10-K 1 d499710d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

Commission file number 000-26481

 

 

FINANCIAL INSTITUTIONS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

NEW YORK   16-0816610

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

220 LIBERTY STREET,

WARSAW, NEW YORK

  14569
(Address of principal executive offices)   (ZIP Code)

Registrant’s telephone number, including area code: (585) 786-1100

Securities registered under Section 12(b) of the Exchange Act:

 

Title of each class

 

Name of exchange on which registered

Common stock, par value $.01 per share   NASDAQ Global Select Market

Securities registered under Section 12(g) of the Exchange Act: NONE

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

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

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 past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the regsitrant 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   ¨    Accelerated filer   x
Non-accelerated filer   ¨      Smaller reporting company   ¨

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

The aggregate market value of the registrant’s common stock, par value $0.01 per share, held by non-affiliates of the registrant, as computed by reference to the June 30, 2012 closing price reported by NASDAQ, was approximately $216,222,000.

As of March 1, 2013, there were outstanding, exclusive of treasury shares, 13,803,158 shares of the registrant’s common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for the 2013 Annual Meeting of Shareholders are incorporated by reference in Part III of this Annual Report on Form 10-K.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         PAGE  
PART I   
Item 1.   Business      5   
Item 1A.   Risk Factors      18   
Item 1B.   Unresolved Staff Comments      25   
Item 2.   Properties      25   
Item 3.   Legal Proceedings      25   
Item 4.   Mine Safety Disclosures      25   
PART II   
Item 5.   Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities      26   
Item 6.   Selected Financial Data      28   
Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      32   
Item 7A.   Quantitative and Qualitative Disclosures About Market Risk      56   
Item 8.   Financial Statements and Supplementary Data      59   
Item 9.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure      115   
Item 9A.   Controls and Procedures      115   
Item 9B.   Other Information      115   
PART III   
Item 10.   Directors, Executive Officers and Corporate Governance      116   
Item 11.   Executive Compensation      116   
Item 12.   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      116   
Item 13.   Certain Relationships and Related Transactions, and Director Independence      116   
Item 14.   Principal Accountant Fees and Services      116   
PART IV   
Item 15.   Exhibits and Financial Statement Schedules      117   
  Signatures      120   


Table of Contents

PART I

FORWARD LOOKING INFORMATION

Statements in this Annual Report on Form 10-K that are based on other than historical data are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:

 

  statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Financial Institutions, Inc. (“the parent” or “FII”) and its subsidiaries (collectively “the Company,” “we,” “our,” “us”); and

 

  statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.

These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in this Annual Report on Form 10-K, including, but not limited to, those presented in the Management’s Discussion and Analysis of Financial Condition and Results of Operations. Factors that might cause such differences include, but are not limited to:

 

  If we experience greater credit losses than anticipated, earnings may be adversely impacted;

 

  Geographic concentration may unfavorably impact our operations;

 

  We depend on the accuracy and completeness of information about or from customers and counterparties;

 

  We are subject to environmental liability risk associated with our lending activities;

 

  Our indirect lending involves risk elements in addition to normal credit risk;

 

  We are highly regulated and may be adversely affected by changes in banking laws, regulations and regulatory practices;

 

  Ongoing financial reform legislation may result in new regulations that could require us to maintain higher capital levels and/or increase our costs of operations or limit certain activities or lines of business;

 

  New or changing tax, accounting, and regulatory rules and interpretations could significantly impact our strategic initiatives, results of operations, cash flows, and financial condition;

 

  If our security systems, or those of merchants, merchant acquirers or other third parties containing information about customers, are compromised, we may be subject to liability and damage to our reputation;

 

  We could be subject to losses if we fail to properly safeguard sensitive and confidential information;

 

  Our information systems may experience an interruption or breach in security;

 

  We rely on other companies to provide key components of our business infrastructure;

 

  We may not be able to attract and retain skilled people and our ongoing leadership transition may be unsuccessful;

 

  The potential for business interruption exists throughout our organization;

 

  Acquisitions may disrupt our business and dilute shareholder value;

 

  We are subject to interest rate risk;

 

  Our business may be adversely affected by conditions in the financial markets and economic conditions generally;

 

  Our earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies;

 

  The soundness of other financial institutions could adversely affect us;

 

  We may be required to recognize an impairment of goodwill:

 

  We operate in a highly competitive industry and market area;

 

  Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business;

 

  Liquidity is essential to our businesses;

 

  We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all;

 

  We rely on dividends from our subsidiaries for most of our revenue;

 

  The market price for our common stock varies, and you should purchase common stock for long-term investment only;

 

  We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could negatively affect the value of our common stock;

 

- 3 -


Table of Contents
  We may not pay dividends on our common stock; and

 

  Our certificate of incorporation, our bylaws, and certain banking laws contain anti-takeover provisions.

We caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and advise readers that various factors, including those described above, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected. See also Item 1A, Risk Factors, in this Form 10-K for further information. Except as required by law, we do not undertake, and specifically disclaim any obligation to publicly release any revisions to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

 

- 4 -


Table of Contents
ITEM 1. BUSINESS

GENERAL

Financial Institutions, Inc. is a financial holding company organized in 1931 under the laws of New York State (“New York” or “NYS”). Through its subsidiaries, including its wholly-owned, New York chartered banking subsidiary, Five Star Bank, Financial Institutions, Inc. provides a broad array of deposit, lending and other financial services to retail, commercial, and municipal customers in Western and Central New York. All references in this Annual Report on Form 10-K to the parent are to Financial Institutions, Inc. (“FII”). Unless otherwise indicated, or unless the context requires otherwise, all references in this Annual Report on Form 10-K to “the Company,” “we,” “our” or “us” means Financial Institutions, Inc. and its subsidiaries on a consolidated basis. Five Star Bank is referred to as Five Star Bank, “FSB” or “the Bank”. FII is a legal entity separate and distinct from its subsidiaries, assisting those subsidiaries by providing financial resources and oversight. Our executive offices are located at 220 Liberty Street, Warsaw, New York.

We conduct business primarily through our banking subsidiary, Five Star Bank, which adopted its current name in 2005 when we merged three of our bank subsidiaries, Wyoming County Bank, National Bank of Geneva and Bath National Bank into our New York chartered bank subsidiary, First Tier Bank & Trust, which was renamed Five Star Bank. In addition, our business operations include a wholly-owned broker-dealer and investment adviser subsidiary, Five Star Investment Services, Inc. (“FSIS”).

Our Business Strategy

Our business strategy has been to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking needs of the businesses, professionals and other residents of the local communities surrounding our banking centers. We believe this focus allows us to be more responsive to our customers’ needs and provide a high level of personal service that differentiates us from larger competitors, resulting in long-standing and broad based banking relationships. Our core customers are primarily comprised of small- to medium-sized businesses, individuals and community organizations who prefer to build a banking relationship with a community bank that offers and combines high quality, competitively-priced banking products and services with personalized service. Because of our identity and origin as a locally operated bank, we believe that our level of personal service provides a competitive advantage over larger banks, which tend to consolidate decision-making authority outside local communities.

A key aspect of our current business strategy is to foster a community-oriented culture where our customers and employees establish long-standing and mutually beneficial relationships. We believe that we are well-positioned to be a strong competitor within our market area because of our focus on community banking needs and customer service, our comprehensive suite of deposit and loan products typically found at larger banks, our highly experienced management team and our strategically located banking centers. A central part of our strategy is generating core deposits to support growth of a diversified and high-quality loan portfolio.

MARKET AREAS AND COMPETITION

We provide a wide range of banking and financial services to individuals, municipalities and businesses through a network of over 50 offices and an extensive ATM network in fifteen contiguous counties of Western and Central New York: Allegany, Cattaraugus, Cayuga, Chautauqua, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Orleans, Seneca, Steuben, Wyoming and Yates counties. Our banking activities, though concentrated in the communities where we maintain branches, also extend into neighboring counties. In addition, we have expanded our consumer indirect lending presence to the Capital District of New York and Northern Pennsylvania.

Our market area is economically diversified in that we serve both rural markets and the larger more affluent markets of suburban Rochester and suburban Buffalo. Rochester and Buffalo are the two largest metropolitan areas in New York outside of New York City, with a combined metropolitan area of over two million people. We anticipate continuing to increase our presence in and around these metropolitan statistical areas in the coming years.

We face significant competition in both making loans and attracting deposits, as both Western and Central New York have a high density of financial institutions. Our competition for loans comes principally from commercial banks, savings banks, savings and loan associations, mortgage banking companies, credit unions, insurance companies and other financial service companies. Our most direct competition for deposits has historically come from commercial banks, savings banks and credit unions. We face additional competition for deposits from non-depository competitors such as the mutual fund industry, securities and brokerage firms and insurance companies. We generally compete with other financial service providers on factors such as: level of customer service, responsiveness to customer needs, availability and pricing of products, and geographic location.

 

- 5 -


Table of Contents

The following table presents the Bank’s market share percentage for total deposits as of June 30, 2012, in each county where we have operations. The table also indicates the ranking by deposit size in each market. All information in the table was obtained from SNL Financial of Charlottesville, Virginia, which compiles deposit data published by the FDIC as of June 30, 2012 and updates the information for any bank mergers and acquisitions completed subsequent to the reporting date.

 

County

   Market
Share
    Market
Rank
     Number of
Branches
 

Allegany

     6.6     4         1   

Cattaraugus

     24.0     2         5   

Cayuga

     3.6     11         1   

Chautauqua

     1.2     9         1   

Chemung

     17.1     3         3   

Erie

     0.4     12         3   

Genesee

     20.4     3         5   

Livingston

     30.7     1         5   

Monroe

     1.6     9         5   

Ontario

     13.9     3         5   

Orleans

     23.7     2         2   

Seneca

     20.7     2         2   

Steuben

     28.6     1         7   

Wyoming

     46.8     1         5   

Yates

     38.6     1         2   

INVESTMENT ACTIVITIES

Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Treasurer, guided by our Asset-Liability Committee (“ALCO”), is responsible for investment portfolio decisions within the established policies.

Our investment securities strategy centers on providing liquidity to meet loan demand and redeeming liabilities, meeting pledging requirements, managing credit risks, managing overall interest rate risks and maximizing portfolio yield. Our current policy generally limits security purchases to the following:

 

  U.S. treasury securities;

 

  U.S. government agency securities, which are securities issued by official Federal government bodies (e.g. the Government National Mortgage Association (“GNMA”) and U.S. government-sponsored enterprise (“GSE”) securities, which are securities issued by independent organizations that are in part sponsored by the federal government (e.g., the Federal Home Loan Bank (“FHLB”) system, the Federal National Mortgage Association (“FNMA”), the Federal Home Loan Mortgage Corporation (“FHLMC”), the Small Business Administration (“SBA”) and the Federal Farm Credit Bureau);

 

  Mortgage-backed securities (“MBS”) include mortgage-backed pass-through securities (“pass-throughs”) and collateralized mortgage obligations (“CMO”) issued by GNMA, FNMA and FHLMC;

 

  Investment grade municipal securities, including revenue, tax and bond anticipation notes, statutory installment notes and general obligation bonds;

 

  Certain creditworthy un-rated securities issued by municipalities;

 

  Certificates of deposit;

 

  Equity securities at the holding company level; and

 

  Limited partnership investments in Small Business Investment Companies.

 

- 6 -


Table of Contents

LENDING ACTIVITIES

General

We offer a broad range of loans including commercial business and revolving lines of credit, commercial mortgages, equipment loans, residential mortgage loans and home equity loans and lines of credit, home improvement loans, automobile loans and personal loans. Newly originated and refinanced fixed rate residential mortgage loans are either retained in our portfolio or sold to the secondary market with servicing rights retained.

We continually evaluate and update our lending policy. The key elements of our lending philosophy include the following:

 

  To ensure consistent underwriting, employees must share a common view of the risks inherent in lending activities as well as the standards to be applied in underwriting and managing credit risk;

 

  Pricing of credit products should be risk-based;

 

  The loan portfolio must be diversified to limit the potential impact of negative events; and

 

  Careful, timely exposure monitoring through dynamic use of our risk rating system is required to provide early warning and assure proactive management of potential problems.

Commercial Business and Commercial Mortgage Lending

We originate commercial business loans in our primary market areas and underwrite them based on the borrower’s ability to service the loan from operating income. We offer a broad range of commercial lending products, including term loans and lines of credit. Short and medium-term commercial loans, primarily collateralized, are made available to businesses for working capital (including inventory and receivables), business expansion (including acquisition of real estate, expansion and improvements) and the purchase of equipment. Commercial business loans are offered to the agricultural industry for short-term crop production, farm equipment and livestock financing. As a general practice, where possible, a collateral lien is placed on any available real estate, equipment or other assets owned by the borrower and a personal guarantee of the owner is obtained. As of December 31, 2012, $84.3 million, or 33%, of our aggregate commercial business loan portfolio were at fixed rates, while $174.4 million, or 67%, were at variable rates.

We also offer commercial mortgage loans to finance the purchase of real property, which generally consists of real estate with completed structures and, to a smaller extent, agricultural real estate financing. Commercial mortgage loans are secured by first liens on the real estate and are typically amortized over a 10 to 20 year period. The underwriting analysis includes credit verification, appraisals and a review of the borrower’s financial condition and repayment capacity. As of December 31, 2012, $142.4 million, or 34%, of our aggregate commercial mortgage portfolio were at fixed rates, while $270.9 million, or 66%, were at variable rates.

We utilize government loan guarantee programs where available and appropriate.

Government Guarantee Programs

We participate in government loan guarantee programs offered by the SBA, U.S. Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2012, we had loans with an aggregate principal balance of $62.8 million that were covered by guarantees under these programs. The guarantees typically only cover a certain percentage of these loans. By participating in these programs, we are able to broaden our base of borrowers while minimizing credit risk.

Residential Mortgage Lending

We originate fixed and variable rate one-to-four family residential mortgages collateralized by owner-occupied properties located in our market areas. We offer a variety of real estate loan products, which are generally amortized over periods of up to 30 years. Loans collateralized by one-to-four family residential real estate generally have been originated in amounts of no more than 80% of appraised value or have mortgage insurance. Mortgage title insurance and hazard insurance are normally required. We sell certain one-to-four family residential mortgages to the secondary mortgage market and typically retain the right to service the mortgages. To assure maximum salability of the residential loan products for possible resale, we have formally adopted the underwriting, appraisal, and servicing guidelines of the FHLMC as part of our standard loan policy. As of December 31, 2012, our residential mortgage servicing portfolio totaled $273.3 million, the majority of which has been sold to FHLMC. As of December 31, 2012, our residential mortgage loan portfolio totaled $133.5 million, or 8% of our total loan portfolio. We do not engage in sub-prime or other high-risk residential mortgage lending as a line-of-business.

 

- 7 -


Table of Contents

Consumer Lending

We offer a variety of loan products to our consumer customers, including home equity loans and lines of credit, automobile loans, secured installment loans and various other types of secured and unsecured personal loans. At December 31, 2012, outstanding consumer loan balances were concentrated in indirect automobile loans and home equity products.

We originate indirect consumer loans for a mix of new and used vehicles through franchised new car dealers. The consumer indirect loan portfolio is primarily comprised of loans with terms that typically range from 36 to 84 months. We have expanded our relationships with franchised new car dealers in Western, Central and the Capital District of New York, and Northern Pennsylvania. As of December 31, 2012, our consumer indirect portfolio totaled $586.8 million, or 34% of our total loan portfolio. The consumer indirect loan portfolio is primarily fixed rate loans with relatively short durations.

We also originate, independently of the indirect loans described above, consumer automobile loans, recreational vehicle loans, boat loans, home improvement loans, closed-end home equity loans, home equity lines of credit, personal loans (collateralized and uncollateralized) and deposit account collateralized loans. The terms of these loans typically range from 12 to 180 months and vary based upon the nature of the collateral and the size of loan. The majority of the consumer lending program is underwritten on a secured basis using the customer’s home or the financed automobile, mobile home, boat or recreational vehicle as collateral. As of December 31, 2012, $152.9 million, or 53%, of our home equity portfolio was at fixed rates, while $133.7 million, or 47%, was at variable rates. Approximately 69% of the loans in our home equity portfolio are first lien positions at December 31, 2012. The other consumer portfolio totaled $26.8 million as of December 31, 2012, all but $1.3 million of which were fixed rate loans.

Credit Administration

Our loan policy establishes standardized underwriting guidelines, as well as the loan approval process and the committee structures necessary to facilitate and ensure the highest possible loan quality decision-making in a timely and businesslike manner. The policy establishes requirements for extending credit based on the size, risk rating and type of credit involved. The policy also sets limits on individual loan officer lending authority and various forms of joint lending authority, while designating which loans are required to be approved at the committee level.

Our credit objectives are as follows:

 

  Compete effectively and service the legitimate credit needs of our target market;

 

  Enhance our reputation for superior quality and timely delivery of products and services;

 

  Provide pricing that reflects the entire relationship and is commensurate with the risk profiles of our borrowers;

 

  Retain, develop and acquire profitable, multi-product, value added relationships with high quality borrowers;

 

  Focus on government guaranteed lending and establish a specialization in this area to meet the needs of the small businesses in our communities; and

 

  Comply with the relevant laws and regulations.

Our policy includes loan reviews, under the supervision of the Audit and Risk Oversight committees of the Board of Directors and directed by our Chief Risk Officer, in order to render an independent and objective evaluation of our asset quality and credit administration process.

Risk ratings are assigned to loans in the commercial business and commercial mortgage portfolios. The risk ratings are specifically used as follows:

 

  Profile the risk and exposure in the loan portfolio and identify developing trends and relative levels of risk;

 

  Identify deteriorating credits;

 

  Reflect the probability that a given customer may default on its obligations; and

 

  Assist with risk-based pricing.

Through the loan approval process, loan administration and loan review program, management seeks to continuously monitor our credit risk profile and assesses the overall quality of the loan portfolio and adequacy of the allowance for loan losses.

We have several procedures in place to assist in maintaining the overall quality of our loan portfolio. Delinquent loan reports are monitored by credit administration to identify adverse levels and trends. Loans, including impaired loans, are generally classified as non-accruing if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-collateralized and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as non-accruing if repayment in full of principal and/or interest is uncertain.

 

- 8 -


Table of Contents

Allowance for Loan Losses

The allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. The allowance reflects management’s estimate of the amount of probable loan losses in the portfolio, based on factors such as:

 

  Specific allocations for individually analyzed credits;

 

  Risk assessment process;

 

  Historical net charge-off experience;

 

  Evaluation of the loan portfolio with loan reviews;

 

  Levels and trends in delinquent and non-accruing loans;

 

  Trends in volume and terms of loans;

 

  Effects of changes in lending policy;

 

  Experience, ability and depth of management;

 

  National and local economic trends and conditions;

 

  Concentrations of credit;

 

  Interest rate environment;

 

  Customer leverage;

 

  Information (availability of timely financial information); and

 

  Collateral values.

Our methodology in the estimation of the allowance for loan losses includes the following:

 

1. Impaired commercial business and commercial mortgage loans, generally in excess of $50 thousand are reviewed individually and assigned a specific loss allowance, if considered necessary, in accordance with U.S. generally accepted accounting principles (“GAAP”).

 

2. The remaining portfolios of commercial business and commercial mortgage loans are segmented by risk rating into the following loan classification categories: uncriticized or pass, special mention, substandard and doubtful. Uncriticized loans, special mention loans, substandard loans and all doubtful loans not assigned a specific loss allowance are assigned allowance allocations based on historical net loan charge-off experience for each of the respective loan categories, supplemented with additional reserve amounts, if considered necessary, based upon qualitative factors. These qualitative factors include the levels and trends in delinquent and non-accruing loans, trends in volume and terms of loans, effects of changes in lending policy, experience, ability, and depth of management, national and local economic trends and conditions, concentrations of credit, interest rate environment, customer leverage, information (availability of timely financial information), and collateral values, among others.

 

3. The retail loan portfolio is segmented into the following types of loans: residential real estate, home equity (home equity loans and lines of credit), consumer indirect and other consumer. Allowance allocations for the real estate related loan portfolios (residential and home equity) are based on the average loss experience for the previous eight quarters, supplemented with qualitative factors similar to the elements described above. Allowance allocations for the consumer indirect and other consumer portfolios are based on vintage analyses performed with historical loss experience at 36 months and 24 months aging, respectively. The allocations on these portfolios are also supplemented with qualitative factors.

Management presents a quarterly review of the adequacy of the allowance for loan losses to our Board of Directors based on the methodology described above. See also the section titled “Allowance for Loan Losses” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.

 

- 9 -


Table of Contents

SOURCES OF FUNDS

Our primary sources of funds are deposits, borrowed funds, scheduled amortization and prepayments of principal from loans and mortgage-backed securities, maturities and calls of investment securities and funds provided by operations.

Deposits

We maintain a full range of deposit products and accounts to meet the needs of the residents and businesses in our primary service area. Products include an array of checking and savings account programs for individuals and businesses, including money market accounts, certificates of deposit, sweep investment capabilities as well as Individual Retirement Accounts and other qualified plan accounts. We rely primarily on competitive pricing of our deposit products, customer service and long-standing relationships with customers to attract and retain these deposits and seek to make our services convenient to the community by offering 24-hour ATM access at some of our facilities, access to other ATM networks available at other local financial institutions and retail establishments, and telephone banking services including account inquiry and balance transfers. We also take advantage of the use of technology by allowing our customers banking access via the Internet and various advanced systems for cash management for our business customers.

We had no traditional brokered deposits at December 31, 2012; however, we do participate in the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep (“ICS”) programs, which enable depositors to receive FDIC insurance coverage for deposits otherwise exceeding the maximum insurable amount. Through these programs, deposits in excess of the maximum insurable amount are placed with multiple participating financial institutions. Reciprocal CDARS deposits and ICS deposits totaled $61.0 million and $18.1 million, respectively, at December 31, 2012.

Borrowings

We have access to a variety of borrowing sources and use both short-term and long-term borrowings to support our asset base. Borrowings from time-to-time include federal funds purchased, securities sold under agreements to repurchase and FHLB advances. We also offer customers a deposit account that sweeps balances in excess of an agreed upon target amount into overnight repurchase agreements.

OPERATING SEGMENTS

Our primary operating segment is our subsidiary bank, FSB. Our brokerage subsidiary, FSIS, is also deemed an operating segment; however, it does not meet the applicable thresholds for separate disclosure requirements.

OTHER INFORMATION

All of the reports we file with the SEC, including this Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments thereto may be read at the public reference facility maintained by the SEC at its public reference room at 100 F. Street, N.E., Room 1580, Washington, DC 20549 and copies of all or any part thereof may be obtained from that office upon payment of the prescribed fees. You may call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference room and you can request copies of the documents upon payment of a duplicating fee, by writing to the SEC. In addition, the SEC maintains a website that contains reports, proxy and information statements and other information regarding registrants, including us, that file electronically with the SEC which can be accessed at www.sec.gov.

We also make available, free of charge, through our website, all reports filed with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, as well as any amendments to those reports, as soon as reasonably practicable after those documents are filed with, or furnished to, the SEC. These filings may be viewed by accessing the Company Filings subsection of the SEC Filings section under the Investor Relations tab on our website (www.fiiwarsaw.com). Information available on our website is not a part of, and is not incorporated into, this Annual Report on Form 10-K.

 

- 10 -


Table of Contents

SUPERVISION AND REGULATION

The Company and our subsidiaries are subject to an extensive system of laws and regulations that are intended primarily for the protection of customers and depositors and not for the protection of our security holders. These laws and regulations govern such areas as capital, permissible activities, allowance for loan losses, loans and investments, and rates of interest that can be charged on loans. Described below are elements of selected laws and regulations. The descriptions are not intended to be complete and are qualified in their entirety by reference to the full text of the statutes and regulations described.

Holding Company Regulation. As a bank holding company and financial holding company, we are subject to comprehensive regulation by the Board of Governors of the Federal Reserve System, frequently referred to as the Federal Reserve Board (“FRB”), under the Bank Holding Company Act, as amended by, among other laws, the Gramm-Leach-Bliley Act of 1999 (the “Gramm-Leach-Bliley Act”), and by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), enacted in 2010. We must file reports with the FRB and such additional information as the FRB may require, and our holding company and non-banking affiliates are subject to examination by the FRB. Under FRB policy, a bank holding company must serve as a source of strength for its subsidiary banks. Under this policy, the FRB may require, and has required in the past, a holding company to contribute additional capital to an undercapitalized subsidiary bank. The Bank Holding Company Act provides that a bank holding company must obtain FRB approval before:

 

  Acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares);

 

  Acquiring all or substantially all of the assets of another bank or bank holding company, or

 

  Merging or consolidating with another bank holding company.

The Bank Holding Company Act generally prohibits a bank holding company from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by FRB regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the FRB includes, among other things: lending; operating a savings institution, mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; underwriting and acting as an insurance agent for certain types of credit related insurance; leasing property on a full-payout, non-operating basis; selling money orders, travelers’ checks and United States Savings Bonds; real estate and personal property appraising; providing tax planning and preparation services; and, subject to certain limitations, providing securities brokerage services for customers. These activities may also be affected by federal legislation.

The Gramm-Leach-Bliley Act amended portions of the Bank Holding Company Act to authorize bank holding companies, such as us, directly or through non-bank subsidiaries to engage in securities, insurance and other activities that are financial in nature or incidental to a financial activity. In order to undertake these activities, a bank holding company must become a “financial holding company” by submitting to the appropriate Federal Reserve Bank a declaration that the company elects to be a financial holding company and a certification that all of the depository institutions controlled by the company are well capitalized and well managed.

Broker-Dealer and Related Regulatory Supervision. FSIS is a member of, and is subject to the regulatory supervision of, the Financial Industry Regulatory Authority. Areas subject to this regulatory review include compliance with trading rules, financial reporting, investment suitability for clients, and compliance with stock exchange rules and regulations. FSIS is also subject to the supervision of the Investor Protection Bureau of the New York Attorney General’s Office for its investment advisory business.

Depository Institution Regulation. Our bank subsidiary is subject to regulation by the Federal Deposit Insurance Corporation (“FDIC”). This regulatory structure includes:

 

  Real estate lending standards, which provide guidelines concerning loan-to-value ratios for various types of real estate loans;

 

  Risk-based capital rules, including accounting for interest rate risk, concentration of credit risk and the risks posed by non-traditional activities;

 

  Rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks;

 

  Rules restricting types and amounts of equity investments; and

 

  Rules addressing various safety and soundness issues, including operations and managerial standards, standards for asset quality, earnings and compensation standards.

 

- 11 -


Table of Contents

The Dodd-Frank Act. The Dodd-Frank Act, enacted in July 2010, significantly changed the bank regulatory structure and affected the lending, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act (as amended) implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things, has or will:

 

   

Centralized responsibility for consumer financial protection by creating a new agency, the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that apply to all banks and certain others, including the examination and enforcement powers with respect to any bank with more than $10 billion in assets.

 

   

Require new capital rules and apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies.

 

   

Changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated average assets less tangible capital. As a result, this change generally imposes more deposit insurance cost on institutions with assets of $10 billion or more.

 

   

Increase the minimum ratio of net worth to insured deposits of the Deposit Insurance Fund from 1.15% to 1.35% and require the FDIC, in setting assessments, to offset the effect of the increase on institutions with assets of less than $10 billion.

 

   

Provide for new disclosure and other requirements relating to executive compensation and corporate governance, including guidelines or regulations on incentive-based compensation and a prohibition on compensation arrangements that encourage inappropriate risks or that could provide excessive compensation.

 

   

Repealed the federal prohibitions on the payment of interest on commercial demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts.

 

   

Allow de novo interstate branching by banks.

 

   

Increased the authority of the FRB to examine us and our non-bank subsidiary.

 

   

Required all bank holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress.

Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on us and the financial services industry more generally. Provisions in the legislation may require us to maintain higher capital levels and/or increase our cost of operations and limit certain activities or lines of business.

Capital Adequacy Requirements. The FRB and FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to bank holding companies and banks. In addition, these regulatory agencies may from time to time require that a bank holding company or bank maintain capital above the minimum levels, based on its financial condition or actual or anticipated growth.

The FRB’s risk-based guidelines establish a two-tier capital framework. Tier 1 capital generally consists of common shareholders’ equity, retained earnings, a limited amount of qualifying perpetual preferred stock, qualifying trust preferred securities and non-controlling interests in the equity accounts of consolidated subsidiaries, less goodwill and certain intangibles. Tier 2 capital generally consists of certain hybrid capital instruments and perpetual debt, mandatory convertible debt securities and a limited amount of subordinated debt, qualifying preferred stock, loan loss allowance, and unrealized holding gains on certain equity securities. The sum of Tier 1 and Tier 2 capital represents qualifying total capital, at least 50% of which must consist of Tier 1 capital.

Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily on relative credit risk. For bank holding companies, generally the minimum Tier 1 risk-based capital ratio is 4% and the minimum total risk-based capital ratio is 8%. Our Tier 1 and total risk-based capital ratios under these guidelines at December 31, 2012 were 10.70% and 11.96%, respectively.

The FRB’s leverage capital guidelines establish a minimum leverage ratio determined by dividing Tier 1 capital by adjusted average total assets. The minimum leverage ratio is 3% for bank holding companies that meet certain specified criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a leverage ratio of at least 4%. At December 31, 2012, we had a leverage ratio of 7.70%. See also the section titled “Capital Resources” in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 11, Regulatory Matters, of the notes to consolidated financial statements, included in this Annual Report on Form 10-K.

 

- 12 -


Table of Contents

In June 2012, the U.S. federal banking agencies issued three notices of proposed rulemaking that would revise and replace the current regulatory capital rules. The proposals were initially intended to be effective on January 1, 2013, but the agencies have deferred implementation due to the volume of comments related to the proposed rules. In the Basel III notice of proposed rulemaking, the agencies proposal included the implementation of a new common equity Tier 1 minimum capital requirement and a higher minimum Tier 1 capital requirement. Common equity is the highest quality equity and most loss absorbing form of capital and establishes the base of Tier 1 common equity as adjusted for minority interests and various deductions. The minimum Tier 1 common equity ratio under Basel III is 4.5%. Depending on the final form of the Basel III capital standards, the outcome will likely result in a higher capital requirement, greater volatility in regulatory capital and the elimination of trust preferred instruments in regulatory capital. It is expected that final rules will be issued in 2013.

Future rulemaking and regulatory changes on capital requirements may impact the Company as it continues to grow and evaluate M&A activity.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991, among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective federal bank regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements within these categories. This act imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified. Failure to meet the capital guidelines could also subject a banking institution to capital raising requirements. An “undercapitalized” bank must develop a capital restoration plan and its parent holding company must guarantee that bank’s compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the bank’s assets at the time it became “undercapitalized” or the amount needed to comply with the plan. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent’s general unsecured creditors. In addition, the Federal Deposit Insurance Corporation Improvement Act requires the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation and permits regulatory action against a financial institution that does not meet these standards.

The various federal bank regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by the Federal Deposit Insurance Corporation Improvement Act, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures. These regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized. Under the regulations, a “well capitalized” institution must have a Tier 1 risk-based capital ratio of at least 6%, a total risk-based capital ratio of at least 10% and a leverage ratio of at least 5% and not be subject to a capital directive or order. An institution is “adequately capitalized” if it has a Tier 1 risk-based capital ratio of at least 4%, a total risk-based capital ratio of at least 8% and a leverage ratio of at least 4% (3% in certain circumstances). An institution is “undercapitalized” if it has a Tier 1 risk-based capital ratio of less than 4%, a total risk-based capital ratio of less than 8% or a leverage ratio of less than 4% (3% in certain circumstances). An institution is “significantly undercapitalized” if it has a Tier 1 risk-based capital ratio of less than 3%, a total risk-based capital ratio of less than 6% or a leverage ratio of less than 3%. An institution is “critically undercapitalized” if its tangible equity is equal to or less than 2% of total assets. Generally, an institution may be reclassified in a lower capitalization category if it is determined that the institution is in an unsafe or unsound condition or engaged in an unsafe or unsound practice.

As of December 31, 2012, our subsidiary bank met the requirements to be classified as “well-capitalized”.

Dividends. The FRB policy is that a bank holding company should pay cash dividends only to the extent that its net income for the past year is sufficient to cover both the cash dividends and a rate of earnings retention that is consistent with the holding company’s capital needs, asset quality and overall financial condition, and that it is inappropriate for a bank holding company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, a bank that is classified under the prompt corrective action regulations as “undercapitalized” will be prohibited from paying any dividends.

Our primary source for cash dividends is the dividends we receive from our subsidiary bank. Our bank is subject to various regulatory policies and requirements relating to the payment of dividends, including requirements to maintain capital above regulatory minimums. Approval of the New York State Department of Financial Services is required prior to paying a dividend if the dividend declared by the Bank exceeds the sum of the Bank’s net profits for that year and its retained net profits for the preceding two calendar years.

Federal Deposit Insurance Assessments. The Bank is a member of the FDIC and pays an insurance premium to the FDIC based upon its assessable deposits on a quarterly basis. Deposits are insured up to applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government.

Under the Dodd-Frank Act, a permanent increase in deposit insurance was authorized to $250,000. The coverage limit is per depositor, per insured depository institution for each account ownership category.

 

- 13 -


Table of Contents

The Dodd-Frank Act also set a new minimum Deposit Insurance Fund (“DIF”) reserve ratio at 1.35% of estimated insured deposits. The FDIC is required to attain this ratio by September 30, 2020. The Dodd-Frank Act also required the FDIC to define the deposit insurance assessment base for an insured depository institution as an amount equal to the institution’s average consolidated total assets during the assessment period minus average tangible equity. Premiums for the Bank are now calculated based upon the average balance of total assets minus average tangible equity as of the close of business for each day during the calendar quarter.

The FDIC has the flexibility to adopt actual rates that are higher or lower than the total base assessment rates adopted without notice and comment, if certain conditions are met.

DIF-insured institutions pay a Financing Corporation (“FICO”) assessment in order to fund the interest on bonds issued in the 1980s in connection with the failures in the thrift industry. For the fourth quarter of 2012, the FICO assessment was equal to 0.64 basis points computed on assets as required by the Dodd-Frank Act. These assessments will continue until the bonds mature in 2019.

The FDIC is authorized to conduct examinations of and require reporting by FDIC-insured institutions. It is also authorized to terminate a depository bank’s deposit insurance upon a finding by the FDIC that the bank’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the bank’s regulatory agency. The termination of deposit insurance for the Bank would have a material adverse effect on our earnings, operations and financial condition.

Transactions with Affiliates. FII and FSB are affiliates within the meaning of the Federal Reserve Act. The Federal Reserve Act imposes limitations on a bank with respect to extensions of credit to, investments in, and certain other transactions with, its parent bank holding company and the holding company’s other subsidiaries. Furthermore, bank loans and extensions of credit to affiliates also are subject to various collateral requirements.

Community Reinvestment Act. Under the Community Reinvestment Act, every FDIC-insured institution is obligated, consistent with safe and sound banking practices, to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act requires the appropriate federal banking regulator, in connection with the examination of an insured institution, to assess the institution’s record of meeting the credit needs of its community and to consider this record in its evaluation of certain applications, such as a merger or the establishment of a branch. An unsatisfactory rating may be used as the basis for the denial of an application and will prevent a bank holding company of the institution from making an election to become a financial holding company.

As of its last Community Reinvestment Act examination, the Bank received a rating of “outstanding.”

Interstate Branching. Pursuant to the Dodd-Frank Act, national and state-chartered banks may open an initial branch in a state other than its home state (e.g., a host state) by establishing a de novo branch at any location in such host state at which a bank chartered in such host state could establish a branch. Applications to establish such branches must still be filed with the appropriate primary federal regulator.

Privacy Rules. Federal banking regulators, as required under the Gramm-Leach-Bliley Act, have adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to non-affiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to non-affiliated third parties. The privacy provisions of the Gramm-Leach-Bliley Act affect how consumer information is transmitted through diversified financial services companies and conveyed to outside vendors.

Anti-Terrorism Legislation. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (“USA Patriot Act”), enacted in 2001:

 

  prohibits banks from providing correspondent accounts directly to foreign shell banks;

 

  imposes due diligence requirements on banks opening or holding accounts for foreign financial institutions or wealthy foreign individuals;

 

  requires financial institutions to establish an anti-money-laundering (“AML”) compliance program; and

 

  generally eliminates civil liability for persons who file suspicious activity reports.

The USA Patriot Act also increases governmental powers to investigate terrorism, including expanded government access to account records. The Department of the Treasury is empowered to administer and make rules to implement the Act, which to some degree, affects our record-keeping and reporting expenses. Should the Bank’s AML compliance program be deemed insufficient by federal regulators, we would not be able to grow through acquiring other institutions or opening de novo branches.

 

- 14 -


Table of Contents

Volcker Rule. The Dodd-Frank Act prohibits insured depository institutions and their holding companies from engaging in proprietary trading except in limited circumstances, and prohibits them from owning equity interests in excess of three percent (3%) of Tier 1 Capital in private equity and hedge funds (known as the “Volcker Rule”). The Federal Reserve released a final rule on February 9, 2011 (effective on April 1, 2011) which requires a “banking entity,” a term that is defined to include bank holding companies like the parent, to bring its proprietary trading activities and investments into compliance with the Dodd-Frank Act restrictions no later than two years after the earlier of: (1) July 21, 2012, or (2) 12 months after the date on which interagency final rules are adopted. Pursuant to the compliance date final rule, banking entities are permitted to request an extension of this timeframe from the Federal Reserve. On October 11, 2011, the federal banking agencies released for comment proposed regulations implementing the Volcker Rule. The public comment period closed on February 13, 2012 and a final rule has not yet been published. The parent will be reviewing the implications of the interagency rules on its investments once those rules are issued and will plan for any adjustments of its activities or its holdings in order to be in compliance by the announced compliance date.

Ability-to-Repay and Qualified Mortgage Rule. Pursuant to the Dodd Frank Act, the CFPB issued a final rule on January 10, 2013 (effective on January 10, 2014), amending Regulation Z as implemented by the Truth in Lending Act, requiring mortgage lenders to make a reasonable and good faith determination based on verified and documented information that a consumer applying for a mortgage loan has a reasonable ability to repay the loan according to its terms. Mortgage lenders are required to determine consumers’ ability to repay in one of two ways. The first alternative requires the mortgage lender to consider the following eight underwriting factors when making the credit decision: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related obligations; (6) current debt obligations, alimony, and child support; (7) the monthly debt-to-income ratio or residual income; and (8) credit history. Alternatively, the mortgage lender can originate “qualified mortgages,” which are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. In general, a “qualified mortgage” is a mortgage loan without negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years. In addition, to be a qualified mortgage the points and fees paid by a consumer cannot exceed 3% of the total loan amount. Qualified mortgages that are “higher-priced” (e.g. subprime loans) garner a rebuttable presumption of compliance with the ability-to-repay rules, while qualified mortgages that are not “higher-priced” (e.g. prime loans) are given a safe harbor of compliance.

Incentive Compensation Policies and Restrictions. In July 2010, the federal banking agencies issued guidance that applies to all banking organizations supervised by the agencies (thereby including both the Parent Company and the Bank). Pursuant to the guidance, to be consistent with safety and soundness principles, a banking organization’s incentive compensation arrangements should: (1) provide employees with incentives that appropriately balance risk and reward; (2) be compatible with effective controls and risk management; and (3) be supported by strong corporate governance including active and effective oversight by the banking organization’s board of directors. Monitoring methods and processes used by a banking organization should be commensurate with the size and complexity of the organization and its use of incentive compensation.

In addition, in March 2011, the federal banking agencies, along with the Federal Housing Finance Agency, and the SEC, released a proposed rule intended to ensure that regulated financial institutions design their incentive compensation arrangements to account for risk. Specifically, the proposed rule would require compensation practices at the Parent Company and at the Bank to be consistent with the following principles: (1) compensation arrangements appropriately balance risk and financial reward; (2) such arrangements are compatible with effective controls and risk management; and (3) such arrangements are supported by strong corporate governance. In addition, financial institutions with $1 billion or more in assets would be required to have policies and procedures to ensure compliance with the rule and would be required to submit annual reports to their primary federal regulator. The comment period has closed but a final rule has not yet been published.

Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance, accounting and reporting measures for companies that have securities registered under the Exchange Act, including publicly-held bank holding companies such as Financial Institutions. Specifically, the Sarbanes-Oxley Act of 2002 and the various regulations promulgated thereunder, established, among other things: (i) requirements for audit committees, including independence, expertise, and responsibilities; (ii) responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) the forfeiture of bonuses or other incentive-based compensation and profits from the sale of the reporting company’s securities by the Chief Executive Officer and Chief Financial Officer in the twelve-month period following the initial publication of any financial statements that later require restatement; (iv) the creation of an independent accounting oversight board; (v) standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (vi) disclosure and reporting obligations for the reporting company and their directors and executive officers, including accelerated reporting of stock transactions and a prohibition on trading during pension blackout periods; (vii) a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions on non-preferential terms and in compliance with other bank regulatory requirements; and (viii) a range of civil and criminal penalties for fraud and other violations of the securities laws.

 

- 15 -


Table of Contents

Consumer Laws and Regulations. In addition to the laws and regulations discussed herein, the Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The Bank must comply with the applicable provisions of these consumer protection laws and regulations as part of its ongoing customer relations. The Check Clearing for the 21st Century Act (the “Check 21 Act”), which became effective on October 28, 2004, creates a new negotiable instrument, called a “substitute check”, which banks are required to accept as the legal equivalent of a paper check if it meets the requirements of the Check 21 Act. The Check 21 Act is designed to facilitate check truncation, to foster innovation in the check payment system, and to improve the payment system by shortening processing times and reducing the volume of paper checks.

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

Impact of Inflation and Changing Prices

Our financial statements included herein have been prepared in accordance with GAAP, which requires us to measure financial position and operating results principally using historic dollars. Changes in the relative value of money due to inflation or recession are generally not considered. The primary effect of inflation on our operations is reflected in increased operating costs. In our view, changes in interest rates affect the financial condition of a financial institution to a far greater degree than changes in the inflation rate. While interest rates are generally influenced by changes in the inflation rate, they do not necessarily change at the same rate or in the same magnitude. Interest rates are sensitive to many factors that are beyond our control, including changes in the expected rate of inflation, general and local economic conditions and the monetary and fiscal policies of the United States government, its agencies and various other governmental regulatory authorities.

Regulatory and Economic Policies

Our business and earnings are affected by general and local economic conditions and by the monetary and fiscal policies of the U.S. government, its agencies and various other governmental regulatory authorities. The FRB regulates the supply of money in order to influence general economic conditions. Among the instruments of monetary policy available to the FRB are (i) conducting open market operations in U.S. government obligations, (ii) changing the discount rate on financial institution borrowings, (iii) imposing or changing reserve requirements against financial institution deposits, and (iv) restricting certain borrowings and imposing or changing reserve requirements against certain borrowings by financial institutions and their affiliates. These methods are used in varying degrees and combinations to directly affect the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason, the policies of the FRB could have a material effect on our earnings.

EMPLOYEES

At December 31, 2012, we had 662 employees. None of the employees are subject to a collective bargaining agreement and management believes its relations with employees are good.

 

- 16 -


Table of Contents

EXECUTIVE OFFICERS OF REGISTRANT

The following table sets forth current information regarding our executive officers and certain other significant employees (ages are as of May 8, 2013, the date of the 2013 Annual Meeting of Shareholders).

 

Name

       Age            Started    
In
  

Positions/Offices

Martin K. Birmingham    46    2005    President and Chief Executive Officer since March 2013. Previously, President and Chief of Community Banking of the Company and the Bank from August 2012. Executive Vice President and Regional President/ Commercial Banking Executive Officer of the Bank since 2009. Senior Vice President and Regional President of the Bank since 2005. Senior Team Leader and Regional President of the Rochester Market at Bank of America (formally Fleet Boston Financial) from 2000 to 2005.
Richard J. Harrison    67    2003    Executive Vice President and Chief Operating Officer of the Company and the Bank since August 2012. Executive Vice President and Senior Retail Lending Administrator of the Bank since 2009. Senior Vice President and Senior Retail Lending Administrator of the Bank since 2005.
Kevin B. Klotzbach    60    2001    Senior Vice President and Treasurer of the Bank since 2005.
Karl F. Krebs    57    2009    Executive Vice President and Chief Financial Officer of the Company and the Bank since 2009. Senior Financial Specialist at West Valley Environmental Services, LLC, an environmental remediation services firm, prior to joining the Company in 2009. President of Robar General Funding Corp., a mortgage and construction loan broker, from 2006 to 2008. Senior Vice President and Line-of-Business Finance Director at Five Star Bank from 2005 to 2006.
R. Mitchell McLaughlin                55    1981    Executive Vice President and Chief Information Officer of the Bank since 2009. Senior Vice President and Chief Information Officer of the Bank since 2006.
John L. Rizzo    63    2007    Senior Vice President and Corporate Secretary of the Company and the Bank since 2010. General counsel for the Company and the Bank since 2007. Genesee County (New York) Attorney from 1976 to 2010.
Kenneth V. Winn    55    2004    Executive Vice President and Chief Risk Officer of the Company and the Bank since July 2012. Senior Vice President and Senior Credit Compliance Administrator since 2006.

 

- 17 -


Table of Contents
ITEM 1A. RISK FACTORS

An investment in our common stock is subject to risks inherent to our business. The material risks and uncertainties that management believes affect us are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below, together with all of the other information included or incorporated by reference herein. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair our business operations. This Annual Report on Form 10-K is qualified in its entirety by these risk factors. Further, to the extent that any of the information contained in this Annual Report on Form 10-K constitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important factors that could cause our actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of us.

If any of the following risks actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.

CREDIT RISKS

If we experience greater credit losses than anticipated, earnings may be adversely impacted.

As a lender, we are exposed to the risk that customers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse impact on our results of operations.

We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral, and we provide an allowance for estimated loan losses based on a number of factors. We believe that the allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, the allowance for loan losses may not be sufficient to cover the actual credit losses. We may have to increase the allowance in the future in response to the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for credit losses may vary from the amount of past provisions.

Geographic concentration may unfavorably impact our operations.

Substantially all of our business and operations are concentrated in the Western and Central New York region. As a result of this geographic concentration, our results depend largely on economic conditions in these and surrounding areas. Deterioration in economic conditions in our market could:

 

  increase loan delinquencies;

 

  increase problem assets and foreclosures;

 

  increase claims and lawsuits;

 

  decrease the demand for our products and services; and

 

  decrease the value of collateral for loans, especially real estate, in turn reducing customers’ borrowing power, the value of assets associated with non-performing loans and collateral coverage.

Generally, we make loans to small to mid-sized businesses whose success depends on the regional economy. These businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. Adverse economic and business conditions in our market areas could reduce our growth rate, affect our borrowers’ ability to repay their loans and, consequently, adversely affect our business, financial condition and performance. For example, we place substantial reliance on real estate as collateral for our loan portfolio. A sharp downturn in real estate values in our market area could leave many of these loans inadequately collateralized. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, the impact on our results of operations could be materially adverse.

We depend on the accuracy and completeness of information about or from customers and counterparties.

In deciding whether to extend credit or enter into other transactions, we may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports, and other financial information. We may also rely on representations of those customers, counterparties, or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports, or other financial information could cause us to enter into unfavorable transactions, which could have a material adverse effect on our financial condition and results of operations.

 

- 18 -


Table of Contents

We are subject to environmental liability risk associated with our lending activities.

A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage regardless of whether we knew, had reason to know of, or caused the release of such substance. Environmental laws may require us to incur substantial expenses and may materially reduce the affected property’s value or limit our ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although we have policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our financial condition and results of operations.

Our indirect lending involves risk elements in addition to normal credit risk.

A portion of our current lending involves the purchase of consumer automobile installment sales contracts from automobile dealers located in Western, Central and the Capital District of New York, and Northern Pennsylvania. These loans are for the purchase of new or used automobiles. We serve customers that cover a range of creditworthiness, and the required terms and rates are reflective of those risk profiles. While these loans have higher yields than many of our other loans, such loans involve risks elements in addition to normal credit risk. Potential risk elements associated with indirect lending include the limited personal contact with the borrower as a result of indirect lending through dealers, the absence of assured continued employment of the borrower, the varying general creditworthiness of the borrower, changes in the local economy, and difficulty in monitoring collateral. While indirect automobile loans are secured, such loans are secured by depreciating assets and characterized by LTV ratios that could result in us not recovering the full value of an outstanding loan upon default by the borrower. If the economic environment in our primary market area contracts, we may experience higher levels of delinquencies, charge-offs and repossessions.

REGULATORY/LEGAL/COMPLIANCE RISKS

We are highly regulated and may be adversely affected by changes in banking laws, regulations and regulatory practices.

We are subject to extensive supervision, regulation and examination. This regulatory structure gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies to address not only compliance with applicable laws and regulations (including laws and regulations governing consumer credit, and anti-money laundering and anti-terrorism laws), but also capital adequacy, asset quality and risk, management ability and performance, earnings, liquidity, and various other factors. As part of this regulatory structure, we are subject to policies and other guidance developed by the regulatory agencies with respect to capital levels, the timing and amount of dividend payments, the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Under this structure the regulatory agencies have broad discretion to impose restrictions and limitations on our operations if they determine, among other things, that our operations are unsafe or unsound, fail to comply with applicable law or are otherwise inconsistent with laws and regulations or with the supervisory policies of these agencies.

This supervisory framework could materially impact the conduct, growth and profitability of our operations. Any failure on our part to comply with current laws, regulations, other regulatory requirements or safe and sound banking practices or concerns about our financial condition, or any related regulatory sanctions or adverse actions against us, could increase our costs or restrict our ability to expand our business and result in damage to our reputation.

Ongoing financial reform legislation may result in new regulations that could require us to maintain higher capital levels and/or increase our costs of operations or limit certain activities or lines of business.

The Dodd-Frank Act has significantly changed the current bank regulatory structure and affects the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations, and to prepare numerous studies and reports for Congress. The federal agencies are given significant discretion in drafting the implementing rules and regulations, and consequently, many of the details and much of the rulemaking of the Dodd-Frank Act will not be known for many months or years, making it difficult to anticipate the overall financial impact on us. However, compliance with this new law and its implementing regulations are expected to result in additional operating costs that could have a material adverse effect on our financial condition and results of operations.

The federal banking agencies have proposed rules that would substantially amend the regulatory risk-based capital rules. The proposed rules implement the Basel III regulatory capital reforms and changes required by the Dodd-Frank Act. The proposed rules include new minimum risk-based capital and leverage ratios, which would be phased in over the next several years and would refine the definition of what constitutes “capital” for purposes of calculating those ratios. While the proposed Basel III changes and other regulatory capital requirements will likely result in generally higher regulatory capital standards, it is difficult at this time to predict when or how any new standards will ultimately be applied to the Company and the Bank.

 

- 19 -


Table of Contents

New or changing tax, accounting, and regulatory rules and interpretations could significantly impact our strategic initiatives, results of operations, cash flows, and financial condition.

The financial services industry is extensively regulated. Federal and state banking regulations are designed primarily to protect the deposit insurance funds and consumers, not to benefit a company’s stockholders. These regulations may sometimes impose significant limitations on operations. The significant federal and state banking regulations that affect us are described in the section captioned “Supervision and Regulation” included in Part I, Item 1, “Business”. These regulations, along with the currently existing tax, accounting, securities, insurance, and monetary laws, regulations, rules, standards, policies, and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time.

OPERATIONAL RISKS

If our security systems, or those of merchants, merchant acquirers or other third parties containing information about customers, are compromised, we may be subject to liability and damage to our reputation.

As part of our business, we collect, process and retain sensitive and confidential client and customer information on our behalf and on behalf of other third parties. Customer data also may be stored on systems of third-party service providers and merchants that may have inadequate security systems. Third-party carriers regularly transport customer data, and may lose sensitive customer information. Unauthorized access to our networks or any of our other information systems potentially could jeopardize the security of confidential information stored in our computer systems or transmitted by our customers or others. If our security systems or those of merchants, processors or other third-party service providers are compromised such that this confidential information is disclosed to unauthorized parties, we may be subject to liability. For example, in the event of a security breach, we may incur losses related to fraudulent use of debit cards issued by us as well as the operational costs associated with reissuing cards. Although we take preventive measures to address these factors, such measures are costly and may become more costly in the future. Moreover, these measures may not protect us from liability, which may not be adequately covered by insurance, or from damage to our reputation.

We could be subject to losses if we fail to properly safeguard sensitive and confidential information.

As part of our normal operations, we maintain and transmit confidential information about our clients as well as proprietary information relating to our business operations. We maintain a system of internal controls designed to provide reasonable assurance that fraudulent activity, including misappropriation of assets, fraudulent financial reporting, and unauthorized access to sensitive or confidential data is either prevented or timely detected. Our systems or our third-party service providers’ systems could be victimized by unauthorized users or corrupted by computer viruses or other malicious software code, or authorized persons could inadvertently or intentionally release confidential or proprietary information. Such disclosure could, among other things:

 

  seriously damage our reputation,

 

  allow competitors access to our proprietary business information,

 

  subject us to liability for a failure to safeguard client data,

 

  result in the loss of our existing customers,

 

  subject us to regulatory action, and

 

  require significant capital and operating expenditures to investigate and remediate the breach.

Our information systems may experience an interruption or breach in security.

We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. While we have policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of our information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.

 

- 20 -


Table of Contents

We rely on other companies to provide key components of our business infrastructure.

Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers or otherwise conduct our business efficiently and effectively. Replacing these third party vendors could also entail significant delay and expense.

We may not be able to attract and retain skilled people and our ongoing leadership transition may be unsuccessful.

Our success depends, in large part, on our ability to attract and retain skilled people. Competition for the best people in most activities engaged in by us can be intense, and we may not be able to hire sufficiently skilled people or to retain them. Further, the rural location of our principal executive offices and many of our bank branches make it difficult for us to attract skilled people to such locations. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of our markets, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.

On January 30, 2012, we eliminated the position of Retail Banking Executive previously held by John J. Witkowski, our former Executive Vice President and on June 30, 2012, George D. Hagi, our Executive Vice President and Chief Risk Officer retired and was replaced by Kenneth V. Winn. In August 2012, Peter G. Humphrey retired as our President and Chief Executive Officer. Following Mr. Humphrey’s retirement, our Board of Directors appointed John E. Benjamin to serve as Interim Chief Executive Officer in August 2012. At the same time, we also announced the promotion of Richard Harrison as Chief Operating Officer and Martin Birmingham as President and Chief of Community Banking. In March 2013, Mr. Birmingham was appointed to the position of President and Chief Executive Officer. These changes in key management could create uncertainty among our employees, customers, and other third parties with whom we do business and could result in changes to the strategic direction of our business, which could negatively affect our business, financial condition and results of operations. Any failure of our management to work together to effectively manage our operations, our inability to hire other key management, and any failure to effectively integrate new management into our controls, systems and procedures could adversely affect our business, financial condition and results of operations.

The potential for business interruption exists throughout our organization.

Integral to our performance is the continued efficacy of our technical systems, operational infrastructure, relationships with third parties and the vast array of associates and key executives in our day-to-day and ongoing operations. Failure by any or all of these resources subjects us to risks that may vary in size, scale and scope. This includes, but is not limited to, operational or technical failures, ineffectiveness or exposure due to interruption in third party support as expected, as well as the loss of key individuals or failure on the part of key individuals to perform properly. Although management has established policies and procedures, including implementation and testing of a comprehensive contingency plan, to address such failures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Acquisitions may disrupt our business and dilute shareholder value.

A key component of our strategy to grow and improve profitability is to expand our branch network into communities within or adjacent to markets where we currently conduct business. We intend to continue to pursue a growth strategy for our business. As a result, negotiations may take place and future mergers or acquisitions involving cash, debt, or equity securities may occur at any time. We seek merger or acquisition partners that are culturally similar, have experienced management, and possess either significant market presence or have potential for improved profitability through financial management, economies of scale, or expanded services.

Acquiring other banks, businesses, or branches involves potential adverse impact to our financial results and various other risks commonly associated with acquisitions, including, among other things:

 

  difficulty in estimating the value of the target company;

 

  payment of a premium over book and market values that may dilute our tangible book value and earnings per share in the short and long term;

 

  potential exposure to unknown or contingent liabilities of the target company;

 

  exposure to potential asset quality issues of the target company;

 

  there may be volatility in reported income as goodwill impairment losses could occur irregularly and in varying amounts;

 

  challenge and expense of integrating the operations and personnel of the target company;

 

  inability to realize the expected revenue increases, cost savings, increases in geographic or product presence, and / or other projected benefits;

 

  potential disruption to our business;

 

  potential diversion of our management’s time and attention;

 

  the possible loss of key employees and customers of the target company; and

 

  potential changes in banking or tax laws or regulations that may affect the target company.

 

- 21 -


Table of Contents

EXTERNAL RISKS

We are subject to interest rate risk.

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and investments and the amount of interest we pay on deposits and borrowings, but such changes could also affect (i) our ability to originate loans and obtain deposits; (ii) the fair value of our financial assets and liabilities; and (iii) the average duration of our mortgage-backed securities portfolio and other interest-earning assets. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.

Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have a material adverse effect on our financial condition and results of operations. Also, our interest rate risk modeling techniques and assumptions likely may not fully predict or capture the impact of actual interest rate changes on our balance sheet.

Our business may be adversely affected by conditions in the financial markets and economic conditions generally.

From December 2007 through June 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 begun to improve, 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 reduced tax collections.

Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to past increases in deposit insurance premiums paid by financial institutions.

Our 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 we offer, is highly dependent on the business environment in the markets where we operate, in the State of New York and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors.

Our earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies.

The policies of the Federal Reserve impact us significantly. The Federal Reserve regulates the supply of money and credit in the United States. Its policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments we hold. Those policies determine to a significant extent our cost of funds for lending and investing. Changes in those policies are beyond our control and are difficult to predict. Federal Reserve policies can also affect our borrowers, potentially increasing the risk that they may fail to repay their loans. For example, a tightening of the money supply by the Federal Reserve could reduce the demand for a borrower’s products and services. This could adversely affect the borrower’s earnings and ability to repay its loan, which could have a material adverse effect on our financial condition and results of operations.

The soundness of other financial institutions could adversely affect us.

Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose us to credit risk in the event of a default by our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due us. Any such losses could have a material adverse effect on our financial condition and results of operations.

 

- 22 -


Table of Contents

We may be required to recognize an impairment of goodwill.

Under current accounting standards, goodwill is not amortized but, instead, is subject to impairment tests on at least an annual basis or more frequently if an event occurs or circumstances change that reduce the fair value of a reporting unit below its carrying amount. Significant and sustained declines in our stock price and market capitalization, significant declines in our expected future cash flows, significant adverse changes in the business climate or slower growth rates could result in impairment of goodwill. During 2012, the annual impairment test performed as of September 30 indicated that the fair value of our single reporting unit exceeded the fair value of its assets and liabilities. In the event that we conclude that all or a portion of our goodwill may be impaired, a non-cash charge for the amount of such impairment would be recorded to earnings, which could have a material adverse impact on our results of operations or financial condition. Such a charge would have no impact on tangible capital. At December 31, 2012, we had goodwill of $49.0 million, representing approximately 19% of shareholders’ equity. For further discussion, see Note 1, Summary of Significant Accounting Policies, and Note 7, Goodwill and Other Intangible Assets, to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

We operate in a highly competitive industry and market area.

We face substantial competition in all areas of our operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional and internet banks within the various markets in which we operate. We also face competition from many other types of financial institutions, including, without limitation, savings and loan associations, credit unions, finance companies, brokerage firms, insurance companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting), and merchant banking. Also, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of our competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than we can.

Our ability to compete successfully depends on a number of factors, including, among other things:

 

   

the ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets;

 

   

the ability to expand our market position;

 

   

the scope, relevance and pricing of products and services offered to meet customer needs and demands;

 

   

the rate at which we introduce new products and services relative to our competitors;

 

   

customer satisfaction with our level of service; and

 

   

industry and general economic trends.

Failure to perform in any of these areas could significantly weaken our competitive position, which could adversely affect our growth and profitability, which, in turn, could have a material adverse effect on our financial condition and results of operations.

Severe weather, natural disasters, acts of war or terrorism, and other external events could significantly impact our business.

Severe weather, natural disasters, acts of war or terrorism, and other adverse external events could have a significant impact on our ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue, and/or cause us to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on our business, which, in turn, could have a material adverse effect on our financial condition and results of operations.

LIQUIDITY RISKS

Liquidity is essential to our businesses.

Our liquidity could be impaired by an inability to access the capital markets or unforeseen outflows of cash. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us. Our efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated reductions in our liquidity. In such events, our cost of funds may increase, thereby reducing our net interest income, or we may need to sell a portion of our investment and/or loan portfolio, which, depending upon market conditions, could result in us realizing a loss.

 

- 23 -


Table of Contents

We may need to raise additional capital in the future and such capital may not be available on acceptable terms or at all.

We may need to raise additional capital in the future to provide sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance.

In addition, we are highly regulated, and our regulators could require us to raise additional common equity in the future. We and our regulators perform a variety of analyses of our assets, including the preparation of stress case scenarios, and as a result of those assessments we could determine, or our regulators could require us, to raise additional capital.

We cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit our access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of the Bank or counterparties participating in the capital markets, or a downgrade of our debt rating, may adversely affect our capital costs and ability to raise capital and, in turn, our liquidity. An inability to raise additional capital on acceptable terms when needed could have a material adverse impact on our business, financial condition, results of operations or liquidity.

We rely on dividends from our subsidiaries for most of our revenue.

We are a separate and distinct legal entity from our subsidiaries. A substantial portion of our revenue comes from dividends from our Bank subsidiary. These dividends are the principal source of funds we use to pay dividends on our common and preferred stock, and to pay interest and principal on our debt. Various federal and/or state laws and regulations limit the amount of dividends that our Bank subsidiary and nonbank subsidiary may pay to us. Also, our right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event our bank subsidiary is unable to pay dividends to us, we may not be able to service debt, pay obligations, or pay dividends on our common and preferred stock. The inability to receive dividends from our bank subsidiary could have a material adverse effect on our business, financial condition, and results of operations.

RISKS RELATED TO AN INVESTMENT IN OUR COMMON STOCK

The market price for our common stock varies, and you should purchase common stock for long-term investment only.

Although our common stock is currently traded on the NASDAQ Global Select Market, we cannot assure you that there will, at any time in the future, be an active trading market for our common stock. Even if there is an active trading market for our common stock, we cannot assure you that you will be able to sell all of your shares of common stock at one time or at a favorable price, if at all. As a result, you should purchase shares of common stock described herein only if you are capable of, and seeking, to make a long-term investment in our common stock.

We may issue debt and equity securities or securities convertible into equity securities, any of which may be senior to our common stock as to distributions and in liquidation, which could negatively affect the value of our common stock.

In the future, we may attempt to increase our capital resources by entering into debt or debt-like financing that is unsecured or secured by all or up to all of our assets, or by issuing additional debt or equity securities, which could include issuances of secured or unsecured commercial paper, medium-term notes, senior notes, subordinated notes, preferred stock or securities convertible into or exchangeable for equity securities. In the event of our liquidation, our lenders and holders of our debt and preferred securities would receive a distribution of our available assets before distributions to the holders of our common stock. Because our decision to incur debt and issue securities in our future offerings will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings and debt financings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future.

We may not pay dividends on our common stock.

Holders of our common stock are only entitled to receive such dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically declared cash dividends on our common stock, we are not required to do so and may reduce or eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock.

Our certificate of incorporation, our bylaws, and certain banking laws may have an anti-takeover effect.

Provisions of our certificate of incorporation, our bylaws, and federal and state banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may discourage others from initiating a potential merger, takeover or other change of control transaction, which, in turn, could adversely affect the market price of our common stock.

 

- 24 -


Table of Contents
ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

 

ITEM 2. PROPERTIES

We own a 27,400 square foot building in Warsaw, New York that serves as our headquarters, and principal executive and administrative offices. Additionally, we are obligated under a lease commitment through 2017 for a 17,750 square foot regional administrative facility in Pittsford, New York.

We are engaged in the banking business through 52 branch offices, of which 36 are owned and 16 are leased, in fifteen contiguous counties of Western and Central New York: Allegany, Cattaraugus, Cayuga, Chautauqua, Chemung, Erie, Genesee, Livingston, Monroe, Ontario, Orleans, Seneca, Steuben, Wyoming and Yates Counties. The operating leases for our branch offices expire at various dates through the year 2036 and generally include options to renew.

We believe that our properties have been adequately maintained, are in good operating condition and are suitable for our business as presently conducted, including meeting the prescribed security requirements. For additional information, see Note 6, Premises and Equipment, Net, and Note 10, Commitments and Contingencies, in the accompanying financial statements included in Part II, Item 8, of this Annual Report on Form 10-K.

 

ITEM 3. LEGAL PROCEEDINGS

From time to time we are a party to or otherwise involved in legal proceedings arising in the normal course of business. Management does not believe that there is any pending or threatened proceeding against us, which, if determined adversely, would have a material adverse effect on our business, results of operations or financial condition.

 

ITEM 4. MINE SAFETY DISCLOSURES

Not applicable.

 

- 25 -


Table of Contents

PART II

 

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

Our common stock is traded on the NASDAQ Global Select Market under the ticker symbol “FISI.” At December 31, 2012, 13,787,709 shares of our common stock were outstanding and held by approximately 1,400 shareholders of record. During 2012, the high sales price of our common stock was $19.52 and the low sales price was $15.22. The closing price per share of common stock on December 31, 2012, the last trading day of our fiscal year, was $18.63. We declared dividends of $0.57 per common share during the year ended December 31, 2012. See additional information regarding the market price and dividends paid in Part II, Item 6, “Selected Financial Data”.

We have paid regular quarterly cash dividends on our common stock and our Board of Directors presently intends to continue this practice, subject to our results of operations and the need for those funds for debt service and other purposes. See the discussions in the section captioned “Supervision and Regulation” included in Part I, Item 1, “Business”, in the section captioned “Liquidity and Capital Resources” included in Part II, Item 7, in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 11, Regulatory Matters, in the accompanying financial statements included in Part II, Item 8, “Financial Statements and Supplementary Data”, all of which are included elsewhere in this report and incorporated herein by reference thereto.

Equity Compensation Plan Information

The following table sets forth, as of December 31, 2012, information about our equity compensation plans that have been approved by our shareholders, including the number of shares of our common stock exercisable under all outstanding options, warrants and rights, the weighted average exercise price of all outstanding options, warrants and rights and the number of shares available for future issuance under our equity compensation plans. We have no equity compensation plans that have not been approved by our shareholders.

 

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

Plan Category

   (a)     (b)     (c)  

Equity compensation plans
approved by shareholders

     398,855 (1)    $ 20.22 (1)      651,464 (2) 

Equity compensation plans
not approved by shareholders

     —        $ —          —     

 

(1) 

Includes 79,580 shares of unvested restricted stock awards outstanding as of December 31, 2012. The weighted average exercise price excludes such awards.

(2) 

Represents the 940,000 aggregate shares approved for issuance under our two active equity compensation plans, reduced by 373,297 shares, which are the 227,623 restricted stock awards issued under these plans to date plus an adjustment of 145,674 shares. Pursuant to the terms of the plans, for purposes of calculating the number of shares available for issuance, each share of common stock granted pursuant to a restricted stock award shall count as 1.64 shares of common stock.

 

- 26 -


Table of Contents

Stock Performance Graph

The stock performance graph below compares (a) the cumulative total return on our common stock for the period beginning December 31, 2007 as reported by the NASDAQ Global Select Market, through December 31, 2012, (b) the cumulative total return on stocks included in the NASDAQ Composite Index over the same period, and (c) the cumulative total return, as compiled by SNL Financial L.C., of Major Exchange (NYSE, AMEX and NASDAQ) Banks with $1 billion to $5 billion in assets over the same period. Cumulative return assumes the reinvestment of dividends. The graph was prepared by SNL Financial, LC and is expressed in dollars based on an assumed investment of $100.

 

LOGO

 

     Period Ending  

Index

   12/31/07      12/31/08      12/31/09      12/31/10      12/31/11      12/31/12  

Financial Institutions, Inc.

     100.00         83.16         71.33         117.63         103.06         122.99   

NASDAQ Composite

     100.00         60.02         87.24         103.08         102.26         120.42   

SNL Bank $1B-$5B Index

     100.00         82.94         59.45         67.39         61.46         75.75   

 

- 27 -


Table of Contents
ITEM 6. SELECTED FINANCIAL DATA

 

     At or for the year ended December 31,  
(Dollars in thousands, except selected ratios and per share data)    2012     2011     2010     2009     2008  

Selected financial condition data:

          

Total assets

   $ 2,764,034      $ 2,336,353      $ 2,214,307      $ 2,062,389      $ 1,916,919   

Loans, net

     1,681,012        1,461,516        1,325,524        1,243,265        1,102,330   

Investment securities

     841,701        650,815        694,530        620,074        606,038   

Deposits

     2,261,794        1,931,599        1,882,890        1,742,955        1,633,263   

Borrowings

     179,806        150,698        103,877        106,390        70,820   

Shareholders’ equity

     253,897        237,194        212,144        198,294        190,300   

Common shareholders’ equity (1)

     236,426        219,721        158,359        144,876        137,226   

Tangible common shareholders’ equity (2)

     185,606        182,352        120,990        107,507        99,577   

Selected operations data:

          

Interest income

   $ 97,567      $ 95,118      $ 96,509      $ 94,482      $ 98,948   

Interest expense

     9,051        13,255        17,720        22,217        33,617   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     88,516        81,863        78,789        72,265        65,331   

Provision for loan losses

     7,128        7,780        6,687        7,702        6,551   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income after provision for loan losses

     81,388        74,083        72,102        64,563        58,780   

Noninterest income (loss) (3)

     24,777        23,925        19,454        18,795        (48,778

Noninterest expense

     71,397        63,794        60,917        62,777        57,461   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes

     34,768        34,214        30,639        20,581        (47,459

Income tax expense (benefit)

     11,319        11,415        9,352        6,140        (21,301
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ 23,449      $ 22,799      $ 21,287      $ 14,441      $ (26,158
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Preferred stock dividends and accretion

     1,474        3,182        3,725        3,697        1,538   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) applicable to common shareholders

   $ 21,975      $ 19,617      $ 17,562      $ 10,744      $ (27,696
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Stock and related per share data:

          

Earnings (loss) per common share:

          

Basic

   $ 1.60      $ 1.50      $ 1.62      $ 0.99      $ (2.54

Diluted

     1.60        1.49        1.61        0.99        (2.54

Cash dividends declared on common stock

     0.57        0.47        0.40        0.40        0.54   

Common book value per share (1)

     17.15        15.92        14.48        13.39        12.71   

Tangible common book value per share (2)

     13.46        13.21        11.06        9.94        9.22   

Market price (NASDAQ: FISI):

          

High

     19.52        20.36        20.74        15.99        22.50   

Low

     15.22        12.18        10.91        3.27        10.06   

Close

     18.63        16.14        18.97        11.78        14.35   

Performance ratios:

          

Net income (loss), returns on:

          

Average assets

     0.93     1.00     0.98     0.71     -1.37

Average equity

     9.46        9.82        10.07        7.43        -14.30   

Average common equity (1)

     9.53        9.47        11.14        7.61        -16.84   

Average tangible common equity (2)

     11.74        11.55        14.59        10.37        -21.87   

Common dividend payout ratio (4)

     35.63        31.33        24.69        40.40        NA   

Net interest margin (fully tax-equivalent)

     3.95        4.04        4.07        4.04        3.93   

Efficiency ratio (5)

     62.87     60.55     60.36     65.52     64.07

 

(1) 

Excludes preferred shareholders’ equity.

(2) 

Excludes preferred shareholders’ equity, goodwill and other intangible assets.

(3) 

The 2012, 2011, 2010, 2009 and 2008 figures include other-than-temporary impairment (“OTTI”) charges of $91 thousand, $18 thousand, $594 thousand, $4.7 million and $68.2 million, respectively.

(4) 

Common dividend payout ratio equals dividends declared during the year divided by earnings per share for the year. There is no ratio shown for years where we both declared a dividend and incurred a loss because the ratio would result in a negative payout since the dividend declared (paid out) will always be greater than 100% of earnings.

(5) 

Efficiency ratio equals noninterest expense less other real estate expense and amortization of intangible assets as a percentage of net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities and proceeds from company owned life insurance included in income (all from continuing operations).

 

- 28 -


Table of Contents
     At or for the year ended December 31,  
(Dollars in thousands, except per share data)    2012     2011     2010     2009     2008  

Capital ratios:

          

Leverage ratio

     7.70     8.63     8.31     7.96     8.05

Tier 1 capital ratio

     10.70        12.20        12.34        11.95        11.83   

Total risk-based capital ratio

     11.96        13.45        13.60        13.21        13.08   

Equity to assets (3)

     9.84        10.20        9.75        9.55        9.60   

Common equity to assets (1) (3)

     9.15        9.10        7.28        6.94        8.63   

Tangible common equity to tangible assets (2) (3)

     7.56     7.58     5.65     5.19     6.78

Asset quality:

          

Non-performing loans

   $ 9,125      $ 7,076      $ 7,582      $ 8,681      $ 8,196   

Non-performing assets

     10,062        9,187        8,895        10,442        9,252   

Allowance for loan losses

     24,714        23,260        20,466        20,741        18,749   

Net loan charge-offs

   $ 5,674      $ 4,986      $ 6,962      $ 5,710      $ 3,323   

Non-performing loans to total loans

     0.53     0.48     0.56     0.69     0.73

Non-performing assets to total assets

     0.36        0.39        0.40        0.51        0.48   

Net charge-offs to average loans

     0.36        0.36        0.54        0.47        0.32   

Allowance for loan losses to total loans

     1.45        1.57        1.52        1.64        1.67   

Allowance for loan losses to non-performing loans

     271     329     270     239     229

Other data:

          

Number of branches

     52        50        50        50        51   

Full time equivalent employees

     628        575        577        572        600   

 

(1) 

Excludes preferred shareholders’ equity.

(2) 

Excludes preferred shareholders’ equity, goodwill and other intangible assets. Ratios calculated using average balances for the periods shown.

 

- 29 -


Table of Contents

SELECTED QUARTERLY DATA

 

     Fourth      Third      Second      First  
(Dollars in thousands, except per share data)    Quarter      Quarter      Quarter      Quarter  

2012

           

Interest income

   $ 25,087       $ 25,299       $ 23,731       $ 23,450   

Interest expense

     1,999         2,200         2,343         2,509   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income

     23,088         23,099         21,388         20,941   

Provision for loan losses

     2,520         1,764         1,459         1,385   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income, after provision for loan losses

     20,568         21,335         19,929         19,556   

Noninterest income

     6,283         6,353         6,690         5,451   

Noninterest expense

     17,541         21,618         16,581         15,657   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     9,310         6,070         10,038         9,350   

Income tax expense

     2,978         1,805         3,382         3,154   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 6,332       $ 4,265       $ 6,656       $ 6,196   
  

 

 

    

 

 

    

 

 

    

 

 

 

Preferred stock dividends

     369         368         368         369   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income applicable to common shareholders

   $ 5,963       $ 3,897       $ 6,288       $ 5,827   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per common share (1):

           

Basic

   $ 0.44       $ 0.28       $ 0.46       $ 0.43   

Diluted

     0.43         0.28         0.46         0.42   

Market price (NASDAQ: FISI):

           

High

   $ 19.39       $ 19.52       $ 17.66       $ 17.99   

Low

     17.61         16.50         15.51         15.22   

Close

     18.63         18.64         16.88         16.17   

Dividends declared

   $ 0.16       $ 0.14       $ 0.14       $ 0.13   

2011

           

Interest income

   $ 23,875       $ 23,774       $ 23,830       $ 23,639   

Interest expense

     2,721         3,156         3,577         3,801   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income

     21,154         20,618         20,253         19,838   

Provision for loan losses

     2,162         3,480         1,328         810   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income, after provision for loan losses

     18,992         17,138         18,925         19,028   

Noninterest income

     5,767         8,036         4,974         5,148   

Noninterest expense

     16,279         17,012         15,153         15,350   
  

 

 

    

 

 

    

 

 

    

 

 

 

Income before income taxes

     8,480         8,162         8,746         8,826   

Income tax expense

     2,718         2,664         3,027         3,006   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

   $ 5,762       $ 5,498       $ 5,719       $ 5,820   
  

 

 

    

 

 

    

 

 

    

 

 

 

Preferred stock dividends

     369         368         370         2,075   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income applicable to common shareholders

   $ 5,393       $ 5,130       $ 5,349       $ 3,745   
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per common share (1):

           

Basic

   $ 0.39       $ 0.38       $ 0.39       $ 0.33   

Diluted

     0.39         0.37         0.39         0.33   

Market price (NASDAQ: FISI):

           

High

   $ 17.26       $ 17.98       $ 17.93       $ 20.36   

Low

     12.18         13.63         15.20         16.40   

Close

     16.14         14.26         16.42         17.52   

Dividends declared

   $ 0.13       $ 0.12       $ 0.12       $ 0.10   

 

(1) 

Earnings per share data is computed independently for each of the quarters presented. Therefore, the sum of the quarterly earnings per common share amounts may not equal the total for the year.

 

- 30 -


Table of Contents

2012 FOURTH QUARTER RESULTS

Net income was $6.3 million for the fourth quarter of 2012 compared with $5.8 million for the fourth quarter of 2011. After preferred dividends, fourth quarter diluted earnings per share for 2012 was $0.43 compared with $0.39 per share for the fourth quarter of 2011.

Net interest income totaled $23.1 million for the three months ended December 31, 2012, an increase of $1.9 million or 9% over the fourth quarter of 2011. Average earning assets increased $293.1 million during the fourth quarter 2012 compared to the same quarter last year, the result of a $219.6 million increase in average loans combined with a $73.5 million increase in investment securities.

The net interest margin on a tax-equivalent basis was 3.92% in the fourth quarter of 2012, compared with 4.07% in the fourth quarter of 2011. Our yield on earning-assets decreased 33 basis points in the fourth quarter of 2012 compared with the same quarter last year, a result of cash flows being reinvested in the current low interest rate environment, which includes the impact of investing the cash from the branch acquisitions into lower yielding securities. The cost of interest-bearing liabilities decreased 22 basis points compared with the fourth quarter of 2011, primarily a result of the continued downward re-pricing of our certificates of deposit.

The provision for loan losses was $2.5 million for the fourth quarter of 2012 compared with $2.2 million for the fourth quarter of 2011. Net charge-offs for the fourth quarter of 2012 were $2.1 million, or 0.50% annualized, of average loans, compared to $1.9 million, or 0.51% annualized, of average loans in the fourth quarter of 2011. See the sections “Allowance for Loan Losses” and “Non-performing Assets and Potential Problem Loans” for additional information on net charge-offs and non-performing loans.

Noninterest income totaled $6.3 million for the fourth quarter of 2012, a 9% increase over the fourth quarter of 2011. The majority of the increase related to a $452 thousand increase in income from service charges on deposit accounts when comparing the fourth quarter 2012 compared with the same quarter last year.

Noninterest expense was $17.5 million for the fourth quarter of 2012, an increase of $1.3 million or 8% from the fourth quarter of 2011. The increases in expenses across all categories for the fourth quarter of 2012 compared to the fourth quarter of 2011 reflect higher infrastructure costs to support the increased number of branches and employees.

Income tax expense for the fourth quarter of 2012 was $3.0 million compared to $2.7 million for the fourth quarter of 2011. The change in income tax expense was primarily due to an $830 thousand increase in pretax income between the periods.

 

- 31 -


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

The following is a discussion and analysis of our financial position and results of operations and should be read in conjunction with the information set forth under Part I, Item 1A, “Risks Factors”, and our consolidated financial statements and notes thereto appearing under Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.

OVERVIEW

Business Overview

Financial Institutions, Inc. is a financial holding company headquartered in New York State, providing banking and nonbanking financial services to individuals and businesses primarily in our Western and Central New York footprint. We have also expanded our indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. Through our wholly-owned banking subsidiary, Five Star Bank, we provide a wide range of services, including business and consumer loan and depository services, as well as other traditional banking services. Through our nonbanking subsidiary, Five Star Investment Services, we provide brokerage and investment advisory services to supplement our banking business.

Our primary sources of revenue are net interest income (interest earned on our loans and securities, net of interest paid on deposits and other funding sources) and noninterest income, particularly fees and other revenue from financial services provided to customers or ancillary services tied to loans and deposits. Business volumes and pricing drive revenue potential, and tend to be influenced by overall economic factors, including market interest rates, business spending, consumer confidence, economic growth, and competitive conditions within the marketplace. We are not able to predict market interest rate fluctuations with certainty and our asset/liability management strategy may not prevent interest rate changes from having a material adverse effect on our results of operations and financial condition.

2012 Significant Events

Branch Acquisitions. During 2012, we successfully completed the acquisition of eight retail bank branch locations in Upstate New York. Former HSBC Bank USA, N.A. branches located in Albion, Elmira, Elmira Heights, and Horseheads were acquired in August, complementing the former First Niagara Bank, N.A. locations in Batavia, Brockport, Medina, and Seneca Falls acquired in June. Through the acquisition we assumed deposits of $286.8 million and acquired in-market performing loans of $75.6 million. The acquisition of these branch offices was a marked success. We were able to integrate the offices and customer accounts seamlessly. Through detailed planning, we ensured that our sales and support staff members were ready to assist customers with any questions or issues. The feedback we received from our customers was positive and executing on our detailed planning process ultimately resulted in deposit retention rates that were better than expected. We incurred approximately $3.0 million in pre-tax expense during 2012 related to the branch acquisitions.

The combined assets acquired and deposits assumed in the two transactions were recorded at their estimated fair values as follows:

 

Cash

   $ 195,778   

Loans

     75,635   

Bank premises and equipment

     1,938   

Goodwill

     11,599   

Core deposit intangible asset

     2,042   

Other assets

     339   
  

 

 

 

Total assets acquired

   $ 287,331   
  

 

 

 

Deposits assumed

   $ 286,819   

Other liabilities

     512   
  

 

 

 

Total liabilities assumed

   $ 287,331   
  

 

 

 

In anticipation of the branch acquisitions, we leveraged our balance sheet through the execution of short-term FHLB advances in order to “pre-acquire” investment securities. This strategy allowed us to purchase securities over time and carry out a dollar cost averaging strategy. Our purchase of investment securities was comprised of mortgage-backed securities, U.S. Government agencies and sponsored enterprise bonds and tax-exempt municipal bonds. The cash received at the time of closing the transactions was used to pay down the short-term FHLB advances used to fund the purchase of the investment securities.

For detailed information on the accounting for the branch acquisitions, see Note 2, Branch Acquisitions, of the notes to consolidated financial statements.

 

- 32 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

Leadership Transition. In August 2012, Peter G. Humphrey our former President and Chief Executive Officer retired. Mr. Humphrey continues to serve as a member of our Board of Directors. Following Mr. Humphrey’s retirement, our Board of Directors appointed John E. Benjamin to serve as our Interim Chief Executive Officer in August 2012. At the same time, we also announced the promotion of Richard Harrison as Chief Operating Officer and Martin Birmingham as President and Chief of Community Banking. Mr. Harrison and Mr. Birmingham were instrumental in the structuring, negotiating and integrating the branch office acquisitions. We incurred approximately $2.6 million in pre-tax expense during 2012 related to the retirement of Mr. Humphrey.

The Board of Directors subsequently appointed Mr. Birmingham as President and Chief Executive Officer, effective March 1, 2013.

2012 Performance Summary

Our net income was $23.4 million for the year ended December 31, 2012, compared to a net income of $22.8 million for the year ended December 31, 2011. For 2012, net income available to common shareholders was $22.0 million, or $1.60 per diluted common share, compared to 2011 net income available to common shareholders of $19.6 million, or $1.49 per diluted common share. Cash dividends of $0.57 and $0.47 per common share were declared in 2012 and 2011, respectively.

We had total assets of $2.764 billion at December 31, 2012 compared to $2.336 billion at December 31, 2011. At December 31, 2012, shareholders’ equity totaled $253.9 million with book value per common share at $17.15, compared to $237.2 million with book value per common share at $15.92 at the end of 2011. The Tier 1 capital ratio was 10.70% as of December 31, 2012 compared to 12.20% at December 31, 2011.

Key factors behind these results are discussed below.

 

  At December 31, 2012, total loans were $1.706 billion, up $220.9 million or 15% from year-end 2011. At December 31, 2012, total loans included $64.5 million in loans obtained in the branch acquisitions. Total deposits at December 31, 2012, were $2.262 billion, up $330.2 million or 17% from year-end 2011, primarily attributable to $286.8 million in retail deposits assumed from the branch acquisitions. Our deposit mix remains favorably weighted in demand, savings and money market accounts, which comprised 71% of total deposits at the end of 2012 compared to 64% of total deposits at the end of 2011.

 

  Nonperforming loans were $9.1 million or 0.53% of total loans at December 31, 2012, compared to $7.1 million or 0.48% of total loans at December 31, 2011.

 

  The provision for loan losses was $7.1 million and $7.8 million, respectively, for 2012 and 2011. Net charge-offs were $5.7 million in 2012 (or 0.36% of average loans) compared to $5.0 million in 2011 (or 0.36% of average loans).

 

  At year-end 2012, the allowance for loan losses of $24.7 million represented 1.45% of total loans (covering 271% of non-performing loans), compared to $23.3 million or 1.57% (covering 329% of non-performing loans) at year-end 2011. Excluding loans acquired in the branch acquisitions during 2012, the allowance for loan losses was 1.51% of total loans at year-end 2012.

 

  Taxable equivalent net interest income was $90.8 million for 2012 or 8% higher than $83.9 million in 2011. Taxable equivalent interest income increased $2.7 million, while interest expense decreased by $4.2 million. The increase in taxable equivalent net interest income was a function of a favorable volume variance (increasing taxable equivalent net interest income by $11.7 million), partially offset by an unfavorable rate variance (decreasing taxable equivalent net interest income by $4.8 million).

 

  The net interest margin for 2012 was 3.95%, 9 basis points lower than 4.04% in 2011.

 

  Noninterest income was $24.8 million for 2012 compared to $23.9 million for 2011. Core fee-based revenues (defined as service charges on deposit accounts, ATM and debit fees, and broker-dealer fees and commissions) totaled $15.4 million for 2012, a $580 thousand or 4% increase from $14.9 million in 2011. Net mortgage banking income was $2.0 million for 2012, an increase of $323 thousand or 19% from $1.7 million in 2011.

 

  Net investment securities gains (defined as net gain on sales and calls of investment securities and impairment charges on investment securities) were $2.6 million for 2012 compared to $3.0 million for 2011.

 

  Noninterest expense for 2012 was $71.4 million, an increase of $7.6 million or 12% over 2011. As previously mentioned, noninterest expense for 2012 includes pre-tax expenses of approximately $3.0 million related to the branch acquisitions and $2.6 million incurred in association with the retirement of our former CEO. Noninterest expense for 2011 includes a loss on extinguishment of debt of $1.1 million, recognized as a result of redeeming our 10.20% junior subordinated debentures. Excluding these expenses, which we consider to be non-recurring in nature, noninterest expense increased $3.1 million or 5% when comparing 2012 to 2011.

 

- 33 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 2012 AND DECEMBER 31, 2011

Net Interest Income and Net Interest Margin

Net interest income is the primary source of our revenue. Net interest income is the difference between interest income on interest-earning assets, such as loans and investment securities, and the interest expense on interest-bearing deposits and other borrowings used to fund interest-earning and other assets or activities. Net interest income is affected by changes in interest rates and by the amount and composition of earning assets and interest-bearing liabilities, as well as the sensitivity of the balance sheet to changes in interest rates, including characteristics such as the fixed or variable nature of the financial instruments, contractual maturities and repricing frequencies.

Interest rate spread and net interest margin are utilized to measure and explain changes in net interest income. Interest rate spread is the difference between the yield on earning assets and the rate paid for interest-bearing liabilities that fund those assets. The net interest margin is expressed as the percentage of net interest income to average earning assets. The net interest margin exceeds the interest rate spread because noninterest-bearing sources of funds (“net free funds”), principally noninterest-bearing demand deposits and stockholders’ equity, also support earning assets. To compare tax-exempt asset yields to taxable yields, the yield on tax-exempt investment securities is computed on a taxable equivalent basis. Net interest income, interest rate spread, and net interest margin are discussed on a taxable equivalent basis.

The following table reconciles interest income per the consolidated statements of income to interest income adjusted to a fully taxable equivalent basis for the years ended December 31 (in thousands):

 

     2012      2011      2010  

Interest income per consolidated statements of income

   $ 97,567       $ 95,118       $ 96,509   

Adjustment to fully taxable equivalent basis

     2,284         2,062         1,895   
  

 

 

    

 

 

    

 

 

 

Interest income adjusted to a fully taxable equivalent basis

     99,851         97,180         98,404   

Interest expense per consolidated statement of income

     9,051         13,255         17,720   
  

 

 

    

 

 

    

 

 

 

Net interest income on a taxable equivalent basis

   $ 90,800       $ 83,925       $ 80,684   
  

 

 

    

 

 

    

 

 

 

Taxable equivalent net interest income of $90.8 million for 2012 was $6.9 million or 8% higher than 2011. The impact of a decline in average yields on our assets was diminished by a $217.4 million or 10% increase in interest-earning assets. The average balance of loans rose $199.6 million or 14% to $1.593 billion, reflecting growth in every loan category. Consistent with our strategic plan, we continue to pursue loan development efforts in the commercial and consumer indirect lending portfolios in accordance with prudent underwriting standards.

The increase in taxable equivalent net interest income was a function of a favorable volume variance as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $11.7 million, partially offset by an unfavorable rate variance that decreased taxable equivalent net interest income by $4.8 million. The change in mix and volume of earning assets increased taxable equivalent interest income by $11.2 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $474 thousand, for a net favorable volume impact of $11.7 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $8.5 million, while changes in rates on interest-bearing liabilities lowered interest expense by $3.7 million, for a net unfavorable rate impact of $4.8 million.

The net interest margin for 2012 was 3.95% compared to 4.04% in 2011.

The decrease in net interest margin was attributable to a 7 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The interest rate spread decreased by 2 basis points to 3.85% for the year ended December 31, 2012, as a 32 basis point decrease in the yield on earning assets more than offset the 30 basis point decrease in the cost of interest-bearing liabilities.

The Federal Reserve left the Federal funds rate unchanged at 0.25% during 2010 through 2012. During 2011, the Federal Reserve disclosed that short-term interest rates would be held near zero through at least the middle of 2013, in anticipation of low growth and little risk of inflation. In April 2012, the Federal Reserve further announced that interest rates will likely remain at exceptionally low levels through late 2014. As a result of the Federal Reserve’s policy, we expect net interest margin and interest rate spread to continue to tighten.

 

- 34 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

For 2012, the yield on average earning assets of 4.35% was 32 basis points lower than 2011. Loan yields decreased 44 basis points to 5.09%. Commercial mortgage and consumer indirect loans in particular, down 28 and 84 basis points, respectively, continued to experience lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 27 basis points to 2.66%, also impacted by the lower interest rate environment, prepayments of mortgage-related investment securities and the impact of investing the excess cash related to our branch acquisitions into low yielding securities. Overall, earning asset rate changes reduced interest income by $8.5 million.

The cost of average interest-bearing liabilities of 0.50% in 2012 was 30 basis points lower than 2011. The average cost of interest-bearing deposits was 0.50% in 2012, 24 basis points lower than 2011, reflecting the sustained low-rate environment. The cost of borrowings decreased 110 basis points to 0.48% for 2012, primarily a result of the redemption of the Company’s 10.20% junior subordinated debentures during the third quarter of 2011. The interest-bearing liability rate changes reduced interest expense by $3.7 million during 2012.

Average interest-earning assets of $2.297 billion in 2012 were $217.4 million or 10% higher than 2011. Average investment securities increased $17.9 million while average loans increased $199.6 million or 14%. The growth in average loans was comprised of increases in all loan categories, with consumer loans up $130.5 million, commercial loans up $63.4 million and residential mortgage loans up $5.6 million.

Average interest-bearing liabilities of $1.825 billion in 2012 were up $162.9 million or 10% versus 2011. The impacts of the recent recession continue to positively impact our deposit balances, as consumers tend to save more when consumer confidence is low. On average, interest-bearing deposits grew $156.2 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $62.0 million. Average borrowings increased $6.7 million, representing a $22.6 million increase and $15.9 million decrease in short-term and long-term borrowings, respectively.

 

- 35 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

The following tables present, for the periods indicated, information regarding: (i) the average balance sheet; (ii) the amount of interest income from interest-earning assets and the resulting annualized yields (tax-exempt yields have been adjusted to a tax-equivalent basis using the applicable Federal tax rate in each year); (iii) the amount of interest expense on interest-bearing liabilities and the resulting annualized rates; (iv) net interest income; (v) net interest rate spread; (vi) net interest income as a percentage of average interest-earning assets (“net interest margin”); and (vii) the ratio of average interest-earning assets to average interest-bearing liabilities. Investment securities are at amortized cost for both held to maturity and available for sale securities. Loans include net unearned income, net deferred loan fees and costs and non-accruing loans. Dollar amounts are shown in thousands.

 

    Years ended December 31,  
    2012     2011     2010  
    Average           Average     Average           Average     Average           Average  
    Balance     Interest     Rate     Balance     Interest     Rate     Balance     Interest     Rate  

Interest-earning assets:

                 

Federal funds sold and other interest-earning deposits

  $ 113      $ —          0.29   $ 140      $ —          0.20   $ 5,034      $ 10        0.21

Investment securities:

                 

Taxable

    525,912        12,202        2.32        545,112        14,185        2.60        571,856        17,101        2.99   

Tax-exempt

    177,731        6,526        3.67        140,657        5,890        4.19        108,900        5,416        4.97   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investment securities

    703,643        18,728        2.66        685,769        20,075        2.93        680,756        22,517        3.31   

Loans:

                 

Commercial business

    242,100        11,263        4.65        215,598        10,311        4.78        206,167        9,939        4.82   

Commercial mortgage

    407,737        22,182        5.44        370,843        21,216        5.72        338,149        20,389        6.03   

Residential mortgage

    127,363        6,637        5.21        121,742        6,868        5.64        138,954        8,157        5.87   

Home equity

    257,537        10,984        4.27        216,428        9,572        4.42        202,189        9,224        4.56   

Consumer indirect

    533,589        27,371        5.13        444,527        26,549        5.97        382,977        25,379        6.63   

Other consumer

    25,058        2,686        10.72        24,686        2,589        10.49        26,950        2,789        10.35   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

    1,593,384        81,123        5.09        1,393,824        77,105        5.53        1,295,386        75,877        5.86   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-earning assets

    2,297,140        99,851        4.35        2,079,733        97,180        4.67        1,981,176        98,404        4.97   
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Less: Allowance for loan losses

    24,305            21,567            20,883       

Other noninterest-earning assets

    246,423            218,983            206,303       
 

 

 

       

 

 

       

 

 

     

Total assets

  $ 2,519,258          $ 2,277,149          $ 2,166,596       
 

 

 

       

 

 

       

 

 

     

Interest-bearing liabilities:

                 

Deposits:

                 

Interest-bearing demand

  $ 423,096        598        0.14      $ 383,122        614        0.16      $ 382,517        705        0.18   

Savings and money market

    586,329        998        0.17        451,030        1,056        0.23        414,953        1,133        0.27   

Certificates of deposit

    693,353        6,866        0.99        712,411        9,764        1.37        726,330        13,015        1.79   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing deposits

    1,702,778        8,462        0.50        1,546,563        11,434        0.74        1,523,800        14,853        0.97   

Short-term borrowings

    121,735        589        0.48        99,122        500        0.50        49,104        365        0.74   

Long-term borrowings

    —          —          —          15,905        1,321        8.31        37,043        2,502        6.75   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total borrowings

    121,735        589        0.48        115,027        1,821        1.58        86,147        2,867        3.33   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing liabilities

    1,824,513        9,051        0.50        1,661,590        13,255        0.80        1,609,947        17,720        1.10   
   

 

 

   

 

 

     

 

 

   

 

 

     

 

 

   

 

 

 

Noninterest-bearing deposits

    430,240            368,268            329,853       

Other liabilities

    16,506            15,041            15,485       

Shareholders’ equity

    247,999            232,250            211,311       
 

 

 

       

 

 

       

 

 

     

Total liabilities and shareholders’ equity

  $ 2,519,258          $ 2,277,149          $ 2,166,596       
 

 

 

       

 

 

       

 

 

     

Net interest income (tax-equivalent)

    $ 90,800          $ 83,925          $ 80,684     
   

 

 

       

 

 

       

 

 

   

Interest rate spread

        3.85         3.87         3.87
     

 

 

       

 

 

       

 

 

 

Net earning assets

  $ 472,627          $ 418,143          $ 371,229       
 

 

 

       

 

 

       

 

 

     

Net interest margin (tax-equivalent)

        3.95         4.04         4.07
     

 

 

       

 

 

       

 

 

 

Ratio of average interest-earning assets to average interest-bearing liabilities

    125.90         125.17         123.06    
 

 

 

       

 

 

       

 

 

     

 

- 36 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Rate/Volume Analysis

The following table presents, on a tax-equivalent basis, the relative contribution of changes in volumes and changes in rates to changes in net interest income for the periods indicated. The change in interest not solely due to changes in volume or rate has been allocated in proportion to the absolute dollar amounts of the change in each (in thousands):

 

     Change from 2012 to 2011     Change from 2011 to 2010  
Increase (decrease) in:    Volume     Rate     Total     Volume     Rate     Total  

Interest income:

            

Federal funds sold and other interest-earning deposits

   $ —        $ —        $ —        $ (5   $ (5   $ (10

Investment securities:

      

Taxable

     (487     (1,496     (1,983     (772     (2,144     (2,916

Tax-exempt

     1,422        (786     636        1,418        (944     474   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investment securities

     935        (2,282     (1,347     646        (3,088     (2,442

Loans:

      

Commercial business

     1,239        (287     952        452        (80     372   

Commercial mortgage

     2,041        (1,075     966        1,905        (1,078     827   

Residential mortgage

     308        (539     (231     (980     (309     (1,289

Home equity

     1,763        (351     1,412        636        (288     348   

Consumer indirect

     4,879        (4,057     822        3,829        (2,659     1,170   

Other consumer

     39        58        97        (237     37        (200
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

     10,269        (6,251     4,018        5,605        (4,377     1,228   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     11,204        (8,533     2,671        6,246        (7,470     (1,224
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense:

            

Deposits:

            

Interest-bearing demand

     60        (76     (16     1        (92     (91

Savings and money market

     271        (329     (58     93        (170     (77

Certificates of deposit

     (255     (2,643     (2,898     (245     (3,006     (3,251
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing deposits

     76        (3,048     (2,972     (151     (3,268     (3,419

Short-term borrowings

     110        (21     89        281        (146     135   

Long-term borrowings

     (660     (661     (1,321     (1,662     481        (1,181
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total borrowings

     (550     (682     (1,232     (1,381     335        (1,046
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

     (474     (3,730     (4,204     (1,532     (2,933     (4,465
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   $ 11,678      $ (4,803   $ 6,875      $ 7,778      $ (4,537   $ 3,241   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Provision for Loan Losses

The provision for loan losses is based upon credit loss experience, growth or contraction of specific segments of the loan portfolio, and the estimate of losses inherent in the current loan portfolio. The provision for loan losses was $7.1 million for the year ended December 31, 2012 compared with $7.8 million for 2011. See the “Allowance for Loan Losses” section of this Management’s Discussion and Analysis for further discussion.

 

- 37 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Noninterest Income

The following table summarizes our noninterest income for the years ended December 31 (in thousands):

 

     2012     2011     2010  

Service charges on deposits

   $ 8,627      $ 8,679      $ 9,585   

ATM and debit card

     4,716        4,359        3,995   

Broker-dealer fees and commissions

     2,104        1,829        1,283   

Company owned life insurance

     1,751        1,424        1,107   

Loan servicing

     617        835        1,124   

Net gain on sale of loans held for sale

     1,421        880        650   

Net gain on disposal of investment securities

     2,651        3,003        169   

Impairment charges on investment securities

     (91     (18     (594

Net (loss) gain on sale and disposal of other assets

     (381     67        (203

Other

     3,362        2,867        2,338   
  

 

 

   

 

 

   

 

 

 

Total noninterest income

   $ 24,777      $ 23,925      $ 19,454   
  

 

 

   

 

 

   

 

 

 

The components of noninterest income fluctuated as discussed below.

Service charges on deposits decreased slightly during 2012 compared to 2011. An increase in the number of customer accounts, including those added from the branch acquisitions in June and August of 2012, helped offset decreases in service charge income related to changes in customer behavior and regulatory changes that included the requirement that customers opt-in for overdraft coverage for certain types of electronic banking activities.

ATM and debit card income was $4.7 million for 2012, an increase of $357 thousand or 8%, compared to 2011. The increased popularity of electronic banking and transaction processing has resulted in higher ATM and debit card point-of-sale usage income.

Broker-dealer fees and commissions were up $275 thousand or 15%, compared to 2011. Broker-dealer fees and commissions fluctuate mainly due to sales volume, which continued to increase during 2012 as a result of improving market and economic conditions and our renewed focus on this line of business.

During the third quarter of 2011 we purchased an additional $18.0 million of company owned life insurance. The increased amount of insurance was largely responsible for the $327 thousand increase in company owned life insurance income for 2012.

Loan servicing income represents fees earned for servicing mortgage and indirect auto loans sold to third parties, net of amortization expense and impairment losses, if any, associated with capitalized loan servicing assets. Loan servicing income was down $218 thousand or 26% for the year ended December 31, 2012 compared to 2011. Loan servicing income decreased as a result of more rapid amortization of servicing rights due to loans paying off, lower fees collected due to a decrease in the sold and serviced portfolio and write-downs on capitalized mortgage servicing assets.

Net gain on loans held for sale was $1.4 million in 2012, an increase of $541 thousand or 61%, compared to 2011, mainly due to increased origination volume related primarily to refinancing activity, a result of low interest rates.

Net gains from the sales of investment securities were $2.7 million for the year ended December 31, 2012, compared to $3.0 million for the year ended December 31, 2011. During 2012, we recognized gains totaling $2.6 million from the sale of five pooled trust-preferred securities. Net gains for 2011 included $2.3 million from the sale of four pooled trust-preferred securities and $730 thousand from the sale of eight mortgage-backed securities. The amount and timing of our sale of investments securities is dependent on a number of factors, including our prudent efforts to realize gains while managing duration, premium and credit risk.

Due to their proximity to our existing locations, we consolidated four branches as part of the branch acquisitions. The majority of the loss on the disposal of other assets for 2012 was due to write-off of leasehold improvements and other fixed assets for these branches that were closed.

Other noninterest income increased $495 thousand or 17% for the year ended December 31, 2012, compared to 2011. Income from our investment in several limited partnerships and dividends from FHLB stock comprised the majority of the year-over-year increase.

 

- 38 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Noninterest Expense

The following table summarizes our noninterest expense for the years ended December 31 (in thousands):

 

     2012      2011      2010  

Salaries and employee benefits

   $ 40,127       $ 35,743       $ 32,844   

Occupancy and equipment

     11,419         10,868         10,818   

Professional services

     4,133         2,617         2,197   

Computer and data processing

     3,271         2,437         2,487   

Supplies and postage

     2,497         1,778         1,772   

FDIC assessments

     1,300         1,513         2,507   

Advertising and promotions

     929         1,259         1,121   

Loss on extinguishment of debt

     —           1,083         —     

Other

     7,721         6,496         7,171   
  

 

 

    

 

 

    

 

 

 

Total noninterest expense

   $ 71,397       $ 63,794       $ 60,917   
  

 

 

    

 

 

    

 

 

 

The components of noninterest expense fluctuated as discussed below.

Salaries and employee benefits (which includes salary-related expenses and fringe benefit expenses) was $40.1 million for 2012, up $4.4 million or 12% from 2011. As discussed earlier, salaries and employee benefits for 2012 included pre-tax costs of approximately $2.6 million that were incurred in association with the retirement of our former CEO. After adjusting for these expenses, the increase in salaries and employee benefits for 2012 when compared to the prior year is attributable to higher pension costs along with increased staffing levels. Full time equivalent employees increased by 9% to 628 at December 31, 2012 from 575 at December 31, 2011, primarily due to the branch acquisitions.

Occupancy and equipment increased by $551 thousand or 5% when comparing 2012 to 2011. The increase was primarily related to the growth in the branch network related to the branch acquisitions.

Professional services expense of $4.1 million in 2012 increased $1.5 million or 58% from 2011. Professional fees increased primarily due to legal expenses related to the branch acquisitions. The management transition described earlier also contributed to the increase in professional fees.

Computer and data processing and supplies and postage expense increased, collectively, by $1.6 million when comparing 2012 to 2011. The year-over-year increase was due to expenses related to the branch acquisition transactions.

FDIC assessments decreased $213 thousand for the year ended December 31, 2012, compared to 2011, primarily a result of changes implemented by the FDIC in the method of calculating assessment rates which became effective in the second quarter of 2011.

Advertising and promotions costs were $330 thousand or 26% lower in 2012 compared to 2011 due to the timing of marketing campaigns and promotions, coupled with cost management strategies.

We redeemed all of our 10.20% junior subordinated debentures during the third quarter of 2011. As a result of the redemption, we recognized a loss on extinguishment of debt of $1.1 million, consisting of a redemption premium of $852 thousand and a write-off of the remaining unamortized issuance costs of $231 thousand in 2011.

Other noninterest expense increased $1.2 million or 19% during 2012 compared to 2011. The increases in other noninterest expenses were primarily related to the branch acquisition transactions.

The efficiency ratio for the year ended December 31, 2012 was 62.87% compared with 60.55% for 2011. The higher efficiency ratio is attributable to the additional expenses related to the branch acquisitions and retirement of our former CEO, as previously discussed. The efficiency ratio is calculated by dividing total noninterest expense, excluding other real estate expense and amortization of intangible assets, by net revenue, defined as the sum of tax-equivalent net interest income and noninterest income before net gains and impairment charges on investment securities. Taxes are not part of this calculation. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same volume of income, while a decrease would indicate a more efficient allocation of resources.

Income Taxes

We recognized income tax expense of $11.3 million for 2012 compared to $11.4 million for 2011. The lower tax provision was primarily attributable to a decrease in our effective tax rate to 32.6% for 2012 compared to 33.4% for 2011. The lower effective tax rate in 2012 was a result of the greater impact of tax-exempt income on lower taxable income. Effective tax rates are impacted by items of income and expense that are not subject to federal or state taxation. Our effective tax rates reflect the impact of these items, which include, but are not limited to, interest income from tax-exempt securities and earnings on company owned life insurance.

 

- 39 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

RESULTS OF OPERATIONS FOR THE YEARS ENDED

DECEMBER 31, 2011 AND DECEMBER 31, 2010

Net Interest Income and Net Interest Margin

Net interest income in the consolidated statements of income (which excludes the taxable equivalent adjustment) was $81.9 million in 2011, compared to $78.8 million in 2010. The taxable equivalent adjustments (the adjustments to bring tax-exempt interest to a level that would yield the same after-tax income had that income been subject to a taxation using a tax rate of 35%) of $2.1 million and $1.9 million for 2011 and 2010, respectively, resulted in fully taxable equivalent net interest income of $83.9 million in 2011 and $80.7 million in 2010.

Taxable equivalent net interest income of $83.9 million for 2011 was $3.2 million or 4% higher than 2010. The impact of a decline in average yields on our assets was diminished by a 5% increase in interest-earning assets. The average balance of loans rose $98.4 million or 8% to $1.394 billion, reflecting growth in the commercial and consumer indirect loan portfolios, and the average balance of interest-earning assets rose $98.6 million to $2.080 billion.

The increase in taxable equivalent net interest income was a function of a favorable volume variance (as balance sheet changes in both volume and mix increased taxable equivalent net interest income by $7.8 million), partially offset by an unfavorable rate variance (decreasing taxable equivalent net interest income by $4.5 million). The change in mix and volume of earning assets increased taxable equivalent interest income by $6.3 million, while the change in volume and composition of interest-bearing liabilities decreased interest expense by $1.5 million, for a net favorable volume impact of $7.8 million on taxable equivalent net interest income. Rate changes on earning assets reduced interest income by $7.4 million, while changes in rates on interest-bearing liabilities lowered interest expense by $2.9 million, for a net unfavorable rate impact of $4.5 million.

The net interest margin for 2011 was 4.04% compared to 4.07% in 2010. The slight decrease in net interest margin was attributable to a 3 basis point lower contribution from net free funds (primarily attributable to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The interest rate spread remained unchanged from the year ended December 31, 2010 at 3.87%, as a 30 basis point decrease in the yield on earning assets offset the 30 basis point decrease in the cost of interest-bearing liabilities.

The Federal Reserve left the Federal funds rate unchanged at 0.25% during 2011 and 2010.

For 2011, the yield on average earning assets of 4.67% was 30 basis points lower than 2010. Loan yields decreased 33 basis points to 5.53%. Commercial mortgage and consumer indirect loans in particular, down 31 and 66 basis points, respectively, experienced lower yields given the competitive pricing pressures and re-pricing of loans in a low interest rate environment. The yield on investment securities dropped 38 basis points to 2.93%, also impacted by the lower interest rate environment and prepayments of mortgage-related investment securities. Overall, earning asset rate changes reduced interest income by $7.5 million.

The cost of average interest-bearing liabilities of 0.80% in 2011 was 30 basis points lower than 2010. The average cost of interest-bearing deposits was 0.74% in 2011, 23 basis points lower than 2010, reflecting the low-rate environment, mitigated by a focus on product pricing to retain balances. The cost of borrowings decreased 175 basis points to 1.58% for 2011, primarily a result of the redemption of the 10.20% junior subordinated debentures. The interest-bearing liability rate changes reduced interest expense by $2.9 million.

Average interest-earning assets of $2.080 billion in 2011 were $98.6 million or 5% higher than 2010. Average investment securities increased $5.0 million while average loans increased $98.4 million or 8%. Commercial loans increased $42.1 million and consumer loans increased $73.5 million, offset by a $17.2 million decrease in residential mortgage loans.

Average interest-bearing liabilities of $1.662 billion in 2011 were up $51.6 million or 3% versus 2010. On average, interest-bearing deposits grew $22.8 million, while average noninterest-bearing demand deposits (a principal component of net free funds) increased by $38.4 million. Average borrowings increased $28.9 million, representing a $50.0 million increase and $21.1 million decrease in short-term and long-term borrowings, respectively.

Provision for Loan Losses

The provision for loan losses was $7.8 million for the year ended December 31, 2011 compared with $6.7 million for 2010.

 

- 40 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Noninterest Income

Service charges on deposits were $8.7 million in 2011, which was $906 thousand or 9% lower than 2010. The decrease was primarily due to changes in customer behavior and regulatory changes that included requirements for customers to opt-in for overdraft coverage for certain types of electronic banking activities.

ATM and debit card income was $4.4 million for 2011, an increase of $364 thousand or 9%, compared to 2010. The increased popularity of electronic banking and transaction processing has resulted in higher ATM and debit card point-of-sale usage income.

Broker-dealer fees and commissions were up $546 thousand or 43%, compared to 2010, as a result of improving market and economic conditions and our renewed focus on this line of business.

Company owned life insurance income was up $317 thousand or 29% for the year ended December 31, 2011 compared to the same period in 2010. The increase was the result of an additional $18.0 million investment in company owned life insurance during the third quarter of 2011.

Loan servicing income was down $289 thousand or 26% for the year ended December 31, 2011 compared to 2010. Loan servicing income decreased as a result of more rapid amortization of servicing rights due to loans paying off, lower fees collected due to a decrease in the sold and serviced portfolio and write-downs on capitalized mortgage servicing assets.

Net gain on loans held for sale was $880 thousand in 2011, an increase of $230 thousand or 35%, compared to 2010, mainly due to the $153 thousand gain relating to the servicing retained sale of $13.0 million of indirect auto loans during the third quarter of 2011.

Net gains from the sales of investment securities were $3.0 million for the year ended December 31, 2011, compared to $169 thousand in 2010. Net gains from the sales of investment securities in 2011 included net gains of $2.3 million from the sale of four pooled trust-preferred securities that had been written down in prior periods and included in non-performing assets. Net gains of $730 thousand from the sale of eight mortgage-backed securities were also recognized during 2011.

Other noninterest income increased $529 thousand or 23% for the year ended December 31, 2011, compared to 2010. Other noninterest income for 2011 includes $152 thousand related to insurance proceeds received for losses relating to an irregular instance of fraudulent debit card activity recorded in the fourth quarter of 2010. Merchant services fees paid by customers for account management and electronic processing of transactions and income from our capital investment in several limited partnerships also contributed to the 2011 increases.

Noninterest Expense

Salaries and employee benefits (which includes salary-related expenses and fringe benefit expenses) was $35.7 million for 2011, up $2.9 million or 9% from 2010. Average full-time equivalent employees (“FTEs”) were 576 for 2011, about the same as 577 for 2010. Salary-related expenses increased $2.0 million for the year ended December 31, 2011, compared to 2010, reflecting an increase in estimated incentive compensation, which was previously limited under the TARP Capital Purchase Program. Fringe benefit expenses increased $672 thousand or 9%, primarily attributable to higher medical expenses.

Professional services expense of $2.6 million in 2011 increased $420 thousand or 19% from 2010, primarily due to legal and shareholder expenses related to our common stock offering and redemption of our Series A preferred stock and 10.20% junior subordinated debentures. We also recognized a loss on extinguishment of debt of $1.1 million in connection with the redemption of the 10.20% junior subordinated debentures during 2011.

FDIC assessments decreased $1.0 million for the year ended December 31, 2011, compared to 2010, primarily a result of changes implemented by the FDIC in the method of calculating assessment rates which became effective in the second quarter of 2011.

Advertising and promotions expenses were $138 thousand or 12% higher in 2011 compared to 2010 due to increases in business development expenses and the opening of a new branch in suburban Rochester in the third quarter of 2011.

Other noninterest expense decreased $404 thousand or 6% during 2011 compared to 2010. The 2010 expense includes a loss of approximately $1.0 million relating to irregular instances of fraudulent debit card activity.

The efficiency ratio for the year ended December 31, 2011 was 60.55% compared with 60.36% for 2010.

Income Taxes

We recognized income tax expense of $11.4 million for 2011 compared to $9.4 million for 2010. The change was due in part to a $3.6 million increase in pretax income between the years. In addition, during 2010, we recorded non-recurring tax benefits of $1.2 million related to valuation of our deferred tax assets as a result of the NYS repeal of the experience method for determining bad debts and re-valuing at the highest Federal statutory rate of 35%. Our effective tax rates were 33.4% in 2011 and 30.5% in 2010.

 

- 41 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

ANALYSIS OF FINANCIAL CONDITION

OVERVIEW

At December 31, 2012, we had total assets of $2.764 billion, an increase of 18% from $2.336 billion as of December 31, 2011, largely attributable to the branch acquisitions combined with our continued core business growth in both loans and deposits. Net loans were $1.681 billion as of December 31, 2012, up $219.5 million, or 15%, when compared to $1.462 billion as of December 31, 2011. The increase in net loans was primarily attributed to the continued expansion of the indirect lending program, commercial business development efforts and loans acquired in the branch acquisition. At December 31, 2012, total loans included $64.5 million in loans obtained in the branch acquisitions. Non-performing assets totaled $10.1 million as of December 31, 2012, up $875 thousand from a year ago. Total deposits amounted to $2.262 billion and $1.932 billion as of December 31, 2012 and 2011, respectively. As of December 31, 2012, borrowed funds totaled $179.8 million, compared to $150.7 million as of December 31, 2011. Book value per common share was $17.15 and $15.92 as of December 31, 2012 and 2011, respectively. As of December 31, 2012 our total shareholders’ equity was $253.9 million compared to $237.2 million a year earlier.

INVESTING ACTIVITIES

The following table summarizes the composition of the available for sale and held to maturity security portfolios (in thousands).

 

     Investment Securities Portfolio Composition  
     At December 31,  
     2012      2011      2010  
     Amortized      Fair      Amortized      Fair      Amortized      Fair  
     Cost      Value      Cost      Value      Cost      Value  

Securities available for sale:

                 

U.S. Government agency and government-sponsored enterprise securities

   $ 128,097       $ 131,695       $ 94,947       $ 97,712       $ 141,591       $ 140,784   

State and political subdivisions

     188,997         195,210         119,099         124,424         105,622         105,666   

Mortgage-backed securities:

                 

Agency mortgage-backed securities

     479,913         494,770         390,375         401,596         414,502         417,709   

Non-Agency mortgage-backed securities

     73         1,098         327         2,089         981         1,572   

Asset-backed securities

     121         1,023         297         1,697         564         637   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total available for sale securities

     797,201         823,796         605,045         627,518         663,260         666,368   

Securities held to maturity:

                 

State and political subdivisions

     17,905         18,478         23,297         23,964         28,162         28,849   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

   $ 815,106       $ 842,274       $ 628,342       $ 651,482       $ 691,422       $ 695,217   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Our investment policy is contained within our overall Asset-Liability Management and Investment Policy. This policy dictates that investment decisions will be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, need for collateral and desired risk parameters. In pursuing these objectives, we consider the ability of an investment to provide earnings consistent with factors of quality, maturity, marketability, pledgeable nature and risk diversification. Our Treasurer, guided by ALCO, is responsible for investment portfolio decisions within the established policies.

Impairment Assessment

We review investment securities on an ongoing basis for the presence of OTTI with formal reviews performed quarterly. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses or the security is intended to be sold or will be required to be sold. The amount of the impairment related to non-credit related factors is recognized in other comprehensive income. Evaluating whether the impairment of a debt security is other than temporary involves assessing i.) the intent to sell the debt security or ii.) the likelihood of being required to sell the security before the recovery of its amortized cost basis. In determining whether the other-than-temporary impairment includes a credit loss, we use our best estimate of the present value of cash flows expected to be collected from the debt security considering factors such as: a.) the length of time and the extent to which the fair value has been less than the amortized cost basis, b.) adverse conditions specifically related to the security, an industry, or a geographic area, c.) the historical and implied volatility of the fair value of the security, d.) the payment structure of the debt security and the likelihood of the issuer being able to make payments that increase in the future, e.) failure of the issuer of the security to make scheduled interest or principal payments, f.) any changes to the rating of the security by a rating agency, and g.) recoveries or additional declines in fair value subsequent to the balance sheet date.

 

- 42 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

As of December 31, 2012, management does not have the intent to sell any of the securities in a loss position and believes that it is not likely that it will be required to sell any such securities before the anticipated recovery of amortized cost. The unrealized losses are largely due to increases in market interest rates over the yields available at the time the underlying securities were purchased. The fair value is expected to recover as the bonds approach their maturity date, repricing date or if market yields for such investments decline. Management does not believe any of the securities in a loss position are impaired due to reasons of credit quality. Accordingly, as of December 31, 2012, management has concluded that unrealized losses on its investment securities are temporary and no further impairment loss has been realized in our consolidated statements of income. The following discussion provides further details of our assessment of the securities portfolio by investment category.

U.S. Government Agencies and Government Sponsored Enterprises (“GSE”). As of December 31, 2012, there were six securities in an unrealized loss position in the U.S. Government agencies and GSE portfolio with unrealized losses totaling $69 thousand. Of these, three were in an unrealized loss position for 12 months or longer and had an aggregate amortized cost of $3.0 million and unrealized losses of $2 thousand. The decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is likely that we will not be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at December 31, 2012.

State and Political Subdivisions. As of December 31, 2012, the state and political subdivisions (“municipals”) portfolio totaled $213.1 million, of which $195.2 million was classified as available for sale. As of that date, $17.9 million was classified as held to maturity with a fair value of $18.5 million. As of December 31, 2012, there were 36 municipals in an unrealized loss position, all of which were available for sale and in an unrealized loss position for less than 12 months. Those 36 securities had an aggregate amortized cost of $8.5 million and unrealized losses totaling $72 thousand.

Because the decline in fair value is attributable to changes in interest rates, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at December 31, 2012.

Agency Mortgage-backed Securities. With the exception of the non-Agency mortgage-backed securities (“non-Agency MBS”) discussed below, all of the mortgage-backed securities held by us as of December 31, 2012, were issued by U.S. Government sponsored entities and agencies (“Agency MBS”), primarily FNMA. The contractual cash flows of our Agency MBS are guaranteed by FNMA, FHLMC or GNMA. The GNMA mortgage-backed securities are backed by the full faith and credit of the U.S. Government.

As of December 31, 2012, there were ten securities in the Agency MBS portfolio that were in an unrealized loss position. Of these, three were in an unrealized loss position for 12 months or longer and had an aggregate amortized cost of $1.2 million and unrealized losses of $2 thousand. Given the high credit quality inherent in Agency MBS, we do not consider any of the unrealized losses as of December 31, 2012 on such MBS to be credit related or other-than-temporary. As of December 31, 2012, we did not intend to sell any of Agency MBS that were in an unrealized loss position, all of which were performing in accordance with their terms.

Non-Agency Mortgage-backed Securities. Our non-Agency MBS portfolio consists of positions in two privately issued whole loan collateralized mortgage obligations with a fair value of $1.1 million and net unrealized gains of $1.0 million as of December 31, 2012. As of that date, each of the two non-Agency MBS were rated below investment grade. None of these securities were in an unrealized loss position.

Asset-backed Securities (“ABS”). As of December 31, 2012, the fair value of our ABS portfolio totaled $1.0 million and consisted of positions in six securities, the majority of which are pooled trust preferred securities (“TPS”) issued primarily by insurance companies and, to a lesser extent, financial institutions located throughout the United States. As a result of some issuers defaulting and others electing to defer interest payments, we considered the TPS to be non-performing and stopped accruing interest on these investments during 2009. As of December 31, 2012, each of the securities in the ABS portfolio was rated below investment grade. None of these securities were in an unrealized loss position.

During 2012, we recognized gains totaling $2.6 million from the sale of five TPS. The five securities had a fair value of $1.1 million at December 31, 2011. We continue to monitor the market for these securities and evaluate the potential for future dispositions.

Other Investments. As a member of the FHLB the Bank is required to hold FHLB stock. The amount of required FHLB stock is based on the Bank’s asset size and the amount of borrowings from the FHLB. We have assessed the ultimate recoverability of our FHLB stock and believe that no impairment currently exists. As a member of the FRB system, we are required to maintain a specified investment in FRB stock based on a ratio relative to our capital. At December 31, 2012, our ownership of FHLB and FRB stock totaled $8.4 million and $3.9 million, respectively and is included in other assets and recorded at cost, which approximates fair value.

 

- 43 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

LENDING ACTIVITIES

Total loans were $1.706 billion at December 31, 2012, an increase of $220.9 million or 15% from December 31, 2011. Commercial loans increased $44.9 million or 7% and represented 39.4% of total loans at the end of 2012. Residential mortgage loans were $133.5 million, up $19.6 million or 17% and represented 7.8% of total loans at December 31, 2012, while consumer loans increased $156.4 million to represent 52.8% of total loans at December 31, 2012 compared to 50.1% at December 31, 2011. The composition of our loan portfolio, excluding loans held for sale and including net unearned income and net deferred fees and costs, is summarized as follows (in thousands):

 

    Loan Portfolio Composition  
    At December 31,  
    2012     2011     2010     2009     2008  
    Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  

Commercial business

  $ 258,675        15.2   $ 233,836        15.7   $ 211,031        15.7   $ 206,383        16.3   $ 180,100        16.1

Commercial mortgage

    413,324        24.2        393,244        26.5        352,930        26.2        330,748        26.2        285,383        25.5   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total commercial

    671,999        39.4        627,080        42.2        563,961        41.9        537,131        42.5        465,483        41.6   

Residential mortgage

    133,520        7.8        113,911        7.7        129,580        9.6        144,215        11.4        177,683        15.8   

Home equity

    286,649        16.8        231,766        15.6        208,327        15.5        200,684        15.9        189,794        16.9   

Consumer indirect

    586,794        34.4        487,713        32.9        418,016        31.1        352,611        27.9        255,054        22.8   

Other consumer

    26,764        1.6        24,306        1.6        26,106        1.9        29,365        2.3        33,065        2.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total consumer

    900,207        52.8        743,785        50.1        652,449        48.5        582,660        46.1        477,913        42.6   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

    1,705,726        100.0     1,484,776        100.0     1,345,990        100.0     1,264,006        100.0     1,121,079        100.0

Allowance for loan losses

    24,714          23,260          20,466          20,741          18,749     
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

Total loans, net

  $ 1,681,012        $ 1,461,516        $ 1,325,524        $ 1,243,265        $ 1,102,330     
 

 

 

     

 

 

     

 

 

     

 

 

     

 

 

   

As of December 31, 2012, the residential mortgage portfolio consisted of $28.2 million of loans acquired with the branch acquisitions and $105.3 million of organic loans. The decrease in organic residential mortgage loans from $129.6 million to $113.9 million to $105.3 million for the periods ending December 31, 2010, 2011 and 2012, respectively, and the increase in consumer indirect loans from $418.0 million to $487.7 million to $586.8 million for the same periods reflects a strategic shift to increase our consumer indirect loan portfolio, while placing less emphasis on expanding our residential mortgage loan portfolio, coupled with our practice of selling the majority of our fixed-rate residential mortgages in the secondary market with servicing rights retained.

Commercial loans increased during 2012 as we continued our commercial business development efforts. The credit risk related to commercial loans is largely influenced by general economic conditions and the resulting impact on a borrower’s operations or on the value of underlying collateral, if any.

The Company participates in various lending programs in which guarantees are supplied by U.S. government agencies, such as the SBA, U.S. Department of Agriculture, Rural Economic and Community Development and Farm Service Agency, among others. As of December 31, 2012, the principal balance of such loans (included in commercial loans) was $62.5 million and the guaranteed portion amounted to $43.1 million. Most of these loans were guaranteed by the SBA.

Commercial business loans were $258.7 million at the end of 2012, up $24.8 million or 11% since year-end 2011, and comprised 15.2% of total loans outstanding at December 31, 2012. We typically originate business loans of up to $15.0 million for small to mid-sized businesses in our market area for working capital, equipment financing, inventory financing, accounts receivable financing, or other general business purposes. Loans of this type are in a diverse range of industries. Within the commercial business classification, loans to finance agricultural production totaled approximately 1% of commercial business loans as of December 31, 2012. As of December 31, 2012, commercial business SBA loans accounted for a total of $38.9 million or 15% of our commercial business loan portfolio.

Commercial mortgage loans totaled $413.3 million at December 31, 2012, up $20.1 million or 5% from December 31, 2011, and comprised 24.2% of total loans, compared to 26.5% at December 31, 2011. Commercial mortgage includes both owner occupied and non-owner occupied commercial real estate loans. Approximately 46% and 45% of the commercial mortgage portfolio at December 31, 2012 and 2011, respectively, was owner occupied commercial real estate. The majority of our commercial real estate loans are secured by office buildings, manufacturing facilities, distribution/warehouse facilities, and retail centers, which are generally located in our local market area. As of December 31, 2012, commercial mortgage SBA loans accounted for a total of $18.1 million or 4% of our commercial mortgage loan portfolio.

Our current lending standards for commercial real estate and real estate construction lending are determined by property type and specifically address many criteria, including: maximum loan amounts, maximum loan-to-value (“LTV”), requirements for pre-leasing and / or pre-sales, minimum debt-service coverage ratios, minimum borrower equity, and maximum loan to cost. Currently, the maximum standard for LTV is 85%, with lower limits established for certain higher risk types, such as raw land which has a 65% LTV maximum.

 

- 44 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Residential mortgage loans totaled $133.5 million at the end of 2012, up $19.6 million or 17% from the prior year and comprised 7.8% of total loans outstanding at December 31, 2012 and 7.7% at December 31, 2011. Residential mortgage loans include conventional first lien home mortgages and we generally limit the maximum loan to 85% of collateral value without credit enhancement (e.g. PMI insurance). As part of management’s historical practice of originating and servicing residential mortgage loans, the majority of our fixed-rate residential mortgage loans are sold in the secondary market with servicing rights retained. Residential mortgage products continue to be underwritten using FHLMC and FNMA secondary marketing guidelines.

Consumer loans totaled $900.2 million at December 31, 2012, up $156.4 million or 21% compared to 2011, and represented 52.8% of the 2012 year-end loan portfolio versus 50.1% at year-end 2011. Loans in this classification include indirect consumer, home equity and other consumer installment loans. Credit risk for these types of loans is generally influenced by general economic conditions, the characteristics of individual borrowers, and the nature of the loan collateral. Risks of loss are generally on smaller average balances per loan spread over many borrowers. Once charged off, there is usually less opportunity for recovery on these smaller retail loans. Credit risk is primarily controlled by reviewing the creditworthiness of the borrowers, monitoring payment histories, and taking appropriate collateral and guaranty positions.

Consumer indirect loans amounted to $586.8 million at December 31, 2012 up $99.1 million or 20% compared to 2011, and represented 34.4% of the 2012 year-end loan portfolio versus 32.9% at year-end 2011. The loans are primarily for the purchase of automobiles (both new and used) and light duty trucks primarily to individuals, but also to corporations and other organizations. The loans are originated through dealerships and assigned to us with terms that typically range from 36 to 84 months. During the year ended December 31, 2012, we originated $324.6 million in indirect loans with a mix of approximately 49% new auto and 51% used vehicles. This compares with $266.7 million in indirect loans with a mix of approximately 46% new auto and 54% used vehicles for the same period in 2011. The increase in loans for new autos reflects changes in market conditions in 2012. We do business with over 400 franchised auto dealers located in Western, Central, and the Capital District of New York, and Northern Pennsylvania.

Home equity consists of home equity lines, as well as home equity loans, some of which are first lien positions. Home equities amounted to $286.6 million at December 31, 2012 up $54.9 million or 24% compared to 2011, and represented 16.8% of the 2012 year-end loan portfolio versus 15.6% at year-end 2011. The increase included home equities acquired in the branch acquisitions, which totaled $26.8 million at December 31, 2012. The portfolio had a weighted average LTV at origination of approximately 54% and 53% at December 31, 2012 and 2011, respectively. Approximately 69% of the loans in the home equity portfolio were first lien positions at December 31, 2012 and 2011.

Our underwriting guidelines for home equity products includes a combination of borrower FICO (credit score), the LTV of the property securing the loan and evidence of the borrower having sufficient income to repay the loan. Currently, for home equity products, the maximum acceptable LTV is 90%. The average FICO score for new home equity production was 758 in 2012 compared to 755 in 2011.

Other consumer loans totaled $26.8 million at December 31, 2012, up $2.5 million or 10% compared to 2011, and represented 1.6% of the loan portfolio at December 31, 2012 and 2011. The increase in other consumer loans is attributed to loans acquired in the branch acquisitions, which totaled $3.4 million at December 31, 2012. Other consumer consists of personal loans (collateralized and uncollateralized) and deposit account collateralized loans.

Factors that are important to managing overall credit quality are sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an appropriate allowance for loan losses, and sound nonaccrual and charge off policies.

An active credit risk management process is used for commercial loans to further ensure that sound and consistent credit decisions are made. Credit risk is controlled by detailed underwriting procedures, comprehensive loan administration, and periodic review of borrowers’ outstanding loans and commitments. Borrower relationships are formally reviewed and graded on an ongoing basis for early identification of potential problems. Further analyses by customer, industry, and geographic location are performed to monitor trends, financial performance, and concentrations.

The loan portfolio is widely diversified by types of borrowers, industry groups, and market areas within our core footprint. Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to numerous borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions. At December 31, 2012, no significant concentrations, as defined above, existed in our portfolio in excess of 10% of total loans.

 

- 45 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Loans Held for Sale and Loan Servicing Rights. Loans held for sale (not included in the loan portfolio composition table) were entirely comprised of residential real estate mortgages and totaled $1.5 million and $2.4 million as of December 31, 2012 and 2011, respectively.

We sell certain qualifying newly originated or refinanced residential real estate mortgages on the secondary market. Residential real estate mortgages serviced for others, which are not included in the consolidated statements of financial condition, amounted to $273.3 million and $297.8 million as of December 31, 2012 and 2011, respectively.

During 2011, we sold $13.0 million of indirect auto loans, which were reclassified from portfolio to loans held for sale during the second quarter of 2011. The loan servicing asset for the sold and serviced indirect auto loans, included in other assets in the consolidated statements of financial condition, was $250 thousand and $574 thousand as of December 31, 2012 and 2011, respectively.

Allowance for Loan Losses

The following table summarizes the activity in the allowance for loan losses (in thousands).

 

     Loan Loss Analysis  
     Year Ended December 31,  
     2012     2011     2010     2009     2008  

Allowance for loan losses, beginning of year

   $ 23,260      $ 20,466      $ 20,741      $ 18,749      $ 15,521   

Charge-offs:

          

Commercial business

     729        1,346        3,426        2,360        720   

Commercial mortgage

     745        751        263        355        1,192   

Residential mortgage

     326        152        290        225        320   

Home equity

     305        449        259        195        110   

Consumer indirect

     6,589        4,713        4,669        3,637        2,011   

Other consumer

     874        877        909        1,058        1,106   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total charge-offs

     9,568        8,288        9,816        7,830        5,459   

Recoveries:

          

Commercial business

     336        401        326        428        684   

Commercial mortgage

     261        245        501        150        315   

Residential mortgage

     130        90        21        12        26   

Home equity

     44        44        36        20        19   

Consumer indirect

     2,769        2,066        1,485        1,030        548   

Other consumer

     354        456        485        480        544   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total recoveries

     3,894        3,302        2,854        2,120        2,136   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs

     5,674        4,986        6,962        5,710        3,323   

Provision for loan losses

     7,128        7,780        6,687        7,702        6,551   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Allowance for loan losses, end of year

   $ 24,714      $ 23,260      $ 20,466      $ 20,741      $ 18,749   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net charge-offs to average loans

     0.36     0.36     0.54     0.47     0.32

Allowance to end of period loans

     1.45     1.57     1.52     1.64     1.67

Allowance to end of period non-performing loans

     271     329     270     239     229

 

- 46 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

The following table sets forth the allocation of the allowance for loan losses by loan category as of the dates indicated. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which actual losses may occur. The total allowance is available to absorb losses from any segment of the loan portfolio (in thousands).

 

    Allowance for Loan Losses by Loan Category  
    At December 31,  
    2012     2011     2010     2009     2008  
          Percentage           Percentage           Percentage           Percentage           Percentage  
    Loan     of loans by     Loan     of loans by     Loan     of loans by     Loan     of loans by     Loan     of loans by  
    Loss     category to     Loss     category to     Loss     category to     Loss     category to     Loss     category to  
    Allowance     total loans     Allowance     total loans     Allowance     total loans     Allowance     total loans     Allowance     total loans  

Commercial business

  $ 4,884        15.2   $ 4,036        15.7   $ 3,712        15.7   $ 4,407        16.3   $ 3,300        16.1

Commercial mortgage

    6,581        24.2        6,418        26.5        6,431        26.2        6,638        26.2        4,635        25.5   

Residential mortgage

    740        7.8        858        7.7        1,013        9.6        1,251        11.4        2,516        15.8   

Home equity

    1,282        16.8        1,242        15.6        972        15.5        1,043        15.9        2,374        16.9   

Consumer indirect

    10,715        34.4        10,189        32.9        7,754        31.1        6,837        27.9        5,152        22.8   

Other consumer

    512        1.6        517        1.6        584        1.9        565        2.3        772        2.9   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 24,714        100.0   $ 23,260        100.0   $ 20,466        100.0   $ 20,741        100.0   $ 18,749        100.0
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Management believes that the allowance for loan losses at December 31, 2012 is adequate to cover probable losses in the loan portfolio at that date. Factors beyond our control, however, such as general national and local economic conditions, can adversely impact the adequacy of the allowance for loan losses. As a result, no assurance can be given that adverse economic conditions or other circumstances will not result in increased losses in the portfolio or that the allowance for loan losses will be sufficient to meet actual loan losses. See Part I, Item 1A “Risk Factors” for the risks impacting this estimate. Management presents a quarterly review of the adequacy of the allowance for loan losses to our Board of Directors based on the methodology that is described in further detail in Part I, Item I “Business” under the section titled “Lending Activities”. See also “Critical Accounting Estimates” for additional information on the allowance for loan losses.

Non-performing Assets and Potential Problem Loans

The following table sets forth information regarding non-performing assets (in thousands):

 

     Non-performing Assets  
     At December 31,  
     2012     2011     2010     2009     2008  

Non-accruing loans:

          

Commercial business

   $ 3,413      $ 1,259      $ 947      $ 650      $ 510   

Commercial mortgage

     1,799        2,928        3,100        2,288        2,670   

Residential mortgage

     2,040        1,644        2,102        2,376        3,365   

Home equity

     939        682        875        880        1,143   

Consumer indirect

     891        558        514        621        445   

Other consumer

     25        —          41        7        56   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-accruing loans

     9,107        7,071        7,579        6,822        8,189   

Restructured accruing loans

     —          —          —          —          —     

Accruing loans contractually past due over 90 days

     18        5        3        1,859        7   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing loans

     9,125        7,076        7,582        8,681        8,196   

Foreclosed assets

     184        475        741        746        1,007   

Non-performing investment securities

     753        1,636        572        1,015        49   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total non-performing assets

   $ 10,062      $ 9,187      $ 8,895      $ 10,442      $ 9,252   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Non-performing loans to total loans

     0.53     0.48     0.56     0.69     0.73

Non-performing assets to total assets

     0.36     0.39     0.40     0.51     0.48

 

- 47 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Non-performing assets include non-performing loans, foreclosed assets and non-performing investment securities. Non-performing assets at December 31, 2012 were $10.1 million, an increase of $875 thousand from the $9.2 million balance at December 31, 2011. The primary component of non-performing assets is non-performing loans, which were $9.1 million or 0.53% of total loans at December 31, 2012, an increase of $2.0 million from $7.1 million or 0.48% of total loans at December 31, 2011. The Company’s ratio of non-performing loans to total loans continues to compare favorably to its peer group average, which was 2.48% of total loans at September 30, 2012, the most recent period for which information is available (Source: Federal Financial Institutions Examination Council — Bank Holding Company Performance Report as of September 30, 2012 — Top-tier bank holding companies having consolidated assets between $1 billion and $3 billion).

Approximately $4.2 million, or 46%, of the $9.1 million in non-performing loans as of December 31, 2012 were current with respect to payment of principal and interest, but were classified as non-accruing because repayment in full of principal and/or interest was uncertain. For non-accruing loans outstanding as of December 31, 2012, the amount of interest income forgone totaled $555 thousand. Included in nonaccrual loans are troubled debt restructurings (“TDRs”) of $636 thousand at December 31, 2012. We had no TDRs that were accruing interest as of December 31, 2012.

Foreclosed assets consist of real property formerly pledged as collateral to loans, which we have acquired through foreclosure proceedings or acceptance of a deed in lieu of foreclosure. Foreclosed asset holdings represented 5 properties totaling $184 thousand at December 31, 2012 and 8 properties totaling $475 thousand at December 31, 2011.

Non-performing investment securities for which we have stopped accruing interest were $753 thousand at December 31, 2012, compared to $1.6 million at December 31, 2011. Non-performing investment securities are included in non-performing assets at fair value and are comprised of pooled trust preferred securities. There have been no securities transferred to non-performing status since the first quarter of 2009. During 2012, we recognized gains totaling $2.6 million from the sale of five ABS securities. The five securities had a fair value of $1.1 million at December 31, 2011. We continue to monitor the market for these securities and evaluate the potential for future dispositions.

Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes management to have concern as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and/or personal or government guarantees. Management considers loans classified as substandard, which continue to accrue interest, to be potential problem loans. We identified $13.8 million and $8.6 million in loans that continued to accrue interest which were classified as substandard as of December 31, 2012 and 2011, respectively. Included in potential problem loans at December 31, 2012 is one credit relationship which we internally downgraded to substandard status from special mention during the fourth quarter 2012. The relationship consists of commercial business and commercial mortgage loans with unpaid principal balances totaling $3.4 million. The downgrade necessitated a provision and increase in our allowance for losses of approximately $400 thousand. These loans were performing in accordance with their contractual terms as of December 31, 2012, however, we continue to monitor this relationship closely.

In addition, we currently have a large commercial relationship with an Industrial Development Agency project in our market area. The relationship consists of a $14.1 million first lien mortgage position and $3.5 million second lien mortgage on a manufacturing facility. Recent events with the underlying third party tenant of the project has resulted in our monitoring the credit relationship more closely and including the first mortgage loan as “uncriticized—watch” and the second mortgage loan as “special mention” in our loan rating system. The loans are current as of December 31, 2012.

 

- 48 -


Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

FUNDING ACTIVITIES

Deposits

The following table summarizes the composition of our deposits (dollars in thousands).

 

     At December 31,  
     2012     2011     2010  
     Amount      Percent     Amount      Percent     Amount      Percent