10-Q 1 d768714d10q.htm 10-Q 10-Q
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2014

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

 

 

 

LOGO

(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

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller company)    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 registrant had 13,863,226 shares of Common Stock, $0.01 par value, outstanding as of July 31, 2014.

 

 

 


Table of Contents

FINANCIAL INSTITUTIONS, INC.

Form 10-Q

For the Quarterly Period Ended June 30, 2014

TABLE OF CONTENTS

 

     PAGE  

PART I.

  FINANCIAL INFORMATION   

ITEM 1.

  Financial Statements   
  Consolidated Statements of Financial Condition — at June 30, 2014 (Unaudited) and December 31, 2013      3   
  Consolidated Statements of Income (Unaudited) — Three and six months ended June 30, 2014 and 2013      4   
  Consolidated Statements of Comprehensive Income (Loss) (Unaudited) — Three and six months ended June 30, 2014 and 2013      5   
  Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) — Six months ended June 30, 2014 and 2013      6   
  Consolidated Statements of Cash Flows (Unaudited) — Six months ended June 30, 2014 and 2013      7   
  Notes to Consolidated Financial Statements (Unaudited)      8   

ITEM 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      28   

ITEM 3.

  Quantitative and Qualitative Disclosures About Market Risk      47   

ITEM 4.

  Controls and Procedures      48   

PART II.

  OTHER INFORMATION   

ITEM 1.

  Legal Proceedings      49   

ITEM 1A.

  Risk Factors      49   

ITEM 6.

  Exhibits      49   
  Signatures      50   

 

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Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Financial Condition

 

(Dollars in thousands, except share and per share data)    June 30,     December 31,  
     2014     2013  
     (Unaudited)        
ASSETS     

Cash and cash equivalents:

    

Cash and due from banks

   $ 64,738      $ 59,598   

Federal funds sold and interest-bearing deposits in other banks

     94        94   
  

 

 

   

 

 

 

Total cash and cash equivalents

     64,832        59,692   

Securities available for sale, at fair value

     601,903        609,400   

Securities held to maturity, at amortized cost (fair value of $266,640 and $250,657, respectively)

     262,057        249,785   

Loans held for sale

     201        3,381   

Loans (net of allowance for loan losses of $27,166 and $26,736, respectively)

     1,869,498        1,806,883   

Company owned life insurance

     50,033        49,171   

Premises and equipment, net

     35,925        36,009   

Goodwill and other intangible assets, net

     49,826        50,002   

Other assets

     58,989        64,313   
  

 

 

   

 

 

 

Total assets

   $ 2,993,264      $ 2,928,636   
  

 

 

   

 

 

 
LIABILITIES AND SHAREHOLDERS’ EQUITY     

Deposits:

    

Noninterest-bearing demand

   $ 551,229      $ 535,472   

Interest-bearing demand

     507,083        470,733   

Savings and money market

     766,594        717,928   

Certificates of deposit

     625,172        595,923   
  

 

 

   

 

 

 

Total deposits

     2,450,078        2,320,056   

Short-term borrowings

     254,683        337,042   

Other liabilities

     18,676        16,699   
  

 

 

   

 

 

 

Total liabilities

     2,723,437        2,673,797   
  

 

 

   

 

 

 

Shareholders’ equity:

    

Series A 3% preferred stock, $100 par value; 1,533 shares authorized; 1,492 and 1,496 shares issued, respectively

     149        149   

Series B-1 8.48% preferred stock, $100 par value; 200,000 shares authorized; 171,906 and 171,927 shares issued, respectively

     17,191        17,193   
  

 

 

   

 

 

 

Total preferred equity

     17,340        17,342   

Common stock, $0.01 par value; 50,000,000 shares authorized; 14,161,597 shares issued

     142        142   

Additional paid-in capital

     67,223        67,574   

Retained earnings

     194,418        186,137   

Accumulated other comprehensive (loss) income

     (3,720     (10,187

Treasury stock, at cost – 299,121 and 332,242 shares, respectively

     (5,576     (6,169
  

 

 

   

 

 

 

Total shareholders’ equity

     269,827        254,839   
  

 

 

   

 

 

 

Total liabilities and shareholders’ equity

   $ 2,993,264      $ 2,928,636   
  

 

 

   

 

 

 

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Income (Unaudited)

 

(In thousands, except per share amounts)    Three months ended      Six months ended  
     June 30,      June 30,  
     2014      2013      2014     2013  

Interest income:

          

Interest and fees on loans

   $ 20,230       $ 20,064       $ 40,497      $ 40,443   

Interest and dividends on investment securities

     4,653         4,278         9,445        8,647   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total interest income

     24,883         24,342         49,942        49,090   
  

 

 

    

 

 

    

 

 

   

 

 

 

Interest expense:

          

Deposits

     1,577         1,665         3,102        3,336   

Short-term borrowings

     203         153         462        343   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total interest expense

     1,780         1,818         3,564        3,679   
  

 

 

    

 

 

    

 

 

   

 

 

 

Net interest income

     23,103         22,524         46,378        45,411   

Provision for loan losses

     1,758         1,193         3,864        3,902   
  

 

 

    

 

 

    

 

 

   

 

 

 

Net interest income after provision for loan losses

     21,345         21,331         42,514        41,509   
  

 

 

    

 

 

    

 

 

   

 

 

 

Noninterest income:

          

Service charges on deposits

     2,241         2,568         4,491        4,709   

ATM and debit card

     1,257         1,317         2,431        2,566   

Investment advisory

     561         650         1,124        1,349   

Company owned life insurance

     425         438         828        853   

Investments in limited partnerships

     81         136         707        297   

Loan servicing

     176         152         330        225   

Net gain on disposal of investment securities

     949         332         1,262        1,224   

Net gain on sale of loans held for sale

     50         35         155        235   

Net gain (loss) on disposal of other assets

     24         38         (11     39   

Other

     813         710         1,617        1,432   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest income

     6,577         6,376         12,934        12,929   
  

 

 

    

 

 

    

 

 

   

 

 

 

Noninterest expense:

          

Salaries and employee benefits

     9,063         9,226         18,319        18,935   

Occupancy and equipment

     3,139         3,035         6,374        6,204   

Professional services

     1,384         1,093         2,356        2,030   

Computer and data processing

     777         812         1,500        1,516   

Supplies and postage

     535         608         1,047        1,288   

FDIC assessments

     388         364         810        725   

Advertising and promotions

     214         253         393        467   

Other

     2,308         2,071         4,222        3,881   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest expense

     17,808         17,462         35,021        35,046   
  

 

 

    

 

 

    

 

 

   

 

 

 

Income before income taxes

     10,114         10,245         20,427        19,392   

Income tax expense

     3,082         3,395         6,176        6,393   
  

 

 

    

 

 

    

 

 

   

 

 

 

Net income

   $ 7,032       $ 6,850       $ 14,251      $ 12,999   
  

 

 

    

 

 

    

 

 

   

 

 

 

Preferred stock dividends

     365         367         731        735   
  

 

 

    

 

 

    

 

 

   

 

 

 

Net income available to common shareholders

   $ 6,667       $ 6,483       $ 13,520      $ 12,264   
  

 

 

    

 

 

    

 

 

   

 

 

 

Earnings per common share (Note 2):

          

Basic

   $ 0.48       $ 0.47       $ 0.98      $ 0.89   

Diluted

   $ 0.48       $ 0.47       $ 0.98      $ 0.89   

Cash dividends declared per common share

   $ 0.19       $ 0.18       $ 0.38      $ 0.36   

Weighted average common shares outstanding:

          

Basic

     13,791         13,739         13,782        13,728   

Diluted

     13,838         13,767         13,831        13,767   

See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss) (Unaudited)

 

(Dollars in thousands)    Three months ended     Six months ended  
     June 30,     June 30,  
     2014      2013     2014      2013  

Net income

   $ 7,032       $ 6,850      $ 14,251       $ 12,999   

Other comprehensive income (loss), net of tax:

          

Net unrealized gains (losses) on securities available for sale

     2,684         (14,470     6,428         (16,785

Pension and post-retirement obligations

     20         199        39         398   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total other comprehensive income (loss), net of tax

     2,704         (14,271     6,467         (16,387
  

 

 

    

 

 

   

 

 

    

 

 

 

Comprehensive income (loss)

   $ 9,736       $ (7,421   $ 20,718       $ (3,388
  

 

 

    

 

 

   

 

 

    

 

 

 

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Changes in Shareholders’ Equity (Unaudited)

Six months ended June 30, 2014 and 2013

 

(Dollars in thousands,

except per share data)

   Preferred
Equity
    Common
Stock
     Additional
Paid-in
Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Treasury
Stock
    Total
Shareholders’
Equity
 

Balance at January 1, 2013

   $  17,471      $  142       $  67,710      $  172,244      $ 3,253      $ (6,923   $  253,897   

Comprehensive income:

               

Net income

     —          —           —          12,999        —          —          12,999   

Other comprehensive loss, net of tax

     —          —           —          —          (16,387     —          (16,387

Purchases of common stock for treasury

     —          —           —          —          —          (229     (229

Repurchase of Series B-1 8.48% preferred stock

     (77     —           (2     —          —          —          (79

Share-based compensation plans:

               

Share-based compensation

     —          —           205        —          —          —          205   

Stock options exercised

     —          —           (3     —          —          62        59   

Restricted stock awards issued, net

     —          —           (427     —          —          427        —     

Excess tax benefit on share-based compensation

     —          —           (10     —          —          —          (10

Directors’ retainer

     —          —           7        —          —          105        112   

Cash dividends declared:

               

Series A 3% Preferred-$1.50 per share

     —          —           —          (2     —          —          (2

Series B-1 8.48% Preferred-$4.24 per share

     —          —           —          (733     —          —          (733

Common-$0.36 per share

     —          —           —          (4,944     —          —          (4,944
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2013

   $ 17,394      $ 142       $ 67,480      $ 179,564      $ (13,134   $ (6,558   $ 244,888   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at January 1, 2014

   $ 17,342      $ 142       $ 67,574      $ 186,137      $ (10,187   $ (6,169   $ 254,839   

Comprehensive income:

               

Net income

     —          —           —          14,251        —          —          14,251   

Other comprehensive income, net of tax

     —          —           —          —          6,467        —          6,467   

Purchases of common stock for treasury

     —          —           —          —          —          (195     (195

Repurchase of Series B-1 8.48% preferred stock

     (2     —           —          —          —          —          (2

Share-based compensation plans:

               

Share-based compensation

     —          —           305        —          —          —          305   

Stock options exercised

     —          —           (1     —          —          133        132   

Restricted stock awards issued, net

     —          —           (655     —          —          655        —     

Cash dividends declared:

               

Series A 3% Preferred-$1.50 per share

     —          —           —          (2     —          —          (2

Series B-1 8.48% Preferred-$4.24 per share

     —          —           —          (729     —          —          (729

Common-$0.38 per share

     —          —           —          (5,239     —          —          (5,239
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2014

   $ 17,340      $ 142       $ 67,223        194,418      $ (3,720   $ (5,576   $ 269,827   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (Unaudited)

 

(Dollars in thousands)    Six months ended  
     June 30,  
     2014     2013  

Cash flows from operating activities:

    

Net income

   $ 14,251      $ 12,999   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     2,061        2,099   

Net amortization of premiums on securities

     1,582        2,560   

Provision for loan losses

     3,864        3,902   

Share-based compensation

     305        205   

Deferred income tax expense

     1,066        2,771   

Proceeds from sale of loans held for sale

     7,705        19,379   

Originations of loans held for sale

     (5,223     (21,049

Increase in company owned life insurance

     (828     (853

Net gain on sale of loans held for sale

     (155     (235

Net gain on disposal of investment securities

     (1,262     (1,224

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

     11        (39

Decrease in other assets

     288        6,562   

Decrease in other liabilities

     (249     (511
  

 

 

   

 

 

 

Net cash provided by operating activities

     23,416        26,566   
  

 

 

   

 

 

 

Cash flows from investing activities:

    

Purchases of available for sale securities

     (125,419     (160,140

Purchases of held to maturity securities

     (28,594     (5,166

Proceeds from principal payments, maturities and calls on available for sale securities

     83,904        94,956   

Proceeds from principal payments, maturities and calls on held to maturity securities

     16,491        5,723   

Proceeds from sales of securities available for sale

     61,428        1,327   

Net loan originations

     (65,937     (41,340

Purchases of company owned life insurance

     (34     (34

Proceeds from sales of other assets

     623        467   

Purchases of premises and equipment

     (2,371     (2,258
  

 

 

   

 

 

 

Net cash used in investing activities

     (59,909     (106,465
  

 

 

   

 

 

 

Cash flows from financing activities:

    

Net increase in deposits

     130,022        62,442   

Net (decrease) increase in short-term borrowings

     (82,359     13,607   

Repurchase of preferred stock

     (2     (79

Purchase of common stock for treasury

     (195     (229

Proceeds from stock options exercised

     132        59   

Excess tax benefit on share-based compensation, net

     —          (10

Cash dividends paid to common and preferred shareholders

     (5,965     (5,400
  

 

 

   

 

 

 

Net cash provided by financing activities

     41,633        70,390   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     5,140        (9,509

Cash and cash equivalents, beginning of period

     59,692        60,436   
  

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 64,832      $ 50,927   
  

 

 

   

 

 

 

Supplemental information:

    

Cash paid for interest

   $ 3,313      $ 3,679   

Cash paid for income taxes

     8,313        1,697   

Noncash investing and financing activities:

    

Real estate and other assets acquired in settlement of loans

     311        626   

Accrued and declared unpaid dividends

     2,986        2,841   

Increase (decrease) in net unsettled security purchases

     2,260        (47,972

Loans transferred from held for sale to held for investment

     853        —     

See accompanying notes to the consolidated financial statements.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

(1.) BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Operations

Financial Institutions, Inc., is a financial holding company organized in 1931 under the laws of New York State (“New York” or “NYS”). Through its wholly-owned New York chartered banking subsidiary, Five Star Bank, Financial Institutions, Inc. offers a broad array of deposit, lending and other financial services to individuals, municipalities and businesses in Western and Central New York. The Company has also expanded its indirect lending network to include relationships with franchised automobile dealers in the Capital District of New York and Northern Pennsylvania. References to “the Company” mean the consolidated reporting entities and references to “the Bank” mean Five Star Bank.

Basis of Presentation

The consolidated financial statements include the accounts of Financial Institutions, Inc. and its subsidiary. All significant intercompany accounts and transactions have been eliminated in consolidation. The accounting and reporting policies conform to U.S. generally accepted accounting principles (“GAAP”). Certain information and footnote disclosures normally included in financial statements prepared in conformity with GAAP have been condensed or omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying consolidated financial statements reflect all adjustments of a normal and recurring nature necessary for a fair presentation of the consolidated statements of financial condition, income, comprehensive income, changes in shareholders’ equity and cash flows for the periods indicated, and contain adequate disclosure to make the information presented not misleading. Prior years’ consolidated financial statements are re-classified whenever necessary to conform to the current year’s presentation. These consolidated financial statements should be read in conjunction with the Company’s 2013 Annual Report on Form 10-K. The results of operations for any interim periods are not necessarily indicative of the results which may be expected for the entire year.

Subsequent Events

The Company has evaluated events and transactions for potential recognition or disclosure through the day the financial statements were issued. Other than completing the acquisition of Scott Danahy Naylon Co., Inc. (“SDN”), as described below, the Company did not have any material recognizable subsequent events.

On August 1, 2014, the Company completed its acquisition of SDN, a full service insurance agency located in Amherst, New York. SDN provides a broad range of insurance services to both personal and business clients. SDN will operate as a subsidiary of Financial Institutions, Inc. and an affiliate of Five Star Bank.

Use of Estimates

The preparation of these financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Material estimates relate to the determination of the allowance for loan losses, the carrying value of goodwill and deferred tax assets, the valuation and other than temporary impairment (“OTTI”) considerations related to the securities portfolio, and assumptions used in the defined benefit pension plan accounting.

Recent Accounting Pronouncements

In January 2014, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2014-04, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure. The objective of this guidance is to clarify when an in substance repossession or foreclosure occurs, that is, when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. ASU No. 2014-04 states that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, ASU No. 2014-04 requires interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. ASU No. 2014-04 is effective for interim and annual reporting periods beginning after December 15, 2014. The adoption of ASU No. 2014-04 is not expected to have a material impact on the Company’s consolidated statements of income and condition.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(2.) EARNINGS PER COMMON SHARE (“EPS”)

The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS (in thousands, except per share amounts).

 

    Three months ended
June 30,
    Six months ended
June 30,
 
    2014     2013     2014     2013  

Net income available to common shareholders

  $ 6,667      $ 6,483      $ 13,520      $ 12,264   

Weighted average common shares outstanding:

       

Total shares issued

    14,162        14,162        14,162        14,162   

Unvested restricted stock awards

    (67     (66     (65     (73

Treasury shares

    (304     (357     (315     (361
 

 

 

   

 

 

   

 

 

   

 

 

 

Total basic weighted average common shares outstanding

    13,791        13,739        13,782        13,728   

Incremental shares from assumed:

       

Exercise of stock options

    28        5        25        6   

Vesting of restricted stock awards

    19        23        24        33   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total diluted weighted average common shares outstanding

    13,838        13,767        13,831        13,767   

Basic earnings per common share

  $ 0.48      $ 0.47      $ 0.98      $ 0.89   
 

 

 

   

 

 

   

 

 

   

 

 

 

Diluted earnings per common share

  $ 0.48      $ 0.47      $ 0.98      $ 0.89   
 

 

 

   

 

 

   

 

 

   

 

 

 

For each of the periods presented, average shares subject to the following instruments were excluded from the computation of diluted EPS because the effect would be antidilutive:

       

Stock options

    —          225        7        188   

Restricted stock awards

    3        9        1        5   
 

 

 

   

 

 

   

 

 

   

 

 

 
    3        234        8        193   
 

 

 

   

 

 

   

 

 

   

 

 

 

(3.) INVESTMENT SECURITIES

The amortized cost and fair value of investment securities are summarized below (in thousands):

 

     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  

June 30, 2014

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

   $ 134,448       $ 1,719       $ 1,050       $ 135,117   

Mortgage-backed securities:

           

Federal National Mortgage Association

     172,449         1,993         2,217         172,225   

Federal Home Loan Mortgage Corporation

     32,922         894         10         33,806   

Government National Mortgage Association

     62,946         2,551         54         65,443   

Collateralized mortgage obligations:

           

Federal National Mortgage Association

     63,224         431         1,427         62,228   

Federal Home Loan Mortgage Corporation

     96,922         215         3,289         93,848   

Government National Mortgage Association

     36,852         911         73         37,690   

Privately issued

     —           1,315         —           1,315   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total collateralized mortgage obligations

     196,998         2,872         4,789         195,081   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage-backed securities

     465,315         8,310         7,070         466,555   

Asset-backed securities

     —           231         —           231   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available for sale securities

   $ 599,763       $ 10,260       $ 8,120       $ 601,903   
  

 

 

    

 

 

    

 

 

    

 

 

 

Securities held to maturity:

           

State and political subdivisions

   $ 262,057       $ 4,661       $ 78       $ 266,640   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(3.) INVESTMENT SECURITIES (Continued)

 

     Amortized      Unrealized      Unrealized      Fair  
     Cost      Gains      Losses      Value  

December 31, 2013

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

   $ 135,840       $ 1,414       $ 2,802       $ 134,452   

Mortgage-backed securities:

           

Federal National Mortgage Association

     173,507         1,511         4,810         170,208   

Federal Home Loan Mortgage Corporation

     36,737         562         205         37,094   

Government National Mortgage Association

     61,832         2,152         142         63,842   

Collateralized mortgage obligations:

           

Federal National Mortgage Association

     63,838         261         3,195         60,904   

Federal Home Loan Mortgage Corporation

     102,660         169         5,856         96,973   

Government National Mortgage Association

     43,734         913         586         44,061   

Privately issued

     —           1,467         —           1,467   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total collateralized mortgage obligations

     210,232         2,810         9,637         203,405   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total mortgage-backed securities

     482,308         7,035         14,794         474,549   

Asset-backed securities

     18         381         —           399   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total available for sale securities

   $ 618,166       $ 8,830       $ 17,596       $ 609,400   
  

 

 

    

 

 

    

 

 

    

 

 

 

Securities held to maturity:

           

State and political subdivisions

   $ 249,785       $ 1,340       $ 468       $ 250,657   
  

 

 

    

 

 

    

 

 

    

 

 

 

Investment securities with a total fair value of $745.5 million and $763.1 million at June 30, 2014 and December 31, 2013, respectively, were pledged as collateral to secure public deposits and for other purposes required or permitted by law.

The scheduled maturities of securities available for sale and securities held to maturity at June 30, 2014 are shown below (in thousands). Actual expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations.

 

     Amortized      Fair  
     Cost      Value  

Debt securities available for sale:

     

Due in one year or less

   $ 25,204       $ 25,204   

Due from one to five years

     83,162         84,857   

Due after five years through ten years

     205,664         205,297   

Due after ten years

     285,733         286,545   
  

 

 

    

 

 

 
   $ 599,763       $ 601,903   
  

 

 

    

 

 

 

Debt securities held to maturity:

     

Due in one year or less

   $ 23,466       $ 23,556   

Due from one to five years

     132,765         134,973   

Due after five years through ten years

     105,784         108,057   

Due after ten years

     42         54   
  

 

 

    

 

 

 
   $ 262,057       $ 266,640   
  

 

 

    

 

 

 

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(3.) INVESTMENT SECURITIES (Continued)

 

Sales and calls of securities available for sale were as follows (in thousands):

 

     Three months ended
June 30,
     Six months ended
June 30,
 
     2014      2013      2014      2013  

Proceeds from sales and calls

   $ 41,958       $ 375       $ 61,428       $ 1,327   

Gross realized gains

     949         332         1,262         1,224   

Unrealized losses on investment securities and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows (in thousands):

 

    Less than 12 months     12 months or longer     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
    Value     Losses     Value     Losses     Value     Losses  

June 30, 2014

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

  $ 30,830      $ 2      $ 41,159      $ 1,048      $ 71,989      $ 1,050   

Mortgage-backed securities:

           

Federal National Mortgage Association

    34,572        107        64,582        2,110        99,154        2,217   

Federal Home Loan Mortgage Corporation

    —          —          3,750        10        3,750        10   

Government National Mortgage Association

    5,440        54        —          —          5,440        54   

Collateralized mortgage obligations:

           

Federal National Mortgage Association

    9,010        22        37,314        1,405        46,324        1,427   

Federal Home Loan Mortgage Corporation

    2,619        22        83,809        3,267        86,428        3,289   

Government National Mortgage Association

    —          —          5,683        73        5,683        73   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

    11,629        44        126,806        4,745        138,435        4,789   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

    51,641        205        195,138        6,865        246,779        7,070   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

    82,471        207        236,297        7,913        318,768        8,120   

Securities held to maturity:

           

State and political subdivisions

    13,285        78        —          —          13,285        78   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 95,756      $ 285      $ 236,297      $ 7,913      $ 332,053      $ 8,198   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2013

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

  $ 86,177      $ 2,788      $ 2,717      $ 14      $ 88,894      $ 2,802   

Mortgage-backed securities:

           

Federal National Mortgage Association

    103,778        3,491        20,689        1,319        124,467        4,810   

Federal Home Loan Mortgage Corporation

    14,166        205        —          —          14,166        205   

Government National Mortgage Association

    14,226        142        —          —          14,226        142   

Collateralized mortgage obligations:

           

Federal National Mortgage Association

    35,632        2,586        11,760        609        47,392        3,195   

Federal Home Loan Mortgage Corporation

    72,655        4,980        15,762        876        88,417        5,856   

Government National Mortgage Association

    8,396        586        —          —          8,396        586   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total collateralized mortgage obligations

    116,683        8,152        27,522        1,485        144,205        9,637   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total mortgage-backed securities

    248,853        11,990        48,211        2,804        297,064        14,794   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total available for sale securities

    335,030        14,778        50,928        2,818        385,958        17,596   

Securities held to maturity:

           

State and political subdivisions

    72,269        468        —          —          72,269        468   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 407,299      $ 15,246      $ 50,928      $ 2,818      $ 458,227      $ 18,064   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(3.) INVESTMENT SECURITIES (Continued)

 

The total number of security positions in the investment portfolio in an unrealized loss position at June 30, 2014 was 129 compared to 331 at December 31, 2013. At June 30, 2014, the Company had positions in 61 investment securities with a fair value of $236.3 million and a total unrealized loss of $7.9 million that have been in a continuous unrealized loss position for more than 12 months. There were a total of 68 securities positions in the Company’s investment portfolio, with a fair value of $95.8 million and a total unrealized loss of $285 thousand at June 30, 2014, that have been in a continuous unrealized loss position for less than 12 months. The unrealized loss on these investment securities was predominantly caused by changes in market interest rates subsequent to purchase. The fair value of most of the investment securities in the Company’s portfolio fluctuates as market interest rates change.

The Company reviews investment securities on an ongoing basis for the presence of other-than-temporary impairment (“OTTI”) with formal reviews performed quarterly. When evaluating debt securities for OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Company has the intention to sell the debt security or whether it is more likely than not that it will be required to sell the debt security before its anticipated recovery. The assessment of whether OTTI exists involves a high degree of subjectivity and judgment and is based on the information then available to management. There was no impairment recorded during the six months ended June 30, 2014 and 2013.

Based on management’s review and evaluation of the Company’s debt securities as of June 30, 2014, the debt securities with unrealized losses were not considered to be OTTI. As of June 30, 2014, the Company did not intend 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. Accordingly, as of June 30, 2014, management has concluded that unrealized losses on its investment securities are temporary and no further impairment loss has been realized in the Company’s consolidated statements of income.

(4.) LOANS

The Company’s loan portfolio consisted of the following as of the dates indicated (in thousands):

 

     Principal
Amount
Outstanding
     Net Deferred
Loan Costs
(Fees)
    Loans, Net  

June 30, 2014

       

Commercial business

   $ 277,609       $ 76      $ 277,685   

Commercial mortgage

     469,936         (881     469,055   

Residential mortgage

     106,342         (136     106,206   

Home equity

     363,243         6,335        369,578   

Consumer indirect

     626,418         26,330        652,748   

Other consumer

     21,205         187        21,392   
  

 

 

    

 

 

   

 

 

 

Total

   $ 1,864,753       $ 31,911        1,896,664   
  

 

 

    

 

 

   

Allowance for loan losses

          (27,166
       

 

 

 

Total loans, net

        $ 1,869,498   
       

 

 

 

December 31, 2013

       

Commercial business

   $ 265,751       $ 15      $ 265,766   

Commercial mortgage

     470,312         (1,028     469,284   

Residential mortgage

     113,101         (56     113,045   

Home equity

     320,658         5,428        326,086   

Consumer indirect

     609,390         26,978        636,368   

Other consumer

     22,893         177        23,070   
  

 

 

    

 

 

   

 

 

 

Total

   $ 1,802,105       $ 31,514        1,833,619   
  

 

 

    

 

 

   

Allowance for loan losses

          (26,736
       

 

 

 

Total loans, net

        $ 1,806,883   
       

 

 

 

Loans held for sale (not included above) were comprised entirely of residential real estate mortgages and totaled $201 thousand and $3.4 million as of June 30, 2014 and December 31, 2013, respectively.

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(4.) LOANS (Continued)

 

Past Due Loans Aging

The Company’s recorded investment, by loan class, in current and nonaccrual loans, as well as an analysis of accruing delinquent loans is set forth as of the dates indicated (in thousands):

 

    30-59 Days
Past Due
    60-89 Days
Past Due
    Greater
Than 90
Days
    Total Past
Due
    Nonaccrual     Current     Total
Loans
 

June 30, 2014

             

Commercial business

  $ 2,005      $ —        $ —        $ 2,005      $ 3,589      $ 272,015      $ 277,609   

Commercial mortgage

    —          —          —          —          2,734        467,202        469,936   

Residential mortgage

    408        —          —          408        758        105,176        106,342   

Home equity

    235        32        —          267        371        362,605        363,243   

Consumer indirect

    1,590        324        —          1,914        1,427        623,077        626,418   

Other consumer

    139        20        6        165        6        21,034        21,205   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans, gross

  $ 4,377      $ 376      $ 6      $ 4,759      $ 8,885      $ 1,851,109      $ 1,864,753   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2013

             

Commercial business

  $ 558      $ 199      $ —        $ 757      $ 3,474      $ 261,520      $ 265,751   

Commercial mortgage

    800        —          —          800        9,663        459,849        470,312   

Residential mortgage

    542        —          —          542        1,078        111,481        113,101   

Home equity

    750        143        —          893        925        318,840        320,658   

Consumer indirect

    2,129        476        —          2,605        1,471        605,314        609,390   

Other consumer

    126        72        6        204        5        22,684        22,893   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans, gross

  $ 4,905      $ 890      $ 6      $ 5,801      $ 16,616      $ 1,779,688      $ 1,802,105   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

There were no loans past due greater than 90 days and still accruing interest as of June 30, 2014 and December 31, 2013. There were $6 thousand in consumer overdrafts which were past due greater than 90 days as of June 30, 2014 and December 31, 2013. Consumer overdrafts are overdrawn deposit accounts which have been reclassified as loans but by their terms do not accrue interest.

Troubled Debt Restructurings

A modification of a loan constitutes a troubled debt restructuring (“TDR”) when a borrower is experiencing financial difficulty and the modification constitutes a concession. The Company offers various types of concessions when modifying loans, however, forgiveness of principal is seldom granted. Commercial loans modified in a TDR may involve temporary interest-only payments, term extensions, reducing the interest rate for the remaining term of the loan, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, requesting additional collateral, releasing collateral for consideration, or substituting or adding a new borrower or guarantor.

The following table presents information related to loans modified in a TDR during the periods indicated (dollars in thousands).

 

    Quarter-to-Date     Year-to-Date  
    Number of
Contracts
    Pre-
Modification
Outstanding
Recorded
Investment
    Post-
Modification
Outstanding
Recorded
Investment
    Number of
Contracts
    Pre-
Modification
Outstanding
Recorded
Investment
    Post-
Modification
Outstanding
Recorded
Investment
 

June 30, 2014

           

Commercial business

    1      $ 1,381      $ 1,381        1      $ 1,381      $ 1,381   

Commercial mortgage

    —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    1      $ 1,381      $ 1,381        1      $ 1,381      $ 1,381   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

June 30, 2013

           

Commercial business

    1      $ 1,273      $ 1,273        3      $ 1,462      $ 1,453   

Commercial mortgage

    —          —          —          —          —          —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

    1      $ 1,273      $ 1,273        3      $ 1,462      $ 1,453   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(4.) LOANS (Continued)

 

All of the loans identified as TDRs by the Company during the six months ended June 30, 2014 and 2013 were previously on nonaccrual status and reported as impaired loans prior to restructuring. The modifications primarily related to extending the amortization periods of the loans. Nonaccrual loans that are restructured remain on nonaccrual status, but may move to accrual status after they have performed according to the restructured terms for a period of time. The TDR classification did not have a material impact on the Company’s determination of the allowance for loan losses because the modified loans were impaired and evaluated for a specific reserve both before and after restructuring.

There were no loans modified as a TDR within the previous 12 months that defaulted during the six months ended June 30, 2014 or 2013. For purposes of this disclosure, a loan modified as a TDR is considered to have defaulted when the borrower becomes 90 days past due.

Impaired Loans

Management has determined that specific commercial loans on nonaccrual status and all loans that have had their terms restructured in a troubled debt restructuring are impaired loans. The following table presents the recorded investment, unpaid principal balance and related allowance of impaired loans as of the dates indicated and average recorded investment and interest income recognized on impaired loans for the three month periods ended as of the dates indicated (in thousands):

 

    Recorded
Investment(1)
    Unpaid
Principal
Balance(1)
    Related
Allowance
    Average
Recorded
Investment
    Interest
Income
Recognized
 

June 30, 2014

         

With no related allowance recorded:

         

Commercial business

  $ 1,618      $ 2,146      $ —        $ 1,823      $ —     

Commercial mortgage

    1,142        1,173        —          1,093        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    2,760        3,319        —          2,916        —     

With an allowance recorded:

         

Commercial business

    1,971        1,982        1,056        1,837        —     

Commercial mortgage

    1,592        1,592        432        6,733        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    3,563        3,574        1,488        8,570        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
  $ 6,323      $ 6,893      $ 1,488      $ 11,486      $ —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

December 31, 2013

         

With no related allowance recorded:

         

Commercial business

  $ 1,777      $ 2,273      $ —        $ 659      $ —     

Commercial mortgage

    875        906        —          760        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    2,652        3,179        —          1,419        —     

With an allowance recorded:

         

Commercial business

    1,697        1,717        201        3,196        —     

Commercial mortgage

    8,788        9,188        1,057        3,758        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
    10,485        10,905        1,258        6,954        —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
  $ 13,137      $ 14,084      $ 1,258      $ 8,373      $ —     
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1)  Difference between recorded investment and unpaid principal balance represents partial charge-offs.

 

- 14 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(4.) LOANS (Continued)

 

Credit Quality Indicators

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors such as the fair value of collateral. The Company analyzes commercial business and commercial mortgage loans individually by classifying the loans as to credit risk. Risk ratings are updated any time the situation warrants. The Company uses the following definitions for risk ratings:

Special Mention: Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company’s credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as Substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loans that do not meet the criteria above that are analyzed individually as part of the process described above are considered “Uncriticized” or pass-rated loans and are included in groups of homogeneous loans with similar risk and loss characteristics.

The following table sets forth the Company’s commercial loan portfolio, categorized by internally assigned asset classification, as of the dates indicated (in thousands):

 

     Commercial
Business
     Commercial
Mortgage
 

June 30, 2014

     

Uncriticized

   $ 260,164       $ 453,747   

Special mention

     7,708         6,136   

Substandard

     9,737         10,053   

Doubtful

     —           —     
  

 

 

    

 

 

 

Total

   $ 277,609       $ 469,936   
  

 

 

    

 

 

 

December 31, 2013

     

Uncriticized

   $ 250,553       $ 449,447   

Special mention

     6,311         6,895   

Substandard

     8,887         13,970   

Doubtful

     —           —     
  

 

 

    

 

 

 

Total

   $ 265,751       $ 470,312   
  

 

 

    

 

 

 

The Company utilizes payment status as a means of identifying and reporting problem and potential problem retail loans. The Company considers nonaccrual loans and loans past due greater than 90 days and still accruing interest to be non-performing. The following table sets forth the Company’s retail loan portfolio, categorized by payment status, as of the dates indicated (in thousands):

 

     Residential
Mortgage
     Home
Equity
     Consumer
Indirect
     Other
Consumer
 

June 30, 2014

           

Performing

   $ 105,584       $ 362,872       $ 624,991       $ 21,193   

Non-performing

     758         371         1,427         12   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 106,342       $ 363,243       $ 626,418       $ 21,205   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2013

           

Performing

   $ 112,023       $ 319,733       $ 607,919       $ 22,882   

Non-performing

     1,078         925         1,471         11   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 113,101       $ 320,658       $ 609,390       $ 22,893   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

- 15 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(4.) LOANS (Continued)

 

Allowance for Loan Losses

Loans and the related allowance for loan losses are presented below as of the dates indicated (in thousands):

 

     Commercial
Business
     Commercial
Mortgage
    Residential
Mortgage
     Home
Equity
     Consumer
Indirect
     Other
Consumer
     Total  

June 30, 2014

                   

Loans:

                   

Ending balance

   $ 277,609       $ 469,936      $ 106,342       $ 363,243       $ 626,418       $ 21,205       $ 1,864,753   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Evaluated for impairment:

                   

Individually

   $ 3,589       $ 2,734      $ —         $ —         $ —         $ —         $ 6,323   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Collectively

   $ 274,020       $ 467,202      $ 106,342       $ 363,243       $ 626,418       $ 21,205       $ 1,858,430   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Allowance for loan losses:

                   

Ending balance

   $ 5,402       $ 7,633      $ 618       $ 1,607       $ 11,446       $ 460       $ 27,166   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Evaluated for impairment:

                   

Individually

   $ 1,056       $ 432      $ —         $ —         $ —         $ —         $ 1,488   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Collectively

   $ 4,346       $ 7,201      $ 618       $ 1,607       $ 11,446       $ 460       $ 25,678   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

June 30, 2013

                   

Loans:

                   

Ending balance

   $ 257,784       $ 438,513      $ 117,939       $ 301,429       $ 572,350       $ 24,107       $ 1,712,122   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Evaluated for impairment:

                   

Individually

   $ 5,043       $ 3,073      $ —         $ —         $ —         $ —         $ 8,116   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Collectively

   $ 252,741       $ 435,440      $ 117,939       $ 301,429       $ 572,350       $ 24,107       $ 1,704,006   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Allowance for loan losses:

                   

Ending balance

   $ 4,755       $ 7,125      $ 701       $ 1,424       $ 11,095       $ 490       $ 25,590   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Evaluated for impairment:

                   

Individually

   $ 956       $ 554      $ —         $ —         $ —         $ —         $ 1,510   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Collectively

   $ 3,799       $ 6,571      $ 701       $ 1,424       $ 11,095       $ 490       $ 24,080   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 
The following table sets forth the changes in the allowance for loan losses for the three and six month periods ended June 30, 2014 (in thousands):    
     Commercial
Business
     Commercial
Mortgage
    Residential
Mortgage
     Home
Equity
     Consumer
Indirect
     Other
Consumer
     Total  

Three months ended June 30, 2014

  

Beginning balance

   $ 4,689       $ 7,980      $ 672       $ 1,371       $ 11,984       $ 456       $ 27,152   

Charge-offs

     3         165        69         156         2,331         224         2,948   

Recoveries

     68         6        8         29         995         98         1,204   

Provision (credit)

     648         (188     7         363         798         130         1,758   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance

   $ 5,402       $ 7,633      $ 618       $ 1,607       $ 11,446       $ 460       $ 27,166   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Six months ended June 30, 2014

                   

Beginning balance

   $ 4,273       $ 7,743      $ 676       $ 1,367       $ 12,230       $ 447       $ 26,736   

Charge-offs

     71         165        147         262         4,786         493         5,924   

Recoveries

     97         13        29         40         2,100         211         2,490   

Provision

     1,103         42        60         462         1,902         295         3,864   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance

   $ 5,402       $ 7,633      $ 618       $ 1,607       $ 11,446       $ 460       $ 27,166   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

- 16 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(4.) LOANS (Continued)

 

The following table sets forth the changes in the allowance for loan losses for the three and six month periods ended June 30, 2013 (in thousands):

 

     Commercial
Business
    Commercial
Mortgage
     Residential
Mortgage
     Home
Equity
     Consumer
Indirect
     Other
Consumer
     Total  

Three months ended June 30, 2013

  

Beginning balance

   $ 5,167      $ 6,971       $ 668       $ 1,283       $ 11,312       $ 426       $ 25,827   

Charge-offs

     292        106         85         53         1,929         229         2,694   

Recoveries

     205        143         13         73         759         71         1,264   

Provision (credit)

     (325     117         105         121         953         222         1,193   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance

   $ 4,755      $ 7,125       $ 701       $ 1,424       $ 11,095       $ 490       $ 25,590   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Six months ended June 30, 2013

                   

Beginning balance

   $ 4,884      $ 6,581       $ 740       $ 1,282       $ 10,715       $ 512       $ 24,714   

Charge-offs

     531        109         247         322         3,647         481         5,337   

Recoveries

     242        157         30         110         1,564         208         2,311   

Provision

     160        496         178         354         2,463         251         3,902   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending balance

   $ 4,755      $ 7,125       $ 701       $ 1,424       $ 11,095       $ 490       $ 25,590   
  

 

 

   

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Risk Characteristics

Commercial business loans primarily consist of loans to small to midsize businesses in our market area in a diverse range of industries. These loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. Further, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value. 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.

Commercial mortgage loans generally have larger balances and involve a greater degree of risk than residential mortgage loans, inferring higher potential losses on an individual customer basis. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral securing the loan. Economic events or conditions in the real estate market could have an adverse impact on the cash flows generated by properties securing the Company’s commercial real estate loans and on the value of such properties.

Residential mortgage loans and home equities (comprised of home equity loans and home equity lines) are generally made on the basis of the borrower’s ability to make repayment from his or her employment and other income, but are secured by real property whose value tends to be more easily ascertainable. 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.

Consumer indirect and other consumer loans may entail greater credit risk than residential mortgage loans and home equities, particularly in the case of other consumer loans which are unsecured or, in the case of indirect consumer loans, secured by depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by adverse personal circumstances such as job loss, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

 

- 17 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(5.) GOODWILL AND OTHER INTANGIBLE ASSETS

The carrying amount of goodwill totaled $48.5 million as of June 30, 2014 and December 31, 2013. The goodwill relates to the Company’s primary subsidiary and reporting unit, Five Star Bank. The Company performs a goodwill impairment test on an annual basis or more frequently if events and circumstances warrant.

The Company’s other intangible assets, consisting entirely of a core deposit intangible asset, were as follows (in thousands):

 

     June 30,     December 31,  
     2014     2013  

Gross carrying amount

   $ 2,042      $ 2,042   

Accumulated amortization

     (752     (576
  

 

 

   

 

 

 

Net carrying value

   $ 1,290      $ 1,466   
  

 

 

   

 

 

 

Amortization expense for the core deposit intangible was $87 thousand and $176 thousand for the three and six months ended June 30, 2014, and $98 thousand and $199 thousand for the three and six months ended June 30, 2013, respectively. As of June 30, 2014, the estimated core deposit intangible amortization expense for the remainder of 2014 and each of the next five years is as follows (in thousands):

 

2014 (remainder of year)

   $ 165   

2015

     296   

2016

     251   

2017

     205   

2018

     160   

2019

     115   

(6.) SHAREHOLDERS’ EQUITY

Common Stock

The changes in shares of common stock were as follows for the six months ended June 30, 2014 and 2013:

 

     Outstanding     Treasury     Issued  

June 30, 2014

      

Shares outstanding at December 31, 2013

     13,829,355        332,242        14,161,597   

Restricted stock awards issued

     43,242        (43,242     —     

Restricted stock awards forfeited

     (8,144     8,144        —     

Stock options exercised

     7,125        (7,125     —     

Treasury stock purchases

     (9,102     9,102        —     
  

 

 

   

 

 

   

 

 

 

Shares outstanding at June 30, 2014

     13,862,476        299,121        14,161,597   
  

 

 

   

 

 

   

 

 

 

June 30, 2013

      

Shares outstanding at December 31, 2012

     13,787,709        373,888        14,161,597   

Restricted stock awards issued

     42,035        (42,035     —     

Restricted stock awards forfeited

     (18,977     18,977        —     

Stock options exercised

     3,300        (3,300     —     

Treasury stock purchases

     (11,349     11,349        —     

Directors’ retainer

     5,672        (5,672     —     
  

 

 

   

 

 

   

 

 

 

Shares outstanding at June 30, 2013

     13,808,390        353,207        14,161,597   
  

 

 

   

 

 

   

 

 

 

 

- 18 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(7.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table presents the components of other comprehensive income (loss) for the six month periods ended June 30, 2014 and 2013 (in thousands):

 

     Pre-tax
Amount
    Tax Effect     Net-of-tax
Amount
 

June 30, 2014

      

Securities available for sale and transferred securities:

      

Change in unrealized gain/loss during the period

   $ 12,168      $ 4,821      $ 7,347   

Reclassification adjustment for net gains included in net income (1)

     (1,521     (602     (919
  

 

 

   

 

 

   

 

 

 

Total securities available for sale and transferred securities

     10,647        4,219        6,428   

Amortization of pension and post-retirement items:

      

Prior service credit

     (24     (9     (15

Net actuarial losses

     88        34        54   
  

 

 

   

 

 

   

 

 

 

Total pension and post-retirement obligations

     64        25        39   
  

 

 

   

 

 

   

 

 

 

Other comprehensive income

   $ 10,711      $ 4,244      $ 6,467   
  

 

 

   

 

 

   

 

 

 

June 30, 2013

      

Securities available for sale:

      

Change in unrealized gain/loss during the period

   $ (26,571   $ (10,525   $ (16,046

Reclassification adjustment for net gains included in net income

     (1,224     (485     (739
  

 

 

   

 

 

   

 

 

 

Total securities available for sale

     (27,795     (11,010     (16,785

Amortization of pension and post-retirement items:

      

Prior service credit

     (24     (9     (15

Net actuarial losses

     682        269        413   
  

 

 

   

 

 

   

 

 

 

Total pension and post-retirement obligations

     658        260        398   
  

 

 

   

 

 

   

 

 

 

Other comprehensive loss

   $ (27,137   $ (10,750   $ (16,387
  

 

 

   

 

 

   

 

 

 

 

(1)  Includes amounts related to the amortization/accretion of unrealized net gains and losses related to the Company’s reclassification of available for sale investment securities to the held to maturity category. The unrealized net gains/losses will be amortized/accreted over the remaining life of the investment securities as an adjustment of yield.

Activity in accumulated other comprehensive income (loss), net of tax, for the six month periods ended June 30, 2014 and 2013 was as follows (in thousands):

 

     Securities
Available for
Sale and
Transferred
Securities
    Pension
and Post-
retirement
Obligations
    Accumulated
Other
Comprehensive
Income (Loss)
 

June 30, 2014

      

Balance at beginning of year

   $ (5,337   $ (4,850   $ (10,187

Other comprehensive income before reclassifications

     7,347        —          7,347   

Amounts reclassified from accumulated other comprehensive income

     (919     39        (880
  

 

 

   

 

 

   

 

 

 

Net current period other comprehensive income

     6,428        39        6,467   
  

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ 1,091      $ (4,811   $ (3,720
  

 

 

   

 

 

   

 

 

 

June 30, 2013

      

Balance at beginning of year

   $ 16,060      $ (12,807   $ 3,253   

Other comprehensive (loss) income before reclassifications

     (16,046     —          (16,046

Amounts reclassified from accumulated other comprehensive income

     (739     398        (341
  

 

 

   

 

 

   

 

 

 

Net current period other comprehensive (loss) income

     (16,785     398        (16,387
  

 

 

   

 

 

   

 

 

 

Balance at end of period

   $ (725   $ (12,409   $ (13,134
  

 

 

   

 

 

   

 

 

 

 

- 19 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(7.) ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (Continued)

 

The following table presents the amounts reclassified out of each component of accumulated other comprehensive income (loss) for the six month periods ended June 30, 2014 and 2013 (in thousands):

 

Details About Accumulated Other

Comprehensive Income Components

  Amount Reclassified from
Accumulated Other
Comprehensive Income
   

Affected Line Item in the

Consolidated Statement of Income

    Six months ended      
    June 30,      
    2014     2013      

Realized gain on sale of investment securities

  $ 1,262      $ 1,224      Net gain on disposal of investment securities

Amortization of unrealized holding gains (losses) on investment securities transferred from available for sale to held to maturity

    259        —        Interest income
 

 

 

   

 

 

   
    1,521        1,224      Total before tax
    (602     (485   Income tax expense
 

 

 

   

 

 

   
    919        739      Net of tax

Amortization of pension and post-retirement items:

     

Prior service credit (1)

    24        24      Salaries and employee benefits

Net actuarial losses (1)

    (88     (682   Salaries and employee benefits
 

 

 

   

 

 

   
    (64     (658   Total before tax
    25        260      Income tax benefit
 

 

 

   

 

 

   
    (39     (398   Net of tax
 

 

 

   

 

 

   

Total reclassified for the period

  $ 880      $ 341     
 

 

 

   

 

 

   

 

(1)  These items are included in the computation of net periodic pension expense. See Note 9 – Employee Benefit Plans for additional information.

 

- 20 -


Table of Contents

FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(8.) SHARE-BASED COMPENSATION PLANS

The Company maintains certain stock-based compensation plans that were approved by the Company’s shareholders and are administered by the Company’s Board of Directors, or the Management Development and Compensation Committee of the Board. The share-based compensation plans were established to allow for the grant of compensation awards to attract, motivate and retain employees, executive officers and non-employee directors who contribute to the success and profitability of the Company and to give such persons a proprietary interest in the Company, thereby enhancing their personal interest in the Company’s success.

The Company awarded grants of 22,642 shares of restricted common stock to certain members of management during the six months ended June 30, 2014. Fifty percent of the shares subject to each grant will be earned based upon achievement of an EPS performance requirement for the Company’s fiscal year ended December 31, 2014. The remaining fifty percent of the shares will be earned based on the Company’s achievement of a relative total shareholder return (“TSR”) performance requirement, on a percentile basis, compared to a defined group of peer companies over a three-year performance period ended December 31, 2016. The shares earned based on the achievement of the EPS and TSR performance requirements, if any, will vest based on the recipient’s continuous service to the Company on December 31, 2016.

The grant-date fair value of the TSR portion of the award granted during the six months ended June 30, 2014 was determined using the Monte Carlo simulation model on the date of grant, assuming the following (i) expected term of 2.87 years, (ii) risk free interest rate of 0.62%, (iii) expected dividend yield of 3.59% and (iv) expected stock price volatility over the expected term of the TSR award of 39.4%. The grant-date fair value of all other restricted stock awards is equal to the closing market price of our common stock on the date of grant.

In addition, the Company granted 11,600 shares of restricted common stock to management during the six months ended June 30, 2014. The shares will vest after completion of a three-year service requirement. The weighted average market price of the restricted stock awards on the date of grant was $21.26.

During the six months ended June 30, 2014, the Company granted 9,000 restricted shares of common stock to directors, of which 4,500 shares vested immediately and 4,500 shares will vest after completion of a one-year service requirement. The market price of the restricted stock on the date of grant was $22.82.

The restricted stock awards granted to management and directors in 2014 do not have rights to dividends or dividend equivalents.

The following is a summary of restricted stock award activity for the six month period ended June 30, 2014:

 

           Weighted  
           Average  
           Market  
     Number of     Price at  
     Shares     Grant Date  

Outstanding at beginning of year

     65,040      $ 16.92   

Granted

     43,242        18.76   

Vested

     (33,728     18.17   

Forfeited

     (8,144     19.77   
  

 

 

   

Outstanding at end of period

     66,410      $ 17.13   
  

 

 

   

As of June 30, 2014, there was $730 thousand of unrecognized compensation expense related to unvested restricted stock awards that is expected to be recognized over a weighted average period of two years.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(8.) SHARE-BASED COMPENSATION PLANS (Continued)

 

The Company uses the Black-Scholes valuation method to estimate the fair value of its stock option awards. There were no stock options awarded during 2014 or 2013. The following is a summary of stock option activity for the six months ended June 30, 2014 (dollars in thousands, except per share amounts):

 

                  Weighted         
           Weighted      Average         
           Average      Remaining      Aggregate  
     Number of     Exercise      Contractual      Intrinsic  
     Options     Price      Term      Value  

Outstanding at beginning of year

     192,934      $ 19.83         

Exercised

     (7,125     18.45         

Expired

     (23,436     23.64         
  

 

 

         

Outstanding and exercisable at end of period

     162,373      $ 19.35         2.4       $ 661   
  

 

 

         

The aggregate intrinsic value (the amount by which the market price of the stock on the date of exercise exceeded the market price of the stock on the date of grant) of option exercises for the six months ended June 30, 2014 and 2013 was $32 thousand and $7 thousand, respectively. The total cash received as a result of option exercises under stock compensation plans for the six months ended June 30, 2014 and 2013 was $132 thousand and $59 thousand, respectively.

The Company amortizes the expense related to restricted stock awards over the vesting period. Share-based compensation expense is recorded as a component of salaries and employee benefits in the consolidated statements of income for awards granted to management and as a component of other noninterest expense for awards granted to directors. The share-based compensation expense included in the consolidated statements of income is as follows (in thousands):

 

     Three months ended     Six months ended  
     June 30,     June 30,  
     2014      2013     2014      2013  

Salaries and employee benefits

   $ 75       $ (6   $ 156       $ 79   

Other noninterest expense

     127         109        149         126   
  

 

 

    

 

 

   

 

 

    

 

 

 

Total share-based compensation expense

   $ 202       $ 103      $ 305       $ 205   
  

 

 

    

 

 

   

 

 

    

 

 

 

(9.) EMPLOYEE BENEFIT PLANS

The components of the Company’s net periodic benefit expense for its pension and post-retirement obligations were as follows (in thousands):

 

     Three months ended     Six months ended  
     June 30,     June 30,  
     2014     2013     2014     2013  

Service cost

   $ 480      $ 516      $ 959      $ 1,032   

Interest cost on projected benefit obligation

     573        505        1,147        1,010   

Expected return on plan assets

     (1,030     (921     (2,059     (1,842

Amortization of prior service credit

     (12     (12     (24     (24

Amortization of net actuarial losses

     44        341        88        682   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic pension expense

   $ 55      $ 429      $ 111      $ 858   
  

 

 

   

 

 

   

 

 

   

 

 

 

The net periodic benefit expense is recorded as a component of salaries and employee benefits in the consolidated statements of income. The Company’s funding policy is to contribute, at a minimum, an actuarially determined amount that will satisfy the minimum funding requirements determined under the appropriate sections of the Internal Revenue Code. The Company has no minimum required contribution for the 2014 fiscal year.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(10.) COMMITMENTS AND CONTINGENCIES

The Company has financial instruments with off-balance sheet risk established in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk extending beyond amounts recognized in the Company’s financial statements.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is essentially the same as that involved with extending loans to customers. The Company uses the same credit underwriting policies in making commitments and conditional obligations as for on-balance sheet instruments.

Off-balance sheet commitments consist of the following (in thousands):

 

     June 30,
2014
     December 31,
2013
 

Commitments to extend credit

   $ 444,617       $ 431,236   

Standby letters of credit

     11,020         8,618   

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Commitments may expire without being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash requirements. Each customer’s creditworthiness is evaluated on a case-by-case basis. The amount of collateral obtained, if any, is based on management’s credit evaluation of the borrower. Standby letters of credit are conditional lending commitments issued by the Company to guarantee the performance of a customer to a third party. These standby letters of credit are primarily issued to support private borrowing arrangements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers.

The Company also extends rate lock agreements to borrowers related to the origination of residential mortgage loans. To mitigate the interest rate risk inherent in these rate lock agreements, the Company may enter into forward commitments to sell individual residential mortgages. Rate lock agreements and forward commitments are considered derivatives and are recorded at fair value. Forward sales commitments totaled $393 thousand at June 30, 2014. There were no forward sales commitments outstanding as of December 31, 2013. In addition, the net change in the fair values of these derivatives was recognized as other noninterest income or other noninterest expense in the consolidated statements of income.

(11.) FAIR VALUE MEASUREMENTS

Determination of Fair Value – Assets Measured at Fair Value on a Recurring and Nonrecurring Basis

Valuation Hierarchy

The fair value of an asset or liability is the price that would be received to sell that asset or paid to transfer that liability in an orderly transaction occurring in the principal market (or most advantageous market in the absence of a principal market) for such asset or liability. ASC Topic 820, “Fair Value Measurements and Disclosures,” establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. There have been no changes in the valuation techniques used during the current period. The fair value hierarchy is as follows:

 

    Level 1—Unadjusted quoted prices in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

    Level 2—Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable for the asset or liability (such as interest rates, volatilities, prepayment speeds, credit risks, etc.) or inputs that are derived principally from or corroborated by market data by correlation or other means.

 

    Level 3—Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

Transfers between levels of the fair value hierarchy are recorded as of the end of the reporting period.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(11.) FAIR VALUE MEASUREMENTS (Continued)

 

In general, fair value is based upon quoted market prices, where available. If such quoted market prices are not available, fair value is based upon internally developed models that primarily use, as inputs, observable market-based parameters. Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments may include amounts to reflect counterparty credit quality and the company’s creditworthiness, among other things, as well as unobservable parameters. Any such valuation adjustments are applied consistently over time. The Company’s valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While management believes the Company’s valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.

Securities available for sale: Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary market prices and investor commitments. Loans held for sale are classified as Level 2 in the fair value hierarchy.

Collateral dependent impaired loans: Fair value of impaired loans with specific allocations of the allowance for loan losses is measured based on the value of the collateral securing these loans and is classified as Level 3 in the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory and/or accounts receivable and collateral value is determined based on appraisals performed by qualified licensed appraisers hired by the Company. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Loan servicing rights: Loan servicing rights do not trade in an active market with readily observable market data. As a result, the Company estimates the fair value of loan servicing rights by using a discounted cash flow model to calculate the present value of estimated future net servicing income. The assumptions used in the discounted cash flow model are those that we believe market participants would use in estimating future net servicing income, including estimates of loan prepayment rates, servicing costs, ancillary income, impound account balances, and discount rates. The significant unobservable inputs used in the fair value measurement of the Company’s loan servicing rights are the constant prepayment rates and weighted average discount rate. Significant increases (decreases) in any of those inputs in isolation could result in a significantly lower (higher) fair value measurement. Although the constant prepayment rate and the discount rate are not directly interrelated, they will generally move in opposite directions. Loan servicing rights are classified as Level 3 measurements due to the use of significant unobservable inputs, as well as significant management judgment and estimation.

Other real estate owned (Foreclosed assets): Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at the lower of carrying amount or fair value, less costs to sell. Fair values are generally based on third party appraisals of the property, resulting in a Level 3 classification. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are typically significant and result in a Level 3 classification of the inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less costs to sell, an impairment loss is recognized.

Commitments to extend credit and letters of credit: Commitments to extend credit and fund letters of credit are principally at current interest rates, and, therefore, the carrying amount approximates fair value. The fair value of commitments is not material.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(11.) FAIR VALUE MEASUREMENTS (Continued)

 

Assets Measured at Fair Value

The following tables present for each of the fair-value hierarchy levels the Company’s assets that are measured at fair value on a recurring and non-recurring basis as of the dates indicated (in thousands).

 

     Quoted Prices in
Active Markets
for Identical
Assets or
Liabilities
     Significant
Other
Observable
Inputs
     Significant
Unobservable
Inputs
        
     (Level 1)      (Level 2)      (Level 3)      Total  

June 30, 2014

           

Measured on a recurring basis:

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

   $ —         $ 135,117       $ —         $ 135,117   

Mortgage-backed securities

     —           466,555         —           466,555   

Asset-backed securities

     —           231         —           231   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ —         $ 601,903       $ —         $ 601,903   
  

 

 

    

 

 

    

 

 

    

 

 

 

Measured on a nonrecurring basis:

           

Loans:

           

Loans held for sale

   $ —         $ 201       $ —         $ 201   

Collateral dependent impaired loans

     —           —           2,075         2,075   

Other assets:

           

Loan servicing rights

     —           —           1,446         1,446   

Other real estate owned

     —           —           554         554   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ —         $ 201       $ 4,075       $ 4,276   
  

 

 

    

 

 

    

 

 

    

 

 

 

December 31, 2013

           

Measured on a recurring basis:

           

Securities available for sale:

           

U.S. Government agencies and government sponsored enterprises

   $ —         $ 134,452       $ —         $ 134,452   

Mortgage-backed securities

     —           474,549         —           474,549   

Asset-backed securities

     —           399         —           399   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ —         $ 609,400       $ —         $ 609,400   
  

 

 

    

 

 

    

 

 

    

 

 

 

Measured on a nonrecurring basis:

           

Loans:

           

Loans held for sale

   $ —         $ 3,381       $ —         $ 3,381   

Collateral dependent impaired loans

     —           —           9,227         9,227   

Other assets:

           

Loan servicing rights

     —           —           1,565         1,565   

Other real estate owned

     —           —           333         333   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ —         $ 3,381       $ 11,125       $ 14,506   
  

 

 

    

 

 

    

 

 

    

 

 

 

There were no transfers between Levels 1 and 2 during the six months ended June 30, 2014 and 2013. There were no liabilities measured at fair value on a recurring or nonrecurring basis during the six month periods ended June 30, 2014 and 2013.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(11.) FAIR VALUE MEASUREMENTS (Continued)

 

The following table presents additional quantitative information about assets measured at fair value on a recurring and nonrecurring basis for which the Company has utilized Level 3 inputs to determine fair value (dollars in thousands).

 

Asset

   Fair
Value
    

Valuation Technique

  

Unobservable Input

  

Unobservable Input
Value or Range

Collateral dependent impaired loans

   $ 2,075       Appraisal of collateral (1)    Appraisal adjustments (2)    25% - 100% discount
      Discounted cash flow    Discount rate    4.5%(3)
         Risk premium rate    11.0%(3)

Loan servicing rights

     1,446       Discounted cash flow    Discount rate    5.2%(3)
         Constant prepayment rate    12.4%(3)

Other real estate owned

     554       Appraisal of collateral (1)    Appraisal adjustments (2)    27% - 43% discount

 

(1)  Fair value is generally determined through independent appraisals of the underlying collateral, which generally include various Level 3 inputs which are not identifiable.
(2)  Appraisals may be adjusted by management for qualitative factors such as economic conditions and estimated liquidation expenses.
(3)  Weighted averages.

Changes in Level 3 Fair Value Measurements

There were no assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) as of or during the six months ended June 30, 2014.

Disclosures about Fair Value of Financial Instruments

The assumptions used below are expected to approximate those that market participants would use in valuing these financial instruments.

Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. Such estimates do not consider the tax impact of the realization of unrealized gains or losses. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial instrument. Care should be exercised in deriving conclusions about our business, its value or financial position based on the fair value information of financial instruments presented below.

The estimated fair value approximates carrying value for cash and cash equivalents, Federal Home Loan Bank (“FHLB”) and Federal Reserve Bank (“FRB”) stock, accrued interest receivable, non-maturity deposits, short-term borrowings and accrued interest payable. Fair value estimates for other financial instruments not included elsewhere in this disclosure are discussed below.

Securities held to maturity: The fair value of the Company’s investment securities held to maturity is primarily measured using information from a third-party pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things.

Loans: The fair value of the Company’s loans was estimated by discounting the expected future cash flows using the current interest rates at which similar loans would be made for the same remaining maturities. Loans were first segregated by type such as commercial, residential mortgage, and consumer, and were then further segmented into fixed and variable rate and loan quality categories. Expected future cash flows were projected based on contractual cash flows, adjusted for estimated prepayments.

Time deposits: The fair value of time deposits was estimated using a discounted cash flow approach that applies prevailing market interest rates for similar maturity instruments. The fair values of the Company’s time deposit liabilities do not take into consideration the value of the Company’s long-term relationships with depositors, which may have significant value.

 

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FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements (Unaudited)

 

(11.) FAIR VALUE MEASUREMENTS (Continued)

 

The following presents (in thousands) the carrying amount, estimated fair value, and placement in the fair value measurement hierarchy of the Company’s financial instruments as of the dates indicated.

 

     Level in    June 30, 2014      December 31, 2013  
     Fair Value           Estimated             Estimated  
     Measurement    Carrying      Fair      Carrying      Fair  
     Hierarchy    Amount      Value      Amount      Value  

Financial assets:

              

Cash and cash equivalents

   Level 1    $ 64,832       $ 64,832       $ 59,692       $ 59,692   

Securities available for sale

   Level 2      601,903         601,903         609,400         609,400   

Securities held to maturity

   Level 2      262,057         266,640         249,785         250,657   

Loans held for sale

   Level 2      201         201         3,381         3,381   

Loans

   Level 2      1,867,423         1,881,386         1,797,656         1,802,407   

Loans (1)

   Level 3      2,075         2,075         9,227         9,227   

Accrued interest receivable

   Level 1      7,647         7,647         8,150         8,150   

FHLB and FRB stock

   Level 2      15,855         15,855         19,663         19,663   

Financial liabilities:

              

Non-maturity deposits

   Level 1      1,824,906         1,824,906         1,724,133         1,724,133   

Time deposits

   Level 2      625,172         626,578         595,923         596,928   

Short-term borrowings

   Level 1      254,683         254,683         337,042         337,042   

Accrued interest payable

   Level 1      3,658         3,658         3,407         3,407   

 

(1)  Comprised of collateral dependent impaired loans.

 

 

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q should be read in conjunction with the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2013. In addition, please read this section in conjunction with our Consolidated Financial Statements and Notes to Consolidated Financial Statements contained herein.

FORWARD LOOKING INFORMATION

Statements and financial analysis contained in this document that are not historical facts are forward looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 (the “Act”). Forward looking statements describe our future plans, strategies and expectations and are based on certain assumptions. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “target,” “project,” and other similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements.

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 identified under the heading “Risk Factors” in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013, could affect our financial performance and could cause our actual results or circumstances for future periods to differ materially from those anticipated or projected.

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.

GENERAL

Financial Institutions, Inc. is a financial holding company headquartered in New York State, providing banking and nonbanking financial services to individuals, municipalities 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 (“the Bank”), we offer a wide range of services, including business and consumer loan and depository services, brokerage and investment advisory services, as well as other financial services and traditional banking services. During February 2014, the Bank formed a wholly-owned subsidiary, Five Star REIT, Inc. as a special purpose real estate investment trust. For further discussion of Five Star REIT, Inc., refer to the “Income Taxes” section of this Management’s Discussion and Analysis. References in this report to “the Company”, “we”, “our” or “us” mean the consolidated reporting entity and references to “the Bank” mean Five Star Bank.

Our primary sources of revenue are net interest income (predominantly from 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.

Our business strategy is to maintain a community bank philosophy, which consists of focusing on and understanding the individualized banking needs of the businesses and residents of the communities we serve. 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 our larger competitors, allowing us to maintain long-standing and broad based banking relationships with our customers. Our core customers are primarily comprised of households, small to medium sized businesses and community organizations who prefer to build a banking relationship with a community bank that offers and combines high quality, competitively-priced banking products with personalized service. We believe that our level of personal service provides us with 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.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

EXECUTIVE OVERVIEW

Summary of 2014 Second Quarter Results

Net income increased $182 thousand or 3% to $7.0 million for the second quarter of 2014 compared to $6.9 million for the second quarter of 2013. Net income available to common shareholders for the second quarter of 2014 was $6.7 million, or $0.48 per diluted share, compared with $6.5 million, or $0.47 per diluted share, for the second quarter of last year. Return on average common equity was 10.66% and return on average assets was 0.95% for the second quarter of 2014 compared to 10.86% and 0.99%, respectively, for the second quarter of 2013.

Net interest income totaled $23.1 million in the second quarter 2014, up from $22.5 million in the second quarter 2013. Average earning assets were up $190.4 million, led by a $144.7 million increase in loans and a $45.9 million increase in investment securities in the second quarter of 2014 compared to the same quarter in 2013. The growth in earning assets was offset by a narrowing net interest margin. Second quarter 2014 net interest margin was 3.47%, a decrease of 16 basis points from 3.63% reported in the second quarter of 2013.

Noninterest income totaled $6.6 million in the second quarter of 2014, compared to $6.4 million in the second quarter of 2013. Included in these totals are gains realized from the sale of investment securities. Exclusive of those gains, noninterest income was $5.6 million in the recently completed quarter and $6.0 million in the second quarter of 2013. The decrease in noninterest income compared to the second quarter of 2013 was primarily due to lower service charges on deposit accounts.

Noninterest expense in the second quarter of 2014 totaled $17.8 million compared with $17.5 million in the second quarter of 2013. The increase in noninterest expense was largely due to professional services associated with the pending acquisition of Scott Danahy Naylon Co., Inc. and the hiring of additional loan officers and related personnel as part of the Company’s expansion initiatives.

The provision for loans losses increased to $1.8 million in the second quarter of 2014 compared to $1.2 million in the second quarter of 2013, primarily a result of net loan growth combined with higher net charge-offs in 2014. Net charge-offs during the recent quarter were $1.7 million, up from $1.4 million in the second quarter of 2013. Net charge-offs expressed as an annualized percentage of average loans outstanding were 0.37% during the second three months of 2014 compared with 0.33% in the second quarter of 2013.

The period end allowance for loan losses to total loans decreased to 1.43% at June 30, 2014 from 1.46% at December 31, 2013. Non-performing loans declined by $7.7 million or 47% to $8.9 million or 0.47% of total loans when comparing June 30, 2014 to December 31, 2013. The decreases reflect meaningful improvement in commercial mortgage non-performing loans.

Our second quarter 2014 leverage ratio increased to 7.64% from 7.59% in the second quarter of 2013. Tier 1 risk-based capital ratio was 10.95% and 10.96% at June 30, 2014 and 2013, respectively.

Acquisition of Scott Danahy Naylon Co., Inc.

In May 2014 we entered into a definitive agreement to acquire Scott Danahy Naylon Co., Inc. (“SDN”), a full service insurance agency located in Amherst, NY, a suburb of Buffalo. SDN provides a broad range of insurance services to both personal and business clients. Upon closing of the acquisition, SDN will operate as a subsidiary of Financial Institutions, Inc. and an affiliate of Five Star Bank.

Some of the attributes and benefits we expect to realize from the acquisition of SDN are:

 

    Strategic step in growing and diversifying noninterest income

 

    Scalable platform provides opportunities to add small independent agencies in the future

 

    Proven, experienced and capable management aligned to drive organic growth and capitalize on strategic opportunities

 

    Current business profile includes over 70% commercial-related activities, providing potential synergies with Five Star Bank’s commercial lending business

 

    Improves our presence in the Buffalo marketplace

The acquisition of Scott Danahy Naylon Co., Inc. was completed on August 1, 2014.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Expectations

Net interest income is expected to increase moderately over the remainder of 2014. We anticipate an increase in earning assets as we remained focused on loan growth, which will be partly funded with expected paydowns and liquidity from our securities portfolio. However, those benefits to net interest income are expected to be partially offset by continued downward pressure on net interest margin. We plan to maintain a disciplined approach to loan pricing, but asset yields remain under pressure due to the low interest rate environment, while the opportunity for deposit repricing is limited.

The commercial loan portfolio is expected to grow consistent with our strategic initiatives and continued support of middle market lending. Automobile loan originations remain strong, reflecting the positive impact from our investment in automotive dealer relationships. The home equity portfolio is expected to increase as the lower origination cost to customers and the convenient application process has made these products an increasingly attractive alternative to residential mortgage loans, accordingly we expect run-off to outpace new originations in the residential mortgage portfolio.

We anticipate the increase in total loans will modestly outpace growth in total deposits. This reflects our continued focus on the overall cost of funds, through the use of short-term borrowings as well as the continued shift towards low- and no-cost demand deposits and money market deposit accounts.

Noninterest income, excluding the impact of any securities gains and investments in limited partnerships, is expected to be higher than recent levels, reflecting our continued efforts to increase both account and transaction-based fee income. Specifically, we expect to see an increase in revenue related to the acquisition of SDN, which was completed on August 1, 2014. Management will continue to explore opportunities to increase noninterest income from non-deposit related sources, which may include expanding the products and services we offer through strategic acquisitions of insurance, wealth management and mortgage banking businesses.

Noninterest expense, excluding costs associated with acquiring SDN and incremental expenses related to SDN operations going forward, is expected to remain around current levels as we remain committed to diligent expense control.

We do not expect significant changes in overall asset quality and allowance measurements.

The effective tax rate for 2014 is expected to be approximately 30%, primarily reflecting the impacts of tax-exempt income, tax advantaged investments, and the formation of our real estate investment trust in early 2014.

RESULTS OF OPERATIONS

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 (dollars in thousands):

 

     Three months ended June 30,      Six months ended June 30,  
     2014      2013      2014      2013  

Interest income per consolidated statements of income

   $ 24,883       $ 24,342       $ 49,942       $ 49,090   

Adjustment to fully taxable equivalent basis

     701         656         1,396         1,284   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest income adjusted to a fully taxable equivalent basis

     25,584         24,998         51,338         50,374   

Interest expense per consolidated statements of income

     1,780         1,818         3,564         3,679   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income on a taxable equivalent basis

   $ 23,804       $ 23,180       $ 47,774       $ 46,695   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

2014 Leverage Strategy

During the first quarter of 2014, we utilized the proceeds of short-term FHLB advances to purchase high-quality investment securities of approximately $50 million. Our purchase of investment securities was comprised of mortgage-backed securities, U.S. Government agencies and sponsored enterprise bonds and tax-exempt municipal bonds. All of the securities purchased were of high credit quality with a low to moderate duration. This strategy allowed us to increase net interest income by taking advantage of the positive interest rate spread between the FHLB advances and the newly acquired investment securities. During the second quarter of 2014 we restructured the leverage by selling approximately $42 million of securities purchased in the first quarter and utilizing the proceeds to fund growth in our home equity portfolio.

Analysis of Net Interest Income for the Three Months ended June 30, 2014 and 2013

Net interest income on a taxable equivalent basis for the three months ended June 30, 2014, was $23.8 million, an increase of $624 thousand or 3% versus the comparable quarter last year. The increase in taxable equivalent net interest income was attributable to favorable volume variances (as changes in the balances and mix of earning assets and interest-bearing liabilities added $1.7 million to taxable equivalent net interest income), partly offset by unfavorable rate variances (as the impact of changes in the interest rate environment and product pricing reduced taxable equivalent net interest income by $1.1 million).

Actions by the Federal Open Market Committee of the Federal Reserve Board have compressed net interest income and net interest margins for the banking industry by maintaining low rates on interest-earning assets. Throughout 2013 and thus far into 2014, margins in the banking industry were pressured downward as higher-yielding legacy assets rolled off and were reinvested in the current low rate environment. Low interest rates, coupled with a competitive lending environment, have proven challenging for the profitability of the banking industry.

The net interest margin for the second quarter of 2014 was 3.47%, 16 basis points lower than 3.63% for the same period in 2013. This comparable period decrease was a function of a 15 basis point decrease in interest rate spread, combined with a lower contribution from net free funds of one basis point (due principally to lower rates on interest-bearing liabilities reducing the value of noninterest-bearing deposits and other net free funds). The lower interest rate spread was a net result of an 18 basis point decrease in the yield on earning assets and a 3 basis point decrease in the cost of interest-bearing liabilities.

For the second quarter of 2014, the yield on average earning assets of 3.73% was 18 basis points lower than the second quarter of 2013. Loan yields decreased 33 basis points to 4.32%. Consumer indirect loans in particular, down 51 basis points, experienced lower yields given the competitive pricing pressures in a low interest rate environment. The yield on investment securities increased 7 basis points to 2.45%. Overall, earning asset rate changes reduced interest income by $1.2 million during the second quarter of 2014, but that was more than offset by a favorable volume variance that increased interest income by $1.8 million, which collectively drove a $586 thousand increase in interest income.

The cost of average interest-bearing liabilities of 0.33% in the second quarter of 2014 was 3 basis points lower than the second quarter of 2013. Rates on interest-bearing deposits were down 3 basis points to 0.33% and the cost of short-term funding decreased 4 basis points to 0.36% for the second quarter of 2014. The interest-bearing liability rate changes resulted in $115 thousand of lower interest expense, which was partly offset by a $77 thousand volume-related increase in interest expense.

Average interest-earning assets were $2.75 billion for the second quarter 2014, an increase of $190.4 million or 7% from the comparable quarter last year, with average loans up $144.7 million and average securities up $45.9 million. The growth in average loans was comprised of increases in most loan categories, with consumer and commercial loans up $100.4 million and $59.0 million, respectively, partially offset by a $14.7 million decrease in residential mortgage loans. The growth in average securities was primarily a result of our previously described leverage strategy.

Average interest-bearing liabilities of $2.15 billion in second quarter of 2014 were $136.5 million or 7% higher than the second quarter of 2013. On average, interest-bearing deposits grew $65.3 million, while noninterest-bearing demand deposits (a principal component of net free funds) were up $36.5 million. The increase in average deposits was largely due to an increase in deposits from our Certificate of Deposit Account Registry Service (“CDARs”) and Insured Cash Sweep (“ICS”) programs. For further discussion of the CDARS and ICS programs, refer to the “Funding Activities—Deposits” section of this Management’s Discussion and Analysis. Average short-term borrowings increased $71.2 million between the second quarter periods, largely due to the incremental borrowings associated with the previously mentioned 2014 leverage strategy.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Analysis of Net Interest Income for the Six Months ended June 30, 2014 and June 30, 2013

Net interest income on a taxable equivalent basis for the first six months of 2014 was $47.8 million, an increase of $1.1 million or 2% versus the same period last year. The increase in taxable equivalent net interest income was primarily attributable to a favorable volume variance (as changes in the balances and mix of earning assets and interest-bearing liabilities added $3.5 million to taxable equivalent net interest income), partially offset by an unfavorable rate variance (as the impact of changes in the interest rate environment and product pricing decreased taxable equivalent net interest income by $2.5 million).

The net interest margin for the first six months of 2014 was 3.49%, 19 basis points lower than 3.68% for the same period last year. This comparable period decrease was a function of a 17 basis point decrease in interest rate spread to 3.43% during the first six months of 2014, combined with a 2 basis point lower contribution from net free funds. The lower interest rate spread was a net result of a 21 basis point decrease in the yield on earning assets and a 4 basis point decrease in the cost of interest-bearing liabilities.

The yield on earning assets was 3.76% for the first six months of 2014, 21 basis points lower than the same period last year, primarily attributable to a decrease in the yields on the loan portfolio (down 35 basis points to 4.39%), partially offset by an increase in the yields on the investment securities portfolio (up 6 basis points, to 2.44%).

The cost on interest-bearing liabilities of 0.33% for the first six months of 2014 was 4 basis points lower than the same period in 2013. Rates on interest-bearing deposits were down 3 basis points to 0.33% and the cost of short-term borrowings decreased 3 basis points to 0.37%.

Average interest-earning assets were $2.75 billion for the first six months of 2014, an increase of $196.4 million or 8% from the comparable period last year, with average loans up $139.4 million and average securities up $57.0 million. The growth in average loans was comprised of increases in most loan categories, with consumer and commercial loans up $95.5 million and $59.8 million, respectively, partially offset by a $15.9 million decrease in residential mortgage loans.

Average interest-bearing liabilities of $2.16 billion in the first six months of 2014 were $137.3 million or 7% higher than the first six months of 2013. On average, interest-bearing deposits grew $60.3 million, while noninterest-bearing demand deposits were up $39.5 million and average short-term borrowings increased $77.1 million.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

The following tables set forth certain information relating to the consolidated balance sheets and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities for the periods indicated (in thousands).

 

     Three months ended June 30,  
     2014     2013  
     Average            Average     Average            Average  
     Balance     Interest      Rate     Balance     Interest      Rate  

Interest-earning assets:

              

Federal funds sold and interest-earning deposits

   $ 94      $ —           0.07   $ 226      $ —           0.19

Investment securities (1):

              

Taxable

     621,967        3,353         2.16        599,931        3,060         2.04   

Tax-exempt (2)

     253,888        2,001         3.15        230,022        1,874         3.26   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     875,855        5,354         2.45        829,953        4,934         2.38   

Loans:

              

Commercial business

     275,105        2,912         4.25        256,332        2,854         4.47   

Commercial mortgage

     473,883        5,692         4.82        433,631        5,397         4.99   

Residential mortgage

     108,535        1,306         4.81        123,263        1,558         5.05   

Home equity

     346,911        3,428         3.96        299,230        3,072         4.12   

Consumer indirect

     651,150        6,297         3.88        595,235        6,518         4.39   

Other consumer

     20,855        595         11.44        24,080        665         11.08   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

     1,876,439        20,230         4.32        1,731,771        20,064         4.65   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-earning assets

     2,752,388        25,584         3.73        2,561,950        24,998         3.91   
    

 

 

    

 

 

     

 

 

    

 

 

 

Allowance for loan losses

     (27,551          (26,282     

Other noninterest-earning assets

     248,898             253,436        
  

 

 

        

 

 

      

Total assets

   $ 2,973,735           $ 2,789,104        
  

 

 

        

 

 

      

Interest-bearing liabilities:

              

Deposits:

              

Interest-bearing demand

   $ 509,398      $ 151         0.12   $ 489,047      $ 176         0.14

Savings and money market

     789,956        232         0.12        739,328        242         0.13   

Time deposits

     629,945        1,194         0.76        635,583        1,247         0.79   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     1,929,299        1,577         0.33        1,863,958        1,665         0.36   

Short-term borrowings

     224,801        203         0.36        153,626        153         0.40   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

     2,154,100        1,780         0.33        2,017,584        1,818         0.36   
    

 

 

    

 

 

     

 

 

    

 

 

 

Noninterest-bearing demand deposits

     537,895             501,354        

Other noninterest-bearing liabilities

     13,583             13,259        

Shareholders’ equity

     268,157             256,907        
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 2,973,735           $ 2,789,104        
  

 

 

        

 

 

      

Net interest income (tax-equivalent)

     $ 23,804           $ 23,180      
    

 

 

        

 

 

    

Interest rate spread

          3.40          3.55
       

 

 

        

 

 

 

Net earning assets

   $ 598,288           $ 544,366        
  

 

 

        

 

 

      

Net interest margin (tax-equivalent)

          3.47          3.63
       

 

 

        

 

 

 

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

          127.77          126.98
       

 

 

        

 

 

 

 

(1)  Investment securities are shown at amortized cost and include non-performing securities.
(2)  The interest on tax-exempt securities is calculated on a tax equivalent basis assuming a Federal tax rate of 35%.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

     Six months ended June 30,  
     2014     2013  
     Average            Average     Average            Average  
     Balance     Interest      Rate     Balance     Interest      Rate  

Interest-earning assets:

              

Federal funds sold and interest-earning deposits

   $ 204      $ —           0.08   $ 272      $ —           0.20

Investment securities (1):

              

Taxable

     638,151        6,854         2.15        611,364        6,262         2.05   

Tax-exempt (2)

     251,917        3,987         3.17        221,730        3,669         3.31   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total investment securities

     890,068        10,841         2.44        833,094        9,931         2.38   

Loans:

              

Commercial business

     270,148        5,823         4.35        257,638        5,725         4.48   

Commercial mortgage

     473,312        11,198         4.77        425,982        10,682         5.06   

Residential mortgage

     110,949        2,679         4.83        126,824        3,208         5.06   

Home equity

     337,922        6,711         4.00        294,140        6,093         4.18   

Consumer indirect

     646,720        12,881         4.02        591,671        13,370         4.56   

Other consumer

     21,455        1,205         11.32        24,804        1,365         11.10   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total loans

     1,860,506        40,497         4.39        1,721,059        40,443         4.74   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-earning assets

     2,750,778        51,338         3.76        2,554,425        50,374         3.97   
    

 

 

    

 

 

     

 

 

    

 

 

 

Allowance for loan losses

     (27,153          (25,537     

Other noninterest-earning assets

     245,966             255,793        
  

 

 

        

 

 

      

Total assets

   $ 2,969,591           $ 2,784,681        
  

 

 

        

 

 

      

Interest-bearing liabilities:

              

Deposits:

              

Interest-bearing demand

   $ 510,231      $ 311         0.12   $ 491,835      $ 314         0.13

Savings and money market

     775,956        467         0.12        716,632        462         0.13   

Time deposits

     624,068        2,324         0.75        641,534        2,560         0.80   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing deposits

     1,910,255        3,102         0.33        1,850,001        3,336         0.36   

Short-term borrowings

     249,470        462         0.37        172,415        343         0.40   
  

 

 

   

 

 

    

 

 

   

 

 

   

 

 

    

 

 

 

Total interest-bearing liabilities

     2,159,725        3,564         0.33        2,022,416        3,679         0.37   
    

 

 

    

 

 

     

 

 

    

 

 

 

Noninterest-bearing demand deposits

     531,158             491,685        

Other noninterest-bearing liabilities

     13,800             14,208        

Shareholders’ equity

     264,908             256,372        
  

 

 

        

 

 

      

Total liabilities and shareholders’ equity

   $ 2,969,591           $ 2,784,681        
  

 

 

        

 

 

      

Net interest income (tax-equivalent)

     $ 47,774           $ 46,695      
    

 

 

        

 

 

    

Interest rate spread

          3.43          3.60
       

 

 

        

 

 

 

Net earning assets

   $ 591,053           $ 532,009        
  

 

 

        

 

 

      

Net interest margin (tax-equivalent)

          3.49          3.68
       

 

 

        

 

 

 

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

          127.37          126.31
       

 

 

        

 

 

 

 

(1)  Investment securities are shown at amortized cost and include non-performing securities.
(2)  The interest on tax-exempt securities is calculated on a tax equivalent basis assuming a Federal tax rate of 35%.

 

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MANAGEMENT’S DISCUSSION AND 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):

 

     Three months ended     Six months ended  
     June 30, 2014 vs. 2013     June 30, 2014 vs. 2013  
     Volume     Rate     Total     Volume     Rate     Total  

Increase (decrease) in:

            

Interest income:

          

Federal funds sold and interest-earning deposits

   $ —        $ —        $ —        $ —        $ —        $ —     

Investment securities:

          

Taxable

     115        178        293        281        311        592   

Tax-exempt

     189        (62     127        483        (165     318   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total investment securities

     304        116        420        764        146        910   

Loans:

          

Commercial business

     203        (145     58        273        (175     98   

Commercial mortgage

     488        (193     295        1,143        (627     516   

Residential mortgage

     (180     (72     (252     (388     (141     (529

Home equity

     475        (119     356        877        (259     618   

Consumer indirect

     580        (801     (221     1,179        (1,668     (489

Other consumer

     (91     21        (70     (187     27        (160
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total loans

     1,475        (1,309     166        2,897        (2,843     54   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

     1,779        (1,193     586        3,661        (2,697     964   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Interest expense:

          

Deposits:

          

Interest-bearing demand

     7        (32     (25     12        (15     (3

Savings and money market

     16        (26     (10     37        (32     5   

Time deposits

     (11     (42     (53     (69     (167     (236
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest-bearing deposits

     12        (100     (88     (20     (214     (234

Short-term borrowings

     65        (15     50        144        (25     119   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

     77        (115     (38     124        (239     (115
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

   $ 1,702      $ (1,078   $ 624      $ 3,537      $ (2,458   $ 1,079   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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. There were provisions for loan losses of $1.8 million and $3.9 million for the three and six month periods ended June 30, 2014, compared with provisions of $1.2 million and $3.9 million for the corresponding periods in 2013, respectively. See the “Allowance for Loan Losses” and “Non-Performing Assets and Potential Problem Loans” sections of this Management’s Discussion and Analysis for further discussion.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Noninterest Income

The following table details the major categories of noninterest income for the periods presented (in thousands):

 

     Three months ended      Six months ended  
     June 30,      June 30,  
     2014      2013      2014     2013  

Service charges on deposits

   $ 2,241       $ 2,568       $ 4,491      $ 4,709   

ATM and debit card

     1,257         1,317         2,431        2,566   

Investment advisory

     561         650         1,124        1,349   

Company owned life insurance

     425         438         828        853   

Investments in limited partnerships

     81         136         707        297   

Loan servicing

     176         152         330        225   

Net gain on disposal of investment securities

     949         332         1,262        1,224   

Net gain on sale of loans held for sale

     50         35         155        235   

Net gain (loss) on disposal of other assets

     24         38         (11     39   

Other

     813         710         1,617        1,432   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total noninterest income

   $ 6,577       $ 6,376       $ 12,934      $ 12,929   
  

 

 

    

 

 

    

 

 

   

 

 

 

Service charges on deposit accounts decreased $327 thousand or 13% in the second quarter of 2014 and $218 thousand or 5% for the six months ended June 30, 2014, compared to the same periods a year earlier. Service charges on deposit accounts for 2013 reflected a retail checking account repositioning that involved simplifying the suite of products offered to customers and modifications to the fee structure for our accounts. As noted at that time, the income from service charges on deposits subsequently stabilized as customers determined the optimal mix of our products and services to best suit their banking needs.

ATM and debit card income decreased $60 thousand or 5% in the second quarter of 2014 and $135 thousand or 5% for the six months ended June 30, 2014, compared to the same periods a year earlier. The decreases are primarily attributable to lower transaction volumes due to card reissuance associated with third-party security breaches.

Investment advisory income decreased $89 thousand or 14% and $225 thousand or 17%, respectively, in the three and six months ended June 30, 2014, compared to the same periods of 2013. Investment advisory income fluctuates mainly due to sales volume, which decreased during the first half of 2014.

We have investments in limited partnerships, primarily small business investment companies, and account for these investments under the equity method. Income from investments in limited partnerships was $81 thousand and $707 thousand for the three and six months ended June 30, 2014, respectively. The income from these equity method investments fluctuates based on the performance of the underlying investments.

Loan servicing income increased $24 thousand and $105 thousand during the three and six months ended June 30, 2014, compared to the same periods a year earlier. The increases were a result of slower amortization of servicing rights consistent with reduced refinancing activity in the sold and serviced portfolio, combined with smaller adjustments to the valuation allowance for capitalized mortgage servicing assets compared to the three and six months ended June 30, 2013, partially offset by lower fees collected due to a decrease in the sold and serviced portfolio.

We recognized pre-tax gains on investment securities of $313 thousand from the sale of five agency securities and one mortgage backed security during the first quarter of 2014. During the second quarter of 2014 we recognized gains of $949 thousand from the sale of one pooled trust preferred security which had been classified as non-performing and 14 securities which we had acquired in the first quarter of 2014 as part of a leverage strategy. The leverage strategy utilized proceeds from short-term Federal Home Loan Bank advances to purchase high-quality investment securities. We recognized pre-tax gains on investment securities of $892 thousand and $332 thousand, respectively, during the first and second quarters of 2013 from the sale of pooled trust-preferred 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.

Other noninterest income increased $103 thousand or 15% in the second quarter of 2014 and $185 thousand or 13% for the six months ended June 30, 2014, compared to the same periods a year earlier. Merchant services income, dividends on FHLB stock and credit card correspondent income comprised the majority of the comparable increases.

 

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Table of Contents

MANAGEMENT’S DISCUSSION AND ANALYSIS

 

Noninterest Expense

The following table details the major categories of noninterest expense for the periods presented (in thousands):

 

     Three months ended      Six months ended  
     June 30,      June 30,  
     2014      2013      2014      2013  

Salaries and employee benefits

   $ 9,063       $ 9,226       $ 18,319       $ 18,935   

Occupancy and equipment

     3,139         3,035         6,374         6,204   

Professional services

     1,384         1,093