10-K 1 bmrc-20141231x10k.htm 10-K BMRC-2014.12.31-10K

 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, 2014
 
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  001-33572

Bank of Marin Bancorp
(Exact name of Registrant as specified in its charter)
 
California  
 
20-8859754
(State or other jurisdiction of incorporation)  
 
(IRS Employer Identification No.)
 
 
 
504 Redwood Boulevard, Suite 100, Novato, CA 
 
94947
(Address of principal executive office)
 
(Zip Code)
 
Registrant’s telephone number, including area code:  (415) 763-4520

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

None

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

   Common Stock, No Par Value,
 
 
and attached Share Purchase Rights
 
NASDAQ Capital Market
(Title of each class)
 
(Name of each exchange on which registered)
 
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

Note - checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Exchange Act from their obligations under these sections.




Indicate by check mark whether the registrant (1) has filed all reports 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 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 is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K.
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
 
Indicate by check mark if the registrant is a shell company, as defined in Rule 12b-2 of the Exchange Act.
Yes   o         No  x
 
As of June 30, 2014, the last business day of the registrant's most recently completed second fiscal quarter, the aggregate market value of the voting common equity held by non-affiliates, based upon the closing price per share of the registrant's common stock as reported by the NASDAQ, was approximately $261 million. For the purpose of this response, directors and officers of the Registrant are considered the affiliates at that date.

As of February 27, 2015, there were 5,942,177 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's Proxy Statement for the Annual Meeting of Shareholders to be held on May 14, 2015 are incorporated by reference into Part III.





TABLE OF CONTENTS
 
PART I
 
 
 
 
Forward-Looking Statements
 
 
 
ITEM 1.
BUSINESS
ITEM 1A.
RISK FACTORS
ITEM 1B.
UNRESOLVED STAFF COMMENTS
ITEM 2.
PROPERTIES
ITEM 3.
LEGAL PROCEEDINGS
ITEM 4.
MINE SAFETY DISCLOSURES
 
 
 
PART II
 
 
 
 
ITEM 5.
MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 6.
SELECTED FINANCIAL DATA
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Forward-Looking Statements
 
Executive Summary
 
Critical Accounting Policies
 
 
 
 
RESULTS OF OPERATIONS
 
Net Interest Income
 
Provision for Loan Losses
 
Non-Interest Income
 
Non-Interest Expense
 
Provision for Income Taxes
 
 
 
 
FINANCIAL CONDITION
 
Investment Securities
 
Loans
 
Allowance for Loan Losses
 
Other Assets
 
Deposits
 
Borrowings
 
Deferred Compensation Obligations
 
Off Balance Sheet Arrangements and Commitments
 
Capital Adequacy
 
Liquidity
 
 
 
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
 
 
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
 
 
 
 
 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Note 1: Summary of Significant Accounting Policies
 
Note 2: Acquisition
 
Note 3: Investment Securities
 
Note 4: Loans and Allowance for Loan Losses
 
Note 5: Bank Premises and Equipment
 
Note 6: Bank Owned Life Insurance
 
Note 7: Deposits
 
Note 8: Borrowings
 
Note 9: Stockholders' Equity and Stock Plans
 
Note 10: Fair Value of Assets and Liabilities
 
Note 11: Benefit Plans
 
Note 12: Income Taxes
 
Note 13: Commitments and Contingencies
 
Note 14: Concentrations of Credit Risk
 
Note 15: Derivative Financial Instruments and Hedging Activities
 
Note 16: Regulatory Matters
 
Note 17: Financial Instruments with Off-Balance Sheet Risk
 
Note 18: Condensed Bank of Marin Bancorp Parent Only Financial Statements
 
 
 
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
 
 
 
ITEM 9A.
CONTROLS AND PROCEDURES
 
 
 
ITEM 9B.
OTHER INFORMATION
 
 
 
PART III
 
 
 
 
ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
 
 
 
ITEM 11.
EXECUTIVE COMPENSATION
 
 
 
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
 
 
 
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
 
 
 
ITEM 14.
PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 
 
PART IV
 
 
 
 
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
 
 
 
SIGNATURES
EXHIBIT INDEX



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PART I       

Forward-Looking Statements
 
This discussion of financial results includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, (the "1933 Act") and Section 21E of the Securities Exchange Act of 1934, as amended, (the "1934 Act"). Those sections of the 1933 Act and 1934 Act provide a "safe harbor" for forward-looking statements to encourage companies to provide prospective information about their financial performance so long as they provide meaningful, cautionary statements identifying important factors that could cause actual results to differ significantly from projected results.
 
Our forward-looking statements include descriptions of plans or objectives of Management for future operations, products or services, and forecasts of revenues, earnings or other measures of economic performance. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include the words "believe," "expect," "intend," "estimate" or words of similar meaning, or future or conditional verbs preceded by "will," "would," "should," "could" or "may."
 
Forward-looking statements are based on Management's current expectations regarding economic, legislative, and regulatory issues that may impact our earnings in future periods. A number of factors—many of which are beyond Management’s control—could cause future results to vary materially from current Management expectations. Such factors include, but are not limited to, general economic conditions, the economic uncertainty in the United States and abroad, changes in interest rates, deposit flows, real estate values, expected future cash flows on acquired loans and securities, integration of acquisitions and competition; changes in accounting principles, policies or guidelines; changes in legislation or regulation; adverse weather conditions, including the drought in California; and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.

Important factors that could cause results or performance to materially differ from those expressed in our prior forward-looking statements are detailed in Item 1A. Risk Factors of this report. Forward-looking statements speak only as of the date they are made. We do not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events.


ITEM 1        BUSINESS

Bank of Marin (the “Bank”) was incorporated in August 1989, received its charter from the California Superintendent of Banks (now the California Department of Business Oversight or "DBO") and commenced operations in January 1990. The Bank is an insured bank under the Federal Deposit Insurance Corporation (“FDIC”). On July 1, 2007 (the “Effective Date”), a bank holding company reorganization was completed whereby Bank of Marin Bancorp (“Bancorp”) became the parent holding company for the Bank, the sole and wholly-owned subsidiary of Bancorp. On the Effective Date, each outstanding share of Bank of Marin common stock was converted into one share of Bank of Marin Bancorp common stock. Bancorp is listed at NASDAQ and assumed the ticker symbol BMRC, which was formerly used by the Bank. Prior to the Effective Date, the Bank filed reports and proxy statements with the FDIC pursuant to Section 12 of the Securities Exchange Act of 1934 (the “1934 Act”). Upon formation of the holding company, Bancorp became subject to regulation under the Bank Holding Company Act of 1956, as amended, which subjects Bancorp to Federal Reserve Board reporting and examination requirements, and Bancorp now files 1934 Act reports with the Securities and Exchange Commission.

References in this report to “Bancorp” mean Bank of Marin Bancorp, parent holding company for the Bank. References to “we,” “our,” “us” mean the holding company and the Bank that are consolidated for financial reporting purposes.

Most of our business is conducted through Bancorp's subsidiary, Bank of Marin, which is headquartered in Novato, California. In addition to our headquarters office, we operate through twenty offices in Marin, Sonoma, San Francisco, Napa and Alameda counties, with a strong emphasis on supporting the local communities. Our customer base is made up of business and personal banking relationships from the communities near the branch office locations. Our business banking focus is on small to medium-sized businesses, professionals and not-for-profit organizations.
 

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We offer a broad range of commercial and retail deposit and lending programs designed to meet the needs of our target markets. Our lending categories include commercial real estate loans, commercial and industrial loans, construction financing, consumer loans, and home equity lines of credit. Merchant card services are available for our business customers. Through a third party vendor, we offer a proprietary Visa® credit card product combined with a rewards program to our customers, as well as a Business Visa® program for business and professional customers. We also offer cash management sweep to business clients through a third party vendor.

We offer a variety of personal and business checking and savings accounts, and a number of time deposit alternatives, including time certificates of deposit, Individual Retirement Accounts (“IRAs”), and Health Savings Accounts. We also offer mobile banking, remote deposit capture, Automated Clearing House services (“ACH”), fraud prevention services including Positive Pay for Checks and ACH, and image lockbox services. A valet deposit pick-up service is available to our professional and business clients.

Automated teller machines (“ATM's”) are available at each retail branch location. Our ATM network is linked to the PLUS, CIRRUS and NYCE networks, as well as to a network of nation-wide surcharge-free ATM's called MoneyPass. We also offer our depositors 24-hour access to their accounts by telephone and through our internet banking products available to personal and business account holders.

We offer Wealth Management and Trust Services (“WMTS”) which include customized investment portfolio management, financial planning, trust administration, estate settlement, custody services, and advice on charitable giving. We also offer 401(k) plan services to small and medium-sized businesses through a third party vendor.

We make international banking services available to our customers indirectly through other financial institutions with whom we have correspondent banking relationships.

We hold no patents, licenses (other than licenses required by the appropriate banking regulatory agencies), franchises or concessions.  The Bank has registered the service marks "The Spirit of Marin", the words “Bank of Marin”, the Bank of Marin logo, and the Bank of Marin tagline “Committed to your business and our community” with the United States Patent & Trademark Office.  In addition, Bancorp has registered the service marks for the words “Bank of Marin Bancorp” and for the Bank of Marin Bancorp logo with the United States Patent & Trademark Office.

All service marks registered by Bancorp or the Bank are registered on the United States Patent & Trademark Office Principal Register, with the exception of the words "Bank of Marin Bancorp" which is registered on the United States Patent & Trademark Office Supplemental Register.

Market Area

Our primary market area consists of Marin, San Francisco, Napa, Sonoma and Alameda counties. Our customer base is primarily made up of business and personal banking relationships within these market areas.

We attract deposit relationships from individuals, merchants, small to medium-sized businesses, not-for-profit organizations and professionals who live and/or work in the communities comprising our market areas. As of December 31, 2014, approximately 65% of our deposits are in Marin County and southern Sonoma County, and approximately 55% of our deposits are from businesses and 45% from individuals.

As discussed in Note 2 to the Consolidated Financial Statements in Item 8 of this report, in November 2013, we expanded our community banking footprint to Alameda County through the acquisition of $280.9 million of assets, the assumption of $246.4 million liabilities, and the addition of four branch offices of the former NorCal Community Bancorp ("NorCal"), parent company of Bank of Alameda (the “Acquisition”).

Competition

The banking business in California generally, and in our market area specifically, is highly competitive with respect to attracting both loan and deposit relationships. The increasingly competitive environment is impacted by changes in regulation, interest rates, technology and product delivery systems, and consolidation among financial service providers. The banking industry is seeing extreme competition for quality loans, with larger banks expanding their activities to businesses that are traditionally community bank customers.

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In all of our five counties, we have significant competition from nationwide banks with much larger branch networks nationwide, as well as credit unions and other independent banks. In Marin County we have the largest market share of business core deposits at 23.4%, according to the Deposit & Market Share Report from the California Banksite Corporation based upon the FDIC deposit market share data as of June 30, 2014. A significant driver of our franchise value is the growth and stability of our checking deposits, a low-cost funding source for our loan portfolio. We have a 3.7% business core deposit market share in Sonoma County and are building our presence in the Napa, Alameda and San Francisco markets.

Other competitors for depositors' funds are money market mutual funds and non-bank financial institutions such as brokerage firms and insurance companies. Among the competitive advantages held by some of these large, non-bank financial institutions is their ability to finance extensive advertising and funding campaigns.

Nationwide banks have the competitive advantages of national advertising campaigns and technology infrastructure to achieve economies of scale. Large commercial banks also have substantially greater lending limits and the ability to offer certain services which are not offered directly by us.

In order to compete with the numerous, and often larger, financial institutions in our primary market area, we use, to the fullest extent possible, the flexibility and rapid response capabilities which are accorded by our independent status, local leadership and local decision making. Our competitive advantages also include an emphasis on personalized service, extensive community involvement, philanthropic giving, local promotional activities and strong relationships with our customers. The commitment and dedication of our directors, officers and staff have also contributed greatly to our success in competing for business.

Employees

At December 31, 2014, we employed 260 full-time equivalent (“FTE”) staff. The actual number of employees, including part-time employees, at year-end 2014 included five executive officers, 103 other corporate officers and 170 staff. None of our employees are presently represented by a union or covered by a collective bargaining agreement. We believe that our employee relations are good. We have been recognized as one of the “Best Places to Work” by the North Bay Business Journal and as a "Top Corporate Philanthropist” by the San Francisco Business Times for many years.

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SUPERVISION AND REGULATION

Bank holding companies and banks are extensively regulated under both federal and state law. The following discussion summarizes certain significant laws, rules and regulations affecting Bancorp and the Bank.

Bank Holding Company Regulation

Upon formation of the bank holding company on July 1, 2007, we became subject to regulation under the Bank Holding Company Act of 1956, as amended (“BHCA”) which subjects Bancorp to Federal Reserve Board ("FRB") reporting and examination requirements. Under the FRB's regulations, a bank holding company is required to serve as a source of financial and managerial strength to its subsidiary banks. Under this requirement, we are expected to commit resources to support the Bank, including at times when we may not be in a financial position to provide such resources, and it may not be in our, or our shareholders’ or creditors’, best interests to do so. In addition, any capital loans we make to the Bank are subordinate in right of payment to depositors and to certain other indebtedness of the Bank. In the event of our bankruptcy, any commitment by us to a federal bank regulatory agency to maintain the capital of the Bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

The BHCA regulates the activities of holding companies including acquisitions, mergers and consolidations and, together with the Gramm-Leach Bliley Act of 1999, the scope of allowable banking activities. Bancorp is also a bank holding company within the meaning of the California Financial Code. As such, Bancorp and its subsidiaries are subject to examination by, and may be required to file reports with, the DBO.

Bank Regulation

Banking regulations are primarily intended to protect consumers, depositors' funds, federal deposit insurance funds and the banking system as a whole. These regulations affect our lending practices, consumer protections, capital structure, investment practices and dividend policy.

As a state chartered bank, we are subject to regulation and examination by the DBO. We are also subject to regulation, supervision and periodic examination by the FDIC. If, as a result of an examination of the Bank, the FDIC or the DBO should determine that the financial condition, capital resources, asset quality, earnings prospects, management, liquidity, or other aspects of our operations are unsatisfactory, or that we have violated any law or regulation, various remedies are available to those regulators including issuing a “cease and desist” order, monetary penalties, restitution, restricting our growth or removing officers and directors.

The following discussion summarizes certain significant laws, rules and regulations affecting both Bancorp and the Bank. The Bank addresses the many state and federal regulations it is subject to through a comprehensive compliance program that addresses the various risks associated with these issues.

Dividends

The payment of cash dividends by the Bank to Bancorp is subject to restrictions set forth in the California Financial Code (the “Code”) in addition to regulations and policy statements of the FRB. Prior to any distribution from the Bank to Bancorp, a calculation is made to ensure compliance with the provisions of the Code and to ensure that the Bank remains within capital guidelines set forth by the DBO and the FDIC. Management anticipates that there will be sufficient earnings at the Bank level to provide dividends to Bancorp to meet its cash requirements for 2015. See also Note 9 to the Consolidated Financial Statements, under the heading “Dividends” in Item 8 of this report.

FDIC Insurance Assessments

Our deposits are insured by the FDIC to the maximum amount permitted by law, which is currently $250,000 per depositor, based on the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).




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Our FDIC insurance assessment base is quarterly average consolidated total assets minus average tangible equity, defined as Common Equity Tier 1 Capital. Assessment rates are between 2.5 and 9 basis points1 annually on the assessment base for banks in the lowest risk category such as us, and 30 to 45 basis points for banks in the highest risk category. In deriving the risk categories, the FDIC uses a bank's capital level, supervisory ratios and other financial measures to determine a bank's ability to withstand financial stress.

Community Reinvestment Act

The Community Reinvestment Act (“CRA”) was enacted in 1977 to encourage financial institutions to meet the credit needs of the communities where they are chartered. All banks and thrifts have a continuing and affirmative obligation, consistent with safe and sound operations, to help meet the credit needs of their entire communities, including low and moderate income neighborhoods. Regulatory agencies rate each bank's performance in assessing and meeting these credit needs. The Bank is committed to serving the credit needs of the communities in which we do business, and it is our policy to respond to all creditworthy segments of our market. The CRA requires a depository institution's primary federal regulator, in connection with its examination of the institution, to assess the institution's record in meeting CRA requirements. The regulatory agency's assessment of the institution's record is made available to the public. The record is taken into consideration when the institution establishes a new branch that accepts deposits, relocates an office, applies to merge or consolidate, or expands into other activities. The FDIC's last CRA performance examination, completed in June 2012, was performed under the intermediate small bank requirements and was assigned a rating of “Satisfactory”. As a result of our growing asset size, the Bank now falls in the "Large Bank" category and will be evaluated by the FDIC according to large bank requirements. As part of its CRA commitment, the Bank has strong philanthropic ties to the community. In addition, special community development projects and programs are in place for consumers of low to moderate income levels. In particular, we invest in affordable housing funds that help economically disadvantaged individuals and residents of low- and moderate-income census tracts, in each case consistent with prudent underwriting practices. We also donate to organizations in our communities that serve small businesses or low-and moderate-income communities or individuals that offer educational and health programs to economically disadvantaged students and families.

Anti Money-Laundering Regulations

A series of banking laws and regulations beginning with the Bank Secrecy Act in 1970 requires banks to prevent, detect, and report illicit or illegal financial activities to the federal government to prevent money laundering, international drug trafficking, and terrorism. Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, financial institutions are subject to prohibitions against specified financial transactions and account relationships, requirements regarding the Customer Identification Program, as well as enhanced due diligence and “know your customer” standards in their dealings with high risk customers, foreign financial institutions, and foreign individuals and entities.

Privacy and Data Security

The Gramm-Leach Bliley Act (“GLBA”) of 1999 imposes requirements on financial institutions with respect to consumer privacy. The GLBA generally prohibits disclosure of consumer information to non-affiliated third parties unless the consumer has been given the opportunity to object and has not objected to such disclosure. Financial institutions are further required to disclose their privacy policies to consumers annually. The GLBA also directs federal regulators, including the FDIC, to prescribe standards for the security of consumer information. We are subject to such standards, as well as standards for notifying consumers in the event of a security breach. We must disclose our privacy policy to consumers and permit consumers to “opt out” of having non-public customer information disclosed to third parties. We are required to have an information security program to safeguard the confidentiality and security of customer information and to ensure proper disposal of information that is no longer needed. Customers must be notified when unauthorized disclosure involves sensitive customer information that may be misused.





___________________________________________________________________________________________
1 Basis points are equal to one hundredth of a percentage point.

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Consumer Protection Regulations

Our lending activities are subject to a variety of statutes and regulations designed to protect consumers, including the CRA, Home Mortgage Disclosure Act, Fair Credit Reporting Act, Equal Credit Opportunity Act, the Fair Housing Act, Truth-in-Lending Act ("TILA"), and the Real Estate Settlement Procedures Act ("RESPA"). Our deposit operations are also subject to laws and regulations that protect consumer rights including Expedited Funds Availability, Truth in Savings, and Electronic Funds Transfers. Other regulatory requirements include: the Unfair, Deceptive or Abusive Acts and Practices, Dodd-Frank Act, Right To Financial Privacy and Privacy of Consumer Financial Information. Additional rules govern check writing ability on certain interest earning accounts and prescribe procedures for complying with administrative subpoenas of financial records. In October 2014, the final rule integrating RESPA and TILA disclosures was issued.

Restriction on Transactions between Bank's Affiliates

Transactions between Bancorp and the Bank are quantitatively and qualitatively restricted under Sections 23A and 23B of the Federal Reserve Act and Federal Reserve Regulation W. Section 23A places restrictions on the Bank's “covered transactions” with Bancorp, including loans and other extensions of credit, investments in the securities of, and purchases of assets from Bancorp. Section 23B requires that certain transactions, including all covered transactions, be on market terms and conditions. Federal Reserve Regulation W combines statutory restrictions on transactions between the Bank and Bancorp with FRB interpretations in an effort to simplify compliance with Sections 23A and 23B.

Capital Requirements

The FRB and the FDIC have adopted risk-based capital guidelines for bank holding companies and banks. Bancorp's ratios exceed the required minimum ratios for capital adequacy purposes and the Bank meets the definition for well capitalized. Undercapitalized depository institutions may be subject to significant restrictions. Payment of dividends could be restricted or prohibited, with some exceptions, if the Bank were categorized as "critically undercapitalized" under applicable FDIC regulations.

In July 2013, the Federal banking regulators approved a final rule to implement the revised capital adequacy standards of the Basel Committee on Banking Supervision, commonly called Basel III, and to address relevant provisions of the Dodd-Frank Act. The final rule strengthens the definition of regulatory capital, increases risk-based capital requirements, makes selected changes to the calculation of risk-weighted assets, and adjusts the prompt corrective action thresholds. We became subject to the new rule on January 1, 2015 and certain provisions of the new rule will be phased in over the period of 2015 through 2019. We have modeled our ratios under the finalized Basel III rules and we do not expect that we will be required to raise additional capital as a result of such rules. For further information on our risk-based capital positions and the impact of the new Basel III rules, see Note 16 to the Consolidated Financial Statements in Item 8 of this Form 10-K.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Act, a landmark financial reform bill comprised of voluminous new rules and restrictions on bank operations as regulations have been promulgated. It includes key provisions aimed at preventing a repeat of the 2008 financial crisis and a new process for winding down failing, systemically important institutions in a manner as close to a controlled bankruptcy as possible. The Dodd-Frank Act includes other key provisions as follows:

(1) Establishes a new Financial Stability Oversight Council to monitor systemic financial risks. The FRB is given extensive new authorities to impose strict controls on large bank holding companies with total consolidated assets equal to or in excess of $50 billion and systemically significant non-bank financial companies to limit the risk they might pose to the economy and other large interconnected companies. The FRB can also take direct control of troubled financial companies that are considered systemically significant.

The Dodd-Frank Act restricts the amount of trust preferred securities (“TruPS”) that may be considered as Tier 1 Capital. For bank holding companies below $15 billion in total assets, TruPS issued before May 19, 2010 are grandfathered, so their status as Tier 1 capital does not change.

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On November 29, 2013, we acquired NorCal and assumed ownership of NorCal Community Bancorp Trusts I and II, respectively (the "Trusts"), which were formed by NorCal for the sole purpose of issuing TruPS. Since the TruPS assumed from the NorCal acquisition were issued prior to May 2010 and they do not exceed 25% of the sum of all our other core capital elements, they are included in our Tier I capital and will continue to be eligible for inclusion under Basel III rules.

(2) Creates a new process to liquidate failed financial firms in an orderly manner, including giving the FDIC broader authority to operate or liquidate a failing financial company.

(3) Establishes a new independent Federal regulatory body for consumer protection within the Federal Reserve System known as the Consumer Financial Protection Bureau ("CFPB"), which assumes responsibility for most consumer protection laws (except the Community Reinvestment Act). It is also in charge of setting appropriate consumer banking fees and caps. The Office of Comptroller of the Currency continues to have authority to preempt state banking and consumer protection laws if these laws "prevent or significantly" interfere with the business of banking.

(4) Places certain limitations on investment and other activities by depository institutions, holding companies and their affiliates, including comprehensive regulation of all over-the-counter derivatives.

(5) Authorizes the FRB to regulate debit card and certain general-use prepaid card transaction interchange fees paid to issuing banks with assets in excess of $10 billion to ensure that fees are “reasonable and proportional” to the cost of processing individual transactions and to prohibit networks and issuers from requiring transactions be processed on a single payment network.

(6) Effects changes in the FDIC assessment as discussed above.

Notice and Approval Requirements Related to Control

Banking laws impose notice, approval and ongoing regulatory requirements on any shareholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution. These laws include the BHCA and the Change in Bank Control Act. Among other things, these laws require regulatory filings by a shareholder or other party that seeks to acquire direct or indirect "control" of an FDIC-insured depository institution or bank holding company. The determination whether an investor "controls" a depository institution is based on all of the facts and circumstances surrounding the investment. As a general matter, a party is deemed to control a depository institution or other company if the party owns or controls 25% or more of any class of voting stock. Subject to rebuttal, a party may be presumed to control a depository institution or other company if the investor owns or controls 10% or more of any class of voting stock. Ownership by family members, affiliated parties, or parties acting in concert, is typically aggregated for these purposes. If a party's ownership of the Company were to exceed certain thresholds, the investor could be deemed to "control" the Company for regulatory purposes. This could subject the investor to regulatory filings or other regulatory consequences.

In addition, except under limited circumstances, bank holding companies are prohibited from acquiring, without prior approval:

control of any other bank or bank holding company or all or substantially all the assets thereof; or
more than 5% of the voting shares of a bank or bank holding company which is not already a subsidiary.

Incentive Compensation

The Dodd-Frank Act requires the federal bank regulators and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities, including us and our bank, having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies proposed such regulations in April 2011, but the regulations have not been finalized. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which we may structure compensation for our executives.

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The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as us, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Available Information

On our Internet web site, www.bankofmarin.com, we post the following filings as soon as reasonably practical after they are filed with or furnished to the Securities and Exchange Commission: Annual Report to Shareholders, Form 10-K, Proxy Statement for the Annual Meeting of Shareholders, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934. The text of the Code of Ethical Conduct for Bancorp and the Bank is also included on the website. All such materials on our website are available free of charge. This website address is for information only and is not intended to be an active link, or to incorporate any website information into this document. In addition, copies of our filings are available by requesting them in writing or by phone from:


Corporate Secretary
Bank of Marin Bancorp    
504 Redwood Boulevard, Suite 100
Novato, CA 94947
415-763-4523


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ITEM 1A      RISK FACTORS

An investment in our common stock is subject to risks inherent in our business. The material risks and uncertainties that Management believes may affect our business are described below. Before making an investment decision, investors should carefully consider the risks, together with all of the other information included or incorporated by reference in this report. The list below is not exhaustive; additional risks and uncertainties that Management is not aware of, or focused on, or currently deems immaterial may also impair business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected.

Earnings are Significantly Influenced by General Business and Economic Conditions

We are subject to changes in general economic conditions that are uncertain and beyond our control. While economic activity has been expanding, the recovery in the labor market is not complete and there is still underutilization of labor resources. Uncertainty in the economies of Europe and emerging markets have the potential to hamper domestic economic performance. The economic environment is impacted by political uncertainty and changes in fiscal and monetary policy, which could adversely affect our business. Economic conditions have led to prolonged low interest rates, particularly medium and longer-term rates, which may have a long-term impact on the composition of our earning assets and our net interest margin. Among other things, a period of prolonged lower rates has caused prepayments to increase as our customers sought to refinance existing loans, which resulted in a decrease in the weighted average yield of our earning assets and variability in our net interest income. Furthermore, financial institutions continue to be affected by a stricter regulatory environment. Unemployment rates in our market areas have continued to improve and are below the California state average rate.1 There can be no assurance that the recent economic improvement is sustainable or that the creditworthiness of our borrowers will not deteriorate.
 
Weakness in real estate values and home sale volumes, financial stress on borrowers, including job losses, and customers' inability to pay debt could adversely affect our financial condition and results of operations in the following ways:

Demand for our products and services may decline
Low cost or non-interest bearing deposits may decrease
Collateral for our loans, especially real estate, may decline in value
Loan delinquencies, problem assets and foreclosures may increase
Investment securities may become impaired

Interest Rate Risk is Inherent in Our Business

Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets, such as loans and securities, and interest expense paid on interest-bearing liabilities, such as deposits and borrowed funds. Interest rates are sensitive to many factors outside our control, including general economic conditions and the policies of various governmental and regulatory agencies and, in particular, the FRB, which regulates the supply of money and credit in the United States. Changes in monetary policy, including changes in interest rates, can influence not only the interest we receive on loans and securities and interest we pay on deposits and borrowings, but can also affect (i) our ability to originate loans and obtain deposits, (ii) the fair value of our financial assets and liabilities, and (iii) the average duration of our securities and loan portfolios. Our portfolio of securities will generally decline in value if market interest rates increase, and increase in value if market interest rates decline. Our mortgage-backed securities are also subject to prepayment risk when interest rates fall, and to borrowers' risk when rates rise.


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1 Based on the latest available labor market information from the California Employment Development Department. December 2014 results show that the unemployment rate in Marin County was the lowest in California at 3.4%. The unemployment rates in San Francisco, Sonoma, Napa and Alameda County are 3.8%, 4.7%, 5.1% and 5.0%, respectively, compared to the state of California at 7.0%.

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In response to the recessionary state of the national economy, the depressed housing market and the volatility of financial markets in 2008, the Federal Open Market Committee of the FRB (“FOMC”) initiated a series of decreases in the federal funds target rate, bringing the target rate to a historically low range of 0% to 0.25%, where it is maintained currently. The FRB's sizable holdings of longer-term securities have placed and will continue to place downward pressure on longer-term interest rates, and hence our net interest margin. Our net interest income is hampered by a flat or falling rate environment, and the prolonged low level of interest rates has resulted in material net interest margin compression over the last several years. Our 2015 net interest margin may compress due to continued repricing on loans and securities, if the prevailing market interest rates do not increase as the general market expects in the second half of 2015. FOMC Chair Janet Yellen also signaled in her testimony before the Senate Banking Committee on February 24, 2015 that, "a high degree of monetary policy accommodation remains appropriate to foster further improvement in labor market conditions and to promote a return of inflation toward 2% over the medium term."

See the sections captioned “Net Interest Income” in Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Quantitative and Qualitative Disclosures about Market Risk in Item 7A of this report for further discussion related to management of interest rate risk.

If interest rates rise, we anticipate that net interest income will increase. However, it may take several upward market rate movements for certain variable rate loans to move above their floor rates and deposit behavior may deviate from our expectations. Further, a rise in index rates leads to lower debt service coverage of variable rate loans if the borrower's operating cash flow does not also rise. This creates a paradox of an improving economy (leading to higher interest rates) with increased credit risk as short-term rates move up faster than the cash flow or income of the borrowers. Higher interest rates may also depress loan demand, making it more difficult for us to grow loans.

Banks and Bank Holding Companies are Subject to Extensive Government Regulation and Supervision

Bancorp and the Bank are subject to extensive federal and state governmental supervision, regulation and control. Holding company regulations affect the range of activities in which Bancorp is engaged. Banking regulations affect the Bank's lending practices, capital structure, investment practices and dividend policy, and compliance costs among other things. Future legislative changes or interpretations may also alter the structure and competitive relationship among financial institutions. Legislation is regularly introduced in the U.S. Congress and the California Legislature which could impact our operating environment in substantive ways. The nature and extent of future legislative and regulatory changes affecting us are unpredictable at this time.

The historic disruptions in the financial marketplace during the recent recession have prompted the Obama administration to reform financial market regulation. This reform includes additional regulations over consumer financial products, bond rating agencies and the creation of a regime for regulating systemic risk across all types of financial service firms. Further restrictions on financial service companies may adversely impact our results of operations and financial condition, as well as increase our compliance risk.

Compliance risk is the current and prospective risk to earnings or capital arising from violations of, or non-conformance with, laws, rules, regulations, prescribed practices, internal policies and procedures, or ethical standards set forth by regulators. Compliance risk also arises in situations where the laws or rules governing certain bank products or activities of our clients may be ambiguous or untested. This risk exposes Bancorp and the Bank to potential fines, civil money penalties, payment of damages and the voiding of contracts. Compliance risk can lead to diminished reputation, reduced franchise value, limited business opportunities, reduced expansion potential and an inability to enforce contracts.

For further information on supervision and regulation, see the section captioned “Supervision and Regulation” in Item 1 above.


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As discussed in Item 1, Section captioned “Supervision and Regulation” above, in 2010, President Obama signed into law a landmark financial reform bill - the Dodd-Frank Act. The rules under the Dodd-Frank Act change banking statutes and the operating environment of Bancorp and the Bank in substantial and unpredictable ways, and could continue to increase the cost of doing business, decrease our revenues, limit or expand permissible activities or affect the competitive balance depending upon whether or how regulations are implemented. In 2013 the federal banking regulators issued a joint final rule that implements Basel III capital standards and establishes minimum capital levels required under the Dodd-Frank Act, which is discussed under "Capital Requirements" on page 9. We may continue to invest significant Management attention and resources to make any necessary changes related to the Dodd-Frank Act and any regulations promulgated thereunder. The ultimate effect that the changes will have on the financial condition or results of operations of Bancorp or the Bank is uncertain at this time.

The broader impact of the enacted legislation and related measures undertaken to alleviate the aftermaths of the credit crisis is also unknown. The capital and credit markets experienced volatility and disruption at unprecedented levels in the last credit crisis. In some cases, the markets have produced downward pressure on credit availability for certain issuers without regard to those issuers' underlying financial strength. If similar disruptions and volatility return, there can be no assurance that we will not experience an adverse effect on our ability to access credit or capital.

Intense Competition with Other Financial Institutions to Attract and Retain Banking Customers

We are facing significant competition for customers from other banks and financial institutions located in the markets we serve. We compete with commercial banks, saving banks, credit unions, non-bank financial services companies and other financial institutions operating within or near our service areas. Some of our non-bank competitors may not be subject to the same extensive regulations as we are, giving them greater flexibility in competing for business. We anticipate intense competition will continue for the coming year due to the consolidation of many financial institutions and more changes in legislature, regulation and technology. National and regional banks much larger than our size have entered into our market through acquisitions and they may be able to benefit from economies of scale through their wider branch networks, more prominent national advertising campaigns, lower cost of borrowing, capital market access and sophisticated technology infrastructures. Further, intense competition for creditworthy borrowers could lead to loan rate concession pressure or impact our ability to generate profitable loans.

Going forward, we may see tighter competition in the industry as competitors seek to expand market share in more profitable and less risky customer segments. Further, with the rebound of the equity markets, our deposit customers may perceive alternative investment opportunities as providing superior expected returns. Recent recovery in the real estate market also supports the sale of real estate that collateralizes our loans, leading to payoff activity. Technology and other changes have made it more convenient for bank customers to transfer funds into alternative investments or other deposit accounts such as online virtual banks and non-bank service providers. Efforts and initiatives we may undertake to retain and increase deposits, including deposit pricing, can increase our costs. When our customers move money into higher yielding deposits or alternative investments, we may lose a relatively inexpensive source of funds, thus increasing our funding costs through more expensive wholesale borrowings.

Negative Conditions Affecting Real Estate May Harm Our Business

Concentration of our lending activities in the California real estate sector could negatively impact our results of operations if adverse changes in our lending area occur or intensify. Although we do not offer traditional first mortgages, nor have sub-prime or Alt-A residential loans or significant amounts of securities backed by such loans in the portfolio, we are not immune to volatility in those markets. Approximately 86% of our loans were secured by real estate at December 31, 2014, of which 63% were secured by commercial real estate and the remaining 23% by residential real estate. Real estate valuations are impacted by demand, and demand is driven by factors such as employment; when unemployment rates rise, demand drops.

Loans secured by commercial real estate include those secured by office buildings, owner-user office/warehouses, mixed-use residential/commercial properties and retail properties. In general, 2014 office, industrial and retail vacancy rates have fallen in Marin, Sonoma and Napa Counties based on the latest available real estate information from Keegan & Coppin Company, Inc. There can be no assurance that the companies or properties securing our loans will

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generate sufficient cash flows to allow borrowers to make full and timely loan payments to us. In the event of default, the collateral value may not cover the outstanding amount due to us, especially during real estate market downturns.

Rising commercial real estate lending concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the investor commercial real estate market. Institutions that are potentially exposed to significant commercial real estate concentration risk may be subject to increased regulatory scrutiny. Institutions that have experienced rapid growth in commercial real estate lending such as us, have notable exposure to a specific type of commercial real estate lending, or are approaching or exceed certain supervisory criteria that measure an institution's commercial real estate portfolio against its capital levels, may be subject to such increased regulatory scrutiny. We maintain heightened review and analyses of our concentrations and have regular conversations with regulators to avoid unexpected regulatory risk.

Severe Weather, Natural Disasters or Other Climate Change Related Matters Could Significantly Impact Our Business

Our primary market is located in an earthquake-prone zone in northern California, which is also subject to other weather or disasters, such as severe rainstorms, wildfire, drought or flood. These events could interrupt our business operations unexpectedly. Climate-related physical changes and hazards could also pose credit risks for us. For example, our borrowers may have collateral properties located in coastal areas at risk to rise in sea level. The properties pledged as collateral on our loan portfolio could also be damaged by tsunamis, floods, earthquakes or wildfires and thereby the recoverability of loans could be impaired. A number of factors can affect credit losses, including the extent of damage to the collateral, the extent of damage not covered by insurance, the extent to which unemployment and other economic conditions caused by the natural disaster adversely affect the ability of borrowers to repay their loans, and the cost of collection and foreclosure to us. Lastly, there could be increased insurance premiums and deductibles, or a decrease in the availability of coverage, due to severe weather-related losses. The ultimate impact on our business of a natural disaster, whether or not caused by climate change, is difficult to predict.

We are Subject to Significant Credit Risk and Loan Losses May Exceed Our Allowance for Loan Losses in the Future

We maintain an allowance for loan losses, which is a reserve established through provisions for loan losses charged to expense, that represents Management's best estimate of probable losses that may be incurred within the existing portfolio of loans (the "incurred loss model"). The level of the allowance reflects Management's continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality and present economic, political and regulatory conditions. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Further, we generally rely on appraisals of the collateral or comparable sales data to determine the level of specific reserve and/or the charge-off amount on certain collateral dependent loans. Inaccurate assumptions in the appraisals or an inappropriate choice of the valuation techniques may lead to an inadequate level of specific reserve or charge-offs.

Changes in economic conditions affecting borrowers, new information regarding existing loans and their collateral, identification of additional problem loans, and other factors may require an increase in our allowance for loan losses. In addition, bank regulatory agencies periodically review our allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs. If charge-offs in future periods exceed the allowance for loan losses or cash flows from acquired loans do not perform as expected, we will need to record additional provision for loan losses.

In December 2012, the Financial Accounting Standards Board (“FASB”) issued a proposed Accounting Standards Update, Financial Instruments: Credit Losses, which establishes a new impairment framework also known as the "current expected credit loss model." In contrast to the incurred loss model currently used by financial entities like Bancorp, the current expected credit loss model requires an allowance be recognized based on the expected credit losses (i.e. all contractual cash flows that the entity does not expect to collect from financial assets or commitments to extend credit). It requires the consideration of more forward-looking information than is permitted under current U.S. generally accepted accounting principles. In addition to relevant information about past events and current conditions, such as borrowers’ current creditworthiness, quantitative and qualitative factors specific to borrowers, and the economic environment in which the entity operates, the new model requires consideration of reasonable and supportable forecasts that affect the expected collectability of the financial assets’ remaining contractual cash flows,

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and evaluation of the forecasted direction of the economic cycle, as well as time value of money. This proposed impairment framework is expected to have wide reaching implications to financial institutions. The allowance for loan losses is likely to increase due to a larger volume of financial assets that fall within the scope of the proposed model, resulting in an adverse impact on net income, volatility in earnings and higher capital requirements. The FASB continued to deliberate the proposed update at its September and October 2014 meetings, and the full effect of the implementation of this new model is unknown until the proposed guidance is finalized.

Non-performing Assets Take Significant Time To Resolve And Adversely Affect Results Of Operations And Financial Condition.

The Bank's non-performing assets have historically been maintained at a manageable level. While we have significantly reduced non-performing assets, such assets may adversely affect our net income in various ways in the future. Until economic improvement continues in a sustainable fashion, we might incur losses relating to non-performing assets if their collateral values deteriorate. We do not record interest income on nonaccrual loans, which adversely affects our income and increases our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related loan to the fair value of the collateral, which may result in a loss. While we have managed our problem assets through workouts, restructurings and other proactive credit management, decreases in the value of the assets, underlying collateral, or borrowers' performance or financial conditions, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition. In addition, the resolution of non-performing assets requires significant commitments of time from Management, which can detract from other responsibilities. There can be no assurance that we will not experience further increases in non-performing assets in the future.

Securities May Lose Value due to Credit Quality of the Issuers

We hold securities issued and/or guaranteed by Federal National Mortgage Association (“FNMA”) and Federal Home Loan Mortgage Corporation (“FHLMC”). Since 2008, both FNMA and FHLMC have been under a U.S. Government conservatorship which purchases mortgage-backed securities (“MBS”) issued by them. As a result, the MBS issued by FNMA and FHLMC have experienced an increase in fair value and our MBS portfolio has benefited from this government support. However, recent introduction of housing and finance reform legislation, which plans to wind down FNMA and FHLMC and incrementally shrink the government's housing-finance footprint, led to uncertainty as to the termination of conservatorship of FNMA and FHLMC.

The fair value of our securities issued or guaranteed by these entities may decline when the U.S. Government starts selling FNMA and FHLMC MBS, when the government support is phased-out or completely withdrawn, or if either FNMA or FHLMC comes under further financial stress or suffers creditworthiness deterioration.

We also invest in obligations of state and political subdivisions, some of which may not have fully recovered from past years' of loss of property tax from falling home values and declines in sales tax revenues. While we generally seek to minimize our exposure by diversifying the geographic location of our portfolio and investing in investment grade securities, there is no guarantee that the issuers will remain financially sound or continue their payments on these debentures.

Unexpected Early Termination of Interest Rate Swap Agreements May Impact Earnings

We have entered into interest-rate swap agreements, primarily as an asset/liability risk management strategy, in order to mitigate the changes in the fair value of specified long-term fixed-rate loans and firm commitments to enter into long-term fixed-rate loans caused by changes in interest rates. These hedges allow us to offer long-term, fixed-rate loans to customers without assuming the interest rate risk of a long-term asset by swapping our fixed-rate interest stream for a floating-rate interest stream. In the event of default by the borrowers on our hedged loans, we may have to terminate these designated interest-rate swap agreements early, resulting in severe prepayment penalties charged by our counterparties. On the other hand, when these interest-rate swap agreements are in an asset position, we are subject to the credit risk of our counterparties, who may default on the interest-rate swap agreements, leaving us vulnerable to interest rate movements.




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Growth May Produce Unfavorable Outcomes

We seek to expand our franchise safely and consistently. A successful growth strategy requires us to manage multiple aspects of the business simultaneously, such as following adequate loan underwriting standards, balancing loan and deposit growth without increasing interest rate risk or compressing our net interest margin, maintaining sufficient capital, and recruiting, training and retaining qualified professionals.

Our growth strategy also includes merger and acquisition possibilities that either enhance our market presence or have potential for improved profitability through financial management, economies of scale or expanded services. We may be exposed to difficulties in combining the operations of acquired institutions into our own operations, which may prevent us from achieving the expected benefits from our acquisition activities. Our earnings, financial condition and prospects after a merger will depend in part on our ability to integrate the operations and management of the acquired institution while continuing to implement other aspects of our business plan. Inherent uncertainties exist in integrating the operations of an acquired institution and there is no assurance that we will be able to do so successfully. Among the issues that we could face are:

unexpected problems with operations, personnel, technology or credit;
loss of customers and employees of the acquiree;
difficulty in working with the acquiree's employees and customers;
the assimilation of the acquiree's operations, culture and personnel;
instituting and maintaining uniform standards, controls, procedures and policies; and
litigation risk not discovered during the due diligence period.

Undiscovered factors as a result of an acquisition could bring liabilities against us, our management and the management of the institutions we acquire. These factors could contribute to our not achieving the expected benefits from our acquisitions within desired time frames, if at all. Further, although we generally anticipate cost savings from acquisitions, we may not be able to fully realize those savings. Any cost savings that are realized may be offset by losses in revenues or other charges to earnings.

We May Not Be Able To Attract and Retain Key Employees

Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in most activities engaged by us can be intense, especially in light of the recent improvement in the job market, and we may not be able to hire skilled people or retain them. We do not have non-compete agreements with any of our senior officers. The unexpected loss of services of key personnel could have a material adverse impact on our business because of the skills, knowledge of our market, years of industry experience and difficulty of promptly finding qualified replacement personnel.

Accounting Estimates and Risk Management Processes Rely On Analytical and Forecasting Models

The processes we use to estimate probable loan losses and to measure the fair value of financial instruments, as well as the processes used to estimate the effects of changing interest rates and other market measures on our financial condition and results of operations, depends upon the use of analytical and forecasting models. These models reflect assumptions that may not be accurate, particularly in times of market stress or other unforeseen circumstances. Even if these assumptions are adequate, the models may prove to be inadequate or inaccurate because of other flaws in their design or their implementation. If the models we use for interest rate risk and asset-liability management are inadequate, we may incur increased or unexpected losses upon changes in market interest rates or other market measures. If the models we use for determining our probable loan losses are inadequate, the allowance for loan losses may not be sufficient to support future charge-offs. If the models we use to measure the fair value of financial instruments are inadequate, the fair value of such financial instruments may fluctuate unexpectedly or may not accurately reflect what we could realize upon sale or settlement of such financial instruments. Any such failure in our analytical or forecasting models could have a material adverse effect on our business, financial condition and results of operations.


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The Value Of Goodwill and Other Intangible Assets May Decline In The Future

As of December 31, 2014, we had goodwill totaling $6.4 million and a core deposit intangible asset totaling $3.7 million from the NorCal acquisition. A significant decline in expected future cash flows, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of our common stock could necessitate taking charges in the future related to the impairment of goodwill or other intangible assets. If we were to conclude that a future write-down of goodwill or other intangible assets is necessary, we would record the appropriate charge, which could have a material adverse effect on our business, financial condition and results of operations.

We May Take Filing Positions or Follow Tax Strategies That May Be Subject to Challenge

We provide for current and deferred taxes in our consolidated financial statements based on our results of operations, business activities and business combinations, legal structure and federal and state legislation and regulations. We may take filing positions or follow tax strategies that are subject to interpretation of tax statutes. Our net income may be reduced if a federal, state or local authority were to assess charges for taxes that have not been provided for in our consolidated financial statements. Taxing authorities could change applicable tax laws, challenge filing positions or assess new taxes and interest charges. If taxing authorities take any of these actions, our business, results of operations or financial condition could be adversely and significantly affected.

Financial Institutions Rely on Technology and Continually Encounter Technological Change

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology will enable efficiency and meet customers' changing needs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Failure to keep pace with technological change affecting the financial services industry could have a material adverse impact on the long-term success of our business and, in turn, our financial condition and results of operations.

Cyber Security is a Growing Risk for Financial Institutions

Our business requires the secure handling of sensitive client information. We also rely heavily on communications and information systems to conduct our business. Cyber incidents include intentional attacks and unintentional events that may present unauthorized access to digital systems that disrupt operations, corrupt data, release sensitive information or cause denial-of-service on our websites. We store, process and transmit account information in connection with lending and deposit relationships, including funds transfer and online banking. A breach of cyber-security systems of the Bank, our vendors or customers, or widely publicized breaches of other financial institutions could significantly harm our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and financial liability. While we have systems and procedures designed to prevent security breaches, we cannot be certain that advances in criminal capabilities, physical system or network break-ins or inappropriate access will not compromise or breach the technology protecting our networks or proprietary client information.

We process debit card transactions initiated by our customers at merchant locations around the world. When a merchant is impacted by a cyber breach, we are exposed to the risk of financial losses due to fraudulent card activity, as well as increases in associated operational expense.

We Rely on Third-Party Vendors for Important Aspects of Our Operation

We depend on the accuracy and completeness of information and systems provided by certain key vendors, including but not limited to data processing, payroll processing, technology support, investment safekeeping and accounting. In particular, we outsource core processing to Fidelity Information Services ("FIS"), a leading financial services solution provider, which allows us access to competitive technology offerings without having to directly invest in development. Our ability to operate, as well as our financial condition and results of operations, could be negatively affected in the event of an interruption of an information system, an undetected error, a cyber breach, or in the event of a natural disaster whereby certain vendors are unable to maintain business continuity.


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Failure of Correspondent Banks and Counterparties May Affect Liquidity

In the economic downturn, the financial services industry in general was materially and adversely affected by the credit crisis. We have witnessed failure of banks in the industry in recent years. We rely on our correspondent banks for lines of credit, which can be revoked unexpectedly. We also have two correspondent banks as counterparties in our derivative transactions (see Note 15 to the Consolidated Financial Statements in item 8 in this Form 10-K). While we continually monitor the financial health of our correspondent banks and we have diverse sources of liquidity, should any one of our correspondent banks become financially impaired, our available credit may decline and/or they may be unable to honor their commitments.

Deterioration of Credit Quality or Insolvency of Insurance Companies May Impede our Ability to Recover Losses

The financial crisis led certain major insurance companies to be downgraded by rating agencies. We have property, casualty and financial institution risk coverage underwritten by several insurance companies, who may not avoid insolvency risk inherent in the insurance industry. In addition, some of our investments in obligations of state and political subdivisions are insured by insurance companies. While we closely monitor the credit ratings of our insurers and the insurers of our municipal securities and we are poised to make quick changes if needed, we cannot predict an unexpected inability to honor commitments. We also invest in bank-owned life insurance policies on certain members of Management, which may lose value in the event of a carrier's insolvency. In the event that a bank-owned life insurance policy carrier's credit ratings fall below investment grade, we may exchange policies to other carriers at a cost charged by the original carrier, or we may terminate the policies which may result in adverse tax consequences.

Our loan portfolio is secured primarily by properties located in earthquake or fire-prone zones. In the event of a disaster that causes pervasive damage to the region in which we operate, not only the Bank, but also the loan collateral may suffer losses not recoverable by insurance.

Bancorp Relies on Dividends from the Bank to Pay Cash Dividends to Shareholders

Bancorp is a separate legal entity from its subsidiary, the Bank. Bancorp receives substantially all of its revenue from the Bank in the form of dividends, which is Bancorp's principal source of funds to pay cash dividends to Bancorp's common shareholders, service subordinated debt, and cover operational expenses of the holding company. Various federal and state laws and regulations limit the amount of dividends that the Bank may pay to Bancorp. In the event that the Bank is unable to pay dividends to Bancorp, Bancorp may not be able to pay dividends to its shareholders or pay interest on the subordinated debentures. As a result, it could have an adverse effect on Bancorp's stock price and investment value.

Under federal law, capital distributions from the Bank would become prohibited, with limited exceptions, if the Bank were categorized as "undercapitalized" under applicable FRB or FDIC regulations. In addition, as a California bank, Bank of Marin is subject to state law restrictions on the payment of dividends. For further information on the distribution limit from the Bank to Bancorp, see the section captioned “Bank Regulation” in Item 1 above and “Dividends” in Note 9 to the Consolidated Financial Statements in Item 8 of this report.

The Trading Volume of Bancorp's Common Stock is Less than That of Other, Larger Financial Services Companies

Our common stock is listed on the NASDAQ Capital Market. Our trading volume is less than that of nationwide or larger regional financial institutions. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence of willing buyers and sellers of common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Given the low trading volume of our common stock, significant trades of our stock in a given time, or the expectations of these trades, could cause volatility in the stock price.


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We may need to Raise Additional Capital in the Future, and if we Fail to Maintain Sufficient Capital, Whether due to Losses, an Inability to Raise Additional Capital or Otherwise, our Financial Condition, Liquidity and Results of Operations, as well as our Ability to Maintain Regulatory Compliance, Could be Adversely Affected

We face significant capital and other regulatory requirements as a financial institution. We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs, which could include the possibility of financing acquisitions. In addition, Bancorp, on a consolidated basis, and the Bank, on a stand-alone basis, must meet certain regulatory capital requirements and maintain sufficient liquidity. Importantly, as discussed below, regulatory capital requirements could increase from current levels, which could require us to raise additional capital or contract our operations. Our ability to raise additional capital depends on conditions in the capital markets, economic conditions and a number of other factors, including investor perceptions regarding the banking industry, market conditions and governmental activities, and on our financial condition and performance. Accordingly, we cannot assure that we will be able to raise additional capital if needed or on terms acceptable to us. If we fail to maintain capital to meet regulatory requirements, our liquidity, business, financial condition and results of operations could be materially and adversely affected.

We may be Subject to more Stringent Capital Requirements in the Future

We are subject to regulatory requirements specifying minimum amounts and types of capital that we must maintain. From time to time, the regulators change these regulatory capital adequacy guidelines. If we fail to meet these minimum capital guidelines and other regulatory requirements, Bancorp or the Bank may be restricted in the types of activities we may conduct and we may be prohibited from taking certain capital actions, such as paying dividends and repurchasing or redeeming capital securities.

In particular, the capital requirements applicable to us under the recently adopted capital rules implementing the Basel III capital framework in the United States began to be phased-in starting on January 1, 2015. As these new rules take effect, we will be required to satisfy additional, more stringent, capital adequacy standards than we have in the past. In addition, if we become subject to annual stress testing requirements, our stress test results may have the effect of requiring us to comply with even greater capital requirements. While we currently meet the requirements of the new Basel III-based capital rules on a fully implemented basis, we may eventually fail to do so. In addition, these requirements could have a negative impact on our ability to lend, grow deposit balances, make acquisitions or make capital distributions in the form of dividends or share repurchases. Higher capital levels could also lower our return on equity.

We may be Subject to Environmental Liabilities in Connection with the Foreclosure on Real Estate Assets Securing our Loan Portfolio

Hazardous or toxic substances or other environmental hazards may be located on the properties that secure our loans. If we acquire such properties as a result of foreclosure or otherwise, we could become subject to various environmental liabilities. For example, we could be held liable for the cost of cleaning up or otherwise addressing contamination at or from these properties. We could also be held liable to a governmental entity or third-party for property damage, personal injury or other claims relating to any environmental contamination at or from these properties. In addition, we own and operate certain properties that may be subject to similar environmental liability risks. Although we have policies and procedures that are designed to mitigate against certain environmental risks, we may not detect all environmental hazards associated with these properties. If we ever became subject to significant environmental liabilities, our business, financial condition and results of operations could be adversely affected.

The Small to Medium-sized Businesses that we Lend to may have Fewer Resources to Weather Adverse Business Developments, which may Impair a Borrower's Ability to Repay a Loan, and such Impairment could Adversely Affect our Results of Operations and Financial Condition

We focus our business development and marketing strategy primarily on small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower's ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have a material adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact the

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California markets in which we operate and small to medium-sized businesses are adversely affected or our borrowers are otherwise affected by adverse business developments, our business, financial condition and results of operations may be negatively affected.

A Lack of Liquidity could Adversely Affect our Operations and Jeopardize our Business, Financial Condition and Results of Operations

Liquidity is essential to our business. We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities, respectively, to ensure that we have adequate liquidity to fund our operations. An inability to raise funds through deposits, borrowings, the sale of investment securities, Federal Home Loan Bank advances, the sale of loans and other sources could have a substantial negative effect on our liquidity. Our most important source of funds consists of deposits. Deposit balances can decrease when customers perceive alternative investments as providing a better risk/return tradeoff. If customers move money out of bank deposits and into other investments, we would lose a relatively low-cost source of funds, increasing our funding costs and reducing our net interest income and net income.

Other primary sources of funds consist of cash flows from operations, investment maturities and sales of investment securities and proceeds from the issuance and sale of any equity and debt securities to investors. Additional liquidity is provided by the ability to borrow from the Federal Reserve Bank of San Francisco and the Federal Home Loan Bank and our ability to raise brokered deposits. We also may borrow funds from third-party lenders, such as other financial institutions. Our access to funding sources in amounts adequate to finance or capitalize our activities, or on terms that are acceptable to us, could be impaired by factors that affect us directly or the bank or non-bank financial services industries or the economy in general, such as disruptions in the financial markets or negative views and expectations about the prospects for the bank or non-bank financial services industries.

Based on past experience, we believe that our deposit accounts are relatively stable sources of funds. If we increase interest rates paid to retain deposits, our earnings may be adversely affected, which could have an adverse effect on our business, financial condition and results of operations.

Any decline in available funding could adversely impact our ability to originate loans, invest in securities, meet our expenses, pay dividends to our shareholders or to fulfill obligations such as repaying our borrowings or meeting deposit withdrawal demands, any of which could have a material adverse impact on our liquidity, business, financial condition and results of operations.


ITEM 1B      UNRESOLVED STAFF COMMENTS

None

ITEM 2     PROPERTIES

We lease our corporate headquarters building in Novato, California, which houses substantial loan production, operations and administration.  We also lease other branch or office facilities within our primary market areas in the cities of Corte Madera, San Rafael, Novato, Sausalito, Mill Valley, Tiburon, Greenbrae, Petaluma, Santa Rosa, Sonoma, Napa, San Francisco, Alameda, and Oakland.  We consider our properties to be suitable and adequate for our needs. For additional information on properties, see Notes 5 and 13 to the Consolidated Financial Statements included in Item 8 of this report.

ITEM 3         LEGAL PROCEEDINGS
 
We may be party to legal actions which arise from time to time as part of the normal course of our business.  We believe, after consultation with legal counsel, that we have meritorious defenses in these actions, and that litigation contingent liability, if any, will not have a material adverse effect on our financial position, results of operations, or cash flows.
 

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We are responsible for our proportionate share of certain litigation indemnifications provided to Visa U.S.A. by its member banks in connection with lawsuits related to anti-trust charges and interchange fees. For further details, see Note 13 to the Consolidated Financial Statements in Item 8 of this report.

ITEM 4      MINE SAFETY DISCLOSURES
 
Not applicable.


Page-22



PART II     
 
ITEM 5      MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Bancorp common stock trades on the NASDAQ Capital Market under the symbol BMRC. At February 28, 2015, 5,942,177 shares of Bancorp's common stock, no par value, were outstanding and held by approximately 1,990 holders of record and beneficial owners. The following table sets forth, for the periods indicated, the range of high and low intra-day sales prices of Bancorp's common stock.

Calendar
2014
2013
 Quarter
High

Low

High

Low

1st Quarter
$
46.09

$
41.59

$
41.45

$
36.89

2nd Quarter
$
47.97

$
42.49

$
40.75

$
37.75

3rd Quarter
$
49.32

$
44.01

$
45.96

$
38.45

4th Quarter
$
53.63

$
45.35

$
46.21

$
40.00


The table below shows cash dividends paid to common shareholders on a quarterly basis in the last two fiscal years.

Calendar
2014
2013
 Quarter
Per Share

Dollars

Per Share

Dollars

1st Quarter
$
0.19

$
1,120,000

$
0.18

$
971,000

2nd Quarter
$
0.19

$
1,123,000

$
0.18

$
979,000

3rd Quarter
$
0.20

$
1,185,000

$
0.18

$
982,000

4th Quarter
$
0.22

$
1,305,000

$
0.19

$
1,038,000


For additional information regarding our ability to pay dividends, see discussion in Note 9 to the Consolidated Financial Statement, under the heading “Dividends,” in Item 8 of this report.

There were no purchases made by or on behalf of Bancorp or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Bancorp's common stock during the fourth quarter of 2014.

On July 2, 2007, Bancorp executed a shareholder rights agreement (“Rights Agreement”) designed to discourage takeovers that involve abusive tactics or do not provide fair value to shareholders. Refer to Exhibit 4.1 to Registration Statement on Form 8-A12B filed with the Securities and Exchange Commission on July 2, 2007. For further information, see Note 9 to the Consolidated Financial Statements, under the heading “Shareholder Rights Plan” in Item 8 of this report.

Securities Authorized for Issuance under Equity Compensation Plans

The following table summarizes information as of December 31, 2014, with respect to equity compensation plans. All plans have been approved by the shareholders.

 
(A)
(B)

(C)
 
Shares to be issued upon exercise of outstanding options
Weighted average exercise price of outstanding options

Shares available for future issuance (Excluding shares in column A)
Equity compensation plans approved by shareholders

194,672 1
$
35.14


372,990 2

1 Represents shares of common stock issuable upon exercise of outstanding options under the Bank of Marin 1999 Stock Option Plan and the Bank of Marin Bancorp 2007 Equity Plan.

2 Represents shares of common stock available for future grants under the 2007 Equity Plan and the 2010 Director Stock Plan.

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Stock Price Performance Graph

The following graph, provided by Keefe, Bruyette, & Woods, Inc., shows a comparison of cumulative total shareholder return on our common stock during the five fiscal years ended December 31, 2014 compared to Russell 2000 Stock index and peer group index of other financial institutions. We have been part of the Russell 2000 index since July 2009. The comparison assumes $100 was invested on December 31, 2009 in our common stock and all of the dividends were reinvested. The performance graph represents past performance and should not be considered to be an indication of future performance.
 
 
2009

2010

2011

2012

2013

2014

BMRC
100

109

120

122

143

177

Peer Group1
100

103

87

127

181

190

Russell 2000
100

127

122

141

196

206

 
 
 
 
 
 
 
1BMRC Peer Group represents public California banks with assets between $1 billion to $5 billion as of December 31, 2014: HAFC, WIBC, TCBK, CYHT, FMCB, WFCL, CUNB, PFBC, PPBI, EXSR, BBNK, HEOP, BSRR, HTBK, AMBZ, FFWM, RCBC, CVCY, PROV, PMBC. The peer group composite index is weighted by market capitalization and reinvests dividends on the ex-date and adjusts for stock splits, if applicable.
 
 
 
 
 
 
 
Source: Company Reports, FactSet, and SNL
 


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ITEM 6        SELECTED FINANCIAL DATA

 
 
2014
2013
2012
2011
2010
2013/2014
(dollars in thousands, except per share data; unaudited)
 
 
 
 
% change
 
 
 
 
 
 
 
 
At December 31,
 
 
 
 
 
 
 
Total assets
$
1,787,130

$
1,805,194

$
1,434,749

$
1,393,263

$
1,208,150

(1.0
)%
 
Total loans
1,363,351

1,269,322

1,073,952

1,031,154

941,400

7.4
 %
 
Total deposits
1,551,619

1,587,102

1,253,289

1,202,972

1,015,739

(2.2
)%
 
Total stockholders' equity
200,026

180,887

151,792

135,551

121,920

10.6
 %
 
Equity-to-asset ratio
11.2
%
10.0
%
10.6
%
9.7
%
10.1
%
12.0
 %
 
 
 
 
 
 
 
 
For year ended December 31,
 
 
 
 
 
 
 
Net interest income
$
70,441

$
58,775

$
63,190

$
63,819

$
54,909

19.8
 %
 
Provision for loan losses
750

540

2,900

7,050

5,350

38.9
 %
 
Non-interest income
9,041

8,066

7,112

6,269

5,521

12.1
 %
 
Non-interest expense1
47,263

44,092

38,694

38,283

33,357

7.2
 %
 
Net income1
19,771

14,270

17,817

15,564

13,552

38.5
 %
 
Net income per share (diluted)
3.29

2.57

3.28

2.89

2.55

28.0
 %
 
Tax-equivalent net interest margin
4.13
%
4.20
%
4.74
%
5.13
%
4.95
%
(1.7
)%
 
Cash dividend payout ratio on common stock 2
23.9
%
27.9
%
21.0
%
22.1
%
23.6
%
(14.3
)%

1 2013 amount included $3.7 million in one-time expenses related to the NorCal acquisition and 2011 amount included $1.0 million in one-time expenses related to the Charter Oak Bank acquisition.

2 Calculated as dividends on common share divided by basic net income per common share.

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ITEM 7     MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion of financial condition as of December 31, 2014 and 2013 and results of operations for each of the years in the three-year period ended December 31, 2014 should be read in conjunction with our consolidated financial statements and related notes thereto, included in Part II Item 8 of this report. Average balances, including balances used in calculating certain financial ratios, are generally comprised of average daily balances.
 
Forward-Looking Statements
 
The disclosures set forth in this item are qualified by important factors detailed in Part I captioned Forward-Looking Statements and Item 1A captioned Risk Factors of this report and other cautionary statements set forth elsewhere in the report.

Executive Summary
 
Earnings in 2014 totaled $19.8 million compared to earnings of $14.3 million in 2013, which included $3.7 million in one-time expenses related to the acquisition of NorCal Community Bancorp ("NorCal") in November 2013. Diluted earnings of $3.29 per share for the year ended December 31, 2014 compared to $2.57 per share in the same period of 2013. 2013 diluted earnings per share included a negative impact of $0.43 per share related to one-time acquisition-related expenses. Return on assets ("ROA") of 1.08% for the year ended December 31, 2014, increased from 0.96% for the same period last year. Return on equity ("ROE") totaled 10.31% in 2014, compared to 8.86% for the year ended December 31, 2013. The increase in ROA and ROE in 2014 was driven by strong earnings, resulting from the successful acquisition of NorCal, a decrease of one-time acquisition related expenses, and active relationship management. Profitability primarily resulting from overhead cost savings from the NorCal transaction has exceeded our expectations.

Loans increased to $1.4 billion at December 31, 2014, compared to $1.3 billion at December 31, 2013, which was driven substantially by commercial and industrial lending and commercial real estate lending. Net loan growth in 2014 totaled $94.0 million, or 7.4% over December 31, 2013, and was primarily the result of strong new loan volume partially offset by high payoffs.

Credit quality continues to be very strong. nonaccrual loans totaled $9.4 million at December 31, 2014 compared to $11.7 million at December 31, 2013, and as a percentage of total loans declined to 0.69% compared to 0.92% a year ago. The decrease in nonaccrual loans from the prior year primarily relates to the successful resolution of several problem loans. Net recoveries for the year ended December 31, 2014 totaled $124 thousand, compared to $24 thousand in the prior year.

The provision for loan losses totaled $750 thousand in 2014, compared to $540 thousand in the prior year. The increase from the prior year primarily relates to the increase in total loans. The ratio of loan loss reserve to loans decreased from 1.12% at December 31, 2013 to 1.11% at December 31, 2014.

Deposits totaled $1.6 billion at December 31, 2014 and December 31, 2013. Non-interest bearing deposits totaled $671 million at December 31, 2014, an increase of $22.7 million, or 3.5%, when compared to December 31, 2013. Non-interest bearing deposits represented 43.2% of total deposits as of December 31, 2014 compared to 40.8% at December 31, 2013. Total deposits decreased $35.5 million, or 2.2%, compared to December 31, 2013, which is primarily due to the cyclical activity of several large business depositors.

The total risk-based capital ratio for Bancorp totaled 13.9% at December 31, 2014 compared to 13.2% at December 31, 2013. The increase was primarily due to the accumulation of net income, net of $4.7 million in dividends paid to stockholders, partially offset by an increase in risk-weighted assets due to increases in loan balances. The risk-based capital ratio continues to be well above regulatory requirements for a well-capitalized institution and the new requirements that took effect January 1, 2015 (Basel Committee on Bank Supervision guidelines for determining regulatory capital).

Net interest income totaled $70.4 million and $58.8 million in 2014 and 2013, respectively. The increase from a year ago relates primarily to higher average balances of loans and investments. The tax-equivalent net interest margin was

Page-26



4.13% in 2014 compared to 4.20% in 2013. The decrease in net interest margin relates to lower yields on new and renewed loans, which was partially offset by accretion and gains on payoffs of acquired loans.

Non-interest income totaled $9.0 million in the year ended 2014 compared to $8.1 million in the same period of 2013, an increase of $975 thousand, or 12.09%. The increase in 2014 compared to 2013 primarily relates to higher dividend income from the Federal Home Loan Bank of San Francisco, debit card interchange fees due to increased volume, and Wealth Management and Trust Services fees.

Non-interest expense totaled $47.3 million and $44.1 million in 2014 and 2013, respectively, an increase of $3.2 million, or 7.19%. The increase in non-interest expense from the prior year reflects the Bank's expansion into the East Bay including increased salaries and benefits, facilities, and amortization of core deposit intangible, partially offset by the absence of one-time acquisition costs.

Critical Accounting Policies and Estimates

Critical accounting policies are those that are both most important to the portrayal of our financial condition and results of operations and require Management's most difficult, subjective, or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Management has determined the following six accounting policies to be critical: Allowance for Loan Losses, Acquired Loans, Other-than-temporary Impairment of Investment Securities, Goodwill and Other Intangible Assets, Accounting for Income Taxes, and Fair Value Measurements.

Allowance for Loan Losses

Allowance for Loan Losses is based upon estimates of loan losses and is maintained at a level considered adequate to provide for probable losses inherent in the loan portfolio. The allowance is increased by provisions for loan losses charged against earnings and reduced by charge-offs, net of recoveries.

In periodic evaluations of the adequacy of the allowance balance, Management considers current economic conditions, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, our past loan loss experience and other factors. The ALLL is based on estimates, and ultimate losses may vary from current estimates. Our Board of Directors' Asset/Liability Management Committee (“ALCO”) reviews the adequacy of the ALLL at least quarterly. The allowance is adjusted based on that review if, in the judgment of the Board of Directors and Management, changes are warranted.

The overall allowance consists of 1) specific allowances for individually identified impaired loans ("ASC 310-10") and 2) general allowances for pools of loans ("ASC 450-20"), which incorporate changing qualitative and environmental factors (e.g., portfolio growth and trends, credit concentrations, economic and regulatory factors, etc.).

The first component, specific allowances, results from the analysis of identified problem credits and the evaluation of sources of repayment including collateral, as applicable. Through Management's ongoing loan grading and credit monitoring process, individual loans are identified that have conditions indicating the borrower may be unable to pay all amounts due in accordance with the contractual terms. These loans are evaluated for impairment individually by Management. Management considers an originated loan to be impaired when it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. For allowances established on acquired loans, refer to Acquired Loans discussed below. When the fair value of the impaired loan is less than the recorded investment in the loan, the difference is recorded as impairment through the establishment of a specific allowance. For loans determined to be impaired, the extent of the impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate at origination (for originated loans), based on the loan's observable market price, or based on the fair value of the collateral if the loan is collateral dependent or if foreclosure is imminent. Generally with problem credits that are collateral dependent, we obtain appraisals of the collateral at least annually. We may obtain appraisals more frequently if we believe the collateral value is subject to market volatility, if a specific event has occurred to the collateral, or if we believe foreclosure is imminent.

The second component is an estimate of the probable inherent losses in each loan pool with similar characteristics. Beginning with the quarter-ended September 30, 2013, Management refined the methodology for estimating general

Page-27



allowances in order to provide a more comprehensive evaluation of the potential risk of loss in our loan portfolio. This analysis encompasses the entire loan portfolio excluding acquired loans until the discount has been fully accreted. For allowances established on acquired loans, see below under Acquired Loans. Under our allowance model, loans are evaluated on a pool basis by loan segment which is further delineated by Federal regulatory reporting codes ("CALL codes"). Each segment is assigned an expected loss factor which is primarily based on a rolling twenty-quarter look-back at our historical losses for that particular segment, as well as a number of other factors.

The model determines loan loss reserves based on objective and subjective factors. Objective factors include an historical loss rate using the rolling twenty-quarter look-back, changes in the volume and nature of the loan portfolio, changes in credit quality metrics (past due loans, nonaccrual loans, net charge-offs and adversely-graded loans), and the existence of credit concentrations. Subjective factors include changes in the overall economic environment, legal and regulatory conditions, lending management and other relevant staff, uncertainties related to acquisitions, as well as the quality of our loan review process. The total amount allocated is determined by applying loss multipliers to outstanding loans by CALL code.

While we believe we use the best information available to determine the allowance for loan losses, our results of operations could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance. A decline in local and national economic conditions, or other factors, could result in a material increase in the allowance for loan losses and may adversely affect our financial condition and results of operations. In addition, the determination of the amount of the allowance for loan losses is subject to review by bank regulators, as part of their routine examination process, which may result in the establishment of additional allowance for loan losses based upon their judgment of information available to them at the time of their examination.

For further information regarding our ALLL methodology, the related provision for loan losses, risks related to asset quality and lending activity, see Item 1A - Risk Factors, Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 4 - Loans and Allowance for Loan Losses in Item 8 - Financial Statements and Supplementary Data of this Form 10-K.

Acquired Loans: From time to time, we acquire loans through business acquisitions. Acquired loans are recorded at their estimated fair values at acquisition date in accordance with ASC 805 Business Combinations, factoring in credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for loan losses is not carried over or recorded for acquired loans as of the acquisition date.

The process of calculating fair values of the acquired loans, including the estimate of losses that are expected to be incurred over the estimated remaining lives of the loans at acquisition date and the ongoing updates to Management's expectation of future cash flows, requires significant subjective judgments and assumptions, particularly considering the economic environment. The economic environment and the lack of market liquidity and transparency are factors that have influenced, and may continue to affect, these assumptions and estimates.

We estimated the fair value of acquired loans at the acquisition date based on a discounted cash flow methodology that considered factors including the type of loan and related collateral, risk classification, fixed or variable interest rate, term of loan, whether or not the loan was amortizing, and current discount rates. Loans, except for purchased credit impaired ("PCI") loans, were grouped together according to similar characteristics and treated in the aggregate when applying various valuation techniques. Expected cash flows incorporate our best estimate of key assumptions at the time, such as property values, default rates, loss severity and prepayment speeds. Discount rates were based on market rates for new originations of comparable loans, where available, and included adjustments for liquidity factors.

To the extent comparable market rates were not readily available, a discount rate was derived based on the assumptions of market participants' cost of funds, servicing costs and return requirements for comparable risk assets. In either case, the discount rate did not include a factor for credit losses, as that had been considered in estimating the cash flows. The initial estimate of cash flows to be collected was derived from assumptions related to default rates, loss severities and prepayment speeds.

For acquired loans not considered credit impaired ("non-PCI") loans, we recognize the entire fair value discount accretion to interest income, based on the acquired loan's contractual cash flows using an effective interest rate method for term loans, and on a straight line basis for revolving lines, as the timing and amount of cash flows under revolving lines are

Page-28



not predictable. When a non-PCI loan is placed on nonaccrual status subsequent to acquisition, accretion stops until it is returned to accrual status. The level of accretion on non-PCI loans varies from period to period due to maturities and early payoffs of these loans during the reporting periods. Subsequent to acquisition, if the probable and estimable losses for non-PCI loans exceed the amount of the remaining unaccreted discount, the excess is established as an allowance for loan losses.

We acquired some loans from business combinations with evidence of credit quality deterioration subsequent to their origination and for which it was probable, at acquisition, that we would be unable to collect all contractually required payments ("PCI loans"). These loans were evaluated on an individual basis. Management applied significant subjective judgment in determining which loans were PCI loans. Evidence of credit quality deterioration as of the purchase date may include data such as past due and nonaccrual status, risk grades and charge-off history. Revolving credit agreements (e.g., home equity lines of credit and revolving commercial loans) where the borrower had revolving rights at acquisition date were not considered PCI loans because the timing and amount of cash flows cannot be reasonably estimated.

According to the accounting guidance for PCI loans, the difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is not recorded. Furthermore, the difference between the expected cash flows and the fair value at acquisition date ("accretable difference") is accreted into interest income at a level yield of return over the remaining term of the loan, provided that the timing and amount of future cash flows is reasonably estimable.

All PCI loans that were classified as nonaccrual loans prior to the acquisition were no longer classified as nonaccrual if we believed that we would fully collect the new carrying value of these loans at acquisition. When there is doubt as to the timing and amount of future cash flows to be collected, PCI loans are classified as nonaccrual loans. It is important to note that judgment is required to classify PCI loans as accruing or nonaccrual, and is dependent on having a reasonable expectation about the timing and amount of cash flows expected to be collected. When the timing and/or amounts of expected cash flows on such loans are not reasonably estimable, no interest is accreted and the PCI loan is reported as a nonaccrual loan; otherwise, interest is accreted and the loans are reported as accruing loans.

If we have probable decreases in cash flows expected to be collected on PCI loans, specific allowances are established to account for credit deterioration subsequent to acquisition. The amount of cash flows expected to be collected and, accordingly, the adequacy of the allowance for loan losses are particularly sensitive to changes in loan credit quality. If we have probable and significant increases in cash flows expected to be collected on PCI loans, we first reverse any previously established specific allowance for loan loss and then increase interest income as a prospective yield adjustment over the remaining life of the loans. The impact of changes in variable interest rates is recognized prospectively as adjustments to interest income.

For PCI loans, the estimate of cash flows expected to be collected is updated each quarter and requires the continued use of key assumptions and estimates similar to the initial estimate of fair value. Given the current economic environment, we apply judgment to develop our estimate of cash flows given the impact of collateral value changes, loan workout plans, changing probability of default, loss severities and prepayments. Therefore, accretion on PCI loans fluctuates based on changes in cash flows expected to be collected.

For purposes of accounting for the PCI loans from past business combinations, we elected not to apply the pooling method but to account for these loans individually. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full by the borrower, or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount. If a PCI loan pays off earlier than expected, a gain is recorded as interest income when the payoff amount exceeds the recorded investment.

For further information regarding our acquired loans, see Note 2 - Acquisition, and Note 4 - Loans and Allowance for Loan Losses in Item 8 - Financial Statements and Supplementary Data of this Form 10-K.


Page-29



Other-than-temporary Impairment of Investment Securities

At each financial statement date, we assess whether declines in the fair value of held-to-maturity and available-for-sale securities below their costs are deemed to be other-than-temporary. We consider, among other things, (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in fair value. Evidence evaluated includes, but is not limited to, the remaining payment terms of the instrument and economic factors that are relevant to the collectability of the instrument, such as: current prepayment speeds, the current financial condition of the issuer(s), industry analyst reports, credit ratings, credit default rates, interest rate trends, the quality of any credit enhancement and the value of any underlying collateral.

For each security in an unrealized loss position ("impaired security"), we assess whether we intend to sell the security or if it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis. If we intend to sell the security or it is more likely than not we will be required to sell the security before recovery of its amortized cost basis, the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date is recognized against earnings.

For impaired securities that are not intended for sale and will not be required to be sold prior to recovery of our amortized cost basis, we determine if the impairment has a credit loss component. For both held-to-maturity and available-for-sale securities, if the amount of cash flows expected to be collected are less than the amortized cost, an other-than-temporary impairment shall be considered to have occurred and the credit loss component is recognized against earnings as the difference between present value of the expected future cash flows and the amortized cost. In determining the present value of the expected cash flows, we discount the expected cash flows at the effective interest rate implicit in the security at the date of purchase. The remaining difference between the fair value and the amortized basis is deemed to be due to factors that are not credit related and is recognized in other comprehensive income, net of applicable taxes.

For held-to-maturity securities, if there is no credit loss component, no impairment is recognized. The portion of other-than-temporary impairment recognized in other comprehensive income for credit impaired debt securities classified as held-to-maturity is accreted from other comprehensive income to the amortized cost of the debt security over the remaining life of the debt security in a prospective manner on the basis of the amount and timing of future estimated cash flows.

For further information regarding our investment securities, investment activity, and related risks, see Item 1A - Risk Factors, Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations, and Note 3 - Investment Securities in Item 8 - Financial Statements and Supplementary Data of this Form 10-K.

Accounting for Income Taxes

Income taxes reported in the consolidated financial statements are computed based on an asset and liability approach. We recognize the amount of taxes payable or refundable for the current year and we recognize deferred tax assets and liabilities related to expected future tax consequences that have been recognized in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We record net deferred tax assets to the extent it is more likely than not that they will be realized. In evaluating our ability to recover the deferred tax assets, Management considers all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax planning strategies and recent financial operations. In projecting future taxable income, Management develops assumptions including the amount of future state and federal pretax operating income, the reversal of temporary differences, and the implementation of feasible and prudent tax planning strategies. These assumptions require significant judgment about the forecasts of future taxable income and are consistent with the plans and estimates being used to manage the underlying business. Bancorp files consolidated federal and combined state income tax returns.

We recognize the financial statement effect of a tax position when it is more likely than not, based on the technical merits and all available evidence, that the position will be sustained upon examination, including the resolution through protests, appeals or litigation processes. For tax positions that meet the more-likely-than-not threshold, we measure and record the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate

Page-30



settlement with the taxing authority. The remainder of the benefits associated with tax positions taken is recorded as unrecognized tax benefits, along with any related interest and penalties. Interest and penalties related to unrecognized tax benefits are recorded in tax expense.

In deciding whether or not our tax positions taken meet the more-likely-than-not recognition threshold, we must make judgments and interpretations about the application of inherently complex state and federal tax laws. To the extent tax authorities disagree with tax positions taken by us, our effective tax rates could be materially affected in the period of settlement with the taxing authorities. Revision of our estimate of accrued income taxes also may result from our own income tax planning, which may impact effective tax rates and results of operations for any reporting period.

We present an unrecognized tax benefit as a reduction of a deferred tax asset for a net operating loss ("NOL") carryforward, or similar tax loss or tax credit carryforward, rather than as a liability, when (1) the uncertain tax position would reduce the NOL or other carryforward under the tax law of the applicable jurisdiction and (2) we intend to and are able to use the deferred tax asset for that purpose. Otherwise, the unrecognized tax benefit is presented as a liability instead of being netted with deferred tax assets.

For further information on our tax assets and liabilities, and related provision for income taxes, see Note 12 - Income Taxes in Item 8 - Financial Statements and Supplementary Data of this Form 10-K.

Fair Value Measurements

We use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. We base our fair values on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Securities available-for-sale and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record certain assets at fair value on a non-recurring basis, such as purchased loans recorded at acquisition date, certain impaired loans held for investment, other real estate owned and securities held-to-maturity that are other-than-temporarily impaired. These non-recurring fair value adjustments typically involve write-downs of individual assets due to application of lower-of-cost or market accounting.

When we develop our fair value measurement process, we maximize the use of observable inputs. Whenever there is no readily available market data, we use our best estimates and assumptions in determining fair value, but these estimates involve inherent uncertainties and the application of Management's judgment. As a result, if other assumptions had been used, our recorded earnings or disclosures could have been materially different from those reflected in these financial statements.

For detailed information on our use of fair value measurements and our related valuation methodologies, see Note 10 - Fair Value of Assets and Liabilities in Item 8 - Financial Statements and Supplementary Data of this Form 10-K.


Page-31



RESULTS OF OPERATIONS
 
Highlights of the financial results are presented in the following table:
 
 For years ended December 31,
 
(dollars in thousands, except per share data; unaudited)
2014
 
2013
 
2012
 
For the period:
 
 
 
 
 
 
Net income
$
19,771

 
$
14,270

 
$
17,817

 
Net income per share
 
 
 
 
 
 
Basic
$
3.35

 
$
2.62

 
$
3.34

 
Diluted
$
3.29

 
$
2.57

 
$
3.28

 
Return on average equity
10.31

%
8.86

%
12.36

%
Return on average assets
1.08

%
0.96

%
1.24

%
Common stock dividend payout ratio
23.93

%
27.82

%
21.06

%
Average shareholders’ equity to average total assets

10.46

%
10.78

%
10.05

%
Efficiency ratio
59.46

%
65.97

%
55.04

%
  Tax equivalent net interest margin
4.13

%
4.20

%
4.74

%
 
 
 
 
 
 
 
At period end:
 

 
 

 
 

 
Book value per common share
$
33.68

 
$
30.78

 
$
28.17

 
Total assets
$
1,787,130

 
$
1,805,194

 
$
1,434,749

 
Total loans
$
1,363,351

 
$
1,269,322

 
$
1,073,952

 
Total deposits
$
1,551,619

 
$
1,587,102

 
$
1,253,289

 
Loan-to-deposit ratio
87.87

%
79.98

%
85.69

%
Total risk-based capital ratio - Bancorp
13.9

%
13.2

%
13.7

%
  

Page-32



SUMMARY OF QUARTERLY RESULTS OF OPERATIONS

Table 1 sets forth the quarterly results of operations for 2014 and 2013:

Table 1        Summarized Statement of Income
 
2014 Quarters Ended
 
2013 Quarters Ended
(dollars in thousands; unaudited)
Dec. 31

Sept. 30

Jun. 30

Mar. 31

 
Dec. 31

Sept. 30

Jun. 30

Mar. 31

Interest income
$
17,722

$
18,108

$
18,456

$
18,504

 
$
16,129

$
14,471

$
14,730

$
15,230

Interest expense
580

577

582

610

 
497

429

425

434

Net interest income
17,142

17,531

17,874

17,894

 
15,632

14,042

14,305

14,796

     Provision for loan losses


600

150

 
150

(480
)
1,100

(230
)
Net interest income after
 
 
 
 
 
 
 
 
 
   provision for loan losses
17,142

17,531

17,274

17,744

 
15,482

14,522

13,205

15,026

Non-interest income
2,156

2,301

2,368

2,216

 
2,063

1,953

1,944

2,106

Non-interest expense
11,613

11,350

11,457

12,843

 
13,871

10,107

10,419

9,695

Income before provision for income taxes
7,685

8,482

8,185

7,117

 
3,674

6,368

4,730

7,437

     Provision for income taxes
2,993

3,104

3,017

2,584

 
1,329

2,364

1,675

2,571

Net income
$
4,692

$
5,378

$
5,168

$
4,533

 
$
2,345

$
4,004

$
3,055

$
4,866

Net income available to common stockholders
$
4,692

$
5,378

$
5,168

$
4,533

 
$
2,345

$
4,004

$
3,055

$
4,866

 
 
 
 
 
 
 
 
 
 
     Net income per common share
 
 
 
 
 
 
 
 
 
     Basic
$
0.79

$
0.91

$
0.88

$
0.77

 
$
0.42

$
0.74

$
0.56

$
0.90

     Diluted
$
0.78

$
0.89

$
0.86

$
0.76

 
$
0.41

$
0.72

$
0.55

$
0.89


Page-33



Net Interest Income
 
Net interest income is the difference between the interest earned on loans, investments and other interest-earning assets and the interest expense incurred on deposits and other interest-bearing liabilities. Net interest income is impacted by changes in general market interest rates and by changes in the amounts and composition of interest-earning assets and interest-bearing liabilities. Interest rate changes can create fluctuations in the net interest margin due to an imbalance in the timing of repricing or maturity of assets or liabilities. We manage interest rate risk exposure with the goal of minimizing the impact of interest rate volatility on net interest margin.
 
Net interest margin is expressed as net interest income divided by average interest-earning assets. Net interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate incurred on total interest-bearing liabilities. Both of these measures are reported on a taxable-equivalent basis. Net interest margin is the higher of the two because it reflects interest income earned on assets funded with non-interest-bearing sources of funds, which include demand deposits and stockholders’ equity.
 
The following table, Average Statements of Condition and Analysis of Net Interest Income, compares interest income and average interest-earning assets with interest expense and average interest-bearing liabilities for the periods presented. The table also indicates net interest income, net interest margin and net interest rate spread for each period presented.


Page-34



 
Table 2 Average Statements of Condition and Analysis of Net Interest Income
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Year ended
 
Year ended
 
Year ended
 
 
 
December 31, 2014
 
December 31, 2013
 
December 31, 2012
 
 
 
 
Interest
 
 
 
Interest
 
 
 
Interest
 
 
 
 
Average
Income/
Yield/
 
Average
Income/
Yield/
 
Average
Income/
Yield/
 
(dollars in thousands; unaudited)
Balance
Expense
Rate
 
Balance
Expense
Rate
 
Balance
Expense
Rate
 
Assets
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing due from banks 1
$
63,150

$
161

0.25
%
 
$
47,401

$
120

0.25
%
 
$
80,643

$
214

0.26
%
 
 
Investment securities 2, 3
341,787

8,385

2.45
%
 
272,767

6,648

2.44
%
 
234,014

6,829

2.92
%
 
 
Loans 1, 3, 4
1,317,794

65,856

4.93
%
 
1,092,885

55,157

4.98
%
 
1,023,165

59,991

5.77
%
 
 
   Total interest-earning assets 1
1,722,731

74,402

4.26
%
 
1,413,053

61,925

4.32
%
 
1,337,822

67,034

4.93
%
 
 
Cash and non-interest-bearing due from banks
44,452

 
 
 
32,903

 
 
 
51,301

 
 
 
 
Bank premises and equipment, net
9,290

 
 
 
9,214

 
 
 
9,183

 
 
 
 
Interest receivable and other assets, net
56,592

 
 
 
38,993

 
 
 
36,155

 
 
 
Total assets
$
1,833,065

 
 
 
$
1,494,163

 
 
 
$
1,434,461

 
 
 
Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing transaction accounts
$
101,133

$
99

0.10
%
 
$
97,336

$
52

0.05
%
 
$
152,778

$
151

0.10
%
 
 
Savings accounts
125,169

46

0.04
%
 
100,185

35

0.03
%
 
86,670

88

0.10
%
 
 
Money market accounts
507,055

550

0.11
%
 
437,441

419

0.10
%
 
436,281

689

0.16
%
 
 
CDARS and other time accounts
155,229

917

0.59
%
 
145,750

922

0.63
%
 
174,122

1,151

0.66
%
 
 
FHLB borrowings and overnight borrowings 1
15,004

315

2.07
%
 
19,054

322

1.67
%
 
16,205

345

2.09
%
 
 
Subordinated debentures
5,070

422

8.36
%
 
407

35

8.57
%
 
3,552

152

4.21
%
5 
 
   Total interest-bearing liabilities
908,660

2,349

0.26
%
 
800,173

1,785

0.22
%
 
869,608

2,576

0.30
%
 
 
Demand accounts
717,738

 
 
 
518,986

 
 
 
406,861

 
 
 
 
Interest payable and other liabilities
14,934

 
 
 
13,970

 
 
 
13,881

 
 
 
 
Stockholders' equity
191,733

 
 
 
161,034

 
 
 
144,111

 
 
 
Total liabilities & stockholders' equity
$
1,833,065

 
 
 
$
1,494,163

 
 
 
$
1,434,461

 
 
 
Tax-equivalent net interest income/margin 1
 
$
72,053

4.13
%
 
 
$
60,140

4.20
%
 
 
$
64,458

4.74
%
 
Reported net interest income/margin 1
 
$
70,441

4.03
%
 
 
$
58,775

4.10
%
 
 
$
63,190

4.65
%
 
Tax-equivalent net interest rate spread
 

4.00
%
 
 
 
4.10
%
 
 
 
4.63
%
 
 
 
1 Interest income/expense is divided by actual number of days in the period times 360 days to correspond to stated interest rate terms, where applicable.
 
2 Yields on available-for-sale securities are calculated based on amortized cost balances rather than fair value, as changes in fair value are reflected as a component of stockholders' equity. Investment security interest is earned on 30/360 basis monthly.
 
3 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35%.
 
4 Average balances on loans outstanding include nonaccrual loans. The amortized portion of net loan origination fees is included in interest income on loans, representing an adjustment to the yield.
 
5 Amount includes $42 thousand accelerated amortization of debt issuance costs in the third quarter of 2012.
 

2014 compared with 2013:
 
The tax-equivalent net interest margin was 4.13% in 2014, compared to 4.20% in 2013.  The decrease of seven basis points was primarily due to a lower yield on interest-earning assets, mainly relating to new loans yielding lower rates and downward repricing on renewed loans offset by an increase in accretion and gains on payoffs of acquired loans. In addition to the decrease on lower yielding interest-earning assets, the cost of interest-bearing liabilities increased by four basis points in 2014, compared to 2013. The net interest spread decreased ten basis points over the same period for the same reasons.

The average yield on interest-earning assets decreased six basis points in 2014 compared to 2013 due to the reasons listed above. The loan portfolio as a percentage of average interest-earning assets, decreased to 76.5% in 2014, from 77.3% in 2013. The investment securities were 19.8% and 19.3% of average interest-earning assets in 2014 and 2013, respectively. Total average interest-earning assets increased $309.7 million, or 21.9%, in 2014 compared to 2013.

Market interest rates are, in part, based on the target federal funds interest rate (the interest rate banks charge each other for short-term borrowings) implemented by the FOMC. In December of 2008, the target federal funds rate reached

Page-35



a historic low with a range of 0% to 0.25% where it remained as of December 31, 2014. The accommodative monetary policy measures taken by the FRB in recent years, including three rounds of quantitative easing, has led to a prolonged low interest rate environment. As a result, we have experienced downward pricing pressure on our interest-earning assets that negatively impacted our net interest margin and yields on our earning assets, and we expect little relief from this downward pricing pressure in 2015.

Our net interest margin fluctuations due to acquired loans were as follows:
 
Years ended December 31,
 
2014
 
2013
 
2012
(dollars in thousands; unaudited)
Dollar Amount
Basis point impact to net interest margin
 
Dollar Amount
Basis point impact to net interest margin
 
Dollar Amount
Basis point impact to net interest margin
Accretion on PCI loans
$
614

4 bps
 
$
725

5 bps
 
$
1,641

12 bps
Accretion on non-PCI loans
$
3,292

19 bps
 
$
1,163

8 bps
 
$
789

6 bps
Gains on payoffs of PCI loans
$
622

4 bps
 
$
469

3 bps
 
$
1,714

13 bps

2013 Compared with 2012:
 
The tax-equivalent net interest margin was 4.20% in 2013, compared to 4.74% in 2012.  The decrease of fifty-four basis points was primarily due to a lower yield on interest-earning assets, mainly relating to new loans yielding lower rates, a lower level of accretion on purchased loans, downward repricing on renewed loans and lower yields on investment securities. These decreases were partially offset by a shift in the mix of interest-earning assets from lower-yielding interest-bearing due from banks towards higher-yielding loans and securities, as well as the downward repricing of deposits and the payoff of the subordinated debenture on September 17, 2012. The net interest spread decreased fifty-three basis points over the same period for the same reasons.

The average yield on interest-earning assets decreased sixty-one basis points in 2013 compared to 2012 due to the reasons listed above. The loan portfolio as a percentage of average interest earning assets, increased to 77.3% in 2013, from 76.5% in 2012. The investment securities were 19.3% and 17.5% of average interest-earning assets in 2013 and 2012, respectively. Total average interest-earning assets increased $75.2 million, or 5.6%, in 2013 compared to 2012.



Page-36




Table 3        Analysis of Changes in Net Interest Income

The following table presents the effects of changes in average balances (volume) or changes in average rates on net interest income for the years indicated. Volume variances are equal to the increase or decrease in average balances multiplied by prior period rates. Rate variances are equal to the increase or decrease in rates multiplied by prior period average balances. Mix variances are attributable to the change in yields or rates multiplied by the change in average balances.
 
 
2014 compared to 2013
 
2013 compared to 2012
(dollars in thousands; unaudited)
Volume

Yield/Rate

Mix

 
Total

 
Volume

Yield/Rate

Mix

 
Total

Assets
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing due from banks
$
40

$
1

$

 
$
41

 
$
(88
)
$
(10
)
$
4

 
$
(94
)
 
Investment securities 2
1,682

44

11

 
$
1,737

 
1,131

(1,126
)
(186
)
 
(181
)
 
Loans 2
11,351

(541
)
(111
)
 
$
10,699

 
4,088

(8,353
)
(569
)
 
(4,834
)
 
Total interest-earning assets
13,073

(496
)
(100
)
 
12,477

 
5,131

(9,489
)
(751
)
 
(5,109
)
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
Interest-bearing transaction accounts
2

43

2

 
47

 
(55
)
(69
)
25

 
(99
)
 
Savings accounts
9

2


 
11

 
14

(58
)
(9
)
 
(53
)
 
Money market accounts
67

55

9

 
131

 
2

(271
)
(1
)
 
(270
)
 
CDARS® & other time deposits
60

(61
)
(4
)
 
(5
)
 
(188
)
(50
)
9

 
(229
)
 
FHLB borrowings and overnight borrowings
(68
)
78

(17
)
 
(7
)
 
60

(71
)
(12
)
 
(23
)
 
Subordinated debentures
401

(1
)
(13
)
 
387

 
(134
)
154

(137
)
 
(117
)
 
Total interest-bearing liabilities
471

116

(23
)
 
564

 
(301
)
(365
)
(125
)
 
(791
)
Tax-equivalent net interest income
$
12,602

$
(612
)
$
(77
)
 
$
11,913

 
$
5,432

$
(9,124
)
$
(626
)
 
$
(4,318
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1 Yields and interest income on tax-exempt securities and loans are presented on a taxable-equivalent basis using the Federal statutory rate of 35%.

Provision for Loan Losses
 
Management assesses the adequacy of the allowance for loan losses on a quarterly basis based on several factors including growth of the loan portfolio, analysis of probable losses in the portfolio, recent loss experience and the current economic climate.  Actual losses on loans are charged against the allowance, and the allowance is increased by loss recoveries and provisions for loan losses charged to expense.  For further discussion, see the section captioned “Critical Accounting Policies.”
 
Our provision for loan losses totaled $750 thousand in 2014, compared to $540 thousand in 2013 and $2.9 million in 2012. The increase compared to 2013 primarily relates to the increase in total loans. The decrease in 2013 compared to 2012 primarily related to a lower level of newly identified problem loans that had significant credit exposure. In addition, loans acquired from Bank of Alameda in 2013 had been marked down to their fair value without allowances established at the acquisition date. The allowance for loan losses of $15.1 million totaled 1.11% of loans at December 31, 2014, compared to 1.12% at December 31, 2013. Net recoveries in 2014 totaled $124 thousand compared to $24 thousand in the prior year. See the section captioned “Allowance for Loan Losses” below for further analysis of the provision for loan losses.


Page-37



Non-interest Income
 
The table below details the components of non-interest income.

Table 4 Components of Non-Interest Income
 
Years ended
 
2014 compared to 2013
 
2013 compared to 2012
 
December 31,
 
Amount
 
Percent
 
Amount
 
Percent
(dollars in thousands; unaudited)
2014
2013
2012
 
Increase (Decrease)
 
Increase (Decrease)
 
Increase (Decrease)
 
Increase (Decrease)
Service charges on deposit accounts
$
2,167

$
2,062

$
2,130

 
$
105

 
5.1
 %
 
$
(68
)
 
(3.2
)%
Wealth Management and Trust Services
2,309

2,162

1,964

 
147

 
6.8
 %
 
198

 
10.1
 %
Debit card interchange fees
1,378

1,104

1,015

 
274

 
24.8
 %
 
89

 
8.8
 %
Merchant interchange fees
803

822

739

 
(19
)
 
(2.3
)%
 
83

 
11.2
 %
Earnings on Bank-owned life insurance
841

954

762

 
(113
)
 
(11.8
)%
 
192

 
25.2
 %
Gain (loss) on sale of securities
80

(1
)
(34
)
 
81

 
NM

 
33

 
NM

Other income
1,463

963

536

 
500

 
51.9
 %
 
427

 
79.7
 %
Total non-interest income
$
9,041

$
8,066

$
7,112

 
$
975

 
12.1
 %
 
$
954

 
13.4
 %
NM - not meaningful
 
 
 
 
 
 
 
 
 
 
 

2014 Compared with 2013:

Service charges on deposit accounts increased in 2014 when compared to 2013 primarily due to increased volume related to the NorCal acquisition.

The increase in Wealth Management and Trust Services ("WMTS") income in 2014 compared to 2013 is due to the acquisition of new assets and market value appreciation of existing assets under management. Assets under management totaled approximately $352.2 million at December 31, 2014 and $335.9 million at December 31, 2013.      

Debit card interchange fees increased in 2014 when compared to the prior year primarily due to an increase in the volume of debit card usage. Bank-owned life insurance (“BOLI”) income decreased in 2014 compared to 2013 due to a $228 thousand benefit realized on the death of an insured employee in the first quarter of 2013, partially offset by earnings from additional policies.

Other income increased when compared to the prior year primarily due to higher dividend income from the FHLB and higher commission income from mortgage brokerage activity. We discontinued the small mortgage brokerage acquired from Bank of Alameda effective June 30, 2014 and the financial impact is not expected to be material.


2013 Compared with 2012:

The increase in Wealth Management and Trust Services ("WMTS") income in 2013 compared to 2012 is due to the acquisition of new assets and the market value appreciation of existing assets under management. The increase is also due to significant non-recurring fees earned for estate and probate administration services performed in the first quarter of 2013. Assets under management totaled approximately $335.9 million at December 31, 2013 and $285.4 million at December 31, 2012.    

Debit card interchange fees increased in 2013 when compared to the prior year primarily due to an increase in the volume of debit card usage. The increase in merchant interchange fees is primarily due to the addition of a new vendor. Bank-owned life insurance ("BOLI") income increased in 2013 compared to 2012 due to a $228 thousand benefit realized on the death of an insured employee in the first quarter of 2013.


Page-38



Other income increased when compared to the prior year primarily due to higher dividend income from the FHLB and higher credit card referral fees.

Non-interest Expense
 
The table below details the components of non-interest expense. Our efficiency ratio (the ratio of non-interest expense divided by the sum of non-interest income and net interest income) totaled 59.46%, 65.97% and 55.04% in 2014, 2013 and 2012, respectively.
Table 5 Components of Non-Interest Expense
 
Years ended
2014 compared to 2013
2013 compared to 2012
 
December 31,
Amount
Percent
Amount
Percent
(dollars in thousands; unaudited)
2014
2013
2012
Increase (Decrease)
Increase (Decrease)
Increase (Decrease)
Increase (Decrease)
Salaries and related benefits
$
25,005

$
21,974

$
21,139

$
3,031

13.8
 %
$
835

4.0
 %
Occupancy and equipment
5,470

4,347

4,230

1,123

25.8
 %
117

2.8
 %
Depreciation and amortization
1,585

1,395

1,355

190

13.6
 %
40

3.0
 %
FDIC insurance
1,032

921

917

111

12.1
 %
4

0.4
 %
Data processing
3,665

5,334

2,514

(1,669
)
(31.3
)%
2,820

112.2
 %
Professional services
2,230

2,985

2,340

(755
)
(25.3
)%
645

27.6
 %
Provision for (reversal of) losses on off-
    balance sheet commitments
334

112

(52
)
222

198.2
 %
164

(315.4
)%
Other non-interest expense
 
 
 








Advertising
400

490

541

(90
)
(18.4
)%
(51
)
(9.4
)%
  Impairment and amortization of core
      deposit intangible
771

69


702

NM

69

NM

    Other expense
6,771

6,465

5,710

306

4.7
 %
755

13.2
 %
Total other non-interest expense
7,942

7,024

6,251

918

13.1
 %
773

12.4
 %
Total non-interest expense
$
47,263

$
44,092

$
38,694

$
3,171

7.2
 %
$
5,398

14.0
 %
NM - not meaningful
 
 
 
 
 
 
 
  
2014 Compared with 2013:

The increase in salaries and benefit expenses was mainly due to higher salaries and commissions and associated payroll taxes, due to an increase in personnel from the NorCal acquisition and the addition of commercial lenders, as well as higher costs incurred in 2014 from the temporary NorCal acquisition integration staff. These expenses were partially offset by higher capitalized and deferred loan origination costs. The number of average FTE totaled 266 in 2014 and 242 in 2013.
 
The increase in occupancy and equipment primarily reflects higher rent and common area maintenance expenses and other occupancy expenses related to new facilities from the NorCal acquisition.

The decrease in data processing expenses in 2014 primarily reflects one-time acquisition-related expenses totaling $2.8 million in the fourth quarter of 2013, mainly relating to NorCal's core processing system contract termination and deconversion fees, partially offset by $746 thousand of NorCal deconversion expense recognized in the first quarter of 2014 and increased data processing transaction volumes due to the NorCal acquisition.
 
Professional service expenses in 2014 decreased when compared to 2013. This is primarily due to $660 thousand of 2013 professional and legal fees related to the NorCal acquisition and cost savings on various professional services in 2014.

FDIC insurance and other expenses include higher on-going expenses as a result of larger size and increased transaction volume. In addition, $771 thousand amortization of core deposit intangibles from the NorCal acquisition were recorded in other expense in 2014 compared to $69 thousand in 2013. The increase in the provision for off-

Page-39



balance sheet commitments was primarily due to a change in allowance for loan loss methodology applied to these commitments.

2013 Compared with 2012:

The increase in salaries and benefit expenses was mainly due to higher salaries and commission and associated payroll taxes, as well as annual merit increases and the addition to FTE staff. These expenses were partially offset by higher capitalized and deferred loan origination costs, as our standard loan origination costs were revised effective January 1, 2013 and applied to 2013 loan originations. The number of average FTE totaled 242 in 2013 and 233 in 2012.

The increase in data processing expenses in 2013 primarily reflects one-time acquisition-related expenses totaling $2.8 million in the fourth quarter, mainly relating to NorCal's core processing system contract termination and deconversion fees.
 
Professional service expenses in 2013 increased when compared to 2012. This is primarily due to $660 thousand of professional and legal fees related to the NorCal acquisition.

The decrease in advertising expenses in 2013 was primarily due to a higher volume of production-related expenses associated with customer testimonials and marketing campaigns that took place in 2012.

The increase in other expenses when compared to 2012 primarily reflects an increase in recruitment fees, merchant card expenses and a higher provision for losses on off-balance sheet commitments, as well as increases in education and training and directors expenses.

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Provision for Income Taxes

The provision for income taxes totaled $11.7 million at an effective tax rate of 37.2% in 2014, compared to $7.9 million at an effective tax rate of 35.7% in 2013 and $10.9 million at an effective tax rate of 37.9% in 2012. The increase in both the provision for income taxes and the effective tax rate from the prior year is primarily due to: 1) a higher amount of pre-tax income with the effect of diluting the tax benefits from tax-exempt earnings; 2) lower amounts of tax-exempt earnings on bank-owned life insurance; and 3) the expiration of the California Enterprise Zone tax benefits at January 1, 2014. These provisions reflect accruals for taxes at the applicable rates for federal income tax and California franchise tax based upon reported pre-tax income, and adjusted for the effects of all permanent differences between income for tax and financial reporting purposes (such as earnings on qualified municipal securities, BOLI and certain tax-exempt loans). Therefore, there are fluctuations in the effective rate from period to period based on the relationship of net permanent differences to income before tax.

Additionally, effective tax rates reflect the adoption of the amended FASB Accounting Standards Codification ("ASC") Topic 323-740 Investments—Equity Method and Joint Ventures—Income Taxes. Beginning 2014, we adopted this ASU to apply the proportional amortization methodology in accounting for low income tax credit investments. In accordance with ASC 323-740, the tax credit investment amortization expense is now presented as a component of provision for income taxes. Previously, the amortization expense was included as non-interest expense. This change resulted in lower non-interest expense, increased income tax expense and an increased effective tax rate, but did not alter the amount of income taxes actually paid by the Bank. For further discussion, see Note 1, Note 3 and Note 12 to Item 8. Financial Statements and Supplementary Data.

We file a consolidated return in the U.S. Federal tax jurisdiction and a combined return in the State of California tax jurisdiction. There were no ongoing federal income tax examinations at the issuance of this report. The State of California is currently examining 2011 and 2012 corporate income tax returns. At the time of issuance of this report, no adjustments have been proposed by the California Franchise Tax Board in connection with the examination. Although timing of the resolution or closure of the examination is uncertain, we do not anticipate a need to establish a reserve for uncertain tax positions in the next 12 months. At December 31, 2014 and 2013, neither the Bank nor Bancorp had accruals for interest and penalties related to unrecognized tax benefits.

FINANCIAL CONDITION

Investment Securities

We maintain an investment securities portfolio to provide liquidity and to generate earnings on funds that have not been loaned to customers. Management determines the maturities and types of securities to be purchased based on liquidity and the desire to attain a reasonable investment yield balanced with risk exposure. Table 6 shows the composition of the debt securities portfolio by expected maturity at December 31, 2014 and 2013. Expected maturities differ from contractual maturities because the issuers of the securities may have the right to call or prepay obligations with or without call or prepayment penalties. We estimate and update expected maturity dates regularly based on current and historical prepayment speeds. The weighted average maturity of the portfolio at December 31, 2014 was approximately four years.

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Table 6 Investment Securities
 
December 31, 2014
 
December 31, 2013
(dollars in thousands; unaudited)
 
 
 
Weighted

 
 
 
 
Weighted

 
Principal

Amortized

Fair

Average

 
Principal

Amortized

Fair

Average

Type and Maturity Grouping
Amount

Cost1

Value

Yield2

 
Amount

Cost1

Value

Yield2

Held-to-maturity
 
 
 
 
 
 
 
 
 
State and municipal
 
 
 
 
 
 
 
 
 
Due within 1 year
$
18,440

$
18,536

$
18,636

2.37
%
 
$
13,475

$
13,588

$
13,655

2.50
%
Due after 1 but within 5 years
34,705

36,287

37,377

3.80

 
48,285

50,228

51,116

3.22

Due after 5 but within 10 years
8,395

8,602

9,108

6.18

 
15,615

16,565

16,658

4.95

Due after 10 years




 




Total
61,540

63,425

65,121

3.70

 
77,375

80,381

81,429

3.45

Corporate bonds
 
 
 
 
 
 
 
 
 
Due within 1 year
24,975

25,060

25,120

1.55

 
1,435

1,435

1,430

0.50

Due after 1 but within 5 years
15,011

15,197

15,328

1.89

 
39,986

40,679

40,999

1.68

Total
39,986

40,257

40,448

1.68

 
41,421

42,114

42,429

1.64

MBS/CMOs issued by U.S. government agencies
 
 
 
 
 
 
 
 
 
Due after 1 but within 5 years
5,798

6,222

6,323

4.32

 




Due after 5 but within 10 years
6,565

6,533

6,751

2.26

 




Total
12,363

12,755

13,074

3.23

 




Total held-to-maturity
113,889

116,437

118,643

2.94

 
118,796

122,495

123,858

2.81

Available-for-sale
 
 
 
 
 
 
 
 
 
MBS/CMOs issued by U.S. government agencies
 
 
 
 
 
 
 
 
 
Due within 1 year




 
544

546

549

2.88

Due after 1 but within 5 years
104,525

105,761

107,190

2.31

 
144,029

146,480

146,517

2.44

Due after 5 but within 10 years
47,130

48,227

48,402

2.25

 
43,264

44,264

43,538

2.47

Due after 10 years
2,542

2,557

2,527

2.13

 




Total
154,197

156,545

158,119

2.29

 
187,837

191,290

190,604

2.45

State and municipal
 
 
 
 
 
 
 
 
 
Due within 1 year
2,355

2,378

2,387

2.01

 
2,980

3,001

3,000

1.82

Due after 1 but within 5 years
10,860

11,264

11,323

2.40

 
11,300

11,626

11,505

2.34

Due after 5 but within 10 years
750

725

736

3.18

 
1,365

1,321

1,266

2.90

Due after 10 years
1,395

1,366

1,434

5.08

 




Total
15,360

15,733

15,880

2.62

 
15,645

15,948

15,771

2.29

Debentures of government sponsored agencies
 
 
 
 
 
 
 
 
 
Due within 1 year




 
2,000

2,019

2,019

0.17

Due after 1 but within 5 years
14,500

14,694

14,557

1.66

 
9,500

9,826

9,889

1.57

Due after 5 but within 10 years




 
10,000

10,000

9,404

1.49

Total
14,500

14,694

14,557

1.66

 
21,500

21,845

21,312

1.40

Privately issued CMOs
 
 
 
 
 
 
 
 
 
Due within 1 year
7,077

6,818

6,988

3.58

 




Due after 1 but within 5 years




 
7,966

7,599

7,835

3.45

Due after 5 but within 10 years




 
3,218

3,050

3,039

2.20

Due after 10 years
319