10-K 1 a2223555z10-k.htm 10-K

Use these links to rapidly review the document

Table of Contents




Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the fiscal year ended December 31, 2014

Commission file number 0-12422

(Exact name of registrant as specified in its charter)

(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)

2105 North State Road 3 Bypass
Greensburg, Indiana 47240

(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code:
(812) 663-6734

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

Title of each class
Common shares, no par value


Name of each exchange on which registered
The NASDAQ Stock Market LLC

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

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

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

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 ý    No o

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

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

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

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

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

The aggregate market value (not necessarily a reliable indication of the price at which more than a limited number of shares would trade) of the voting stock held by non-affiliates of the registrant was $352,913,662 as of June 30, 2014.

As of March 13, 2015, there were outstanding 21,672,475 common shares, without par value, of the registrant.


Part of Form 10-K
Into Which Incorporated
Definitive Proxy Statement for Annual
Meeting of Shareholders to be held
April 29, 2015
  Part III (Items 10 through 14)

Table of Contents





Item 1




Item 1A   Risk Factors   11
Item 1B   Unresolved Staff Comments   16
Item 2   Properties   16
Item 3   Legal Proceedings   16
Item 4   Mine Safety Disclosures   16








Item 5


Market For Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities


Item 6   Selected Financial Data   19
Item 7   Management's Discussion and Analysis of Financial Condition and Results of Operations   20
Item 7A   Quantitative and Qualitative Disclosures About Market Risk   32
Item 8   Financial Statements and Supplementary Data   33
Item 9   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   79
Item 9A   Controls and Procedures   79
Item 9B   Other Information   79








Item 10


Directors, Executive Officers and Corporate Governance


See below
Item 11   Executive Compensation   See below
Item 12   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   See below
Item 13   Certain Relationships and Related Transactions and Director Independence   See below
Item 14   Principal Accounting Fees and Services   See below








Item 15


Exhibits, Financial Statement Schedules



       Pursuant to General Instruction G, the information called for by Items 10-14 is omitted by MainSource Financial Group, Inc. since MainSource Financial Group, Inc. will file with the Commission a definitive proxy statement for its 2015 Annual Meeting of Shareholders pursuant to Regulation 14A not later than 120 days after the close of the fiscal year containing the information required by Items 10-14.


Table of Contents


(Dollar amounts in thousands except per share data)

Cautionary Note Regarding Forward-Looking Statements

       Except for historical information contained herein, the discussion in this Annual Report includes certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Any statement that does not describe historical or current facts is a forward-looking statement. These statements often include the words "believes," "expects," "anticipates," "estimates," "intends," "plans," "goals," "targets," "initiatives," "potentially," "probably," "projects," "outlook" or similar expressions or future conditional verbs such as "may," "will," "should," "would," and "could." Actual results and experience could differ materially from the anticipated results or other expectations expressed in the Company's forward-looking statements. The Company disclaims any intent or obligation to update such forward looking statements. Factors which could cause future results to differ from these expectations include the following: general economic conditions; legislative and regulatory initiatives; monetary and fiscal policies of the federal government; deposit flows; the cost of funds; general market rates of interest; interest rates on competing investments; demand for loan products; demand for financial services; changes in accounting policies or guidelines; changes in the quality or composition of the Company's loan and investment portfolios; the Company's ability to integrate acquisitions, and other factors, including the risk factors set forth in Item 1A of this Annual Report on Form 10-K and in other reports we file from time to time with the Securities and Exchange Commission. The Company intends the forward looking statements set forth herein to be covered by the safe harbor provisions for forward looking statements contained in the Private Securities Litigation Reform Act of 1995.



       MainSource Financial Group, Inc. ("MainSource" or the "Company") is an Indiana corporation and bank holding company, within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHC Act"), that has elected to become a financial holding company ("FHC"). The Company is based in Greensburg, Indiana. As of December 31, 2014, the Company operated one banking subsidiary: MainSource Bank ("the Bank"), an Indiana state chartered bank. Through its non-bank affiliates, the Company provides services incidental to the business of banking. Since its formation in 1982, the Company has acquired and established various institutions and financial services companies and may acquire additional financial institutions and financial services companies in the future. For further discussion of the business of the Company see Management's Discussion and Analysis in Part II, Item 7.

       As of December 31, 2014, the Company operated 80 branch banking offices in Indiana, Illinois, Ohio and Kentucky. As of December 31, 2014, the Company had consolidated assets of $3,122,516, consolidated deposits of $2,468,321 and shareholders' equity of $360,662.

       Through the Bank, the Company offers a broad range of financial services, including: accepting time and transaction deposits; making consumer, commercial, agribusiness and real estate mortgage loans; renting safe deposit facilities; providing personal and corporate trust services; and providing other corporate services such as letters of credit and repurchase agreements.

       The lending activities of the Bank are separated into primarily the categories of commercial, commercial real estate, residential, and consumer. Loans are originated by the lending officers of the Bank subject to limitations set forth in lending policies. The Board of Directors of the Bank monitors concentrations of credit, problem and past due loans and charge-offs of uncollectible loans and approves loan policy. The Bank maintains conservative loan policies and underwriting practices in order to address and manage loan risks. These policies and practices include granting loans on a sound and collectible basis, serving the legitimate needs of the community and the general market area while obtaining a balance between maximum yield and minimum risk, ensuring that primary and secondary sources of repayment are adequate in relation to the amount of the loan, developing and maintaining adequate diversification of the loan portfolio as a whole and of the loans within each category and developing and applying adequate collection policies.

       Commercial loans include secured and unsecured loans, including real estate loans, to individuals and companies and to governmental units predominantly within the market area of the Bank for a myriad of business purposes.

       Agricultural loans are generated in the Bank's markets. Most of the loans are real estate loans on farm properties. Loans are also made for agricultural production and such loans are generally reviewed annually.

       Residential real estate lending has been the largest component of the loan portfolio for many years. The Bank generates residential mortgages for its own portfolio. However, the Company elects to sell the majority of its fixed rate mortgages into the secondary market while maintaining the servicing of such loans. At December 31, 2014, the Company was servicing a $880 million residential real estate loan portfolio. By originating loans for sale in the secondary market, the Company can more fully satisfy


Table of Contents

customer demand for fixed rate residential mortgages and increase fee income, while reducing the risk of loss caused by rising interest rates.

       The principal source of revenues for the Company is interest and fees on loans, which accounted for 53.7% of total revenues in 2014, 53.4% in 2013 and 55.0% in 2012. While the Company's chief decision makers monitor the revenue streams of the various Company products and services, the identifiable segments are not material and operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company's financial service operations are considered by management to be aggregated in one reportable operating segment.

       The Company's investment securities portfolio is primarily comprised of state and municipal bonds; U.S. government sponsored entities' mortgage-backed securities and collateralized mortgage obligations; and corporate securities. The Company has classified its entire investment portfolio as available for sale, with fair value changes reported separately in shareholders' equity. Funds invested in the investment portfolio generally represent funds not immediately required to meet loan demand. Income related to the Company's investment portfolio accounted for 16.6% of total revenues in 2014, 16.7% in 2013 and 16.2% in 2012. As of December 31, 2014, the Company had not identified any securities as being "high risk" as defined by the FFIEC Supervisory Policy Statement on Securities Activities.

       The primary source of funds for the Bank is deposits generated in local market areas. To attract and retain stable depositors, the Bank markets various programs for demand, savings and time deposit accounts. These programs include interest and non-interest bearing demand and individual retirement accounts.

       Currently, national retailing and manufacturing subsidiaries, brokerage and insurance firms and credit unions are fierce competitors within the financial services industry. Mergers between financial institutions within Indiana and neighboring states, which became permissible under the Interstate Banking and Branching Efficiency Act of 1994, have also added competitive pressure.

       The branches of the Bank are predominantly located in non-metropolitan areas and the Bank's business is centered in loans and deposits generated within markets considered largely rural in nature. In addition to competing vigorously with other banks, thrift institutions, credit unions and finance companies located within their service areas, we also compete, directly and indirectly, with all providers of financial services.


       As of December 31, 2014, the Company and its subsidiaries had 801 full-time equivalent employees to whom they provide a variety of benefits and with whom they enjoy excellent relations. None of our employees are subject to collective bargaining agreements.

Available Information

       We make available free of charge on or through our Internet web site, www.mainsourcebank.com, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission ("SEC"). Such materials are also available free of charge on the SEC website, www.sec.gov. We have included our and the SEC's Internet website addresses throughout this Annual Report on Form 10-K as textual references only. The information contained on these websites is not incorporated into this Annual Report on Form 10-K.

Regulation and Supervision

       The Company is a financial holding company ("FHC") within the meaning of the Bank Holding Company Act of 1956, as amended. As a FHC, the Company is subject to regulation by the Federal Reserve Board ("FRB"). The Bank is an Indiana state chartered bank subject to supervision and regulation by the Federal Deposit Insurance Corporation ("FDIC") and the Indiana Department of Financial Institutions. The following is a discussion of material statutes and regulations affecting the Company and the Bank. The discussion is qualified in its entirety by reference to such statutes and regulations.

    Bank Holding Company Act of 1956, as amended

       Generally, the BHC Act governs the acquisition and control of banks and nonbanking companies by bank holding companies. A bank holding company is subject to regulation by and is required to register with the FRB under the BHC Act. The BHC Act requires a bank holding company to file an annual report of its operations and such additional information as the FRB may require. The FRB has issued regulations under the BHC Act requiring a bank holding company to serve as a source of financial and managerial


Table of Contents

strength to its subsidiary banks. It is the policy of the FRB 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.

       The acquisition of 5% or more of the voting shares of any bank or bank holding company generally requires the prior approval of the FRB and is subject to applicable federal and state law, including the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 ("Riegle-Neal") for interstate transactions. The FRB evaluates acquisition applications based on, among other things, competitive factors, supervisory factors, adequacy of financial and managerial resources, and banking and community needs considerations.

       The BHC Act also prohibits, with certain exceptions, a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any "nonbanking" company unless the nonbanking activities are found by the FRB to be "so closely related to banking...as to be a proper incident thereto." Under current regulations of the FRB, a bank holding company and its nonbank subsidiaries are permitted, among other activities, to engage in such banking-related business ventures as consumer finance, equipment leasing, data processing, mortgage banking, financial and investment advice, and securities brokerage services. The BHC Act does not place territorial restrictions on the activities of a bank holding company or its nonbank subsidiaries.

       Federal law prohibits acquisition of "control" of a bank or bank holding company without prior notice to certain federal bank regulators. "Control" is defined in certain cases as the acquisition of as little as 10% of the outstanding shares of any class of voting stock. Furthermore, under certain circumstances, a bank holding company may not be able to purchase its own stock, where the gross consideration will equal 10% or more of the company's net worth, without obtaining approval of the FRB. Under the Federal Reserve Act, banks and their affiliates are subject to certain requirements and restrictions when dealing with each other (affiliate transactions include transactions between a bank and its bank holding company).

    Gramm-Leach-Bliley Financial Modernization Act of 1999

       The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the "Modernization Act") was enacted on November 12, 1999. The Modernization Act, which amended the BHC Act, provides the following:

    it allows bank holding companies that qualify as "financial holding companies" to engage in a broad range of financial and related activities;

    it allows insurers and other financial services companies to acquire banks;

    it removes various restrictions that applied to bank holding company ownership of securities firms and mutual fund advisory companies; and

    it establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

       The Company initially qualified as a financial holding company in December, 2004. Thus the Company is authorized to operate as a financial holding company and is eligible to engage in, or acquire companies engaged in, the broader range of activities that are permitted by the Modernization Act. These activities include those that are determined to be "financial in nature," including insurance underwriting, securities underwriting and dealing, and making merchant banking investments in commercial and financial companies. If a banking subsidiary ceases to be "well capitalized" or "well managed" under applicable regulatory standards, the FRB may, among other things, place limitations on our ability to conduct these broader financial activities or, if the deficiencies persist, require us to divest the banking subsidiary. In addition, if a banking subsidiary receives a rating of less than satisfactory under the Community Reinvestment Act of 1977 ("CRA"), we would be prohibited from engaging in any additional activities other than those permissible for bank holding companies that are not financial holding companies.

    Bank Secrecy Act and USA Patriot Act

       In 1970, Congress enacted the Currency and Foreign Transactions Reporting Act, commonly known as the Bank Secrecy Act (the "BSA"). The BSA requires financial institutions to maintain records of certain customers and currency transactions and to report certain domestic and foreign currency transactions, which may have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings. Under this law, financial institutions are required to develop a BSA compliance program.

       In 2001, the President signed into law comprehensive anti-terrorism legislation known as the USA Patriot Act. Title III of the USA Patriot Act requires financial institutions, including the Company and the Bank, to help prevent and detect international money laundering and the financing of terrorism and prosecute those involved in such activities. The Department of the Treasury has adopted additional requirements to further implement Title III.

       Under these regulations, a mechanism has been established for law enforcement officials to communicate names of suspected terrorists and money launderers to financial institutions to enable financial institutions to promptly locate accounts and transactions involving those suspects. Financial institutions receiving names of suspects must search their account and transaction records for


Table of Contents

potential matches and report positive results to the U.S. Department of the Treasury Financial Crimes Enforcement Network ("FinCEN"). Each financial institution must designate a point of contact to receive information requests. These regulations outline how financial institutions can share information concerning suspected terrorist and money laundering activity with other financial institutions under the protection of a statutory safe harbor if each financial institution notifies FinCEN of its intent to share information. The Department of the Treasury has also adopted regulations intended to prevent money laundering and terrorist financing through correspondent accounts maintained by U.S. financial institutions on behalf of foreign banks. Financial institutions are required to take reasonable steps to ensure that they are not providing banking services directly or indirectly to foreign shell banks. In addition, banks must have procedures in place to verify the identity of the persons with whom they deal.

    FDIC Improvement Act of 1991

       The Federal Deposit Insurance Act, as amended ("FDIA"), requires among other things, the federal banking agencies to take "prompt corrective action" in respect of depository institutions that do not meet minimum capital requirements. The FDIA includes the following five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." A depository institution's capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total risk-based capital ratio, the Tier 1 risk-based capital ratio, the common equity Tier 1 risk-based capital ratio, and the leverage ratio.

       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, a common equity Tier 1 risk-based capital ratio of 6.5% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any 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 6.0% or greater, a common equity Tier 1 risk-based capital ratio of 4.5% 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 6.0%, a common equity Tier 1 risk-based capital ratio of less than 4.5%, 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 4.0%, a common equity 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 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.

       The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The FDIA provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice. The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

       The Company believes that, as of December 31, 2014, the Company and the Bank were each "well capitalized" based on the aforementioned ratios.


Table of Contents

    The Sarbanes-Oxley Act

       The Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") represents a comprehensive revision of laws affecting corporate governance, accounting obligations and corporate reporting. Among other requirements, the Sarbanes-Oxley Act established: (i) requirements for audit committees of public companies, including independence and expertise standards; (ii) additional responsibilities regarding financial statements for the chief executive officers and chief financial officers of reporting companies; (iii) standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies regarding various matters relating to corporate governance, and (v) new and increased civil and criminal penalties for violation of the securities laws.

    Deposit Insurance Fund

       The deposits of the Bank are insured to the maximum extent permitted by law by the Deposit Insurance Fund ("DIF") of the FDIC, which was created in 2006 as the result of the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the "FDI Act"). The FDIC maintains the DIF by assessing depository institutions an insurance premium. Pursuant to the Dodd-Frank Act, the FDIC is required to set a DIF reserve ratio of 1.35% of estimated insured deposits and is required to achieve this ratio by September 30, 2020.

       Under the FDIC's risk-based assessment system, insured institutions are required to pay deposit insurance premiums based on the risk that each institution poses to the DIF. An institution's risk to the DIF is measured by its regulatory capital levels, supervisory evaluations, and certain other factors. An institution's assessment rate depends upon the risk category to which it is assigned. As noted above, pursuant to the Dodd-Frank Act, the FDIC will calculate an institution's assessment level based on its total average consolidated assets during the assessment period less average tangible equity (i.e., Tier 1 capital) as opposed to an institution's deposit level which was the previous basis for calculating insurance assessments. Pursuant to the Dodd-Frank Act, institutions will be placed into one of four risk categories for purposes of determining the institution's actual assessment rate. The FDIC will determine the risk category based on the institution's capital position (well capitalized, adequately capitalized, or undercapitalized) and supervisory condition (based on exam reports and related information provided by the institution's primary federal regulator).


       The Company is a legal entity separate and distinct from the Bank. There are various legal limitations on the extent to which the Bank can supply funds to the Company. The principal source of the Company's funds consists of dividends from the Bank. State and Federal law restricts the amount of dividends that may be paid by banks. The specific limits depend on a number of factors, including the bank's type of charter, recent earnings, recent dividends, level of capital and regulatory status. The regulators are authorized, and under certain circumstances are required, to determine that the payment of dividends or other distributions by a bank would be an unsafe or unsound practice and to prohibit that payment. For example, the FDI Act generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be undercapitalized.

       The Dodd-Frank Act and its accompanying regulations also limit a depository institution's ability to make capital distributions if it does not hold a 2.5% capital buffer above the required minimum risk-based capital ratios. Regulators also review and limit proposed dividend payments as part of the supervisory process and review of an institution's capital planning. In addition to dividend limitations, the Bank is subject to certain restrictions on extensions of credit to the Company, on investments in the stock or other securities of the Company and in taking such stock or securities as collateral for loans.

    Community Reinvestment Act

       The Community Reinvestment Act requires that the federal banking regulators evaluate the records of a financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could result in the imposition of additional requirements and limitations on the Bank.

    The Dodd-Frank Wall Street Reform and Consumer Protection Act

       On July 21, 2010, President Obama signed into law the sweeping financial regulatory reform act entitled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (Dodd-Frank Act). This significant law affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. Various federal agencies are given significant discretion in drafting and implementing a broad range of new rules and regulations, and consequently, while many new rules and regulation have been adopted, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.


Table of Contents

       Certain provisions of Dodd-Frank are now effective and have been fully implemented, including the revisions in the deposit insurance assessment base for FDIC insurance and the permanent increase in coverage to $250,000; the permissibility of paying interest on business checking accounts; the removal of barriers to interstate branching and required disclosure and shareholder advisory votes on executive compensation. Recent action to implement the final Dodd-Frank provisions included (i) final new capital rules, (ii) a final rule to implement the so called "Volcker rule" restrictions on certain proprietary trading and investment activities and (iii) final rules and increased enforcement action by the Consumer Finance Protection Bureau ("CFPB").

       Key provisions of the Dodd-Frank Act are as follows:

    eliminated the federal prohibitions on paying interest on demand deposits, thus allowing businesses to have interest bearing checking accounts.

    broadened the base for Federal Deposit Insurance Corporation insurance assessments.

    required publicly traded companies to give stockholders a nonbinding vote on executive compensation and so-called "golden parachute" payments.

    broadened the scope of derivative instruments, and subjected covered institutions to increased regulation of their derivative businesses, including margin requirements, record keeping and reporting requirements, and heightened supervision.

    created a new Consumer Financial Protection Bureau with broad powers to supervise and enforce consumer protection laws. Banks and savings institutions with $10 billion or less in assets will continue to be examined for compliance with consumer laws by their primary bank regulators. The CFPB, along with the Department of Justice and bank regulatory authorities also seek to enforce discriminatory lending laws. In such actions, the CFPB and others have used a disparate impact analysis, which measures discriminatory results without regard to intent.

    mandated that debit card and interchange fees be reasonable and proportional to the issuer's cost for processing the transaction. The Federal Reserve Board has approved a debit card interchange regulation which caps an issuer's base fee at $0.21 per transaction plus an additional fee computed at five basis-points of the transaction value. These standards apply to issuers that, together with their affiliates, have assets of $10 billion or more. The Company's assets are under $10 billion and therefore it is not directly impacted by these provisions.

    S.A.F.E. Act Requirements

       Regulations issued under the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (the "S.A.F.E. Act") require residential mortgage loan originators who are employees of institutions regulated by the foregoing agencies, including national banks, to meet the registration requirements of the S.A.F.E. Act. The S.A.F.E. Act requires residential mortgage loan originators who are employees of regulated financial institutions to be registered with the Nationwide Mortgage Licensing System and Registry, a database created by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators to support the licensing of mortgage loan originators by the states. Employees of regulated financial institutions are generally prohibited from originating residential mortgage loans unless they are registered.

    Regulatory Capital Requirements

       Prior Capital Rules.    As discussed above, the Company and the Bank must meet certain minimum capital requirements mandated by each of their state or federal regulators. The risk-based capital guidelines applicable to the Company and the Bank through December 31, 2014 were based on the 1988 capital accord, known as Basel I, of the Basel Committee on Banking Supervision (the "Basel Committee") as implemented by the federal banking regulators. Assets and off-balance sheet items were assigned to one of two weighted risk categories, and capital classified in tiers depending on its characteristics. The first, Tier 1 (Core) Capital, includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, minority interests in equity accounts of consolidated subsidiaries (and, under existing standards, a limited amount of qualifying trust preferred securities at the holding company level), less goodwill, most intangible assets and certain other assets. The second, Tier 2 (Supplementary) Capital, includes perpetual preferred stock and trust preferred securities not meeting the definition of Tier 1 capital, qualifying mandatory convertible debt securities, qualifying subordinated debt and a limited amount of allowances for loan and lease losses.

       Under the requirements in effect through December 31, 2014, the Company and the Bank were required to maintain Tier 1 capital and total capital (Tier 1 capital plus Tier 2 capital, less certain deductions) equal to at least 4% and 8%, respectively, of total risk-weighted assets (including various off-balance sheet items such as letters of credit), with similar required capital ratios for the Bank. Additionally, the Company and the Bank were required to comply with minimum leverage requirements, measured based on the ratio of a bank holding company's or a bank's, as applicable, Tier 1 capital to adjusted quarterly average total assets (as defined for regulatory purposes). These requirements generally necessitated a minimum Tier 1 leverage ratio of 4% for all bank holding companies and banks, with a lower 3% minimum for bank holding companies and banks meeting certain specified criteria, including having the highest composite regulatory supervisory rating. As of December 31, 2014, the Company's Tier 1 Capital to


Table of Contents

Risk-Weighted Assets Ratio was 14.9%, its Total Capital to Risk-Weighted Assets Ratio was 16.0%, and its leverage ratio of capital to total assets was 10.2%. The Bank had capital to asset ratios and risk- adjusted capital ratios at December 31, 2014, in excess of the applicable minimum regulatory requirements.

    Basel III and the New Capital Rules

       In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, officially identified by the Basel Committee as "Basel III". The Basel III standards operate in conjunction with portions of standards previously released by the Basel Committee and commonly known as "Basel II" and "Basel 2.5."

       On July 2, 2013, the Federal Reserve adopted a final rule for the Basel III capital framework and, on July 9, 2013, the FDIC adopted the same provisions (the "New Capital Rules"). The New Capital Rules apply to all national and state banks and savings associations and most bank holding companies and savings and loan holding companies, which are collectively referred to herein as "covered" banking organizations. The requirements in the New Capital Rules began to phase in on January 1, 2015 for covered banking organizations (including the Company). The requirements in the New Capital Rules will be fully phased in by January 1, 2019. Although many of the rules contained in these final regulations are applicable only to large, internationally active banks, some of them will apply on a phased in basis to all banking organizations, including the Company and the Bank.

       The following are among the new requirements that are being phased in beginning January 1, 2015:

    an increase in the minimum Tier 1 capital ratio from 4.00% to 6.00% of risk-weighted assets.

    a new category and a required 4.50% of risk-weighted assets ratio for "common equity Tier 1" ("CET1") as a subset of Tier 1 capital limited to common equity.

    a minimum non-risk-based leverage ratio of 4.00%, eliminating the 3.00% exception for higher rated banks.

    changes in the permitted composition of Tier 1 capital to exclude trust preferred securities, mortgage servicing rights and certain deferred tax assets and include unrealized gains and losses on available for sale debt and equity securities. However, bank holding companies such as the Company who had less than $15 billion in assets as of December 31, 2009 (and who continue to have less than $15 billion in assets) are permitted to include trust preferred securities issued prior to May 19, 2010 as Additional Tier 1 capital under the New Capital Rules.

    a new additional capital conservation buffer of 2.5% of risk weighted assets over each of the required capital ratios that will be phased in from 2016 to 2019, compliance with which will be necessary to avoid limitations in the ability of the Bank to pay dividends, repurchase shares or pay discretionary bonuses.

    the risk-weights of certain assets for purposes of calculating the risk-based capital ratios are changed for high volatility commercial real estate acquisition, development and construction loans, certain past due non-residential mortgage loans and certain mortgage-backed and other securities exposures.

    an additional "countercyclical capital buffer" for larger and more complex institutions. We do not anticipate the countercyclical capital buffer will be applicable to the Company or the Bank.

       Under the New Capital Rules, the minimum capital ratios as of January 1, 2015 are (i) 4.5% CET1 to risk-weighted assets, (ii) 6% Tier 1 capital (CET1 plus Additional Tier 1 capital) to risk-weighted assets and (iii) 8% total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets. The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and will be phased in over a three-year period (increasing by 0.625% on each subsequent January 1, until it reaches 2.5% on January 1, 2019). When fully phased-in, the New Capital Rules will require us, and the Bank, to maintain such additional capital conservation buffer of 2.5% of CET1, effectively resulting in minimum ratios of (i) 7% CET1 to risk-weighted assets, (ii) 8.5% Tier 1 capital to risk-weighted assets, and (iii) 10.5% total capital to risk-weighted assets. We believe that, as of December 31, 2014, the Company and the Bank would meet all capital adequacy requirements under the New Capital Rules on a fully phased-in basis as if such requirements were then in effect.

    Volcker Rule

       On December 10, 2013, the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, the CFTC and the SEC issued final rules to implement the Volcker Rule contained in section 619 of the Dodd-Frank Act, generally to become effective on July 21, 2015. On December 15, 2014, the Federal Reserve Bank granted a one-year extension of the Volcker Rule conformance period to July 21, 2016, and signaled an intention to grant another one-year extension to July 21, 2017.

       The Volcker Rule prohibits an insured depository institution and its affiliates from: (i) engaging in "proprietary trading" and (ii) investing in or sponsoring certain types of funds ("covered funds") subject to certain limited exceptions. The rule also effectively


Table of Contents

prohibits short-term trading strategies by any U.S. banking entity if those strategies involve instruments other than those specifically permitted for trading and prohibits the use of some hedging strategies.

       Under these rules and subject to certain exceptions, banking entities, including the Company and the Bank, will be restricted from engaging in activities that are considered proprietary trading and from sponsoring or investing in certain entities, including hedge or private equity funds that are considered "covered funds." Certain collateralized debt obligations ("CDO") securities backed by trust preferred securities were initially defined as covered funds subject to the investment prohibitions of the final rule. Action taken by the Federal Reserve in January 2014 exempted many such securities to address the concern that community banks holding such CDO securities may have been required to recognize losses on those securities. Banks with less than $10 billion in total consolidated assets, such as the Bank, that do not engage in any covered activities, other than trading in certain government agency, state or municipal obligations, do not have any significant compliance obligations under the rules implementing the Volcker Rule.

    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.

    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 having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal stockholder with excessive compensation, fees, or benefits that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure of incentive-based compensation arrangements to regulators. The agencies proposed such regulations in April 2011, but these regulations have not yet been finalized.

       In June 2010, the FRB and the 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 FRB will review, as part of its regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not "large, complex banking organizations." These reviews will be tailored to each organization based on the scope and complexity of the organization's activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization's supervisory ratings, which can affect the organization's ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization's safety and soundness and the organization is not taking prompt and effective measures to correct the deficiency.

    Future Legislation

       In addition to the specific legislation described above, various additional legislation is currently being considered by Congress. This legislation may change banking statutes and the Company's operating environment in substantial and unpredictable ways and may increase reporting requirements and governance. 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. The Company cannot predict whether any potential legislation will be enacted and, if enacted, the effect that it, or any implementing regulations, would have on its business, results of operations, or financial condition.


Table of Contents


       In addition to the other information contained in this report, the following risks may affect us. If any of these risks actually occur, our business, financial condition or results of operations may suffer. As a result, the price of our common shares could decline.

Risks Related to Our Business.

Like most banking organizations, a significant portion of our assets consists of loans, which if not repaid could result in losses to the Company.

       As a lender, we are exposed to the risk that our customers will be unable to repay their loans according to their terms and that the collateral securing the payment of their loans (if any) may not be sufficient to assure repayment. Credit losses could have a material adverse effect on our operating results.

       As of December 31, 2014, our total loan portfolio was approximately $1,958 million or 63% of our total assets. Three major components of the loan portfolio are loans principally secured by real estate, approximately $1,589 million or 81% of total loans; other commercial loans, approximately $323 million or 17% of total loans; and consumer loans, approximately $46 million or 2% of total loans. Our credit risk with respect to our consumer installment loan portfolio and commercial loan portfolio relates principally to the general creditworthiness of individuals and businesses within our local market area. Our credit risk with respect to our residential and commercial real estate mortgage and construction loan portfolio relates principally to the general creditworthiness of individuals and businesses and the value of real estate serving as security for the repayment of the loans. A related risk in connection with loans secured by commercial real estate is the effect of unknown or unexpected environmental contamination, which could make the real estate effectively unmarketable or otherwise significantly reduce its value as security. Continued or worsening declines in the economy could cause additional credit issues, particularly within our residential and commercial real estate mortgage and construction loan portfolio.

Our allowance for loan losses may not be sufficient to cover actual loan losses, which could adversely affect our earnings.

       We maintain an allowance for loan losses at a level estimated by management to be sufficient to cover probable incurred loan losses in our loan portfolio. Loan losses will likely occur in the future and may occur at a rate greater than we have experienced to date. In determining the size of the allowance, our management makes various assumptions and judgments about the collectability of our loan portfolio, including the diversification by industry of our commercial loan portfolio, the effect of changes in the local real estate markets on collateral values, the results of recent regulatory examinations, the effects on the loan portfolio of current economic indicators and their probable impact on borrowers, the amount of charge-offs for the period, the amount of nonperforming loans and related collateral security, and the evaluation of our loan portfolio by an external loan review. If our assumptions and judgments prove to be incorrect, our current allowance may not be sufficient and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Additionally, continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside the Company's control, may require an increase in the allowance for loan losses. Federal and state regulators also periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs could have an adverse effect on our operating results and financial condition. There can be no assurance that our monitoring procedures and policies will reduce certain lending risks or that our allowance for loan losses will be adequate to cover actual losses.

If we foreclose on collateral property, we may be subject to the increased costs associated with ownership of real property, resulting in reduced revenues and earnings.

       We may have to foreclose on collateral property to protect our investment and may thereafter own and operate such property, in which case we will be exposed to the risks inherent in the ownership of real estate. The amount that we, as a mortgagee, may realize after a default is dependent upon factors outside of our 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 we may have to advance funds in order to protect our investment, or we may be required to dispose of the real property at a loss. The foregoing expenditures and costs could adversely affect our ability to generate revenues, resulting in reduced levels of profitability.


Table of Contents

Significant interest rate volatility could reduce our profitability.

       The interest rate risk inherent in our lending, investing, and deposit taking activities is a significant market risk to us and our business. We derive our income mainly from the difference or "spread" between the interest earned on loans, securities and other interest earning assets, and interest paid on deposits, borrowings and other interest bearing liabilities. In general, the wider the spread, the more net interest income we earn. When market rates of interest change, the interest we receive on our assets and the interest we pay on our liabilities will fluctuate. This can cause decreases in our spread and can greatly affect our income. In addition, interest rate fluctuations can affect how much money we may be able to lend. Changes in interest rates may also affect the level of voluntary prepayments on our loans and the level of financing or refinancing by customers. There can be no assurance that we will be successful in minimizing the adverse effects of changes in interest rates.

New mortgage regulations may adversely impact our business.

       Revisions made pursuant to Dodd-Frank to Regulation Z, which implements the Truth in Lending Act (TILA), effective in January 2014, apply to all consumer mortgages (except home equity lines of credit, timeshare plans, reverse mortgages, or temporary loans), and mandate specific underwriting criteria and "ability to repay" requirements for home loans. This may impact our offering and underwriting of single family residential loans in our residential mortgage lending operation and could have a resulting unknown effect on potential delinquencies. In addition, the relatively uniform requirements may make it difficult for regional and community banks to compete against the larger national banks for single family residential loan originations.

We may be required to pay significantly higher Federal Deposit Insurance Corporation (FDIC) premiums in the future.

       Insured institution failures during the past several years have significantly increased FDIC loss provisions, resulting in a decline in the designated reserve ratio to historical lows. In addition the Dodd-Frank Act permanently implemented FDIC insurance coverage for all deposit accounts up to $250,000 and revised the insurance premium assessment base from all domestic deposits to the average of total assets less tangible equity. The minimum reserve ratio of the deposit insurance fund has been increased from 1.15% to 1.35%, with the increase to be covered by assessments on insured institutions with assets over $10 billion until the new reserve ratio is reached.

       We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional bank or financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Additionally, the FDIC may make material changes to the calculation of the prepaid assessment from the current proposal. Any future changes in the calculation or assessment of FDIC insurance premiums may have a material adverse effect on our results of operations, financial condition and our ability to continue to pay dividends on our common shares at the current rate or at all.

Future growth or operating results may require the Company to raise additional capital but that capital may not be available or it may be dilutive.

       We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. To the extent our future operating results erode capital or we elect to expand through loan growth or acquisition we may be required to raise capital. Our ability to raise capital will depend on conditions in the capital markets, which are outside of our control, and on our financial performance. Accordingly, we cannot be assured of our ability to raise capital if needed or on favorable terms. If we cannot raise additional capital when needed, we will be subject to increased regulatory supervision and the imposition of restrictions on our growth and business. These could negatively impact our ability to operate or further expand our operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on our financial condition and results of operations.

We rely heavily on our management and other key personnel, and the loss of any of them may adversely affect our operations.

       We are and will continue to be dependent upon the services of our management team. The loss of any of our senior managers could have an adverse effect on our growth and performance because of their skills, knowledge of the markets in which we operate and years of industry experience and the difficulty of promptly finding qualified replacement personnel. The loss of key personnel in a particular market could have an adverse effect on our performance in that market because it may be difficult to find qualified replacement personnel who are already located in or would be willing to relocate to a non-metropolitan market. Additionally, recent regulations issued by banking regulators regarding executive compensation may impact our ability to compensate executives and, as a result, to attract and retain qualified personnel.

The geographic concentration of our markets makes our business highly susceptible to local economic conditions.

       Unlike larger banking organizations that are more geographically diversified, our operations are currently concentrated in 31 counties in Indiana, three counties in Illinois, three counties in Ohio, and five counties in Kentucky. As a result of this geographic


Table of Contents

concentration in four fairly contiguous markets, our financial results depend largely upon economic conditions in these market areas. A deterioration in economic conditions in one or all of these markets could result in one or more of the following:

    an increase in loan delinquencies;

    an increase in problem assets and foreclosures;

    a decrease in the demand for our products and services; or

    a decrease in the value of collateral for loans, especially real estate, in turn reducing customers' borrowing power, the value of assets associated with problem loans and collateral coverage.

If we do not adjust to rapid changes in the financial services industry, our financial performance may suffer.

       We face substantial competition for deposit, credit and trust relationships, as well as other sources of funding in the communities we serve. Competing providers include other banks, thrifts and trust companies, insurance companies, mortgage banking operations, credit unions, finance companies, money market funds and other financial and nonfinancial companies which may offer products functionally equivalent to those offered by the Bank. Competing providers may have greater financial resources than we do and offer services within and outside the market areas we serve. In addition to this challenge of attracting and retaining customers for traditional banking services, our competitors now include securities dealers, brokers, mortgage bankers, investment advisors and finance and insurance companies who seek to offer one-stop financial services to their customers that may include services that banks have not been able or allowed to offer to their customers in the past. The increasingly competitive environment is primarily a result of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. If we are unable to adjust both to increased competition for traditional banking services and changing customer needs and preferences, it could adversely affect our financial performance and your investment in our common stock.

Acquisitions entail risks which could negatively affect our operations.

       Acquisitions involve numerous risks, including:

    exposure to asset quality problems of the acquired institution;

    maintaining adequate regulatory capital;

    diversion of management's attention from other business concerns;

    risks and expenses of entering new geographic markets;

    potential significant loss of depositors or loan customers from the acquired institution; or

    exposure to undisclosed or unknown liabilities of an acquired institution.

       Any of these acquisition risks could result in unexpected losses or expenses and thereby reduce the expected benefits of the acquisition.

Unanticipated costs related to our acquisitions could reduce our future earnings per share.

       We believe we have reasonably estimated the likely costs of integrating the operations of the banks we acquire into the Company and the incremental costs of operating such banks as a part of the MainSource family. However, it is possible that unexpected transaction costs such as taxes, fees or professional expenses or unexpected future operating expenses, such as increased personnel costs or increased taxes, as well as other types of unanticipated adverse developments, could have a material adverse effect on the results of operations and financial condition of MainSource. If unexpected costs are incurred, acquisitions could have a dilutive effect on our earnings per share. Current accounting guidance requires expensing of acquisition costs. In prior years, these costs could be capitalized. In other words, if we incur such unexpected costs and expenses as a result of our acquisitions, we believe that the earnings per share of our common stock could be less than they would have been if those acquisitions had not been completed.

We may be unable to successfully integrate the operations of the banks we have acquired and may acquire in the future and retain employees of such banks.

       Our acquisition strategy involves the integration of the banks we have acquired and may acquire in the future as MainSource subsidiary banks. The difficulties of integrating the operations of such banks with MainSource and its other subsidiary banks include:

    coordinating geographically separated organizations;


Table of Contents

    integrating personnel with diverse business backgrounds;

    combining different corporate cultures; or

    retaining key employees.

       The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of the Company, our subsidiary banks and the banks we have acquired and may acquire in the future and the loss of key personnel. The integration of such banks as MainSource subsidiary banks requires the experience and expertise of certain key employees of such banks who we expect to retain. We cannot be sure, however, that we will be successful in retaining these employees for the time period necessary to successfully integrate such banks' operations as subsidiary banks of MainSource. The diversion of management's attention and any delays or difficulties encountered in connection with the mergers, along with the integration of the banks as MainSource subsidiary banks, could have an adverse effect on our business and results of operation.

Risks Relating to the Banking Industry

Changes in governmental regulation and legislation could limit our future performance and growth.

       We are subject to extensive state and federal regulation, supervision and legislation that governs almost all aspects of our operations, as well as any acquisitions we may propose to make. Any change in applicable federal or state laws or regulations could have a substantial impact on us, our subsidiary banks and our operations. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could reduce the value of your investment.

The implementation of final rules under the many provisions of Dodd-Frank Act could adversely affect us.

       Regulation of the financial services industry is undergoing major changes from the enactment and ongoing implementation of Dodd-Frank. Certain provisions of Dodd-Frank are effective and have been fully implemented, including the revisions in the deposit insurance assessment base for FDIC insurance and the permanent increase in FDIC coverage to $250,000; the permissibility of paying interest on business checking accounts; the removal of remaining barriers to interstate branching and required disclosure and shareholder advisory votes on executive compensation. Other recent actions to implement the final Dodd-Frank provisions include (i) final new capital rules, (ii) a final rule to implement the "Volcker Rule" restrictions on certain proprietary trading and investment activities and (iii) the promulgation of final rules and increased enforcement action by the CFPB. The full implementation of certain final rules is delayed or phased in over several years; therefore, as yet we cannot definitively assess what may be the short or longer term specific or aggregate effect of the full implementation of Dodd-Frank on us.

Changes in regulation or oversight may have a material adverse impact on our operations.

       We are subject to extensive regulation, supervision and examination by the Indiana Department of Financial Institutions, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and other regulatory bodies. Such regulation and supervision governs the activities in which we may engage. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, investigations and limitations related to our securities, the classification of our assets and determination of the level of our allowance for loan losses. In light of the recent conditions in the U.S. financial markets and economy, Congress and regulators have increased their focus on the regulation of the financial services industry. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material adverse impact on our business, financial condition or results of operations.

Difficult conditions in the capital markets and the economy generally have affected and may continue to materially adversely affect our business and results of operations.

       From 2007 through 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U.S. was greatly reduced. Although economic conditions have improved, certain sectors, such as real estate, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and the lack of liquidity in the credit markets. The Company'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 the Company offers, is highly dependent upon the business environment in the markets where the Company 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


Table of Contents

cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters, or a combination of these or other factors.

       During 2013 and 2014, the business environment continued to be adverse for many households and businesses in the United States and worldwide. While economic conditions in the United States and worldwide have begun to improve, there can be no assurance that this improvement will continue. Such conditions have affected, and could continue to adversely affect, the credit quality of the Company's loans, results of operations and financial condition.

Changes in consumer use of banks and changes in consumer spending and savings habits could adversely affect our 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 our operations, and we may be unable to timely develop competitive new products and services in response to these changes that are accepted by new and existing customers.

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 MainSource, 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, 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.

Risks Related to the Company's Stock

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

       The Company has traditionally paid a quarterly dividend to common stockholders. The Company is a separate legal entity from the Bank and receives substantially all of its revenue and cash flow from dividends paid by the Bank to the Company. Indiana state law and agreements between the Bank and its federal and state regulators may limit the amount of dividends that the Bank may pay to the Company. In the event that the Bank is unable to pay dividends to the Company for an extended period of time, the Company may not be able to service its debt obligations or pay dividends on its common stock. Additionally, any payment of dividends in the future will depend, in large part, on the Bank's earnings, capital requirements, financial condition and other factors considered relevant by the Company's Board of Directors. Starting in the second quarter of 2009 and continuing to the second quarter of 2012, the Company reduced the amount of cash dividends paid. This reduction was made to preserve capital levels at the Company. Beginning in the third quarter of 2012, the Company has steadily raised the dividend, including an increase to $.12/share in the third quarter of 2014 and $.13/share in the first quarter of 2015.

The price of the Company'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 the Company's common stock. In addition, the following factors may cause the market price for shares of the Company's common stock to fluctuate:

    announcements of developments related to the Company's business;

    fluctuations in the Company's results of operations;

    sales or purchases of substantial amounts of the Company's securities in the marketplace;

    general conditions in the Company'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

    the Company's announcement of new acquisitions or other projects.


Table of Contents

The Company's charter documents and federal regulations may inhibit a takeover, or prevent a transaction that may favor or otherwise limit the Company's growth opportunities, which could cause the market price of the Company's common stock to decline.

       Certain provisions of the Company's charter documents and federal regulations could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of the Company. In addition, the Company must obtain approval from regulatory authorities before acquiring control of any other company.




       As of December 31, 2014, the Company leased an office building located in Greensburg, Indiana, from one of its subsidiaries for use as its corporate headquarters. The Company's subsidiaries own, or lease, all of the facilities from which they conduct business. All leases are comparable to other leases in the respective market areas and do not contain provisions materially detrimental to the Company or its subsidiaries. As of December 31, 2014 the Company had 80 banking locations. At December 31, 2014, the Company had approximately $60,527 invested in premises and equipment.


       The Company and its subsidiaries may be parties (both plaintiff and defendant) to ordinary litigation incidental to the conduct of business. Management is presently not aware of any material pending or contemplated legal proceedings.


       Not applicable.


Table of Contents



Market Information

       The Company's Common Stock is traded on the NASDAQ Stock Market under the symbol MSFG. The Common Stock was held by approximately 5,000 shareholders at March 13, 2015. The quarterly high and low closing prices for the Company's common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the tables below. All per share data is retroactively restated for all stock dividends and splits.

       The range of known per share prices by calendar quarter, based on actual transactions, excluding commissions, is shown below.

  Market Prices  


  $ 18.03   $ 17.89   $ 17.97   $ 20.92  


  $ 15.78   $ 16.12   $ 16.33   $ 16.76  












  $ 15.10   $ 14.12   $ 15.53   $ 18.05  


  $ 12.65   $ 12.02   $ 13.81   $ 14.05  
Cash Dividends

  $ 0.10   $ 0.10   $ 0.11   $ 0.11  











  $ 0.06   $ 0.06   $ 0.08   $ 0.08  

       It is expected that the Company will continue to consider the Company's results of operations, capital levels and other external factors beyond management's control in making the decision to maintain or further raise the dividend.

Issuer Purchases of Equity Securities

       The Company purchased the following equity securities of the Company during the quarter ended December 31, 2014:

  Total Number
of Shares (or
Units) Purchased

  Average Price Paid Per
Share (or Unit)

  Total Number of Shares
(or Units) Purchased as
Part of Publicly
Announced Plans or
Programs (1)

  Maximum Number (or
Approximate Dollar Value)
of Shares (or Units) That
May Yet Be Purchased
Under the Plans or Programs


October 1-31, 2014


November 1-30, 2014


December 1-31, 2014




On December 19, 2014, the Company announced that its Board of Directors has authorized a stock repurchase program effective January 1, 2015, pursuant to which up to 5.0% of the Corporation's outstanding shares of common stock, or approximately 1,085,000 shares, may be repurchased. The stock repurchase plan will expire December 31, 2015, unless completed sooner or otherwise extended.


Table of Contents

Stock Performance Graph

       The following performance graph compares the performance of our common shares to the performance of the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index for the 60 months ended December 31, 2014. The graph assumes an investment of $100 in each of the Company's common shares, the NASDAQ Market Index (U.S.) and the NASDAQ Bank Stocks Index on December 31, 2009.



MainSource Financial Group

    100.00     207.34     175.99     252.98     363.29     423.41  


    100.00     116.92     114.81     133.08     184.05     208.73  

NASDAQ Bank Stocks Index

    100.00     111.87     98.00     113.46     157.60     162.08  


Table of Contents


Selected Financial Data
(Dollar amounts in thousands except per share data)


Results of Operations


Net interest income

  $ 94,208   $ 91,300   $ 94,082   $ 99,848   $ 101,252  

Provision for loan losses

    1,500     4,534     9,850     17,800     35,250  

Noninterest income

    43,287     43,129     43,891     45,308     41,291  

Noninterest expense

    99,220     98,231     94,838     99,805     92,252  

Income before income tax

    36,775     31,664     33,285     27,551     15,041  

Income tax

    7,779     5,319     6,027     3,738     239  

Net income

    28,996     26,345     27,258     23,813     14,802  

Preferred dividends and accretion

        504     2,110     3,054     3,054  

Net income available to common shareholders

    28,996     25,693     26,505     20,759     11,748  

Dividends paid on common stock

    8,726     5,709     1,623     807     805  

Per Common Share*


Earnings per share (basic)

  $ 1.40   $ 1.26   $ 1.31   $ 1.03   $ 0.58  

Earnings per share (diluted)

    1.39     1.26     1.30     1.03     0.58  

Dividends paid

    0.42     0.28     0.08     0.04     0.04  

Book value — end of period

    16.63     14.96     15.21     13.87     12.24  

Tangible book value — end of period

    13.01     11.53     11.72     10.45     8.71  

Market price — end of period

    20.92     18.03     12.67     8.83     10.41  

At Year End


Total assets

  $ 3,122,516   $ 2,847,209   $ 2,769,288   $ 2,754,180   $ 2,769,312  


    867,760     891,106     902,341     876,090     806,071  

Loans, excluding held for sale

    1,957,765     1,671,926     1,553,383     1,534,379     1,680,971  

Allowance for loan losses

    23,250     27,609     32,227     39,889     42,605  

Total deposits

    2,468,321     2,200,628     2,185,054     2,159,900     2,211,564  

Federal Home Loan Bank advances

    214,413     247,858     141,052     151,427     152,065  

Subordinated debentures

    41,239     46,394     50,418     50,267     50,117  

Shareholders' equity

    360,662     305,526     323,751     336,553     302,570  

Financial Ratios


Return on average assets

    0.99 %   0.95 %   0.99 %   0.85 %   0.51 %

Return on average common shareholders' equity

    8.81     8.35     8.15     7.44     4.86  

Allowance for loan losses to total loans (year end, excluding held for sale)

    1.19     1.65     2.07     2.60     2.53  

Allowance for loan losses to total non-performing loans (year end)

    80.62     104.02     63.04     61.18     46.55  

Shareholders' equity to total assets (year end)

    11.55     10.73     11.69     12.22     10.93  

Average equity to average total assets

    11.27     11.32     12.12     11.46     10.59  

Dividend payout ratio

    30.09     22.22     6.12     3.89     6.85  

       The allowance for loan losses to total loans ratio at December 31, 2014 includes The Merchant's Bank and Trust Company loans brought over at fair value with no associated allowance (See NOTE 26).

Adjusted for stock split and dividends


Table of Contents


Management's Discussion and Analysis
(Dollar amounts in thousands except per share data)


       MainSource Financial Group, Inc. ("MainSource" or the "Company") is a financial holding company whose principal activity is the ownership and management of its wholly owned subsidiary bank: MainSource Bank headquartered in Greensburg, Indiana (the "Bank"). The Bank operates under an Indiana state charter and is subject to regulation by the Indiana Department of Financial Institutions and the Federal Deposit Insurance Corporation. Non-banking subsidiaries include MainSource Insurance, LLC, Insurance Services Marketing, LLC, MainSource Title, LLC, MainSource Risk Management, Inc., and New American Real Estate, LLC. The first three subsidiaries are subject to regulation by the Indiana Department of Insurance.

Business Strategy

       The Company operates under the broad tenets of a long-term strategic plan ("Plan") designed to improve the Company's financial performance, expand its competitive position and enhance long-term shareholder value. The Plan is premised on the belief of the Company's Board of Directors that it can best promote long-term shareholder interests by pursuing strategies which will continue to preserve its community-focused philosophy. The dynamics of the Plan assure continually evolving goals, with the enhancement of shareholder value being the constant, overriding objective. The extent of the Company's success will depend upon how well it anticipates and responds to competitive changes within its markets, the interest rate environment and other external forces.

Results of Operations

       Net income attributable to common shareholders was $28,996 in 2014, $25,693 in 2013, and $26,505 in 2012. Earnings per common share on a fully diluted basis were $1.39 in 2014, $1.26 in 2013, and $1.30 in 2012. The primary drivers that led to the increase in net income in 2014 versus 2013 were an increase in net interest income of $2,908, a smaller provision for loan losses of $3,034, an increase in service charge income of $271, an increase in interchange income of $534, reduced losses on OREO sales of $386, a reduction in marketing expenses of $473, a reduction in collection expenses of $1,970 and a prepayment penalty of $2,239 on a FHLB advance that was incurred in 2013. An increase in earning assets (primarily loans) and a continued reduction in interest costs resulted in higher net interest income. Improvements in collection efforts led to a reduction in problem credits which resulted in lower loan loss provision expense needed, a reduction in collection expenses, and lower losses on the sale of OREO properties. Continued emphasis on new deposit generation led to increased service charge and interchange income. The reduction in marketing costs was due to fewer initiatives undertaken in 2014. Offsetting these increases were lower securities gains in 2014 of $811, higher salary and employee benefit costs of $1,967, higher occupancy costs of $489, higher equipment expenses of $406, higher interchange expenses of $369, and conversion costs incurred in 2014 as a result of the acquisition of MBT Bancorp of $3,119. The higher salary and employee benefit costs, occupancy expenses, and equipment expenses were related to the Company's entry into new markets in 2014. The increase in interchange expenses is a direct result of higher interchange income in 2014.

       The primary drivers that led to the small decrease in net income in 2013 versus 2012 were decreases in mortgage banking income of $3,128, a decrease in net interest income of $2,782, decreases in securities gains of $1,032, increases in salary and employee benefits of $3,175, an increase in equipment costs of $1,367, and an increase in a prepayment penalty of $926 on an FHLB advance. An increase in rates led to a decrease in mortgage refinancing activity. The reduction in the Company's yield on earnings assets was not completely offset by the reduction in the Company's cost of funds. As a result of favorable pricing in 2012 versus 2013, the Company had fewer securities gains taken in 2013. The increase in employee and benefit costs was a result of the new markets the Company entered in the second half of 2012 and 2013. The increase in equipment costs is a result of several technology initiatives which enhance the customer experience with the Company. Finally, the Company paid off a FHLB advance early and incurred a prepayment penalty which was slightly higher than the penalty incurred in 2012. Offsetting these decreases were lower loan loss provision expense of $5,316, higher trust and investment product fees of $1,106, a reduction of OREO losses of $820, a reduction in FDIC assessment of $784, and a reduction in marketing expenses of $737. Credit losses continued to decline and new impaired loans decreased in 2013. An increase in financial advisors as a result of 2012 acquisitions resulted in higher trust and investment product fees. OREO losses continued to decline as a result of a reduced amount of OREO property. FDIC premiums were reduced as a result of the use of a smaller multiplier to calculate the Company's premiums. Finally, a reduction in marketing expenses was a result of fewer branches in new markets in 2013 versus 2012 which required additional marketing dollars.


Table of Contents

Net Interest Income

       Net interest income and net interest margin are influenced by the volume and yield or cost of earning assets and interest-bearing liabilities. Tax equivalent net interest income of $100,944 in 2014 increased from $98,310 in 2013. Net interest margin, on a fully-taxable equivalent basis, was 3.81% for 2014 compared to 3.91% for the same period a year ago. The Company was unable to match reductions in its yield on earning assets with a corresponding reduction in its cost of funds, as the cost of funds has floored. The Company experienced loan growth in 2014 which partially offset the reduction in its yield. The Company was also able to continue to lower the interest paid on deposit accounts. The Federal Reserve Bank continues to target the fed funds rate at 0%-.25%.

       The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years.

Average Balance Sheet and Net Interest Analysis (Taxable Equivalent Basis)*










Short-term investments

  $ 19,389   $ 51     0.26 % $ 12,413   $ 35     0.28 % $ 48,712   $ 134     0.28 %

Federal funds sold and money market accounts

    14,582     46     0.32     11,298     29     0.26     10,811     30     0.28  




    558,848     12,366     2.21     576,959     11,873     2.06     567,437     12,510     2.20  


    308,953     18,249     5.91     314,120     18,841     6.00     302,040     18,707     6.19  

Total securities

    867,801     30,615     3.53     891,079     30,714     3.45     869,477     31,217     3.59  




    1,035,645     47,820     4.62     909,099     46,242     5.09     889,313     50,523     5.68  

Residential real estate

    415,390     17,852     4.30     411,054     18,188     4.42     393,844     19,969     5.07  


    299,940     13,167     4.39     277,544     13,081     4.71     270,459     13,867     5.13  

Total loans

    1,750,975     78,839     4.50     1,597,697     77,511     4.85     1,553,616     84,359     5.43  

Total earning assets

    2,652,747     109,551     4.13     2,512,487     108,289     4.31     2,482,616     115,740     4.66  

Cash and due from banks

    43,143                 42,522                 43,107              

Unrealized gains (losses) on securities

    16,271                 21,489                 41,035              

Allowance for loan losses

    (25,816 )               (29,563 )               (37,626 )            

Premises and equipment, net

    56,103                 55,988                 50,710              

Intangible assets

    70,914                 70,296                 68,704              

Accrued interest receivable and other assets

    109,267                 113,431                 112,177              

Total assets

  $ 2,922,629               $ 2,786,650               $ 2,760,723              



Interest-bearing deposits DDA, savings, and money market accounts

  $ 1,489,938   $ 1,647     0.11   $ 1,375,556   $ 1,448     0.11   $ 1,321,901   $ 2,138     0.16  

Certificates of deposit

    341,343     2,031     0.60     415,176     3,479     0.84     494,142     5,499     1.11  

Total interest-bearing deposits

    1,831,281     3,678     0.20     1,790,732     4,927     0.28     1,816,043     7,637     0.42  

Short-term borrowings

    30,320     71     0.23     33,238     70     0.21     30,514     104     0.34  

Subordinated debentures

    41,042     1,286     3.13     49,000     1,675     3.42     49,000     1,825     3.72  

Notes payable and FHLB borrowings

    200,598     3,572     1.78     155,834     3,307     2.12     148,466     5,120     3.45  

Total interest-bearing liabilities

    2,103,241     8,607     0.41     2,028,804     9,979     0.49     2,044,023     14,686     0.72  

Demand deposits

    463,197                 414,084                 348,858              

Other liabilities

    26,951                 28,263                 33,354              

Total liabilities

    2,593,389                 2,471,151                 2,426,235              

Shareholders' equity

    329,240                 315,499                 334,488              

Total liabilities and shareholders' equity

  $ 2,922,629     8,607     0.32   $ 2,786,650     9,979     0.40 *** $ 2,760,723     14,686     0.59 ***

Net interest income

        $ 100,944     3.81 ****       $ 98,310     3.91 ****       $ 101,054     4.07 ****

Conversion of tax exempt income to a fully taxable equivalent basis using a marginal rate of 35%

        $ 6,736         $ 7,010                     $ 6,972        

       Security yields are calculated based on amortized cost.

Adjusted to reflect income related to securities and loans exempt from Federal income taxes.

Nonaccruing loans have been included in the average balances.

Total interest expense divided by total earning assets.

Net interest income divided by total earning assets.


Table of Contents

       The following table sets forth for the periods indicated a summary of the changes in interest income and interest expense resulting from changes in volume and changes in rates.

Volume/Rate Analysis of Changes in Net Interest Income
(Tax Equivalent Basis)

  2014 OVER 2013   2013 OVER 2012  

Interest income



  $ 7,131   $ (5,803 ) $ 1,328   $ 2,340   $ (9,188 ) $ (6,848 )


    (812 )   713     (99 )   764     (1,267 )   (503 )

Federal funds sold and money market funds

    10     7     17     1     (2 )   (1 )

Short-term investments

    18     (2 )   16     (102 )   3     (99 )

Total interest income

    6,347     (5,085 )   1,262     3,003     (10,454 )   (7,451 )

Interest expense


Interest-bearing DDA, savings, and money market accounts

  $ 124   $ 75   $ 199   $ 84   $ (774 ) $ (690 )

Certificates of deposit

    (550 )   (898 )   (1,448 )   (794 )   (1,226 )   (2,020 )


    690     (424 )   266     314     (2,161 )   (1,847 )

Subordinated debentures

    (257 )   (132 )   (389 )       (150 )   (150 )

Total interest expense

    7     (1,379 )   (1,372 )   (396 )   (4,311 )   (4,707 )

Change in net interest income

    6,340     (3,706 )   2,634     3,399     (6,143 )   (2,744 )

Change in tax equivalent adjustment

                (274 )               38  

Change in net interest income before tax equivalent adjustment

              $ 2,908               $ (2,782 )

       Variances not attributed to rate or volume are allocated between rate and volume in proportion to the relationship of the absolute dollar amount of the change in each.

Provision for Loan Losses

       The Company expensed $1,500, $4,534, and $9,850 in provision for loan losses in 2014, 2013, and 2012 respectively. This level of provision allowed the Company to maintain an adequate allowance for loan losses. This topic is discussed in detail under the heading "Loans, Credit Risk and the Allowance and Provision for Loan Losses".


Table of Contents

Non-interest Income and Expense

  Percent Change  

Non-interest income


Mortgage banking

  $ 6,754   $ 6,799   $ 9,927     –0.7%     –31.5%  

Trust and investment product fees

    4,712     4,756     3,650     –0.9%     30.3%  

Service charges on deposit accounts

    20,698     20,427     19,815     1.3%     3.1%  

Net realized gains on securities sales

    24     835     1,367     –97.1%     –38.9%  

Increase in cash surrender value of life insurance              

    1,298     1,378     1,206     –5.8%     14.3%  

Interchange income

    7,590     7,056     6,540     7.6%     7.9%  

Gain/(loss) on sale of OREO

    (153 )   (539 )   (1,359 )   71.6%     60.3%  


    2,364     2,417     2,745     –2.2%     –11.9%  

Total non-interest income

  $ 43,287   $ 43,129   $ 43,891     0.4%     –1.7%  

Non-interest expense


Salaries and employee benefits

  $ 54,132   $ 52,165   $ 48,990     3.8%     6.5%  

Net occupancy

    7,628     7,139     6,769     6.8%     5.5%  


    10,337     9,931     8,564     4.1%     16.0%  

Intangibles amortization

    1,690     1,868     1,835     –9.5%     1.8%  


    1,747     1,796     1,729     –2.7%     3.9%  

Stationery, printing, and supplies

    1,174     1,190     1,337     –1.3%     –11.0%  

FDIC assessment

    1,620     1,711     2,495     –5.3%     –31.4%  


    3,187     3,660     4,397     –12.9%     –16.8%  

Collection expenses

    1,330     3,300     3,768     –59.7%     –12.4%  

Consultant expense

    1,400     1,582     1,150     –11.5%     37.6%  

Prepayment penalty on FHLB advance

        2,239     1,313     –100%     70.5%  

Interchange expense

    2,287     1,918     1,591     19.2%     20.6%  

Bank acquisition expense

    3,119             NA     NA  


    9,569     9,732     10,900     –1.7%     –10.7%  

Total non-interest expense

  $ 99,220   $ 98,231   $ 94,838     1.0%     3.6%  

Non-interest Income

       Non-interest income was $43,287 for 2013 compared to $43,129 for the same period in 2013, an increase of $158 or 0.4%. Increases in service charges, interchange income, and lower OREO sales losses were offset by lower securities gains. Increases in new account openings generated additional service charges and interchange income. Improvement in problem credits resulted in fewer OREO properties and resulting sales.

       Non-interest income was $43,129 for 2013 compared to $43,891 for the same period in 2012, a decrease of $762 or 1.7%. Decreases in mortgage banking income, securities gains, and other income (primarily title insurance revenue) were the primary causes of the decrease. These decreases were offset by increases in service charges on deposit accounts, interchange income, trust and investment product fees, lower losses on the sale of OREO, and an increase in the cash surrender value of life insurance. An increase in interest rates in 2013 led to decreased mortgage activity and title revenue. As a result of favorable pricing, the Company recorded gains during 2012 on the sale of securities at a higher level than 2013. Continued emphasis on new account growth generated additional service charge and interchange income. The Company acquired two brokerage firms in late 2012 which resulted in higher trust and investment product fees in 2013. OREO losses declined as a result of a reduced number of OREO properties.

Non-interest Expense

       Total non-interest expense was $99,220 in 2014 compared to $98,231 in 2013, an increase of $989 or 1.0%. The increase was primarily attributable to increases in salaries and employee benefits, occupancy and equipment costs, interchange expenses and conversion expenses related to the MBT Bancorp acquisition in the fourth quarter of 2014. The Company's entry into new markets, including the MBT Bancorp markets, resulted in increases of the above mentioned expenses with the exception of interchange expenses which increased as a result of higher interchange income. Offsetting these increases were a reduction in marketing and collection expenses as well as a prepayment penalty on a FHLB advance in 2013. Fewer large marketing initiatives in 2014 led to lower spending. Improvement in problem credits resulted in lower collection expenses.


Table of Contents

       Total non-interest expense was $98,231 in 2013 compared to $94,838 in 2012, an increase of $3,393 or 3.6%. The increase was primarily attributable to increases in salaries and employee benefits, occupancy and equipment costs, a prepayment penalty on a FHLB advance, consultant expenses, and interchange expense. Salaries and employee benefit and occupancy costs increased as a result of the full year effect of de novo branches in 2012 and the opening of several more offices in 2013. The increase in equipment costs is a result of several technology initiatives which enhance the customer experience. The Company paid off a FHLB advance early and incurred a prepayment penalty of $2,239. However, the payoff of this advance lowered interest expense costs by approximately $675 on an annual basis. Consultant expenses increased due to several revenue enhancement initiatives suggested by the consultants. The increase in interchange expenses is a direct correlation with the increase in interchange income. Offsetting these increases were decreases in FDIC expenses, marketing expense, collection expense, and other expense. FDIC premiums were reduced as a result of the use of a lower multiplier for calculation of the Company's premiums. Marketing expenses decreased as the Company did not enter any markets in 2013 that required a large outlay of marketing dollars. Collection expenses decreased due to the continued reduction in new problem loans. The reduction in other expense is primarily attributable to professional/legal expenses connected with the Company's participation in the U.S. Department of the Treasury secondary public offering of the Company's preferred stock in 2012.

Income Taxes

       The effective tax rate was 21.2% in 2014, 16.8% in 2013, and 18.1% in 2012. The increase in the Company's effective rate from 2013 to 2014 was due primarily from an increase in taxable income with the tax exempt income and tax credits remaining the same from year to year. The decrease in the Company's effective rate from 2012 to 2013 was due primarily from a decrease in taxable income with the tax exempt income and tax credits remaining the same from year to year.

Balance Sheet

       At December 31, 2014, total assets were $3,122,516 compared to $2,847,209 at December 31, 2013, an increase of $275 million. Increases in loans ($286 million) were offset by a decrease in investment securities ($23 million).

Loans, Credit Risk and the Allowance and Provision for Loan Losses

       Loans remain the Company's largest concentration of assets and continue to represent the greatest potential risk. The loan underwriting standards observed by the Bank are viewed by management as a means of controlling problem loans and the resulting charge-offs. The Company also believes credit risks may be elevated if undue concentrations of loans in specific industry segments and to out-of-area borrowers are incurred. Accordingly, the Company's Board of Directors regularly monitors such concentrations to determine compliance with its loan concentration policy. The Company believes it has no undue concentrations of loans.

       Total loans (excluding those held for sale) increased by $285,839 in 2014. $184,048 of the increase came from the acquisition of MBT Bancorp in the fourth quarter of 2014. Almost all categories of loans experienced loan growth in 2014. The Company has also invested in additional lending personnel and opened branches in new markets which has contributed to the growth. Commercial real estate loans continue to represent the largest portion of the total loan portfolio and were 38% of total loans at December 31, 2014 compared to 39% of total loans at the end of 2013.

       The following table details the Company's loan portfolio by type of loan.

Loan Portfolio


Types of loans


Commercial and industrial

  $ 275,646   $ 180,378   $ 134,156   $ 114,367   $ 138,291  

Agricultural production financing

    46,784     30,323     22,355     20,741     27,178  

Farm real estate

    76,849     76,082     66,119     46,308     48,307  

Commercial real estate mortgage

    741,379     655,196     638,726     687,110     741,608  

Construction and development

    61,640     35,731     25,208     30,746     59,319  

Residential real estate mortgage

    709,495     648,010     618,524     577,912     594,594  


    45,972     46,206     48,295     57,195     71,674  

Total loans

  $ 1,957,765   $ 1,671,926   $ 1,553,383   $ 1,534,379   $ 1,680,971  

       The following table indicates the amounts of loans (excluding residential and commercial mortgages and consumer loans) outstanding as of December 31, 2014 which, based on remaining scheduled repayments of principal, are due in the periods indicated.


Table of Contents

Maturities and Sensitivity to Changes in Interest Rates of Commercial and Construction Loans

1 Year

  1-5 Years
5 years


Loan Type


Commercial and industrial

      $ 73,631   $ 121,387   $ 80,628   $ 275,646  

Agricultural production financing

        34,399     10,076     2,309     46,784  

Construction and development

        6,501     20,104     35,035     61,640  


      $ 114,531   $ 151,567   $ 117,972   $ 384,070  


        30%     39%     31%     100%  

Rate Sensitivity


Fixed Rate

      $ 9,838   $ 121,282   $ 51,665   $ 182,785  

Variable Rate

        144,984     51,607     4,694     201,285  


      $ 154,822   $ 172,889   $ 56,359   $ 384,070  

       Loans are placed on "non-accrual" status when, in management's judgment, the collateral value and/or the borrower's financial condition does not justify accruing interest. As a general rule, commercial, commercial real estate, residential, and consumer loans are reclassified to non-accrual status at or before becoming 90 days past due. Interest previously recorded is reversed and charged against current income. Subsequent interest payments collected on non-accrual loans are thereafter applied as a reduction of the loan's principal balance. Non-performing loans were $28,839 as of December 31, 2014 compared to $26,543 as of December 31, 2013 and represented 1.47% of total loans at December 31, 2014 versus 1.59% one year ago. The slight increase in 2014 is the result of two large credits going to TDR status in 2014 offset by a decrease in other non-accruing loans as a result of the Company's continued emphasis on reducing the amount of non-performing loans.

       The following table details the Company's non-performing loans as of December 31 for the years indicated.

Non-performing Loans


Non-accruing loans

  $ 13,596   $ 22,341   $ 35,451   $ 41,528   $ 68,236  

Troubled debt restructurings (accruing)

    15,243     4,188     15,102     20,402     22,250  

Accruing loans contractually past due 90 days or more

        14     565     3,266     990  


  $ 28,839   $ 26,543   $ 51,118   $ 65,196   $ 91,476  

% of total loans

    1.47%     1.59%     3.29%     4.25%     5.44%  

       A reconciliation of non-performing assets ("NPA") for 2014 and 2013 is as follows:


Beginning Balance — NPA — January 1

  $ 30,663   $ 57,795  



Add: New non-accruals

    12,547     15,538  

Less: To accrual/payoff/restructured

    (13,208 )   (15,491 )

Less: To OREO

    (2,585 )   (4,005 )

Less: Charge offs

    (5,499 )   (9,152 )

Increase/(Decrease): Non-accrual loans

    (8,745 )   (13,110 )

Other Real Estate Owned (OREO)


Add: New OREO properties

    2,585     4,005  

Less: OREO sold

    (3,597 )   (5,708 )

Less: OREO losses (write-downs)

    (420 )   (854 )

Increase/(Decrease): OREO

    (1,432 )   (2,557 )

Increase/(Decrease): 90 Days Delinquent

    (14 )   (551 )

Increase/(Decrease): TDR's

    11,055     (10,914 )

Total NPA change

    864     (27,132 )

Ending Balance — NPA — December 31

  $ 31,527   $ 30,663  


Table of Contents

       At December 31, 2014, the Company had only five non-accrual loans over $250 and none over $1,000. All of the Company's non-accrual loans are real estate backed loans. The Company is working with these borrowers in an attempt to minimize its losses. In the course of resolving problem loans, the Company may choose to restructure the contractual terms of certain loans. The Company attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure actions. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring has occurred, which is when for economic or legal reasons related to a borrower's financial difficulties, the Company 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 and could include reduction of the stated interest rate, other than normal market rate adjustments, extension of maturity dates, or reduction of principal balance or accrued interest. The decision to restructure a loan, versus aggressively enforcing the collection of the loan, may benefit us by increasing the ultimate probability of collection. The Company reviews each relationship before it grants the concession to insure the creditor can comply with the new terms. To date, most of the concessions have been extensions of maturity dates. The provision for loan losses was $1,500 in 2014, $4,534 in 2013, and $9,850 in 2012. The Company's provision for loan losses continued to decline in 2014 due to the stabilization of problem credits. New non-accrual loans declined almost 20% in 2014. Net charge-offs were $5,859 in 2014 compared to $9,152 in 2013 and $17,512 in 2012. As a percentage of average loans, net charge-offs equaled 0.33%, 0.57%, and 1.13% in 2014, 2013, and 2012, respectively.

       Potential problem loans are identified on the Company's watch list and consist of loans that require close monitoring by management and are not necessarily considered classified credits by regulators. Credits may be considered as a potential problem loan for reasons that are temporary or correctable, such as for a deficiency in loan documentation or absence of current financial statements of the borrower. Potential problem loans may also include credits where adverse circumstances are identified that may affect the borrower's ability to comply with the contractual terms of the loan. Other factors which might indicate the existence of a potential problem loan include the delinquency of a scheduled loan payment, deterioration in a borrower's financial condition identified in a review of periodic financial statements, a decrease in the value of the collateral securing the loan, or a change in the economic environment in which the borrower operates. Substandard commercial loans that were not classified as non-accrual were $22,927 at December 31, 2014 and $27,277 at December 31, 2013, a decrease of $4,351. These loans which are $250 or greater are reviewed at least quarterly by senior management. This review includes monitoring how the borrower is performing versus their workout plan, obtaining and reviewing the borrower's financial information, and monitoring collateral values. Management believes these loans were well secured and had adequate allowance allocations at December 31, 2014.

Summary of the Allowance for Loan Losses


Balance at January 1

  $ 27,609   $ 32,227   $ 39,889   $ 42,605   $ 46,648  




    241     1,152     1,946     2,211     8,190  

Commercial real estate mortgage

    5,583     6,353     13,553     16,954     29,177  

Residential real estate mortgage

    2,295     2,349     3,547     3,093     2,220  


    2,899     2,648     3,286     2,636     2,859  

Total Chargeoffs

    11,018     12,502     22,332     24,894     42,446  




    1,131     341     543     1,172     518  

Commercial real estate mortgage

    2,262     1,087     2,432     1,371     873  

Residential real estate mortgage

    410     650     265     648     524  


    1,356     1,272     1,580     1,187     1,238  

Total Recoveries

    5,159     3,350     4,820     4,378     3,153  

Net Chargeoffs

    5,859     9,152     17,512     20,516     39,293  

Provision for loan losses

    1,500     4,534     9,850     17,800     35,250  

Balance at December 31

  $ 23,250   $ 27,609   $ 32,227   $ 39,889   $ 42,605  

Net Chargeoffs to average loans

    0.31%     0.57%     1.13%     1.27%     2.21%  

Provision for loan losses to average loans

    0.09%     0.28%     0.63%     1.10%     1.98%  

Allowance to total loans at year end

    1.19%     1.65%     2.07%     2.60%     2.53%  

       Although the allowance for loan losses is available for any loan that, in management's judgment, should be charged off, 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.


Table of Contents

Allocation of the Allowance for Loan Losses

  2014   2013   2012   2011   2010  
December 31
of loans
to total

of loans
to total

of loans
to total

of loans
to total

of loans
to total


Real estate



  $ 3,501     36%   $ 3,409     39%   $ 3,180     40%   $ 2,972     38%   $ 2,281     45%  

Farm real estate

    576     4     194     5     722     4     456     3     740     2  


    13,536     38     17,679     39     20,465     41     24,187     45     20,034     31  

Construction and development

    1,493     3     2,337     2     2,970     2     5,833     2     11,879     5  

Total real estate

    19,106     81     23,619     85     27,337     87     33,448     88     34,934     83  




    192     3     64     2     166     2     151     1     370     2  

Other commercial

    2,785     14     3,227     10     3,728     8     5,411     7     6,016     10  

Total Commercial

    2,977     17     3,291     12     3,894     10     5,562     8     6,386     12  


    1,167     2     699     3     996     3     879     4     1,285     5  


  $ 23,250     100%   $ 27,609     100%   $ 32,227     100%   $ 39,889     100%   $ 42,605     100%  

       Management maintains a list of loans warranting either the assignment of a specific reserve amount or other special administrative attention. This watch list, together with a listing of all classified loans, non-accrual loans and delinquent loans, is reviewed monthly by management. Additionally, the Company evaluates its consumer and residential real estate loan pools for probable losses incurred based on historical trends, adjusted by current delinquency and non-performing loan levels.

       The Company has both internal and external loan review personnel who annually review approximately 50% of all loans. External loan review personnel examine the top 75 commercial credit relationships. This equates to all relationships above approximately $3,675.

       The ability to absorb loan losses promptly when problems are identified is invaluable to a banking organization. Most often, losses incurred as a result of prompt, aggressive collection actions are much lower than losses incurred after prolonged legal proceedings. Accordingly, the Company observes the practice of quickly initiating stringent collection efforts in the early stages of loan delinquency.

       The adequacy of the allowance for loan losses is reviewed at least quarterly. The determination of the provision amount in any period is based upon management's continuing review and evaluation of loan loss experience, changes in the composition of the loan portfolio, classified loans including non-accrual and impaired loans, current economic conditions, the amount of loans presently outstanding, and the amount and composition of loan growth. The Company's allowance for loan losses was $23,250, or 1.19% of total loans, at December 31, 2014 compared to $27,609, or 1.65% of total loans, at the end of 2013. This $4,359 decrease in the allowance was due in large part to continued monitoring of problem loans as well as a write off of two non-performing loans of $3,812 during 2014. Approximately 75% of this write off was provided for in 2013. The Company's significant decrease in the allowance percentage to total loans was due primarily to the acquisition of The Merchant's Bank and Trust Company loans during 2014. These loans were brought over at fair value with no allowance for loan losses (See NOTE 26).

Securities, at Fair Value

  December 31,  

Available for Sale


U.S. Government-sponsored entities

  $ 661   $ 798   $ 1,638  

State and municipal

    334,298     331,112     337,939  


    525,609     550,738     554,278  

Equity and other

    7,192     8,458     8,486  

Total securities

  $ 867,760   $ 891,106   $ 902,341  


Table of Contents

       Securities offer flexibility in the Company's management of interest rate risk, and are the primary means by which the Company provides liquidity and responds to changing maturity characteristics of assets and liabilities. The Company's investment policy prohibits trading activities and does not allow investment in high-risk derivative products or junk bonds.

       As of December 31, 2014, all of the Company's securities were classified as available for sale ("AFS") and were carried at fair value with unrealized gains and losses, net of taxes, excluded from earnings and reported as a separate component of shareholders' equity. A net unrealized gain of $20,778 was recorded to adjust the AFS portfolio to current market value at December 31, 2014 compared to a net unrealized gain of $1,746 at December 31, 2013.

(Carrying Values at December 31)

1 Year

  2-5 Yrs
  6-10 Yrs
10 Years

  Total 2014

Available for sale


US government agency

  $   $   $ 661   $   $ 661  

State and municipal

    13,935     54,734     143,964     121,665     334,298  

Mortgage-backed securities

        8,549     28,304     488,756     525,609  

Other securities

    1,503     1,000             2,503  

Total available for sale

  $ 15,438   $ 64,283   $ 172,929   $ 610,421   $ 863,071  

Weighted average yield*

    5.38%     4.98%     5.11%     2.88%     3.53%  

Adjusted to reflect income related to securities exempt from federal income taxes.

       Amounts in the table above are based on scheduled maturity dates. Variable interest rates are subject to change not less than annually based upon certain interest rate indexes. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Equity securities of $4,689 do not have contractual maturities and are excluded from the table above.

       As of December 31, 2014, there were no corporate bonds and other securities which represented more than 10% of shareholders' equity.

       For 2014 the tax equivalent yield of the investment securities portfolio was 3.53%, compared to 3.45% and 3.59% for 2013 and 2012, respectively. The average life of the Company's investment securities portfolio was 4.88 years at December 31, 2014. During 2014 the investment portfolio decreased slightly in size as the Company's excess cash was invested in loans as loan demand increased significantly. The reinvestments were focused on a balanced approach between a likely long term low interest rate horizon and protection against cash flow extensions when rates do move higher. This investment strategy will allow the portfolio to meet cash needs for future loan growth.

       The Company and its investment advisor monitor the securities portfolio on at least a quarterly basis for other-than-temporary impairment ("OTTI"). The amount of the OTTI recognized in earnings depends on whether the Company intends to sell the security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment's amortized cost basis and its fair value at the balance sheet date. If an entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis less any current-period loss, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable taxes. In 2014, the Company had a recovery of a $500 impairment loss on one of its equity securities.

       In December, 2013, banking regulators published the final rules under Section 619 of the Dodd-Frank Act (commonly referred to as the "Volcker Rule"). Under the Volcker Rule, collateralized debt obligations, including pooled trust preferred securities, are no longer a permissible investment and would have to be divested prior to July 15, 2015. On January 14, 2014, banking regulators released their interim final rule regarding the Volcker Rule and its impact on collateralized debt obligations. Under the interim final rule, regulators clarified the final rule and said that collateralized debt obligations primarily backed by trust preferred securities issued by depository institutions could continue to be held by banks. The Company was informed from an outside third party that it may be holding one security that would need to be divested by the conformance date. The conformance date for the Volcker Rule has been extended to July 21, 2016, and federal banking regulators have indicated an intention to further extend the implementation date to July 21, 2017.


Table of Contents

Sources of Funds

       The Company relies primarily on customer deposits and securities sold under agreement to repurchase ("repurchase agreements") along with shareholders' equity to fund earning assets. Federal Home Loan Bank ("FHLB") advances are used to provide additional funding. The Company also attempts to obtain deposits through branch and whole bank acquisitions.

       Deposits generated within local markets provide the major source of funding for earning assets. Average total deposits were 86.5% and 87.8% of total average earning assets for 2014 and 2013, respectively. Total interest-bearing deposits averaged 79.8% and 81.2% of average total deposits during 2014 and 2013. Management strives to increase the percentage of transaction-related deposits to total deposits due to the positive effect on earnings.

       Repurchase agreements are high denomination investments utilized by public entities and commercial customers as an element of their cash management responsibilities. During 2014, repurchase agreements averaged $25,006, with an average cost of 0.18%.

       Another source of funding is the Federal Home Loan Bank (FHLB). The Company had FHLB advances of $214,413 outstanding at December 31, 2014. These advances have interest rates ranging from 0.4% to 4.8% (see Note 12 to the consolidated financial statements for the maturity schedule of these advances). The Company averaged $198,447 in FHLB advances during 2014 compared to $153,672 during 2013. This increase in the average balance of FHLB borrowings was primarily due to the increased loans generated by the Company in 2014 which created the need for other funding sources. One final source of funding is federal funds purchased. The Company had $8,000 of federal funds purchased as of December 31, 2014 and $9,200 at December 31, 2013.

Average Deposits



  $ 463,197         $ 414,084         $ 348,858        

Interest Bearing Demand

    959,186     0.12 %   879,921     0.12 %   866,493     0.17 %

Savings/Money Markets

    530,752     0.09     495,635     0.09     455,408     0.14  

Certificates of Deposit

    341,343     0.60     415,176     0.84     494,142     1.11  


  $ 2,294,478     0.16 % $ 2,204,816     0.22 % $ 2,164,901     0.35 %

       As of December 31, 2014, certificates of deposit and other time deposits of $100 or more mature as follows:

  3 months or less
  4-6 months
  6-12 months
  over 12 months


  $ 31,743   $ 28,682   $ 17,585   $ 40,511   $ 118,521  


    27%     24%     15%     34%        

Capital Resources

       The Federal Reserve Board and other regulatory agencies have adopted risk-based capital guidelines that assign risk weightings to assets and off-balance sheet items. The Company's core capital ("Tier 1") consists of common shareholders' equity adjusted for unrealized gains or losses on available for sale (AFS) securities plus limited amounts of Trust Preferred Securities less goodwill and intangible assets. Total capital consists of core capital, certain debt instruments and a portion of the allowance for loan losses. At December 31, 2014, Tier 1 capital to average assets was 10.2%. Total capital to risk-weighted assets was 16.0%. Both ratios exceed all required ratios established for bank holding companies. Risk-adjusted capital levels of the Bank also exceed regulatory definitions of well-capitalized institutions.

       The Trust Preferred Securities (which are classified as subordinated debentures) currently qualify as Tier 1 capital or core capital with respect to the Company under the risk-based capital guidelines established by the Federal Reserve. Under such guidelines, capital received from the proceeds of the sale of these securities cannot constitute more than 25% of the total Tier 1 capital of the Company. Consequently, the amount of Trust Preferred Securities in excess of the 25% limitation constitutes Tier 2 capital, or supplementary capital, of the Company. As of December 31, 2014, all of the Company's Trust Preferred Securities qualify as Tier 1 capital. The Company redeemed $5,155 of these securities in March, 2014 and $4,124 of these securities in December, 2013.

       Common shareholders' equity is impacted by the Company's decision to categorize its securities portfolio as available for sale (AFS). Securities in this category are carried at fair value, and common shareholders' equity is adjusted to reflect unrealized gains and losses, net of taxes.

       The Company declared and paid common dividends of $.42 per share in 2014 compared to $.28 in 2013 and $.08 2012. Book value per common share increased to $16.63 at December 31, 2014 compared to $14.96 at the end of 2013. The increase is primarily


Table of Contents

the result of the net income for the year, the acquisition of MBT Bancorp in 2014, and the increase in the AFS equity adjustment. The net adjustment for AFS securities increased book value per share by $0.63 at December 31, 2014 and increased book value per share by $0.06 at December 31, 2013. Depending on market conditions, the adjustment for AFS securities can cause significant fluctuations in shareholders' equity.

       On January 16, 2009, the Company entered into an agreement with the United States Department of Treasury (the "Treasury Department") as part of the Treasury Department's Capital Purchase Program. Under this agreement, the Company issued to the Treasury Department 57,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A ("preferred stock") and a warrant to purchase up to 571,906 shares ("warrant shares") of the Company's common stock. Like stock options, the warrant issued through the Capital Purchase Program is potentially dilutive. The average stock price for the Company for 2014 and 2013 was $17.27 and $14.58 per share respectively, and the warrant issued in 2009 has an exercise price of $14.95 per share. This resulted in 76,828 dilutive shares in 2014 and no additional potentially dilutive shares during 2013.

       On March 28, 2012, the U.S. Department of the Treasury priced its secondary public offering of 57,000 shares of the Company's Preferred Stock. The Company successfully bid for the purchase of 21,030 shares of the Preferred Stock. During the remainder of 2013, the Company purchased the remaining shares of the preferred stock. See Note 2 in the Consolidated Financial Statements for more information related to the sale and subsequent repurchase of the Preferred Stock.


       Liquidity management involves maintaining sufficient cash levels to fund operations and to meet the requirements of borrowers, depositors and creditors. Higher levels of liquidity bear higher corresponding costs, measured in terms of lower yields on short-term, more liquid earning assets and higher interest expense involved in extending liability maturities. Liquid assets include cash and cash equivalents, loans and securities maturing within one year and money market instruments. In addition, the Company holds approximately $852,322 of AFS securities maturing after one year, which can be sold to meet liquidity needs.

       Maintaining a relatively stable funding base, which is achieved by diversifying funding sources, supports liquidity, extends the contractual maturity of liabilities, and limits reliance on volatile short-term purchased funds. Short-term funding needs may arise from declines in deposits or other funding sources, funding of loan commitments and requests for new loans. The Company's strategy is to fund assets to the maximum extent possible with core deposits, which provide a sizable source of relatively stable low-cost funds. The Company defines core deposits as all deposits except certificates of deposits greater than $100. Average core deposits funded approximately 82.1% of total earning assets during 2014 and approximately 82.2% in 2013.

       Management believes the Company has sufficient liquidity to meet all reasonable borrower, depositor and creditor needs in the present economic environment. The Company has not received any directives from regulatory authorities that would materially affect liquidity, capital resources or operations.

Contractual Obligations as of December 31, 2014

  Less than
1 Year

  1-3 Years
  3-5 Years
  More than
5 Years


Time Deposits

  $ 340,387   $ 204,636   $ 102,489   $ 25,796   $ 7,466  

FHLB Advances

    214,413     54,832     34,414     90,000     35,167  

Subordinated Debentures

    41,239                 41,239  

Other Borrowings

    26,349     26,349              

Capital Lease Payment

    2,239     96     192     192     1,759  

Operating Lease Commitments

    6,678     1,348     1,894     1,441     1,995  


  $ 631,305   $ 287,261   $ 138,989   $ 117,429   $ 87,626  

Off-balance Sheet Arrangements

       The Bank incurs off-balance sheet risks in the normal course of business in order to meet the financing needs of its customers. These risks derive from commitments to extend credit and standby letters of credit. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. See Note 16 to the Consolidated Financial Statements for additional details on the Company's off-balance sheet arrangements.


Table of Contents

Interest Rate Risk Management

       Interest rate risk is the exposure of the Company's financial condition to adverse changes in market interest rates. In an effort to estimate the impact of sustained interest rate movements to the Company's earnings, the Company monitors interest rate risk through computer-assisted simulation modeling of its net interest income. The Company's simulation modeling monitors the potential impact to net interest income under various interest rate scenarios. The Company's objective is to actively manage its asset/liability position within a one-year interval and to limit the risk in any of the interest rate scenarios to a reasonable level of tax-equivalent net interest income within that interval. The Company monitors compliance within established guidelines of the Funds Management Policy. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk section for further discussion regarding interest rate risk.

Critical Accounting Policies

       The accounting and reporting policies of the Company comply with accounting principles generally accepted in the United States and conform to general practices within the banking industry. These policies require estimates and assumptions. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company's future financial condition and results of operations. In management's opinion, some of these areas have a more significant impact than others on the Company's financial reporting. These areas currently include accounting for securities, the allowance for loan losses, goodwill, income taxes, and mortgage servicing rights.

       Securities Valuation and Other Than Temporary Impairment of Securities — Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. In estimating the fair value for the majority of securities, fair values are based on observable market prices of the same or similar investments. The majority of securities are priced by an independent third party pricing service. Equity securities that do not have readily determinable fair values are carried at cost. When the fair value of securities is less than its amortized cost for an extended period, the Company will decide if the security is other than temporarily impaired. If the security is deemed to be other than temporarily impaired, an impairment charge will be recorded through earnings. In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Company intends to sell or believes it will be required to sell the securities prior to recovery.

       Allowance for Loan Losses — The level of the allowance for loan losses is based upon management's evaluation of the loan and lease portfolios, past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), the estimated value of any underlying collateral, composition of the loan portfolio, economic conditions, and other pertinent factors. This evaluation is inherently subjective as it requires material estimates including the amounts and timing of future cash flows expected to be received on impaired loans that may be susceptible to significant change. The level of allowance maintained is believed by management to be adequate to cover losses inherent in the portfolio. The allowance is increased by provisions charged to expense and decreased by charge-offs, net of recoveries of amounts previously charged-off.

       Goodwill — Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. The Company has selected June 30 as its date for annual impairment testing, but will test more frequently if circumstances warrant. No goodwill impairment was identified during testing performed in 2014 or 2013.

       Income taxes — The Company is subject to the income tax laws of the U.S., its states and the municipalities in which it operates. These tax laws are complex and subject to different interpretations by the taxpayer and the relevant government taxing authorities. The Company reviews income tax expense and the carrying value of deferred tax assets; and as new information becomes available, the balances are adjusted as appropriate. In establishing a provision for income tax expense, the Company makes judgments and interpretations about the application of these inherently complex tax laws and also makes estimates about when in the future certain items will affect taxable income in the various tax jurisdictions.

       Mortgage servicing rights — The Company originally records mortgage servicing rights at fair value and amortizes them over the period of the estimated future net servicing income of the underlying loans. The servicing rights are evaluated for impairment based upon the fair value of the rights as compared to the carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount.

New Accounting Matters

       See Note 1 to the Consolidated Financial Statements regarding the adoption of new accounting standards in 2014.


Table of Contents


       The Company's exposure to market risk is reviewed on a regular basis by the Credit and Risk Committee of the Board of Directors and by the Boards of Directors of the Company and the Bank. Primary market risks, which impact the Company's operations, are liquidity risk and interest rate risk, as discussed above.

       As discussed previously, the Company monitors interest rate risk by the use of computer simulation modeling to estimate the potential impact on its net interest income under various interest rate scenarios. Another method by which the Company's interest rate risk position can be estimated is by computing estimated changes in its net portfolio value ("NPV"). This method estimates interest rate risk exposure from movements in interest rates by using interest rate sensitivity analysis to determine the change in the NPV of discounted cash flows from assets and liabilities. Computations are based on a number of assumptions, including the relative levels of market interest rates and prepayments in mortgage loans and certain types of investments. These computations do not contemplate any actions management may undertake in response to changes in interest rates, and should not be relied upon as indicative of actual results. In addition, certain shortcomings are inherent in the method of computing NPV. Should interest rates remain or decrease below current levels, the proportion of adjustable rate loans could decrease in future periods due to refinancing activity. In the event of an interest rate change, prepayment levels would likely be different from those assumed in the table. Lastly, the ability of many borrowers to repay their adjustable rate debt may decline during a rising interest rate environment.

       The following tables provide an assessment of the risk to NPV in the event of sudden and sustained 1% and 2% increases and decreases in prevailing interest rates. The table indicates that as of December 31, 2014 the Company's estimated NPV might be expected to increase in the event of a decrease in prevailing interest rates, and might be expected to generally decrease in the event of an increase in prevailing interest rates (dollars in thousands). As of December 31, 2013 the Company's estimated NPV would generally increase in the event of a decrease in prevailing rates and decrease in the event of an increase in prevailing interest rates.

December 31, 2014

  $ Amount
  $ Change
  NPV Ratio
      +2%     753,390     (69,138 )   24.14%     (61 )
      +1%     788,925     (33,603 )   24.51%     (24 )