-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, FojPJuOGYc2pzeZaH/SEU672wbJpRNFqT1PrNQ7zFtfIM7hQaLumV+hvmLs7XDkA 6wzeAZQDCOjWtPQE0pTZog== 0000702902-99-000003.txt : 19990330 0000702902-99-000003.hdr.sgml : 19990330 ACCESSION NUMBER: 0000702902-99-000003 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990329 FILER: COMPANY DATA: COMPANY CONFORMED NAME: HARLEYSVILLE NATIONAL CORP CENTRAL INDEX KEY: 0000702902 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 232210237 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-15237 FILM NUMBER: 99575718 BUSINESS ADDRESS: STREET 1: 483 MAIN ST STREET 2: P O BOX 195 CITY: HARLEYSVILLE STATE: PA ZIP: 19438 BUSINESS PHONE: 2152568851 MAIL ADDRESS: STREET 1: 483 MAIN STREET CITY: HARLEYSVILLE STATE: PA ZIP: 19438 10-K 1 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, 1998. ----------------- OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED] For the transition period from to . ---------- ----------- Commission file number 0-15237 ------- HARLEYSVILLE NATIONAL CORPORATION --------------------------------- (Exact name of registrant as specified in its charter) Pennsylvania 23-2210237 ------------ ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 483 Main Street, Harleysville, Pennsylvania 19438 ------------------------------------------- ----- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (215) 256-8851 Securities registered pursuant to Section 12(b) of the Act: N/A Name of each exchange Title of each class on which registered .N/A N/A. --------------------- Securities registered pursuant to Section 12(g) of the Act: Common Stock, $1.00 par value ----------------------------- Title of Class Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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. --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ( ) PAGE 1 State the aggregate market value of the voting stock held by nonaffiliates of the registrant. The aggregate market value shall be computed by reference to the price at which the stock was sold, or the average bid and asked prices of such stock, as of a specified date within 60 days prior to the date of filing. $236,053,383 as of February 26, 1999 Indicate the number of shares outstanding of each class of the registrant's classes of common stock, as of the latest practicable date. 7,535,899 shares of Common Stock, $1 par value per share, were outstanding as of February 26, 1999. DOCUMENTS INCORPORATED BY REFERENCE: 1. Portions of the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1998 are incorporated by reference into Parts I, II and IV of this report. 2. Portions of the Registrant's Definitive Proxy Statement relating to the Annual Meeting of Shareholders to be held April 13, 1999 are incorporated by reference into Part III of this report. PAGE 2
HARLEYSVILLE NATIONAL CORPORATION INDEX TO FORM 10-K REPORT PAGE ---- I. PART I. Item 1. Business 4 Item 2. Properties 16 Item 3. Legal Proceeding. 18 Item 4. Submission of Matters to a Vote of Security Holders 18 II. PART II. Item 5. Market for Registrant's Common Stock and Related Shareholder Matters 19 Item 6. Selected Financial Data 19 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. 19 Item 7.A. Quantitative and Qualitative Disclosure about Market Risk 19 Item 8. Financial Statements and Supplementary Data 19 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 19 III. PART III. Item 10. Directors and Executive Officers of the Registrant 20 Item 11. Executive Compensation 21 Item 12. Security Ownership of Certain Beneficial Owners and Management 21 Item 13. Certain Relationships and Related Transactions 21 IV. PART IV. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K 22 Signatures 25
PAGE 3 PART I Item 1. Business. - ------- History and Business - ---------------------- Harleysville National Corporation, a Pennsylvania corporation (the Corporation), was incorporated in June 1982. On January 1, 1983, the Corporation became the parent bank holding company of Harleysville National Bank and Trust Company (HNB), a wholly owned subsidiary of the Corporation. On February 13, 1991, the Corporation acquired all of the outstanding common stock of The Citizens National Bank of Lansford (CNB). On June 1, 1992, the Corporation acquired all of the outstanding stock of Summit Hill Trust Company (Summit Hill). On September 25, 1992, Summit Hill merged into CNB and is now operating as a branch office of CNB. On July 1, 1994 the Corporation acquired all of the outstanding stock of Security National Bank (SNB). On March 1, 1996, the Corporation acquired all of the outstanding common stock of Farmers & Merchants Bank ("F & M"). F & M was merged into CNB and is now operating as a branch office of CNB. On March 17, 1997, the HNC Financial Company was incorporated as a Delaware Corporation. HNC Financial Company's principal business function is to expand the investment opportunities of the Corporation. The Corporation is primarily a bank holding company that provides financial services through its three bank subsidiaries. Since commencing operations, the Corporation's business has consisted primarily of managing HNB, CNB and SNB (collectively the Banks), and its principal source of income has been dividends paid by the Banks. The Corporation is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. HNB, which was established in 1909, CNB, which was established in 1903, and SNB, which was established in 1988, (collectively the Banks), are national banking associations under the supervision of the Office of the Comptroller of the Currency (the OCC). The Corporation and HNB's legal headquarters are located at 483 Main Street, Harleysville, Pennsylvania 19438. CNB's legal headquarters is located at 13-15 West Ridge Street, Lansford, Pennsylvania 18232. SNB's legal headquarters is located at One Security Plaza, Pottstown, Pennsylvania 19464. HNC Financial Company's legal headquarters is located at 300 Delaware Avenue, Suite 1704, Wilmington, Delaware 19801. In addition to historical information, this Form 10-K contains forward-looking statements. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of Harleysville National Corporation and its subsidiaries. When we use words such as "believes," "expects," "anticipates," or similar expressions, we are making forward-looking statements. Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that we incorporate by reference, could affect the future financial results of Harleysville National Corporation and its subsidiaries and could cause those results to differ materially from those expressed in our forward-looking statements contained or incorporated by reference in this document. These factors include the following: - - operating, legal and regulatory risks; - - economic, political and competitive forces affecting our banking, securities, asset management and credit services businesses; and - - the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful. As of December 31, 1998, the Corporation had total assets of $1,332,389,000, total shareholders' equity of $122,811,000 and total deposits of $1,033,968,000. The Banks engage in the full-service commercial banking and trust business, including accepting time and demand deposits, making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and performing corporate pension and PAGE 4 personal trust services. Their deposits are insured by the Federal Deposit Insurance Corporation to the extent provided by law. The Banks have 30 branch offices located in Montgomery, Bucks, Carbon, Wayne, Chester and Schuylkill counties, Pennsylvania, 18 of which are owned by the Banks and 12 of which are leased from third parties. The Banks enjoy a stable base of core deposits and are leading community banks in their service areas. The Banks believe they have gained their position as a result of a customer-oriented philosophy and a strong commitment to service. Senior management has made the development of a sales orientation throughout the Banks one of their highest priorities and emphasizes this objective with extensive training and sales incentive programs that the Company believes are unusual for community banks. The Banks maintain close contact with the local business community to monitor commercial lending needs and believe they respond to customer requests quickly and with flexibility. Management believes these competitive strengths are reflected in the Corporation's results of operations. As of December 31, 1998, the Corporation and the Banks employed approximately 483 full-time equivalent employees. The Corporation provides a variety of employment benefits and considers its relationships with its employees to be satisfactory. Competition - ----------- The Banks compete actively with other eastern Pennsylvania financial institutions, many larger than the Banks, as well as with financial and non-financial institutions headquartered elsewhere. The Banks are generally competitive with all competing institutions in their service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts, interest rates charged on loans, and fees and charges for trust services. At December 31, 1998, HNB's legal lending limit to a single customer was $10,829,000 and CNB's and SNB's legal lending limits to a single customer were $3,484,000 and $1,152,000, respectively. Many of the institutions with which the Banks compete are able to lend significantly more than these amounts to a single customer. Supervision and Regulation - The Registrant - ------------------------------------------------ The Corporation is a registered bank holding company subject to the provisions of the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"), and to supervision by the Board of Governors of the Federal Reserve System. The Bank Holding Company Act requires the Registrant to secure the prior approval of the Federal Reserve Board before it owns or controls, directly or indirectly, more than 5% of the voting shares or substantially all of the assets of any institution, including another bank. In addition, the Bank Holding Company Act has been amended by the Riegle-Neal Interstate Banking and Branching Efficiency Act which permits bank holding companies to acquire a bank located in any state subject to certain limitations and restrictions which are more fully described below. A bank holding company is prohibited from engaging in or acquiring direct or indirect control of more than 5% of the voting shares of any company engaged in non-banking activities unless the Federal Reserve, by order or regulation, has found such activities to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making this determination, the Federal Reserve considers whether the performance of these activities by a bank holding company would offer benefits to the public that outweigh possible adverse effects. Federal law also prohibits acquisitions of control of a bank holding company without prior notice to certain federal bank regulators. Control is defined for this purpose as the power, directly or indirectly, to direct the management or policies of the bank or bank holding company or to vote 25% or more of any class of voting securities. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, on investments in the stock or other securities of the bank holding company and on taking of such stock or securities of the bank holding company as collateral for loans to any borrower. PAGE 5 Permitted Activities - --------------------- The Federal Reserve permits bank holding companies to engage in certain activities so closely related to banking or managing or controlling banks as to be proper incident thereto. Other than making an equity investment in a low to moderate income housing limited partnership, the Corporation does not at this time engage in any other permissible activities, nor does the Corporation have any current plans to engage in any other permissible activities in the foreseeable future. Legislation and Regulatory Changes - ------------------------------------- There are currently a number of issues before Congress that may affect the Corporation and its business operations, and the business operations of its subsidiaries. However, management does not believe these issues will have a material adverse effect on liquidity, capital resources or the results of operations. Congress is currently considering legislative reforms to modernize the financial services industry. In addition to including repealing the Glass-Steagall Act, which prohibits commercial banks from engaging in various securities activities, the reforms would allow, if the legislation passes, banks to be involved in underwriting and selling insurance. The Corporation does not currently have plans for entering into these activities, but will continue to investigate business opportunities as they become available The Corporation has analyzed the recently enacted changes to the federal tax law. The impact of such changes on liquidity, operating results, and capital should not be material. From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restrictions on, the business of the Corporation and the Banks. We cannot predict whether the legislation will be enacted or, if enacted, how the legislation would affect the business of the Corporation and the Banks. As a consequence of the extensive regulation of commercial banking activities in the United States, the Corporation's and the Banks' business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Except as specifically described above, management believes that the effect of the provisions of the aforementioned legislation on liquidity, capital resources and results of operations of the Corporation will be immaterial. Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation, which if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation's results of operations. Further, the business of the Corporation is also affected by the state of the financial services industry in general. As a result of legal and industry changes, management predicts that the industry will continue to experience an increase in consolidations and mergers as the financial services industry strives for greater cost efficiencies and market share. Management also expects increased diversification of financial products and services offered by the Banks and its competitors. Management believes that such consolidations and mergers, and diversification of products and services may enhance the Banks' competitive position. Pending Legislation - -------------------- There are numerous proposals before Congress to modify the financial services industry and the way commercial banks and other financial institutions operate. Some of these proposals include changes to the ownership of financial companies and the types of products and services that may be offered by financial institutions. However, it is difficult to determine at this time what effect such provisions may have until they are enacted into law. Management believes that the effect of the provisions of the aforementioned legislation on the liquidity, capital resources, and results of operations of the Corporation will be immaterial. Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, PAGE 6 capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation's results of operations. Effects of Inflation - ---------------------- Inflation has some impact on the Corporation's and the Banks' operating costs. Unlike many industrial companies, however, substantially all of the Banks' assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporation's and the Banks' performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services. Effect of Government Monetary Policies - ------------------------------------------ The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits. The Banks are members of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve have a significant effect on its deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Banks' operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and the Banks cannot be predicted. Environmental Regulations - -------------------------- There are several federal and state statutes which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor the Banks are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and the Banks aware of any circumstances that may give rise to liability under any such statute. Supervision and Regulation - Banks - -------------------------------------- The operations of the Banks are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, to members of the Federal Reserve and to banks whose deposits are insured by the FDIC. The Banks' operations are also subject to regulations of the OCC, the Federal Reserve and the FDIC. The primary supervisory authority of the Banks is the OCC, who regularly examines the Banks. The OCC has authority to prevent a national bank from engaging in unsafe or unsound practices in conducting its business. Federal and state banking laws and regulations govern, among other things, the scope of a bank's business, the investments a bank may make, the reserves against deposits a bank must maintain, loans a bank makes and collateral it takes, the maximum interest rates a bank may pay on deposits, the activities of a bank with respect to mergers and consolidations and the establishment of branches. As a subsidiary bank of a bank holding company, the Banks are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or its subsidiaries, or investments in the stock or other securities as collateral for loans. The Federal Reserve Act and Federal Reserve regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its PAGE 7 parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person becoming a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship. Under the Federal Deposit Insurance Act, the OCC possesses the power to prohibit institutions regulated by it (such as the Banks) from engaging in any activity that would be an unsafe and unsound banking practice or would otherwise be in violation of the law. Under the Community Reinvestment Act of 1977, as amended ("CRA"), the OCC is required to assess the record of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community (including low and moderate income neighborhoods) which they serve and to take this record into account in its evaluation of any application made by any of such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of bank shares. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 amended the CRA to require, among other things, that the OCC make publicly available the evaluation of a bank's record of meeting the credit needs of its entire community, including low and moderate income neighborhoods. This evaluation will include a descriptive rating ("outstanding", "satisfactory", "needs to improve" or "substantial noncompliance") and a statement describing the basis for the rating. These ratings are publicly disclosed. Under the Bank Secrecy Act, banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions of which the bank is aware in any one day that aggregate in excess of $10,000. Civil and criminal penalties are provided under the Bank Secrecy Act for failure to file a required report, for failure to supply information required by the Bank Secrecy Act or for filing a false or fraudulent report. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires that institutions must be classified, based on their risk-based capital ratios into one of five defined categories, as illustrated below (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized).
Total Tier 1 Under a Risk Risk Tier 1 Capital Based Based Leverage Order or Ratio Ratio Ratio Directive ----- ------ -------- --------- CAPITAL CATEGORY - ------------------------------ Well capitalized >10.0 >6.0 >5.0 NO ----- ------ -------- Adequately capitalized > 8.0 >4.0 >4.0* ----- ------ -------- Undercapitalized < 8.0 <4.0 <4.0* Significantly undercapitalized < 6.0 <3.0 <3.0 Critically undercapitalized <2.0 *3.0 for those banks having the highest available regulatory rating.
In the event an institution's capital deteriorates to the undercapitalized category or below, FDICIA prescribes an increasing amount of regulatory intervention, including: (1) the institution of a capital restoration plan and a guarantee of the plan by a parent institution; and (2) the placement of a hold on increases in assets, number of branches or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and (in critically undercapitalized situations) appointment of a receiver. For well capitalized institutions, FDICIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity. All but well capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval. Under FDICIA, financial institutions are subject to increased regulatory PAGE 8 scrutiny and must comply with certain operational, managerial and compensation standards to be developed by Federal Reserve Board regulations. FDICIA also requires the regulators to issue new rules establishing certain minimum standards to which an institution must adhere including standards requiring a minimum ratio of classified assets to capital, minimum earnings necessary to absorb losses and minimum ratio of market value to book value for publicly held institutions. Additional regulations are required to be developed relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and excessive compensation, fees and benefits. Annual full-scope, on site regulatory examinations are required for all the FDIC-insured institutions except institutions with assets under $100 million which are well capitalized, well-managed and not subject to a recent change in control, in which case, the examination period is every 18 months. Banks with total assets of $500 million or more, as of the beginning of fiscal year 1993, are required to submit to their supervising federal and state banking agencies a publicly available annual audit report. The independent accountants of such bank are required to attest to the accuracy of management's report regarding the internal control structure of the bank. In addition, such banks also are required to have an independent audit committee composed of outside directors who are independent of management, to review with management and the independent accountants, the reports that must be submitted to the bank regulatory agencies. If the independent accountants resign or are dismissed, written notification must be given to the bank's supervising government banking agencies. These accounting and reporting reforms do not apply to an institution such as a bank with total assets at the beginning of its fiscal year of less than $500 million, such as CNB or SNB. FDICIA also requires that banking agencies reintroduce loan-to-value ratio regulations which were previously repealed by the 1982 Act. Loan-to-values limit the amount of money a financial institution may lend to a borrower, when the loan is secured by real estate, to no more than a percentage, set by regulation, of the value of the real estate. A separate subtitle within FDICIA, called the "Bank Enterprise Act of 1991", requires "truth-in-savings" on consumer deposit accounts so that consumers can make meaningful comparisons between the competing claims of banks with regard to deposit accounts and products. Under this provision, the Bank is required to provide information to depositors concerning the terms of their deposit accounts, and in particular, to disclose the annual percentage yield. The operational cost of complying with the Truth-In-Savings law had no material impact on liquidity, capital resources or reported results of operations. While the overall impact of fully implementing all provisions of the FDICIA cannot be accurately calculated, Management believes that full implementation of the FDICIA had no material impact on liquidity, capital resources or reported results of operation in future periods. From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restriction on, the business of the Banks. It cannot be predicted whether any such legislation will be adopted or, if adopted, how such legislation would affect the business of the Banks. As a consequence of the extensive regulation of commercial banking activities in the United States, the Banks' business is particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business. Year 2000 - ---------- The following section contains forward-looking statements, which involve risks and uncertainties. The actual impact on the Corporation of the Year 2000 issue could materially differ from that which is anticipated in the forward-looking statements as a result of certain factors identified below. Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming century date change. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000 (Y2K). The Year 2000 issue affects virtually all companies and organizations. PAGE 9 Corporation's State of Readiness: The Corporation began addressing the Y2K issue in August 1997. Management has initiated an enterprise-wide program to prepare the Corporation's computer systems and applications for the Year 2000. The Corporation developed a Y2K plan to include assessing the impact of the Y2K issue on the Corporation, renovating systems to alleviate Y2K problems, validating the new systems and implementing them. The Corporation focused on information technology and non-information technology systems. A non-information system could be, for example, a microcontroller in an elevator, which may be subject to Y2K problems. The Corporation also reviewed Y2K issues related to material third parties. The assessment phase of the Y2K plan included assigning accountabilities throughout the Corporation. An inventory was completed of mainframe and PC based applications, third-party relationships and non-information technology systems. The final step in the assessment phase was to identify non-compliant Y2K systems. The assessment phase was completed in November 1997. The Corporation began the renovation phase of the Y2K plan in January 1998. The renovation phase included developing action plans to correct non-compliant Y2K systems. The action plans included either enhancing the current system to resolve the Y2K problem or purchasing a new system that is Y2K compliant. The renovation phase was completed in May 1998. The Corporation developed a remediation plan for the non-compliant systems. As of December 31, 1998, 88% of the remediation phase has been completed. The next phase of the plan was to validate the Y2K compliance of all of the systems. This phase includes developing written test plans and completing the testing of the systems. The validation phase is scheduled to be completed by March 31, 1999. As of December 31, 1998, 74% of the computer applications, including all mission-critical systems, have been validated to be Y2K compliant. The Corporation has reviewed the Y2K issues related to material third parties and completed an analysis on the loan portfolio. The Corporation's third parties include its vendors and commercial customers. Our material third party relationships are primarily our commercial borrowers. These borrowers may pose a credit risk to the Corporation if they are not Y2K compliant. We have contacted the material commercial customers and their responses were evaluated. We have also performed an analysis on the impact of Y2K issues on the remaining loan portfolio. The Corporation has allocated a portion of the allowance for loans losses as a result of the Y2K issues. Because most computer systems are, by their very nature, interdependent, it is possible that noncompliant third-party computers could impact the Corporation's computer systems. The Corporation could be adversely affected by the Y2K problem if it or unrelated parties fail to successfully address the problem. The Corporation has taken steps to communicate with the unrelated parties with whom it deals to coordinate Year 2000 compliance. Additionally, we are dependent on external suppliers, such as, wire transfer systems, telephone systems, electric companies, and other utility companies for continuation of service. Cost of Year 2000: The Committee has prepared a Y2K budget and has tracked expenses related to the Y2K issue. As of December 31, 1998, the Corporation has expensed $117,000 and capitalized fixed assets of $54,000 related to the Y2K issue. The Corporation has estimated the future Y2K expenditures to be $60,000 and future capitalized fixed assets to be under $69,000. The Y2K project is being funded through operating cash flows. The cost of the projects and the date on which the Corporation plans to complete both Year 2000 modifications and systems conversions are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third-party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material PAGE 10 differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. Risk of Year 2000: At present, management believes its progress in remedying the proprietary programs and installing the Y2K compliant upgrades to the third-party vendor mainframe and PC based computer applications is on plan. The Y2K computer problem creates risk for the Corporation from unforeseen problems in its own computer systems and from third-party vendors who provide the majority of mainframe and PC based computer applications. Failure of third-party systems relative to the Y2K issue could have a material impact on the Corporation's ability to conduct business and on its financial position and results of operation. Contingency Plans: A contingency plan is being developed to handle the most reasonably likely Y2K worst-case scenario should it occur. The contingency plan will involve obtaining back-up service providers, working up contingency plans and assessing the potential adverse risks to the Corporation. The contingency plan is scheduled to be completed by March 31, 1999. The Corporation has also utilized an independent consulting firm to verify and validate the Corporation's Y2K plans. Statistical Data - ----------------- The information for this item is listed below and is incorporated by reference to pages 24 through 32 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998 which pages are included at Exhibit (13) to this Annual Report on Form 10-K. INVESTMENT PORTFOLIO The following shows the carrying value of the Corporation's investment securities held to maturity:
(Dollars in Thousands) 1998 1997 1996 ------- ------- ------- Obligations of other U.S. Government agencies and corporations $ 6,490 $21,707 $33,129 Obligations of states and political subdivisions 17,093 19,589 26,701 Mortgage-backed securities 1,039 2,048 1,499 Other securities 1,366 2,894 3,897 ------- ------- ------- Total investment securities held to maturity $25,988 $46,238 $65,226 ======= ======= =======
The following shows the carrying value of the Corporation's investment securities available for sale:
(Dollars in Thousands) 1998 1997 1996 -------- -------- -------- U. S. Treasury notes $ 44,168 $ 46,614 $ 35,127 Obligations of other U.S. Government agencies and corporations 45,668 42,945 43,885 Obligations of states and political subdivisions 164,045 94,305 62,423 Mortgage-backed securities 87,373 57,299 55,511 Other securities 48,090 15,905 12,849 -------- -------- -------- Total investment securities available for sale $389,344 $257,068 $209,795 ======== ======== ========
There are no significant concentrations of securities (greater than 10% of PAGE 11 shareholders' equity) in any individual security issuer. The maturity analysis of investment securities held to maturity, including the weighted average yield for each category as of December 31, 1998, is as follows:
Under 1 - 5 5 - 10 Over 1 year Years years 10 years Total -------- ------- -------- ---------- -------------- (Dollars in thousands) Obligations of other U.S. Government agencies and corporations: Amortized cost $ - $5,990 $ - $ 500 $ 6,490 Weighted average yield - % 7.54% - % 8.18% 7.59% Weighted average maturity 5 yrs 11 mos Obligations of states and political subdivisions: Amortized cost 3,665 1,894 784 10,750 17,093 Weighted average yield 8.70% 8.43% 8.72% 8.82% 8.75% Weighted average maturity 8 yrs 5 mos Mortgage-backed securities: Amortized cost - 154 885 - 1,039 Weighted average yield - % 6.70% 6.37% - % 6.42% Weighted average maturity 6 yrs 6 mos Other securities: Amortized cost 111 1,255 - - 1,366 Weighted average yield 7.10% 7.50% - % - % 7.47% Weighted average maturity 3 yrs 2 mos Total: Amortized cost 3,776 9,293 1,669 11,250 25,988 Weighted average yield 8.65% 7.70% 7.48% 8.79% 8.26% Weighted average maturity 7 yrs 5 mos
The maturity analysis of securities available for sale, including the weighted average yield for each category, as of December 31, 1998 is as follows:
Under 1 - 5 5 - 10 Over (Dollars in thousands) 1 year Years years 10 years Total -------- -------- -------- ---------- --------------- U.S. Treasury notes: Amortized cost $11,492 $31,516 $ - $ - $ 43,008 Weighted average yield 6.23% 5.99% - % - % 6.05% Weighted average maturity 1 yrs 8 mos Obligations of other U.S. Government agencies and Corporations: Amortized cost - 2,004 40,157 2,490 44,651 Weighted average yield - % 7.31% 6.82% 7.00% 6.85% Weighted average maturity 8 yrs 7 mos Obligations of states and Political subdivisions: Amortized cost 2,500 5,153 9,698 143,702 161,053 Weighted average yield 5.91% 7.62% 7.88% 7.80% 7.20% Weighted average maturity 15 yrs 0 mos Mortgage-backed securities: Amortized cost - 1,123 9,165 76,646 86,934 Weighted average yield - % 6.41% 6.28% 6.46% 6.44% Weighted average maturity 18 yrs 11 mos Other securities: Amortized cost - 6,665 13,622 25,104 45,391 Weighted average yield - % 6.23% 6.36% 6.81% 6.59% Weighted average maturity 10 yrs 0 mos Total: Amortized Cost 13,992 46,461 72,642 247,942 381,037 Weighted average yield 6.17% 6.27% 8.08% 7.27% 7.02% Weighted average maturity 13 yrs 0 mos
PAGE 12 Weighted average yield is computed by dividing the annualized interest income, including the accretion of discounts and the amortization of premiums, by the carrying value. Tax-exempt securities were adjusted to a tax-equivalent basis and are based on the federal statutory tax rate of 35%. LOANS The following table shows the composition of the Banks' loans:
December 31, ------------- (Dollars in thousands) 1998 1997 1996 1995 1994 ------------- -------- -------- -------- -------- Real estate $ 306,575 $246,259 $237,155 $227,458 $220,091 Commercial and industrial 204,173 192,694 164,327 165,491 156,387 Consumer loans 265,688 249,242 238,098 201,329 187,170 Lease financing 68,753 55,413 49,623 43,942 41,233 ------------- -------- -------- -------- -------- Total loans $ 845,189 $743,608 $689,203 $638,220 $604,881 ============= ======== ======== ======== ========
The following table details maturities and interest sensitivity of real estate, commercial and industrial, consumer loans and lease financing at December 31, 1998.
Within 1 - 5 Over (Dollars in thousands) 1 year Years 5 years Total -------- -------- -------- -------- Real estate $ 41,227 $152,985 $112,363 $306,575 Commercial and industrial 140,627 29,439 34,107 204,173 Consumer loans 64,343 116,972 84,373 265,688 Lease financing 23,230 45,523 - 68,753 -------- -------- -------- -------- Total $269,427 $344,919 $230,843 $845,189 ======== ======== ======== ======== Loans with variable or Floating interest rates $199,198 $67,759 $- $266,957 Loans with fixed predetermined Interest rates 70,229 277,160 230,843 578,232 -------- -------- -------- -------- Total $269,427 $344,919 $230,843 $845,189 ======== ======== ======== ========
The following table details those loans that were placed on nonaccrual status, were accounted for as troubled debt restructuring or were delinquent by 90 days or more and still accruing interest:
December 31, ------------- (Dollars in thousands) 1998 1997 1996 1995 1994 ------------- ------ ------ ------- ------ Nonaccrual loans $ 2,950 $2,621 $2,983 $ 9,055 $2,521 Trouble debt restructurings 583 1,099 1,717 1,183 1,867 Delinquent loans 824 2,253 1,848 1,553 2,234 ------------- ------ ------ ------- ------ Total $ 4,357 $5,973 $6,548 $11,791 $6,622 ============= ====== ====== ======= ======
ALLOWANCE FOR LOAN LOSSES A summary of the activity in the allowance for loan losses is as follows:
December 31, -------------- (Dollars in thousands) 1998 1997 1996 1995 1994 -------------- --------- --------- --------- --------- Average loans $ 781,459 $706,643 $652,157 $607,335 $540,030 ============== ========= ========= ========= ========= Allowance, beginning of period $ 11,925 $ 10,710 $ 9,891 $ 8,150 $ 6,087 -------------- --------- --------- --------- --------- Loans charged off: Real estate 424 544 412 127 84 Commercial and industrial 217 66 392 240 491 Consumer loans 627 1,038 614 277 387 Lease financing 145 78 33 39 44 -------------- --------- --------- --------- --------- Total loans charged off 1,413 1,726 1,451 683 1,006 -------------- --------- --------- --------- --------- Recoveries: Real estate 88 206 30 1 56 Commercial and industrial 94 113 84 143 170 Consumer loans 98 104 56 72 152 Lease financing 18 18 18 36 26 -------------- --------- --------- --------- --------- Total recoveries 298 441 188 252 404 -------------- --------- --------- --------- --------- Net loans charged off 1,115 1,285 1,263 431 602 -------------- --------- --------- --------- --------- Provision for loan losses 2,140 2,500 2,082 2,172 2,665 -------------- --------- --------- --------- --------- Allowance, end of period $ 12,950 $ 11,925 $ 10,710 $ 9,891 $ 8,150 ============== ========= ========= ========= ========= Ratio of net charge offs to Average loans outstanding 0.14% 0.18% 0.19% 0.07% 0.11% ============== ========= ========= ========= =========
PAGE 13 The following table sets forth an allocation of the allowance for loan losses by category. The specific allocations in any particular category may be reallocated in the future to reflect then current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category.
December 31, ------------- 1998 1997 1996 1995 1994 ------------- ------- ------- ------- ------- (Dollars in thousands) Percent Percent Percent Percent Percent Amount of Loans Amount of Loans Amount of Loans Amount of Loans Amount of Loans ------------- --------- ------- --------- ------- --------- ------- --------- ------- --------- Real estate $ 1,153 36% $ 1,469 33% $ 1,434 34% $ 1,292 35% $ 1,010 36% Commercial and industrial 2,249 24% 2,719 28% 2,897 24% 3,952 26% 2,967 26% Consumer loans 1,747 32% 1,566 32% 1,251 35% 885 32% 1,063 31% Lease financing 220 8% 177 7% 104 7% 127 7% 139 7% Unallocated 7,581 N/A 5,994 N/A 5,024 N/A 3,635 N/A 2,971 N/A ------------- --------- ------- --------- ------- --------- ------- --------- ------- --------- Total 12,950 100% 11,925 100% 10,710 100% 9,891 100% 8,150 100% ============= ========= ======= ========= ======= ========= ======= ========= ======= =========
DEPOSIT STRUCTURE The following table is a distribution of average balances and average rates paid on the deposit categories for the last three years:
December 31, ------------ 1998 1997 1996 ------------- -------- -------- (Dollars in thousands) Amount Rate Amount Rate Amount Rate ------------- ----- -------- ----- ------ ---- Demand - noninterest-bearing $ 150,274 --% $135,307 --% $122,459 --% Demand - interest-bearing 112,733 1.48% 98,397 1.54% 91,856 1.57% Money market and savings 317,813 3.12% 282,917 3.05% 270,034 3.03% Time - under $100,000 304,058 5.53% 297,263 5.57% 298,777 5.63% Time -- $100,000 or greater 85,754 5.48% 64,282 5.49% 38,261 5.29% ------------- -------- -------- Total $ 970,632 $878,166 $821,387 ============= ======== ======== The maturity distribution of certificates of deposit of $100,000 and over is as follows: December 31, ------------- (Dollars in thousands) 1998 1997 1996 ------------- -------- --------- Three months or less $ 48,789 $ 43,499 $ 29,919 Over three months to six months 20,425 13,505 12,850 Over six months to twelve months 9,800 7,535 4,512 Over twelve months 9,222 4,015 4,079 ------------- -------- -------- Total $ 88,236 $ 68,554 $ 51,360 ============= ======== ========
PAGE 14 NET INTEREST INCOME For analytical purposes, the following table reflects tax-equivalent net interest income in recognition of the income tax savings on tax-exempt items such as interest on municipal securities and tax-exempt loans. Adjustments are made using a statutory federal tax rate of 35%.
Year ended December 31, ------------------------ (Dollars in thousands) 1998 1997 1996 -------- ------- ------- Interest income $ 87,597 $80,202 $73,718 Interest expense 37,809 33,851 30,876 -------- ------- ------- Net interest income 49,788 46,351 42,842 Tax equivalent adjustment 4,640 3,331 2,489 -------- ------- ------- Net interest income $ 54,428 $49,682 $45,331 ======== ======= =======
The rate volume analysis set forth in the following table, which is computed on a tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income for the last three years by their rate and volume components.
1998 over (under) 1997 1997 over (under) 1996 due to changes in due to changes in -------------------------- ------------------------ Change Rate Volume Change Rate Volume -------- -------- -------- ------- ------ ------- INTEREST INCOME: Investment securities (1) $ 4,202 $ (502) $ 4,704 $ 2,472 $ 423 $ 2,049 Loans 4,878 (1,442) 6,320 4,318 (410) 4,728 Other assets (376) (132) (244) 536 60 476 -------- -------- -------- ------- ------ ------- Total 8,704 (2,076) 10,780 7,326 73 7,253 -------- -------- -------- ------- ------ ------- INTEREST EXPENSE: Savings deposits 1,447 121 1,326 533 16 517 Time deposits 1,436 (124) 1,560 1,222 (139) 1,361 Borrowings and other interest- bearing liabilities 1,075 (192) 1,267 1,220 (16) 1,236 -------- -------- -------- ------- ------ ------- Total 3,958 (195) 4,153 2,975 (139) 3,114 -------- -------- -------- ------- ------ ------- Changes in net interest income $ 4,746 $(1,881) $ 6,627 $ 4,351 $ 212 $ 4,139 ======== ======== ======== ======= ====== =======
(1) The interest earned on nontaxable investment securities and loans is shown on a tax equivalent basis. Tax-equivalent net interest income was $54,428,000 for 1998, compared to $49,682,000 for 1997, an increase of $4,746,000, or 9.6%. This increase in tax-equivalent net interest income was primarily due to the net $6,627,000 increase related to volume, partially offset by a decrease related to interest rates of $1,881,000. Total interest income increased $8,704,000, the result of higher volumes of interest-earning assets, in part offset by the lower rates experienced during 1998. Interest Income on loans grew 8.0% and investment interest income increased 20.2%. These increases were the result of the 1998 average loan and investment volumes increasing 10.6% and 23.2% respectively. The growth in loans is a result of persistent sales efforts and new branch openings. The increase in investment securities was due to both the institution of a capital leverage program during 1998 and the planned growth related to the increase in deposit funding. PAGE 15 Total interest expense grew $3,958,000 during 1998 or 11.7%, compared to 1997. This growth was the result of increases in all interest-bearing liability categories. The volumes of savings deposits, time deposits and borrowings and other interest-bearing liabilities grew 12.9%, 7.8% and 36.9%, respectively. Borrowings and other interest-bearing liabilities include federal funds purchased, FHLB borrowings, securities sold under agreements to repurchase and U.S. Treasury notes. The increase in borrowings and other interest-bearing liabilities was primarily due to the growth in FHLB borrowings related to the institution of a capital leverage program during 1998. The 1997 tax-equivalent net interest income was $49,682,000, a $4,351,000 increase compared to $45,331,000 for 1996. This increase in tax-equivalent net interest income was primarily due to both the $7,253,000 increase related to earning asset volumes, partially offset by the $3,114,000 increase in interest expense related to interest-bearing liabilities volumes. The growth in earning asset volumes was primarily in investment securities and loans and the growth in interest-bearing liabilities was principally the result of higher time deposit and borrowing volumes. Item 2. Properties. - -------------------- The principal executive offices of the Corporation and of HNB are located in Harleysville, Pennsylvania in a two-story office building owned by HNB, built in 1929. HNB also owns the buildings in which twelve of its branches are located and leases space for the other nine branches from unaffiliated third parties under leases expiring at various times through 2036. The principal executive offices of CNB are located in Lansford, Pennsylvania in a two-story office building owned by CNB. Citizens also owns the buildings where its branches are located. The principal executive offices of SNB are located in Pottstown, Pennsylvania, in a building leased by SNB. SNB leases its East End and North End branches, and owns its Pottstown Center branch. HNC Investment Company leases an office in Wilmington, Delaware.
Office Office Location Owned/Leased - ------------------- ------------------------------ ------------ Harleysville 483 Main Street Owned Harleysville Pa Skippack Route 73 Owned Skippack Pa Limerick Ridge Pike Owned Limerick Pa North Penn Welsh & North Wales Rd Owned North Wales Pa Gilbertsville Gilbertsville Shopping Leased Gilbertsville Pa Hatfield Snyder Square Leased Hatfield PA North Broad North Broad Street Owned Lansdale Pa Marketplace Marketplace Shopping Leased Lansdale Pa Normandy Farms Morris Road Leased Blue Bell Pa Horsham Babylon Business Center Leased Horsham Pa PAGE 16 Meadowood Route 73 Leased Worcester Pa Collegeville 364 Main Street Owned Collegeville Pa Sellersville 209 North Main St. Owned Sellersville Pa Trainers Corner Trainers Corner Center Leased Quakertown Pa Quakertown Main 224 West Broad St. Owned Quakertown PA Spring House 1017-1021 North Bethlehem Pike Owned Spring House PA Red Hill 400 Main Street Owned Red Hill PA Doylestown 500 East State Road Leased Doylestown PA Audubon 2624 Egypt Road Owned Audubon PA Chalfont 251 West Butler Avenue Leased Chalfont PA Spring City 44 North Main Street Owned Spring City PA Citizens 13-15 West Ridge Street Owned Lansford PA Summit Hill 2 East Ludlow Street Owned Summit Hill PA Lehighton 904 Blakeslee Blvd. Owned Lehighton PA Farmers & Merchants 1001 Main Street Owned Honesdale PA McAdoo 25 North Kennedy Drive Owned McAdoo PA Pottstown One Security Plaza Leased Pottstown PA Pottstown 1450 East High Street Leased Pottstown PA Pottstown Charlotte & Mervine Sts. Leased Pottstown PA Pottstown Rte. 100 & Shoemaker Road Owned Pottstown PA
PAGE 17 In management's opinion, all of the above properties are in good condition and are adequate for the Registrant's and the Banks' purposes. Item 3. Legal Proceedings. - ---------------------------- Management, based on consultation with the Corporation's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries - Harleysville National Bank and Trust Company, The Citizens National Bank of Lansford, Security National Bank and HNC Financial Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and the Banks by government authorities. Item 4. Submission of Matters to a Vote of Security Holders. - --------------------------------------------------------------------- No matter was submitted during the fourth quarter of 1998 to a vote of holders of the Corporation's Common Stock. PAGE 18 PART II Item 5. Market for the Registrant's Common Stock and Related Shareholder - -------------------------------------------------------------------------------- Matters. - -------- The information required by this Item is incorporated by reference to pages 8, 19 and 20 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 6. Selected Financial Data. - ------------------------------------ The information required by this Item is incorporated by reference to page 24 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 7. Management's Discussion and Analysis of Financial Condition and Results - -------------------------------------------------------------------------------- of Operations. - -------------- The information required by this Item is incorporated by reference to pages 24 through 32 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 7.A. Quantitative and Qualitative Disclosure about Market Risk. - ---------------------------------------------------------------------------- The information required by this Item is incorporated by reference to pages 28 and 29 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 8. Financial Statements and Supplementary Data. - --------------------------------------------------------- The information required by this Item is incorporated by reference to pages 8 through 23 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which pages are included at Exhibit (13) to this Annual Report on Form 10-K. Item 9. Changes in and Disagreements with Accountants on Accounting and - -------------------------------------------------------------------------------- Financial Disclosure. - --------------------- None. PAGE 19 PART III Item 10. Directors and Executive Officers of the Registrant. - ------------------------------------------------------------------- The information required by this Item with respect to the Corporation's directors is incorporated by reference to pages 15 through 18 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 13, 1999.
Executive Officers of Registrant - ----------------------------------- Name Age Position - --------------------- --- ----------------------------------------------------- Walter E. Daller, Jr. 59 Chairman of the Board, President and Chief Executive Officer of the Corporation. Demetra M. Takes 48 President and Chief Operating Officer of Harleysville since 1998, prior position was Executive Vice President and Chief Operating Officer of Harleysville. Fred C. Reim, Jr. 55 President and Chief Executive Officer of Security National bank since 1998, prior position was Senior Vice President of Harleysville. Thomas D. Oleksa 45 President and Chief Executive Officer of Citizens. Vernon L. Hunsberger 50 Treasurer of the Company, Senior Vice President/CFO and Cashier of Harleysville. Geoffrey D. Brandon 33 Senior Vice President of Branch Administration for Harleysville since 1998, prior position was Vice President of Harleysville. Mikkalya W. Brown 43 Senior Vice President of Loan Administration of Harleysville. David Crews 47 Senior Vice President of Harleysville since 1998, prior position was Vice President of Business Development. Dennis L. Detwiler 51 Senior Vice President of Harleysville. Bruce D. Fellman 52 Senior Vice President of Harleysville since 1998, prior position was Vice President. James W. Hamilton 52 Senior Vice President of Harleysville. Clay T. Henry 38 Senior Vice President and Senior Trust Officer of Harleysville since 1998, prior position was Director of Investments Services for the Private Bank of PNC Financial Corporation. Frank J. Lochetto 51 Senior Vice President of Harleysville. Linda C. Lockhart 47 Senior Vice President of Customer Support of Harleysville since 1998, Vice President of Customer Support since 1997, Vice President of First Sterling Bank (1991-1996). Gregg J. Wagner 38 Senior Vice President of Finance of Harleysville since 1998, prior position was Vice President & Comptroller of Harleysville. Harry T. Weierbach 54 Senior Vice President and Chief Investment Officer of Harleysville since 1998, Vice President (1996 to 1998), Assistant Vice President (1994 to 1998).
PAGE 20 Item 11. Executive Compensation. - ---------------------------------- The information required by this Item is incorporated by reference to pages 19 through 24 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 13, 1999. Item 12. Security Ownership of Certain Beneficial Owners and Management. - ------------------------------------------------------------------------------- The information required by this Item is incorporated by reference to pages 15 through 16 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 13, 1999. Item 13. Certain Relationships and Related Transactions. - ------------------------------------------------------------- The information required by this Item is incorporated by reference to page 28 of the Corporation's Proxy Statement relating to the Annual Meeting of Shareholders to be held April 13, 1999, and to page 17 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which page is included at Exhibit (13) to this Annual Report on Form 10-K. PAGE 21 PART IV ------- Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. - ---------------------------------------------------------------------- -------- (a) Financial Statements, Financial Statement Schedules and Exhibits Filed: (1) Consolidated Financial Statements Page ---- Harleysville National Corporation and Subsidiary: Consolidated Balance Sheets as of December 31, 1998 and 1997 9* Consolidated Statements of Income for the Years Ended December 31, 1998, 1997 and 1996 10* Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1998, 1997 and 1996 11* Consolidated Statements of Cash Flows for the Years Ended December 31, 1998, 1997 and 1996 12* Notes to Consolidated Financial Statements 13-23* Independent Auditors' Report 8* (2) Financial Statement Schedules Financial Statements Schedules are omitted because the required information is either not applicable, not required, or the information is included in the consolidated financial statements or notes thereto. - -------------------------------------------------------------------------------- *Refers to the respective page of the Annual Report to Shareholders. The Consolidated Financial Statements and Notes to Consolidated Financial Statements and Auditor's Report thereon on pages 8 to 23 of the Annual Report to Shareholders, are incorporated herein by reference and attached at Exhibit 13 to this Annual Report on Form 10-K. With the exception of the portions of such Annual Report specifically incorporated by reference in this Item and in Items 1, 5, 6, 7 and 8, such Annual Report shall not be deemed filed as part of this Annual Report on Form 10-K or otherwise subject to the liabilities of Section 18 of the Securities Exchange Act of 1934. PAGE 22 (3) Exhibits
Exhibit No. Description of Exhibits - ----------- ------------------------- (3.1) Harleysville National Corporation Articles of Incorporation, as amended. (Incorporated by reference to Exhibit 3(a) to the Corporation's Registration Statement No.33-65021 on Form S-4, as filed on December 14, 1995.) (3.2) Harleysville National Corporation By-laws. (Incorporated by reference to Exhibit 3(b) to the Corporation's Registration Statement No. 33-65021 on Form S-4, as filed on December 14, 1995.) (10.1) Harleysville National Corporation 1993 Stock Incentive Plan. (Incorporated by Reference to Exhibit 4.3 of Registrant's Registration Statement No.33-57790 on Form S-8,filed with the Commission on October 1, 1993.) (10.2) Harleysville National Corporation Stock Bonus Plan. (Incorporated by Reference to Exhibit 99A of Registrant's Registration Statement No.33-17813 on Form S-8, filed with the Commission on December 13, 1996.) (10.3) Supplemental Executive Retirement Plan. (Incorporated by Reference to Exhibit 10.3 of Registrant's Annual Report in Form 10-K for the year ended December 31, 1997, filed with the Commission on March 27, 1998.) (10.4) Walter E. Daller, Jr., Chairman, President and Chief Executive Officer's employment agreement. (Incorporated by Reference to Registrant's Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.) (10.5) Demetra M. Takes, President and Chief Operating Officer of Harleysville employment agreement. (Incorporated by Reference to Registrant's Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.) (10.6) Vernon L. Hunsberger. Senior Vice President/CFO and Cashier's employment agreement. (Incorporated by Reference to Registrant's Registration Statement on Form 8-K, filed with the Commission on March 25, 1999.) (11) Computation of Earnings per Common Share. The information for this Exhibit is incorporated by reference to page 15 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which is included as Exhibit (13) to this Form 10-K Report. (12) Statements Re: Computation of Ratios. The information for this exhibit is incorporated by reference to page 1 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1998, which is included as Exhibit (13) to this Form 10-K Report. (13) Excerpts from the Corporation's 1998 Annual Report to Shareholders. (This excerpt includes only page 1 and pages 8 through 32 which are incorporated in this Report by reference.) (21) Subsidiaries of Registrant (23) Consent of Grant Thornton LLP, Independent Certified Public Accountants (27) Financial Data Schedule. (99) Additional Exhibits None. PAGE 23 (b) Reports on Form 8-K During the quarter ended December 31, 1998, the Registrant did not file any reports on Form 8-K.
PAGE 24 SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HARLEYSVILLE NATIONAL CORPORATION Date: March 11, 1999 By:/s/ Walter Daller, Jr. -------------------------- Walter E. Daller, Jr. President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Signature Title Date - --------- ----- ---- ____________________ Director March 11, 1999 LeeAnn Bergy /s/ Walter E. Daller, Jr. Chairman of the Board, President March 11, 1999 - ----------------------------- and Chief Executive Officer and Walter E. Daller, Jr. Director (Principal Executive Officer) /s/ Martin E. Fossler Director March 11, 1999 - ------------------------ Martin E. Fossler /s/ Harold Herr Director March 11, 1999 - ----------------- Harold A. Herr /s/ Vernon L. Hunsberger Treasurer (Principal Financial March 11, 1999 - --------------------------- and Accounting Officer) Vernon L. Hunsberger ____________________ Director March 11, 1999 Thomas S. McCready ___________________ Director March 11, 1999 Henry M. Pollak /s/ Palmer E. Retzlaff Director March 11, 1999 - ------------------------- Palmer E. Retzlaff PAGE 25 /s/ Walter F. Vilsmeier Director March 11, 1999 - -------------------------- Walter F. Vilsmeier /s/ William M. Yocum Director March 11, 1999 - ----------------------- William M. Yocum
PAGE 26 EXHIBIT INDEX - -------------- Exhibit ------- (10.3) Supplemental Executive Retirement Plan. (13) Excerpts from the Corporation's 1998 Annual Report to Shareholders (This excerpt includes only page 1 and pages 8 through 32, which are incorporated in this Report by reference.) (21) Subsidiaries of Registrant (23) Consent of Grant Thornton LLP, Independent Certified Public Accountants (99) Additional Exhibits None. PAGE 27 EX-13 2 Financial Ratios and Summary of Key Information Harleysville National Corporation and Subsidiaries
Year Ended December 31, ------------------------------------------------ (Dollars in thousands, except per share data and average shares outstanding) 1998 1997 1996 ----------- ---------- ---------- Per Share Information Basic earnings ................................................................. $ 2.67 $ 2.38* $ 2.06* Diluted earnings ............................................................... 2.67 2.38* 2.06* Cash dividends paid ............................................................ 1.00 0.91* 0.80* Book value (at year-end) ....................................................... 17.45 15.64 14.67 Market Value Bid price of common stock (high) ............................................... $ 43.50 $ 42.00* $ 25.85* Bid price of common stock (low) ................................................ 32.50 23.10* 22.38* Average basic shares outstanding ............................................... 7,029,394 7,005,184* 6,993,535* Average Balance Sheet Loans .......................................................................... $ 781,459 $ 706,643 $ 652,157 Earning assets ................................................................. 1,158,162 1,020,983 929,589 Total assets ................................................................... 1,209,273 1,075,702 978,899 Deposits ....................................................................... 970,632 878,166 821,387 Interest-bearing liabilities plus demand deposits .............................. 1,067,864 949,200 868,200 Shareholders' equity ........................................................... 116,480 103,807 91,687 Selected Operating Ratios Return on average assets ....................................................... 1.55% 1.55% 1.47% Return on average shareholders' equity ......................................... 16.12% 16.05% 15.71% Leverage (assets divided by shareholders' equity) .............................. 10.85X 10.17X 10.51X Average shareholders' equity as a percentage of: Average loans ............................................................... 14.91% 14.69% 14.06% Average deposits ............................................................ 12.00 11.82 11.16 Average assets .............................................................. 9.63 9.65 9.37 Average earning assets ...................................................... 10.06 10.17 9.86 Dividend payout ratio .......................................................... 37.45 38.23 38.76 Average total loans as a percentage of average deposits and borrowed funds...... 73.18 74.45 75.12 Net interest margin on average earning assets: Interest income** ........................................................... 7.96% 8.18% 8.20% Interest expense ............................................................ (3.26) (3.31) (3.32) Net interest margin ......................................................... 4.70 4.87 4.88 Noninterest margin .......................................................... (1.97) (2.07) (2.23)
*Adjusted for 5% stock dividends effective 6/30/97 and 6/28/96 **Tax-Equivalent Basis 1 PAGE 1 Description of Business Harleysville National Corporation, a Pennsylvania corporation (the Corporation), was incorporated in June 1982. On January 1, 1983, the Corporation became the parent bank holding company of Harleysville National Bank and Trust Company (HNB), a wholly-owned subsidiary of the Corporation. On February 13, 1991, the Corporation acquired all of the outstanding common stock of The Citizens National Bank of Lansford (CNB). On June 1, 1992, the Corporation acquired all of the outstanding stock of Summit Hill Trust Company (Summit Hill). On September 25, 1992, Summit Hill merged into CNB and is now operating as a branch office of CNB. On July 1, 1994, the Corporation acquired all of the outstanding stock of Security National Bank (SNB). On March 1, 1996, the Corporation acquired all of the outstanding common stock of Farmers & Merchants Bank (F&M). F&M was merged into CNB and is now operating as a branch office of CNB. On March 17, 1997, the HNC Financial Company was incorporated as a Delaware Corporation. HNC Financial Company's principal business function is to expand the investment opportunities of the Corporation. HNB, which was established in 1909, CNB, which was established in 1903, and SNB, which was established in 1988, (collectively the Banks), are national banking associations under the supervision of the Office of the Comptroller of the Currency. The Corporation's and HNB's legal headquarters are located at 483 Main Street, Harleysville, Pennsylvania 19438. CNB's legal headquarters are located at 13-15 West Ridge Street, Lansford, Pennsylvania 18232. SNB's legal headquarters are located at One Security Plaza, Pottstown, Pennsylvania 19464. HNC Financial Company's legal headquarters are located at 300 Delaware Avenue, Suite 1704, Wilmington, Delaware 19801. As of December 31, 1998, the Banks had total assets of $1,332,389,000, total shareholders' equity of $122,811,000 and total deposits of $1,033,968,000. The Banks engage in full-service commercial banking and the trust business, including accepting time and demand deposits, making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and performing corporate pension and personal trust services. Their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) Bank Insurance Fund to the extent provided by law. The Banks have 30 branch offices located in Montgomery, Bucks, Carbon, Wayne, Chester and Schuylkill Counties, Pennsylvania. On December 31, 1998, the Banks had 483 full-time equivalent employees. Competition The Banks compete actively with other eastern Pennsylvania financial services companies, many larger than the Banks, as well as with financial and nonfinancial institutions headquartered elsewhere. The Banks are generally competitive with all competing institutions in their service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts, interest rates charged on loans, and fees and charges for trust services. Supervision and Regulation The operations of the Banks are subject to federal, state and local statutes applicable to banks chartered under the banking laws of the United States, to members of the Federal Reserve System and to banks whose deposits are insured by the FDIC. The Banks' operations are also subject to the regulations of the Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency (who regularly examines the Banks' areas such as asset quality, investments, management practices and other aspects of bank operations). The Corporation is subject to federal and state securities laws, certain rules and regulations of the Securities and Exchange Commission, to the provisions of the Bank Holding Company Act of 1956, as amended, and to supervision by the Federal Reserve Board. Market Information The following table sets forth quarterly dividend information and the high and low prices for the Corporation's common stock for 1998 and 1997. The Corporation's stock is traded in the over-the-counter market under the symbol "HNBC" and commonly quoted under NASDAQ National Market Issues.
- -------------------------------------------------------------------------------- Price of Common Stock 1998 Low Price High Price Dividend - -------------------------------------------------------------------------------- First Quarter ................ $ 39.00 $ 43.50 $ .240 Second Quarter ............... 40.06 43.38 .240 Third Quarter ................ 34.50 42.88 .250 Fourth Quarter ............... 32.50 41.50 .270
1997 Low Price* High Price* Dividend* - -------------------------------------------------------------------------------- First Quarter* $ 23.10 $ 27.38 $ .210 Second Quarter* 25.48 32.00 .210 Third Quarter 31.25 38.75 .230 Fourth Quarter 36.50 42.00 .260
*Adjusted for a 5% stock dividend effective 6/30/97. - -------------------------------------------------------------------------------- Report of Independent Certified Public Accountants Harleysville National Corporation and Subsidiaries To the Board of Directors and Shareholders, Harleysville National Corporation: We have audited the accompanying consolidated balance sheets of Harleysville National Corporation and Subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1998. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Harleysville National Corporation and Subsidiaries as of December 31, 1998 and 1997, and the consolidated results of their operations and their consolidated cash flows for each of the years in the three-year period ended December 31, 1998, in conformity with generally accepted accounting principles. Grant Thornton LLP Philadelphia, Pennsylvania January 7, 1999 (Except for Note 2, as to which the date is January 20, 1999.) PAGE 8 Consolidated Balance Sheets Harleysville National Corporation and Subsidiaries
(Dollars in thousands) December 31, -------------------------- Assets 1998 1997 ---------- ---------- Cash and due from banks .......................... $ 37,763 $ 38,471 Federal funds sold ............................... 11,486 11,050 ---------- ---------- Total cash and cash equivalents ............... 49,249 49,521 ---------- ---------- Interest-bearing deposits in banks ............... 3,707 5,574 Investment securities available for sale ......... 389,344 257,068 Investment securities held to maturity (market value $26,681 and $47,354, respectively) 25,988 46,238 Loans ............................................ 845,189 743,608 Less: Unearned income ............................ (2,302) (4,155) Allowance for loan losses .................. (12,950) (11,925) ---------- ---------- Net loans .............................. 829,937 727,528 ---------- ---------- Bank premises and equipment, net ................. 18,891 17,934 Accrued interest receivable ...................... 9,271 7,719 Other real estate owned .......................... 664 453 Intangible assets, net ........................... 1,936 1,851 Other assets ..................................... 3,402 2,368 ---------- ---------- Total assets ........................... $1,332,389 $1,116,254 ========== ========== Liabilities and Shareholders' Equity Deposits: Noninterest-bearing ........................... $ 183,057 $ 152,621 Interest-bearing: Checking accounts ......................... 129,037 108,954 Money market accounts ..................... 205,656 180,949 Savings ................................... 120,156 108,199 Time, under $100,000 ...................... 307,826 299,794 Time, $100,000 or greater ................. 88,236 68,554 ---------- ---------- Total deposits ......................... 1,033,968 919,071 Accrued interest payable ......................... 13,836 14,388 U.S. Treasury demand notes ....................... 1,320 2,150 Federal funds purchased .......................... 11,000 13,700 Federal Home Loan Bank (FHLB) borrowings ......... 93,500 17,000 Securities sold under agreements to repurchase ... 43,158 31,288 Other liabilities ................................ 12,796 8,865 ---------- ---------- Total liabilities ...................... 1,209,578 1,006,462 ---------- ---------- Shareholders' equity: Series preferred stock, par value $1 per share; authorized 3,000,000 shares, none issued .... -- -- Common stock, par value $1 per share; authorized 30,000,000 shares; issued and outstanding 7,037,814 shares in 1998 and 7,020,211 shares in 1997 .............................. 7,038 7,020 Additional paid in capital .................... 49,641 49,305 Retained earnings ............................. 60,733 48,988 Accumulated other comprehensive income ........ 5,399 4,479 ---------- ---------- Total shareholders' equity ............. 122,811 109,792 ---------- ---------- Total liabilities and shareholders' equity $1,332,389 $1,116,254 ========== ==========
================================================================================ See accompanying notes to consolidated financial statements. PAGE 9 Consolidated Statements of Income Harleysville National Corporation and Subsidiaries
(Dollars in thousands except weighted average number of common shares and per share information) Year Ended December 31, ------------------------------------ 1998 1997 1996 ---------- ---------- ---------- Interest Income Loans, including fees ...................................... $ 60,611 $ 56,381 $ 52,873 Lease financing ............................................ 5,084 4,531 3,811 Investment securities: Taxable ................................................. 13,167 12,433 12,110 Exempt from federal taxes ............................... 7,671 5,417 4,020 Federal funds sold ......................................... 859 1,035 622 Deposits in banks .......................................... 205 405 282 ---------- ---------- ---------- Total interest income ................................... 87,597 80,202 73,718 ---------- ---------- ---------- Interest Expense Savings deposits ........................................... 11,596 10,149 9,616 Time, under $100,000 ....................................... 16,812 16,550 16,830 Time, $100,000 or greater .................................. 4,700 3,526 2,024 Borrowed funds ............................................. 4,701 3,626 2,406 ---------- ---------- ---------- Total interest expense .................................. 37,809 33,851 30,876 ---------- ---------- ---------- Net interest income ..................................... 49,788 46,351 42,842 Provision for loan losses .................................. 2,140 2,500 2,082 ---------- ---------- ---------- Net interest income after provision for loan losses ............................................ 47,648 43,851 40,760 ---------- ---------- ---------- Other Operating Income Service charges ............................................ 3,205 2,841 2,587 Security (losses) gains, net ............................... 1,543 1,757 (39) Trust income ............................................... 2,117 1,509 1,293 Other income ............................................... 2,945 1,284 1,274 ---------- ---------- ---------- Total other operating income ............................ 9,810 7,391 5,115 ---------- ---------- ---------- Net interest income after provision for loan losses and other operating income ................ 57,458 51,242 45,875 ---------- ---------- ---------- Other Operating Expenses Salaries, wages and employee benefits ...................... 17,716 15,479 14,398 Occupancy .................................................. 2,140 1,980 1,873 Furniture and equipment .................................... 3,449 2,817 2,083 Other expenses ............................................. 9,268 8,253 7,520 ---------- ---------- ---------- Total other operating expenses .......................... 32,573 28,529 25,874 ---------- ---------- ---------- Income before income tax expense ........................ 24,885 22,713 20,001 Income tax expense ......................................... 6,109 6,051 5,593 ---------- ---------- ---------- Net income ................................................. $ 18,776 $ 16,662 $ 14,408 ========== ========== ========== Weighted average number of common shares: Basic ................................................... 7,029,394 7,005,184 6,993,535 ========== ========== ========== Diluted ................................................. 7,033,612 7,012,279 7,017,402 ========== ========== ========== Net income per share information: Basic ................................................... $ 2.67 $ 2.38 $ 2.06 ========== ========== ========== Diluted ................................................. $ 2.67 $ 2.38 $ 2.06 ========== ========== ========== Cash dividends per share ................................... $ 1.00 $ 0.91 $ 0.80 ========== ========== ==========
================================================================================ See accompanying notes to consolidated financial statements PAGE 10 Consolidated Statements of Shareholders' Equity Harleysville National Corporation and Subsidiaries
(Dollars in thousands) Common Stock Accumulated ------------------ Other Number of Par Additional Retained Comprehensive Comprehensive Shares Value Paid in Capital Earnings Income Total Income --------- ------ --------------- -------- ------------- -------- ------------ Balance, January 1, 1996 .............. 5,878 $5,878 $27,602 $44,621 $1,383 $ 79,484 Acquisition of Farmers & Merchants Bank 438 438 3,281 3,159 -- 6,878 Stock options ......................... 14 14 335 (237) -- 112 Stock dividends ....................... 316 316 8,171 (8,502) -- (15) Stock awards .......................... 11 11 -- (16) -- (5) Stock compensation tax benefit ........ -- -- 927 -- -- 927 Net income for 1996 ................... -- -- -- 14,408 -- 14,408 $14,408 Other comprehensive income, net of reclassifications and tax ... -- -- -- -- 1,426 1,426 1,426 Cash dividends ........................ -- -- -- (5,584) -- (5,584) ---------------------------------------------------------------------------------- Comprehensive income .................. $15,834 ======= Balance, December 31, 1996 ............ 6,657 6,657 40,316 47,849 2,809 97,631 Stock options ......................... 29 29 187 -- -- 216 Stock dividends ....................... 333 333 8,785 (9,135) -- (17) Stock awards .......................... 1 1 17 (18) -- -- Net income for 1997 ................... -- -- -- 16,662 -- 16,662 $16,662 Other comprehensive income, net of reclassifications and tax ... -- -- -- -- 1,670 1,670 1,670 Cash dividends ........................ -- -- -- (6,370) -- (6,370) ---------------------------------------------------------------------------------- Comprehensive income .................. $18,332 ======= Balance, December 31, 1997 ............ 7,020 7,020 49,305 48,988 4,479 109,792 Stock options ......................... 18 18 331 -- -- 349 Stock awards .......................... -- -- 5 -- -- 5 Net income for 1998 ................... -- -- -- 18,776 -- 18,776 $18,776 Other comprehensive income, net of reclassifications and tax ... -- -- -- -- 920 920 920 Cash dividends ........................ -- -- -- (7,031) -- (7,031) ---------------------------------------------------------------------------------- Comprehensive income .................. $19,696 ======= Balance, December 31, 1998 ............ 7,038 $7,038 $49,641 $60,733 $5,399 $122,811 ======================================================================
================================================================================ See accompanying notes to consolidated financial statements. PAGE 11 Consolidated Statements of Cash Flows Harleysville National Corporation and Subsidiaries (Dollars in thousands)
Year Ended December 31, ----------------------------------- 1998 1997 1996 --------- --------- --------- Operating Activities Net income .......................................... $ 18,776 $ 16,662 $ 14,408 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses ........................ 2,140 2,500 2,082 Depreciation and amortization .................... 2,153 1,762 1,412 Net amortization of investment securities discount/premiums .............................. 425 280 403 Deferred income taxes ............................ 1,475 1,420 844 Net realized securities (gain) loss .............. (1,543) (1,757) 39 Increase in accrued income receivable ............ (1,552) (1,066) (503) (Decrease) increase in accrued interest payable .. (552) 461 1,845 Net (increase) decrease in other assets .......... (1,034) 64 (564) Net increase (decrease) in other liabilities ..... 1,960 (804) 1,984 Decrease in unearned income ...................... (1,853) (3,637) (1,689) Write-down of other real estate owned ............ 65 73 144 (Increase) decrease in intangible assets ......... (85) (193) 302 --------- --------- --------- Net cash provided by operating activities ..... 20,375 15,765 20,707 --------- --------- --------- Investing Activities Proceeds from sales of investment securities available for sale ................................ 52,921 39,571 64,327 Proceeds, maturity or calls of investment securities held to maturity ....................... 20,170 16,210 9,078 Proceeds, maturity or calls of investment securities available for sale ..................... 29,238 23,331 29,789 Purchases of investment securities held to maturity . -- (1,001) (5,847) Purchases of investment securities available for sale (211,821) (102,351) (127,591) Net decrease (increase) in interest-bearing deposits in banks ................................. 1,867 2,901 (6,772) Net increase in loans ............................... (103,938) (56,709) (53,491) Net increase in premises and equipment .............. (3,110) (4,886) (4,227) Proceeds from sales of other real estate ............ 966 1,465 1,348 --------- --------- --------- Net cash used in investing activities ......... (213,707) (81,469) (93,386) --------- --------- --------- Financing Activities Net increase in deposits ............................ 114,897 71,372 53,200 (Decrease) increase in U.S. Treasury demand notes ... (830) (422) 735 (Decrease) increase in federal funds purchased ...... (2,700) 13,700 -- Increase (decrease) in FHLB borrowings .............. 76,500 (18,000) 13,800 Increase in securities sold under agreement ......... 11,870 9,339 5,236 Cash dividends and fractional shares ................ (7,031) (6,370) (5,584) Dividends reinvestment .............................. -- (17) (20) Stock options ....................................... 354 216 112 --------- --------- --------- Net cash provided by financing activities ..... 193,060 69,818 67,479 --------- --------- --------- Net (decrease) increase in cash and cash equivalents ... (272) 4,114 (5,200) Cash and cash equivalents at beginning of year ......... 49,521 45,407 50,607 --------- --------- --------- Cash and cash equivalents at end of year ............... $ 49,249 $ 49,521 $ 45,407 ========= ========= ========= Cash paid during the year for: Interest ............................................ $ 38,362 $ 33,389 $ 29,030 ========= ========= ========= Income taxes ........................................ 3,950 5,100 3,710 ========= ========= ========= Supplemental disclosure of noncash investing and financing activities: Transfer of assets from loans to other real estate owned ................................. $ 1,242 $ 1,019 $ 1,243 ========= ========= =========
================================================================================ See accompanying notes to consolidated financial statements. PAGE 12 Notes to Consolidated Financial Statements Harleysville National Corporation and Subsidiaries 1 - Summary of Significant Accounting Policies - -------------------------------------------------------------------------------- Business Harleysville National Corporation (the Corporation) through its subsidiary banks, Harleysville National Bank and Trust Company, The Citizens National Bank of Lansford, and Security National Bank (collectively the Banks), provides a full range of banking services to individual and corporate customers located in eastern Pennsylvania. The Banks compete with other banking and financial institutions in their primary market communities, including financial institutions with resources substantially greater than their own. Commercial banks, savings banks, savings and loan associations, credit unions and money market funds actively compete for deposits and for types of loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors of the Banks with respect to one or more of the services they render. In addition to being subject to competition from other financial institutions, the Banks are subject to federal and state laws and to regulations of certain federal agencies, and, accordingly, they are periodically examined by those regulatory authorities. Basis of Financial Statement Presentation The accounting and reporting policies of the Corporation and its Subsidiaries conform with generally accepted accounting principles applicable to banks. All significant intercompany transactions are eliminated in consolidation and certain reclassifications are made when necessary to conform with the previous years' financial statements to the current year's presentation. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Investment Securities The Corporation accounts for securities under the Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires among other things, that debt and equity securities classified as available for sale be reported at fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income, net of income taxes. The net effect of unrealized gains or losses, caused by marking an available for sale portfolio to market, could cause fluctuations in the level of shareholders' equity and equity-related financial ratios as market interest rates cause the fair value of fixed-rate securities to fluctuate. Investment securities are classified as held to maturity when the Corporation and its Subsidiaries have the ability and intent to hold those securities to maturity. These investment securities are carried at cost, adjusted for amortization of premiums and accretion of discounts. Investment securities expected to be held for an indefinite period of time are classified as available for sale and are stated at fair value. Investment securities expected to be held for an indefinite period of time include securities that management intends to use as part of its asset/liability strategy (other than securities that are intended to be held to maturity because they offset core deposits that have demonstrated stability) or that may be sold in response to changes in interest rates, changes in prepayment risks, the need to increase regulatory capital or other similar factors. Realized gains and losses on the sale of investment securities are recognized using the specific identification method and are included in the consolidated statements of income. Loans Loans are stated at the principal amount outstanding. Net loans represent the principal loan amount outstanding reduced by unearned income and allowance for loan losses. Interest on loans is credited to income based on the principal amount outstanding. Lease financing represents automobile and equipment leasing. The lease financing receivable included in loans is stated at the gross amount of lease payments receivable plus the residual value less income to be earned over the life of the leases. Such income is recognized over the term of the leases using the level yield method. Loan origination fees and direct loan origination costs of completed loans are deferred and recognized over the life of the loan as an adjustment to yield. The net loan origination fees recognized as yield adjustments are reflected in total interest income in the consolidated statements of income, and the unamortized balance of such net loan origination fees is reported in the consolidated balance sheets as part of unearned income. Income recognition of interest is discontinued when, in the opinion of management, the collectibility of such interest becomes doubtful. A loan is generally classified as nonaccrual when principal or interest has consistently been in default for a period of 90 days or more or because of a deterioration in the financial condition of the borrower, and payment in full of principal or interest is not expected. Loans past due 90 days or more and still accruing interest are loans that are generally well-secured and expected to be restored to a current status in the near future. The Corporation accounts for impaired loans under SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures," on January 1, 1995. This standard requires that a creditor measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. Regardless of the measurement method, a creditor must measure impairment based on the fair value of the collateral when the creditor determines that foreclosure is probable. The Corporation adopted SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," as amended by SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125 -- An Amendment of FASB Statement No. 125" on January 1, 1997. SFAS No. 125 applies a control-oriented, financial components approach to financial-asset-transfer transactions whereby the Corporation (1) recognizes the financial and servicing assets it controls and the liabilities it has incurred, (2) derecognizes financial assets when control has been surrendered, and (3) derecognizes liabilities once they are extinguished. Under SFAS No. 125, control is considered to have been surrendered only if: (i) the transferred assets have been isolated from the transferor and its creditors, even in bankruptcy or other receivership (ii) the transferee has the PAGE 13 right to pledge or exchange the transferred assets, or, is a qualifying special purpose entity (as defined) and the holders of beneficial interests in that entity have the right to pledge or exchange those interests; and (iii) the transferor does not maintain effective control over the transferred assets through an agreement which both entitles and obligates it to repurchase or redeem those assets prior to maturity, or through an agreement which both entitles and obligates it to repurchase or redeem those assets if they were not readily obtainable elsewhere. If any of these conditions are not met, the Corporation accounts for the transfer as a secured borrowing. SFAS No. 125 also requires that the Corporation derecognize a liability if and when it is extinguished. A liability is considered extinguished under SFAS No. 125 if (1) the Corporation pays the creditor, and thus, is relieved of its obligation for the liability, or (2) is legally released from being the primary obligor under the liability, either judicially or by the creditor. The adoption of this statement did not have a material impact on the Corporation's consolidated financial position or results of operations. Allowance for Loan Losses The allowance for loan losses is maintained at a level that management considers adequate to provide for potential losses based upon an evaluation of known and inherent risks in the loan portfolio. Allowance for loan losses is based on estimated net realizable value unless it is probable that loans will be foreclosed, in which case allowance for loan losses is based on fair value less selling costs. Management's periodic evaluation is based upon evaluation of the portfolio, past loss experience, current economic conditions and other relevant factors. While management uses the best information available to make such evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Banks' allowances for loan losses. Such agencies may require the Banks to recognize additions to the allowance based on their judgment of information available to them at the time of their examination. Bank Premises and Equipment Bank premises and equipment are stated at cost less accumulated depreciation. Depreciation is recorded using the straight-line and accelerated depreciation methods over the estimated useful life of the assets. Leasehold improvements are amortized over the term of the lease or estimated useful life, whichever is shorter. On January 1, 1996, the Corporation adopted SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of," which provides guidance on when to recognize and how to measure impairment losses of long-lived assets and certain identifiable intangibles and how to value long-lived assets to be disposed of. The adoption of SFAS No. 121 did not have a material impact on the Corporation's consolidated financial position or results of operations. Other Real Estate Owned Other real estate owned includes foreclosed real estate which is carried at the lower of cost (lesser of carrying value of loan or fair value at date of acquisition) or estimated fair value less selling costs. Any write-down, at or prior to the dates the real estate is considered foreclosed, is charged to the allowance for loan losses. Subsequent write-downs are recorded in other expenses, and expenses incurred in connection with holding such assets and any gains or losses upon their sale are included in other income and expenses. Intangible Assets Intangible assets consist of a core deposit intangible which represents the present value of the difference in costs between the acquired core deposits and the market alternative funding sources and a covenant not to compete. Intangible assets also include mortgage servicing rights. The core deposit intangibles are being amortized over a 10-year life on an accelerated basis. The amortization charged to income related to the core deposit intangibles was $325,000, $309,000 and $302,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The mortgage servicing rights are amortized in proportion to and over the period of estimated net servicing income. Stock Options On January 1, 1996, the Corporation adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which contains a fair value-based method for valuing stock-based compensation that entities may use, which measures compensation cost at the grant date based on the fair value of the award. Compensation is then recognized over the service period, which is usually the vesting period. Alternatively, the standard permits entities to continue accounting for employee stock options and similar instruments under Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees." Entities that continue to account for stock options using APB Opinion No. 25 are required to make pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS No. 123 had been applied. The Corporation's employee stock option plan is accounted for under APB Opinion No. 25. Accordingly, the adoption of SFAS No. 123 did not have an impact on the Corporation's consolidated financial position or results of operations. Income Taxes The Corporation accounts for income taxes under the liability method specified by SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The principal types of accounts, resulting in differences between assets and liabilities for financial statement and tax return purposes, are the allowance for possible loan losses, leased assets, deferred loan fees and compensation. Pension Plans The Corporation has certain employee benefit plans covering substantially all employees. The Corporation accrues service cost as incurred. Advertising Costs The Corporation expenses advertising costs as incurred. Restrictions on Cash and Due From Banks As of December 31, 1998, the Banks did not need to maintain reserves (in the form of deposits with the Federal Reserve Bank) to satisfy federal regulatory requirements. PAGE 14 Net Income Per Share During 1997, the Corporation adopted the provisions of SFAS No. 128, "Earnings per Share." SFAS No. 128 eliminates primary and fully diluted earnings per share and requires presentation of basic and diluted earnings per share (EPS) in conjunction with the disclosure of the methodology used in the computing such earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average common shares outstanding during the period. Diluted earnings per share take into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. Prior periods' earnings per share calculations have been restated to reflect the adoption of SFAS No. 128. The reconciliation of the numerators and denominators of the basic and diluted EPS follows: Year Ended December 31, 1998 -------------------------------------- Income Shares Per Share (Numerator) (Denominator) Amount ----------- ------------- --------- Net income .................. $18,776,000 =========== Basic EPS Income available to common shareholders ......... $18,776,000 7,029,394 $ 2.67 ====== Effect of Dilutive Securities Stock options ............... -- 4,218 ----------- --------- Diluted EPS Income available to common shareholders ......... $18,776,000 7,033,612 $ 2.67 =========== ========= ====== Year Ended December 31, 1997 -------------------------------------- Net income .................. $16,662,000 =========== Basic EPS Income available to common shareholders ......... $16,662,000 7,005,184 $ 2.38 ====== Effect of Dilutive Securities Stock options ............... -- 7,095 ----------- --------- Diluted EPS Income available to common shareholders ......... $16,662,000 7,012,279 $ 2.38 =========== ========= ====== Year Ended December 31, 1996 -------------------------------------- Net income .................. $14,408,000 =========== Basic EPS Income available to common shareholders ......... $14,408,000 6,993,535 $ 2.06 ====== Effect of Dilutive Securities Stock options ............... -- 23,867 ----------- --------- Diluted EPS Income available to common shareholders ......... $14,408,000 7,017,402 $ 2.06 =========== ========= ====== Comprehensive Income On January 1, 1998 the Corporation adopted the FASB issued SFAS No. 130, "Reporting Comprehensive Income," SFAS No. 130 establishes standards to provide prominent disclosure of comprehensive income items. Comprehensive income is the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other comprehensive income consists of net unrealized gains on investment securities available for sale. Comprehensive income for 1998, 1997 and 1996 was $19,696,000, $18,332,000, and $15,834,000, respectively. The components of other comprehensive income are as follows: (Dollars in thousands) Before tax Tax Net of tax December 31, 1998 amount expense amount - ----------------- ---------- -------- ---------- Unrealized gains on securities: Unrealized holding gains arising during period .... $2,958 $(1,035) $1,923 Less reclassification adjustment for gains realized in net income ... 1,543 (540) 1,003 ------ ------- ------ Other comprehensive income, net $1,415 $ (495) $ 920 ====== ======= ====== Before tax Tax Net of tax December 31, 1997 amount expense amount - ----------------- ---------- -------- ---------- Unrealized gains on securities: Unrealized holding gains arising during period .... $4,326 $(1,514) $2,812 Less reclassification adjustment for gains realized in net income ... 1,757 (615) $1,142 ------ ------- ------ Other comprehensive income, net $2,569 $ (899) $1,670 ====== ======= ====== Before tax Tax Net of tax December 31, 1996 amount expense amount - ----------------- ---------- -------- ---------- Unrealized gains on securities: Unrealized holding gains arising during period .... $2,155 $ (754) $1,401 Less reclassification adjustment for losses realized in net income ... (39) 14 (25) ------ ------- ------ Other comprehensive income, net $2,194 $(768) $1,426 ====== ======= ====== Other Information On January 1, 1998, the Corporation adopted the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 redefines how operating segments are determined and requires disclosures of certain financial and descriptive information about a company's operating segments. Management has determined that under current conditions, the Corporation will report one business segment. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activity." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments imbedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge. The accounting for changes in the fair value of derivative (gains and losses) depends on the intended use of the derivative and resulting designation. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after PAGE 15 June 15, 1999. Earlier application is permitted only as of the beginning of any fiscal quarter. On January 1, 1999, the Corporation adopted SFAS No. 133. Concurrent with the adoption, the Corporation reclassified $7,530,000 of investment securities from the held to maturity category to the available for sale category and recorded $221,000 net of taxes of unrealized holding gains in accumulated other comprehensive income. 2 - Acquisitions - -------------------------------------------------------------------------------- Subsequent Event. On January 20, 1999, the Corporation consummated its acquisition of Northern Lehigh Bancorp, Inc., parent company of Citizens National Bank of Slatington. Accounted for as a pooling-of-interest, Northern Lehigh Bancorp, shareholders received 3.57 shares of Harleysville National Corporation common stock for each share of Northern Lehigh Bancorp common stock. The acquisition was affected by the merger of Northern Lehigh Bancorp, Inc. with Citizens National Bank, a bank holding company and wholly-owned subsidiary of Harleysville National Corporation. Citizens National Bank of Slatington merged with and into The Citizens National Bank of Lansford, a national banking association and wholly-owned subsidiary of Harleysville National Corporation North, Inc., under the name Citizens National Bank. A summary of pro-forma unaudited condensed consolidated financial information of the Corporation and Northern Lehigh Bancorp follows: (Dollars in thousands except weighted average number of common shares and per share information) Year Ended December 31, ---------------------------------- 1998 1997 1996 ---------- ---------- ---------- Operating results (unaudited): Net interest income ..................... $ 53,255 $ 49,741 $ 45,915 Noninterest income ...................... 10,008 7,591 5,311 Net income from continuing operations ... 19,308 17,642 15,267 Net income per share: Basic ................................ 2.56 2.35 2.04 Diluted .............................. 2.56 2.35 2.03 Weighted average number of common shares: Basic ................................ 7,527,402 7,505,023 7,498,147 Diluted .............................. 7,541,130 7,517,520 7,525,720 On March 1, 1996, the Corporation consummated the acquisition of Farmers & Merchants Bank (Honesdale, PA) ("Farmers"). For each share of Farmers common stock outstanding, 0.6190 shares of the Corporation's Common Stock were issued at the effective date on March 1, 1996. As a result of the transaction, 438,126 new shares of the Corporation's Common Stock, par value $1.00 per share, were issued on March 1, 1996, pursuant to the Agreements. Farmer's Banking operations were merged into those of Citizens. The Farmers merger was accounted for on a pooling-of-interest basis, and all prior periods have been restated to reflect the combination. The results of operations for the previously separate companies follows: (Dollars in thousands) Revenue Net Income -------- ---------- Year Ended December 31, 1996 Harleysville National Corporation .... $78,115 $14,282 Farmers & Merchants Bank, as of February 29, 1996 ........... 718 126 ------- ------- Total .......................... $78,833 $14,408 ======= ======= 3 - Investment Securities - -------------------------------------------------------------------------------- The amortized cost, unrealized gains and losses, and the estimated market values of the Corporation's investment securities held to maturity and available for sale are as follows: (Dollars in thousands) December 31, 1998 ------------------------------------------- Gross Gross Estimated Amortized Unrealized Unrealized Market Held to Maturity Cost Gains (Losses) Value --------- ---------- ---------- --------- Obligations of other U.S. Government agencies and corporations ..... $ 6,490 $ 80 $ (3) $ 6,567 Obligations of states and political subdivisions 17,093 544 (1) 17,636 Mortgage-backed securities ........... 1,039 11 -- 1,050 Other securities ........ 1,366 62 -- 1,428 --------- ------- -------- -------- Totals ............... $ 25,988 $ 697 $ (4) $ 26,681 ========= ======= ======== ======== Available for Sale U.S. Treasury notes ..... $ 43,008 $ 1,160 $ -- $ 44,168 Obligations of other U.S. Government agencies and corporations ..... 44,651 1,017 -- 45,668 Obligations of states and political subdivisions 161,053 4,009 (1,017) 164,045 Mortgage-backed securities ........... 86,934 487 (48) 87,373 Other securities ........ 45,391 2,868 (169) 48,090 --------- ------- -------- -------- Totals ............... $ 381,037 $ 9,541 $(1,234) $389,344 ========= ======= ======== ======== Held to Maturity December 31, 1997 - ---------------- ---------------------------------------- Obligations of other U.S. Government agencies and corporations ...... $ 21,707 $ 303 $ (14) $ 21,996 Obligations of states and political subdivisions 19,589 765 (6) 20,348 Mortgage-backed securities ............ 2,048 13 -- 2,061 Other securities ......... 2,894 55 -- 2,949 -------- ------- ------- -------- Totals ................ $ 46,238 $ 1,136 $ (20) $ 47,354 ======== ======= ======= ======== Available for Sale - ------------------ U.S. Treasury notes ...... $ 45,988 $ 634 $ (8) $ 46,614 Obligations of other U.S. Government agencies and corporations ...... 42,211 738 (4) 42,945 Obligations of states and political subdivisions 92,007 2,508 (210) 94,305 Mortgage-backed securities ............ 56,455 850 (6) 57,299 Other securities ......... 13,518 2,413 (26) 15,905 -------- ------ ------ -------- Totals ................ $250,179 $7,143 $(254) $257,068 ======== ====== ====== ======== There are no significant concentrations of securities (greater than 10% of shareholders' equity) in any individual security issuer. PAGE 16 Securities with a carrying value of $151,039,000 and $138,121,000 at December 31, 1998 and 1997, respectively, were pledged to secure public funds, government deposits and repurchase agreements. The amortized cost and estimated market value of investment securities, at December 31, 1998, by contractual maturities, are shown below. Actual maturities will differ from contractual maturities because issuers and borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. (Dollars in thousands) Held to Maturity Available for Sale ------------------- --------------------- Estimated Estimated Amortized Market Amortized Market Cost Value Cost Value --------- --------- --------- --------- Due in one year or less $ 3,776 $ 3,832 $ 13,992 $ 14,046 Due after one year through five years . 9,139 9,344 45,338 46,667 Due after five years through ten years .. 784 800 63,477 65,159 Due after ten years ... 11,250 11,655 171,296 176,099 ------- ------- -------- -------- 24,949 25,631 294,103 301,971 Mortgage-backed securities ......... 1,039 1,050 86,934 87,373 ------- ------- -------- -------- Totals ............. $25,988 $26,681 $381,037 $389,344 ======= ======= ======== ======== Proceeds from sales of investment securities available for sale during 1998 were $52,921,000. Gross gains of $1,544,000 and gross losses of $1,000 were realized on these sales. Proceeds from sales of investment securities available for sale during 1997 were $39,571,000. Gross gains of $2,073,000 and gross losses of $316,000 were realized on these sales. Proceeds from sales of investment securities available for sale during 1996 were $64,327,000. Gross gains of $168,000 and gross losses of $207,000 were realized on these sales. 4 - Loans - -------------------------------------------------------------------------------- Major classifications of loans are as follows: (Dollars in thousands) December 31, --------------------- 1998 1997 -------- -------- Real estate ................ $306,575 $246,259 Commercial and industrial .. 204,173 192,694 Consumer loans ............. 265,688 249,242 Lease financing ............ 68,753 55,413 -------- -------- Total loans ............. 845,189 743,608 Less: Unearned income ......... 2,302 4,155 Allowance for loan losses 12,950 11,925 -------- -------- Net loans ............... $829,937 $727,528 ======== ======== On December 31, 1998, nonaccrual loans were $2,950,000, loans 90 days or more past due and still accruing interest were $824,000 and troubled debt restructured loans were $583,000. On December 31, 1997, nonaccrual loans were $2,621,000, loans 90 days or more past due and still accruing interest were $2,253,000 and troubled debt restructured loans were $1,099,000. The balance of impaired loans was $2,096,000 at December 31, 1998, compared to $2,441,000 at December 31, 1997. The Banks have identified a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The December 31, 1998, impaired loan balance included $1,513,000 of nonaccrual loans and $583,000 of troubled debt restructured loans. The December 31, 1997, impaired loan balance included $1,429,000 of nonaccrual loans and $1,012,000 of troubled debt restructured loans. The allowance for loan loss associated with the impaired loans was $302,000 at December 31, 1998, and $341,000 at December 31, 1997. The average impaired loan balance was $2,263,000 in 1998, compared to $3,538,000 in 1997. The income recognized on impaired loans during 1998 and 1997 was $103,000 and $135,000, respectively. The Banks' policy for interest income recognition on impaired loans is to recognize income on restructured loans under the accrual method. The Banks recognize income on nonaccrual loans under the cash basis when the loans are both current and the collateral on the loan is sufficient to cover the outstanding obligation to the Banks. The Banks will not recognize income if these factors do not exist. The Banks have no concentration of loans to borrowers which exceeded 10% of total loans at December 31, 1998 and 1997. The Banks continued to pursue new lending opportunities while seeking to maintain a portfolio that is diverse as to industry concentration, type and geographic distribution. The Banks' geographic lending area is primarily concentrated in Montgomery, Carbon, Bucks, and Wayne counties, but also includes Chester, Berks and Schuylkill Counties, Pennsylvania. Loans to directors, executive officers and their associates, are made in the ordinary course of business and on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with others. Activity of these loans is as follows: (Dollars in thousands) Year Ended December 31, -------------------------------- 1998 1997 1996 -------- -------- -------- Balance, January 1 .... $ 3,574 $ 7,723 $ 12,586 New loans .......... 12,183 9,462 7,721 Repayments ......... (11,286) (13,611) (12,584) -------- -------- -------- Balance, December 31... $ 4,471 $ 3,574 $ 7,723 ======== ======== ======== PAGE 17 5 - Allowance for Loan Losses - -------------------------------------------------------------------------------- Transactions in the allowance for loan losses are as follows: (Dollars in thousands) Year Ended December 31, ------------------------------- 1998 1997 1996 ------- ------- ------- Balance, beginning of year $11,925 $10,710 $ 9,891 ------- ------- ------- Provision charged to operating expenses ... 2,140 2,500 2,082 ------- ------- ------- Loans charged off: Commercial and industrial ....... (217) (66) (392) Consumer .............. (627) (1,038) (614) Real estate ........... (424) (544) (412) Lease financing ....... (145) (78) (33) ------- ------- ------- Total charged off .. (1,413) (1,726) (1,451) ------- ------- ------- Recoveries: Commercial and industrial ....... 94 113 84 Consumer .............. 98 104 56 Real estate ........... 88 206 30 Lease financing ....... 18 18 18 ------- ------- ------- Total recoveries ... 298 441 188 ------- ------- ------- Balance, end of year ..... $12,950 $11,925 $10,710 ======= ======= ======= 6 - Bank Premises and Equipment - ------------------------------------------------------------------------------- Bank premises and equipment consist of the following: (Dollars in thousands) Estimated December 31, Useful ----------------- Lives 1998 1997 ----------- ------- ------- Land ................................ $ 2,841 $ 2,851 Building ............................ 15-39 years 16,349 15,858 Furniture, fixtures and equipment.... 3-10 years 14,788 12,250 ------- ------- Total cost ....................... 33,978 30,959 Less accumulated depreciation and amortization ................. 15,087 13,025 ------- ------- $18,891 $17,934 ======= ======= 7 - Deposits and Borrowings - -------------------------------------------------------------------------------- At December 31, 1998, scheduled maturities of certificates of deposit are as follows: (Dollars in thousands) Year Ended December 31, 1999 2000 2001 2002 2003 Thereafter Total -------- ------- ------- ------- ------- ---------- -------- Amount $240,263 $71,960 $40,679 $30,912 $12,223 $25 $396,062 ======== ======= ======= ======= ======= === ======== Federal Home Loan Bank (FHLB) advances at December 31, 1998, totaled $93,500,000. The advances are collateralized by FHLB stock and certain first mortgage loans and mortage-backed securities. First mortgages used as collateral for these advances totaled $69,934,000. These advances had a weighted average interest rate of 5.06.%. Advances are made pursuant to several different credit programs offered from time to time by the FHLB. Unused lines of credit at the FHLB were $105,935,000 at December 31, 1998. Outstanding borrowings mature as follows (dollars in thousands): 2000 ................................... $ 500 2002 ................................... 15,000 2003 and thereafter .................... 78,000 ------- $93,500 ======= The Banks, pursuant to a designated cash management agreement, utilize securities sold under agreements to repurchase as vehicles for customers' sweep and term investment products. Securitization under these cash management agreements are in U.S. Treasury Securities. The U.S. Treasury Securities are held in a third party custodian's account, designated by the Banks under a written custodial agreement that explicitly recognizes the Banks' interest in the securities. The U.S. Treasury Securities are non-deliverable and held in the name of the customer in the custodial account. At December 31, 1998, these agreements matured within one year. The average balance of securities sold under agreements to repurchase for 1998 was $39,002,000, and the maximum amounts outstanding at any month-end during 1998 was $51,176,000. 8 - Federal Income Taxes - -------------------------------------------------------------------------------- Income tax expense from current operations is composed of the following: (Dollars in thousands) Year Ended December 31, ------------------------ 1998 1997 1996 ------ ------ ------ Current tax payable ..... $4,602 $4,631 $4,699 Deferred income tax ..... 1,507 1,420 894 ------ ------ ------ Tax expense ............ $6,109 $6,051 $5,593 ====== ====== ====== The effective income tax rates of 24.5% for 1998, 26.6% for 1997 and 28.0% for 1996 were less than the applicable federal income tax rate of 35% for each year. The reason for these differences follows: (Dollars in thousands) Year Ended December 31, ----------------------------- 1998 1997 1996 ------- ------- ------- Expected tax expense ....... $ 8,710 $ 7,722 $ 6,800 Tax-exempt income (net of expense disallowance) ... (2,688) (1,893) (1,414) Other ...................... 87 222 207 ------- ------- ------- Actual tax expense ...... $ 6,109 $ 6,051 $ 5,593 ======= ======= ======= PAGE 18 The tax effect of temporary differences that give rise to significant portions of deferred tax assets and liabilities are as follows: (Dollars in thousands) 1998 1997 ----------------- ------------------- Asset Liability Asset Liability ----- --------- ----- --------- Allowance for loan losses................. $ 4,532 $ -- $ 4,174 $ -- Lease assets .................. -- 11,021 -- 9,330 Deferred loan fees ............ 449 -- 628 -- Deferred compensation ......... 722 -- 620 -- Unrealized gain on securities .............. -- 2,907 -- 2,410 Other ......................... 114 -- 212 -- ------- ------- ------- ------- Total deferred taxes ....... $ 5,817 $13,928 $ 5,634 $11,740 ======= ======= ======= ======= The exercise of stock options which have been granted under the Corporation's various stock option plans gives rise to compensation, which is includable in the taxable income of the applicable employees and deductible by the Corporation for income tax purposes. Compensation resulting from increases in the fair market value of the Corporation's Common Stock subsequent to the date of grant of the applicable exercised stock options is not recognized, in accordance with APB Opinion No. 25, as an expense for financial accounting purposes and the related tax benefits are taken directly to Additional Paid in Capital. For the year ended December 31, 1996, such deductions resulted in $927,000 of income tax benefits which increased the Additional Paid in Capital. 9 - Pension Plans - -------------------------------------------------------------------------------- The Corporation has noncontributory defined benefit pension plans covering substantially all employees. Benefits are based on years of service and the employee's average compensation during any five consecutive years within the 10-year period preceding retirement. The plans' funded status and amounts recognized in the financial statements follow: (Dollars in thousands) 1998 1997 ------------- ------------ Change in benefit obligation: - ----------------------------- Benefit obligation at beginning of year ........ $ 4,382 $ 3,967 Service cost ................................... 264 247 Interest cost .................................. 297 275 Actual gain .................................... 241 (42) Benefits paid .................................. (842) (65) Change in assumptions .......................... 634 -- ------- ------- Benefits obligation at end of year.............. $ 4,976 $ 4,382 ======= ======= Change in plans assets: - ----------------------- Fair value of plan assets at beginning of year.. $ 6,295 $ 5,436 Actual return on plan assets ................... 521 924 Employer contribution .......................... -- -- Benefits paid .................................. (842) (65) ------- ------- Fair value of plan assets at end of year ....... $ 5,974 $ 6,295 ======= ======= Funded status .................................. $ 998 $ 1,913 Unrecognized transition liability (asset)....... (207) (224) Unrecognized prior service cost ................ (661) (772) Unrecognized net (gain) or loss ................ 527 (258) ------- ------- Prepaid (accrued) benefit cost ............ $ 657 $ 659 ======= ======= Weighted-average assumptions as of December 31: 1998 1997 1996 - ---------------------------------- -------- -------- -------- Discount rate ............................ 6.00% 7.00% 7.15% Expected return on plan assets ........... 7.00% 7.00% 7.50% Rate of compensation increase ............ 4.50% 5.00% 5.35% Components of net periodic benefit cost 1998 1997 1996 - --------------------------------------- -------- -------- -------- Service cost ............................. $ 264 $ 247 $ 295 Interest cost ............................ 297 275 222 Expected return on plan assets ........... (431) (394) (220) Amortization of prior service cost ....... (111) (110) 4 Recognized net actuarial loss ............ (17) 18 24 ----- ----- ----- Net periodic benefit cost $ 2 $ 36 $ 325 ===== ===== ===== As of December 31, 1998, the pension plan had an investment in the Corporation's stock with a market value of $239,000. The Banks had a profit sharing plan for eligible employees. The continuation of the profit sharing plan was voluntary on the part of the Banks. The Banks expressly reserved the right to amend or terminate the plan and to reduce, suspend or discontinue contributions at any time. In 1996, the profit sharing plan was modified to a 401(K) plan. All employees may contribute up to a maximum of 15% of salary on a pre-tax basis with a 50% employer match up to a maximum of 3% of salary. Contributions charged to earnings were $241,942, $202,857, and $699,282 for 1998, 1997 and 1996, respectively. The Corporation has a Supplemental Executive Retirement Plan (SERP) for certain individuals. The SERP provides for payments based on a certain percentage of salary for a period of 10 years after retirement. As of December 31, 1998, and 1997, the Corporation had accrued a liability of $1,246,500 and $992,589, respectively, for the SERP. 10 - Shareholders' Equity - -------------------------------------------------------------------------------- On June 30, 1997, the Corporation paid a 5% stock dividend on its common stock to shareholders of record as of June 13, 1997. On June 28, 1996, the Corporation paid a 5% stock dividend on its common stock to shareholders of record as of June 14, 1996. 11 - Stock Options - -------------------------------------------------------------------------------- The Corporation has a fixed stock option plan accounted for under APB Opinion No. 25 and related interpretations. The plan allows the Corporation to grant options to employees for up to 80,000 shares of common stock. The options have a term of 10 years when issued and are completely vested over a five-year period. The exercise price of each option equals the market price of the Corporation's stock on the date of grant. Accordingly, no compensation cost has been recognized for the plan. Had compensation cost for the plan been determined based on the fair value of the options at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," the Corporation's net income and earnings per share for all periods presented would not be materially different from amounts reported. Disclosures are not likely to be representative of the effect on reported net income for future years, since options vest over several years and additional awards may be made each year. PAGE 19 Under the Corporation's stock option plan, the exercisable option prices ranged from $24.38 to $42.69 at December 31, 1998. The weighted-average exercise price and weighted-average remaining contractual life of the stock option plan is $35.25 and 9 years and 8 months, respectively. A summary of the status of the Corporation's fixed stock option plans as of December 31, 1998, 1997 and 1996, and changes during the years ending on those dates is presented below. 1998 1997 1996 -------- -------- -------- Number of Common Shares: Outstanding, January 1* ............. 20,539 55,076 71,853 Granted ............................. 72,500 -- -- Exercised ........................... (18,802) (34,537) (16,777) ------- ------- ------- Outstanding, December 31 ............ 74,237 20,539 55,076 ======= ======= ======= Exercisable, December 31 ............ 1,042 20,539 55,076 ======= ======= ======= * Adjusted for stock splits and stock dividends. 12 - Commitments and Contingent Liabilities - -------------------------------------------------------------------------------- Based on consultation with the Corporation's legal counsel, management is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its Subsidiaries. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation or its Subsidiaries by government authorities. Lease commitments for equipment and banking locations expire intermittently over the years through 2036. Most banking location leases require the lessor to pay insurance, maintenance costs and property taxes. Approximate minimum rental commitments for existing operating leases at December 31, 1998 are as follows: Total Operating Leases ---------------- 1999 $ 1,460,000 2000 1,350,000 2001 1,055,000 2002 535,000 2003 517,000 Thereafter 4,341,000 ------------ Total .................. $ 9,258,000 ============ Total lease expense amounted to $1,494,000 in 1998, $1,259,000 in 1997 and $895,000 in 1996. 13 - Financial Instruments with Off-Balance Sheet Risk - -------------------------------------------------------------------------------- The Banks have not entered into any interest rate swaps, caps, floors or collars and are not a party to any forward or futures transactions. However, the Banks are a party to various other financial instruments at December 31, 1998 and 1997 which are not included in the consolidated financial statements, but are required in the normal course of business to meet the financing needs of its customers and to assist in managing its exposure to changes in interest rates. Management does not expect any material losses from these transactions, which include standby letters of credit at December 31, 1998 and 1997 of $6,215,000 and $5,463,000, respectively; commitments to extend credit of $36,349,000 and $23,945,000, respectively for revolving home equity lines; $99,106,000 and $78,715,000, respectively for commercial and real estate loans; $21,356,000 and $21,059,000, respectively, for consumer loans. The Banks' exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amounts of those instruments. The Banks use the same stringent credit policies in extending these commitments as they do for recorded financial instruments and control their exposure to loss through credit approval and monitoring procedures. These commitments are generally issued for one year or less, often expire without being drawn upon, and often are secured with appropriate collateral. The Banks offer commercial, mortgage and consumer credit products to their customers in the normal course of business, which are detailed in note 4. These products represent a diversified credit portfolio and are generally issued to borrowers within the Banks' branch office systems in eastern Pennsylvania. The ability of the customers to repay their credits is, to some extent, dependent upon the economy in the Banks' market areas. 14 - Regulatory Capital - -------------------------------------------------------------------------------- The Banks are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on the Corporation's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Banks must meet specific capital guidelines that involve quantitative measures of the Banks' assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Banks' capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Banks to maintain minimum amounts and ratios (set forth in the table) of total and Tier 1 capital to risk-weighted assets. Management believes, as of December 31, 1998, that the Banks meet all capital adequacy requirements to which they are subject. To be categorized as well capitalized, the Banks must maintain minimum total risk-based, Tier 1 risk-based, Tier 1 leverage ratios as set forth in the table. There are no conditions or events which have occurred that management believes have changed the institutions' category. PAGE 20
- ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in thousands) To Be Well Capitalized Under Actual For Capital Adequacy Purposes Prompt Corrective Action Provision As of December 31, 1998 Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------------------------ Total Capital (to risk weighted assets): - ---------------------------------------- Corporation ............................. $128,441 13.84% $74,226 8.00% $92,783 10.00% Harleysville National Bank .............. 70,733 9.70% 58,316 8.00% 72,895 10.00% Citizens National Bank .................. 23,186 21.08% 8,798 8.00% 10,997 10.00% Security National Bank .................. 7,629 10.74% 5,680 8.00% 7,101 10.00% Tier 1 Capital (to risk weighted assets): - ---------------------------------------- Corporation ............................. $115,982 12.50% $37,113 4.00% $55,670 6.00% Harleysville National Bank .............. 61,603 8.45% 29,158 4.00% 43,737 6.00% Citizens National Bank .................. 21,811 19.83% 4,399 4.00% 6,598 6.00% Security National Bank .................. 6,741 9.49% 2,840 4.00% 4,260 6.00% Tier 1 Capital (to average assets): - ---------------------------------- Corporation ............................. $115,982 8.98% $51,643 4.00% $64,554 5.00% Harleysville National Bank .............. 61,603 6.11% 40,191 4.00% 50,238 5.00% Citizens National Bank .................. 21,811 12.31% 7,089 4.00% 8,861 5.00% Security National Bank .................. 6,741 7.10% 3,799 4.00% 4,749 5.00%
- ------------------------------------------------------------------------------------------------------------------------------------ (Dollars in thousands) To Be Well Capitalized Under Actual For Capital Adequacy Purposes Prompt Corrective Action Provision As of December 31, 1997 Amount Ratio Amount Ratio Amount Ratio - ------------------------------------------------------------------------------------------------------------------------------------ Total Capital (to risk weighted assets): - --------------------------------------- Corporation ............................. $113,276 14.68% $61,745 8.00% $77,182 10.00% Harleysville National Bank .............. 80,778 12.96% 49,851 8.00% 62,314 10.00% Citizens National Bank .................. 21,971 23.74% 7,403 8.00% 9,254 10.00% Security National Bank .................. 6,884 12.39% 4,446 8.00% 5,558 10.00% Tier 1 Capital (to risk weighted assets): - ---------------------------------------- Corporation ............................. $103,600 13.42% $30,873 4.00% $46,309 6.00% Harleysville National Bank .............. 72,965 11.71% 24,926 4.00% 37,388 6.00% Citizens National Bank .................. 20,811 22.49% 3,701 4.00% 5,552 6.00% Security National Bank .................. 6,188 11.13% 2,223 4.00% 3,335 6.00% Tier 1 Capital (to average assets): - --------------------------------- Corporation ............................. $103,600 9.36% $44,327 4.00% $55,408 5.00% Harleysville National Bank .............. 72,965 8.42% 34,740 4.00% 43,425 5.00% Citizens National Bank .................. 20,811 13.00% 6,405 4.00% 8,006 5.00% Security National Bank .................. 6,188 8.20% 3,018 4.00% 3,773 5.00%
The National Banking Laws require the approval of the Office of the Comptroller of the Currency if the total of all dividends declared by a national bank in any calendar year exceed the net profits of the bank (as defined) for that year combined with its retained net profits for the preceding two calendar years. Under this formula, the Banks may declare dividends in 1999 of approximately $22,000,000 plus an amount equal to the net profits of the Banks in 1999 up to the date of any such dividend declaration. Additionally, banking regulations limit the amount of investments, loans, extensions of credit and advances that one subsidiary bank can make to the Corporation at any time to 10% and in the aggregate 20% of the Banks' capital stock and surplus. These regulations also require that any such investment, loan, extension of credit or advance be secured by securities having a market value in excess of the amount thereof. At December 31, 1998, there were no investments, loans, extensions of credit or advances from any of the subsidiary banks to the Corporation. 15 - Fair Value of Financial Instruments - -------------------------------------------------------------------------------- SFAS No. 107 "Disclosures about Fair Values of Financial Instruments," requires disclosure of the estimated fair value of an entity's assets and liabilities considered to be financial instruments. For the Corporation, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments as defined in SFAS No. 107. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Corporation's general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities, except for certain loans and investments. Therefore, the Corporation had to use significant estimates and present value calculations to prepare this disclosure. PAGE 21 Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values. Estimated fair values have been determined by the Corporation using the best available data and an estimation methodology suitable for each category of financial instruments. The estimation methodologies used, the estimated fair values and recorded book balances at December 31, 1998 and 1997 are outlined below. For cash and due from banks, interest-bearing deposits in banks and federal funds sold, the recorded book values of $52,956,000 and $55,095,000 at December 31, 1998 and 1997, respectively, approximate fair values. The estimated fair values of investment securities are based on quoted market prices, if available. Estimated fair values are based on quoted market prices of comparable instruments if quoted market prices are not available. The loan portfolio, net of unearned income, at December 31, 1998 and 1997 has been valued using a present value discounted cash flow analysis where market prices were not available. The discount rate used in these calculations is the estimated current market rate adjusted for credit risk. The carrying value approximates its fair value. 1998 1997 -------------------------- ------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------- ----------- -------- ---------- Investment securities ....... $ 415,332,000 $ 416,025,000 $ 303,306,000 $ 304,422,000 Loans, net ......... $ 842,887,000 $ 847,289,000 $ 739,453,000 $ 747,008,000 The estimated fair values of demand deposits (i.e., interest and noninterest-bearing checking accounts, savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The carrying amounts of variable rate, fixed-term money market accounts and certificates of deposit approximate their fair values at the reporting date. The carrying amount of accrued interest receivable and payable approximates fair value. 1998 1997 -------------------------- ------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------- ----------- -------- ---------- Time deposits ....... $ 396,062,000 $ 399,770,000 $ 368,348,000 $ 369,709,000 The fair values of demand notes, borrowings, and securities sold under agreements to repurchase of $147,986,000 and $64,143,000 at December 31, 1998 and 1997, respectively, approximate their recorded book balances. There was no material difference between the notional amount and the estimated fair value of off-balance-sheet items which totaled approximately $163,026,000 and $129,182,000 at December 31, 1998 and 1997, respectively, and primarily comprised unfunded loan commitments which are generally priced at market at the time of funding. 16 - Condensed Financial Information - Parent Company Only - -------------------------------------------------------------------------------- Condensed financial statements of Harleysville National Corporation follow: CONDENSED BALANCE SHEETS (Dollars in thousands) December 31, ----------------------------- 1998 1997 ------------- ------------ Assets: Cash .................................... $ 244 $ 748 Investments in subsidiaries ............. 123,014 109,493 -------- -------- Total assets ............................ $123,258 $110,241 ======== ======== Liabilities and shareholders' equity: Other liabilities ....................... $ 447 $ 449 -------- -------- Total liabilities ....................... $ 447 $ 449 -------- -------- Shareholders' equity: Common stock ............................ $ 7,038 $ 7,020 Additional paid in capital .............. 49,641 49,305 Retained earnings ....................... 60,733 48,988 Net unrealized gain on investment securities available for sale ......... 5,399 4,479 -------- -------- Total shareholders' equity .............. 122,811 109,792 -------- -------- Total liabilities and shareholders' equity .................. $123,258 $110,241 ======== ======== CONDENSED STATEMENTS OF INCOME (Dollars in thousands) Year Ended December 31, -------------------------------- 1998 1997 1996 -------- -------- -------- Dividends from banks ................. $ 27,845 $ 8,371 $ 5,584 Other income ......................... 1 71 156 -------- ------- ------- Total operating income ............ 27,846 8,442 5,740 -------- ------- ------- Operating expense .................... 9 -- -- -------- ------- ------- Income before income tax expense and equity in undistributed net income of banks ............... 27,837 8,442 5,740 Income tax expense ................... (3) 24 55 -------- ------- ------- Income before equity in undistributed. net income of banks ............... 27,840 8,418 5,685 Equity in undistributed net income of banks ............... (9,064) 8,244 8,723 -------- ------- ------- Net income ........................ $ 18,776 $16,662 $14,408 ======== ======= ======= PAGE 22 CONDENSED STATEMENTS OF CASH FLOWS (Dollars in thousands) Year Ended December 31, -------------------------------- 1998 1997 1996 -------- -------- -------- Operating activities: Net income .......................... $18,776 $16,662 $14,408 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed net income of banks ........... 9,064 (8,244) (8,723) Realized gain on sale of securities ................. -- (6) (68) Net increase in other liabilities ............. (3) 24 55 Net cash provided by operating activities ................ 27,837 8,436 5,672 Investing activities: Capital contributions made to the banks ................. (21,664) (3,944) -- Proceeds from sales of securities ..................... -- 1,874 405 Purchase of securities available for sale ................ -- -- (1,576) Net cash (used in) provided by investing activities ............. (21,664) (2,070) (1,171) Financing activities: Cash dividends and fractional shares ................. (7,031) (6,387) (5,604) Stock options and awards ............ 354 216 112 Net cash used in financing activities ................ (6,677) (6,171) (5,492) Net (decrease) increase in cash ........ (504) 195 (991) Cash and cash equivalents at beginning of year ................... 748 553 1,544 Cash and cash equivalents at end of year ......................... $ 244 $ 748 $ 553 17 - Quarterly Financial Data (Unaudited) - -------------------------------------------------------------------------------- The following is the summarized (unaudited) consolidated quarterly financial data of the Corporation which, in the opinion of management, reflects all adjustments, consisting only of normal recurring adjustments, necessary for fair presentation of the Corporation's results of operations: (Dollars in thousands, except per share information) Three Months Ended --------------------------------------------- 1998: March 31 June 30 Sept. 30 Dec. 31 -------- ------- -------- ------- Interest income ............. $20,911 $21,627 $ 22,182 $22,877 Net interest income ......... 12,112 12,346 12,540 12,790 Provision for losses ........ 535 535 535 535 Noninterest income .......... 1,862 2,172 2,895 2,881 Operating expenses .......... 7,804 8,019 7,941 8,809 Income before income tax expense .............. 5,635 5,964 6,959 6,327 Income tax expense .......... 1,385 1,439 1,885 1,400 -------- ------- -------- ------- Net income .................. $ 4,250 $ 4,525 $ 5,074 $ 4,927 ======== ======= ======== ======= Net income per share Basic .................... $ 0.61 $ 0.64 $ 0.72 $ 0.70 ======== ======= ======== ======= Diluted .................. $ 0.61 $ 0.64 $ 0.72 $ 0.70 ======== ======= ======== ======= 1997: Interest income ............. $19,340 $19,795 $ 20,482 $20,585 Net interest income ......... 11,366 11,407 11,795 11,783 Provision for losses ........ 540 590 540 830 Noninterest income .......... 1,390 2,126 1,651 2,224 Operating expenses .......... 6,833 6,904 7,149 7,643 Income before income tax expense .............. 5,383 6,039 5,757 5,534 Income tax expense .......... 1,469 1,669 1,513 1,400 -------- ------- -------- ------- Net income .................. $ 3,914 $ 4,370 $ 4,244 $ 4,134 ======== ======= ======== ======= Net income per share Basic .................... $ 0.57 $ 0.62 $ 0.60 $ 0.59 ======== ======= ======== ======= Diluted .................. $ 0.57 $ 0.62 $ 0.60 $ 0.59 ======== ======= ======== ======= ================================================================================ PAGE 23 Management's Discussion and Analysis of Financial Condition and Results of Operations Harleysville National Corporation and Subsidiaries
Consolidated Summary of Operations (Dollars in thousands, except per share Year Ended December 31, data and average shares outstanding) ----------------------------------------------------------- 1998 1997 1996 1995 1994 -------- ------- ------- ------- ------- Income And Expense Interest income .................................... $ 87,597 $ 80,202 $ 73,718 $ 68,491 $ 58,381 Interest expense ................................... 37,809 33,851 30,876 28,784 21,101 ---------- ---------- ---------- ---------- ---------- Net interest income ................................ 49,788 46,351 42,842 39,707 37,280 Provision for loan losses .......................... 2,140 2,500 2,082 2,172 2,665 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for loan losses. 47,648 43,851 40,760 37,535 34,615 Noninterest income ................................. 9,810 7,391 5,115 4,437 4,746 Noninterest expense ................................ 32,573 28,529 25,874 24,267 23,314 ---------- ---------- ---------- ---------- ---------- Income before income tax expense ................... 24,885 22,713 20,001 17,705 16,047 Income tax expense ................................. 6,109 6,051 5,593 5,277 4,767 ---------- ---------- ---------- ---------- ---------- Net income ......................................... $ 18,776 $ 16,662 $ 14,408 $ 12,428 $ 11,280 ========== ========== ========== ========== ========== - ---------------------------------------------------------------------------------------------------------------------- Per Share Basic earnings ..................................... $ 2.67 $ 2.38* $ 2.06* $ 1.79* $ 1.66* Diluted earnings ................................... 2.67 2.38* 2.06* 1.78* 1.62* Cash dividends paid ................................ 1.00 0.91* 0.80* 0.71* 0.55* Basic average shares outstanding ................... 7,029,394 7,005,184* 6,993,535* 6,949,275* 6,789,795* Diluted average shares outstanding ................. 7,033,612 7,012,279* 7,017,402* 6,983,099* 6,948,892* *Adjusted for 5% stock dividends effective 6/30/97, 6/28/96 and 12/30/94. - ---------------------------------------------------------------------------------------------------------------------- Average Balance Sheet Loans .............................................. $ 781,459 $ 706,643 $ 652,157 $ 607,335 $ 540,030 Investments ........................................ 356,109 289,018 260,483 226,747 236,319 Other interest-earning assets ...................... 20,594 25,322 16,949 14,605 10,351 Total assets ....................................... 1,209,273 1,075,702 978,899 894,350 829,241 Deposits ........................................... 970,632 878,166 821,387 761,089 738,029 Other interest-bearing liabilities ................. 97,232 71,034 46,813 37,067 8,348 Shareholders' equity ............................... 116,480 103,807 91,687 81,788 74,234 - ---------------------------------------------------------------------------------------------------------------------- Balance Sheet At Year-End Loans .............................................. $ 842,887 $ 739,453 $ 681,410 $ 628,738 $ 594,754 Investments ........................................ 415,332 303,306 275,021 242,995 216,816 Other earning assets ............................... 15,193 16,624 14,475 17,998 2,980 Total assets ....................................... 1,332,389 1,116,254 1,026,128 937,345 862,669 Deposits ........................................... 1,033,968 919,071 847,699 794,499 743,326 Other interest-bearing liabilities ................. 148,978 64,138 59,521 39,751 35,322 Shareholders' equity ............................... 122,811 109,792 97,631 86,362 74,182 - ----------------------------------------------------------------------------------------------------------------------
PAGE 24 Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of Harleysville National Corporation and its Subsidiaries. When we use words such as "believes," "expects," "anticipates," or similar expressions, we are making forward-looking statements. Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that we incorporate by referenece, could affect the future financial results of Harleysville National Corporation and its Subsidiaries and could cause those results to differ materially from those expressed in our forward-looking statements contained or incorporated by reference in this document. These factors include the following: o operating, legal and regulatory risks; o economic, political and competitive forces affecting our banking, securities, asset management and credit services businesses; and o the risk that our analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful. Introduction The Corporation reported a strong earnings performance during 1998. This performance was accomplished through an increase in assets, efforts to contain overhead expenses, and an increased emphasis on the origination and sales of residential mortgages. The results of 1998 also included an improvement in the quality of the loan portfolio. Net income amounted to $18,776,000 in 1998, compared to the $16,662,000 reported in 1997. Both basic and diluted earnings per share increased 12.2% to $2.67, from $2.38 earned in 1997. Earnings were enhanced by the growth in earning assets and an increase in income from the Investment Management and Trust Services Division. Average earning assets increased $137,179,000, or 13.4%, from a year ago. During 1998, the Corporation instituted a capital leverage program, which contributed to the increase in earning assets. An improvement in asset quality in 1998 was reflected by a decline in loans past due 90 days or more. At December 31, 1998, loans past due 90 days or more were reduced by $1,429,000, to $824,000, compared to the December 31, 1997, balance of $2,253,000. Nonperforming assets as a percentage of total loans and net assets acquired in foreclosure at December 31, 1998, declined to 0.50%, from 0.56% at December 31, 1997. Interest-Earning Assets and Interest-Bearing Liabilities Average interest-earning assets totaled $1,158,162,000 in 1998, an increase of $137,179,000, or 13.4%, compared to 1997. The increase occurred in the loan and investment portfolios. During 1998, the average balance of the loan portfolio increased $74,816,000, or 10.6%, while the average balance of investment securities increased $67,091,000 or 23.2%. Average interest earning assets were $929,589,000 in 1996. Average interest-bearing liabilities totaled $917,590,000 in 1998, an increase of $103,697,000, or 12.7%, compared to 1997. This increase was attributable to an increase in savings, time, and other borrowings of $49,232,000, $28,267,000, and $26,198,000, respectively. Average interest-bearing liabilities were $745,741,000 in 1996. PAGE 25 BALANCE SHEET ANALYSIS The table below presents the major asset and liability categories on an average daily basis for the periods presented, along with interest income and expense, and key rates and yields. Distribution Of Assets, Liabilities And Shareholders' Equity, Interest Rates And Interest Differential
Year Ended December 31, -------------------------------------------------------------------------- 1998 1997 ------------------------------------ ------------------------------------ Average Average Average Average (Dollars in thousands) Balance Rate Interest Balance Rate Interest ---------- ------- --------- --------- -------- ---------- Assets Investment securities: Taxable investments ................... $ 209,143 6.30% $ 13,167 $ 188,935 6.58% $ 12,433 Nontaxable investments (1) ............ 146,966 8.03 11,802 100,083 8.33 8,334 ---------- ---- -------- ---------- ---- -------- Total investment securities ...... 356,109 7.01 24,969 289,018 7.19 20,767 Loans (1) (2) ................................ 781,459 8.47 66,204 706,643 8.68 61,326 Other rate-sensitive assets .................. 20,594 5.17 1,064 25,322 5.69 1,440 ---------- ---- -------- ---------- ---- -------- Total earning assets ............. 1,158,162 7.96 92,237 1,020,983 8.18 83,533 Noninterest-earning assets ................... 51,111 -- -- 54,719 -- -- ---------- ---- -------- ---------- ---- ------- Total assets ..................... $1,209,273 7.63% $ 92,237 $1,075,702 7.77% $83,533 ========== ==== ======== ========== ==== ======= Liabilities And Shareholders' Equity Deposits: Demand ................................ $ 150,274 --% $ -- $ 135,307 --% $ -- Savings ............................... 430,546 2.69 11,596 381,314 2.66 10,149 Time .................................. 389,812 5.52 21,512 361,545 5.55 20,076 ---------- ---- -------- ---------- ---- ------- Total ............................ 970,632 3.41 33,108 878,166 3.44 30,225 Borrowings and other interest-bearing liabilities .............. 97,232 4.83 4,701 71,034 5.10 3,626 Other liabilities ............................ 24,929 -- -- 22,695 -- -- ---------- ---- -------- ---------- ---- ------- Total liabilities ................ 1,092,793 3.46 37,809 971,895 3.48 33,851 Shareholders' equity ......................... 116,480 -- -- 103,807 -- -- ---------- ---- -------- ---------- ---- ------- Total liabilities and shareholders' equity .......... $1,209,273 3.13% $ 37,809 $1,075,702 3.15% $33,851 ========== ==== ======== ========== ==== ======= Average effective rate on interest-bearing liabilities .............. $ 917,590 4.12% $ 37,809 $ 813,893 4.16% $33,851 ========== ==== ======== ========== ==== ======= ================================================================================================================================= Interest Income/Earning Assets ............... $1,158,162 7.96% $ 92,237 $1,020,983 8.18% $83,533 Interest Expense/Earning Assets .............. $1,158,162 3.26 $ 37,809 $1,020,983 3.31 $33.851 ---- ---- Effective Interest Differential .............. 4.70% 4.87% ==== ====
- ------ STUB - ------
-------------------------------------- 1996 -------------------------------------- Average Average (Dollars in thousands) Balance Rate Interest --------- ------- -------- Assets Investment securities: Taxable investments ...................... $ 186,213 6.50% $12,110 Nontaxable investments (1) ............... 74,270 8.33 6,185 --------- ---- ------- Total investment securities ......... 260,483 7.02 18,295 Loans (1) (2) ................................... 652,157 8.74 57,008 Other rate-sensitive assets ..................... 16,949 5.33 904 --------- ---- ------- Total earning assets ................ 929,589 8.20 76,207 Noninterest-earning assets ...................... 49,310 -- -- --------- ---- ------- Total assets ........................ $ 978,899 7.78% 76,207 ========= ==== ======= Liabilities And Shareholders' Equity Deposits: Demand ................................... $ 122,459 --% $ -- Savings .................................. 361,890 2.66 9,616 Time ..................................... 337,038 5.59 18,854 --------- ---- ------- Total ............................... 821,387 3.47 28,470 Borrowings and other interest-bearing liabilities ................. 46,813 5.14 2,406 Other liabilities ............................... 19,012 -- -- --------- ---- ------- Total liabilities ................... 887,212 3.48 30,876 Shareholders' equity ............................ 91,687 -- -- --------- ---- ------- Total liabilities and shareholders' equity ............. $ 978,899 3.15% $30,876 ========= ==== ======= Average effective rate on interest-bearing liabilities ................. $ 745,741 4.14% $30,876 ========= ==== ======= ========================================================================================== Interest Income/Earning Assets .................. $929,589 8.20% $76,207 Interest Expense/Earning Assets ................. $929,589 3.32 $30,876 ---- Effective Interest Differential ................. 4.88% ====
(1) The interest earned on nontaxable investment securities and loans is shown on a tax-equivalent basis. (2) Nonaccrual loans have been included in the appropriate average loan balance category, but interest on nonaccrual loans has not been included for purposes of determining interest income. - -------------------------------------------------------------------------------- PAGE 26 Investment Securities Statement of Financial Accounting (SFAS) Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," requires, among other things, that debt and equity securities classified as available for sale be reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The net effect of unrealized gains or losses, caused by marking an available for sale portfolio to market, causes fluctuations in the level of shareholders' equity and equity-related financial ratios as market interest rates cause the fair value of fixed-rate securities to fluctuate. Total investment securities at December 31, 1998 of $415,332,000 grew $112,026,000, or 36.9% over the December 31, 1997 balance of $303,306,000. This increase included the $53,000,000 in securities purchased as part of the capital leverage program. The increase in deposit balances and borrowings funded the growth in securities during this period. Investment securities held to maturity decreased $20,250,000 during 1998, as a result of maturities and calls. Investment securities available for sale increased $132,276,000. The increase in the investments available for sale were funded by proceeds from the maturities and calls in the held to maturity portfolio and through the increase in deposits and borrowings during 1998. Loans Total loans grew $101,581,000, from $743,608,000 at December 31, 1997 to $845,189,000 at December 31, 1998. The banks experienced growth in all loan categories. During 1997, real estate, consumer, lease financing and commercial loans grew $60,316,000, $11,479,000, $16,446,000, and 13,340,000, respectively. Residential mortgages sold during 1998 were $34,313,000 compared to $11,514,000 in 1997. At December 31, 1998, there were no loan concentrations over 10% of loans outstanding in any one category or to any one borrower. The Banks have no foreign loans, and the impact of nonaccrual, restructured troubled debt and delinquent loans on total interest income was not material. A loan is generally classified as nonaccrual when principal or interest has consistently been in default for a period of 90 days or more or because of a deterioration in the financial condition of the borrower or payment in full of principal or interest is not expected. Delinquent loans past due 90 days or more and still accruing interest are loans that are generally well-secured and expected to be restored to a current status in the near future. Nonperforming assets (nonaccruing loans, net assets in foreclosure and troubled debt restructured loans) were 0.50% of total loans and net assets acquired in foreclosure at December 31, 1998, compared to 0.56% at December 31, 1997, and 0.83% at December 31, 1996. The ratio of the allowance to nonperforming assets was 308.5% at December 31, 1998, compared to 285.8% at December 31, 1997, and 188.8% at December 31, 1996. Nonaccruing loans of $2,950,000 at December 31, 1998, increased $329,000 from the December 31, 1997, balance of $2,621,000. This increase was associated with real estate related loans. The December 31, 1997, balance of nonaccrual loans was $362,000 less than the December 31, 1996 balance. Net assets in foreclosure totaled $664,000 as of December 31, 1998, an increase of $211,000, from the December 31, 1997, balance. During 1998, sales of foreclosed properties totaled $966,000, transfers from loans to assets in foreclosure were $1,242,000 and write-downs of assets in foreclosure equaled $65,000. Efforts to liquidate assets acquired in foreclosure are proceeding as quickly as potential buyers can be located and legal constraints permit. Generally accepted accounting principles require foreclosed assets to be carried at the lower of cost (lesser of carrying value of asset or fair value at date of acquisition) or estimated fair value, less selling costs. Loans past due 90 days or more and still accruing interest are loans that are generally well secured and are in the process of collection. As of December 31, 1998, loans past due 90 days or more and still accruing interest were $824,000, compared to $2,253,000 as of December 31, 1997. This decrease was a result of a reduction in real estate loans past due 90 days at December 31, 1998. As of December 31, 1998, there were three unrelated commercial borrowers with troubled debt restructured loans totaling $583,000. These customers were complying with the restructured terms as of December 31, 1998. The Banks' policy is to maintain allowances for loan losses at a level believed by management to be adequate to absorb potential losses. Management's determination of the adequacy of the allowance is determined monthly based on a continuing evaluation of the portfolio, past loss experience, current and anticipated economic conditions and other factors deemed relevant. Additions to the allowances are charged to operations. The allowance for loan losses grew 8.6% from $11,925,000 at December 31, 1997 to $12,950,000 at December 31, 1998. Year Ended December 31, ------------------------------------- 1998 1997 1996 ---------- ---------- ---------- Nonperforming assets ................. $4,197,000 $4,172,000 $5,672,000 Allowance for loan losses to nonperforming assests ............ 308.5% 285.8% 188.8% Nonperforming assets to total loans and net assets acquired in foreclosure ................... .50% .56% .83% Allowance for loan losses to total loans ................... 1.54% 1.61% 1.57% Unallocated allowance for loan losses to total allowance for loan losses ...................... 58.5% 50.3% 46.9% Deposits and Borrowings and Other Interest-Bearing Liabilities The primary funding sources of the Corporation is deposits and other borrowings. Total deposits of $1,033,968,000 at December 31, 1998, increased $114,897,000, or 12.5% from the $919,071,000 balance at December 31, 1997. All deposit categories increased during this period. Other borrowings of $148,978,000 at December 31, 1998, grew $84,840,000, or 132.3% compared to the December 31, 1997, balance. This increase included $53,000,000 in FHLB borrowings related to the capital leverage program. Borrowings and other interest-bearing liabilities include federal funds purchased, FHLB borrowings, securities sold under agreements to repurchase and U.S. Treasury notes. PAGE 27 INCOME STATEMENT ANALYSIS Results of Operations Consolidated net income for 1998 was $18,776,000, an increase of $2,114,000, or 12.7%, over 1997. On a per share basis, basic and diluted earnings were $2.67 in 1998, compared to basic and diluted earnings per share of $2.38 in 1997. Consolidated net income increased in 1997 by $2,254,000, a 15.6% increase over 1996. Return on average assets in 1998 of 1.55% was the same as 1997. The 1996 return on average assets was 1.47%. The return on average shareholders' equity was 16.12% for 1998, compared to 16.05% for 1997 and 15.71% in 1996. Net income is affected by five major elements: net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for losses on loans; other operating income, which is made up primarily of certain fees and gains and losses from sales of securities; other operating expenses, which consist primarily of salaries and other operating expenses; and income taxes. Each of these major elements is reviewed in more detail in the following discussion. Net Interest Income Net interest income for 1998 increased by $3,437,000, or 7.4%, to $49,788,000. Net interest income was $46,351,000 during 1997, which was 8.2% above the $42,842,000 reported in 1996. Interest income at December 31, 1998, of $87,597,000 grew $7,395,000, or 9.2% from the $80,202,000 balance at December 31, 1997. The increase in interest income is the result of the growth in both average loans and investment securities during this period. This growth in interest income was partially offset by the $3,958,000, or 11.7% increase in interest expense at December 31, 1998, compared to December 31, 1997. This rise in interest expense was the result of the increase in both average interest-bearing deposits and borrowings during this period. Net Interest Margin The 1998 net interest margin of 4.70% was lower than both the net interest margins for 1997 and 1996 of 4.87% and 4.88%, respectively. The lower net interest margin experienced in 1998 is related to the high cost of attracting new deposits and the impact of the capital leverage program. During the falling interest rate environment experienced during 1998, the Banks saw the tax-equivalent yield on total interest-earning assets decrease 22 basis points from 8.18% in 1997 to 7.96% in 1998. This decrease was not matched by a reduction in the cost of interest-bearing liabilities. The 1998 cost of interest-bearing liabilities only decreased 4 basis points from 4.16% in 1997 to 4.12% in 1998. The institution of a capital leverage program during 1998 also contributed to the decrease in the net interest margin. To more fully leverage its capital, the Corporation entered into $53,000,000 of structured transactions in which the Bank borrows funds from the FHLB and invests these borrowed funds into securities that are priced to yield a spread over the FHLB borrowing rate. The actual leverage program yield spread earned during 1998 was 1.60%. Since the current competitive interest rate environment will continue to place downward pressure on the net interest margin, the Banks expect to increase net interest income through the continued growth in market share of loans and deposits. The 1996 tax-equivalent yield on total interest-earning assets, cost of interest-bearing liabilities and net interest margin were 8.20%, 4.14% and 4.88%, respectively. Interest Rate Sensitivity Analysis The Banks actively manages its interest rate sensitivity positions. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve consistent growth in net interest income. The Asset/Liability Committee, using policies and procedures approved by the Banks Boards of Directors, is responsible for managing the rate sensitivity position. The Banks manage interest rate sensitivity by changing mix and repricing characteristics of their assets and liabilities through their investment securities portfolios, borrowings from the FHLB and their offering of loan and deposit terms. The nature of the Banks current operations is such that it is not subject to foreign currency exchange or commodity price risk. The Banks do not own trading assets and they do not have any hedging transactions in place such as interest rate swaps, caps or floors. The Banks utilize three principal reports to measure interest rate risk: gap analysis reports, asset/liability simulation reports and net interest margin reports. The table on the next page shows the interest rate sensitivity gap position as of December 31, 1998. The table presents data at a single point of time and includes management assumptions estimating the prepayment rate and the interest rate environment prevailing at December 31, 1998. Money Market, Interest-bearing Checking Accounts and Savings Accounts have always been considered a stable source of funds, and although the rates are subject to change, rates on these accounts historically have not changed as quickly or as often as the other deposits included in the following analysis. On a cumulative basis over the next 12 months, the Banks are in a negative gap position of (4.14)% of earning assets at December 31, 1998. This gap position is within the guidelines set by the Banks' Asset/Liability policy. PAGE 28
December 31, 1998 ----------------------------------------------------------------- less than less than 1 year 3 years 0 to 90 91 to 365 greater than greater than Over 5 Dollars in thousands) days days 3 years 5 years years --------- ---------- ------------ ------------ ------- Assets Other rate-sensitive assets ..................... $ 15,053 $ 40 $ 100 $ -- $ -- Loans ........................................... 201,948 66,798 212,224 131,675 230,242 Investment securities ........................... 20,224 37,059 119,862 44,183 185,697 -------- -------- -------- -------- -------- Total rate-sensitive assets ..................... 237,225 103,897 332,186 175,858 415,939 -------- -------- -------- -------- -------- Liabilities Time deposits ................................... 101,589 138,674 112,740 43,034 25 Money market savings funds ...................... 5,459 21,515 24,942 18,599 135,141 Interest-bearing checking accounts .............. 8,248 14,494 17,265 13,308 75,722 Savings accounts ................................ 6,513 11,928 15,352 19,149 67,214 U.S. Treasury demand notes ...................... 1,320 -- -- -- -- Other borrowings ................................ 83,158 1,000 20,500 31,000 12,000 -------- -------- -------- -------- -------- Total rate-sensitive liabilities ................ $206,287 $187,611 $190,799 $125,090 $290,102 -------- -------- -------- -------- -------- Incremental gap ................................. $ 30,938 $(83,714) $141,387 $ 50,768 $125,837 ======== ======== ======== ======== ======== Cumulative gap .................................. $ 30,938 $(52,776) $ 88,611 $139,379 $265,216 ======== ======== ======== ======== ======== % of earning assets ............................. 2.43% (4.14)% 6.96% 10.95% 20.83% ======== ======== ======== ======== ========
Management also simulates possible economic conditions and interest rate scenarios in order to quantify the impact on net interest income. The effect that changing interest rates has on the Banks' net interest income is simulated by increasing and decreasing interest rates. This simulation is known as rate shocks. The report below forecasts changes in the banks market value of equity under alternative interest rate environments. The market value of equity is defined as the net present value of the Banks existing assets and liabilities. The results of the December 31, 1998 rate shock simulations show the Banks are within all guidelines set by the Banks' Asset/Liability policy.
Asset/Liability Change in Policy Market Value Market Value Percentage Approved of Equity of Equity Change Percent Change ------------ ------------ ---------- --------------- +200 Basis Points .................................. 219,679 (32,169) -12.77% +/- 20% +150 Basis Points .................................. 228,154 (23,694) -9.41% +/- 20% +100 Basis Points .................................. 236,437 (15,411) -6.12% +/- 20% +50 Basis Points ................................... 244,555 (7,293) -2.90% +/- 20% Flat Rate .......................................... 251,848 -- 0.00% +/- 20% - -50 Basis Points ................................... 255,789 3,941 1.56% +/- 20% - -100 Basis Points .................................. 255,475 3,627 1.44% +/- 20% - -150 Basis Points .................................. 253,049 1,201 0.48% +/- 20% - -200 Basis Points .................................. 249,514 (2,334) -0.93% +/- 20%
In the event the Bank should experience a mismatch in their desired GAP ranges or an excessive decline in its market value of equity resulting from changes in interest rate, it has a number of options which it could utilize to remedy such mismatch. The Bank could restructure its investment portfolio through sale or purchase of securities with more favorable repricing attributes. It could also emphasize loan products with appropriate maturities or repricing attributes, or it could attract deposits or obtain borrowings with desired maturities. PAGE 29 Provision for Loan Losses The provision for loan losses is based on management's analysis of the adequacy of the allowance for loan losses. In its evaluation, management considers past loan experience, overall characteristics of the loan portfolio, current economic conditions and other relevant factors. Based on the latest monthly evaluation of potential loan losses, the allowance is adequate to absorb known and inherent losses in the loan portfolio. Ultimately however, the adequacy of the allowance is largely dependent upon the economy, a factor beyond the Corporation's control. With this in mind, additions to the allowance for loan losses may be required in future periods, especially if economic trends worsen or certain borrowers' abilities to repay decline. The provision in 1998 was $2,140,000, a decrease of $360,000 or 14.4%, compared to the 1997 provision of $2,500,000. The decrease in the provision during 1998 is related to the improvement in the ratio of the allowance for loan losses to nonperforming assets ratio. The allowance for loan losses to noperforming assets ratio for December 31, 1998, 1997 and 1996 was 308.5%, 285.8%, and 188.8%, respectively. Total loans charged off decreased 18.1% from $1,726,000 in 1997 to $1,413,000 in 1998. Recoveries of $298,000 during 1998, decreased from the 1997 recoveries of $441,000. The charged off loans and recoveries for 1996 were $1,451,000 and $188,000, respectively. Other Operating Income Other operating income for 1998 of $9,810,000 increased $2,419,000, or 32.7%, compared to the 1997 level of $7,391,000. This increase was primarily due to the $1,661,000 increase in other income. Also contributing to this increase was a $608,000 rise in trust income and a $364,000 growth in service charges. Security gains decreased $214,000 in 1998, compared to 1997. The 1997 other operating income was 44.5% higher than 1996, primarily due to an increase in gains recognized on the sale of investment securities available for sale. Income from service charges on deposit accounts of $3,205,000 in 1998 increased $364,000, or 12.8% from the 1997 income from service charges on deposit accounts of $2,841,000. The increase in service charges during 1998 is attributed to the 12.4% rise in average fee earning deposits, and management's continued focus on growing noninterest income. The 1997 service charges grew 9.8% over 1996 service charges. The Corporation recorded a $1,543,000 net security gain in 1998, compared to a net security gain of $1,757,000 in 1997. The majority of the security gains in 1998 and 1997 were the result of the sale of equity securities held at HNC Financial Company. From time to time, the Corporation sells investment securities available for sale to fund the purchase of other securities in an effort to enhance the overall return on the portfolio. The Corporation recognized $39,000 of net securities losses in 1996. The 1998 income from the Investment Management and Trust Services Division of $2,117,000 increased $608,000, or 40.3%, compared to the $1,509,000 recorded in 1997. This increase was the result of both an increase in the book value of trust assets of 22.1% from December 31, 1997 to December 31, 1998 and the Corporation's continuing emphasis on marketing the Investment Management and Trust Services Division's products and services. The 1996 Investment Management and Trust Services Division income was $1,293,000. Other income increased $1,661,000 during 1998, from $1,284,000 in 1997 to $2,945,000 in 1998. This increase was primarily due to the gain on the sale of residential mortgages of $716,000 in 1998, compared to a loss on the sale of residential mortgages of $160,000 in 1997. During the last half of 1997, the Banks entered into the strategy of increasing the booking and selling of residential mortgages. Residential mortgages sold during 1998 were $34,313,000 compared to $11,514,000 in 1997. All loans sold in 1998 were originated with the intention to be sold. The majority of loans sold in 1997 were loans in the Banks residential mortgage portfolio. The Banks used the funds generated from the 1997 sale of residential mortgages to purchase residential mortgages that currently earn a higher rate of return and reduce the overall interest rate risk of the residential mortgage portfolio. The Banks continuously researches different strategies it can use to enhance both the interest rate earned on loans, and to reduce the interest rate risk of the loan portfolios. The increase in other income is also due to higher automated teller machine fees and debit card fees earned by the Banks. Other income in 1996 was $1,274,000. Other Operating Expenses Other operating expenses rose to $32,573,000 for 1998, a 14.2% increase over the $28,529,000 for 1997. The 1997 amount was 10.3% above the $25,874,000 for 1996. The rise in operating expenses in 1998 was primarily due to higher expenses related to four new branches opened after April 30, 1997, increases in equipment expenses and other expenses related to the overall growth in the Banks. Employee salaries and benefits increased $2,237,000, or 14.5%, from $15,479,000 in 1997 to $17,716,000 in 1998. The salary and benefits increase directly related to the staffing of the four new branches was $415,000, or 18.6% of the total salary and benefits increase. Net of the salary and benefit expenses related to the new branches, the increase in 1998 was 11.8%. The remaining increase in salaries and benefits reflects cost-of-living increases, merit increases and additional staff necessitated by current and planned future growth. The 1997 salaries and benefits expense increased 7.5% over the 1996 salary and benefits expense of $14,398,000. The 1997 expenses included a reduction of $496,000 in profit sharing expenses, compared to 1996, related to the modification of the Banks' profit-sharing plan into a 401(K) plan during 1996. Net occupancy costs increased by $160,000, or 8.1%, in 1998, compared with a $107,000, or 5.7%, increase in 1997. The four new branches were responsible for $138,000 of the increase in 1998. Equipment expenses increased by $632,000, or 22.4%, during 1998, and $734,000, or 35.2%, in 1997. The four new branches were responsible for $78,000 of the increase in equipment expenses during 1998. The remainder of this rise is due to equipment depreciation, rental and maintenance associated with planned increased data processing capabilities used to manage the rise in volume related to the growth of the Corporation. Other expenses increased $1,015,000, or 12.3%, from $8,253,000 in 1997 to $9,268,000 in 1998. The 1997 other expenses increased 9.7%, compared to 1996. These increases are the result of expenses associated with the overall growth of the Banks. PAGE 30 Income Taxes The Corporation accounts for income taxes under the liability method specified by SFAS No. 109, "Accounting for Income Taxes." Under SFAS No. 109, deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. The principal types of accounts resulting in differences between assets and liabilities for financial statement and tax return purposes are the allowance for loan losses, leased assets, deferred loan fees and compensation. The effective income tax rates of 24.5% for 1998, 26.6% for 1997 and 28.0% for 1996 were less than the applicable federal income tax rate of 35.0%, primarily as a result of tax-exempt income. CAPITAL Capital formation is critical to the Corporation's well-being and future growth. Capital at the end of 1998 was $122,811,000, an increase of $13,019,000, or 11.9%, over the end of 1997. The increase came as a result of the retention of the Corporation's earnings and from the adjustment for the net unrealized gains (losses) on the investment securities available for sale. Management believes that the Corporation's current capital position and liquidity position are strong and that its capital position is adequate to support its operations. Except as previously discussed, management is not aware of any recommendation by any regulatory authority, which, if it were to be implemented, would have a material effect on the Corporation's capital. The Corporation's capital ratios exceed regulatory requirements. Existing minimum regulatory capital ratio requirements are 5.0% for primary capital and 6.0% for total capital. The primary capital ratio was 9.73% at December 31, 1998, compared with 10.65% at December 31, 1997. Because the Corporation's only capital is primary capital, the total capital ratios are the same as the primary capital ratios. Pursuant to the federal regulators' risk-based capital adequacy guidelines, the components of capital are called Tier 1 and Tier 2 capital. For the Corporation, Tier 1 capital is the shareholders' equity, and Tier 2 capital is the allowance for loan losses. The risk-based capital ratios are computed by dividing the components of capital by risk-adjusted assets. Risk-adjusted assets are determined by assigning credit risk-weighting factors from 0% to 100% to various categories of assets and off-balance-sheet financial instruments. The minimum for the Tier 1 capital ratio is 4.0%, and the total capital ratio (Tier 1 plus Tier 2 capital divided by risk-adjusted assets) minimum is 8.0%. At December 31, 1998, the Corporation's Tier 1 risk-adjusted capital ratio was 12.50%, and the total risk-adjusted capital ratio was 13.84%, both well above regulatory requirements. The risk-based capital ratios of each of the Corporation's commercial banks also exceeded regulatory requirements at the end of 1998. To supplement the risk-based capital adequacy guidelines, the Federal Reserve Board (FRB) established a leverage ratio guideline. The leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding intangible assets. The minimum leverage ratio guideline is 3% for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality, high liquidity, good earnings and, in general, are considered top-rated, strong banking organizations. Other banking organizations are expected to have ratios of at least 4% or 5%, depending upon their particular condition and growth plans. Higher leverage ratios could be required by the particular circumstances or risk profile of a given bank organization. The Corporation's leverage ratios were 8.98% and 9.36% at December 31, 1998 and 1997, respectively. Under FDIC the regulations, a "well capitalized" institution must have a leverage ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10% and not be subject to a capital directive order. To be considered "adequately capitalized," an institution must generally have a leverage ratio of at least 4%, a Tier 1 risk-based capital ratio of at least 4% and a total risk-based capital ratio of at least 8%. An institution is deemed to be "critically undercapitalized" if it has a tangible equity ratio of 2% or less. As illustrated in the chart below, the Corporation is above the regulatory minimum guidelines and meet the criteria to be categorized as a "well capitalized" institution at December 31, 1998. Well Adequately Corporation Capitalized Capitalized --------------------------------------- Leverage ratio ................... 8.98% 5.00% 4.00% Tier 1 capital ratio ............. 12.50% 6.00% 4.00% Total capital ratio .............. 13.84% 10.00% 8.00% Liquidity Liquidity is a measure of the ability of the Banks to meet their needs and obligations on a timely basis. For a bank, liquidity requires the ability to meet the day-to-day demands of deposit customers, along with the ability to fulfill the needs of borrowing customers. Generally, the Banks arrange their mix of cash, money market investments, investment securities and loans in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. Federal funds sold averaged $15,763,000 during 1998, and investment securities available for sale averaged $319,474,000 during 1998, more than sufficient to match normal fluctuations in loan demand or deposit fund supplies. Backup sources of liquidity are provided by federal fund lines of credit established with correspondent banks. Additional liquidity could be generated through borrowings from the Federal Reserve Bank of Philadelphia, of which Harleysville, Citizens and Security are members and from the Federal Home Loan Bank of Pittsburgh, of which Harleysville, Citizens and Security are members. Unused lines of credit at the FHLB were $105,935,000, as of December 31, 1998. There are no known trends or any known demands, commitments, events or uncertainties that will result in, or that are reasonably likely to result in, liquidity increasing or decreasing in any material way. PAGE 31 YEAR 2000 The following section contains forward-looking statements which involve risks and uncertainties. The actual impact on the Corporation of the Year 2000 issue could materially differ from that which is anticipated in the forward-looking statements as a result of certain factors identified below. Many existing computer programs use only two digits to identify a year in the date field. These programs were designed and developed without considering the impact of the upcoming century date change. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000 (Y2K). The Year 2000 issue affects virtually all companies and organizations. Corporation's State of Readiness The Corporation began addressing the Y2K issue in August 1997. Management has initiated an enterprise-wide program to prepare the Corporation's computer systems and applications for the Year 2000. The Corporation developed a Y2K plan to include assessing the impact of the Y2K issue on the Corporation, renovating systems to alleviate Y2K problems, validating the new systems and implementing them. The Corporation focused on information technology and non-information technology systems. A non-information system could be, for example, a microcontroller in an elevator, which may be subject to Y2K problems. The Corporation also reviewed Y2K issues related to material third parties. The assessment phase of the Y2K plan included assigning accountabilities throughout the Corporation. An inventory was completed of mainframe and PC based applications, third-party relationships and non-information technology systems. The final step in the assessment phase was to identify non-compliant Y2K systems. The assessment phase was completed in November 1997. The Corporation began the renovation phase of the Y2K plan in January 1998. The renovation phase included developing action plans to correct non-compliant Y2K systems. The action plans included either enhancing the current system to resolve the Y2K problem or purchasing a new system that is Y2K compliant. The renovation plan was completed in May 1998. The Corporation developed a remediation plan for the non-compliant systems. As of December 31, 1998, 88% of the remediation phase has been completed. The next phase of the plan is to validate the Y2K compliance of all of the systems. This phase includes developing written test plans and completing the testing of the systems. The validation phase is scheduled to be completed by March 31, 1999. As of December 31, 1998, 74% of the computer applications, including all mission-critical systems, have been validated to be Y2K compliant. The Corporation reviewed the Y2K issues related to material third parties and completed an analysis on the loan portfolio. The Corporation's third parties include its vendors and commercial customers. The material third party relationships are primarily the commercial borrowers. These borrowers may pose a credit risk to the Corporation if they are not Y2K compliant. We have contacted the material commercial customers and their responses were evaluated. We have also performed an analysis on the impact of Y2K issues on the remaining loan portfolio. The Corporation has allocated a portion of the allowance for loan losses as a result of the Y2K issues. Because most computer systems are, by their very nature, interdependent, it is possible that noncompliant third-party computers could impact the Corporation's computer systems. The Corporation could be adversely affected by the Y2K problem if it or unrelated parties fail to successfully address the problem. The Corporation has taken steps to communicate with the unrelated parties with whom it deals to coordinate Year 2000 compliance. Additionally, we are dependent on external suppliers, such as, wire transfer systems, telephone systems, electric companies, and other utility companies for continuation of service. Cost of Year 2000 The Corporation has prepared a Y2K budget and has tracked expenses related to the Y2K issue. As of December 31, 1998, the Corporation has expensed $117,000 and capitalized fixed assets of $54,000 related to the Y2K issue. The Corporation has estimated the future Y2K expenditures to be $60,000 and future capitalized fixed assets to be $69,000. The Y2K project is being funded through operating cash flows. The cost of the projects and the date on which the Corporation plans to complete both Year 2000 modifications and systems conversions are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third-party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. Risk of Year 2000 At present, management believes its progress in remedying the proprietary programs and installing the Y2K compliant upgrades to the third-party vendor mainframe and PC based computer applications is on plan. The Y2K computer problem creates risk for the Corporation from unforeseen problems in its own computer systems and from third-party vendors who provide the majority of mainframe and PC based computer applications. Failure of third-party systems relative to the Y2K issue could have a material impact on the Corporation's ability to conduct business and on its financial position and results of operation. Contingency Plans A contingency plan is being developed to handle the most reasonably likely Y2K worst-case scenario should it occur. The contingency plan will involve obtaining back-up service providers, working up contingency plans and assessing the potential adverse risks to the Corporation. The contingency plan is scheduled to be completed by March 31, 1999. The Corporation has also utilized an independent consulting firm to verify and validate the Corporation's Y2K plans. OTHER ITEMS Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation, which if they were implemented would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation's results of operations. ================================================================================ PAGE 32 EX-21 3 Exhibit 21 Registrant owns all of the issued and outstanding capital stock of Harleysville National Bank and Trust Company, a National banking association headquartered at 483 Main Street, Harleysville, PA 19438, the Citizens National Bank of Lansford, a national banking association headquartered at 13-15 West Ridge Street, Lansford, PA 18232, Security National Bank, a national banking association headquartered at One Security Plaza, Pottstown, PA 19464 and of HNC Financial Company, a Delaware Corporation headquartered at 300 Delaware Avenue, Suite 1704, Wilmington, Delaware 19801 PAGE 29 EX-23 4 Exhibit 23 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS We have issued our report dated January 7, 1999, (except for Note 2, as to which the date is January 20, 1999) accompanying the consolidated financial statements incorporated by reference or included in the 1998 Annual Report of Harleysville National Corporation on Form 10-K for the year ended December 31, 1998. We hereby consent to the incorporation by reference of said report in the Registration Statements of Harleysville National Corporation on Form S-3 (Registration No. 33-57790) and on Forms S-8 (Registration No. 33-69784 and Registration No. 33-17813). GRANT THORNTON LLP Philadelphia, Pennsylvania March 25, 1999 PAGE 30 EX-27 5
9 1,000 YEAR DEC-31-1998 DEC-31-1998 37,763 3,707 11,486 0 389,344 25,988 26,681 842,887 12,950 1,332,389 1,033,968 55,478 26,632 93,500 0 0 7,038 115,773 1,332,389 65,695 20,838 1,064 87,597 33,108 37,809 49,788 2,140 1,543 32,573 24,885 24,885 0 0 18,776 2,67 2,67 4,70 2,950 824 583 0 11,925 1,413 298 12,950 12,950 0 7,581
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