Note 3 - Loans

Year-end loans consisted of the following:


	2012			2011

Commercial and industrial:
Commercial	$	4,357,100		$	3,553,989
Leases		278,535			193,412
Asset-based		192,977			169,466

Total commercial and industrial		4,828,612			3,916,867

Commercial real estate:
Commercial mortgages		2,495,481			2,383,479
Construction		608,306			434,870
Land		216,008			202,478

Total commercial real estate		3,319,795			3,020,827

Consumer real estate:
Home equity loans		310,675			282,244
Home equity lines of credit		186,522			191,960
1-4 family residential mortgages		38,323			45,943
Construction		17,621			17,544
Other		224,206			225,118

Total consumer real estate		777,347			762,809

Total real estate		4,097,142			3,783,636

Consumer and other:
Consumer installment		311,310			301,518
Other		8,435			11,018

Total consumer and other		319,745			312,536

Unearned discounts		(21,651	)		(17,910	)

Total loans	$	9,223,848		$	7,995,129

Loan Origination/Risk Management. The Corporation has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions.

Commercial and industrial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and prudently expand its business. Underwriting standards are designed to promote relationship banking rather than transactional banking. Once it is determined that the borrower’s management possesses sound ethics and solid business acumen, the Corporation’s management examines current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial and industrial loans are primarily made based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial and industrial loans are secured by the assets being financed or other business assets such as accounts receivable or inventory and may incorporate a personal guarantee; however, some short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

Commercial real estate loans are subject to underwriting standards and processes similar to commercial and industrial loans, in addition to those of real estate loans. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally largely dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Corporation’s commercial real estate portfolio are diverse in terms of type and geographic location. This diversity helps reduce the Corporation’s exposure to adverse economic events that affect any single market or industry. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. As a general rule, the Corporation avoids financing single-purpose projects unless other underwriting factors are present to help mitigate risk. The Corporation also utilizes third-party experts to provide insight and guidance about economic conditions and trends affecting market areas it serves. In addition, management tracks the level of owner-occupied commercial real estate loans versus non-owner occupied loans. At December 31, 2012, approximately 56% of the outstanding principal balance of the Corporation’s commercial real estate loans were secured by owner-occupied properties.

With respect to loans to developers and builders that are secured by non-owner occupied properties that the Corporation may originate from time to time, the Corporation generally requires the borrower to have had an existing relationship with the Corporation and have a proven record of success. Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews, sensitivity analysis of absorption and lease rates and financial analysis of the developers and property owners. Construction loans are generally based upon estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Corporation until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

The Corporation originates consumer loans utilizing a computer-based credit scoring analysis to supplement the underwriting process. To monitor and manage consumer loan risk, policies and procedures are developed and modified, as needed, jointly by line and staff personnel. This activity, coupled with relatively small loan amounts that are spread across many individual borrowers, minimizes risk. Additionally, trend and outlook reports are reviewed by management on a regular basis. Underwriting standards for home equity loans are heavily influenced by statutory requirements, which include, but are not limited to, a maximum loan-to-value percentage of 80%, collection remedies, the number of such loans a borrower can have at one time and documentation requirements.

The Corporation maintains an independent loan review department that reviews and validates the credit risk program on a periodic basis. Results of these reviews are presented to management. The loan review process complements and reinforces the risk identification and assessment decisions made by lenders and credit personnel, as well as the Corporation’s policies and procedures.

Concentrations of Credit. Most of the Corporation’s lending activity occurs within the State of Texas, including the four largest metropolitan areas of Austin, Dallas/Ft. Worth, Houston and San Antonio, as well as other markets. The majority of the Corporation’s loan portfolio consists of commercial and industrial and commercial real estate loans. Other than energy loans, as of December 31, 2012 and 2011, there were no concentrations of loans related to any single industry in excess of 10% of total loans.

Student Loans Held for Sale. Prior to the second quarter of 2008, the Corporation originated student loans primarily for sale in the secondary market. These loans were generally sold on a non-recourse basis and were carried at the lower of cost or market on an aggregate basis. During the second quarter of 2008, the Corporation elected to discontinue the origination of student loans for resale, aside from previously outstanding commitments. All remaining student loans were sold during the second quarter of 2010.

Foreign Loans. The Corporation has U.S. dollar denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at December 31, 2012 or 2011.

Overdrafts. Deposit account overdrafts reported as loans totaled $102.4 million and $5.2 million at December 31, 2012 and 2011. At December 31, 2012, commercial and industrial loans included $95.3 million related to an overdraft by a correspondent bank customer. The overdraft cleared subsequent to year-end.

Related Party Loans. In the ordinary course of business, the Corporation has granted loans to certain directors, executive officers and their affiliates (collectively referred to as “related parties”). These loans were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other unaffiliated persons and do not involve more than normal risk of collectibility. Activity in related party loans during 2012 is presented in the following table. Other changes were primarily related to decreased letters of credit and changes in related party status.


Balance outstanding at December 31, 2011	$	61,357
Principal additions		107,935
Principal reductions		(99,273	)
Other changes		(4,773	)

Balance outstanding at December 31, 2012	$	65,246

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. In determining whether or not a borrower may be unable to meet payment obligations for each class of loans, the Corporation considers the borrower’s debt service capacity through the analysis of current financial information, if available, and/or current information with regards to the Corporation’s collateral position. Regulatory provisions would typically require the placement of a loan on non-accrual status if (i) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection or (ii) full payment of principal and interest is not expected. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income on non-accrual loans is recognized only to the extent that cash payments are received in excess of principal due. A loan may be returned to accrual status when all the principal and interest amounts contractually due are brought current and future principal and interest amounts contractually due are reasonably assured, which is typically evidenced by a sustained period (at least six months) of repayment performance by the borrower.

Year-end non-accrual loans, segregated by class of loans, were as follows:


	2012		2011

Commercial and industrial:
Energy	$	1,150	$	-
Other commercial		45,158		43,874
Commercial real estate:
Buildings, land and other		38,631		43,820
Construction		1,100		1,329
Consumer real estate		2,773		4,587
Consumer and other		932		728

Total	$	89,744	$	94,338

As of December 31, 2012, non-accrual loans reported in the table above included $2.2 million related to loans that were restructured as “troubled debt restructurings” during 2012. See the section captioned “Troubled Debt Restructurings” elsewhere in this note.

Had non-accrual loans performed in accordance with their original contract terms, the Corporation would have recognized additional interest income, net of tax, of approximately $2.6 million in 2012, $3.3 million in 2011, and $3.9 million in 2010.

An age analysis of past due loans (including both accruing and non-accruing loans), segregated by class of loans, as of December 31, 2012 was as follows:


	Loans 30-89 Days Past Due		Loans 90 or More Days Past Due		Total Past Due Loans		Current Loans			Total Loans			Accruing Loans 90 or More Days Past Due

Commercial and industrial:
Energy	$	714	$	1,427	$	2,141	$	1,081,045		$	1,083,186		$	1,427
Other commercial		21,328		8,438		29,766		3,715,660			3,745,426			1,722
Commercial real estate:
Buildings, land and other		14,413		4,528		18,941		2,692,548			2,711,489			438
Construction		1,028		-		1,028		607,278			608,306			-
Consumer real estate		5,601		3,874		9,475		767,872			777,347			2,786
Consumer and other		2,755		827		3,582		316,163			319,745			621
Unearned discounts		-		-		-		(21,651	)		(21,651	)		-

Total	$	45,839	$	19,094	$	64,933	$	9,158,915		$	9,223,848		$	6,994

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Corporation will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectibility of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Regulatory guidelines require the Corporation to reevaluate the fair value of collateral supporting impaired collateral dependent loans on at least an annual basis. While the Corporation’s policy is to comply with the regulatory guidelines, the Corporation’s general practice is to reevaluate the fair value of collateral supporting impaired collateral dependent loans on a quarterly basis. Thus, appraisals are never considered to be outdated, and the Corporation does not need to make any adjustments to the appraised values. The fair value of collateral supporting impaired collateral dependent loans is evaluated by the Corporation’s internal appraisal services using a methodology that is consistent with the Uniform Standards of Professional Appraisal Practice. The fair value of collateral supporting impaired collateral dependent construction loans is based on an “as is” valuation.

Year-end impaired loans are set forth in the following table. No interest income was recognized on impaired loans subsequent to their classification as impaired.


	Unpaid Contractual Principal Balance		Recorded Investment With No Allowance		Recorded Investment With Allowance		Total Recorded Investment		Related Allowance		Average Recorded Investment

2012
Commercial and industrial:
Energy	$	1,255	$	-	$	1,069	$	1,069	$	900	$	214
Other commercial		56,784		21,709		19,096		40,805		4,200		42,630
Commercial real estate:
Buildings, land and other		44,652		19,010		17,149		36,159		3,137		40,258
Construction		1,497		1,100		-		1,100		-		1,392
Consumer real estate		961		864		-		864		-		1,617
Consumer and other		428		400		-		400		-		469

Total	$	105,577	$	43,083	$	37,314	$	80,397	$	8,237	$	86,580

2011
Commercial and industrial:
Energy	$	-	$	-	$	-	$	-	$	-	$	-
Other commercial		57,723		34,712		4,619		39,331		2,696		53,830
Commercial real estate:
Buildings, land and other		51,163		38,686		2,243		40,929		1,113		48,635
Construction		1,568		1,281		-		1,281		-		4,339
Consumer real estate		2,499		1,719		751		2,470		95		1,845
Consumer and other		562		554		-		554		-		265

Total	$	113,515	$	76,952	$	7,613	$	84,565	$	3,904	$	108,914

The average recorded investment in impaired loans was $130.8 million in 2010.

Troubled Debt Restructurings. The restructuring of a loan is considered a “troubled debt restructuring” if both (i) the borrower is experiencing financial difficulties and (ii) the creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Troubled debt restructurings during 2012 and 2011 are set forth in the following table. There were no troubled debt restructurings during 2010.


	2012				2011
	Balance at Restructure		Balance at Year-end		Balance at Restructure		Balance at Year-end

Commercial and industrial:
Other commercial	$	1,602	$	1,478	$	191	$	179
Commercial real estate:
Buildings, land and other		714		710		7,519		6,183
Consumer real estate		-		-		969		932
Consumer		-		-		469		456

	$	2,316	$	2,188	$	9,148	$	7,750

All of the loans identified as troubled debt restructurings by the Corporation were previously on non-accrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans or converting the loans to interest only for a limited period of time. The Corporation did not grant interest-rate concessions on any restructured loan. All loans restructured during 2011 and 2012 that remain outstanding are on non-accrual status as of December 31, 2012. See the section captioned “Non-accrual Loans” elsewhere in this note. Because the loans were classified and on non-accrual status both before and after restructuring, the modifications did not impact the Corporation’s determination of the allowance for loan losses. Payment defaults on loans restructured in troubled debt restructurings during the reported periods were not significant.

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Corporation’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) the delinquency status of consumer loans (see details above) (iv) net charge-offs, (v) non-performing loans (see details above) and (vi) the general economic conditions in the State of Texas.

The Corporation utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 14. A description of the general characteristics of the 14 risk grades is as follows:

Grades 1, 2 and 3 - These grades include loans to very high credit quality borrowers of investment or near investment grade. These borrowers are generally publicly traded (grades 1 and 2), have significant capital strength, moderate leverage, stable earnings and growth, and readily available financing alternatives. Smaller entities, regardless of strength, would generally not fit in these grades.

Grades 4 and 5 - These grades include loans to borrowers of solid credit quality with moderate risk. Borrowers in these grades are differentiated from higher grades on the basis of size (capital and/or revenue), leverage, asset quality and the stability of the industry or market area.

Grades 6, 7 and 8 - These grades include “pass grade” loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Grades 4 and 5 in terms of size, secondary sources of repayment or they are of lesser stature in other key credit metrics in that they may be over-leveraged, under capitalized, inconsistent in performance or in an industry or an economic area that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

Grade 9 - This grade includes loans on management’s “watch list” and is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term.

Grade 10 - This grade is for “Other Assets Especially Mentioned” in accordance with regulatory guidelines. This grade is intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

Grade 11 - This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has not been stopped. By definition under regulatory guidelines, a “Substandard” loan has defined weaknesses which make payment default or principal exposure likely, but not yet certain. Such loans are apt to be dependent upon collateral liquidation, a secondary source of repayment or an event outside of the normal course of business.

Grade 12 - This grade includes “Substandard” loans, in accordance with regulatory guidelines, for which the accrual of interest has been stopped. This grade includes loans where interest is more than 120 days past due and not fully secured and loans where a specific valuation allowance may be necessary, but generally does not exceed 30% of the principal balance.

Grade 13 - This grade includes “Doubtful” loans in accordance with regulatory guidelines. Such loans are placed on non-accrual status and may be dependent upon collateral having a value that is difficult to determine or upon some near-term event which lacks certainty. Additionally, these loans generally have a specific valuation allowance in excess of 30% of the principal balance.

Grade 14 - This grade includes “Loss” loans in accordance with regulatory guidelines. Such loans are to be charged-off or charged-down when payment is acknowledged to be uncertain or when the timing or value of payments cannot be determined. “Loss” is not intended to imply that the loan or some portion of it will never be paid, nor does it in any way imply that there has been a forgiveness of debt.

In monitoring credit quality trends in the context of assessing the appropriate level of the allowance for loan losses, the Corporation monitors portfolio credit quality by the weighted-average risk grade of each class of commercial loan. Individual relationship managers review updated financial information for all pass grade loans to recalculate the risk grade on at least an annual basis. When a loan has a calculated risk grade of 9, it is still considered a pass grade loan; however, it is considered to be on management’s “watch list,” where a significant risk-modifying action is anticipated in the near term. When a loan has a calculated risk grade of 10 or higher, a special assets officer monitors the loan on an on-going basis. The following table presents weighted average risk grades for all commercial loans by class.


	December 31, 2012				December 31, 2011
	Weighted Average Risk Grade		Loans		Weighted Average Risk Grade		Loans

Commercial and industrial:
Energy
Risk grades 1-8		5.24	$	1,081,725		5.21	$	868,561
Risk grade 9		9.00		392		9.00		2,025
Risk grade 10		10.00		-		10.00		-
Risk grade 11		11.00		-		11.00		-
Risk grade 12		12.00		169		12.00		-
Risk grade 13		13.00		900		13.00		-

Total energy		5.25	$	1,083,186		5.22	$	870,586

Other commercial
Risk grades 1-8		5.81	$	3,367,443		6.20	$	2,802,037
Risk grade 9		9.00		250,508		9.00		55,105
Risk grade 10		10.00		28,440		10.00		49,982
Risk grade 11		11.00		53,797		11.00		96,046
Risk grade 12		12.00		40,603		12.00		39,826
Risk grade 13		13.00		4,635		13.00		3,285

Total other commercial		6.21	$	3,745,426		6.55	$	3,046,281

Commercial real estate:
Buildings, land and other
Risk grades 1-8		6.63	$	2,460,448		6.69	$	2,266,576
Risk grade 9		9.00		92,041		9.00		103,894
Risk grade 10		10.00		42,603		10.00		45,278
Risk grade 11		11.00		77,658		11.00		126,594
Risk grade 12		12.00		35,602		12.00		41,747
Risk grade 13		13.00		3,137		13.00		1,868

Total commercial real estate		6.97	$	2,711,489		7.14	$	2,585,957

Construction
Risk grades 1-8		6.82	$	579,108		6.95	$	378,530
Risk grade 9		9.00		23,046		9.00		30,376
Risk grade 10		10.00		4,435		10.00		16,186
Risk grade 11		11.00		617		11.00		8,449
Risk grade 12		12.00		1,100		12.00		1,329
Risk grade 13		13.00		-		13.00		-

Total construction		6.94	$	608,306		7.30	$	434,870

The Corporation has established maximum loan to value standards to be applied during the origination process of commercial and consumer real estate loans. The Corporation does not subsequently monitor loan-to-value ratios (either individually or on a weighted-average basis) for loans that are subsequently considered to be of a pass grade (grades 9 or better) and/or current with respect to principal and interest payments. As stated above, when an individual commercial real estate loan has a calculated risk grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired. At that time, the Corporation reassesses the loan to value position in the loan. If the loan is determined to be collateral dependent, specific allocations of the allowance for loan losses are made for the amount of any collateral deficiency. If a collateral deficiency is ultimately deemed to be uncollectible, the amount is charged-off. These loans and related assessments of collateral position are monitored on an individual, case-by-case basis. The Corporation does not monitor loan-to-value ratios on a weighted-average basis for commercial real estate loans having a calculated risk grade of 10 or higher. Nonetheless, there were 4 commercial real estate loans having a calculated risk grade of 10 or higher in excess of $5 million as of December 31, 2012, which totaled $38.5 million and had a weighted-average loan-to-value ratio of 65.9%. When an individual consumer real estate loan becomes past due by more than 10 days, the assigned relationship manager will begin collection efforts. The Corporation only reassesses the loan to value position in a consumer real estate loan if, during the course of the collections process, it is determined that the loan has become collateral dependent, and any collateral deficiency is recognized as a charge-off to the allowance for loan losses. Accordingly, the Corporation does not monitor loan-to-value ratios on a weighted-average basis for collateral dependent consumer real estate loans.

Generally, a commercial loan, or a portion thereof, is charged-off immediately when it is determined, through the analysis of any available current financial information with regards to the borrower, that the borrower is incapable of servicing unsecured debt, there is little or no prospect for near term improvement and no realistic strengthening action of significance is pending or, in the case of secured debt, when it is determined, through analysis of current information with regards to the Corporation’s collateral position, that amounts due from the borrower are in excess of the calculated current fair value of the collateral. Notwithstanding the foregoing, generally, commercial loans that become past due 180 cumulative days are classified as a loss and charged-off. Generally, a consumer loan, or a portion thereof, is charged-off in accordance with regulatory guidelines which provide that such loans be charged-off when the Corporation becomes aware of the loss, such as from a triggering event that may include new information about a borrower’s intent/ability to repay the loan, bankruptcy, fraud or death, among other things, but in no case should the charge-off exceed specified delinquency timeframes. Such delinquency timeframes state that closed-end retail loans (loans with pre-defined maturity dates, such as real estate mortgages, home equity loans and consumer installment loans) that become past due 120 cumulative days and open-end retail loans (loans that roll-over at the end of each term, such as home equity lines of credit) that become past due 180 cumulative days should be classified as a loss and charged-off.

Net (charge-offs)/recoveries, segregated by class of loan, were as follows:


	2012			2011			2010

Commercial and industrial:
Energy	$	4		$	6		$	-
Other commercial		(13,627	)		(29,158	)		(28,530	)
Commercial real estate:
Buildings, land and other		698			(8,980	)		(5,928	)
Construction		78			(454	)		(616	)
Consumer real estate		(638	)		(2,293	)		(2,059	)
Consumer and other		(2,289	)		(2,735	)		(5,471	)

Total	$	(15,774	)	$	(43,614	)	$	(42,604	)

In assessing the general economic conditions in the State of Texas, management monitors and tracks the Texas Leading Index (“TLI”), which is produced by the Federal Reserve Bank of Dallas. The TLI is a single summary statistic that is designed to signal the likelihood of the Texas economy’s transition from expansion to recession and vice versa. Management believes this index provides a reliable indication of the direction of overall credit quality. The TLI is a composite of the following eight leading indicators: (i) Texas Value of the Dollar, (ii) U.S. Leading Index, (iii) real oil prices (iv) well permits, (v) initial claims for unemployment insurance, (vi) Texas Stock Index, (vii) Help-Wanted Index and (viii) average weekly hours worked in manufacturing. The TLI totaled 123.0 at November 30, 2012 (most recent date available) and 120.3 at December 31, 2011. A higher TLI value implies more favorable economic conditions.

Allowance for Loan Losses. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for loan loss methodology follows the accounting guidance set forth in U.S. generally accepted accounting principles and the Interagency Policy Statement on the Allowance for Loan and Lease Losses, which was jointly issued by the U.S. bank regulatory agencies. In that regard, the Corporation’s allowance for loan losses includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions. The Corporation’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools.

The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss and recovery experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate determination of the appropriate level of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including, among other things, the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time.

The Corporation’s allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with ASC Topic 310 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with ASC Topic 450 based on historical loan loss experience for similar loans with similar characteristics and trends, adjusted, as necessary, to reflect the impact of current conditions; and (iii) general valuation allowances determined in accordance with ASC Topic 450 based on general economic conditions and other risk factors both internal and external to the Corporation.

The allowances established for probable losses on specific loans are based on a regular analysis and evaluation of problem loans. Loans are classified based on an internal credit risk grading process that evaluates, among other things: (i) the obligor’s ability to repay; (ii) the underlying collateral, if any; and (iii) the economic environment and industry in which the borrower operates. This analysis is performed at the relationship manager level for all commercial loans. When a loan has a calculated grade of 10 or higher, a special assets officer analyzes the loan to determine whether the loan is impaired and, if impaired, the need to specifically allocate a portion of the allowance for loan losses to the loan. Specific valuation allowances are determined by analyzing the borrower’s ability to repay amounts owed, collateral deficiencies, the relative risk grade of the loan and economic conditions affecting the borrower’s industry, among other things.

Historical valuation allowances are calculated based on the historical gross loss experience of specific types of loans and the internal risk grade of such loans at the time they were charged-off. The Corporation calculates historical gross loss ratios for pools of similar loans with similar characteristics based on the proportion of actual charge-offs experienced to the total population of loans in the pool. The historical gross loss ratios are periodically updated based on actual charge-off experience. A historical valuation allowance is established for each pool of similar loans based upon the product of the historical gross loss ratio and the total dollar amount of the loans in the pool. The Corporation’s pools of similar loans include similarly risk-graded groups of commercial and industrial loans, commercial real estate loans, consumer real estate loans and consumer and other loans.

The components of the general valuation allowance include (i) the additional reserves allocated as a result of applying an environmental risk adjustment factor to the base historical loss allocation, (ii) the additional reserves allocated for loans to borrowers in distressed industries and (iii) the additional reserves allocated for groups of similar loans with risk characteristics that exceed certain concentration limits established by management.

The environmental adjustment factor is based upon a more qualitative analysis of risk and is calculated through a survey of senior officers who are involved in credit making decisions at a corporate-wide and/or regional level. On a quarterly basis, survey participants rate the degree of various risks utilizing a numeric scale that translates to varying grades of high, moderate or low levels of risk. The results are then input into a risk-weighting matrix to determine an appropriate environmental risk adjustment factor. The various risks that may be considered in the determination of the environmental adjustment factor include, among other things, (i) the experience, ability and effectiveness of the bank’s lending management and staff; (ii) the effectiveness of the Corporation’s loan policies, procedures and internal controls; (iii) changes in asset quality; (iv) the impact of legislative and governmental influences affecting industry sectors; (v) the effectiveness of the internal loan review function; (vi) the impact of competition on loan structuring and pricing; and (vii) the impact of rising interest rates on portfolio risk. In periods where the surveyed risks are perceived to be higher, the risk-weighting matrix will generally result in a higher environmental adjustment factor, which, in turn will result in higher levels of general valuation allowance allocations. The opposite holds true in periods where the surveyed risks are perceived to be lower.

During 2011, the Corporation refined its methodology for the determination of reserves allocated to specific loan portfolio segments to provide reserves for loans to borrowers in distressed industries. To determine the amount of the allocation, management calculates the weighted-average risk grade for all loans to borrowers in distressed industries by loan portfolio segment. A multiple is then applied to the amount by which the weighted-average risk grade for loans to borrowers in distressed industries exceeds the weighted-average risk grade for all pass-grade loans within the loan portfolio segment to derive an allocation factor for loans to borrowers in distressed industries. The amount of the allocation for each loan portfolio segment is the product of this allocation factor and the outstanding balance of pass-grade loans within the identified distressed industries that have a risk grade of 6 or higher. This change in the Corporation’s methodology for the determination of reserves allocated to specific loan portfolio segments did not significantly impact the provision for loan losses recorded during 2011. Management identifies potential distressed industries by analyzing industry trends related to delinquencies, classifications and charge-offs. At December 31, 2012 and 2011, contractors were considered to be a distressed industry based on elevated levels of delinquencies, classifications and charge-offs relative to other industries within the Corporation’s loan portfolio. Furthermore, the Corporation determined, through a review of borrower financial information that, as a whole, contractors have experienced, among other things, decreased revenues, reduced backlog of work, compressed margins and little, if any, net income.

General valuation allowances include allocations for groups of loans with similar risk characteristics that exceed certain concentration limits established by management and/or the Corporation’s board of directors. Concentration risk limits have been established, among other things, for certain industry concentrations, large balance and highly leveraged credit relationships that exceed specified risk grades, and loans originated with policy, credit and/or collateral exceptions that exceed specified risk grades. Additionally, general valuation allowances are provided for loans that did not undergo a separate, independent concurrence review during the underwriting process (generally those loans under $1.0 million at origination). The Corporation’s allowance methodology for general valuation allowances also includes a reduction factor for recoveries of prior charge-offs to compensate for the fact that historical loss allocations are based upon gross charge-offs rather than net. The adjustment for recoveries is based on the lower of annualized, year-to-date gross recoveries or the total gross recoveries for the preceding four quarters, adjusted, when necessary, for expected future trends in recoveries.

The following table presents details of the allowance for loan losses, segregated by loan portfolio segment. Prior to 2012, certain general valuation allowances were not allocated to specific loan portfolio segments.


	Commercial and Industrial			Commercial Real Estate			Consumer Real Estate			Consumer and Other			Unallocated			Total

December 31, 2012
Historical valuation allowances	$	30,565		$	15,687		$	3,013		$	7,344		$	-		$	56,609
Specific valuation allowances		5,100			3,137			-			-			-			8,237
General valuation allowances:
Environmental risk adjustment		6,593			3,682			684			1,816			-			12,775
Distressed industries		5,883			1,182			-			-			-			7,065
Excessive industry concentrations		4,291			2,795			-			-			-			7,086
Large relationship concentrations		1,420			981			-			-			-			2,401
Highly-leveraged credit relationships		2,905			699			-			-			-			3,604
Policy exceptions		-			-			-			-			2,466			2,466
Credit and collateral exceptions		-			-			-			-			1,635			1,635
Loans not reviewed by concurrence		2,277			2,413			2,411			1,159			-			8,260
Adjustment for recoveries		(4,870	)		(1,230	)		(856	)		(6,812	)		-			(13,768	)
General macroeconomic risk		-			-			-			-			8,083			8,083

Total	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184		$	104,453

December 31, 2011
Historical valuation allowances	$	30,368		$	15,153		$	2,742		$	9,876		$	-		$	58,139
Specific valuation allowances		2,696			1,113			95			-			-			3,904
General valuation allowances:
Environmental risk adjustment		5,656			3,724			703			2,759			-			12,842
Distressed industries		4,054			922			-			-			-			4,976
Excessive industry concentrations		-			-			-			-			6,995			6,995
Large relationship concentrations		-			-			-			-			2,232			2,232
Highly-leveraged credit relationships		-			-			-			-			3,530			3,530
Policy exceptions		-			-			-			-			2,121			2,121
Credit and collateral exceptions		-			-			-			-			1,603			1,603
Loans not reviewed by concurrence		-			-			-			-			9,030			9,030
Adjustment for recoveries		-			-			-			-			(13,071	)		(13,071	)
General macroeconomic risk		-			-			-			-			17,846			17,846

Total	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147

The Corporation monitors whether or not the allowance for loan loss allocation model, as a whole, calculates an appropriate level of allowance for loan losses that moves in direct correlation to the general macroeconomic and loan portfolio conditions the Corporation experiences over time. In assessing the general macroeconomic trends/conditions, the Corporation analyzes trends in the components of the TLI, as well as any available information related to regional, national and international economic conditions and events and the impact such conditions and events may have on the Corporation and its customers. With regard to assessing loan portfolio conditions, the Corporation analyzes trends in weighted-average portfolio risk-grades, classified and non-performing loans and charge-off activity. In periods where general macroeconomic and loan portfolio conditions are in a deteriorating trend or remain at deteriorated levels, based on historical trends, the Corporation would expect to see the allowance for loan loss allocation model, as a whole, calculate higher levels of required allowances than in periods where general macroeconomic and loan portfolio conditions are in an improving trend or remain at an elevated level, based on historical trends.

The following table details activity in the allowance for loan losses by portfolio segment for 2012, 2011 and 2010. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.


	Commercial and Industrial			Commercial Real Estate			Consumer Real Estate			Consumer and Other			Unallocated			Total

2012
Beginning balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147
Provision for loan losses		25,013			7,658			2,350			(6,839	)		(18,102	)		10,080
Charge-offs		(18,493	)		(3,951	)		(1,495	)		(9,101	)		-			(33,040	)
Recoveries		4,870			4,727			857			6,812			-			17,266

Net charge-offs		(13,623	)		776			(638	)		(2,289	)		-			(15,774	)

Ending balance	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184		$	104,453

Period-end amount allocated to:
Loans individually evaluated for impairment	$	13,171		$	4,366		$	-		$	-		$	-		$	17,537
Loans collectively evaluated for impairment		40,993			24,980			5,252			3,507			12,184			86,916

Ending balance	$	54,164		$	29,346		$	5,252		$	3,507		$	12,184		$	104,453

2011
Beginning balance	$	57,789		$	28,534		$	3,223		$	11,974		$	24,796		$	126,316
Provision for loan losses		14,137			1,812			2,610			3,396			5,490			27,445
Charge-offs		(33,678	)		(10,776	)		(2,789	)		(9,442	)		-			(56,685	)
Recoveries		4,526			1,342			496			6,707			-			13,071

Net charge-offs		(29,152	)		(9,434	)		(2,293	)		(2,735	)		-			(43,614	)

Ending balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147

Period-end amount allocated to:
Loans individually evaluated for impairment	$	15,829		$	3,625		$	95		$	-		$	-		$	19,549
Loans collectively evaluated for impairment		26,945			17,287			3,445			12,635			30,286			90,598

Ending balance	$	42,774		$	20,912		$	3,540		$	12,635		$	30,286		$	110,147


	Commercial and Industrial			Commercial Real Estate			Consumer Real Estate			Consumer and Other			Unallocated		Total

2010
Beginning balance	$	57,394		$	28,514		$	2,560		$	16,929		$	19,912	$	125,309
Provision for loan losses		28,925			6,564			2,722			516			4,884		43,611
Charge-offs		(31,324	)		(7,524	)		(2,682	)		(11,893	)		-		(53,423	)
Recoveries		2,794			980			623			6,422			-		10,819

Net charge-offs		(28,530	)		(6,544	)		(2,059	)		(5,471	)		-		(42,604	)

Ending balance	$	57,789		$	28,534		$	3,223		$	11,974		$	24,796	$	126,316

Period-end amount allocated to:
Loans individually evaluated for impairment	$	31,948		$	8,591		$	-		$	-		$	-	$	40,539
Loans collectively evaluated for impairment		25,841			19,943			3,223			11,974			24,796		85,777

Ending balance	$	57,789		$	28,534		$	3,223		$	11,974		$	24,796	$	126,316

The Corporation’s recorded investment in loans as of December 31, 2012 and 2011 related to each balance in the allowance for loan losses by portfolio segment and disaggregated on the basis of the Corporation’s impairment methodology was as follows:


	Commercial and Industrial		Commercial Real Estate		Consumer Real Estate		Consumer and Other		Unearned Discounts			Total

2012
Loans individually evaluated for impairment	$	128,544	$	165,152	$	864	$	400	$	-		$	294,960
Loans collectively evaluated for impairment		4,700,068		3,154,643		776,483		319,345		(21,651	)		8,928,888

Ending balance	$	4,828,612	$	3,319,795	$	777,347	$	319,745	$	(21,651	)	$	9,223,848

2011
Loans individually evaluated for impairment	$	189,139	$	241,451	$	2,470	$	554	$	-		$	433,614
Loans collectively evaluated for impairment		3,727,728		2,779,376		760,339		311,982		(17,910	)		7,561,515

Ending balance	$	3,916,867	$	3,020,827	$	762,809	$	312,536	$	(17,910	)	$	7,995,129