10-K 1 a17-1009_210k.htm 10-K

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

 

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

 

For the fiscal year ended December 31, 2016

 

or

 

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

 

For the transition period from           to           

 

Commission file number: 0-24557

 

CARDINAL FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Virginia
(State or other jurisdiction
of incorporation or organization)

 

54-1874630
(I.R.S. Employer
Identification No.)

 

 

 

8270 Greensboro Drive, Suite 500
McLean, Virginia
(Address of principal executive offices)

 

22102
(Zip Code)

 

Registrant’s telephone number, including area code:  (703) 584-3400

 

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

 

Title of each class

 

Name of each exchange on which registered

Common Stock, par value $1.00 per share

 

The Nasdaq Stock Market

 

Securities registered pursuant to Section 12(g) of the Act: None

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

 

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

 

Large accelerated filer o

 

Accelerated filer x

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of June 30, 2016: $683,205,040.

 

The number of shares outstanding of Common Stock, as of March 9, 2017, was 33,083,928.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

None.

 

 

 



 

TABLE OF CONTENTS

 

 

 

Page

 

PART I

 

 

 

 

Item 1.

Business

4

 

 

 

Item 1A.

Risk Factors

24

 

 

 

Item 1B.

Unresolved Staff Comments

36

 

 

 

Item 2.

Properties

36

 

 

 

Item 3.

Legal Proceedings

36

 

 

 

Item 4.

Mine Safety Disclosures

37

 

 

 

 

PART II

 

 

 

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

38

 

 

 

Item 6.

Selected Financial Data

40

 

 

 

Item 7.

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

41

 

 

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

83

 

 

 

Item 8.

Financial Statements and Supplementary Data

84

 

 

 

Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

169

 

 

 

Item 9A.

Controls and Procedures

169

 

 

 

Item 9B.

Other Information

169

 

 

 

 

PART III

 

 

 

 

Item 10.

Directors, Executive Officers and Corporate Governance

170

 

 

 

Item 11.

Executive Compensation

174

 

 

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

204

 

 

 

Item 13.

Certain Relationships and Related Transactions, and Director Independence

205

 

 

 

Item 14.

Principal Accounting Fees and Services

206

 

 

 

 

Part IV

 

 

 

 

Item 15.

Exhibits, Financial Statement Schedules

208

 

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This Annual Report on Form 10-K has not been reviewed, or confirmed for accuracy or relevance, by the Federal Deposit Insurance Corporation.

 

3



 

PART I

 

Item 1.  Business

 

Overview

 

Cardinal Financial Corporation (“Cardinal”), a financial holding company, was formed in late 1997 as a Virginia corporation, principally in response to opportunities resulting from the consolidation of several Virginia-based banks.  These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.

 

We own Cardinal Bank (the “Bank”), a Virginia state-chartered community bank with 29 banking offices located in Northern Virginia, Maryland and the greater Washington, D.C. metropolitan area.    The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers.  Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.

 

On January 16, 2014, we announced the completion of our acquisition of United Financial Banking Companies, Inc. (“UFBC”), the holding company of The Business Bank (“TBB”), pursuant to a previously announced definitive merger agreement.  The merger of UFBC into Cardinal was effective January 16, 2014.  Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of our common stock in exchange for each share of UFBC common stock they owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014.

 

Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC (“George Mason”) and retail securities brokerage through Cardinal Wealth Services, Inc. (“CWS”).

 

George Mason engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts and mandatory basis through 18 offices located throughout the metropolitan Washington, D.C. region.  George Mason is one of the largest residential mortgage originators in the greater Washington metropolitan area, generating originations of approximately $4.1 billion in 2016 and $3.6 billion in 2015.  George Mason sells its mortgage loans to third party investors servicing released.  The profitability of George Mason is cyclical as loan production levels are sensitive to changes in the level of interest rates and changes in local home buying activity, which may be seasonal or may be caused by tightening credit conditions or a deteriorating local economy.

 

George Mason offers a construction-to-permanent loan program.  This program provides variable rate financing for customers to construct their residences.  Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market.  These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.

 

CWS provides brokerage and investment services through a contract with Raymond James Financial Services, Inc.  Under this contract, financial advisors can offer our customers an extensive range of financial products and services, including estate planning, qualified retirement

 

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plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations.  CWS’s principal source of revenue is the net commissions it earns on the purchases and sales of investment products to its customers.

 

On August 18, 2016, we announced that we will merge with United Bankshares, Inc., (“United”), a West Virginia corporation headquartered in Charleston.   Under the terms of the merger agreement, United will acquire Cardinal, with common shareholders of Cardinal receiving 0.71 shares of United common stock for each share of Cardinal. The transaction is subject to shareholder and regulatory approvals, and is expected to close during the second quarter of 2017.

 

Business Segment Operations

 

We operate in three business segments, commercial banking, mortgage banking and wealth management services.  The commercial banking segment includes both commercial and consumer lending and provides customers such products as commercial loans, real estate loans, and other business financing and consumer loans.  In addition, this segment provides customers with several choices of deposit products, including demand deposit accounts, savings accounts and certificates of deposit.  The mortgage banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market.  The wealth management services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, and investment management.

 

For financial information about the reportable segments, see “Business Segment Operations” in Item 7 below and Note 22 of the notes to the consolidated financial statements in Item 8 below.

 

Market Area

 

We consider our primary target market to include the Virginia counties of Arlington, Fairfax, Loudoun, Prince William, and Stafford and the cities of Alexandria, Fairfax, Falls Church, Fredericksburg, Manassas and Manassas Park; Washington, D.C. and Montgomery County in Maryland.  In addition to our primary market, we consider the Virginia counties of Spotsylvania, Culpeper and Fauquier and the Maryland county of Prince George’s as secondary markets and the remaining Greater Washington Metropolitan area as a tertiary market.  In addition, the metropolitan statistical areas of Richmond, Charlottesville, and Virginia Beach as well as Rappahannock, Madison, and Orange counties in Virginia plus the metropolitan statistical areas of Baltimore-Towson and California-Lexington Park in Maryland are also considered tertiary markets.

 

Based on 2014 estimates released by the U.S. Census Bureau, the population of the greater Washington metropolitan area was approximately 6.03 million people, the seventh largest statistical area in the country.  The median annual household income for this area in 2013 was approximately $90,149, which makes it one of the wealthiest regions in the country.  For 2015, based on estimates released by the Bureau of Labor Statistics of the U.S. Department of Labor, the unemployment rate for the greater Washington metropolitan area was approximately 3.8%, compared to a national unemployment rate of 5.0%.  As of June 30, 2015, total deposits in this area were approximately $214.7 billion as reported by the Federal Deposit Insurance Corporation (“FDIC”).

 

Our headquarters are located in the center of the business district of Fairfax County, Virginia.  Fairfax County, with over one million people, is the most populous county in Virginia and the most populous jurisdiction in the Washington, D.C. area.  According to the latest U.S.

 

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Census Bureau estimates, Fairfax County also has the second highest median household income of any county in the United States of $111,079, surpassed only by its neighbor, Loudoun County with $119,134.

 

We believe the diversity of our economy, including the stability provided by businesses serving the U.S. Government, provides us with the opportunities necessary to prudently grow our business.

 

Competition

 

The greater Washington region is dominated by branches of large regional or national banks headquartered outside of the region.  Our market area is a highly competitive, highly branched, banking market.  We compete as a financial intermediary with other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, mutual fund groups and other types of financial institutions. George Mason faces significant competition from both traditional financial institutions and other national and local mortgage banking operations.

 

The competition to acquire deposits and to generate loans, including mortgage loans, is intense, and pricing is important.  Many of our competitors are larger and have substantially greater resources and lending limits than we do.  In addition, many competitors offer more extensive branch and ATM networks than we currently have.  Larger institutions operating in the greater Washington market have access to funding sources at lower costs than are available to us since they have larger and more diverse fund generating capabilities. However, we believe that we have and will continue to be successful in competing in this environment due to an emphasis on a high level of personalized customer service, localized and more responsive decision making, and community involvement.

 

Of the $215 billion in bank deposits in the greater Washington region at June 30, 2015, approximately 82% were held by banks that are either based outside of the greater Washington region or are operating wholesale banks that generate deposits nationally. Excluding institutions based outside our region, we have grown to the fourth largest financial institution headquartered in the greater Washington region as measured by total deposits.  By providing competitive products and more personalized service and being actively involved in our local communities, we believe we can continue to increase our share of this deposit market.

 

Customers

 

We believe that the recent and ongoing bank consolidation within Northern Virginia and the greater Washington, D.C. region provides a significant opportunity to build a successful, locally-oriented banking franchise.  We also believe that many of the larger financial institutions in our area do not emphasize the high level of personalized service to small and medium-sized commercial businesses, professionals or individual retail customers that we emphasize.

 

We expect to continue serving these business and professional markets with experienced commercial relationship managers, and we have increased our retail marketing efforts through the expansion of our branch network (both through acquisition and de novo office expansion) and through the development of additional retail products and services. We expanded our deposit market share through aggressive marketing of our First Choice Checking, President’s Club, Chairman’s Club, Simply Savings and Monster Money Market relationship products and our Simply Checking product.

 

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Banking Products and Services

 

Our principal business is to accept deposits from the public and to make loans and other investments.  The principal sources of funds for the Bank’s loans and investments are demand, time, savings and other deposits, repayments of existing loans, and borrowings.  Our principal source of income is interest collected on loans, investment securities and other investments.  Non-interest income, which includes among other things deposit and loan fees and service charges, realized and unrealized gains on mortgage banking activities, and investment fee income, is the next largest component of our revenues. Our principal expenses are interest expense on deposits and borrowings, employee compensation and benefits, occupancy-related expenses, and other overhead expenses.

 

The principal business of George Mason is to originate residential loans for sale into the secondary market.  These loans are closed and serviced by George Mason on an interim basis pending their ultimate sale to a permanent investor.  The mortgage subsidiary funds these loans through a line of credit from Cardinal Bank and cash available through its own operations.  George Mason’s income on these loans is generated from the fees it charges its customers, the gains it recognizes upon the sales of loans and the interest income it earns prior to the delivery of the loan to the investor.  Costs associated with these loans are primarily comprised of salaries and commissions paid to loan originators and support personnel, interest expense incurred on funds borrowed to hold the loans pending sale and other expenses associated with the origination of the loans.

 

George Mason also offers a construction-to-permanent loan program.  This program provides variable rate financing for customers to construct their residences.  Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market.  These construction-to-permanent loans generate fee income as well as net interest income and are classified as loans held for sale.

 

The mortgage banking segment’s business is both cyclical and seasonal.  The cyclical nature of its business is influenced by, among other things, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy.  Historically, the mortgage banking segment has its lowest levels of quarterly loan closings during the first quarter of the year.

 

Both Cardinal Bank and George Mason are committed to providing high quality products and services to their customers, and have made a significant investment in their core information technology systems.  These systems provide the technology that fully automates the branches, processes bank transactions, mortgage originations, other loans and electronic banking, conducts database and direct response marketing, provides cash management solutions, streamlined reporting and reconciliation support.

 

With this investment in technology, the Bank offers internet-based delivery of products for both individuals and commercial customers.  Customers can open accounts, apply for loans, check balances, check account history, transfer funds, pay bills, download account transactions into various third party software solutions, and correspond via e-mail with the Bank over the internet.  The internet provides an inexpensive way for the Bank to expand its geographic borders and branch activities while providing services offered by larger banks.

 

We offer a broad array of products and services to our customers.  A description of our products and services is set forth below.

 

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Lending

 

We offer a full range of short to long-term commercial, real estate and consumer lending products and services, which are described in further detail below.  We have established target percentage goals for each type of loan to insure adequate diversification of our loan portfolio.  These goals, however, may change from time to time as a result of competition, market conditions, employee expertise, and other factors.  Commercial and industrial loans, real estate-commercial loans, real estate-construction loans, real estate-residential loans, home equity loans, and consumer loans account for approximately 11%, 51%, 18%, 14%, 5% and less than 1%, respectively of our loan portfolio at December 31, 2016.

 

Commercial and Industrial Loans.  We make commercial loans to qualified businesses in our market area.  Our commercial lending portfolio consists primarily of commercial and industrial loans for the financing of accounts receivable, property, plant and equipment.  Our government contract lending group provides secured lending to government contracting firms and businesses based primarily on receivables from the federal government.  We also offer Small Business Administration (SBA) guaranteed loans and asset-based lending arrangements to our customers.  We are certified as a preferred lender by the SBA, which provides us with much more flexibility in approving loans guaranteed under the SBA’s various loan guaranty programs.

 

Historically, commercial and industrial loans generally have a higher degree of risk than residential mortgage loans.  Residential mortgage loans generally are made on the basis of the borrower’s ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which generally is readily ascertainable.  In contrast, commercial loans typically are made on the basis of the borrower’s ability to repay the loan from the cash flow from its business and are secured by business assets, such as commercial real estate, accounts receivable, equipment and inventory, the values of which may fluctuate over time and generally cannot be appraised with as much precision as residential real estate.  As a result, the availability of funds for the repayment of commercial loans may be substantially dependent upon the commercial success of the business itself.

 

To manage these risks, our policy is to secure the commercial loans we make with both the assets of the business, which are subject to the risks described above, and other additional collateral and guarantees that may be available.  In addition, for larger relationships, we actively monitor certain attributes of the borrower and the credit facility, including advance rate, cash flow, collateral value and other credit factors that we consider appropriate.

 

Commercial Mortgage Loans.  We originate commercial mortgage loans.  These loans are primarily secured by various types of commercial real estate, including office, retail, warehouse, industrial and other non-residential types of properties and are made to the owners and/or occupiers of such property.  These loans generally have maturities ranging from one to ten years.

 

Historically, commercial mortgage lending entails additional risk compared with traditional residential mortgage lending.  Commercial mortgage loans typically involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Additionally, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of a business or real estate project and thus may be subject, to a greater extent than has historically been the case with residential mortgage loans, to adverse conditions in the commercial real estate market or in the general economy.  Our commercial real estate loan underwriting criteria require an examination of debt service coverage ratios, the borrower’s creditworthiness and prior credit history, and we generally require personal guarantees or endorsements with respect to these loans.  In the loan underwriting process, we also carefully consider the location of the property that will be collateral for the loan.

 

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Loan-to-value ratios for commercial mortgage loans generally do not exceed 80%.  We permit loan-to-value ratios of up to 80% if the borrower has appropriate liquidity, net worth and cash flow.

 

Residential Mortgage Loans.  Residential mortgage loans are originated by Cardinal Bank and George Mason.  Our residential mortgage loans consist of residential first and second mortgage loans, residential construction loans and home equity lines of credit and term loans secured by the residences of borrowers.  Second mortgage and home equity lines of credit are used for home improvements, education and other personal expenditures.  We make mortgage loans with a variety of terms, including fixed, floating and variable interest rates, with maturities ranging from three months to thirty years.

 

Residential mortgage loans generally are made on the basis of the borrower’s ability to repay the loan from his or her salary and other income and are secured by residential real estate, the value of which is generally readily ascertainable.  These loans are made consistent with our appraisal and real estate lending policies, which detail maximum loan-to-value ratios and maturities.  Residential mortgage loans and home equity lines of credit secured by owner-occupied property generally are made with a loan-to-value ratio of up to 80%.   Loan-to-value ratios of up to 90% may be allowed on residential owner-occupied property if the borrower exhibits unusually strong creditworthiness.  We generally do not make residential loans which, at the time of inception, have loan-to-value ratios in excess of 90%.

 

Construction Loans.  Our construction loan portfolio consists of single-family residential properties, multi-family properties and commercial projects.  Construction lending entails significant additional risks compared with residential mortgage lending.  Construction loans often involve larger loan balances concentrated with single borrowers or groups of related borrowers.  Construction loans also involve additional risks since funds are advanced while the property is under construction, which property has uncertain value prior to the completion of construction.  Thus, it is more difficult to accurately evaluate the total loan funds required to complete a project and related loan-to-value ratios.  To reduce the risks associated with construction lending, we limit loan-to-value ratios to 80% of when-completed appraised values for owner-occupied residential or commercial properties and for investor-owned residential or commercial properties.  We expect that these loan-to-value ratios will provide sufficient protection against fluctuations in the real estate market to limit the risk of loss.  Maturities for construction loans generally range from 12 to 24 months for non-complex residential, non-residential and multi-family properties.

 

Construction loan agreements may include provisions which allow for the payment of contractual interest from an interest reserve.  Amounts drawn from an interest reserve increase the amount of the outstanding balance of the construction loan.  This is an industry standard practice.

 

Consumer Loans.  Our consumer loans consist primarily of installment loans made to individuals for personal, family and household purposes.  The specific types of consumer loans we make include home improvement loans, automobile loans, debt consolidation loans and other general consumer lending.

 

Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured, such as lines of credit, or secured by rapidly depreciable assets, such as automobiles.  In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation.  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 continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy.

 

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Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such loans.  A loan may also give rise to claims and defenses by a consumer loan borrower against an assignee of such loan, such as the bank, and a borrower may be able to assert against such assignee claims and defenses that it has against the seller of the underlying collateral.

 

Our policy for consumer loans is to accept moderate risk while minimizing losses, primarily through a careful credit and financial analysis of the borrower.  In evaluating consumer loans, we require our lending officers to review the borrower’s level and stability of income, past credit history, amount of debt currently outstanding and the impact of these factors on the ability of the borrower to repay the loan in a timely manner.  In addition, we require our banking officers to maintain an appropriate differential between the loan amount and collateral value.

 

We also issue credit cards to certain of our customers.  In determining to whom we will issue credit cards, we evaluate the borrower’s level and stability of income, past credit history and other factors.

 

Finally, we make additional loans that are not classified in one of the above categories.  In making such loans, we attempt to ensure that the borrower meets our loan underwriting standards.

 

Loan Participations

 

From time to time we purchase and sell commercial loan participations to or from other banks within our market area.  All loan participations purchased have been underwritten using the Bank’s standard and customary underwriting criteria and are in good standing.

 

Deposits

 

We offer a broad range of interest-bearing and non-interest-bearing deposit accounts, including commercial and retail checking accounts, money market accounts, individual retirement accounts, regular interest-bearing savings accounts and certificates of deposit with a range of maturity date options.  The primary sources of deposits are small and medium-sized businesses and individuals within our target market.  Senior management has the authority to set rates within specified parameters in order to remain competitive with other financial institutions in our market area.  All deposits are insured by the FDIC up to the maximum amount permitted by law.  We have a service charge fee schedule, which is generally competitive with other financial institutions in our market, covering such matters as maintenance fees and per item processing fees on checking accounts, returned check charges and other similar fees.

 

Courier Services

 

We offer courier services to our business customers.  Courier services permit us to provide the convenience and personalized service that our customers require by scheduling pick-ups of deposits and other banking transactions.

 

Deposit on Demand

 

We provide our commercial banking customers electronic deposit capability through our Deposit on Demand product.  Business customers who sign up for this service can scan their deposits and send electronic batches of their deposits to the Bank.  This product reduces or eliminates the need for businesses with daily deposits and high check volume to visit the Bank and provides the benefit of viewing images of deposited checks.

 

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Internet and Mobile Banking

 

We believe that there is a strong demand within our market for internet banking and to a much lesser extent telephone banking.  These services allow both commercial and retail customers to access detailed account information and execute a wide variety of the banking transactions, including balance transfers and bill payment.  We believe that these services are particularly attractive to our customers, as it enables them at any time to conduct their banking business and monitor their accounts. Internet banking assists us in attracting and retaining customers and encourages our existing customers to consider Cardinal for all of their banking and financial needs.

 

We offer Cardinal Mobile Banking to our customers.  Customers who sign up for this service can access their accounts from any internet-enabled mobile device.  Customers can check their balance, view account activity, make deposits to their account through Mobile Deposit, transfer funds between deposit accounts, and may pay their bill online.  Cardinal Mobile Banking is encrypted using the Wireless Transport Layer Security (WTLS) protocol, which provides the highest level of security available today.  Additionally, all data that passes between the wireless gateway and Cardinal Bank’s web servers is encrypted using Secure Socket Layer (SSL).

 

Automatic Teller Machines

 

We have an ATM at each of our branch offices and we make other financial institutions’ ATMs available to our customers.

 

Other Products and Services

 

We offer other banking-related specialized products and services to our customers, such as travelers’ checks, coin counters, wire services, and safe deposit box services.  We issue letters of credit for some of our commercial customers, most of which are related to real estate construction loans.  We have not engaged in any securitizations of loans.

 

Credit Policies

 

Our chief credit officer and senior lending officers are primarily responsible for maintaining both a quality loan portfolio and a strong credit culture throughout the organization.  The chief credit officer is responsible for developing and updating our credit policies and procedures, which are approved by the board of directors.  The chief credit officer and senior lending officers may make exceptions to these credit policies and procedures as appropriate, but any such exception must be documented and made for sound business reasons.

 

Credit quality is controlled by the chief credit officer through compliance with our credit policies and procedures.  Our risk-decision process is actively managed in a disciplined fashion to maintain an acceptable risk profile characterized by soundness, diversity, quality, prudence, balance and accountability.  Our credit approval process consists of specific authorities granted to the lending officers and combinations of lending officers.  Loans exceeding a particular lending officer’s level of authority, or the combined limit of several officers, are reviewed and considered for approval by an officers’ loan committee and, when above a specified amount, by a committee of the Bank’s board of directors.  Generally, loans of $1,500,000 or more require committee approval.  Our policy allows exceptions for very specific conditions, such as loans secured by deposits at our Bank.  The chief credit officer works closely with each lending officer at the Bank level to ensure that the business being solicited is of the quality and structure that fits our desired risk profile.

 

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Under our credit policies, we monitor our concentration of credit risk.  We have established credit concentration guideline limits for commercial and industrial loans, real estate-commercial loans, real estate-residential loans and consumer purpose loans, which include home equity loans.  Furthermore, the Bank has established limits on the total amount of the Bank’s outstanding loans to one borrower, all of which are set below legal lending limits.

 

Loans closed by George Mason are underwritten in accordance with guidelines established by the various secondary market investors to which George Mason sells its loans.

 

Brokerage and Asset Management Services

 

CWS provides brokerage and investment services through an arrangement with Raymond James Financial Services, Inc.  Under this arrangement, financial advisors can offer our customers an extensive range of investment products and services, including estate planning, qualified retirement plans, mutual funds, annuities, life insurance, fixed income and equity securities and equity research and recommendations.

 

Employees

 

At December 31, 2016, we had 839 full-time equivalent employees.  None of our employees are represented by any collective bargaining unit.  We believe our relations with our employees are good.

 

Government Supervision and Regulation

 

General

 

As a financial holding company, we are subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Board of Governors of the Federal Reserve System.  Other federal and state laws govern the activities of our bank subsidiary, including the activities in which it may engage, the investments that it makes, the aggregate amount of loans that it may grant to one borrower, and the dividends it may declare and pay to us.  Our bank subsidiary is also subject to various consumer and compliance laws.  As a state-chartered bank, the Bank is primarily subject to regulation, supervision and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission.  The Bank and its’ subsidiary, George Mason, are also subject to regulation, supervision and examination by the Federal Deposit Insurance Corporation.

 

The following description summarizes the more significant federal and state laws applicable to us.  To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.

 

The Bank Holding Company Act

 

Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and required to file periodic reports regarding our operations and any additional information that the Federal Reserve may require.  Our activities at the bank holding company level are limited to:

 

·                  banking, managing or controlling banks;

·                  furnishing services to or performing services for our subsidiaries; and

 

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·                  engaging in other activities that the Federal Reserve has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.

 

Some of the activities that the Federal Reserve Board has determined by regulation to be closely related to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser.

 

With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

 

·                  acquiring substantially all the assets of any bank; and

·                  acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares), or merging or consolidating with another bank holding company.

 

In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act, together with their regulations, require Federal Reserve approval prior to any person or company acquiring 25% or more of any class of voting securities of the bank holding company.  Prior notice to the Federal Reserve is required before a person acquires 10% or more, but less than 25%, of any class of voting securities and if the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 or no other person owns a greater percentage of that class of voting securities immediately after the transaction.

 

In November 1999, Congress enacted the Gramm-Leach-Bliley Act (“GLBA”), which made substantial revisions to the statutory restrictions separating banking activities from other financial activities.  Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.”  As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities, such as insurance underwriting and securities underwriting and distribution. In addition, financial holding companies may also acquire or engage in certain activities in which bank holding companies are not permitted to engage in, such as travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities.  Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries.  For example, insurance activities would be subject to supervision and regulation by state insurance authorities.  We became a financial holding company in 2004.

 

Payment of Dividends

 

Regulators have indicated that financial holding companies should generally pay dividends only if the organization’s net income available to common shareholders is sufficient to fully fund the dividends, and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition.

 

We are a legal entity separate and distinct from Cardinal Bank, CWS, Cardinal Statutory Trust I and UFBC Capital Trust I.  Virtually all of our cash revenues will result from dividends paid to us by our bank subsidiary and interest earned on short term investments.  Our bank subsidiary is subject to laws and regulations that limit the amount of dividends that it can pay.  Under Virginia law, a bank may not declare a dividend in excess of its accumulated retained earnings.  Additionally, our bank subsidiary may declare a dividend out of undivided earnings,

 

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but not if the total amount of all dividends, including the proposed dividend, declared by the bank in any calendar year exceeds the total of the bank’s retained net income of that year to date, combined with its retained net income of the two preceding years, unless the dividend is approved by the FDIC.  Our bank subsidiary may not declare or pay any dividend if, after making the dividend, the bank would be “undercapitalized,” as defined in the banking regulations.

 

The FDIC and the state have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice.  Both the state and the FDIC have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.

 

In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums.  These regulatory requirements regarding capital affect our dividend policies.  Our regulators also may restrict our ability to repurchase securities.

 

Insurance of Accounts, Assessments and Regulation by the FDIC

 

The deposits of our bank subsidiary are insured by the FDIC up to the limits set forth under applicable law.  The deposits of our bank subsidiary are subject to the deposit insurance assessments of the Deposit Insurance Fund, or “DIF”, of the FDIC.

 

The FDIC has implemented a risk-based deposit insurance assessment system under which the assessment rate for an insured institution may vary according to regulatory capital levels of the institution and other factors, including supervisory evaluations.  In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the FDIC insurance fund in relation to total deposits in FDIC insured banks.  The FDIC has authority to impose special assessments.

 

The FDIC is required to maintain a designated minimum ratio of the DIF to insured deposits in the United States.  In July 2010, the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Financial Reform Act”) was signed into law.  The Financial Reform Act requires the FDIC to achieve a DIF ratio of at least 1.35 percent by September 30, 2020.  The FDIC has also adopted new regulations that establish a long-term target DIF ratio of greater than two percent.  Deposit insurance assessment rates are subject to change by the FDIC and will be impacted by the overall economy and the stability of the banking industry as a whole.

 

Pursuant to the Financial Reform Act, FDIC insurance coverage limits were permanently increased to $250,000 per customer.

 

The Financial Reform Act also changed the methodology for calculating deposit insurance assessments by changing the assessment base from the amount of an insured depository institution’s domestic deposits to its total assets minus tangible equity.  The new regulation implementing revisions to the assessment system mandated by the Financial Reform Act was effective April 1, 2011 and was reflected in the June 30, 2011 FDIC fund balance and the invoices for assessments due September 30, 2011.  While the burden on replenishing the DIF will be placed primarily on institutions with assets of greater than $10 billion, any future increases in required deposit insurance premiums or other bank industry fees could have a significant adverse impact on our financial condition and results of operations.

 

The FDIC is authorized to prohibit any insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the DIF.  Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary

 

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regulatory authority an opportunity to take such action.  The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC.  It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital.  If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC.  We are unaware of any existing circumstances that could result in termination of any of our bank subsidiary’s deposit insurance.

 

Consumer Financial Protection Bureau. The Financial Reform Act created a new, independent federal agency, the Consumer Financial Protection Bureau (“CFPB”) having broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions, including the Bank, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Financial Reform Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

 

In 2013, the CFPB adopted a rule, effective in January 2014, to implement certain sections of the Dodd-Frank Act requiring creditors to make a reasonable, good faith determination of a consumer’s ability to repay any closed-end consumer credit transaction secured by a 1-4 family dwelling.  The rule also establishes certain protections from liability under this requirement to ensure a borrower’s ability to repay for loans that meet the definition of “qualified mortgage.”  Loans that satisfy this “qualified mortgage” safe harbor will be presumed to have complied with the new ability-to-repay standard.

 

Capital Requirements

 

In 2013, the Federal Reserve, the FDIC and the OCC approved a new rule that substantially amended the regulatory risk-based capital rules applicable to us. The final rule implemented the “Basel III” regulatory capital reforms and changes required by the Financial Reform Act.  The final rule includes new minimum risk-based capital and leverage ratios which were effective for us on January 1, 2015, and refines the definition of what constitutes “capital” for purposes of calculating these ratios.

 

Under the risk-based capital requirements, we and our bank subsidiary are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%.  At least half of the total capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings, qualifying perpetual preferred stock and minority interests in common equity accounts of consolidated subsidiaries, less certain intangibles.  The remainder may consist of “Tier 2 Capital”, which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance and pretax net unrealized holding gains on certain equity securities.  In addition, each of the federal banking

 

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regulatory agencies has established minimum leverage capital requirements for banking organizations.  In summary, the capital measures used by the federal banking regulators are:

 

·                  Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital (which includes common shareholders’ equity, trust preferred securities, minority interests and qualifying preferred stock, less goodwill and other adjustments)  and Tier 2 Capital (which includes preferred stock not qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of subordinated debt, other qualifying term debt and the allowance for loan losses up to 1.25 percent of risk-weighted assets and other adjustments) as a percentage of total risk-weighted assets

 

·                  Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets)

 

·                  Common Equity Tier I (“CET1”) Capital ratio (which includes common shareholders’ equity less disallowed intangibles adjusted for associated deferred tax liabilities) as a percentage of total risk-weighted assets and

 

·                  the Leverage ratio (Tier 1 capital divided by adjusted average total assets).

 

The new minimum capital requirements under Basel III are: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6.0%, which is increased from 4%; (iii) a total capital ratio of 8.0%, which is unchanged from the former rules; and (iv) a Tier 1 leverage ratio of 4%.

 

The Financial Reform Act contains a number of provisions dealing with capital adequacy of insured depository institutions and their holding companies, which result in more stringent capital requirements.  Under the Collins Amendment to the Financial Reform Act, federal regulators have been directed to establish minimum leverage and risk-based capital requirements for, among other entities, bank holding companies on a consolidated basis.  These minimum requirements cannot be less than the generally applicable leverage and risk-based capital requirements established for insured depository institutions nor quantitatively lower than the leverage and risk-based capital requirements established for insured depository institutions that were in effect as of July 21, 2010.  These requirements in effect create capital level floors for bank holding companies similar to those in place currently for insured depository institutions.  The Collins Amendment also excludes trust preferred securities issued after May 19, 2010 from being included in Tier 1 capital unless the issuing company is a bank holding company with less than $500 million in total assets.  Trust preferred securities issued prior to that date will continue to count as Tier 1 capital for bank holding companies with less than $15 billion in total assets, and such securities will be phased out of Tier 1 capital treatment for bank holding companies with over $15 billion in total assets over a three-year period beginning in 2013.  Accordingly, our trust preferred securities will continue to qualify as Tier 1 capital.

 

The final rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios, and when fully effective in 2019, will result in the following minimum ratios: (a) a CET1 capital ratio of 7.0%; (b) a Tier 1 to risk-based assets capital ratio of 8.5%; and (c) a total capital ratio of 10.5%. The new capital conservation buffer requirement would be phased in beginning in January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such activities.

 

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The final rule also provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing assets, deferred tax assets related to temporary differences that could not be realized through net operating loss carrybacks, and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.

 

The final rule prescribes a standardized approach for risk weightings that expand the risk-weighting categories from the previous four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories.

 

The risk-based capital standards of each of the FDIC and the Federal Reserve Board explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy.  The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

 

The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan acceptable to the FDIC.  These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any financial holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers.

 

At December 31, 2016, the Company and its banking subsidiary met all capital adequacy requirements under the Basel III capital rules.  We are considered “well-capitalized” at December 31, 2016 and, in addition, our bank subsidiary maintained sufficient capital to remain in compliance with capital requirements and is considered “well-capitalized” at December 31, 2016.

 

Other Safety and Soundness Regulations

 

There are significant obligations and restrictions imposed on financial holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event that the depository institution is insolvent or is in danger of becoming insolvent.  These obligations and restrictions are not for the benefit of investors.  Regulators may pursue an administrative action against any financial holding company or bank which violates the law, engages in an unsafe or unsound banking practice, or which is about to engage in an unsafe or unsound banking practice.  The administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil monetary penalty action.  A cease and desist order, in addition to prohibiting certain action, could also require that certain actions be undertaken.  Under the Financial Reform Act and longstanding policies of the Federal Reserve Board, we are required to serve as a source of financial strength to our subsidiary depository institution and to commit resources to support the Bank in circumstances where we might not do so otherwise.

 

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The Bank Secrecy Act

 

Under the Bank Secrecy Act (“BSA”), a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction.  Financial institutions are generally required to report cash transactions involving more than $10,000 to the United States Treasury.  In addition, financial institutions are required to file Suspicious Activity Reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect, involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose.  The USA PATRIOT Act of 2001, enacted in response to the September 11, 2001 terrorist attacks, requires bank regulators to consider a financial institution’s compliance with the BSA when reviewing applications from a financial institution.  As part of its BSA program, the USA PATRIOT Act of 2001 also requires a financial institution to follow customer identification procedures when opening accounts for new customers and to review U.S. government-maintained lists of individuals and entities that are prohibited from opening accounts at financial institutions.

 

Monetary Policy

 

The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve Board.  The instruments of monetary policy employed by the Federal Reserve Board include open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against deposits held by federally insured banks.  The Federal Reserve Board’s monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.  In view of changing conditions in the national and international economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve System, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the business and earnings of our bank subsidiary, its subsidiary, or any of our other subsidiaries.

 

Federal Reserve System

 

In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or non-personal time deposits.  NOW accounts and demand deposit accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements.  Effective January 2017, the first $15.5 million of balances will be exempt from reserve requirements.  A 3% reserve ratio will be assessed on net transaction account balances over $15.5 million to and including $115.1 million.  A 10% reserve ratio will be applied to amounts in net transaction account balances in excess of $115.1 million.  These percentages are subject to adjustment by the Federal Reserve Board.  Because required reserves must be maintained in the form of vault cash or in a non-interest-bearing account at, or on behalf of, a Federal Reserve Bank, the effect of the reserve requirement is to reduce the amount of our interest-earning assets.  Beginning October 2008, the Federal Reserve Banks pay financial institutions interest on their required reserve balances and excess funds deposited with the Federal Reserve.  The interest rate paid is the targeted federal funds rate.

 

Transactions with Affiliates

 

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act.  An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank.  Generally, Sections 23A and 23B (i) limit the

 

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extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same as, or at least as favorable to those that, the bank has provided to a non-affiliate.  Certain covered transactions also must be adequately secured by eligible collateral.  The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions.  Section 23B applies to “covered transactions” as well as sales of assets and payments of money to an affiliate.  These transactions must also be conducted on terms substantially the same as, or at least favorable to those that, the bank has provided to non-affiliates.

 

The Financial Reform Act also provides that banks may not “purchase an asset from, or sell an asset to” a bank insider (or their related interests) unless (i) the transaction is conducted on market terms between the parties, and (ii) if the proposed transaction represents more than 10 percent of the capital stock and surplus of the bank, it has been approved in advance by a majority of the bank’s non-interested directors.

 

Loans to Insiders

 

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks.  Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and to entities controlled by any of the foregoing, may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the bank’s loan-to-one borrower limit.  Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100,000,000, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus.  Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting.  The FDIC has prescribed the aggregate loan amount to such person for which prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000).  Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

 

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Community Reinvestment Act

 

Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice.  The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs.  Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard.  Banking regulators consider a depository institution’s Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution.  An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a financial holding company or its depository institution subsidiaries.

 

GLBA and federal bank regulators have made various changes to the Community Reinvestment Act.  Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulator. A financial holding company or any of its subsidiaries will not be permitted to engage in new activities authorized under the GLBA if any bank subsidiary received less than a “satisfactory” rating in its latest Community Reinvestment Act examination.

 

Consumer Laws Regarding Fair Lending

 

In addition to the Community Reinvestment Act described above, other federal and state laws regulate various lending and consumer aspects of our business.  Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers may experience discrimination in their efforts to obtain loans from depository and other lending institutions.  These agencies have brought litigation against depository institutions alleging discrimination against borrowers.  Many of these suits have been settled, in some cases for material sums of money, short of a full trial.

 

These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.

 

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations.  These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.

 

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Gramm-Leach-Bliley Act of 1999

 

The Gramm-Leach-Bliley Act of 1999 covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies.  The following description summarizes some of its significant provisions.

 

The GLBA repealed sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms.  It also permits bank holding companies to elect to become financial holding companies.  A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities.  In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating.  We became a financial holding company in 2004.

 

The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities.  Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in areas identified under the law.  Under the law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures.

 

The GLBA adopts a system of functional regulation under which the Federal Reserve Board is designated as the umbrella regulator for financial holding companies, but financial holding company affiliates are principally regulated by functional regulators such as the FDIC for bank affiliates, the Securities and Exchange Commission for securities affiliates, and state insurance regulators for insurance affiliates.  It repeals the broad exemption of banks from the definitions of “broker” and “dealer” for purposes of the Securities Exchange Act of 1934, as amended.  It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a “broker,” and a set of activities in which a bank may engage without being deemed a “dealer.”  Additionally, GLBA makes conforming changes in the definitions of “broker” and “dealer” for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended.

 

The GLBA contains extensive customer privacy protection provisions.  Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information.  The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure.  An institution may not disclose to a non-affiliated third party, other than to a consumer credit reporting agency, customer account numbers or other similar account identifiers for marketing purposes.  The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.

 

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The Financial Reform Act

 

On July 21, 2010, the Financial Reform Act was signed into law.  The Financial Reform Act provides for sweeping financial regulatory reform and may alter the way in which we conduct certain businesses.

 

The Financial Reform Act contains a broad range of significant provisions that could affect our businesses, including, without limitation, the following:

 

·                  Mandating that the Federal Reserve limit debit card interchange fees;

 

·                  Changing the assessment base used in calculating FDIC deposit insurance fees from assessable deposits to total assets less tangible capital;

 

·                  Creating a new regulatory body to set requirements around the terms and conditions of consumer financial products and expanding the role of state regulators in enforcing consumer protection requirements over banks;

 

·                  Increasing the minimum reserve ratio of the DIF to 1.35 percent and eliminating the maximum reserve ratio;

 

·                  Making permanent the $250,000 limit for federal deposit insurance;

 

·                  Allowing depository institutions to pay interest on business demand deposits effective July 21, 2011;

 

·                  Imposing new requirements on mortgage lending, including new minimum underwriting standards, prohibitions on certain yield-spread compensation to mortgage originators, special consumer protections for mortgage loans that do not meet certain provision qualifications, prohibitions and limitations on certain mortgage terms and various new mandated disclosures to mortgage borrowers;

 

·                  Establishing minimum capital levels for holding companies that are at least as stringent as those currently applicable to banks;

 

·                  Allowing national and state banks to establish de novo interstate branches outside of their home state, and mandating that bank holding companies and banks be well-capitalized and well managed in order to acquire banks located outside their home state;

 

·                  Enhancing the requirements for certain transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and increasing the amount of time for which collateral requirements regarding covered transactions must be maintained;

 

·                  Placing restrictions on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors;

 

·                  Including a variety of corporate governance and executive compensation provisions and requirements.

 

The Financial Reform Act is expected to have a negative impact on our earnings through fee reductions, higher costs and new restrictions.  The Financial Reform Act may have a material adverse impact on the value of certain assets and liabilities on our balance sheet.

 

Most provisions of the Financial Reform Act require various federal banking and securities regulators to issue regulations to clarify and implement its provisions or to conduct studies on significant issues.  These proposed regulations and studies are generally subject to a public notice and comment period.  The timing of issuance of final regulations, their effective dates and their potential impacts to our businesses will be determined over the coming months and years.  As a result, the ultimate impact of the Financial Reform Act’s final rules on our businesses and results of operations will depend on regulatory interpretation and rulemaking, as well as the success of any of our actions to mitigate the negative earnings impact of certain provisions.

 

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Future Regulatory Uncertainty

 

Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and, as a result, impact our operations.  We fully expect that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.  Congress and the federal government have continued to evaluate and develop legislation, programs, and initiatives designed to, among other things, stabilize the financial and housing markets, stimulate the economy, including the federal government’s foreclosure prevention program, and prevent future financial crises by further regulating the financial services industry.  At this time, we cannot determine the final form of any proposed programs or initiatives or related legislation, the likelihood and timing of any other future proposals or legislation, and the impact they might have on us.

 

In addition, it is difficult to predict the legislative and regulatory changes that will result from the combination of a new President of the United States and the first year since 2010 in which both Houses of Congress and the White House have majority memberships from the same political party. In recent years, however, both the new President and senior members of the House of Representatives have advocated for significant reduction of financial services regulation, to include amendments to the Financial Reform Act and structural changes to the CFPB. The new administration and Congress also may cause broader economic changes due to changes in governing ideology and governing style. Future legislation, regulation, and government policy could affect the banking industry as a whole, including the business and results of operations of the Company and the Bank, in ways that are difficult to predict.

 

Additional Information

 

We file with or furnish to the Securities and Exchange Commission (“SEC”) annual, quarterly and current reports, proxy statements, and various other documents under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  The public may read and copy any materials that we file with or furnish to the SEC at the SEC’s Public Reference Room, which is located at 100 F Street, NE, Washington, D.C. 20549.  The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.  Also, the SEC maintains an internet website at www.sec.gov that contains reports, proxy and information statements and other information regarding registrants, including us, that file or furnish documents electronically with the SEC.

 

We also make available free of charge on or through our internet website (www.cardinalbank.com) our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and, if applicable, amendments to those reports as filed or furnished pursuant to Section 13(a) of the Exchange Act as soon as reasonably practicable after we electronically file such materials with, or furnish them to, the SEC.

 

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Item 1A.  Risk Factors

 

We are subject to various risks, including the risks described below.  Our operations, financial condition and performance and, therefore, the market value of our Common Stock could be adversely affected by any of these risks or additional risks not presently known or that we currently deem immaterial.

 

Risks Related to the Merger with United Bankshares, Inc. (“UBSI”)

 

Termination of the Merger Agreement could negatively impact us.

 

If our Agreement with UBSI (for the purposes of these Risk Factors, the “Merger Agreement”) is terminated and the parties fail to consummate the Merger, there may be various negative consequences to us and the Bank. For example, our businesses may have been adversely affected by the failure to pursue other beneficial opportunities due to the focus of management on the Merger, without realizing any of the anticipated benefits of completing the Merger. If the Merger Agreement is terminated and our board of directors seeks another merger or business combination, our shareholders cannot be certain that we will be able to find a party willing to pay the equivalent or greater consideration than that which UBSI has agreed to pay with respect to the Merger. In addition, under certain circumstances, the termination of the Merger Agreement may require us to pay to UBSI a termination fee in the amount of $36.0 million.

 

We will be subject to business uncertainties and contractual restrictions while the Merger is pending.

 

Uncertainty about the effect of the Merger on employees and customers may have an adverse effect on us and our business. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Merger is completed, and could cause customers and others that deal with us and the Bank to seek to change existing business relationships. Retention of certain employees by us and the Bank may be challenging while the Merger is pending, as certain employees may experience uncertainty about their future roles with the Bank. If key employees depart because of issues relating to the uncertainty and difficulty of integration or a desire not to remain with our organization, our business following the Merger could be harmed. In addition, subject to certain exceptions, we have agreed to operate our business in the ordinary course prior to closing.

 

Combining the two companies may be more difficult, costly or time-consuming than expected.

 

UBSI and Cardinal have operated and, until the completion of the Merger, will continue to operate independently. The success of the Merger will depend, in part, on our ability to successfully combine the businesses of UBSI with ours. To realize these anticipated benefits, after the completion of the Merger, UBSI expects to integrate our business into its own. It is possible that the integration process could result in the loss of key employees, the disruption of each company’s ongoing businesses or inconsistencies in standards, controls, procedures and policies that adversely affect the combined company’s ability to maintain relationships with clients, customers, depositors and employees or to achieve the anticipated benefits of the Merger. The loss of key employees could adversely affect UBSI’s ability to successfully conduct its business in the markets in which we now operate, which could have an adverse effect on UBSI’s financial results and the value of its common stock. If UBSI experiences difficulties with the integration process, the anticipated benefits of the Merger may not be realized fully or at all, or may take longer to realize than expected. As with any merger of financial institutions, there also may be business disruptions that cause the Bank to lose customers or cause customers to remove their accounts from the Bank and move their business to competing financial institutions.

 

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Integration efforts between UBSI and Cardinal will also divert management attention and resources. These integration matters could have an adverse effect on each of Cardinal, the Bank and UBSI during this transition period and for an undetermined period after consummation of the Merger.

 

Our ability to complete the Merger with UBSI is subject to the receipt of consents and approvals from regulatory agencies which may impose conditions that could adversely affect us or cause the Merger to be abandoned.

 

Before the Merger may be completed, we must obtain various approvals or consents from the Federal Reserve Board and various bank regulatory and other authorities. These regulators may impose conditions on the completion of the Merger or require changes to the terms of the Merger. Although UBSI and Cardinal do not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be, and such conditions or changes could have the effect of delaying completion of the Merger or imposing additional costs on or limiting the revenues of UBSI following the Merger. There can be no assurance as to whether the regulatory approvals will be received, the timing of those approvals, or whether any conditions will be imposed.

 

Fluctuations in market prices of UBSI common stock will affect the value that our shareholders receive for their shares of our common stock.

 

Under the terms of the Merger Agreement, our shareholders will receive 0.71 shares of UBSI common stock for each share of the Cardinal’s common stock (such ratio, the “Exchange Ratio”). The market price of the UBSI common stock may vary from its price on the date immediately prior to the public announcement of the Merger as a result of a variety of factors, including, among other things, changes in UBSI’s businesses, operations and prospects, regulatory considerations and general market and economic conditions. Many of these factors are beyond the control of UBSI or Cardinal. As a result of the fixed number of shares of UBSI common stock to be issued in the merger, the market value of the shares of UBSI common stock that our shareholders receive in the merger will decline correspondingly with any declines in the market price of UBSI common stock prior to and as of the date the merger consideration is paid, subject to the conditions and limitations discussed in the following paragraph.

 

As addressed in more detail in the Merger Agreement, we may terminate the Merger Agreement by a vote of a majority of our board of directors if (a) the average closing price per share (calculated in accordance with the Merger Agreement) of UBSI common stock declines 20 percent from the closing price per share on the last trading day prior to publicly announcing the Merger Agreement and (b) the percentage decline in the average closing price per share of UBSI common stock is at least 15 percent greater than the percentage decline in the closing price of the Nasdaq Bank Index over the same period; except provided as follows. Even if the conditions in (a) and (b) are met, UBSI may adjust the Exchange Ratio as provided in the Merger Agreement to increase the consideration received by our shareholders in the Merger, and if such adjustment is made our right to terminate the Merger Agreement will be extinguished. Because the price of UBSI common stock and the Nasdaq Bank Index will fluctuate prior to the Merger, and because in certain circumstances UBSI has the right to adjust the consideration received in the Merger by our shareholders, we cannot assure our shareholders of the market value or number of shares of UBSI common stock that they will receive in the merger.

 

Risks Related to the Operations of Cardinal

 

Our mortgage banking revenue is cyclical and is sensitive to the level of interest rates, changes in economic conditions, decreased economic activity, a slowdown in the housing market, any

 

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of which could adversely impact our profits.

 

Recently, we have significantly expanded our mortgage banking operations by adding mortgage loan officers and support staff, and this segment has become a larger portion of our consolidated business.  Maintaining our revenue stream in this segment is dependent upon our ability to originate loans and sell them to investors at or near current volumes.  Loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions.   Loan production levels may also suffer if we experience a slowdown in the local housing market or tightening credit conditions.  Any sustained period of decreased activity caused by less refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect our mortgage originations and, consequently, could significantly reduce our income from mortgage banking activities.  As a result, these conditions would also adversely affect our net income.  In addition, the effect of any such slowdown in volume on our net income could be exacerbated by accounting rules which require mortgage revenues to be realized prior to certain associated expenses.

 

Deteriorating economic conditions may also cause home buyers to default on their mortgages.  In certain cases where we have originated loans and sold them to investors, we may be required to repurchase loans or provide a financial settlement to investors if it is proven that the borrower failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor.  Such repurchases or settlements would also adversely affect our net income.

 

George Mason, as part of the service it previously provided to its managed companies, purchased the loans managed companies originate at the time of origination.  These loans were then sold by George Mason to investors.  George Mason has agreements with these managed companies requiring that, for any loans that were originated by a managed company and for which investors have requested George Mason to repurchase due to the borrowers failure to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor, the managed company be responsible for buying back the loan.  In the event that the managed company’s financial condition deteriorates and it is unable to fund the repurchase of such loans, George Mason may have to provide the funds to repurchase these loans from investors.

 

We may be adversely affected by economic conditions in our market area.

 

We are headquartered in Northern Virginia, and our market is the greater Washington, D.C. metropolitan area. Because our lending and deposit-gathering activities are concentrated in this market, we will be affected by the general economic conditions in the greater Washington area, which may, among other factors, be impacted by the level of federal government spending.  Federal government cuts in spending could severely impact negatively the unemployment rate in our region and business development activity.  Changes in the economy, and government spending in particular, may influence the growth rate of our loans and deposits, the quality of the loan portfolio and loan and deposit pricing. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors, would impact these local economic conditions and the demand for banking products and services generally, and could negatively affect our financial condition and performance.

 

Government measures to regulate the financial industry, including the Financial Reform Act, could require us to change certain of our business practices, impose significant additional costs on us, limit the products that we offer, limit our ability to pursue business opportunities

 

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in an efficient manner, require us to increase our regulatory capital, impact the value of the assets we hold, significantly reduce our revenues or otherwise materially affect our businesses, financial condition or results of operations.

 

As a financial institution, we are heavily regulated at the state and federal levels.  As a result of the financial crisis and related global economic downturn that began in 2007, we have faced, and expect to continue to face, increased public and legislative scrutiny as well as stricter and more comprehensive regulation of our financial services practices.  In July 2010, the Financial Reform Act was signed into law.  Many of the provisions of the Financial Reform Act have been phased in and we will be subject both to further rulemaking and the discretion of applicable regulatory bodies.  Although we cannot predict the full effect of the Financial Reform Act on our operations, it could, impose significant additional costs on us, limit the products we offer, could limit our ability to pursue business opportunities in an efficient manner, require us to increase our regulatory capital, impact the values of assets that we hold, significantly reduce our revenues or otherwise materially and adversely affect our businesses, financial condition, or results of operations.

 

The ultimate impact of the final rules on our businesses and results of operations, however, will depend on regulatory interpretation and rulemaking, as well as the success of any of our actions to mitigate the negative earnings impact of certain provisions.

 

We are subject to more stringent capital requirements, which could adversely affect our results of operations and future growth.

 

In 2013, the Federal Reserve, the FDIC and the OCC approved a new rule that substantially amended the regulatory risk-based capital rules applicable to us. The final rule implements the “Basel III” regulatory capital reforms and changes required by the Financial Reform Act.  The final rule includes new minimum risk-based capital and leverage ratios which became effective for us on January 1, 2015, and refines the definition of what constitutes “capital” for purposes of calculating these ratios. The minimum capital requirements effective for 2016 include: (i) common equity Tier 1 (“CET1”) capital ratio of 4.5%; (ii) a Tier 1 to risk-based assets capital ratio of 6.0%, which is increased from 4%; (iii) a total capital ratio of 8.0%, which is unchanged from the former rules; and (iv) a Tier 1 leverage ratio of 4%.  The final rule also establishes a “capital conservation buffer” of 2.5% above the new regulatory minimum capital ratios, and when fully effective in 2019, will result in the following minimum ratios: (a) a common equity Tier 1 capital ratio of 7.0%; (b) a Tier 1 to risk-based assets capital ratio of 8.5%; and (c) a total capital ratio of 10.5%. The new capital conservation buffer requirement was phased in beginning January 2016 at 0.625% of risk-weighted assets and would increase each year until fully implemented in January 2019. An institution will be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount. These limitations will establish a maximum percentage of eligible retained income that can be utilized for such activities.  In addition, the final rule provides for a number of new deductions from and adjustments to capital and prescribes a revised approach for risk weightings that could result in higher risk weights for a variety of asset categories.

 

The application of these more stringent capital requirements for us could, among other things, result in lower returns on equity, require the raising of additional capital, adversely affect our future growth opportunities, and result in regulatory actions such as a prohibition on the payment of dividends or on the repurchase shares if we were unable to comply with such requirements.

 

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At December 31, 2016, the Company and its banking subsidiary met all capital adequacy requirements under the Basel III capital rules.

 

We may not be able to successfully manage our growth or implement our growth strategies, which may adversely affect our results of operations and financial condition.

 

During the last five years, we have experienced significant growth, and a key aspect of our business strategy is our continued growth and expansion. If our Merger with United is not consummated, our ability to continue to grow will depend, in part, upon our ability to:

 

· attract deposits to those locations and cross-sell new and existing depositors additional products and services; and

 

· identify attractive loan and investment opportunities.

 

We may not be able to implement our growth strategy successfully if we are unable to identify attractive markets, locations or opportunities to expand. Our ability to successfully manage our growth will also depend upon our ability to maintain capital levels sufficient to support this growth, maintain effective cost controls and adequate asset quality such that earnings are not adversely impacted to a material degree.

 

We have goodwill and other intangibles that may become impaired, and thus result in a charge against earnings.

 

At December 31, 2016, we had $10.1 million of goodwill related to the George Mason acquisition and $24.9 million related to acquisitions that occurred within the commercial banking segment of our Company.  Goodwill and other intangibles are tested for impairment on an annual basis or when facts and circumstances indicate that impairment may have occurred.

 

We may be forced to recognize impairment charges in the future as operating and economic conditions change.

 

We may be adversely impacted by changes in the condition of financial markets.

 

We are directly and indirectly affected by changes in market conditions. Market risk generally represents the risk that values of assets and liabilities or revenues will be adversely affected by changes in market conditions. Market risk is inherent in the financial instruments associated with our operations and activities including loans, deposits, securities, short-term borrowings, long-term debt, trading account assets and liabilities, and derivatives. Just a few of the market conditions that may shift from time to time, thereby exposing us to market risk, include fluctuations in interest and currency exchange rates, equity and futures prices, and price deterioration or changes in value due to changes in market perception or actual credit quality of issuers. Accordingly, depending on the instruments or activities impacted, market risks can have adverse effects on our results of operations and our overall financial condition.

 

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The subprime mortgage market dislocation which occurred in prior years has impacted the ratings of certain monoline insurance providers which, in turn, has affected the pricing of certain municipal securities and the liquidity of the short term public finance markets.  We have some exposure to monolines and, as a result, are continuing to monitor this exposure.  Additionally, unfavorable economic or political conditions and changes in government policy could impact the operating budgets or credit ratings of U.S. states and U.S. municipalities and expose us to credit risk.

 

Our concentration in commercial real estate and business loans may increase our future credit losses, which would negatively affect our financial results.

 

We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Approximately 88% of our loans are secured by real estate, both residential and commercial, substantially all of which are located in our market area. A major change in the region’s real estate market, resulting in a further deterioration in real estate values, or in the local or national economy, including changes caused by raising interest rates, could adversely affect our customers’ ability to pay these loans, which in turn could adversely impact us. Risk of loan defaults and foreclosures are inherent in the banking industry, and we try to limit our exposure to this risk by carefully underwriting and monitoring our extensions of credit. We cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

 

Commercial real estate and business loans increase our exposure to credit risks.

 

At December 31, 2016, our portfolio of commercial and industrial and commercial real estate (including construction) totaled $2.7 billion, or 81% of total loans. We plan to continue to emphasize the origination of loans to small and medium-sized businesses as well as government contractors, professionals, such as physicians, accountants and attorneys, and commercial real estate developers and builders, which generally exposes us to a greater risk of nonpayment and loss than residential real estate loans because repayment of such loans often depends on the successful operations and cash flows of the borrowers. Additionally, such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to residential real estate loans. Also, many of our borrowers have more than one commercial loan outstanding. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a residential real estate loan. In addition, 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, our results of operations and financial condition may be adversely affected. This concentration also exposes us more to the market risks of real estate sales leasing and other activity in the areas we serve. An adverse change in local real estate conditions and markets could materially adversely affect the values of our loans and the real estate held as collateral for such loans, and materially affect our results of operations and financial condition.

 

Federal bank regulatory agencies have released guidance on “Concentrations in Commercial Real Estate Lending” (the “Guidance”). The Guidance defines commercial real estate (“CRE”) loans as exposures secured by raw land, land development and construction (including 1-4 family residential construction), multi-family property, and non-farm nonresidential property where the primary or a significant source of repayment is derived from rental income associated with the property (that is, loans for which 50% or more of the source of repayment comes from third party, non-affiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. The Guidance requires that appropriate

 

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processes be in place to identify, monitor and control risks associated with real estate lending concentrations. This could include enhanced strategic planning, CRE underwriting policies, risk management, internal controls, portfolio stress testing and risk exposure limits as well as appropriately designed compensation and incentive programs. Higher allowances for loan losses and capital levels may also be required. The Guidance is triggered when CRE loan concentrations exceed either:

 

·                  Total reported loans for construction, land development, and other land of 100% or more of a bank’s total capital; or

 

·                  Total reported loans secured by multifamily and nonfarm nonresidential properties and loans for construction, land development, and other land of 300% or more of a bank’s capital.

 

The Guidance applies to our CRE lending activities. Although our regulators have not required us to maintain elevated levels of capital or liquidity due to our CRE concentrations, the regulators may do so in the future, especially if there is a material downturn in our local real estate markets.

 

If our allowance for loan losses is not appropriate, our results of operations may be affected.

 

We maintain an allowance for loan losses that we believe is a reasonable estimate of known and inherent losses in our loan portfolio. Through a periodic review and analysis of the loan portfolio, management determines the appropriateness of the allowance for loan losses by considering such factors as general and industry-specific market conditions, credit quality of the loan portfolio, the collateral supporting the loans and financial performance of our loan customers relative to their financial obligations to us. The amount of future losses is impacted by changes in economic, operating and other conditions, including changes in interest rates, which may be beyond our control. Actual losses may exceed our current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned.  Estimating loan loss allowances for an unseasoned portfolio is more difficult than with seasoned portfolios, and may be more susceptible to changes in estimates and to losses exceeding estimates.  Although we believe the allowance for loan losses is a reasonable estimate of known and inherent losses in our loan portfolio, we cannot fully predict such losses or assert that our loan loss allowance will be appropriate in the future. Future loan losses that are greater than current estimates could have a material impact on our future financial performance.

 

Banking regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize additional loan charge-offs, based on credit judgments different than those of our management. Any increase in the amount of our allowance or loans charged-off as required by these regulatory agencies could have a negative effect on our operating results.

 

Our liquidity could be impaired by our inability to access the capital markets on favorable terms.

 

Liquidity is essential to our business.  Under normal business conditions, primary sources of funding for our parent company may include dividends received from banking and nonbanking subsidiaries and proceeds from the issuance of equity capital in the capital markets.  The primary sources of funding for our banking subsidiary include customer deposits and wholesale market-based funding.  Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits.  This situation may arise due to circumstances that we may be unable to control, such as a general market disruption, negative views about the financial services industry generally, or an operational problem that affects third parties or us.

 

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For further discussion on our liquidity position and other liquidity matters, including policies and procedures we use to manage our liquidity risks, see “Capital Resources” and “Liquidity” in Item 7 of this report.

 

Increases in FDIC insurance premiums may cause our earnings to decrease.

 

Since the financial crisis began several years ago, an increasing number of bank failures have imposed significant costs on the FDIC in resolving those failures, and the regulator’s deposit insurance fund has been depleted.  In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC has increased, and may increase in the future, assessment rates of insured institutions, including Cardinal Bank.

 

Deposits are insured by the FDIC, subject to limits and conditions or applicable law and the FDIC’s regulations.  Pursuant to the Financial Reform Act, FDIC insurance coverage limits were permanently increased to $250,000 per customer.  The FDIC administers the deposit insurance fund, and all insured depository institutions are required to pay assessments to the FDIC that fund the DIF.  The Financial Reform Act changed the methodology for calculating deposit insurance assessments by changing the assessment base from the amount of an insured depository institution’s domestic deposits to its total assets minus tangible equity, and we expect higher annual deposit insurance assessments than we historically incurred before the financial crisis.  While the burden of replenishing the DIF will be placed primarily on institutions with assets of greater than $10 billion, any future increases in required deposit insurance premiums or other bank industry fees could have a significant adverse impact on our financial condition and results of operations.

 

The soundness of other financial institutions could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial industry. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. There is no assurance that any such losses would not materially and adversely affect our results of operations.

 

We rely heavily on our management team and the unexpected loss of any of those personnel could adversely affect our operations; we depend on our ability to attract and retain key personnel.

 

We are a customer-focused and relationship-driven organization. We expect our future growth to be driven in a large part by the relationships maintained with our customers by our Executive Chairman, Bernard H. Clineburg, and our other executive and senior lending officers. We have entered into employment agreements with Mr. Clineburg and several other executive officers. The existence of such agreements, however, does not necessarily assure us that we will be able to continue to retain their services. The unexpected loss of Mr. Clineburg or other key employees could have a significant adverse effect on our business and possibly result in reduced revenues and earnings. We maintain bank owned life insurance policies on all of our corporate executives, of which we are the beneficiary.

 

The implementation of our business strategy will also require us to continue to attract,

 

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hire, motivate and retain skilled personnel to develop new customer relationships, as well as develop new financial products and services. Many experienced banking professionals employed by our competitors are covered by agreements not to compete or solicit their existing customers if they were to leave their current employment. These agreements make the recruitment of these professionals more difficult. While we have been recently successful in acquiring what we consider to be talented banking professionals, the market for talented people is competitive and we may not continue to be successful in attracting, hiring, motivating or retaining experienced banking professionals.

 

Failure to maintain effective systems of internal and disclosure control could have a material adverse effect on our results of operation and financial condition.

 

Effective internal and disclosure controls are necessary for us to provide reliable financial reports and effectively prevent fraud, and to operate successfully as a public company. If we cannot provide reliable financial reports or prevent fraud, our reputation and operating results would be harmed. As part of our ongoing monitoring of internal control, we may discover material weaknesses or significant deficiencies in internal control that require remediation. A “material weakness” is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis.

 

We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. Even so, we continue to work to improve our internal controls. We cannot be certain that these measures will ensure that we implement and maintain adequate controls over our financial processes and reporting in the future. Any failure to maintain effective controls or to timely implement any necessary improvement of our internal and disclosure controls could, among other things, result in losses from fraud or error, harm our reputation, or cause investors to lose confidence in the reported financial information, all of which could have a material adverse effect on our results of operations and financial condition.

 

We may incur losses if we are unable to successfully manage interest rate risk.

 

Our future profitability will substantially depend upon our ability to maintain or increase the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. Changes in interest rates will affect our operating performance and financial condition.  The shape of the yield curve can also impact net interest income.  Changing rates will impact how fast our mortgage loans and mortgage backed securities will have the principal repaid.  Rate changes can also impact the behavior of our depositors, especially depositors in non-maturity deposits such as demand, interest checking, savings and money market accounts. While we attempt to minimize our exposure to interest rate risk, we are unable to eliminate it as it is an inherent part of our business. Our net interest spread will depend on many factors that are partly or entirely outside our control, including competition, federal economic, monetary and fiscal policies, and industry-specific conditions and economic conditions generally.

 

Our future success is dependent on our ability to compete effectively in the highly competitive banking and financial services industry.

 

We face vigorous competition from other commercial banks, savings and loan associations, savings banks, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other types of financial institutions for deposits, loans and other financial services in our market area. A number of these

 

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banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services.  Many of our nonbank competitors are not subject to the same extensive regulations that govern us. As a result, these nonbank competitors have advantages over us in providing certain services. This competition may reduce or limit our margins and our market share and may adversely affect our results of operations and financial condition.

 

Changes in accounting standards could impact reported earnings.

 

The authorities that promulgate accounting standards, including the FASB, SEC, and other regulatory authorities, periodically change the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes are difficult to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we could be required to apply a new or revised standard retroactively, resulting in the restatement of financial statements for prior periods. Such changes could also require us to incur additional personnel or technology costs.

 

Our businesses and earnings are impacted by governmental, fiscal and monetary policy.

 

We are affected by domestic monetary policy. For example, the Federal Reserve Board regulates the supply of money and credit in the United States and its policies determine in large part our cost of funds for lending, investing and capital raising activities and the return we earn on those loans and investments, both of which affect our net interest margin. The actions of the Federal Reserve Board also can materially affect the value of financial instruments we hold, such as loans and debt securities, and its policies also can affect our borrowers, potentially increasing the risk that they may fail to repay their loans. Our businesses and earnings also are affected by the fiscal or other policies that are adopted by various regulatory authorities of the United States. Changes in fiscal or monetary policy are beyond our control and hard to predict.

 

Our information systems may experience an interruption or breach in security.

 

We rely heavily on communications and information systems to conduct our business.  In addition, as part of our business, we collect, process and retain sensitive and confidential client and customer information.  Our facilities and systems, and those of our third party service providers, may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors, or other similar events. Any failure, interruption or breach in security of these systems could result in failures or disruptions in customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

 

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The operational functions of business counterparties over which we may have limited or no control may experience disruptions that could adversely impact us.

 

Multiple major U.S. retailers have recently experienced data systems incursions reportedly resulting in the thefts of credit and debit card information, online account information, and other financial data of tens of millions of the retailers’ customers. Retailer incursions affect cards issued and deposit accounts maintained by many banks, including our subsidiary Bank. Although our systems are not breached in retailer incursions, these events can cause us to reissue a significant number of cards and take other costly steps to avoid significant theft loss to the Bank and its customers. In some cases, the Bank may be required to reimburse customers for the losses they incur. Other possible points of intrusion or disruption not within our control include internet service providers, electronic mail portal providers, social media portals, distant-server (“cloud”) service providers, electronic data security providers, telecommunications companies, and smart phone manufacturers.

 

Our profitability and the value of any equity investment in us may suffer because of rapid and unpredictable changes in the highly regulated environment in which we operate.

 

We are subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking and other legislation and regulations have had, and will continue to have, or may have a significant impact on the financial services industry. These regulations, which are generally intended to protect depositors and not our shareholders, and the interpretation and application of them by federal and state regulators, are beyond our control, may change rapidly and unpredictably, and can be expected to influence our earnings and growth. Our success depends on our continued ability to maintain compliance with these regulations. Many of these regulations increase our costs and thus place other financial institutions that may not be subject to similar regulation in stronger, more favorable competitive positions.

 

If we need additional capital in the future to continue our growth, we may not be able to obtain it on terms that are favorable. This could negatively affect our performance and the value of our common stock.

 

If our Merger with United is not consummated, our business strategy calls for continued growth. We anticipate that we would be able to support this growth through the generation of additional deposits at existing and new branch locations, as well as expanded loan and other investment opportunities. However, we may need to raise additional capital in the future to support our continued growth and to maintain desired capital levels. Our ability to raise capital through the sale of additional equity securities or the placement of financial instruments that qualify as regulatory capital will depend primarily upon our financial condition and the condition of financial markets at that time. We may not be able to obtain additional capital in the amounts or on terms satisfactory to us. Our growth may be constrained if we are unable to raise additional capital as needed.

 

We have extended off-balance sheet commitments to borrowers which expose us to credit and interest rate risk.

 

We enter into certain off-balance sheet arrangements in the normal course of business to meet the financing needs of our customers. These off-balance sheet arrangements include commitments to extend credit, standby letters of credit and guarantees which would impact our liquidity and capital resources to the extent customers accept or use these commitments. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and guarantees written is represented by the contractual or notional

 

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amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.

 

We have operational risk that could impact our ability to provide services to our customers.

 

Third parties provide key components of our business operations such as data processing, recording and monitoring transactions, online banking interfaces and services, internet connections, and network access. While we have selected these third party vendors carefully, we do not control their actions. Any problem caused by these third parties, including poor performance of services failure to provide services, disruptions in communication services provided by a vendor and failure to handle current or higher volumes, could adversely affect our ability to deliver products and services to our customers and otherwise conduct our business, and may harm our reputation. Financial or operational difficulties of a third party vendor could also hurt our operations if those difficulties affect the vendor’s ability to serve us. Replacing these third party vendors could also create significant delay and expense. Accordingly, use of such third parties creates an unavoidable inherent risk to our business operations.

 

We may be parties to certain legal proceedings that may impact our earnings.

 

We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high.  Substantial legal liability or significant regulatory action against us could have material adverse financial impact or cause significant reputational risk to us, which in turn could seriously harm our business prospects.

 

Our ability to pay dividends is limited and we may be unable to pay future dividends.

 

Our ability to pay dividends is limited by banking laws and regulations and the need to maintain sufficient consolidated capital in the Company and in our subsidiaries. The ability of our bank subsidiary to pay dividends to us is limited by its obligations to maintain sufficient capital, earnings and liquidity and by other general restrictions on its dividends under federal and state bank regulatory requirements. In addition, as a bank holding company, our ability to declare and pay dividends is subject to the guidelines of the Federal Reserve regarding capital adequacy and dividends. The Federal Reserve guidelines generally require us to review the effects of the cash payment of dividends on common stock and other Tier 1 capital instruments (i.e., perpetual preferred stock and trust preferred debt) on our financial condition. These guidelines also require that we review our net income for the current and past four quarters, and the level of dividends on common stock and other Tier 1 capital instruments for those periods, as well as our projected rate or earnings retention. Under the Federal Reserve’s policy, the board of directors of a bank holding company should also consider different factors to ensure that its dividend level is prudent relative to the organization’s financial position and is not based on overly optimistic earnings scenarios such as any potential events that may occur before the payment date that could affect its ability to pay while still maintaining a strong financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce bank holding company’s dividends if: (i) its net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends; (ii) its prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or (iii) it will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios. If we do not satisfy these regulatory requirements or the Federal Reserve’s policies, we will be unable to pay dividends on our common stock.

 

35



 

Consumers may increasingly decide not to use the Bank to complete their financial transactions, which would have a material adverse impact on our financial condition and operations.

 

Technology and other changes are allowing parties to complete financial transactions through alternative methods that historically have involved banks. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts, mutual funds or general-purpose reloadable prepaid cards. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost of deposits as a source of funds could have a material adverse effect on our financial condition and results of operations.

 

Item 1B.  Unresolved Staff Comments

 

None.

 

Item 2.  Properties

 

Cardinal Bank, excluding its George Mason subsidiary, conducts its business from 29 branch offices.   Nine of these facilities are owned and 20 are leased.  Leased branch banking facilities range in size from 457 square feet to 9,000 square feet.  Our leases on these facilities expire at various dates through 2025, and all but five of our leases have renewal options.  Seventeen of our branch banking locations have drive-up banking capabilities and all have ATMs.

 

Cardinal Wealth Services, Inc. conducts its business from one of Cardinal Bank’s branch facilities.

 

George Mason conducts its business from 18 leased facilities which range in size from 1,852 square feet to 38,315 square feet.  The leases have various expiration dates through 2022 and 10 of their 18 locations have renewal options.

 

Our headquarters facility in Tysons Corner, Virginia comprises 41,818 square feet of leased office space.  This lease expires in January 2022 and has renewal options.  In addition to housing various administrative functions — including accounting, data processing, compliance, treasury, marketing, deposit and loan operations — certain members of our commercial and industrial and commercial real estate lending functions and various other departments are located there.

 

We believe that all of our properties are maintained in good operating condition and are suitable and adequate for our operational needs.

 

Item 3.  Legal Proceedings

 

In the ordinary course of our operations, we become party to various legal proceedings.  Other than as set forth below, currently, we are not party to any material legal proceedings, and no such proceedings are, to management’s knowledge, threatened against us.

 

On December 20, 2016, Henry Kwong, individually and purportedly on behalf of all other shareholders of Cardinal, filed a putative class action complaint in the U.S. District Court for the Eastern District of Virginia, Alexandria Division (Case No. 1:16-cv-01582-TSE-MSN), challenging our pending merger with United. On January 11, 2017, a separate putative class action complaint was filed by Kyle Miller, individually and purportedly on behalf of all other shareholders of Cardinal, in the same court (Case No. 1:17-cv-00044-TSE-MSN). By Order dated January 27, 2017, these actions were consolidated for all purposes and merged, and, on February 14, 2017, the plaintiffs filed a Consolidated Amended Complaint. The plaintiffs generally claim that Cardinal and its directors violated federal securities laws by filing with the SEC a materially false and misleading prospectus and joint proxy statement. The amended complaint seeks, among other things, an order enjoining the parties from proceeding with or consummating the merger, as well as other equitable relief or money damages in the event that the transaction is completed. We believe that the claims are without merit and have filed a motion to dismiss.

 

36



 

Item 4.  Mine Safety Disclosures

 

None.

 

37



 

PART II

 

Item 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Price for Common Stock and Dividends.  Our common stock is currently listed for quotation on the Nasdaq Global Select Market under the symbol “CFNL.”  As of March 3, 2017, our common stock was held by 606 shareholders of record.  In addition, we estimate that there were 5,095 beneficial owners of our common stock who own their shares through brokers or banks.

 

The high and low sale prices per share for our common stock for each quarter of 2016 and 2015 as reported on the market at the time and dividends declared during those periods were as follows:

 

Periods Ended

 

High

 

Low

 

Dividends

 

2016

 

 

 

 

 

 

 

First Quarter

 

$

22.62

 

$

17.51

 

$

0.12

 

Second Quarter

 

23.16

 

19.21

 

0.12

 

Third Quarter

 

28.16

 

20.89

 

0.12

 

Fourth Quarter

 

34.75

 

25.30

 

0.12

 

2015

 

 

 

 

 

 

 

First Quarter

 

$

20.52

 

$

17.62

 

$

0.11

 

Second Quarter

 

22.47

 

19.72

 

0.11

 

Third Quarter

 

24.20

 

21.11

 

0.11

 

Fourth Quarter

 

24.99

 

21.68

 

0.12

 

 

Dividend Policy.  The board of directors intends to follow a policy of retaining any earnings necessary to operate our business in accordance with all regulatory policies while maximizing the long-term return for the Company’s investors.  Our future dividend policy is subject to the discretion of the board of directors and future dividend payments will depend upon a number of factors, including future earnings, alternative investment opportunities, financial condition, cash requirements, and general business conditions.

 

Our ability to distribute cash dividends will depend primarily on the ability of our subsidiaries to pay dividends to us.  Cardinal Bank is subject to legal limitations on the amount of dividends it is permitted to pay.  Furthermore, neither Cardinal Bank nor we may declare or pay a cash dividend on any of our capital stock if we are insolvent or if the payment of the dividend would render us insolvent or unable to pay our obligations as they become due in the ordinary course of business.  For additional information on these limitations, see “Government Regulation and Supervision — Payment of Dividends” in Item 1 above.

 

Repurchases.  On February 26, 2007, we publicly announced that the Board of Directors had adopted a program to repurchase up to 1,000,000 shares of our common stock.  The timing and amount of repurchases, if any, will depend on market conditions, share price, trading volume, and other factors, and there is no assurance that we will purchase shares during any period.  No termination date was set for the buyback program.  Shares may be repurchased in the open market or through privately negotiated transactions.

 

Since the inception of the program, we have purchased 477,608 shares of our common stock at a total cost of $4.1 million.  All of these shares have been cancelled and retired.  No shares were repurchased during 2016.

 

38



 

Stock Performance Graph.  The graph set forth below shows the cumulative shareholder return on the Company’s Common Stock during the five-year period ended December 31, 2016, as compared with: (i) an overall stock market index, the NASDAQ Composite; and (ii) a published industry index, the SNL Bank Index.  The stock performance graph assumes that $100 was invested on December 31, 2011 in our common stock and each of the comparable indices and that dividends were reinvested.

 

 

 

 

Period Ending

 

Index

 

12/31/11

 

12/31/12

 

12/31/13

 

12/31/14

 

12/31/15

 

12/31/16

 

Cardinal Financial Corporation

 

100.00

 

154.04

 

172.44

 

193.81

 

227.03

 

334.27

 

NASDAQ Composite

 

100.00

 

117.45

 

164.57

 

188.84

 

201.98

 

219.89

 

SNL Bank

 

100.00

 

134.95

 

185.28

 

207.12

 

210.65

 

266.16

 

 

39



 

Item 6.  Selected Financial Data

 

Selected Financial Data

(In thousands, except per share data)

 

 

 

Years Ended December 31,

 

 

 

2016

 

2015

 

2014

 

2013

 

2012

 

Income Statement Data:

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

153,478

 

$

140,465

 

$

128,863

 

$

114,115

 

$

115,050

 

Interest expense

 

25,621

 

24,071

 

21,163

 

21,770

 

24,047

 

Net interest income

 

127,857

 

116,394

 

107,700

 

92,345

 

91,003

 

Provision for loan losses

 

(264

)

1,388

 

1,938

 

(32

)

7,123

 

Net interest income after provision for loan losses

 

128,121

 

115,006

 

105,762

 

92,377

 

83,880

 

Non-interest income

 

62,354

 

52,692

 

39,178

 

29,911

 

63,392

 

Non-interest expense

 

115,170

 

96,298

 

96,228

 

84,603

 

79,317

 

Net income before income taxes

 

75,305

 

71,400

 

48,712

 

37,685

 

67,955

 

Provision for income taxes

 

24,814

 

24,066

 

16,029

 

12,175

 

22,658

 

Net income

 

$

50,491

 

$

47,334

 

$

32,683

 

$

25,510

 

$

45,297

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Data:

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

4,210,514

 

$

4,029,921

 

$

3,399,134

 

$

2,894,230

 

$

3,039,187

 

Loans receivable, net of fees

 

3,281,159

 

3,056,310

 

2,581,114

 

2,040,168

 

1,803,429

 

Allowance for loan losses

 

31,767

 

31,723

 

28,275

 

27,864

 

27,400

 

Loans held for sale

 

297,766

 

383,768

 

315,323

 

373,993

 

785,751

 

Total investment securities

 

400,117

 

423,794

 

348,222

 

359,686

 

286,420

 

Total deposits

 

3,282,700

 

3,032,771

 

2,535,330

 

2,058,859

 

2,243,758

 

Other borrowed funds

 

426,671

 

537,965

 

437,995

 

475,232

 

392,275

 

Total shareholders’ equity

 

452,177

 

413,147

 

377,321

 

320,532

 

308,066

 

Common shares outstanding

 

32,910

 

32,373

 

32,078

 

30,333

 

30,226

 

 

 

 

 

 

 

 

 

 

 

 

 

Per Common Share Data:

 

 

 

 

 

 

 

 

 

 

 

Basic net income

 

$

1.52

 

$

1.45

 

$

1.01

 

$

0.83

 

$

1.53

 

Fully diluted net income

 

1.50

 

1.43

 

1.00

 

0.82

 

1.51

 

Book value

 

13.74

 

12.76

 

11.76

 

10.57

 

10.19

 

Tangible book value (1) 

 

12.65

 

11.63

 

10.60

 

10.23

 

9.85

 

 

 

 

 

 

 

 

 

 

 

 

 

Performance Ratios:

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

1.23

%

1.29

%

1.02

%

0.92

%

1.70

%

Return on average equity

 

11.40

 

11.76

 

8.82

 

7.96

 

16.02

 

Dividend payout ratio

 

30.95

 

29.92

 

33.28

 

27.30

 

13.01

 

Net interest margin (2)

 

3.33

 

3.37

 

3.59

 

3.52

 

3.61

 

Efficiency ratio (3) 

 

60.55

 

56.95

 

65.52

 

69.20

 

51.37

 

Non-interest income to average assets

 

1.52

 

1.44

 

1.23

 

1.07

 

2.37

 

Non-interest expense to average assets

 

2.80

 

2.62

 

3.01

 

3.04

 

2.97

 

Loans receivable, net of fees to total deposits

 

99.95

 

100.78

 

101.81

 

99.09

 

80.38

 

 

 

 

 

 

 

 

 

 

 

 

 

Asset Quality Ratios:

 

 

 

 

 

 

 

 

 

 

 

Net charge-offs (recoveries) to average loans receivable, net of fees

 

(0.01

)%

(0.07

)%

0.06

%

(0.03

)%

0.35

%

Nonperforming loans to loans receivable, net of fees

 

0.00

 

0.02

 

0.17

 

0.11

 

0.42

 

Nonperforming loans to total assets

 

0.00

 

0.01

 

0.13

 

0.08

 

0.25

 

Allowance for loan losses to nonperforming loans

 

N/A

 

6,100.58

 

628.75

 

1,204.15

 

359.30

 

Allowance for loan losses to loans receivable, net of fees

 

0.97

 

1.04

 

1.10

 

1.37

 

1.52

 

 

 

 

 

 

 

 

 

 

 

 

 

Capital Ratios:

 

 

 

 

 

 

 

 

 

 

 

Tier 1 risk-based capital

 

11.48

%

10.52

%

10.89

%

11.85

%

11.94

%

Total risk-based capital

 

12.31

 

11.37

 

11.78

 

12.89

 

13.04

 

Common Equity Tier 1 capital

 

10.83

 

9.86

 

N/A

 

N/A

 

N/A

 

Leverage capital ratio

 

10.77

 

10.18

 

10.81

 

11.70

 

10.49

 

 

 

 

 

 

 

 

 

 

 

 

 

Other:

 

 

 

 

 

 

 

 

 

 

 

Average shareholders’ equity to average total assets

 

10.78

%

10.97

%

11.59

%

11.52

%

10.59

%

Average loans receivable, net of fees to average total deposits

 

99.06

%

97.43

%

98.20

%

86.91

%

83.43

%

Average common shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

Basic

 

33,173

 

32,744

 

32,392

 

30,687

 

29,654

 

Diluted

 

33,690

 

33,208

 

32,824

 

31,077

 

29,996

 

 


(1) Tangible book value is calculated as total shareholders’ equity, less goodwill and other intangible assets, divided by common shares outstanding.

(2) Net interest margin is calculated as net interest income divided by total average earning assets and reported on a tax equivalent basis at a rate of 36% for 2016, 35% for 2015, and 33% for 2014.

(3) Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income.

 

40



 

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

 

The following presents management’s discussion and analysis of our consolidated financial condition at December 31, 2016 and 2015 and the results of our operations for the years ended December 31, 2016, 2015, and 2014.  The discussion should be read in conjunction with the consolidated financial statements and related notes included in this report.

 

Caution About Forward-Looking Statements

 

We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties.  These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals.  The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.

 

These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

 

·                  the businesses of Cardinal and United may not be combined successfully, or such combination may take longer, be more difficult, time-consuming or costly to accomplish than expected;

 

·                  the expected growth opportunities or cost savings from the Merger may not be fully realized or may take longer to realize than expected;

 

·                  deposit attrition, operating costs, customer losses, and business disruption following the Merger, including adverse effects on relationships with employees, may be greater than expected;

 

·                  the regulatory approvals required for the Merger may not be obtained on the proposed terms or on the anticipated schedule;

 

·                  shareholders of Cardinal or United may fail to approve the Merger;

 

·                  termination of the Merger Agreement, or failure to complete the Merger, could negatively impact our stock and our future business and financial results;

 

·                  we will be subject to business uncertainties and contractual restrictions while the Merger is pending that could be harmful to our operations;

 

·                  if the Merger is not completed, we will have incurred substantial expenses and committed substantial time and resources without realizing the expected benefits of the Merger;

 

·                  the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;

 

·                  changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchases of mortgage loans sold and other estimates;

 

·                  changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;

 

·                  decrease in the volume of loan originations at our mortgage banking subsidiary as a result of the cyclical nature of mortgage banking, changes in interest rates, economic conditions, decreased economic activity, and slowdowns in the housing market which would negatively impact the income recorded on the sales of loans held for sale;

 

·                  risks inherent in making loans such as repayment risks and fluctuating collateral values;

 

·                  declines in the prices of assets and market illiquidity may cause us to record an other-than-temporary impairment or other losses, specifically in our pooled trust preferred securities portfolio resulting from increases in underlying issuers’ defaulting or deferring payments;

 

41



 

·                  changes in operations within the wealth management services segment, its customer base and assets under management;

 

·                  changes in operations of George Mason Mortgage, LLC as a result of the activity in the residential real estate market and any associated impact on the fair value of goodwill in the future;

 

·                  legislative and regulatory changes, including the Financial Reform Act, and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;

 

·                  exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;

 

·                  the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;

 

·                  the ability to successfully manage our growth or implement our growth strategies as we implement new or change internal operating systems or if we are unable to identify attractive markets, locations or opportunities to expand in the future;

 

·                  the effects of future economic, business and market conditions;

 

·                  governmental monetary and fiscal policies;

 

·                  changes in accounting policies, rules and practices;

 

·                  maintaining cost controls and asset quality as we open or acquire new branches;

 

·                  maintaining capital levels adequate to support our growth;

 

·                  reliance on our management team, including our ability to attract and retain key personnel;

 

·                  competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

 

·                  demand, development and acceptance of new products and services;

 

·                  problems with technology utilized by us;

 

·                  changing trends in customer profiles and behavior; and

 

·                  other factors described from time to time in our reports filed with the SEC.

 

Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.  In addition, our past results of operations do not necessarily indicate our future results.

 

In addition, this section should be read in conjunction with the description of our “Risk Factors” in Item 1A above.

 

Overview

 

We are a financial holding company formed in 1997 and headquartered in Fairfax County, Virginia.  We were formed principally in response to opportunities resulting from the consolidation of several Virginia-based banks.  These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.

 

On January 16, 2014, we announced the completion of our acquisition of United Financial Banking Companies, Inc. (“UFBC”), the holding company of The Business Bank (“TBB”), pursuant to a previously announced definitive merger agreement.  The merger of UFBC into Cardinal was effective January 16, 2014.  Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of our common stock in exchange for each

 

42



 

share of UFBC common stock they owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014.

 

We own Cardinal Bank (the “Bank”), a Virginia state-chartered community bank with 29 banking offices located in Northern Virginia and the greater Washington, D.C. metropolitan area.  The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers.  Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.

 

Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC (“George Mason”) and retail securities brokerage though Cardinal Wealth Services, Inc. (“CWS”).

 

George Mason, based in Fairfax, Virginia, engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through 18 offices located throughout the metropolitan Washington region.  George Mason does business in eight states, primarily Virginia and Maryland, and the District of Columbia.  George Mason is one of the largest residential mortgage originators in the greater Washington, D.C. metropolitan area, generating originations of approximately $4.1 billion in 2016 and $3.6 billion in 2015.  George Mason’s primary sources of revenue include loan origination fees, net interest income earned on loans held for sale, and gains on sales of loans.  Our mortgage loans are then sold servicing released.

 

George Mason also offers a construction-to-permanent loan program.  This program provides variable rate financing for customers to construct their residences.  Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market.  These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.

 

The mortgage banking segment’s business is both cyclical and seasonal.  The cyclical nature of its business is influenced by, among other factors, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy.  Historically, the mortgage banking segment has its lowest levels of quarterly loan closings during the first quarter of the year.

 

We formed a wholly-owned subsidiary, Cardinal Statutory Trust I, for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures (“trust preferred securities”).  These trust preferred securities are due in 2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly.  These securities are redeemable at par.  The interest rate on this debt was 3.36% at December 31, 2016.  We have guaranteed payment of these securities.  The $20.6 million payable by us to Cardinal Statutory Trust I is included in other borrowed funds in the consolidated statements of condition since Cardinal Statutory Trust I is an unconsolidated subsidiary as we are not the primary beneficiary of this entity.  We utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank.

 

In connection with the UFBC acquisition, we acquired all of the voting and common shares of UFBC Capital Trust I (the “UFBC Trust”), which is a wholly-owned subsidiary established for the sole purpose of issuing $5.0 million of floating rate junior subordinated deferrable interest debentures.  These trust preferred securities are due in 2035 and have an interest rate of LIBOR plus 2.10%, which adjusts quarterly.  At December 31, 2016, the interest

 

43



 

rate on trust preferred securities was 3.06%. The UFBC Trust is an unconsolidated subsidiary since we are not the primary beneficiary of this entity.  The additional $155,000 that is payable by us to the UFBC Trust represents the unfunded capital investment in the UFBC Trust.

 

On August 18, 2016, we announced that we will merge with United Bankshares, Inc., (“United”), a West Virginia corporation headquartered in Charleston.   Under the terms of the merger agreement, United will acquire Cardinal, with our common shareholders receiving 0.71 shares of United common stock for each share of Cardinal (the “Merger”). The transaction is subject to shareholder and regulatory approvals, and is expected to close during the second quarter of 2017.

 

Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income.  As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income.  We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities.  We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely.   In addition to managing interest rate risk, we also analyze our loan portfolio for exposure to credit risk.  Loan defaults and foreclosures are inherent risks in the banking industry, and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit.  In addition to net interest income, non-interest income is an important source of revenue for us and includes, among other things, service charges on deposits and loans, investment fee income, gains and losses on sales of investment securities available-for-sale, and gains on sales of mortgage loans.

 

Net interest income and non-interest income represented the following percentages of total revenue, which is calculated as net interest income plus non-interest income, for the three years ended December 31, 2016:

 

 

 

Net Interest 
Income

 

Non-Interest 
Income

 

 

 

 

 

 

 

2016

 

67.2

%

32.8

%

2015

 

68.8

%

31.1

%

2014

 

73.3

%

26.7

%

 

Non-interest income represented a larger portion of our total revenue for 2016 relative to 2015 as a result of a significant increase in gains realized and unrealized on mortgage loans held for sale.  In addition to an increase in originations in 2016 compared to 2015, we also experienced an increase in gain on sale margins of approximately 15 basis points which was result of having our mandatory delivery loan sale program for the full year of 2016.  For 2015, non-interest income was a larger portion of our total revenue base compared to 2014 as a result of the increase in gain on sale margins of approximately 20 basis points due to our implementation of our mandatory delivery loan sale program during the last six months of 2015.

 

2016 Economic Environment

 

The banking environment and the markets in which we conduct our businesses will continue to be strongly influenced by developments in the U.S. and global economies, as well as the continued implementation of rulemaking from recent financial reforms.  U.S. economic growth continued modestly in 2016 despite early concerns related to a free falling Chinese stock market and weak trade data.  While economic growth struggled to come near 2% during 2016, the

 

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labor market continued to improve.  Employment gains were generally steady as the national unemployment rate fell to 4.70% by year end.  U.S. Treasury yields dropped early in 2016 due to market turmoil and continued to decrease until late third quarter of 2016 as a Federal Reserve rate increase was expected.  U.S Treasury yields continued their climb post-election as President Trump’s potential tax policies and infrastructure spending are expected to expand the U.S. economy going forward.  At its final meeting in 2016, the Federal Open Market Committee raised its targeted Federal funds rate by 25 basis points, its only rate increase during 2016.

 

Although global economic conditions remain unsettled as Great Britain deals with their “Brexit” vote, the metropolitan Washington, D.C. area, the region we operate in, continued to perform relatively well, compared to other regions.  As we believe that our region has weathered the recession better than most over the past several years, a protracted low interest rate environment, and the burden of regulatory requirements enacted in response to the past financial crisis made for a challenging 2016.  Progress in the near future for employment and the housing industry is uncertain given the prospect for higher long-term interest rates.  We continue to consider future economic events and their impact on our performance.

 

The unemployment rate in the Washington, D.C. metropolitan area decreased in tandem to the national unemployment rate to 3.4%, and commercial and residential real estate values held up well compared to other regions.

 

Our credit quality continues to remain strong.  At December 31, 2016, we had no loans on nonaccrual and no loans contractually past due 90 days or more as to principal or interest and still accruing.  We recorded annualized net recoveries of 0.01% of our average loans receivable for the year ended December 31, 2016. As a result of a decrease in mortgage interest rates during the first six months of 2016, refinancing originations from our mortgage banking segment remained steady during 2016 to 32% of total originations for the full year 2016 compared to 31% of total originations for 2015.

 

Market illiquidity and concerns over credit risk continue to impact the ratings of our pooled trust preferred securities. We hold investments of $3.5 million in par value of pooled trust preferred securities, which are below book value as of December 31, 2016 due to the lack of liquidity in the market, deferrals and defaults of issuers, and continued investor apprehension for investing in these types of investments.

 

While our loan growth has continued to be strong, unexpected changes in economic growth could adversely affect our loan portfolio, including causing increases in delinquencies and default rates, which would adversely impact our charge-offs and provision for loan losses.  Deterioration in real estate values and household incomes may also result in higher credit losses for us.  Also, in the ordinary course of business, we may be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer.  A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our businesses, perhaps materially. The systems by which we set limits and monitor the level of our credit exposure to individual entities and industries also may not function as we have anticipated.

 

Liquidity is essential to our business.  The primary sources of funding for our Bank include customer deposits and wholesale funding.  Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits.  This situation may arise due to circumstances that we may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or us.  Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by disruptions in the capital markets or other events.  While we believe we have a healthy liquidity position, any of the above factors could materially impact our liquidity position in the future.

 

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Critical Accounting Policies

 

General

 

U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters.  Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical.  These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates.  Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements.  Actual results, in fact, could differ from initial estimates.

 

The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, accounting for purchased credit-impaired loans, the fair value measurements of certain assets and liabilities, accounting for economic hedging activities, and accounting for impairment testing of goodwill.

 

Allowance for Loan Losses

 

We maintain the allowance for loan losses at a level that represents management’s best estimate of known and inherent losses in our loan portfolio.  Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers.  Unusual and infrequently occurring events, such as weather-related disasters, may impact our assessment of possible credit losses.  As a part of our analysis, we use our historical losses, loss emergence experience and qualitative factors, such as levels of and trends in delinquencies, nonaccrual loans, charged-off loans, changes in volume and terms of loans, effects of changes in lending policy, experience and ability and depth of management, national and local economic trends and conditions and concentrations of credit, competition, and loan review results to support estimates.

 

The allowance for loan losses is based first on a segmentation of the loan portfolio by general loan type, or portfolio segments.  For originated loans, certain portfolio segments are further disaggregated and evaluated collectively for impairment based on class segments, which are largely based on the type of collateral underlying each loan.  For purposes of this analysis, we categorize loans into one of five categories:  commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans.  We also maintain an allowance for loan losses for acquired loans when: (i) for loans accounted for under ASC 310-30, there is deterioration in credit quality subsequent to acquisition, and (ii) for loans accounted for under ASC 310-20, the inherent losses in the loans exceed the remaining credit discount recorded at the time of acquisition.

 

During the fourth quarter of 2014, we transitioned to using its historical loss experience and trends in losses for each category which were then adjusted for portfolio trends and economical and environmental factors in determining the allowance for loan losses.  The indicated loss factors resulting from this analysis are applied to each of the five categories of loans.  Prior to the fourth quarter of 2014, the allowance model used the average loss rates of similar institutions based on its custom peer group as a baseline, which was adjusted for its particular loan portfolio characteristics and environmental factors.  These changes did not have an impact to the overall allowance.

 

The allowance for loan losses consists of specific and general components. The specific component relates to loans that are determined to be impaired and, therefore, individually

 

46



 

evaluated for impairment. We individually assigns loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent.  In certain cases, we apply, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful.  Loans classified as loss loans are fully reserved or charged-off.   However, in most instances, we evaluate the impairment of certain loans on a loan by loan basis for those loans that are adversely risk rated.  For these loans, we analyze the fair value of the collateral underlying the loan and consider estimated costs to sell the collateral on a discounted basis.  If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) we recognize an impairment and establish a specific reserve for the impaired loan. Because of the limited number of impaired loans within the portfolio, we are able to evaluate each impaired loan individually and therefore specific reserves for impaired loans are generally less than those recommended by the listed regulatory guidelines above.

 

The general component relates to groups of homogeneous loans not designated for a specific allowance and are collectively evaluated for impairment. The general component is based on historical loss experience adjusted for qualitative factors. To arrive at the general component, the loan portfolio is grouped by loan type. A weighted average historical loss rate is computed for each group of loans over the trailing seven year period.   We selected a seven year evaluation period as a result of the limited historical loss experience we have incurred, even during the recent economic downturn.  We also believe that a seven year time horizon represents a full economic cycle.  The historical loss factors are updated at least annually, unless a more frequent review of such factors is warranted.  In addition to the use of historical loss factors, a qualitative adjustment factor is applied. This qualitative adjustment factor, which may be favorable or unfavorable, represents management’s judgment that inherent losses in a given group of loans are different from historical loss rates due to environmental factors unique to that specific group of loans. These factors may relate to growth rate factors within the particular loan group; whether the recent loss history for a particular group of loans differs from its historical loss rate; the amount of loans in a particular group that have recently been designated as impaired and that may be indicative of future trends for this group; reported or observed difficulties that other banks are having with loans in the particular group; changes in the experience, ability, and depth of lending personnel; changes in the nature and volume of the loan portfolio and in the terms of loans; and changes in the volume and severity of past due loans, nonaccrual loans, and adversely classified loans. The sum of the historical loss rate and the qualitative adjustment factor comprise the estimated annual loss rate. To adjust for inherent loss levels within the loan portfolio, a loss emergence factor is estimated based on an evaluation of the period of time it takes for a loan within each of our loan segments to deteriorate to the point an impairment loss is recorded within the allowance.  The loss emergence factor is applied to the estimated annual loss rate to determine the expected annual loss amount.

 

Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are appropriate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment.  Additional provisions for such losses, if necessary, would be recorded in the commercial banking or mortgage banking segments, as appropriate, and would negatively impact earnings.

 

47



 

Allowance for Loan Losses - Acquired Loans

 

Acquired loans accounted for under ASC 310-30

 

For our acquired loans, to the extent that we experience a deterioration in borrower credit quality resulting in a decrease in our expected cash flows subsequent to the acquisition of the loans, an allowance for loan losses would be established based on our estimate of future credit losses over the remaining life of the loans.

 

Acquired loans accounted for under ASC 310-20

 

Subsequent to the acquisition date, we establish our allowance for loan losses through a provision for loan losses based upon an evaluation process that is similar to our evaluation process used for originated loans. This evaluation, which includes a review of loans on which full collectability may not be reasonably assured, considers, among other factors, the estimated fair value of the underlying collateral, economic conditions, historical net loan loss experience, carrying value of the loans, which includes the remaining net purchase discount or premium, and other factors that warrant recognition in determining our allowance for loan losses.

 

Purchased Credit-Impaired Loans

 

Purchased credit-impaired (PCI) loans, which are the loans acquired in our acquisition of UFBC, are loans acquired at a discount (that is due, in part, to credit quality). These loans are initially recorded at fair value (as determined by the present value of expected future cash flows) with no allowance for loan losses. We account for interest income on all loans acquired at a discount (that is due, in part, to credit quality) based on the acquired loans’ expected cash flows. The acquired loans may be aggregated and accounted for as a pool of loans if the loans being aggregated have common risk characteristics. A pool is accounted for as a single asset with a single composite interest rate and an aggregate expectation of cash flow. The difference between the cash flows expected at acquisition and the investment in the loans, or the “accretable yield,” is recognized as interest income utilizing the level-yield method over the life of each pool. Increases in expected cash flows subsequent to the acquisition are recognized prospectively through adjustment of the yield on the pool over its remaining life, while decreases in expected cash flows are recognized as impairment through a loss provision and an increase in the allowance for loan losses. Therefore, the allowance for loan losses on these impaired pools reflect only losses incurred after the acquisition (representing the present value of all cash flows that were expected at acquisition but currently are not expected to be received).  At December 31, 2016, there was no reserve for impairment of PCI loans within our allowance for loan losses.

 

We periodically evaluate the remaining contractual required payments due and estimates of cash flows expected to be collected. These evaluations, performed quarterly, require the continued use of key assumptions and estimates, similar to the initial estimate of fair value. Changes in the contractual required payments due and estimated cash flows expected to be collected may result in changes in the accretable yield and non-accretable difference or reclassifications between accretable yield and the non-accretable difference. On an aggregate basis, if the acquired pools of PCI loans perform better than originally expected, we would expect to receive more future cash flows than originally modeled at the acquisition date. For the pools with better than expected cash flows, the forecasted increase would be recorded as an additional accretable yield that is recognized as a prospective increase to our interest income on loans.

 

48



 

Fair Value Measurements

 

We determine the fair values of financial instruments based on the fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standard describes three levels of inputs that may be used to measure fair value.  Our investment securities available-for-sale are recorded at fair value using reliable and unbiased evaluations by an industry-wide valuation service.  This service uses evaluated pricing models that vary based on asset class and include available trade, bid, and other market information.  Generally, the methodology includes broker quotes, proprietary models, vast descriptive terms and conditions databases, as well as extensive quality control programs.

 

We also fair value our interest rate lock commitments, forward loan sales commitments, and mortgage-backed securities used to hedge our interest rate lock commitments and certain loans held for sale.  The fair value of our interest rate lock commitments considers the expected premium (discount) to par and we apply certain fallout rates for those rate lock commitments for which we do not close a mortgage loan.  In addition, we calculate the effects of the changes in interest rates from the date of the commitment through loan origination, and then period end, using applicable published mortgage-backed investment security prices for fixed rate loan products and investor indicated pricing for adjustable rate products.  The fair value of the forward sales contracts to investors and mortgage-backed securities considers the market price movement of the same type of security between the trade date and the balance sheet date.

 

We sell mortgage loans on either a best efforts or mandatory delivery basis.  Loans held for sale that are delivered on a best efforts basis are recorded at the lower of cost or fair value.  For loans sold on a mandatory delivery basis, we have elected to record these loans at fair value using valuations from investors for loans with similar characteristics which is then adjusted for GMM’s actual sales experience versus the investor’s indicated pricing.

 

Accounting for Economic Hedging Activities

 

We record all derivative instruments on the statement of condition at their fair values.  We do not enter into derivative transactions for speculative purposes. For derivatives designated as hedges, we contemporaneously document the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness.  We evaluate the effectiveness of these transactions at inception and on an ongoing basis.  Ineffectiveness is recorded through earnings.  For derivatives designated as cash flow hedges, the fair value adjustment is recorded as a component of other comprehensive income, except for the ineffective portion which is recorded in earnings.

 

We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective.  In situations in which cash flow hedge accounting is discontinued, we continue to carry the derivative at its fair value on the statement of condition and recognize any subsequent changes in fair value in earnings over the term of the forecasted transaction.  When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.

 

In the normal course of business, we enter into contractual commitments, including rate lock commitments, to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the timeframe established by us. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to

 

49



 

residential mortgage loans intended to be sold are considered derivatives and are marked to market through earnings.

 

To mitigate the effect of interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into a forward loan sales contract under best efforts or a trade of mortgage-backed securities for mandatory delivery (the “residual hedge”). During the rate lock commitment period, these forward loan sales contracts and the residual hedge are marked to market through earnings and are not designated as accounting hedges. Exclusive of the fair value elements of the rate lock commitment related to servicing and the wholesale and retail rate spread, the changes in fair value related to movements in market rates of the rate lock commitments and the forward loan sales contracts and residual hedge generally move in opposite directions, and the net impact of changes in these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and we record a loan held for sale and continue to be obligated under the same forward loan sales contract under best efforts.  Loans held for sale that are delivered on a best efforts basis are recorded at the lower of cost or fair value.  For mandatory delivery, we close out of the trading mortgage-backed securities assigned within the residual hedge and replace them with a forward sales contract once a price has been accepted by an investor.  For loans sold on a mandatory delivery basis, we have elected to record these loans at fair value using valuations from investors for loans with similar characteristics which is then adjusted for GMM’s actual sales experience versus the investor’s indicated pricing.

 

Accounting for Impairment Testing of Goodwill

 

We test goodwill for impairment pursuant to ASU 2011-08, Testing Goodwill for Impairment.  This ASU permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. We perform our annual review of the goodwill during the third quarter.

 

In the event we are required to perform a Step 1 fair value evaluation of the reporting unit, we make estimates of the discounted cash flows from the expected future operations of the reporting unit. This discounted cash flow analysis involves the use of unobservable inputs including:  estimated future cash flows from operations; an estimate of a terminal value; a discount rate; and other inputs.  Our estimated future cash flows are largely based on our historical actual cash flows.  If the analysis indicates that the fair value of the reporting unit is less than its carrying value, we do an analysis to compare the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all its assets and liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.

 

New Financial Accounting Standards

 

In August 2015, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of Effective Date.  The amendments in ASU 2015-14 defer the effective date of ASU 2014-09 for all entities by one year. Public business entities, certain not-for-profit entities, and certain employee benefit plans should apply the guidance in ASU 2014-09 to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that reporting period. Earlier application is permitted only as of annual reporting periods beginning after December 15, 2016, including

 

50



 

interim reporting periods within that reporting period. The Company does not expect the adoption of ASU 2015-14 (or ASU 2014-09) to have a material impact on its consolidated financial statements.

 

In January 2016, the FASB issued ASU 2016-01, Financial Instruments — Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.  The amendments in ASU 2016-01, among other things: 1) Requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. 2) Requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes. 3) Requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables). 4) Eliminates the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. The amendments in this ASU are effective for public companies for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company is currently assessing the impact that ASU 2016-01 will have on its consolidated financial statements.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842). Among other things, in the amendments in ASU 2016-02, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (1) A lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (2) A right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company is currently assessing the impact that ASU 2016-02 will have on its consolidated financial statements.

 

During March 2016, the FASB issued ASU No. 2016-09, Compensation — Stock Compensation (Topic 718): Improvements to Employee Shares-Based Payment Accounting. The amendments in this ASU simplify several aspects of the accounting for share-based payment award transactions including: (a) income tax consequences; (b) classification of awards as either equity or liabilities; and (c) classification on the statement of cash flows. The amendments are effective for public companies for annual periods beginning after December 15, 2016, and interim periods within those annual periods. The Company elected to early adopt ASU 2016-09 during the quarter ended December 31, 2016. As a result of adopting this standard the Company recorded excess tax benefits during 2016 through income tax expense as a discrete item; excess tax benefits were included with other income tax cash flows within operating cash flows on a prospective basis; and the Company has elected to continue its current policy of estimating forfeitures rather than recognizing forfeitures when they occur.

 

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During June 2016, the FASB issued ASU No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The amendments in this ASU, among other things, require the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration. The amendments in this ASU are effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. The Company is currently assessing the impact that ASU 2016-13 will have on its consolidated financial statements.

 

During August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, to address diversity in how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The amendments should be applied using a retrospective transition method to each period presented. If retrospective application is impractical for some of the issues addressed by the update, the amendments for those issues would be applied prospectively as of the earliest date practicable.  Early adoption is permitted, including adoption in an interim period.  The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.

 

Financial Overview

 

For the year ended December 31, 2016, we reported net income of $50.5 million on a consolidated basis.  The commercial banking segment recorded net income of $48.3 million and our mortgage banking segment recorded net income of $7.3 million.  The wealth management services business segment reported net income of $62,000 for the year ended December 31, 2016.

 

For the year ended December 31, 2015, we reported net income of $47.3 million on a consolidated basis.  The commercial banking segment recorded net income of $39.2 million and our mortgage banking segment recorded net income of $9.2 million.  The wealth management services business segment reported net income of $37,000 for the year ended December 31, 2015.

 

2016 Compared to 2015

 

At December 31, 2016, total assets were $4.21 billion, an increase of 4.5%, or $180.6 million, from $4.03 billion at December 31, 2015.  Total loans receivable, net of deferred fees and costs, increased 7.4%, or $224.8 million, to $3.28 billion at December 31, 2016, from $3.06 billion at December 31, 2015.  Total investment securities decreased by $23.7 million, or 5.6%, to $400.1 million at December 31, 2016, from $423.8 million at December 31, 2015.  Total deposits increased 8.2%, or $249.9 million, to $3.28 billion at December 31, 2016, from $3.03 billion at December 31, 2015.  Other borrowed funds, which primarily include customer repurchase agreements, federal funds sold and Federal Home Loan Bank (“FHLB”) advances, decreased $111.3 million to $426.7 million at December 31, 2016, from $538.0 million at December 31, 2015.

 

Shareholders’ equity at December 31, 2016 was $452.2 million, an increase of $39.0 million from $413.1 million at December 31, 2015.  The increase in shareholders’ equity was attributable to the recognition of net income of $50.5 million less dividends paid to shareholders

 

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totaling $15.6 million for the year ended December 31, 2016.  Changes in accumulated other comprehensive income decreased shareholders’ equity $6.4 million during 2016.  Accumulated other comprehensive income decreased for the year ended December 31, 2016 primarily as a result of the decrease in market value of our available-for-sale investment securities portfolio.  Total shareholders’ equity to total assets for December 31, 2016 and 2015 was 10.7% and 10.3%, respectively.  Book value per share at December 31, 2016 and 2015 was $13.74 and $12.76, respectively.  Total risk-based capital to risk-weighted assets was 12.31% at December 31, 2016 compared to 11.37% at December 31, 2015.  Accordingly, we were considered “well capitalized” for regulatory purposes at December 31, 2016.

 

We recorded net income of $50.5 million, or $1.50 per diluted common share, for the year ended December 31, 2016, compared to net income of $47.3 million, or $1.43 per diluted common share, in 2015.  Net interest income increased $11.5 million to $127.9 million for the year ended December 31, 2016, compared to $116.4 million for the year ended December 31, 2015, a result of increase in interest earning assets.  Provision for loan losses was a recovery of $264,000 for the year ended December 31, 2016, compared to a $1.4 million provision for 2015.  Non-interest income increased $9.7 million to $62.4 million for the year ended December 31, 2016 as compared to $52.7 million for 2015 due primarily to an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking business segment.  Non-interest expense was $115.2 million for the year ended December 31, 2016 compared to $96.3 million for the year ended December 31, 2015.  An increase in salaries and benefits expense during 2016 and an increase in merger and acquisition expense contributed to the increase in non-interest expense during 2016.

 

The return on average assets for the years ended December 31, 2016 and 2015 was 1.23% and 1.29%, respectively.  The return on average equity for the years ended December 31, 2016 and 2015 was 11.40% and 11.76%, respectively.

 

2015 Compared to 2014

 

At December 31, 2015, total assets were $4.03 billion, an increase of 18.6%, or $630.8 million, from $3.40 billion at December 31, 2014.  Total loans receivable, net of deferred fees and costs, increased 18.4%, or $475.2 million, to $3.06 billion at December 31, 2015, from $2.58 billion at December 31, 2014.  Total investment securities increased by $75.6 million, or 21.7%, to $423.8 million at December 31, 2015, from $348.2 million at December 31, 2014.  Total deposits increased 19.6%, or $497.4 million, to $3.03 billion at December 31, 2015, from $2.54 billion at December 31, 2014.  Other borrowed funds, which primarily include customer repurchase agreements, federal funds sold and Federal Home Loan Bank (“FHLB”) advances, increased $100.0 million to $538.0 million at December 31, 2015, from $438.0 million at December 31, 2014.

 

Shareholders’ equity at December 31, 2015 was $413.1 million, an increase of $35.8 million from $377.3 million at December 31, 2014.  The increase in shareholders’ equity was attributable to the recognition of net income of $47.3 million less dividends paid to shareholders totaling $14.2 million for the year ended December 31, 2015.  Changes in accumulated other comprehensive income decreased shareholders’ equity $3.1 million during 2015.  Accumulated other comprehensive income decreased for the year ended December 31, 2015 primarily as a result of the decrease in market value of our available-for-sale investment securities portfolio.  Total shareholders’ equity to total assets for December 31, 2015 and 2014 was 10.3% and 11.1%, respectively.  Book value per share at December 31, 2015 and 2014 was $12.76 and $11.76, respectively.  Total risk-based capital to risk-weighted assets was 11.37% at December 31, 2015 compared to 11.78% at December 31, 2014.  Accordingly, we were considered “well capitalized” for regulatory purposes at December 31, 2015.

 

53



 

We recorded net income of $47.3 million, or $1.43 per diluted common share, for the year ended December 31, 2015, compared to net income of $32.7 million, or $1.00 per diluted common share, in 2014.  Net interest income increased $8.7 million to $116.4 million for the year ended December 31, 2015, compared to $107.7 million for the year ended December 31, 2014, a result of increase in interest earning assets.  Provision for loan losses was $1.4 million for the year ended December 31, 2015, compared to $1.9 million for 2014.  Non-interest income increased $13.5 million to $52.7 million for the year ended December 31, 2015 as compared to $39.2 million for 2014 due primarily to an increase in realized and unrealized gains on mortgage banking activities from our mortgage banking business segment.  Non-interest expense was $96.3 million for the year ended December 31, 2015 compared to $96.2 million for the year ended December 31, 2014.  An increase in salaries and benefits expense during 2015 was offset by a decrease in merger and acquisition expense as we added to the sales and operational staffing areas of the Company over the past year as a result of our continued growth and increased regulatory environment in addition to an increase in the variable component of compensation expense.

 

The return on average assets for the years ended December 31, 2015 and 2014 was 1.29% and 1.02%, respectively.  The return on average equity for the years ended December 31, 2015 and 2014 was 11.76% and 8.82%, respectively.

 

Efficiency Ratio

 

The efficiency ratio measures the costs expended to generate a dollar of revenue.  It represents non-interest expense as a percentage of net interest income and non-interest income.  The lower the percentage, the more efficient we are operating.  We believe use of the efficiency ratio, which is a non-GAAP financial measure, provides additional clarity in assessing our operating results.

 

See the table below for the components of our calculation of our efficiency ratio as of December 31, 2016, 2015, and 2014.  Our efficiency ratio increased during 2016 as compared to 2015 primarily because non-interest expense increased due to merger and acquisition expenses associated with our pending merger with United.  Our efficiency ratio decreased during 2015 as compared to 2014 because of a combined increase in net interest income and non-interest income, specifically income related to our mortgage banking business segment, while maintaining non-interest expense during 2015 at the same level as for 2014.

 

Efficiency Ratio Calculation

 Years Ended December 31, 2016, 2015, and 2014 

(In thousands, except per share data)

 

 

 

2016

 

2015

 

2014

 

Calculation of efficiency ratio (1):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

$

127,857

 

$

116,394

 

$

107,700

 

 

 

 

 

 

 

 

 

Non-interest income

 

62,354

 

52,692

 

39,178

 

Total net interest income and non-interest income for efficiency ratio

 

190,211

 

169,086

 

146,878

 

 

 

 

 

 

 

 

 

Non-interest expense

 

$

115,170

 

$

96,298

 

$

96,228

 

 

 

 

 

 

 

 

 

Efficiency ratio

 

60.55

%

56.95

%

65.52

%

 


(1) Efficiency ratio is calculated as total non-interest expense divided by the total of net interest income and non-interest income

 

Statements of Income

 

Net Interest Income/Margin

 

Net interest income is our primary source of revenue, representing the difference between interest and fees earned on interest-earning assets and the interest paid on deposits and other interest-bearing liabilities.  The level of net interest income is affected primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates.  Interest rates have remained at historic lows for the last several years as the Federal Reserve has had an extremely accommodative policy.  We expect this low interest rate environment to change during 2017 as the Federal Reserve has begun to gradually increase the targeted federal funds rate.  See “Interest Rate Sensitivity” for further information.

 

54



 

Average Balance Sheets and Interest Rates on Interest-Earning Assets and Interest-Bearing Liabilities

 Years Ended December 31, 2016, 2015, and 2014 

(In thousands)

 

 

 

2016

 

2015

 

2014

 

 

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Interest

 

Average

 

 

 

Average

 

Income/

 

Yield/

 

Average

 

Income/

 

Yield/

 

Average

 

Income/

 

Yield/

 

 

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

Balance

 

Expense

 

Rate

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1) (2):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

$

254,725

 

$

9,584

 

3.76

%

$

272,026

 

$

10,533

 

3.87

%

$

285,930

 

$

12,374

 

4.33

%

Commercial and industrial - tax exempt

 

101,786

 

2,920

 

2.87

%

73,460

 

2,119

 

2.88

%

13,478

 

293

 

2.17

%

Real estate - commercial

 

1,577,443

 

67,596

 

4.29

%

1,305,202

 

56,976

 

4.37

%

1,182,306

 

52,635

 

4.45

%

Real estate - construction

 

601,106

 

27,296

 

4.54

%

554,527

 

25,907

 

4.67

%

414,248

 

20,845

 

5.03

%

Real estate - residential

 

444,588

 

15,947

 

3.59

%

405,517

 

15,107

 

3.73

%

340,150

 

13,376

 

3.89

%

Home equity lines

 

160,315

 

5,217

 

3.25

%

143,180

 

4,537

 

3.17

%

120,002

 

4,356

 

3.63

%

Consumer

 

5,245

 

259

 

4.94

%

4,819

 

272

 

5.64

%

5,307

 

485

 

5.74

%

Total loans (1) (2)

 

3,145,208

 

128,819

 

4.10

%

2,758,731

 

115,451

 

4.18

%

2,361,421

 

104,364

 

4.42

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans held for sale

 

360,147

 

13,117

 

3.64

%

344,501

 

13,273

 

3.85

%

288,299

 

12,177

 

4.22

%

Investment securities

 

402,763

 

15,024

 

3.73

%

366,611

 

13,605

 

3.71

%

349,343

 

13,695

 

3.92

%

Federal funds sold

 

41,973

 

200

 

0.48

%

41,167

 

91

 

0.22

%

40,323

 

92

 

0.23

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest-earning assets and interest income (2)

 

3,950,091

 

157,160

 

3.98

%

3,511,010

 

142,420

 

4.06

%

3,039,386

 

130,328

 

4.29

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Noninterest-earning assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and due from banks

 

21,453

 

 

 

 

 

21,069

 

 

 

 

 

23,917

 

 

 

 

 

Premises and equipment, net

 

24,498

 

 

 

 

 

25,191

 

 

 

 

 

25,672

 

 

 

 

 

Goodwill and other intangibles, net

 

36,267

 

 

 

 

 

36,943

 

 

 

 

 

32,813

 

 

 

 

 

Accrued interest and other assets

 

108,134

 

 

 

 

 

104,991

 

 

 

 

 

104,521

 

 

 

 

 

Allowance for loan losses

 

(32,888

)

 

 

 

 

(30,346

)

 

 

 

 

(29,749

)

 

 

 

 

Total assets

 

$

4,107,555

 

 

 

 

 

$

3,668,858

 

 

 

 

 

$

3,196,560

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest - bearing liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest - bearing deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest checking

 

$

444,269

 

$

1,631

 

0.37

%

$

430,276

 

$

2,088

 

0.49

%

$

428,030

 

$

2,170

 

0.51

%

Money markets

 

465,129

 

1,779

 

0.38

%

411,369

 

1,416

 

0.34

%

335,785

 

1,051

 

0.31

%

Statement savings

 

322,044

 

1,376

 

0.43

%

275,567

 

984

 

0.36

%

252,832

 

685

 

0.27

%

Certificates of deposit

 

770,683

 

9,440

 

1.22

%

691,026

 

8,465

 

1.22

%

550,772

 

6,056

 

1.10

%

Brokered certificates of deposit

 

457,730

 

4,200

 

0.92

%

404,293

 

3,241

 

0.80

%

283,365

 

2,296

 

0.81

%

Total interest - bearing deposits

 

2,459,855

 

18,426

 

0.75

%

2,212,531

 

16,194

 

0.73

%

1,850,784

 

12,258

 

0.66

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other borrowed funds

 

444,619

 

7,195

 

1.62

%

394,536

 

7,877

 

2.00

%

387,394

 

8,905

 

2.30

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest-bearing liabilities and interest expense

 

2,904,474

 

25,621

 

0.88

%

2,607,067

 

24,071

 

0.92

%

2,238,178

 

21,163

 

0.95

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Noninterest-bearing liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Demand deposits

 

715,291

 

 

 

 

 

618,988

 

 

 

 

 

553,949

 

 

 

 

 

Other liabilities

 

44,829

 

 

 

 

 

40,264

 

 

 

 

 

33,989

 

 

 

 

 

Common shareholders’ equity

 

442,961

 

 

 

 

 

402,539

 

 

 

 

 

370,444

 

 

 

 

 

Total liabilities and shareholders’ equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

4,107,555

 

 

 

 

 

$

3,668,858

 

 

 

 

 

$

3,196,560

 

 

 

 

 

Net interest income and net interest margin (2)

 

 

 

$

131,539

 

3.33

%

 

 

$

118,349

 

3.37

%

 

 

$

109,165

 

3.59

%

 


(1) Non-accrual loans are included in average balances and do not have a material effect on the average yield.  Interest income on non-accruing loans was not material for the years presented.

(2) Interest income for loans receivable and investment securities available-for-sale is reported on a fully taxable-equivalent basis at a rate of 36% for 2016, 35% for 2015, and 33% for 2014.

 

55



 

Rate and Volume Analysis

Years Ended December 31, 2016, 2015, and 2014

(In thousands)

 

 

 

2016 Compared to 2015

 

2015 Compared to 2014

 

 

 

Average

 

Average

 

Increase

 

Average

 

Average

 

Increase

 

 

 

Volume (3)

 

Rate

 

(Decrease)

 

Volume (3)

 

Rate

 

(Decrease)

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans (1) (2):

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

$

(670

)

$

(279

)

$

(949

)

$

(602

)

$

(1,239

)

$

(1,841

)

Commercial and industrial - tax exempt

 

817

 

(16

)

801

 

1,304

 

522

 

1,826

 

Real estate - commercial

 

11,884

 

(1,264

)

10,620

 

5,471

 

(1,130

)

4,341

 

Real estate - construction

 

2,176

 

(787

)

1,389

 

7,059

 

(1,997

)

5,062

 

Real estate - residential

 

1,456

 

(616

)

840

 

2,408

 

(677

)

1,731

 

Home equity lines

 

543

 

137

 

680

 

841

 

(660

)

181

 

Consumer

 

24

 

(37

)

(13

)

(208

)

(5

)

(213

)

Total loans (1) (2) 

 

16,230

 

(2,862

)

13,368

 

16,273

 

(5,186

)

11,087

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans held for sale

 

603

 

(759

)

(156

)

2,374

 

(1,278

)

1,096

 

Investment securities

 

1,342

 

77

 

1,419

 

677

 

(767

)

(90

)

Federal funds sold

 

2

 

107

 

109

 

2

 

(3

)

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest income (2)

 

18,177

 

(3,437

)

14,740

 

19,326

 

(7,234

)

12,092

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest - bearing deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest checking

 

68

 

(525

)

(457

)

11

 

(93

)

(82

)

Money markets

 

185

 

178

 

363

 

237

 

128

 

365

 

Statement savings

 

166

 

226

 

392

 

62

 

237

 

299

 

Certificates of deposit

 

976

 

(1

)

975

 

1,542

 

867

 

2,409

 

Brokered certificates of deposit

 

428

 

531

 

959

 

980

 

(35

)

945

 

Total interest - bearing deposits

 

1,823

 

409

 

2,232

 

2,832

 

1,104

 

3,936

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other borrowed funds

 

1,000

 

(1,682

)

(682

)

164

 

(1,192

)

(1,028

)

Total interest expense

 

2,823

 

(1,273

)

1,550

 

2,996

 

(88

)

2,908

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest income (2)

 

$

15,354

 

$

(2,164

)

$

13,190

 

$

16,330

 

$

(7,146

)

$

9,184

 

 


(1) Non-accrual loans are included in average balances and do not have a material effect on the average yield.  Interest income on non-accruing loans was not material for the years presented.

(2) Interest income for loans receivable and investment securities available-for-sale is reported on a fully taxable-equivalent basis at a rate of 36% for 2016, 35% for 2015, and 33% for 2014.

 

56



 

2016 Compared to 2015

 

Net interest income for the year ended December 31, 2016 was $127.9 million, compared to $116.4 million for the year ended December 31, 2015, an increase of $11.5 million, or 9.9%.  The increase in net interest income was primarily a result of an increase in the volume of interest-earning assets during 2016 compared to 2015.  The yield on interest-earning assets decreased 8 basis points to 3.98% for the year ended December 31, 2016 compared to 4.06% for the same period of 2015.  To offset this decrease in yield, during the second quarter of 2016, we executed a balance sheet restructuring which helped to enhance net interest income.  As a result of the restructuring, we incurred $3.6 million of prepayment penalties related to the extinguishment of FHLB advances totaling $95 million.  As part of the restructuring, we sold $50 million in investment securities available-for-sale and recorded gains of $3.6 million.  This restructuring had minimal impact on interest rate risk and no impact to regulatory capital ratios.  This restructuring reduced our FHLB advance funding costs from 2.78% to 2.39%.

 

Our net interest margin, on a tax equivalent basis, for the years ended December 31, 2016 and 2015 was 3.33% and 3.37%, respectively.  The decrease in our net interest margin was primarily a result of a decrease in the yields on our interest-earning assets partially offset by a decrease in the costs related to our interest-bearing liabilities during 2016.  Net interest income, on a tax equivalent basis, is a financial measure that we believe provides a more accurate picture of the interest margin for comparative purposes. To derive our net interest margin on a tax equivalent basis, net interest income is adjusted to reflect tax-exempt income on an equivalent before tax basis with a corresponding increase in income tax expense.  For purposes of this calculation, we use our federal statutory tax rates for the periods presented. This measure ensures comparability of net interest income arising from taxable and tax-exempt sources.  See information in Table 4 below for a reconciliation of our GAAP net interest income to our tax-equivalent net interest income.

 

Supplemental Financial Data and Reconciliations to GAAP Financial Measures

 Years Ended December 31, 2016, 2015, and 2014 

(In thousands)

 

 

 

2016

 

2015

 

2014

 

GAAP Financial Measurements:

 

 

 

 

 

 

 

Interest income:

 

 

 

 

 

 

 

Loans receivable

 

$

127,428

 

$

114,878

 

$

104,175

 

Loans held for sale

 

13,117

 

13,273

 

12,177

 

Federal funds sold

 

200

 

91

 

92

 

Investment securities available-for-sale

 

11,881

 

11,558

 

11,694

 

Investment securities held-to-maturity

 

57

 

63

 

145

 

Other investments

 

795

 

602

 

580

 

Total interest income

 

153,478

 

140,465

 

128,863

 

Interest expense: