock. The local economic conditions in these areas have a significant impact on the demand for the Corporation’s products and services as well as the ability of the Corporation’s customers to repay loans, the value of the collateral securing loans and the stability of the Corporation’s deposit funding sources. A significant decline in general economic conditions caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation’s financial condition and results of operations.

 

The Corporation Operates In A Highly Competitive Industry and Market Area

 

The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets in which the Corporation operates. The Corporation also faces competition from many other types of financial institutions, including but not limited to, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Corporation’s competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can. The Corporation’s ability to compete successfully depends on a number of factors, including, among other things:

 

•   The ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets.

 

13.
 

 

•   The ability to expand the Corporation’s market position.

•   The scope, relevance and pricing of products and services offered to meet customer needs and demands.

•   The rate at which the Corporation introduces new products and services relative to its competitors.

•   Customer satisfaction with the Corporation’s level of service.

•   Industry and general economic trends.

 

Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.

 

The Corporation Is Subject To Extensive Government Regulation and Supervision

 

The Corporation, primarily through Commercial Savings Bank, is subject to extensive federal regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations. While the Corporation has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the section captioned “Supervision and Regulation” in Part I, Item 1, located elsewhere in this report.

 

The Corporation’s Controls and Procedures May Fail or Be Circumvented

 

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

 

The Corporation Relies on Dividends From Its Subsidiaries For Most Of Its Revenue

 

The Corporation is a separate and distinct legal entity from Commercial Savings Bank. It receives substantially all of its revenue from dividends from Commercial Savings Bank. These dividends are the principal source of funds to pay dividends on the Corporation’s common stock and interest and principal on the Corporation’s debt. Various federal and/or state laws and regulations limit the amount of dividends that Commercial Savings Bank may pay to the Corporation. Also, the Corporation’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event Commercial Savings Bank is unable to pay dividends to the Corporation, the Corporation may not be able to service debt, pay obligations or pay dividends on the Corporation’s common stock.

 

The inability to receive dividends from Commercial Savings Bank could have a material adverse effect on the Corporation’s business, financial condition and results of operations. See the section captioned “Supervision and Regulation” in Part I, Item 1, located elsewhere in this report.

 

14.
 

 

The Corporation May Not Be Able To Attract and Retain Skilled People

 

The Corporation’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Corporation can be intense and the Corporation may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Corporation’s key personnel could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

 

The Corporation’s Information Systems May Experience An Interruption Or Breach In Security

 

The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations.

 

The Corporation Continually Encounters Technological Change

 

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Corporation’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as create additional efficiencies in the operations of the Corporation. Many of the Corporation’s competitors have substantially greater resources to invest in technological improvements. The Corporation may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.

 

The Corporation’s Articles Of Incorporation and Code of Regulations, As Well As Certain Banking Laws, May Have An Anti-Takeover Effect

 

Provisions of the Corporation’s articles of incorporation and code of regulations and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Corporation’s common shares.

 

ITEM 1B. UNRESOLVED STAFF COMMENTS.

 

None.

 

15.
 

 

ITEM 2 - PROPERTIES

 

The Corporation’s headquarters and the Bank’s main office are located at 118 South Sandusky Avenue, Upper Sandusky, Ohio, in Wyandot County. The building is used exclusively by the Corporation and the Bank.

 

    Location   Description
1.   Main Office   Two story building built in the early 1900’s and remodeled in 2012.
    118 S. Sandusky Ave.    
    Upper Sandusky, Ohio 43351    
         
2.   Carey Office   One story building built and opened in 1973, and remodeled in 2007.
    128 S. Vance Street    
    Carey, OH 43316    
         
3.   Harpster Office   One story building purchased in 1978.
    17480 Cherokee Street    
    Harpster, OH 43323    
         
4.   North Drive-In Office   One story drive in office opened in 1981.
    400 N. Sandusky Avenue    
    Upper Sandusky, OH 43351    
         
5.   Findlay Tiffin Avenue Office   One story building purchased in 1992.  The building was renovated
    1600 Tiffin Avenue   in 1999 to add more office space.
    Findlay, OH 45840    
         
6.   Marion Jamesway Office   One story building constructed and opened in 1996.
    279 Jamesway    
    Marion, OH 43302    
         
7.   Findlay Lincoln Street Office   One story building purchased in 1999 and opened in 2000.
    201 Lincoln Street    
    Findlay, OH 45850    
         
8.   Operations Center   One story building constructed and opened in 2006.
    245 Tarhee Trail    
    Upper Sandusky, OH  43351    
         
9.   Marion Barks Rd West Office   One story building purchased in 2008.  The building was renovated
    195 Barks Rd West   and opened in 2009.
    Marion, OH  43302    
         
10.   Arlington Office   Leased (with option to buy).  Two-story building opened in 2009.
    112 East Liberty Street    
     Arlington, OH 45814    

 

The Bank considers its physical properties to be in good operating condition (subject to reasonable wear and tear) and suitable for the purposes for which they are being used.

 

ITEM 3 – LEGAL PROCEEDINGS

 

There is no pending litigation, other than routine litigation incidental to the business of the Corporation, Bank or Commercial Financial of a material nature involving or naming the Corporation, Bank or Commercial Financial as a defendant. Furthermore, there are no material legal proceedings in which any director, officer or affiliate of the Corporation, or any security holder owning five percent of the Corporation’s common stock; or any associates of such persons is a party or has a material interest that is adverse to the Corporation, Bank or Commercial Financial. None of the routine litigation in which the Corporation, Bank or Commercial Financial is involved is expected to have a material adverse impact on the financial position or results of operations of the Corporation, Bank or Commercial Financial.

 

16.
 

 

PART II

 

ITEM 4 – MINE SAFETY DISCLOSURES

 

Not applicable

 

ITEM 5 – MARKET FOR COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

The information set forth under the heading “Shareholder Information” on page 54 of the Annual Report is incorporated herein by reference.

 

Issuer Purchases of Equity Securities

 

For the three months ended December 31, 2012, the Corporation purchased 1,250 shares totaling $24,781 and delivered 3,106 shares totaling $51,772 under the Commercial Savings Bank Deferred Compensation Plan, a nonqualified deferred compensation plan, to various members of the Board. Shares are purchased on the open market and are credited to the respective accounts of the deferred compensation plan participants. These transactions were not registered, but were made in reliance upon the exemption from registration contained in Section 4(a)(2) of the Securities Act of 1933. Additionally, the Corporation issued 200 shares of treasury stock totaling $5,466 under stock option plans, the issuance of which were also exempt from registration under Section 4(a)(2) of the Securities Act of 1933.

 

The following table reflects shares repurchased by the Corporation during the fourth quarter, ended December 31, 2012, including any shares purchased as part of a repurchase program approved by the Corporation’s Board of Directors in June 2009.

 

Period  Total
Number
of Shares
Purchased		   Average
Price 
Paid 
per
Share		   Total Number of
Shares Purchased
as Part of Publicly
Announced Plans 
or Programs		   Maximum Number  
(or Approximate 
Dollar Value)
of Shares that May
Yet be Purchased
Under the Plans or
Programs		 
                 
10/01/2012 – 10/31/2012   -0-    n/a    -0-    23,548 
                     
11/01/2012 – 11/30/2012   -0-    n/a    -0-    23,548 
                     
12/01/2012 – 12/31/2012   1,250    19.52    -0-    23,548 
                     
Total   1,250    19.52    -0-    23,548 

 

ITEM 6 – SELECTED FINANCIAL DATA

 

The information set forth under the heading “Comparative Summary of Selected Financial Data” on page 2 of the Annual Report is incorporated herein by reference.

 

ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

 

The information set forth under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” on pages 3 through 22, inclusive, of the Annual Report is incorporated herein by reference.

 

17.
 

 

ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The information set forth under the heading “Quantitative and Qualitative Disclosures about Market Risk” on page 20 through 21 of the Annual Report is incorporated herein by reference.

 

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The information contained in the consolidated financial statements and related notes and the report of independent registered public accounting firm thereon, on pages 23 through 54, inclusive, of the Annual Report is incorporated herein by reference.

 

ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

There were no changes in or disagreements with the Corporation’s independent accountants on accounting and financial disclosures.

 

ITEM 9A – CONTROLS AND PROCEDURES

 

Commercial Bancshares, Inc. carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures as of December 31, 2012, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Corporation’s disclosure controls and procedures were effective as of December 31, 2012, in timely alerting them to material information required to be in the Corporation’s (including its consolidated subsidiaries) periodic SEC filings.

 

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Corporation. Under the supervision and with the participation of management, including principal executive and principal financial officers, an evaluation of the effectiveness of internal control over financial reporting was conducted based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, as required by paragraph (c) of §240.13a-15 of this chapter. Based on the evaluation under Internal Control – Integrated Framework, management concluded that the Corporation’s internal control over financial reporting was effective as of December 31, 2012. This annual report does not include an attestation report of the Corporation’s registered public accounting firm regarding internal control over financial accounting. Management’s report was not subject to attestation by the Corporation’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Corporation to provide only management’s report in this annual report. There was no change in the Corporation’s internal control over financial reporting that occurred during the Corporations’ fiscal quarter ending December 31, 2012 that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

 

ITEM 9B – OTHER INFORMATION

 

None.

 

PART III

 

ITEM 10 – DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

 

Information concerning Directors and Executive Officers of the Corporation appear under the captions “Board and Committee Membership,” “Committees of the Board,” “Information relating to Nominees and other Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Corporation’s Definitive Proxy Statement dated April 3, 2013 for the Annual Meeting of Shareholders to be held on May 16, 2013 and is incorporated herein by reference.

 

18.
 

 

The Corporation has adopted a code of ethics that applies to its principal executive officer, principal financial officer, and principal accounting officer. A copy of the Corporation’s Code of Ethics may be viewed on the Corporation’s website, www.csbanking.com. In the event the Corporation makes an amendment to, or grants any waiver of, a provision of its code of ethics, the Corporation intends to disclose such amendment or waiver, the reasons for it, and the nature of any waiver, the name of the person to whom it was granted, and the date, on the Corporation’s internet website.

 

ITEM 11 – EXECUTIVE COMPENSATION

 

Information concerning executive compensation appears, under the captions “Executive Compensation,” “Summary Compensation Table,” “Outstanding Equity Awards at Fiscal Year End,” “Deferred Compensation Plan,” and “Employment Agreements” in the Corporation’s Definitive Proxy Statement dated April 3, 2013 for the Annual Meeting of Shareholders to be held on May 16, 2013 and is incorporated herein by reference.

 

ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

Information concerning security ownership of certain beneficial owners and management is contained under the captions “Information Relating to Nominees and other Directors,” and “Share Ownership of Management and Directors” in the Corporation’s Definitive Proxy Statement dated April 3, 2013 for the Annual Meeting of Shareholders to be held on May 16, 2013 and is incorporated herein by reference.

 

The Corporation has two stock option plans, the 1997 Stock Option Plan and the 2009 Incentive Stock Option Plan. No additional grants may be made under the 1997 Stock Option Plan. The 2009 Plan, which is shareholder approved, permits the grant of stock options, restricted stock and certain other stock-based awards for up to 150,000 shares. All stock options have an exercise price that is equal to the closing market value of the Corporation’s stock on the date options are granted. During 2012, 15,200 stock options with an exercise price of $19.28 were granted to executive officers and certain key employees. The weighted average fair value of options granted was $3.01 per share. In 2011, 9,800 stock options with an exercise price of $17.40 were granted to executive officers and certain key employees. The weighted average fair value of options granted was $2.94 per share. Options will vest over three years and expire ten years from the date of grant.

 

Additionally, the Corporation granted 2,200 shares of restricted stock awards to executive officers and directors during 2012 compared to 3,750 shares during 2011. Restricted stock awards are recorded as deferred compensation, a component of shareholders’ equity, at fair value at the date of grant and amortized to compensation expense over the vesting period

 

The following table includes information as of December 31, 2012 with respect to the Stock Option Plans, under which equity securities of the Corporation are authorized for issuance.

 

Plan category  Number of securities to be
issued upon exercise of
outstanding options,
warrants and rights		   Weighted-average
 exercise price of
outstanding options,
warrants and rights		   Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column[a])		 
   (a)   (b)   (c) 
Equity Compensation plans approved by security holders   52,500   $15.47    86,300 
                
Equity Compensation plans not approved security holders   2,130   $24.63    -0- 

 

19.
 

 

ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

Information concerning director independence and certain relationships and related transactions is contained under the caption “Director Independence and Related Party Transactions” in the Corporation’s Definitive Proxy Statement dated April 3, 2013 for the Annual Meeting of Shareholders to be held on May 16, 2013 and is incorporated herein by reference.

 

ITEM 14 – PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

Information concerning principal accountant fees and services is contained under the caption “Principal Accounting Firm Fees” of the Corporation’s Definitive Proxy Statement dated April 3, 2013 for the Annual Meeting of Shareholders to be held on May 16, 2013 and is incorporated herein by reference.

 

PART IV

 

ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

(a)The following Consolidated Financial Statements and related Notes to Consolidated Financial Statements, together with the report of the Independent Registered Public Accounting Firm dated March 15, 2013 appear on pages 23 through 54 of the Commercial Bancshares, Inc., 2012 Annual Report and are incorporated herein by reference.

 

1.Financial Statements

 

Consolidated Balance Sheets
December 31, 2012 and 2011

Consolidated Statements of Income for the Years Ended
December 31, 2012, 2011 and 2010

 

Consolidated Statements of Comprehensive Income for the Years Ended

December 31, 2012, 2011 and 2010

Consolidated Statements of Shareholders’ Equity for the Years Ended
December 31, 2012, 2011 and 2010

Consolidated Statements of Cash Flows for the Years Ended
December 31, 2012, 2011 and 2010

Notes to Consolidated Financial Statements for the Years Ended
December 31, 2012, 2011 and 2010

Report of Independent Registered Public Accounting Firm

Financial statement schedules are omitted as they are not required or are not applicable or because the required information is included in the consolidated financial statements or notes thereto.

 

20.
 

 

(b) EXHIBITS

 

Exhibit Number   Description of Document
     
3.1.a   Amended Articles of Incorporation of the Corporation (incorporated by reference to Registrant’s Form 8-K dated April 27, 1995)
     
3.1.b   Amendment to the Corporation’s Amended Articles of Incorporation to increase the number of shares authorized for issuance to 4,000,000 common shares, no par value (incorporated by reference to Appendix I to Registrant’s Definitive Proxy Statement filed March 13, 1997)
     
3.2   Code of Regulations of the Corporation (incorporated by reference to Registrant’s Form 8-K dated April 27, 1995)
     
4   Form of Certificate of Common Shares of the Corporation (incorporated by reference to Registrant’s Form 8-K dated April 27, 1995)
     
10.1   Commercial Bancshares, Inc. 1997 Stock Option Plan (incorporated by reference to Appendix II to our Proxy Statement, as filed with the SEC on Schedule 14A on March 13, 1997)
     
10.2   Commercial Bancshares, Inc. Deferred Compensation Plan (incorporated by reference to Exhibit 4.1 to our Registration Statement Form S-8, as filed with the SEC on March 17, 1999)
     
10.3   Executive Employment Contract with Robert E. Beach dated November 1, 2007 (incorporated by reference to Exhibit 10 to Registrant’s Form 8-K filed November 7, 2007)
     
10.4   Executive Employment Contract with Scott A. Oboy, dated June 8, 2005 (incorporated by reference to Exhibit 10.5 to Registrant’s Form 10-K filed March 31, 2006)
     
10.5   Commercial Bancshares Inc. Supplemental Executive Retirement Plan (incorporated by reference to Exhibit 10.3 to Registrant’s Form 10-K filed March 31, 2005)
     
10.6   Executive Employment Contract with Steven M. Strine dated March 3, 2008 (incorporated by reference to Exhibit 10 to Registrant’s Form 8-K filed March 31, 2008)
     
13   Annual Report to Shareholders for the Year Ended 2012
     
21   Subsidiaries of the Registrant
     
23   Consent of Independent Registered Public Accounting Firm
     
31.1   Rule 13a-14(a) Certification (CEO)
     
31.2   Rule 13a-14(a) Certification (CFO)
     
32.1   Section 1350 Certification (CEO)
     
32.2   Section 1350 Certification (CFO)
     
101.INS   XBRL Instance Document(1)
     
101.SCH   XBRL Taxonomy Extension Schema Document(1)

 

21.
 

 

101.CAL   XBRL Taxonomy Extension Calculation Linkbase Document(1)
     
101.LAB   XBRL Taxonomy Extension Label Linkbase Document(1)
     
101.PRE   XBRL Taxonomy Extension Presentation Linkbase Document(1)
     
101.DED   XBRL Taxonomy Extension Definitions Linkbase Document(1)

 

(1)As provided in Rule 406T of Regulation S-T, this information shall not be deemed “filed” for the purpose of Sections 11 and 12 of the Securities Act of 1933 and Section 18 of the Securities Exchange Act of 1934 or otherwise subject to liability under those sections.

 

22.
 

 

SIGNATURES

 

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the under signed, thereunto duly authorized.

 

03/26/2013   COMMERCIAL BANCSHARES, INC.  
Date        
    By: /s/ROBERT E. BEACH  
      Robert E. Beach, President and CEO  

 

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 26, 2013.

 

Signatures   Signatures
     
/s/ROBERT E. BEACH   /s/MARK DILLON
Robert E. Beach   Mark Dillon
President and Principal Executive Officer   Director
     
/s/SCOTT A. OBOY   /s/DEBORAH J. GRAFMILLER
Scott A. Oboy   Deborah J. Grafmiller
Executive Vice President and Chief Financial Officer   Director
     
/s/MICHAEL A. SHOPE   /s/KURT D. KIMMEL
Michael A. Shope   Kurt D. Kimmel
Director, Chairman of the Board   Director
     
/s/STANLEY K. KINNETT   /s/LYNN R. CHILD
Stanley K. Kinnett   Lynn R. Child
Director, Vice Chairman of the Board   Director
     
/s/DANIEL E. BERG   /s/LEE M. SISLER
Daniel E. Berg   Lee M. Sisler
Director   Director
     
/s/J. WILLIAM BREMYER    
J. William Bremyer    
Director    

 

23.
 

 

EXHIBIT 13

 

COMMERCIAL BANCSHARES, INC.

Upper Sandusky, Ohio

 

ANNUAL REPORT

December 31, 2012

 

CONTENTS

 

President’s Letter 1
   
Comparative Summary of Selected Financial Data 2
   
Management’s Discussion and Analysis of Financial Condition and Results of Operations 3
   
Report of Independent Registered Public Accounting Firm 23
   
Consolidated Financial Statements 24
   
Notes to Consolidated Financial Statements 30
   
Shareholder Information 54
   
Officers 55
   
Board of Directors 56

  

i.
 

 

December 31, 2012

 

Dear Shareholders:

 

In 2012 your bank reported record earnings of $2,938,000, which is $2.49 per diluted share and a 5.72% increase over 2011 earnings of $2,779,000 or $2.38 per diluted share. This amounts to a 0.98% return on average assets and a 10.33% return on average equity. Our dividend increased 12% at year-end to $0.14 per share and we had a year-end share price of $18.90, providing a 2.96% yield, which is in line or slightly above other peer banks.

 

We had strong growth in net loans of 5.28% and continued strong growth in our DDA accounts of $21,200,000 or 14.93%, allowing us to reduce our time deposits which in turn reduced our overall cost of funds and helped us maintain a strong margin in a challenging environment.

 

We have continued to increase our loan loss reserve to further strengthen the bank as we maintain our disciplined approach to loan underwriting and continue to look for ways to grow revenue and reduce expenses. We have continued to invest in our facilities and our people along with providing state of the art products and services.

 

The bank’s total footings grew 4.79% last year. We currently have plenty of funds so spread the word to family, friends and businesses that we are capable and willing to lend funds to promote personal or business growth. Our market maker is Boenning & Scattergood or look to your broker to purchase stock in our profitable, growing and successful bank.

 

I look forward to seeing you at our May 16, 2013 annual shareholders’ meeting.

 

Sincerely,

 

 

Robert E. Beach,

President and Chief Executive Officer

 

 
 

 

TABLE 1      COMPARATIVE SUMMARY OF SELECTED FINANCIAL DATA

 

Year ended December 31                    
(Dollars in thousands, except per share data)  2012   2011   2010   2009   2008 
                     
Total assets  $301,564   $287,779   $304,403   $294,280   $259,795 
                          
Total investment securities   17,032    27,111    36,103    36,733    37,621 
                          
Loans, net   243,303    231,094    227,460    225,264    196,167 
                          
Total deposits   268,439    259,128    277,244    264,709    231,668 
                          
Total borrowed funds   1,922    0    0    5,000    5,000 
                          
Total shareholders’ equity   29,388    26,999    24,389    22,695    21,305 
                          
Book value per outstanding share   25.12    23.22    21.18    19.93    18.75 
                          
Shares outstanding   1,169,840    1,162,725    1,151,345    1,138,497    1,136,397 
                          
Results of Operations                         
Interest income  $14,252   $15,041   $15,745   $15,541   $16,304 
Interest expense   (1,493)   (2,112)   (3,589)   (4,967)   (6,277)
Net interest income   12,759    12,929    12,156    10,574    10,027 
Provision for loan losses   (798)   (989)   (1,370)   (1,484)   (1,127)
Other income   2,297    2,211    2,447    2,466    2,649 
Salaries and employee benefits   (5,625)   (5,701)   (5,293)   (5,046)   (5,415)
Other expenses   (4,518)   (4,642)   (4,875)   (5,320)   (4,645)
Income before income taxes   4,115    3,808    3,065    1,190    1,489 
Income tax expense   (1,177)   (1,029)   (742)   (89)   (188)
Net income  $2,938   $2,779   $2,323   $1,101   $1,301 
                          
Per Share Data                         
                          
Net income                         
Basic  $2.52   $2.40   $2.03   $0.97   $1.14 
Diluted  $2.49   $2.38   $2.03   $0.97   $1.14 
                          
Cash dividend paid  $0.515   $0.485   $0.420   $0.580   $0.760 
                          
Financial Ratios                         
                          
Return on average total assets   0.98%   0.94%   0.77%   0.40%   0.50%
Return on average shareholders’ equity   10.33%   10.73%   9.76%   4.96%   6.09%
Average shareholders’ equity to average total assets   9.50%   8.78%   7.89%   8.01%   8.15%
                          
Dividend payout   20.46%   20.22%   20.70%   59.90%   66.38%

  

2.
 

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

INTRODUCTION

 

This financial review presents management’s discussion and analysis of the consolidated financial condition of the Corporation and its wholly owned subsidiaries, Commercial Savings Bank and Commercial Financial and Insurance Agency, LTD at December 31, 2012 and 2011, and the consolidated results of operations for each of the years in the three year period ended December 31, 2012. This discussion should be read in conjunction with the consolidated financial statements, notes to consolidated financial statements and other financial data presented elsewhere in this annual report and on Form 10K.

 

The Corporation is designated as a financial holding company by the Federal Reserve Bank of Cleveland. As a result of being a financial holding company, the Corporation may be able to engage in an expanded array of activities determined to be financial in nature. This will help the Corporation remain competitive in the future with other financial service providers in the markets in which the Corporation does business. There are more stringent capital requirements associated with being a financial holding company. The Corporation intends to maintain its categorization as a “well capitalized” bank, as defined by regulatory capital requirements.

 

The registrant is not aware of any trends, events or uncertainties that will have or are reasonably likely to have a material effect on the liquidity, capital resources or operations except as discussed herein. Furthermore, the Corporation is not aware of any current recommendations by regulatory authorities that would have such effect if implemented.

 

FORWARD-LOOKING STATEMENTS

 

In addition to historical information, this report may contain forward-looking statements. For this purpose, any statement that is not a statement of historical fact may be deemed to be a forward-looking statement. These forward-looking statements may include statements regarding profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy and financial and other goals. Words such as “believes,” “expects,” “plans,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends” or other words of similar meaning are intended to identify forward-looking statements. They can also be identified by the fact that they do not relate strictly to historical or current facts. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, and actual results could differ materially from historical results or those anticipated by such statements.

 

There are many factors that could have a material adverse effect on the operations and future prospects of the Corporation including, but not limited to:

 

·Local, regional and national economic conditions and the impact they may have on the Corporation and its customers and the assessment of that impact on estimates including, but not limited to, the allowance for loan losses and fair value of other real estate owned.

 

·Changes in the level of non-performing assets and charge-offs.

 

·Changes in the fair value of securities available for sale and management’s assessments of other-than-temporary impairment of such securities.

 

·The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Securities and Exchange Commission, the Financial Accounting Standards Board and other accounting standard setters.

 

·The effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board.

 

·Changes in consumer spending and savings habits; and

 

·The Corporation’s success at managing the risks detailed above.

 

3.
 

 

CRITICAL ACCOUNTING POLICIES

 

The Corporation has established various accounting policies which govern the application of U.S. GAAP in the preparation of its financial statements. Certain accounting policies involve significant judgments and assumptions by management which has a material impact on the reported amount of assets, liabilities, capital, revenues and expenses and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company’s critical accounting policies as the ones that are most important to the portrayal of the company’s financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates on matters that are inherently uncertain. Because of the nature of the judgments and assumptions made by management, actual results could differ from estimates and have a material impact on the carrying value of assets, liabilities, capital or the results of operations of the Corporation.

 

Allowance for loan losses: The Corporation believes the allowance for loan losses is a critical accounting policy that requires the most significant judgments and estimates used in the preparation of its consolidated financial statements. Adequacy of the allowance for loan losses is determined quarterly using a consistent, systematic methodology, which analyzes the risk inherent in the loan portfolio. In addition to evaluating the collectability of specific loans when determining the adequacy of the allowance, management also takes into consideration other qualitative factors such as changes in the mix and size of the loan portfolio, historical loss experience, the amount of delinquencies and loans adversely classified, industry trends, and the impact of the local and regional economy on the Corporation’s borrowers. Changes in these qualitative factors may cause management’s estimate of the adequacy of the allowance for loan losses to increase or decrease and result in adjustments to the Corporation’s provision for loan losses in future periods. For additional information see “Allowance for Loan Losses” under Financial Condition as well as the Consolidated Financial Statement Footnotes, below.

 

Fair value estimates: Fair value is defined as the price that would be received, without adjustment for transaction costs, to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value measurement reflects all of the assumptions that market participants would use in pricing the asset or liability, including assumptions about the risk inherent in a particular valuation technique, the effect of a restriction on the sale or use of an asset and the risk of non-performance. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on-and-off balance sheet financial instruments does not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments. For additional information see Note 18, Fair Values and Measurements of Financial Instruments.

 

OVERVIEW

 

The Corporation’s profitability, as with most financial institutions, is significantly dependent upon net interest income, which is the difference between interest received on interest-earning assets, such as loans and securities, and the interest paid on interest-bearing liabilities, principally deposits and borrowings. During a period of economic slowdown the lack of interest income from non-performing assets and an additional provision for loan losses can greatly reduce profitability. Results of operations are also affected by noninterest income, such as service charges on deposit accounts and fees on other services, income from lending activities and bank-owned life insurance as well as noninterest expenses such as salaries and employee benefits, occupancy, furniture and equipment, professional and other services, and other expenses, including income taxes. Economic conditions, competition and the monetary and fiscal policies of the Federal government significantly affect financial institutions.

 

The Corporation recorded net income of $2,938,000 for the year ended December 31, 2012, or $2.49 per diluted common share, compared to net income of $2,779,000, or $2.38 per diluted common share in 2011 and net income of $2,323,000 or $2.03 per diluted common share in 2010. Return on average assets and return on average common equity were 0.98% and 10.33%, respectively, for year-end 2012, compared to 0.94% and 10.73% for year-end 2011 and 0.77% and 9.76% for year-end 2010.

 

Key items affecting the Corporation’s results in 2012 compared to 2011 and 2010:

 

·In 2012, net interest income decreased $170,000 or 1.31% from 2011, compared to an increase of $773,000 or 6.36% in 2011 over 2010. The current low market interest rate environment has had a positive impact on net interest income in previous years because the Corporation’s balance sheet is liability sensitive which typically results in its average cost of funds decreasing faster than the average yield on interest-earning assets in a declining rate environment. In 2012, the Corporation did not recognize this benefit to the same degree, as deposit interest rates are at historic lows and have essentially reached a threshold in which they cannot reasonably be further reduced. However, total cost of funds did decrease 25 basis points from 2011, primarily due to a shift from high cost CDs into noninterest and interest-bearing demand deposit accounts.

 

4.
 

 

·A 19.31% decrease in loan loss provision in 2012, following net charge-offs of $536,000, compared to a 27.81% decrease in loan loss provision in 2011, following net charge-offs of $408,000.

 

·Significant loan and core deposit growth: Average net loans grew to $232,734,000, an increase of $10,730,000 or 4.83% from the previous year, while average core deposits grew to $241,413,000, an increase of $10,977,000 or 4.76% over the previous year.

 

·The Bank’s capital position remained strong and grew during 2012 with a Tier 1 leverage ratio of 9.4% and a Tier 1 capital ratio of 11.3%, compared to leverage and capital ratios of 8.9% and 10.8%, respectively, in 2011. In addition, at December 31, 2012, the Bank’s total risk-based capital ratio was 12.5%, compared to 12.0% at December 31, 2011. Given the strength of its capital position and on-going ability to generate significant capital through earnings, the Corporation was able to return 20.46% of its earnings to shareholders in the form of dividends totaling $601,000 during 2012.

 

·Continued focus on effectively managing cost structure, with an efficiency ratio (the ratio of noninterest expense to tax-equivalent net revenue, excluding net securities gains and losses) of 66.16% in 2012 compared to 66.75% in 2011 and 67.69% in 2010.

 

RESULTS OF OPERATIONS

 

Net interest income can be analyzed by segregating the volume and rate components of interest income and interest expense. The table below illustrates the volume and rate changes in net interest income on a tax-equivalent basis. For purposes of this table, changes in interest income and interest expense are allocated to volume and rate categories based upon the respective percentage changes in average balances and average rates. Changes in net interest income that could not be specifically identified as either a rate or volume change were allocated proportionately to changes in volume and changes in rate.

 

TABLE 2      VOLUME AND RATE ANALYSIS (a)

 

At December 31,  2012 Compared to 2011   2011 Compared to 2010 
(Dollars in thousands)  Total   Volume   Rate   Total   Volume   Rate 
Increase (decrease) in                        
Interest Income                              
Federal funds sold  $18   $13   $5   $(13)  $(12)  $(1)
Taxable investment securities   (205)   (266)   61    (105)   (7)   (98)
Tax-exempt investment securities   (148)   (135)   (13)   (140)   (139)   (1)
Loans   (499)   645    (1,144)   (489)   49    (538)
Total interest income   (834)   257    (1,091)   (747)   (109)   (638)
Interest Expense                              
Interest-bearing deposits   (14)   11    (25)   (242)   12    (254)
Savings deposits   (7)   3    (10)   (23)   6    (29)
Time deposits   (617)   (332)   (285)   (1,141)   (437)   (704)
Borrowed funds   19    0    19    (71)   (71)   0 
Total interest expense   (619)   (318)   (301)   (1,477)   (490)   (987)
                               
Net interest income  $(215)  $575   $(790)  $730   $381   $349 

(a)This table shows the components of the change in net interest income by volume and rate on a tax-equivalent basis utilizing a federal tax rate of 34 percent.

 

5.
 

 

 

The following table presents the Corporation’s (i) average assets, liabilities, and shareholders’ equity, (ii) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (iii) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (iv) interest rate spread and (v) net interest margin.

 

TABLE 3DISTRIBUTION OF ASSETS, LIABILITIES, AND SHAREHOLDERS’ EQUITY

For the years ended December 31, 2012, 2011 and 2010

 

   2012   2011   2010 
       Interest           Interest           Interest     
   Average   Income/   Yield/   Average   Income/   Yield/   Average   Income/   Yield/ 
(In thousands)  Balance   Expense   Rate   Balance   Expense   Rate   Balance   Expense   Rate 
Federal funds sold  $20,208   $46    0.23%  $13,960   $28    0.20%  $19,436   $41    0.21%
Investment securities:                                             
Taxable securities(1)   9,322    310    3.33    19,279    515    2.67    19,493    620    3.18 
Tax-exempt securities(1)   13,347    765    5.73    15,664    913    5.83    18,037    1,053    5.84 
Loans(2)(3)   232,734    13,399    5.76    222,004    13,898    6.26    220,455    14,387    6.53 
Earning assets   275,611    14,520    5.27%   270,907    15,354    5.67%   277,421    16,101    5.80%
Other assets   23,799              23,936              24,399           
Total assets  $299,410             $294,843             $301,820           
Interest-bearing demand deposits  $116,022    116    0.10%  $105,516    130    0.12%  $100,729    372    0.37%
Savings deposits   20,762    11    0.05    18,040    18    0.10    15,771    41    0.26 
Time deposits   90,937    1,347    1.48    110,580    1,964    1.78    129,040    3,105    2.41 
Borrowed funds   895    19    2.12    15    0    0.00    2,099    71    3.38 
Interest-bearing liabilities   228,616    1,493    0.65%   234,151    2,112    0.90%   247,639    3,589    1.45%
Noninterest-bearing demand deposits   40,676              32,799              28,008           
Other liabilities   1,670              2,003              2,372           
Shareholders’ equity   28,448              25,890              23,801           
Total liabilities and shareholders’ equity  $299,410             $294,843             $301,820           
Net interest income       $13,027             $13,242             $12,512      
Interest rate spread             4.62%             4.77%             4.35%
Net interest margin             4.73%             4.89%             4.51%

(1)Average yields on all securities have been computed based on amortized cost. Income on tax-exempt securities has been computed on a tax-equivalent basis using a 34% federal tax rate and a 20% disallowance of interest expense deductibility under TEFRA rules. The amount of such adjustment was $268,000, $313,000 and $356,000 for 2012, 2011 and 2010, respectively.
(2)Average balance is net of deferred loan fees of $347,000, $156,000, and $53,000 for 2012, 2011 and 2010, respectively, as well as $0, $1,000, and $60,000 of unearned income for the same years.
(3)Average loan balances include nonaccruing loans.

 

Net Interest Income

 

Net interest income, the major source of the Corporation’s earnings, is the income generated by interest-earning assets reduced by the total interest cost of the funds incurred to carry them. Net interest income is impacted by market interest rates and the mix and volume of earning assets and interest-bearing liabilities. For comparative purposes, income from tax-exempt securities is adjusted to a tax-equivalent basis using the federal statutory tax rate of 34% and a 20% disallowance of interest expense deductibility under the Tax Equity and Fiscal Responsibility Act (“TEFRA”) rules. By making these adjustments, tax-exempt income and their yields are presented on a comparable basis with income and yields from fully taxable earning assets. The net interest margin is calculated by expressing tax-equivalent net interest income as a percentage of average interest-earning assets, and represents the Corporation’s net yield on its earning assets. Net interest margin is an indicator of the Corporation’s effectiveness in generating income from its earning assets. The net interest margin is affected by the structure of the balance sheet as well as by competitive pressures, Federal Reserve regulatory and monetary policies and the economy.

 

6.
 

 

Net interest income, on a fully tax-equivalent basis, decreased $215,000 or 1.62% to $13,027,000 at December 31, 2012 from $13,242,000 in 2011, compared to an increase of $730,000 or 5.83% from $12,512,000 in 2010. Net interest spread and net interest margin were 4.62% and 4.73%, respectively, for the year ended December 31, 2012, compared to 4.77% and 4.89% in 2011 and 4.35% and 4.51% in 2010. The decrease in net interest margin in 2012 was primarily attributable to the decline in average rates earned on interest-earning assets, which exceeded the decline in the average rates paid on interest-bearing liabilities, as historically low interest rates inhibited the Corporation’s ability to further reduce the rates paid on deposits. This effect was somewhat mitigated by the growth in noninterest-bearing deposits, which provided no-cost funding compared to the cost of borrowed funds. The margin increase in 2011 compared to 2010 was driven primarily by the decline in average certificate of deposit balances of $18,460,000 as well as a reduction of 55 basis points in total funding costs. The extremely low interest rate environment has caused deposits to remain at elevated levels which have also strengthened the Corporation’s liquidity position. Many banks are experiencing similar situations resulting in the industry liquidity to be at significantly elevated levels.

 

Total interest income, on a fully tax-equivalent basis, decreased $834,000 or 5.43% to $14,520,000 for the year ended December 31, 2012, down from $15,354,000 at December 31, 2011. Average net loans, representing 84.44% and 81.95% of average interest-earning assets during 2012 and 2011, respectively, increased $10,730,000 or 4.83%, while the average tax-equivalent yield decreased 50 basis points. The decline in interest income was largely driven by the downward repricing of variable rate loans and the origination of new loans at lower market rates as well as maturities and repayments of loans with higher rates. Average investment securities, representing 8.22% and 12.90% of average interest-earning assets during 2012 and 2011, respectively, decreased $12,274,000 or 35.13%, while the average tax-equivalent yield earned increased 65 basis points. The decrease in investment securities as well as the increase in the tax-equivalent yield on investment securities is largely due to calls of low yielding U.S. Government agencies. Average federal funds sold, representing 7.33% and 5.15% of average interest-earning assets, increased $6,248,000 or 44.76%, while the average yield earned increased 3 basis points.

 

Interest expense decreased $619,000 or 29.31% to $1,493,000 for the year ended December 31, 2012, down from $2,112,000 at December 31, 2011. The decrease in interest expense was primarily the result of a favorable shift in the deposit mix as well as the repricing of time deposits to lower rates. Average interest-bearing demand deposits, representing 50.75% and 45.06% of average interest-bearing liabilities during 2012 and 2011, respectively, increased $10,506,000 or 9.96%, while the average rate paid decreased 2 basis points. Average time deposits, representing 39.78% and 47.23% of average interest-bearing liabilities during 2012 and 2011, respectively, decreased $19,643,000 or 17.76%, while the average rate paid decreased 30 basis points.

 

The increase in net interest income during 2011 was primarily driven by the rate payable on interest-bearing liabilities declining more rapidly than the yield on interest-earning assets and is reflective of the magnitude and timing of the downward repricing of the Corporation’s liabilities in a low interest rate environment. Total interest income, on a fully tax-equivalent basis, decreased $747,000 or 4.64% to $15,354,000 for the year ended December 31, 2011, down from $16,101,000 at December 31, 2010. Average net loans, representing 81.95% and 79.47% of average interest-earning assets during 2011 and 2010, respectively, increased $1,549,000 or 0.70%, while the average tax-equivalent yield decreased 27 basis points. Average investment securities, representing 12.90% and 13.53% of average interest-earning assets during 2011 and 2010, respectively, decreased $2,587,000 or 6.89%, while the average tax-equivalent yield decreased 37 basis points.

 

Interest expense decreased $1,477,000 or 41.15% to $2,112,000 for the year ended December 31, 2011, down from $3,589,000 at December 31, 2010. A decrease of $987,000 in interest expense was primarily due to lower rates paid on certificates of deposits and interest-bearing demand deposits while a decrease of $490,000 in interest expense was largely due to the decline in certificates of deposit average balances. Average interest-bearing demand deposits, representing 45.06% and 40.68% of average interest-bearing liabilities during 2011 and 2010, respectively, increased $4,787,000 or 4.75%, while the average rate paid decreased 25 basis points. Average time deposits, representing 47.23% and 52.11% of average interest-bearing liabilities during 2011 and 2010, respectively, decreased $18,460,000 or 14.31%, while the average rate paid decreased 63 basis points.

 

7.
 

  

Provision for Loan Losses 

 

The Corporation establishes an allowance for loan losses through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Through the provision for loan losses, an allowance is maintained that reflects management’s best estimate of probable incurred loan losses related to specifically identified loans as well as the inherent risk of loss related to the remaining portfolio. In evaluating the allowance for loan losses, management considers various factors that include loan growth, the amount and composition of the loan portfolio, (including non-performing and potential problem loans), diversification, or conversely, concentrations by industry, geography or collateral within the portfolio, historical loan loss experience, current delinquency levels, the estimated value of the underlying collateral, prevailing economic conditions and other relevant factors. Loan charge-offs are recorded to this allowance when loans are deemed uncollectible, in whole or in part. Impacting the provision for loan losses in any accounting period are several factors including the amount of loan growth during the period, broken down by loan type, the level of charge-offs during the period, the changes in the amount of impaired loans, changes in risk ratings assigned to loans, specific loan impairments, credit quality, and ultimately, the results of management’s assessment of the inherent risks of the loan portfolio.

 

Provisions for loan losses totaled $798,000, $989,000 and $1,370,000 in 2012, 2011 and 2010, respectively. Provisions for loan losses in all periods were largely driven by loan growth, an increase in nonaccrual loans as well as impairment charges on troubled debt restructured loans. Management considers the allowance for loan losses at December 31, 2012 adequate to cover loan losses based on its assessment of various factors affecting the loan portfolio, including the level of problem loans, overall delinquencies, business conditions, estimated collateral values and loss experience. A further decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses which could adversely affect the Corporation’s financial condition and results of operations. For further information about factors affecting the allowance for loan losses, see “Allowance for Loan Losses,” under Financial Condition.

 

Noninterest Income

 

Noninterest income consists primarily of fees and commissions earned on services that are provided to the Corporation’s banking customers, and to a lesser extent, gains on sales of OREO and other repossessed assets and other miscellaneous income. Noninterest income for 2012 totaled $2,297,000, an increase of $86,000 or 3.89% from 2011. Following are some of the more significant factors affecting noninterest income in 2012:

 

·A decrease of $60,000 or 3.88% in service and overdraft charges, largely driven by a decline in the volume of insufficient funds (“NSF”) activity and partially offset by an increase in ATM income.

 

·An increase of $143,000 or 63.12% in third-party origination activities, primarily due to an increase in mortgage production as a result of the escalated demand in home purchases and refinancing due in part to the low interest rate environment.

 

Noninterest income for 2011 totaled $2,211,000, a decrease of $236,000 or 9.64% from $2,447,000 in 2010. Following are some of the more significant factors affecting noninterest income in 2011:

 

·A decrease of $133,000 or 7.92% in service and overdraft charges, primarily due to a decline in the volume of insufficient funds (“NSF”) activity. Management believes part of this decrease is due to customers more diligently monitoring their personal accounts and to the increased use of debit cards, which do not typically generate NSF fees. Debit card transactions for which customers do not have available funds are declined at the point of sale instead of posting to the account and generating a NSF charge. Further impacting service fees was the revision to Regulation E during the third quarter of 2010, prohibiting financial institutions from charging a customer fees for paying overdrafts on ATMs and one-time debit card transactions unless that customer consented, or opted in to the overdraft service for those types of transactions.

 

·A decrease of $141,000 or 38.37% in third-party origination fees, primarily due to a reduced level of residential mortgage production when compared to the prior year.

 

·An increase of $55,000 or 96.46% in rental income. During the third quarter of 2010, a portion of the operations center was rented out as office space to a local business.

 

8.
 

  

Noninterest Expense

 

Noninterest expense consists primarily of personnel, occupancy, equipment and other operating expenses. Noninterest expense for 2012 totaled $10,143,000, a decrease of $200,000 or 1.93% from 2011. Following are some of the more significant factors affecting noninterest expense in 2012:

 

·A decrease of $76,000 or 1.33% in salaries and employee benefits, largely due to a decrease of $110,000 in medical insurance costs, primarily reflecting a change in employee health care plans, a decrease of $27,000 in severance expense, offset with an increase of $69,000 in salary and bonus expense, primarily due to annual merit increases. Along with its more traditional priority health care plan, the Corporation introduced an HDHP/HSA plan (high deductible health plan with health savings account) to its employees in 2012. Compared to traditional insurance plans, HDHPs generally offer lower premiums to employees but require greater out-of-pocket spending.

 

·A decrease of $78,000 or 15.23% in professional fees, primarily reflecting a decrease in legal fees relating to loan workouts. All legal settlements in 2011 were resolved prior to 2012 thus reducing legal expenses in 2012.

 

·An increase of $54,000 or 14.92% in software maintenance, largely driven by an increase in third-party and web-based software programs as well as core processing upgrades, all of which increase software maintenance contracts.

 

·A decrease of $68,000 or 81.93% in net losses on repossessed asset sales, primarily due to a decrease in the number of OREO properties and other repossessed assets sold in 2012 compared to 2011.

 

Noninterest expense for 2011 totaled $10,343,000, an increase of $175,000 or 1.72% from $10,168,000 in 2010. Following are some of the more significant factors affecting noninterest expense in 2011:

 

·An increase of $408,000 or 7.71% in salaries and employee benefits, primarily due to higher medical insurance costs and increased employee compensation expense relating to stock option awards granted.

 

·An increase of $101,000 or 24.57% in professional fees, largely due to legal fees pertaining to a settlement and release agreement from executive compensation plan for a past executive officer as well as legal expenses relating to the workout of problem loans.

 

·A decrease of $188,000 or 69.37% in net losses on repossessed asset sales, primarily due to a decrease in the number of OREO properties and other repossessed assets sold in 2011 compared to 2010.

 

·A decrease of $167,000 or 36.46% in FDIC deposit insurance, largely due to a decline in average deposit balances as well as changes made by the FDIC in the method of calculating assessment rates under the Dodd-Frank Act.

 

·A decrease of $114,000 or 33.33% in OREO and miscellaneous loan expense, primarily due to higher credit related costs in the prior year. Specifically, OREO expense decreased $158,000 due to the write down and operating costs associated with an increased number of OREO properties in 2010.

 

Income Tax Expense

 

The Corporation generated income before taxes of $4,115,000, resulting in a tax provision of $1,177,000 in 2012, compared to income before taxes of $3,808,000 with a tax provision of $1,029,000 in 2011. In 2010, the Corporation generated income before taxes of $3,065,000, resulting in a tax provision of $742,000. The increase in income tax expense was largely driven by an increase in pre-tax income offset by earning adjustments relating to tax-free revenue. The Corporation’s effective tax rate for 2012 was 28.60%, compared to 27.02% and 24.21% for 2011 and 2010, respectively. The difference between the Corporation’s effective tax rate and the statutory rate is primarily attributable to the Corporation’s tax-exempt income. Tax-exempt income includes income earned on certain municipal investments that qualify for state and/or federal income tax exemption and the Corporation’s earnings on Bank-owned life insurance policies, which are exempt from federal taxation. Further analysis of income taxes is presented in Note 12 of the “Notes to Consolidated Financial Statements.”

 

9.
 

  

FINANCIAL CONDITION

 

The Corporation’s assets at December 31, 2012 totaled $301,564,000, consisting principally of $243,303,000 in net loans, $17,032,000 in investment securities, $22,904,000 in cash equivalents and federal funds sold, $7,175,000 in premises and equipment (net of accumulated depreciation of $7,615,000) and $11,149,000 in accrued interest receivable and other assets. Liabilities at December 31, 2012 totaled $272,176,000, consisting principally of $245,550,000 in core deposits, $22,889,000 in large certificates of deposit, $1,922,000 in borrowed funds and $1,815,000 in accrued interest payable and other liabilities while shareholders’ equity totaled $29,388,000.

 

The Corporation’s assets at December 31, 2011 totaled $287,779,000, consisting principally of $231,094,000 in net loans, $27,111,000 in investment securities, $10,723,000 in cash equivalents and federal funds sold, $7,406,000 in premises and equipment (net of accumulated depreciation of $7,181,000) and $11,445,000 in accrued interest receivable and other assets. Liabilities at December 31, 2011 totaled $260,780,000, consisting principally of $228,881,000 in core deposits, $30,247,000 in large certificates of deposit and $1,652,000 in accrued interest payable and other liabilities while shareholders’ equity totaled $26,999,000.

 

TABLE 4LOAN PORTFOLIO DISTRIBUTION

 

At December 31  2012   2011   2010   2009   2008 
(In thousands)  Amount   Amount   Amount   Amount   Amount 
Commercial  $193,546   $177,402   $172,424   $168,611   $141,968 
Residential real estate   16,129    15,456    13,775    11,825    8,921 
Consumer   18,271    22,175    23,065    23,721    21,596 
Home equity   19,398    19,818    21,231    22,685    22,244 
Indirect finance   0    22    163    1,166    3,921 
Total loans  $247,344   $234,873   $230,658   $228,008   $198,650 

  

Loans

 

Loans are reported at their outstanding principal balances less unearned income, the allowance for loan losses and any deferred fees or costs on originated loans. Interest income on loans is accrued based on the principal balance outstanding. Loan origination fees, net of certain loan origination costs, are deferred and recognized as an adjustment to the related loan yield. Loans make up the largest component of total assets. At December 31, 2012 net loans of $243,303,000, representing 80.68% of total assets, increased $12,209,000 or 5.28% from $231,094,000 at December 31, 2011, predominantly in commercial and agricultural loans, up $11,698,000 and $4,446,000, respectively. Contributing factors to the increase in commercial loan demand is the stabilization in the regional economy in which the Corporation operates as well as the efforts of the Corporation’s experienced loan officers in developing new loan relationships combined with the support of existing customers. Consumer real estate loans increased $673,000 or 4.35% while installment and home equity loans decreased $3,926,000 and $420,000, respectively. Table 4 above, provides a summary of the loan distribution by product type.

 

The following is a schedule of commercial loan maturities (in thousands) based on contract terms as of December 31, 2012.

 

One Year   One Through   Over 
or Less   Five Years   Five Years 
$67,238   $39,814   $86,494 

 

Of the commercial loans included in the preceding schedule with maturities exceeding one year, $24,344,000 have fixed rates to maturity, while $101,964,000 have adjustable rates.

 

10.
 

 

The Corporation’s loan portfolio represents its largest and highest yielding assets. The fundamental lending business of the Corporation is based on understanding, measuring and controlling the credit risk inherent in the loan portfolio. The Corporation’s loan portfolio is subject to varying degrees of credit risk. Credit risk entails both general risks, which are inherent in the process of lending, and risk specific to individual borrowers. The Corporation’s credit risk is mitigated through portfolio diversification, which limits exposure to any single customer, industry or collateral type. Typically, each consumer and residential lending product has a generally predictable level of credit losses based on historical loss experience. Home mortgage and home equity loans and lines generally have the lowest credit loss experience, while loans secured by personal property, such as auto loans, are generally expected to experience more elevated credit losses. Credit risk in commercial lending can vary significantly, as losses as a percentage of outstanding loans can shift widely during economic cycles and are particularly sensitive to changing economic conditions. Generally, improving economic conditions result in improved operating results on the part of commercial customers, enhancing their ability to meet their particular debt service requirements. Improvements, if any, in operating cash flows can be offset by the impact of rising interest rates that may occur during improved economic times. Declining economic conditions have an adverse affect on the operating results of commercial customers, reducing their ability to meet debt service obligations.

 

To control and manage credit risk, management has a credit process in place to ensure credit standards are maintained along with strong oversight and review procedures. The primary purpose of loan underwriting is the evaluation of specific lending risks and involves the analysis of the borrower’s ability to service the debt as well as the assessment of the value of the underlying collateral. Oversight and review procedures include the monitoring of portfolio credit quality, early identification of potential problem credits and the aggressive management of problem credits. Executive management has implemented the following measures to proactively manage credit risk in the loan portfolios:

 

1)Reviewed all underwriting guidelines for various loan portfolios and have strengthened underwriting guidelines where needed.

 

2)Evaluated outside loan review parameters, engaging the services of a well-established firm to continue with such loan review, addressing not only specific loans but underwriting analysis, documentation, credit evaluation and risk identification.

 

3)Increased the frequency of internal reviews of past due and delinquent loans to assess probable credit risks early in the delinquency process to minimize losses.

 

4)Aggressively seeks ownership and control, when appropriate, of real estate properties, which would otherwise go through time-consuming and costly foreclosure proceedings to effectively control the disposition of such collateral.

 

5)Aggressively obtaining updated financial information on commercial credits and performing analytical reviews to determine debt source capacities in business performance trends.

 

6)Engaged a well-established auditing firm to analyze the Corporation’s loan loss reserve methodology and documentation.

 

Allowance for Loan Losses

 

As part of the oversight and review process, the Corporation maintains an allowance for loan losses to absorb estimated and probable losses inherent in the loan portfolio at the balance sheet date. The allowance is based on two basic principles of accounting: (1) the requirement that a loss be accrued when it is probable that the loss has occurred at the date of the financial statements and the amount of the loss can be reasonably estimated and (2) the requirement that losses, if any, be accrued when it is probable that the Corporation will not collect all principal and interest payments according to the loan’s contractual terms.

 

The Corporation’s allowance for loan losses has two basic components: a general reserve reflecting historical losses by loan category and loan classification, as adjusted by several factors whose effects are not reflected in historical loss ratios, and specific allowances for individually identified loans. General reserves are based upon historical loss experience by portfolio segment measured and supplemented to address various risk characteristics of the Corporation’s loan portfolio including:

 

·Trends in delinquencies and other non-performing loans
·Changes in the risk profile related to large loans in the portfolio
·Changes in the categories of loans comprising the loan portfolio

 

11.
 

 

·Concentrations of loans to specific industry segments
·Changes in economic conditions on both a local and a national level
·Changes in the Corporation’s credit administration and loan portfolio management processes
·Quality of the Corporation’s credit risk identification process

 

The portion of the reserve representing specific allowances is derived by accumulating the specific allowances established on individually impaired loans that have significant conditions or circumstances that indicate that a loss may be probable. Specific reserves are calculated on individually impaired loans and are established based on the Corporation’s calculation of the probable losses inherent in an individual loan. For loans on which the Corporation has not elected to use the collateral value as a basis to establish the measure of impairment, the Corporation measures impairment based on the present value of expected future cash flows discounted at the loan’s effective interest rate. In determining the cash flows to be included in the discount calculation the Corporation considers a number of factors, that combined is used to estimate the probability and severity of potential losses.

 

·The borrower’s overall financial condition
·Resources and payment record
·Support available from financial guarantors

 

The general reserve comprised 86% of the total allowance at December 31, 2012, compared to 88% at December 31, 2011 while the specific allowance accounted for 14% of the total allowance at December 31, 2012, compared to 12% at December 31, 2011. The severity of estimated losses on impaired loans can differ substantially from actual losses. The general reserve is calculated in two parts based on an internal risk classification of loans within each portfolio segment. General reserves on loans considered to be “classified” under regulatory guidance are calculated separately from loans considered to be “pass” rated under the same guidance. This segregation allows the Corporation to monitor the reserves related to higher risk loans separate from the remainder of the portfolio in order to better manage risk and ensure the sufficiency of reserves.

 

The allowance for loan losses is increased by charges to income through the provision for loan losses and decreased by charge-offs, net of recoveries. The allowance is established and maintained at a level management deems adequate to cover losses inherent in the portfolio as of the balance sheet date and is based on management’s evaluation of the risks in the loan portfolio and changes in the nature and volume of loan activity. There are risks inherent in all loans, so an allowance is maintained for loans to absorb probable losses on existing loans that may become uncollectible. The allowance is established and maintained as losses are estimated to have occurred through a provision for loan losses charged to earnings, which increases the balance of the allowance. Loan losses for all segments are charged against the allowance when management believes the uncollectibility of a loan is confirmed, which decreases the balance of the allowance. Subsequent recoveries of principal, if any, are credited back to the allowance.

 

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

 

The allowance for loan losses totaled $4,041,000 at December 31, 2012, an increase of $262,000 from $3,779,000 at December 31, 2011. The ratio of net charge-offs to average outstanding loans was 0.23% for December 31, 2012, compared to 0.18% for December 31, 2011. The ratio of the allowance for loan losses to total loans was 1.63% at December 31, 2012, compared to 1.61% at year-end 2011. The Corporation provided $798,000 to the allowance for loan losses for the year ended December 31, 2012 to maintain the balance at an adequate level following net charge-offs of $536,000.

 

Before loans are charged off, they typically go through a phase of non-performing status. Various stages exist when dealing with such non-performance. The first stage is simple delinquency, where customers consistently start paying late, 30, 60, 90 days at a time. These accounts may then be put on a list of loans to “watch” as they continue to under-perform according to original terms. Loans are placed on nonaccrual status when management believes the collection of the principal and interest is doubtful. A delinquent loan is generally placed on nonaccrual status when principal and/or interest is past due 90 days or more or if the financial strength of the borrower has declined, collateral value has declined or other facts would make the repayment of the loan suspect, unless the loan is well-secured or in the process of collection. When a loan is placed on nonaccrual, all interest which has been accrued is charged back against current earnings as a reduction in interest income, which adversely affects the yield on loans in the period of reversal. No additional interest is accrued on the loan balance until collection of both principal and interest becomes reasonably certain. Loans placed on nonaccrual status may be returned to accrual status after payments are received for a minimum of six consecutive months in accordance with the loan documents, and any doubt as to the loan’s full collectability has been removed or the troubled loan is restructured and evidenced by a credit evaluation of the borrower’s financial condition and the prospects for full payment.

 

12.
 

 

TABLE 5SUMMARY OF ALLOWANCE FOR LOAN LOSSES

 

The following schedule summarizes the charge-offs and recoveries, by loan segment, charged to the allowance for loan losses (in thousands) at December 31,

 

   2012   2011   2010   2009   2008 
Balance at beginning of period  $3,779   $3,198   $2,744   $2,483   $2,411 
Loans charged-off:                         
Commercial   (387)   (241)   (610)   (579)   (690)
Real Estate   (64)   0    (25)   (96)   (35)
Consumer   (151)   (269)   (404)   (640)   (554)
Total loans charged-off   (602)   (510)   (1,039)   (1,315)   (1,279)
Recoveries of loans previously charged-off:                         
Commercial   12    15    34    4    94 
Real Estate   0    0    0    0    0 
Consumer   54    87    89    88    130 
Total loan recoveries   66    102    123    92    224 
Provision charged to operating expense   798    989    1,370    1,484    1,127 
Balance at end of period  $4,041   $3,779   $3,198   $2,744   $2,483 
Allowance for loan losses as a percentage of:                         
Period-end loans   1.63%   1.61%   1.39%   1.20%   1.25%

 

The Corporation’s methodology for evaluating whether a loan is impaired begins with risk-rating credits on an individual basis. Loans with a pass rating represent those not classified on the Corporation’s rating scale for problem credits, as minimal credit risk has been identified. Loans classified as special mention have potential weaknesses that deserve management’s close attention. If uncorrected, the potential weaknesses may result in deterioration of the repayment prospects. Loans classified as substandard have a well-defined weakness that jeopardizes the liquidation of the debt. Loans classified doubtful have all the weaknesses inherent in loans classified substandard with the added characteristic that collection or liquidation in full, on the basis of current conditions and facts, is highly improbable. Loans rated as doubtful in whole, or in part, are placed in nonaccrual status.

 

At December 31, 2012, classified loans totaled $15,697,000, an increase of $1,941,000 or 14.11% from classified loans of $13,756,000 at December 31, 2011, primarily reflecting the downgrade of two commercial real estate credits. Management regularly reviews the updated financial position of all such loans in its portfolio and any deterioration in such position can result in a credit being downgraded.

 

Loans are placed on nonaccrual status when management believes the collection of principal and interest is doubtful, or when loans are past due as to principal and interest 90 days or more, except in certain circumstances when interest accruals are continued on loans deemed by management to be fully collateralized and in the process of being collected. At December 31, 2012 and 2011, there were no 90 day delinquent loans that were on accrual status. In such cases, the loans are individually evaluated in order to determine whether to continue income recognition after 90 days beyond the due dates. When loans are charged off, any accrued interest recorded in the current fiscal year is charged against interest income. The remaining balance is treated as a loan charged-off.

 

13.
 

 

Management considers a loan to be impaired when, based on current information and events, it is determined that the Corporation will not be able to collect all amounts due according to the contractual terms of the loan agreement, including scheduled interest payments. When management identifies a loan as impaired, the impairment is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or the observable market price of the loan, except when the sole (remaining) source of repayment for the loan is the liquidation of the collateral. In these cases, management uses the current fair value of the collateral, less selling costs when foreclosure is probable, instead of discounted cash flows. If management determines the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs and deferred loan fees or costs), impairment is recognized through an allowance estimate or a charge-off to the allowance. When management determines an impaired loan is a confirmed loss, the estimated impairment is directly charged-off to the loan rather than creating a specific reserve for inclusion in the allowance for loan losses. However, not all impaired loans are in nonaccrual status because they may be current with regards to the payment terms. Their determination as an impaired loan is based on some inherent weakness in the credit that may, if certain circumstances occur or arise, result in an inability to comply with the loan agreement’s contractual terms. Impaired loans exclude large groups of smaller-homogeneous loans that are collectively evaluated for impairment such as consumer real estate and installment loans.

 

TABLE 6PERCENTAGE OF EACH LOAN SEGMENT TO TOTAL LOANS

 

Summary of the allowance for loan losses (in thousands) allocated by loan segment at December 31,

 

   2012   2011   2010   2009   2008 
   Allowance   Total   Allowance   Total   Allowance   Total   Allowance   Total   Allowance   Total 
Loan Type  Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans   Amount   Loans 
Commercial  $3,175    78%  $2,849    75%  $2,307    75%  $1,927    74%  $1,772    71%
Real Estate   284    7    278    7    182    6    158    5    67    5 
Consumer   582    15    652    18    709    19    659    21    644    24 
Total LLR  $4,041    100%  $3,779    100%  $3,198    100%  $2,744    100%  $2,483    100%

 

The allowance for loan losses, specifically related to impaired loans at December 31, 2012 and December 31, 2011 was $557,000 and $451,000, respectively, related to loans with principal balances of $5,910,000 and $6,146,000. The increase in impaired loans with specified reserves was primarily due to the addition of two commercial real estate credits. Impaired loans with no related allowance recorded at December 31, 2012 was $5,577,000, compared to $3,817,000 at December 31, 2011, representing the addition of a commercial real estate credit and a commercial operating credit. The Corporation’s financial statements are prepared on the accrual basis of accounting, including the recognition of interest income on the loan portfolio, unless a loan is placed on nonaccrual status. Amounts received on nonaccrual loans generally are applied first to principal and then to interest only after all principal has been collected. For the year ended December 31, 2012, the Corporation received interest payments related to these loans of $114,000, compared to interest payments of $31,000 for the year ended December 31, 2011.

 

Management has taken what it believes to be a proactive position on identifying problems with credits and their ultimate collectability using both internal and external portfolio loan reviews, and believes any potential losses which may be incurred on these credits in the future are incorporated into its analysis of the adequacy of the Corporation’s allowance for loan losses.

 

In certain circumstances, the Corporation may modify the terms of a loan to maximize the collection of amounts due when a borrower is experiencing financial difficulties or is expected to experience difficulties in the near term. In most cases the modification is either a concessionary reduction in interest rate, extension of the maturity date or reduction in the principal balance that would otherwise not be considered. Concessionary modifications are classified as troubled debt restructurings (“TDR”) unless the modification results in only an insignificant delay in the payments to be received. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a Troubled debt restructuring is considered to be collateral dependent, the loan is reported, net, at the fair value of the collateral. All such restructured loans are considered impaired loans and may either be in accruing or nonaccruing status. If the borrower has demonstrated performance under the previous terms and the Corporation’s underwriting process shows the borrower has the capacity to continue to perform under the restructured terms, the loan will continue to accrue interest. The Corporation continues to work with customers to modify loans for borrowers who are experiencing financial difficulties.

 

14.
 

 

Troubled debt restructured loans totaled $7,906,000 at December 31, 2012, representing seven credit relationships in which economic concessions were granted to borrowers to better align the terms of their loans with their current ability to pay. Of the $7,906,000 in TDR loans at December 31, 2012, $2,601,000 were on accrual status. Troubled debt restructured loans totaled $5,942,000 at December 31, 2011 of which $5,173,000 were on accrual status. During the twelve months ended December 31, 2012, the Corporation restructured three commercial real estate loans totaling $3,522,000, requiring specific reserves of $191,000. During the twelve months ended December 31, 2011, the Corporation restructured one commercial operating loan and four commercial real estate loans for a total of $4,132,000, requiring specific reserves of $324,000. The specific reserve required for these TDRs, whether collateral dependent or not, was $474,957 on December 31, 2012. This represents 11.7% of the total loan loss reserve. As the $474,957 represents 85% of the total specified reserve, management determines this effect on reserve to be predictable and manageable.

 

There are no commitments to lend additional amounts to borrowers with loans that are classified as troubled debt restructurings as of December 31, 2012.

 

TABLE 7SUMMARY OF IMPAIRED LOANS

 

The following schedule summarizes impaired and non-performing loans (in thousands) at December 31,

 

   2012   2011   2010   2009   2008 
Impaired loans  $12,056   $7,400   $1,864   $1,728   $2,965 
Loans accounted for on a nonaccrual basis  $7,111   $1,852   $1,934   $2,641   $5,355 
Accruing loans, which are contractually past due 90 days or more as to interest or principal payments   0    0    0    0    0 
Total non-performing loans  $7,111   $1,852   $1,934   $2,641   $5,355 
Non-performing loans to allowance for loan losses   1.76    0.49    0.60    0.96    2.16 

 

Non-performing loans, comprised of loans on nonaccrual status along with loans that are contractually past due 90 days or more but have not been classified as nonaccrual, totaled $7,111,000 at December 31, 2012, an increase of $5,259,000, compared to non-performing loans of $1,852,000 at December 31, 2011. The increase in non-performing loans was primarily due to three large commercial real estate credits. Management evaluated non-performing loans for impairment at December 31, 2012. Based on this impairment analysis, a specified reserve of $557,000 was recorded. Non-performing loans to total loans was 2.87% at December 31, 2012 and 0.79% at December 31, 2011. Non-performing loans represented 2.36% of total assets at December 31, 2012 compared to 0.64% at December 31, 2011.

 

At December 31, 2012, no other interest-bearing assets were required to be disclosed in the table above, if such assets were loans.

 

Investment Securities

 

The Corporation’s securities portfolio has been structured in such a way as to maintain a prudent level of liquidity while also providing an acceptable rate of return. Investment securities include securities that may be sold to effectively manage interest rate risk exposure, prepayment risk and other factors such as liquidity requirements. These available for sale securities are reported at fair value with unrealized aggregate appreciation/depreciation excluded from income and credited/charged to accumulated other income/(loss) within shareholders’ equity on a net of tax basis. While the Corporation’s focus is to generate interest revenue primarily through loan growth, the investment portfolio serves an important role in the overall context of balance sheet management in terms of balancing capital utilization and liquidity. The decision to purchase or sell securities is based upon the current assessment of economic and financial conditions, including the interest rate environment, liquidity and credit considerations along with the Corporation’s level of pledgeable collateral for potential borrowings. The portfolio’s scheduled maturities represent a significant source of liquidity.

 

15.
 

 

TABLE 8CARRYING VALUE OF INVESTMENT SECURITIES

For the years ended December 31,

(Dollars in thousands)

   2012   2011   2010 
U.S. Government Agency securities  $0   $4,066   $9,065 
Obligations of states and political subdivisions   10,272    14,372    16,069 
Mortgage-backed securities   4,501    6,414    8,709 
Other investment securities   2,259    2,259    2,260 
Total investment securities  $17,032   $27,111   $36,103 

 

Investment securities, consisting of available-for-sale and other equity securities decreased $10,079,000 or 37.18% to $17,032,000 at December 31, 2012 from $27,111,000 at December 31, 2011. Available-for-sale securities are carried at fair value, with unrealized gains or losses based on the difference between amortized cost and fair value, reported net of deferred tax, as accumulated other comprehensive income (loss), a separate component of shareholders’ equity. Declines in the fair value of individual available-for-sale securities below their cost that are other-than-temporary result in write downs of the individual securities to their fair values. At December 31, 2012, the investment portfolio consisted primarily of state and municipal securities and mortgage-backed securities. The decline in investment securities was predominantly due to the call of $8,010,000 in U.S. Government-sponsored agencies and municipal securities along with principal pay downs and prepayments of $1,791,000 in mortgage-backed securities. At December 31, 2012, there were no concentrations of securities of any one issuer, whose carrying value exceeded 10% of shareholders’ equity.

 

TABLE 9MATURITY SCHEDULE OF INVESTMENT SECURITIES

 

Maturity schedule (by contractual maturity or if applicable, earliest call date) of the Corporation’s investment securities, by carrying value, and the related weighted average yield at December 31, 2012:

 

       Maturing   Maturing         
   Maturing in   After One   After Five   Maturing 
   One Year   Year Through   Years Through   After 
   or Less   Five Years   Ten Years   Ten Years 
(Dollars in thousands)  Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield 
Obligations of state and political subdivisions  $2,566    6.52%  $6,892    5.85%  $680    6.07%  $134    6.89%
Mortgage-backed securities   58    3.45%   631    4.11%   419    4.52%   3,393    3.73%
Total  $2,624    6.45%  $7,523    5.71%  $1,099    5.48%  $3,527    3.85%

 

The weighted average interest rates are based on coupon rates for investment and mortgage-backed securities purchased at par value and on effective interest rates considering amortization or accretion if the investment and mortgage-backed securities were purchased at a premium or discount. The weighted average yield on tax-exempt obligations has been determined on a tax equivalent basis. Other investment securities consisting of Federal Home Loan Bank stock that bears no stated maturity or yield is not included in this analysis. Maturities are reported based on stated maturities and do not reflect principal prepayment assumptions. Yields are based on amortized cost balances.

 

Cash and Cash Equivalents

 

Cash equivalents and federal funds sold include working cash funds, due from banks, interest-bearing deposits in other banks, items in process of collection and federal funds sold. Cash equivalents and federal funds sold totaled $22,904,000 at December 31, 2012 compared to $10,723,000 at December 31, 2011. Management believes the current level of cash and cash equivalents is sufficient to meet the Corporation’s liquidity and performance needs. Total cash and cash equivalents fluctuate on a daily basis due to transactions in process and corresponding liquidity sources and uses. Management believes the Corporation’s liquidity needs in the near term will be satisfied by the current level of cash and cash equivalents, readily available access to traditional and non-traditional funding sources and the portions of the investment and loan portfolios that will mature within one year, allowing the Corporation to meet cash obligations as they come due.

 

16.
 

  

Premises and Equipment

 

Premises and equipment decreased $230,000 or 3.11% to $7,175,000 at December 31, 2012 from $7,406,000 at December 31, 2011. The decrease in premises and equipment during 2012 represents capital purchases of $428,000, offset with depreciation expense of $658,000. Capital purchases in 2012 consisted principally of $175,000 in renovation costs to remodel two banking centers, $84,000 in furniture for the newly remodeled banking centers, and $117,000 in computers and computer equipment. Capital purchases in 2011 largely consisted of $192,000 in renovation costs to remodel three banking centers and $181,000 for the purchase of computers and computer equipment.

 

Other Assets

 

Other assets totaled $9,969,000 at December 31, 2012, a decrease of $201,000 or 1.98% from $10,170,000 at December 31, 2011, primarily reflecting decreases of $443,000 in accounts receivable and a decrease of $211,000 in prepaid FDIC assessments, offset by an increase of $267,000 in the cash surrender value of Bank-owned life insurance and an increase of $139,000 in OREO and other repossessed assets. The decrease in accounts receivable from year-end pertains to health insurance costs due from the insurance company relating to participants exceeding their stop/gap limits in 2011.

 

OREO is comprised of properties acquired by the Corporation in partial or total satisfaction of problem loans. OREO and other repossessed assets are initially recorded at the lower of cost or fair value on the date of acquisition less estimated costs of disposal (net realizable value). Losses existing at the time of acquisition of such properties are charged against the allowance for loan losses. Subsequent write downs that may be required are expensed as incurred. Gains and losses realized from the sale of OREO and other repossessed assets, as well as valuation adjustments, are included in noninterest expense as well as expenses of operation. The Corporation held one property, with a carrying value of $128,000 in OREO and $58,000 in other repossessed assets at December 31, 2012. At December 31, 2011 there were no OREO properties and $47,000 in other repossessed assets.

 

Deposits and Borrowings

 

The Corporation’s primary source of funds is customer deposits. The Bank offers a variety of deposit products in an attempt to remain competitive and respond to changes in consumer demand. The Corporation relies primarily on its high quality customer service, sales programs, customer referrals and advertising to attract and retain these deposits. Deposits provide the primary source of funding for the Corporation’s lending and investment activities and the interest paid for deposits must be carefully managed to control the level of interest expense.

 

Deposits at December 31, 2012, totaled $268,439,000, an increase of $9,311,000 or 3.59% from $259,128,000 at December 31, 2011. The growth in deposits was largely driven by increases in interest-bearing and noninterest-bearing demand account balances of $10,485,000 and $7,427,000, respectively, and to a lesser extent, increases of $3,421,000 and $3,289,000 in savings and money market accounts, respectively. The increase in demand deposits appear to reflect customer preference for the liquidity these types of deposits provide over the rates currently offered on certificates of deposits as these balances decreased $15,311,000 or 15.54% to $83,191,000 at December 31, 2012 from $98,502,000 at December 31, 2011.

 

TABLE 10   LARGE TIME DEPOSITS

 

Maturity of time deposits in amounts of $100,000 or more at December 31,

 

(Dollars in thousands)  2012   2011 
Three months or less  $2,360   $4,337 
Over three months through six months   3,886    4,927 
Over six months through twelve months   5,362    7,766 
Over twelve months   11,281    13,217 
Total  $22,889   $30,247 

 

17.
 

  

TABLE 11AVERAGE DEPOSITS

 

Average deposit balances and average rates paid are summarized as follows for the years ended December 31,

 

   2012   2011   2010 
           % of           % of           % of 
(In thousands)  Balance   Rate   Total   Balance   Rate   Total   Balance   Rate   Total 
Interest-bearing demand  $116,022    0.10%   43%  $105,516    0.12%   40%  $100,729    0.37%   37%
Savings deposits   20,762    0.05    8    18,040    0.10    7    15,771    0.26    6 
Time deposits   90,937    1.48    34    110,580    1.78    41    129,040    2.41    47 
Noninterest-bearing demand   40,676         15    32,799         12    28,008         10 
Total average deposits  $268,397         100%  $266,935         100%  $273,548         100%

  

Borrowed funds that may be utilized by the Corporation are comprised of Federal Home Loan Bank (FHLB) advances and federal funds purchased. Borrowed funds are an alternate funding source to deposits and can be used to fund the Corporation’s liquidity needs. FHLB advances are loans from the FHLB that can mature daily or have longer maturities for fixed or floating rates of interest. Federal funds purchased are borrowings from other banks that mature daily. FHLB advances totaled $1,922,000 at December 31, 2012.

 

CAPITAL RESOURCES

 

Shareholders’ equity increased $2,389,000 or 8.85% to $29,388,000 at December 31, 2012 from $26,999,000 at December 31, 2011. The increase in shareholders’ equity for 2012 represents current earnings of $2,938,000, plus adjustments related to employee compensation costs, stock option accounting, deferred compensation plan activity and treasury stock activity of $160,000, less dividends of $601,000. Included in shareholders’ equity is accumulated other comprehensive income which includes the net after-tax impact of unrealized gains on investment securities classified as available for sale which decreased $108,000 during 2012. Such unrealized gains or losses are generally due to changes in interest rates and represent the difference, net of applicable income tax effect, between the estimated fair value and amortized cost of investment securities classified as available for sale. At December 31, 2011, the increase in shareholders’ equity represents current earnings of $2,779,000, plus adjustments related to employee compensation costs, deferred compensation plan and treasury stock activity of $163,000 and a increase in the market value of investment securities classified as available-for-sale, net of tax of $230,000, less dividends paid of $562,000.

 

During 2012, the Corporation returned 20.46% of earnings through dividends of $601,000 at $0.515 per share compared to a return on earnings of 20.22% through dividends of $562,000 at $0.485 per share during 2011. Average total shareholders’ equity to average total assets was 9.50% at December 31, 2012 compared to 8.78% at December 31, 2011.

 

Banking regulations have established minimum capital requirements for banks including risk-based capital ratios and leverage ratios. Regulations require all banks to have a minimum total risk-based capital ratio of 8.0%, with half of the capital composed of core capital. Minimum leverage ratios range from 3.0% to 5.0% of total assets. Conceptually, risk-based capital requirements assess the riskiness of a financial institution’s balance sheet and off-balance sheet commitments in relation to its capital. Core capital, or Tier 1 capital, includes common equity, perpetual preferred stock and minority interests that are held by others in consolidated subsidiaries minus intangible assets. Supplementary capital, or Tier 2 capital, includes core capital and such items as mandatory convertible securities, subordinated debt and the allowance for loans and lease losses, subject to certain limitations. Qualified Tier 2 capital can equal up to 100% of an institution’s Tier 1 capital with certain limitations in meeting the total risk-based capital requirements. At December 31, 2012, the Bank’s total risk-based capital ratio and leverage ratio were 12.5% and 9.4%, respectively, thus exceeding the minimum regulatory requirements. At December 31, 2011, the ratios were 12.0% and 8.9%.

 

18.
 

 

TABLE 12CONTRACTUAL OBLIGATIONS AND COMMITMENTS

  

The Corporation has certain obligations and commitments to make future payments under contract. The aggregate contractual obligations and commitments (in thousands) at December 31, 2012:

 

Contractual obligations  Payments Due by Period 
       Less Than           After 
   Total   One Year   1-3 Years   3-5 Years   5 Years 
Time deposits and certificates of deposit  $83,191   $46,729   $25,006   $5,962   $5,494 
Borrowed funds   1,922    0    0    0    1,922 
Total contractual obligations  $85,113   $46,729   $25,006   $5,962   $7,416 

  

Other commitments  Amount of Commitment – Expiration by Period 
       Less Than           After 
   Total   One Year   1-3 Years   3-5 Years   5 Years 
Commitments to extend commercial credit  $22,790   $14,068   $490   $563   $7,669 
Commitments to extend consumer credit   11,214    1,873    2,258    4,153    2,930 
Standby letters of credit   57    47    10    0    0 
Total other commitments  $34,061   $15,988   $2,758   $4,716   $10,599 

 

Other obligations & commitments which are not included above include the deferred compensation plan, index plan reserve and split dollar life insurance. The timing of payments for these plans is unknown. See Note 1 for additional details.

 

Items listed under “Contractual obligations” represent standard bank financing activity under normal terms and practices. Such funds normally rollover or are replaced by like items depending on then-current financing needs. Items shown under “Other commitments” also represent standard bank activity, but for extending credit to bank customers. Commercial credits generally represent lines of credit or approved loans with drawable funds still available under the contract terms. On an on-going basis, about half of these amounts are expected to be drawn. Consumer credits generally represent amounts drawable under revolving home equity lines or credit card programs. Such amounts are usually deemed less likely to be drawn upon in total as consumers tend not to draw down all amounts on such lines. Utilization rates tend to be fairly constant over time. Standby letters of credit represent guarantees to finance specific projects whose primary source of financing come from other sources. In the unlikely event of the other source’s failure to provide sufficient financing, the bank would be called upon to fill the need. The Corporation is also continually engaged in the process of approving new loans in a bidding competition with other banks. Management and Board committees approve the terms of these potential new loans with conditions and/or counter terms made to the applicant customers. Customers may accept the terms, make a counter proposal, or accept terms from a competitor. These loans are not yet under contract, but offers have been tendered and would be required to be funded if accepted. Such agreements represent approximately $9,001,000 at December 31, 2012, in varying maturity terms.

 

LIQUIDITY

 

Liquidity is the ability to satisfy demands for deposit withdrawals, lending commitments and other corporate needs. The Corporation’s liquidity, primarily represented by cash equivalents and federal funds sold, is a result of its operating, investing and financing activities which are summarized in the Consolidated Statements of Cash Flows. Primary sources of funds are deposits, prepayments and maturities of outstanding loans and securities. While scheduled payments from the amortization of loans and securities are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and industry competition. Funds are primarily utilized to meet ongoing commitments, satisfy operational expenses, pay out maturing certificates of deposit and savings withdrawals and fund loan demand, with excess funds being invested in short-term, interest-earning assets. Additional funds are generated through Federal Home Loan Bank advances, overnight borrowings and other sources.

 

The Corporation’s liquidity ratio at December 31, 2012 was 8.52% compared to 6.42% and 10.09% at December 31, 2011 and 2010, respectively. Another measure of liquidity is the relationship of net loans to deposits and borrowed funds with lower ratios indicating greater liquidity. At December 31, 2012 the ratio of net loans to deposits and borrowed funds was 89.99% compared to 89.18% and 82.04% at December 31, 2011 and 2010, respectively.

 

19.
 

 

In 2012, total cash from operating activities of $4,652,000 and proceeds from the maturities and repayments of investment securities, proceeds from the sale of OREO and other repossessed assets of $9,932,000, along with the increase in deposit balances and FHLB advances of $11,233,000 and the increase from treasury stock and deferred compensation plan activity of $89,000 was used to fund loan growth of $12,696,000, fund capital expenditures of $428,000 and pay dividends of $601,000.

 

In 2011, total cash from operating activities of $2,646,000 and proceeds from the maturities and repayments of investment securities, proceeds from OREO and other repossessed assets sales and an adjustment for the disposal of premises and equipment of $13,769,000 along with an increase from treasury stock and deferred compensation plan activity of $113,000 was used to fund loan growth of $4,619,000, purchase investment securities of $4,149,000, fund capital expenditures of $439,000, pay dividends of $562,000 and satisfy deposit withdrawals of $18,116,000.

 

In 2010, total cash from operating activities of $5,008,000 and proceeds from the maturities and repayments of investment securities, proceeds from OREO and other repossessed asset sales and proceeds from premises and equipment sales of $6,740,000 along with the increase in deposit balances of $12,535,000 and the increase from treasury stock activity of $117,000 was used to fund loan growth of $2,776,000, purchase investment securities of $6,001,000, fund capital expenditures of $308,000, pay dividends of $481,000 and repay FHLB advances of $5,000,000.

 

Net cash flows resulted in an increase in cash equivalents and federal funds sold of $12,181,000 for 2012, compared to a decrease of $11,357,000 in cash equivalents and federal funds sold for 2011 and an increase of $9,834,000 in cash equivalents and federal funds sold for 2010. Liquidity is monitored and closely managed by the Asset-Liability Management Committee (ALCO). Management believes that its sources and levels of liquidity are adequate to meet the needs of the Corporation.

 

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign currency exchange rates, commodity prices, and other relevant market rates and prices. Management seeks to reduce fluctuations in its net interest margin and to optimize net interest income with acceptable levels of risk through periods of changing interest rates. Accordingly, the Corporation’s interest rate sensitivity and liquidity are monitored on an ongoing basis by its Asset and Liability Committee (“ALCO”). ALCO establishes risk measures, limits and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. A variety of measures are used to provide for a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time and the exposure to changes in certain interest rate relationships. ALCO continuously monitors and manages the balance between interest rate sensitive assets and liabilities. The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective, management may lengthen or shorten the duration of assets or liabilities. Management considers market interest rate risk to be one of the Corporation’s most significant ongoing business risk considerations.

 

One method used to manage interest rate risk is a rate sensitivity gap analysis, which monitors the relationship between the maturity and repricing of its interest-earning assets and interest-bearing liabilities. The interest rate sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that same time period. A “positive gap” occurs when the amount of interest rate-sensitive assets maturing or repricing within a given period exceeds the amount of interest-sensitive liabilities maturing or repricing within the same period. Conversely, a “negative gap” occurs when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. 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. During a period of falling interest rates, a negative gap would result in an increase in net interest income, while a positive gap would negatively affect net interest income. Management monitors its gap position in order to maintain earnings at an acceptable level. This has historically been accomplished through offering loan products that are either short-term in nature or which carry variable rates of interest. Interest rates of the majority of the commercial and real estate loan portfolios vary based on U.S. Treasury rates and the prime commercial lending rates published by The Wall Street Journal. Consumer loans have primarily fixed rates of interest, except for home equity loans. At December 31, 2012, as well as December 31, 2011, the Corporation’s gap position was negative as more rate-sensitive liabilities were set to re-price in the coming year than rate-sensitive assets.

 

20.
 

  

TABLE 13PRINCIPAL / NOTIONAL AMOUNT WITH EXPECTED MATURITIES IN:

 (Dollars in thousands)

  

For the Year Ended December 31, 2012:                              Fair 
Rate sensitive assets:  2013   2014   2015   2016   2017   Thereafter   Total   Value 
Fixed interest rate loans  $10,196   $4,746   $5,538   $11,769   $17,587   $21,262   $71,098   $70,410 
Average interest rate   5.30%   6.69%   6.13%   5.56%   5.27%   5.89%   5.67%     
Variable interest rate loans  $14,895   $2,951   $5,817   $2,154   $9,568   $140,861   $176,246   $174,541 
Average interest rate   4.71%   4.94%   4.75%   4.92%   5.31%   5.30%   5.22%     
Fixed interest rate securities  $712   $909   $568   $975   $1,328   $10,636   $15,128   $15,128 
Average interest rate   3.89%   3.77%   4.49%   4.25%   4.32%   4.33%   4.27%     
Variable interest rate securities  $0   $0   $0   $0   $0   $1,904   $1,904   $1,904 
Average interest rate                            2.83%   2.83%     
Rate sensitive liabilities:                                        
Noninterest-bearing deposits  $11,403   $9,123   $6,842   $5,703   $5,703   $6,842   $45,616   $45,616 
Interest-bearing demand deposits  $25,381   $25,381   $25,381   $25,381   $25,381   $12,727   $139,632   $139,632 
Average interest rate   0.09%   0.09%   0.09%   0.09%   0.09%   0.09%   0.09%     
Interest-bearing time deposits  $46,729   $18,388   $6,618   $4,162   $1,800   $5,494   $83,191   $82,216 
Average interest rate   1.43%   1.75%   2.15%   1.71%   1.04%   1.79%   1.59%     
Fixed interest rate borrowing  $0   $0   $0   $0   $0   $1,922   $1,922   $1,854 
Average interest rate                        2.14%   2.14%     
Variable interest rate borrowing  $0   $0   $0   $0   $0   $0   $0   $0 
Average interest rate                                        

  

For the Year Ended December 31, 2011:                             Fair 
Rate sensitive assets:  2012   2013   2014   2015   2016   Thereafter   Total   Value 
Fixed interest rate loans  $15,123   $5,235   $8,969   $6,102   $12,067   $22,561   $70,057   $68,010 
Average interest rate   5.73%   6.73%   6.73%   6.79%   5.81%   6.31%   6.22%     
Variable interest rate loans  $40,616   $2,352   $4,103   $6,000   $2,047   $109,698   $164,816   $159,999 
Average interest rate   5.63%   4.63%   4.64%   5.34%   4.95%   5.76%   5.66%     
Fixed interest rate securities  $171   $781   $1,383   $1,239   $3,477   $17,466   $24,517   $24,517 
Average interest rate   3.78%   3.89%   3.78%   4.05%   2.33%   3.87%   3.65%     
Variable interest rate securities  $0   $0   $0   $0   $0   $2,594   $2,594   $2,594 
Average interest rate                            3.10%   3.10%     
Rate sensitive liabilities:                                        
Noninterest-bearing deposits  $9,547   $7,637   $5,728   $4,775   $4,775   $5,727   $38,189   $38,189 
Interest-bearing demand deposits  $22,255   $22,255   $22,255   $22,255   $22,255   $11,162   $122,437   $122,437 
Average interest rate   0.12%   0.12%   0.12%   0.12%   0.12%   0.12%   0.12%     
Interest-bearing time deposits  $45,112   $28,741   $10,968   $6,072   $4,128   $3,481   $98,502   $97,712 
Average interest rate   0.75%   2.19%   2.24%   2.34%   1.79%   1.95%   1.52%     
Fixed interest rate borrowing  $0   $0   $0   $0   $0   $0   $0   $0 
Average interest rate                                        
Variable interest rate borrowing  $0   $0   $0   $0   $0   $0   $0   $0 
Average interest rate                                        

 

The tables above provide information about the Corporation’s financial instruments, used for purposes other than trading, which are sensitive to changes in interest rates. For loans, securities, and liabilities with contractual maturities, the table presents principal cash flows and related weighted-average interest rates by contractual maturities. For core deposits (demand, interest-bearing checking, savings and money market) that have no contractual maturity, the table presents principal cash flows and, as applicable, related weighted-average interest rates based upon the Corporation’s historical experience, management’s judgments and statistical analysis, as applicable, concerning their most likely withdrawal behaviors, and does not represent when the rates on these items may be changed. Weighted-average variable rates are based upon rates existing at the reporting date.

 

21.
 

  

FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The estimates of fair values of securities and other financial instruments are based on a variety of factors. In some cases, fair values represent quoted market prices for identical or comparable instruments. In other cases, fair values have been estimated based on assumptions concerning the amount and timing of estimated future cash flows and assumed discount rates reflecting varying degrees of risk. Accordingly, the fair values may not represent actual values of the financial instruments that could have been realized as of year-end or that will be realized in the future.

 

The estimated fair value of the Corporation’s financial assets was below carrying value by $2,393,000 at December 31, 2012, compared to $6,864,000 below carrying value at December 31, 2011. The fair value of interest-bearing liabilities was above carrying value by $1,043,000 at December 31, 2012, compared to $790,000 above carrying value at December 31, 2011. The net result for 2012 was a net market loss of $1,350,000, compared to a net market loss of $6,074,000 at year-end 2011. Further information relating to the Corporation’s estimated fair value of its financial instruments is disclosed in Note 18 of the Consolidated Financial Statements.

 

IMPACT OF INFLATION

 

The financial data included herein has been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP), which generally do not recognize changes in the relative value of money due to inflation or recession.

 

In management’s opinion, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are greatly influenced by changes in the inflation rate, they do not change at the same rate or in the same magnitude as the inflation rate. Rather, interest rate volatility is based on changes in monetary and fiscal policy. A financial institution’s ability to be relatively unaffected by changes in interest rates is a good indicator of its capability to perform in today’s volatile economic environment. The Corporation seeks to insulate itself from interest rate volatility by ensuring that rate-sensitive assets and rate-sensitive liabilities respond to changes in interest rates in a similar period and to a similar degree.

 

22.
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Shareholders

Commercial Bancshares, Inc.

Upper Sandusky, Ohio

 

We have audited the accompanying consolidated balance sheets of Commercial Bancshares, Inc. as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2012. These financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Corporation is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Corporation’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Commercial Bancshares, Inc. as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America.

 

 

Auburn Hills, MI

March 15, 2013

 

23.
 

 

COMMERCIAL BANCSHARES, INC.

 

CONSOLIDATED BALANCE SHEETS

December 31, 2012 and 2011

  

 

 

(Dollars in thousands)

 

   2012   2011 
ASSETS          
Cash and cash equivalents  $7,114   $5,435 
Federal funds sold   15,790    5,288 
Cash equivalents and federal funds sold   22,904    10,723 
           
Securities available for sale   14,773    24,852 
Other investment securities   2,259    2,259 
Total loans   247,344    234,873 
Allowance for loan losses   (4,041)   (3,779)
Loans, net   243,303    231,094 
Premises and equipment, net   7,175    7,406 
Accrued interest receivable   1,181    1,275 
Other assets   9,969    10,170 
Total assets  $301,564   $287,779 
           
LIABILITIES          
Deposits          
Noninterest-bearing demand  $45,616   $38,189 
Interest-bearing demand   117,548    103,774 
Savings and time deposits   82,386    86,918 
Time deposits $100,000 and greater   22,889    30,247 
Total deposits   268,439    259,128 
FHLB advances   1,922    0 
Accrued interest payable   93    106 
Other liabilities   1,722    1,546 
Total liabilities   272,176    260,780 
           
SHAREHOLDERS’ EQUITY          
Common stock, no par value; 4,000,000 shares authorized, 1,186,638 shares issued and 1,169,840 outstanding in 2012 1,186,638 shares issued and 1,162,725 outstanding in 2011   11,721    11,621 
Retained earnings   18,331    16,058 
Unearned compensation   (77)   (76)
Deferred compensation plan shares; at cost, 44,826 shares in 2012 and 41,606 shares in 2011   (787)   (717)
Treasury stock; 16,798 shares in 2012 and 23,913 shares in 2011   (459)   (654)
Accumulated other comprehensive income   659    767 
Total shareholders’ equity   29,388    26,999 
Total liabilities and shareholders’ equity  $301,564   $287,779 

 

See accompanying notes to consolidated financial statements.

 

24.
 

 

COMMERCIAL BANCSHARES, INC.

 

CONSOLIDATED STATEMENTS OF INCOME

Years ended December 31, 2012, 2011 and 2010

 

 

 

(Dollars in thousands, except per share data)

 

   2012   2011   2010 
Interest income               
Interest and fees on loans  $13,387   $13,886   $14,375 
Interest on investment securities:               
Taxable   310    515    620 
Tax-exempt   509    612    709 
Federal funds sold   46    28    41 
Total interest income   14,252    15,041    15,745 
                
Interest expense               
Interest on deposits   1,474    2,112    3,518 
Interest on borrowings   19    0    71 
Total interest expense   1,493    2,112    3,589 
                
Net interest income   12,759    12,929    12,156 
                
Provision for loan losses   798    989    1,370 
Net interest income after provision for loan loss   11,961    11,940    10,786 
                
Noninterest income               
Service fees and overdraft charges   1,486    1,546    1,679 
Other income   811    665    768 
Total noninterest income   2,297    2,211    2,447 
                
Noninterest expenses               
Salaries and employee benefits   5,625    5,701    5,293 
Premises and equipment   1,257    1,281    1,220 
OREO and miscellaneous loan expense   202    228    342 
Professional fees   434    512    411 
Data processing   198    198    224 
Software maintenance   416    362    318 
Advertising and promotional   238    233    213 
FDIC deposit insurance   256    291    458 
Franchise tax   330    315    285 
Losses on repossessed asset sales, net   15    83    271 
Other operating expense   1,172    1,139    1,133 
Total noninterest expense   10,143    10,343    10,168 
                
Income before income taxes   4,115    3,808    3,065 
Income tax expense   1,177    1,029    742 
Net income  $2,938   $2,779   $2,323 
                
Basic earnings per common share  $2.52   $2.40   $2.03 
Diluted earnings per common share  $2.49   $2.38   $2.03 

 

See accompanying notes to consolidated financial statements.

 

25.
 

 

 

COMMERCIAL BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Years ended December 31, 2012, 2011 and 2010
 

 

(Dollars in thousands)

 

   2012   2011   2010 
             
Net income  $2,938   $2,779   $2,323 
                
Unrealized holding gain (loss) on securities:               
Net gain (loss) arising during period   (163)   348    (449)
Reclassifications to net income of net realized loss   0    0    0 
Net securities gain (loss) during the period   (163)   348    (449)
Tax effect   (55)   118    (152)
Other comprehensive income (loss), net of tax   (108)   230    (297)
Comprehensive income, net of tax   2,830    3,009    2,026 

 

See accompanying notes to consolidated financial statements.

  

26.
 

 

COMMERCIAL BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31, 2012, 2011 and 2010
 

 

(Dollars in thousands)

                   Accumulated             
                   Other   Deferred       Total 
   Outstanding   Common   Retained   Unearned   Comprehensive   Compensation   Treasury   Shareholders’ 
   Shares   Stock   Earnings   Compensation   Income (Loss)   Plan Shares   Stock   Equity 
                                 
Balance at January 1, 2010   1,138,497   $11,266   $12,278   $(26)  $834   $(494)  $(1,163)  $22,695 
Net income             2,323                        2,323 
Other comprehensive loss        0    0    0    (297)   0    0    (297)
                                         
Cash dividends ($0.420 per share)        0    (481)   0    0    0    0    (481)
Shares acquired: deferred compensation; 2,102 shares        22    0    0    0    (22)   0    0 
Shares divested: deferred compensation; 335 shares        (7)   0    0    0    7    0    0 
Restricted shares awarded   1,850    24    0    (24)   0    0    0    0 
Stock-based compensation expense        18    0    14    0    0    0    32 
Issuance of treasury stock for deferred compensation plan   10,998    117    (184)   0    0    (117)   301    117 
                                         
Balance at December 31, 2010   1,151,345   $11,440   $13,936   $(36)  $537   $(626)  $(862)  $24,389 
                                         
Net income             2,779                        2,779 
Other comprehensive income        0    0    0    230    0    0    230 
                                         
Cash dividends ($0.485 per share)        0    (562)   0    0    0    0    (562)
Shares divested: deferred compensation; 691 shares        (12)   0    0    0    12    0    0 
Restricted shares awarded   3,750    65    0    (65)   0    0    0    0 
Stock-based compensation expense        25    0    25    0    0    0    50 
Issuance of treasury stock under stock option plans   800    0    (12)   0    0    0    22    10 
Issuance of treasury stock for deferred compensation plan   6,830    103    (83)   0    0    (103)   186    103 
                                         
Balance at December 31, 2011   1,162,725   $11,621   $16,058   $(76)  $767   $(717)  $(654)  $26,999 

 

See accompanying notes to consolidated financial statements.

 

27.
 

 

COMMERCIAL BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years ended December 31, 2012, 2011 and 2010
 

 

(Dollars in thousands)

                            Accumulated                    
                            Other     Deferred           Total  
    Outstanding     Common     Retained     Unearned     Comprehensive     Compensation     Treasury     Shareholders’  
    Shares     Stock     Earnings     Compensation     Income (Loss)     Plan Shares     Stock     Equity  
                                                 
Balance at January 1, 2012     1,162,725     $ 11,621     $ 16,058     $ (76 )   $ 767     $ (717 )   $ (654 )   $ 26,999  
                                                                 
Net income                     2,938                                       2,938  
Other comprehensive loss             0       0       0       (108 )     0       0       (108 )
                                                                 
Cash dividends ($0.515 per share)             0       (601 )     0       0       0       0       (601 )
Shares acquired: deferred compensation; 2,455 shares             50       0       0       0       (50 )     0       0  
Shares divested: deferred compensation; 3,650 shares             (62 )     0       0       0       62       0       0  
Restricted shares awarded     2,200       0       (18 )     (42 )     0       0       60       0  
Stock-based compensation expense             30       0       41       0       0       0       71  
Issuance of treasury stock for stock option plan     500       0       (8 )     0       0       0       14       6  
Issuance of treasury stock for deferred compensation plan     4,415       82       (38 )     0       0       (82 )     121       83  
                                                                 
Balance at December 31, 2012     1,169,840     $ 11,721     $ 18,331     $ (77 )   $ 659     $ (787 )   $ (459 )   $ 29,388  

 

  

See accompanying notes to consolidated financial statements.

28.
 

 

COMMERCIAL BANCSHARES, INC.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 2012, 2011 and 2010
 

 

(Dollars in thousands)

             
   2012   2011   2010 
Cash flows from operating activities               
Net income  $2,938   $2,779   $2,323 
Adjustments to reconcile net income to net cash from operating activities               
Depreciation   658    649    645 
Provision for loan losses   798    989    1,370 
Deferred income taxes   (201)   33    107 
Loss on sale of repossessed assets, net   12    83    271 
Net amortization on securities   114    218    182 
Increased cash value of Bank-owned life insurance   (267)   (279)   (282)
Stock-based compensation expense   71    50    32 
Changes in:               
Interest receivable   94    13    (141)
Interest payable   (13)   (86)   (47)
Other assets and liabilities   448    (1,803)   548 
Net cash from operating activities   4,652    2,646    5,008 
                
Cash flows from investing activities               
Securities available for sale:               
Purchases   0    (4,149)   (5,999)
Maturities, calls and repayments   9,801    13,271    6,001 
Purchases of other investment securities   0    0    (2)
Net change in loans   (12,696)   (4,619)   (2,776)
Proceeds from sale of OREO and other repossessed assets   131    476    731 
Proceeds from the disposition of premises and equipment   0    22    8 
Bank premises and equipment expenditures   (428)   (439)   (308)
Net cash from investing activities   (3,192)   4,562    (2,345)
                
Cash flows from financing activities               
Net change in deposits   9,311    (18,116)   12,535 
FHLB Advances   1,968    0    0 
Repayments of FHLB advances   (46)   0    (5,000)
Cash dividends paid   (601)   (562)   (481)
Issuance of treasury stock under stock option plans   6    10    0 
Issuance of treasury stock for deferred compensation plan   83    103    117 
Net cash from financing activities   10,721    (18,565)   7,171 
                
Net change in cash equivalents and federal funds sold   12,181    (11,357)   9,834 
Cash equivalents and federal funds sold at beginning of year   10,723    22,080    12,246 
                
Cash equivalents and federal funds sold at end of year  $22,904   $10,723   $22,080 
                
Supplemental disclosures:               
Cash paid for interest  $1,506   $2,198   $3,636 
Cash paid for income taxes   1,010    1,735    166 
Non-cash transfer of loans to foreclosed/repossessed assets   302    530    454 

 

See accompanying notes to consolidated financial statements.

 

29.
 

 

NOTE 1   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation: The consolidated financial statements include the accounts of Commercial Bancshares, Inc. (the “Corporation”) and its wholly owned subsidiaries, Commercial Financial and Insurance Agency, LTD (“Commercial Financial”) and The Commercial Savings Bank (the “Bank”). The Bank also owns a 49.9% interest in Beck Title Agency, Ltd., which is accounted for using the equity method of accounting. All significant inter-company balances and transactions have been eliminated in consolidation.

 

Nature of Operations: Commercial Bancshares, Inc. is a financial holding corporation whose banking subsidiary, The Commercial Savings Bank, is engaged in the business of commercial and retail banking, with operations conducted through its main office and branches located in Upper Sandusky, Ohio and neighboring communities in Wyandot, Marion and Hancock counties. These market areas provide the source of substantially all of the Corporation’s deposit and loan activities. The Corporation’s primary deposit products are checking, savings and term certificate accounts, and its primary lending products are residential mortgage, commercial and installment loans. Substantially all loans are secured by specific items of collateral including business assets, consumer assets and real estate. Other financial instruments that potentially represent concentrations of credit risk include deposit accounts in other financial institutions and federal funds sold.

 

Use of Estimates: The preparation of financial statements in conformity with accounting principles generally accepted in the United States inherently involves the use of estimates and assumptions that affect the amounts reported in the financial statements and the related disclosures. The most significant of these estimates relate to the determination of the allowance for loan losses, income taxes and the fair value of financial instruments. Due to potential changes in conditions, it is at least reasonably possible that change in estimates will occur in the near term and that such changes could be material to the amounts reported in the Corporation’s financial statements.

 

Cash and Cash Equivalents: Cash and cash equivalents include cash, interest-bearing and noninterest-bearing demand deposits with banks, and federal funds sold.

 

Cash and Due from Banks: Federal Reserve Board regulations require the Bank to maintain reserve balances on deposits with the Federal Reserve Bank of Cleveland. The required ending reserve balance was $3,748,000 on December 31, 2012 and $2,950,000 on December 31, 2011.

 

Investment Securities: Securities are classified as available for sale. Securities available for sale are carried at fair value, with unrealized holding gains and losses reported separately in shareholders’ equity, net of tax. Interest income includes net amortization of purchase premiums and discounts. Realized gains and losses on sales are determined using the amortized cost of the specific security sold. Securities are written down to fair value when a decline in fair value is considered other-than-temporary. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

 

Loans Receivable: Loans are reported at the principal balance outstanding, net of deferred loan fees and costs, allowance for loan losses, and charge-offs. Interest income is reported on the accrual method and includes amortization of net deferred loan fees and costs over the loan term. Interest income is not reported when full loan repayment is in doubt, typically when the loan is impaired or payments are past due over 90 days. When a loan is placed on nonaccrual status, all unpaid interest is reversed from interest income. Payments received on such loans are reported as principal reductions until qualifying for return to accrual status. Accrual is resumed when all contractually due payments are brought current and future payments are reasonably assured.

 

Allowance for Loan Losses: The allowance for loan losses is a valuation allowance, increased by the provision for loan losses and decreased by charge-offs, minus recoveries. Management estimates the allowance balance required based on past loan loss experience, known and inherent risks in the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.

 

30.
 

 

The allowance consists of specific and general components. The specific component relates to loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. A loan is considered impaired when management believes full collection of principal and interest under the loan terms is not probable. Often this is associated with a significant delay or shortfall in payments. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral.

 

Premises and Equipment: Land is carried at cost. Premises and equipment are stated at cost less accumulated depreciation. Depreciation expense is calculated using the straight-line method based on the estimated useful lives of the assets. Buildings and related components are depreciated using useful lives ranging from 5 to 39 years. Furniture, fixtures and equipment are depreciated using useful lives of 3 to 10 years. These assets are reviewed for impairment when events indicate the carrying amount may not be recoverable.

 

Other Real Estate: Real estate acquired through foreclosure is carried at the lower of the recorded investment in the property or its fair value less estimated costs to sell. Upon repossession, the value of the underlying loan is written down to the fair value of the real estate less estimated costs to sell by a charge to the allowance for loan losses, if necessary. Any subsequent write downs are charged to operating expenses. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in other expense.

 

Bank Owned Life Insurance: Bank owned life insurance policies are stated at the current cash surrender value of the policy, or the policy death proceeds less any obligation to provide a death benefit to an insured’s beneficiaries if that value is less than the cash surrender value. Increases in the asset value are recorded as earnings in other income.

 

Income Taxes: Income tax expense is the sum of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

 

Long-Term Assets: Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at discounted amounts.

 

Benefit Plans: Profit-sharing and 401(k) plan contributions are determined by a formula based on employee deferrals with additional contributions at the discretion of the Board of Directors.

 

Directors and executive officers of the Corporation are permitted to defer compensation paid for service to the Corporation under the Corporation’s Deferred Compensation Plan. Deferred compensation costs are expensed over the individual’s service period. Shares of the Corporation’s common stock that are held in trust for the benefit of deferred compensation plan participants may be available to the Corporation’s creditors in certain circumstances. Such shares acquired by the trustee are reported as a reduction to shareholders’ equity, with a corresponding increase to common stock. In addition to the Corporation’s stock, cash is also held in trust for the benefit of deferred compensation plan participants.

 

Stock Compensation: The Corporation recognizes expense for stock-based compensation using the fair value method of accounting. The Corporation uses an option pricing model to estimate the grant date present value of stock options granted. The fair value of the restricted stock awards is the closing market price of the Corporation’s stock on the date of grant. Compensation is then recognized over the service period, which is usually the vesting period.

 

Financial Instruments: Financial instruments include off-balance-sheet credit instruments, such as commitments to make loans and standby letters of credit, issued to meet customer-financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

 

31.
 

 

Fair Values of Financial Instruments: Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed separately. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates. The fair value estimates of existing on-and-off balance sheet financial instruments does not include the value of anticipated future business or the values of assets and liabilities not considered financial instruments.

 

Comprehensive Income: Accounting principles generally require that recognized revenue, expenses, gains and losses be included in net income. Although certain changes in assets and liabilities, such as unrealized gains and losses on available for sale securities, are reported as a separate component of the equity section of the balance sheet, such items, along with net income are components of comprehensive income. The only item in accumulated other comprehensive income is net unrealized gains and losses on available for sale securities, reported net of tax.

 

Loss Contingencies: Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are such matters that will have a material effect on the financial statements.

 

Earnings Per Share: Basic earnings per share (“EPS”), is calculated by dividing net income by the weighted average number of common shares outstanding. The computation of diluted EPS assumes the issuance of common shares for all dilutive potential common shares outstanding during the reporting period. The dilutive effect of stock options is considered in earnings per share calculations, if dilutive, using the treasury stock method.

 

Industry Segments: While the Corporation’s chief decision makers monitor the revenue streams of various products and services, operations are managed and financial performance is evaluated on a Corporation-wide basis. Accordingly, all of the financial service operations are considered by management to be aggregated in one reportable segment.

 

New Accounting Pronouncements:

ASC Topic 310: Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. On April 5, 2011, the FASB issued a final standard to assist creditors in determining whether a modification of the terms of a receivable meets the definition of a troubled debt restructuring (TDR). The final standard, ASU No. 2011-02, “Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring,” was issued as a result of stakeholders questioning whether additional guidance or clarification was needed to assist creditors with determining whether a modification is a TDR. The final standard does not change the long-standing guidance that a restructuring of a debt constitutes a TDR “if the creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.” In other words, the creditor must conclude that both the restructuring constitutes a concession, and the debtor is experiencing financial difficulties. The new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and has been applied retrospectively to restructurings occurring on or after January 1, 2011.

 

FASB ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU represents the converged guidance of the FASB and the IASB (the “Boards”) on fair value measurement. The collective efforts of the Boards and their staffs, reflected in ASU 2011-04, have resulted in common requirements for measuring fair value and for disclosing information about fair value measurements, including a consistent meaning of the term “fair value.” The Boards have concluded the common requirements will result in greater comparability of fair value measurements presented and disclosed in financial statements prepared in accordance with U.S. GAAP and IFRSs. The amendments to the Codification in this ASU are to be applied prospectively. For public entities, the amendments are effective during interim and annual periods beginning after December 15, 2011. The adoption of this ASU did not have a material impact on the consolidated financial statements.

 

32.
 

 

ASC Topic 220: Comprehensive Income: Presentation of Comprehensive Income. On June 16, 2011, the FASB issued Accounting Standards Update (ASU) 2011-05. This ASU is intended to increase the prominence of other comprehensive income in financial statements. The new guidance does not change whether items are reported in net income or in other comprehensive income or whether and when items of other comprehensive income are reclassified to net income. ASU 2011-05 eliminates the option in current U.S. generally accepted accounting principles that permits the presentation of other comprehensive income in the statement of changes in equity. The new guidance in the ASU requires that an entity report comprehensive income in either a single continuous statement that presents the components of net income or a separate but consecutive statement. The new guidance is to be applied retrospectively and early adoption is permitted. For public entities, the amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The adoption of this pronouncement did not have a material impact on the Corporation’s financial statements.

 

NOTE 2   INVESTMENT SECURITIES

 

The amortized cost and estimated fair value of securities available for sale (in thousands) at the dates indicated are presented in the following table:

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
December 31, 2012  Cost   Gains   Losses   Value 
State and political subdivisions  $9,535   $742   $(5)  $10,272 
Mortgage-backed securities   4,239    262    0    4,501 
Total securities available for sale  $13,774   $1,004   $(5)  $14,773 
                     
December 31, 2011                    
U.S. Government and federal agencies  $4,057   $9   $0   $4,066 
State and political subdivisions   13,578    798    (4)   14,372 
Mortgage-backed securities   6,054    360    0    6,414 
Total securities available for sale  $23,689   $1,167   $(4)  $24,852 

 

The estimated fair values of investment securities (in thousands) at December 31, 2012, by contractual maturity are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

 

   Fair Value 
Due less than one year  $686 
Due after one year through five years   3,747 
Due after five years through ten years   4,915 
Due after ten years   924 
Mortgage-backed securities   4,501 
Total securities available for sale  $14,773 

 

Proceeds from maturities, calls and repayments of principal were $9,801,000, $13,271,000 and $6,001,000 in 2012, 2011 and 2010, respectively. At year-end 2012 and 2011 securities with a carrying value of $13,123,000 and $18,219,000, respectively, were pledged to secure public deposits and other deposits and liabilities as required or permitted by law.

 

33.
 

 

Gross unrealized losses on securities and the estimated fair value of the related securities aggregated by security category and length of time the individual securities have been in continuous loss positions at December 31, 2012 and 2011 are as follows:

 

   Less Than Twelve Months   Over Twelve Months 
(Dollars in thousands)  Gross      Gross     
   Unrealized   Fair   Unrealized   Fair 
December 31, 2012  Losses   Value   Losses   Value 
State and political subdivisions  $(4)  $1,015   $(1)  $385 
Mortgage-backed securities   0    0    0    0 
Total available for sale  $(4)  $1,015   $(1)  $385 

 

   Less Than Twelve Months   Over Twelve Months 
(Dollars in thousands)  Gross      Gross     
   Unrealized   Fair   Unrealized   Fair 
December 31, 2011  Losses   Value   Losses   Value 
U.S. Government and federal agencies  $0   $0   $0   $0 
State and political subdivisions   (3)   880    (1)   310 
Mortgage-backed securities   0    0    0    0 
Total available for sale  $(3)  $880   $(1)  $310 

 

At December 31, 2012, two individual securities had been in a continuous loss position for more than twelve months with four securities in a continuous loss position for less than twelve months. At December 31, 2011, three individual securities had been in a continuous loss position for more than twelve months with one security in a continuous loss position for less than twelve months.

 

The unrealized losses are primarily due to the changes in market interest rates subsequent to purchase. The Corporation does not consider these investments to be other than temporarily impaired at December 31, 2012 and December 31, 2011 since the decline in market value is primarily attributable to changes in interest rates and not credit quality. In addition, the Corporation does not intend to sell and does not believe that it is more likely than not that the Corporation will be required to sell these investments until there is a full recovery of the unrealized loss, which may be at maturity. As a result, no impairment loss was recognized during the 12 months ended December 31, 2012 and 2011.

 

Other investment securities are carried at cost and consist principally of stock in the Federal Home Loan Bank of Cincinnati.

 

34.
 

 

NOTE 3   ALLOWANCE FOR LOAN LOSSES

 

The following tables provide information on the activity in the allowance for loan losses by the respective loan portfolio segment for the period indicated:

 

   Commercial   Real Estate   Consumer   Total 
  (Amounts in thousands) 
December 31, 2012    
Beginning balance – January 1, 2012  $2,849   $278   $652   $3,779 
Charge-offs   (387)   (64)   (151)   (602)
Recoveries   12    0    54    66 
Net (charge-offs) recoveries   (375)   (64)   (97)   (536)
Provision   701    70    27    798 
Ending balance – December 31, 2012  $3,175   $284   $582   $4,041 
                     
December 31, 2011                    
Beginning balance – January 1, 2011  $2,307   $182   $709   $3,198 
Charge-offs   (241)   0    (269)   (510)
Recoveries   15    0    87    102 
Net (charge-offs) recoveries   (226)   0    (182)   (408)
Provision   768    96    125    989 
Ending Balance – December 31, 2011  $2,849   $278   $652   $3,779 
                     
December 31, 2010                    
Beginning balance – January 1, 2010  $1,927   $158   $659   $2,744 
Charge-offs   (610)   (25)   (404)   (1,039)
Recoveries   34    0    89    123 
Net (charge-offs) recoveries   (576)   (25)   (315)   (916)
Provision   956    49    365    1,370 
Ending Balance – December 31, 2010  $2,307   $182   $709   $3,198 

 

The following tables present the recorded investment with respect to impaired loans and the related allowance by portfolio segment at the dates indicated:

 

   Collectively Evaluated   Individually Evaluated   Total 
(Dollars in thousands)  Allowance   Recorded   Allowance   Recorded   Allowance   Recorded 
   for loan   investment   for loan   investment   for loan   investment 
   losses   in loans   losses   in loans   Losses   in loans 
December 31, 2012                              
Commercial  $2,618   $181,490   $557   $12,056   $3,175   $193,546 
Real estate   284    16,129    0    0    284    16,129 
Consumer   582    37,669    0    0    582    37,669 
Total  $3,484   $235,288   $557   $12,056   $4,041   $247,344 
                               
December 31, 2011                              
Commercial  $2,398   $170,002   $451   $7,400   $2,849   $177,402 
Real estate   278    15,456    0    0    278    15,456 
Consumer   652    42,015    0    0    652    42,015 
Total  $3,328   $227,473   $451   $7,400   $3,779   $234,873 
                               
December 31, 2010                              
Commercial  $2,191   $170,650   $116   $1,774   $2,307   $172,424 
Real estate   182    13,775    0    0    182    13,775 
Consumer   669    44,369    40    90    709    44,459 
Total  $3,042   $228,794   $156   $1,864   $3,198   $230,658 

 

35.
 

 

NOTE 4   CREDIT QUALITY INDICATORS

  

As part of its monitoring process, the Corporation utilizes a risk rating system which quantifies the risk the Corporation estimates it has assumed when entering into a loan transaction and during the life of that loan. The system rates the strength of the borrower and the transaction and is designed to provide a program for risk management and early detection of problems. Loans are graded on a scale of 1 through 9, with a grade of 5 or below classified as “Pass” rated credits. Following is a description of the general characteristics of risk grades 6 through 9:

  

  6 – Special Mention The weighted overall risk associated with this credit is considered higher than normal (but still acceptable) or the loan possesses deficiencies which corrective action by the Bank would remedy, thereby reducing risk.
     
  7 – Substandard The weighted overall risk associated with this credit (based on each of the Bank’s creditworthiness criteria) is considered undesirable, the credit demonstrates a well-defined weakness or the Bank is inadequately protected and there exists the distinct possibility of sustaining some loss if not corrected
     
  8 – Doubtful Weakness makes collection or liquidation in full (based on currently existing facts) improbable.
     
  9 – Loss This credit is of little value and not warranted as a bankable asset.  Accordingly, the Bank does not carry any loans on the books that are graded 9 – loss, instead these loans are charged-off.

 

The Corporation’s strategy for credit risk management includes ongoing credit examinations and management reviews of loans exhibiting deterioration of credit quality. A deteriorating credit indicates an elevated likelihood of delinquency. When a loan becomes delinquent, its credit grade is reviewed and changed accordingly. Each downgrade to a classified credit results in a higher percentage of reserve to reflect the increased likelihood of loss for similarly graded credits. Further deterioration could result in a certain credit being deemed impaired resulting in a collateral valuation for purposes of establishing a specific reserve which reflects the possible extent of such loss for that credit.

 

The following tables present the risk category of loans by class of loans based on the most recent analysis performed at December 31, 2012 and December 31, 2011.

 

Commercial Credit Exposure

Credit risk profile by credit worthiness category

  

           Commercial   Commercial 
   Commercial   Commercial   Real Estate   Real Estate 
   Operating   Agricultural   1-4 Family   Other 
Category  12/31/12   12/31/11   12/31/12   12/31/11   12/31/12   12/31/11   12/31/12   12/31/11 
Pass  $27,636   $25,323   $32,416   $27,650   $36,248   $33,854   $78,586   $71,921 
6   0    1,234    0    320    0    608    4,667    4,452 
7   1,388    873    0    0    2,812    1,386    9,793    9,781 
8   0    0    0    0    0    0    0    0 
Total  $29,024   $27,430   $32,416   $27,970   $39,060   $35,848   $93,046   $86,154 

 

36.
 

 

Consumer Credit Exposure

Credit risk by credit worthiness category

  

   Residential   Residential 
   Real Estate, Construction   Real Estate, Other 
Category  12/31/12   12/31/11   12/31/12   12/31/11 
Pass  $3,051   $3,437   $11,582   $10,434 
6   0    0    147    205 
7   71    73    1,278    1,307 
8   0    0    0    0 
Total  $3,122   $3,510   $13,007   $11,946 

  

Consumer Credit Exposure

Credit risk by credit worthiness category

  

   Consumer   Consumer   Consumer 
   Equity   Auto   Other 
Category  12/31/12   12/31/11   12/31/12   12/31/11   12/31/12   12/31/11 
Pass  $19,091   $19,565   $6,225   $8,365   $11,961   $13,673 
6   32    68    0    2    5    6 
7   275    185    14    46    66    105 
8   0    0    0    0    0    0 
Total  $19,398   $19,818   $6,239   $8,413   $12,032   $13,784 

 

NOTE 5 SUMMARY OF IMPAIRED LOANS

 

Loans evaluated for impairment include loans classified as troubled debt restructurings and non-performing multi-family, commercial and construction loans. The following tables set forth certain information regarding the Corporation’s impaired loans (in thousands), segregated by those for which a specific allowance was required and those for which a specific allowance was not necessary for the periods indicated:

 

       Unpaid     
   Recorded   Principal   Related 
December 31, 2012  Investment   Balance   Allowance 
With no related allowance recorded:               
Commercial operating  $234   $234   $0 
Commercial real estate, 1-4 family   92    92    0 
Commercial real estate, other   5,820    5,820    0 
Subtotal   6,146    6,146    0 
                
With an allowance recorded:               
Commercial operating   925    925    107 
Commercial real estate, 1-4 family   1,732    1,732    248 
Commercial real estate, other   3,253    3,253    202 
Subtotal   5,910    5,910    577 
Total  $12,056   $12,056   $557 

 

37.
 

 

       Unpaid     
   Recorded   Principal   Related 
December 31, 2011  Investment   Balance   Allowance 
With no related allowance recorded:               
Commercial operating  $149   $181   $0 
Commercial real estate, other   3,668    3,668    0 
Subtotal   3,817    3,849    0 
                
With an allowance recorded:               
Commercial operating   177    177    94 
Commercial real estate, 1-4 family   283    283    200 
Commercial real estate, other   3,123    3,123    157 
Subtotal   3,583    3,583    451 
Total  $7,400   $7,432   $451 

 

      Unpaid     
   Recorded   Principal   Related 
December 31, 2010  Investment   Balance   Allowance 
With no related allowance recorded:               
Commercial operating  $331   $363   $0 
Commercial real estate, 1-4 family   53    106    0 
Commercial real estate, other   500    562    0 
Subtotal   884    1,031    0 
                
With an allowance recorded:               
Commercial real estate, 1-4 family   405    452    71 
Commercial real estate, other   485    713    45 
Consumer, other   90    90    40 
Subtotal   980    1,255    156 
Total  $1,864   $2,286   $156 

 

Impaired loans with no related allowance recorded at December 31, 2012, increased 61.02% or $2,329,000 from year-end 2011, primarily due to one large commercial real estate credit. Impaired loans with a specified reserve increased 64.97% or $2,328,000, principally due to two large hotel loans. The specified reserve related to impaired loans totaled $557,000 at December 31, 2012, an increase of 23.50% or $106,000 from specified reserves of $451,000 at December 31, 2011, compared to an increase of $295,000 from specified reserves of $156,000 at December 31, 2010.

 

38.
 

 

The following tables present the average recorded investment in impaired loans and the amount of interest income recognized on impaired loans after impairment by portfolio segment and class for the periods indicated. (All dollar amounts reported in thousands)

 

   No Related   With Related     
   Allowance Recorded   Allowance Recorded   Total 
   Average   Total Interest   Average   Total interest   Average   Total Interest 
   Recorded   Income   Recorded   Income   Recorded   Income 
   Investment   Recognized   Investment   Recognized   Investment   Recognized 
December 31, 2012                              
Commercial:                              
Operating  $181   $9   $346   $28   $527   $37 
Real estate, 1-4 family   52    0    1,017    39    1,069    39 
Real estate, other   5,144    311    3,342    48    8,486    359 
Total  $5,377   $320   $4,705   $115   $10,082   $435 
                               
December 31, 2011                              
Commercial:                              
Operating  $151   $9   $176   $9   $327   $18 
Real estate, 1-4 family   0    0    307    11    307    11 
Real estate, other   1,954    218    2,356    163    4,310    381 
Total  $2,105   $227   $2,839   $183   $4,944   $410 
                               
December 31, 2010                              
Commercial:                              
Operating  $170   $26   $0   $0   $170   $26 
Real estate, 1-4 family   53    0    112    29    165    29 
Real estate, other   238    19    638    14    876    33 
Consumer, other   0    0    8    0    8    0 
Total  $461   $45   $758   $43   $1,219   $88 

 

NOTE 6   TROUBLED DEBT RESTRUCTURINGS

 

The following table summarizes information relative to loan modifications determined to be troubled debt restructurings during the twelve months ended December 31, 2012 and December 31, 2011.

 

       Pre-Modification   Post-Modification 
       Outstanding   Outstanding 
   Number   Recorded   Recorded 
   of TDRs   Investment   Investment 
December 31, 2012            
Commercial real estate, 1-4 family   2   $1,542   $1,500 
Commercial real estate, other   1    2,148    2,022 
Total   3   $3,690   $3,522 
                
December 31, 2011               
Commercial operating   2   $218   $177 
Commercial real estate, 1-4 family   1    340    283 
Commercial real estate, other   2    3,773    3,672 
Total   5   $4,331   $4,132 

 

39.
 

 

A modification of a loan constitutes a troubled debt restructuring when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Corporation offers various types of concessions when modifying a loan. Loan terms that may be modified due to a borrower’s financial situation include, but are not limited to, a reduction in the stated interest rate, a reduction in the face amount of the debt, a reduction of the accrued interest, temporary interest-only payments, or re-aging, extensions, deferrals, renewals and rewrites. In mitigation, additional collateral, a co-borrower or a guarantor may be requested.

 

Loans modified in a TDR may already be on nonaccrual status and partial charge-offs may have in some cases been taken against the outstanding loan balance. The allowance for impaired loans that has been modified in a TDR is measured based on the estimated fair value of the collateral, less any selling costs, if the loan is collateral dependent or on the present value of expected future cash flows, discounted at the loan’s original effective interest rate. Management exercises significant judgment in developing these determinations.

 

During the twelve months ended December 31, 2012, the Corporation restructured three loans with a recorded investment of $3,522,000. Loan modifications consisted primarily of interest rate reductions and no modifications resulted in the reduction of the recorded investment in the associated loan balances. Restructured loans are subject to periodic credit reviews to determine the necessity and adequacy of a specific loan loss allowance based on the collectability of the recorded investment in the restructured loan. Loans restructured during 2012 increased the allowance for loan losses by $191,000. During the twelve months ended December 31, 2011, the Corporation restructured five loans with a recorded investment of $4,132,000. Loan modifications during 2011 consisted primarily of temporary interest-only payments and no modifications resulted in the reduction of the recorded investment in the associated loan balances. Loans restructured during 2011 increased the allowance for loan losses by $324,000.

 

There have been no financing receivables modified as troubled debt restructurings within the previous twelve months that have subsequently defaulted as of December 31, 2012.

 

NOTE 7   AGE ANALYSIS OF PAST DUE FINANCING RECEIVABLES

 

The following table presents the loan portfolio summarized by aging categories, at December 31, 2012 and 2011.

  

                           Recorded 
(In thousands)  30-59   60-89   > 90           Total   Investment 
   Days   Days   Days   Total       Financing   > 90 Days 
2012  Past Due   Past Due   Past Due   Past Due   Current   Receivables   and Accruing 
Commercial                                   
Operating  $154   $0   $0   $154   $28,870   $29,024   $0 
Agricultural   0    0    0    0    32,416    32,416    0 
Real estate, 1-4 fam   13    0    1,592    1,605    37,455    39,060    0 
Real estate, other   1,374    2,261    340    3,975    89,071    93,046    0 
Residential                                   
Construction   0    0    0    0    3,122    3,122    0 
Other   57    28    35    120    12,887    13,007    0 
Consumer                                   
Equity   61    0    0    61    19,337    19,398    0 
Auto   12    9    0    21    6,218    6,239    0 
Other   49    0    0    49    11,983    12,032    0 
Total  $1,720   $2,298   $1,967   $5,985   $241,359   $247,344   $0 

 

40.
 

 

                           Recorded 
(In thousands)  30-59   60-89   > 90           Total   Investment 
   Days   Days   Days   Total       Financing   > 90 Days 
2011  Past Due   Past Due   Past Due   Past Due   Current   Receivables   and Accruing 
Commercial                                   
Operating  $14   $93   $15   $122   $27,308   $27,430   $0 
Agricultural   0    0    0    0    27,970    27,970    0 
Real estate, 1-4 fam   45    1    0    46    35,802    35,848    0 
Real estate, other   121    0    309    430    85,724    86,154    0 
Residential                                   
Construction   0    0    0    0    3,510    3,510    0 
Other   28    0    0    28    11,918    11,946    0 
Consumer                                   
Equity   27    0    0    27    19,791    19,818    0 
Auto   17    0    19    36    8,377    8,413    0 
Other   20    5    35    60    13,724    13,784    0 
Total  $272   $99   $378   $749   $234,124   $234,873   $0 

 

NOTE 8   FINANCING RECEIVABLES ON NONACCRUAL STATUS

 

The following summarizes loans (in thousands) on nonaccrual status at December 31, 2012 and 2011.

 

   December 31, 2012   December 31, 2011 
Commercial          
Operating  $1,087   $433 
Real estate, 1-4 family   1,825    384 
Real estate, other   4,040    761 
Residential real estate          
Other   73    192 
Consumer          
Equity   63    12 
Auto   9    30 
Other   14    40 
Total  $7,111   $1,852 

 

NOTE 9   PREMISES AND EQUIPMENT

 

Year-end premises and equipment (in thousands) were as follows:

 

   2012   2011 
Land  $1,078   $1,066 
Buildings   8,700    8,592 
Furniture and equipment   4,938    4,910 
Construction in process   74    19 
Total   14,790    14,587 
Accumulated depreciation   7,615    7,181 
Premises and equipment, net  $7,175   $7,406 

 

Depreciation expense charged to operations was $658,000, $649,000, and $645,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

 

41.
 

 

NOTE 10   TIME DEPOSITS

 

At December 31, 2012, scheduled maturities of time deposits (in thousands) were as follows:

 

2013  $46,729 
2014   18,388 
2015   6,618 
2016   4,162 
2017   1,800 
2018 and thereafter   5,494 
   $83,191 

 

NOTE 11   FHLB ADVANCES

 

FHLB advances (in thousands) consisted of the following at year-end:

 

   Current         
   Interest         
   Rate   2012   2011 
FHLB fixed rate advance, with monthly principal and interest payments; due July 2027   2.14%  $1,922   $0 

 

The advances are subject to prepayment penalties and the provisions and conditions of the credit policy of the Federal Home Loan Bank of Cincinnati. FHLB advances are collateralized by all shares of FHLB stock owned by the Bank and by the Bank’s qualified mortgage loans. At December 31, 2012, the loans pledged for FHLB advances had a carrying value of $35,975,000.

 

NOTE 12   INCOME TAXES

 

The provision for income taxes (in thousands) consists of:

 

   2012   2011   2010 
Current provision  $1,378   $996   $635 
Deferred provision (benefit)   (201)   33    107 
Total income tax expense (credit)  $1,177   $1,029   $742 

 

Year-end deferred tax assets and liabilities (in thousands) consist of:

 

Items giving rise to deferred tax assets  2012   2011 
Allowance for loan losses in excess of tax reserve  $1,041   $913 
Deferred compensation   266    263 
Alternative minimum tax credit carry forward   0    22 
Restricted stock awards   19    0 
Nonaccrual loan interest   52    8 
Accrued expenses and other   10    15 
Total   1,388    1,221 
           
Items giving rise to deferred tax liabilities          
Depreciation   (291)   (309)
Deferred loan fees and costs   (68)   (82)
FHLB stock dividend   (309)   (309)
Unrealized gain on securities available for sale   (340)   (395)
Prepaid expenses and other   (130)   (132)
Total   (1,138)   (1,227)
Net deferred tax asset (liability)  $250   $(6)

 

42.
 

 

Income tax expense attributable to continuing operations (in thousands) is reconciled between the financial statement provision and amounts computed by applying the statutory federal income tax rate of 34% to income before income taxes as follows:

 

   2012   2011   2010 
Tax at statutory rates  $1,399   $1,295   $1,042 
Increase (decrease) in tax resulting from:               
Tax-exempt income   (246)   (283)   (310)
Other   24    17    10 
Total income tax expense  $1,177   $1,029   $742 

 

The Corporation had no reportable income tax expense pertaining to security gains for 2012, 2011 or 2010.

 

NOTE 13   STOCK-BASED COMPENSATION

 

The Corporation has two share-based compensation plans in existence, the 1997 Stock Option Plan (expired but having outstanding options that may still be executed) and the 2009 Incentive Stock Option Plan, which is described below.

 

The Corporation’s 2009 Incentive Stock Option Plan, is a shareholder approved plan that permits the granting of stock options, restricted stock and certain other stock-based awards to selected key employees on a periodic basis at the discretion of the board. The plan authorizes the issuance of up to 150,000 shares of common stock of which 86,300 shares are available for issuance at December 31, 2012. Option awards are granted with an exercise price equal to the market price of the Corporation’s common stock at the date of grant and have an expiration period of ten years.

 

The fair value of each option award is estimated on the date of grant using an option-pricing model that uses the assumptions noted in the table below. Expected volatilities are based on several factors including historical volatility of the Corporation’s common stock, implied volatility determined from traded options and other factors. The Corporation uses historical data to estimate option exercises and employee terminations to estimate the expected life of options. The risk-free interest rate for the expected term of the options is based on the U.S. Treasury yield curve in effect at the time of the grant. The expected dividend yield is based on the Corporation’s expected dividend yield over the life of the options.

 

The fair value of options granted in 2012 and 2011 was determined using the following weighted-average assumptions as of the date of grant.

 

   2012   2011 
Dividend yield   3.20%   3.32%
Risk-free interest rate   1.15%   1.65%
Expected volatility   23.62%   24.14%
Weighted average expected life   8 years    8 years 
Weighted average per share fair value of options  $3.01   $2.94 

 

In the third quarter of 2012, 15,200 stock options were granted subject to a three year vesting period with one third of the options vesting each year on the anniversary date of the grant.

 

Intrinsic value represents the amount by which the fair market value of the underlying stock exceeds the exercise price of the stock options. At December 31, 2012, the aggregate intrinsic value of stock options outstanding and exercisable was $186,000 and $155,000, respectively, compared to an aggregate intrinsic value of $165,000 and $85,000 at December 31, 2011.

 

43.
 

 

The following table summarizes stock option activity for the years ended December 31, 2012, 2011 and 2010.

 

   2012   2011   2010 
       Weighted       Weighted       Weighted 
       Average       Average       Average 
       Exercise       Exercise       Exercise 
   Shares   Price   Shares   Price   Shares   Price 
Outstanding at beginning of year   40,330   $14.45    31,330   $13.47    24,702   $15.58 
Granted   15,200    19.28    9,800    17.40    11,100    13.25 
Exercised   (500)   12.30    (800)   12.30    0    0 
Expired   0    0    0    0    (4,472)   24.55 
Forfeited   (400)   12.30    0    0    0    0 
Outstanding at year-end   54,630   $15.83    40,330   $14.45    31,330   $13.47 
Options exercisable at year-end   29,199         17,105         7,167      
Weighted average fair value of options granted during the year  $3.01        $2.94        $2.14      

 

The fair value of options granted is amortized as compensation expense, recognized on a straight-line basis over the vesting period of the respective stock option grant. Compensation expense related to employees is included in personnel expense while compensation expense related to directors is included in other operating expense. The Corporation recognized compensation expense of $30,000 for the year ended December 31, 2012, related to the awards of nonrestricted stock options compared to $25,000 and $18,000 for the same periods in 2011 and 2010, respectively. At December 31, 2012, the Corporation had $59,000 of unrecognized compensation expense related to nonrestricted stock options. This remaining cost is expected to be recognized over a weighted average vesting period of approximately 26.1 months. The fair value of nonrestricted stock options vesting during 2012 was $178,000.

 

The following is a summary of outstanding and exercisable stock options at December 31, 2012:

 

    Number   Weighted Average   Number 
    Of Shares   Remaining   Of Shares 
Exercise Price   Outstanding   Contractual Life   Exercisable 
$22.75    1,130    0.00    years    1,130 
 26.75    1,000    3.00    years    1,000 
 12.30    16,400    6.62    years    16,400 
 13.25    11,100    7.62    years    7,402 
 17.40    9,800    8.62    years    3,267 
 19.28    15,200    9.53    years    0 
Total    54,630    7.79    years    29,199 

 

The following table summarizes information about the Corporation’s nonvested stock option activity for the year ended December 31, 2012:

 

   Number   Weighted 
   Of   Average 
Nonvested Options  Options   Price 
Nonvested options at December 31, 2011   23,225   $14.75 
Granted   15,200    19.28 
Vested   (12,828)   13.78 
Forfeited   (166)   12.30 
Nonvested options at December 31, 2012   25,431   $17.92 

 

44.
 

 

In the third quarter of 2012, the Corporation granted 2,200 shares of restricted stock awards with a total grant date fair value of $42,000. The fair value of restricted stock is equal to the fair market value of the Corporation’s common stock on the date of grant. Restricted stock awards are recorded as unearned compensation, a component of shareholders’ equity, and amortized to compensation expense over the vesting period. The Corporation recognized compensation expense of $41,000 for the year ended December 31, 2012, related to restricted stock grants compared to $25,000 and $14,000 for the same periods in 2011 and 2010, respectively. At December 31, 2012 the Corporation had $77,000 of unrecognized compensation expense relating to restricted stock awards. This remaining cost is expected to be recognized over a weighted average vesting period of approximately 24 months.

 

The following table summarizes restricted stock activity for the year ended December 31, 2012.

 

       Weighted 
   Nonvested   Average 
   Number of   Grant Date 
Restricted Stock  Shares   Fair Value 
Nonvested balance at January 1, 2012   7,700   $15.01 
Granted   2,200    19.28 
Vested   (2,100)   12.30 
Forfeited/expired   0    0.00 
Nonvested balance at December 31, 2012   7,800   $16.95 

 

NOTE 14   BENEFIT PLANS

 

The Corporation maintains a 401(k) plan covering substantially all employees who have attained the age of twenty-one and have completed thirty days of service with the Corporation. This is a salary deferral plan, which calls for matching contributions by the Corporation based on a percentage (50%) of each participant’s voluntary contribution (limited to a maximum of six percent (6%) of a covered employee’s annual compensation). In addition to the Corporation’s required matching contribution, a contribution to the plan may be made at the discretion of the Board of Directors. The Corporation’s matching and discretionary contributions were $108,000, $94,000 and $87,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

 

At December 31, 2012, the Corporation has agreements with two former executive officers to provide postretirement benefits including split dollar life insurance arrangements and deferred compensation. The Corporation’s future obligations under the agreements have been provided for through the single purchase of split dollar life insurance policies on the executives. The Corporation has a liability recorded for the present value of the future benefits of approximately $309,000 and $291,000 at December 31, 2012 and 2011, respectively. The Corporation recognized expense in connection with these benefits of $21,000, $53,000 and $40,000 for the years ended December 31, 2012, 2011 and 2010, respectively. The decrease of $32,000 in postretirement benefits expense from 2011 was primarily due to a settlement with a former executive officer.

 

The Corporation has deferred director fee arrangements with certain directors and executive officers. The amounts deferred under the arrangements are invested in the Corporation’s common stock and are maintained in a rabbi trust. The Corporation had 44,826 and 41,606 shares in the plan with a related obligation of $787,000 and $717,000 established within stockholders’ equity as of December 31, 2012 and 2011, respectively.

 

NOTE 15   COMMITMENTS, OFF-BALANCE-SHEET RISK AND CONTINGENCIES

 

Some financial instruments are used in the normal course of business to meet the financing needs of customers. These financial instruments include commitments to extend credit and standby letters of credit that involve, to varying degrees, credit and interest-rate risk in excess of the amount reported in the financial statements.

 

Commitments to extend credit are legally binding and generally have fixed expiration dates or other termination clauses. The contractual amount represents the Corporation’s exposure to credit loss, in the event of default by the borrower. The Corporation manages this credit risk by using the same credit policies it applies to loans. Collateral is obtained to secure commitments based on management’s credit assessment of the borrower. The collateral may include inventories, receivables, equipment, income-producing commercial properties and real estate. Since many of the commitments are expected to expire without being drawn, total commitments do not necessarily represent future cash requirements.

45.
 

 

 

Standby letters of credit are commitments the Corporation issues to guarantee the performance of a customer to a third party. The Corporation issues commercial letters of credit on behalf of customers to ensure payment or collection in connection with trade transactions. In the event of a customer’s non-performance, the Corporation’s credit loss exposure is the same in any extension of credit, up to the letter’s contractual amount. Management assesses the borrower’s credit to determine the necessary collateral. Since the conditions requiring the Bank to fund letters of credit may not occur, the Corporation expects its liquidity requirements to be less than the total outstanding commitments.

 

The following is a summary of commitments to extend credit (in thousands) at year-end:

 

   2012   2011 
Commitments to extend commercial credit  $22,790   $19,588 
Commitments to extend consumer credit   11,214    12,256 
Standby letters of credit   57    10 
   $34,061   $31,854 
Fixed rate  $6,593   $6,158 
Variable rate   27,468    25,696 
   $34,061   $31,854 

 

At year-end 2012, the fixed rate commitments had a range of rates from 2.30% to 25.00%, with a weighted average term to maturity of 53.6 months. At year-end 2011, the fixed rate commitments had a range of rates from 4.75% to 25.00%, with a weighted average term to maturity of 41.8 months.

 

NOTE 16     REGULATORY MATTERS

 

The Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators regarding components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the Corporation’s financial statements.

 

The prompt corrective action regulations provide five classifications, including well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required. The minimum requirements are:

 

   Capital to risk-weighted assets   Tier 1 capital 
   Total   Tier 1   to average assets 
Well capitalized   10%   6%   5%
Adequately capitalized   8%   4%   4%
Undercapitalized   6%   3%   3%

 

46.
 

 

At year-end 2012, actual capital levels and minimum required levels for the Bank were as follows:

 

           Minimum Required   Minimum Required 
(Dollars in thousands)          For Capital   To Be Well 
   Actual   Adequacy Purposes   Capitalized 
December 31, 2012  Amount   Ratio   Amount   Ratio   Amount   Ratio 
Total capital (to risk-weighted assets)  $31,296    12.5%  $20,009    8.0%  $25,011    10.0%
Tier 1 capital (to risk-weighted assets)  $28,158    11.3%  $10,004    4.0%  $15,007    6.0%
Tier 1 capital (to average assets)  $28,158    9.4%  $11,997    4.0%  $14,996    5.0%

 

At year-end 2011, actual capital levels and minimum required levels, for the Bank were as follows:

 

           Minimum Required   Minimum Required 
(Dollars in thousands)          For Capital   To Be Well 
   Actual   Adequacy Purposes   Capitalized 
December 31, 2011  Amount   Ratio   Amount   Ratio   Amount   Ratio 
Total capital (to risk-weighted assets)  $28,729    12.0%  $19,139    8.0%  $23,923    10.0%
Tier 1 capital (to risk-weighted assets)  $25,729    10.8%  $9,569    4.0%  $14,354    6.0%
Tier 1 capital (to average assets)  $25,729    8.9%  $11,558    4.0%  $14,448    5.0%

 

Based on the most recent notifications from its regulators, the Bank has been categorized as “well-capitalized” at December 31, 2012 and 2011. Management is not aware of any conditions or events since its last notification that would affect the Bank’s “well-capitalized” status.

 

Dividend payments to the holding company by its subsidiaries are subject to regulatory review and statutory limitations and, in some instances, regulatory approval. Dividends paid by the Bank are the primary source of funds available to the Corporation for payment of dividends to shareholders and for other working capital needs. Ohio law prohibits the Bank, without the prior approval of the Ohio Division of Financial Institutions, from paying dividends in an amount greater than the lesser of its undivided profits or the total of its net income for that year, combined with its retained net income from the preceding two years. The payment of dividends by any financial institution or its holding company is also affected by the requirement to maintain adequate capital pursuant to applicable capital adequacy guidelines and regulations, and a financial institution generally is prohibited from paying any dividends if, following payment thereof, the institution would be under-capitalized. As described above, the Bank exceeded its minimum capital requirements under applicable guidelines at year-end. The amount of dividends available to the Corporation from the Bank at December 31, 2012, was approximately $11,287,000.

 

NOTE 17     RELATED PARTY TRANSACTIONS

 

Certain directors, executive officers and principal shareholders of the Corporation, including their immediate families and companies in which they are principal owners, were loan customers during 2012 and 2011. The following is a summary of the activity on these borrower relationships (in thousands):

 

   2012 
Beginning balance  $3,103 
New loans and advances   525 
Change in status   (59)
Payments   (655)
Ending balance  $2,914 

 

Deposit accounts of directors and executive officers of the Corporation totaled $3,403,000 and $3,609,000 at December 31, 2012 and 2011, respectively.

 

47.
 

 

NOTE 18     FAIR VALUES AND MEASUREMENTS OF FINANCIAL INSTRUMENTS

 

The Corporation groups its assets and liabilities measured at fair value into a three-level hierarchy for valuation techniques used to measure assets and liabilities at fair value. This hierarchy is based on whether the valuation inputs are observable or unobservable. These levels are:

 

·Level 1 – Quoted prices in active markets for identical assets or liabilities.

 

·Level 2 – Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

 

·Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

 

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Corporation’s assessment of the significance of particular inputs to these fair value measurements requires significant management judgment or estimation and considers factors specific to each asset or liability.

 

U.G. Government and federal agencies and mortgage-backed securities

 

Valuations are based on active market data and use of evaluated broker pricing models that vary based by asset class and includes available trade, bid, and other market information. Generally, the methodology includes broker quotes, proprietary models, descriptive terms and conditions databases coupled with extensive quality control programs. Multiple quality control evaluation processes review available market, credit and deal level information to support the evaluation of the security. If there is a lack of objectively verifiable information available to support the valuation, the evaluation of the security is discontinued. Additionally, proprietary models and pricing systems, mathematical tools, actual transacted prices, integration of market developments and experienced evaluators are used to determine the value of a security based on a hierarchy of market information regarding a security or securities with similar characteristics. Management reviews the data and assumptions used in pricing the securities by its third party provider to ensure the highest level of significant inputs are derived from market observable data.

 

State and political subdivisions

 

Proprietary valuation matrices are used for valuing all tax-exempt municipals that can incorporate changes in the municipal market as they occur. Market evaluation models include the ability to value bank qualified municipals and general market municipals that can be broken down further according to insurer, credit support, state of issuance and rating to incorporate additional spreads and municipal curves. Taxable municipals are valued using a third party model that incorporates a methodology that captures the trading nuances associated with these bonds.

 

48.
 

 

The following table presents information about the Corporation’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 and 2011, and the valuation techniques used by the Corporation to determine those fair values.

 

Assets and liabilities measured at fair value on a recurring basis for the periods shown:

 

   Quoted Prices in   Significant   Significant     
(Dollars in thousands)  Active Markets   Observable   Unobservable     
   For Identical   Inputs   Inputs     
December 31, 2012  Assets (Level 1)   (Level 2)   (Level 3)   Balance 
Assets                    
State and political subdivisions   0    10,272    0    10,272 
Mortgage-backed securities   0    4,501    0    4,501 
Total Assets  $0   $14,773   $0   $14,773 
Liabilities  $0   $0   $0   $0 
                     
December 31, 2011                    
Assets                    
U.S. Government and federal agencies  $0   $4,066   $0   $4,066 
State and political subdivisions   0    14,372    0    14,372 
Mortgage-backed securities   0    6,414    0    6,414 
Total Assets  $0   $24,852   $0   $24,852 
Liabilities  $0   $0   $0   $0 

 

Securities characterized as having Level 2 inputs generally consist of obligations of U.S. Government and federal agencies, government-sponsored organizations and obligations of state and political subdivisions. There were no transfers in or out of Levels 1 and 2 for the year ended December 31, 2012.

 

The Corporation also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At December 31, 2012, such assets consist primarily of impaired loans and other real estate owned (“OREO”). The Corporation has estimated the fair values of these assets using Level 3 inputs. Management considers third party appraisals as well as independent fair market value assessments from realtors or persons involved in selling other real estate owned when determining the fair value of particular properties.

 

The following table presents financial assets and liabilities measured on a nonrecurring basis.

 

       Fair Value Measurements 
   Balance at   At Reporting Date Using: 
(In thousands)  December 31,   Level 1   Level 2   Level 3 
2012                    
Impaired loans  $12,056   $0   $0   $12,056 
Real estate acquired                    
through foreclosure   128    0    0    128 
                     
2011                    
Impaired loans  $7,400   $0   $0   $7,400 
Real estate acquired                    
through foreclosure   0    0    0    0 

 

49.
 

 

A loan is considered impaired when, based on current information and events it is probable the Corporation will be unable to collect all amounts due (both interest and principal) according to the contractual terms of the loan agreement. Loan impairment is measured using the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral (less selling costs) if the loan is collateral dependent. Collateral may be real estate and/or business assets, including equipment, inventory and accounts receivable. The value of business equipment, inventory and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Impaired loans are subject to nonrecurring fair value adjustments to reflect (1) partial write downs that are based on the observable market price or current appraised value of the collateral, or (2) the full charge-off of the loan carrying value.

 

Other real estate owned acquired through or instead of loan foreclosure is adjusted to fair value upon transfer of the loan to OREO. Subsequently, OREO is carried at the lower of carrying value or fair value. The estimated fair value for other real estate owned is determined by independent market-based appraisals and other available market information. Accordingly, the valuations of OREO and other repossessed assets are subject to significant judgment. If the fair value of the collateral deteriorates subsequent to initial recognition, a valuation allowance is recorded through expense. Additionally, any operating costs incurred after acquisition are also expensed.

 

The valuations referred to above for impaired loans and OREO include assumptions related to cash flow projections, discount rates and/or recent comparable sales. The numerical range of unobservable inputs for these valuation assumptions are not meaningful.

 

The tables below presents the estimated fair values (in thousands) of the Corporation’s financial instruments for the periods indicated:

 

           Quoted Prices   Significant     
           In Active   Other   Significant 
           Markets for   Observable   Unobservable 
   Carrying   Estimated   Identical Assets   Inputs   Inputs 
December 31, 2012  Amount   Fair Value   (Level 1)   (Level 2)   (Level 3) 
Financial Assets:                         
Cash equivalents and federal funds sold  $22,904   $22,904   $22,904   $0   $0 
Securities available for sale   14,773    14,733    0    14,733    0 
Other investment securities   2,259    2,259    0    0    2,259 
Loans, net of allowance for loan loss   243,303    240,910    0    0    240,910 
Accrued interest receivable   1,181    1,181    0    0    1,181 
                          
Financial Liabilities:                         
Noninterest-bearing deposits  $(45,616)  $(45,616)  $(45,616)  $0   $0 
Interest-bearing deposits   (139,632)   (139,632)   0    (139,632)   0 
Time Deposits   (83,191)   (82,216)   0    (82,216)   0 
FHLB advances   (1,922)   (1,854)   0    (1,854)   0 
Accrued interest payable   (93)   (93)   0    0    (93)

 

   Carrying   Estimated 
December 31, 2011  Amount   Fair Value 
Financial Assets:          
Cash equivalents and federal funds sold  $10,723   $10,723 
Securities available for sale   24,852    24,852 
Other investment securities   2,259    2,259 
Loans, net of allowance for loan loss   231,094    224,230 
Accrued interest receivable   1,275    1,275 
           
Financial Liabilities:          
Noninterest-bearing deposits  $(38,189)  $(38,189)
Interest-bearing deposits   (122,437)   (122,437)
Time deposits   (98,502)   (97,712)
Accrued interest payable   (106)   (106)

 

50.
 

 

The following describes the valuation methodologies used by management to measure financial assets and liabilities at fair value. Where appropriate, the description includes information about the valuation models and key inputs to those models.

 

·Cash equivalents and federal funds sold - The carrying value of cash, amounts due from banks and federal funds sold assumed to approximate fair value.

 

·Investment securities – Fair value is based on quoted market prices in active markets for identical assets or similar assets in active markets. If quoted market prices are not available, with the assistance of an independent pricing service, management’s fair value measurements consider observable data which may include market maker bids, quotes and pricing models. Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.

 

·Other investment securities – principally consists of investments in Federal Home Loan Bank stock, which has limited marketability and is carried at cost.

 

·Loans – The loan portfolio includes adjustable and fixed-rate loans, the fair value of which is estimated using discounted cash flow analyses. To calculate discounted cash flows, the loans are aggregated into pools of similar types and expected repayment terms. The expected cash flows were based on historical prepayment experiences and estimated credit losses for non-performing loans and were discounted using current rates at which similar loans would be made to borrowers with similar credit ratings and similar remaining maturities. Fair values for impaired loans are estimated using discounted cash flow analyses or underlying collateral values, where applicable.

 

·Accrued interest receivable – The carrying value of accrued interest receivable approximates fair value due to the short-term duration.

 

·Noninterest-bearing deposits – The fair value of noninterest-bearing demand deposits, which have no stated maturity, were considered equal to their carrying amount, representing the amount payable on demand.

 

·Interest-bearing deposits – The fair value of demand, money market and savings deposits, which have no stated maturity, were considered equal to their carrying amount, representing the amount payable on demand.

 

·Time deposits – The fair value for fixed-rate time deposits is estimated using a discounted cash flow calculation that applies interest rates currently being offered for time deposits with similar terms and similar remaining maturities.

 

·FHLB advances – The fair value of long-term debt was estimated using a discounted cash flow calculation which utilizes the interest rates currently offered for borrowings of similar remaining maturities.

 

·Accrued interest payable – The carrying value of accrued interest payable approximates fair value due to the short-term duration.

 

NOTE 19     EARNINGS PER SHARE

 

Weighted average shares used in determining basic and diluted earnings per share for the year ended December 31, 2012, 2011 and 2010:

 

   2012   2011   2010 
Weighted average shares outstanding during the year   1,166,866    1,157,477    1,142,610 
Dilutive effect of stock options   10,899    8,128    388 
Weighted average shares considering dilutive effect   1,177,765    1,165,605    1,142,998 
                
Anti-dilutive stock options not considered in computing diluted earnings per share   2,130    2,130    13,230 

 

51.
 

 

NOTE 20     PARENT CORPORATION STATEMENTS

 

The following are condensed financial statements of Commercial Bancshares, Inc.

 

CONDENSED BALANCE SHEETS

December 31, 2012 and 2011

(Dollars in thousands)

 

   2012   2011 
ASSETS          
Cash on deposit with subsidiary  $202   $164 
Investment in common stock of subsidiaries   28,844    26,530 
Other assets   365    350 
Total assets  $29,411   $27,044 
           
LIABILITIES AND SHAREHOLDERS’ EQUITY          
Liabilities  $23   $45 
Shareholders’ equity   29,388    26,999 
Total liabilities and shareholders’ equity  $29,411   $27,044 

 

CONDENSED STATEMENTS OF INCOME

Years ended December 31, 2012, 2011 and 2010

(Dollars in thousands)

 

   2012   2011   2010 
INCOME               
Dividends from Bank subsidiary  $601   $562   $600 
Total income   601    562    600 
                
EXPENSES               
Professional fees   31    65    67 
Other   97    97    76 
Total expenses   128    162    143 
                
Tax benefit   (44)   (55)   (47)
Income before equity in undistributed earnings of subsidiaries   517    455    504 
Equity in undistributed earnings of subsidiaries   2,421    2,324    1,819 
NET INCOME  $2,938   $2,779   $2,323 

 

52.
 

 

CONDENSED STATEMENTS OF CASH FLOWS

Years ended December 31, 2012, 2011 and 2010

(Dollars in thousands)

 

   2012   2011   2010 
CASH FLOWS FROM OPERATING ACTIVITIES               
Net income  $2,938   $2,779   $2,323 
Adjustments to reconcile net income to net cash from operating activities               
Equity in undistributed earnings of subsidiaries   (2,421)   (2,324)   (1,819)
Stock-based compensation   71    50    32 
Other   (38)   (5)   (92)
Net cash from operating activities   550    500    444 
CASH FLOWS FROM INVESTING ACTIVITIES               
Net cash from investing activities   0    0    0 
CASH FLOWS FROM FINANCING ACTIVITIES               
Treasury stock issued for deferred compensation plan   83    103    117 
Treasury stock issued under stock option plans   6    10    0 
Cash dividends paid   (601)   (562)   (481)
Net cash from financing activities   (512)   (449)   (364)
                
Net change in cash   38    51    80 
Cash at beginning of period   164    113    33 
Cash at end of period  $202   $164   $113 

 

NOTE 21     QUARTERLY INFORMATION (Unaudited)

 

The following quarterly information (in thousands, except per share data) is provided for the three-month periods ending as follows:

 

2012  March 31,   June 30,   September 30,   December 31, 
Total interest income  $3,627   $3,531   $3,539   $3,555 
Total interest expense   383    370    371    369 
Net interest income  $3,244   $3,161   $3,168   $3,186 
Provision for loan losses   150    90    408    150 
Net income  $763   $794   $580   $801 
Basic earnings per common share   0.66    0.68    0.50    0.68 
Diluted earnings per common share   0.65    0.67    0.49    0.68 

 

2011  March 31,   June 30,   September 30,   December 31, 
Total interest income  $3,714   $3,760   $3,834   $3,733 
Total interest expense   628    557    515    412 
Net interest income  $3,086   $3,203   $3,319   $3,321 
Provision for loan losses   195    330    229    235 
Net income  $617   $628   $794   $740 
Basic earnings per common share   0.54    0.54    0.68    0.64 
Diluted earnings per common share   0.53    0.54    0.68    0.63 

 

53.
 

 

SHAREHOLDER INFORMATION

 

While there is no established public trading market for our common stock, our shares are currently quoted in the inter-dealer quotation or “over-the-counter,” marketplace under the trading symbol “CMOH.” Over-the-counter securities are generally considered to be any equity securities not otherwise listed on a national exchange, such as NASDAQ, NYSE or Amex. The principal over-the-counter market is operated by OTC Markets Group, Inc. (formerly Pink OTC Markets Inc.), which provides quotes for the Company on its middle tier, the OTCQB. All OTCQB companies are reporting with the SEC or a U.S. banking regulator, but there are no financial or qualitative standards to be in this tier. Current quotations, historical data and reports are available on-line at FINANCE.YAHOO.COM by searching for CMOH, with values provided by Commodity Systems, Inc. (CSI).

 

   Dividends         
2012  Declared   Low Bid   High Bid 
Three months ended March 31  $0.125   $18.21   $19.70 
Three months ended June 30   0.125    19.75    22.00 
Three months ended September 30   0.125    18.00    20.30 
Three months ended December 31   0.140    18.25    20.00 

 

   Dividends         
2011  Declared   Low Bid   High Bid 
Three months ended March 31  $0.120   $14.27   $20.00 
Three months ended June 30   0.120    17.00    19.00 
Three months ended September 30   0.120    17.20    18.50 
Three months ended December 31   0.125    17.50    18.65 

 

Management does not have knowledge of the prices paid in all transactions and has not verified the accuracy of those reported prices. Because of the lack of an established market for the Corporation’s stock, these prices may not reflect the prices at which the stock would trade in an active market.

 

The Corporation has 1,169,840 outstanding shares of common stock held by approximately 1,530 shareholders as of December 31, 2012. The Corporation paid cash dividends in March, June, September and December totaling $0.515 per share in 2012 and $0.485 per share in 2011.

 

For a discussion of certain regulatory restrictions limiting the payment of dividends, please see Note 16 to the audited financial statements provided herewith.

 

54.
 

 

COMMERCIAL BANCSHARES, INC.

 

DIRECTORS EMERITUS

 

B. E. Beaston

Edwin G. Emerson

Frederick Reid

William E. Ruse

William A. Sheaffer

 

COMMERCIAL BANCSHARES, INC.

 

EXECUTIVE OFFICERS

 

Robert E. Beach, President and Chief Executive Officer

Scott A. Oboy, Executive Vice President, Chief Financial Officer

 

COMMERCIAL SAVINGS BANK OFFICERS

 

EXECUTIVE OFFICERS

 

Robert E. Beach, President and Chief Executive Officer

Bruce J. Beck, Senior Vice President, Risk Management and Staff Counsel

Susan E. Brown, Senior Vice President, Chief Retail Banking Officer

Scott A. Oboy, Executive Vice President, Chief Financial Officer

Steven M. Strine, Senior Vice President, Chief Lending Officer

 

TRANSFER AGENT, REGISTRAR & DIVIDEND DISBURSING AGENT

 

Registrar and Transfer Company

Attn: Investor Relations

10 Commerce Drive

Cranford, NJ 07016

1-800-368-5948

E-Mail: info@rtco.com

Website: www.rtco.com

 

ANNUAL MEETING

 

The annual shareholders’ meeting will be held Thursday, May 16, 2013 at 4:30 p.m. in the main office of the Commercial Savings Bank, 118 South Sandusky Avenue, Upper Sandusky, Ohio.

 

55.
 

 

COMMERCIAL BANCSHARES, INC.

BOARD OF DIRECTORS

 

Michael A. Shope – Chairman Retired CFO, Walbro Corporation
  Norwalk, Ohio
   
Stanley K. Kinnett – Vice Chairman President and CEO, Dixie-Southern
  Bradenton, Florida
   
Robert E. Beach President and CEO of Commercial
  Bancshares, Inc. and the Commercial
  Savings Bank, Upper Sandusky, Ohio
   
Daniel E. Berg Director of Operations, Tower International
  Livonia, Michigan
   
J. William Bremyer Foot and Ankle Surgery
  Mercy Health Systems, Tiffin, Ohio
  Blanchard Valley Medical Center, Findlay, Ohio
   
Lynn R. Child Chairman and Co-Founder, CentraComm
  Communications, Ltd., and CEO, Aardvark, Inc.
  Findlay, Ohio
   
Mark Dillon President and CEO, Fairborn USA, Inc.
  Upper Sandusky, Ohio
   
Deborah J. Grafmiller State Certified General Appraiser
  Professional Appraisal Service
  Findlay, Ohio
   
Kurt D. Kimmel President/Co-owner, Kimmel Cleaners
  Upper Sandusky, Ohio
   
Lee M. Sisler President, Sisler and Associates
  Marion, Ohio

 

56.