10-K 1 d12245.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X} ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED] For the Fiscal Year Ended December 31, 2002 OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transaction period from ___________________ to ___________________ Commission File Number: 0-23975 FIRST NIAGARA FINANCIAL GROUP, INC. -------------------------------------------------------------------------------- (Exact Name of Registrant as specified in its Charter) Delaware 42-1556195 --------------------------------------------------------------- ------------------------------------------- (State or Other Jurisdiction of Incorporation or Organization (I.R.S. Employer Identification Number) 6950 South Transit Road, P.O. Box 514, Lockport, NY 14095-0514 --------------------------------------------------------------- ------------------------------------------- (Address of Principal Executive Officer) (Zip Code)
(716) 625-7500 -------------------------------------------------------------------------------- (Registrant's Telephone Number Including Area Code) Securities Registered Pursuant to Section 12(b) of the Act: None -------------------------------------------------------------------------------- Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share -------------------------------------------------------------------------------- (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file reports) and (2) has been subject to such requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act) Yes [X] No [_] As of March 14, 2003, there were outstanding, 70,735,114 shares of the Registrant's Common Stock. The aggregate market value of the 67,583,850 shares of voting stock held by non-affiliates of the Registrant was $784,648,499, as computed by reference to the last sales price on March 14, 2003, as reported by the NASDAQ National Market. Solely for purposes of this calculation, all persons who are directors and executive officers of the Registrant and all persons who are beneficial owners of more than 10% of its outstanding stock have been deemed to be affiliates. 34 DOCUMENTS INCORPORATED BY REFERENCE The following documents, in whole or in part, are specifically incorporated by reference in the indicated Part of the Company's Proxy Statement:
Document Part -------------------------------------------------- ---------------------------------------------------- Proxy Statement for the 2003 Annual Part III, Item 10 Meeting of Stockholders "Directors and Executive Officers of the Registrant" Part III, Item 11 "Executive Compensation" Part III, Item 12 "Security Ownership of Certain Beneficial Owners and Management" Part III, Item 13 "Certain Relationships and Related Transactions"
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TABLE OF CONTENTS ITEM PAGE NUMBER NUMBER ----------- ----------- PART I 1 Business.............................................................................................. 4 2 Properties............................................................................................ 22 3 Legal Proceedings..................................................................................... 22 4 Submission of Matters to a Vote of Security Holders................................................... 23 PART II 5 Market for Registrant's Common Equity and Related Stockholder Matters................................. 23 6 Selected Financial Data............................................................................... 24 7 Management's Discussion and Analysis of Financial Condition and Results of Operations................. 27 7A Quantitative and Qualitative Disclosure about Market Risk............................................. 45 8 Financial Statements and Supplementary Data........................................................... 48 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................. 91 PART III 10 Directors and Executive Officers of the Registrant.................................................... 91 11 Executive Compensation................................................................................ 91 12 Security Ownership of Certain Beneficial Owners and Management........................................ 91 13 Certain Relationships and Related Transactions........................................................ 91 14 Controls and Procedures............................................................................... 91 PART IV 15 Exhibits, Financial Statement Schedules and Reports on Form 8-K....................................... 92 Signatures............................................................................................ 93 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002..................................................................................... 95 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002..................................................................................... 96
3 PART I ITEM 1. BUSINESS -------------------------------------------------------------------------------- GENERAL First Niagara Financial Group, Inc. First Niagara Financial Group, Inc. ("FNFG") is a Delaware corporation, which holds all of the capital stock of First Niagara Bank ("First Niagara"), a federally chartered savings bank. FNFG and First Niagara are hereinafter referred to collectively as "the Company." At December 31, 2002, FNFG had consolidated assets of $2.9 billion, deposits of $2.1 billion and stockholders' equity of $283.7 million. First Niagara originally was organized in 1870 as a New York State chartered mutual savings bank. FNFG was organized by First Niagara in connection with its conversion from a New York State chartered mutual savings bank to a New York State chartered stock savings bank and the reorganization to a two-tiered mutual holding company, which was completed in April 1998. As part of the reorganization, FNFG sold shares of common stock to eligible depositors of First Niagara and issued approximately 53% of its shares of common stock to First Niagara Financial Group, MHC ("the MHC"), a mutual holding company. As a result of share repurchases subsequent to the reorganization, the MHC's ownership interest grew to 61% of the issued and outstanding shares of common stock of FNFG. The Company utilized the proceeds raised in its initial offering to make three bank and five non-bank acquisitions between 1999 and 2001. In March 2000, FNFG acquired Albion Banc Corp, Inc., the holding company of Albion Federal Savings and Loan Association ("Albion"). Subsequent to the acquisition, Albion's two branch locations were merged into First Niagara's banking center network. In July 2000, FNFG acquired CNY Financial Corporation ("CNY"), the holding company of Cortland Savings Bank ("Cortland"). In November 2000, FNFG acquired all of the common stock of Iroquois Bancorp, Inc. ("Iroquois"), the holding company of Cayuga Bank ("Cayuga") and The Homestead Savings, FA. Following completion of this transaction, The Homestead Savings was merged into Cayuga. Initially, Cortland and Cayuga were operated as wholly owned subsidiaries of FNFG. In June 2002, FNFG announced its decision to convert to a federal charter subject to Office of Thrift Supervision ("OTS") regulation, and to merge Cortland and Cayuga into First Niagara. The mergers of Cortland and Cayuga into First Niagara, as well as the conversion to federal charters for First Niagara and the MHC were approved by the OTS and were effective November 8, 2002. The conversion of FNFG to a federal charter was approved by stockholders' of the Company on January 9, 2003 and was effective January 17, 2003. The merger of the three banks will allow the Company to further promote the First Niagara brand and gain operational efficiencies, while the conversion to a federal charter provides the Company with greater corporate flexibility. On July 21, 2002, the Boards of Directors of the MHC, FNFG and First Niagara adopted a plan of conversion and reorganization to convert the MHC from mutual to stock form ("the Conversion"). In connection with the Conversion, the 61% ownership interest of the MHC in FNFG was sold to depositors of First Niagara and the public ("the Offering"). Completion of the Conversion and Offering was effective on January 17, 2003 and resulted in the issuance of 67.4 million shares of common stock. A total of 41.0 million shares were sold in subscription, community and syndicated offerings, at $10.00 per share, and an additional 26.4 million shares were issued to the former public stockholders of FNFG based upon an exchange ratio of 2.58681 new shares for each share of FNFG held as of the close of business on January 17, 2003. Share and per share data have not been restated in this annual report on Form 10-K to give retroactive recognition to the exchange ratio applied. Following the completion of the Conversion and Offering, FNFG was succeeded by a new, fully public, Delaware corporation with the same name and the MHC ceased to exist. On January 17, 2003, in conjunction with the Conversion and Offering, the Company acquired Finger Lakes Bancorp, Inc. ("FLBC") the holding company of Savings Bank of the Finger Lakes ("SBFL"), headquartered in Geneva, New York. FLBC operated seven branch locations and had assets of $379.0 million and deposits of $259.8 million at December 31, 2002. Subsequent to the acquisition, SBFL was merged into First Niagara and its branch located in Cayuga County was merged into an existing First Niagara banking center. The SBFL branches bridged the Company's western and central New York markets and provided an initial branch presence in two additional central New York counties (Ontario and Seneca). The business of FNFG consists of the management of First Niagara and its Financial Services Group. First Niagara's business is primarily accepting deposits from customers through its banking centers and investing those deposits, together with funds generated from operations and borrowings, in one- to four-family residential, multi-family residential and commercial real estate loans, commercial business loans and leases, consumer loans, and investment securities. The Company's Financial Services Group focuses 4 on the delivery of risk and wealth management products and services. The former consists primarily of consumer and commercial insurance products and services and the latter primarily consists of investment products and advisory services, and trust services. The Company emphasizes personal service, attention and customer convenience in serving the financial needs of the individuals, families and businesses residing in its market areas. The Company maintains a website at www.fnfg.com and makes available, free of charge, through this website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission ("SEC"). These forms can be accessed within the Investor Relations portion of the Company's website by clicking on "SEC Filings." First Niagara Bank First Niagara was organized in 1870 as a New York State chartered mutual savings bank and operates as a wholly owned subsidiary of FNFG. Through demutualization, acquisitions, de novo expansion and the introduction of new products and services, First Niagara has become a full-service, multi-market community-oriented savings bank that provides financial services to individuals, families and businesses through 38 banking centers, a loan production office and 75 ATM's located in western and central New York. Giving effect to the merger of SBFL into First Niagara and the opening of an additional banking center in January 2003, First Niagara now conducts its business through 45 banking centers and 84 ATM's. As of December 31, 2002, First Niagara had $2.9 billion of assets, deposits of $2.1 billion, $270.9 million of stockholder's equity and employed over one thousand people. First Niagara Bank Subsidiaries First Niagara Securities, Inc. (formerly First Niagara Financial Services, Inc.) First Niagara Securities, Inc. ("FNS"), a wholly owned subsidiary of First Niagara incorporated in 1984, is engaged in the sale of annuities, mutual funds and other investment products, as well as insurance, through First Niagara's banking center network. FNS acts as an agent for third-party companies to sell and service their investment and insurance products. First Niagara Funding, Inc. First Niagara Funding, Inc. is a wholly owned real estate investment trust ("REIT") of First Niagara incorporated in 1997 that primarily owns commercial mortgage loans. The REIT supplements its holdings of commercial real estate loans with fixed rate residential mortgages, home equity loans and commercial business loans. First Niagara Leasing, Inc. First Niagara Leasing, Inc. ("FNL") was acquired by First Niagara on January 1, 2000 and provides direct financing in the commercial small ticket lease market to the equipment industry. First Niagara Portfolio Management, Inc. (formerly First Niagara Securities, Inc.) First Niagara Portfolio Management, Inc., a wholly-owned subsidiary of First Niagara incorporated in 1984, is a New York State Article 9A company, which is primarily involved in the investment in U.S. government agency and Treasury obligations. First Niagara Investment Advisors, Inc. (formerly Niagara Investment Advisors, Inc.) First Niagara Investment Advisors, Inc. ("FNIA") is a registered investment advisory firm that was acquired by First Niagara on May 31, 2000. FNIA specializes in equity, fixed-income and balanced portfolio accounts for individuals, pension plans, corporations, unions and charitable institutions. NOVA Healthcare Administrators, Inc. NOVA Healthcare Administrators, Inc. ("NOVA") was acquired by First Niagara on January 1, 1999 in conjunction with its acquisition of Warren-Hoffman & Associates, Inc. NOVA provides third-party administration of employee benefit plans. Effective February 19, 2003, First Niagara sold NOVA to an independent third party, as it was not considered one of the Company's strategic core businesses of banking, investments or insurance. First Niagara Risk Management, Inc. (formerly Warren-Hoffman & Associates, Inc.) First Niagara Risk Management, Inc. ("FNRM") was acquired on January 1, 1999 by First Niagara and is a full service insurance agency engaged in the sale of insurance products including business and personal insurance, surety bonds, risk management, life, disability and long-term care coverage. FNRM was founded in 1968 and serves commercial and personal clients throughout the Company's market areas. In July 2001, FNRM began offering consulting and risk management services to commercial customers in the areas of alternative risk and self-insurance. On January 1, 2001, FNRM acquired Allied Claim Services, Inc. ("Allied"), an independent insurance adjusting firm and third party administrator. Allied represents insurance companies and self-insured employers in the investigation, settlement and administration of claims brought under an insurance contract or as a self-insured. It operates primarily in the coverage areas of workers' compensation, automobile, general liability and property. 5 During 2001, FNFG organized all of its financial services activities, namely insurance, fiduciary and investment products and services, under one Financial Services Group directed by one dedicated executive. The Financial Services Group includes the operations of the Company's FNRM, FNIA and FNS subsidiaries and a trust department of First Niagara. This reorganization was done in order to maximize the Company's cross-selling capabilities and management of its financial services subsidiaries. FORWARD LOOKING STATEMENTS This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that involve substantial risks and uncertainties. These forward-looking statements can be identified by the use of such words as estimate, project, believe, intend, anticipate, plan, seek, expect and similar expressions. These forward-looking statements include: statements of the Company's goals, intentions and expectations; statements regarding the Company's business plans, prospects, growth and operating strategies; statements regarding the asset quality of the Company's loan and investment portfolios; and estimates of the Company's risks and future costs and benefits. These forward-looking statements are subject to significant risks, assumptions and uncertainties, including, among other things, the following important factors that could affect the actual outcome of future events: general economic conditions, either nationally or in the Company's market areas, that are worse than expected; significantly increased competition among depository and other financial institutions; inflation and changes in the interest rate environment that reduce the Company's margins or reduce the fair value of financial instruments; changes in laws or government regulations affecting financial institutions, including changes in regulatory fees and capital requirements; the Company's ability to enter new markets successfully and capitalize on growth opportunities; the Company's ability to successfully integrate acquired entities; changes in consumer spending, borrowing and savings habits; changes in accounting policies and practices, as may be adopted by the bank regulatory agencies and the Financial Accounting Standards Board ("FASB"); and changes in the Company's organization, compensation and benefit plans. Because of these and other uncertainties, the Company's actual future results may be materially different from the results indicated by these forward-looking statements. Discussion of some of these uncertainties and others can be found in the "Risk Factors" section filed herewith beginning on page 19. MARKET AREAS AND COMPETITION The Company's primary lending and deposit gathering areas have historically been concentrated in the same counties as its banking centers. The Company faces significant competition in both making loans and attracting deposits. The upstate New York regions have a high density of financial institutions, some of which are significantly larger and have greater financial resources than the Company, and all of which are competitors of the Company to varying degrees. The Company's competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial services companies. Its most direct competition for deposits has historically come from savings and loan associations, savings banks, commercial banks and credit unions. The Company faces additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies. Further competition may arise as a result of, among other things, Internet banking, the elimination of restrictions on the interstate operations of financial institutions, and legislation that permits affiliations between banks, securities firms and insurance companies. The Company offers a variety of financial services to meet the needs of the communities it serves and function under a philosophy that includes a commitment to customer service and the community. Giving effect to the merger of SBFL into First Niagara and the opening of an additional banking center in January 2003, the Company presently operates 45 banking centers in eleven counties that span from Buffalo to Utica, New York where the aggregate deposit market provides significant scale to grow. The three largest cities in the markets the Company does business are Buffalo, Rochester and Syracuse. They have a combined total population of nearly 3.0 million and are the 36th, 40th and 59th largest Metropolitan Statistical Areas in the nation and the 1st, 2nd and 4th largest in New York State outside of New York City, respectively. In Niagara, Cayuga and Cortland Counties, the Company has one of the largest deposit market shares of 27%, 47% and 40%, respectively. Growth opportunity is most evident in the Buffalo/Erie, Rochester/Monroe, Utica/Oneida and Syracuse/Onondaga markets that respectively are $19.8 billion, $13.5 billion, $3.1 billion and $5.9 billion deposit markets. 6 LENDING ACTIVITIES General. The Company's principal lending activity has been the origination of one- to four-family residential, adjustable-rate commercial real estate and multi-family residential loans and short-term or variable rate commercial business loans and equipment leases to customers located within its primary market areas. The Company generally sells in the secondary market 20-30 year monthly fixed rate and 25-30 year bi-weekly fixed rate residential mortgage loans, and retains for its portfolio both commercial real estate and residential adjustable-rate loans and fixed-rate monthly 10-15 year residential mortgage loans, together with fixed-rate bi-weekly mortgage loans with maturities of 20 years or less. In line with its long-term customer relationship strategic focus, the Company retains the servicing rights on all residential mortgage loans sold, which results in monthly service fee income. The Company also originates for retention in its portfolio, home equity and consumer loans with the exception of education loans, which, as they enter their out of school repayment phase, are sold to the Student Loan Marketing Association ("Sallie Mae"). One- to Four-Family Real Estate Lending. The Company's primary lending activity has been the origination of mortgage loans to enable borrowers to finance one- to four-family, owner-occupied properties located in its primary market areas. The Company offers conforming and non-conforming, fixed-rate and adjustable-rate, monthly and bi-weekly, residential mortgage loans with maturities up to 30 years and maximum loan amounts generally up to $500 thousand. The Company's bi-weekly mortgages, feature an accelerated repayment structure and a linked deposit account. The Company currently offers both fixed and adjustable rate conventional and government guaranteed Federal Housing Administration ("FHA") and Veterans Administration ("VA") mortgage loans with terms of 10 to 30 years that are fully amortizing with monthly or bi-weekly loan payments. One- to four-family residential loans are generally underwritten according to the Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") uniform guidelines. The Company generally originates both fixed-rate and adjustable-rate loans in amounts up to the maximum conforming loan limits as established by FNMA and FHLMC secondary market standards. Private mortgage insurance ("PMI") and mortgage escrow accounts, from which disbursements are made for real estate taxes, hazard and flood insurance, are required for loans with loan-to-value ratios in excess of 80%. The Company generally sells newly originated conventional, conforming 20-30 year monthly fixed, and 25-30 year bi-weekly, loans in the secondary market to government sponsored enterprises such as FNMA and FHLMC. The Company intends to continue to sell into the secondary market its newly originated loans to assist in asset/liability management. In addition to removing a level of interest rate risk from the balance sheet, the operation of a secondary marketing function within the lending area allows the Company the flexibility to continue to make loans available to customers when deposit flows decline or funds are not otherwise available for lending purposes. In an effort to provide financing for low and moderate income buyers, the Company actively participates in residential mortgage programs and products sponsored by FNMA, FHLMC, and the State of New York Mortgage Agency ("SONYMA"). The SONYMA mortgage programs provide low and moderate income households with fixed-rate loans which are generally set below prevailing fixed-rate mortgage loans and which allow below-market down payments. These loans are sold by the Company to SONYMA, with the Company retaining the contractual servicing rights. The Company currently offers several one- to four-family, adjustable-rate monthly and bi-weekly mortgage loan ("ARM") products secured by residential properties. The one- to four-family ARMs are offered with terms up to 30 years, with rates that adjust every one, five or seven years. After origination, the interest rate on one- to four-family ARMs is reset based upon a contractual spread or margin above a specified index (i.e. U.S. Treasury Constant Maturity Index). The appropriate index utilized at each interest rate change date corresponds to the initial one, five, or seven year adjustment period of the loan. ARMs are generally subject to limitations on interest rate increases of up to 2% per adjustment period and an aggregate adjustment of up to 6% over the life of the loan. The ARMs require that any payment adjustment resulting from a change in the interest rate be sufficient to result in full amortization of the loan by the end of the loan term, and thus, do not permit any of the increased payment to be added to the principal amount of the loan, commonly referred to as negative amortization. 7 The retention of ARMs in the Company's portfolio helps to reduce its exposure to interest rate risk. However, ARMs generally pose credit risks different from the credit risks inherent in fixed-rate loans primarily because, as interest rates rise, the underlying debt service payments of the borrowers rise, thereby increasing the potential for default. In order to minimize this risk, borrowers of one- to four-family one year adjustable-rate loans are qualified at the rate which would be in effect after the first interest rate adjustment, if that rate is higher than the initial rate. The Company believes that these risks, which have not had a material adverse effect on the Company to date, generally are less onerous than the interest rate risks associated with holding fixed-rate loans. Certain of the Company's conforming ARMs can be converted at a later date to a fixed-rate mortgage loan with interest rates based upon the then-current market rates plus a predetermined margin or spread that was established at the loan closing. The Company sells ARMs, which are converted to 25 to 30 year fixed-rate term loans, to either FNMA or FHLMC. Home Equity Lending. The Company offers fixed-rate, fixed-term, monthly and bi-weekly home equity loans, and prime rate, variable rate home equity lines of credit ("HELOCs") in its market areas. Both fixed-rate and floating rate home equity products are offered in amounts up to 100% of the appraised value of the property (including the first mortgage) with a maximum loan amount generally up to $150 thousand. PMI is required for all fixed rate home equity loans and HELOCs with combined first and second mortgage loan-to-value ratios in excess of 80%. Monthly fixed-rate home equity loans are offered with repayment terms up to 15 years and HELOCs are offered with terms up to 30 years. The line may be drawn upon for 10 years, during which time principal and interest is paid on the outstanding balance. Repayment of the remaining principal and interest is then amortized over the remaining 20 years. Bi-weekly fixed-rate home equity loans are offered with repayment terms up to 20 years, however, because the loan amortizes bi-weekly and two additional half payments are made each year, actual loan terms are significantly less. Commercial Real Estate and Multi-family Lending. The Company originates real estate loans secured predominantly by first liens on apartment houses, office complexes, and commercial and industrial real estate. The commercial real estate loans are predominately secured by properties such as office buildings, shopping centers, retail strip centers, industrial and warehouse properties and to a lesser extent, by more specialized properties such as nursing homes, churches, mobile home parks, restaurants, motels/hotels and auto dealerships. The Company's current policy with regard to such loans is to emphasize geographic distribution within its market areas, diversification of property types and minimization of credit risk. As part of the Company's ongoing strategic initiative to minimize interest rate risk, commercial and multi-family real estate loans originated for the Company's portfolio are generally limited to one, three or five year ARM products which are priced at prevailing market interest rates. The initial interest rates are subsequently reset after completion of the initial one, three or five year adjustment period at new market rates that generally range between 200 and 300 basis points over the then, current one, three or five year U.S. Treasury Constant Maturity Index subject to interest rate floors. The maximum term for commercial real estate loans is generally not more than 10 years, with a payment schedule based on not more than a 25-year amortization schedule for multi-family loans, and 20 years for commercial real estate loans. The Company also offers commercial real estate and multi-family construction mortgage loans. Most construction loans are made as "construction/permanent" loans, which provide for disbursement of loan funds during the construction period and conversion to a permanent loan upon the completion of construction and the attainment of either tenant lease-up provisions or prescribed debt service coverage ratios. The construction phase of the loan is made on a short-term basis, usually not exceeding 2 years, with floating interest rate levels generally established at a spread in excess of either the LIBOR or prime rate. The construction loan application process includes the same criteria which are required for permanent commercial mortgage loans, as well as a submission to the Company of completed plans, specifications and cost estimates related to the proposed construction. These items are used as an additional basis to determine the appraised value of the subject property. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. The Company has increased its emphasis on commercial real estate and multi-family lending desiring to invest in assets bearing higher interest rates, which are more sensitive to changes in market interest rates but are less susceptible to prepayment risk. Commercial real estate and multi-family loans, however, entail significant additional risk as compared with one- to four-family residential mortgage lending, as they typically involve larger loan balances concentrated with single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by income producing properties is typically dependent on the successful operation of the related real estate project and thus, may be subject to a greater extent to adverse conditions in the real estate market or in the general economy. To help mitigate this risk, the Company has put in place concentration limits based upon loan types and property types and maximum amounts that may be lent to an individual or group of borrowers. 8 Consumer Loans. The Company originates a variety of fixed-rate installment and variable rate lines-of-credit consumer loans, including indirect new and used automobile loans, mobile home loans, education loans and personal secured and unsecured loans. Mobile home loans have shorter terms to maturity than traditional 30-year residential loans and higher yields than single-family residential mortgage loans. The Company generally offers mobile home loans in New York and New Jersey with fixed-rate, fully amortizing loan terms of 10 to 20 years. The Company has contracted with an independent third party to generate all mobile home loan applications. However, prior to funding, all mobile home loan originations must be underwritten and approved by designated Company underwriters. As part of a negotiated servicing contract, the third party originator will, at the request of the Company, contact borrowers who become delinquent in their payments and when necessary, will oversee the repossession and sale of mobile homes on the Company's behalf. For such services, and as part of the origination and servicing contract, the Company pays the originator a fee at loan funding, of which generally 50% is deposited into a noninterest bearing escrow account, and is under the sole control of the Company to absorb future losses which may be incurred on the loans. The Company participates in indirect automobile lending programs with New York State auto dealerships. These loans are underwritten by the Company's consumer lending officers in accordance with Company policy. The Company does not engage in sub-prime lending. The Company also purchases "A" quality lease paper through a third-party finance company. While the Company retains the credit risk associated with the auto leases, the residual risk, repossessions and remarketing remains the contractual responsibility of the financing company. Indirect auto loans have terms up to 72 months while auto leases have terms up to 60 months. The Company originates personal secured and unsecured fixed rate installment loans and variable rate lines of credit. Terms of the loans range from 6 to 60 months and generally do not exceed $50 thousand. Secured loans are collateralized by vehicles, savings accounts or certificates of deposit. Unsecured loans are only approved for more creditworthy customers. The Company continues to be an active originator of education loans. Substantially all of the loans are originated under the auspices of the New York State Higher Education Services Corporation ("NYSHESC") or the American Student Association ("ASA"). Under the terms of these loans, no repayment is due until the student graduates, with 98% of the principal guaranteed by NYSHESC or ASA. The Company's general practice is to sell these education loans to Sallie Mae as the loans reach repayment status. The Company generally receives a premium of 0.50% to 1.25% on the sale of these loans. Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that tend to depreciate, such as automobiles and mobile homes. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continued financial stability, which can be adversely affected by job loss, divorce, illness or personal bankruptcy. Commercial Business Loans. The Company offers commercial business term loans, letters of credit, equipment leases and lines-of-credit to small and medium size companies in its market areas, some of which are secured in part by additional real estate collateral. Additionally, secured and unsecured commercial loans and lines-of-credit are made for the purpose of financing equipment acquisition, inventory, business expansion, working capital and other general business purposes. The terms of these loans generally range from less than one year to seven years. The loans are either negotiated on a fixed-rate basis or carry variable interest rates indexed to the prime rate or LIBOR. Lines of credit expire after one year and generally carry a variable rate of interest indexed to the prime rate. The Company has recently increased its strategic focus to allocate a greater portion of available funds and personnel resources to both the commercial middle market and small business lending markets. To facilitate the Company's expansion of these areas, the Company has added commercial business products such as cash management, merchant services, wire transfer capabilities, business credit and debit cards, and Internet banking to enhance customer service. The Company offers installment direct financing "small ticket" equipment leases, generally in amounts between $15 thousand to $125 thousand with terms no greater than 60 months, which are guaranteed by the principals of the lessee and collateralized by the leased equipment, and generally bear rates in excess of 8%. Given the Company's strategy to shift its loan portfolio mix to higher yielding commercial loans, this product line continues to be an area of focus. 9 In 2000, the Company began to dedicate more resources to commercial business and real-estate loans, which are 50% - 85% government guaranteed through the Small Business Administration ("SBA"). Terms of these loans range from one year to twenty-five years and generally carry a variable rate of interest indexed to the prime rate. This product allows the Company to better meet the needs of its small business customers in the market areas it serves, while protecting the Company from undue credit risk. Commercial business lending is generally considered to involve a higher degree of credit risk than secured real estate lending. The repayment of unsecured commercial business loans are wholly dependent upon the success of the borrower's business, while secured commercial business loans may be secured by collateral that is not readily marketable. Classification of Assets. Loans are reviewed on a regular basis and are placed on nonaccrual status when, in the opinion of management, the collection of additional interest is doubtful. Loans are generally placed on nonaccrual status when either principal or interest is 90 days or more past due. Interest accrued and unpaid at the time a loan is placed on nonaccrual status is reversed from interest income. Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as Real Estate Owned ("REO") until such time as it is sold. When real estate is acquired through foreclosure or by deed in lieu of foreclosure, it is recorded at its fair value, less estimated costs of disposal. If the value of the property is less than the carrying value of the loan, the difference is charged against the allowance for credit losses. Any subsequent write-down of REO is charged against earnings. Consistent with regulatory guidelines, the Company provides for the classification of loans considered to be of lesser quality as "substandard," "doubtful," or "loss" assets. A loan is considered substandard if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard loans include those characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. Loans classified as loss are those considered uncollectible and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Loans that do not expose the Company to risk sufficient to warrant classification in one of the aforementioned categories, but which possess some weaknesses, are required to be designated "watch" or "special mention" by management. When the Company classifies problem loans as either substandard or doubtful, it establishes a specific valuation allowance in an amount deemed prudent by management. General allowances represent loss allowances that have been established to recognize the inherent risk associated with outstanding loans, but which, unlike specific allowances, have not been allocated to particular problem loans. When the Company classifies problem loans as a loss, it is required either to establish a specific allowance for losses equal to 100% of the amount of the loans classified, or to charge-off such amount. The Company's determination as to the classification of its loans and the amount of its valuation allowance is subject to review by its regulatory agencies, which can order the establishment of additional general or specific loss allowances. The Company regularly reviews its loan portfolio to determine whether any loans require classification in accordance with Company policy or applicable regulations. The allowance for credit losses is established through a provision for credit losses based on management's evaluation of both known and inherent losses in the loan portfolio. Such evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured, considers among other matters, the estimated net realizable value or the fair value of the underlying collateral, economic conditions, historical loan loss experience and other factors that warrant recognition in determining the credit loss allowance. The Company continues to monitor and modify the level of the allowance for credit losses in order to include all known and inherent losses at each reporting date that are both probable and reasonable to estimate. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for credit losses and valuation of REO. Management's evaluation of the allowance for credit losses is based on a continuing review of the loan portfolio. The methodology for determining the amount of the allowance for credit losses consists of several elements. Both commercial business lines of credit, as well as all individual borrower commercial loan credit concentrations in excess of $1.0 million have annual credit reviews in accordance with Company policy. Non-accruing, impaired and delinquent commercial loans are reviewed individually every month and the value of any underlying collateral is considered in determining estimates of losses associated with those loans and the need, if any, for a specific reserve. Another element involves estimating losses inherent in categories of smaller balance homogeneous loans (one- to four-family, home equity, consumer) based primarily on historical experience, industry trends and trends in the real estate market and the current economic environment in the Company's market areas. The unallocated portion of the allowance for credit losses is based on management's evaluation of various conditions, and involves a higher degree of uncertainty because this 10 component of the allowance for credit losses is not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with this element include the following: industry and regional conditions (primarily upstate New York where the Company is subject to a high degree of concentration risk); seasoning of the loan portfolio and changes in the composition of and growth in the loan portfolio; the strength and duration of the current business cycle; existing general economic and business conditions in the lending areas; credit quality trends, including trends in nonaccruing loans; historical loan charge-off experience; and the results of regulatory examinations. INVESTMENT ACTIVITIES General. The Company's investment policy, established by the Board of Directors of First Niagara, provides that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, and desired risk parameters. In pursuing these objectives, consideration is given to the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability and risk diversification. The Company limits securities investments to U.S. Government and agency securities, municipal bonds, corporate debt obligations and corporate equity securities. In addition, the policy permits investments in mortgage-related securities, including securities issued and guaranteed by FNMA, FHLMC, Government National Mortgage Association ("GNMA") and privately-issued collateralized mortgage obligations ("CMOs"). Also permitted are investments in asset-backed securities ("ABSs"), backed by auto loans, credit card receivables, home equity loans, student loans, and home improvement loans. The investment strategy generally utilizes a risk management approach of diversified investing between short-, intermediate- and long-term categories in order to increase overall investment yields in addition to managing interest rate risk. To accomplish these objectives, the Company's focus is on investments in mortgage-backed securities, CMOs and ABSs, while U.S. Government and other non-amortizing securities are utilized for call protection and liquidity purposes. The Company attempts to maintain a high degree of liquidity in its investment securities and generally does not invest in debt securities with expected average lives in excess of 10 years. During 2002 emphasis was placed on investments with shorter durations as a result of the lower interest rate environment. Although this puts pressure on the Company's margins, in the long-run it should benefit the Company as interest rates rise. Additionally, as a result of converting to a federal charter in 2002, First Niagara is no longer permitted to hold equity securities beyond November 8, 2003. Accordingly, management transferred $1.6 million of equity securities owned by First Niagara to FNFG in January 2003. SOURCES OF FUNDS General. Deposits and borrowed funds, primarily Federal Home Loan Bank ("FHLB") advances and reverse repurchase agreements, are the primary sources of the Company's funds for use in lending, investing and for other general purposes. In addition, repayments on loans, proceeds from sales of loans and securities, and cash flows from operations have historically been additional sources of funds. The Company has available lines of credit with the FHLB and Federal Reserve Bank ("FRB"), which can provide liquidity if the above funding sources are not sufficient to meet the Company's short-term liquidity needs. Deposits. The Company offers a variety of deposit account products with a range of interest rates and terms. The deposit accounts consist of savings accounts, negotiable order of withdrawal ("NOW") accounts, checking accounts, money market accounts, and certificates of deposit. The Company offers certificates of deposit with balances in excess of $100 thousand at preferential rates (jumbo certificates) and also offers Individual Retirement Accounts ("IRAs") and other qualified plan accounts. To enhance its deposit product offerings, the Company also provides commercial business, as well as totally free checking accounts. Borrowed Funds. Borrowings are utilized to lock-in lower cost funding, better match interest rates and maturities of certain assets and liabilities and leverage capital for the purpose of improving return on equity. Such borrowings primarily consist of advances and reverse repurchase agreements entered into with the FHLB, with nationally recognized securities brokerage firms and with commercial customers. 11 FINANCIAL SERVICES GROUP General. To complement its traditional core banking products, the Company offers a wide-range of insurance and investment products and services to help customers achieve their financial goals. These products and services are delivered through the Company's Financial Services Group, a business unit that is organized along the lines of Risk Management and Wealth Management. The goal of this unified financial services team is to help customers identify and achieve long- and short-range financial goals, regardless of their entry point or changing financial needs. Risk Management. The Company's Risk Management services consists of the sale of personal and commercial insurance on an agency basis to individual consumers, as well as small and medium sized companies located in its market areas. The Company offers life, auto, home, long-term care, disability, key-person life, property insurance, and general liability business insurance, which includes product professional and umbrella policies. In addition to its insurance products sold, the Company provides claims investigation and adjusting services, as well as alternative risk management and self-insurance consulting services. The revenue attributable to the Company's Risk Management services consists primarily of fees paid by clients and commissions, fees and contingent income paid by insurance companies. These revenues may be affected by premium rate levels in the insurance markets and available insurance capacity, since compensation is frequently related to the premiums paid by insureds. Revenue is also affected by insured values, the development of new products, markets and services, new and lost business, as well as merging of and the volume of business from new and existing clients. Contingent income includes payments or allowances by insurance companies based upon such factors as the overall volume of business placed by the Company with that insurer and/or the profitability or loss to the insurer of the risks placed. Revenues vary from quarter to quarter as a result of the timing of policy renewals, the net effect of new and lost business and achievement of contingent compensation thresholds, whereas expenses tend to be more uniform throughout the year. Commission rates vary in amount depending upon the type of insurance coverage provided, the particular insurer, the capacity in which the agent acts and negotiations with clients. Wealth Management. The Company's Wealth Management services consist of the sale of mutual funds and annuities, including various individual retirement accounts and education savings plans. Additionally, the Company offers investment advisory services, trust services and individual managed account programs. Revenue from the sale of mutual funds and annuities consist primarily of commissions paid by investment product providers. Revenue is affected by the development of new products, markets and services, new and lost business, marketing of new investment products, the relative attractiveness of the investment products offered under prevailing market conditions, changes in the investment patterns of clients and the flow of monies to and from accounts. The investment management services are performed pursuant to advisory contracts, which provide for fees payable to the Company. The amount of the fees varies depending on the individual account and is usually based upon a sliding scale in relation to the level of assets under management. Investment management revenues depend largely on the total value and composition of assets under management. Assets under management and revenue levels are particularly affected by fluctuations in stock and bond market prices, the composition of assets under management and by the level of investments and withdrawals for current and new clients. U.S. equity markets were volatile throughout 2002 and 2001 and declined in each of those years after several years of substantial growth. This volatility contributed to the decline in assets under management and, accordingly, to the reduction in revenue recognized by the Company. A continued decline in general market levels will reduce future revenue. Items affecting revenue also include, but are not limited to, actual and relative investment performance, service to clients, the relative attractiveness of the investment style under prevailing market conditions, changes in the investment patterns of clients and the ability to maintain investment management fees at appropriate levels. Assets managed by the Company aggregated approximately $132.9 million and $190.4 million as of December 31, 2002 and 2001, respectively. The Company provides personal trust, employee benefit trust, and custodial services to clients in its market areas. Similar to its investment management services, trust revenue is derived primarily from investment management fees, which depend largely on the total value and composition of assets under management. Assets under management relating to trust services are included within the assets managed amounts reported above. 12 SEGMENT INFORMATION Information about the Company's business segments is included in note 18 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Based on the "Management Approach" model as described in the provisions of Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Company has determined it has two business segments, its banking activities and its financial services activities. Financial services activities consist of the results of the Company's insurance and investment advisory subsidiaries, as well as First Niagara's trust department, which were organized under one Financial Services Group in 2001. Banking activities consists of the results of FNFG's banking subsidiaries excluding financial services activities. SUPERVISION AND REGULATION General. As a result of the conversion of First Niagara to a federally chartered savings bank, FNFG became a savings and loan holding company. First Niagara is examined and supervised by the OTS and the Federal Deposit Insurance Corporation ("FDIC"), while FNFG is examined and supervised by the OTS. This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the FDIC's deposit insurance funds and depositors. Under this system of federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Following completion of its examination, the federal agency critiques the institution's operations and assigns its rating (known as an institution's CAMELS rating). Under federal law, an institution may not disclose its CAMELS rating to the public. First Niagara also is a member of and owns stock in the FHLB of New York, which is one of the twelve regional banks in the FHLB System. First Niagara also is regulated to a lesser extent by the Board of Governors of the Federal Reserve System, governing reserves to be maintained against deposits and other matters. The OTS examines First Niagara and prepares reports for the consideration of its Board of Directors on any operating deficiencies. First Niagara's relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in matters concerning the ownership of deposit accounts and the form and content of First Niagara's loan documents. Any change in these laws or regulations, whether by the FDIC, OTS or Congress, could have a material adverse impact on the Company and its operations. Federal Banking Regulation Business Activities. A federal savings bank derives its lending and investment powers from the Home Owners' Loan Act, as amended, and the regulations of the OTS. Under these laws and regulations, First Niagara may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other assets. First Niagara also may establish subsidiaries that may engage in activities not otherwise permissible, including real estate investment and securities and insurance brokerage. Capital Requirements. OTS regulations require savings banks to meet three minimum capital standards: A 1.5% tangible capital ratio, a 4% leverage ratio (3% for banks receiving the highest rating on the CAMELS rating system) and an 8% risk-based capital ratio. The prompt corrective action standards discussed below, in effect, establish a minimum 2% tangible capital standard. The risk-based capital standard for savings banks requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 200%, assigned by the OTS capital regulation based on the risks believed inherent in the type of asset. Core capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of net unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital. 13 At December 31, 2002, First Niagara exceeded all minimum regulatory capital requirements. The current requirements and the actual levels for First Niagara are detailed in note 11 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Loans-to-One-Borrower. A federal savings bank generally may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus on an unsecured basis. An additional amount may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, but generally does not include real estate. First Niagara is in compliance with the loans-to-one-borrower limitations. As a result of the recently completed Offering, the Company's regulatory loans-to-one-borrower limit has increased to approximately $65.0 million (15% of unimpaired capital and surplus) as of January 31, 2003. However, given the Company's conservative underwriting standards and risk management philosophy, management and the Board of Directors has established an internal loans-to-one-borrower limit of approximately $43.5 million (10% of unimpaired capital and surplus) as of January 31, 2003. Qualified Thrift Lender Test. As a federal savings bank, First Niagara is subject to a qualified thrift lender ("QTL") test. Under the QTL test, First Niagara must maintain at least 65% of its "portfolio assets" in "qualified thrift investments" in at least nine months of the most recent 12-month period. "Portfolio assets" generally means total assets of a savings institution, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings bank's business. "Qualified thrift investments" includes various types of loans made for residential and housing purposes, investments related to such purposes, including certain mortgage-backed and related securities, and loans for personal, family, household and certain other purposes up to a limit of 20% of portfolio assets. "Qualified thrift investments" also include 100% of an institution's credit card loans, education loans and small business loans. First Niagara also may satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986, as amended. Capital Distributions. OTS regulations govern capital distributions by a federal savings bank, which include cash dividends, stock repurchases and other transactions charged to the capital account. A savings bank must file an application for approval of a capital distribution if: The total capital distributions for the applicable calendar year exceed the sum of the savings bank's net income for that year to date plus the savings bank's retained net income for the preceding two years; the bank would not be at least adequately capitalized following the distribution; the distribution would violate any applicable statute, regulation, agreement or OTS-imposed condition; or the savings bank is not eligible for expedited treatment of its filings. Even if an application is not otherwise required, every savings bank that is a subsidiary of a holding company must file a notice with the OTS at least 30 days before the Board of Directors declares a dividend or approves a capital distribution. The OTS may disapprove a notice or application if: The savings bank would be undercapitalized following the distribution; the proposed capital distribution raises safety and soundness concerns; or the capital distribution would violate a prohibition contained in any statute, regulation or agreement. In addition, the Federal Deposit Insurance Act provides that an insured depository institution shall not make any capital distribution, if after making such distribution, the institution would be undercapitalized. Liquidity. A federal savings bank is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation. Community Reinvestment Act and Fair Lending Laws. All savings banks have a responsibility under the Community Reinvestment Act ("CRA") and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of a federal savings bank, the OTS is required to assess the savings bank's record of compliance with the CRA. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. A bank's failure to comply with the provisions of the CRA could, at a minimum, result in regulatory restrictions on its activities. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the OTS, as well as other federal regulatory agencies and the Department of Justice. First Niagara received a "satisfactory" CRA rating in its most recent federal examination. Transactions with Related Parties. A federal savings bank's authority to engage in transactions with its "affiliates" is limited by OTS regulations and by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term "affiliates" for these purposes generally means any company that controls or is under common control with an institution. FNFG and its non-savings institution subsidiaries are affiliates of First Niagara. In general, transactions with affiliates must be on terms that are as favorable to the savings bank as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the savings bank's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the 14 savings bank. In addition, OTS regulations prohibit a savings bank from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. First Niagara's authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and (ii) do not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of First Niagara's capital. In addition, extensions of credit in excess of certain limits must be approved by First Niagara's Board of Directors. Enforcement. The OTS has primary enforcement responsibility over federal savings institutions and has the authority to bring enforcement action against all "institution-affiliated parties," including stockholders, and attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or a cease and desist order for the removal of officers and/or directors of the institution, receivership, conservatorship or the termination of deposit insurance. Civil penalties cover a wide range of violations and actions, and range up to $25 thousand per day, unless a finding of reckless disregard is made, in which case penalties may be as high as $1.1 million per day. The FDIC also has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the OTS Director, the FDIC has authority to take action under specified circumstances. Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. The federal banking agencies adopted Interagency Guidelines Prescribing Standards for Safety and Soundness to implement the safety and soundness standards required under federal law. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit systems, credit underwriting, loan documentation, interest rate risk exposure, asset growth, compensation, fees and benefits. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan. Prompt Corrective Action Regulations. Under the prompt corrective action regulations, the OTS is required and authorized to take supervisory actions against undercapitalized savings banks. For this purpose, a savings bank is placed in one of the following five categories based on the bank's capital: well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based capital); adequately capitalized (at least 3% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital); undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based capital or 3% leverage capital); significantly undercapitalized (less than 6% total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital); and critically undercapitalized (less than 2% tangible capital). Generally, the banking regulator is required to appoint a receiver or conservator for a bank that is "critically undercapitalized." The regulation also provides that a capital restoration plan must be filed with the OTS within 45 days of the date a bank receives notice that it is "undercapitalized," "significantly undercapitalized," or "critically undercapitalized." A capital restoration plan must disclose, among other things, the steps an insured institution will take to become adequately capitalized without appreciably increasing the risk to which the institution is exposed. In addition, each company that controls the institution must guarantee that the institution will comply with the plan until the institution has been adequately capitalized on average during each of four consecutive calendar quarters. Such guarantee could have a material adverse affect on the financial condition of such guarantor. In addition, numerous mandatory supervisory actions become immediately applicable to the bank, including, but not limited to, restrictions on growth, investment activities, capital distributions and affiliate transactions. The OTS may also take any one of a number of discretionary supervisory actions against undercapitalized banks, including the issuance of a capital directive and the replacement of senior executive officers and directors. 15 At December 31, 2002, First Niagara met the criteria for being considered "well-capitalized." The current requirements and the actual levels for First Niagara are detailed in note 11 of "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." Insurance of Deposit Accounts. Deposit accounts in First Niagara are insured by the FDIC, primarily through the Bank Insurance Fund, generally up to a maximum of $100 thousand per separately insured depositor. First Niagara's deposits therefore are subject to FDIC deposit insurance assessments. The FDIC has adopted a risk-based system for determining deposit insurance assessments. The FDIC is authorized to raise the assessment rates as necessary to maintain the required ratio of reserves to insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay assessments to the FDIC at an annual rate, as of January 1, 2002, of approximately 0.0182% of insured deposits to fund interest payments on bonds maturing in 2017 issued by a federal agency to recapitalize the predecessor to the Savings Association Insurance Fund. Prohibitions Against Tying Arrangements. Federal savings banks are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution. Federal Home Loan Bank System. First Niagara is a member of the FHLB System, which consists of 12 regional Federal Home Loan Banks. The FHLB System provides a central credit facility primarily for member institutions. As a member of the FHLB of New York, First Niagara is required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its borrowings from the FHLB, whichever is greater. First Niagara is in compliance with this requirement. Federal Reserve System The Federal Reserve Board regulations require savings banks to maintain non-interest-earning reserves against their transaction accounts, such as NOW and regular checking accounts. First Niagara is in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements imposed by the OTS. Holding Company Regulation Upon completion of the Conversion of First Niagara to a federally chartered savings bank, FNFG became a savings and loan holding company, subject to regulation and supervision by the OTS. The OTS has enforcement authority over FNFG and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a risk to First Niagara. Under prior law, a unitary savings and loan holding company generally had no regulatory restrictions on the types of business activities in which it may engage, provided that its subsidiary savings bank was a qualified thrift lender. The Gramm-Leach-Bliley ("GLB") Act of 1999, however, restricts unitary savings and loan holding companies not existing or applied for before May 4, 1999 to those activities permissible for financial holding companies or for multiple savings and loan holding companies. FNFG is not a grandfathered unitary savings and loan holding company and, therefore, is limited to the activities permissible for financial holding companies or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance, incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain additional activities authorized by OTS regulations. Federal law prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring control of another savings institution or holding company thereof, without prior written approval of the OTS. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources, future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors. 16 Recent Legislation USA Patriot Act of 2001. In October 2001, the USA Patriot Act of 2001 ("the Patriot Act") was enacted in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C., which occurred on September 11, 2001. The Patriot Act is intended to strengthen U.S. law enforcement's and the intelligence communities' abilities 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 standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Financial Services Modernization Legislation. In November 1999, the GLB Act of 1999 was enacted. The GLB repeals provisions of the Glass-Steagall Act which restricted the affiliation of Federal Reserve member banks with firms "engaged principally" in specified securities activities, and which restricted officer, director, or employee interlocks between a member bank and any company or person "primarily engaged" in specified securities activities. In addition, the GLB also contains provisions that expressly preempt any state law restricting the establishment of financial affiliations, primarily related to insurance. The general effect of the law is to establish a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms, and other financial service providers by revising and expanding the Bank Holding Company Act framework to permit a holding company to engage in a full range of financial activities through a new entity known as a "financial holding company." "Financial activities" is broadly defined to include not only banking, insurance and securities activities, but also merchant banking and additional activities that the Federal Reserve Board, in consultation with the Secretary of the Treasury, determines to be financial in nature, incidental to such financial activities, or complementary activities that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system. The GLB provides that no company may acquire control of an insured savings association unless that company engages, and continues to engage, only in the financial activities permissible for a financial holding company, unless the company is grandfathered as a unitary savings and loan holding company on May 4, 1999 or became a unitary savings and loan holding company pursuant to an application pending on that date. The GLB also permits national banks to engage in expanded activities through the formation of financial subsidiaries. A national bank may have a subsidiary engaged in any activity authorized for national banks directly or any financial activity, except for insurance underwriting, insurance investments, real estate investment or development, or merchant banking, which may only be conducted through a subsidiary of a financial holding company. Financial activities include all activities permitted under new sections of the Bank Holding Company Act or permitted by regulation. Sarbanes-Oxley Act. On July 30, 2002, the Sarbanes-Oxley Act of 2002 ("SOA") was signed into law. The stated goals of the SOA are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The SOA includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The SOA represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees. The SOA addresses, among other matters: Audit committees; certification of financial statements by the chief executive officer and the chief financial officer; the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement; a prohibition on insider trading during pension plan black out periods; disclosure of off-balance sheet transactions; a prohibition on certain loans to directors and officers; expedited filing requirements for Forms 4; disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code; "real time" filing of periodic reports; the formation of a public accounting oversight board; auditor independence; and various increased criminal penalties for violations of securities laws. The SOA contains provisions that became effective upon enactment, and provisions that will become effective from within 30 days to one year from enactment. The SEC has been delegated the task of enacting rules to implement various provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act. 17 TAXATION Federal Taxation General. FNFG and First Niagara are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to FNFG and First Niagara. Method of Accounting. For federal income tax purposes, First Niagara currently reports its income and expenses on the accrual method of accounting and uses a tax year ending December 31 for filing its consolidated federal income tax returns. Bad Debt Reserves. The Small Business Protection Act of 1996 eliminated the use of the reserve method of accounting for bad debt reserves by savings institutions, effective for taxable years beginning after 1995. Prior to this, First Niagara was permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions could, within specified formula limits, be deducted in arriving at First Niagara's taxable income. As a result of the Small Business Protection Act, First Niagara must use the specific charge off method in computing its bad debt deduction beginning with its 1996 federal tax return. In addition, the federal legislation required the recapture (over a six-year period) of the excess of tax bad debt reserves at December 31, 1995 over those established as of December 31, 1987. As of December 31, 2002, First Niagara had fully recaptured these excess reserves. Taxable Distributions and Recapture. Prior to the Small Business Protection Act of 1996, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income should First Niagara fail to meet certain thrift asset and definitional tests. New federal legislation eliminated these thrift related recapture rules. However, under current law, pre-1988 reserves remain subject to recapture should First Niagara make certain nondividend distributions or cease to maintain a bank charter. At December 31, 2002, First Niagara's federal pre-1988 reserve, which no federal income tax provision has been made, was approximately $7.7 million. Minimum Tax. The Internal Revenue Code of 1986 imposes an alternative minimum tax ("AMT") at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The AMT is payable to the extent such AMTI is in excess of an exemption amount. Net operating losses can offset no more than 90% of AMTI. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. First Niagara has not been subject to the alternative minimum tax and has no such amounts available as credits for carryover. Net Operating Loss Carryovers. A financial institution may carry back net operating losses to the preceding five taxable years (for losses incurred in 2001 and subsequent years) and forward to the succeeding 20 taxable years. At December 31, 2002, First Niagara had no net operating loss carryforwards for federal income tax purposes. Corporate Dividends. FNFG may exclude from its income 100% of dividends received from First Niagara as a member of the same affiliated group of corporations. Status of Internal Revenue Service Audits. FNFG's federal income tax returns have not been audited by the Internal Revenue Service during the last five years. State Taxation State of New York. FNFG will report income on a consolidated calendar year basis to New York State. New York State franchise tax on corporations is imposed in an amount equal to the greater of (a) 8.0% (for 2002) and 7.5% (for 2003 and forward) of "entire net income" allocable to New York State, (b) 3% of "alternative entire net income" allocable to New York State, (c) 0.01% of the average value of assets allocable to New York State, or (d) nominal minimum tax. Entire net income is based on Federal taxable income, subject to certain modifications. Alternative entire net income is based on entire net income with certain modifications. 18 RISK FACTORS In addition to the various risks and uncertainties discussed throughout this Form 10-K, the Company is also subject to the following risk factors: Commercial Real Estate, Commercial Business and Multi-Family Loans Expose the Company to Increased Credit Risks The Company plans to continue its emphasis on the origination of commercial real estate, commercial business and multi-family loans. These types of loans generally expose a lender to greater risk of non-payment and loss than one- to four-family residential mortgage loans because repayment of the loans often depends on the successful operations and the income stream of the borrowers. Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Also, many of the Company's borrowers have more than one commercial real estate, commercial business or multi-family loan outstanding with the Company. Consequently, an adverse development with respect to one loan or one credit relationship can expose the Company to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan. If the Allowance for Credit Losses is Not Sufficient to Cover Actual Loan Losses, the Company's Earnings Could Decrease. The Company's loan customers may not repay their loans according to the terms of the loans, and the collateral securing the payment of those loans may be insufficient to pay any remaining loan balance. The Company may experience significant loan losses, which could have a material adverse effect on its operating results. Management makes various assumptions and judgments about the collectibility of the loan portfolio, including the creditworthiness of borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. In determining the amount of the allowance for credit losses, management relies on its loan quality reviews, experience and evaluation of economic conditions, among other factors. If the assumptions prove to be incorrect, the allowance for credit losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in additions to the allowance for credit losses. Material additions to the allowance for credit losses would materially decrease the Company's net income. Management's emphasis on continued diversification of the Company's loan portfolio through the origination of commercial real estate, multi-family and commercial business loans is one of the more significant factors management takes into account in evaluating the allowance for credit losses and provision for credit losses. As the Company further increases the amount of such types of loans, management may determine to make additional or increased provisions for credit losses, which could adversely affect the Company`s earnings. In addition, bank regulators periodically review the Company's allowance for credit losses and may require it to increase the provision for credit losses or recognize further loan charge-offs. Any increase in the allowance for credit losses or loan charge-offs as required by these regulatory authorities could have a material adverse effect on the Company's results of operations and financial condition. The Continuing Concentration of Loans in the Company's Primary Market Areas May Increase Risk The Company's success depends primarily on the general economic conditions in upstate New York. Unlike larger banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in upstate New York. The local economic conditions in upstate New York have a significant impact on the Company's loans, the ability of borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond the Company's control would impact these local economic conditions and could negatively affect the financial results of the Company's operations. Additionally, because the Company has a significant amount of commercial real estate loans, decreases in tenant occupancy may also have a negative effect on the ability of borrowers to make timely repayments of their loans, which would have an adverse impact on the Company's earnings. The Company targets its business lending and marketing strategy towards loans that primarily serve the banking and financial services needs of small- to medium-sized businesses in upstate New York. These small to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact these businesses, the Company's results of operations and financial condition may be adversely affected. 19 Changes in Interest Rates Could Adversely Affect the Company's Results of Operations and Financial Condition. The Company's results of operations and financial condition are significantly affected by changes in interest rates. The Company's results of operations depend substantially on net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense paid on interest-bearing liabilities. Because the Company's interest-bearing liabilities generally reprice or mature more quickly than its interest-earning assets, an increase in interest rates generally would tend to result in a decrease in net interest income. Management has taken steps to mitigate this risk such as holding fewer longer-term residential mortgages, as well as investing excess funds in short-term investments. As a result of these steps, as of December 31, 2002, the Company's net interest income simulation model indicates that the Company's net interest income would benefit from a rise in interest rates. See the "Quantitative and Qualitative Disclosure About Market Risk" section filed herewith in Part II, Item 7A, for further detail on the Company's interest rate risk management strategy. Changes in interest rates also affect the value of the Company's interest-earning assets, and in particular its securities portfolio. Generally, the value of securities fluctuates inversely with changes in interest rates. At December 31, 2002, investment and mortgage-backed securities available for sale totaled $632.4 million. Unrealized gains on securities available for sale, net of tax, amounted to $4.2 million and are reported as a separate component of stockholders' equity. Decreases in the fair value of securities available for sale, therefore, could have an adverse effect on stockholders' equity. The Company is also subject to reinvestment risk associated with changes in interest rates. Changes in interest rates may affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, the Company is subject to reinvestment risk to the extent that it is unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on existing loans and securities. Additionally, increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable rate loans. The Company's Ability to Grow May Be Limited if it Cannot Make Acquisitions In an effort to fully deploy the additional capital raised in the Offering, and to increase its loan and deposit growth, the Company will continue to seek to expand its banking and financial services franchise by acquiring other financial institutions or branches primarily in the Company's market areas. The Company's ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring and integrating them. The Company competes with other financial institutions with respect to proposed acquisitions and cannot assure that it will be able to identify attractive acquisition candidates or make acquisitions on favorable terms. In addition, management cannot assure that it can successfully integrate any acquired institutions or branches into the Company's organization in a timely or efficient manner, that it will be successful in retaining existing customer relationships or that it can achieve anticipated operating efficiencies. The Company May Have Difficulty Managing its Growth, Which May Divert Resources and Limit its Ability to Successfully Expand its Operations. The Company expects to continue to experience significant growth in assets, deposits, customers and operations. There can be no assurance that the Company's ongoing banking center expansion strategy will be accretive to earnings, or that it will be accretive to earnings within a reasonable period of time. Numerous factors contribute to the performance of a new banking center, such as a suitable location, qualified personnel and an effective marketing strategy. Additionally, it takes time for a new banking center to gather significant loans and deposits to generate enough income to offset its expenses, some of which, like salaries and occupancy expense, are relatively fixed costs. The Company has incurred substantial expenses to build its management team and personnel, develop its delivery systems and establish its infrastructure to support future growth. The Company's future success will depend on the ability of its officers and key employees to continue to implement and improve operational, financial and management controls, reporting systems and procedures, and to manage a growing number of client relationships. The Company may not be able to successfully implement improvements to its management information and control systems in an efficient or timely manner and may discover deficiencies in existing systems and controls. Thus, the Company cannot give assurances that its growth strategy will not place a strain on administrative and operational infrastructure or require the Company to incur additional expenditures beyond current projections to support future growth. The Company's future profitability will depend in part on its continued ability to grow and can give no assurance that it will be able to sustain its historical growth rate or even be able to grow at all. 20 Strong Competition Within the Company's Market Areas May Limit Growth and Profitability Competition in the banking and financial services industry is intense. In the Company's market areas, it competes with commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Many of these competitors (whether regional or national institutions) have substantially greater resources and lending limits than the Company and may offer certain services that it does not or cannot provide. The Company's profitability depends upon its continued ability to successfully compete in its market areas. The Company Operates in a Regulated Environment and May be Adversely Affected by Changes in Laws and Regulations. The Company is subject to extensive regulation, supervision and examination by the OTS, its chartering authority, and by the FDIC, as insurer of its deposits. As a savings and loan holding company, FNFG is subject to regulation and supervision by the OTS. Such regulation and supervision govern the activities in which a savings bank and its holding company may engage and are intended primarily for the protection of the insurance fund and depositors. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of a bank, the classification of assets by a bank and the adequacy of a bank's allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, could have a material impact on the Company's operations. The Company's operations are also subject to extensive regulation by other federal, state and local governmental authorities and is subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. Management believe's that the Company is in substantial compliance, in all material respects, with applicable federal, state and local laws, rules and regulations. Because the Company's business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There are currently proposed various laws, rules and regulations that, if adopted, would impact the Company's operations, including, among other things, matters pertaining to corporate governance, requirements for listing and maintenance on national securities exchanges and over the counter markets, and SEC rules pertaining to public reporting disclosures. In addition, the FASB, is considering changes which may require, among other things, expensing the costs relating to the issuance of stock options. There can be no assurance that these proposed laws, rules and regulations, or any other laws, rules or regulations, will not be adopted in the future, which could make compliance more difficult or expensive or otherwise adversely affect the Company's business, financial condition or prospects. Various Factors May Make Takeover Attempts More Difficult to Achieve The Company's Board of Directors has no current intention to sell control of FNFG. Provisions of the Company's certificate of incorporation and bylaws, federal regulations and various other factors may make it more difficult for companies or persons to acquire control of FNFG without the consent of its Board of Directors. The factors that may discourage takeover attempts or make them more difficult include: OTS regulations. OTS regulations prohibit, for three years following the completion of a mutual-to-stock conversion, the acquisition of more than 10% of any class of equity security of a converted institution without the prior approval of the OTS. In addition, the OTS has required, as a condition to approval of the conversion, that First Niagara maintain a federal thrift charter for a period of three years. Certificate of incorporation and statutory provisions. Provisions of the certificate of incorporation and bylaws of FNFG and Delaware law may make it more difficult and expensive to pursue a takeover attempt that management opposes. These provisions also make more difficult the removal of the current Board of Directors or management, or the appointment of new directors. These provisions include: limitations on voting rights of beneficial owners of more than 10% of FNFG common stock; supermajority voting requirements for certain business combinations; and the election of directors to staggered terms of three years. The Company's bylaws also contain provisions regarding the timing and content of stockholder proposals and nominations and qualification for service on the Board of Directors. Required change in control payments. The Company has entered into employment agreements with certain executive officers that will require payments to be made to them in the event their employment is terminated following a change in control of FNFG or First Niagara. These payments may have the effect of increasing the costs of acquiring FNFG, thereby discouraging future attempts. 21 The Company May Fail to Realize the Anticipated Benefits of the Merger with FLBC The success of the merger with FLBC will depend on, among other things, the Company's ability to realize anticipated cost savings, to combine the businesses of First Niagara and SBFL in a manner that does not materially disrupt the existing customer relationships of SBFL nor result in decreased revenues resulting from any loss of customers, and permits growth opportunities to occur. If the Company is not able to successfully achieve these objectives, the anticipated benefits of the merger may not be realized fully or at all or may take longer to realize than expected. It is possible that the integration process could result in the loss of key employees, the disruption of FLBC's ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the Company's ability to maintain relationships with customers and employees or to achieve the anticipated benefits of the merger. ITEM 2. PROPERTIES Both FNFG and First Niagara maintain their executive offices at an administrative center, located at 6950 South Transit Road, Lockport, New York. The administrative center, built in 1997, has 76 thousand square feet of space and is owned by First Niagara. In addition to its banking center network, First Niagara leases eight offices and owns eight buildings that it utilizes for its financial services subsidiaries, back office operations, training, tenant rental and storage. The total square footage for these facilities is approximately 199 thousand square feet, which are located in Cayuga, Cortland, Erie, Niagara and Oneida Counties. As of December 31, 2002, First Niagara conducted its business through 38 full-service banking centers, a loan production office and 75 ATM locations. Of the 38 banking centers, 13 are located in Erie County, 5 each in Cayuga, Niagara and Oneida Counties, 4 in Monroe County, 3 in Cortland County, 2 in Orleans County and 1 in Genesee County. Additionally, 22 of the banking centers are owned and 16 are leased. The loan production office is leased and located in Monroe County. Taking into consideration the merger of SBFL into First Niagara and the opening of an additional banking center in January 2003, First Niagara now conducts its business through 45 banking centers and 84 ATM's. The additional banking centers are located in Ontario (3), Seneca (1) and Tompkins (3) Counties, of which 5 are leased and 2 are owned. At December 31, 2002, the Company's premises and equipment had an aggregate net book value of $40.4 million. See note 6 of the "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data" for further detail on the Company's premises and equipment and operating leases. All of these properties are generally in good condition and are appropriate for their intended use. ITEM 3. LEGAL PROCEEDINGS The Company is not involved in any legal proceedings other than proceedings occurring in the ordinary course of business. 22 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS A special meeting of stockholders of FNFG was held on January 9, 2003. The Meeting was conducted for the purpose of considering and acting upon the approval of the plan of re-chartering and approval of the plan of conversion and reorganization. The following table reflects the tabulation of the votes with respect to each matter voted upon at the special meeting:
Number of votes (1) ----------------------------------------------------------- Matters considered For Against Abstain ----------------------------------------------------------------- ------------------- ---------------- -------------- (1) A plan of re-chartering by which 23,589,821 32,840 3,516 FNFG will convert its charter from a Delaware corporation to a Federal corporation. (2) A plan of conversion and 23,587,735 34,724 3,717 reorganization pursuant to which the MHC will be merged into First Niagara and FNFG will be succeeded by a new Delaware corporation with the same name. As part of the conversion and reorganization, shares of common stock representing the MHC's ownership interest in FNFG will be offered for sale in a subscription and community offering.
(1) For matters (1) and (2) there were no broker non-votes. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock of FNFG is traded under the symbol of FNFG on the NASDAQ National Market. At March 14, 2003, FNFG had 70,735,114 shares of common stock outstanding and had approximately 12,982 shareholders of record. During 2002, the high and low sales price of the common stock was $32.10 and $15.70, respectively. FNFG paid dividends of $0.43 per common share during the year ended December 31, 2002. Share and per share data have not been restated in this annual report on Form 10-K to give retroactive recognition to the 2.58681 exchange ratio applied on January 17, 2003. See additional information regarding the market price and dividends paid filed herewith in Part II, Item 6, "Selected Financial Data." The Company does not have any equity compensation program that was not approved by stockholders, other than its employee stock ownership plan. Set forth below is certain information as of December 31, 2002 regarding equity compensation to directors and employees of the Company that has been approved by stockholders.
Number of securities to be issued upon Equity compensation exercise of Number of securities plans approved by outstanding options Weighted average remaining available for stockholders and rights exercise price issuance under the plan --------------------------------------------------- -------------------- ---------------- ----------------------- First Niagara Financial Group, Inc. 1999 Stock Option Plan........................ 1,209,843 $11.18 17 First Niagara Financial Group, Inc. 1999 Recognition and Retention Plan................ 203,675 (1) Not Applicable 160,399 First Niagara Financial Group, Inc. 2002 Long-Term Incentive Stock Benefit Plan........ 116,900 $30.29 717,496 -------------- ------------ Total...................................... 1,530,418 $12.86 877,912 ============== ============
(1) Represents shares that have been granted but have not yet vested. 23 ITEM 6. SELECTED FINANCIAL DATA
At or for the year ended December 31, ------------------------------------------------------------------- 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- (Dollar and share amounts in thousands, except per share amounts) Selected financial condition data: Total assets ........................... $2,934,795 $2,857,946 $2,624,686 $1,711,712 $1,508,734 Loans, net ............................. 1,974,560 1,853,141 1,823,174 985,628 744,739 Securities available for sale: Mortgage-backed ..................... 340,319 339,881 302,334 384,329 392,975 Other ............................... 292,045 354,016 199,500 179,144 187,776 Deposits ............................... 2,129,469 1,990,830 1,906,351 1,113,302 1,060,897 Borrowings ............................. 397,135 559,040 429,567 335,645 142,597 Stockholders' equity ................... $ 283,696 $ 260,617 $ 244,540 $ 232,616 $ 263,825 Common shares outstanding (5) .......... 25,005 24,802 24,667 25,658 28,716 Selected operations data: Interest income ........................ $ 167,637 $ 178,368 $ 137,040 $ 107,814 $ 92,102 Interest expense ....................... 76,107 99,352 76,862 57,060 47,966 ---------- ---------- ---------- ---------- ---------- Net interest income ................. 91,530 79,016 60,178 50,754 44,136 Provision for credit losses ............ 6,824 4,160 2,258 2,466 2,084 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for credit losses ..................... 84,706 74,856 57,920 48,288 42,052 Noninterest income (1) ................. 49,691 42,072 34,090 27,688 9,182 Noninterest expense .................... 84,448 83,005 61,518 47,643 35,946 (4) ---------- ---------- ---------- ---------- ---------- Income before income taxes ............. 49,949 33,923 30,492 28,333 15,288 Income taxes (2) ....................... 19,154 12,703 10,973 9,893 4,906 ---------- ---------- ---------- ---------- ---------- Net income ........................... $ 30,795 $ 21,220 $ 19,519 $ 18,440 $ 10,382 (4) ========== ========== ========== ========== =========== Adjusted net income (3) .............. $ 30,795 $ 25,962 $ 21,633 $ 18,992 $ 10,382 ========== ========== ========== ========== =========== Stock and related per share data (5): Earnings per common share: Basic ............................... $ 1.24 $ 0.86 $ 0.79 $ 0.69 $ -- Diluted ............................. 1.21 0.85 0.79 0.69 -- Adjusted earnings per common share (3): Basic ............................... 1.24 1.05 0.87 0.71 -- Diluted ............................. 1.21 1.04 0.87 0.71 -- Cash dividends ........................ 0.43 0.36 0.28 0.14 0.06 Book value ............................ $ 11.35 $ 10.51 $ 9.91 $ 9.07 $ 9.19 Market Price (NASDAQ: FNFG): High ................................ $ 32.10 $ 17.90 $ 11.06 $ 11.13 $ 17.06 Low ................................. 15.70 10.75 8.25 9.00 8.38 Close ............................... 26.12 16.83 10.81 10.25 10.50
24
At or for the year ended December 31, ---------------------------------------------------------------------- 2002 2001 2000 1999 1998 ---- ---- ---- ---- ---- (Dollars in thousands) Selected financial ratios and other data: Performance ratios: Return on average assets ........................... 1.08% 0.79% 0.98% 1.13% 0.77 (4) Adjusted return on average assets (3) .............. 1.08 0.97 1.09 1.17 0.77 (4) Return on average equity ........................... 11.22 8.30 8.38 7.52 4.65 (4) Adjusted return on average equity (3) .............. 11.22 10.16 9.29 7.75 4.65 (4) Net interest rate spread ........................... 3.30 2.99 2.82 2.72 2.75 Net interest margin ................................ 3.52 3.25 3.26 3.33 3.48 As a percentage of average assets: Noninterest income (6) .......................... 1.78 1.57 1.73 1.67 0.67 Noninterest expense (3) ......................... 2.96 2.92 2.98 2.89 2.68 (4) ---- ---- ---- ---- ---- Net overhead .................................. 1.18 1.35 1.25 1.22 2.01 (4) Efficiency ratio (3)(6) ............................ 59.36 64.59 62.79 60.40 67.59 (4) Dividend payout ratio .............................. 34.68% 41.86% 35.44% 20.30% 16.60% Capital Ratios (7): Total risk-based capital ........................... 11.34% 11.36% 11.13% 23.56% 32.88% Tier 1 risk-based capital .......................... 10.27 10.27 9.96 22.40 31.67 Core (leverage) capital ............................ 6.54 6.71 6.78 13.51 18.05 Tangible capital ................................... 6.54 N/A N/A N/A N/A Ratio of stockholders' equity to total assets ...... 9.67% 9.12% 9.32% 13.59% 17.49% Asset quality ratios: Total non-accruing loans ........................... $ 7,478 $ 11,480 $ 6,483 $ 1,929 $ 3,296 Other non-performing assets ........................ 1,423 665 757 1,073 589 Allowance for credit losses ........................ 20,873 18,727 17,746 9,862 8,010 Net loan charge-offs ............................... $ 4,678 $ 3,179 $ 735 $ 614 $ 995 Total non-accruing loans to total loans ............ 0.38% 0.61% 0.35% 0.19% 0.44% Total non-performing assets as a percentage of total assets .......................................... 0.30 0.42 0.28 0.18 0.26 Allowance for credit losses to non-accruing loans .. 279.13 163.13 273.73 511.25 243.02 Allowance for credit losses to total loans ......... 1.05 1.00 0.96 0.99 1.06 Net charge-offs to average loans ................... 0.24% 0.17% 0.06% 0.07% 0.15% Other data: Number of banking centers .......................... 38 37 36 18 18 Full time equivalent employees ..................... 945 919 930 625 402
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2002 2001 ---------------------------------------- ---------------------------------------- Fourth Third Second First Fourth Third Second First quarter quarter quarter quarter quarter quarter quarter quarter -------- -------- -------- -------- -------- -------- -------- ------- Selected Quarterly Data: (In thousands except per share amounts) ----------------------- Interest income ........................... $40,654 $41,914 $42,536 $42,533 $43,774 $44,880 $44,627 $45,087 Interest expense .......................... 17,103 18,857 19,828 20,319 22,686 24,787 25,537 26,342 ------- ------- ------- ------- ------- ------- ------- ------- Net interest income .................. 23,551 23,057 22,708 22,214 21,088 20,093 19,090 18,745 Provision for credit losses ............... 1,835 1,729 1,730 1,530 1,150 1,110 860 1,040 ------- ------- ------- ------- ------- ------- ------- ------- Net interest income after provision for credit losses ...... 21,716 21,328 20,978 20,684 19,938 18,983 18,230 17,705 Noninterest income (1) .................... 13,936 11,980 12,565 11,210 11,112 10,171 10,257 10,532 Noninterest expense ....................... 22,167 21,019 20,154 20,235 20,393 18,552 19,083 19,299 Amortization of goodwill and other intangibles ............................... 224 227 211 211 1,421 1,421 1,418 1,418 ------- ------- ------- ------- ------- ------- ------- ------- Net income before income taxes ............................ 13,261 12,062 13,178 11,448 9,236 9,181 7,986 7,520 Income taxes (2) .......................... 4,859 4,126 6,171 3,998 3,440 3,432 2,973 2,858 ------- ------- ------- ------- ------- ------- ------- ------- Net income ........................... $ 8,402 $ 7,936 $ 7,007 $ 7,450 $ 5,796 $ 5,749 $ 5,013 $ 4,662 ======= ======= ======= ======= ======= ======= ======= ======= Adjusted net income (3) ............... $ 8,402 $ 7,936 $ 7,007 $ 7,450 $ 6,983 $ 6,936 $ 6,197 $ 5,846 ======= ======= ======= ======= ======= ======= ======= ======= Earnings per share (5): Basic ................................ $ 0.34 $ 0.32 $ 0.28 $ 0.30 $ 0.23 $ 0.23 $ 0.20 $ 0.19 Diluted .............................. 0.33 0.31 0.28 0.30 0.23 0.23 0.20 0.19 Adjusted earnings per common share (3) (5): Basic ................................. 0.34 0.32 0.28 0.30 0.28 0.28 0.25 0.24 Diluted ............................... 0.33 0.31 0.28 0.30 0.28 0.28 0.25 0.24 Market price (5) (NASDAQ:FNFG): High ................................. $ 32.04 $ 32.10 $ 29.99 $ 19.45 $ 17.45 $ 17.90 $ 15.99 $ 12.00 Low .................................. 25.95 26.66 17.00 15.70 15.20 12.76 10.75 10.75 Close ................................ 26.12 31.59 27.76 17.44 16.83 15.87 15.53 11.19 Cash Dividends (5) ........................ $ 0.11 $ 0.11 $ 0.11 $ 0.10 $ 0.10 $ 0.09 $ 0.09 $ 0.08
(1) On October 25, 2002, the Company sold its Lacona Banking Center. In connection with this transaction, $2.6 million of assets and $26.4 million of deposits were sold, which resulted in a pre-tax gain of $2.4 million. (2) First Niagara is subject to special provisions in the New York State tax law that allows it to deduct on its tax return bad debt expenses in excess of those actually incurred based on a specified formula ("excess reserve"). First Niagara is required to repay this excess reserve if it does not maintain a certain percentage of qualified assets (primarily residential mortgages and mortgage-backed securities) to total assets, as prescribed by the tax law. For accounting purposes, First Niagara is required to record a tax liability for the recapture of this excess reserve when it can no longer assert that the test will continue to be passed for the "foreseeable future." As a result of the Company's decision to combine its three subsidiary banks, First Niagara could no longer make this assertion and accordingly, recorded a $1.8 million tax liability in the second quarter of 2002. It is anticipated that this tax liability will be repaid over the next 10-15 years. (3) With the adoption of SFAS No. 142, "Goodwill and Other Intangible Assets" on January 1, 2002, the Company is no longer required to amortize goodwill. Accordingly, for the prior periods presented, goodwill amortization has been excluded from adjusted amounts for consistency purposes. The remaining amortization relates to identifiable intangible assets. (4) FNFG completed its initial public offering on April 17, 1998. In connection with the completion of the conversion, FNFG contributed $4.0 million, net of applicable income taxes to the First Niagara Foundation. Noninterest expense includes $6.8 million for the one-time contribution of cash and common stock. The following presentation excludes the effect of the contribution, and the earnings per share calculation includes pro forma earnings of $0.10 per share for the period January 1, 1998 through April 17, 1998. (Dollars in thousands except per share amounts): Net income................................ $14,366 Net income per share (5): Basic.................................. $ 0.50 Diluted................................ $ 0.50 Return on average assets.................. 1.07% Return on average equity.................. 6.43% As a percentage of average assets: Noninterest expense.................... 2.18% Net overhead........................... 1.50% Efficiency ratio.......................... 54.90% (5) Share and per share data have not been restated to give retroactive recognition to the 2.58681 exchange ratio applied in the January 17, 2003 conversion. (6) Excludes net gain/loss on securities available for sale. (7) Effective November 8, 2002, First Niagara converted to a federal charter subject to OTS capital requirements. These capital requirements apply only to First Niagara, and do not consider additional capital retained by FNFG. Prior to converting to federal charters, FNFG and First Niagara were required to maintain minimum capital ratios calculated in a similar manner to, but not entirely the same as, the framework of the OTS. Amounts prior to 2002 have not been recomputed to reflect OTS requirements. 26 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The following is an analysis of the financial condition and results of operations of the Company, which should be read in conjunction with the consolidated financial statements and related notes filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data." The Company's results of operations are dependent primarily on net interest income, the provision for credit losses, noninterest income and noninterest expenses. Additionally, results of operations are significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and actions of regulatory authorities. As discussed further in note 2 of the "Notes to Consolidated Financial Statements," as a result of the Conversion and Offering former public stockholders of FNFG received an exchange ratio of 2.58681 new shares for each share of FNFG held as of the close of business on January 17, 2003. Share and per share data have not been restated in this annual report on Form 10-K to give retroactive recognition to the exchange ratio. ANALYSIS OF FINANCIAL CONDITION Overview Total assets increased to $2.93 billion at December 31, 2002 from $2.86 billion at December 31, 2001. This $76.8 million, or 3%, increase was primarily a result of a $15.9 million and $121.4 million increase in cash and cash equivalents and net loans, respectively, partially offset by a decrease in securities available for sale of $61.5 million. The increase in cash and cash equivalents is mainly attributable to the decrease in securities available for sale and a $138.6 million increase in deposits from December 31, 2001 to December 31, 2002, the excess funds from which were invested in short-term assets in anticipation of rising interest rates. During 2002, the Company continued to shift its loan portfolio mix from one- to four-family real estate loans to higher yielding commercial real estate, multi-family, commercial construction and commercial business loans (commercial loans). As a result, commercial loans increased $168.8 million or 29% from December 31, 2001 to December 31, 2002, while one- to four-family real estate loans decreased $55.7 million or 6% during the same period. During 2001, total assets increased $233.3 million, or 9%, from $2.62 billion at December 31, 2000, primarily due to an increase in net loans and investment securities available for sale of $30.0 million and $192.1 million, respectively. Total liabilities increased from $2.4 billion at December 31, 2000 to $2.6 billion at December 31, 2001. Of this $217.2 million increase, approximately $84.5 million was attributable to growth in deposits, while $129.5 million can be attributed to an increase in borrowings. Lending Activities Loan Portfolio Composition. Set forth below is selected information concerning the composition of the Company's loan portfolio in dollar amounts and in percentages as of the dates indicated.
At December 31, ------------------------------------------------------------------------------------- 2002 2001 2000 1999 -------------------- -------------------- -------------------- ------------------- Amount Percent Amount Percent Amount Percent Amount Percent ---------- ------- ---------- ------- ------- ------- --------- ------- (Dollars in thousands) Real estate loans: One- to four-family ...... $ 927,453 46.54% $ 980,638 52.44% $1,089,607 59.21% $ 609,742 61.55% Home equity .............. 136,986 6.87 114,443 6.12 104,254 5.67 22,499 2.27 Multi-family ............. 170,357 8.55 133,439 7.13 111,668 6.07 74,652 7.54 Commercial ............... 303,136 15.21 259,457 13.87 217,759 11.83 120,758 12.19 Construction (1) ......... 107,200 5.38 64,502 3.45 35,059 1.91 28,413 2.87 ---------- ------ ---------- ------ ---------- ------ --------- ------ Total real estate loans ..... 1,645,132 82.55 1,552,479 83.01 1,558,347 84.69 856,064 86.42 Total consumer loans ........ 169,155 8.49 182,126 9.74 188,129 10.22 110,233 11.13 Total commercial business loans .................... 178,555 8.96 135,621 7.25 93,730 5.09 24,301 2.45 ---------- ------ ---------- ------ ---------- ------ --------- ------ Total loans ................. 1,992,842 100.00% 1,870,226 100.00% 1,840,206 100.00% 990,598 100.00% ========== ====== ========== ====== ========== ====== ========= ====== Net deferred costs and unearned discounts ....... 2,591 1,642 714 4,892 Allowance for credit losses . (20,873) (18,727) (17,746) (9,862) ---------- ---------- ---------- --------- Total loans, net ............ $1,974,560 $1,853,141 $1,823,174 $ 985,628 ========== ========== ========== ========= At December 31, -------------------- 1998 -------------------- Amount Percent ---------- ------- (Dollars in thousands) Real estate loans: One- to four-family ...... $ 456,197 60.97% Home equity .............. 15,520 2.07 Multi-family ............. 72,672 9.71 Commercial ............... 98,693 13.19 Construction (1) ......... 19,476 2.60 --------- ------ Total real estate loans ..... 662,558 88.54 Total consumer loans ........ 79,059 10.58 Total commercial business loans .................... 6,616 0.88 --------- ------ Total loans ................. 748,233 100.00% ========= ====== Net deferred costs and unearned discounts ....... 4,516 Allowance for credit losses . (8,010) --------- Total loans, net ............ $ 744,739 ========
(1) Construction loans consist primarily of commercial construction loans and to a lesser extent residential construction loans. See note 5 to the Consolidated Financial Statements. 27 Total loans outstanding at December 31, 2002 increased 7% to $1.99 billion from the December 31, 2001 balance of $1.87 billion. During 2002, the Company continued to shift its portfolio mix from one- to four-family real estate loans to higher yielding commercial real estate and commercial business loans to improve net interest margins and to diversify the loan portfolio. Commercial loans increased $168.8 million or 29% from December 31, 2001 to December 31, 2002, while one- to four-family real estate loans decreased $55.7 million or 6% during the same period. This shift was primarily achieved through continued emphasis on the origination of variable-rate commercial loans through the Company's Commercial Business Banking unit and management's asset/liability strategy of selling the majority of longer-term fixed rate residential mortgage loans originated, which should benefit the Company during periods of higher interest rates. Additionally, during 2002 home equity loans increased $22.5 million, or 20%, as a result of the low interest rate environment and sales efforts by the Company, while consumer loans decreased $13.0 million due to decreased emphasis on these types of loans. During 2001, loans increased $30.0 million from $1.84 billion at December 31, 2000. This increase is mainly attributable to commercial loans, which increased $132.6 million, or 29% for 2001, which was almost entirely offset by a decrease in one- to four-family residential mortgage loans of $106.7 million for the same period. These variances were a result of management's strategy, which began in 2000, of transforming the Company's loan portfolio to become more commercial bank-like, as discussed above. Additionally, home equity loans increased $10.2 million, or 10%, from December 31, 2000 to December 31, 2001. Allocation of Allowance for Credit Losses. The following table sets forth the allocation of the allowance for credit losses by loan category as of the dates indicated.
At December 31, ------------------------------------------------------------------------------- 2002 2001 2000 ---------------------- ----------------------- ---------------------- Percent Percent Percent of loans of loans of loans Amount of in each Amount of in each Amount of in each allowance category allowance category allowance category for credit to total for credit to total for credit to total losses loans losses loans losses loans --------- -------- --------- -------- ---------- ---------- (Dollars in thousands) One- to four-family ......................... $ 1,828 47% $ 1,996 53% $ 3,248 59% Home equity ................................. 524 7 614 6 885 6 Commercial real estate and multi-family ..... 4,917 29 4,824 24 4,027 19 Consumer .................................... 3,811 8 3,379 10 3,014 11 Commercial business ......................... 7,329 9 4,883 7 4,307 5 Unallocated ................................. 2,464 -- 3,031 -- 2,265 -- ------- --- ------- --- ------- --- Total .................................... $20,873 100% $18,727 100% $17,746 100% ======= === ======= === ======= === At December 31, ------------------------------------------------- 1999 1998 ------------------------ ---------------------- Percent Percent of loans of loans Amount of in each Amount of in each allowance category allowance category for credit to total for credit to total losses loans losses loans --------- --------- --------- -------- (Dollars in thousands) One- to four-family ......................... $1,522 62% $1,155 61% Home equity ................................. 352 2 237 2 Commercial real estate and multi-family ..... 1,944 22 1,809 25 Consumer .................................... 1,739 12 1,177 11 Commercial business ......................... 1,790 2 599 1 Unallocated ................................. 2,515 -- 3,033 -- ------ --- ------ --- Total .................................... $9,862 100% $8,010 100% ====== === ====== ===
28 The allowance for credit losses increased $2.1 million, or 11%, from $18.8 million at December 31, 2001 to $20.9 million at December 31, 2002. This increase is primarily attributable to a $2.4 million increase in the reserve on commercial business loans due to a 32% increase in the aggregate balance of these loans from the end of 2001, as well as the increased charge-offs experienced on these loans in 2002. Additionally, the amount of the allowance for credit losses allocated to consumer loans increased $432 thousand from the end of 2001 to the end of 2002 as a result of the increased charge-offs relating to the Company's overdraft protection service. These increases were partially offset by a decrease in the amount of the allowance for credit losses allocated to one- to four-family and commercial real estate loans as a result of a decline in the aggregate balance and the amount of non-accrual loans related to these loans, respectively. The allowance for credit losses increased as a percentage of total loans to 1.05% at December 31, 2002, compared to 1.00% at December 31, 2001. The allowance for credit losses increased $981 thousand, or 6%, from December 31, 2000 to December 31, 2001. This increase can primarily be attributed to the increase in delinquent and non-accrual commercial loans in 2001. Additionally, the unallocated reserve increased $766 thousand as a result of the economic downturn in 2001 and the trend observed near the end of 2001 of increased balances in classified and non-accruing loans. These increases were partially offset by a decrease in the amount of allowance for credit losses allocated to one- to four-family residential mortgage loans primarily due to the decline in the aggregate balance of these loans. While management uses available information to recognize losses on loans, future credit loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for credit losses and may require the Company to recognize additional provisions based on their judgment of information available to them at the time of their examination. To the best of management's knowledge, the allowance for credit losses includes all known and inherent losses at each reporting date that are both probable and reasonable to estimate. However, there can be no assurance that the allowance for loan losses will be adequate to cover all losses that may in fact be realized in the future or that additional provisions for loan losses will not be required. Non-Accruing Loans and Non-Performing Assets. The following table sets forth information regarding non-accruing loans and other non-performing assets.
At December 31, --------------------------------------------------- 2002 2001 2000 1999 1998 ------ ------- ------ ------ ------ (Dollars in thousands) Non-accruing loans (1): Real estate: One- to four-family .............. $4,071 $ 4,833 $3,543 $ 974 $1,459 Home equity ...................... 332 491 641 130 13 Commercial and multi-family ...... 1,225 2,402 926 640 1,706 Consumer ............................ 652 510 515 33 62 Commercial business ................. 1,198 3,244 858 152 56 ------ ------- ------ ------ ------ Total non-accruing loans ............... 7,478 11,480 6,483 1,929 3,296 ------ ------- ------ ------ ------ Non-performing assets: Real estate owned (2) ............... 1,423 665 757 1,073 589 ------ ------- ------ ------ ------ Total non-performing assets (3) ........ $8,901 $12,145 $7,240 $3,002 $3,885 ====== ======= ====== ====== ====== Total non-performing assets as a percentage of total assets (3) ...... 0.30% 0.42% 0.28% 0.18% 0.26% ====== ======= ====== ====== ====== Total non-accruing loans to total loans (3) ..................... 0.38% 0.61% 0.35% 0.19% 0.44% ====== ======= ====== ====== ======
(1) Loans generally are placed on non-accrual status when they become 90 days or more past due or if they have been identified by the Company as presenting uncertainty with respect to the collectibility of interest or principal. (2) Real estate owned balances are shown net of related allowances. (3) Excludes loans that are 90 days or more past due but are still accruing interest, which is primarily comprised of loans that have matured and the Company has not formally extended the maturity date. Regular principal and interest payments continue in accordance with the original terms of the loan. The Company continued to accrue interest on these loans as long as regular payments received were less than 90 days delinquent. These loans totaled $510 thousand, $221 thousand and $379 thousand at December 31, 2001, 2000 and 1999, respectively. There were no such loans at December 31, 2002 and 1998. 29 Non-accruing loans were $7.5 million at December 31, 2002 compared to $11.5 million at December 31, 2001. This decrease is the result of the Company's continued focus on credit quality and resolving classified credits, as well as the "deed in lieu" transfer to REO of a commercial real estate participation loan in the fourth quarter of 2002. This transfer resulted in a $1.9 million decrease in non-accrual loans from December 31, 2001 and caused REO and net charge-offs at and for the year ended December 31, 2002 to increase $975 thousand and $889 thousand, respectively. Interest income that would have been recorded if non-accrual loans had been performing in accordance with their original terms amounted to $182 thousand for the year ended December 31, 2002. The ratio of non-accruing loans to total loans decreased to 0.38% at December 31, 2002 from 0.61% at December 31, 2001. Nonaccrual loans increased $5.0 million from December 31, 2000 to December 31, 2001. This increase was primarily attributable to the higher level of commercial loans at the end of 2001 compared to 2000. Interest income that would have been recorded if non-accrual loans had been performing in accordance with their original terms amounted to $604 thousand for the year ended December 31, 2001. The ratio of non-accruing loans to total loans increased to 0.61% at December 31, 2001 from 0.35% at December 31, 2000. Investing Activities Securities Portfolio. At December 31, 2002, all of the Company's security investments were classified as available for sale in order to maintain flexibility in satisfying future investment and lending requirements. The following table sets forth certain information with respect to the amortized cost and fair values of the Company's portfolio as of the dates indicated.
At December 31, --------------------------------------------------------------------- 2002 2001 2000 -------------------- -------------------- ---------------------- Amortized Fair Amortized Fair Amortized Fair cost value cost value cost value ---------- -------- ---------- -------- ----------- --------- Investment securities available for sale: (Dollars in thousands) Debt securities: U.S. Treasury ............................ $140,060 $140,054 $164,992 $165,120 $ 37,970 $ 38,216 U.S. Government agencies ................. 89,522 90,529 79,419 81,016 56,379 56,928 Corporate ................................ 14,665 14,563 27,264 27,026 8,209 8,193 States and political subdivisions ........ 32,957 34,566 26,696 27,208 23,548 23,948 ---------- -------- ---------- -------- ---------- -------- Total debt securities .................... 277,204 279,712 298,371 300,370 126,106 127,285 ---------- -------- ---------- -------- ---------- -------- Asset-backed securities ....................... 3,776 3,837 28,062 28,850 41,783 42,007 Equity securities ............................. 3,677 3,497 21,530 20,325 23,547 25,764 Other securities .............................. 4,953 4,999 4,453 4,471 4,453 4,444 ---------- -------- ---------- -------- ---------- -------- Total investment securities ............. $289,610 $292,045 $352,416 $354,016 $195,889 $199,500 ========== ======== ========== ======== ========== ======== Average remaining life of investment securities (1) ............................. 2.31 years 2.09 years 3.75 years ========== ========== ========== Mortgage-backed securities: FHLMC .................................... $ 51,024 $ 52,960 $ 37,081 $ 38,339 $ 48,891 $ 49,526 GNMA ..................................... 9,910 10,569 16,094 16,799 22,645 23,016 FNMA ..................................... 12,619 13,790 18,213 19,169 18,668 19,447 CMOs ..................................... 262,161 263,000 265,489 265,574 215,181 210,345 ---------- -------- ---------- -------- ---------- -------- Total mortgage-backed securities .......... $335,714 $340,319 $336,877 $339,881 $305,385 $302,334 ========== ======== ========== ======== ========== ======== Average remaining life of mortgage- backed securities (1) ...................... 1.64 years 4.82 years 6.41 years ========== ========== ========== Net unrealized gains on available for sale securities .................................. $ 7,040 $ 4,604 $ 560 ---------- ---------- ---------- Total securities available for sale .... $632,364 $632,364 $693,897 $693,897 $501,834 $501,834 ========== ======== ========== ======== ========== ======== Average remaining life of investment securities available for sale (1) .......... 1.94 years 3.48 years 5.46 years ========== ========== ==========
(1) Average remaining life does not include common stock or other securities available for sale and is computed utilizing estimated maturities and prepayment assumptions. 30 The Company's investment securities available for sale decreased from $693.9 million at December 31, 2001 to $632.4 million at December 31, 2002. This $61.5 million decrease was primarily a result of the Company restructuring its investment portfolio in 2002 by selling longer-term asset and mortgage backed securities and equity securities as part of its asset/liability management strategy and in order to comply with OTS regulations, which doesn't allow First Niagara to hold equity securities. Additionally, any excess funds generated during the year were used to purchase short-term investments (included in securities available for sale and federal funds sold and other short-term investments) in order to better match the maturities of the Company's short-term liabilities. As a result, the average estimated remaining life of the investment securities portfolio decreased from 3.48 years at December 31, 2001 to 1.94 years at December 31, 2002, which should benefit the Company during periods of higher interest rates. The unrealized gain on investment securities increased $2.4 million during 2002 mainly due to the declining interest rate environment, which caused the Company's fixed income securities to appreciate in value. During 2001, the Company's investment securities portfolio increased $192.1 million from $501.8 million at December 31, 2000. This increase primarily resulted from the purchase of $155.0 million of U.S. Treasury securities in late 2001. Additionally, investment securities increased due to the investment of excess funds generated from the sale and prepayment of fixed rate residential real estate loans and the increase in deposits during 2001. These funds were invested in shorter-term investments (included in securities available for sale and federal funds sold and other short-term investments) in order to reduce the Company's interest rate risk. The unrealized gain on investment securities increased $4.0 million during 2001 mainly due to the declining interest rate environment. Funding Activities Deposits. The following tables set forth information regarding the average daily balance and rate of deposits by type for the years indicated.
For the year ended December 31, ------------------------------------------------------------------------------------------------------ 2002 2001 2000 -------------------------------- -------------------------------- ------------------------------------ Percent of Percent of Percent of total Weighted total Weighted total Weighted Average average average Average average average Average average average balance deposits rate balance deposits rate balance deposits rate ----------- ---------- -------- ---------- ---------- -------- ---------- ---------- -------- (Dollars in thousands) Money market accounts ...... $ 344,580 16.29% 1.87% $ 391,745 20.10% 3.66% $ 295,588 21.56% 5.02% Savings accounts ........... 590,965 27.93 2.16 417,256 21.41 2.62 338,475 24.69 2.77 NOW accounts ............... 162,725 7.69 0.83 153,373 7.87 1.01 116,190 8.48 1.02 Noninterest-bearing accounts 115,977 5.48 -- 90,023 4.62 -- 46,799 3.41 -- ---------- ------ ---------- ----- ---------- ------ Total transaction accounts .............. 1,214,247 57.39 1.69 1,052,397 54.00 2.55 797,052 58.14 3.19 Mortgagors' payments held in escrow ................... 17,579 0.83 1.69 19,198 0.98 1.71 14,959 1.09 1.74 ---------- ------ ---------- ----- ---------- ------ Total ................... 1,231,826 58.22 1.69 1,071,595 54.98 2.53 812,011 59.23 3.16 ---------- ------ ---------- ----- ---------- ------ Certificates of deposit: Less than 6 months ......... 292,232 13.81 3.77 342,596 17.58 5.55 201,279 14.67 N/A Over 6 through 12 months ... 231,044 10.92 3.45 241,709 12.40 5.34 168,686 12.31 N/A Over 12 through 24 months .. 150,986 7.14 3.72 100,549 5.16 5.20 83,437 6.09 N/A Over 24 months ............. 38,128 1.80 4.85 34,295 1.76 5.56 18,046 1.32 N/A Over $100,000 .............. 171,477 8.11 3.70 158,279 8.12 5.18 87,412 6.38 N/A ---------- ------ ---------- ----- ---------- ------ Total certificates of deposit ............... 883,867 41.78 3.71 877,428 45.02 5.39 558,860 40.77 5.47 ---------- ------ ---------- ----- ---------- ------ Total average deposits .. $2,115,693 100.00% 2.54% $1,949,023 100.00% 3.82% $1,370,871 100.00% 4.10% ========== ====== ========== ====== ========== ======
N/A - Information is not available. 31 Total deposits increased $138.6 million from $1.99 billion at December 31, 2001 to $2.13 billion at December 31, 2002. This increase was a result of the Company's focus on increasing its customer base, which included the opening of two new banking centers and the introduction of a money market savings account in 2002. As a result, savings accounts increased $182.1 million from December 31, 2001 to December 31, 2002. Additionally, non-interest bearing deposits increased $24.3 million or 22% during 2002 as a result of a "totally free" checking product introduced in late 2001, an increase in commercial business relationships and the popularity of the Company's bi-weekly mortgage product, which generally results in new deposit relationships, as customers have loan repayments made directly from a deposit account. These increases were partially offset by the sale of the Lacona Banking Center in 2002, which was outside of the Company's strategic market area, and resulted in a $26.4 million deposit outflow. Total deposits increased $84.5 million, or 4% during 2001 from $1.91 billion at December 31, 2000. This increase was generally across all product lines and was a result of the Company's focus on increasing its customer base, which included the opening of a new banking center. Additionally, noninterest-bearing deposits increased $23.7 million during 2001 primarily due to an increase in commercial business accounts and the popularity of the Company's bi-weekly mortgage product. Borrowings. The following table sets forth certain information as to the Company's borrowings for the years indicated.
At or for the year ended December 31, ------------------------------------- 2002 2001 2000 -------- -------- -------- (Dollars in thousands) Period end balance: FHLB advances ............................ $236,003 $315,416 $294,876 Reverse repurchase agreements ............ 155,132 235,124 118,691 Other borrowings ......................... 6,000 8,500 16,000 -------- -------- -------- Total borrowings ......................... $397,135 $559,040 $429,567 ======== ======== ======== Maximum balance: FHLB advances ............................ $315,416 $315,416 $314,043 Reverse repurchase agreements ............ 235,124 235,124 137,365 Other borrowings ......................... 8,500 16,000 16,000 Average balance: FHLB advances ............................ $249,974 $277,813 $224,014 Reverse repurchase agreements ............ 157,890 136,452 121,339 Other borrowings ......................... 6,201 11,278 2,606 Period end weighted average interest rate: FHLB advances ............................ 5.52% 5.01% 6.05% Reverse repurchase agreements ............ 5.09% 3.97% 5.77% Other borrowings ......................... 2.19% 3.01% 8.64%
Borrowed funds decreased to $397.1 million at December 31, 2002 from $559.0 million at December 31, 2001. This $161.9 million decrease, as well as the increase in period end weighted average interest rate, was the result of the maturity of $140.0 million of FHLB advances and reverse repurchase agreements during 2002, which had been utilized to purchase U.S. Treasury securities at the end of 2001. Excluding these funds, borrowings decreased $21.9 million as cash on hand, as well as funds from the decrease in investment securities and the increase in deposits for 2002, were more than adequate to meet the funding needs of the Company. During 2001, borrowed funds increased $129.5 million from $429.6 million at December 31, 2000. This increase was almost exclusively attributable to the $140.0 million of FHLB advances and reverse repurchase agreements utilized to purchase U.S. Treasury securities near the end of 2001. Excluding these funds, borrowings decreased $10.5 million from December 31, 2000 to December 31, 2001. 32 Equity Activities Stockholders' equity increased to $283.7 million at December 31, 2002 compared to $260.6 million at December 31, 2001. This increase was primarily attributable to net income during 2002 of $30.8 million partially offset by common stock dividends declared of $0.43 per share, which reduced stockholders' equity by $10.8 million. During 2002, stockholders' equity also increased $3.6 million from the exercise of stock options and vesting of restricted stock and ESOP shares. Additionally, a decrease in interest rates during 2002 resulted in a $1.5 million (net of tax) increase in the unrealized gain on investment securities available for sale included in accumulated other comprehensive income. This increase was partially offset by a $2.2 million (net of tax) reduction of accumulated other comprehensive income related to the minimum pension liability recorded by the Company due to the underfunded status of its defined benefit pension plan. This underfunded status was primarily a result of the weak equity markets and the lower interest rate environment over the last several years, which caused the fair value of the Company's pension plan assets to fall below the plans' accumulated benefit obligation. Accordingly, in the fourth quarter of 2002, the Company was required to record an additional minimum pension liability and a charge to stockholders' equity. As of December 31, 2002, the Company has met all ERISA minimum funding requirements. See note 16 of the "Notes to Consolidated Financial Statements" filed herewith in Part II, Item 8, "Financial Statements and Supplementary Data" for further details. The increase in stockholders' equity of $16.1 million from December 31, 2000 to December 31, 2001 was primarily attributable to net income of $21.2 million. Additionally, accumulated other comprehensive income increased $2.4 million as a result of the increase in the unrealized gain on securities available for sale. These increases were partially offset by the payment of dividends of $9.0 million during 2001. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2002 AND DECEMBER 31, 2001 Net Income Net income for the year ended December 31, 2002 increased 45% to $30.8 million, or $1.21 per diluted share from $21.2 million, or $0.85 per diluted share for the year ended December 31, 2001. On January 1, 2002, the Company was required to adopt a new accounting standard, which no longer permits goodwill to be amortized. Adjusting 2001 amounts to exclude the effects of goodwill amortization, similar to the 2002 results, net income for 2002 increased $4.8 million or 19% from 2001. Net income for 2002 represented an annualized return on average stockholders' equity of 11.22% as compared to 10.16% for 2001, adjusted for goodwill amortization. Net income growth in 2002 can mainly be attributed to a $12.5 million increase in net interest income as a result of the declining interest rate environment in 2002, expansion of the Company's noninterest income and effective cost control. During 2002 the Company recorded a $1.8 million tax charge related to the recapture of excess bad debt reserves for New York State tax purposes, triggered by its decision to combine its three banking subsidiaries. Additionally, during 2002 the Company realized $998 thousand in gains from the curtailment of its defined benefit pension plan, a $2.4 million gain from the sale of its Lacona Banking Center and recorded $1.0 million of losses from investment securities. 33 Net Interest Income Average Balance Sheet. The following table sets forth certain information relating to the Company's consolidated statements of financial condition and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the years indicated. Such yields and rates were derived by dividing interest income or expense by the average balances of interest-earning assets or interest-bearing liabilities, respectively, for the years shown. No tax equivalent adjustments were made. All average balances are average daily balances. Non-accruing loans have been excluded from the yield calculations in this table.
For the year ended December 31, ------------------------------------------------------------------------ 2002 2001 Average Interest Average Interest outstanding earned/ outstanding earned/ balance paid Yield/rate balance paid Yield/rate ------------ ------- ---------- ---------- ------- ---------- (Dollars in thousands) Interest-earning assets: Federal funds sold and other short-term investments ................................. $ 137,639 $ 2,446 1.78% $ 39,533 $ 1,503 3.80% Investment securities (1) ....................... 192,992 7,496 3.88 206,415 10,888 5.27 Mortgage-backed securities (1) .................. 320,569 16,100 5.02 312,863 20,138 6.44 Loans (2) ....................................... 1,920,101 140,459 7.32 1,845,812 144,274 7.82 Other interest-earning assets (3) ............... 25,841 1,136 4.40 24,544 1,565 6.38 ----------- -------- ------ ----------- -------- ----- Total interest-earning assets ................. 2,597,142 $167,637 6.45% 2,429,167 $178,368 7.34 ----------- -------- ------ ----------- -------- ----- Allowance for credit losses ....................... (19,815) (18,469) Other noninterest-earning assets (4)(5) ........... 275,472 268,633 ----------- ----------- Total assets .................................. $ 2,852,799 $ 2,679,331 =========== =========== Interest-bearing liabilities: Savings accounts ................................ $ 590,965 $ 12,750 2.16% $ 417,256 $ 10,919 2.62% NOW and money market accounts ................... 507,305 7,791 1.54 545,118 15,878 2.91 Certificates of deposit ......................... 883,867 32,774 3.71 877,428 47,284 5.39 Mortgagors' payments held in escrow ............. 17,579 296 1.69 19,198 328 1.71 Borrowed funds .................................. 414,065 22,496 5.43 425,543 24,943 5.86 ----------- -------- ------ ----------- -------- ----- Total interest-bearing liabilities ............ 2,413,781 $ 76,107 3.15% 2,284,543 $ 99,352 4.35% ----------- -------- ------ ----------- -------- ----- Noninterest-bearing deposits ...................... 115,977 90,023 Other noninterest-bearing liabilities ............. 48,508 49,128 ----------- ----------- Total liabilities ............................. 2,578,266 2,423,694 Stockholders' equity (4) .......................... 274,533 255,637 ----------- ----------- Total liabilities and stockholders' equity .................. $ 2,852,799 $ 2,679,331 =========== =========== Net interest income ............................... $ 91,530 $ 79,016 ======== ======== Net interest rate spread .......................... 3.30% 2.99% ====== ===== Net earning assets ................................ $ 183,361 $ 144,624 =========== =========== Net interest income as a percentage of average interest-earning assets ....................... 3.52% 3.25% ======== ======== Ratio of average interest-earning assets to average interest-bearing liabilities .................. 107.60% 106.33% =========== =========== For the year ended December 31, ------------------------------------ 2000 Average Interest outstanding earned/ balance paid Yield/rate ----------- -------- ---------- (Dollars in thousands) Interest-earning assets: Federal funds sold and other short- term investments ................................. $ 12,312 $ 771 6.26% Investment securities (1) ....................... 159,464 8,804 5.52 Mortgage-backed securities (1) .................. 361,890 24,045 6.64 Loans (2) ....................................... 1,288,978 101,825 7.90 Other interest-earning assets (3) ............... 24,186 1,595 6.59 ----------- -------- ----- Total interest-earning assets ................. 1,846,830 $137,040 7.42% ----------- -------- ----- Allowance for credit losses ....................... (12,766) Other noninterest-earning assets (4)(5) ........... 157,968 ----------- Total assets .................................. $ 1,992,032 =========== Interest-bearing liabilities: Savings accounts ................................ $ 338,475 $ 9,380 2.77% NOW and money market accounts ................... 411,778 16,038 3.89 Certificates of deposit ......................... 558,860 30,593 5.47 Mortgagors' payments held in escrow ............. 14,959 261 1.74 Borrowed funds .................................. 347,959 20,590 5.92 ----------- -------- ----- Total interest-bearing liabilities ............ 1,672,031 $ 76,862 4.60% ----------- -------- ----- Noninterest-bearing deposits ...................... 46,799 Other noninterest-bearing liabilities ............. 40,253 ----------- Total liabilities ............................. 1,759,083 Stockholders' equity (4) .......................... 232,949 ----------- Total liabilities and stockholders' equity .................. $ 1,992,032 =========== Net interest income ............................... $ 60,178 ======== Net interest rate spread .......................... 2.82% ===== Net earning assets ................................ $ 174,799 =========== Net interest income as a percentage of average interest-earning assets ....................... 3.26% ======== Ratio of average interest-earning assets to average interest-bearing liabilities .................. 110.45% ========
(1) Amounts shown are at amortized cost. (2) Net of deferred costs, unearned discounts, negative balance deposits reclassified to loans and non-accruing loans. (3) Primarily includes FHLB stock. (4) Includes unrealized gains/losses on securities available for sale. (5) Includes bank-owned life insurance, earnings from which are reflected in other noninterest income, and non-accruing loans. 34 Net interest income rose 16% to $91.5 million for the year ended December 31, 2002 from $79.0 million for the year ended December 31, 2001. Additionally, the Company's net interest margin increased to 3.52% for 2002 from 3.25% for 2001. The increase in net interest income and margin resulted primarily from a 31 basis point increase in the net interest rate spread, as the Company's interest-bearing liabilities repriced faster than its interest-earning assets during the declining rate environment in 2002. Additionally, the Company's net interest rate spread benefited in 2002 from the redeployment of funds from lower yielding residential mortgages into higher yielding commercial loans. The increase in net interest income and margin can also be attributed to the increase in average net earning assets from $144.6 million for 2001 to $183.4 million for 2002, which was primarily funded by a $26.0 million, increase in average noninterest-bearing demand deposits. Management anticipates that the Company's net interest margin will decline in 2003 as the proceeds from the stock offering are invested in lower yielding short-term investments with minimal extension risk, and as the Company's assets begin to reprice faster than its liabilities due to the continuation of the low interest rate environment and competitive interest rate floors on the Company's deposit products. Rate/Volume Analysis. The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the years indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
For the year ended December 31, -------------------------------------------------------------------- 2002 vs. 2001 2001 vs. 2000 ------------------------------- ------------------------------- Increase/(decrease) Total Increase/(decrease) Total due to increase due to increase Volume Rate (decrease) Volume Rate (decrease) ------ ---- ---------- ------ ---- ---------- (In thousands) Interest-earning assets: Federal funds sold and other short-term investments .. $ 2,095 $ (1,152) $ 943 $ 1,136 $ (404) $ 732 Investment securities ................................ (671) (2,721) (3,392) 2,499 (415) 2,084 Mortgage-backed securities ........................... 485 (4,523) (4,038) (3,185) (722) (3,907) Loans ................................................ 5,663 (9,478) (3,815) 43,488 (1,039) 42,449 Other interest-earning assets ........................ 79 (508) (429) 23 (53) (30) -------- -------- -------- -------- --------- -------- Total interest-earning assets ........................... $ 7,651 $(18,382) $(10,731) $ 43,961 $ (2,633) $ 41,328 -------- -------- -------- -------- --------- -------- Interest-bearing liabilities: Savings accounts ..................................... $ 3,968 $ (2,137) $ 1,831 $ 2,076 $ (537) $ 1,539 NOW and money market accounts ........................ (1,035) (7,052) (8,087) 4,464 (4,624) (160) Certificates of deposit .............................. 345 (14,855) (14,510) 17,169 (478) 16,691 Mortgagors' payments held in escrow .................. (27) (5) (32) 72 (5) 67 Borrowed funds ....................................... (661) (1,786) (2,447) 4,554 (201) 4,353 -------- -------- -------- -------- --------- -------- Total interest-bearing liabilities ...................... $ 2,590 $(25,835) $(23,245) $ 28,335 $ (5,845) $ 22,490 ======== ======== ======== ======== ========= ======== Net interest income ..................................... $ 12,514 $ 18,838 ======== ========
Interest income decreased $10.7 million to $167.6 million for the year ended December 31, 2002 compared to $178.4 million for the year ended December 31, 2001. This reflects an 89 basis point decrease in the overall yield on interest-earning assets from 7.34% for 2001 to 6.45% for 2002. This primarily resulted from the lower interest rate environment in 2002, which caused interest-earning assets to reprice at lower rates partially offset by the shift in loan portfolio mix to higher yielding commercial loans. Additionally, the yield on interest-earning assets was reduced by management's strategic decision to invest excess funds in lower yielding short-term investments with minimal extension risk or potential market value fluctuations in anticipation of rising interest rates. The decreased rate earned on interest-earning assets was partially offset by an increase in average interest-earning asset balances to $2.60 billion for 2002 from $2.43 billion for 2001 as a result of increased funding from deposits. Interest expense decreased to $76.1 million for the year ended December 31, 2002 compared to $99.4 million for the year ended December 31, 2001. This $23.2 million decline is primarily due to the 120 basis point decrease in the rate paid on interest-bearing liabilities from 4.35% to 3.15% due to the lower interest rate environment in 2002 as compared to 2001. This decreased rate paid on interest-bearing liabilities was partially offset by an increase in the average balance of interest-bearing liabilities to $2.41 billion for 2002 from $2.28 billion for 2001. More specifically, the average balance of interest bearing deposits increased $140.7 million when comparing 2002 to 2001, while the average balance of borrowed funds decreased $11.5 million for the same period. 35 Provision for Credit Losses The following table sets forth the analysis of the allowance for credit losses, including charge-off and recovery data, for the years indicated.
For the year ended December 31, ------------------------------------------------------- 2002 2001 2000 1999 1998 ------- -------- ------- ------- ------- (Dollars in thousands) Balance at beginning of year .......... $18,727 $17,746 $ 9,862 $ 8,010 $ 6,921 Charge-offs: Real estate: One- to four- family ............ 370 382 175 101 14 Home equity ..................... -- 158 28 35 -- Multi-family .................... -- -- 53 84 177 Commercial ...................... 390 901 78 62 581 Consumer ........................... 2,572 1,571 534 447 428 Commercial business ................ 2,472 1,059 204 6 52 ------- ------- ------- ------- ------- Total ........................ 5,804 4,071 1,072 735 1,252 ------- ------- ------- ------- ------- Recoveries: Real estate: One- to four- family ............ 107 30 22 -- -- Home equity ..................... -- -- 13 -- -- Multi-family .................... -- -- 30 37 -- Commercial ...................... 270 268 1 4 155 Consumer ........................... 536 425 224 80 98 Commercial business ................ 213 169 47 -- 4 ------- ------- ------- ------- ------- Total ........................ 1,126 892 337 121 257 ------- ------- ------- ------- ------- Net charge-offs ....................... 4,678 3,179 735 614 995 Provision for credit losses ........... 6,824 4,160 2,258 2,466 2,084 Allowance obtained through acquisitions -- -- 6,361 -- -- ------- ------- ------- ------- ------- Balance at end of year ................ $20,873 $18,727 $17,746 $ 9,862 $ 8,010 ======= ======= ======= ======= ======= Ratio of net charge-offs to average loans outstanding during the year . 0.24% 0.17% 0.06% 0.07% 0.15% ======= ======= ======= ======= ======= Ratio of allowance for credit losses to total loans .................... 1.05% 1.00% 0.96% 0.99% 1.06% ======= ======= ======= ======= ======= Ratio of allowance for credit losses to non-accruing loans ............. 279.13% 163.13% 273.73% 511.25% 243.02% ======= ======= ======= ======= =======
Net charge-offs for 2002 amounted to $4.7 million compared to $3.2 million in 2001. This $1.5 million increase was primarily a result of having an increased amount of higher-risk commercial business loans as a percentage of total loans and the downturn in the economy. Additionally, consumer loan net charge-offs increased $890 thousand when comparing 2002 to 2001, as a result of the Company's overdraft protection service, initiated in the fourth quarter of 2001, whose balances have a higher rate of charge-off than other consumer loans. Even though this service results in higher net-charge-offs, the revenues received, recorded in non-interest income, are in excess of the losses incurred. As a percentage of average loans outstanding, net charge-offs increased to 0.24% for 2002 from 0.17% in 2001. As a result of the increased level of historical net charge-offs the Company has experienced over the last two years, as well as the increase in the aggregate balance of unseasoned higher risk commercial loans in the Company's loan portfolio and the weaker economic conditions in 2002, the Company increased the provision for credit losses to $6.8 million in 2002 from $4.2 million in 2001. The provision for credit losses is based on management's quarterly assessment of the adequacy of the allowance for credit losses with consideration given to such interrelated factors as the loan composition and inherent risk within the loan portfolio, the level of non-accruing loans and charge-offs, as well as both current and historic economic conditions. The Company establishes the provision for credit losses in order to maintain the allowance for credit losses at a level which covers all known and inherent losses in the loan portfolio that are both probable and reasonable to estimate. 36 Noninterest Income For 2002 the Company had $49.7 million in noninterest income, an increase of 18% over the $42.1 million for 2001. This increase was primarily due to the sale of the Lacona Banking Center, which resulted in a $2.4 million pre-tax gain, increased banking service charges and fee income, as well as increased revenue from the Company's financial services subsidiaries. The primary driver for the increased banking service charges and fee income for 2002 was the Company's overdraft protection service, initiated in the fourth quarter of 2001, which helped non-sufficient funds fees to increase $4.0 million. During 2002, the Company benefited from strong annuity and insurance markets, which caused financial services revenue to increase $2.5 million. These increases were partially offset by a $1.1 million decrease in covered call option premium income, as a result of the Company's decision to exit this program in 2002, and increased losses incurred on investment securities of $961 thousand, which were primarily due to weak equity markets. Noninterest income continues to be a stable source of earnings for the Company, as it represented 35% of net revenue for 2002. Noninterest Expenses Noninterest expenses totaled $84.4 million for the year ended December 31, 2002 representing a $1.4 million increase over the 2001 total of $83.0 million. Adjusting 2001 amounts for the change in accounting for goodwill, noninterest expense for 2002 increased $6.2 million. This increase is mainly attributable to higher salaries and benefits expense of $4.2 million, higher technology and communications expense of $1.5 million and increased marketing and advertising costs of $490 thousand. During 2002, the Company incurred approximately $500 thousand of severance, $200 thousand of technology costs, $250 thousand in marketing expenses and $375 thousand of professional fees and other costs in connection with the consolidation of its three banks and the new "First Niagara" branding campaign. These consolidation and branding costs are comparable to the $700 thousand in expenses recorded in 2001 related to final integration costs from the Company's acquisitions and severance from various reorganization initiatives. In addition to the severance charges, the increase in salaries and benefits from 2001 to 2002 was primarily due to internal growth and a $545 thousand increase in stock based compensation expense, primarily as a result of the rise in the Company's stock price. These increases in salaries and benefits were partially offset by a $998 thousand curtailment gain realized in 2002 from the freezing of the Company's defined benefit pension plan. The increase in technology and communications expense is mainly due to the consolidation related costs mentioned above, internal growth and the upgrading of systems. Even with the increase in noninterest expenses, the Company's efficiency ratio improved to 59.4% for 2002 from 64.6% for 2001, adjusted for goodwill. Income Taxes The effective tax rate increased to 38.3% for 2002 compared to 32.9% for 2001, adjusted for goodwill amortization. Excluding the $1.8 million New York State bad debt tax expense recapture charge, the effective tax rate for 2002 increased to 34.8% as First Niagara Bank was no longer able to take advantage of the special provisions in the New York State tax law that allowed it to deduct bad debt expenses in excess of those actually incurred. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2001 AND DECEMBER 31, 2000 Net Income For the year ended December 31, 2001, net income increased 9% to $21.2 million, or $0.85 per diluted share as compared to $19.5 million, or $0.79 per diluted share for 2000. Net income represented a return on average assets in 2001 of 0.79% compared to 0.98% in 2000 and a return on average equity in 2001 of 8.30% compared to 8.38% in 2000. Net Interest Income Net interest income rose 31%, to $79.0 million for 2001 from $60.2 million for 2000. However, the Company's net interest margin decreased slightly to 3.25% for 2001 from 3.26% for 2000. The narrowing of the net interest margin resulted primarily from a $30.2 million decline in average net earning assets to $144.6 million in 2001, as funds previously available for investment were utilized to fund the Company's acquisition activity in 2000. This decrease in average net earning assets was almost entirely offset by a 17 basis point increase in net interest rate spread, as the Company's interest bearing liabilities repriced faster than its interest earning assets during the declining rate environment in 2001. Additionally, the Company's net interest margin benefited in 2001 from the redeployment of funds from lower yielding residential mortgages into higher yielding commercial loans and the 92% increase in average noninterest bearing deposits due to increased commercial business relationships and the popularity of the Company's bi-weekly mortgage product. 37 Interest income rose to $178.4 million in 2001 from $137.0 million in 2000. This $41.3 million, or 30%, increase was a result of growth in the Company's average interest-earning assets of $582.3 million partially offset by a decrease in the interest rate earned on those assets during 2001 of 8 basis points. Interest income on loans increased $42.4 million to $144.3 million for 2001 from $101.8 million for 2000. This increase resulted from a $556.8 million increase in average loans outstanding during 2001, due to the bank acquisitions in 2000 and growth in commercial loans. Offsetting this increase was an 8 basis point decrease in the average yield earned on loans caused by the lower interest rate environment in 2001 partially offset by the change in the Company's loan portfolio composition to higher yielding commercial loans. Interest earned on investment securities decreased $1.8 million during 2001 primarily due to the prepayments received on mortgage backed securities and the sale of mortgage-backed securities in the second half of 2000 to fund acquisitions, which caused the average balance on those investments to decrease $49.0 million. The 2000 bank acquisitions added approximately $42.3 million of additional interest income in 2001 compared to 2000, primarily from loans acquired and internal growth. Interest expense increased to $99.4 million for 2001 from $76.9 million for 2000. This $22.5 million, or 29%, increase is primarily attributable to the increase in average interest-bearing liabilities of $612.5 million partially offset by a decrease in the interest rate paid on those liabilities of 25 basis points in 2001. Interest expense on deposits increased $18.1 million to $74.4 million for 2001 from $56.3 million for 2000. This resulted from a $534.9 million increase in average interest bearing deposits outstanding during 2001, mainly due to the bank acquisitions in 2000 and internal growth, partially offset by a decrease in the average rate paid on those deposits over the same period. Interest expense on borrowed funds increased to $24.9 million for the year ended December 31, 2001, compared to $20.6 million for the same period in 2000. This was a result of an increase in the average balance of borrowed funds of $77.6 million in 2001 resulting from the bank acquisitions in 2000, partially offset by a 6 basis point decrease in the average rate paid on those borrowings over the same period. The decline in the rates paid on deposits and borrowings can be attributed to the lower interest rate environment during 2001. Overall, the 2000 bank acquisitions added approximately $22.4 million of additional interest expense in 2001 compared to 2000. Provision for Credit Losses Net charge-offs for 2001 amounted to $3.2 million compared to $735 thousand in 2000. This $2.4 million increase was primarily a result of having a full year of the Cayuga, Cortland and Albion acquisitions in 2001 versus a partial year in 2000. Additionally, net charge-offs increased due to an increase in commercial loans as a percentage of total loans and the downturn in the economy. As a percentage of average loans outstanding, net charge-offs increased to 0.17% for 2001 from 0.06% in 2000. Given the increase in non-accrual and delinquent loans, the Company increased the provision for credit losses to $4.2 million for the year ending December 31, 2001, from $2.3 million in 2000. Of this $1.9 million increase, approximately $1.6 million related to Cortland and Cayuga which were acquired in 2000. Noninterest Income Noninterest income increased $8.0 million, or 23%, to $42.1 million in 2001 from $34.1 million in 2000. Revenue associated with the acquisitions resulted in $5.4 million of additional noninterest income for 2001, of which $3.1 million related to bank service charges and fees and lending and leasing income from the banks acquired and $1.1 million related to the acquisition of Allied. Other factors that contributed to the overall increase in noninterest income included an increase in gains on sales of mortgages of $1.0 million, due to the Company's decision to sell the majority of fixed rate mortgage loans originated in 2001, and an increase of $1.2 million in non-sufficient funds fee income primarily due to the Company's new overdraft protection service. Noninterest income continues to be a stable source of earnings for the Company, and represented 35% of total revenue during 2001. Noninterest Expenses Noninterest expenses totaled $83.0 million for the year ended December 31, 2001 reflecting a $21.5 million, or 35%, increase over the 2000 total of $61.5 million. Approximately $19.2 million of this increase was attributable to the acquisitions and was primarily in salaries and employee benefits and the amortization of goodwill. Overall, salaries and employee benefits were $46.0 million in 2001 compared with $34.2 million in 2000. During 2001, the Company's noninterest expense was impacted by the increased amortization of goodwill and other intangibles associated with its acquisitions, which increased $2.7 million when compared to 2000. Other increases in noninterest expenses related to internal growth, which included the ongoing upgrades of technology and communications systems that will facilitate future expansion and $700 thousand of costs which were related to final integration costs from the Company's acquisitions and severance from various reorganization initiatives. 38 Income Taxes The effective tax rate increased to 37.4% in 2001 from 36.0% in 2000, primarily due to the nondeductible amortization of goodwill and other intangibles related to the acquisitions. LIQUIDITY AND CAPITAL RESOURCES In addition to the Company's primary funding sources of income from operations, deposits and borrowings, funding is provided from the principal and interest payments on loans and investment securities, proceeds from the maturities and sale of investment securities, as well as proceeds from the sale of mortgage loans in the secondary market. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit outflows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition. The primary investing activities of the Company are the origination of residential one- to four-family mortgages, commercial loans, consumer loans, as well as the purchase of mortgage-backed and other debt securities. During 2002, loan originations totaled $764.9 million compared to $534.3 million and $419.5 million for 2001 and 2000, respectively, while purchases of investment securities totaled $756.7 million, $434.6 million and $37.1 million for the same years. The increase in investment security purchases during 2002 is primarily due to the reinvestment of funds received from the high level of loan and mortgage-backed security prepayments, as well as from the sale of investment securities, as a result of management's decision to restructure this portfolio in 2002. The sales, maturity and principal payments received on investment securities, as well as deposit growth and existing liquid assets were used to fund the above investing activities. During 2002 cash flow provided by the sale, maturity and principal payments received on securities available for sale amounted to $816.3 million compared to $245.4 million and $241.2 million in 2001 and 2000. Deposit growth, primarily the Company's savings and non-interest bearing accounts, provided $165.0 million, $84.5 million and $60.4 million of funding for the years ending December 31, 2002, 2001 and 2000, respectively. Borrowings, excluding the repayment of $140.0 million used to fund the purchase of U.S. Treasury securities in late 2001, decreased slightly from the end of 2001 as the increase in deposits and sales, maturity and principal payments received on investment securities were more than adequate to meet the funding needs of the Company. Maturity Schedule of Certificates of Deposit. The following table indicates the funding obligations of the Company relating to certificates of deposit by time remaining until maturity.
At December 31, 2002 ------------------------------------------------------- 3 months Over 3 to 6 Over 6 to 12 Over 12 or less months months months Total ------- ------ ------ ------ ----- (In thousands) Certificates of deposit less than $100,000 ....... $138,207 $138,484 $228,396 $204,208 $709,295 Certificates of deposit of $100,000 or more ...... 30,674 34,583 60,243 44,451 169,951 -------- -------- -------- -------- -------- Total certificates of deposit ............ $168,881 $173,067 $288,639 $248,659 $879,246 ======== ======== ======== ======== ========
In addition to the funding requirements of certificates of deposit illustrated above, the Company has repayment obligations related to its borrowings as follows: $69.3 million in 2003; $42.3 million in 2004; $58.9 million in 2005; $43.3 million in 2006; $27.3 million in 2007; and $156.0 million in years thereafter. However, certain advances and reverse repurchase agreements have call provisions that could accelerate their maturity if interest rates were to rise significantly from current levels as follows: $98.0 million in 2003; $23.0 million in 2004; $0 in 2005; and $27.1 million in 2006. Loan Commitments. In the ordinary course of business the Company extends commitments to originate one- to-four family mortgages, commercial loans and consumer loans. As of December 31, 2002, the Company had outstanding commitments to originate loans of approximately $124.6 million, which generally have an expiration period of less than one year. These commitments do not necessarily represent future cash requirements since certain of these instruments may expire without being funded. Commitments to sell residential mortgages amounted to $5.0 million at December 31, 2002. 39 The Company extends credit to consumer and commercial customers, up to a specified amount, through lines of credit. The borrower is able to draw on these lines as needed, thus the funding is generally unpredictable. Unused consumer and commercial lines of credit amounted to $167.4 million at December 31, 2002 and generally have an expiration period of less than one year. In addition to the above, the Company issues standby letters of credit to third parties which guarantees payments on behalf of commercial customers in the event that the customer fails to perform under the terms of the contract between the customer and the third-party. Standby letters of credit amounted to $12.1 million at December 31, 2002 and generally have an expiration period greater than one year. Since the majority of unused lines of credit and outstanding standby letters of credit expire without being funded, the Company's obligation to fund the above commitment amounts is substantially less than the amounts reported. It is anticipated that there will be sufficient funds available to meet the current loan commitments and other obligations through the sources described above. Security Yields, Maturities and Repricing Schedule. The following table sets forth certain information regarding the carrying value, weighted average yields and estimated maturities, including prepayment assumptions, of the Company's available for sale securities portfolio as of December 31, 2002. Adjustable-rate securities are included in the period in which interest rates are next scheduled to adjust and fixed-rate securities are included based upon the weighted average life date. No tax equivalent adjustments were made to the weighted average yields. Amounts are shown at fair value.
At December 31, 2002 ------------------------------------------------------------------------------------------------ More than one More than five One year or less year to five years years to ten years After ten years Total ----------------- ------------------ ------------------ ----------------- ------------------ Weighted Weighted Weighted Weighted Weighted carrying Average carrying Average carrying Average carrying Average carrying Average value yield value yield value yield value yield value yield ----------------- ------------------- ------------------ ------------------ ------------------ (Dollars in thousands) Mortgage-backed securities: CMO's ..................... $172,643 1.05% $ 90,357 2.94% $ -- --% $ -- --% $263,000 1.70% FHLMC ..................... 3,403 6.47 45,892 4.90 -- -- 3,665 6.96 52,960 5.15 GNMA ...................... 706 2.54 6,708 6.41 1,692 8.23 1,463 7.87 10,569 6.65 FNMA ...................... 468 5.73 13,061 6.18 -- -- 261 5.58 13,790 6.15 ------- -------- ------ ------ ------- Total mortgage-backed securities ....... 177,220 1.17 156,018 3.94 1,692 8.23 5,389 7.14 340,319 2.57 ------- -------- ------ ------ ------- Debt securities: U.S. Treasury ............. 140,038 1.11 16 5.25 -- -- -- -- 140,054 1.11 U.S. Government agencies .. 27,307 3.49 63,222 2.54 -- -- -- -- 90,529 2.83 States and political subdivisions ........... 6,221 1.80 21,081 3.36 7,206 4.79 58 4.60 34,566 3.38 Corporate ................. 2,016 4.46 9,800 4.19 886 2.72 1,861 3.25 14,563 4.02 ------- -------- ------ ------ ------- Total debt securities .... 175,582 1.54 94,119 2.90 8,092 4.56 1,919 3.29 279,712 2.10 ------- -------- ------ ------ ------- Common stock (1) ............ -- -- -- -- -- -- -- -- 3,497 -- Asset-backed securities ..... -- -- 503 6.14 2,189 2.28 1,145 2.03 3,837 2.71 Other securities (1) ........ -- -- -- -- -- -- -- -- 4,999 2.68 ------- -------- ------ ------ ------- Total securities available for sale ................. $352,802 1.36% $250,640 3.55% $11,973 4.66% $8,453 5.57% $632,364 2.36% ======= ======= ====== ====== ========
(1) Estimated maturities do not include common stock or other securities available for sale. 40 Loan Maturity and Repricing Schedule. The following table sets forth certain information as of December 31, 2002, regarding the amount of loans maturing or repricing in the Company's portfolio. Demand loans having no stated schedule of repayment and no stated maturity and overdrafts are reported as due in one year or less. Adjustable- and floating-rate loans are included in the period in which interest rates are next scheduled to adjust rather than the period in which they contractually mature, and fixed-rate loans (including bi-weekly loans) are included in the period in which the final contractual repayment is due. No adjustments have been made for amortization or prepayment of principal.
One Within through After one five five year years years Total -------- -------- -------- ---------- (In thousands) Real estate loans: One- to four-family ................... $240,276 $498,273 $188,904 $ 927,453 Home equity ............................ 80,936 43,388 12,662 136,986 Commercial and multi-family ............ 131,578 248,433 93,482 473,493 Construction ........................... 80,627 18,281 8,292 107,200 -------- -------- -------- ---------- Total real estate loans ............ 533,417 808,375 303,340 1,645,132 -------- -------- -------- ---------- Consumer loans .............................. 91,161 72,817 5,177 169,155 Commercial business loans ................... 101,934 65,562 11,059 178,555 -------- -------- -------- ---------- Total loans ........................ $726,512 $946,754 $319,576 $1,992,842 ======== ======== ======== ==========
Fixed- and Adjustable-Rate Loan Schedule. The following table sets forth at December 31, 2002, the dollar amount of all fixed-rate and adjustable-rate loans due after December 31, 2003. Due after December 31, 2003 ---------------------------------- Fixed Adjustable Total -------- ---------- ---------- (In thousands) Real estate loans: One- to four-family ....... $591,373 $ 95,804 $ 687,177 Home equity ............... 56,050 -- 56,050 Commercial and multi-family 114,582 227,333 341,915 Construction .............. -- 26,573 26,573 -------- -------- ---------- Total real estate loans 762,005 349,710 1,111,715 -------- -------- ---------- Consumer loans ................. 77,994 -- 77,994 Commercial business loans ...... 76,621 -- 76,621 -------- -------- ---------- Total loans ........... $916,620 $349,710 $1,266,330 ======== ======== ========== The Company has lines of credit with the FHLB and FRB that provide secondary funding sources for lending, liquidity, and asset/liability management. At December 31, 2002, the FHLB line of credit totaled $732.9 million under which $236.0 million was utilized. The FRB line of credit totaled $4.3 million, under which there were no borrowings outstanding as of December 31, 2002. Cash, interest-bearing demand accounts at correspondent banks, federal funds sold, and other short-term investments are the Company's most liquid assets. The level of these assets are monitored daily and are dependent on operating, financing, lending and investing activities during any given period. Excess short-term liquidity is usually invested in overnight federal funds sold. In the event that funds beyond those generated internally are required as a result of higher than expected loan commitment fundings, deposit outflows or the amount of debt being called, additional sources of funds are available through the use of reverse repurchase agreements, the sale of loans or investments or the Company's various lines of credit. As of December 31, 2002, the total of cash, interest-bearing demand accounts, federal funds sold and other short-term investments was $90.5 million, or 3.1% of total assets. 41 FOURTH QUARTER RESULTS Net income for the quarter ended December 31, 2002 increased 45% to $8.4 million, or $0.33 per diluted share from $5.8 million, or $0.23 per diluted share for the same period of 2001. Adjusting fourth quarter 2001 results to exclude the effects of goodwill amortization, similar to the 2002 fourth quarter, net income for the current quarter increased $1.4 million or 20%. Net interest income increased 12% to $23.6 million for the fourth quarter of 2002 from $21.1 million for the same period in 2001 as the Company continued to benefit from the lower interest rate environment and its ongoing focus on higher yielding commercial loans. As a result, the net interest rate spread improved 22 basis points to 3.39% for the quarter ended December 31, 2002 compared to 3.17% for the fourth quarter of 2001. Total loans increased to $1.99 billion at December 31, 2002, when compared to the quarter ended September 30, 2002 balance of $1.96 billion. This $35.0 million increase is almost exclusively attributable to commercial loans, which increased $34.9 million during that period. Overall, deposits remained consistent from September 30, 2002 to December 31, 2002 at $2.1 billion. However, during the fourth quarter of 2002, noninterest bearing deposits increased 5% to $134.2 million from $127.6 million at September 30, 2002. As a result of this and the increase in net interest rate spread discussed above, the net interest margin increased to 3.60% for the quarter ended December 31, 2002, from 3.42% for the same period in 2001. For the fourth quarter of 2002, the Company had $13.9 million in noninterest income, an increase of 25% over the $11.1 million for the same period in 2001. This increase was primarily due to the sale of the Lacona Banking Center, which resulted in a $2.4 million pre-tax gain. Additionally, noninterest income was positively impacted by the popularity of the Company's overdraft protection service, prepayment penalties received from increased commercial real estate loan refinancing, as well as strong annuity and insurance markets. These increases were partially offset by a decrease in covered call option premium income, as a result of the Company's decision to exit this program in 2002, and lower income from investment advisory services, fiduciary services and losses incurred on investment securities, due to weak equity markets. Noninterest expense for the three months ended December 31, 2002 was $22.4 million as compared to $21.8 million for the comparable period of 2001. Adjusting the final quarter of 2001 for the change in accounting for goodwill, noninterest expense for the current 2002 quarter increased $1.8 million, primarily due to higher salaries and benefits expense. This increase was mainly a result of internal growth and the rise in the Company's stock price, which was reflected in higher stock based compensation expense. In the fourth quarter of 2002, the Company incurred approximately $850 thousand of expenses related to the consolidation of its three banks and the new "First Niagara" branding campaign. This amount is comparable to the $700 thousand in expenses incurred in the fourth quarter of 2001 related to final integration costs from the Company's acquisitions and severance from various reorganization initiatives. CRITICAL ACCOUNTING ESTIMATES Pursuant to recent SEC guidance, management of the Company is encouraged to evaluate and disclose those accounting estimates that are judged to be critical - those most important to the portrayal of the Company's financial condition and results, and that require management's most difficult, subjective and complex judgements. Management considers the accounting estimates relating to the allowance for credit losses and goodwill to be critical given the inherent uncertainty in evaluating the levels of the allowance required to cover credit losses in the portfolio and assessing whether or not goodwill is impaired. The judgments made regarding the allowance for credit losses and goodwill can have a material effect on the results of operations of the Company. A more detailed description of the Company's methodology for calculating the allowance for credit losses and assumptions made is included within the "Lending Activities" section filed herewith in Part I, Item 1, "Business." Goodwill is not subject to amortization but must be tested for possible impairment at least annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment testing requires that the fair value of each reporting unit be compared to its carrying amount, including goodwill. Reporting units were identified based upon an analysis of each of the Company's individual operating segments. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. Goodwill was allocated to the carrying value of each reporting unit based on its relative fair value at the time it was acquired. 42 Determining the fair value of a reporting unit requires a high degree of subjective management assumption. Discounted cash flow valuation models are utilized that incorporate such variables as revenue growth rates, expense trends, interest rates and terminal values. Based upon an evaluation of key data and market factors, management selects from a range the specific variables to be incorporated into the valuation model. Future changes in the economic environment or the operations of the reporting units could cause changes to these variables. The Company has established November 1 of each year as the date for conducting its annual goodwill impairment assessment. The variables are selected as of that date and the valuation models are run to determine the fair value of each reporting unit. At January 1, 2002 and November 1, 2002, the Company did not identify any individual reporting unit where fair value was less than carrying value, including goodwill. IMPACT OF NEW ACCOUNTING STANDARDS In June 2001, the FASB issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. When the liability is initially recorded, the entity capitalizes the asset retirement cost by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value each period and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss. The provisions of SFAS No. 143 are effective for fiscal years beginning after June 15, 2002 and are not expected to have a material impact on the Company's consolidated financial statements. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" and the provisions for the disposal of a segment of a business in APB Opinion No. 30, "Reporting the Results of Operations -- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." This statement requires that long-lived assets to be disposed of by sale be measured at the lower of its carrying amount or fair value less cost to sell, and recognition of impairment losses on long-lived assets to be held if the carrying amount of the long-lived asset is not recoverable from its undiscounted cash flows and exceeds its fair value. Additionally, SFAS No. 144 resolved various implementation issues related to SFAS No. 121. The provisions of SFAS No. 144 were adopted on January 1, 2002 and had no effect on the Company's consolidated financial statements. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This statement eliminates SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" as amended by SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." As a result, gains and losses from extinguishment of debt can only be classified as extraordinary items if they meet the definition of unusual and infrequent as prescribed in APB Opinion No. 30. Additionally, SFAS No. 145 amends SFAS No. 13 "Accounting for Leases" to require that lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS No. 145 addresses a number of additional issues that were not substantive in nature. The provisions of this statement are effective at various dates in 2002 and 2003 and are not expected to have a material impact on the Company's consolidated financial statements. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement nullifies Emerging Issues Task Force Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" and requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is probable and represents obligations to transfer assets or provide services as a result of past transactions. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002. 43 In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions - an Amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9." This statement removes acquisitions of financial institutions from the scope of both SFAS No. 72 and Interpretation No. 9 and requires that those transactions be accounted for in accordance with SFAS No. 141 "Business Combinations" and No. 142 "Goodwill and Other Intangible Assets." As a result, the requirement in paragraph 5 of SFAS No. 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset (SFAS No. 72 goodwill) no longer applies to acquisitions within the scope of the Statement. The provisions of this statement were effective October 1, 2002 and did not have a material impact on the Company's consolidated financial statements as the Company did not have any SFAS No. 72 goodwill. In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This Interpretation enhances the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of Interpretation No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002. The Company has made the applicable transition disclosures required by Interpretation No. 45 in this annual report on Form 10-K. The Company is required to adopt the recognition and measurement provisions of Interpretation No. 45 effective January 1, 2003, which is not expected to have a material impact on the Company's consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." This statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation," to provide three alternative methods for a voluntary change to the fair value based method of accounting for stock-based compensation and requires prominent disclosures in both interim and annual financial statements about the method of accounting for stock-based compensation and its effect on reported results. The provisions of this statement were effective for fiscal years ending after December 15, 2002 and interim periods beginning after December 15, 2002. The Company has made the applicable disclosures required by SFAS No. 148 in this annual report on Form 10-K. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," which clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." More specifically, the Interpretation explains how to identify variable interest entities and how to determine whether or not those entities should be consolidated. The Interpretation requires the primary beneficiaries of variable interest entities to consolidate the variable interest entities if they are subject to a majority of the risk of loss or are entitled to receive a majority of the residual returns. It also requires that both the primary beneficiary and all other enterprises with a significant variable interest in a variable interest entity make certain disclosures. Interpretation No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The provisions of this Interpretation are not expected to have a material impact on the Company's consolidated financial statements. 44 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The principal objective of the Company's interest rate risk management is to evaluate the interest rate risk inherent in certain assets and liabilities, determine the appropriate level of risk given the Company's business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the Board's approved guidelines to reduce the vulnerability of operations to changes in interest rates. The asset/liability committee ("ALCO") is comprised of senior management and selected banking officers who are responsible for reviewing with the Board its activities and strategies, the effect of those strategies on the net interest margin, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. The Company utilizes the following strategies to manage interest rate risk: (1) emphasizing the origination and retention of residential monthly and bi-weekly fixed-rate mortgage loans having terms to maturity of not more than twenty years, residential and commercial adjustable-rate mortgage loans, and home equity loans; (2) selling substantially all newly originated 20-30 year monthly and 25-30 year bi-weekly fixed-rate, residential mortgage loans into the secondary market without recourse and on a servicing retained basis; and (3) investing in shorter term securities which generally bear lower yields as compared to longer term investments, but which better position the Company for increases in market interest rates. Shortening the maturities of the Company's interest-earning assets by increasing shorter term investments better matches the maturities of the Company's deposit accounts, in particular its certificates of deposits that mature in one year or less. During 1999 and 2000 the Company entered into interest rate swap agreements in order to manage the interest rate risk related to the repricing of its money market deposit accounts. Under the agreements the Company paid an annual fixed rate of interest and received a floating three-month U.S. Dollar LIBOR rate over a two-year period. The last of the Company's interest rate swap agreements expired in December 2002. The Company intends to continue to analyze the future utilization of swap agreements as part of its overall asset/liability management process. Gap Analysis. The matching of assets and liabilities may be analyzed by examining the extent to which such assets and liabilities are "interest rate sensitive" and by monitoring a Company's interest rate sensitivity "gap." An asset or liability is said to be interest rate sensitive within a specific time period if it will mature or reprice within that time period. 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. At December 31, 2002, the Company's one-year gap position, the difference between the amount of interest-earning assets maturing or repricing within one year and interest-bearing liabilities maturing or repricing within one year, was a negative 6.28%. A gap is considered positive when the amount of interest rate sensitive assets exceeds the amount of interest rate sensitive liabilities. A gap is considered negative when the amount of interest rate sensitive liabilities exceeds the amount of interest rate sensitive assets. Accordingly, during a period of rising interest rates, an institution with a negative gap position is likely to experience a decline in net interest income as the cost of its interest-bearing liabilities increase at a rate faster than its yield on interest-earning assets. In comparison, an institution with a positive gap is likely to realize an increase in its net interest income in a rising interest rate environment. Given the Company's existing liquidity position, its ability to sell investment securities and the results of the Company's net interest income simulation modeling analysis discussed below, which management believes is a better indicator of the Company's interest rate risk exposure, management believes that its negative gap position will not have a material adverse effect on its operating results or liquidity position. The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2002, which are anticipated by the Company, based upon certain assumptions, to reprice or mature in each of the future time periods shown (the "Gap table"). Except as stated below, the amount of assets and liabilities shown which reprice or mature during a particular period were determined in accordance with the earlier of the repricing date or the contractual maturity of the asset or liability. The table sets forth an approximation of the projected repricing of assets and liabilities at December 31, 2002, on the basis of contractual maturities, anticipated prepayments, and scheduled rate adjustments within the selected time intervals. One- to four-family residential and commercial real estate loans were projected to repay at rates between 4% and 31% annually, while mortgage-backed securities were projected to prepay at rates between 26% and 50% annually. Savings and negotiable order of withdrawal ("NOW") accounts were assumed to decay, or run-off, at 18% annually. While the Company believes such assumptions to be reasonable, there can be no assurance that assumed prepayment rates and decay rates will approximate actual future loan prepayment and deposit withdrawal activity. 45
Amounts maturing or repricing as of December 31, 2002 --------------------------------------------------------------------------------------- Less than 3-6 6 months Over 10 3 months months to 1 year 1-3 years 3-5 years 5-10 years years --------- --------- --------- -------- -------- -------- --------- (Dollars in thousands) Interest-earning assets: Federal funds sold and other short-term investments .............. $ 45,167 $ -- $ -- $ -- $ -- $ -- $ -- Mortgage-backed securities (1) ......... 51,103 38,446 45,067 96,089 61,376 43,633 -- Investment securities (1) .............. 154,450 15,231 17,094 74,980 3,933 11,191 12,731 Loans (2) .............................. 349,976 120,723 250,223 568,683 375,327 305,544 13,464 Other (1)(3) ........................... -- -- -- -- -- -- 21,763 --------- --------- --------- -------- -------- -------- --------- Total interest-earning assets .... 600,696 174,400 312,384 739,752 440,636 360,368 47,958 --------- --------- --------- -------- -------- -------- --------- Interest-bearing liabilities: Savings accounts ....................... 81,853 27,968 55,936 49,172 49,172 122,930 245,863 NOW and money market accounts .......... 283,543 9,993 19,985 35,860 13,902 34,756 69,511 Certificates of deposit ................ 168,881 173,067 288,639 215,871 30,137 2,447 204 Mortgagors' payments held in escrow .... 3,105 3,105 6,209 -- -- -- 3,200 Stock offering subscription proceeds ... 75,952 -- -- -- -- -- -- Other borrowed funds ................... 33,666 10,582 29,302 100,616 65,437 126,779 30,753 --------- --------- --------- -------- -------- -------- --------- Total interest-bearing liabilities 647,000 224,715 400,071 401,519 158,648 286,912 349,531 --------- --------- --------- -------- -------- -------- --------- Interest rate sensitivity gap ............. ($ 46,304) ($ 50,315) ($ 87,687) $338,233 $281,988 $ 73,456 ($301,573) ========= ========= ========= ======== ======== ======== ========= Cumulative interest rate sensitivity gap .. ($ 46,304) ($ 96,619) ($184,306) $153,927 $435,915 $509,371 $ 207,798 ========= ========= ========= ======== ======== ======== ========= Ratio of interest-earning assets to interest-bearing liabilities ........... 92.84% 77.61% 78.08% 184.24% 277.74% 125.60% 13.72% Ratio of cumulative gap to total assets ... (1.58%) (3.29%) (6.28%) 5.24% 14.85% 17.36% 7.08% Amounts maturing or repricing as of December 31, 2002 ------------------- Total ---------- Interest-earning assets: Federal funds sold and other short-term investments .............. $ 45,167 Mortgage-backed securities (1) ......... 335,714 Investment securities (1) .............. 289,610 Loans (2) .............................. 1,983,940 Other (1)(3) ........................... 21,763 ---------- Total interest-earning assets .... 2,676,194 Interest-bearing liabilities: Savings accounts ....................... 632,894 NOW and money market accounts .......... 467,550 Certificates of deposit ................ 879,246 Mortgagors' payments held in escrow .... 15,619 Stock offering subscription proceeds ... 75,952 Other borrowed funds ................... 397,135 ---------- Total interest-bearing liabilities 2,468,396 ---------- Interest rate sensitivity gap ............. $ 207,798 Cumulative interest rate sensitivity gap .. Ratio of interest-earning assets to interest-bearing liabilities ........... 108.42% Ratio of cumulative gap to total assets ...
(1) Amounts shown are at amortized cost. (2) Amounts shown include principal balance net of deferred costs, unearned discounts, negative balance deposits reclassified to loans and non-accruing loans. (3) Primarily includes FHLB stock. Certain shortcomings are inherent in the method of analysis presented in the gap table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate loans, have features, which restrict changes in interest rates, both on a short-term basis and over the life of the asset. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in calculating the table. Finally, the ability of many borrowers to service their adjustable-rate loans may decrease in the event of an interest rate increase. As a result of these shortcomings, the Company focuses more attention on simulation modeling, such as the net interest income, analysis discussed below, rather than gap analysis. Even though the gap analysis reflects a ratio of cumulative gap to total assets within the Company's targeted range of acceptable limits, the net interest income simulation modeling is considered by management to be more informative in forecasting future income. 46 Net Interest Income Analysis. The accompanying table as of December 31, 2002 and 2001 sets forth the estimated impact on the Company's net interest income resulting from changes in interest rates during the next twelve months. These estimates require making certain assumptions including loan and mortgage-related investment prepayment speeds, reinvestment rates, and deposit maturities and decay rates similar to the gap analysis. These assumptions are inherently uncertain and, as a result, the Company cannot precisely predict the impact of changes in interest rates on net interest income. Actual results may differ significantly due to timing, magnitude and frequency of interest rate changes and changes in market conditions. During 2002, management of the Company has continued to restructure the loan, investment securities and borrowing portfolios as part of their asset liability management process. This strategy included selling long-term fixed rate residential mortgages originated, an increased emphasis on variable rate commercial loans, replacing long-term investment securities with shorter-term investment securities, and replacing short-term borrowings with long-term borrowings, in order to make the Company less liability sensitive. These initiatives have impacted the Company's interest rate sensitivity position since December 31, 2001, which should benefit the Company during periods of higher interest rates, as follows.
Calculated increase (decrease) at ------------------------------------------------------------------------------------------ December 31, 2002 December 31, 2001 ------------------------------------------- ----------------------------------------- Changes in Net interest Net interest interest rates income % Change income % Change --------------------------- ------------------- ------------------ ----------------- ------------------- (In thousands) +200 basis points $ 64 0.07% $ (670) (0.76)% +100 basis points 97 0.10 (155) (0.18) -100 basis points (1,014) (1.09) (22) (0.03)
As is the case with the gap table, certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in net interest income requires the making of certain assumptions that may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the net interest income table presented assumes that the composition of the Company's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Accordingly, although the net interest income table provides an indication of the Company's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Company's net interest income and will differ from actual results. 47 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Independent Auditors' Report The Board of Directors First Niagara Financial Group, Inc.: We have audited the accompanying consolidated statements of condition of First Niagara Financial Group, Inc. and subsidiaries (the Company) as of December 31, 2002 and 2001, and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 the Company as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 1, the Company adopted prospectively the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, in 2002. /S/ KPMG LLP January 24, 2003 Buffalo, New York 48 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Condition December 31, 2002 and 2001 (In thousands except share and per share amounts)
Assets 2002 2001 ----------- ----------- Cash and cash equivalents: Cash and due from banks $ 45,358 52,423 Federal funds sold and other short-term investments 45,167 22,231 ----------- ----------- Total cash and cash equivalents 90,525 74,654 Securities available for sale 632,364 693,897 Loans, net 1,974,560 1,853,141 Premises and equipment, net 40,445 40,233 Goodwill, net 74,101 74,213 Amortizing intangible assets, net 6,392 6,797 Other assets 116,408 115,011 ----------- ----------- Total assets $ 2,934,795 2,857,946 =========== =========== Liabilities and Stockholders' Equity Liabilities: Deposits $ 2,129,469 1,990,830 Stock offering subscription proceeds 75,952 -- Short-term borrowings 69,312 212,992 Long-term borrowings 327,823 346,048 Other liabilities 48,543 47,459 ----------- ----------- Total liabilities 2,651,099 2,597,329 ----------- ----------- Commitments and contingencies (see note 5, 6, 9, 10, 11 and 17) -- -- Stockholders' equity: Preferred stock, $0.01 par value, 5,000,000 shares authorized, none issued -- -- Common stock, $0.01 par value, 45,000,000 shares authorized, 29,756,250 shares issued 298 298 Additional paid-in capital 137,624 135,917 Retained earnings 196,074 176,073 Accumulated other comprehensive income 2,074 2,561 Common stock held by ESOP, 832,747 shares in 2002 and 878,533 shares in 2001 (11,024) (11,630) Treasury stock, at cost, 3,918,978 shares in 2002 and 4,075,498 shares in 2001 (41,350) (42,602) ----------- ----------- Total stockholders' equity 283,696 260,617 ----------- ----------- Total liabilities and stockholders' equity $ 2,934,795 2,857,946 =========== ===========
See accompanying notes to consolidated financial statements 49 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Income Years ended December 31, 2002, 2001 and 2000 (In thousands except per share amounts)
2002 2001 2000 --------- --------- --------- Interest income: Real estate loans $ 115,795 119,203 85,213 Other loans 24,664 25,071 16,612 Investment securities 7,496 10,888 8,804 Mortgage-backed securities 16,100 20,138 24,045 Federal funds sold and other short-term investments 2,446 1,503 771 Other 1,136 1,565 1,595 --------- --------- --------- Total interest income 167,637 178,368 137,040 Interest expense: Deposits 53,611 74,409 56,272 Borrowings 22,496 24,943 20,590 --------- --------- --------- Total interest expense 76,107 99,352 76,862 --------- --------- --------- Net interest income 91,530 79,016 60,178 Provision for credit losses 6,824 4,160 2,258 --------- --------- --------- Net interest income after provision for credit losses 84,706 74,856 57,920 --------- --------- --------- Noninterest income: Banking service charges and fees 14,226 10,222 7,257 Lending and leasing income 5,523 4,310 3,105 Insurance services and fees 20,514 18,456 16,685 Bank-owned life insurance income 2,706 2,507 2,070 Annuity and mutual fund commissions 2,585 1,750 1,348 Investment and fiduciary services income 1,112 1,456 965 Net realized losses on securities available for sale (1,044) (83) (339) Gain on sale of banking center 2,429 -- -- Other 1,640 3,454 2,999 --------- --------- --------- Total noninterest income 49,691 42,072 34,090 --------- --------- --------- Noninterest expense: Salaries and employee benefits 50,181 45,989 34,224 Occupancy and equipment 7,897 7,664 5,735 Technology and communications 9,125 7,642 5,733 Marketing and advertising 2,616 2,126 2,603 Amortization of goodwill -- 4,742 2,114 Amortization of other intangibles 873 969 937 Other 13,756 13,873 10,172 --------- --------- --------- Total noninterest expense 84,448 83,005 61,518 --------- --------- --------- Income before income taxes 49,949 33,923 30,492 Income tax expense: Federal and state 17,370 12,703 10,973 New York State bad debt tax expense recapture 1,784 -- -- --------- --------- --------- Total income tax expense 19,154 12,703 10,973 --------- --------- --------- Net income $ 30,795 21,220 19,519 ========= ========= ========= Adjusted net income (see note 7) $ 30,795 25,962 21,633 ========= ========= ========= Basic earnings per common share (see note 2 and 15): Net income $ 1.24 0.86 0.79 Adjusted net income (see note 7) 1.24 1.05 0.87 Diluted earnings per common share (see note 2 and 15): Net income $ 1.21 0.85 0.79 Adjusted net income (see note 7) 1.21 1.04 0.87 Weighted average common shares outstanding (see note 2): Basic 24,913 24,728 24,847 Diluted 25,469 25,010 24,858
See accompanying notes to consolidated financial statements. 50 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income Years Ended December 31, 2002, 2001 and 2000 (In thousands)
2002 2001 2000 -------- -------- -------- Net income $ 30,795 21,220 19,519 -------- -------- -------- Other comprehensive income (loss), net of income taxes: Securities available for sale: Net unrealized gains arising during the year 836 2,381 9,025 Reclassification adjustment for realized losses included in net income 627 50 204 -------- -------- -------- 1,463 2,431 9,229 -------- -------- -------- Cash flow hedges: Net unrealized losses arising during the year (105) (503) -- Reclassification adjustment for realized losses included in net income 311 392 -- -------- -------- -------- 206 (111) -- -------- -------- -------- Defined benefit pension plan: Minimum pension liability arising during the year (2,156) -- -- -------- -------- -------- Total other comprehensive (loss) income before cumulative effect of change in accounting principle (487) 2,320 9,229 Cumulative effect of change in accounting principle for derivatives, net of tax -- (95) -- -------- -------- -------- Total other comprehensive (loss) income (487) 2,225 9,229 -------- -------- -------- Total comprehensive income $ 30,308 23,445 28,748 ======== ======== ========
See accompanying notes to consolidated financial statements. 51 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Changes in Stockholders' Equity Years Ended December 31, 2002, 2001 and 2000 (In thousands except share and per share amounts)
Accumulated Common Additional other stock Common paid-in Retained comprehensive held by Treasury stock capital earnings income (loss) ESOP stock Total -------- -------- -------- ------------- -------- -------- -------- Balances at January 1, 2000 $ 298 135,964 151,341 (8,893) (13,076) (33,018) 232,616 Net income -- -- 19,519 -- -- -- 19,519 Unrealized gain on securities available for sale, net of taxes and reclassification adjustment -- -- -- 9,229 -- -- 9,229 Purchase of treasury stock (1,098,300 shares) -- -- -- -- -- (10,871) (10,871) ESOP shares released (52,727 shares) -- (204) -- -- 698 -- 494 Vested restricted stock plan awards (54,970 shares) -- 16 -- -- -- 561 577 Common stock dividends of $0.28 per share -- -- (7,024) -- -- -- (7,024) -------- -------- -------- -------- -------- -------- -------- Balances at December 31, 2000 $ 298 135,776 163,836 336 (12,378) (43,328) 244,540 Net income -- -- 21,220 -- -- -- 21,220 Unrealized gain on securities available for sale, net of taxes and reclassification adjustment -- -- -- 2,431 -- -- 2,431 Unrealized loss on interest rate swaps, net of taxes and reclassification adjustment -- -- -- (111) -- -- (111) Cumulative effect of change in accounting principle for derivatives -- -- -- (95) -- -- (95) Exercise of stock options (39,700 shares) -- 99 -- -- -- 381 480 ESOP shares released (56,550 shares) -- 55 -- -- 748 -- 803 Vested restricted stock plan awards (38,982 shares) -- (13) -- -- -- 345 332 Common stock dividends of $0.36 per share -- -- (8,983) -- -- -- (8,983) -------- -------- -------- -------- -------- -------- -------- Balances at December 31, 2001 $ 298 135,917 176,073 2,561 (11,630) (42,602) 260,617 Net income -- -- 30,795 -- -- -- 30,795 Unrealized gain on securities available for sale, net of taxes and reclassification adjustment -- -- -- 1,463 -- -- 1,463 Unrealized gain on interest rate swaps, net of taxes and reclassification adjustment -- -- -- 206 -- -- 206 Minimum pension liability adjustment, net of taxes -- -- -- (2,156) -- -- (2,156) Exercise of stock options (90,350 shares) -- 533 -- -- -- 886 1,419 ESOP shares released (45,786 shares) -- 547 -- -- 606 -- 1,153 Vested restricted stock plan awards (66,170 shares) -- 627 -- -- -- 366 993 Common stock dividends of $0.43 per share -- -- (10,794) -- -- -- (10,794) -------- -------- -------- -------- -------- -------- -------- Balances at December 31, 2002 $ 298 137,624 196,074 2,074 (11,024) (41,350) 283,696 ======== ======== ======== ======== ======== ======== ========
See accompanying notes to consolidated financial statements. 52 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years Ended December 31, 2002, 2001 and 2000 (In thousands)
2002 2001 2000 --------- --------- --------- Cash flows from operating activities: Net income $ 30,795 21,220 19,519 Adjustments to reconcile net income to net cash provided by operating activities: Amortization (accretion) of fees and discounts, net 3,853 (124) (271) Depreciation of premises and equipment 5,286 4,763 3,665 Provision for credit losses 6,824 4,160 2,258 Amortization of goodwill and other intangibles 873 5,711 3,051 Net (increase) decrease in loans held for sale (1,004) 1,560 (1,751) Net realized losses on securities available for sale 1,044 83 339 Gain on curtailment of defined benefit pension plan (998) -- -- Gain on sale of banking center (2,429) -- -- ESOP compensation expense 1,153 803 494 Deferred income tax expense 1,096 829 420 (Increase) decrease in other assets (1,834) 1,094 8,589 Increase (decrease) in other liabilities 674 3,529 (4,120) --------- --------- --------- Net cash provided by operating activities 45,333 43,628 32,193 --------- --------- --------- Cash flows from investing activities: Proceeds from sales of securities available for sale 449,110 76,751 135,556 Proceeds from maturities of securities available for sale 196,961 65,388 32,595 Principal payments received on securities available for sale 170,181 103,301 73,044 Purchases of securities available for sale (756,685) (434,582) (37,116) Net increase in loans (128,740) (35,834) (152,589) Purchase of bank-owned life insurance -- (4,000) -- Acquisitions, net of cash acquired (605) (980) (90,865) Net cash distributed for banking center sale (21,566) -- -- Other, net (7,246) (6,965) (5,018) --------- --------- --------- Net cash used in investing activities (98,590) (236,921) (44,393) --------- --------- --------- Cash flows from financing activities: Net increase in deposits 165,038 84,479 60,381 Proceeds from stock offering subscription 75,952 -- -- (Repayments of) proceeds from short-term borrowings (175,492) 59,209 (41,850) Proceeds from long-term borrowings 30,000 88,100 42,900 Repayments of long-term borrowings (16,518) (18,079) (10,470) Proceeds from exercise of stock options 942 406 -- Purchase of treasury stock -- -- (10,871) Dividends paid on common stock (10,794) (8,983) (7,024) --------- --------- --------- Net cash provided by financing activities 69,128 205,132 33,066 --------- --------- --------- Net increase in cash and cash equivalents 15,871 11,839 20,866 Cash and cash equivalents at beginning of year 74,654 62,815 41,949 --------- --------- --------- Cash and cash equivalents at end of year $ 90,525 74,654 62,815 ========= ========= ========= Supplemental disclosure of cash flow information: Cash paid during the year for: Income taxes $ 16,970 10,050 9,661 Interest expense 76,684 100,121 75,886 ========= ========= ========= Acquisition of banks and financial services companies: Assets acquired (noncash) $ -- 141 872,460 Liabilities assumed -- 67 854,230 Purchase price payable -- 656 1,120 ========= ========= ========= Sale of banking center Assets sold (noncash) $ 2,403 -- -- Liabilities sold 26,399 -- -- ========= ========= =========
See accompanying notes to consolidated financial statements. 53 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 1) Summary of Significant Accounting Policies First Niagara Financial Group, Inc. ("FNFG") is a Delaware corporation, which holds all of the capital stock of First Niagara Bank ("First Niagara"), a federally chartered savings bank. FNFG and First Niagara are hereinafter referred to collectively as "the Company." First Niagara was originally organized in 1870 as a New York State chartered mutual savings bank. FNFG was organized in April 1998 by First Niagara in connection with its conversion to a New York State chartered stock savings bank and the reorganization to a two-tiered mutual holding company. On July 21, 2002, the Boards of Directors of First Niagara Financial Group, MHC ("the MHC"), FNFG and First Niagara adopted a plan of conversion and reorganization to convert the MHC from mutual to stock form ("the Conversion"). In connection with the Conversion, which was completed on January 17, 2003, the 61% of outstanding shares of FNFG common stock owned by the MHC were sold to depositors of First Niagara and the public ("the Offering"). As a result of the Conversion and Offering the MHC ceased to exist, and FNFG became a fully public Company. See note 2 for additional information. The Company provides financial services to individuals and businesses in upstate New York. The Company's business is primarily accepting deposits from customers through its banking centers and investing those deposits, together with funds generated from operations and borrowings, in one- to four-family residential, multi-family residential and commercial real estate loans, commercial business loans and leases, consumer loans, and investment securities. Additionally, the Company offers insurance products and services, as well as trust and investment services. The accounting and reporting policies of the Company conform to general practices within the banking industry and to accounting principles generally accepted in the United States of America. Certain reclassification adjustments were made to the 2001 and 2000 financial statements to conform them to the 2002 presentation. The following is a description of the Company's significant accounting policies: (a) Principles of Consolidation The consolidated financial statements include the accounts of FNFG and its subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. (b) Cash and Cash Equivalents Cash and cash equivalents include cash on hand, cash items in the process of collection, amounts due from banks, federal funds sold, money market accounts and other short-term investments, which mature within three months or less. (c) Investment Securities All debt and marketable equity securities are classified as available for sale. The securities are carried at fair value, with unrealized gains and losses, net of the related deferred income tax effect, reported as a component of accumulated other comprehensive income. Realized gains and losses are included in the consolidated statement of income and are determined using the specific identification method. A decline in the fair value of any available for sale security below cost that is deemed other than temporary is charged to earnings, resulting in the establishment of a new cost basis. Premiums and discounts on investment securities are amortized/accreted to interest income utilizing the interest method. 54 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (d) Loans Loans are stated at the principal amount outstanding, adjusted for net unamortized deferred fees, costs, discounts and premiums that are amortized to income by the interest method. Accrual of interest income on loans is generally discontinued after payments become more than ninety days delinquent, unless the status of a particular loan clearly indicates earlier discontinuance is more appropriate. All uncollected interest income previously recognized on non-accrual loans is reversed and subsequently recognized only to the extent payments are received. In those instances where there is doubt as to the collectibility of principal, interest payments are applied to principal. Loans are generally returned to accrual status when principal and interest payments are current, full collectibility of principal and interest is reasonably assured and a consistent record of performance, generally six months, has been demonstrated. (e) Direct Financing Leases The Company accounts for its direct financing leases in accordance with Statement of Financial Accounting Standards ("SFAS") No. 13, "Accounting for Leases." At lease inception, the present values of future rentals and the residual are recorded as a net investment in direct financing leases. Unearned interest income and sales commissions and other direct costs incurred are capitalized and are amortized to interest income over the lease term utilizing the interest method. (f) Real Estate Owned Real estate owned consists of property acquired in settlement of loans which are initially valued at the lower of the carrying amount of the loan or fair value, based on appraisals at foreclosure, less the estimated cost to sell the property ("net realizable value"). These properties are periodically adjusted to the lower of adjusted cost or net realizable value throughout the holding period. (g) Allowance for Credit Losses The allowance for credit losses is established through charges to earnings through the provision for credit losses. Loan and lease losses are charged and recoveries are credited to the allowance for credit losses. Management's evaluation of the allowance is based on a continuing review of the loan portfolio. The methodology for determining the amount of the allowance for credit losses consists of several elements. Larger balance nonaccruing, impaired and delinquent loans are reviewed individually and the value of any underlying collateral is considered in determining estimates of losses associated with those loans and the need, if any, for a specific reserve. Another element involves estimating losses inherent in categories of smaller balance homogeneous loans based primarily on historical experience, industry trends and trends in the real estate market and the current economic environment in the Company's market areas. The unallocated portion of the allowance for credit losses is based on management's evaluation of various conditions, and involves a higher degree of uncertainty because this component of the allowance is not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with this element include the following: industry and regional conditions; seasoning of the loan portfolio and changes in the composition of and growth in the loan portfolio; the strength and duration of the current business cycle; existing general economic and business conditions in the lending areas; credit quality trends, including trends in nonaccruing loans; historical loan charge-off experience; and the results of bank regulatory examinations. 55 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts of principal and interest under the original terms of the agreement. Such loans are measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, the loan's observable market price or the fair value of the underlying collateral if the loan is collateral dependent. The Company collectively evaluates smaller-balance homogeneous loans for impairment, including one- to four-family residential mortgage loans, student loans and consumer loans, other than those modified in a troubled debt restructuring. (h) Premises and Equipment Premises and equipment are carried at cost, net of accumulated depreciation and amortization. Depreciation is computed on the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized on the straight-line method over the lesser of the life of the improvements or the lease term. The Company generally amortizes buildings over a period of 20 to 39 years, furniture and equipment over a period of 3 to 10 years, and capital leases over the respective lease term. Impairment losses on premises and equipment are realized if the carrying amount is not recoverable from its undiscounted cash flows and exceeds its fair value. (i) Goodwill and Intangible Assets The excess of the cost of acquired entities over the fair value of identifiable tangible and intangible assets acquired, less liabilities assumed, is recorded as goodwill. Acquired intangible assets (other than goodwill) are amortized over their useful economic life. Effective with the Company's adoption of SFAS No. 142, "Goodwill and Other Intangible Assets" on January 1, 2002, the Company no longer is permitted to amortize goodwill and any acquired intangible assets with an indefinite useful economic life, but is required to review these assets for impairment annually based upon guidelines specified by the Statement. The Company has established November 1 of each year as the date for conducting its annual goodwill impairment assessment. Impairment testing requires that the fair value of the Company's reporting units be compared to their carrying amount, including goodwill. Reporting units are identified based upon an analysis of each of the Company's individual operating segments. A reporting unit is defined as any distinct, separately identifiable component of an operating segment for which complete, discrete financial information is available that management regularly reviews. Discounted cash flow valuation models that incorporate such variables as revenue growth rates, expense trends, interest rates and terminal values are utilized to determine the fair value of the Company's reporting units. Prior to January 1, 2002, the Company amortized goodwill on a straight-line basis over periods of ten to twenty years and periodically assessed whether events or changes in circumstances indicated that the carrying amount of goodwill might be impaired. 56 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (j) Derivative Instruments Effective January 1, 2001, the Company adopted the provisions of SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" as amended by SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities - An Amendment of FASB Statement No. 133." SFAS No. 133 and SFAS No. 138 establish accounting and reporting standards for derivative instruments, including certain derivatives embedded in other contracts, and for hedging activities. These statements require that an entity recognize all derivatives as either assets or liabilities in the statement of condition and measures those instruments at fair value. Changes in the fair value of the derivatives are recorded each period in current earnings or other comprehensive income, depending on whether the derivative is used in a qualifying hedge strategy and, if so, whether the hedge is a cash flow or fair value hedge. In order to qualify as a hedge, the Company must document the hedging strategy at its inception, including the nature of the risk being hedged and how the effectiveness of the hedge will be measured. The Company accounted for the interest rate swap agreements that it used to hedge a portion of its Money Market Demand Accounts ("MMDA") as cash flow hedges. The Company recognized the portion of the change in fair value of the interest rate swaps that is considered effective in hedging cash flows as a direct charge or credit to accumulated other comprehensive income (equity), net of tax. The ineffective portion of the change in fair value, if any, was recorded to earnings. Amounts recorded in accumulated other comprehensive income were periodically reclassified to interest expense on deposits to offset interest expense on the hedged MMDA accounts resulting from fluctuations in interest rates. Prior to January 1, 2001, interest income or expense on the swaps was recognized as an adjustment to interest expense on deposits as accrued. The fair value of interest rate swaps as of January 1, 2001, net of the related deferred income tax effect, was recorded as a cumulative effect of a change in accounting principle in accumulated other comprehensive income. Commitments to originate residential real estate loans that the Company intends to sell, forward commitments to sell residential real estate loans, and residential real estate loans held for sale are generally recorded in the consolidated statement of condition at fair value, with the corresponding unrealized gain or loss being included in other noninterest income. Prior to January 1, 2001 these financial instruments were recorded at the lower of aggregate cost or market value. (k) Employee Benefits The Company maintains a non-contributory, qualified, defined benefit pension plan ("the pension plan") that covers substantially all employees who meet certain age and service requirements. The actuarially determined pension benefit in the form of a life annuity is based on the employee's combined years of service, age and compensation. The Company's policy is to fund the minimum amount required by government regulations. Effective February 1, 2002, the Company froze all benefit accruals and participation in the pension plan. Additionally, in 2002, 2001 and 2000, the Company maintained several defined contribution 401(k) plans related to the companies acquired in 1999 and 2000. The Company accrues contributions due under these plans as earned by employees. 57 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The Company also provides certain post-retirement benefits, principally health care and group life insurance ("the post-retirement plan"), to employees who meet certain age and service requirements and their beneficiaries and dependents. The expected cost of providing these post-retirement benefits are accrued during an employee's active years of service. Effective January 19, 2001, the Company modified its post-retirement plan so that participation was closed to those employees who did not meet the retirement eligibility by December 31, 2001. (l) Stock-Based Compensation The Company maintains various long-term incentive stock benefit plans under which fixed award stock options and restricted stock awards may be granted to certain officers, directors, key employees and other persons providing services to the Company. SFAS No. 123, "Accounting for Stock-Based Compensation," established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed under SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting prescribed by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and has only adopted the disclosure requirements of SFAS No. 123, as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." As such, compensation expense is recorded on the date the options are granted only if the current market price of the underlying stock exceeded the exercise price. Compensation expense equal to the market value of FNFG's stock on the grant date is accrued ratably over the vesting period for shares of restricted stock granted. Had the Company determined compensation cost based on the fair value method under SFAS No. 123, the Company's net income would have been reduced to the pro forma amounts indicated below. These amounts may not be representative of the effects on reported net income for future years due to changes in market conditions and the number of options outstanding:
2002 2001 2000 ---------- ---------- ---------- (in thousands except per share amounts) Net Income As reported $ 30,795 21,220 19,519 Add: Stock-based employee compensation expense included in net income, net of related tax effects 556 420 398 Deduct: Stock-based employee compensation expense determined under the fair-value based method, net of related tax effects (1,172) (996) (1,011) ---------- ---------- ---------- Pro forma $ 30,179 20,644 18,906 ========== ========== ========== Basic earnings per share As reported $ 1.24 0.86 0.79 Pro forma 1.21 0.83 0.76 Diluted earnings per share As reported $ 1.21 0.85 0.79 Pro forma 1.18 0.83 0.76
58 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The per share weighted-average fair value of stock options granted for 2002, 2001 and 2000 were $10.22, $4.19 and $2.89 on the date of grant, respectively, using the Black Scholes option-pricing model. The following weighted-average assumptions were utilized: 2002, 2001 and 2000 expected dividend yield of 1.51%, 2.79% and 3.13%; risk-free interest rate of 3.91%, 5.02% and 6.44%; expected life of 6.5 years for 2002 and 7.5 years for 2001 and 2000; and expected volatility of 33.71%, 32.30% and 30.13%, respectively. The Company also deducted 10% in each year to reflect an estimate of the probability of forfeiture prior to vesting. (m) Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the periods in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through income tax expense. (n) Earnings Per Share Basic earnings per share ("EPS") is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. (o) Investment and Fiduciary Services Assets held in fiduciary or agency capacity for customers are not included in the accompanying consolidated statements of condition, since such assets are not assets of the Company. Fee income is recognized on the accrual method based on the fair value of assets administered. (p) New Accounting Standards In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143, "Accounting for Asset Retirement Obligations." This statement requires entities to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. When the liability is initially recorded, the entity capitalizes the asset retirement cost by increasing the carrying amount of the related long-lived asset. The liability is accreted to its present value each period and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss. The provisions of SFAS No. 143 are effective for fiscal years beginning after June 15, 2002 and are not expected to have a material impact on the Company's consolidated financial statements. 59 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" and the provisions for the disposal of a segment of a business in APB Opinion No. 30, "Reporting the Results of Operations -- Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions." This statement requires that long-lived assets to be disposed of by sale be measured at the lower of its carrying amount or fair value less cost to sell, and recognition of impairment losses on long-lived assets to be held if the carrying amount of the long-lived asset is not recoverable from its undiscounted cash flows and exceeds its fair value. Additionally, SFAS No. 144 resolved various implementation issues related to SFAS No. 121. The provisions of SFAS No. 144 were adopted on January 1, 2002 and had no effect on the Company's consolidated financial statements. In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections." This statement eliminates SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" as amended by SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." As a result, gains and losses from extinguishment of debt can only be classified as extraordinary items if they meet the definition of unusual and infrequent as prescribed in APB Opinion No. 30. Additionally, SFAS No. 145 amends SFAS No. 13 "Accounting for Leases" to require that lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. SFAS No. 145 addresses a number of additional issues that were not substantive in nature. The provisions of this statement are effective at various dates in 2002 and 2003 and are not expected to have a material impact on the Company's consolidated financial statements. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This statement nullifies Emerging Issues Task Force Issue No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" and requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is probable and represents obligations to transfer assets or provide services as a result of past transactions. The provisions of this statement are effective for exit or disposal activities that are initiated after December 31, 2002. In October 2002, the FASB issued SFAS No. 147, "Acquisitions of Certain Financial Institutions - an Amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9." This statement removes acquisitions of financial institutions from the scope of both SFAS No. 72 and Interpretation No. 9 and requires that those transactions be accounted for in accordance with SFAS No. 141 "Business Combinations" and No. 142 "Goodwill and Other Intangible Assets." As a result, the requirement in paragraph 5 of SFAS No. 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an unidentifiable intangible asset ("SFAS No. 72 goodwill") no longer applies to acquisitions within the scope of the Statement. The provisions of this statement were effective October 1, 2002 and did not have a material impact on the Company's consolidated financial statements as the Company did not have any SFAS No. 72 goodwill. 60 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others." This Interpretation enhances the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of Interpretation No. 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002. The Company has made the applicable transition disclosures required by Interpretation No. 45 in this annual report on Form 10-K. The Company is required to adopt the recognition and measurement provisions of Interpretation No. 45 effective January 1, 2003, which is not expected to have a material impact on the Company's consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123." This statement amends FASB Statement No. 123, "Accounting for Stock-Based Compensation," to provide three alternative methods for a voluntary change to the fair value based method of accounting for stock-based compensation and requires prominent disclosures in both interim and annual financial statements about the method of accounting for stock-based compensation and its effect on reported results. The provisions of this statement were effective for fiscal years ending after December 15, 2002 and interim periods beginning after December 15, 2002. The Company has made the applicable disclosures required by SFAS No. 148 in this annual report on Form 10-K. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," which clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements." More specifically, the Interpretation explains how to identify variable interest entities and how to determine whether or not those entities should be consolidated. The Interpretation requires the primary beneficiaries of variable interest entities to consolidate the variable interest entities if they are subject to a majority of the risk of loss or are entitled to receive a majority of the residual returns. It also requires that both the primary beneficiary and all other enterprises with a significant variable interest in a variable interest entity make certain disclosures. Interpretation No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The provisions of this Interpretation are not expected to have a material impact on the Company's consolidated financial statements. (q) Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and disclosure of contingent assets and liabilities to prepare these financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates. 61 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (2) Corporate Structure and Stock Offering First Niagara was organized in 1870 as a New York State chartered mutual savings bank. In April 1998 First Niagara reorganized into the mutual holding company structure as the wholly-owned subsidiary of FNFG, which simultaneously conducted an initial public offering. Under this structure, at least 51% of FNFG's voting shares were required to be owned by the MHC. The Company utilized the proceeds raised in its initial offering to make three bank and five non-bank acquisitions between 1999 and 2001. In July 2000, FNFG acquired CNY Financial Corporation, the holding company for Cortland Savings Bank ("Cortland"). In November 2000, FNFG acquired all of the common stock of Iroquois Bancorp, Inc., the holding company of Cayuga Bank ("Cayuga") and The Homestead Savings, FA. Following completion of this transaction, The Homestead Savings was merged into Cayuga. Initially, Cortland and Cayuga were operated as wholly owned subsidiaries of FNFG. In June 2002, FNFG announced its decision to convert to a federal charter subject to Office of Thrift Supervision ("OTS") regulation, and to merge Cortland and Cayuga into First Niagara. The mergers of Cortland and Cayuga into First Niagara, as well as the conversion to federal charters for First Niagara and the MHC were approved by the OTS and were effective November 8, 2002. The conversion of FNFG to a federal charter was approved by stockholders' of the Company on January 9, 2003 and was effective January 17, 2003. On July 21, 2002, the Boards of Directors of the MHC, FNFG and First Niagara adopted a plan of conversion and reorganization to convert the MHC from mutual to stock form. In connection with the Conversion the 61% ownership interest of the MHC in FNFG was sold to depositors of First Niagara and the public. Completion of the Conversion and Offering, which was effective on January 17, 2003, resulted in the issuance of 67.4 million shares of common stock. A total of 41.0 million shares were sold in subscription, community and syndicated offerings, at $10.00 per share, and an additional 26.4 million shares were issued to the former public stockholders of FNFG based upon an exchange ratio of 2.58681 new shares for each share of FNFG held as of the close of business on January 17, 2003. Cash was paid in lieu of fractional shares. As a result of the Conversion and Offering, current and prior year share and per share amounts will be restated to give retroactive recognition to the exchange ratio applied in the conversion. On a restated basis, diluted EPS for 2002, 2001 and 2000 was $0.47, $0.33 and $0.30, respectively. Costs related to the Offering, primarily marketing fees paid to the Company's investment banking firm, professional fees, registration fees and printing and mailing costs, were approximately $19 million and accordingly, net offering proceeds were approximately $391 million. As a result of the Conversion and Offering, FNFG was succeeded by a new, fully public, Delaware corporation with the same name and the MHC ceased to exist. At December 31, 2002 stock subscription proceeds received, exclusive of $13.2 million of funds authorized for withdrawal from deposit accounts, amounted to $76.0 million. Upon the completion of the reorganization, the Company established a special "liquidation account" for the benefit of certain depositors of First Niagara of $128.1 million which is equal to the amount of the retained earnings of First Niagara at the time it reorganized into the MHC in 1998. Under the rules of the OTS, First Niagara is not be permitted to pay dividends on its capital stock to FNFG, its sole stockholder, if First Niagara's stockholder's equity would be reduced below the amount of the liquidation account. 62 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (3) Acquisitions and Dispositions of Assets On January 17, 2003, in conjunction with the Conversion and Offering, the Company acquired Finger Lakes Bancorp, Inc. ("FLBC") the holding company of Savings Bank of the Finger Lakes ("SBFL"), headquartered in Geneva, New York. SBFL operated seven branch locations and had assets of $379.0 million and deposits of $259.8 million at December 31, 2002. Subsequent to the acquisition, SBFL was merged into First Niagara. Under the terms of the agreement, the Company paid $20.00 per share, in an equal combination of cash and stock from the Offering, for all of the outstanding shares and options of FLBC for an aggregate purchase price of $67.1 million. As a result, 3.4 million shares of FNFG stock were issued and cash payments totaling $33.6 million were made. This acquisition was accounted for under the purchase method of accounting. On October 25, 2002, the Company sold its Lacona Banking Center. In connection with this transaction, $2.6 million of assets and $26.4 million of deposits were sold, which resulted in a pre-tax gain of $2.4 million. In 2002 First Niagara Risk Management, Inc. ("FNRM"), First Niagara's wholly owned insurance subsidiary, acquired the customer lists of a property and casualty insurance agency and an insurance adjustment firm, both located in western New York. In connection with these purchases, $468 thousand of customer lists were recorded and are being amortized on a straight-line basis over a period of three to five years. 63 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (4) Securities Available for Sale The amortized cost, gross unrealized gains and losses and approximate fair value of securities available for sale at December 31, 2002 are summarized as follows (in thousands):
Amortized Unrealized Unrealized Fair cost gains losses value -------- ---------- ---------- ------- Debt securities: U.S. Treasury $140,060 1 (7) 140,054 U.S. Government agencies 89,522 1,007 -- 90,529 Corporate 14,665 137 (239) 14,563 States and political subdivisions 32,957 1,609 -- 34,566 -------- ----- ------ ------- Total debt securities 277,204 2,754 (246) 279,712 -------- ----- ------ ------- Mortgage-backed securities: Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 142,008 529 (182) 142,355 Government National Mortgage Association 14,999 32 (6) 15,025 Federal National Mortgage Association 52,611 303 (65) 52,849 Privately issued 52,543 316 (88) 52,771 -------- ----- ------ ------- Total collateralized mortgage obligations 262,161 1,180 (341) 263,000 -------- ----- ------ ------- Other mortgage-backed securities: Federal Home Loan Mortgage Corporation 51,024 1,936 -- 52,960 Government National Mortgage Association 9,910 659 -- 10,569 Federal National Mortgage Association 12,619 1,171 -- 13,790 -------- ----- ------ ------- Total other mortgage-backed securities 73,553 3,766 -- 77,319 -------- ----- ------ ------- Total mortgage-backed securities 335,714 4,946 (341) 340,319 -------- ----- ------ ------- Asset-backed securities: Non-U.S. government agencies 500 3 -- 503 U.S. government agencies 3,276 60 (2) 3,334 -------- ----- ------ ------- Total asset-backed securities 3,776 63 (2) 3,837 -------- ----- ------ ------- Equity securities - common stock 3,677 550 (730) 3,497 Other 4,953 46 -- 4,999 -------- ----- ------ ------- Total investment securities $625,324 8,359 (1,319) 632,364 ======== ===== ====== =======
64 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The amortized cost, gross unrealized gains and losses and approximate fair value of securities available for sale at December 31, 2001 are summarized as follows (in thousands):
Amortized Unrealized Unrealized Fair cost gains losses value -------- ------ ------ ------- Debt securities: U.S. Treasury $164,992 128 -- 165,120 U.S. Government agencies 79,419 1,647 (50) 81,016 Corporate 27,264 176 (414) 27,026 States and political subdivisions 26,696 575 (63) 27,208 -------- ------ ------ ------- Total debt securities 298,371 2,526 (527) 300,370 -------- ------ ------ ------- Mortgage-backed securities: Collateralized mortgage obligations: Federal Home Loan Mortgage Corporation 100,646 526 (599) 100,573 Government National Mortgage Association 4,927 -- (193) 4,734 Federal National Mortgage Association 33,482 145 (501) 33,126 Privately issued 126,434 1,512 (805) 127,141 -------- ------ ------ ------- Total collateralized mortgage obligations 265,489 2,183 (2,098) 265,574 -------- ------ ------ ------- Other mortgage-backed securities: Federal Home Loan Mortgage Corporation 37,081 1,258 -- 38,339 Government National Mortgage Association 16,094 705 -- 16,799 Federal National Mortgage Association 18,213 956 -- 19,169 -------- ------ ------ ------- Total other mortgage-backed securities 71,388 2,919 -- 74,307 -------- ------ ------ ------- Total mortgage-backed securities 336,877 5,102 (2,098) 339,881 -------- ------ ------ ------- Asset-backed securities: Non-U.S. government agencies 23,380 735 -- 24,115 U.S. government agencies 4,682 55 (2) 4,735 -------- ------ ------ ------- Total asset-backed securities 28,062 790 (2) 28,850 -------- ------ ------ ------- Equity securities - common stock 21,530 3,318 (4,523) 20,325 Other 4,453 18 -- 4,471 -------- ------ ------ ------- Total investment securities $689,293 11,754 (7,150) 693,897 ======== ====== ====== =======
65 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Scheduled contractual maturities of certain investment securities owned by the Company at December 31, 2002 are as follows (in thousands): Amortized Fair cost value -------- ------- Debt securities: Within one year $173,607 173,943 After one year through five years 79,440 80,796 After five years through ten years 9,589 10,454 After ten years 14,568 14,519 -------- ------- 277,204 279,712 Mortgage-backed securities 335,714 340,319 Asset-backed securities 3,776 3,837 -------- ------- $616,694 623,868 ======== ======= The contractual maturities of mortgage and asset-backed securities available for sale generally exceed ten years. However, the effective lives are expected to be shorter due to anticipated prepayments. Gross realized gains and losses on securities available for sale in 2002, 2001 and 2000 are summarized as follows (in thousands): 2002 2001 2000 ------- ----- ----- Gross realized gains $ 8,924 2,080 1,295 Gross realized losses (9,968) (2,163) (1,634) ------- ----- ----- Net realized gains (losses) $(1,044) (83) (339) ======= ===== ===== At December 31, 2002, $228.7 million of securities were pledged to secure borrowings and lines of credit from the Federal Home Loan Bank ("FHLB") and Federal Reserve Bank ("FRB"), repurchase agreements and deposits. At December 31, 2002, no investments in securities of a single non-U.S. Government or government agency issuer exceeded 10% of stockholders' equity 66 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (5) Loans Loans receivable at December 31, 2002 and 2001 consist of the following (in thousands): 2002 2001 ----------- ---------- Real estate: One-to four-family $ 927,453 980,638 Home equity 136,986 114,443 Commercial and multi-family 473,493 392,896 Construction: Commercial 101,633 56,394 Residential 5,567 8,108 ----------- --------- Total real estate loans 1,645,132 1,552,479 Consumer loans 169,155 182,126 Commercial business loans 178,555 135,621 ----------- --------- Total loans 1,992,842 1,870,226 Net deferred costs and unearned discounts 2,591 1,642 Allowance for credit losses (20,873) (18,727) ----------- --------- Total loans, net $ 1,974,560 1,853,141 =========== ========= Included in commercial business loans are $41.5 million and $18.4 million of direct financing leases at December 31, 2002 and 2001, respectively. Under direct financing leases, the Company leases equipment to small businesses with terms ranging from two to five years. During 2002, $34.6 million of equipment leases were originated by the Company, of which $2.6 million were sold to outside investors. The remainder of the leases originated were retained by the Company. Non-accrual loans amounted to $7.5 million, $11.5 million and $6.5 million at December 31, 2002, 2001 and 2000, respectively, representing 0.38%, 0.61% and 0.35% of total loans, respectively. Interest income that would have been recorded if the loans had been performing in accordance with their original terms amounted to $182 thousand, $604 thousand and $273 thousand for 2002, 2001 and 2000, respectively. At December 31, 2002 and 2001, the balance of impaired loans amounted to $4.2 million and $5.3 million, respectively, and $897 thousand and $1.3 million, respectively, was included within the allowance for credit losses to specifically reserve for losses relating to those loans. Residential real estate owned, net of related allowances of $0 and $363 thousand, at December 31, 2002 and December 31, 2001, respectively, was $1.4 million and $665 thousand, respectively. Residential mortgage loans held for sale were $4.3 million and $3.3 million at December 31, 2002 and December 31, 2001, respectively, and are included in one-to four-family real estate loans. Mortgages serviced for others by the Company amounted to $242.9 million, $252.3 million and $190.1 million at December 31, 2002, 2001 and 2000, respectively. Mortgage loans sold amounted to $55.5 million, $105.5 million and $56.3 million for 2002, 2001 and 2000, respectively. Gains on the sale of loans amounted to $1.0 million, $1.4 million and $378 thousand for 2002, 2001 and 2000, respectively. 67 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Changes in the Company's capitalized mortgage servicing assets, classified within other assets in the consolidated statements of condition for 2002, 2001 and 2000 are summarized as follows (in thousands): 2002 2001 2000 ------- ------- ------- Balance, beginning of year $ 1,265 519 122 Originations 482 952 417 Amortization (339) (206) (20) ------- ------- ------- Balance, end of year $ 1,408 1,265 519 ======= ======= ======= The Company had outstanding commitments to originate loans of approximately $124.6 million and $81.3 million at December 31, 2002 and 2001, respectively. These commitments have fixed expiration dates and are at market rates. These commitments do not necessarily represent future cash requirements since certain of these instruments may expire without being funded. Commitments to sell residential mortgages amounted to $5.0 million and $2.6 million at December 31, 2002 and 2001, respectively. Unused lines of credit and outstanding letters of credit amounted to $179.5 million and $140.5 million at December 31, 2002 and 2001, respectively. Since the majority of unused lines of credit and outstanding letters of credit expire without being funded, the Company's obligation to fund the above commitment amounts is substantially less than the amounts reported. Changes in the allowance for credit losses for 2002, 2001 and 2000 are summarized as follows (in thousands): 2002 2001 2000 -------- ------ ------ Balance, beginning of year $ 18,727 17,746 9,862 Provision for credit losses 6,824 4,160 2,258 Allowance obtained through acquisitions -- -- 6,361 Charge-offs (5,804) (4,071) (1,072) Recoveries 1,126 892 337 -------- ------ ------ Balance, end of year $ 20,873 18,727 17,746 ======== ====== ====== Virtually all of the Company's mortgage and consumer loans are to customers located in Upstate New York. Accordingly, the ultimate collectibility of the Company's loan portfolio is susceptible to changes in market conditions in this market area. Loans due from certain officers and directors of the Company and affiliates amounted to $1.5 million and $5.9 million at December 31, 2002 and 2001, respectively. 68 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (6) Premises and Equipment A summary of premises and equipment at December 31, 2002 and 2001 follows (in thousands): 2002 2001 -------- ----- Land $ 3,511 3,531 Buildings and improvements 31,190 30,742 Furniture and equipment 33,670 31,065 Property under capital leases 1,365 1,365 -------- ----- 69,736 66,703 Accumulated depreciation and amortization (29,291) (26,470) -------- ----- Premises and equipment, net $ 40,445 40,233 ======== ====== Future minimum rental commitments for premises and equipment under noncancellable operating leases at December 31, 2002 were $1.7 million in 2003; $1.6 million in 2004; $1.6 million in 2005; $1.5 million in 2006; $1.4 million in 2007; and $6.7 million in years thereafter through 2021. Real estate taxes, insurance and maintenance expenses related to these leases are obligations of the Company. Rent expense was $1.8 million, $1.5 million and $1.3 million for 2002, 2001 and 2000, respectively, and is included in occupancy and equipment expense. (7) Goodwill and Intangible Assets The following is a reconciliation of reported net income and earnings per share to net income and earnings per share adjusted as if SFAS No. 142 had been adopted on January 1, 2000 (in thousands except per share amounts):
2002 2001 2000 ---------- ---------- ---------- Net income: As reported $ 30,795 21,220 19,519 Add back: Goodwill amortization -- 4,742 2,114 ---------- ---------- ---------- Adjusted net income $ 30,795 25,962 21,633 ========== ========== ========== Basic earnings per share: As reported $ 1.24 0.86 0.79 Add back: Goodwill amortization -- 0.19 0.08 ---------- ---------- ---------- Adjusted basic earnings per share $ 1.24 1.05 0.87 ========== ========== ========== Diluted earnings per share: As reported $ 1.21 0.85 0.79 Add back: Goodwill amortization -- 0.19 0.08 ---------- ---------- ---------- Adjusted diluted earnings per share $ 1.21 1.04 0.87 ========== ========== ==========
69 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The following tables set forth information regarding the Company's amortizing intangible assets (in thousands): 2002 2001 -------- -------- Customer lists: Gross carrying amount $ 10,113 9,645 Accumulated amortization (3,721) (2,848) -------- -------- Net carrying amount $ 6,392 6,797 ======== ======== Estimated future intangible asset amortization expense: 2003 $896 2004 896 2005 873 2006 818 2007 728 In 2002 FNRM acquired the customer lists of a property and casualty insurance agency and an insurance adjustment firm, both located in western New York. In connection with these purchases, $468 thousand of customer lists were recorded and are being amortized on a straight-line basis over a period of three to five years, based upon management's evaluation of their useful economic life. The following table sets forth information regarding the Company's goodwill for 2002, 2001 and 2000 (in thousands):
Financial Consolidated Banking segment services segment total --------------- ----------------- ---------------- Balances at January 1, 2000 $ -- 4,977 4,977 Acquired 71,857 2,782 74,639 Amortization (1,400) (714) (2,114) Contingent earn-out adjustments -- (31) (31) -------- -------- -------- Balances at December 31, 2000 70,457 7,014 77,471 Acquired -- 1,279 1,279 Amortization (3,787) (955) (4,742) Purchase accounting adjustment 205 -- 205 -------- -------- -------- Balances at December 31, 2001 66,875 7,338 74,213 Contingent earn-out adjustments -- (112) (112) -------- -------- -------- Balances at December 31, 2002 $ 66,875 7,226 74,101 ======== ======== ========
The Company has performed the required transitional and annual goodwill impairment tests as of January 1, 2002 and November 1, 2002, respectively. Based upon the results of these tests, the Company has determined that goodwill was not impaired as of either date. 70 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (8) Other Assets A summary of other assets at December 31, 2002 and 2001 follows (in thousands): 2002 2001 -------- ------- Cash surrender value of bank- owned life insurance $ 54,082 51,357 FHLB stock 20,863 24,865 Net deferred tax assets (see note 14) 9,188 9,961 Accrued interest receivable 12,093 13,203 Other receivables and prepaid assets 7,975 3,499 Other 12,207 12,126 -------- ------- $116,408 115,011 ======== ======= (9) Deposits Deposits consist of the following at December 31, 2002 and 2001 (in thousands):
2002 2001 --------------------- ----------------------- Weighted Weighted average average Balance rate Balance rate ---------- -------- ---------- ------- Savings accounts $ 632,894 1.49% $ 450,762 2.56% Certificates of deposit maturing: Within one year 630,587 3.15 674,637 4.41 After one year, through two years 195,372 3.24 148,965 4.23 After two years, through three years 20,499 4.68 19,996 5.20 After three years, through four years 25,231 4.50 10,771 5.81 After four years, through five years 4,906 4.17 6,662 5.10 After five years 2,651 4.72 2,686 5.14 ---------- ---------- 879,246 3.26 863,717 4.43 ---------- ---------- Checking accounts: Non-interest bearing 134,160 -- 109,895 -- Interest-bearing: NOW accounts 161,063 0.68 157,886 0.94 Money market accounts 306,487 1.44 391,420 2.14 ---------- ---------- 601,710 659,201 ---------- ---------- Mortgagors' payments held in escrow 15,619 2.00 17,150 2.00 ---------- ---------- $2,129,469 2.06% $1,990,830 3.01% ========== ==========
Included within deposits is approximately $13.2 million of funds authorized for withdrawal in connection with the Company's second step stock offering. These funds were withdrawn from their respective deposit accounts and credited to stockholders' equity upon completion of the offering on January 17, 2003. 71 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Interest expense on deposits for 2002, 2001 and 2000 is summarized as follows (in thousands): 2002 2001 2000 ------- ------- ------- Certificates of deposit $32,774 47,284 30,593 Money market accounts 6,437 14,334 14,848 Savings accounts 12,750 10,919 9,380 NOW accounts 1,354 1,544 1,190 Mortgagors' payments held in escrow 296 328 261 ------- ------- ------- $53,611 74,409 56,272 ======= ======= ======= Certificates of deposit issued in amounts over $100 thousand amounted to $170.0 million, $157.8 million and $162.4 million at December 31, 2002, 2001 and 2000, respectively. Interest expense thereon approximated $6.3 million, $9.3 million and $4.8 million in 2002, 2001 and 2000, respectively. The Federal Deposit Insurance Corporation does not insure deposit amounts that are in excess of $100 thousand. Interest rates on certificates of deposit range from 1.34% to 7.03% at December 31, 2002. First Niagara is required to maintain reserves against certain deposit accounts. At December 31, 2002, $600 thousand of the Company's cash and due from banks is restricted from withdrawal to meet these reserve requirements. The carrying value of investment securities pledged as collateral for deposits at December 31, 2002 was $21.2 million. The aggregate amount of deposits that have been reclassified as loans at December 31, 2002 due to such deposits being in an overdraft position was $1.4 million. (10) Other Borrowed Funds Information relating to outstanding borrowings at December 31, 2002 and 2001 is summarized as follows (in thousands): 2002 2001 -------- -------- Short-term borrowings: FHLB advances $ 48,180 99,368 Reverse repurchase agreements 15,132 105,124 Loan payable to First Niagara Financial Group, MHC 6,000 6,000 Commercial bank loan -- 2,500 -------- -------- $ 69,312 212,992 ======== ======== Long-term borrowings: FHLB advances $187,823 216,048 Reverse repurchase agreements 140,000 130,000 -------- -------- $327,823 346,048 ======== ======== FHLB advances generally bear fixed interest rates ranging from 1.84% to 7.71% at December 31, 2002. Reverse repurchase agreements generally bear fixed interest rates ranging from 1.50% to 6.53% at December 31, 2002. At December 31, 2001, FNFG had a $2.5 million loan with a commercial bank that was repaid on January 28, 2002 and had an interest rate equal to the LIBOR rate plus 150 basis points. 72 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Interest expense on borrowings for 2002, 2001 and 2000 is summarized as follows (in thousands): 2002 2001 2000 ------- ------- ------- FHLB advances $14,081 16,514 13,099 Reverse repurchase agreements 8,256 7,669 7,253 Loan payable to First Niagara Financial Group, MHC 153 394 90 Commercial bank loan 6 366 148 ------- ------- ------- $22,496 24,943 20,590 ======= ======= ======= The Company has a line of credit with the FHLB and FRB that provides a secondary funding source for lending, liquidity, and asset/liability management. At December 31, 2002, the FHLB line of credit totaled $732.9 million under which $236.0 million was utilized. The FRB line of credit totaled $4.3 million, under which there were no borrowings outstanding as of December 31, 2002. The Company is required to pledge loans or investment securities as collateral for these borrowing facilities. Approximately $259.7 million of residential mortgage and multifamily loans were pledged to secure the amount outstanding under the FHLB line of credit at December 31, 2002. The Company pledged to the FHLB and to broker-dealers, available for sale securities with a carrying value of $147.6 million at December 31, 2002. These are treated as financing transactions and the obligations to repurchase are reflected as a liability in the consolidated financial statements. The dollar amount of securities underlying the agreements are included in securities available for sale in the consolidated statements of condition. However, the securities are delivered to the dealer with whom each transaction is executed. The dealers may sell, loan or otherwise dispose of such securities to other parties in the normal course of their business, but agree to resell to the Company the same securities at the maturities of the agreements. The Company also retains the right of substitution of collateral throughout the terms of the agreements. At December 31, 2002, there were no amounts at risk under reverse repurchase agreements with any individual counterparty or group of related counterparties that exceeded 10% of stockholders' equity. The amount at risk is equal to the excess of the carrying value (or market value if greater) of the securities sold under agreements to repurchase over the amount of the repurchase liability. The aggregate maturities of long-term borrowings at December 31, 2002 are as follows (in thousands): 2004 $ 42,316 2005 58,878 2006 43,323 2007 27,271 Thereafter 156,035 -------- $327,823 ======== (11) Capital As discussed further in note 2, effective November 8, 2002, Cortland and Cayuga merged into First Niagara, and First Niagara converted to a federal charter subject to OTS regulation. OTS regulations require savings institutions to maintain a minimum ratio of tangible capital to total adjusted assets of 1.5%, a minimum ratio of Tier 1 (core) capital to total adjusted assets of 4.0%, and a minimum ratio of total (core and supplementary) capital to risk-weighted assets of 8.0%. 73 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Under its prompt corrective action regulations, the OTS is required to take certain supervisory actions (and may take additional discretionary actions) with respect to an undercapitalized institution. Such actions could have a direct material effect on the institution's financial statements. The regulations establish a framework for the classification of savings institutions into five categories -- well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Generally, an institution is considered well capitalized if it has a Tier 1 (core) capital ratio of at least 5.0%, a Tier 1 risk-based capital ratio of at least 6.0%, and a total risk-based capital ratio of at least 10.0%. The foregoing capital ratios are based in part on specific quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by the OTS about capital components, risk weightings and other factors. These capital requirements apply only to First Niagara, and do not consider additional capital retained by FNFG. Prior to converting to federal charters, FNFG and First Niagara were required to maintain minimum capital ratios calculated in a similar manner to, but not entirely the same as, the framework of the OTS. Management believes that as of December 31, 2002, First Niagara met all capital adequacy requirements to which it was subject. Further, the most recent Federal Deposit Insurance Corporation notification categorized First Niagara as a well-capitalized institution under the prompt corrective action regulations. Management is unaware of any conditions or events since the latest notification from federal regulators that have changed the capital adequacy category of First Niagara. The actual capital amounts and ratios for First Niagara at December 31, 2002 and 2001 are presented in the following table. For comparative purposes, prior year amounts and ratios have been recomputed to conform to OTS regulations to illustrate the effect of the consolidation of Cortland and Cayuga into First Niagara as if it occurred on December 31, 2001 (in thousands):
To be well capitalized Minimum under prompt corrective Actual capital adequacy action provisions -------------------- ------------------- ----------------------- Amount Ratio Amount Ratio Amount Ratio -------- ------ -------- ----- -------- ------ December 31, 2002: Tangible capital $186,218 6.54% 42,699 1.50% N/A N/A% Tier 1 (core) capital 186,218 6.54 113,863 4.00 142,328 5.00 Tier 1 risk-based capital 186,218 10.27 N/A N/A 108,743 6.00 Total risk-based capital 205,508 11.34 144,990 8.00 181,238 10.00 December 31, 2001: Tangible capital $165,805 5.99% 41,517 1.50% N/A N/A% Tier 1 (core) capital 165,805 5.99 110,711 4.00 138,389 5.00 Tier 1 risk-based capital 165,805 9.78 N/A N/A 101,677 6.00 Total risk-based capital 166,083 9.80 135,569 8.00 169,462 10.00
74 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The following is a reconciliation of stockholders' equity under generally accepted accounting principles ("GAAP") to regulatory capital for First Niagara as of December 31, 2002 an 2001 (in thousands):
2002 2001 --------- --------- First Niagara GAAP stockholders' equity $ 270,946 250,021 Capital adjustments: Goodwill and other intangibles (80,493) (81,010) Unrealized losses on equity securities available for sale (net of tax) (408) (928) Fair value adjustment included in stockholders' equity (3,930) (2,391) Disallowed portion of mortgage servicing rights (140) (126) Minority interest 243 239 --------- --------- Tier 1 capital 186,218 165,805 Allowable portion of allowance for credit losses 20,873 18,727 Fair value of equity securities (1,583) (18,449) --------- --------- Total capital $ 205,508 166,083 ========= =========
FNFG's ability to pay dividends is primarily dependent upon the ability of First Niagara to pay dividends to FNFG. The payment of dividends by subsidiary banks is subject to continued compliance with minimum regulatory capital requirements. In addition, regulatory approval is required prior to a subsidiary bank declaring dividends in excess of net income for that year plus net income retained in the preceding two years. First Niagara established a liquidation account at the time of conversion to a New York State chartered stock savings bank in an amount equal to its net worth as of the date of the latest consolidated statement of financial condition appearing in the final prospectus. In the event of a complete liquidation of First Niagara, each eligible account holder will be entitled, under New York State Law, to receive a distribution from the liquidation account in an amount equal to their current adjusted account balance for all such depositors then holding qualifying deposits in First Niagara. Accordingly, retained earnings of the Company are deemed to be restricted up to the balances of the liquidation accounts at December 31, 2002 and 2001. The liquidation account is maintained for the benefit of eligible pre-conversion account holders who continue to maintain their accounts at First Niagara after the date of conversion. The liquidation account, which is reduced annually to the extent that eligible account holders have reduced their qualifying deposits as of each anniversary date, totaled $30.4 million at December 31, 2002 and $36.0 million at December 31, 2001. Similarly, a liquidation account is also maintained for depositors acquired from Cortland in connection with its reorganization into a New York State chartered stock savings bank. This liquidation account totaled $8.2 million at December 31, 2002 and $9.4 million at December 31, 2001. (12) Derivative and Hedging Activities During 1999 and 2000 the Company entered into interest rate swap agreements in order to manage the interest rate risk related to the repricing of its Money Market Deposit Accounts ("MMDA"). Under the agreements the Company paid an annual fixed rate of interest and received a floating three-month U.S. Dollar LIBOR rate over a two-year period. The last of the Company's interest rate swap agreements expired in December 2002. Since the swap agreements qualified as cash flow hedges under the provisions of SFAS No. 133, the Company recognized the portion of the change in fair value of the interest rate swaps that was considered effective in 75 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 hedging cash flows as a direct charge or credit to other comprehensive income, net of tax, each period. With the adoption of SFAS No. 133 on January 1, 2001 a negative fair value adjustment of $95 thousand was recorded in other comprehensive income, net of income taxes of $63 thousand, as a cumulative effect of a change in accounting principle, as required by the Statement. The Company intends to continue to analyze the future utilization of swap agreements as part of its overall asset/liability management process. The following table illustrates the effect of interest rate swaps on other comprehensive income for 2002 and 2001 (in thousands): Before-tax Income Net-of-tax amount taxes amount ---------- ------ ---------- Year ended December 31, 2002: Net unrealized losses arising during 2002 $(175) 70 (105) Reclassification adjustment for realized losses included in net income 518 (207) 311 ----- ----- ----- Net gains included in other comprehensive income $ 343 (137) 206 ===== ===== ===== Year ended December 31, 2001: Net unrealized losses arising during 2001 $(837) 334 (503) Reclassification adjustment for realized losses included in net income 652 (260) 392 ----- ----- ----- Net losses included in other comprehensive income $(185) 74 (111) ===== ===== ===== For 2002, interest expense on deposits was reduced by $117 thousand for the portion of the change in fair value of swaps that was determined to be ineffective. For 2001, interest expense on deposits was increased by $117 thousand for the portion of the change in fair value of swaps that was determined to be ineffective. Amounts included in other comprehensive income relating to the unrealized losses on swaps was reclassified to interest expense on deposit accounts as interest expense on the hedged MMDA accounts increased or decreased, based upon fluctuations in the U.S. Dollar LIBOR rate. During 2000, $94 thousand of net interest income relating to interest rate swaps was reflected in interest expense on the hedged MMDA accounts. Prior to January 1, 2001 the net interest income or expense on these instruments was recognized in income or expense over the lives of the respective contracts as accrued. (13) Stock Based Compensation The Company has two stock based compensation plans pursuant to which options may be granted to officers, directors and key employees. The 1999 Stock Option Plan authorizes grants of options to purchase up to 1,390,660 shares of common stock. In 2002, the Board of Directors and stockholders of FNFG adopted a long-term incentive stock benefit plan. This plan authorizes the issuance of up to 834,396 shares of common stock pursuant to grants of stock options, stock appreciation rights, accelerated ownership option rights or stock awards. During 2002, only stock options were granted under this plan. Stock options are granted with an exercise price equal to the stock's market value on the date of grant. All options have a 10-year term and become fully vested and exercisable over a period of 4 to 5 years from the grant date. At December 31, 2002, there were options for 1,326,743 shares outstanding and 717,513 additional shares available for grant under the plans. 76 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The following is a summary of stock option activity for 2002, 2001 and 2000: Number of Weighted average shares exercise price --------- ---------------- Balance at January 1, 2000 783,250 $10.75 Granted 471,500 9.07 Exercised -- -- Forfeited (15,600) 10.05 --------- Balance at December 31, 2000 1,239,150 10.12 Granted 173,375 13.06 Exercised (39,700) 10.22 Forfeited (120,600) 10.23 --------- Balance at December 31, 2001 1,252,225 10.51 Granted 164,868 29.38 Exercised (90,350) 10.43 Forfeited -- -- --------- Balance at December 31, 2002 1,326,743 $12.86 ========= The following is a summary of stock options outstanding at December 31, 2002 and 2001:
Weighted Weighted Weighted average average average Options exercise remaining Options exercise Exercise price outstanding price life (years) exercisable price -------------------------- -------------- ------------ ------------- ------------- ------------- December 31, 2002: $9.03 - $12.60 1,135,375 $10.41 6.99 544,495 $10.37 $13.80 - $16.86 26,500 $15.48 8.73 5,125 $15.67 $25.35 - $31.54 164,868 $29.38 9.62 -- -- -------------- ------------- Total 1,326,743 $12.86 7.35 549,620 $10.42 ============== ============= December 31, 2001: $9.03 - $12.60 1,224,725 $10.40 7.97 348,500 $10.35 $13.80 - $16.86 27,500 $15.47 9.73 -- -- -------------- ------------- Total 1,252,225 $10.51 8.01 348,500 $10.35 ============== =============
During 1999, the Company allocated 556,264 shares for issuance under a Restricted Stock Plan. The plan grants shares of FNFG's stock to executive management and members of the Board of Directors. The restricted stock generally becomes fully vested over five years from the grant date. Compensation expense equal to the market value of FNFG's stock on the grant date is accrued ratably over the service period for shares granted. At December 31, 2002, there were 203,675 unvested shares outstanding and 160,399 additional shares available for grant under the plan. Unearned compensation expense related to granted but unvested restricted stock amounted to $2.5 million and $2.2 million at December 31, 2002 and 2001, respectively. Shares of restricted stock are issued from treasury stock as they vest. 77 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Shares granted under the Restricted Stock Plan during 2002, 2001 and 2000 totaled 45,315, 51,500 and 139,250, respectively, and had a weighted average market value on the date of grant of $26.99, $13.51 and $9.06, respectively. Compensation expense related to this plan amounted to $927 thousand, $648 thousand and $663 thousand for 2002, 2001 and 2000, respectively. (14) Income Taxes Total income taxes for 2002, 2001 and 2000 were allocated as follows (in thousands): 2002 2001 2000 -------- -------- -------- Income from operations $ 19,154 12,703 10,973 Stockholders' equity (1,345) (1,403) 6,404 First Niagara is subject to special provisions in the New York State tax law that allows it to deduct on its tax return bad debt expenses in excess of those actually incurred based on a specified formula ("excess reserve"). First Niagara is required to repay this excess reserve if it does not maintain a certain percentage of qualified assets (primarily residential mortgages and mortgage-backed securities) to total assets, as prescribed by the tax law. In accordance with accounting guidelines, the Company is required to record a deferred tax liability for the recapture of this excess reserve when it can no longer assert that the test will continue to be passed for the "foreseeable future." As a result of the Company's decision to combine its three banks, First Niagara can no longer make this assertion and accordingly, recorded a $1.8 million deferred income tax liability in the second quarter of 2002. As anticipated, as of December 31, 2002, First Niagara did not maintain the required percentage of qualified assets. It is anticipated that the tax liability will be repaid over a period of 10 to 15 years through lower bad debt deductions on the Company's tax return. The components of income taxes attributable to income from operations for 2002, 2001 and 2000 are as follows (in thousands): 2002 2001 2000 -------- -------- -------- Current: Federal $ 16,507 11,402 10,207 State 1,551 472 346 -------- -------- -------- 18,058 11,874 10,553 -------- -------- -------- Deferred: Federal (553) 809 166 State 1,649 20 254 -------- -------- -------- 1,096 829 420 -------- -------- -------- $ 19,154 12,703 10,973 ======== ======== ======== 78 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 The Company's effective tax rate for 2002, 2001 and 2000 were 38.3%, 37.4% and 36.0%, respectively. Income tax expense attributable to income from operations for 2002, 2001 and 2000 differs from the expected tax expense (computed by applying the Federal corporate tax rate of 35% to income before income taxes) as follows (in thousands): 2002 2001 2000 -------- -------- -------- Expected tax expense $ 17,482 11,873 10,672 Increase (decrease) attributable to: State income taxes, net of Federal benefit and deferred state tax 873 326 479 New York State bad debt tax expense recapture, net of Federal benefit 1,784 -- -- Bank-owned life insurance income (930) (877) (724) Municipal interest (430) (537) (126) Amortization of goodwill and other intangibles 302 1,936 1,016 Decrease in federal valuation allowance for deferred tax assets -- (292) (542) Other 73 274 198 -------- -------- -------- $ 19,154 12,703 10,973 ======== ======== ======== The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 2002 and 2001 are presented below (in thousands): 2002 2001 -------- -------- Deferred tax assets: Financial reporting allowance for credit losses $ 8,328 7,472 Net purchase discount on acquired companies 1,738 1,705 Deferred compensation 2,144 2,081 Post-retirement benefit obligation 1,403 1,450 Losses on investments in affiliates -- 418 Acquired intangibles 696 779 Pension obligation 1,135 -- Other 528 1,058 -------- -------- Total gross deferred tax assets 15,972 14,963 Valuation allowance -- -- -------- -------- Net deferred tax assets 15,972 14,963 -------- -------- Deferred tax liabilities: Tax allowance for credit losses, in excess of base year amount (2,266) (820) Unrealized gain on securities available for sale (2,808) (2,879) Excess of tax depreciation over financial reporting depreciation (1,078) (694) Other (632) (609) -------- -------- Total gross deferred tax liabilities (6,784) (5,002) -------- -------- Net deferred tax asset $ 9,188 9,961 ======== ======== 79 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, availability of operating loss carrybacks, projected future taxable income, and tax planning strategies in making this assessment. Based upon the level of historical taxable income, the opportunity for net operating loss carrybacks, and projections for future taxable income over the periods which deferred tax assets are deductible, management believes it is more likely than not the Company will realize the benefits of these deductible differences at December 31, 2002. (15) Earnings Per Share The computation of basic and diluted earnings per share for 2002, 2001 and 2000 are as follows (in thousands except per share amounts):
2002 2001 2000 -------- -------- -------- Net income available to common stockholders $ 30,795 21,220 19,519 ======== ======== ======== Weighted average shares outstanding basic and diluted Total shares issued 29,756 29,756 29,756 Unallocated ESOP shares (861) (914) (968) Treasury shares (3,982) (4,114) (3,941) -------- -------- -------- Total basic weighted average shares outstanding 24,913 24,728 24,847 Incremental shares from assumed exercise of stock options 473 220 9 Incremental shares from assumed vesting of restricted stock awards 83 62 2 -------- -------- -------- Total diluted weighted average shares outstanding $ 25,469 25,010 24,858 ======== ======== ======== Basic earnings per share $ 1.24 0.86 0.79 ======== ======== ======== Diluted earnings per share $ 1.21 0.85 0.79 ======== ======== ========
80 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (16) Benefit Plans Pension Plan The reconciliation of the change in the projected benefit obligation, the fair value of plan assets and the funded status of the Company's pension plan as of December 31, 2002 and 2001 are as follows (in thousands): 2002 2001 -------- ----- Change in projected benefit obligation: Projected benefit obligation at beginning of year $ 11,874 8,339 Service cost 288 676 Interest cost 751 739 Actuarial loss 1,290 783 Benefits paid (331) (299) Settlements (23) (9) Plan amendments 119 1,645 Curtailment (2,795) -- -------- ------ Projected benefit obligation at end of year 11,173 11,874 -------- ------ Change in fair value of plan assets: Fair value of plan assets at beginning of year 9,763 11,753 Actual loss on plan assets (1,223) (1,682) Benefits paid (331) (299) Settlements (23) (9) -------- ------ Fair value of plan assets at end of year 8,186 9,763 -------- ------ Projected benefit obligation in excess of plan assets at end of year (2,987) (2,111) Unrecognized actuarial loss 3,587 393 Unrecognized actuarial prior service cost -- 1,524 -------- ------ Prepaid (accrued) pension costs $ 600 (194) ======== ====== Amounts recognized in the consolidated balance sheet consist of: Accrued pension liability $(2,987) (194) Accumulated other comprehensive loss 3,587 -- -------- ------ Net amount recognized $ 600 (194) ======== ====== 81 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Net pension cost for the years 2002, 2001 and 2000 is comprised of the following (in thousands): 2002 2001 2000 ------ ------ ------ Service cost $ 288 676 408 Interest cost 751 739 621 Expected return on plan assets (892) (1,026) (862) Amortization of unrecognized gain -- (152) (76) Amortization of unrecognized prior service liability 58 121 1 Curtailment credit (998) -- -- ------ ------ ----- Net periodic pension (gain) cost $ (793) 358 92 ====== ====== ===== The principal actuarial assumptions used in 2002, 2001 and 2000 were as follows: 2002 2001 2000 ------ ------ ----- Discount rate 6.50% 7.25% 8.00% Expected long-term rate of return on plan assets 8.50% 9.00% 9.00% Assumed rate of future compensation increase N/A 4.50% 5.00% ====== ====== ===== The plan assets are in mutual funds consisting primarily of listed stocks and bonds, government securities and cash equivalents. Effective February 1, 2002, the Company froze all benefit accruals and participation in the pension plan. Accordingly, subsequent to that date, no employees will be permitted to commence participation in the plan and future salary increases and years of credited service will not be considered when computing an employee's benefits under the plan. As a result, the Company recognized a one-time pension curtailment gain of $998 thousand in 2002. As of October 1, 2002, the latest measurement date, the accumulated benefit obligation of the pension plan exceeded the fair value of its assets. Accordingly, the Company was required to record a $3.6 million (gross) additional minimum pension liability, included as a reduction of stockholders' equity net of taxes of $1.4 million. As of December 31, 2002, the Company has met all ERISA minimum funding requirements. 82 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Other Post-retirement Benefits A reconciliation of the change in the benefit obligation and the accrued benefit cost of the Company's post-retirement plan as of December 31, 2002 and 2001 are as follows (in thousands):
2002 2001 ------- ----- Change in accumulated post-retirement benefit obligation: Accumulated post-retirement benefit obligation at beginning of year $ 3,284 3,256 Service cost -- 47 Interest cost 230 208 Actuarial loss 792 924 Benefits paid (295) (210) Plan amendments -- (930) Curtailment credit -- (11) ------- ----- Accumulated post-retirement benefit obligation at end of year 4,011 3,284 ------- ----- Fair value of plan assets at end of year -- -- ------- ----- Post-retirement benefit obligation in excess of plan assets at end of year (4,011) (3,284) Unrecognized actuarial loss 1,313 535 Unrecognized prior service credit (819) (884) ------- ----- Accrued post-retirement benefit cost at end of year $(3,517) (3,633) ======= ======
The components of net periodic post-retirement benefit cost for 2002, 2001 and 2000 are as follows (in thousands): 2002 2001 2000 ----- --- --- Service cost $ -- 47 95 Interest cost 230 208 140 Amortization of unrecognized loss (gain) 13 1 (12) Amortization of unrecognized prior service credit (64) (46) -- Curtailment credit -- (11) -- ----- --- --- Total periodic cost $ 179 199 223 ===== === === The post-retirement benefit obligation was determined using a discount rate of 6.50% for 2002, 7.25% for 2001 and 8.00% for 2000 and an assumed rate of future compensation increases of 4.00% for 2002, 4.50% for 2001 and 5.00% for 2000. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 9.00% for 2003, and gradually decreased to 4.50% in the year 2008 and thereafter, over the projected payout of benefits. The health care cost trend rate assumption can have a significant effect on the amounts reported. If the health care cost trend rate were increased one percent, the accumulated post-retirement benefit obligation as of December 31, 2002 would have increased by 7.8% and the aggregate of service and interest cost would have increased by 5.8%. If the health care cost trend rate were decreased one percent, the accumulated post-retirement benefit obligation as of December 31, 2002 would have decreased by 6.7% and the aggregate of service and interest cost would have decreased by 5.1%. 83 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Effective January 19, 2001, the Company modified all of its post-retirement health care and life insurance plans. Participation in the plans was closed to those employees who did not meet the retirement eligibility requirements as of December 31, 2001. 401(k) Plan All full-time and part-time employees of the Company that meet certain age and service requirements are eligible to participate in the Company sponsored 401(k) plan. Under the plan, participants may make contributions, in the form of salary reductions, up to the maximum Internal Revenue Code limit. The Company contributes an amount to the plan equal to 100% of the first 2% of employee contributions plus 75% of employee contributions between 3% and 6%. The Company's contribution to these plans amounted to $1.3 million, $1.2 million and $524 thousand for 2002, 2001 and 2000, respectively. Employee Stock Ownership Plan ("ESOP") The Company's ESOP plan is accounted for in accordance with Statement of Position 93-6, "Employers' Accounting for Employee Stock Ownership Plans." All full-time and part-time employees of the Company that meet certain age and service requirements are eligible to participate. The ESOP holds shares of FNFG common stock that were purchased in the 1998 initial public offering and in the open market. The purchased shares were funded by a loan from FNFG payable in equal quarterly installments over 30 years bearing an interest rate that is adjustable with the prime rate. Loan payments are funded by cash contributions from First Niagara and dividends on FNFG stock held by the ESOP. The loan can be prepaid without penalty. Shares purchased by the ESOP are maintained in a suspense account and held for allocation among the participants. As quarterly loan payments are made, shares are committed to be released and subsequently allocated to employee accounts at each calendar year end. Compensation expense is recognized in an amount equal to the average market price of the committed to be released shares during the respective quarterly period. Compensation expense of $1.2 million, $803 thousand and $494 thousand was recognized for 2002, 2001 and 2000, respectively, in connection with the 45,786, 56,550 and 52,727 shares allocated to participants during those respective years. The fair value of unallocated ESOP shares was $21.8 million at December 31, 2002 and $14.8 million at December 31, 2001. Other Plans The Company also sponsors various non-qualified compensation plans for officers and employees. Awards are payable if certain earnings and performance objectives are met. Awards under these plans amounted to $2.7 million, $2.5 million and $1.3 million for 2002, 2001 and 2000, respectively. The Company also maintains supplemental benefit plans for certain executive officers. 84 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (17) Fair Value of Financial Instruments The carrying value and estimated fair value of the Company's financial instruments at December 31, 2002 and 2001 are as follows (in thousands): Carrying Estimated fair value value ----------- -------------- December 31, 2002: Financial assets: Cash and cash equivalents $ 90,525 90,525 Securities available for sale 632,364 632,364 Loans, net 1,974,560 2,073,157 Other assets 87,038 87,593 Financial liabilities: Deposits $ 2,129,469 2,136,427 Borrowings 397,135 427,572 Stock offering subscription proceeds 75,952 75,952 Other liabilities 2,380 2,380 December 31, 2001: Financial assets: Cash and cash equivalents $ 74,654 74,654 Securities available for sale 693,897 693,897 Loans, net 1,853,141 1,915,712 Other assets 89,425 89,534 Financial liabilities: Deposits $ 1,990,830 1,996,810 Borrowings 559,040 574,642 Other liabilities 2,957 2,957 Interest rate swaps (460) (460) Fair value estimates are based on existing on and off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in these estimates. Fair value estimates, methods, and assumptions are set forth below for each type of financial instrument. Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instruments, including judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Cash and Cash Equivalents The carrying value approximates the fair value because the instruments have original maturities of three months or less. 85 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 Securities The carrying value and fair value are estimated based on quoted market prices. See note 4 for the amortized cost of securities available for sale. Loans Residential revolving home equity and personal and commercial open ended lines of credit reprice as the prime rate changes. Therefore, the carrying value of such loans approximates their fair value. The fair value of fixed-rate performing loans is calculated by discounting scheduled cash flows through estimated maturity using current origination rates. The estimate of maturity is based on the contractual cash flows adjusted for prepayment estimates based on current economic and lending conditions. Fair value for significant nonaccruing loans is based on carrying value, which does not exceed recent external appraisals of any underlying collateral. Deposits The fair value of deposits with no stated maturity, such as savings, money market, checking, as well as mortgagors' payments held in escrow, is equal to the amount payable on demand. The fair value of certificates of deposit is based on the discounted value of contractual cash flows, using rates currently offered for deposits of similar remaining maturities. Borrowings The fair value of borrowings is calculated by discounting scheduled cash flows through the estimated maturity using current market rates. Stock Offering Subscription Proceeds The fair value of stock offering subscription proceeds is equal to its carrying value similar to other deposit accounts with no stated maturity. Other Assets and Liabilities The fair value of accrued interest receivable on loans and investments and accrued interest payable on deposits and borrowings approximates the carrying value because all interest is receivable or payable in 90 to 120 days. The fair value of bank-owned life insurance is calculated by discounting scheduled cash flows through the estimated maturity using current market rates. FHLB stock carrying value approximates fair value. Interest Rate Swaps The fair value of interest rate swaps is calculated by discounting expected future cash flows through maturity using current market rates. Commitments The fair value of commitments to extend credit, standby letters of credit and financial guarantees are not included in the above table as the carrying value generally approximates fair value. These instruments generate fees that approximate those currently charged to originate similar commitments. 86 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (18) Segment Information Based on the "Management Approach" model as described in the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," the Company has determined it has two business segments, its banking activities and its financial services activities. Financial services activities consist of the results of the Company's insurance and investment advisory subsidiaries, as well as First Niagara's trust department, which were organized under one Financial Services Group in 2001. Banking activities consists of the results of FNFG's banking subsidiaries excluding financial services activities. Transactions between the banking and financial services segments are primarily related to interest income and expense from intercompany deposit accounts, which are eliminated in consolidation and are accounted for under the accrual method of accounting. Information about the Company's segments at or for the years ended December 31, 2002, 2001 and 2000 is presented in the following table (in thousands):
Financial Banking services Consolidated At or for the year ended: activities activities Eliminations total ---------- ---------- ------------ ------------ December 31, 2002 Interest income $ 167,637 105 (105) 167,637 Interest expense 76,212 -- (105) 76,107 ---------- ---------- ---------- ---------- Net interest income 91,425 105 -- 91,530 Provision for credit losses 6,824 -- -- 6,824 ---------- ---------- ---------- ---------- Net interest income after provision for credit losses 84,601 105 -- 84,706 Noninterest income 25,500 24,276 (85) 49,691 Amortization of other intangibles -- 873 -- 873 Other noninterest expense 63,873 19,787 (85) 83,575 ---------- ---------- ---------- ---------- Income before income taxes 46,228 3,721 -- 49,949 Income tax expense 17,236 1,918 -- 19,154 ---------- ---------- ---------- ---------- Net income $ 28,992 1,803 -- 30,795 ========== ========== ========== ========== Total assets $2,914,242 28,726 (8,173) 2,934,795 ========== ========== ========== ==========
87 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000
Financial Banking services Consolidated At or for the year ended: activities activities Eliminations total ---------- ---------- ------------ ------------ December 31, 2001 Interest income $ 178,368 149 (149) 178,368 Interest expense 99,501 -- (149) 99,352 ---------- ---------- ---------- ---------- Net interest income 78,867 149 -- 79,016 Provision for credit losses 4,160 -- -- 4,160 ---------- ---------- ---------- ---------- Net interest income after provision for credit losses 74,707 149 -- 74,856 Noninterest income 20,433 21,662 (23) 42,072 Amortization of goodwill and other intangibles 3,787 1,924 -- 5,711 Other noninterest expense 59,668 17,649 (23) 77,294 ---------- ---------- ---------- ---------- Income before income taxes 31,685 2,238 -- 33,923 Income tax expense 11,148 1,555 -- 12,703 ---------- ---------- ---------- ---------- Net income $ 20,537 683 -- 21,220 ========== ========== ========== ========== Total assets $2,837,552 27,767 (7,373) 2,857,946 ========== ========== ========== ========== December 31, 2000 Interest income $ 137,040 117 (117) 137,040 Interest expense 76,969 10 (117) 76,862 ---------- ---------- ---------- ---------- Net interest income 60,071 107 -- 60,178 Provision for credit losses 2,258 -- -- 2,258 ---------- ---------- ---------- ---------- Net interest income after provision for credit losses 57,813 107 -- 57,920 Noninterest income 15,101 18,998 (9) 34,090 Amortization of goodwill and other intangibles 1,401 1,650 -- 3,051 Other noninterest expense 43,716 14,760 (9) 58,467 ---------- ---------- ---------- ---------- Income before income taxes 27,797 2,695 -- 30,492 Income tax expense 9,336 1,637 -- 10,973 ---------- ---------- ---------- ---------- Net income $ 18,461 1,058 -- 19,519 ========== ========== ========== ========== Total assets $2,605,507 24,724 (5,545) 2,624,686 ========== ========== ========== ==========
88 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000 (19) Condensed Parent Company Only Financial Statements The following condensed statements of condition as of December 31, 2002 and 2001 and the condensed statements of income and cash flows for 2002, 2001 and 2000 should be read in conjunction with the consolidated financial statements and related notes (in thousands): 2002 2001 -------- -------- Condensed Statements of Condition Assets: Cash and cash equivalents $ 3,724 3,106 Securities available for sale 1,915 5,094 Loan receivable from ESOP 12,034 12,511 Investment in subsidiaries 270,946 250,021 Other assets 1,938 578 -------- -------- Total assets $290,557 271,310 ======== ======== Liabilities: Accounts payable and other liabilities $ 861 193 Short-term borrowings -- 4,500 Short-term loan payable to related parties 6,000 6,000 Stockholders' equity 283,696 260,617 -------- -------- Total liabilities and stockholders' equity $290,557 271,310 ======== ========
2002 2001 2000 -------- -------- -------- Condensed Statements of Income Interest income $ 736 1,482 3,538 Dividends received from subsidiaries 10,900 16,000 95,000 -------- -------- -------- Interest income 11,636 17,482 98,538 Interest expense 166 924 415 -------- -------- -------- Net interest income 11,470 16,558 98,123 Net gain (loss) on securities available for sale 397 98 (422) Noninterest expenses 1,817 1,674 1,244 -------- -------- -------- Income before income taxes and undisbursed (overdisbursed) income of subsidiaries 10,050 14,982 96,457 Income tax (benefit) expense (355) (425) 587 -------- -------- -------- Income before undisbursed (overdisbursed) income of subsidiaries 10,405 15,407 95,870 Undisbursed (overdisbursed) income of subsidiaries 20,390 5,813 (76,351) -------- -------- -------- Net income $ 30,795 21,220 19,519 ======== ======== ========
89 FIRST NIAGARA FINANCIAL GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements Years Ended December 31, 2002, 2001 and 2000
Condensed Statements of Cash Flows 2002 2001 2000 ---------- ---------- ---------- Cash flows from operating activities: Net income $ 30,795 21,220 19,519 Adjustments to reconcile net income to net cash provided by operating activities: Accretion of fees and discounts, net (16) (17) (18) (Undisbursed) overdisbursed income of subsidiaries (20,390) (5,813) 76,351 Net (gain) loss on securities available for sale (397) (98) 422 Deferred income taxes 36 678 767 (Increase) decrease in other assets (460) 2,711 2,869 Increase (decrease) in liabilities 1,116 (60) (3,468) ---------- ---------- ---------- Net cash provided by operating activities 10,684 18,621 96,442 ---------- ---------- ---------- Cash flow from investing activities: Proceeds from sales of securities available for sale 986 195 25,085 Purchases of securities available for sale (582) (125) (841) Principal payments on securities available for sale 3,405 2,353 5,105 Acquisitions, net of cash acquired -- (322) (120,713) Repayment of ESOP loan receivable 477 477 476 ---------- ---------- ---------- Net cash provided by (used in) investing activities 4,286 2,578 (90,888) ---------- ---------- ---------- Cash flows from financing activities: Purchase of treasury stock -- -- (10,871) Repayment of loans from related parties -- -- (5,408) (Repayment) proceeds of short-term borrowings (4,500) (10,709) 15,209 Proceeds from exercise of stock options 942 406 -- Dividends paid on common stock (10,794) (8,983) (7,024) ---------- ---------- ---------- Net cash used in financing activities (14,352) (19,286) (8,094) ---------- ---------- ---------- Net increase (decrease) in cash and cash equivalents 618 1,913 (2,540) Cash and cash equivalents at beginning of year 3,106 1,193 3,733 ---------- ---------- ---------- Cash and cash equivalents at end of year $ 3,724 3,106 1,193 ========== ========== ==========
90 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors and executive officers of FNFG in the Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation in the Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding security ownership of certain beneficial owners of FNFG management in the Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions in the Proxy Statement for the 2003 Annual Meeting of Stockholders is incorporated herein by reference. ITEM 14. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-14(c) and 15d-14(c) under the Exchange Act) as of a date (the "Evaluation Date") within 90 days prior to the filing date of this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the Evaluation Date. 91 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial statements are filed as part of this Annual Report on Form 10-K. See Part II, Item 8. "Financial Statements and Supplementary Data." (b) Reports on Form 8-K On November 13, 2002, the Company filed a Current Report on Form 8-K which disclosed that First Niagara and the MHC have completed their conversions from New York chartered institutions to federally chartered institutions. The Company also disclosed that Cayuga and Cortland, formerly operated as wholly owned subsidiaries, have been merged into First Niagara. Such Current Report, as an Item 7 exhibit included the Company's press release dated November 12, 2002. On November 18, 2002, the Company filed a Current Report on Form 8-K which disclosed that First Niagara, has received approval from the OTS for the second step conversion of the MHC. Additionally, the Company reported information regarding the conversion, offering and stock information center. Such Current Report, as an Item 7 exhibit included the Company's press release dated November 15, 2002. On December 19, 2002, the Company filed a Current Report on Form 8-K which disclosed that FNFG received OTS approval for the acquisition of FLBC and its wholly owned subsidiary, SBFL, and that the merger remained subject to the approval of the shareholders of FLBC, which had a special meeting scheduled for December 30, 2002. Such Current Report, as an Item 7 exhibit included the Company's press release dated December 13, 2002. On December 30, 2002, the Company filed a Current Report on Form 8-K which disclosed that orders for approximately 11,000,000 shares of common stock had been received in the subscription and community offering portion of its second step conversion offering, which concluded on December 23, 2002. In addition, the Company disclosed that Ryan Beck & Co., Inc. had been authorized to proceed with a syndicated community offering of unsold shares of common stock, which is expected to commence on or about January 6, 2003. Finally, the Company disclosed that, subject to market conditions and regulatory approval, it anticipated completing the offering at no more than the midpoint of the offering range. Such Current Report, as an Item 7 exhibit included the Company's press release dated December 27, 2002. 92 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Con't) (c) Exhibits The exhibits listed below are filed herewith or are incorporated by reference to other filings.
Exhibit Index to Form 10-K -------------------------- Exhibit 3.3 Certificate of Incorporation (1) Exhibit 3.4 Bylaws (1) Exhibit 10.1 Form of Employment Agreement with the Named Executive Officers (2) Exhibit 10.2 First Niagara Bank Deferred Compensation Plan (3) Exhibit 10.3 First Niagara Financial Group, Inc. 1999 Stock Option Plan (4) Exhibit 10.4 First Niagara Financial Group, Inc. 1999 Recognition and Retention Plan(4) Exhibit 10.5 First Niagara Financial Group, Inc. 2002 Long-Term Incentive Stock Benefit Plan(5) Exhibit 11 Calculations of Basic Earnings Per Share and Diluted Earnings Per Share (See Note 15 to Notes to Consolidated Financial Statements) Exhibit 21 Subsidiaries of First Niagara Financial Group, Inc. (See Part I, Item 1 of Form 10-K) Exhibit 23 Consent of Independent Auditors' Exhibit 99.1 Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(1) Incorporated by reference to the Company's Registration Statement on Form S-1, originally filed with the Securities and Exchange Commission on September 18, 2002. (2) Incorporated by reference to the Company's Pre-effective Amendment No. 1 to the Registration Statement on Form S-1, filed with the Securities and Exchange Commission on November 14, 2002. (3) Incorporated by reference to the Company's Registration Statement on Form S-1, originally filed with the Securities and Exchange Commission on December 22, 1997. (4) Incorporated by reference to the Company's Proxy Statement for the 1999 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 31, 1999. (5) Incorporated by reference to the Company's Proxy Statement for the 2002 Annual Meeting of Stockholders filed with the Securities and Exchange Commission on March 27, 2002. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST NIAGARA FINANCIAL GROUP, INC. Date: March 24, 2003 By: /s/ William E. Swan -------------------------------------- William E. Swan Chairman, President and Chief Executive Officer 93 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signatures Title Date ---------- ----- ---- /s/ William E. Swan Chairman, President and Chief Executive March 24, 2003 ----------------------------- Officer William E. Swan /s/ Paul J. Kolkmeyer Executive Vice President, Chief Operating March 24, 2003 ----------------------------- Officer and Chief Financial Officer Paul J. Kolkmeyer /s/ Gordon P. Assad Director March 24, 2003 ----------------------------- Gordon P. Assad /s/ John J. Bisgrove, Jr. Director March 24, 2003 ----------------------------- John J. Bisgrove, Jr. /s/ G. Thomas Bowers Director March 24, 2003 ----------------------------- G. Thomas Bowers /s/ James W. Currie Director March 24, 2003 ----------------------------- James W. Currie /s/ Daniel W. Judge Director March 24, 2003 ----------------------------- Daniel W. Judge /s/ B. Thomas Mancuso Director March 24, 2003 ----------------------------- B. Thomas Mancuso /s/ James Miklinski Director March 24, 2003 ----------------------------- James Miklinski /s/ Sharon D. Randaccio Director March 24, 2003 ----------------------------- Sharon D. Randaccio /s/ Robert G. Weber Director March 24, 2003 ----------------------------- Robert G. Weber /s/ Louise Woerner Director March 24, 2003 ----------------------------- Louise Woerner /s/ David M. Zebro Director March 24, 2003 ----------------------------- David M. Zebro
94 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, William E. Swan, Chairman, President and Chief Executive Officer, certify that: 1. I have reviewed this annual report on Form 10-K of First Niagara Financial Group, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the years covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the years presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the year in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the Audit Committee of registrant's Board of Directors: a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 24, 2003 /s/ William E. Swan ---------------------------------------- William E. Swan Chairman, President and Chief Executive Officer 95 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Paul J. Kolkmeyer, Executive Vice President, Chief Operating Officer and Chief Financial Officer, certify that: 1. I have reviewed this annual report on Form 10-K of First Niagara Financial Group, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the years covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the years presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the year in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the Audit Committee of registrant's Board of Directors: a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 24, 2003 /s/ Paul J. Kolkmeyer ---------------------------------------- Paul J. Kolkmeyer Executive Vice President, Chief Operating Officer and Chief Financial Officer 96