10-K 1 d293667d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Annual Report Pursuant to Section 13 or 15(d)

Of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2016

Commission File Number 1-15817

 

 

OLD NATIONAL BANCORP

(Exact name of the Registrant as specified in its charter)

 

 

 

INDIANA   35-1539838

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

One Main Street

Evansville, Indiana

  47708
(Address of principal executive offices)   (Zip Code)

(812) 464-1294

(Registrant’s telephone number, including area code)

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

 

Title of Each Class

 

Name of each exchange on which registered

Common Stock, No Par Value

Preferred Stock Purchase Rights

  The NASDAQ Stock Market LLC

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

None

 

 

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

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

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (s232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (s229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☐

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

 

  Large accelerated filer      Accelerated filer  
  Non-accelerated filer    ☐  (Do not check if a smaller reporting company)   Smaller reporting company  

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

The aggregate market value of the Registrant’s voting common stock held by non-affiliates on June 30, 2016, was $1,657,955,950 (based on the closing price on that date of $12.53). In calculating the market value of securities held by non-affiliates of the Registrant, the Registrant has treated as securities held by affiliates as of June 30, 2016, voting stock owned of record by its directors and principal executive officers, and voting stock held by the Registrant’s trust department in a fiduciary capacity for benefit of its directors and principal executive officers. This calculation does not reflect a determination that persons are affiliates for any other purposes.

The number of shares outstanding of the Registrant’s common stock, as of January 31, 2017, was 135,198,000.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held April 27, 2017, are incorporated by reference into Part III of this Form 10-K.

 

 

 


Table of Contents

OLD NATIONAL BANCORP

2016 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

 

PART I         PAGE   

Item 1.

   Business      4   

Item 1A.

   Risk Factors      17   

Item 1B.

   Unresolved Staff Comments      24   

Item 2.

   Properties      24   

Item 3.

   Legal Proceedings      25   

Item 4.

   Mine Safety Disclosures      25   

PART II

     

Item 5.

   Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      26   

Item 6.

   Selected Financial Data      29   

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      30   

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk      59   

Item 8.

   Financial Statements and Supplementary Data      59   

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      141   

Item 9A.

   Controls and Procedures      141   

Item 9B.

  

Other Information

     142   

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance of the Registrant      143   

Item 11.

   Executive Compensation      143   

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      143   

Item 13.

   Certain Relationships and Related Transactions, and Director Independence      143   

Item 14.

   Principal Accounting Fees and Services      143   

PART IV

        143   

Item 15.

   Exhibits and Financial Statement Schedules      144   

SIGNATURES

        147   

 

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OLD NATIONAL BANCORP

2016 ANNUAL REPORT ON FORM 10-K

FORWARD-LOOKING STATEMENTS

In this report, we have made various statements regarding current expectations or forecasts of future events, which speak only as of the date the statements are made. These statements are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are also made from time-to-time in press releases and in oral statements made by the officers of Old National Bancorp (“Old National,” or the “Company”). Forward-looking statements can be identified by the use of the words “expect,” “may,” “could,” “intend,” “project,” “estimate,” “believe,” “anticipate,” and other words of similar meaning. Forward-looking statements also include, but are not limited to, statements regarding estimated cost savings, plans and objectives for future operations, the Company’s business and growth strategies, including future acquisitions of banks, regulatory developments, and expectations about performance as well as economic and market conditions and trends.

Such forward-looking statements are based on assumptions and estimates, which although believed to be reasonable, may turn out to be incorrect. Therefore, undue reliance should not be placed upon these estimates and statements. We cannot assure that any of these statements, estimates, or beliefs will be realized and actual results may differ from those contemplated in these “forward-looking statements.” We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise. You are advised to consult further disclosures we may make on related subjects in our filings with the SEC. In addition to other factors discussed in this report, some of the important factors that could cause actual results to differ materially from those discussed in the forward-looking statements include the following:

 

    economic, market, operational, liquidity, credit, and interest rate risks associated with our business;

 

    economic conditions generally and in the financial services industry;

 

    expected cost savings in connection with the consolidation of recent acquisitions may not be fully realized or realized within the expected time frames, and deposit attrition, customer loss, and revenue loss following completed acquisitions may be greater than expected;

 

    failure to properly understand risk characteristics of newly entered markets;

 

    increased competition in the financial services industry either nationally or regionally, resulting in, among other things, credit quality deterioration;

 

    our ability to achieve loan and deposit growth;

 

    volatility and direction of market interest rates;

 

    governmental legislation and regulation, including changes in accounting regulation or standards;

 

    our ability to execute our business plan;

 

    a weakening of the economy which could materially impact credit quality trends and the ability to generate loans;

 

    changes in the securities markets; and

 

    changes in fiscal, monetary, and tax policies.

Investors should consider these risks, uncertainties, and other factors in addition to risk factors included in our other filings with the SEC.

 

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PART I

ITEM 1. BUSINESS

GENERAL

Old National is a financial holding company incorporated in the state of Indiana and maintains its principal executive office in Evansville, Indiana. We, through our wholly owned banking subsidiary, provide a wide range of services, including commercial and consumer loan and depository services, private banking, brokerage, trust, investment advisory, and other traditional banking services. At December 31, 2016, we employed 2,733 full-time equivalent associates.

COMPANY PROFILE

Old National Bank, our wholly owned banking subsidiary (“Old National Bank”), was founded in 1834 and is the oldest company in Evansville, Indiana. In 1982, Old National Bancorp was formed; in 2001 we became a financial holding company and we are currently the largest financial holding company headquartered in the state of Indiana. Also in 2001, we completed the consolidation of 21 bank charters enabling us to operate under a common name with consistent product offerings throughout the financial center locations, consolidating back-office operations and allowing us to provide more convenient service to clients. At December 31, 2016, Old National Bank operated 203 banking centers located primarily in Indiana, Kentucky, Michigan, and Wisconsin.

OPERATING SEGMENTS

Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Old National Bank, Old National’s bank subsidiary, is the only significant subsidiary upon which management makes decisions regarding how to allocate resources and assess performance. Each of the branches of Old National Bank provide a group of similar community banking services, including such products and services as commercial, real estate and consumer loans, time deposits, checking and savings accounts, cash management, brokerage, trust, and investment advisory services. The individual bank branches located throughout our Midwest footprint have similar operating and economic characteristics. While the chief decision maker monitors the revenue streams of the various products, services, and regional locations, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the community banking services and branch locations are considered by management to be aggregated into one reportable operating segment, community banking.

Lending Activities

We earn interest income on loans as well as fee income from the origination of loans. Lending activities include loans to individuals, which primarily consist of home equity lines of credit, residential real estate loans and consumer loans, and loans to commercial clients, which include commercial loans, commercial real estate loans, letters of credit, and lease financing. Residential real estate loans are either kept in our loan portfolio or sold to secondary investors, with gains or losses from the sales being recognized.

Depository Activities

We strive to serve individuals and commercial clients by providing depository services that fit their needs at competitive rates. We pay interest on the interest-bearing deposits and receive service fee revenue on various accounts. Deposit accounts include products such as noninterest-bearing demand, negotiable order of withdrawal (“NOW”), savings and money market, and time deposits. Debit and ATM cards provide clients with access to their accounts 24 hours a day at any ATM location. We also provide 24-hour telephone access and online banking as well as other electronic and mobile banking services.

MARKET AREA

We own the largest Indiana-based bank headquartered in Indiana. Operating from a home base in Evansville, Indiana, we have continued to grow our footprint in Indiana, Kentucky, Michigan, and Wisconsin. We have expanded into the attractive Louisville, Lexington, Indianapolis, Lafayette, Ann Arbor, Grand Rapids, Madison,

 

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Milwaukee, and Fox Valley triangle markets. In February 2007, we expanded into northern Indiana by acquiring St. Joseph Capital Corporation, which had banking offices in Mishawaka and Elkhart, Indiana. In March 2009, we completed the acquisition of the Indiana retail branch banking network of Citizens Financial Group, which consisted of 65 branches and a training facility located primarily in the Indianapolis area. On January 1, 2011, we closed on our acquisition of Monroe Bancorp, strengthening our presence in Bloomington, Indiana and the central and south central Indiana markets. On July 29, 2011, we acquired the banking operations of Integra Bank N.A. (“Integra”) in an FDIC-assisted transaction. Integra was a full service community bank headquartered in Evansville, Indiana that operated 52 branch locations, primarily in southwest Indiana, southeastern Illinois and western Kentucky. On September 15, 2012, we closed on our acquisition of Indiana Community Bancorp (“IBT”), strengthening our presence in Columbus, Indiana and the south central Indiana market. On July 12, 2013, we closed on our acquisition of 24 bank branches from Bank of America, which increased our presence in the South Bend/Elkhart, Indiana area and provided an entry into southwest Michigan. On April 25, 2014, we closed on our acquisition of Tower Financial Corporation (“Tower”), which added seven full-service branches in the Fort Wayne, Indiana market. On July 31, 2014, we completed the acquisition of United Bancorp, Inc. (“United”), which added 18 branches in Ann Arbor, Michigan and the surrounding area. On November 1, 2014, we completed the acquisition of LSB Financial Corp. (“LSB”), which added five branches in Lafayette, Indiana. On January 1, 2015, we completed the acquisition of Founders Financial Corporation (“Founders”), which added four branches in the Grand Rapids, Michigan market. On May 1, 2016, we completed the acquisition of Anchor BanCorp Wisconsin Inc. (“Anchor”), which added 46 branches in the Madison, Milwaukee and Fox Valley triangle markets.

The following table reflects the market locations where we have a significant share of the deposit market. The market share data is by metropolitan statistical area. The Evansville, Indiana data includes branches in Henderson, Kentucky.

Old National Deposit Market Share and Number of Branch Locations

Deposits as of June 30, 2016

 

Market Location

   Number of
Branches
     Deposit Market
Share Rank
 

Evansville, Indiana

     18         1   

Adrian, Michigan

     7         1   

Bloomington, Indiana

     6         1   

Central City, Kentucky

     2         1   

North Vernon, Indiana

     1         1   

Terre Haute, Indiana

     7         2   

Jasper, Indiana

     6         2   

Columbus, Indiana

     4         2   

Washington, Indiana

     2         2   

Vincennes, Indiana

     3         3   

Madisonville, Kentucky

     2         3   

Danville, Illinois

     2         3   

Seymour, Indiana

     1         3   

Madison, Indiana

     1         3   

 

Source: FDIC

ACQUISITION AND DIVESTITURE STRATEGY

Since the formation of Old National in 1982, we have acquired over 50 financial institutions and other financial services businesses. Future acquisitions and divestitures will be driven by a disciplined financial process and will be consistent with the existing focus on community banking, client relationships and consistent quality earnings. Targeted geographic markets for acquisitions include mid-size markets with average to above average growth rates.

As with previous acquisitions, the consideration paid by us will be in the form of cash, debt or Old National stock, or a combination thereof. The amount and structure of such consideration is based on reasonable growth and cost savings assumptions and a thorough analysis of the impact on both long- and short-term financial results.

On January 1, 2011, we acquired Monroe Bancorp in an all stock transaction. Monroe Bancorp was headquartered in Bloomington, Indiana and had 15 banking centers. Pursuant to the merger agreement, the shareholders of Monroe

 

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Bancorp received approximately 7.6 million shares of Old National stock valued at approximately $90.1 million. On January 1, 2011, unaudited financial statements of Monroe Bancorp showed assets of $808.1 million, which included $509.6 million of loans, $166.4 million of securities and $711.5 million of deposits. The acquisition strengthened our deposit market share in the Bloomington, Indiana market and improved our deposit market share rank to first place in 2011.

On June 1, 2011, Old National’s wholly owned trust subsidiary, American National Trust and Investment Management Company d/b/a Old National Trust Company (“ONTC”), acquired the trust business of Integra. As of the closing, the trust business had approximately $328 million in assets under management. Old National paid Integra $1.3 million in an all cash transaction.

On July 29, 2011, Old National acquired the banking operations of Integra in an FDIC- assisted transaction. Integra was a full service community bank headquartered in Evansville, Indiana that operated 52 branch locations. As part of the purchase and assumption agreement, Old National and the FDIC entered into loss sharing agreements (each, a “loss sharing agreement” and collectively, the “loss sharing agreements”), whereby the FDIC would cover a substantial portion of any future losses on loans (and related unfunded commitments), other real estate owned (“OREO”) and up to 90 days of certain accrued interest on loans. The acquired loans and OREO subject to the loss sharing agreements are referred to collectively as “covered assets.” Old National entered into an agreement with the FDIC on June 22, 2016 to terminate its loss share agreements. As a result of the termination of the loss share agreements, the remaining covered assets that were covered by the loss share arrangements were reclassified to noncovered assets effective June 22, 2016. Prior to the termination of the loss share agreements, the FDIC would have reimbursed us for 80% of expenses and valuation write-downs related to covered assets up to $275.0 million, an amount which we never reached. As a result of the termination of the loss share agreements, all future gains and losses associated with covered assets will be recognized entirely by Old National since the FDIC will no longer be sharing in these gains and losses.

On September 15, 2012, Old National acquired IBT in an all stock transaction. IBT was headquartered in Columbus, Indiana and had 17 full-service banking centers serving the South Central Indiana area. Pursuant to the merger agreement, the shareholders of IBT received approximately 6.6 million shares of Old National common stock valued at approximately $88.5 million. Old National recorded assets with a fair value of approximately $907.1 million, including $497.4 million of loans, as well as $784.6 million of deposits. The acquisition strengthened our deposit market share in Columbus, Indiana and south central Indiana market.

On July 12, 2013, Old National acquired 24 bank branches from Bank of America in a cash transaction. Old National paid a deposit premium of 2.94%. The acquisition doubled Old National’s presence in the South Bend/Elkhart, Indiana area and provided an entry into southwest Michigan.

On April 25, 2014, Old National acquired Tower through a stock and cash merger. Tower was an Indiana bank holding company with Tower Bank & Trust Company as its wholly-owned subsidiary. Headquartered in Fort Wayne, Indiana, Tower operated seven banking centers and had approximately $556 million in trust assets under management on the closing date of the acquisition. Pursuant to the merger agreement, the shareholders of Tower received approximately 5.6 million shares of Old National common stock valued at approximately $78.7 million. Old National recorded assets with a fair value of approximately $683.1 million, including $371.1 million of loans, as well as $528.0 million of deposits. The merger strengthened Old National’s position as one of the largest deposit holders in Indiana.

On July 31, 2014, Old National acquired United through a stock and cash merger. United was a Michigan bank holding company with United Bank & Trust as its wholly-owned subsidiary. Headquartered in Ann Arbor, Michigan, United operated 18 banking centers and had approximately $688 million in trust assets under management as of June 30, 2014. Pursuant to the merger agreement, the shareholders of United received approximately 9.1 million shares of Old National common stock valued at approximately $122.0 million, and the assumption of United’s options and stock appreciation rights, valued at $1.8 million. Old National recorded assets with a fair value of approximately $952.7 million, including $632.0 million of loans, as well as $763.7 million of deposits. This acquisition added 18 branches in Ann Arbor, Michigan and the surrounding area, doubling our presence in this state.

On November 1, 2014, Old National acquired LSB through a stock and cash merger. LSB was savings and loan holding company with Lafayette Savings Bank as its wholly-owned subsidiary. LSB was the largest bank

 

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headquartered in Lafayette, Indiana and operated five full-service banking centers. Pursuant to the merger agreement, the shareholders of LSB received approximately 3.6 million shares of Old National common stock valued at approximately $51.8 million. Old National recorded assets with a fair value of approximately $381.4 million, including $235.4 million of loans, as well as $292.1 million of deposits. This acquisition added five branches in Lafayette, Indiana.

On January 1, 2015, Old National acquired Grand Rapids, Michigan-based Founders Financial Corporation (“Founders”) through a stock and cash merger. Founders was a bank holding company with Founders Bank & Trust as its wholly-owned subsidiary. Founders Bank & Trust operated four full-service banking centers in Kent County. Pursuant to the merger agreement, the shareholders of Founders received approximately 3.4 million shares of Old National common stock valued at approximately $50.6 million. Old National recorded assets with a fair value of approximately $509.0 million, including $339.6 million of loans, as well as $376.7 million of deposits.

On May 1, 2016, Old National acquired Anchor BanCorp Wisconsin Inc. (“Anchor”) through a stock and cash merger. Anchor was a savings and loan holding company with AnchorBank, fsb (“AnchorBank”) as its wholly-owned subsidiary. AnchorBank operated 46 banking centers, including 32 banking centers in the Madison, Milwaukee and Fox Valley triangle. Pursuant to the merger agreement, shareholders of Anchor could elect to receive either 3.5505 shares of Old National common stock or $48.50 in cash for each share of Anchor they held, subject to a maximum of 40% of the purchase price in cash. The total purchase price for Anchor was $459.8 million, consisting of $186.2 million of cash and the issuance of 20.4 million shares of Old National Common Stock valued at $273.6 million. This acquisition was accounted for under the acquisition method of accounting. Accordingly, the Company recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values. Old National recorded assets with a fair value of approximately $2.353 billion, including $1.638 billion of loans, as well as $1.853 billion of deposits.

Over the past decade, we have transitioned our footprint into higher growth markets and opportunistically will continue to do so. We believe we have the right people and the right products in the right markets, with strong leadership in place.

Divestitures

On August 14, 2015, Old National divested its southern Illinois region (twelve branches) along with four branches in eastern Indiana and one in Ohio. At closing, the purchasers assumed loans of $193.6 million and deposits of $555.8 million. Old National recorded a net pre-tax gain of $15.6 million in connection with the divestitures, which included a deposit premium of $19.3 million, goodwill allocation of $3.8 million, and $0.9 million of other transaction expenses.

In addition, the Company consolidated 23 branches throughout the Old National franchise during 2015 based on an ongoing assessment of our service and delivery network and on our goal to continue to move our franchise into stronger growth markets.

On May 31, 2016, the Company sold its insurance operations, ONB Insurance Group, Inc. (“ONI”). The Company received approximately $91.8 million in cash resulting in a pre-tax gain of $41.9 million and an after-tax gain of $17.6 million. See Note 17 to the consolidated financial statements for further details on the income tax impact of this sale. Goodwill and intangible assets of approximately $47.5 million were eliminated as part of this transaction. ONI was an ancillary business and did not meet the criteria to be treated as a discontinued operation as defined in Accounting Standards Update 2014-08 “Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity”.

Based on an ongoing assessment of our service and delivery network, the Company consolidated five banking centers during 2016 and an additional fifteen in January 2017 into nearby banking centers.

COMPETITION

The banking industry and related financial service providers operate in a highly competitive market. Old National competes with financial service providers such as other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other financial intermediaries. In addition, Financial Technology, or FinTech, start-ups are emerging in key areas of banking.

 

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Many of our nonfinancial institution competitors have fewer regulatory constraints, broader geographic service areas, greater capital, and, in some cases, lower cost structures. In addition, competition for quality customers has intensified as a result of changes in regulation, advances in technology and product delivery systems, consolidation among financial service providers, bank failures, and the conversion of certain former investment banks to bank holding companies.

SUPERVISION AND REGULATION

Old National is subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds, and the banking system as a whole and not for the protection of shareholders and creditors.

Significant elements of the laws and regulations applicable to Old National and its subsidiaries are described below. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Old National and its subsidiaries could have a material effect on the business of the Company.

The Dodd-Frank Act. On July 21, 2010, financial regulatory reform legislation entitled the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Dodd-Frank Act”) was signed into law. The Dodd-Frank Act significantly restructured the financial regulatory environment in the United States. The Dodd-Frank Act contains numerous provisions that affect all bank holding companies and banks, including Old National and Old National Bank, some of which are described in more detail below. The scope and impact of many of the Dodd-Frank Act provisions were determined and issued over time. The impact of the Dodd-Frank Act on Old National has been substantial. Provisions in the legislation that affect the payment of interest on demand deposits and collection of interchange fees increased the costs associated with certain deposits and placed limitations on certain revenues those deposits generate.

The Volcker Rule. Section 619 of the Dodd-Frank Act contains provisions prohibiting proprietary trading and restricting the activities involving private equity and hedge funds (the “Volcker Rule”). Rules implementing the Volcker Rule were adopted in December 2013. Proprietary trading is defined as the trading of securities, derivatives, or futures (or options on any of the foregoing) as principal, where such trading is principally for the purpose of short-term resale, benefiting from actual or expected short-term price movements and realizing short-term arbitrage profits. The rule’s definition of proprietary trading specifically excludes market-making-related activity, certain government issued securities trading and certain risk management activities. Old National and Old National Bank do not engage in any prohibited proprietary trading activities.

The final text of the Volcker Rule contained provisions to the effect that collateralized debt obligations (“CDOs”), including pooled trust preferred securities, would have to be sold prior to July 15, 2015. The practical implication of this rule provision, which was not expected by the industry, was that those instruments could no longer be accorded “held-to-maturity” accounting treatment but would have to be switched to “available-for-sale” accounting, and that all covered CDOs, regardless of the accounting classification, would need to be adjusted to fair value through an other-than-temporary impairment non-cash charge to earnings. On January 14, 2014, federal banking agencies released an interim final rule regarding the Volcker Rule’s impact on trust preferred CDOs, which included a nonexclusive list of CDOs backed by trust preferred securities that depository institutions will be permitted to continue to hold. All of the trust preferred securities owned by Old National are on this list and held as “available-for-sale”. Any unrealized losses associated with these instruments have already impacted our capital. As of December 31, 2016, Old National does not have any securities that will have to be divested as a result of the Volcker Rule.

The Durbin Amendment. The Dodd-Frank Act included provisions (the “Durbin Amendment”) which restrict interchange fees to those which are “reasonable and proportionate” for certain debit card issuers and limits the ability of networks and issuers to restrict debit card transaction routing. The Federal Reserve issued final rules implementing the Durbin Amendment on June 29, 2011. In the final rules, interchange fees for debit card transactions were capped at $0.21 plus five basis points in order to be eligible for a safe harbor such that the fee is

 

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conclusively determined to be reasonable and proportionate. The interchange fee restrictions contained in the Durbin Amendment, and the rules promulgated thereunder, apply to debit card issuers with $10 billion or more in total consolidated assets. We exceeded $10 billion in assets during the second quarter of 2014 and became subject to these interchange fee restrictions beginning July 1, 2015. The Durbin Amendment negatively impacted debit card and ATM fees beginning in the second half of 2015.

Bank Holding Company Regulation. Old National is registered as a bank holding company and has elected to be a financial holding company. It is subject to the supervision of, and regulation by, the Board of Governors of the Federal Reserve System (“Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (“BHC Act”). The Federal Reserve has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the policy of the Federal Reserve that, pursuant to this requirement, a bank holding company should stand ready to use its resources to provide adequate capital funds to its subsidiary banks during periods of financial stress or adversity. Under this requirement, Old National is expected to commit resources to support Old National Bank, including at times when Old National may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

The BHC Act requires the prior approval of the Federal Reserve to acquire more than a 5% voting interest of any bank or bank holding company. Additionally, the BHC Act restricts Old National’s non-banking activities to those which are determined by the Federal Reserve to be closely related to banking and a proper incident thereto.

Under the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), a bank holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become “undercapitalized” (as defined in FDICIA) with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal bank regulatory agency.

Capital and Liquidity Requirements. Bank holding companies are required to comply with the Federal Reserve’s risk-based capital guidelines. The Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”) have adopted risk-based capital ratio guidelines to which depository institutions under their respective supervision, including Old National Bank, are subject. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet commitments to four risk-weighted categories, with higher levels of capital being required for the categories perceived as representing greater risk. Old National’s banking affiliate, Old National Bank, exceeded all risk-based minimum capital requirements of the FDIC and OCC as of December 31, 2016. For Old National’s regulatory capital ratios and regulatory requirements as of December 31, 2016 and 2015, see Note 25 to the consolidated financial statements.

The federal regulatory authorities’ current risk-based capital guidelines are based upon the 1988 capital accord of the Basel Committee on Banking Supervision. The Basel Committee is a committee of central banks and bank regulators from the major industrialized countries that develops broad policy guidelines for use by a country’s regulators in determining appropriate supervisory policies. In December 2010 and January 2011, the Basel Committee published the final texts of reforms on capital and liquidity supervisory policies generally referred to as “Basel III.”

Effective July 2, 2013, the Federal Reserve and the OCC approved final rules known as the “Basel III Capital Rules” substantially revising the risk-based capital and leverage capital requirements applicable to bank holding companies and depository institutions, including Old National and Old National Bank. The Basel III Capital Rules address the components of capital and other issues affecting the numerator in banking institutions’ regulatory capital ratios. Basel III Capital Rules also implement the requirements of Section 939A of the Dodd-Frank Act to remove references to credit ratings from the federal banking agencies’ rules. Certain of the Basel III Capital Rules came into effect for Old National and Old National Bank on January 1, 2015; these rules are subject to a phase-in period which began on January 1, 2015.

 

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The Basel III Capital Rules introduced a new capital measure “Common Equity Tier 1” (“CET1”). The rules specify that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements. CET1 capital consists of common stock instruments that meet the eligibility criteria in the final rules, retained earnings, accumulated other comprehensive income, and common equity Tier 1 minority interest. The rules also define CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1, and not to the other components of capital. They also expand the scope of the adjustments as compared to existing regulations.

When fully phased-in on January 1, 2019, the Basel III Capital Rules will require banking organizations to maintain:

 

    a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased-in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7.0% upon full implementation);

 

    a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the 2.5% capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased-in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation);

 

    a minimum ratio of total capital (that is, Tier 1 plus Tier 2 capital) to risk-weighted assets of at least 8.0%, plus the 2.5% capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased-in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation); and

 

    a minimum leverage ratio of 4.0%, calculated as the ratio of Tier 1 capital to adjusted average consolidated assets.

The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and is not expected to have any current applicability to Old National or Old National Bank.

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer will face limitations on the payment of dividends, common stock repurchases and discretionary cash payments to executive officers based on the amount of the shortfall.

The Basel III Capital Rules provides for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III Capital Rules, Old National and Old National Bank are given a one-time election (the “Opt-out Election”) to filter certain accumulated other comprehensive income (“AOCI”) components, comparable to the treatment under the current general risk-based capital rule. The Company chose the AOCI Opt-out Election on the March 31, 2015 Call Report and FR Y-9C for Old National Bank and Old National, respectively.

Implementation of the deductions and other adjustments to CET1 began on January 1, 2015 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer began on January 1, 2016 at the 0.625% level and will be phased-in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).

In addition, the Basel III Capital Rules revise the rules for calculating risk-weighted assets to enhance their risk sensitivity. They establish a new framework under which mortgage-backed securities and other securitization exposures will be subject to risk-weights ranging from 20% to 1,250%. The rules also establish adjusted risk-weights for credit exposures, including multi-family and commercial real estate exposures that are 90 days or more past due or on non-accrual, which will be subject to a 150% risk-weight, except in situations where qualifying collateral and/or guarantees are in place. The existing treatment of residential mortgage exposures will remain subject to either a 50% risk-weight (for prudently underwritten owner-occupied first liens that are current or less than 90 days past due) or a 100% risk-weight (for all other residential mortgage exposures including 90 days or more past due exposures).

Management believes that, as of December 31, 2016, Old National and Old National Bank would meet all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis if such requirements were currently effective. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Company’s net income.

 

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The final Basel III Capital Rules were effective for Old National on January 1, 2015. The final rules permit banks with less than $15 billion in assets to continue to treat trust preferred securities as Tier 1 capital. This treatment is permanently grandfathered as Tier 1 capital even if Old National should ever exceed $15 billion assets due to organic growth. Should Old National exceed $15 billion in assets as the result of a merger or acquisition, then the Tier 1 treatment of its outstanding trust preferred securities will be phased out, but those securities will still be treated as Tier 2 capital. The final rule also permits banks with less than $250 billion in assets to choose to continue excluding unrealized gains and losses on certain securities holdings for purposes of calculating regulatory capital. The Company chose the Opt-out Election in its March 31, 2015 Call Report. The rules limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of CET1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.

Historically, the regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without minimum required formulaic measures. The Basel III liquidity framework requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements are expected to incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. The Basel III liquidity framework was implemented as a minimum standard on January 1, 2015, with a phase-in period ending January 1, 2019. The NSFR was subject to an observation period through mid-2016 and, subject to any revisions resulting from the analyses conducted and data collected during the observation period, implemented as a minimum standard by January 1, 2018. These new standards are subject to further rulemaking and their terms may well change before implementation. The federal banking agencies have not proposed rules implementing the Basel III liquidity framework and have not determined to what extent they will apply to U.S. banks that are not large, internationally active banks.

Management believes that, as of December 31, 2016, Old National Bank would meet the LCR requirement under the Basel III on a fully phased-in basis if such requirements were currently effective. Management’s evaluation of the impact of the NSFR requirement is ongoing as of December 31, 2016. Requirements to maintain higher levels of liquid assets could adversely impact the Company’s net income.

Stress Tests. The Dodd-Frank Act mandates company-run stress test requirements for U.S. bank holding companies with total consolidated assets of $10 billion to $50 billion. The objective of the stress test is to ensure that the financial institution has capital planning processes that account for its unique risks, and to help ensure that the institution has sufficient capital to continue operations throughout times of economic and financial stress. The stress tests are conducted with baseline, adverse and severely adverse economic scenarios. The final stress test rule defines total consolidated assets as the average of the institution’s total consolidated assets over the four most recent consecutive quarters as reported in the institution’s Call Report. An institution must comply with the stress test requirements beginning with the stress test cycle that commences in the calendar year after the year in which the institution meets the asset threshold. Old National’s consolidated assets exceeded $10 billion in the second quarter of 2014. Old National completed its annual stress test that covered a nine-quarter planning horizon beginning January 1, 2016 and ending on March 31, 2018 and publicly disclosed a summary of the stress test results on October 25, 2016. The stress test showed that Old National would maintain capital levels well above the regulatory guideline minimum levels for all periods and under all stress test scenarios.

Prompt Corrective Action Regulations. The Federal Deposit Insurance Act (the “FDIA”) requires, among other things, federal bank regulatory authorities to take “prompt corrective action” with respect to banks which do not meet minimum capital requirements. Under current prompt corrective action regulations, a bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any

 

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such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

The Basel III Capital Rules revised the “prompt corrective action” regulations pursuant to Section 38 of the FDIA, by:

 

    introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status;

 

    increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 risk-based capital ratio for well-capitalized status being 8.0% (as compared to the previous 6.0%); and

 

    eliminating the provision that provides that a bank with a composite supervisory rating of 1 may have a 3.0% leverage ratio and still be well-capitalized.

The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

Management believes that, as of December 31, 2016, Old National Bank was “well capitalized” based on the aforementioned existing ratios and the ratios as modified by the Basel III Capital Rules.

Deposit Insurance. Substantially all of the deposits of Old National Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and Old National Bank is subject to deposit insurance assessments to maintain the DIF. Deposit insurance assessments are based on average consolidated total assets minus average tangible equity. Under the FDIC’s risk-based assessment system, insured institutions with at least $10 billion in assets, such as Old National Bank, are assessed on the basis of a scoring system that combines the institution’s regulatory ratings and certain financial measures. The scoring system assesses risk measures to produce two scores, a performance score and a loss severity score, that will be combined and converted to an initial assessment rate.

The performance score measures an institution’s financial performance and its ability to withstand stress. The loss severity score quantifies the relative magnitude of potential losses to the FDIC in the event of an institution’s failure. Once the performance and loss severity scores are calculated, these scores will be converted to a total score. An institution with a total score of 30 or less will pay the minimum base assessment rate, and an institution with a total score of 90 or more will pay the maximum initial base assessment rate. For total scores between 30 and 90, initial base assessment rates will rise at an increasing rate as the total score increases. The FDIC has the authority to raise or lower assessment rates, subject to limits, and to impose special additional assessments.

 

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In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the DIF reserve ratio reaches 1.35%, as required by the Dodd-Frank Act. The FDIC approved a final rule in March 2016 to meet this requirement by 2018. To meet the 1.35% DIF reserve ratio by 2018, the FDIC will assess banks with consolidated assets of more than $10 billion a surcharge assessment of 0.045% once the DIF reserve ratio reaches 1.15%. The reserve ratio reached 1.15% in the second half of 2016.

The temporary unlimited deposit insurance coverage for non-interest-bearing transaction accounts that became effective on December 31, 2010 pursuant to rules adopted in accordance with the Dodd-Frank Act terminated on December 31, 2012. These accounts are now insured under the general deposit insurance coverage rules of the FDIC.

Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.

Safety and Soundness Regulations. In accordance with the FDIA, the federal banking agencies adopted guidelines establishing general standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal shareholder. In addition, regulations adopted by the federal banking agencies authorize the agencies to require that an institution that has been given notice that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, the institution fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the agency must issue an order directing corrective actions and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of FDIA. If the institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

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

In June 2010, the Federal Reserve Board, OCC and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. These three principles are incorporated into the proposed joint compensation regulations under the Dodd-Frank Act, discussed above.

The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as Old National, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the

 

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supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions.

Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Loans to One Borrower. Old National Bank generally may not make loans or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus. An additional amount may be loaned, up to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, which generally does not include real estate. As of December 31, 2016, Old National Bank was in compliance with the loans-to-one-borrower limitations.

Depositor Preference. The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.

Community Reinvestment Act. The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings that must be publicly disclosed. In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of certain applications. Old National Bank received a rating of “outstanding” in its latest CRA examination for the period ended December 31, 2012.

Financial Privacy. The federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

Old National Bank is also subject to regulatory guidelines establishing standards for safeguarding customer information. These guidelines describe the federal banking agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer.

Anti-Money Laundering and the USA Patriot Act. A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations on financial institutions, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.

On May 11, 2016, the Financial Crimes Enforcement Network (“FinCEN”) issued new anti-money laundering (“AML”) rules governing corporate entities doing business with banks and other financial institutions that are subject to the requirements of the USA Patriot Act. The AML rules impose significant due diligence obligations on

 

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financial institutions with respect to opening of new accounts and the monitoring of existing accounts. Under the AML rules, a financial institution must identify persons owning or controlling 25% or more of a “legal entity,” whenever the legal entity opens a new account at the bank. The financial institution must also identify an individual who has substantial management authority at the legal entity, such as a CEO, CFO, or managing partner.

The AML rules codify within the FinCEN regulations the “pillars” that must be included in a financial institutions AML compliance program. Regulators previously communicated their expectations with respect to four of these pillars: (1) the development of internal policies, procedures, and control; (2) the designation of a compliance officer; (3) the establishment of an ongoing employee training program; and (4) the implementation of an independent audit function to test programs. The new beneficial ownership requirement establishes a fifth pillar. Among other things, this new pillar includes the necessity to monitor and update the beneficial ownership of a legal entity, including the need to subject corporate borrowers to due diligence requests from financial institutions for certifications with respect to their beneficial owners. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

Office of Foreign Assets Control Regulation. The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others which are administered by the U.S. Treasury Department Office of Foreign Assets Control. Failure to comply with these sanctions could have serious legal and reputational consequences, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

Transactions with Affiliates. Transactions between Old National Bank and its affiliates are regulated by the Federal Reserve under sections 23A and 23B of the Federal Reserve Act and related regulations. These regulations limit the types and amounts of covered transactions engaged in by Old National Bank and generally require those transactions to be on an arm’s-length basis. The term “affiliate” is defined to mean any company that controls or is under common control with Old National Bank and includes Old National and its non-bank subsidiaries. “Covered transactions” include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve) from the affiliate, certain derivative transactions that create a credit exposure to an affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. In general, these regulations require that any such transaction by Old National Bank (or its subsidiaries) with an affiliate must be secured by designated amounts of specified collateral and must be limited to certain thresholds on an individual and aggregate basis.

Federal law also limits Old National Bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such extensions of credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Old National Bank’s capital.

Federal Home Loan Bank System. Old National Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions. As a member of the Federal Home Loan Bank of Indianapolis (“FHLBI”), Old National Bank is required to acquire and hold shares of capital stock of the FHLBI in an amount at least equal to the sum of the membership stock purchase requirement, determined on an annual basis at the end of each calendar year, and the activity-based stock purchase requirement, determined on a daily basis. For Old National Bank, the membership stock purchase requirement is 1.0% of the Mortgage-Related Assets, as defined by the FHLBI, which consists principally of residential mortgage loans and mortgage-backed securities, held by Old National Bank. The activity-based stock purchase requirement is equal to the sum of: (1) a specified percentage ranging from 2.0% to 5.0%, which for Old National Bank is 5.0%, of outstanding borrowings from the FHLBI; (2) a specified percentage ranging from 0.0% to 5.0%, which for Old National Bank is 3.0%, of the outstanding principal balance of Acquired Member Assets, as defined by the FHLBI, and delivery commitments for Acquired Member Assets; (3) a specified

 

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dollar amount related to certain off-balance sheet items, which for Old National Bank is inapplicable; and (4) a specified percentage ranging from 0.0% to 5.0% of the carrying value on the FHLBI’s balance sheet of derivative contracts between the FHLBI and Old National Bank, which for Old National Bank is inapplicable. The FHLBI can adjust the specified percentages and dollar amount from time to time within the ranges established by the FHLBI capital plan. As of December 31, 2016, Old National Bank was in compliance with the minimum stock ownership requirement.

Federal Reserve System. Federal Reserve regulations require depository institutions to maintain cash reserves against their transaction accounts (primarily NOW and demand deposit accounts). A reserve of 3% is to be maintained against aggregate transaction accounts between $12.4 million and $79.5 million (subject to adjustment by the Federal Reserve) plus a reserve of 10% (subject to adjustment by the Federal Reserve between 8% and 14%) against that portion of total transaction accounts in excess of $79.5 million. The first $12.4 million of otherwise reservable balances (subject to adjustment by the Federal Reserve) is exempt from the reserve requirements. Old National Bank is in compliance with the foregoing requirements.

Other Regulations. Old National Bank is subject to federal consumer protection statutes and regulations promulgated under those laws, including, but not limited to, the:

 

    Truth-In-Lending Act and Regulation Z, governing disclosures of credit terms to consumer borrowers;

 

    Home Mortgage Disclosure Act and Regulation C, requiring financial institutions to provide certain information about home mortgage and refinanced loans;

 

    Fair Credit Reporting Act and Regulation V, governing the provision of consumer information to credit reporting agencies and the use of consumer information;

 

    Equal Credit Opportunity Act and Regulation B, prohibiting discrimination on the basis of race, religion or other prohibited factors in the extension of credit;

 

    Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

    Truth in Savings Act and Regulation DD, which requires disclosure of deposit terms to consumers;

 

    Regulation CC, which relates to the availability of deposit funds to consumers;

 

    Right to Financial Privacy Act, which imposes a duty to maintain the confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records; and

 

    Electronic Funds Transfer Act, governing automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services.

The Dodd-Frank Act also significantly impacts the various consumer protection laws, rules and regulations applicable to financial institutions. The statute rolls back the federal preemption of state consumer protection laws that was enjoyed by national banks by (1) requiring that a state consumer financial law prevent or significantly interfere with the exercise of a national bank’s powers before it can be preempted, (2) mandating that any preemption decision be made on a case by case basis rather than a blanket rule, and (3) ending the applicability of preemption to subsidiaries and affiliates of national banks. As a result, we may now be subject to state consumer protection laws in each state where we do business, and those laws may be interpreted and enforced differently in each state.

The Dodd-Frank Act also created a new Consumer Financial Protection Bureau (“CFPB”), which took over responsibility for enforcing the principal federal consumer protection laws, such as the Truth in Lending Act, the Equal Credit Opportunity Act, the Real Estate Settlement Procedures Act and the Truth in Saving Act, among others, on July 21, 2011. Institutions that have assets of $10 billion or less will continue to be supervised and examined in this area by their primary federal regulators (in the case of the Bank, the OCC). Old National’s consolidated assets exceeded $10 billion in the second quarter of 2014, and we are now subject to the regulation of the CFPB.

The CFPB has broad rulemaking authority for a wide range of consumer financial laws that apply to all banks including, among other things, the authority to prohibit “unfair, deceptive, or abusive” acts and practices. Abusive acts or practices are defined as those that (1) materially interfere with a consumer’s ability to understand a term or condition of a consumer financial product or service, or (2) take unreasonable advantage of a consumer’s (a) lack of financial savvy, (b) inability to protect himself in the selection or use of consumer financial products or services, or

 

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(c) reasonable reliance on a covered entity to act in the consumer’s interests. The CFPB has the authority to investigate possible violations of federal consumer financial law, hold hearings and commence civil litigation. The CFPB can issue cease-and-desist orders against banks and other entities that violate consumer financial laws. The CFPB may also institute a civil action against an entity in violation of federal consumer financial law in order to impose a civil penalty or an injunction.

The rules issued by the CFPB will have a long-term impact on our mortgage loan origination and servicing activities. Compliance with these rules will likely increase our overall regulatory compliance costs.

Dividend Limitation. Old National Bank is subject to the provisions of the National Bank Act, is supervised, regulated and examined by the OCC, and is subject to the rules and regulations of the OCC, Federal Reserve and the FDIC. A substantial portion of Old National’s cash revenue is derived from dividends paid to it by Old National Bank. These dividends are subject to various legal and regulatory restrictions as summarized in Note 25 to the consolidated financial statements.

Legislative and Regulatory Initiatives. From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of Old National in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. Old National cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of Old National. A change in statutes, regulations or regulatory policies applicable to Old National or any of its subsidiaries could have a material effect on Old National’s business, financial condition and results of operations.

AVAILABLE INFORMATION

All reports filed electronically by Old National with the Securities and Exchange Commission (“SEC”), including the annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements, other information and amendments to those reports filed or furnished (if applicable), are accessible at no cost on Old National’s web site at www.oldnational.com as soon as reasonably practicable after electronically submitting such materials to the SEC. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC, and Old National’s filings are accessible on the SEC’s web site at www.sec.gov. The public may read and copy any materials filed by Old National with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

ITEM 1A. RISK FACTORS

Old National’s business could be harmed by any of the risks noted below. In analyzing whether to make or to continue an investment in Old National, investors should consider, among other factors, the following:

Risks Related to the Banking Industry

Old National operates in a highly regulated environment, and changes in laws and regulations to which Old National is subject may adversely affect Old National’s results of operations.

Old National operates in a highly regulated environment and is subject to extensive regulation, supervision and examination by, among others, the OCC, the FDIC, the CFPB, the Federal Reserve, and the State of Indiana. Such regulation and supervision of the activities in which an institution may engage is primarily intended for the protection of the depositors and federal deposit insurance funds. In addition, the Treasury has certain supervisory and oversight duties and responsibilities under EESA and the CPP. See “Business - Supervision and Regulation” herein. Applicable laws and regulations may change, and such changes may adversely affect Old National’s business. The Dodd-Frank Act, enacted in July 2010, mandated the most wide-ranging overhaul of financial industry regulation in decades. This legislation, among other things, weakened federal preemption of state

 

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consumer protection laws and established the CFPB with broad authority to administer and enforce a new federal regulatory framework of consumer financial regulation, including consumer mortgage banking. The scope and impact of many of the Dodd-Frank Act provisions were determined and issued over time. The impact of the Dodd-Frank Act on Old National has been substantial. Provisions in the legislation that affect the payment of interest on demand deposits and collection of interchange fees increased the costs associated with certain deposits and placed limitations on certain revenues those deposits generate. In addition, the Dodd-Frank Act required Old National to change certain of its business practices, intensified the regulatory supervision of Old National and the financial services industry, increased Old National’s capital requirements, and imposed additional assessments and costs on Old National. In addition, certain provisions in the legislation that had not previously applied to Old National became effective as Old National and its consolidated assets increased to over $10 billion in June 2014. This includes oversight by the CFPB and a requirement to submit our first stress test report in 2016. Requirements to maintain higher levels of capital or liquidity to address potential adverse stress scenarios could adversely impact the Company’s net income.

Regulatory authorities also have extensive discretion in connection with their supervisory and enforcement activities, including but not limited to the imposition of restrictions on the operation of an institution, the classification of assets by the institution, the adequacy of an institution’s Bank Secrecy Act/Anti Money Laundering program management, and the adequacy of an institution’s allowance for loan losses. Any change in such regulation and oversight, whether in the form of restrictions on activities, regulatory policy, regulations, or legislation, including but not limited to changes in the regulations governing institutions, could have a material impact on Old National and its operations.

If Old National fails to meet regulatory capital requirements which may require heightened capital, we may be forced to raise capital or sell assets.

Old National is subject to regulations that require us to satisfy certain capital ratios, such as the ratio of our Tier 1 capital to our risk-based assets. Both the Dodd-Frank Act, which reformed the regulation of financial institutions in a comprehensive manner, and the Basel III regulatory capital reforms, which increase both the amount and quality of capital that financial institutions must hold, will impact our capital requirements. Specifically, in July 2013, the U.S. federal banking authorities approved the implementation of the Basel III Rule. The Basel III Rule is applicable to all U.S. banks that are subject to minimum capital requirements as well as to bank and saving and loan holding companies, other than “small bank holding companies” (generally bank holding companies with consolidated assets of less than $500 million). The Basel III Rule not only increases most of the required minimum regulatory capital ratios, it introduces a new Common Equity Tier 1 Capital ratio and the concept of a capital conservation buffer. The Basel III Rule also expands the current definition of capital by establishing additional criteria that capital instruments must meet to be considered Additional Tier 1 Capital (i.e., Tier 1 Capital in addition to Common Equity) and Tier 2 Capital. A number of instruments that now generally qualify as Tier 1 Capital will not qualify or their qualifications will change when the Basel III Rule is fully implemented. The Basel III Rule has maintained the general structure of the current prompt corrective action thresholds while incorporating the increased requirements, including the Common Equity Tier 1 Capital ratio. In order to be a “well-capitalized” depository institution under the new regime, an institution must maintain a Common Equity Tier 1 Capital ratio of 6.5% or more, a Tier 1 Capital ratio of 8% or more, a Total Capital ratio of 10% or more, and a leverage ratio of 5% or more. Institutions must also maintain a capital conservation buffer consisting of Common Equity Tier 1 Capital. Financial institutions became subject to the Basel III Rule on January 1, 2015 with a phase-in period through 2019 for many of the changes. If we are unable to satisfy these heightened regulatory capital requirements, due to a decline in the value of our loan portfolio or otherwise, we will be required to improve such capital ratios by either raising additional capital or by disposing of assets. If we choose to dispose of assets, we cannot be certain that we will be able to do so at prices that we believe to be appropriate, and our future operating results could be negatively affected. If we choose to raise additional capital, we may accomplish this by selling additional shares of common stock, or securities convertible into or exchangeable for common stock, which could significantly dilute the ownership percentage of holders of our common stock and cause the market price of our common stock to decline. Additionally, events or circumstances in the capital markets generally may increase our capital costs and impair our ability to raise capital at any given time.

 

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A reduction in our credit rating could adversely affect our business and/or the holders of our securities.

The credit rating agencies rating our indebtedness regularly evaluate Old National and Old National Bank, and credit ratings are based on a number of factors, including our financial strength and ability to generate earnings, as well as factors not entirely within our control, including conditions affecting the financial services industry and the economy and changes in rating methodologies. There can be no assurance that we will maintain our current credit ratings. A downgrade of the credit ratings of Old National or Old National Bank could adversely affect our access to liquidity and capital, and could significantly increase our cost of funds, and decrease the number of investors and counterparties willing to lend to us or purchase our securities. This could affect our growth, profitability and financial condition, including liquidity.

Changes in interest rates could adversely affect Old National’s results of operations and financial condition.

Old National’s earnings depend substantially on Old National’s interest rate spread, which is the difference between (i) the rates Old National earns on loans, securities and other earning assets and (ii) the interest rates Old National pays on deposits and other borrowings. These rates are highly sensitive to many factors beyond Old National’s control, including general economic conditions and the policies of various governmental and regulatory authorities. If market interest rates rise, Old National will have competitive pressures to increase the rates that Old National pays on deposits, which could result in a decrease of Old National’s net interest income. If market interest rates decline, Old National could experience fixed rate loan prepayments and higher investment portfolio cash flows, resulting in a lower yield on earnings assets.

A failure or breach, including cyber-attacks, of our operational or security systems, could disrupt our business, result in the disclosure of confidential information, damage our reputation and create significant financial and legal exposure.

Although we devote significant resources to maintain and regularly upgrade our systems and processes that are designed to protect the security of our computer systems, software, networks and other technology assets and the confidentiality, integrity and availability of information belonging to us and our customers, there is no assurance that our security measures will provide absolute security. In fact, many other financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage systems, often through the introduction of computer viruses or malware, cyberattacks and other means. Certain financial institutions in the United States have also experienced attacks from technically sophisticated and well-resourced third parties that were intended to disrupt normal business activities by making internet banking systems inaccessible to customers for extended periods. These “denial-of-service” attacks have not breached our data security systems, but require substantial resources to defend, and may affect customer satisfaction and behavior.

Despite our efforts to ensure the integrity of our systems, it is possible that we may not be able to anticipate or to implement effective preventive measures against all security breaches of these types, especially because the techniques used change frequently or are not recognized until launched, and because security attacks can originate from a wide variety of sources, including persons who are involved with organized crime or associated with external service providers or who may be linked to terrorist organizations or hostile foreign governments. Those parties may also attempt to fraudulently induce employees, customers or other users of our systems to disclose sensitive information in order to gain access to our data or that of our customers or clients. These risks may increase in the future as we continue to increase our mobile payments and other internet-based product offerings and expand our internal usage of web-based products and applications.

If our security systems were penetrated or circumvented, it could cause serious negative consequences for us, including significant disruption of our operations, misappropriation of our confidential information or that of our customers, or damage our computers or systems and those of our customers and counterparties, and could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, customer dissatisfaction, significant litigation exposure, and harm to our reputation, all of which could have a material adverse effect on us.

 

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We rely on third party vendors, which could expose Old National to additional risk.

Third party vendors provide key components of our business infrastructure, including certain data processing and information services. On our behalf, third parties may transmit confidential, propriety information. Although we require third party providers to maintain certain levels of information security, such providers may remain vulnerable to breaches, unauthorized access, misuse, computer viruses, or other malicious attacks that could ultimately compromise sensitive information. While we may contractually limit our liability in connection with attacks against third party providers, Old National remains exposed to the risk of loss associated with such vendors. In addition, a number of our vendors are large national entities with dominant market presence in their respective fields. Their services could prove difficult to replace in a timely manner if a failure or other service interruption were to occur. Failures of certain vendors to provide contracted services could adversely affect our ability to deliver products and services to our customers and cause us to incur significant expense.

Changes in economic or political conditions could adversely affect Old National’s earnings, as the ability of Old National’s borrowers to repay loans, and the value of the collateral securing such loans, decline.

Old National’s success depends, to a certain extent, upon economic or political conditions, local and national, as well as governmental monetary policies. Conditions such as recession, unemployment, changes in interest rates, inflation, money supply and other factors beyond Old National’s control may adversely affect its asset quality, deposit levels and loan demand and, therefore, Old National’s earnings. Because Old National has a significant amount of commercial real estate loans, decreases in real estate values could adversely affect the value of property used as collateral. Adverse changes in the economy may also have a negative effect on the ability of Old National’s borrowers to make timely repayments of their loans, which would have an adverse impact on Old National’s earnings. In addition, substantially all of Old National’s loans are to individuals and businesses in Old National’s market area. Consequently, any economic decline in Old National’s primary market areas, which include Indiana, Kentucky, Michigan, and Wisconsin could have an adverse impact on Old National’s earnings.

Old National continually encounters technological change.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Old National’s future success depends, in part, upon its ability to address customer needs by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in Old National’s operations. Old National may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could negatively affect Old National’s growth, revenue, and profit.

Changes in consumer use of banks and changes in consumer spending and savings habits could adversely affect Old National’s financial results.

Technology and other changes now allow many customers to complete financial transactions without using banks. For example, consumers can pay bills and transfer funds directly without going through a bank. This process of eliminating banks as intermediaries could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits. In addition, changes in consumer spending and savings habits could adversely affect Old National’s operations, and Old National may be unable to timely develop competitive new products and services in response to these changes.

Our earnings could be adversely impacted by incidences of fraud and compliance failure.

Financial institutions are inherently exposed to fraud risk. A fraud can be perpetrated by a customer of Old National, an employee, a vendor, or members of the general public. We are most subject to fraud and compliance risk in connection with the origination of loans, ACH transactions, wire transactions, ATM transactions, and checking transactions. Our largest fraud risk, associated with the origination of loans, includes the intentional misstatement of information in property appraisals or other underwriting documentation provided to us by third parties. Compliance risk is the risk that loans are not originated in compliance with applicable laws and regulations and our standards. There can be no assurance that we can prevent or detect acts of fraud or violation of law or our compliance standards by the third parties that we deal with. Repeated incidences of fraud or compliance failures would adversely impact the performance of our loan portfolio.

 

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Risks Related to Old National’s Business

Acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties and dilution to existing shareholder value.

We have acquired, and expect to continue to acquire, other financial institutions or parts of those institutions in the future, and we may engage in de novo branch expansion. We may also consider and enter into new lines of business or offer new products or services.

We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance that integration efforts for any mergers or acquisitions will be successful. Also, we may issue equity securities in connection with acquisitions, which could cause ownership and economic dilution to our current shareholders. There is no assurance that, following any mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve profits comparable to, or better than, our historical experience.

Acquisitions and mergers involve a number of expenses and risks, including:

 

    the time and costs associated with identifying potential new markets, as well as acquisition and merger targets;

 

    the accuracy of the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;

 

    the time and costs of evaluating new markets, hiring experienced local management and opening new offices, and the time lags between these activities and the generation of sufficient assets and deposits to support the costs of the expansion;

 

    our ability to finance an acquisition and possible dilution to our existing shareholders;

 

    the diversion of our management’s attention to the negotiation of a transaction, and the integration of the operations and personnel of the combined businesses;

 

    entry into new markets where we lack experience;

 

    the introduction of new products and services into our business;

 

    the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations;

 

    closing delays and increased expenses related to the resolution of lawsuits filed by shareholders of targets; and

 

    the risk of loss of key employees and customers.

Old National must generally receive federal regulatory approval before it can acquire a bank or bank holding company. Old National cannot be certain when or if, or on what terms and conditions, any required regulatory approvals will be granted. Old National may be required to sell banks or branches as a condition to receiving regulatory approval.

Future acquisitions could be material to Old National and it may issue additional shares of stock to pay for those acquisitions, which would dilute current shareholder’s ownership interests.

Economic conditions have affected and could continue to adversely affect our revenues and profits.

Old National’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services that Old National offers, is highly dependent upon the business environment in the markets where Old National operates and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, terrorist acts, or a combination of these or other factors.

 

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Although the domestic economy has been in the recovery phase since 2009, the recovery is modest and there can be no assurance that the economy will not enter into another recession, whether in the near term or long term. Continuation of the slow recovery or another economic downturn or sustained, high unemployment levels may negatively impact our operating results and have a negative effect on the ability of our borrowers to make timely repayments of their loans increasing the risk of loan defaults and losses.

If Old National’s actual loan losses exceed Old National’s allowance for loan losses, Old National’s net income will decrease.

Old National makes various assumptions and judgments about the collectibility of Old National’s loan portfolio, including the creditworthiness of Old National’s borrowers and the value of the real estate and other assets serving as collateral for the repayment of Old National’s loans. Despite Old National’s underwriting and monitoring practices, the effect of a declining economy could negatively impact the ability of Old National’s borrowers to repay loans in a timely manner and could also negatively impact collateral values. As a result, Old National may experience significant loan losses that could have a material adverse effect on Old National’s operating results. Since Old National must use assumptions regarding individual loans and the economy, Old National’s current allowance for loan losses may not be sufficient to cover actual loan losses. Old National’s assumptions may not anticipate the severity or duration of the current credit cycle; and Old National may need to significantly increase Old National’s provision for losses on loans if one or more of Old National’s larger loans or credit relationships becomes delinquent or if Old National expands its commercial real estate and commercial lending. In addition, federal and state regulators periodically review Old National’s allowance for loan losses and may require Old National to increase the provision for loan losses or recognize loan charge-offs. Material additions to Old National’s allowance would materially decrease Old National’s net income. There can be no assurance that Old National’s monitoring procedures and policies will reduce certain lending risks or that Old National’s allowance for loan losses will be adequate to cover actual losses.

Old National’s loan portfolio includes loans with a higher risk of loss.

Old National Bank originates commercial real estate loans, commercial loans, agricultural real estate loans, agricultural loans, consumer loans, and residential real estate loans primarily within Old National’s market areas. Commercial real estate, commercial, consumer, and agricultural real estate and operating loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. These loans also have greater credit risk than residential real estate for the following reasons:

 

    Commercial Real Estate Loans. Repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service.

 

    Commercial Loans. Repayment is dependent upon the successful operation of the borrower’s business.

 

    Consumer Loans. Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss.

 

    Agricultural Loans. Repayment is dependent upon the successful operation of the business, which is greatly dependent on many things outside the control of either Old National Bank or the borrowers. These factors include weather, input costs, commodity and land prices, and interest rates.

Our wholesale funding sources may prove insufficient to replace deposits or support our future growth.

As a part of our liquidity management, we use a number of funding sources in addition to core deposit growth and repayments and maturities of loans and investments. These sources include brokered certificates of deposit, repurchase agreements, and federal funds purchased. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. Our financial flexibility could be constrained if we are unable to maintain our access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if we are required to rely more heavily on more expensive funding sources to support future growth, our revenues may not increase proportionately to cover our costs. In this case, our results of operations and financial condition would be negatively affected.

 

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Our accounting estimates and risk management processes rely on analytical and forecasting models.

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

If Old National forecloses on collateral property, Old National may be subject to the increased costs associated with the ownership of real property, resulting in reduced revenues.

Old National may have to foreclose on collateral property to protect Old National’s investment and may thereafter own and operate such property, in which case Old National will be exposed to the risks inherent in the ownership of real estate. The amount that Old National, as a mortgagee, may realize after a default is dependent upon factors outside of Old National’s control, including, but not limited to: (i) general or local economic conditions; (ii) neighborhood values; (iii) interest rates; (iv) real estate tax rates; (v) operating expenses of the mortgaged properties; (vi) environmental remediation liabilities; (vii) ability to obtain and maintain adequate occupancy of the properties; (viii) zoning laws; (ix) governmental rules, regulations and fiscal policies; and (x) acts of God. Certain expenditures associated with the ownership of real estate, principally real estate taxes, insurance, and maintenance costs, may adversely affect the income from the real estate. Therefore, the cost of operating real property may exceed the income earned from such property, and Old National may have to advance funds in order to protect Old National’s investment, or Old National may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect Old National’s ability to generate revenues, resulting in reduced levels of profitability.

Old National operates in an extremely competitive market, and Old National’s business will suffer if Old National is unable to compete effectively.

In our market area, Old National encounters significant competition from other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds, and other financial intermediaries. In addition, Financial Technology, or FinTech, start-ups are emerging in key areas of banking. Our competitors may have substantially greater resources and lending limits than Old National does and may offer services that Old National does not or cannot provide. Many of our nonfinancial institution competitors have fewer regulatory constraints, broader geographic service areas, and, in some cases, lower cost structures. Old National’s profitability depends upon Old National’s continued ability to compete successfully in Old National’s market area.

Our business could suffer if we fail to attract and retain skilled people.

Our success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities we engage in can be intense. We may not be able to hire the best people or to keep them. The loss of any of our key personnel or an inability to continue to attract, retain, and motivate key personnel could adversely affect our business.

We have risk related to legal proceedings.

We are involved in judicial, regulatory and arbitration proceedings concerning matters arising from our business activities and fiduciary responsibilities. We establish reserves for legal claims when payments associated with the claims become probable and the costs can be reasonably estimated. We may still incur legal costs for a matter even if we have not established a reserve. In addition, the actual cost of resolving a legal claim may be substantially

 

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higher than any amounts reserved for that matter. The ultimate resolution of a pending or future legal proceeding, depending on the remedy sought and granted, could materially adversely affect our results of operations and financial condition.

Risks Related to Old National’s Stock

We may not be able to pay dividends in the future in accordance with past practice.

Old National has traditionally paid a quarterly dividend to common stockholders. The payment of dividends is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on Old National’s earnings, capital requirements, financial condition, and other factors considered relevant by Old National’s Board of Directors.

Old National is an entity separate and distinct from Old National Bank. The Bank conducts most of our operations and Old National depends upon dividends from the Bank to service its debt and to pay dividends to Old National’s shareholders. The availability of dividends from the Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition including liquidity and capital adequacy of the Bank and other factors, that the OCC could assert that the payment of dividends or other payments is an unsafe or unsound practice. In addition, the payment of dividends by our other subsidiaries is also subject to the laws of the subsidiary’s state of incorporation, and regulatory capital and liquidity requirements applicable to such subsidiaries. At December 31, 2016, the Bank could pay dividends of $79.8 million without prior regulatory approval. In the event that the Bank was unable to pay dividends to us, we in turn would likely have to reduce or stop paying dividends on our Common Stock. Our failure to pay dividends on our Common Stock could have a material adverse effect on the market price of our Common Stock. See “Business – Supervision and Regulation – Dividend Limitations” and Note 25 to the consolidated financial statements.

The price of Old National’s common stock may be volatile, which may result in losses for investors.

General market price declines or market volatility in the future could adversely affect the price of Old National’s common stock. In addition, the following factors may cause the market price for shares of Old National’s common stock to fluctuate:

 

    announcements of developments related to Old National’s business;

 

    fluctuations in Old National’s results of operations;

 

    sales or purchases of substantial amounts of Old National’s securities in the marketplace;

 

    general conditions in Old National’s banking niche or the worldwide economy;

 

    a shortfall or excess in revenues or earnings compared to securities analysts’ expectations;

 

    changes in analysts’ recommendations or projections; and

 

    Old National’s announcement of new acquisitions or other projects.

As previously noted, the Dodd-Frank Act and its implementing regulations impose various additional requirements on bank holding companies with $10 billion or more in total assets, including compliance with portions of the Federal Reserve’s enhanced prudential oversight requirements and annual stress testing requirements. Compliance with the annual stress testing requirements, part of which must be publicly disclosed, may also be negatively interpreted by the market generally or our customers and, as a result, may adversely affect our stock price or our ability to retain our customers or effectively compete for new business opportunities.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

ITEM 2. PROPERTIES

As of December 31, 2016, Old National and its affiliates operated a total of 203 banking centers, primarily in the states of Indiana, Kentucky, Michigan, and Wisconsin. Of these facilities, 122 were owned. We lease 81 banking centers from unaffiliated third parties. The terms of these leases range from six months to twenty-four years. See Note 9 to the consolidated financial statements.

 

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Impacting the number of the Company’s banking centers in 2016 was the acquisition of Anchor (46 banking centers) and the consolidation of 5 banking centers throughout the franchise. In addition, we purchased 23 banking centers in 2016 that we had previously leased. Subsequent to December 31, 2016, an additional 15 banking centers were consolidated into nearby banking centers.

Old National also has several administrative offices located throughout its footprint, including the executive offices of Old National which are located at 1 Main Street, Evansville, Indiana. This building, which was previously leased, was purchased in 2016.

ITEM 3. LEGAL PROCEEDINGS

In the normal course of business, Old National Bancorp and its subsidiaries have been named, from time to time, as defendants in various legal actions. Certain of the actual or threatened legal actions may include claims for substantial compensatory and/or punitive damages or claims for indeterminate amounts of damages.

Old National contests liability and/or the amount of damages as appropriate in each pending matter. In view of the inherent difficulty of predicting the outcome of such matters, particularly in cases where claimants seek substantial or indeterminate damages or where investigations and proceedings are in the early stages, Old National cannot predict with certainty the loss or range of loss, if any, related to such matters, how or if such matters will be resolved, when they will ultimately be resolved, or what the eventual settlement, or other relief, if any, might be. Subject to the foregoing, Old National believes, based on current knowledge and after consultation with counsel, that the outcome of such pending matters will not have a material adverse effect on the consolidated financial condition of Old National, although the outcome of such matters could be material to Old National’s operating results and cash flows for a particular future period, depending on, among other things, the level of Old National’s revenues or income for such period. Old National will accrue for a loss contingency if (1) it is probable that a future event will occur and confirm the loss and (2) the amount of the loss can be reasonably estimated.

Old National is not currently involved in any material litigation.

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Old National’s common stock is traded on the NASDAQ Stock Market (“NASDAQ”) under the ticker symbol ONB. The following table lists the high and low closing sales prices as reported by the NASDAQ, share volume, and dividend data for 2016 and 2015:

 

     Price Per Share      Share
Volume
     Dividend
Declared
 
     High      Low        

2016

           

First Quarter

   $ 13.18       $ 10.85         72,116,846       $ 0.13   

Second Quarter

     13.40         11.64         72,798,438         0.13   

Third Quarter

     14.16         12.08         48,908,322         0.13   

Fourth Quarter

     18.35         13.80         51,422,870         0.13   

2015

           

First Quarter

   $ 14.63       $ 13.29         39,532,157       $ 0.12   

Second Quarter

     14.84         13.46         35,091,031         0.12   

Third Quarter

     14.84         13.26         36,742,644         0.12   

Fourth Quarter

     14.94         13.42         52,015,374         0.12   

There were 44,698 shareholders of record as of December 31, 2016. Old National declared cash dividends of $0.52 per share during the year ended December 31, 2016 and $0.48 per share during the year ended December 31, 2015. Old National’s ability to pay cash dividends depends primarily on cash dividends received from Old National Bank. Dividend payments from Old National Bank are subject to various regulatory restrictions. See Note 25 to the consolidated financial statements for additional information.

The following table summarizes the purchases of equity securities made by Old National during the fourth quarter of 2016:

 

Period    Total
Number
of Shares
Purchased
     Average
Price

Paid Per
Share
     Total Number
of Shares
Purchased as
Part of Publicly
Announced Plans

or Programs
     Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans or Programs
 

10/01/16 - 10/31/16

     360       $ 14.06         —           —     

11/01/16 - 11/30/16

     563         17.00         —           —     

12/01/16 - 12/31/16

     1,209         17.42         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     2,132       $ 16.74         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

The Board of Directors did not authorize a stock repurchase plan for 2016. During the twelve months ended December 31, 2016, Old National repurchased a limited number of shares associated with employee share-based incentive programs.

On January 26, 2017, the Board of Directors declared a quarterly cash dividend of $0.13 per common share. The Board of Directors did not authorize a new stock repurchase plan for 2017.

 

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EQUITY COMPENSATION PLAN INFORMATION

The following table contains information concerning the 2008 Equity Incentive Plan approved by security holders, as of December 31, 2016.

 

     Number of securities to
be issued upon exercise
of outstanding options,
warrants, and rights
     Weighted-average
exercise price of
outstanding options,
warrants, and rights
     Number of securities
remaining available for
future issuance under
equity compensation plans
(excluding securities
reflected in column (a))
 

Plan Category

   (a)      (b)      (c)  

Equity compensation plans approved by security holders

     1,916,624       $ 13.47         4,861,807   

Equity compensation plans not approved by security holders

     —           —           —     
  

 

 

    

 

 

    

 

 

 

Total

     1,916,624       $ 13.47         4,861,807   
  

 

 

    

 

 

    

 

 

 

At December 31, 2016, 4.9 million shares remain available for issuance under the 2008 Equity Incentive Plan.

 

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The following table compares cumulative five-year total shareholder returns, assuming reinvestment of dividends, for our common stock to cumulative total returns of a broad-based equity market index and two published industry indices. The comparison of shareholder returns (change in December year end stock price plus reinvested dividends) for each of the periods assumes that $100 was invested on December 31, 2011, in common stock of each of the Company, the S&P Small Cap 600 Index, the NYSE Financial Index and the SNL Bank and Thrift Index with investment weighted on the basis of market capitalization.

 

LOGO

 

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ITEM 6. SELECTED FINANCIAL DATA

 

(dollars in thousands, except per share data)

   2016     2015     2014     2013     2012  

Operating Results

          

Net interest income

   $ 402,703      $ 366,116      $ 366,370      $ 317,424      $ 308,757   

Conversion to fully taxable equivalent (1)

     21,293        19,543        16,999        16,876        13,188   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income - tax equivalent basis

     423,996        385,659        383,369        334,300        321,945   

Provision for loan losses

     960        2,923        3,097        (2,319     5,030   

Noninterest income

     252,830        230,632        165,129        184,758        189,816   

Noninterest expense

     454,147        430,932        386,438        361,984        365,758   

Net income

     134,264        116,716        103,667        100,920        91,675   

Common Share Data (2)

          

Weighted average diluted shares

     128,301        116,255        108,365        101,198        96,833   

Net income (diluted)

   $ 1.05      $ 1.00      $ 0.95      $ 1.00      $ 0.95   

Cash dividends

     0.52        0.48        0.44        0.40        0.36   

Common dividend payout ratio (3)

     50.30        47.60        46.48        39.91        37.80   

Book value at year-end

     13.42        13.05        12.54        11.64        11.81   

Stock price at year-end

     18.15        13.56        14.88        15.37        11.87   

Balance Sheet Data (at December 31)

          

Loans (4)

   $ 9,101,194      $ 6,962,215      $ 6,531,691      $ 5,090,669      $ 5,209,185   

Total assets

     14,860,237        11,991,527        11,646,051        9,581,744        9,543,623   

Deposits

     10,743,253        8,400,860        8,490,664        7,210,903        7,278,953   

Borrowings

     2,152,086        1,920,246        1,469,911        1,018,720        827,308   

Shareholders’ equity

     1,814,417        1,491,170        1,465,764        1,162,640        1,194,565   

Performance Ratios

          

Return on average assets (ROA)

     0.98 %      0.98     0.99     1.05     1.04

Return on average common shareholders’ equity (ROE)

     7.84        7.88        7.91        8.54        8.34   

Average equity to average assets

     12.55        12.42        12.57        12.33        12.49   

Net interest margin (5)

     3.58        3.72        4.22        4.02        4.23   

Efficiency ratio (6)

     65.82        68.65        70.03        68.61        71.83   

Asset Quality (7)

          

Net charge-offs (recoveries) to average loans

     0.04 %      (0.02 )%      0.04     0.10     0.17

Allowance for loan losses to ending loans

     0.55        0.75        0.76        0.93        1.05   

Allowance for loan losses

   $ 49,808      $ 52,233      $ 47,849      $ 47,145      $ 54,763   

Underperforming assets (8)

     164,657        160,072        170,535        165,656        302,643   

Allowance for loan losses to nonaccrual loans (9)

     37.90 %      39.46     33.97     36.71     21.53

Other Data

          

Full-time equivalent employees

     2,733        2,652        2,938        2,608        2,684   

Banking centers

     203        160        195        169        180   

 

(1) Calculated using the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations.
(2) Diluted data assumes the exercise of stock options and the vesting of restricted stock.
(3) Cash dividends divided by net income.
(4) Includes loans and finance leases held for sale.
(5) Defined as net interest income on a tax equivalent basis as a percentage of average earning assets.
(6) Defined as noninterest expense before amortization of intangibles as a percent of fully taxable equivalent net interest income and noninterest income, excluding net gains from securities transactions. This presentation excludes intangible amortization and net securities gains, as is common in other company disclosures, and better aligns with true operating performance.
(7) Excludes loans and finance leases held for sale.
(8) Includes nonaccrual loans, renegotiated loans, loans 90 days past due still accruing and other real estate owned. Includes $12.4 million, $24.4 million, $45.5 million, and $130.1 million of covered assets in 2015, 2014, 2013, and 2012, respectively, acquired in an FDIC assisted transaction, which were covered by loss sharing agreements with the FDIC providing for specified loss protection. On June 22, 2016, Old National entered into an early termination agreement with the FDIC that terminated all loss share agreements.
(9) Includes approximately $16.7 million, $15.9 million, $41.2 million, $38.3 million, and $156.8 million for 2016, 2015, 2014 2013, and 2012, respectively, of purchased credit impaired loans that are categorized as nonaccrual because the collection of principal or interest is doubtful. These loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.

 

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is an analysis of our results of operations for the fiscal years ended December 31, 2016, 2015, and 2014, and financial condition as of December 31, 2016 and 2015. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes. This discussion contains forward-looking statements concerning our business. Readers are cautioned that, by their nature, forward-looking statements are based on estimates and assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from our expectations that are expressed or implied by any forward-looking statement. The discussion in Item 1A, “Risk Factors,” lists some of the factors that could cause our actual results to vary materially from those expressed or implied by any forward-looking statements, and such discussion is incorporated into this discussion by reference.

GENERAL OVERVIEW

Old National is the largest financial holding company incorporated in the state of Indiana and maintains its principal executive offices in Evansville, Indiana. Old National, through Old National Bank, provides a wide range of services, including commercial and consumer loan and depository services, and other traditional banking services. Old National also provides services to supplement the traditional banking business including fiduciary and wealth management services, investment and brokerage services, investment consulting, and other financial services.

Our basic mission is to be THE community bank in the cities and towns we serve. We focus on establishing and maintaining long-term relationships with customers, and are committed to serving the financial needs of the communities in our market area. Old National provides financial services primarily in Indiana, Kentucky, Michigan, and Wisconsin.

CORPORATE DEVELOPMENTS IN FISCAL 2016

In 2016, we expanded our footprint into the state of Wisconsin through our acquisition of Anchor BanCorp Wisconsin Inc. (“Anchor”). In addition to our entry into this vibrant new market, management remained keenly focused on organic growth and efficiency efforts. This is evidenced by the following 2016 initiatives:

 

    organic loan growth of over 7% (including loans held for sale);

 

    the sale of our insurance subsidiary and the redeployment of capital into our higher yielding banking business;

 

    the termination of our frozen pension plan, which will eliminate future annual expense associated with the plan;

 

    the termination of our labor-intensive loss share agreements with the FDIC at a minimal financial impact; and

 

    the on-going assessment of our service and delivery network, resulting in the consolidation of five banking centers in 2016 and fifteen additional banking centers in January 2017.

Total revenues increased to $655.5 million, or 10%, from $596.7 million in 2015 and noninterest expenses remained well controlled, increasing to $454.1 million, or 5%, from $430.9 million in 2015. Net income for 2016 was $134.3 million, which compares favorably to 2015 net income of $116.7 million. Diluted earnings per share were $1.05 per share in 2016, compared to $1.00 per share in 2015.

BUSINESS OUTLOOK

Post-election, equity prices have surged and there is optimism that several policy changes will boost GDP growth. While it is yet to be seen if these proposals will pass and if they will truly benefit United States business, there appears to be rising consumer confidence. If our commercial loan pipeline is at all predictive, it appears that companies may be coming off the sidelines, and we may see an uptick in business investment during 2017.

Old National, along with all financial institutions, is also watching interest rates closely, and is encouraged by the 25 basis-point rate increase at the end of 2016. Additional rate increases in 2017 will benefit Old National as our assets tend to re-price faster and with more margin than our liabilities. In addition, Old National’s dominant market share in many of the communities in which we serve will become more valuable as deposits typically cost less than other types of funding.

 

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Our focus for 2017 will be much like our focus in 2016, as we execute on our revenue growth and expense management strategy. We have transitioned our footprint into higher growth markets and opportunistically will continue to do so. We believe we have the right people and the right products in the right markets, with strong leadership in place. Core revenue growth, improvement in our operating leverage, and the prudent use of capital will remain priorities.

RESULTS OF OPERATIONS

The following table sets forth certain income statement information of Old National for the years ended December 31, 2016, 2015, and 2014:

 

(dollars in thousands)

   2016     2015     2014  

Income Statement Summary:

      

Net interest income

   $ 402,703      $ 366,116      $ 366,370   

Provision for loan losses

     960        2,923        3,097   

Noninterest income

     252,830        230,632        165,129   

Noninterest expense

     454,147        430,932        386,438   

Other Data:

      

Return on average common equity

     7.84 %      7.88     7.91

Efficiency ratio (1)

     65.82 %      68.65     70.03

Tier 1 leverage ratio

     8.43 %      8.54     8.79

Net charge-offs (recoveries) to average loans

     0.04 %      (0.02 ) %      0.04

 

(1) Efficiency ratio is defined as noninterest expense before amortization of intangibles as a percent of fully taxable net interest income and noninterest income, excluding net gains from securities transactions. This presentation excludes intangible amortization and net securities gains, as is common in other company disclosures, and better aligns with true operating performance. This is a non-GAAP financial measure that management believes to be helpful in understanding Old National’s results of operations.

Comparison of Fiscal Years 2016 and 2015

Net Interest Income

Net interest income is the most significant component of our earnings, comprising 61% of 2016 revenues. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources, and interest rate fluctuations. Other factors include the level of accretion income on purchased loans, prepayment risk on mortgage and investment-related assets, and the composition and maturity of earning assets and interest-bearing liabilities.

Interest rates increased in the fourth quarter 2016, driven by improving economic conditions evidenced by the Federal Reserve increasing the discount rate 25 basis points at their December meeting. The yield curve steepened as the spread between short and longer duration Treasuries widened. These factors improve the outlook for our net interest income and margin.

Loans typically generate more interest income than investment securities with similar maturities. Funding from client deposits generally costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve Board monetary policy, and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.

Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented in the table that follows, adjusted to a taxable equivalent basis to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. We used the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations. This analysis portrays the income tax benefits associated in tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets.

 

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Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.

 

(dollars in thousands)

   2016     2015     2014  

Net interest income

   $ 402,703      $ 366,116      $ 366,370   

Conversion to fully taxable equivalent

     21,293        19,543        16,999   
  

 

 

   

 

 

   

 

 

 

Net interest income - taxable equivalent basis

   $ 423,996      $ 385,659      $ 383,369   
  

 

 

   

 

 

   

 

 

 

Average earning assets

   $
 
11,840,967
 
  
  
  $ 10,363,098      $ 9,082,768   

Net interest margin

     3.40 %      3.53     4.03

Net interest margin - taxable equivalent basis

     3.58 %      3.72     4.22

Net interest income was $402.7 million in 2016, a $36.6 million increase from $366.1 million in 2015. Taxable equivalent net interest income was $424.0 million in 2016, a 10% increase from $385.7 million in 2015. The net interest margin on a fully taxable equivalent basis was 3.58% in 2016, a 14 basis point decrease compared to 3.72% in 2015. Both 2016 and 2015 included accretion income (interest income in excess of contractual interest income) associated with acquired loans. Excluding this accretion income in both periods, net interest income on a fully taxable equivalent basis would have been $365.9 million in 2016 compared to $322.6 million in 2015; and the net interest margin on a fully taxable equivalent basis would have been 3.09% in 2016 and 3.11% in 2015.

The increase in net interest income in 2016 when compared to 2015 was primarily due to an increase in average earning assets of $1.478 billion in 2016. Partially offsetting the higher average earning assets was a decrease in accretion income of $5.0 million. We expect accretion income on our purchased credit impaired loans to decrease over time, but this may be offset by future acquisitions.

The following table presents a three-year average balance sheet and for each major asset and liability category, its related interest income and yield, or its expense and rate for the years ended December 31.

 

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    2016     2015     2014  

(tax equivalent basis,

dollars in thousands)

  Average
Balance
    Interest
& Fees
    Yield/
Rate
    Average
Balance
    Interest
& Fees
    Yield/
Rate
    Average
Balance
    Interest
& Fees
     Yield/
Rate
 

Earning Assets

                  

Money market and other interest- earning investments (1)

  $ 32,697      $ 130        0.40   $ 43,383      $ 47        0.11   $ 20,148      $ 42         0.21

Investment securities: (2)

                  

U.S. Treasury & government- sponsored agencies (3)

    1,968,408        37,381        1.90        1,967,293        36,725        1.87        2,041,978        38,742         1.90   

States and political subdivisions (4)

    1,125,713        53,003        4.71        1,023,983        49,162        4.80        889,343        45,112         5.07   

Other securities

    438,832        10,391        2.37        444,520        10,903        2.45        418,714        11,322         2.70   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

    3,532,953        100,775        2.85        3,435,796        96,790        2.82        3,350,035        95,176         2.84   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Loans (including loans held for sale): (5)

                  

Commercial (4)

    1,835,317        70,591        3.85        1,754,141        75,900        4.33        1,527,436        70,471         4.61   

Commercial real estate

    2,648,911        150,592        5.69        1,862,055        118,237        6.35        1,474,136        130,780         8.87   

Residential real estate

    1,995,060        80,963        4.06        1,712,636        70,908        4.14        1,497,122        60,904         4.07   

Consumer, net of unearned income

    1,796,029        65,376        3.64        1,555,087        56,850        3.66        1,213,891        49,355         4.07   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

    8,275,317        367,522        4.44        6,883,919        321,895        4.68        5,712,585        311,510         5.45   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total earning assets

    11,840,967      $ 468,427        3.96     10,363,098      $ 418,732        4.04     9,082,768      $ 406,728         4.48
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

    

 

 

 

Less: Allowance for loan losses

    (52,215         (50,538         (47,254     

Non-Earning Assets

                  

Cash and due from banks

    192,401            163,275            171,789        

Other assets

    1,661,200            1,451,125            1,224,272        
 

 

 

       

 

 

       

 

 

      

Total assets

  $ 13,642,353          $ 11,926,960          $ 10,431,575        
 

 

 

       

 

 

       

 

 

      

Interest-Bearing Liabilities

                  

NOW deposits

    2,389,143      $ 1,529        0.06   $ 2,160,019      $ 758        0.04   $ 1,989,794      $ 595         0.03

Savings deposits

    2,595,622        3,723        0.14        2,299,357        3,199        0.14        2,104,076        2,875         0.14   

Money market deposits

    763,909        840        0.11        677,414        577        0.09        490,247        250         0.05   

Time deposits

    1,361,647        11,191        0.82        1,063,782        9,634        0.91        1,024,377        9,606         0.94   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

    7,110,321        17,283        0.24        6,200,572        14,168        0.23        5,608,494        13,326         0.24   

Federal funds purchased and interbank borrowings

    137,997        673        0.49        126,124        265        0.21        77,512        136         0.18   

Securities sold under agreements to repurchase

    368,757        1,509        0.41        406,117        1,488        0.37        377,407        1,434         0.38   

Federal Home Loan Bank advances

    1,121,413        15,547        1.39        793,703        8,122        1.02        597,905        4,275         0.71   

Other borrowings

    222,708        9,419        4.23        217,978        9,030        4.14        105,453        4,188         3.97   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

  $ 8,961,196      $ 44,431        0.50   $ 7,744,494      $ 33,073        0.43   $ 6,766,771      $ 23,359         0.35
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

 

Noninterest-Bearing Liabilities

                  

Demand deposits

    2,776,140            2,500,571            2,166,628        

Other liabilities

    192,443            200,994            186,910        

Shareholders’ equity

    1,712,574            1,480,901            1,311,266        
 

 

 

       

 

 

       

 

 

      

Total liabilities and shareholders’ equity

  $ 13,642,353          $ 11,926,960          $ 10,431,575        
 

 

 

       

 

 

       

 

 

      

Interest Margin Recap

                  

Interest income/average earning assets

    $ 468,427        3.96     $ 418,732        4.04     $ 406,728         4.48

Interest expense/average earning assets

      44,431        0.38          33,073        0.32          23,359         0.26   
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

    

 

 

 

Net interest income and margin

    $ 423,996        3.58     $ 385,659        3.72     $ 383,369         4.22
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

    

 

 

 

 

(1) The 2016, 2015, and 2014 average balances include $24.8 million, $35.2 million, and $12.3 million, respectively, of required and excess balances held at the Federal Reserve.
(2) Changes in fair value are reflected in the average balance; however, yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.
(3) Includes U.S. government-sponsored entities and agency mortgage-backed securities at December 31, 2016.
(4) Interest on state and political subdivision investment securities and commercial loans includes the effect of taxable equivalent adjustments of $15.2 million and $6.1 million, respectively, in 2016; $13.7 million and $5.9 million, respectively, in 2015; and $11.8 million and $5.2 million, respectively, in 2014; using the federal statutory tax rate in effect of 35% for all periods adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations.
(5) Includes principal balances of nonaccrual loans. Interest income relating to nonaccrual loans is included only if received.

 

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The yield on average earning assets decreased 8 basis points from 4.04% in 2015 to 3.96% in 2016 and the cost of interest-bearing liabilities increased 7 basis points from 0.43% in 2015 to 0.50% in 2016. Average earning assets increased by $1.478 billion, or 14%. The increase in average earning assets consisted of a $1.391 billion increase in loans, a $97.2 million increase in lower yielding investment securities, partially offset by a $10.7 million decrease in money market and other interest-earning investments. Average interest-bearing liabilities increased $1.217 billion, or 16%. The increase in average interest-bearing liabilities consisted of a $909.7 million increase in interest-bearing deposits, an $11.9 million increase in federal funds purchased and interbank borrowings, a $37.4 million decrease in securities sold under agreements to repurchase, a $327.7 million increase in Federal Home Loan Bank advances, and a $4.7 million increase in other borrowings. Average noninterest-bearing deposits increased by $275.6 million.

The increase in average earning assets in 2016 compared to 2015 was primarily due to our acquisition of Anchor in May 2016. Including loans held for sale, the loan portfolio, which generally has an average yield higher than the investment portfolio, was approximately 70% of average interest earning assets in 2016 compared to 66% in 2015.

Average loans including loans held for sale increased $1.391 billion in 2016 compared to 2015 reflecting $1.152 billion of average loans acquired from Anchor in May 2016, along with $239.2 million of organic loan growth. These increases were partially offset by the sale of $193.6 million of loans associated with our branch divestitures during the third quarter of 2015.

The increases in average investments and average deposits also reflected the Anchor acquisition.

Average non-interest bearing deposits increased $275.6 million in 2016 compared to 2015 reflecting $241.8 million of average non-interest bearing deposits from the Anchor acquisition. Average interest bearing deposits increased $909.7 million in 2016 compared to 2015 reflecting $963.6 million of average interest bearing deposits from the Anchor acquisition. These increases were partially offset by a $555.8 million reduction associated with our branch divestitures during the third quarter of 2015.

Average borrowed funds increased $307.0 million in 2016 compared to 2015 primarily due to increased funding needed as a result of growth in our investment and loan portfolios that outpaced deposit growth.

 

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The following table shows fluctuations in taxable equivalent net interest income attributable to changes in the average balances of assets and liabilities and the yields earned or rates paid for the years ended December 31.

 

     2016 vs. 2015     2015 vs. 2014  

(dollars in thousands)

   Total
Change
     Attributed to     Total
Change
     Attributed to  
      Volume     Rate        Volume      Rate  

Interest Income

               

Money market and other interest-earning investments

   $ 83       $ (27   $ 110      $ 5       $ 36       $ (31

Investment securities (1)

     3,985         2,754        1,231        1,614         2,426         (812

Loans (1)

     45,627         63,428        (17,801     10,385         59,322         (48,937
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total interest income

     49,695         66,155        (16,460     12,004         61,784         (49,780
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Interest Expense

               

NOW deposits

     771         114        657        163         55         108   

Savings deposits

     524         419        105        324         269         55   

Money market deposits

     263         84        179        327         127         200   

Time deposits

     1,557         2,572        (1,015     28         363         (335

Federal funds purchased and interbank borrowings

     408         41        367        129         94         35   

Securities sold under agreements to repurchase

     21         (145     166        54         107         (53

Federal Home Loan Bank advances

     7,425         3,948        3,477        3,847         1,702         2,145   

Other borrowings

     389         198        191        4,842         4,565         277   
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Total interest expense

     11,358         7,231        4,127        9,714         7,282         2,432   
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

Net interest income

   $ 38,337       $ 58,924      $ (20,587   $ 2,290       $ 54,502       $ (52,212
  

 

 

    

 

 

   

 

 

   

 

 

    

 

 

    

 

 

 

The variance not solely due to rate or volume is allocated equally between the rate and volume variances.

 

(1) Interest on investment securities and loans includes the effect of taxable equivalent adjustments of $15.2 million and $6.2 million, respectively, in 2016; $13.7 million and $5.9 million, respectively, in 2015; and $11.8 million and $5.2 million, respectively, in 2014; using the federal statutory rate in effect of 35% for all periods adjusted for the TEFRA

interest disallowance applicable to certain tax-exempt obligations.

Provision for Loan Losses

The provision for loan losses was an expense of $1.0 million in 2016, compared to an expense of $2.9 million in 2015. Net charge-offs totaled $3.4 million in 2016, compared to net recoveries of $1.5 million in 2015. The lower provision for loan losses is the result of the increase in purchased loans that were recorded at fair value and improved asset quality. The fair value adjustment considers credit impairment resulting in no need for an allowance for loan losses at the date of acquisition. Continued loan growth in future periods, or a decline in our current level of recoveries, could result in an increase in provision expense. For additional information about non-performing loans, charge-offs, and additional items impacting the provision, refer to the “Risk Management—Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Noninterest Income

We generate revenues in the form of noninterest income through client fees, sales commissions, and other gains and losses from our core banking franchise and other related businesses, such as wealth management, investment consulting, and investment products. This source of revenue as a percentage of total revenue was 39% in 2016 and 2015.

Noninterest income was $252.8 million in 2016, an increase of $22.2 million, or 10%, compared to $230.6 million in 2015. The increase in noninterest income in 2016 was primarily due to a pre-tax gain of $41.9 million resulting from the sale of ONB Insurance Group, Inc. (“ONI”) in May 2016 and noninterest income attributable to the Anchor acquisition. The increase in noninterest income was partially offset by a $15.6 million gain on branch divestitures in the third quarter of 2015 and lower insurance premiums and commissions resulting from the sale on ONI.

 

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The following table details the components of noninterest income for the years ended December 31.

 

                       % Change From
Prior Year
 

(dollars in thousands)

   2016     2015     2014     2016     2015  

Wealth management fees

   $ 34,641      $ 34,395      $ 28,737        0.7 %      19.7

Service charges on deposit accounts

     41,578        43,372        47,433        (4.1 )      (8.6

Debit card and ATM fees

     16,769        21,340        25,835        (21.4 )      (17.4

Mortgage banking revenue

     20,240        12,540        6,017        61.4        108.4   

Insurance premiums and commissions

     20,527        42,714        41,466        (51.9 )      3.0   

Investment product fees

     18,822        17,924        17,136        5.0        4.6   

Company-owned life insurance

     8,479        8,604        6,924        (1.5 )      24.3   

Other income

     27,772        20,988        18,919        32.3        10.9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total fee and service charge income

     188,828        201,877        192,467        (6.5 )      4.9   

Net securities gains

     5,848        5,718        9,830        2.3        (41.8

Impairment on available-for-sale securities

     —          —          (100     N/M        100.0   

Gain on sale leaseback transactions

     16,057        16,444        6,094        (2.4 )      169.8   

Gain on sale of ONB Insurance Group, Inc.

     41,864        —          —          N/M        N/M   

Net gain on branch divestitures

     —          15,627        —          (100.0 )      N/M   

Change in FDIC indemnification asset

     233        (9,034     (43,162     (102.6 )      (79.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 252,830      $ 230,632      $ 165,129        9.6 %      39.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Noninterest income to total revenue (1)

     37.4     37.4     30.1    

 

(1) Total revenue includes the effect of a taxable equivalent adjustment of $21.3 million in 2016, $19.5 million

in 2015, and $17.0 million in 2014.

N/M = Not meaningful

Service charges and overdraft fees on deposit accounts continued to be challenged. The divestiture of the southern Illinois region during the third quarter of 2015 also contributed to the decrease in service charges and overdraft fees on deposit accounts year over year. These decreases were partially offset by $3.7 million of service charges and overdraft fees attributable to the Anchor acquisition.

Debit card and ATM fees decreased $4.6 million in 2016 compared to 2015 as the Durbin Amendment, which limits interchange fees on debit card transactions for banks with $10 billion or more in assets, became effective for us on July 1, 2015. The decrease in debit card and ATM fees was partially offset by $1.7 million of debit card and ATM fees attributable to the Anchor acquisition.

Mortgage banking revenue increased $7.7 million to $20.2 million in 2016 compared to $12.5 million in 2015 primarily due to increased sales to the secondary market in 2016 and an increase in production largely attributable to our new associates in the Wisconsin region.

Insurance premiums and commissions decreased $22.2 million in 2016 reflecting the sale of ONI in May 2016.

In 2016, we recorded a $41.9 million pre-tax gain resulting from the sale of ONI in May 2016. The after-tax gain related to the sale totaled $17.6 million.

In 2015, we recorded a net gain of $15.6 million in connection with the August 2015 divestitures of our southern Illinois region (twelve branches) along with four branches in eastern Indiana and one in Ohio.

Other income increased $6.8 million in 2016 compared to 2015. Included in 2016 was $7.6 million of recoveries on Anchor loans that had been fully charged-off prior to the acquisition.

Noninterest Income Related to Covered Assets and Indemnification Asset

In 2011, Old National acquired the banking operations of Integra Bank N.A. in an FDIC-assisted transaction. The FDIC had agreed to reimburse Old National for losses incurred on certain acquired loans, and we recorded an indemnification asset at fair value on the date that we acquired these loans. The indemnification asset, on the

 

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acquisition date, reflected the reimbursements expected to be received from the FDIC. Deterioration in the expected credit quality of both OREO and loans increased the basis of the indemnification asset. The offset for both OREO and loans was recorded through the consolidated statement of income. Increases in the credit quality or cash flows of loans (reflected as an adjustment to yield and accreted into income over the remaining life of the loans) decreased the basis of the indemnification asset, with the decrease being amortized into income over the same period or the life of the loss share agreements, whichever was shorter.

Old National entered into an agreement with the FDIC on June 22, 2016 to terminate its loss share agreements. Under the early termination agreement, the FDIC made a final payment of $8.7 million to Old National as consideration for the early termination. After the elimination of the remaining FDIC indemnification asset and the payment of settlement charges, Old National realized a pre-tax gain of $0.2 million during 2016. All remaining assets that were covered by the loss share arrangements were reclassified to noncovered assets effective June 22, 2016. All future gains and losses associated with covered assets will be recognized entirely by Old National.

Noninterest Expense

Noninterest expense totaled $454.1 million in 2016, an increase of $23.2 million, or 5%, from $430.9 million in 2015. Noninterest expense during 2016 was impacted by our transition into the higher growth markets in Wisconsin, the divestitures of our Illinois franchise and our insurance business, and other branch restructuring during 2015.

The following table details the components of noninterest expense for the years ended December 31.

 

                          % Change From
Prior Year
 

(dollars in thousands)

   2016      2015      2014      2016     2015  

Salaries and employee benefits

   $ 252,892       $ 243,875       $ 219,301         3.7 %      11.2

Occupancy

     50,947         53,239         49,099         (4.3 )      8.4   

Equipment

     13,448         13,183         12,453         2.0        5.9   

Marketing

     14,620         10,410         9,591         40.4        8.5   

Data processing

     32,002         27,309         25,382         17.2        7.6   

Communication

     9,959         9,586         10,476         3.9        (8.5

Professional fees

     15,705         11,756         16,390         33.6        (28.3

Loan expense

     7,632         6,373         6,107         19.8        4.4   

Supplies

     2,865         2,275         2,958         25.9        (23.1

FDIC assessment

     8,681         7,503         6,261         15.7        19.8   

Other real estate owned expense

     4,195         2,703         3,101         55.2        (12.8

Amortization of intangibles

     12,486         11,746         9,120         6.3        28.8   

Other expense

     28,715         30,974         16,199         (7.3 )      91.2   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expense

   $ 454,147       $ 430,932       $ 386,438         5.4 %      11.5
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Salaries and benefits, the largest component of noninterest expense, totaled $252.9 million in 2016, compared to $243.9 million in 2015, an increase of $9.0 million, or 4%. Impacting salaries and benefits expense were the acquisition of Anchor and the divestitures described above. Also contributing to the increase in salaries and benefits was a pension plan settlement loss of $9.8 million resulting from the termination of the Employee Retirement Plan. The increase was partially offset by a higher level of severance expense in 2015 related to early retirement offers and other workforce reductions along with lower incentive bonus accruals in 2016.

Occupancy expenses decreased $2.3 million to $50.9 million in 2016 compared to 2015 primarily due to branch divestures and consolidations in the third quarter of 2015. The decrease was partially offset by occupancy expenses attributable to the Anchor acquisition.

Marketing expense increased $4.2 million in 2016 compared to 2015 primarily due to additional expenses recorded in 2016 associated with the Anchor acquisition, higher advertising, and public relations expense.

 

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Data processing expense increased $4.7 million in 2016 compared to 2015 primarily due the systems conversion associated with the Anchor acquisition.

Professional fees increased $3.9 million in 2016 compared to 2015 primarily due additional expenses recorded in 2016 associated with the Anchor acquisition.

Other expense was $28.7 million in 2016 compared to $31.0 million in 2015. Included in other expense in 2016 were $4.8 million of costs related to the consolidation of fifteen banking centers in January 2017, Anchor acquisition and integration costs of $2.4 million, and higher charitable contributions of $2.1 million when compared to 2015. Included in other expense in 2015 were costs associated with branch divestitures, closures, and consolidations totaling $7.8 million and a $4.8 million legal settlement accrual.

Provision for Income Taxes

We record a provision for income taxes currently payable and for income taxes payable or benefits to be received in the future, which arise due to timing differences in the recognition of certain items for financial statement and income tax purposes. The major difference between the effective tax rate applied to our financial statement income and the federal statutory tax rate is caused by interest on tax-exempt securities and loans. The effective tax rate was 33.0% in 2016 compared to 28.3% in 2015. The higher effective tax rate in 2016 when compared to 2015 is primarily the result of the sale of ONI in May 2016 and the associated tax expense of $8.3 million to record a deferred tax liability relating to ONI’s nondeductible goodwill. See Note 17 to the consolidated financial statements for additional details on Old National’s income tax provision.

Comparison of Fiscal Years 2015 and 2014

In 2015, we generated net income of $116.7 million and diluted net income per share of $1.00 compared to $103.7 million and diluted net income per share of $0.95, respectively, in 2014. The 2015 earnings included a $0.2 million decrease in provision for loan losses and a $65.5 million increase in noninterest income. These increases to net income were partially offset by a $0.3 million decrease in net interest income, a $44.5 million increase in noninterest expense, and a $7.9 million increase in income tax expense.

Net interest income was $366.1 million in 2015, a $0.3 million decrease from $366.4 million in 2014. Taxable equivalent net interest income was $385.7 million in 2015, a 1% increase from $383.4 million in 2014. The net interest margin on a fully taxable equivalent basis was 3.72% in 2015, a 50 basis point decrease compared to 4.22% in 2014. Average earning assets increased by $1.280 billion during 2015 and the yield on average earning assets decreased 44 basis points from 4.48% in 2014 to 4.04% in 2015. Average interest-bearing liabilities increased $977.7 million and the cost of interest-bearing liabilities increased from 0.35% to 0.43% in 2015.

The provision for loan losses was an expense of $2.9 million in 2015, compared to an expense of $3.1 million in 2014. Charge-offs remained low during 2015 and we continued to see positive trends in credit quality.

Noninterest income was $230.6 million in 2015, an increase of $65.5 million, or 40%, compared to $165.1 million in 2014. The increase in noninterest income in 2015 was primarily due to a negative adjustment of $9.0 million for the FDIC indemnification asset in 2015 compared to a negative adjustment of $43.2 million for the FDIC indemnification asset in 2014. The increase was also due to acquisitions during 2014 and 2015, a $15.6 million gain on branch divestitures in 2015, and pre-tax deferred gains of $10.8 million resulting from the acquisition of fourteen bank properties that Old National had previously leased.

Noninterest expense totaled $430.9 million in 2015, an increase of $44.5 million, or 12%, from $386.4 million in 2014. The increase was primarily due to higher salaries and benefits, other expense, occupancy expenses, and amortization of intangibles. These increases were partially offset by lower acquisition and integration costs. Operating expenses associated with the acquisitions of Tower, United, LSB, and Founders totaled $39.0 million in 2015 compared to $18.5 million in 2014. In addition, noninterest expense also included acquisition and integration costs associated with these transactions totaling $5.7 million in 2015 compared to $15.6 million in 2014. Noninterest expense in 2015 also included costs associated with branch divestitures, closures, and consolidations totaling $9.5 million, $5.6 million of severance expense related to early retirement offers and other workforce reductions, and a $4.8 million legal settlement accrual.

 

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The provision for income taxes was $46.2 million in 2015 compared to $38.3 million in 2014. Old National’s effective tax rate was 28.3% in 2015 compared to 27.0% in 2014.

FINANCIAL CONDITION

Overview

At December 31, 2016, our assets were $14.860 billion, a 24% increase compared to $11.992 billion at December 31, 2015. The increase was primarily due to the acquisition of Anchor in May 2016, which had $2.166 billion in assets as of the closing date of the acquisition.

Earning Assets

Earning assets, comprised of investment securities, portfolio loans, loans held for sale, money market investments, interest earning accounts with the Federal Reserve, and trading securities, were $12.796 billion at December 31, 2016, an increase of 22% compared to $10.471 billion at December 31, 2015.

Investment Securities

We classify the majority of our investment securities as available-for-sale to give management the flexibility to sell the securities prior to maturity if needed, based on fluctuating interest rates or changes in our funding requirements. However, we also have $10.6 million of 15- and 20-year fixed-rate mortgage-backed securities, $40.1 million of U.S. government-sponsored entity and agency securities, and $694.3 million of state and political subdivision securities in our held-to-maturity investment portfolio at December 31, 2016.

Trading securities, which consist of mutual funds held in trusts associated with deferred compensation plans for former directors and executives, are recorded at fair value and totaled $5.0 million at December 31, 2016 compared to $3.9 million at December 31, 2015. The increase was primarily due to the acquisition of Anchor, which had $0.9 million in trading securities as of the closing date of the acquisition.

At December 31, 2016, the investment securities portfolio, including trading securities, was $3.649 billion compared to $3.380 billion at December 31, 2015, an increase of $268.5 million, or 8%. Investment securities attributable to the Anchor acquisition totaled $239.8 million as of the closing date of the acquisition. Investment securities represented 29% of earning assets at December 31, 2016, compared to 32% at December 31, 2015. Investment securities also decreased as a percentage of total earning assets due to a proportionately larger increase in loan balances. Stronger commercial loan demand in the future and management’s decision to deleverage the balance sheet could result in a reduction in the securities portfolio. As of December 31, 2016, management does not intend to sell any securities in an unrealized loss position and does not believe we will be required to sell such securities.

The investment securities available-for-sale portfolio had net unrealized losses of $61.5 million at December 31, 2016, compared to net unrealized losses of $5.8 million at December 31, 2015. Net unrealized losses increased from December 31, 2015 to December 31, 2016 primarily due to an increase in long-term interest rates on municipal bonds and mortgage-backed securities.

The investment portfolio had an effective duration of 4.61 at December 31, 2016, compared 3.99 at December 31, 2015. Effective duration measures the percentage change in value of the portfolio in response to a change in interest rates. Generally, there is more uncertainty in interest rates over a longer average maturity, resulting in a higher duration percentage. The weighted average yields on available-for-sale investment securities were 2.44% in 2016 and 2.38% in 2015. The average yields on the held-to-maturity portfolio were 5.35% in 2016 and 4.99% in 2015.

At December 31, 2016, Old National had a concentration of investment securities issued by certain states and their political subdivisions with the following aggregate market values: $369.4 million by Indiana, which represented 20.4% of shareholders’ equity, and $198.2 million by Texas, which represented 10.9% of shareholders’ equity. Of the Indiana municipal bonds, 97% are rated “A” or better, and the remaining 3% generally represent non-rated local interest bonds where Old National has a market presence. All of the Texas municipal bonds are rated “AA” or better, and the majority of issues are backed by the “AAA” rated State of Texas Permanent School Fund Guarantee Program.

 

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Loan Portfolio

We lend primarily to consumers and small to medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Kentucky, Michigan, and Wisconsin.

The following table presents the composition of the loan portfolio at December 31.

 

(dollars in thousands)

   2016      2015      2014      2013      2012      Four-Year
Growth Rate
 

Commercial

   $ 1,917,099       $ 1,814,940       $ 1,646,767       $ 1,402,750       $ 1,392,459         8.3

Commercial real estate

     3,130,853         1,868,972         1,751,907         1,242,818         1,438,709         21.5   

Consumer

     1,875,030         1,603,158         1,379,117         1,049,974         1,004,827         16.9   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans excluding residential real estate

     6,922,982         5,287,070         4,777,791         3,695,542         3,835,995         15.9   

Residential real estate

     2,087,530         1,661,335         1,540,410         1,387,422         1,360,599         11.3   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total loans

     9,010,512         6,948,405         6,318,201         5,082,964         5,196,594         14.8
                 

 

 

 

Less: Allowance for loan losses

     49,808         52,233         47,849         47,145         54,763      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Net loans

   $ 8,960,704       $ 6,896,172       $ 6,270,352       $ 5,035,819       $ 5,141,831      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

Commercial and Commercial Real Estate Loans

At December 31, 2016, commercial and commercial real estate loans were $5.048 billion, an increase of $1.364 billion, or 37%, compared to December 31, 2015. Commercial and commercial real estate loans attributable to the Anchor acquisition totaled $968.6 million as of the closing date of the acquisition.

The following table presents the maturity distribution and rate sensitivity of commercial loans at December 31, 2016 and an analysis of these loans that have predetermined and floating interest rates. A significant percentage of commercial loans are due within one year, reflecting the short-term nature of a large portion of these loans.

 

(dollars in thousands)

   Within
1 Year
     1 - 5
Years
     Beyond
5 Years
     Total      % of
Total
 

Interest rates:

              

Predetermined

   $ 244,703       $ 463,443       $ 232,595       $ 940,741         49

Floating

     598,531         297,097         80,730         976,358         51   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 843,234       $ 760,540       $ 313,325       $ 1,917,099         100
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Residential Real Estate Loans

Residential real estate loans, primarily 1-4 family properties, increased $426.2 million, or 26%, at December 31, 2016 compared to December 31, 2015. Residential real estate loans attributable to the Anchor acquisition totaled $456.1 million as of the closing date of the acquisition. Future increases in interest rates could result in a decline in the level of refinancings and new originations.

Consumer Loans

Consumer loans, including automobile loans, personal and home equity loans and lines of credit, and student loans, increased $271.9 million, or 17%, at December 31, 2016 compared to December 31, 2015. Consumer loans attributable to the Anchor acquisition totaled $213.0 million as of the closing date of the acquisition. Management plans to slow indirect consumer loan originations, which are least profitable, in 2017.

 

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Allowance for Loan Losses

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The determination of the allowance is based upon the size and current risk characteristics of the loan portfolio and includes an assessment of individual problem loans, actual loss experience, current economic events, and regulatory guidance. Additional information about our Allowance for Loan Losses is included in the “Risk Management - Credit Risk” section of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Notes 1 and 6 to the consolidated financial statements.

At December 31, 2016, the allowance for loan losses was $49.8 million, a decrease of $2.4 million compared to $52.2 million at December 31, 2015. Continued loan growth in future periods, or a decline in our current level of recoveries, could result in an increase in provision expense. As a percentage of total loans excluding loans held for sale, the allowance was 0.55% at December 31, 2016, compared to 0.75% at December 31, 2015. The decrease in the percentage from December 31, 2015 is primarily a result of the addition of Anchor’s $1.638 billion loan portfolio. In accordance with ASC 805, no allowance for loan losses is recorded at the date of acquisition and a reserve is only established to absorb any subsequent credit deterioration or adverse changes in expected cash flows. The provision for loan losses was an expense of $1.0 million in 2016 compared to an expense of $2.9 million in 2015.

For commercial loans, the allowance for loan losses decreased by $4.1 million at December 31, 2016 compared to December 31, 2015. The allowance for loan losses as a percentage of the commercial loan portfolio decreased to 1.12% at December 31, 2016, from 1.45% at December 31, 2015. The lower allowance for loan losses as a percentage of the commercial loan portfolio is the result of lower loss ratios and a change in the mix between acquired and originated loans.

For commercial real estate loans, the allowance for loan losses increased by $2.2 million at December 31, 2016 compared to December 31, 2015. The allowance for loan losses as a percentage of the commercial real estate loan portfolio decreased to 0.58% at December 31, 2016, from 0.86% at December 31, 2015. The lower allowance for loan losses need is the result of the increase in purchased loans that were recorded at fair value and improved asset quality. The fair value adjustment considers credit impairment resulting in no need for an allowance for loan losses at the date of acquisition. An allowance may be recorded in future periods if the loan experiences subsequent deterioration. See the discussion in the section “Asset Quality” for additional details.

The allowance for loan losses for residential real estate loans as a percentage of that portfolio decreased to 0.08% at December 31, 2016, from 0.12% at December 31, 2015. The allowance for loan losses for consumer loans as a percentage of that portfolio decreased to 0.45% at December 31, 2016, from 0.49% at December 31, 2015.

Allowance for Losses on Unfunded Commitments

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. This allowance is reported as a liability on the balance sheet within accrued expenses and other liabilities, while the corresponding provision for these loan losses is recorded as a component of other expense. The allowance for losses on unfunded commitments was $3.2 million at December 31, 2016, compared to $3.6 million at December 31, 2015.

Loans Held for Sale

Mortgage loans held for immediate sale in the secondary market were $90.7 million at December 31, 2016, compared to $13.8 million at December 31, 2015. Certain mortgage loans are committed for sale at or prior to origination at a contracted price to an outside investor. Other mortgage loans held for immediate sale are hedged with To Be Announced (“TBA”) forward agreements and committed for sale when they are ready for delivery and remain on the Company’s balance sheet for a short period of time (typically 30 to 60 days). These loans are sold without recourse, beyond customary representations and warranties, and Old National has not experienced material losses arising from these sales. Mortgage originations are subject to volatility due to interest rates and home sales, among other factors.

 

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We have elected the fair value option under FASB ASC 825-10 (SFAS No. 159) prospectively for residential loans held for sale. The aggregate fair value exceeded the unpaid principal balance by $0.1 million as of December 31, 2016, compared to $0.2 million as of December 31, 2015.

During the fourth quarter of 2014, $197.9 million of loans were reclassified to loans held for sale at the lower of cost or fair value. When the branch divestitures closed during the third quarter of 2015, these loans were valued at $193.6 million, resulting in a gain of $0.1 million. At December 31, 2016, there were no loans held for sale under this arrangement. See Note 2 to the consolidated financial statements for additional information.

Covered Assets

On July 29, 2011, Old National acquired the banking operations of Integra in an FDIC assisted transaction. We entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and OREO. Old National entered into an agreement with the FDIC on June 22, 2016 to terminate its loss share agreements. Under the early termination agreement, the FDIC made a final payment of $8.7 million to Old National as consideration for the early termination. After the elimination of the remaining FDIC indemnification asset and the payment of settlement charges, Old National realized a pre-tax gain of $0.2 million during the three months ended June 30, 2016. All remaining assets that were covered by the loss share arrangements were reclassified to noncovered assets effective June 22, 2016. All future gains and losses associated with covered assets will be recognized entirely by Old National.

Premises and Equipment

Premises and equipment, net of accumulated depreciation increased $232.9 million since December 31, 2015. During 2016, the Company purchased certain bank properties that it had previously leased, including its executive offices, for an aggregate purchase price of $196.1 million. Premises and equipment attributable to the Anchor acquisition totaled $35.7 million as of the closing date of the acquisition.

Goodwill and Other Intangible Assets

Goodwill and other intangible assets at December 31, 2016 totaled $692.7 million, an increase of $72.8 million compared to $619.9 million at December 31, 2015. During 2016, we recorded $132.9 million of goodwill and other intangible assets associated with the acquisition of Anchor. Also during 2016, Old National eliminated $47.7 million of goodwill and intangible assets associated with the sale of its insurance operations. Total amortization expense associated with intangible assets was $12.5 million in 2016.

Net Deferred Tax Assets

Net deferred tax assets increased $71.9 million since December 31, 2015 primarily due to the acquisition of Anchor. Net deferred tax assets acquired from Anchor totaled $98.1 million, consisting primarily of deferred tax assets related to federal and state net operating loss carryforwards and acquired loans. Future decreases in the corporate tax rate could result in a loss in value of Old National’s deferred tax assets, but would reduce future income tax expense. See Note 17 to the consolidated financial statements for additional information.

Other Assets

Other assets increased $9.1 million, or 9%, since December 31, 2015 primarily due to an increase in low income housing partnership investments. Offsetting the increase were lower deferred rent payments resulting from the purchase of certain bank properties that were previously leased and lower receivables resulting from the divestiture of our insurance operations.

 

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Funding

Total funding, comprised of deposits and wholesale borrowings, was $12.895 billion at December 31, 2016, an increase of $2.574 billion from $10.321 billion at December 31, 2015. Total deposits were $10.743 billion, including $9.275 billion in transaction accounts and $1.468 billion in time deposits at December 31, 2016. Total deposits increased $2.342 billion, or 28%, compared to December 31, 2015. Deposits attributable to the Anchor acquisition totaled $1.853 billion as of the closing date of the acquisition. Noninterest-bearing demand deposits increased $527.2 million from December 31, 2015 to December 31, 2016. NOW deposits increased $463.1 million from December 31, 2015 to December 31, 2016, while savings deposits increased $753.4 million. Money market deposits increased $130.7 million from December 31, 2015 to December 31, 2016, while time deposits increased $468.0 million.

We use wholesale funding to augment deposit funding and to help maintain our desired interest rate risk position. At December 31, 2016, wholesale borrowings, including federal funds purchased and interbank borrowings, securities sold under agreements to repurchase, Federal Home Loan Bank advances, and other borrowings, totaled $2.152 billion, an increase of $231.8 million, or 12%, from December 31, 2015. The increase in wholesale funding from December 31, 2015 to December 31, 2016 was primarily due to an increase in Federal Home Loan Bank advances. Wholesale funding as a percentage of total funding was 17% at December 31, 2016, compared to 19% at December 31, 2015. See Notes 14, 15, and 16 to the consolidated financial statements for additional details on our financing activities.

The following table details the average balances of all funding sources for the years ended December 31.

 

                          % Change From
Prior Year
 

(dollars in thousands)

   2016      2015      2014      2016     2015  

Demand deposits

   $ 2,776,140       $ 2,500,571       $ 2,166,628         11.0     15.4

NOW deposits

     2,389,143         2,160,019         1,989,794         10.6        8.6   

Savings deposits

     2,595,622         2,299,357         2,104,076         12.9        9.3   

Money market deposits

     763,909         677,414         490,247         12.8        38.2   

Time deposits

     1,361,647         1,063,782         1,024,377         28.0        3.8   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total deposits

     9,886,461         8,701,143         7,775,122         13.6        11.9   

Federal funds purchased and interbank borrowings

     137,997         126,124         77,512         9.4        62.7   

Securities sold under agreements to repurchase

     368,757         406,117         377,407         (9.2     7.6   

Federal Home Loan Bank advances

     1,121,413         793,703         597,905         41.3        32.7   

Other borrowings

     222,708         217,978         105,453         2.2        106.7   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total funding sources

   $ 11,737,336       $ 10,245,065       $ 8,933,399         14.6     14.7
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

The following table presents a maturity distribution for certificates of deposit with denominations of $100,000 or more at December 31.

 

     Year-End
Balance
     Maturity Distribution  

(dollars in thousands)

      1-90
Days
     91-180
Days
     181-365
Days
     Beyond
1 Year
 

2016

   $ 544,803       $ 142,806       $ 91,704       $ 115,151       $ 195,142   

2015

     303,759         56,273         28,657         86,625         132,204   

2014

     313,629         64,149         33,443         70,043         145,994   

Accrued Expenses and Other Liabilities

Accrued expenses and other liabilities decreased $28.8 million, or 16%, from December 31, 2015 primarily due to lower deferred gain on sale leaseback transactions and lower accrued expenses and other liabilities resulting from the divestiture of our insurance operations. Offsetting the decrease was an increase in unfunded commitments on low income housing partnership investments.

 

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Capital

Shareholders’ equity totaled $1.814 billion, or 12% of total assets, at December 31, 2016 and $1.491 billion, or 12% of total assets, at December 31, 2015. Shareholders’ equity at December 31, 2016 included $273.6 million from the 20.4 million shares of common stock that were issued in conjunction with the acquisition of Anchor. The change in unrealized gains (losses) on investment securities decreased equity by $34.0 million during 2016. We paid cash dividends of $0.52 per share in 2016, which reduced equity by $67.5 million. Shares issued for reinvested dividends, stock options, restricted stock, and stock compensation plans increased shareholders’ equity by $9.2 million in 2016.

Capital Adequacy

Old National and the banking industry are subject to various regulatory capital requirements administered by the federal banking agencies. For additional information on capital adequacy see Note 25 to the consolidated financial statements.

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires bank holding companies and any subsidiary banks with consolidated assets of more than $10 billion and less than $50 billion, including Old National, to complete and publicly disclose annual stress tests. The objective of the stress test is to ensure that the financial institution has capital planning processes that account for its unique risks, and to help ensure that the institution has sufficient capital to continue operations throughout times of economic and financial stress. The stress tests are conducted with baseline, adverse, and severely adverse economic scenarios. Old National completed its annual stress test that covered a nine-quarter planning horizon beginning January 1, 2016 and ending on March 31, 2018 and publicly disclosed a summary of the stress test results on October 25, 2016. The stress test showed that Old National would maintain capital levels well above the regulatory guideline minimum levels for all periods and under all stress test scenarios.

RISK MANAGEMENT

Overview

Old National has adopted a Risk Appetite Statement to enable the Board of Directors, Executive Leadership Group, and Senior Management to better assess, understand, and mitigate the risks of the Company. The Risk Appetite Statement addresses the following major risks: strategic, market, liquidity, credit, operational/technology, regulatory/compliance/legal, reputational, and human resources. Our Chief Risk Officer is independent of management and reports directly to the Chair of the Board’s Enterprise Risk Management Committee. The following discussion addresses three of these major risks: credit, market, and liquidity.

Credit Risk

Credit risk represents the risk of loss arising from an obligor’s inability or failure to meet contractual payment or performance terms. Our primary credit risks result from our investment and lending activities.

Investment Activities

We carry a higher exposure to loss in our pooled trust preferred securities, which are collateralized debt obligations, due to illiquidity in that market and the performance of the underlying collateral. At December 31, 2016, we had pooled trust preferred securities with a fair value of $8.1 million, or less than 1% of the available-for-sale securities portfolio. These securities remained classified as available-for-sale and at December 31, 2016, the unrealized loss on our pooled trust preferred securities was approximately $8.9 million. The fair value of these securities should improve as we get closer to maturity. There was no other-than-temporary impairment recorded in 2016 or 2015 on these securities.

All of our mortgage-backed securities are backed by U.S. government-sponsored or federal agencies. Municipal bonds, corporate bonds, and other debt securities are evaluated by reviewing the credit-worthiness of the issuer and general market conditions. See Note 4 to the consolidated financial statements for additional details about our investment security portfolio.

 

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Counterparty Exposure

Counterparty exposure is the risk that the other party in a financial transaction will not fulfill its obligation. We define counterparty exposure as nonperformance risk in transactions involving federal funds sold and purchased, repurchase agreements, correspondent bank relationships, and derivative contracts with companies in the financial services industry. Old National manages exposure to counterparty risk in connection with its derivatives transactions by generally engaging in transactions with counterparties having ratings of at least A by Standard & Poor’s Rating Service or A2 by Moody’s Investors Service. Total credit exposure is monitored by counterparty, and managed within limits that management believes to be prudent. Old National’s net counterparty exposure was an asset of $363.2 million at December 31, 2016.

Lending Activities

Commercial

Commercial and industrial loans are made primarily for the purpose of financing equipment acquisition, expansion, working capital, and other general business purposes. Lease financing consists of direct financing leases and are used by commercial customers to finance capital purchases ranging from computer equipment to transportation equipment. The credit decisions for these transactions are based upon an assessment of the overall financial capacity of the applicant. A determination is made as to the applicant’s ability to repay in accordance with the proposed terms as well as an overall assessment of the risks involved. In addition to an evaluation of the applicant’s financial condition, a determination is made of the probable adequacy of the primary and secondary sources of repayment, such as additional collateral or personal guarantees, to be relied upon in the transaction. Credit agency reports of the applicant’s credit history supplement the analysis of the applicant’s creditworthiness.

Commercial mortgages and construction loans are offered to real estate investors, developers, and builders primarily domiciled in the geographic market areas we serve: Indiana, Kentucky, Michigan, and Wisconsin. These loans are secured by first mortgages on real estate at loan-to-value (“LTV”) margins deemed appropriate for the property type, quality, location, and sponsorship. Generally, these LTV ratios do not exceed 80%. The commercial properties are predominantly non-residential properties such as retail centers, apartments, industrial properties and, to a lesser extent, more specialized properties. Substantially all of our commercial real estate loans are secured by properties located in our primary market area.

In the underwriting of our commercial real estate loans, we obtain appraisals for the underlying properties. Decisions to lend are based on the economic viability of the property and the creditworthiness of the borrower. In evaluating a proposed commercial real estate loan, we primarily emphasize the ratio of the property’s projected net cash flows to the loan’s debt service requirement. The debt service coverage ratio normally is not less than 120% and it is computed after deduction for a vacancy factor and property expenses as appropriate. In addition, a personal guarantee of the loan or a portion thereof is often required from the principal(s) of the borrower. In most cases, we require title insurance insuring the priority of our lien, fire, and extended coverage casualty insurance, and flood insurance, if appropriate, in order to protect our security interest in the underlying property. In addition, business interruption insurance or other insurance may be required.

Construction loans are underwritten against projected cash flows derived from rental income, business income from an owner-occupant, or the sale of the property to an end-user. We may mitigate the risks associated with these types of loans by requiring fixed-price construction contracts, performance and payment bonding, controlled disbursements, and pre-sale contracts or pre-lease agreements.

Consumer

We offer a variety of first mortgage and junior lien loans to consumers within our markets, with residential home mortgages comprising our largest consumer loan category. These loans are secured by a primary residence and are underwritten using traditional underwriting systems to assess the credit risks of the consumer. Decisions are primarily based on LTV ratios, debt-to-income (“DTI”) ratios, liquidity, and credit scores. A maximum LTV ratio of 80% is generally required, although higher levels are permitted with mortgage insurance or other mitigating factors. We offer fixed rate mortgages and variable rate mortgages with interest rates that are subject to change every year after the first, third, fifth, or seventh year, depending on the product and are based on fully-indexed rates such as the Prime Rate. We do not offer payment-option facilities, sub-prime loans, or any product with negative amortization.

 

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Home equity loans are secured primarily by second mortgages on residential property of the borrower. The underwriting terms for the home equity product generally permits borrowing availability, in the aggregate, up to 90% of the appraised value of the collateral property at the time of origination. We offer fixed and variable rate home equity loans, with variable rate loans underwritten at fully-indexed rates. Decisions are primarily based on LTV ratios, DTI ratios, liquidity, and credit scores. We do not offer home equity loan products with reduced documentation.

Automobile loans include loans and leases secured by new or used automobiles. We originate automobile loans and leases primarily on an indirect basis through selected dealerships. We require borrowers to maintain collision insurance on automobiles securing consumer loans, with us listed as loss payee. Our procedures for underwriting automobile loans include an assessment of an applicant’s overall financial capacity, including credit history and the ability to meet existing obligations and payments on the proposed loan. Although an applicant’s creditworthiness is the primary consideration, the underwriting process also includes a comparison of the value of the collateral security to the proposed loan amount.

We assumed student loans in the acquisition of Anchor in May 2016. As of December 31, 2016, student loans totaled $77.1 million and are guaranteed by the government from 97% to 100%.

Asset Quality

Community-based lending personnel, along with region-based independent underwriting and analytic support staff, extend credit under guidelines established and administered by our Enterprise Risk Committee. This committee, which meets quarterly, is made up of outside directors. The committee monitors credit quality through its review of information such as delinquencies, credit exposures, peer comparisons, problem loans, and charge-offs. In addition, the committee reviews and approves recommended loan policy changes to assure it remains appropriate for the current lending environment.

We lend primarily to small- and medium-sized commercial and commercial real estate clients in various industries including manufacturing, agribusiness, transportation, mining, wholesaling, and retailing. At December 31, 2016, we had no concentration of loans in any single industry exceeding 10% of our portfolio and had minimal exposure to foreign borrowers and no sovereign debt. Our policy is to concentrate our lending activity in the geographic market areas we serve, primarily Indiana, Kentucky, Michigan, and Wisconsin. We are experiencing a slow and gradual improvement in the economy of our principal markets. Management expects that trends in under-performing, criticized, and classified loans will be influenced by the degree to which the economy strengthens or weakens.

During the third quarter of 2011, Old National acquired the banking operations of Integra Bank in an FDIC assisted transaction. The Company entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and other real estate owned. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. On June 22, 2016, Old National entered into an agreement with the FDIC that terminated its loss share agreements. As a result of the termination of the loss share agreements, the remaining assets that were covered by the loss share arrangements were reclassified to noncovered assets effective June 22, 2016.

On May 1, 2016, Old National closed on its acquisition of Anchor. As of the closing date of the acquisition, loans totaled $1.638 billion and other real estate owned totaled $17.3 million. In accordance with accounting for business combinations, there was no allowance brought forward on any of the acquired loans, as the credit losses evident in the loans were included in the determination of the fair value of the loans at the acquisition date. Old National reviewed the acquired loans and determined that as of December 31, 2016, $8.3 million met the definition of criticized and $34.2 million were considered classified (of which $30.6 million are reported with nonaccrual loans). Our current preference would be to work these loans and avoid foreclosure actions unless additional credit deterioration becomes apparent. These acquired impaired loans, along with $10.6 million of other real estate owned, are included in our summary of under-performing, criticized, and classified assets found below.

 

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Summary of under-performing, criticized and classified assets:

 

(dollars in thousands)

   2016     2015     2014     2013     2012  

Nonaccrual loans:

          

Commercial

   $ 56,585      $ 57,536      $ 38,460      $ 28,635      $ 36,766   

Commercial real estate

     44,026        47,350        67,402        52,363        95,829   

Residential real estate

     17,674        14,953        13,968        10,333        11,986   

Consumer

     13,122        5,198        5,903        5,318        5,809   

Covered loans (1)

     —          7,336        15,124        31,793        103,946   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total nonaccrual loans (2)

     131,407        132,373        140,857        128,442        254,336   

Renegotiated loans not on nonaccrual:

          

Noncovered loans

     14,376        14,147        12,710        15,596        9,737   

Covered loans (1)

     —          138        148        148        177   

Past due loans still accruing (90 days or more):

          

Commercial

     23        565        33        —          322   

Commercial real estate

     —          —          138        —          236   

Residential real estate

     2        114        1        35        66   

Consumer

     303        227        286        189        438   

Covered loans (1)

     —          10        —          14        15   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total past due loans

     328        916        458        238        1,077   

Other real estate owned

     18,546        7,594        7,241        7,562        11,179   

Other real estate owned, covered (1)

     —          4,904        9,121        13,670        26,137   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total under-performing assets

   $ 164,657      $ 160,072      $ 170,535      $ 165,656      $ 302,643   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Classified loans (includes nonaccrual, renegotiated, past due 90 days, and other problem loans)

   $ 220,429      $ 204,710      $ 233,486      $ 159,783      $ 233,445   

Classified loans, covered (1)

     —          8,584        17,413        35,500        121,977   

Other classified assets (3)

     7,063        6,857        14,752        32,650        43,887   

Criticized loans

     95,462        132,898        194,809        135,401        113,264   

Criticized loans, covered (1)

     —          1,449        4,525        8,421        9,344   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total criticized and classified assets

   $ 322,954      $ 354,498      $ 464,985      $ 371,755      $ 521,917   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Asset Quality Ratios including covered assets:

          

Non-performing loans/total loans (4) (5)

     1.62     2.11     2.43     2.84     5.08

Under-performing assets/total loans and foreclosed properties (4)

     1.82        2.30        2.69        3.25        5.78   

Under-performing assets/total assets

     1.11        1.33        1.46        1.73        3.17   

Allowance for loan losses/under-performing assets (6)

     30.25        32.63        28.06        28.46        18.09   

Allowance for loan losses/nonaccrual loans (2)

     37.90        39.46        33.97        36.71        21.53   

 

(1) The Company entered into separate loss sharing agreements with the FDIC providing for specified credit loss protection for substantially all acquired single family residential loans, commercial loans, and other real estate owned. On June 22, 2016 Old National entered into an early termination agreement with the FDIC that terminated all loss share agreements. The Company reclassified all covered assets to noncovered assets effective June 22, 2016.
(2) Includes approximately $16.7 million, $15.9 million, $41.2 million, $38.3 million, and $156.8 million for 2016, 2015, 2014, 2013, and 2012, respectively, of purchased credit impaired loans that are categorized as nonaccrual because the collection of principal or interest is doubtful. These loans are accounted for under FASB ASC 310-30 and accordingly treated as performing assets.
(3) Includes 2 pooled trust preferred securities, 2 corporate securities, and 1 insurance policy at December 31, 2016.
(4) Loans exclude loans held for sale and leases held for sale.
(5) Non-performing loans include nonaccrual and renegotiated loans.
(6) Because the acquired loans were recorded at fair value in accordance with ASC 805 at the date of acquisition, the credit risk is incorporated in the fair value recorded. No allowance for loan losses is recorded on the acquisition date.

Under-performing assets totaled $164.7 million at December 31, 2016, compared to $160.1 million at December 31, 2015. Under-performing assets as a percentage of total loans and other real estate owned at December 31, 2016 were 1.82%, a 48 basis point improvement from 2.30% at December 31, 2015.

 

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Nonaccrual loans decreased $1.0 million from December 31, 2015 to December 31, 2016 primarily due to a decrease in nonaccrual commercial and commercial real estate loans. Substantially offsetting these decreases were increases in nonaccrual residential real estate and consumer loans. Nonaccrual loans at December 31, 2016 include $30.6 million of loans related to the Anchor acquisition. As a percentage of nonaccrual loans, the allowance for loan losses was 37.90% at December 31, 2016, compared to 39.46% at December 31, 2015. Purchased credit impaired loans that were included in the nonaccrual category because the collection of principal or interest is doubtful totaled $16.7 million at December 31, 2016, compared to $15.9 million at December 31, 2015. However, they are accounted for under FASB ASC 310-30 and accordingly treated as performing assets. We would expect our nonaccrual loans to remain at elevated levels until management can work through and resolve these purchased credit impaired loans.

Interest income of approximately $6.4 million and $7.2 million would have been recorded on nonaccrual and renegotiated loans outstanding at December 31, 2016 and 2015, respectively, if such loans had been accruing interest throughout the year in accordance with their original terms. Excluding purchased credit impaired loans accounted for under ASC 310-30, the amount of interest income actually recorded on nonaccrual and renegotiated loans was $1.4 million in 2016 and $2.1 million in 2015. We had $26.3 million of renegotiated loans which are included in nonaccrual loans at December 31, 2016, compared to $30.0 million at December 31, 2015.

Total criticized and classified assets were $323.0 million at December 31, 2016, a decrease of $31.5 million from December 31, 2015. Other classified assets include investment securities that fell below investment grade rating totaling $7.1 million at December 31, 2016, compared to $6.9 million at December 31, 2015.

Old National may choose to restructure the contractual terms of certain loans. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit Old National by increasing the ultimate probability of collection.

Any loans that are modified are reviewed by Old National to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Bank grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial status. The modification of the terms of such loans include one or a combination of the following: a reduction of the stated interest rate of the loan, an extension of the maturity date at a stated rate of interest lower than the current market rate of new debt with similar risk, or a permanent reduction of the recorded investment of the loan.

Loans modified in a TDR are typically placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which generally requires that the borrower demonstrate a period of performance according to the restructured terms for six months.

If we are unable to resolve a nonperforming loan issue, the credit will be charged off when it is apparent there will be a loss. For large commercial type loans, each relationship is individually analyzed for evidence of apparent loss based on quantitative benchmarks or subjectively based upon certain events or particular circumstances. Old National charges off small commercial loans scored through our small business credit center with contractual balances under $250,000 that have been placed on nonaccrual status or became 90 days or more delinquent, without regard to the collateral position. For residential and consumer loans, a charge off is recorded at the time foreclosure is initiated or when the loan becomes 120 to 180 days past due, whichever is earlier.

For commercial TDRs, an allocated reserve is established within the allowance for loan losses for the difference between the carrying value of the loan and its computed value. To determine the value of the loan, one of the following methods is selected: (1) the present value of expected cash flows discounted at the loan’s original effective interest rate, (2) the loan’s observable market price, or (3) the fair value of the collateral value, if the loan is collateral dependent. The allocated reserve is established as the difference between the carrying value of the loan and the collectable value. If there are significant changes in the amount or timing of the loan’s expected future cash flows, impairment is recalculated and the valuation allowance is adjusted accordingly.

When a residential or consumer loan is identified as a troubled debt restructuring, the loan is typically written down to its collateral value less selling costs.

 

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At December 31, 2016, our TDRs consisted of $16.8 million of commercial loans, $18.3 million of commercial real estate loans, $3.0 million of residential loans, and $2.6 million of consumer loans totaling $40.7 million. Approximately $26.3 million of the TDRs at December 31, 2016 were included with nonaccrual loans. At December 31, 2015, our TDRs consisted of $23.4 million of commercial loans, $14.6 million of commercial real estate loans, $2.7 million of residential loans, and $3.6 million of consumer loans totaling $44.3 million. Approximately $30.0 million of the TDRs at December 31, 2015 were included with nonaccrual loans.

Old National has allocated specific reserves to customers whose loan terms have been modified in TDRs totaling $4.0 million at December 31, 2016 and $2.3 million at December 31, 2015. As of December 31, 2016, Old National had committed to lend an additional $6.0 million to customers with outstanding loans that are classified as TDRs.

The terms of certain other loans were modified during 2016 that did not meet the definition of a TDR. It is our process to review all classified and criticized loans that, during the period, have been renewed, have entered into a forbearance agreement, have gone from principal and interest to interest only, or have extended the maturity date. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on its debt in the foreseeable future without the modification. The evaluation is performed under our internal underwriting policy. We also evaluate whether a concession has been granted or if we were adequately compensated through a market interest rate, additional collateral, or a bona fide guarantee. We also consider whether the modification was insignificant relative to the other terms of the agreement or the delay in a payment.

Purchased credit impaired (“PCI”) loans are not considered impaired until after the point at which there has been a degradation of cash flows below our expected cash flows at acquisition. If a PCI loan is subsequently modified, and meets the definition of a TDR, it will be removed from PCI accounting and accounted for as a TDR only if the PCI loan was being accounted for individually. If the purchased credit impaired loan is being accounted for as part of a pool, it will not be removed from the pool. As of December 31, 2016, it has not been necessary to remove any loans from PCI accounting.

In general, once a modified loan is considered a TDR, the loan will always be considered a TDR, and therefore impaired, until it is paid in full, otherwise settled, sold, or charged off. However, guidance also permits for loans to be removed from TDR status when subsequently restructured under these circumstances: (1) at the time of the subsequent restructuring, the borrower is not experiencing financial difficulties, and this is documented by a current credit evaluation at the time of the restructuring, (2) under the terms of the subsequent restructuring agreement, the institution has granted no concession to the borrower; and (3) the subsequent restructuring agreement includes market terms that are no less favorable than those that would be offered for a comparable new loan. For loans subsequently restructured that have cumulative principal forgiveness, the loan should continue to be measured in accordance with ASC 310-10, “Receivables – Overall”. However, consistent with ASC 310-40-50-2, “Troubled Debt Restructurings by Creditors, Creditor Disclosure of Troubled Debt Restructurings,” the loan would not be required to be reported in the years following the restructuring if the subsequent restructuring meets both of these criteria: (1) has an interest rate at the time of the subsequent restructuring that is not less than a market interest rate; and (2) is performing in compliance with its modified terms after the subsequent restructuring.

To provide for the risk of loss inherent in extending credit, we maintain an allowance for loan losses. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses incurred in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience.

 

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The activity in our allowance for loan losses was as follows:

 

(dollars in thousands)

   2016     2015     2014     2013     2012  

Balance, January 1

   $ 52,233      $ 47,849      $ 47,145      $ 54,763      $ 58,060   

Loans charged-off:

          

Commercial

     5,047        3,513        3,535        4,435        7,746   

Commercial real estate

     2,632        1,921        3,647        9,302        4,609   

Residential real estate

     800        1,039        793        1,487        2,204   

Consumer credit

     6,131        6,404        4,675        6,279        8,094   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     14,610        12,877        12,650        21,503        22,653   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Recoveries on charged-off loans:

          

Commercial

     3,102        5,218        3,125        4,723        5,276   

Commercial real estate

     4,763        4,685        3,871        6,838        5,327   

Residential real estate

     174        354        205        310        464   

Consumer credit

     3,186        4,081        3,056        4,333        3,259   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     11,225        14,338        10,257        16,204        14,326   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs (recoveries)

     3,385        (1,461     2,393        5,299        8,327   

Provision for loan losses

     960        2,923        3,097        (2,319     5,030   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31

   $ 49,808      $ 52,233      $ 47,849      $ 47,145      $ 54,763   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Average loans for the year (1)

   $ 8,265,169      $ 6,756,135      $ 5,703,294      $ 5,135,139      $ 4,857,522   

Asset Quality Ratios:

          

Allowance/year-end loans (1)

     0.55     0.75     0.76     0.93     1.05

Allowance/average loans (1)

     0.60        0.77        0.84        0.92        1.13   

Net charge-offs (recoveries)/average loans (2)

     0.04        (0.02     0.04        0.10        0.17   

 

(1) Loans exclude loans held for sale.
(2) Net charge-offs include write-downs on loans transferred to held for sale.

The allowance for loan losses decreased $2.4 million, or 5%, from December 31, 2015 to December 31, 2016. Net charge-offs totaled $3.4 million in 2016 compared to net recoveries of $1.5 million in 2015. There were no industry segments representing a significant share of total net charge-offs. Net charge-offs (recoveries) to average loans was 0.04% in 2016 compared to (0.02)% in 2015. Over the last twelve months, net charge-offs have remained low. Continued loan growth in future periods, or a decrease in our current level of recoveries, could result in an increase in provision expense.

The allowance to year-end loans, which ranged from 0.55% to 1.05% for the last five years, was 0.55% at December 31, 2016. Our ratio of allowance for loan losses to total loans declined as of December 31, 2016 with the addition of Anchor’s $1.638 billion loan portfolio. In accordance with ASC 805, no allowance for loan losses is recorded at the date of acquisition and a reserve is only established to absorb any subsequent credit deterioration or adverse changes in expected cash flows.

 

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The following table provides additional details of the following components of the allowance for loan losses, including FAS 5/ASC 450 (Accounting for Contingencies), FAS 114/ASC 310-35 (Accounting by Creditors for Impairment of a Loan) and SOP 03-3/ASC 310-30 (Accounting for Certain Loans or Debt Securities Acquired in a Transfer):

 

(dollars in thousands)

   FAS 5      FAS 114      SOP 03-3      Total  

Loan balance

   $ 8,940,492       $ 110,993       $ 88,710       $ 9,140,195   

Remaining purchase discount

     (88,589      (7,803      (33,291      (129,683
  

 

 

    

 

 

    

 

 

    

 

 

 

Loans, net of discount

   $ 8,851,903       $ 103,190       $ 55,419       $ 9,010,512   
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, January 1, 2016

   $ 39,386       $ 11,488       $ 1,359       $ 52,233   

Charge-offs

     (7,366      (5,383      (1,861      (14,610

Recoveries

     3,290         6,517         1,418         11,225   

Provision expense

     6,222         (4,624      (638      960   
  

 

 

    

 

 

    

 

 

    

 

 

 

Allowance, December 31, 2016

   $ 41,532       $ 7,998       $ 278       $ 49,808   
  

 

 

    

 

 

    

 

 

    

 

 

 

We maintain an allowance for losses on unfunded commercial lending commitments and letters of credit to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses, modified to take into account the probability of a drawdown on the commitment. The reserve for unfunded loan commitments is classified as a liability account on the balance sheet and totaled $3.2 million at December 31, 2016, compared to $3.6 million at December 31, 2015.

The following table details the allowance for loan losses by loan category and the percent of loans in each category compared to total loans at December 31.

 

     2016     2015     2014     2013     2012  

(dollars in thousands)

   Amount      % of
Loans
to Total
Loans
    Amount      % of
Loans
to Total
Loans
    Amount      % of
Loans
to Total
Loans
    Amount      % of
Loans
to Total
Loans
    Amount      % of
Loans
to Total
Loans
 

Commercial

   $ 21,481         21.3 %    $ 25,568         26.0   $ 17,401         25.8   $ 15,013         27.0   $ 14,642         25.7

Commercial real estate

     18,173         34.7        15,993         26.6        17,348         27.1        19,031         22.8        26,391         24.2   

Residential real estate

     1,643         23.2        2,051         23.7        2,962         24.1        3,123         26.8        3,677         25.5   

Consumer credit

     8,511         20.8        7,684         22.2        6,586         20.7        4,574         19.1        4,337         17.4   

Covered loans

     —           —          937         1.5        3,552         2.3        5,404         4.3        5,716         7.2   
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 49,808         100.0   $ 52,233         100.0   $ 47,849         100.0   $ 47,145         100.0   $ 54,763         100.0
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Market Risk

Market risk is the risk that the estimated fair value of our assets, liabilities, and derivative financial instruments will decline as a result of changes in interest rates or financial market volatility, or that our net income will be significantly reduced by interest rate changes.

The objective of our interest rate management process is to maximize net interest income while operating within acceptable limits established for interest rate risk and maintaining adequate levels of funding and liquidity.

 

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Potential cash flows, sales, or replacement value of many of our assets and liabilities, especially those that earn or pay interest, are sensitive to changes in the general level of interest rates. This interest rate risk arises primarily from our normal business activities of gathering deposits and extending loans. Many factors affect our exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships, and re-pricing characteristics of financial instruments. Our earnings can also be affected by the monetary and fiscal policies of the U.S. Government and its agencies, particularly the Federal Reserve Board.

In managing interest rate risk, we, through the Funds Management Committee, a committee of the Board of Directors, establish guidelines, for asset and liability management, including measurement of short and long-term sensitivities to changes in interest rates. Based on the results of our analysis, we may use different techniques to manage changing trends in interest rates including:

 

    adjusting balance sheet mix or altering interest rate characteristics of assets and liabilities;

 

    changing product pricing strategies;

 

    modifying characteristics of the investment securities portfolio; or

 

    using derivative financial instruments, to a limited degree.

A key element in our ongoing process is to measure and monitor interest rate risk using a model to quantify the impact of changing interest rates on the Company. The model quantifies the effects of various possible interest rate scenarios on projected net interest income. The model measures the impact on net interest income relative to a base case scenario. The base case scenario assumes that the balance sheet and interest rates are held at current levels. The model shows our projected net interest income sensitivity based on interest rate changes only and does not consider other forecast assumptions.

 

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The following table illustrates our projected net interest income sensitivity over a two year cumulative horizon based on the asset/liability model as of December 31, 2016 and 2015:

 

     Immediate
Rate Decrease
           Immediate Rate Increase  
     -50           +100        +200        +300   

(dollars in thousands)

   Basis Points     Base      Basis Points     Basis Points     Basis Points  

December 31, 2016

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 226,586      $ 234,297       $ 246,329      $ 255,974      $ 265,942   

Loans

     628,100        672,942         762,859        852,007        940,961   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     854,686        907,239         1,009,188        1,107,981        1,206,903   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     21,039        40,795         103,290        165,778        228,259   

Borrowings

     48,624        61,043         89,063        117,004        144,902   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     69,663        101,838         192,353        282,782        373,161   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 785,023      $ 805,401       $ 816,835      $ 825,199      $ 833,742   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (20,378 )       $ 11,434      $ 19,798      $ 28,341   

% change from base

     -2.53 %         1.42 %      2.46 %      3.52 % 

December 31, 2015

           

Projected interest income:

           

Money market, other interest earning investments, and investment securities

   $ 202,753      $ 214,385       $ 229,147      $ 243,069      $ 256,974   

Loans

     479,834        512,210         577,959        642,455        705,686   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest income

     682,587        726,595         807,106        885,524        962,660   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Projected interest expense:

           

Deposits

     15,935        26,548         72,564        118,580        164,597   

Borrowings

     46,618        56,125         78,905        101,685        124,464   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Total interest expense

     62,553        82,673         151,469        220,265        289,061   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Net interest income

   $ 620,034      $ 643,922       $ 655,637      $ 665,259      $ 673,599   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

 

Change from base

   $ (23,888      $ 11,715      $ 21,337      $ 29,677   

% change from base

     -3.71        1.82     3.31     4.61

Our asset sensitivity decreased slightly year over year primarily due to changes in our balance sheet mix, investment duration, and prepayment speed behavior.

A key element in the measurement and modeling of interest rate risk is the re-pricing assumptions of our transaction deposit accounts, which have no contractual maturity dates. We assume this deposit base is comprised of both core and more volatile balances and consists of both non-interest bearing and interest bearing accounts. Core deposit balances are assumed to be less interest rate sensitive and provide longer term funding. Volatile balances are assumed to be more interest rate sensitive and shorter in term. As part of our semi-static balance sheet modeling, we assume interest rates paid on the volatile deposits move in conjunction with changes in interest rates, in order to retain these deposits. This may include current non-interest bearing accounts.

Because the models are driven by expected behavior in various interest rate scenarios and many factors besides market interest rates affect our net interest income, we recognize that model outputs are not guarantees of actual results. For this reason, we model many different combinations of interest rates and balance sheet assumptions to understand our overall sensitivity to market interest rate changes, including shocks, yield curve flattening, yield curve steepening, as well as forecasts of likely interest rate scenarios. As of December 31, 2016, our projected net interest income sensitivity based on the asset/liability models we utilize was within the limits of the Company’s interest rate risk policy for the scenarios tested.

We use derivative instruments, primarily interest rate swaps, to mitigate interest rate risk, including certain cash flow hedges on variable-rate debt with a notional amount of $625 million at December 31, 2016. Our derivatives had an estimated fair value loss of $5.9 million at December 31, 2016, compared to an estimated fair value loss of $11.0 million at December 31, 2015. See Note 22 to the consolidated financial statements for further discussion of derivative financial instruments.

 

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Liquidity Risk

Liquidity risk arises from the possibility that we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The Funds Management Committee of the Board of Directors establishes liquidity risk guidelines and, along with the Balance Sheet Management Committee, monitors liquidity risk. The objective of liquidity management is to ensure we have the ability to fund balance sheet growth and meet deposit and debt obligations in a timely and cost-effective manner. Management monitors liquidity through a regular review of asset and liability maturities, funding sources, and loan and deposit forecasts. We maintain strategic and contingency liquidity plans to ensure sufficient available funding to satisfy requirements for balance sheet growth, properly manage capital markets’ funding sources and to address unexpected liquidity requirements.

Loan repayments and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities and prepayments of loans and mortgage-related securities are strongly influenced by interest rates, the housing market, general and local economic conditions, and competition in the marketplace. We continually monitor marketplace trends to identify patterns that might improve the predictability of the timing of deposit flows or asset prepayments.

A time deposit maturity schedule for Old National Bank is shown in the following table as of December 31, 2016.

 

(dollars in thousands)              

Maturity Bucket

   Amount      Rate  

2017

   $ 895,033         0.56

2018

     292,371         0.88   

2019

     108,978         1.28   

2020

     86,090         1.70   

2021

     44,005         1.37   

2021 and beyond

     41,631         1.59   
  

 

 

    

 

 

 

Total

   $ 1,468,108         0.80
  

 

 

    

 

 

 

Our ability to acquire funding at competitive prices is influenced by rating agencies’ views of our credit quality, liquidity, capital, and earnings. Moody’s Investor Service places us in an investment grade that indicates a low risk of default. For both Old National and Old National Bank:

 

    Moody’s Investor Service confirmed the Long-Term Rating of A3 of Old National Bancorp’s senior unsecured/issuer rating on May 2, 2016.

 

    Moody’s Investor Service confirmed Old National Bank’s long-term deposit rating of Aa3 on May 2, 2016. The bank’s short-term deposit rating was affirmed at P-1 and the bank’s issuer rating was confirmed at A3.

The rating outlook from Moody’s Investor Service is stable. Moody’s Investor Service concluded a rating review of Old National Bank on May 2, 2016.

The credit ratings of Old National and Old National Bank at December 31, 2016 are shown in the following table.

 

     Moody’s Investor Service
     Long-term    Short-term

Old National Bancorp

   A3    N/A

Old National Bank

   Aa3    P-1

 

N/A = not applicable

Old National Bank maintains relationships in capital markets with brokers and dealers to issue certificates of deposit and short-term and medium-term bank notes as well. As of December 31, 2016, Old National Bancorp and its subsidiaries had the following availability of liquid funds and borrowings.

 

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(dollars in thousands)

   Parent
Company
     Subsidiaries  

Available liquid funds:

     

Cash and due from banks

   $ 98,347       $ 157,172   

Unencumbered government-issued debt securities

     —           1,215,831   

Unencumbered investment grade municipal securities

     —           361,791   

Unencumbered corporate securities

     —           80,908   

Availability of borrowings:

     

Amount available from Federal Reserve discount window*

     —           500,197   

Amount available from Federal Home Loan Bank Indianapolis*

     —           502,541   
  

 

 

    

 

 

 

Total available funds

   $ 98,347       $ 2,818,440   
  

 

 

    

 

 

 

 

* Based on collateral pledged

The Parent Company (Old National Bancorp) has routine funding requirements consisting primarily of operating expenses, dividends to shareholders, debt service, net derivative cash flows, and funds used for acquisitions. The Parent Company can obtain funding to meet its obligations from dividends and management fees collected from its subsidiaries, operating line of credit, and through the issuance of debt securities. Additionally, the Parent Company has a shelf registration in place with the Securities and Exchange Commission permitting ready access to the public debt and equity markets. At December 31, 2016, the Parent Company’s other borrowings outstanding were $214.8 million.

Federal banking laws regulate the amount of dividends that may be paid by banking subsidiaries without prior approval. Prior regulatory approval is required if dividends to be declared in any year would exceed net earnings of the current year plus retained net profits for the preceding two years. Prior regulatory approval to pay dividends was not required in 2015 or 2016 and is not currently required.

OFF-BALANCE SHEET ARRANGEMENTS

Off-balance sheet arrangements include commitments to extend credit and financial guarantees. Commitments to extend credit and financial guarantees are used to meet the financial needs of our customers. Our banking affiliates have entered into various agreements to extend credit, including loan commitments of $2.354 billion and standby letters of credit of $51.7 million at December 31, 2016. At December 31, 2016, approximately $2.207 billion of the loan commitments had fixed rates and $146.5 million had floating rates, with the floating interest rates ranging from 0% to 25%. At December 31, 2015, loan commitments were $1.746 billion and standby letters of credit were $62.6 million. The term of these off-balance sheet arrangements is typically one year or less.

Old National entered into a risk participation in an interest rate swap during the second quarter of 2007, which had a notional amount of $6.8 million at December 31, 2016. Old National entered into an additional risk participation in an interest rate swap during the third quarter of 2014, which had a notional amount of $9.9 million at December 31, 2016.

CONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENT LIABILITIES

The following table presents our significant fixed and determinable contractual obligations and significant commitments at December 31, 2016. Further discussion of each obligation or commitment is included in the referenced note to the consolidated financial statements.

 

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     Note
Reference
     Payments Due In      Total  

(dollars in thousands)

      One Year or
Less
     One to
Three Years
     Three to
Five Years
     Over
Five Years
    

Deposits without stated maturity

      $ 9,275,145       $ —         $ —         $ —         $ 9,275,145   

IRAs, consumer, and brokered certificates of deposit

     13         895,033         401,349         130,095         41,631         1,468,108   

Federal funds purchased and interbank borrowings

        213,003         —           —           —           213,003   

Securities sold under agreements to repurchase

     14         342,052         25,000         —           —           367,052   

Federal Home Loan Bank advances

     15         945,544         172,505         50,000         185,043         1,353,092   

Other borrowings

     16         196         164         190         218,389         218,939   

Fixed interest payments (1)

        16,813         25,967         24,287         45,889         112,956   

Operating leases

     9         16,928         31,180         28,840         79,881         156,829   

Other long-term liabilities (2)

        17,421         3,475         44         76         21,016   

 

(1) Our senior notes, subordinated notes, certain trust preferred securities, and certain Federal Home Loan Bank advances have fixed rates ranging from 0.56% to 6.76%. All of our other long-term debt is at LIBOR based variable rates at December 31, 2016. The projected variable interest assumes no increase in LIBOR rates from December 31, 2016.
(2) Includes amount expected to be contributed to the Restoration Plan in 2017 (amounts for 2018 and beyond are unknown at this time) and unfunded commitments on qualified affordable housing projects and other tax credit investments.

We rent certain premises and equipment under operating leases. See Note 9 to the consolidated financial statements for additional information on long-term lease arrangements.

We are party to various derivative contracts as a means to manage the balance sheet and our related exposure to changes in interest rates, to manage our residential real estate loan origination and sale activity, and to provide derivative contracts to our clients. Since the derivative liabilities recorded on the balance sheet change frequently and do not represent the amounts that may ultimately be paid under these contracts, these liabilities are not included in the table of contractual obligations presented above. Further discussion of derivative instruments is included in Note 22 to the consolidated financial statements.

In the normal course of business, various legal actions and proceedings are pending against us and our affiliates which are incidental to the business in which they are engaged. Further discussion of contingent liabilities is included in Note 23 to the consolidated financial statements.

In addition, liabilities recorded under FASB ASC 740-10 (FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109) are not included in the table because the amount and timing of any cash payments cannot be reasonably estimated. Further discussion of income taxes and liabilities recorded under FASB ASC 740-10 is included in Note 17 to the consolidated financial statements.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our accounting policies are described in Note 1 to the consolidated financial statements. Certain accounting policies require management to use significant judgment and estimates, which can have a material impact on the carrying value of certain assets and liabilities. We consider these policies to be critical accounting policies. The judgment and assumptions made are based upon historical experience or other factors that management believes to be reasonable under the circumstances. Because of the nature of the judgment and assumptions, actual results could differ from estimates, which could have a material effect on our financial condition and results of operations.

The following accounting policies materially affect our reported earnings and financial condition and require significant judgments and estimates. Management has reviewed these critical accounting estimates and related disclosures with our Audit Committee.

 

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Goodwill and Intangibles

 

    Description. For acquisitions, we are required to record the assets acquired, including identified intangible assets, and the liabilities assumed at their fair value. These often involve estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques that may include estimates of attrition, inflation, asset growth rates, or other relevant factors. In addition, the determination of the useful lives over which an intangible asset will be amortized is subjective. Under FASB ASC 350 (SFAS No. 142 Goodwill and Other Intangible Assets), goodwill and indefinite-lived assets recorded must be reviewed for impairment on an annual basis, as well as on an interim basis if events or changes indicate that the asset might be impaired. An impairment loss must be recognized for any excess of carrying value over fair value of the goodwill or the indefinite-lived intangible asset.

 

    Judgments and Uncertainties. The determination of fair values is based on valuations using management’s assumptions of future growth rates, future attrition, discount rates, multiples of earnings or other relevant factors.

 

    Effect if Actual Results Differ From Assumptions. Changes in these factors, as well as downturns in economic or business conditions, could have a significant adverse impact on the carrying values of goodwill or intangible assets and could result in impairment losses affecting our financials as a whole and the individual lines of business in which the goodwill or intangibles reside.

Acquired Impaired Loans

 

    Description. Loans acquired with evidence of credit deterioration since inception and for which it is probable that all contractual payments will not be received are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality (“ASC 310-30”). These loans are recorded at fair value at the time of acquisition, with no carryover of the related allowance for loan losses. Fair value of acquired loans is determined using a discounted cash flow methodology based on assumptions about the amount and timing of principal and interest payments, principal prepayments and principal defaults and losses, and current market rates. In recording the acquisition date fair values of acquired impaired loans, management calculates a non-accretable difference (the credit component of the purchased loans) and an accretable difference (the yield component of the purchased loans).

Over the life of the acquired loans, we continue to estimate cash flows expected to be collected on pools of loans sharing common risk characteristics, which are treated in the aggregate when applying various valuation techniques. We evaluate at each balance sheet date whether the present value of our pools of loans determined using the effective interest rates has decreased significantly and if so, recognize a provision for loan loss in our consolidated statement of income. For any significant increases in cash flows expected to be collected, we adjust the amount of accretable yield recognized on a prospective basis over the pool’s remaining life.

 

    Judgments and Uncertainties. These cash flow evaluations are inherently subjective as they require management to make estimates about expected cash flows, market conditions and other future events that are highly subjective in nature and subject to change.

 

    Effect if Actual Results Differ From Assumptions. Changes in these factors, as well as changing economic conditions will likely impact the carrying value of these acquired loans.

Allowance for Loan Losses

 

    Description. The allowance for loan losses is maintained at a level believed adequate by management to absorb probable incurred losses in the consolidated loan portfolio. Management’s evaluation of the adequacy of the allowance is an estimate based on reviews of individual loans, pools of homogeneous loans, assessments of the impact of current and anticipated economic conditions on the portfolio, and historical loss experience. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

 

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The allowance is increased through a provision charged to operating expense. Uncollectible loans are charged-off through the allowance. Recoveries of loans previously charged-off are added to the allowance. A loan is considered impaired when it is probable that contractual interest and principal payments will not be collected either for the amounts or by the dates as scheduled in the loan agreement. Our policy for recognizing income on impaired loans is to accrue interest unless a loan is placed on nonaccrual status. A loan is generally placed on nonaccrual status when principal or interest becomes 90 days past due unless it is well secured and in the process of collection, or earlier when concern exists as to the ultimate collectibility of principal or interest. We monitor the quality of our loan portfolio on an on-going basis and use a combination of detailed credit assessments by relationship managers and credit officers, historic loss trends, and economic and business environment factors in determining the allowance for loan losses. We record provisions for loan losses based on current loans outstanding, grade changes, mix of loans, and expected losses. A detailed loan loss evaluation on an individual loan basis for our highest risk loans is performed quarterly. Management follows the progress of the economy and how it might affect our borrowers in both the near and the intermediate term. We have a formalized and disciplined independent loan review program to evaluate loan administration, credit quality, and compliance with corporate loan standards. This program includes periodic, regular reviews of problem loan reports, delinquencies and charge-offs.

 

    Judgments and Uncertainties. We utilize a probability of default (“PD”)/loss given default (“LGD”) model as a tool to determine the adequacy of the allowance for loan losses for performing commercial and commercial real estate loans. The PD is forecast using a transition matrix to determine the likelihood of a customer’s asset quality rating (“AQR”) migrating from its current AQR to any other status within the time horizon. Transition rates are measured using Old National’s own historical experience. The model assumes that recent historical transition rates will continue into the future. The LGD is defined as credit loss incurred when an obligor of the bank defaults. The sum of all net charge-offs for a particular portfolio segment are divided by all loans that have defaulted over a given period of time. The expected loss derived from the model considers the PD, LGD, and exposure at default. Additionally, qualitative factors, such as changes in lending policies or procedures, and economic business conditions are also considered.

We use historic loss ratios adjusted for economic conditions to determine the appropriate level of allowance for residential real estate and consumer loans.

 

    Effect if Actual Results Differ From Assumptions. The allowance represents management’s best estimate, but significant downturns in circumstances relating to loan quality and economic conditions could result in a requirement for additional allowance. Likewise, an upturn in loan quality and improved economic conditions may allow a reduction in the required allowance. In either instance, unanticipated changes could have a significant impact on results of operations.

Management’s analysis of probable losses in the portfolio at December 31, 2016 resulted in a range for allowance for loan losses of $16.5 million. The range pertains to general (FASB ASC 450, Contingencies/SFAS 5) reserves for both retail and performing commercial loans. Specific (FASB ASC 310, Receivables/SFAS 114) reserves do not have a range of probable loss. Due to the risks and uncertainty associated with the economy and our projection of FAS 5 loss rates inherent in the portfolio, we establish a range of probable outcomes (a high-end estimate and a low-end estimate) and evaluate our position within this range. The potential effect to net income based on our position in the range relative to the high and low endpoints is a decrease of $1.6 million and an increase of $9.1 million, respectively, after taking into account the tax effects. These sensitivities are hypothetical and may not represent actual results.

Derivative Financial Instruments

 

   

Description. As part of our overall interest rate risk management, we use derivative instruments to reduce exposure to changes in interest rates and market prices for financial instruments. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items. To the extent hedging relationships are found to be effective, as determined by FASB ASC 815 (SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities) (“ASC Topic 815”), changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. Management believes hedge effectiveness is

 

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evaluated properly in preparation of the financial statements. All of the derivative financial instruments we use have an active market and indications of fair value can be readily obtained. We are not using the “short-cut” method of accounting for any fair value derivatives.

 

    Judgments and Uncertainties. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of derivative financial instruments and hedged items.

 

    Effect if Actual Results Differ From Assumptions. To the extent hedging relationships are found to be effective, as determined by ASC Topic 815, changes in fair value of the derivatives are offset by changes in the fair value of the related hedged item or recorded to other comprehensive income. However, if in the future the derivative financial instruments used by us no longer qualify for hedge accounting treatment, all changes in fair value of the derivative would flow through the consolidated statements of income in other noninterest income, resulting in greater volatility in our earnings.

Income Taxes

 

    Description. We are subject to the income tax laws of the U.S., its states, and the municipalities in which we operate. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. We review income tax expense and the carrying value of deferred tax assets quarterly; and as new information becomes available, the balances are adjusted as appropriate. FASB ASC 740-10 (FIN 48) prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. See Note 17 to the consolidated financial statements for a further description of our provision and related income tax assets and liabilities.

 

    Judgments and Uncertainties. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of these inherently complex tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various tax jurisdictions. Disputes over interpretations of the tax laws may be subject to review/adjudication by the court systems of the various tax jurisdictions or may be settled with the taxing authority upon examination or audit.

 

    Effect if Actual Results Differ From Assumptions. Although management believes that the judgments and estimates used are reasonable, actual results could differ and we may be exposed to losses or gains that could be material. To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective income tax rate in a given financial statement period could be materially affected. An unfavorable tax settlement would result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement would result in a reduction in our effective income tax rate in the period of resolution.

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee and the Audit Committee has reviewed our disclosure relating to it in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information contained under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk” of this Form 10-K is incorporated herein by reference in response to this item.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF MANAGEMENT

MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL REPORTING

Management is responsible for the preparation of the financial statements and related financial information appearing in this annual report on Form 10-K. The financial statements and notes have been prepared in conformity

 

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with accounting principles generally accepted in the United States and include some amounts which are estimates based upon currently available information and management’s judgment of current conditions and circumstances. Financial information throughout this annual report on Form 10-K is consistent with that in the financial statements.

Management maintains a system of internal accounting controls which is believed to provide, in all material respects, reasonable assurance that assets are safeguarded against loss from unauthorized use or disposition, transactions are properly authorized and recorded, and the financial records are reliable for preparing financial statements and maintaining accountability for assets. In addition, Old National has a Code of Business Conduct and Ethics, a Senior Financial and Executive Officer Code of Ethics and Corporate Governance Guidelines that outline high levels of ethical business standards. Old National has also appointed a Chief Ethics Officer and had a third party perform an independent validation of our ethics program. All systems of internal accounting controls are based on management’s judgment that the cost of controls should not exceed the benefits to be achieved and that no system can provide absolute assurance that control objectives are achieved. Management believes Old National’s system provides the appropriate balance between cost of controls and the related benefits.

In order to monitor compliance with this system of controls, Old National maintains an extensive internal audit program. Internal audit reports are issued to appropriate officers and significant audit exceptions, if any, are reviewed with management and the Audit Committee.

The Board of Directors, through an Audit Committee comprised solely of independent outside directors, oversees management’s discharge of its financial reporting responsibilities. The Audit Committee meets regularly with Old National’s independent registered public accounting firm, Crowe Horwath LLP, and the managers of financial reporting, internal audit, and risk. During these meetings, the committee meets privately with the independent registered public accounting firm as well as with financial reporting and internal audit personnel to review accounting, auditing, and financial reporting matters. The appointment of the independent registered public accounting firm is made by the Audit Committee.

The consolidated financial statements in this annual report on Form 10-K have been audited by Crowe Horwath LLP, for the purpose of determining that the consolidated financial statements are presented fairly, in all material respects in conformity with accounting principles generally accepted in the United States. Crowe Horwath LLP’s report on the financial statements follows.

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The management of Old National is responsible for establishing and maintaining adequate internal control over financial reporting. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Old National’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria established in 2013 by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework. Based on that assessment Old National has concluded that, as of December 31, 2016, the Company’s internal control over financial reporting is effective. Old National’s independent registered public accounting firm has audited the effectiveness of Old National’s internal control over financial reporting as of December 31, 2016 as stated in their report which follows.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

LOGO   

 

Crowe Horwath LLP

Independent Member Crowe Horwath International

LOGO

  

Board of Directors and Shareholders

Old National Bancorp

Evansville, Indiana

We have audited the accompanying consolidated balance sheets of Old National Bancorp as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. We also have audited Old National Bancorp’s internal control over financial reporting as of December 31, 2016, based on criteria established in 2013 in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Old National Bancorp’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Old National Bancorp as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Old National Bancorp maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in 2013 in Internal Control—Integrated Framework issued by the COSO.

 

LOGO

Crowe Horwath LLP

Indianapolis, Indiana

February 15, 2017

 

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OLD NATIONAL BANCORP

CONSOLIDATED BALANCE SHEETS

 

     December 31,  

(dollars and shares in thousands, except per share data)

   2016     2015  

Assets

    

Cash and due from banks

   $ 209,381      $ 91,311   

Money market and other interest-earning investments

     46,138        128,507   
  

 

 

   

 

 

 

Total cash and cash equivalents

     255,519        219,818   

Trading securities, at fair value

     4,982        3,941   

Investment securities - available-for-sale, at fair value

     2,797,174        2,418,221   

Investment securities - held-to-maturity, at amortized cost (fair value $784,172 and $929,417, respectively)

     745,090        872,111   

Federal Home Loan Bank/Federal Reserve Bank stock, at cost

     101,716        86,146   

Loans held for sale, at fair value

     90,682        13,810   

Loans, net of unearned income

     9,010,512        6,840,818   

Covered loans, net of discount

     —          107,587   
  

 

 

   

 

 

 

Total loans

     9,010,512        6,948,405   

Allowance for loan losses

     (49,808 )      (51,296

Allowance for loan losses - covered loans

     —          (937
  

 

 

   

 

 

 

Net loans

     8,960,704        6,896,172   
  

 

 

   

 

 

 

FDIC indemnification asset

     —          9,030   

Premises and equipment, net

     429,622        196,676   

Accrued interest receivable

     81,381        69,098   

Goodwill

     655,018        584,634   

Other intangible assets

     37,677        35,308   

Company-owned life insurance

     352,956        341,294   

Net deferred tax assets

     181,863        109,984   

Loan servicing rights

     25,561        10,468   

Assets held for sale

     5,970        5,679   

Other real estate owned and repossessed personal property

     18,546        7,594   

Other real estate owned - covered

     —          4,904   

Other assets

     115,776        106,639   
  

 

 

   

 

 

 

Total assets

   $ 14,860,237      $ 11,991,527   
  

 

 

   

 

 

 

Liabilities

    

Deposits:

    

Noninterest-bearing demand

   $ 3,016,093      $ 2,488,855   

Interest-bearing:

    

NOW

     2,596,595        2,133,536   

Savings

     2,954,709        2,201,352   

Money market

     707,748        577,050   

Time

     1,468,108        1,000,067   
  

 

 

   

 

 

 

Total deposits

     10,743,253        8,400,860   
  

 

 

   

 

 

 

Federal funds purchased and interbank borrowings

     213,003        291,090   

Securities sold under agreements to repurchase

     367,052        387,409   

Federal Home Loan Bank advances

     1,353,092        1,023,491   

Other borrowings

     218,939        218,256   

Accrued expenses and other liabilities

     150,481        179,251   
  

 

 

   

 

 

 

Total liabilities

     13,045,820        10,500,357   
  

 

 

   

 

 

 

Commitments and contingencies (Note 23)

    

Shareholders’ Equity

    

Preferred stock, series A, 2,000 shares authorized, no shares issued or outstanding

     —          —     

Common stock, $1.00 per share stated value, 300,000 shares authorized, 135,159 and 114,297 shares issued and outstanding, respectively

     135,159        114,297   

Capital surplus

     1,348,338        1,087,911   

Retained earnings

     390,292        323,759   

Accumulated other comprehensive income (loss), net of tax

     (59,372 )      (34,797
  

 

 

   

 

 

 

Total shareholders’ equity

     1,814,417        1,491,170   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 14,860,237      $ 11,991,527   
  

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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OLD NATIONAL BANCORP    

CONSOLIDATED STATEMENTS OF INCOME    

 

     Years Ended December 31,  

(dollars and shares in thousands, except per share data)

   2016      2015     2014  

Interest Income

       

Loans including fees:

       

Taxable

   $ 349,095       $ 304,452      $ 296,141   

Nontaxable

     12,287         11,566        10,207   

Investment securities:

       

Taxable

     57,005         57,336        60,903   

Nontaxable

     28,617         25,788        22,436   

Money market and other interest-earning investments

     130         47        42   
  

 

 

    

 

 

   

 

 

 

Total interest income

     447,134         399,189        389,729   
  

 

 

    

 

 

   

 

 

 

Interest Expense

       

Deposits

     17,283         14,168        13,326   

Federal funds purchased and interbank borrowings

     673         265        136   

Securities sold under agreements to repurchase

     1,509         1,488        1,434   

Federal Home Loan Bank advances

     15,547         8,121        4,275   

Other borrowings

     9,419         9,031        4,188   
  

 

 

    

 

 

   

 

 

 

Total interest expense

     44,431         33,073        23,359   
  

 

 

    

 

 

   

 

 

 

Net interest income

     402,703         366,116        366,370   

Provision for loan losses

     960         2,923        3,097   
  

 

 

    

 

 

   

 

 

 

Net interest income after provision for loan losses

     401,743         363,193        363,273   
  

 

 

    

 

 

   

 

 

 

Noninterest Income

       

Wealth management fees

     34,641         34,395        28,737   

Service charges on deposit accounts

     41,578         43,372        47,433   

Debit card and ATM fees

     16,769         21,340        25,835   

Mortgage banking revenue

     20,240         12,540        6,017   

Insurance premiums and commissions

     20,527         42,714        41,466   

Investment product fees

     18,822         17,924        17,136   

Company-owned life insurance

     8,479         8,604        6,924   

Net securities gains

     5,848         5,718        9,830   

Total other-than-temporary impairment losses

     —           —          (100

Loss recognized in other comprehensive income

     —           —          —     
  

 

 

    

 

 

   

 

 

 

Impairment losses recognized in earnings

     —           —          (100

Recognition of deferred gain on sale leaseback transactions

     16,057         16,444        6,094   

Gain on sale of ONB Insurance Group, Inc.

     41,864         —          —     

Net gain on branch divestitures

     —           15,627        —     

Change in FDIC indemnification asset

     233         (9,034     (43,162

Other income

     27,772         20,988        18,919   
  

 

 

    

 

 

   

 

 

 

Total noninterest income

     252,830         230,632        165,129   
  

 

 

    

 

 

   

 

 

 

Noninterest Expense

       

Salaries and employee benefits

     252,892         243,875        219,301   

Occupancy

     50,947         53,239        49,099   

Equipment

     13,448         13,183        12,453   

Marketing

     14,620         10,410        9,591   

Data processing

     32,002         27,309        25,382   

Communication

     9,959         9,586        10,476   

Professional fees

     15,705         11,756        16,390   

Loan expense

     7,632         6,373        6,107   

Supplies

     2,865         2,275        2,958   

FDIC assessment

     8,681         7,503        6,261   

Other real estate owned expense

     4,195         2,703        3,101   

Amortization of intangibles

     12,486         11,746        9,120   

Other expense

     28,715         30,974        16,199   
  

 

 

    

 

 

   

 

 

 

Total noninterest expense

     454,147         430,932        386,438   
  

 

 

    

 

 

   

 

 

 

Income before income taxes

     200,426         162,893        141,964   

Income tax expense

     66,162         46,177        38,297   
  

 

 

    

 

 

   

 

 

 

Net income

   $ 134,264       $ 116,716      $ 103,667   
  

 

 

    

 

 

   

 

 

 

Net income per common share - basic

   $ 1.05       $ 1.01      $ 0.96   

Net income per common share - diluted

     1.05         1.00        0.95   
  

 

 

    

 

 

   

 

 

 

Weighted average number of common shares outstanding - basic

     127,705         115,726        107,818   

Weighted average number of common shares outstanding - diluted

     128,301         116,255        108,365   
  

 

 

    

 

 

   

 

 

 

Dividends per common share

   $ 0.52       $ 0.48      $ 0.44   

The accompanying notes to consolidated financial statements are an integral part of these statements.

 

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OLD NATIONAL BANCORP    

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME    

 

     Years Ended December 31,  

(dollars in thousands)

   2016     2015     2014  

Net income

   $ 134,264      $ 116,716      $ 103,667   

Other comprehensive income (loss):

      

Change in securities available-for-sale:

      

Unrealized holding gains (losses) for the period

     (49,813     1,173        42,515   

Reclassification adjustment for securities gains realized in income

     (5,848     (5,718     (9,830

Other-than-temporary-impairment on available-for-sale securities associated with credit loss realized in income

     —          —          100   

Income tax effect

     20,455        1,487        (12,425
  

 

 

   

 

 

   

 

 

 

Unrealized gains (losses) on available-for-sale securities

     (35,206     (3,058     20,360   

Change in securities held-to-maturity:

      

Amortization of fair value for securities held-to-maturity previously recognized into accumulated other comprehensive income

     1,776        1,692        1,437   

Income tax effect

     (606     (396     (446
  

 

 

   

 

 

   

 

 

 

Changes from securities held-to-maturity

     1,170        1,296        991   

Cash flow hedges:

      

Net unrealized derivative losses on cash flow hedges

     (2,323     (8,107     (9,514

Reclassification adjustment for losses realized in net income

     6,453        2,719        248   

Income tax effect

     (1,569     2,047        3,521   
  

 

 

   

 

 

   

 

 

 

Changes from cash flow hedges

     2,561        (3,341     (5,745

Defined benefit pension plans:

      

Amortization of net (gain) loss and settlement cost recognized in income

     11,203        3,002        (4,333

Income tax effect

     (4,303     (1,141     1,638   
  

 

 

   

 

 

   

 

 

 

Changes from defined benefit pension plans

     6,900        1,861        (2,695
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss), net of tax

     (24,575     (3,242     12,911   
  

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 109,689      $ 113,474      $ 116,578   
  

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.    

 

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OLD NATIONAL BANCORP    

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY    

 

(dollars in thousands)

   Common
Stock
    Capital
Surplus
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Total
Shareholders’
Equity
 

Balance, January 1, 2014

   $ 99,859      $ 900,254      $ 206,993      $ (44,466   $ 1,162,640   

Net income

     —          —          103,667        —          103,667   

Other comprehensive income

     —          —          —          12,911        12,911   

Acquisition of Tower Financial Corporation

     5,626        73,101        —          —          78,727   

Acquisition of United Bancorp

     9,117        114,689        —          —          123,806   

Acquisition of LSB Financial Corp.

     3,557        48,201        —          —          51,758   

Dividends - common stock

     —          —          (48,181     —          (48,181

Common stock issued

     24        302        —          —          326   

Common stock repurchased

     (1,886     (23,944     —          —          (25,830

Stock based compensation expense

     —          4,162        —          —          4,162   

Stock activity under incentive compensation plans

     550        1,527        (299     —          1,778   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2014

     116,847        1,118,292        262,180        (31,555     1,465,764   

Net income

     —          —          116,716        —          116,716   

Other comprehensive loss

     —          —          —          (3,242     (3,242

Acquisition of Founders Financial Corporation

     3,402        47,224        —          —          50,626   

Dividends - common stock

     —          —          (55,552     —          (55,552

Common stock issued

     29        362        —          —          391   

Common stock repurchased

     (6,399     (82,296     —          —          (88,695

Stock based compensation expense

     —          4,255        —          —          4,255   

Stock activity under incentive compensation plans

     418        74        415        —          907   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2015

     114,297        1,087,911        323,759        (34,797     1,491,170   

Net income

     —          —          134,264        —          134,264   

Other comprehensive loss

     —          —          —          (24,575     (24,575

Acquisition of Anchor BanCorp Wisconsin Inc.

     20,415        253,150        —          —          273,565   

Dividends - common stock

     —          —          (67,536     —          (67,536

Common stock issued

     32        356        —          —          388   

Common stock repurchased

     (154     (1,890     —          —          (2,044

Stock based compensation expense

     —          7,318        —          —          7,318   

Stock activity under incentive compensation plans

     569        1,493        (195     —          1,867   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2016

   $ 135,159      $ 1,348,338      $ 390,292      $ (59,372   $ 1,814,417   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes to consolidated financial statements are an integral part of these statements.    

 

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OLD NATIONAL BANCORP    

CONSOLIDATED STATEMENTS OF CASH FLOWS    

 

     Years Ended December 31,  

(dollars in thousands)

   2016     2015     2014  

Cash Flows From Operating Activities

      

Net income

   $ 134,264      $