UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-K

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

For the fiscal year ended December 31, 2013

 

Commission File Number 001-15877

 

 

GERMAN AMERICAN BANCORP, INC.
(Exact name of registrant as specified in its charter)

 

INDIANA   35-1547518
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

711 Main Street, Box 810, Jasper, Indiana   47546
(Address of Principal Executive Offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (812) 482-1314

 

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

Title of Each Class   Name of each exchange on which registered
Common Shares, no par value   The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.   ¨  Yes þ No
       
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.   ¨  Yes þ No
       
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   þ  Yes ¨ No
       
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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).   þ  Yes ¨ No

 

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

    ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company:

 

Large accelerated filer ¨ Accelerated filer þ Non-accelerated filer ¨ Smaller reporting company ¨

 

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

 

The aggregate market value of the registrant’s common shares held by non-affiliates as of June 30, 2013 was approximately $260,154,858. This calculation does not reflect a determination that persons are (or are not) affiliates for any other purpose.

 

As of March 1, 2014, there were outstanding 13,173,793 common shares, no par value, of the registrant.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement of German American Bancorp, Inc., for the Annual Meeting of its Shareholders to be held May 15, 2014, to the extent stated herein, are incorporated by reference into Part III.

 

 
 

 

GERMAN AMERICAN BANCORP, INC.

ANNUAL REPORT ON FORM 10-K

For Fiscal Year Ended December 31, 2013

 

Table of Contents

 

PART I      
       
Item 1. Business   3-12
       
Item 1A. Risk Factors   12-16
       
Item 1B. Unresolved Staff Comments   16
       
Item 2. Properties   16
       
Item 3. Legal Proceedings   16
       
Item 4. Mine Safety Disclosures   16
       
PART II      
       
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities   17-18
       
Item 6. Selected Financial Data   19
       
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations   20-38
       
Item 7A. Quantitative and Qualitative Disclosures About Market Risk   38
       
Item 8. Financial Statements and Supplementary Data   39-89
       
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   90
       
Item 9A. Controls and Procedures   90
       
Item 9B. Other Information   90
       
PART III      
       
Item 10. Directors, Executive Officers, and Corporate Governance   91
       
Item 11. Executive Compensation   91
       
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters   91-92
       
Item 13. Certain Relationships and Related Transactions, and Director Independence   92
       
Item 14. Principal Accounting Fees and Services   92
       
PART IV      
       
Item 15. Exhibits, Financial Statement Schedules   93
       
SIGNATURES   94
     
INDEX OF EXHIBITS   95-98

 

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Information included in or incorporated by reference in this Annual Report on Form 10-K, our other filings with the Securities and Exchange Commission and our press releases or other public statements, contain or may contain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Please refer to a discussion of our forward- looking statements and associated risks in Item 1, “Business – Forward-Looking Statements and Associated Risks” and our discussion of risk factors in Item 1A, “Risk Factors” in this Annual Report on Form 10-K.

 

PART I

 

Item 1. Business.

General

 

German American Bancorp, Inc., is a NASDAQ-traded (symbol: GABC) financial services holding company based in Jasper, Indiana. German American, through its banking subsidiary German American Bancorp, operates 37 retail and commercial banking offices in 13 southern Indiana counties. The Company also owns a trust, brokerage, and financial planning subsidiary (German American Financial Advisors & Trust Company) and a full line property and casualty insurance agency (German American Insurance, Inc.).

 

Throughout this report, when we use the term “Company”, we will usually be referring to the business and affairs (financial and otherwise) of German American Bancorp, Inc. and its consolidated subsidiaries as a whole. Occasionally, we will refer to the term “parent company” or “holding company” when we mean to refer to only German American Bancorp, Inc. and the term “Bank” when we mean to refer only to the Company’s bank subsidiary.

 

The Company’s lines of business include retail and commercial banking, comprehensive financial planning, full service brokerage and trust administration, and a full range of personal and corporate insurance products. Financial and other information by segment is included in Note 15 – Segment Information of the Notes to the Consolidated Financial Statements included in Item 8 of this Report and is incorporated into this Item 1 by reference. Substantially all of the Company’s revenues are derived from customers located in, and substantially all of its assets are located in, the United States.

 

Subsidiaries

 

The Company’s principal operating subsidiaries are described in the following table:

 

Name   Type of Business   Principal Office Location
German American Bancorp   Commercial Bank   Jasper, IN
German American Insurance, Inc.   Multi-Line Insurance Agency   Jasper, IN
German American Financial Advisors & Trust Company   Trust, Brokerage, Financial Planning   Jasper, IN

 

Business Development

 

The Company opened a loan production office in Columbus, Indiana, during the second quarter of 2012 as an entry point into the Columbus market. During the fourth quarter of 2013, the Company’s opened a full service retail and commercial branch location in Columbus and vacated the loan production office. The Company continues its focus on growing its base of operations in the Columbus, Indiana, market.

 

The Company acquired by merger (effective October 1, 2013) United Commerce Bancorp and its subsidiary, United Commerce Bank. United Commerce Bank provided a full range of commercial and consumer banking services in the Bloomington, Indiana, market, from two banking offices. During the fourth quarter of 2013, one of those branch locations was consolidated into an existing branch banking location of German American Bancorp. United Commerce had consolidated assets and deposits (unaudited) as of October 1, 2013 that totaled $119.7 million and $106.6 million, respectively. The Company continues its focus on growing its base of operations in the Bloomington, Indiana, market.

 

The Company expects to continue to evaluate opportunities to expand its business through opening of new banking, insurance or trust, brokerage and financial planning offices, and through acquisitions of other banks, bank branches, portfolios of loans or other assets, and other financial-service-related businesses and assets in the future.

 

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Office Locations

 

The Indiana map below illustrates the locations of the Company’s 39 retail and commercial banking, insurance and investment offices as of March 1, 2014.

 

 

Competition

 

The industries in which the Company operates are highly competitive. The Bank competes for commercial and retail banking business within its core banking segment not only with financial institutions that have offices in the same counties but also with financial institutions that compete from other locations in Southern Indiana and elsewhere. Further, the Bank competes for loans and deposits not only with commercial banks but also with savings and loan associations, savings banks, credit unions, production credit associations, federal land banks, finance companies, credit card companies, personal loan companies, investment brokerage firms, insurance agencies, insurance companies, lease finance companies, money market funds, mortgage companies, and other non-depository financial intermediaries. There are numerous alternative providers (including national providers that advertise extensively via television and the Internet and that provide their services through direct mail, telephone and the Internet) for the insurance products and services offered by German American Insurance, Inc., and the trust, brokerage and financial planning products and services offered by German American Financial Advisors & Trust Company. Many of these competitors have substantially greater resources than the Company.

 

Employees

 

At March 1, 2014 the Company and its subsidiaries employed approximately 480 full-time equivalent employees. There are no collective bargaining agreements, and employee relations are considered to be good.

 

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Regulation and Supervision

Overview

 

The Company is subject to regulation and supervision by the Board of Governors of the Federal Reserve System (“FRB”) under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and is required to file with the FRB annual reports and such additional information as the FRB may require. The FRB may also make examinations or inspections of the Company. The Bank is under the supervision of and subject to examination by the Indiana Department of Financial Institutions (“DFI”), and the Federal Deposit Insurance Corporation (“FDIC”). Regulation and examination by banking regulatory agencies are primarily for the benefit of depositors rather than shareholders.

 

Under FRB policy and the Dodd-Frank Wall Street Reform and Consumer Protection Act, a complex and wide-ranging statute that was enacted by Congress and signed into law during July 2010 (the “Dodd-Frank Act”), the Company is required to act as a source of financial and managerial strength to the Bank, and to commit resources to support the Bank, even in circumstances where the Company might not do so absent such a requirement. Under current federal law, the FRB may require a bank holding company to make capital injections into a troubled subsidiary bank. It may charge the bank holding company with engaging in unsafe and unsound practices if the bank holding company fails to commit resources to such a subsidiary bank or if it undertakes actions that the FRB believes might jeopardize the bank holding company’s ability to commit resources to such subsidiary bank.

 

With certain exceptions, the BHC Act prohibits a bank holding company from engaging in (or acquiring direct or indirect control of more than 5 percent of the voting shares of any company engaged in) nonbanking activities. One of the principal exceptions to this prohibition is for activities deemed by the FRB to be “closely related to banking.” Under current regulations, bank holding companies and their subsidiaries are permitted to engage in such banking-related business ventures as consumer finance; equipment leasing; credit life insurance; computer service bureau and software operations; mortgage banking; and securities brokerage.

 

Under the BHC Act, certain well-managed and well-capitalized bank holding companies may elect to be treated as a “financial holding company” and, as a result, be permitted to engage in a broader range of activities that are “financial in nature” and in activities that are determined to be incidental or complementary to activities that are financial in nature. These activities include underwriting and dealing in and making a market in securities (subject to certain limits and compliance procedures required by the so-called Volcker Rule provisions added by the Dodd-Frank Act, described below under “Other Aspects of the Dodd-Frank Act”); insurance underwriting, and merchant banking. Banks may also engage through financial subsidiaries in certain of the activities permitted for financial holding companies, subject to certain conditions. The Company has not elected to become a financial holding company and its subsidiary bank has not elected to form financial subsidiaries.

 

The Bank and the subsidiaries of the Bank may generally engage in activities that are permissible activities for state chartered banks under Indiana banking law, without regard to the limitations that might apply to such activities under the BHC Act if the Company were to engage directly in such activities at the parent company level or through parent company subsidiaries that were not also bank subsidiaries.

 

Indiana law and the BHC Act restrict certain types of expansion by the Company and its bank subsidiary. The Company and its subsidiaries may be required to apply for prior approval from (or give prior notice and an opportunity for review to) the FRB, the DFI, and/or other bank regulatory or other regulatory agencies, as a condition to the acquisition or establishment of new offices, or the acquisition (by merger or consolidation, purchase or otherwise) of the stock, business or properties of other banks or other companies.

 

The earnings of commercial banks and their holding companies are affected not only by general economic conditions but also by the policies of various governmental regulatory authorities. In particular, the FRB regulates money and credit conditions and interest rates in order to influence general economic conditions, primarily through open-market operations in U.S. Government securities, varying the discount rate on bank borrowings, and setting reserve requirements against bank deposits. These policies have a significant influence on overall growth and distribution of bank loans, investments and deposits, and affect interest rates charged on loans and earned on investments or paid for time and savings deposits. FRB monetary policies have had a significant effect on the operating results of commercial banks in the past and this is expected to continue in the future. The general effect, if any, of such policies upon the future business and earnings of the Company cannot accurately be predicted.

 

Capital Requirements Generally

 

The FRB has issued risk-based capital ratio and leverage ratio guidelines for bank holding companies. Under the guidelines and related policies, bank holding companies must maintain capital sufficient to meet both a risk-based asset ratio test and a leverage ratio test on a consolidated basis. The risk-based ratio is determined by allocating assets and specified off-balance sheet commitments into four weighted categories, with higher weighting assigned to categories perceived as representing greater risk. The risk-based ratio represents total capital divided by total risk-weighted assets. The leverage ratio is core capital divided by total assets adjusted as specified in the guidelines. Our bank subsidiary is subject to substantially similar capital requirements under regulations and policies adopted by the FDIC and the Indiana Department of Financial Institutions. The FRB and FDIC during 2013 issued final rules (or interim final rules) to comprehensively revise the regulatory capital framework for US banking institutions and their affiliates, as discussed below.

 

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Current Capital Requirements

 

Current guidelines that continue to apply throughout 2014 (prior to the phase-in of the new rules effective January 1, 2015) require all bank holding companies and federally regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% of risk-weighted assets must be Tier I Capital. Tier I Capital, which includes common shareholders’ equity, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock and certain trust preferred securities, less certain goodwill items and other intangible assets, is required to equal at least 4% of risk-weighted assets. The remainder (“Tier II Capital”) may consist of (i) an allowance for loan losses of up to 1.25% of risk-weighted assets, (ii) excess of qualifying perpetual preferred stock, (iii) hybrid capital instruments, (iv) perpetual debt, (v) mandatory convertible securities, and (vi) subordinated debt and intermediate-term preferred stock up to 50% of Tier I Capital. Total capital is the sum of Tier I and Tier II Capital less reciprocal holdings of other banking organizations’ capital instruments, investments in unconsolidated subsidiaries and any other deductions as determined by the appropriate regulator (determined on a case by case basis or as a matter of policy after formal rule making).

 

In computing total risk-weighted assets, bank holding company assets are given risk-weights of 0%, 20%, 50% and 100%. In addition, certain off-balance sheet items are given similar credit conversion factors to convert them to asset equivalent amounts to which an appropriate risk-weight will apply. Most loans will be assigned to the 100% risk category, except for performing first mortgage loans fully secured by 1- to 4-family and certain multi-family residential property, which carry a 50% risk rating. Most investment securities (including, primarily, general obligation claims on states or other political subdivisions of the United States) will be assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% risk-weight, and direct obligations of the U.S. Treasury or obligations backed by the full faith and credit of the U.S. Government, which have a 0% risk-weight. In covering off-balance sheet items, direct credit substitutes, including general guarantees and standby letters of credit backing financial obligations, are given a 100% conversion factor. Transaction-related contingencies such as bid bonds, standby letters of credit backing non-financial obligations, and undrawn commitments (including commercial credit lines with an initial maturity of more than one year) have a 50% conversion factor. Short-term commercial letters of credit are converted at 20% and certain short-term unconditionally cancelable commitments have a 0% factor.

 

The federal bank regulatory authorities have also adopted regulations that supplement the risk-based guidelines. These regulations generally require banks and financial holding companies to maintain a minimum level of Tier I Capital to total assets less goodwill of either 3% or 4%, depending upon factors such as the regulatory ratings, earnings and financial condition of the institution (the “leverage ratio”). Banking organizations experiencing or anticipating significant growth will be required to maintain higher minimum leverage ratios and may be required to commit to achieve or maintain higher minimum ratios (including “tangible Tier I leverage ratios”) in order to secure regulatory approvals needed for such organizations to acquire other banks or other businesses or engage in new activities. The tangible Tier I leverage ratio is the ratio of a banking organization’s Tier I Capital, less deductions for intangibles otherwise includable in Tier I Capital, to total tangible assets.

 

New Capital Requirements Applicable to Us in the Future

 

In July 2013, the federal banking agencies released final rules that will implement in the United States certain regulatory capital reforms based upon international banking supervision principles adopted by the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Act. Generally, under these final rules, (a) minimum requirements will increase for both the quality and quantity of capital held by banking organizations, (b) new and stricter criteria for determining the eligibility for inclusion in regulatory capital of capital instruments (other than common equity) will be applied, and (c) the methodology for calculating risk-weighted assets will change. The rules include, among other requirements:

 

•a new minimum ratio of “Common Equity Tier 1 Capital” to risk-weighted assets of 4.5%
•a new conservation buffer of Common Equity Tier 1 Capital equal to (when fully phased in) an additional 2.5% of risk-weighted assets
•a minimum ratio of Tier 1 Capital to risk-weighted assets (raised from 4% to 6%) plus (when fully phased in) the conservation buffer of an additional 2.5%, resulting in a minimum required total Tier 1 Capital to risk-weighted assets ratio of 8.5%
•a minimum ratio of Total Capital (that is, Tier 1 Capital plus Tier 2 Capital) to risk-weighted assets of at least 8.0%, plus (when fully phased in) the capital conservation buffer (which is added to the 8.0% Total Capital ratio as that buffer is phased-in, effectively resulting in a minimum Total Capital ratio of 10.5% upon full implementation)
•a minimum leverage ratio of 4% (calculated as the ratio of Tier 1 Capital to adjusted average consolidated assets)

 

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The new capital measure “Common Equity Tier 1” (“CET1”) Capital consists of common stock instruments that meet the eligibility criteria in the final rules, retained earnings, accumulated other comprehensive income (“AOCI”) and common equity Tier 1 minority interest. Tier 1 Capital will consist of CET1 and “additional Tier 1 capital” instruments meeting specified requirements, plus, in the case of smaller holding companies like ours, trust preferred securities in accordance with prior requirements for their inclusion in Tier I Capital. A number of deductions from and adjustments to CET1 will apply. Changes will apply to the calculation of Tier 2 Capital and to the types of capital elements that will be eligible for inclusion as Tier 2 capital.

 

Under current capital standards, the effects of AOCI items included in capital are excluded for the purposes of determining regulatory capital ratios; under the new rules, we and our bank subsidiary will have a one-time election (the “Opt-out Election”) to filter certain AOCI components, comparable to their treatment under the current general risk-based capital rule. The AOCI Opt-out Election must be made in connection with the regulatory financial reports that we and our bank subsidiary will file with banking agencies for our fiscal quarter ended March 31, 2015.

 

Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer will technically comply with minimum capital requirements, but will face limitations on the payment of dividends, common stock repurchases and discretionary cash payments to executive officers based on the amount of the shortfall.

 

As applied to us, these rules will generally become effective January 1, 2015; the new Common Equity Tier 1 Capital conservation buffer, however, will be phased in from 2016 through 2019.

 

Capital Classifications

 

Federal law and regulations establish a capital-based regulatory framework designed to promote early intervention for troubled banks and require the FDIC to choose the least expensive resolution of bank failures. The capital-based regulatory framework contains five categories of compliance with regulatory capital requirements, including “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” To qualify as a “well-capitalized” institution, a bank under current guidelines must have a leverage ratio of no less than 5%, a Tier I Capital ratio of no less than 6%, and a total risk-based capital ratio of no less than 10%, and the bank must not be under any order or directive from the appropriate regulatory agency to meet and maintain a specific capital level. Generally, a financial institution must be “well capitalized” before the Federal Reserve will approve an application by a bank holding company to acquire or merge with a bank or bank holding company.

 

Under the regulations, the applicable agency can treat an institution as if it were in the next lower category if the agency determines (after notice and an opportunity for hearing) that the institution is in an unsafe or unsound condition or is engaging in an unsafe or unsound practice. The degree of regulatory scrutiny of a financial institution will increase, and the permissible activities of the institution will decrease, as it moves downward through the capital categories. Institutions that fall into one of the three undercapitalized categories may be required to (i) submit a capital restoration plan; (ii) raise additional capital; (iii) restrict their growth, deposit interest rates, and other activities; (iv) improve their management; (v) eliminate management fees; or (vi) divest themselves of all or a part of their operations. Bank holding companies can be called upon to boost the capital of the financial institutions that they control, and to partially guarantee the institutions’ performance under their capital restoration plans.

 

The minimum ratios referred to above are merely guidelines and the bank regulators possess the discretionary authority to require higher capital ratios.

 

As of December 31, 2013, we exceeded the requirements contained in the applicable regulations, policies and directives pertaining to capital adequacy to be classified as “well capitalized”, and are unaware of any material violation or alleged violation of these regulations, policies or directives.

 

Failure to meet applicable capital guidelines could subject the financial institution to a variety of enforcement remedies available to the federal regulatory authorities. These include limitations on the ability to pay dividends, the issuance by the regulatory authority of a directive to increase capital, and the termination of deposit insurance by the FDIC. In addition, the financial institution could be subject to the measures described below under a regulatory program known as Prompt Corrective Action as applicable to Under-capitalized institutions.

 

The risk-based capital standards of the FRB and the FDIC specify that evaluations by the banking agencies of a bank’s capital adequacy will include an assessment of the exposure to declines in the economic value of a bank’s capital due to changes in interest rates. These banking agencies issued a joint policy statement on interest rate risk describing prudent methods for monitoring such risk that rely principally on internal measures of exposure and active oversight of risk management activities by senior management.

 

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The Federal Deposit Insurance Corporation Improvements Act (enacted in 1991) (FDICIA) requires federal banking regulatory authorities to take regulatory enforcement actions known as Prompt Corrective Action with respect to depository institutions that do not meet minimum capital requirements. For these purposes, FDICIA establishes five capital tiers: Well-capitalized, Adequately-capitalized, Under-capitalized, Significantly under-capitalized, and Critically under-capitalized.

 

Throughout 2013, the Company’s consolidated regulatory capital ratios and those of the Bank were in excess of the levels established for Well-capitalized institutions for purposes of the Prompt Corrective Action provisions under FDICIA. An institution is deemed to be Well-capitalized under the current FDICIA tiers if it has a total risk-based capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or greater, and a Tier 1 leverage ratio of 5% or greater and is not subject to a regulatory order, agreement, or directive to meet and maintain a specific capital level for any capital measure. For a tabular presentation of our regulatory capital ratios and those of the Bank as of December 31, 2013, see Note 8 to the Company’s consolidated financial statements that are presented in Item 8 of this Report, which Note 8 is incorporated herein by reference.

 

FDICIA generally prohibits a depository institution from making any capital distribution, including payment of a cash dividend or paying any management fee to its holding company, if the depository institution would become Under-capitalized after such payment. Under-capitalized institutions are also subject to growth limitations and are required by the appropriate federal banking agency to submit a capital restoration plan. If any depository institution subsidiary of a holding company is required to submit a capital restoration plan, the holding company would be required to provide a limited guarantee regarding compliance with the plan as a condition of approval of such plan.

 

Depending upon the severity of the under capitalization, the Under-capitalized institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become Adequately-capitalized, requirements to reduce total assets, cessation of receipt of deposits from correspondent banks, and restrictions on making any payment of principal or interest on their subordinated debt. Critically under-capitalized institutions are subject to appointment of a receiver or conservator within 90 days of becoming so classified.

 

Under FDICIA, a depository institution that is not Well-capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. Since the Bank is Well-capitalized, the FDICIA brokered deposit rule did not adversely affect its ability to accept brokered deposits. The Bank had no such brokered deposits at December 31, 2013. Further, a depository institution or its holding company that is not Well-capitalized will generally not be successful in seeking regulatory approvals that may be necessary in connection with any plan or agreement to expand its business, such as through the acquisition (by merger or consolidation, purchase or otherwise) of the stock, business or properties of other banks or other companies.

 

The new Basel capital rules revised the “Prompt Corrective Action” requirements applicable to our bank subsidiary effective January 1, 2015, by (i) introducing a CET1 ratio requirement at each level (other than critically undercapitalized), with the required CET1 ratio being 6.5% for well-capitalized status; (ii) increasing the minimum Tier 1 capital ratio requirement for each category, with the minimum Tier 1 risk-based capital ratio for well-capitalized status being 8.0% (as compared to the current 6.0%); (iii) creating a minimum leverage ratio requirement of 5% for well-capitalized status; and (iv) eliminating the current provision that provides that a bank with a composite supervisory rating of 1 may have a 3.0% leverage ratio and still be well-capitalized.

 

Future rulemaking and regulatory changes on capital requirements may impact the Company as it continues to grow and evaluate potential mergers and acquisitions.

 

Restrictions on Bank Dividends or Loans to, or other Transactions with, the Parent Company, and on Parent Company Dividends

 

German American Bancorp, Inc., which is the publicly-held parent of the Bank (German American Bancorp), is a corporation that is separate and distinct from the Bank and its other subsidiaries. Most of the parent company’s revenues historically have been comprised of dividends, fees, and interest paid to it by the Bank, and this is expected to continue in the future. There are, however, statutory limits under Indiana law on the amount of dividends that the Bank can pay to its parent company without regulatory approval. The Bank may not, without the approval of the DFI, pay a dividend in an amount greater than its undivided profits. In addition, the prior approval of the DFI is required for the payment of a dividend by an Indiana state-chartered bank if the total of all dividends declared in a calendar year would exceed the total of its net income for the year combined with its retained net income for the two preceding years, unless such a payment qualifies under certain exemptive criteria that exempt certain dividend payments by certain qualified banks from the prior approval requirement. At December 31, 2013, the Bank was eligible for payment of dividends under the exemptive criteria established by DFI policy for this purpose, and could have declared and paid to the holding company $39,000,000 of its undivided profits without approval by the DFI in accordance with such criteria. See Note 8 of the Notes to Consolidated Financial Statements included in Item 8 of this Report for further discussion.

 

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In addition, the FRB and other bank regulatory agencies have issued policy statements or advisories that provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings.

 

In addition to these statutory restrictions, if, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in, or is about to engage in, an unsafe or unsound practice, such authority may require, after notice and hearing, that such bank cease and desist from such practice. Accordingly, if the Bank were to experience financial difficulties, it is possible that the applicable regulatory authority could determine that the Bank would be engaged in an unsafe or unsound practice if the Bank were to pay dividends and could prohibit the Bank from doing so, even if availability existed for dividends under the statutory formulae.

 

Further, the Bank is subject to affiliate transaction restrictions under federal laws, which limit certain transactions generally involving the transfer of funds by a subsidiary bank or its subsidiaries to its parent corporation or any nonbank subsidiary of its parent corporation, whether in the form of loans, extensions of credit, investments, or asset purchases, or otherwise undertaking certain obligations on behalf of such affiliates. Furthermore, covered transactions that are loans and extensions of credit must be secured within specified amounts. In addition, all covered transactions and other affiliate transactions must be conducted on terms and under circumstances that are substantially the same as such transactions with unaffiliated entities.

 

Other Aspects of the Dodd-Frank Act

 

The Dodd-Frank Act (in addition to the regulatory changes discussed elsewhere in this “Regulation and Supervision” discussion and below under “Federal Deposit Insurance Premiums and Assessments”) made a variety of changes that will affect the business and affairs of the Company and the Bank in other ways. For instance, the Dodd-Frank Act (or agency regulations adopted and implemented (or to be adopted and implemented) under the Dodd-Frank Act) altered the authority and duties of the federal banking and securities regulatory agencies, implemented certain corporate governance requirements for all public companies including financial institutions with regard to executive compensation, proxy access by shareholders, and certain whistleblower provisions; restricted certain proprietary trading and hedge fund and private equity activities of banks and their affiliates; eliminated the former statutory prohibition against the payment of interest on business checking accounts; limited interchange fees on debit card transactions by certain large processors; and established the Consumer Financial Protection Bureau (“CFPB”).

 

The CFPB was granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorized the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, Dodd-Frank allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

 

The CFPB issued a rule, effective as of January 14, 2014, designed to clarify for lenders how they can avoid monetary damages under the Dodd-Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that satisfy this “qualified mortgage” safe-harbor will be presumed to have complied with the new ability-to-repay standard. Under the Consumer Financial Protection Bureau’s rule, a “qualified mortgage” loan must not contain certain specified features, and the borrower’s total monthly debt-to-income ratio may not exceed a specified percentage. Lenders must also verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the loan based on a fully amortizing payment schedule and maximum interest rate during the first five years, taking into account all applicable taxes, insurance and assessments.

 

On December 10, 2013, five financial regulatory agencies, including the FRB and FDIC, adopted final rules implementing the so-called Volcker Rule added to banking law by Section 619 of the Dodd-Frank Act. These final rules prohibit banking entities from, among other things, (1) engaging in short-term proprietary trading for their own accounts, and (2) having certain ownership interests in and relationships with hedge funds or private equity funds (“covered funds”). Community banks like us have been afforded some relief under these final rules from onerous compliance obligations created by the rules; if banks are engaged only in exempted proprietary trading, such as trading in U.S. government, agency, state and municipal obligations, they are exempt entirely from compliance program requirements. Moreover, even if a community bank engages in proprietary trading or covered fund activities under the rule, they need only incorporate references to the Volcker Rule into their existing policies and procedures. The Final Rules are effective April 1, 2014, but the conformance period has been extended from its statutory end date of July 21, 2014 until July 21, 2015. We are currently evaluating the Final Rules, which are lengthy and detailed.

 

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Certain Other Laws and Regulations

 

In November 2009, the FRB amended its Regulation E under the Electronic Fund Transfer Act to prohibit banks from charging overdraft fees for ATM or point-of-sale debit card transactions that overdrew the account unless the customer opt-in to the discretionary overdraft service and to require banks to explain the terms of their overdraft services and their fees for the services. Compliance with this Regulation E amendment was required by July 1, 2010.

 

The Community Reinvestment Act of 1977, or the CRA, requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. These factors are also considered in evaluating mergers, acquisitions and applications to open a branch or facility. The applicable federal regulators regularly conduct CRA examinations to assess the performance of financial institutions and assign one of four ratings to the institution’s records of meeting the credit needs of its community. During its last examination, a rating of “satisfactory” was received by the Bank.

 

In accordance with the Gramm-Leach-Bliley Financial Modernization Act of 1999, or the GLB Act, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. The privacy provisions of the GLB Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.

 

A major focus of governmental policy on financial institutions over the past decade has been combating money laundering and terrorist financing. The USA PATRIOT Act of 2001, or the USA Patriot Act, substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department has issued a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as the Bank. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.

 

The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”). The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.

 

Federal Deposit Insurance Premiums and Assessments

 

Our bank subsidiary’s deposit accounts are currently insured by the Deposit Insurance Fund, or the DIF, of the FDIC. The insurance benefit generally covers up to a maximum of $250,000 per separately insured depositor. As an FDIC-insured bank, our bank subsidiary is subject to deposit insurance premiums and assessments to maintain the DIF. The Bank’s deposit insurance premium assessment rate depends on the capital category and supervisory category to which it is assigned. The FDIC has authority to raise or lower assessment rates on insured banks in order to achieve statutorily required reserve ratios in the DIF and to impose special additional assessments.

 

Under the current assessment system, the FDIC assigns a banking institution to one of four risk categories designed to measure risk. Total base assessment rates currently range from 0.025% of deposits for an institution in the highest rated sub-category of the highest rated category to 0.45% of deposits for an institution in the lowest rated category. The FDIC may increase or decrease its rates by 2.0 basis points without further rulemaking. In an emergency, the FDIC may also impose a special assessment.

 

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In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately six tenths of a basis point of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.

 

Internet Address; Internet Availability of SEC Reports

 

The Company’s Internet address is www.germanamerican.com.

 

The Company makes available, free of charge through the Investor Relations – Financial Information section of its Internet website, the Company’s annual report on Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after those reports are filed with or furnished to the SEC.

 

Forward-Looking Statements and Associated Risks

 

The Company from time to time in its oral and written communications makes statements relating to its expectations regarding the future. These types of statements are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements can include statements about the Company’s net interest income or net interest margin; adequacy of allowance for loan losses, and the quality of the Company’s loans, investment securities and other assets; simulations of changes in interest rates; litigation results; dividend policy; acquisitions or mergers; estimated cost savings, plans and objectives for future operations; and expectations about the Company’s financial and business performance and other business matters as well as economic and market conditions and trends. All statements other than statements of historical fact included in this report, including statements regarding our financial position, business strategy and the plans and objectives of our management for future operations, are forward-looking statements. When used in this report, words such as “anticipate”, “believe”, “estimate”, “expect”, “intend”, and similar expressions, as they relate to us or our management, identify forward-looking statements.

 

Such forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to our management, and are subject to risks, uncertainties, and other factors.

 

Actual results may differ materially and adversely from the expectations of the Company that are expressed or implied by any forward-looking statement. The discussions in Item 1A, “Risk Factors,” and in Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” list some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statements. Other risks, uncertainties, and factors that could cause the Company’s actual results to vary materially from those expressed or implied by any forward-looking statement include but not limited to:

 

·the unknown future direction of interest rates and the timing and magnitude of any changes in interest rates;

 

·changes in competitive conditions;

 

·the introduction, withdrawal, success and timing of asset/liability management strategies or of mergers and acquisitions and other business initiatives and strategies;

 

·changes in customer borrowing, repayment, investment and deposit practices;

 

·changes in fiscal, monetary and tax policies;

 

·changes in financial and capital markets;

 

·continued deterioration in general economic conditions, either nationally or locally, resulting in, among other things, credit quality deterioration;

 

·capital management activities, including possible future sales of new securities, or possible repurchases or redemptions by the Company of outstanding debt or equity securities;

 

·risks of expansion through acquisitions and mergers, such as unexpected credit quality problems of the acquired loans or other assets, unexpected attrition of the customer base of the acquired institution or branches, and difficulties in integration of the acquired operations;

 

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·factors driving impairment charges on investments;

 

·the impact, extent and timing of technological changes;

 

·litigation liabilities, including related costs, expenses, settlements and judgments, or the outcome of matters before regulatory agencies, whether pending or commencing in the future;

 

·actions of the FRB;

 

·changes in accounting principles and interpretations;

 

·potential increases of federal deposit insurance premium expense, and possible future special assessments of FDIC premiums, either industry wide or specific to the Company’s banking subsidiary;

 

·actions of the regulatory authorities under the Dodd-Frank Act and the Federal Deposit Insurance Act and other possible legislative and regulatory actions and reforms; and

 

·the continued availability of earnings and excess capital sufficient for the lawful and prudent declaration and payment of cash dividends.

 

Such statements reflect our views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to the operations, results of operations, growth strategy and liquidity of the Company. Readers are cautioned not to place undue reliance on these forward-looking statements. It is intended that these forward-looking statements speak only as of the date they are made. We do not undertake any obligation to release publicly any revisions to these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

 

Item 1A. Risk Factors.

 

While we have a history of profitability and operate with capital that exceeds the requirements of bank regulatory agencies, the financial services industry in which we operate was adversely affected by the severe recession that commenced in 2008, and our industry is continuing to be affected by continuing weak economic conditions throughout the United States. The following describes some of the principal risks and uncertainties to which our industry in general, and we and our assets and businesses specifically, are subject; other risks are briefly identified in our cautionary statement that is included under the heading “Forward-Looking Statements and Associated Risks” in Part I, Item 1, “Business.” Although we seek ways to manage these risks and uncertainties and to develop programs to control those that we can, we ultimately cannot predict the future. Future results may differ materially from past results, and from our expectations and plans.

 

Risks Related to the Financial Services Industry

 

We operate in a highly regulated environment and changes in laws and regulations to which we are subject may adversely affect our results of operations.

 

The banking industry in which we operate is subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which we conduct our business, undertake new investments and activities and obtain financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit our shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation, none of which is in our control. Significant new laws or changes in, or repeals of, existing laws (including changes in federal or state laws affecting corporate taxpayers generally or financial institutions specifically) could have a material adverse effect on our business, financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions, and any unfavorable change in these conditions could have a material adverse effect on our business, financial condition, results of operations or liquidity.

 

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The Dodd-Frank Act and regulations adopted under that law could materially and adversely affect us by increasing compliance costs and heightening our risk of noncompliance with applicable regulations.

 

The Dodd-Frank Act (discussed in Item 1 – Business – Regulation and Supervision) has resulted in sweeping changes in the regulation of financial institutions. The Dodd-Frank Act contains numerous provisions that affect all banks and bank holding companies. Many of these provisions remain subject to regulatory rule-making and implementation, the effects of which are not yet known. Accordingly, we cannot predict the specific impact and long-term effects that the Dodd-Frank Act and the regulations promulgated thereunder will have on us and our prospects, our target markets and the financial industry more generally. However, the Dodd-Frank Act and the regulations promulgated thereunder have imposed (and are likely to result in the imposition of) additional administrative and regulatory burdens that will obligate us to incur additional expenses (which adversely affect our margins and profitability) and increase the risk that we might not comply in all respects with the new requirements. Further, the Consumer Financial Protection Bureau’s newly-adopted rule on qualified mortgages could limit our ability or desire to make certain types of loans or loans to certain borrowers, or could make it more expensive and/or time consuming to make these loans, which could adversely impact our growth or profitability.

 

The new Basel Capital Standards may have an adverse effect on us.

 

We must begin transitioning to new capital rules, adopted by the federal banking agencies but based on the international Basel guidelines, effective January 1, 2015. See Item 1- Business – Regulation and Supervision. The impact of the new capital rules may require us to maintain higher levels of capital, which could lower our return on equity.

 

Our FDIC insurance premiums may increase, and special assessments could be made, which might negatively impact our results of operations.

 

High levels of insured institution failures, as a result of the recent recession, as well as the continuing weak economic conditions in the United States, significantly increased losses to the Deposit Insurance Fund of the FDIC. Further, the Dodd-Frank Act, and the Dodd-Frank Act mandates the FDIC to increase the level of its reserves for future losses in its Deposit Insurance Fund. Since the Deposit Insurance Fund is funded by premiums and assessments paid by insured banks, our FDIC insurance premium could increase in future years depending upon the FDIC’s actual loss experience, changes in our Bank’s financial condition or capital strength, and future conditions in the banking industry.

 

Risks Related to Our Operations and Business and Financial Strategies

 

Continuing economic weakness could negatively affect us.

 

Our performance could be negatively affected to the extent that continuing weaknesses in business and economic conditions have direct or indirect material adverse impacts on us, or on our customers or on the financial institutions with whom we deal as counterparties to financial transactions. These conditions could result in one or more of the following:

 

·a decrease in the demand for loans and other products and services offered by us;
·a decrease in customer savings generally and in the demand for savings and investment products offered by us; and
·an increase in the number of customers and counterparties who become delinquent, file for protection under bankruptcy laws, or default on their loans or other obligations to us.

 

Continued weakness or future deterioration in the economy, real estate markets or unemployment rates, particularly in the Southern Indiana markets in which we operate, might place downward pressure on the credit worthiness of our Bank’s customers and their inclinations to borrow. A continued or worsening disruption and volatility could negatively impact customers’ ability to obtain new loans or to repay existing loans, diminish the values of any collateral securing such loans and could cause increases in the number of the Company’s customers experiencing financial distress and in the levels of the Company’s delinquencies, non-performing loans and other problem assets, charge-offs and provision for credit losses, all of which could materially adversely affect our financial condition and results of operations. The underwriting and credit monitoring policies and procedures that we have adopted cannot eliminate the risk that we might incur losses on account of factors relating to the economy like those identified above, and those losses could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

If our actual loan losses exceed our estimates, our earnings and financial condition will be impacted.

 

A significant source of risk for any bank or other enterprise that lends money arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail (because of financial difficulties or other reasons) to perform in accordance with the terms of their loan agreements. In our case, we originate many loans that are secured, but some loans are unsecured depending on the nature of the loan. With respect to secured loans, the collateral securing the repayment of these loans includes a wide variety of real and personal property that may be insufficient to cover the obligations owed under such loans, due to adverse changes in collateral values caused by changes in prevailing economic, environmental and other conditions, including declines in the value of real estate and other external events.

 

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We could be adversely affected by changes in interest rates.

 

Our earnings and cash flows are largely dependent upon our net interest income. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions, demand for loans, securities and deposits, and policies of various governmental and regulatory agencies and, in particular, the monetary policies of the FRB. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on our financial condition, results of operations, and cash flows.

 

Our success is tied to the economic vitality of our Southern Indiana markets.

 

We conduct business from offices that are exclusively located in 13 Southern Indiana counties, from which substantially all of our customer base is drawn. Because of the geographic concentration of our operations and customer base, our results depend largely upon economic conditions in this area. If current levels of market disruption and volatility worsen in our primary service areas, the quality of our loan portfolio, and the demand for our products and services, could be adversely affected, and this could have a material adverse effect on our business, financial condition, results of operations or liquidity.

 

We face substantial competition.

 

The banking and financial services business in our markets is highly competitive. We compete with much larger regional, national, and international competitors, including competitors that have no (or only a limited number of) offices physically located within our markets, many of which compete with us via Internet and other electronic product and service offerings. In addition, banking and other financial services competitors (including newly organized companies) that are not currently represented by physical locations within our geographic markets could establish office facilities within our markets, including through their acquisition of existing competitors.  Developments increasing the nature or level of our competition, or decreasing the effectiveness by which we compete, could have a material adverse effect on our business, financial condition, results of operations or liquidity.  See also Part I, Item 1, of this Report, “Business – Competition,” and “Business – Regulation and Supervision.”

 

The manner in which we report our financial condition and results of operations may be affected by accounting changes.

 

Our financial condition and results of operations that are presented in our consolidated financial statements, accompanying notes to the consolidated financial statements, and selected financial data appearing in this report, are, to a large degree, dependent upon our accounting policies. The selection of and application of these policies involve estimates, judgments and uncertainties that are subject to change, and the effect of any change in estimates or judgments that might be caused by future developments or resolution of uncertainties could be materially adverse to our reported financial condition and results of operations. In addition, authorities that prescribe accounting principles and standards for public companies from time to time change those principles or standards or adopt formal or informal interpretations of existing principles or standards. Such changes or interpretations (to the extent applicable to us) could result in changes that would be materially adverse to our reported financial condition and results of operations.

 

Liquidity risk could impair our ability to fund operations and jeopardize our financial condition.

 

Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of securities or loans and other sources could have a substantial negative effect on our liquidity. Our access to funding sources in amounts adequate to finance our activities or the terms of which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general. Although we have historically been able to replace maturing deposits and borrowings as necessary, we might not be able to replace such funds in the future if, among other things, our results of operations or financial condition or the results of operations or financial condition of our lenders or market conditions were to change.

 

The value of securities in our investment securities portfolio may be negatively affected by disruptions in securities markets.

 

Prices and volumes of transactions in the nation’s securities markets can be affected suddenly by economic crises, such as that experienced in the United States and internationally in 2008, or by other national or international crises, such as national disasters, acts of war or terrorism, changes in commodities markets, or instability in foreign governments. Disruptions in securities markets may detrimentally affect the value of securities that we hold in our investment portfolio, such as through reduced valuations due to the perception of heightened credit and liquidity risks. There can be no assurance that declines in market value associated with these disruptions will not result in other than temporary impairments of these assets, which would lead to accounting charges that could have a material adverse effect on our net income and capital levels.

 

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The soundness of other financial institutions could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. As a result, defaults by, or even rumors or questions about, one or more financial services companies, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized or is liquidated at prices not sufficient to recover the full amount due us.

 

We are dependent on key personnel and the loss of one or more of those key personnel could harm our business.

 

Competition for qualified employees and personnel in the financial services industry (including banking personnel, trust and investments personnel, and insurance personnel) is intense and there are a limited number of qualified persons with knowledge of and experience in our local Southern Indiana markets. Our success depends to a significant degree upon our ability to attract and retain qualified loan origination executives, sales executives for our trust and investment products and services, and sales executives for our insurance products and services. We also depend upon the continued contributions of our management personnel, and in particular upon the abilities of our senior executive management, and the loss of the services of one or more of them could harm our business.

 

Our controls and procedures may fail or be circumvented.

 

Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations, cash flows and financial condition.

 

We are subject to security and operational risks relating to our use of technology, both internally and with our customers, that could damage our reputation and our business.

 

We rely heavily on communications and information systems to conduct our business; any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. Further, we increasingly offer our customers the ability to bank online with us. Although we believe that our online systems are secure in accordance with best industry standards, our online banking networks or those of our customers could be vulnerable to unauthorized access, computer viruses, phishing schemes and other security problems. We may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. In addition, security breaches and viruses could expose us to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in our systems and could adversely affect our reputation and our ability to generate deposits.

 

We are exposed to risk of environmental liabilities with respect to properties to which we take title.

 

In the course of our business, we may own or foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties (including liabilities for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination), or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property.

 

Any acquisitions of banks, bank branches, or loans or other financial service assets pose risks to us.

 

We may buy banks, bank branches and other financial-service-related businesses and assets in the future. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:

 

·potential exposure to unknown or contingent liabilities of the acquired assets, operations or company;

 

·exposure to potential asset quality issues of the acquired assets, operations or company;

 

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·environmental liability with acquired real estate collateral or other real estate;

 

·difficulty and expense of integrating the operations, systems and personnel of the acquired assets, operations or company;

 

·potential disruption to our ongoing business, including diversion of our management’s time and attention;

 

·the possible loss of key employees and customers of the acquired operations or company;

 

·difficulty in estimating the value of the acquired assets, operations or company; and

 

·potential changes in banking or tax laws or regulations that may affect the acquired assets, operations or company.

 

We may not be successful in overcoming these risks or any other problems encountered in connection with mergers or acquisitions.

 

Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Company’s tangible book value per common share or net income per common share (or both) may occur in connection with any future transaction.

 

We may incur substantial costs to expand by acquisition, and such acquisitions may not result in the levels of profits we seek. Integration efforts for any future acquisitions may not be successful and following any future acquisition, after giving it effect, we may not achieve financial results comparable to or better than our historical experience.

 

We may participate in FDIC-assisted acquisitions, which could present additional risks to our financial condition.

 

We may make opportunistic whole or partial acquisitions of troubled financial institutions in transactions facilitated by the FDIC. In addition to the risks frequently associated with acquisitions, an acquisition of a troubled financial institution may involve a greater risk that the acquired assets underperform compared to our expectations. Because these acquisitions are structured in a manner that would not allow us the time normally associated with preparing for and evaluating an acquisition, including preparing for integration of an acquired institution, we may face additional risks including, among other things, the loss of customers, strain on management resources related to collection and management of problem loans and problems related to integration of personnel and operating systems. Additionally, while the FDIC may agree to assume certain losses in transactions that it facilitates, there can be no assurances that we would not be required to raise additional capital as a condition to, or as a result of, participation in an FDIC-assisted transaction. Any such transactions and related issuances of stock may have dilutive effect on earnings per share and share ownership.

 

Item 1B. Unresolved Staff Comments. None.

 

Item 2. Properties.

 

The Company’s executive offices are located in the main office building of the Bank at 711 Main Street, Jasper, Indiana. The main office building, which is owned by the Bank and also serves as the main office of the Company’s other subsidiaries, contains approximately 23,600 square feet of office space. The Bank and the Company’s other subsidiaries also conduct their operations from 41 other locations in Southern Indiana of which 32 are owned by the Company and nine are leased from third parties.

 

Item 3. Legal Proceedings.

 

There are no material pending legal proceedings, other than routine litigation incidental to the business of the Company’s subsidiaries, to which the Company or any of its subsidiaries is a party or of which any of their property is the subject.

 

Item 4. Mine Safety Disclosures.

 

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Market and Dividend Information

 

German American Bancorp, Inc.’s stock is traded on NASDAQ’s Global Select Market under the symbol GABC. The quarterly high and low closing prices for the Company’s common stock as reported by NASDAQ and quarterly cash dividends declared and paid are set forth in the table below.

 

   2013   2012 
           Cash           Cash 
   High   Low   Dividend   High   Low   Dividend 
                         
Fourth Quarter  $30.15   $23.51   $0.15   $24.10   $19.98   $0.14 
Third Quarter  $28.15   $22.86   $0.15   $24.89   $19.76   $0.14 
Second Quarter  $22.69   $19.96   $0.15   $20.50   $17.94   $0.14 
First Quarter  $23.63   $21.54   $0.15   $21.74   $18.43   $0.14 
             $0.60             $0.56 

 

The Common Stock was held of record by approximately 3,429 shareholders at March 1, 2014.

 

Cash dividends paid to the Company’s shareholders are primarily funded from dividends received by the parent company from its bank subsidiary. The declaration and payment of future dividends will depend upon the earnings and financial condition of the Company and its subsidiaries, general economic conditions, compliance with regulatory requirements affecting the ability of the bank subsidiary and the Company to declare dividends, (for further discussion of such requirements, see Item 1, “Business - Regulation and Supervision - Restrictions on Bank Dividends or Loans to, or other Transactions with, the Parent Company and Parent Company Dividends”), and other factors.

 

Transfer Agent: Computershare   Shareholder Terri A. Eckerle
  Priority Processing   Information and German American Bancorp, Inc.
  250 Royall St   Corporate Office:   P. O. Box 810
  Canton, MA  02021     Jasper, Indiana  47547-0810
  Contact: Shareholder Relations     (812) 482-1314
  (800) 884-4225     (800) 482-1314

 

17
 

 

Stock Performance Graph

 

The following graph compares the Company’s five-year cumulative total returns with those of the Russell 2000 Stock Index, Russell Microcap Stock Index, and the Indiana Bank Peer Group. The Indiana Bank Peer Group (which is a custom peer group identified by Company management) includes all Indiana-based commercial bank holding companies (excluding companies owning thrift institutions that are not regulated as bank holding companies) that have been in existence as commercial bank holding companies throughout the five-year period ended December 31, 2013, the stocks of which have been traded on an established securities market (NYSE, AMEX, NASDAQ) throughout that five-year period. The companies comprising the Indiana Bank Peer Group for purposes of the December 2013 comparison were: 1st Source Corp., Community Bank Shares of IN, First Financial Corp., First Merchants Corp., Lakeland Financial Corp., MainSource Financial Group, Old National Bancorp, Horizon Bancorp, and Tower Financial Corp. The returns of each company in the Indiana Bank Peer Group have been weighted to reflect the company’s market capitalization. The Russell 2000 Stock Index, which is designed to measure the performance of the small-cap segment of the U.S. equity universe, is a subset of the Russell 3000 Index (which measures the performance of the largest 3,000 U.S. companies) that includes approximately 2,000 of the smallest securities in that index based on a combination of their market cap and current index membership, and is annually reconstituted at the end of each June. The Russell Microcap Stock Index is an index representing the smallest 1,000 securities in the small-cap Russell 2000 Index plus the next 1,000 securities, which is also annually reconstituted at the end of each June. The Company’s stock is currently included in the Russell 2000 Index and Russell Microcap Index.

 

 

Stock Repurchase Program Information

 

The following table sets forth information regarding the Company’s purchases of its common shares during each of the three months ended December 31, 2013.

 

   Total           Maximum Number 
   Number       Total Number of Shares   (or Approximate Dollar 
   of Shares   Average Price   (or Units) Purchased as Part   Value) of Shares (or Units) 
   (or Units)   Paid Per Share   of Publicly Announced Plans   that May Yet Be Purchased 
Period  Purchased   (or Unit)   or Programs   Under the Plans or Programs (1) 
                 
October 2013   —    —    —    272,789 
November 2013   —    —    —    272,789 
December 2013   —    —    —    272,789 

 

(1) On April 26, 2001, the Company announced that its Board of Directors had approved a stock repurchase program for up to 607,754 of its outstanding common shares, of which the Company had purchased 334,965 common shares through December 31, 2013 (both such numbers adjusted for subsequent stock dividends). The Board of Directors established no expiration date for this program. The Company purchased no shares under this program during the quarter ended December 31, 2013.

 

18
 

 

Item 6. Selected Financial Data.

 

The following selected data should be read in conjunction with the consolidated financial statements and related notes that are included in Item 8 of this Report, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is included in Item 7 of this Report (dollars in thousands, except per share data). Year-to-year financial information comparability is affected by the acquisition accounting treatment for mergers and acquisitions, including but not limited to the Company’s acquisitions of two branches of another bank in May 2010, the Company’s acquisition of American Community Bancorp, Inc., effective January 1, 2011 and the Company’s acquisition of United Commerce Bancorp, effective October 1, 2013.

 

   2013   2012   2011   2010   2009 
Summary of Operations:                         
Interest Income  $75,672   $77,160   $80,161   $64,193   $63,736 
Interest Expense   7,155    10,912    16,180    15,522    19,223 
Net Interest Income   68,517    66,248    63,981    48,671    44,513 
Provision for Loan Losses   350    2,412    6,800    5,225    3,750 
Net Interest Income after Provision                         
For Loan Losses   68,167    63,836    57,181    43,446    40,763 
Non-interest Income   23,615    21,811    21,576    16,943    15,859 
Non-interest Expense   54,905    50,923    50,782    41,361    40,391 
Income before Income Taxes   36,877    34,724    27,975    19,028    16,231 
Income Tax Expense   11,464    10,669    7,726    5,623    4,013 
Net Income  $25,413   $24,055   $20,249   $13,405   $12,218 
                          
Year-end Balances:                         
Total Assets  $2,163,827   $2,006,300   $1,873,767   $1,375,888   $1,242,965 
Total Loans, Net of Unearned Income   1,382,382    1,204,866    1,120,993    917,236    877,822 
Total Deposits   1,812,156    1,640,931    1,556,198    1,087,286    969,643 
Total Long-term Debt   87,237    89,472    90,974    81,016    113,320 
Total Shareholders’ Equity   200,097    185,026    167,610    121,534    113,549 
                          
Average Balances:                         
Total Assets  $2,037,236   $1,934,123   $1,823,703   $1,330,540   $1,230,596 
Total Loans, Net of Unearned Income   1,272,055    1,147,891    1,114,181    906,127    891,322 
Total Deposits   1,695,796    1,618,712    1,521,204    1,046,295    963,928 
Total Shareholders’ Equity   189,689    177,207    159,765    119,867    109,887 
                          
Per Share Data:                         
Net Income (1)
  $1.98   $1.90   $1.61   $1.21   $1.10 
Cash Dividends   0.60    0.56    0.56    0.56    0.56 
Book Value at Year-end   15.19    14.64    13.31    10.94    10.25 
                          
Other Data at Year-end:                         
Number of Shareholders   3,444    3,105    3,221    3,194    3,364 
Number of Employees   478    439    417    359    332 
Weighted Average Number of Shares (1)   12,807,678    12,637,743    12,587,748    11,104,887    11,068,988 
                          
Selected Performance Ratios:                         
Return on Assets   1.25%   1.24%   1.11%   1.01%   0.99%
Return on Equity   13.40%   13.57%   12.67%   11.18%   11.12%
Equity to Assets   9.25%   9.22%   8.95%   8.83%   9.14%
Dividend Payout   30.18%   29.38%   34.80%   46.36%   50.71%
Net Charge-offs to Average Loans   0.10%   0.19%   0.43%   0.32%   0.25%
Allowance for Loan Losses to Loans   1.05%   1.29%   1.37%   1.45%   1.25%
Net Interest Margin   3.67%   3.74%   3.84%   3.98%   3.95%

 

(1)Share and Per Share Data includes the dilutive effect of stock options.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

INTRODUCTION

 

 

German American Bancorp, Inc., is a NASDAQ-traded (symbol: GABC) financial services holding company based in Jasper, Indiana. German American, through its banking subsidiary German American Bancorp, operates 37 commercial and retail banking offices in 13 southern Indiana counties. The Company also owns a trust, brokerage, and financial planning subsidiary (German American Financial Advisors & Trust Company) and a full line property and casualty insurance agency (German American Insurance, Inc.).

 

Throughout this Management’s Discussion and Analysis, as elsewhere in this report, when we use the term “Company”, we will usually be referring to the business and affairs (financial and otherwise) of the Company and its subsidiaries and affiliates as a whole. Occasionally, we will refer to the term “parent company” or “holding company” when we mean to refer to only German American Bancorp, Inc., and the term “Bank” when we mean to refer to only the Company’s bank subsidiary.

 

This Management’s Discussion and Analysis includes an analysis of the major components of the Company’s operations for the years 2011 through 2013 and its financial condition as of December 31, 2013 and 2012. This information should be read in conjunction with the accompanying consolidated financial statements and footnotes contained elsewhere in this report and with the description of business included in Item 1 of this Report (including the cautionary disclosure regarding “Forward Looking Statements and Associated Risks”). Financial and other information by segment is included in Note 15 to the Company’s consolidated financial statements included in Item 8 of this Report and is incorporated into this Item 7 by reference.

 

The statements of management’s expectations and goals concerning the Company’s future operations and performance that are set forth in the following Management Overview and in other sections of this Item 7 are forward-looking statements, and readers are cautioned that these forward-looking statements are based on assumptions and are subject to risks, uncertainties, and other factors. Actual results may differ materially from the expectations of the Company that is expressed or implied by any forward-looking statement. This Item 7, as well as the discussions in Item 1 (“Business”) entitled “Forward-Looking Statements and Associated Risks” and in Item 1A (“Risk Factors”) (which discussions are incorporated in this Item 7 by reference) list some of the factors that could cause the Company’s actual results to vary materially from those expressed or implied by any such forward-looking statements.

 

MANAGEMENT OVERVIEW

 

The Company’s 2013 net income totaled $25,413,000, or $1.98 per diluted share, which was a record level of earnings for the Company and represented a 4% increase on a per share basis over the Company’s 2012 net income of $24,055,000, or $1.90 per diluted share. The Company’s return on average equity for 2013 was 13.4%, representing the ninth consecutive year the Company has achieved a double-digit return on equity.

 

The record earnings performance during 2013 was attributable to both an increased level of net interest income, driven by a higher level of earning assets and more specifically the Company’s loan portfolio, increased levels of non-interest income, and a reduced level of provision for loan loss, as the Company’s asset quality remained strong while showing continued improvement. These positive impacts were partially mitigated by an increased level of non-interest expenses.

 

Net interest income improved by $2,269,000, or approximately 3%, during 2013 compared with 2012. Provision for loan loss declined $2,062,000, or 85%, during 2013 compared with 2012. The Company’s 2013 earnings were positively impacted by a $1,804,000, or 8%, increase in the level of non-interest income. The key drivers in the increased level of non-interest income was higher trust and investment product fees, increased insurance revenues, and higher levels of gains related to sales of securities. Non-interest expenses increased $3,982,000, or 8%, during 2013 compared with 2012 largely driven by an increased level of salaries and employees benefits.

 

The Company completed the acquisition of United Commerce Bancorp and its subsidiary, United Commerce Bank effective October 1, 2013. United Commerce Bank provided a full range of commercial and consumer banking services in the Bloomington, Indiana, market, from two banking offices. United Commerce had total loans and deposits (unaudited) as of October 1, 2013 that totaled $79.6 million and $106.6 million, respectively. The impact of the acquisition on the Company’s overall financial performance during 2013 was not significant given that only a single quarter of performance was included in operating results of the Company.

 

20
 

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

 

The financial condition and results of operations for German American Bancorp, Inc. presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements, and selected financial data appearing elsewhere within this Report, are, to a large degree, dependent upon the Company’s accounting policies. The selection of and application of these policies involve estimates, judgments, and uncertainties that are subject to change. The critical accounting policies and estimates that the Company has determined to be the most susceptible to change in the near term relate to the determination of the allowance for loan losses, the valuation of securities available for sale, and the valuation allowance on deferred tax assets.

 

Allowance for Loan Losses

 

The Company maintains an allowance for loan losses to cover probable incurred credit losses at the balance sheet date. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. A provision for loan losses is charged to operations based on management’s periodic evaluation of the necessary allowance balance. Evaluations are conducted at least quarterly and more often if deemed necessary. The ultimate recovery of all loans is susceptible to future market factors beyond the Company’s control.

 

The Company has an established process to determine the adequacy of the allowance for loan losses. The determination of the allowance is inherently subjective, as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on other classified loans and pools of homogeneous loans, and consideration of past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors, all of which may be susceptible to significant change. The allowance consists of two components of allocations, specific and general. These two components represent the total allowance for loan losses deemed adequate to cover losses inherent in the loan portfolio.

 

Commercial and agricultural loans are subject to a standardized grading process administered by an internal loan review function. The need for specific reserves is considered for credits when graded substandard or when: (a) the customer’s cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or, (d) other reasons where the ultimate collectibility of the loan is in question, or the loan characteristics require special monitoring. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that we believe indicates the loan is impaired. Specific allocations on impaired loans are determined by comparing the loan balance to the present value of expected cash flows or expected collateral proceeds. Allocations are also applied to categories of loans not considered individually impaired but for which the rate of loss is expected to be greater than historical averages, including those graded substandard and non-performing consumer or residential real estate loans. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values.

 

General allocations are made for other pools of loans, including non-classified loans, homogeneous portfolios of consumer and residential real estate loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a three-year historical average for loan losses for these portfolios, judgmentally adjusted for economic factors and portfolio trends.

 

Due to the imprecise nature of estimating the allowance for loan losses, the Company’s allowance for loan losses includes a minor unallocated component. The unallocated component of the allowance for loan losses incorporates the Company’s judgmental determination of inherent losses that may not be fully reflected in other allocations, including factors such as economic uncertainties, lending staff quality, industry trends impacting specific portfolio segments, and broad portfolio quality trends. Therefore, the ratio of allocated to unallocated components within the total allowance may fluctuate from period to period.

 

Securities Valuation

 

Securities available-for-sale are carried at fair value, with unrealized holding gains and losses reported separately in accumulated other comprehensive income (loss), net of tax. The Company obtains market values from a third party on a monthly basis in order to adjust the securities to fair value. Equity securities that do not have readily determinable fair values are carried at cost. Additionally, when securities are deemed to be other than temporarily impaired, a charge will be recorded through earnings; therefore, future changes in the fair value of securities could have a significant impact on the Company’s operating results. In determining whether a market value decline is other than temporary, management considers the reason for the decline, the extent of the decline, the duration of the decline and whether the Company intends to sell or believes it will be required to sell the securities prior to recovery. As of December 31, 2013, gross unrealized losses on the securities available-for-sale portfolio totaled approximately $13,938,000 and gross unrealized gains totaled approximately $5,885,000. As of December 31, 2013, held-to-maturity securities had a gross unrecognized gain of approximately $3,000.

 

21
 

 

Income Tax Expense

 

Income tax expense involves estimates related to the valuation allowance on deferred tax assets and loss contingencies related to exposure from tax examinations.

 

A valuation allowance reduces deferred tax assets to the amount management believes is more likely than not to be realized. In evaluating the realization of deferred tax assets, management considers the likelihood that sufficient taxable income of appropriate character will be generated within carryback and carryforward periods, including consideration of available tax planning strategies. Tax related loss contingencies, including assessments arising from tax examinations and tax strategies, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. In considering the likelihood of loss, management considers the nature of the contingency, the progress of any examination or related protest or appeal, the views of legal counsel and other advisors, experience of the Company or other enterprises in similar matters, if any, and management’s intended response to any assessment.

 

RESULTS OF OPERATIONS

 

 

NET INCOME

 

Net income for the year ended December 31, 2013 totaled $25,413,000 or $1.98 per diluted share, an increase of $1,358,000 or approximately 4% on a per share basis, from the year ended December 31, 2012 net income of $24,055,000 or $1.90 per diluted share. For 2013, the improvement in earnings was attributable to an increased level of net interest income, improved non-interest income, and a reduced level of provision for loan loss partially offset by a higher level of non-interest expense.

 

Net income for the year ended December 31, 2012 totaled $24,055,000 or $1.90 per diluted share, an increase of $3,806,000 or approximately 18% on a per share basis, from the year ended December 31, 2011 net income of $20,249,000 or $1.61 per diluted share. For 2012, the improvement in earnings was attributable to both an increased level of net interest income, driven by a higher level of earning assets within both the Company’s loan portfolio and securities portfolio, and a reduced level of provision for loan loss.

 

NET INTEREST INCOME

 

Net interest income is the Company’s single largest source of earnings, and represents the difference between interest and fees realized on earning assets, less interest paid on deposits and borrowed funds. Several factors contribute to the determination of net interest income and net interest margin, including the volume and mix of earning assets, interest rates, and income taxes. Many factors affecting net interest income are subject to control by management policies and actions. Factors beyond the control of management include the general level of credit and deposit demand, Federal Reserve Board monetary policy, and changes in tax laws.

 

Net interest income increased $2,269,000 or 3% (an increase of $2,500,000 or 4% on a tax-equivalent basis) during the year ended December 31, 2013 compared with 2012. The increased net interest income during 2013 compared with 2012 was largely driven by an increased level of earning assets primarily attributable to average loan growth and an overall decline in the Company’s cost of funds partially mitigated by a decline in the accretion of loan discounts on acquired loans and a lower net interest margin (expressed as a percentage of average earning assets).

 

The tax equivalent net interest margin was 3.67% for 2013 compared to 3.74% during 2012. The yield on earning assets totaled 4.04% during 2013 compared to 4.34% in 2012 while the cost of funds (expressed as a percentage of average earning assets) totaled 0.37% during 2013 compared to 0.60% in 2012.

 

The decline in the net interest margin in 2013 compared with 2012 was largely attributable to the continued downward pressure on earning asset yields being driven by a historically low market interest rate environment and a competitive marketplace for lending opportunities. Also contributing to the lower net interest margin was a decline in the accretion of loan discounts on certain acquired loans. Accretion contributed approximately 8 basis points on an annualized basis to the net interest margin during 2013 compared to approximately 12 basis points during 2012. The decline in the Company’s cost of funds by approximately 23 basis points during 2013 compared to 2012 was largely driven by a continued decline in deposit rates and also attributable to the repayment of $19.3 million of subordinated debentures with an interest rate of 8% that occurred in the second quarter of 2013.

 

22
 

 

Average earning assets increased by approximately $103.7 million, or 6%, during 2013 compared with 2012. Average loans outstanding increased $124.2 million, or 11%, during 2013 compared with 2012. Average federal funds sold and other short-term investments decreased by $29.5 million, or 66%, during 2013 compared with 2012. The average securities portfolio remained relatively stable increasing approximately $9.0 million, or 1%, in 2013 compared to 2012. The funding for the increased level of earning assets was largely driven through an increase level of average core deposits (core deposits defined as demand deposits - both interest and non-interest bearing, savings, money market and time deposits in denominations of less than $100,000). The increase in average core deposits totaled $62.3 million, or approximately 4%, during 2013 compared with 2012.

 

Net interest income increased $2,267,000 or 4% (an increase of $2,617,000 or 4% on a tax-equivalent basis) during the year ended December 31, 2012 compared with 2011. The increased net interest income during 2012 compared with 2011 was driven by a higher level of earning assets including both average loan growth and growth in the securities portfolio which resulted from growth of the Company’s deposit base.

 

The tax equivalent net interest margin was 3.74% for the year ended December 31, 2012 compared to 3.84% in 2011. The yield on earning assets totaled 4.34% in 2012 compared to 4.79% in 2011 while the cost of funds (expressed as a percentage of average earning assets) totaled 0.60% during 2012 compared to 0.95% in 2011.

 

The decline in the net interest margin in 2012 compared with 2011 was largely attributable to the continued downward pressure on earning asset yields. Accretion of loan discounts on certain acquired loans contributed approximately 12 basis points to the net interest margin in 2012 compared with 13 basis points in 2011. The decline in the Company’s cost of funds by 35 basis points during 2012 compared to 2011 was driven by a continued decline in deposit rates.

 

23
 

 

The following table summarizes net interest income (on a tax-equivalent basis) for each of the past three years. For tax-equivalent adjustments, an effective tax rate of 35% was used for all years presented (1).

 

Average Balance Sheet

(Tax-equivalent basis, dollars in thousands)

 

   Twelve Months Ended   Twelve Months Ended   Twelve Months Ended 
   December 31, 2013   December 31, 2012   December 31, 2011 
             
   Principal   Income /   Yield /   Principal   Income /   Yield /   Principal   Income /   Yield /  
   Balance   Expense   Rate   Balance   Expense   Rate   Balance   Expense   Rate 
                                     
ASSETS                                             
Federal Funds Sold and Other Short-term Investments  $15,507   $30    0.19%  $44,999   $91    0.20%  $85,217   $216    0.25%
                                              
Securities:                                             
Taxable   541,478    11,091    2.05%   547,949    12,946    2.36%   450,099    13,677    3.04%
Non-taxable   87,471    4,491    5.13%   71,961    3,743    5.20%   49,260    2,805    5.69%
Total Loans and Leases (2)   1,272,055    61,862    4.86%   1,147,891    61,951    5.40%   1,114,181    64,684    5.81%
                                              
TOTAL INTEREST EARNING ASSETS   1,916,511    77,474    4.04%   1,812,800    78,731    4.34%   1,698,757    81,382    4.79%
                                              
Other Assets   136,170              137,594              139,658           
Less: Allowance for Loan Losses   (15,445)             (16,271)             (14,712)          
                                              
TOTAL ASSETS  $2,037,236             $1,934,123             $1,823,703           
                                              
LIABILITIES AND SHAREHOLDERS’ EQUITY                                             
Interest-bearing Demand Deposits  $534,095   $856    0.16%  $512,232   $972    0.19%  $478,486   $2,374    0.50%
Savings Deposits   466,391    717    0.15%   435,475    792    0.18%   392,166    1,940    0.49%
Time Deposits   339,469    3,124    0.92%   357,193    5,194    1.45%   394,008    7,672    1.95%
FHLB Advances and Other Borrowings   136,569    2,458    1.80%   118,201    3,954    3.35%   126,922    4,194    3.30%
                                              
TOTAL INTEREST-BEARING LIABILITIES   1,476,524    7,155    0.48%   1,423,101    10,912    0.77%   1,391,582    16,180    1.16%
                                              
Demand Deposit Accounts   355,841              313,812              256,544           
Other Liabilities   15,182              20,003              15,812           
TOTAL LIABILITIES   1,847,547              1,756,916              1,663,938           
                                              
Shareholders’ Equity   189,689              177,207              159,765           
                                              
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY  $2,037,236             $1,934,123             $1,823,703           
                                              
COST OF FUNDS             0.37%             0.60%             0.95%
                                              
NET INTEREST INCOME       $70,319             $67,819             $65,202      
                                              
NET INTEREST MARGIN             3.67%             3.74%             3.84%

 

(1)Effective tax rates were determined as though interest earned on the Company’s investments in municipal bonds and loans was fully taxable.

 

(2)Loans held-for-sale and non-accruing loans have been included in average loans. Interest income on loans includes loan fees of $2,055, $3,164 and $3,335 for 2013, 2012 and 2011, respectively.

 

24
 

 

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

 

Net Interest Income – Rate / Volume Analysis

(Tax-Equivalent basis, dollars in thousands)

 

   2013 compared to 2012   2012 compared to 2011 
   Increase / (Decrease) Due to (1)   Increase / (Decrease) Due to (1) 
   Volume   Rate   Net   Volume   Rate   Net 
Interest Income:                              
Federal Funds Sold and Other                              
Short-term Investments  $(57)  $(4)  $(61)  $(88)  $(37)  $(125)
Taxable Securities   (151)   (1,704)   (1,855)   2,646    (3,377)   (731)
Non-taxable Securities   797    (49)   748    1,199    (261)   938 
Loans and Leases   6,354    (6,443)   (89)   1,916    (4,649)   (2,733)
Total Interest Income   6,943    (8,200)   (1,257)   5,673    (8,324)   (2,651)
                               
Interest Expense:                              
Savings and Interest-bearing Demand   94    (285)   (191)   352    (2,903)   (2,551)
Time Deposits   (247)   (1,823)   (2,070)   (667)   (1,810)   (2,477)
FHLB Advances and Other Borrowings   543    (2,039)   (1,496)   (291)   51    (240)
Total Interest Expense   390    (4,147)   (3,757)   (606)   (4,662)   (5,268)
                               
Net Interest Income  $6,553   $(4,053)  $2,500   $6,279   $(3,662)  $2,617 

 

(1)The change in interest due to both rate and volume has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the change in each.

 

See the Company’s Average Balance Sheet and the discussions headed USES OF FUNDS, SOURCES OF FUNDS, and “RISK MANAGEMENT – Liquidity and Interest Rate Risk Management” for further information on the Company’s net interest income, net interest margin, and interest rate sensitivity position.

 

PROVISION FOR LOAN LOSSES

 

The Company provides for loan losses through regular provisions to the allowance for loan losses. The provision is affected by net charge-offs on loans and changes in specific and general allocations required on the allowance for loan losses. Provisions for loan losses totaled $350,000, $2,412,000, and $6,800,000 in 2013, 2012, and 2011, respectively.

 

The provision for loan loss declined $2,062,000, or 85%, during 2013 compared to 2012. The decline in the provision for loan losses during 2013 compared with 2012 was attributable to a reduced level of net charge-offs, lower levels of non-performing loans, and a lower level of adversely classified loans. During 2013, the provision for loan loss represented approximately 3 basis points of average outstanding loans while net charge-offs represented approximately 10 basis points of average outstanding loans.

 

The Company’s allowance for loan losses represented 1.05% of total loans at year-end 2013 compared with 1.29% at year-end 2012. The decline in the allowance compared with total loans at year-end 2013 compared with year-end 2012 was in part attributable to the improvement in the Company’s asset quality and also in part attributable to the acquisition of United Commerce Bank. Under acquisition accounting, loans are recorded at fair value which includes a credit risk component, and therefore the allowance on loans acquired is not carried over from the seller.

 

The provision for loan loss declined $4,388,000, or 65%, during 2012 compared to 2011. During 2012, the provision for loan loss represented approximately 21 basis points of average outstanding loans while net charge-offs represented approximately 19 basis points of average outstanding loans. The significant decline in the Company’s provision for loan loss during 2012 compared with 2011 was largely attributable to a lower level of net charge-offs and overall improvement in the level of adversely classified and non-performing loans. The Company’s allowance for loan losses represented 1.29% of total loans at year-end 2012 compared with 1.37% at year-end 2011.

 

Provisions for loan losses in all periods were made at a level deemed necessary by management to absorb estimated, probable incurred losses in the loan portfolio. A detailed evaluation of the adequacy of the allowance for loan losses is completed quarterly by management, the results of which are used to determine provisions for loan losses. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other qualitative factors. Refer also to the sections entitled CRITICAL ACCOUNTING POLICIES AND ESTIMATES and “RISK MANAGEMENT – Lending and Loan Administration” for further discussion of the provision and allowance for loan losses.

 

25
 

 

NON-INTEREST INCOME

 

During 2013, non-interest income increased $1,804,000 or 8% compared with 2012 and during 2012 increased $235,000 or 1% compared with 2011. 

 

               % Change From 
Non-interest Income (dollars in thousands)  Years Ended December 31,   Prior Year 
   2013   2012   2011   2013   2012 
Trust and Investment Product Fees  $3,358   $2,657   $2,145    26%   24%
Service Charges on Deposit Accounts   4,144    4,076    4,154    2    (2)
Insurance Revenues   6,217    5,524    5,819    13    (5)
Company Owned Life Insurance   965    974    1,100    (1)   (11)
Interchange Fee Income   1,854    1,724    1,501    8    15 
Other Operating Income   2,003    1,955    1,452    2    35 
Subtotal   18,541    16,910    16,171    10    5 
Net Gains on Sales of Loans   2,645    3,234    2,381    (18)   36 
Net Gain on Securities   2,429    1,667    3,024    46    (45)
TOTAL NON-INTEREST INCOME  $23,615   $21,811   $21,576    8    1 

 

Trust and investment product fees increased $701,000, or 26%, during 2013 compared with 2012 following an increase of $512,000, or 24%, during 2012 compared with 2011. The increase during 2013 compared to 2012 was attributable to a 35% increase in trust revenues and a 19% increase in brokerage revenues. The increase during 2012 compared to 2011 was primarily attributable to a 50% increase in trust revenues supplemented by a 7% increase in retail brokerage revenues.

 

Insurance revenues increased $693,000, or 13%, during 2013 as compared to 2012 primarily as a result of increased commercial insurance revenue and to a lesser extent increased contingency revenue. Contingency revenue totaled $246,000 during 2013 compared to $88,000 in 2012. Insurance revenues decreased approximately $295,000 or 5% during 2012 as compared to 2011 as a result of lower contingency revenue. Contingency revenue totaled $88,000 during 2012 compared to $872,000 in 2011. The decline in contingency revenue was partially offset by an increased level of commercial insurance revenues during 2012 compared with 2011.

 

Net gain on sales of residential loans decreased $589,000, or 18%, during 2013 compared with 2012. During 2012, the net gain on sales of residential loans increased $853,000, or 36%, compared with 2011. Loan sales for 2013, 2012, and 2011 totaled $166.6 million, $186.8 million, and $134.2 million, respectively.

 

During 2013, the Company realized net gains on the sale of securities of $2,429,000 related to the sale of $90.5 million of securities. Included in the gain during 2013 was a $343,000 gain the Company realized related to the acquisition accounting treatment of the existing equity ownership position the Company held in United Commerce at the time of acquisition. During 2012, the Company realized net gains on the sale of securities of $1,667,000 related to the sale of approximately $94.3 million of securities. During 2011, the Company realized net gains on securities of $3,024,000 related to the sale of approximately $59.3 million of securities. Included in the gain during 2011 was a $1,045,000 gain related to the acquisition accounting treatment of the existing equity ownership position the Company held in American Community Bancorp, Inc. at the time of acquisition of American Community.

 

26
 

 

NON-INTEREST EXPENSE

 

During 2013, non-interest expense increased $3,982,000, or 8%, compared with 2012. During 2012, non-interest expense remained very stable compared with 2011, increasing by less than 1%.

 

               % Change From 
Non-interest Expense (dollars in thousands)  Years Ended December 31,   Prior Year 
   2013   2012   2011   2013   2012 
Salaries and Employee Benefits  $31,482   $29,086   $27,992    8%   4%
Occupancy, Furniture and Equipment Expense   7,741    7,064    7,198    10    (2)
FDIC Premiums   1,050    1,116    1,473    (6)   (24)
Data Processing Fees   1,765    1,071    2,092    65    (49)
Professional Fees   2,577    2,247    2,056    15    9 
Advertising and Promotion   1,863    1,714    1,525    9    12 
Intangible Amortization   1,416    1,655    1,956    (14)   (15)
Other Operating Expenses   7,011    6,970    6,490    1    7 
TOTAL NON-INTEREST EXPENSE  $54,905   $50,923   $50,782    8    n/m(1)

 

(1)n/m = not meaningful

 

Salaries and employee benefits increased $2,396,000, or 8%, during 2013 compared with 2012. The increase was primarily the result of an increased number of full-time equivalent employees due in part to an increased number of banking locations including the acquisition of United Commerce, increased costs related to the Company’s health insurance plan, and the termination of a frozen defined benefit pension plan. Also contributing to the increase was approximately $287,000 of merger-related salary and benefit costs related to the acquisition of United Commerce. Salaries and employee benefits increased $1,094,000 or 4% during 2012 compared with 2011. The increase in salaries and benefits during 2012 compared with 2011 was primarily the result of an increased number of full-time equivalent employees, increased costs related to the Company’s partially self-insured health insurance plan and increased commission payout related to higher levels of mortgage loan sales revenues in the secondary market and increased insurance revenues.

 

Occupancy, furniture and equipment expense increased $677, or approximately 10%, during 2013 compared with 2012 following a 2% decrease in 2012 compared with 2011. The increase during 2013 was largely attributable to service contracts related to equipment and software, additional branch banking locations, and the acquisition of United Commerce Bancorp. The costs associated with United Commerce totaled $127,000 during 2013.

 

Data processing fees increased $694,000, or 65%, during 2013 compared with 2012. The increase was largely related to the resolution of a contractual dispute during 2012 related to the acquisition of American Community Bancorp. An expense for the cancellation of a data processing contract was recorded in the first half of 2011, and upon resolution of the contractual dispute, a portion of that accrued expense was reversed during 2012. Also contributing to the increase was $261,000 in data processing charges for United Commerce Bancorp. Data processing fees declined $1,021,000, or 49%, during 2012 compared with 2011. This decline was largely related to running the Bank of Evansville’s separate core processing system during the first four months of 2011 and aforementioned contractual issues.

 

Professional fees increased $330,000, or 15%, during 2013 compared with 2012 following an increase of $191,000, or 9%, during 2012 compared with 2011. The increase during 2013 compared with 2012 was largely related to professional fees associated with the acquisition of United Commerce Bancorp and related to fees associated with the Company’s review of its overall operating effectiveness and efficiency. The increase during 2012 compared with 2011 was attributable to increased professional fees related to strategic customer service and leadership development initiatives and increased legal fees.

 

Advertising and promotion increased $149,000, or 9%, during 2013 compared with 2012 following an increase of $189,000, or 12%, during 2012 compared with 2011. The increase during 2013 compared with 2012 was attributable to increased level of contributions and general advertising expenditures. The increase during 2012 was related to an increased level of contributions to community based organizations in the Company’s primary market areas.

 

Intangible amortization declined $239,000, or 14%, during 2013 compared with 2012 following a decline of $301,000, or 15%, in 2012 compared with 2011. The decline during 2013 compared with 2012 was related to a lower level of core deposit intangible amortization and a lower level of customer list intangible related to the Company’s property and casualty insurance operations. The decline during 2012 compared with 2011 was related to a lower level of core deposit intangible amortization.

 

27
 

 

PROVISION FOR INCOME TAXES

 

The Company records a provision for current income taxes payable, along with a provision for deferred taxes payable in the future. Deferred taxes arise from temporary differences, which are items recorded for financial statement purposes in a different period than for income tax returns. The Company’s effective tax rate was 31.1%, 30.7%, and 27.6%, respectively, in 2013, 2012, and 2011. The effective tax rate in all periods is lower than the blended statutory rate. The lower effective rate in all periods primarily resulted from the Company’s tax-exempt investment income on securities, loans, and company owned life insurance, income tax credits generated by investments in affordable housing projects and investments in new market tax credit projects, and income generated by subsidiaries domiciled in a state with no state or local income tax. See Note 10 to the Company’s consolidated financial statements included in Item 8 of this Report for additional details relative to the Company’s income tax provision.

 

CAPITAL RESOURCES

 

 

The Company and its affiliate bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. The prompt corrective action regulations provide five classifications, including well-capitalized, adequately capitalized, under-capitalized, significantly under-capitalized and critically under-capitalized, although these terms are not used to represent overall financial condition. The Company and its affiliate bank at year-end 2013 were categorized as well-capitalized as that term is defined by applicable regulations. See Note 8 to the Company’s consolidated financial statements included in Item 8 of this Report for actual and required capital ratios and for additional information regarding capital adequacy.

 

In July 2013, the two federal banking regulatory agencies that have authority to regulate the Company’s capital resources and capital structure (the Board of Governors of the Federal Reserve System (FRB) and Federal Deposit Insurance Corporation (FDIC)) took action to finalize the application to the United States banking industry of new regulatory capital requirements that are established by the international banking framework commonly referred to as “Basel III” and to implement certain other changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules make significant changes to the U.S. bank regulatory capital framework, and generally increase capital requirements for banking organizations. Although the Company believes that these new rules, as they are phased in over a multi-year period commencing January 1, 2015, will in general increase the amount of capital that the Company and the Bank may be required to maintain, the Company does not presently expect that any materially burdensome compliance efforts with these final capital rules will be required of the Company prior to January 1, 2015. For additional information, also see the discussion in Item 1 of this Report.

 

As of December 31, 2013, shareholders’ equity increased by $15.1 million to $200.1 million compared with $185.0 million at year-end 2012. The increase in shareholders’ equity was primarily attributable to an increase of $17.7 million in retained earnings and an increase of $12.9 million in common stock and additional paid in capital. The increase in common stock and paid in capital was primarily the result of shares issued in conjunction with the acquisition of United Commerce Bancorp. These increases were partially offset by a decline of $15.6 million in accumulated other comprehensive income primarily related to a decrease in the fair value of the Company’s available-for-sale securities portfolio. Shareholders’ equity represented 9.3% of total assets at December 31, 2013 and 9.2% of total assets at December 31, 2012. Shareholders’ equity included $23.9 million of goodwill and other intangible assets at year-end 2013 compared to $21.6 million of goodwill and other intangible assets at December 31, 2012.

 

USES OF FUNDS

 

 

LOANS

 

December 31, 2013 loans outstanding increased approximately $177.3 million, or 15% from year-end 2012. The loans acquired from United Commerce Bancorp totaled approximately $76.9 million at year-end 2013. Commercial and industrial loans increased $15.6 million or 5%, commercial real estate loans increased $93.6 million or 19%, agricultural loans increased $13.0 million or 7%, consumer loans increased $15.1 million or 13%, and residential mortgage loans increased $40.1 million or 45% during 2013.

 

December 31, 2012 loans outstanding increased $84.4 million, or 8% from year-end 2011. The increase in loans during 2012 was broad based including commercial and industrial loans, commercial real estate loans and agricultural loans and with growth occurring across virtually the entire market area of the Company. Commercial and industrial loans increased $42.2 million, or 14%, commercial real estate loans increased $36.4 million, or 8%, agricultural loans increased $12.2 million, or 7%, and residential mortgage loans increased $2.5 million, or 3%, while consumer loans decreased $8.9 million or 7%.

 

28
 

 

The composition of the loan portfolio has remained relatively stable over the past several years including 2013. The portfolio is most heavily concentrated in commercial real estate loans at 42% of the portfolio. The Company’s exposure to non-owner occupied commercial real estate was limited to 21% of the total loan portfolio at year-end 2013. The Company’s commercial lending is extended to various industries, including hotel, agribusiness and manufacturing, as well as health care, wholesale, and retail services. The Company has only limited exposure in construction and development lending with this segment representing approximately 3% of the total loan portfolio.

 

Loan Portfolio  December 31, 
(dollars in thousands)  2013   2012   2011   2010   2009 
                     
Commercial and Industrial Loans and Leases  $350,955   $335,373   $293,172   $218,443   $188,962 
Commercial Real Estate Loans   582,066    488,496    452,071    339,555    334,255 
Agricultural Loans   192,880    179,906    167,693    165,166    156,845 
Consumer Loans   130,628    115,540    124,479    118,244    114,736 
Residential Mortgage Loans   128,683    88,586    86,134    77,310    84,677 
Total Loans   1,385,212    1,207,901    1,123,549    918,718    879,475 
Less: Unearned Income   (2,830)   (3,035)   (2,556)   (1,482)   (1,653)
Subtotal   1,382,382    1,204,866    1,120,993    917,236    877,822 
Less: Allowance for Loan Losses   (14,584)   (15,520)   (15,312)   (13,317)   (11,016)
Loans, Net  $1,367,798   $1,189,346   $1,105,681   $903,919   $866,806 
                          
Ratio of Loans to Total Loans                         
Commercial and Industrial Loans and Leases   25%   28%   26%   24%   21%
Commercial Real Estate Loans   42%   40%   40%   37%   38%
Agricultural Loans   14%   15%   15%   18%   18%
Consumer Loans   10%   10%   11%   13%   13%
Residential Mortgage Loans   9%   7%   8%   8%   10%
Total Loans   100%   100%   100%   100%   100%

 

The Company’s policy is generally to extend credit to consumer and commercial borrowers in its primary geographic market area in Southern Indiana. Commercial extensions of credit outside this market area are generally concentrated in real estate loans within a 120 mile radius of the Company’s primary market and are granted on a selective basis. These out-of-market credits include participations that the Company may purchase from time to time in loans that are originated by banks in which the Company owns (or previously owned) non-controlling common stock investments.

 

The following table indicates the amounts of loans (excluding residential mortgages on 1-4 family residences and consumer loans) outstanding as of December 31, 2013, which, based on remaining scheduled repayments of principal, are due in the periods indicated (dollars in thousands).

 

   Within   One to Five   After     
   One Year   Years   Five Years   Total 
                     
Commercial and Agricultural  $521,705   $514,308   $89,888   $1,125,901 

 

   Interest Sensitivity  
   Fixed Rate   Variable Rate   
             
Loans Maturing After One Year  $160,412   $443,784   

 

29
 

 

INVESTMENTS

 

The investment portfolio is a principal source for funding the Company’s loan growth and other liquidity needs of its subsidiaries. The Company’s securities portfolio primarily consists of money market securities, uncollateralized federal agency securities, municipal obligations of state and political subdivisions, and mortgage-backed securities issued by U.S. government agencies. Money market securities include federal funds sold, interest-bearing balances with banks, and other short-term investments. The composition of the year-end balances in the investment portfolio is presented in Note 2 to the Company’s consolidated financial statements included in Item 8 of this Report and in the table below:

 

Investment Portfolio, at Amortized Cost  December 31, 
(dollars in thousands)  2013   %   2012   %   2011   % 
                         
Federal Funds Sold and Other Short-term Investments  $22,762    3%  $7,463    1%  $32,737    6%
U.S. Treasury and Agency Securities   20,000    3    23,570    4    6,340    1 
Corporate Securities   —    —    —    —    1,003    n/m(1)
Obligations of State and Political Subdivisions   112,276    18    71,698    13    61,296    12 
Mortgage-backed Securities - Residential   481,724    76    475,452    82    431,495    81 
Equity Securities   353    n/m(1)   684    n/m(1)   684    n/m(1)
Total Securities Portfolio  $637,115    100%  $578,867    100%  $533,555    100%

 

(1)n/m = not meaningful

 

The amortized cost of investment securities, including federal funds sold and short-term investments, increased $58.2 million at year-end 2013 compared with year-end 2012 and increased $45.3 million at year-end 2012 compared with year-end 2011. The largest concentration in the investment portfolio continues to be in mortgage related securities representing 76% of the total securities portfolio at December 31, 2013. The Company’s level of obligations of state and political subdivisions increased to $112.3 million or 18% of the portfolio at December 31, 2013.

 

The Company’s equity securities portfolio at year-end 2013 and 2012 consisted of non-controlling common stock investments in unaffiliated banking companies. The decline in 2013 compared with year-end 2012 in the equity securities portfolio was primarily the result of the acquisition of United Commerce Bancorp effective October 1, 2013 in which the Company had a non-controlling common stock investment prior to the acquisition.

 

Investment Securities, at Carrying Value

(dollars in thousands)

 

   December 31, 
Securities Held-to-Maturity  2013   2012   2011 
Obligations of State and Political Subdivisions  $268   $346   $690 
                
Securities Available-for-Sale               
U.S. Treasury and Agency Securities  $18,952   $23,472   $6,422 
Corporate Securities   —    —    1,005 
Obligations of State and Political Subdivisions   113,497    76,485    64,799 
Mortgage-backed Securities - Residential   473,230    486,912    443,934 
Equity Securities   353    733    684 
Subtotal of Securities Available-for-Sale   606,032    587,602    516,844 
Total Securities  $606,300   $587,948   $517,534 

 

The Company’s $606.0 million available-for-sale portion of the investment portfolio provides an additional funding source for the liquidity needs of the Company’s subsidiaries and for asset/liability management requirements. Although management has the ability to sell these securities if the need arises, their designation as available-for-sale should not necessarily be interpreted as an indication that management anticipates such sales.

 

The amortized cost of both available for sale and held to maturity debt securities at December 31, 2013 are shown in the following table by expected maturity. Mortgage-backed securities are based on estimated average lives. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations. Equity securities do not have contractual maturities, and are excluded from the table below.

 

30
 

 

Maturities and Average Yields of Securities at December 31, 2013

(dollars in thousands)

 

   Within   After One But   After Five But   After Ten 
   One Year   Within Five Years   Within Ten Years   Years 
   Amount   Yield   Amount   Yield   Amount   Yield   Amount   Yield 
U.S. Treasury and Agency Securities  $—    N/A   $—    N/A   $20,000    1.30%  $—    N/A 
Obligations of State and Political Subdivisions   2,935    4.91%   10,158    3.50%   49,906    5.16%   49,277    5.53%
Mortgage-backed Securities - Residential   12,682    3.70%   314,260    2.30%   154,782    2.03%   —    N/A 
                                         
Total Securities  $15,617    3.93%  $324,418    2.34%  $224,688    2.66%  $49,277    5.53%

 

A tax-equivalent adjustment using a tax rate of 35 percent was used in the above table.

 

In addition to the other uses of funds discussed previously, the Company had certain long-term contractual obligations as of December 31, 2013. These contractual obligations primarily consisted of long-term borrowings with the Federal Home Loan Bank (“FHLB”), parent company term debt, and junior subordinated debentures assumed as a part of the American Community Bancorp, Inc. acquisition which was completed in 2011, time deposits, and lease commitments for certain office facilities. Scheduled principal payments on long-term borrowings, time deposits, and future minimum lease payments are outlined in the table below.

 

Contractual Obligations  Payments Due By Period 
(dollars in thousands)  Total   Less Than 1 Year   1-3 Years   3-5 Years   More Than 5 Years 
                     
Long-term Borrowings  $83,507   $43,039   $24,087   $10,776   $5,605 
Time Deposits   349,034    174,109    142,338    32,408    179 
Capital Lease Obligation   8,658    495    990    960    6,213 
Operating Lease Commitments   3,486    608    957    413    1,508 
Total Contractual Obligations  $444,685   $218,251   $168,372   $44,557   $13,505 

 

SOURCES OF FUNDS

 

The Company’s primary source of funding is its base of core customer deposits. Core deposits consist of demand deposits, savings, interest-bearing checking, money market accounts, and certificates of deposit of less than $100,000. Other sources of funds are certificates of deposit of $100,000 or more, brokered deposits, overnight borrowings from other financial institutions and securities sold under agreement to repurchase. The membership of the Company’s affiliate bank in the Federal Home Loan Bank System provides a significant additional source for both long and short-term collateralized borrowings. In addition, the Company, as a separate and distinct corporation from its bank and other subsidiaries, also has the ability to borrow funds from other financial institutions and to raise debt or equity capital from the capital markets and other sources. The following pages contain a discussion of changes in these areas.

 

31
 

 

The table below illustrates changes between years in the average balances of all funding sources:

  

Funding Sources - Average Balances
(dollars in thousands)		  December 31,   % Change From
Prior Year		 
   2013   2012   2011   2013   2012 
Demand Deposits                         
Non-interest-bearing  $355,841   $313,812   $256,544    13%   22%
Interest-bearing   534,095    512,232    478,486    4    7 
Savings Deposits   134,283    116,515    95,748    15    22 
Money Market Accounts   332,108    318,960    296,418    4    8 
Other Time Deposits   223,239    255,722    285,564    (13)   (10)
Total Core Deposits   1,579,566    1,517,241    1,412,760    4    7 
Certificates of Deposits of $100,000 or more and Brokered Deposits   116,230    101,471    108,444    15    (6)
FHLB Advances and Other Borrowings   136,569    118,201    126,922    16    (7)
Total Funding Sources  $1,832,365   $1,736,913   $1,648,126    5    5 

 

Maturities of certificates of deposit of $100,000 or more and brokered deposits are summarized as follows:

(dollars in thousands) 

   3 Months   3 Thru   6 Thru   Over     
   Or Less   6 Months   12 Months   12 Months   Total 
                          
December 31, 2013  $44,574   $21,219   $20,443   $38,437   $124,673 

 

CORE DEPOSITS

 

The Company’s overall level of average core deposits increased approximately $62.3 million, or 4%, during 2013 following a $104.5 million, or 7%, increase during 2012. During both 2013 and 2012, the increase in average core deposits came from across the Company’s branch network and market areas. The acquisition of United Community Bancorp, which occurred in the fourth quarter of 2013, had a relatively minor impact on the average core deposit balances.

 

The Company’s ability to attract core deposits continues to be influenced by competition and the interest rate environment, as well as the availability of alternative investment products. Core deposits continue to represent a significant funding source for the Company’s operations and represented 86% of average total funding sources during 2013 compared with 87% during 2012 and 86% during 2011.

 

Demand, savings, and money market deposits have provided a growing source of funding for the Company in each of the periods reported. Average demand, savings, and money market deposits increased 8% during 2013 following 12% growth during 2012. Average demand, savings, and money market deposits totaled $1.356 billion or 86% of core deposits (74% of total funding sources) in 2013 compared with $1.262 billion or 83% of core deposits (73% of total funding sources) in 2012 and $1.127 billion or 80% of core deposits (68% of total funding sources) in 2011.

 

Other time deposits consist of certificates of deposits in denominations of less than $100,000. These deposits declined by 13% during 2013 following a decrease of 10% in 2012. Other time deposits comprised 14% of core deposits in 2013, 17% in 2012 and 20% in 2011.

 

OTHER FUNDING SOURCES

 

Federal Home Loan Bank advances and other borrowings represent the Company’s most significant source of other funding. Average borrowed funds increased $18.4 million, or 16%, during 2013 following a decline of $8.7 million, or 7% in 2012. Borrowings comprised approximately 7% of average total funding sources in 2013 and 2012 and 8% in 2011.

 

Certificates of deposits in denominations of $100,000 or more and brokered deposits are an additional source of other funding for the Company’s bank subsidiary. Large denomination certificates and brokered deposits increased $14.8 million, or 15% during 2013 following a decrease of $7.0 million, or 6% during 2012. Large certificates and brokered deposits comprised approximately 6% of average total funding sources in 2013 and 2012 and 7% in 2011. This type of funding is used as both long-term and short-term funding sources.

 

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The bank subsidiary of the Company also utilizes short-term funding sources from time to time. These sources consist of overnight federal funds purchased from other financial institutions, secured repurchase agreements that generally mature within one day of the transaction date, and secured overnight variable rate borrowings from the FHLB. These borrowings represent an important source of short-term liquidity for the Company’s bank subsidiary. Long-term debt at the Company’s bank subsidiary is in the form of FHLB advances, which are secured by the pledge of certain investment securities, residential and housing-related mortgage loans, and certain other commercial real estate loans. See Note 7 to the Company’s consolidated financial statements included in Item 8 of this Report for further information regarding borrowed funds.

 

PARENT COMPANY FUNDING SOURCES

 

The parent company is a corporation separate and distinct from its bank and other subsidiaries. For information regarding the financial condition, result of operations, and cash flows of the Company, presented on a parent-company-only basis, see Note 16 to the Company’s consolidated financial statements included in Item 8 of this Report.

 

The Company uses funds at the parent company level to pay dividends to its shareholders, to acquire or make other investments in other businesses or their securities or assets, to repurchase its stock from time to time, and for other general corporate purposes. The parent company does not have access at the parent-company level to the deposits and certain other sources of funds that are available to its bank subsidiary to support its operations. Instead, the parent company has historically derived most of its revenues from dividends paid to the parent company by its bank subsidiary. The Company’s banking subsidiary is subject to statutory restrictions on its ability to pay dividends to the parent company. See Note 8, Shareholders’ Equity, of the Notes to the Consolidated Financial Statements included in Item 8 of this Report, which is incorporated herein by reference. The parent company has in recent years supplemented the dividends received from its subsidiaries with borrowings, which are discussed in detail below.

 

At year-end 2013, the Company had an outstanding credit facility pursuant to which the parent company was obligated for a term loan made to the parent company in January 2013 in the original principal amount of $10 million, of which $7 million was outstanding as of year-end 2013. Of the remaining $7 million principal amount of the term loan (which may be prepaid at any time without premium or penalty), $3 million is payable on or before December 31, 2014 and the remaining $4 million of principal is due on or before the maturity of the Term Note on December 30, 2015. Interest is payable quarterly at a floating rate based upon 90-day LIBOR plus a margin.

 

The Company also has a $10 million revolving line of credit with the same lender that will mature on December 31, 2014. Borrowings are available for general working capital purposes from time to time; no borrowings have yet been made under the revolving line of credit. Quarterly interest payments calculated at the same floating rate as then in effect for the Term Note will be payable in respect of any principal amounts advanced under the revolving line of credit. There was no outstanding balance as of December 31, 2013.

 

Effective January 1, 2011, and as a result of the acquisition of American Community Bancorp, Inc., the Company assumed long-term debt obligations of American Community in the form of two junior subordinated debentures issued by American Community in the aggregate unpaid principal amount of approximately $8.3 million. The junior subordinated debentures were issued to certain statutory trusts established by American Community (in support of related issuances of trust preferred securities issued by those trusts) and both mature in single installments of principal payable in 2035, and bear interest payable on a quarterly basis at a floating rate, adjustable quarterly based on the 90-day LIBOR plus a specified percentage. These debentures are of a type that are eligible (under current regulatory capital requirements) to qualify as Tier 1 capital (with certain limitations) for regulatory purposes and as of December 31, 2013 approximately $4.9 million of the junior subordinated debentures were treated as Tier 1 capital for regulatory capital purposes.

 

See Note 7 to the Company’s consolidated financial statements included in Item 8 of this Report for further information regarding the parent company borrowed funds and other indebtedness.

 

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RISK MANAGEMENT

 

The Company is exposed to various types of business risk on an on-going basis. These risks include credit risk, liquidity risk and interest rate risk. Various procedures are employed at the Company’s subsidiary bank to monitor and mitigate risk in the loan and investment portfolios, as well as risks associated with changes in interest rates. Following is a discussion of the Company’s philosophies and procedures to address these risks.

 

LENDING AND LOAN ADMINISTRATION

 

Primary responsibility and accountability for day-to-day lending activities rests with the Company’s subsidiary bank. Loan personnel at the subsidiary bank have the authority to extend credit under guidelines approved by the bank’s board of directors. The executive loan committee serves as a vehicle for communication and for the pooling of knowledge, judgment and experience of its members. The committee provides valuable input to lending personnel, acts as an approval body, and monitors the overall quality of the bank’s loan portfolio. The Corporate Credit Risk Management Committee comprised of members of the Company’s and its subsidiary bank’s executive officers and board of directors, strives to ensure a consistent application of the Company’s lending policies. The Company also maintains a comprehensive risk-grading and loan review program, which includes quarterly reviews of problem loans, delinquencies and charge-offs. The purpose of this program is to evaluate loan administration, credit quality, loan documentation and the adequacy of the allowance for loan losses.

 

The Company maintains an allowance for loan losses to cover probable, incurred credit losses identified during its loan review process. Management estimates the required level of allowance for loan losses using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed.

 

The allowance for loan losses is comprised of: (a) specific reserves on individual credits; (b) general reserves for certain loan categories and industries, and overall historical loss experience; and (c) unallocated reserves based on performance trends in the loan portfolios, current economic conditions, and other factors that influence the level of estimated probable losses. The need for specific reserves are considered for credits when: (a) the customer’s cash flow or net worth appears insufficient to repay the loan; (b) the loan has been criticized in a regulatory examination; (c) the loan is on non-accrual; or, (d) other reasons where the ultimate collectability of the loan is in question, or the loan characteristics require special monitoring.

 

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Allowance for Loan Losses
(dollars in thousands)		  Years Ended December 31, 
   2013   2012   2011   2010   2009 
                         
Balance of Allowance for Possible Losses at Beginning of Period  $15,520   $15,312   $13,317   $11,016   $9,522 
                          
Loans Charged-off:                         
Commercial and Industrial Loans   503    162    1,513    345    941 
Commercial Real Estate Loans   538    1,789    2,604    2,842    1,248 
Agricultural Loans   —    —    —    44    — 
Consumer Loans   607    380    575    465    640 
Residential Mortgage Loans   24    199    497    518    345 
Total Loans Charged-off   1,672    2,530    5,189    4,214    3,174 
                          
Recoveries of Previously Charged-off Loans:                         
Commercial and Industrial Loans   128    74    98    24    — 
Commercial Real Estate Loans   102    97    139    1,089    588 
Agricultural Loans   —    —    —    —    17 
Consumer Loans   148    125    131    171    192 
Residential Mortgage Loans   8    30    16    6    121 
Total Recoveries   386    326    384    1,290    918 
                          
Net Loans Recovered (Charged-off)   (1,286)   (2,204)   (4,805)   (2,924)   (2,256)
Additions to Allowance Charged to Expense   350    2,412    6,800    5,225    3,750 
Balance at End of Period  $14,584   $15,520   $15,312   $13,317   $11,016 
                          
Net Charge-offs to Average Loans Outstanding   0.10%   0.19%   0.43%   0.32%   0.25%
Provision for Loan Losses to Average Loans Outstanding   0.03%   0.21%   0.61%   0.58%   0.42%
Allowance for Loan Losses to Total Loans at Year-end   1.05%   1.29%   1.37%   1.45%   1.25%

 

The following table indicates the breakdown of the allowance for loan losses for the periods indicated (dollars in thousands):

 

Commercial and Industrial Loans  $3,983   $4,555   $3,493   $3,713   $2,146 
Commercial Real Estate Loans   8,335    8,931    9,297    7,497    6,477 
Agricultural Loans   946    989    926    750    872 
Consumer Loans   427    355    448    582    520 
Residential Mortgage Loans   281    186    402    543    545 
Unallocated   612    504    746    232    456 
                          
Total Allowance for Loan Losses  $14,584   $15,520   $15,312   $13,317   $11,016 

 

The Company’s allowance for loan losses totaled $14.6 million at December 31, 2013 representing a decrease of $936,000 or 6% compared with year-end 2012. The significant contributing factors that led to the decrease of the allowance for loan losses included positive trends in the level of non-performing and adversely classified loans as well as a decline in the level of net-charge-offs in 2013 compared with 2012.

 

The allowance for loan losses represented 1.05% of period end loans at December 31, 2013 compared with 1.29% at December 31, 2012. Under acquisition accounting treatment, loans acquired are recorded at fair value which includes a credit risk component, and therefore the allowance on loans acquired is not carried over from the seller. The Company held a discount on acquired loans of $5.9 million (including $3.9 million attributable to the United Commerce acquisition) as of December 31, 2013 and $3.5 million at year-end 2012.

 

The allowance for loan loss at year-end 2013 represented 174% of non-performing loans compared to 150% at year-end 2012. Net charge-offs totaled $1.3 million or 0.10% of average loans during 2013 compared with net charge-offs of $2.2 million or 0.19% of average loans outstanding during 2012.

 

Please see “RESULTS OF OPERATIONS – Provision for Loan Losses” and “CRITICAL ACCOUNTING POLICIES AND ESTIMATES – Allowance for Loan Losses” for additional information regarding the allowance.

 

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NON-PERFORMING ASSETS

 

Non-performing assets consist of: (a) non-accrual loans; (b) loans which have been renegotiated to provide for a reduction or deferral of interest or principal because of deterioration in the financial condition of the borrower; (c) loans past due 90 days or more as to principal or interest; and, (d) other real estate owned. Loans are placed on non-accrual status when scheduled principal or interest payments are past due for 90 days or more or when the borrower’s ability to repay becomes doubtful. Uncollected accrued interest is reversed against income at the time a loan is placed on non-accrual. Loans are typically charged-off at 180 days past due, or earlier if deemed uncollectible. Exceptions to the non-accrual and charge-off policies are made when the loan is well secured and in the process of collection. The following table presents an analysis of the Company’s non-performing assets.

 

Non-performing Assets  December 31, 
(dollars in thousands)  2013   2012   2011   2010   2009 
                     
Non-accrual Loans  $8,378   $10,357   $17,857   $10,150   $8,374 
Past Due Loans (90 days or more)   8    —    —    671    113 
Total Non-performing Loans   8,386    10,357    17,857    10,821    8,487 
Other Real Estate   1,029    1,645    2,343    2,095    2,363 
Total Non-performing Assets  $9,415   $12,002   $20,200   $12,916   $10,850 
                          
Restructured Loans  $2,418   $362   $409   $396   $306 
                          
Non-performing Loans to Total Loans   0.61%   0.86%   1.59%   1.18%   0.97%
                          
Allowance for Loan Losses to Non-performing Loans   173.91%   149.85%   85.75%   123.07%   129.80%

 

Non-performing assets totaled $9.4 million or 0.44% of total assets at December 31, 2013 compared to $12.0 million or 0.60% of total assets at December 31, 2012. Non-performing loans totaled $8.4 million or 0.61% of total loans at December 31, 2013 representing a $2.0 million, or 19%, decline in non-performing loans compared to the $10.4 million of non-performing loans at December 31, 2012.

 

The improvement in non-performing loans was largely the result of the placement of a commercial and industrial loan to a mechanical contractor back into accrual status based on the performance of the loan and company over an extended period of time. This loan was restructured and placed into non-accrual status in a prior period. After upgrading, because the loan was previously restructured, the Company continues to carry this credit as a restructured loan at December 31, 2013. This resulted in the increase in restructured loans to $2.4 million at December 31, 2013 compared to $0.4 million at December 31, 2012.

 

Non-accrual commercial real estate loans totaled $6.7 million at December 31, 2013 representing a decline of $0.6 million, or 8%, from the $7.3 million of non-accrual commercial real estate loans at year-end 2012. Non-accrual commercial real estate loans represented 79% of the total non-performing loans at December 31, 2013 compared to 70% of total non-performing loans at year-end 2012. Non-accrual commercial and industrial loans totaled $0.03 million at December 31, 2013 representing a decrease of $2.4 million, or 99%, from the $2.5 million of non-accrual commercial and industrial loans at December 31, 2012. Non-accrual commercial and industrial loans represented less than 1% of the total non-performing loans at December 31, 2013 compared with 24% of total non-performing loans at year-end 2012. Non-accrual residential mortgage loans totaled $1.3 million at December 31, 2013 representing an increase of $1.1 million from the $0.2 million at year-end 2012. Non-accrual residential mortgage loans represented 16% of the total non-performing loans at December 31, 2013 compared to 2% of total non-performing loans at year-end 2012.

 

At December 31, 2013, two commercial loan relationships represented approximately 47% of the total non-performing loans of the Company and represented the only loan relationships greater than $1.0 million included in non-performing loans. The first relationship was a $2.1 million commercial real estate loan secured by various commercial real estate properties. This loan was in non-performing status as of December 31, 2012. The borrower has made all contractual payments due during 2013 and the principal balance of the loan was reduced by approximately $0.6 million during 2013. The second relationship was a $1.9 million commercial real estate loan secured by a commercial warehouse facility. This loan was in non-performing status as of year-end 2012. The borrower has made all contractual payments due during 2013 and the principal balance of this relationship was reduced by $0.09 million during 2013.

 

The Company purchases individual loans and groups of loans. Purchased loans that show evidence of credit deterioration since origination are recorded at the amount paid (or allocated fair value in a purchase business combination), such that there is no carryover of the seller’s allowance for loan losses. After acquisition, incurred losses are recognized by an increase in the allowance for loan losses.

 

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Purchased loans that indicated evidence of credit deterioration since origination at the time of acquisition by the Company did not have a material adverse impact on the Company’s key credit metrics during 2013 or 2012. The key credit metrics the Company measures generally include non-performing loans, past due loans, and adversely classified loans.

 

Non-performing purchased loans with evidence of credit deterioration since origination totaled $1,705,000 at December 31, 2013 compared with $148,000 at December 31, 2012. The non-performing purchased loans with evidence of credit deterioration since origination represented approximately 20% of total non-performing loans at December 31, 2013 compared with approximately 1% of total non-performing loans at December 31, 2012.

 

Past due purchased loans with evidence of credit deterioration since origination totaled $1,250,000 at December 31, 2013 and $118,000 at year-end 2012. Past due purchased loans with evidence of credit deterioration since origination represented approximately 16% of total past due loans at December 31, 2013 and approximately 1% of total past due loans at year-end 2012.

 

Adversely classified purchased loans with evidence of credit deterioration since origination totaled $9.0 million at December 31, 2013 compared with $7.3 million at December 31, 2012. Adversely classified purchased loans with evidence of credit deterioration since origination represented approximately 25% of total adversely classified loans at December 31, 2013 compared with approximately 19% of total adversely classified loans at year-end 2012.

 

Loan impairment is reported when full repayment under the terms of the loan is not expected. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from the collateral. Commercial and industrial loans, commercial real estate loans, and agricultural loans are evaluated individually for impairment. Smaller balance homogeneous loans are evaluated for impairment in total. Such loans include real estate loans secured by one-to-four family residences and loans to individuals for household, family and other personal expenditures. Individually evaluated loans on non-accrual are generally considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible. The amount of loans individually evaluated for impairment including purchase credit impaired loans totaled $8.9 million at December 31, 2013. For additional detail on impaired loans, see Note 4 to the Company’s consolidated financial statements included in Item 8 of this Report.

 

Interest income recognized on non-accrual loans for 2013 was $172,000. The gross interest income that would have been recognized in 2013 on non-performing loans if the loans had been current in accordance with their original terms was $675,000. Loans are typically placed on non-accrual status when scheduled principal or interest payments are past due for 90 days or more, unless the loan is well secured and in the process of collection.

 

LIQUIDITY AND INTEREST RATE RISK MANAGEMENT

 

Liquidity is a measure of the ability of the Company’s subsidiary bank to fund new loan demand, existing loan commitments and deposit withdrawals. The purpose of liquidity management is to match sources of funds with anticipated customer borrowings and withdrawals and other obligations to ensure a dependable funding base, without unduly penalizing earnings. Failure to properly manage liquidity requirements can result in the need to satisfy customer withdrawals and other obligations on less than desirable terms. The liquidity of the parent company is dependent upon the receipt of dividends from its bank subsidiary, which are subject to certain regulatory limitations explained in Note 8 to the Company’s consolidated financial statements included in Item 8 of this Report, as enhanced by its ability to draw upon term financing arrangements and a line of credit established by the parent company with a correspondent bank lender as described under “SOURCES OF FUNDS – Parent Company Funding Sources”, above. The subsidiary bank’s source of funding is predominately core deposits, time deposits in excess of $100,000 and brokered certificates of deposit, maturities of securities, repayments of loan principal and interest, federal funds purchased, securities sold under agreements to repurchase and borrowings from the Federal Home Loan Bank and Federal Reserve Bank.

 

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

 

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OFF-BALANCE SHEET ARRANGEMENTS

 

The Company has no off-balance sheet arrangements other than stand-by letters of credit as disclosed in Note 13 to the Company’s consolidated financial statements included in Item 8 of this Report.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

 

The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee and Board of Directors. Primary market risks, which impact the Company’s operations, are liquidity risk and interest rate risk, as discussed above.

 

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

 

The following table provides an assessment of the risk to NPV in the event of sudden and sustained 1% and 2% increases and decreases in prevailing interest rates. The table indicates that as of December 31, 2013 the Company’s estimated NPV might be expected to decrease under either an increase or decrease of 2% in prevailing interest rates (dollars in thousands).

 

Interest Rate Sensitivity as of December 31, 2013 

           Net Portfolio Value 
   Net Portfolio   as a % of Present Value 
   Value   of Assets 
Changes                
in Rates  Amount   % Change   NPV Ratio   Change 
+2%  $191,689    (17.09)%   9.28%   (139) b.p.
+1%   211,987    (8.31)%   10.02%   (65) b.p.
Base   231,209    —    10.67%   —
-1%   219,248    (5.17)%   9.98%   (69) b.p.
-2%   207,280    (10.35)%   9.36%   (131) b.p.

 

The above discussion, and the portions of MANAGEMENT’S DISCUSSION AND ANALYSIS in Item 7 of this Report that are referenced in the above discussion contain statements relating to future results of the Company that are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to, among other things, simulation of the impact on net interest income from changes in interest rates. Actual results may differ materially from those expressed or implied therein as a result of certain risks and uncertainties, including those risks and uncertainties expressed above, those that are described in MANAGEMENT’S DISCUSSION AND ANALYSIS in Item 7 of this Report, and those that are described in Item 1 of this Report, “Business,” under the caption “Forward-Looking Statements and Associated Risks,” which discussions are incorporated herein by reference.

 

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Item 8. Financial Statements and Supplementary Data.

 

Report of Independent Registered Public Accounting Firm

 

Board of Directors and Shareholders

German American Bancorp, Inc.

Jasper, Indiana

 

We have audited the accompanying consolidated balance sheets of German American Bancorp, Inc. (the Company) as of December 31, 2013 and 2012 and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2013. We also have audited German American Bancorp, Inc.’s internal control over financial reporting as of December 31, 2013, based on criteria established in the 1992 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). German American Bancorp, Inc.’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

 

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

 

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

 

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

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of German American Bancorp, Inc. as of December 31, 2013 and 2012, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion German American Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in the 1992 Internal Control – Integrated Framework issued by the COSO.

 

  /s/ Crowe Horwath LLP
  Crowe Horwath LLP

 

Indianapolis, Indiana

March 13, 2014

 

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Consolidated Balance Sheets
Dollars in thousands, except per share data

 

   December 31, 
     
   2013   2012 
ASSETS          
Cash and Due from Banks  $37,370   $41,624 
Federal Funds Sold and Other Short-term Investments   22,762    7,463 
           
Cash and Cash Equivalents   60,132    49,087 
           
Interest-bearing Time Deposits with Banks   100    2,707 
Securities Available-for-Sale, at Fair Value   606,032    587,602 
Securities Held-to-Maturity, at Cost (Fair value of $271 and $351 on          
December 31, 2013 and 2012, respectively)   268    346 
           
Loans Held-for-Sale, at Fair Value   9,265    16,641 
           
Loans   1,385,212    1,207,901 
Less:   Unearned Income   (2,830)   (3,035)
Allowance for Loan Losses   (14,584)   (15,520)
Loans, Net   1,367,798    1,189,346 
           
Stock in FHLB of Indianapolis and Other Restricted Stock, at Cost   9,004    8,340 
Premises, Furniture and Equipment, Net   40,430    36,554 
Other Real Estate   1,029    1,645 
Goodwill   20,536    18,865 
Intangible Assets   3,328    2,692 
Company Owned Life Insurance   31,178    30,223 
Accrued Interest Receivable and Other Assets   14,727    62,252 
           
TOTAL ASSETS  $2,163,827   $2,006,300 
           
LIABILITIES          
Non-interest-bearing Demand Deposits  $400,024   $349,174 
Interest-bearing Demand, Savings, and Money Market Accounts   1,063,098    962,574 
Time Deposits   349,034    329,183 
           
Total Deposits   1,812,156    1,640,931 
           
FHLB Advances and Other Borrowings   140,770    161,006 
Accrued Interest Payable and Other Liabilities   10,804    19,337 
           
TOTAL LIABILITIES   1,963,730    1,821,274 
           
Commitments and Contingencies (Note 13)          
           
SHAREHOLDERS’ EQUITY          
Preferred Stock, no par value; 500,000 shares authorized, no shares issued   —    — 
Common Stock, no par value, $1 stated value; 30,000,000 shares authorized   13,174    12,637 
Additional Paid-in Capital   108,022    95,617 
Retained Earnings   84,164    66,421 
Accumulated Other Comprehensive Income (Loss)   (5,263)   10,351 
           
TOTAL SHAREHOLDERS’ EQUITY   200,097    185,026 
           
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY  $2,163,827   $2,006,300 
           
End of period shares issued and outstanding   13,173,793    12,636,656 

 

See accompanying notes to consolidated financial statements.

 

40
 

 

Consolidated Statements of Income
Dollars in thousands, except per share data

 

   Years Ended December 31, 
     
   2013   2012   2011 
             
INTEREST INCOME               
                
Interest and Fees on Loans  $61,632   $61,691   $64,445 
Interest on Federal Funds Sold and Other Short-term Investments   30    91    216 
Interest and Dividends on Securities:               
Taxable   11,091    12,946    13,677 
Non-taxable   2,919    2,432    1,823 
                
TOTAL INTEREST INCOME   75,672    77,160    80,161 
                
INTEREST EXPENSE               
                
Interest on Deposits   4,697    6,958    11,986 
Interest on FHLB Advances and Other Borrowings   2,458    3,954    4,194 
                
TOTAL INTEREST EXPENSE   7,155    10,912    16,180 
                
NET INTEREST INCOME   68,517    66,248    63,981 
                
Provision for Loan Losses   350    2,412    6,800 
                
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES   68,167    63,836    57,181 
                
NON-INTEREST INCOME               
                
Trust and Investment Product Fees   3,358    2,657    2,145 
Service Charges on Deposit Accounts   4,144    4,076    4,154 
Insurance Revenues   6,217    5,524    5,819 
Company Owned Life Insurance   965    974    1,100 
Interchange Fee Income   1,854    1,724    1,501 
Other Operating Income   2,003    1,955    1,452 
Net Gains on Sales of Loans   2,645    3,234    2,381 
Net Gain on Securities   2,429    1,667    3,024 
                
TOTAL NON-INTEREST INCOME   23,615    21,811    21,576 
                
NON-INTEREST EXPENSE               
Salaries and Employee Benefits   31,482    29,086    27,992 
Occupancy Expense   4,545    4,277    4,264 
Furniture and Equipment Expense   3,196    2,787    2,934 
FDIC Premiums   1,050    1,116    1,473 
Data Processing Fees   1,765    1,071    2,092 
Professional Fees   2,577    2,247    2,056 
Advertising and Promotion   1,863    1,714    1,525 
Intangible Amortization   1,416    1,655    1,956 
Other Operating Expenses   7,011    6,970    6,490 
                
TOTAL NON-INTEREST EXPENSE   54,905    50,923    50,782 
                
Income before Income Taxes   36,877    34,724    27,975 
Income Tax Expense   11,464    10,669    7,726 
                
NET INCOME  $25,413   $24,055   $20,249 
                
Basic Earnings per Share  $1.99   $1.91   $1.61 
Diluted Earnings per Share  $1.98   $1.90   $1.61 

 

See accompanying notes to consolidated financial statements

 

41
 

 

Consolidated Statements of Comprehensive Income
Dollars in thousands, except per share data

 

   Years Ended December 31, 
     
   2013   2012   2011 
             
NET INCOME  $25,413   $24,055   $20,249 
                
Other Comprehensive Income (Loss):               
Unrealized Gains (Losses) on Securities               
Unrealized Holding Gain (Loss) Arising During the Period   (22,169)   1,495    11,830 
Reclassification Adjustment for Losses (Gains) Included in Net Income   (2,429)   (1,667)   (3,024)
Tax Effect   8,724    48    (3,129)
Net of Tax   (15,874)   (124)   5,677 
Defined Benefit Pension Plans               
Net (Loss) Gain Arising During the Period   749    (155)   14 
Reclassification Adjustment for Amortization of Prior Service Cost and Net               
(Gain) Loss Included in Net Periodic Pension Cost   (373)   78    (7)
Tax Effect   (145)   30    (3)
Net of Tax   231    (47)   4 
Postretirement Benefit Obligation               
Net (Loss) Gain Arising During the Period   80    (79)   (122)
Reclassification Adjustment for Amortization of Prior Service Cost and Net               
(Gain) Loss Included in Net Periodic Pension Cost   (37)   42    57 
Tax Effect   (14)   16    27 
Net of Tax   29    (21)   (38)
                
Total Other Comprehensive Income (Loss)   (15,614)   (192)   5,643 
                
COMPREHENSIVE INCOME  $9,799   $23,863   $25,892 

 

See accompanying notes to consolidated financial statements.

 

42
 

 

Consolidated Statements of Changes in Shareholders’ Equity
Dollars in thousands, except per share data

 

                   Accumulated     
           Additional       Other   Total 
   Common Stock   Paid-in   Retained   Comprehensive   Shareholders’ 
   Shares   Amount   Capital   Earnings   Income (Loss)   Equity 
                         
Balances, January 1, 2011   11,105,583   $11,105   $69,297   $36,232   $4,900   $121,534 
                               
Net Income                  20,249         20,249 
Other Comprehensive Income (Loss)                       5,643    5,643 
Cash Dividends ($.56 per share)                  (7,047)        (7,047)
Issuance of Common Stock for:                              
Exercise of Stock Options   1,652    2    10              12 
Acquisition of American Community Bancorp, Inc.   1,448,520    1,449    25,123              26,572 
Restricted Share Grants   38,503    38    597              635 
Employee Stock Purchase Plan             (25)             (25)
Income Tax Benefit From Restricted Share Grant             37              37 
                               
Balances, December 31, 2011   12,594,258    12,594    95,039    49,434    10,543    167,610 
                               
Net Income                  24,055         24,055 
Other Comprehensive Income (Loss)                       (192)   (192)
Cash Dividends ($.56 per share)                  (7,068)        (7,068)
Issuance of Common Stock for:                              
Exercise of Stock Options   7,278    8    29             37 
Restricted Share Grants   35,120    35    593             628 
Employee Stock Purchase Plan             (67)            (67)
Income Tax Benefit From Restricted Share Grant             23             23 
                               
Balances, December 31, 2012   12,636,656    12,637    95,617    66,421    10,351    185,026 
                               
Net Income                  25,413         25,413 
Other Comprehensive Income (Loss)                       (15,614)   (15,614)
Cash Dividends ($.60 per share)                  (7,670)        (7,670)
Issuance of Common Stock for:                              
Exercise of Stock Options   1,999    2    18              20 
Acquisition of United Commerce Bancorp   502,560    503    12,071              12,574 
Restricted Share Grants   32,578    32    297              329 
Employee Stock Purchase Plan             (9)             (9)
Income Tax Benefit From Restricted Share Grant             28              28 
                               
Balances, December 31, 2013   13,173,793   $13,174   $108,022   $84,164   $(5,263)  $200,097 

 

See accompanying notes to consolidated financial statements.

 

43
 

 

Consolidated Statements of Cash Flows
Dollars in thousands

 

   Years Ended December 31, 
     
CASH FLOWS FROM OPERATING ACTIVITIES  2013   2012   2011 
Net Income  $25,413   $24,055   $20,249 
Adjustments to Reconcile Net Income to Net Cash from Operating Activities:               
Net Amortization on Securities   2,875    4,567    2,509 
Depreciation and Amortization   4,461    4,688    5,139 
Loans Originated for Sale   (158,845)   (181,993)   (143,738)
Proceeds from Sales of Loans Held-for-Sale   169,242    189,984    136,364 
Loss in Investment in Limited Partnership   —    —    20 
Provision for Loan Losses   350    2,412    6,800 
Gain on Sale of Loans, net   (2,645)   (3,234)   (2,381)
Gain on Securities, net   (2,429)   (1,667)   (3,024)
Loss (Gain) on Sales of Other Real Estate and Repossessed Assets   291    (221)   165 
Loss (Gain) on Disposition and Impairment of Premises and Equipment   (70)   (1)   28 
Post Retirement Medical Benefit   17    31    — 
Other-than-temporary Impairment on Securities   —    —    110 
Increase in Cash Surrender Value of Company Owned Life Insurance   (955)   (960)   (1,107)
Equity Based Compensation   329    628    635 
Excess Tax Benefit from Restricted Share Grant   (28)   (23)   (37)
Change in Assets and Liabilities:               
Interest Receivable and Other Assets   6,016    3,433    5,020 
Interest Payable and Other Liabilities   (2,376)   298    (136)
Net Cash from Operating Activities   41,646    41,997    26,616 
                
CASH FLOWS FROM INVESTING ACTIVITIES               
Proceeds from Maturity of Other Short-term Investments   2,690    3,236    6,223 
Proceeds from Maturities, Calls, Redemptions of Securities Available-for-Sale   136,173    143,253    99,272 
Redemption of Federal Reserve Bank Stock   —    —    694 
Proceeds from Sales of Securities Available-for-Sale   162,344    92,344    20,061 
Purchase of Securities Available-for-Sale   (271,218)   (312,063)   (296,547)
Proceeds from Maturities of Securities Held-to-Maturity   78    344    915 
Proceeds from Redemption of Federal Home Loan Bank Stock   —    —    1,523 
Purchase of Loans   (744)   —    — 
Proceeds from Sales of Loans   3,250    9,560    3,364 
Loans Made to Customers, net of Payments Received   (102,722)   (98,620)   3,498 
Proceeds from Sales of Other Real Estate   2,081    3,899    4,231 
Property and Equipment Expenditures   (3,659)   (3,617)   (3,965)
Proceeds from Sales of Property and Equipment   88    1    12 
Acquire Capitalized Lease   (1,455)   —    (7)
Acquisition of United Commerce Bank   5,858    —    — 
Acquisition of American Community Bancorp, Inc.   —    —    55,780 
Net Cash from Investing Activities   (67,236)   (161,663)   (104,946)
                
CASH FLOWS FROM FINANCING ACTIVITIES               
Change in Deposits   64,645    84,779    166,416 
Change in Short-term Borrowings   (18,000)   31,515    (32,682)
Advances in Long-term Debt   47,000    20,000    — 
Repayments of Long-term Debt   (49,379)   (21,569)   (6,549)
Issuance of Common Stock   20    37    12 
Income Tax Benefit from Restricted Share Grant   28    23    37 
Employee Stock Purchase Plan   (9)   (67)   (25)
Dividends Paid   (7,670)   (7,068)   (7,047)
Net Cash from Financing Activities   36,635    107,650    120,162 
                
Net Change in Cash and Cash Equivalents   11,045    (12,016)   41,832 
Cash and Cash Equivalents at Beginning of Year   49,087    61,103    19,271 
Cash and Cash Equivalents at End of Year  $60,132   $49,087   $61,103 
                
Cash Paid During the Year for               
Interest  $7,653   $11,521   $16,577 
Income Taxes   10,268    8,990    6,693 
                
Supplemental Non Cash Disclosures (See Note 17 for Business Combinations)               
Loans Transferred to Other Real Estate  $851   $2,980   $3,492 
Securities Transferred to Accounts Receivable   —    45,803    43,167 
Accounts Receivable Transferred to Securities   (45,803)   (43,167)   — 

 

See accompanying notes to consolidated financial statements.

 

44
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 1 – Summary of Significant Accounting Policies

 

Description of Business and Basis of Presentation

German American Bancorp, Inc. operations are primarily comprised of three business segments: core banking, trust and investment advisory services, and insurance operations. The accounting and reporting policies of German American Bancorp, Inc. and its subsidiaries conform to U.S. generally accepted accounting principles. The more significant policies are described below. The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of all material intercompany accounts and transactions. Certain prior year amounts have been reclassified to conform with current classifications. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts and disclosures. Actual results could differ from those estimates. Estimates susceptible to change in the near term include the allowance for loan losses, fair value of financial instruments, other-than-temporary impairment of securities, the valuation allowance on deferred tax assets, and loss contingencies.

 

Securities

Securities classified as available-for-sale are securities that the Company intends to hold for an indefinite period of time, but not necessarily until maturity. These include securities that management may use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, or similar reasons. Equity securities with readily determinable fair values are classified as available-for-sale. Equity securities that do not have readily determinable fair values are carried at historical cost and evaluated for impairment on a periodic basis. Securities classified as available-for-sale are reported at fair value with unrealized gains or losses included as a separate component of equity, net of tax. Securities classified as held-to-maturity are securities that the Company has both the ability and positive intent to hold to maturity. Securities held-to-maturity are carried at amortized cost.

 

Premium amortization is deducted from, and discount accretion is added to, interest income using the level yield method without anticipating prepayments, except for mortgage-backed securities where prepayments are anticipated. Gains and losses on sales are recorded on trade date and are computed on the identified securities method.

 

Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation.  For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings.  For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) OTTI related to other factors, which is recognized in other comprehensive income.  The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.

 

Loans Held for Sale

Mortgage loans originated and intended for sale in the secondary market are carried at fair value. Fair value is determined based on collateral value and prevailing market prices for loans with similar characteristics. Net unrealized gains or losses are recorded through earnings.

 

Mortgage loans held for sale are generally sold on a servicing released basis. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.

 

Loans

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at the principal balance outstanding, net of unearned interest, deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on unpaid principal balance and includes amortization of net deferred loan fees and costs over the loan term without anticipating prepayments.

 

45
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 1 – Summary of Significant Accounting Policies (continued)

 

All classes of loans are generally placed on non-accrual status when scheduled principal or interest payments are past due for 90 days or more or when the borrower’s ability to repay becomes doubtful. Uncollected accrued interest for each class of loans is reversed against income at the time a loan is placed on non-accrual. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. All classes of loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loans are typically charged-off at 180 days past due, or earlier if deemed uncollectible. Exceptions to the non-accrual and charge-off policies are made when the loan is well secured and in the process of collection.

 

Certain Purchased Loans

The Company purchases individual loans and groups of loans. Purchased loans that show evidence of credit deterioration since origination are recorded at the amount paid (or allocated fair value in a purchase business combination), such that there is no carryover of the seller’s allowance for loan losses. After acquisition, incurred losses are recognized by an increase in the allowance for loan losses.

 

Such purchased loans are accounted for individually. The Company estimates the amount and timing of expected cash flows for each purchased loan or pool, and the expected cash flows in excess of amount paid is recorded as interest income over the remaining life of the loan or pool (accretable yield). The excess of the loan’s or pool’s contractual principal and interest over expected cash flows is not recorded (nonaccretable difference).

 

Over the life of the loan, expected cash flows continue to be estimated. If the present value of expected cash flows is less than the carrying amount, a loss is recorded. If the present value of expected cash flows is greater than the carrying amount, it is recognized as part of future interest income.

 

Allowance for Loan Losses

The allowance for loan losses is a valuation allowance for probable incurred credit losses. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. Management estimates the allowance balance required using past loan loss experience, the nature and volume of the portfolio, information about specific borrower situations and estimated collateral values, economic conditions, and other factors. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged-off. The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or special mention. The general component covers non-classified loans and is based on historical loss experience adjusted for current factors. For 2012 and 2011, the Company utilized a 4 quarter rolling historical loan loss average. Beginning in 2013, management deemed a rolling 12 quarter historical loan loss average to be more indicative of the inherent losses in the Company’s loan portfolio in the current economic environment than the 4 quarter average. As the Company continues to monitor the current portfolio, the methodology could change in the future.

 

Loan impairment is reported when full repayment under the terms of the loan is not expected. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from the collateral. Commercial and industrial loans, commercial real estate loans, and agricultural loans are evaluated individually for impairment. Smaller balance homogeneous loans are evaluated for impairment in total. Such loans include real estate loans secured by one-to-four family residences and loans to individuals for household, family and other personal expenditures. Individually evaluated loans on non-accrual are generally considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.

 

46
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 1 – Summary of Significant Accounting Policies (continued)

 

The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and risk classifications and is based on the actual loss history experienced by the Company over the most recent twelve quarters. This actual loss experience is supplemented with other economic factors based on the risks present for each portfolio segment. These economic factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. The following portfolio segments have been identified: Commercial Loans and Retail Loans. Commercial Loans have been classified according to the following risk characteristics: Commercial and Industrial Loans and Leases, Commercial Real Estate, and Agricultural Loans. Commercial and Industrial loans are primarily based on the cash flows of the business operations and secured by assets being financed and other assets such as accounts receivable and inventory. Commercial Real Estate Loans and Agricultural Loans are primarily based on cash flow of the borrower and their business and further secured by real estate. All types of commercial and agricultural (real estate secured and non-real estate) may also come with personal guarantees of the borrowers and business owners. Retail Loans have been classified according to the following risk characteristics: Home Equity Loans, Consumer Loans and Residential Mortgage Loans. Retail loans are generally dependent on personal income of the customer, and repayment is dependent on borrower’s personal cash flow and employment status which can be affected by general economic conditions. Additionally, collateral values may fluctuate based on the impact of economic conditions on residential real estate values and other consumer type assets such as automobiles.

 

Loans or portions of loans shall be charged off when there is a distinct probability of loss identified. A distinct probability of loss exists when it has been determined that any remaining sources of repayment are insufficient to cover all outstanding principal. The probable loss is immediately calculated based on the value of the remaining sources of repayment and charged to the allowance for loan loss.

 

Federal Home Loan Bank (FHLB) Stock

The Bank is a member of the FHLB of Indianapolis. Members are required to own a certain amount of stock based on the level of borrowings and other factors, and may invest in additional amounts. FHLB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.

 

Premises, Furniture and Equipment

Land is carried at cost. Premises, furniture, and equipment are stated at cost less accumulated depreciation. Buildings and related components are depreciated using the straight-line method with useful lives ranging generally from 10 to 40 years. Furniture, fixtures, and equipment are depreciated using the straight-line method with useful lives ranging generally from 3 to 10 years.

 

Other Real Estate

Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.

 

Goodwill and Other Intangible Assets

Goodwill resulting from business combinations prior to January 1, 2009 represents the excess of the purchase price over the fair value of the net assets of businesses acquired. Goodwill resulting from business combinations after January 1, 2009, is generally determined as the excess of the fair value of the consideration transferred, plus the fair value of any noncontrolling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but tested for impairment at least annually. The Company has selected December 31 as the date to perform the annual impairment test. Intangible assets with definite useful lives are amortized over their estimated useful lives to their estimated residual values. Goodwill is the only intangible asset with an indefinite life on the Company’s balance sheet.

 

Other intangible assets consist of core deposit and acquired customer relationship intangible assets. They are initially measured at fair value and then are amortized over their estimated useful lives, which range from 6 to 10 years.

 

47
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 1 – Summary of Significant Accounting Policies (continued)

 

Company Owned Life Insurance

The Company has purchased life insurance policies on certain directors and executives. This life insurance is recorded at its cash surrender value or the amount that can be realized, which considers any adjustments or changes that are probable at settlement.

 

Loss Contingencies

Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe currently that there are any such matters that will have a material impact on the financial statements.

 

Loan Commitments and Related Financial Instruments

Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.

 

Restrictions on Cash

At December 31, 2013 and 2012, respectively, the Company was required to have $7,431 and $10,752 on deposit with the Federal Reserve, or as cash on hand.

 

Long-term Assets

Premises and equipment, core deposit and other intangible assets, and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

 

Stock Based Compensation

Compensation cost is recognized for stock options and restricted stock awards issued to employees and directors, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Corporation’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period.

 

Comprehensive Income

Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale and changes in unrecognized amounts in pension and other postretirement benefits, which are also recognized as a separate component of equity.

 

Income Taxes

Deferred tax liabilities and assets are determined at each balance sheet date and are the result of differences in the financial statement and tax bases of assets and liabilities. Income tax expense is the amount due on the current year tax returns plus or minus the change in deferred taxes. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

 

A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.

 

Retirement Plans

Pension expense under the suspended defined benefit plan is the net of interest cost, return on plan assets and amortization of gains and losses not immediately recognized. Employee 401(k) and profit sharing plan expense is the amount of matching contributions. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.

 

Earnings Per Share

Earnings per share are based on net income divided by the weighted average number of shares outstanding during the period. Diluted earnings per share show the potential dilutive effect of additional common shares issuable under the Company’s stock based compensation plans. Earnings per share are retroactively restated for stock dividends.

 

48
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 1 – Summary of Significant Accounting Policies (continued)

 

Cash Flow Reporting

The Company reports net cash flows for customer loan transactions, deposit transactions, deposits made with other financial institutions and short-term borrowings. Cash and cash equivalents are defined to include cash on hand, demand deposits in other institutions and Federal Funds Sold.

 

Fair Values of Financial Instruments

Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in Note 14. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect the estimates.

 

New Accounting Pronouncements 

In February 2013, the FASB issued an update (ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income) impacting FASB ASC 220, Comprehensive Income.  This update requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income.  An entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.  For other amounts not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about these amounts.  This update became effective for the Company for interim and annual periods beginning after December 15, 2012 and did not have a material impact on the consolidated financial statements.

 

NOTE 2 – Securities

 

The amortized cost, unrealized gross gains and losses recognized in accumulated other comprehensive income (loss), and fair value of Securities Available-for-Sale were as follows:

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
Securities Available-for-Sale:  Cost   Gains   Losses   Value 
                 
2013                    
U.S. Treasury and Agency Securities  $20,000   $—   $(1,048)  $18,952 
Obligations of State and Political Subdivisions   112,008    2,388    (899)   113,497 
Mortgage-backed Securities – Residential   481,724    3,497    (11,991)   473,230 
Equity Securities   353    —    —    353 
Total  $614,085   $5,885   $(13,938)  $606,032 
                     
2012                    
U.S. Treasury and Agency Securities  $23,570   $40   $(138)  $23,472 
Obligations of State and Political Subdivisions   71,352    5,145    (12)   76,485 
Mortgage-backed Securities - Residential   475,452    11,505    (45)   486,912 
Equity Securities   684    49    —    733 
Total  $571,058   $16,739   $(195)  $587,602 

 

The carrying amount, unrecognized gains and losses and fair value of Securities Held-to-Maturity were as follows:

 

       Gross   Gross     
   Carrying   Unrecognized   Unrecognized   Fair 
Securities Held-to-Maturity:  Amount   Gains   Losses   Value 
                 
2013                    
Obligations of State and Political Subdivisions  $268   $3   $—   $271 
                     
2012                    
Obligations of State and Political Subdivisions  $346   $5   $—   $351 

 

49
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 2 – Securities (continued)

 

The amortized cost and fair value of Securities at December 31, 2013 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because some issuers have the right to call or prepay certain obligations with or without call or prepayment penalties. Mortgage-backed and Equity Securities are not due at a single maturity date and are shown separately.

 

   Amortized   Fair 
   Cost   Value 
Securities Available-for-Sale:          
Due in one year or less  $2,935   $2,996 
Due after one year through five years   9,890    10,038 
Due after five years through ten years   69,906    69,802 
Due after ten years   49,277    49,613 
Mortgage-backed Securities - Residential   481,724    473,230 
Equity Securities   353    353 
Total  $614,085   $606,032 

 

   Carrying   Fair 
   Amount   Value 
Securities Held-to-Maturity:          
Due in one year or less  $—   $— 
Due after one year through five years   268    271 
Due after five years through ten years   —    — 
Due after ten years   —    — 
Total  $268   $271 

 

Proceeds from the Sales of Securities are summarized below: 

   2013   2012   2011 
   Available-   Available-   Available- 
   for-Sale   for-Sale   for-Sale 
             
Proceeds from Sales  $162,344   $92,344   $20,061 
Gross Gains on Sales   2,086    1,667    2,089 
                
Income Taxes on Gross Gains   730    583    721 

 

The Company held a minority interest in United Commerce Bancorp prior to the acquisition on October 1, 2013. For the year ended December 31, 2013, the Company recognized a gain of $343 on the stock held of United Commerce Bancorp as a result of the acquisition.

 

The Company held a minority interest in American Community Bancorp, Inc. prior to the acquisition on January 1, 2011. For the year ended December 31, 2011, the Company recognized a gain of $1.045 million on the stock held of American Community Bancorp, Inc. as a result of the acquisition.

 

The carrying value of securities pledged to secure repurchase agreements, public and trust deposits, and for other purposes as required by law was $141,240 and $61,744 as of December 31, 2013 and 2012, respectively.

 

50
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 2 – Securities (continued)

 

Below is a summary of securities with unrealized losses as of year-end 2013 and 2012, presented by length of time the securities have been in a continuous unrealized loss position:

 

   Less than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
At December 31, 2013                              
U.S. Treasury and Agency Securities  $18,952   $(1,048)  $—   $—   $18,952   $(1,048)
Obligations of State and Political Subdivisions   38,878    (899)   —    —    38,878    (899)
Mortgage-backed Securities - Residential   346,028    (11,903)   1,735    (88)   347,763    (11,991)
Equity Securities   —    —    —    —    —    — 
Total  $403,858   $(13,850)  $1,735   $(88)  $405,593   $(13,938)

 

   Less than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Loss   Value   Loss   Value   Loss 
At December 31, 2012                              
U.S. Treasury and Agency Securities  $19,862   $(138)  $—   $—   $19,862   $(138)
Obligations of State and Political Subdivisions   1,042    (12)   —    —    1,042    (12)
Mortgage-backed Securities - Residential   18,323    (45)   —    —    18,323    (45)
Equity Securities   —    —    —    —    —    — 
Total  $39,227   $(195)  $—   $—   $39,227   $(195)

 

Securities are written down to fair value when a decline in fair value is not considered temporary. In estimating other-than-temporary losses, 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 intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The Company doesn’t intend to sell or expect to be required to sell these securities, and the decline in fair value is largely due to changes in market interest rates, therefore, the Company does not consider these securities to be other-than-temporarily impaired. All mortgage-backed securities in the Company’s portfolio are guaranteed by government sponsored entities, are investment grade, and are performing as expected.

 

The Company’s equity securities consist of non-controlling investments in other banking organizations. When a decline in fair value below cost is deemed to be other-than-temporary, the unrealized loss must be recognized as a charge to earnings. At December 31, 2013 and 2012, none of the Company’s equity securities had an unrealized loss.

 

NOTE 3 – Derivatives

 

The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. The notional amounts of these interest rate swaps and the offsetting counterparty derivative instruments were $17.9 million and $6.1 million at December 31, 2013 and 2012, respectively. These interest rate swaps are simultaneously hedged by offsetting interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions with approved, reputable, independent counterparties with substantially matching terms. The agreements are considered stand alone derivatives and changes in the fair value of derivatives are reported in earnings as non-interest income.

 

Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. The Company’s exposure is limited to the replacement value of the contracts rather than the notional, principal or contract amounts. There are provisions in the agreements with the counterparties that allow for certain unsecured credit exposure up to an agreed threshold. Exposures in excess of the agreed thresholds are collateralized. In addition, the Company minimizes credit risk through credit approvals, limits, and monitoring procedures.

 

51
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 3 – Derivatives (continued)

 

The following table reflects the fair value hedges included in the Consolidated Balance Sheets as of December 31:

 

   2013   2012 
   Notional       Notional     
   Amount   Fair Value   Amount   Fair Value 
Included in Other Assets:                    
Interest Rate Swaps  $17,853   $866   $6,051   $187 
                     
Included in Other Liabilities:                    
Interest Rate Swaps  $17,853   $737   $6,051   $178 

 

 

The following tables present the effect of derivative instruments on the Consolidated Statement of Income for the years ended December 31, 2013, 2012 and 2011 are as follows: 

   2013   2012   2011 
Interest Rate Swaps:               
Included in Interest Income / (Expense)  $—   $—   $— 
Included in Other Income / (Expense)   528    163    — 

 

NOTE 4 – Loans

 

Loans were comprised of the following classifications at December 31: 

   2013   2012 
Commercial:          
Commercial and Industrial Loans and Leases  $350,955   $335,373 
Commercial Real Estate Loans   582,066    488,496 
Agricultural Loans   192,880    179,906 
Retail:          
Home Equity Loans   81,504    74,437 
Consumer Loans   49,124    41,103 
Residential Mortgage Loans   128,683    88,586 
Subtotal   1,385,212    1,207,901 
Less: Unearned Income   (2,830)   (3,035)
  Allowance for Loan Losses   (14,584)   (15,520)
Loans, net  $1,367,798   $1,189,346 

 

52
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

The following tables present the activity in the allowance for loan losses by portfolio class for the years ended December 31, 2013, 2012 and 2011:

 

   Commercial                             
   and                             
   Industrial   Commercial       Home       Residential         
   Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage         
   Leases   Loans   Loans   Loans   Loans   Loans   Unallocated   Total 
December 31, 2013                                        
Beginning Balance  $4,555   $8,931   $989   $141   $214   $186   $504   $15,520 
Provision for Loan Losses   (197)   (160)   (43)   419    112    111    108    350 
Recoveries   128    102    —    —    148    8    —    386 
Loans Charged-off   (503)   (538)   —    (321)   (286)   (24)   —    (1,672)
Ending Balance  $3,983   $8,335   $946   $239   $188   $281   $612   $14,584 

 

   Commercial                             
   and                             
   Industrial   Commercial       Home       Residential         
   Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage         
   Leases   Loans   Loans   Loans   Loans   Loans   Unallocated   Total 
December 31, 2012                                        
Beginning Balance  $3,493   $9,297   $926   $258   $190   $402   $746   $15,312 
Provision for Loan Losses   1,150    1,326    63    (32)   194    (47)   (242)   2,412 
Recoveries   74    97    —    2    123    30    —    326 
Loans Charged-off   (162)   (1,789)   —    (87)   (293)   (199)   —    (2,530)
Ending Balance  $4,555   $8,931   $989   $141   $214   $186   $504   $15,520 

 

   Commercial                             
   and                             
   Industrial   Commercial       Home       Residential         
   Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage         
   Leases   Loans   Loans   Loans   Loans   Loans   Unallocated   Total 
December 31, 2011                                        
Beginning Balance  $3,713   $7,497   $750   $220   $362   $543   $232   $13,317 
Provision for Loan Losses   1,195    4,265    176    287    23    340    514    6,800 
Recoveries   98    139    —    6    125    16    —    384 
Loans Charged-off   (1,513)   (2,604)   —    (255)   (320)   (497)   —    (5,189)
Ending Balance  $3,493   $9,297   $926   $258   $190   $402   $746   $15,312 

 

In determining the adequacy of the allowance for loan loss, general allocations are made for pools of loans, including non-classified loans, homogeneous portfolios of consumer and residential real estate loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a three-year historical average for loan losses for these portfolios, judgmentally adjusted for current economic factors and portfolio trends. For 2012 and 2011, the Company utilized a 4 quarter rolling historical loan loss average. Beginning in 2013, management deemed a rolling 12 quarter historical loan loss average to be more indicative of the inherent losses in the Company’s loan portfolio in the current economic environment than the 4 quarter average. This change in methodology resulted in an increase to the required loan loss allowance of approximately $280 in 2013.

 

53
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

Loan impairment is reported when full repayment under the terms of the loan is not expected. This methodology is used for all loans, including loans acquired with deteriorated credit quality. For purchased loans, the assessment is made at the time of acquisition as well as over the life of loan. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from the collateral. Commercial and industrial loans, commercial real estate loans, and agricultural loans are evaluated individually for impairment. Smaller balance homogeneous loans are evaluated for impairment in total. Such loans include real estate loans secured by one-to-four family residences and loans to individuals for household, family and other personal expenditures. Individually evaluated loans on non-accrual are generally considered impaired. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

 

The following tables present the balance in the allowance for loan losses and the recorded investment in loans by portfolio class and based on impairment method as of December 31, 2013 and 2012:

 

       Commercial                         
       and                         
       Industrial   Commercial       Home       Residential     
       Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage     
December 31, 2013  Total   Leases   Loans   Loans   Loans   Loans   Loans   Unallocated 
Allowance for Loan Losses:                                        
Ending Allowance Balance Attributable to Loans:                                        
Individually Evaluated for Impairment  $3,095   $45   $3,050   $—   $—   $—   $—   $— 
Collectively Evaluated for Impairment   11,481    3,938    5,277    946    239    188    281    612 
Acquired with Deteriorated Credit Quality   8    —    8    —    —    —    —    — 
Total Ending Allowance Balance  $14,584   $3,983   $8,335   $946   $239   $188   $281   $612 
                                         
Loans:                                        
Loans Individually Evaluated for Impairment  $8,458   $2,114   $6,344   $—   $—   $—   $—   $— 
Loans Collectively Evaluated for Impairment   1,367,591    347,808    566,389    195,171    81,812    49,131    127,280    — 
Loans Acquired with Deteriorated Credit Quality   14,753    1,981    10,871    —    —    134    1,767    — 
Total Ending Loans Balance (1)  $1,390,802   $351,903   $583,604   $195,171   $81,812   $49,265   $129,047   $— 

 

(1) Total recorded investment in loans includes $5,590 in accrued interest.

 

54
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

       Commercial                         
       and                         
       Industrial   Commercial       Home       Residential     
       Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage     
December 31, 2012  Total   Leases   Loans   Loans   Loans   Loans   Loans   Unallocated 
Allowance for Loan Losses:                                        
Ending Allowance Balance Attributable to Loans:                                        
Individually Evaluated  for Impairment  $5,323   $1,279   $3,894   $150   $—   $—   $—   $— 
Collectively Evaluated for Impairment   10,109    3,208    5,017    839    141    214    186    504 
Acquired with Deteriorated Credit Quality   88    68    20    —    —    —    —    — 
Total Ending Allowance Balance  $15,520   $4,555   $8,931   $989   $141   $214   $186   $504 
                                         
Loans:                                        
Loans Individually Evaluated for Impairment  $12,520   $2,547   $7,550   $2,423   $—   $—   $—   $— 
Loans Collectively Evaluated for Impairment   1,189,729    331,920    473,209    180,152    74,699    41,083    88,666    — 
Loans Acquired with Deteriorated Credit Quality   11,174    1,840    9,037    —    —    148    149    — 
Total Ending Loans Balance (1)  $1,213,423   $336,307   $489,796   $182,575   $74,699   $41,231   $88,815   $— 

 

(1) Total recorded investment in loans includes $5,522 in accrued interest.

 

The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2013 and 2012:

 

   Unpaid       Allowance for 
   Principal   Recorded   Loan Losses 
   Balance(1)   Investment   Allocated 
December 31, 2013               
With No Related Allowance Recorded:               
Commercial and Industrial Loans and Leases  $2,163   $2,072   $— 
Commercial Real Estate Loans   4,710    2,383    — 
Agricultural Loans   —    —    — 
Subtotal   6,873    4,455    — 
With An Allowance Recorded:               
Commercial and Industrial Loans and Leases   45    45    45 
Commercial Real Estate Loans   4,428    4,417    3,058 
Agricultural Loans   —    —    — 
Subtotal   4,473    4,462    3,103 
Total  $11,346   $8,917   $3,103 
                
Loans Acquired With Deteriorated Credit Quality With No Related Allowance Recorded (Included in the Total Above)  $987   $451   $— 
Loans Acquired With Deteriorated Credit Quality With An Additional Allowance Recorded (Included in the Total Above)  $33   $8   $8 

 

(1) Unpaid Principal Balance is the remaining contractual payments inclusive of partial charge-offs.

 

55
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

   Unpaid       Allowance for 
   Principal   Recorded   Loan Losses 
   Balance(1)   Investment   Allocated 
December 31, 2012               
With No Related Allowance Recorded:               
Commercial and Industrial Loans and Leases  $108   $87   $— 
Commercial Real Estate Loans   4,312    2,154    — 
Agricultural Loans   2,126    2,137    — 
Subtotal   6,546    4,378    — 
With An Allowance Recorded:               
Commercial and Industrial Loans and Leases   2,642    2,581    1,347 
Commercial Real Estate Loans   5,579    5,418    3,914 
Agricultural Loans   285    286    150 
Subtotal   8,506    8,285    5,411 
Total  $15,052   $12,663   $5,411 
                
Loans Acquired With Deteriorated Credit Quality With No Related Allowance Recorded (Included in the Total Above)  $45   $25   $— 
Loans Acquired With Deteriorated Credit Quality With An Additional Allowance Recorded (Included in the Total Above)  $155   $118   $88 

 

(1) Unpaid Principal Balance is the remaining contractual payments inclusive of partial charge-offs.

 

The following table presents loans individually evaluated for impairment by class of loans for the years ended December 31, 2013 and 2012:

 

   Average   Interest   Cash 
   Recorded   Income   Basis 
   Investment   Recognized   Recognized 
December 31, 2013               
With No Related Allowance Recorded:               
Commercial and Industrial Loans and Leases  $1,192   $65   $65 
Commercial Real Estate Loans   2,251    5    7 
Agricultural Loans   1,420    209    225 
Subtotal   4,863    279    297 
With An Allowance Recorded:               
Commercial and Industrial Loans and Leases   1,360    3    3 
Commercial Real Estate Loans   5,424    22    18 
Agricultural Loans   —    —    — 
Subtotal   6,784    25    21 
Total  $11,647   $304   $318 
                
Loans Acquired With Deteriorated Credit Quality With No Related Allowance Recorded (Included in the Total Above)  $30   $3   $3 
Loans Acquired With Deteriorated Credit Quality With An Additional Allowance Recorded (Included in the Total Above)  $142   $2   $2 

 

56
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

   Average   Interest   Cash 
   Recorded   Income   Basis 
   Investment   Recognized   Recognized 
December 31, 2012               
With No Related Allowance Recorded:               
Commercial and Industrial Loans and Leases  $252   $3   $3 
Commercial Real Estate Loans   4,506    18    18 
Agricultural Loans   535    2    2 
Subtotal   5,293    23    23 
With An Allowance Recorded:               
Commercial and Industrial Loans and Leases   2,726    9    8 
Commercial Real Estate Loans   6,660    23    19 
Agricultural Loans   74    —    — 
Subtotal   9,460    32    27 
Total  $14,753   $55   $50 
                
Loans Acquired With Deteriorated Credit Quality With No Related Allowance Recorded (Included in the Total Above)  $26   $2   $2 
Loans Acquired With Deteriorated Credit Quality With An Additional Allowance Recorded (Included in the Total Above)  $154   $6   $4 

 

   Average   Interest   Cash 
   Recorded   Income   Basis 
   Investment   Recognized   Recognized 
December 31, 2011               
With No Related Allowance Recorded:               
Commercial and Industrial Loans and Leases  $1,107   $9   $9 
Commercial Real Estate Loans   4,438    75    75 
Agricultural Loans   19    6    6 
Subtotal   5,564    90    90 
With An Allowance Recorded:               
Commercial and Industrial Loans and Leases   3,642    11    11 
Commercial Real Estate Loans   9,390    37    34 
Agricultural Loans   —    —    — 
Subtotal   13,032    48    45 
Total  $18,596   $138   $135 
                
Loans Acquired With Deteriorated Credit Quality With No Related Allowance Recorded (Included in the Total Above)  $28   $4   $4 
Loans Acquired With Deteriorated Credit Quality With An Additional Allowance Recorded (Included in the Total Above)  $77   $1   $1 

 

All classes of loans, including loans acquired with deteriorated credit quality, are generally placed on non-accrual status when scheduled principal or interest payments are past due for 90 days or more or when the borrower’s ability to repay becomes doubtful. For purchased loans, the determination is made at the time of acquisition as well as over the life of the loan. Uncollected accrued interest for each class of loans is reversed against income at the time a loan is placed on non-accrual. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. All classes of loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured. Loans are typically charged-off at 180 days past due, or earlier if deemed uncollectible. Exceptions to the non-accrual and charge-off policies are made when the loan is well secured and in the process of collection.

 

57
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

The following table presents the recorded investment in non-accrual loans and loans past due 90 days or more still on accrual by class of loans as of December 31, 2013 and 2012:

 

           Loans Past Due 
           90 Days or More 
   Non-Accrual   & Still Accruing 
   2013   2012   2013   2012 
Commercial and Industrial Loans and Leases  $31   $2,480   $—   $— 
Commercial Real Estate Loans   6,658    7,275    8    — 
Agricultural Loans   —    —    —    — 
Home Equity Loans   114    178    —    — 
Consumer Loans   236    167    —    — 
Residential Mortgage Loans   1,339    257    —    — 
Total  $8,378   $10,357   $8   $— 

Loans Acquired With Deteriorated Credit Quality
(Included in the Total Above)

  $1,705   $148   $—   $— 

 

The following table presents the aging of the recorded investment in past due loans by class of loans as of December 31, 2013 and 2012:

 

               90 Days         
       30-59 Days   60-89 Days   or More   Total   Loans Not 
   Total   Past Due   Past Due   Past Due   Past Due   Past Due 
December 31, 2013                              
Commercial and Industrial Loans and Leases  $351,903   $256   $78   $—   $334   $351,569 
Commercial Real Estate Loans   583,604    613    62    2,234    2,909    580,695 
Agricultural Loans   195,171    62    —    —    62    195,109 
Home Equity Loans   81,812    303    33    114    450    81,362 
Consumer Loans   49,265    149    66    102    317    48,948 
Residential Mortgage Loans   129,047    2,206    192    1,115    3,513    125,534 
Total (1)   $1,390,802   $3,589   $431   $3,565   $7,585   $1,383,217 
Loans Acquired With Deteriorated Credit Quality
(Included in the Total Above)		  $14,753   $148   $—   $1,103   $1,251   $13,502 

 

(1) Total recorded investment in loans includes $5,590 in accrued interest.

 

               90 Days         
       30-59 Days   60-89 Days   or More   Total   Loans Not 
   Total   Past Due   Past Due   Past Due   Past Due   Past Due 
December 31, 2012                              
Commercial and Industrial Loans and Leases  $336,307   $436   $133   $448   $1,017   $335,290 
Commercial Real Estate Loans   489,796    1,352    —    2,063    3,415    486,381 
Agricultural Loans   182,575    42    14    —    56    182,519 
Home Equity Loans   74,699    177    48    178    403    74,296 
Consumer Loans   41,231    431    23    18    472    40,759 
Residential Mortgage Loans   88,815    2,070    495    257    2,822    85,993 
Total (1)   $1,213,423   $4,508   $713   $2,964   $8,185   $1,205,238 
Loans Acquired With Deteriorated Credit Quality
(Included in the Total Above)		  $11,174   $—   $120   $—   $120   $11,054 

 

(1) Total recorded investment in loans includes $5,522 in accrued interest.

 

Troubled Debt Restructurings:

 

In certain instances, the Company may choose to restructure the contractual terms of loans. A troubled debt restructuring occurs when the Bank grants a concession to the borrower that it would not otherwise consider due to a borrower’s financial difficulty. In order to determine whether a borrower is experiencing financial difficulty, an evaluation is performed of the probability that the borrower will be in payment default on any of its debt in the foreseeable future without modification. This evaluation is performed under the Company’s internal underwriting policy. The Company uses the same methodology for loans acquired with deteriorated credit quality as for all other loans when determining whether the loan is a troubled debt restructuring.

 

58
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

During the years ended December 31, 2013 and 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan. There were no troubled debt restructurings for the years ended December 31, 2013 and 2012 for loans acquired with deteriorated credit quality at the time of acquisition.

 

The following table presents the recorded investment of troubled debt restructurings by class of loans as of December 31, 2013 and 2012:

 

   Total   Performing   Non-Accrual(1) 
December 31, 2013               
Commercial and Industrial Loans and Leases  $2,092   $2,086   $6 
Commercial Real Estate Loans   4,325    364    3,961 
Total  $6,417   $2,450   $3,967 

 

   Total   Performing   Non-Accrual(1) 
December 31, 2012               
Commercial and Industrial Loans and Leases  $2,461   $66   $2,395 
Commercial Real Estate Loans   6,031    304    5,727 
Total  $8,492   $370   $8,122 

 

(1) The non-accrual troubled debt restructurings are included in the Non-Accrual Loan table presented on previous page.

 

The Company has committed to lending an additional amount of $40 as of December 31, 2013 to customers with outstanding loans that are classified as troubled debt restructurings. The Company had not committed to lending any additional amounts as of December 31, 2012 to customers with outstanding loans that are classified as troubled debt restructurings.

 

The following table presents loans by class modified as troubled debt restructurings that occurred during the year ending December 31, 2013, 2012 and 2011:

 

                                            Pre-Modification   Post-Modification 
  

Number of

   Outstanding Recorded   Outstanding Recorded 
December 31, 2013 

Loans

   Investment   Investment 
Commercial and Industrial Loans and Leases   1   $224   $230 
Commercial Real Estate Loans   1    81    118 
Total   2   $305   $348 

 

The troubled debt restructurings described above decreased the allowance for loan losses by $210 and resulted in charge-offs of $0 during the year ending December 31, 2013.

 

                                            Pre-Modification   Post-Modification 
   Number of   Outstanding Recorded   Outstanding Recorded 
December 31, 2012  Loans   Investment   Investment 
Commercial and Industrial Loans and Leases   2   $9   $9 
Commercial Real Estate Loans   —    —    — 
Total   2   $9   $9 

 

The troubled debt restructurings described above increased the allowance for loan losses by $0 and resulted in charge-offs of $0 during the year ending December 31, 2012.

 

                                            Pre-Modification   Post-Modification 
   Number of   Outstanding Recorded   Outstanding Recorded 
December 31, 2011  Loans   Investment   Investment 
Commercial and Industrial Loans and Leases   4   $4,541   $4,499 
Commercial Real Estate Loans   6    7,099    6,850 
Total   10   $11,640   $11,349 

 

The troubled debt restructurings described above increased the allowance for loan losses by $1,945 and resulted in charge-offs of $834 during the year ending December 31, 2011.

 

59
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

The following tables present loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the years ending December 31, 2013, 2012 and 2011:

 

Troubled Debt Restructurings That Subsequently Defaulted:  Number of Loans   Recorded Investment 
December 31, 2013                  
Commercial and Industrial Loans and Leases   —   $— 
Commercial Real Estate Loans   —    — 
Total   —   $— 

 

The troubled debt restructurings that subsequently defaulted described above resulted in no change to the allowance for loan losses and no charge-offs during the year ending December 31, 2013.

 

Troubled Debt Restructurings That Subsequently Defaulted:  Number of Loans   Recorded Investment 
December 31, 2012          
Commercial and Industrial Loans and Leases   1   $565 
Commercial Real Estate Loans   3    1,377 
Total   4   $1,942 

 

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $12 and resulted in charge-offs of $306 during the year ending December 31, 2012.

 

Troubled Debt Restructurings That Subsequently Defaulted:  Number of Loans   Recorded Investment 
December 31, 2011          
Commercial and Industrial Loans and Leases   1   $527 
Commercial Real Estate Loans   —    — 
Total   1   $527 

 

The troubled debt restructurings that subsequently defaulted described above decreased the allowance for loan losses by $500 and resulted in charge-offs of $500 during the year ending December 31, 2011.

 

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

 

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. The Company classifies loans as to credit risk by individually analyzing loans. This analysis includes commercial and industrial loans, commercial real estate loans, and agricultural loans with an outstanding balance greater than $100. This analysis is typically performed on at least an annual basis. 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 institution’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 institution 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.

 

60
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

 

       Special             
   Pass   Mention   Substandard   Doubtful   Total 
December 31, 2013                         
Commercial and Industrial Loans and Leases  $324,685   $15,485   $11,733   $—   $351,903 
Commercial Real Estate Loans   539,533    20,168    23,903    —    583,604 
Agricultural Loans   192,609    2,357    205    —    195,171 
Total  $1,056,827   $38,010   $35,841   $—   $1,130,678 
Loans Acquired with Deteriorated Credit Quality
(Included in the Total Above)		  $3,121   $661   $9,070   $—   $12,852 

 

       Special             
   Pass   Mention   Substandard   Doubtful   Total 
December 31, 2012                         
Commercial and Industrial Loans and Leases  $307,997   $14,441   $13,869   $—   $336,307 
Commercial Real Estate Loans   446,639    21,338    21,819    —    489,796 
Agricultural Loans   176,730    2,855    2,990    —    182,575 
Total  $931,366   $38,634   $38,678   $—   $1,008,678 
Loans Acquired with Deteriorated Credit Quality
(Included in the Total Above)		  $319   $3,220   $7,338   $—   $10,877 

 

The Company considers the performance of the loan portfolio and its impact on the allowance for loan losses. For home equity, consumer and residential mortgage loan classes, the Company also evaluates credit quality based on the aging status of the loan, which was previously presented, and by payment activity. The following table presents the recorded investment in home equity, consumer and residential mortgage loans based on payment activity as of December 31, 2013 and 2012:

 

   Home Equity   Consumer   Residential 
   Loans   Loans   Mortgage Loans 
December 31, 2013               
Performing  $81,698   $49,029   $127,708 
Nonperforming   114    236    1,339 
Total  $81,812   $49,265   $129,047 
Loans Acquired with Deteriorated Credit Quality
(Included in the Total Above)		  $—   $134   $1,767 

 

   Home Equity   Consumer   Residential 
   Loans   Loans   Mortgage Loans 
December 31, 2012               
Performing  $74,521   $41,064   $88,558 
Nonperforming   178    167    257 
Total  $74,699   $41,231   $88,815 
Loans Acquired with Deteriorated Credit Quality
(Included in the Total Above)		  $—   $148   $149 

 

The following table presents financing receivables purchased during the year ended December 31, 2013 by portfolio class (for further discussion, see Note 17 Business Combinations, Goodwill and Intangible Assets):

 

   Commercial                         
   and                         
   Industrial   Commercial       Home       Residential     
   Loans and   Real Estate   Agricultural   Equity   Consumer   Mortgage     
   Leases   Loans   Loans   Loans   Loans   Loans   Total 
                                    
Purchases  $6,399   $47,021   $769   $4,536   $1,666   $19,184   $79,575 

 

61
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 4 – Loans (continued)

 

The Company has purchased loans, for which there was, at acquisition, evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected. The recorded investment of those loans at December 31, is as follows:

 

   2013   2012   2011 
Commercial and Industrial Loans  $1,981   $1,840   $2,596 
Commercial Real Estate Loans   10,871    9,037    13,209 
Home Equity Loans   —    —    — 
Consumer Loans   134    148    164 
Residential Mortgage Loans   1,767    149    152 
Total  $14,753   $11,174   $16,121 
                
Carrying Amount, Net of Allowance  $14,745   $11,086   $16,044 

 

Accretable yield, or income expected to be collected, is as follows:

 

   2013   2012   2011 
Balance at January 1  $170   $967   $— 
New Loans Purchased   2,885    —    2,042 
Accretion of Income   (265)   (1,265)   (1,130)
Reclassifications from Non-accretable Difference   —    468    129 
Charge-off of Accretable Yield   —    —    (74)
Balance at December 31  $2,790   $170   $967 

 

For those purchased loans disclosed above, the Company increased the allowance for loan losses by $0, $88 and $77 for the years ended December 31, 2013, 2012 and 2011. No allowances for loan losses were reversed during the same period.

 

Contractually required payments receivable of loans purchased during the years ended December 31:

 

   2013   2012   2011 
Commercial and Industrial Loans  $401   $—   $4,542 
Commercial Real Estate Loans   6,640    —    19,260 
Home Equity Loans   —    —    28 
Consumer Loans   —    —    217 
Residential Mortgage Loans   3,684    —    458 
Total  $10,725   $—   $24,505 
                
Cash Flows Expected to be Collected at Acquisition  $7,642   $—   $19,695 
Fair Value of Acquired Loans at Acquisition   6,252    —    17,653 

 

Certain directors, executive officers, and principal shareholders of the Company, including their immediate families and companies in which they are principal owners, were loan customers of the Company during 2013. A summary of the activity of these loans follows:

 

Balance       Changes           Balance 
January 1,       in Persons   Deductions   December 31, 
2013   Additions   Included   Collected   Charged-off   2013 
                            
$9,002   $5,426   $1,290   $(5,387)  $—   $10,331 

 

62
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 5 – Premises, Furniture, and Equipment

 

Premises, furniture, and equipment was comprised of the following classifications at December 31:

 

   2013   2012 
         
Land  $8,366   $7,948 
Buildings and Improvements   47,677    43,706 
Furniture and Equipment   21,544    19,584 
Total Premises, Furniture and Equipment   77,587    71,238 
Less:  Accumulated Depreciation   (37,157)   (34,684)
Total  $40,430   $36,554 

 

Depreciation expense was $2,910, $2,941 and $3,261 for 2013, 2012 and 2011, respectively.

 

The Company leases three of its branch buildings under a capital lease. These lease arrangements require monthly payments through 2033. The Company has included the leases in buildings and improvements as follows:

 

   2013   2012 
         
Capital Leases  $3,896   $2,442 
Less: Accumulated Depreciation   (483)   (344)
Total  $3,413   $2,098 

 

The following is a schedule of future minimum lease payments under the capitalized leases, together with the present value of net minimum lease payments at year end 2013:

 

2014  $495 
2015   495 
2016   495 
2017   495 
2018   465 
Thereafter   6,216 
Total minimum lease payments   8,661 
Less: Amount representing interest   (4,931)
Present Value of Net Minimum Lease Payments  $3,730 

 

NOTE 6 – Deposits

 

At year end 2013, stated maturities of time deposits were as follows:

 

2014  $174,109 
2015   66,131 
2016   76,207 
2017   17,943 
2018   14,465 
Thereafter   179 
Total  $349,034 

 

Time deposits of $100 or more and brokered deposits at December 31, 2013 and 2012 were $124,673 and $95,761, respectively.

 

Time deposits originated from outside the geographic area, generally through brokers, totaled $1,648 and $0 at December 31, 2013 and 2012, respectively.

 

63
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 7 – FHLB Advances and Other Borrowings

 

The Company’s funding sources include Federal Home Loan Bank advances, borrowings from other third party correspondent financial institutions, issuance and sale of subordinated debt and other capital securities, and repurchase agreements. Information regarding each of these types of borrowings or other indebtedness is as follows:

 

   December 31, 
   2013   2012 
         
Long-term Advances from Federal Home Loan Bank collateralized by qualifying mortgages, investment securities, and mortgage-backed securities  $71,483   $51,526 
Term Loans   7,000    1,500 
Junior Subordinated Debentures assumed from American Community Bancorp, Inc.   5,024    4,874 
Subordinated Debentures   —    29,250 
Capital Lease Obligation   3,730    2,322 
Long-term Borrowings   87,237    89,472 
           
Overnight Variable Rate Advances from Federal Home Loan Bank collateralized by qualifying mortgages, investment securities, and mortgage-backed securities  $38,000   $48,500 
Federal Funds Purchased   —    5,400 
Repurchase Agreements   15,533    17,634 
Short-term Borrowings   53,533    71,534 
           
Total Borrowings  $140,770   $161,006 

 

Repurchase agreements, which are classified as secured borrowings, generally mature within one day of the transaction date. Repurchase agreements are reflected at the amount of cash received in connection with the transaction. The Company may be required to provide additional collateral based on the value of the underlying securities.

 

   2013   2012 
         
Average Daily Balance During the Year  $14,772   $19,813 
Average Interest Rate During the Year   0.20%   0.23%
Maximum Month-end Balance During the Year  $17,722   $24,220 
Weighted Average Interest Rate at Year-end   0.20%   0.20%

 

At December 31, 2013 interest rates on the fixed rate long-term FHLB advances ranged from 0.35% to 7.22% with a weighted average rate of 0.95%. At December 31, 2013, the Company had no advances containing options whereby the FHLB may convert a fixed rate advance to an adjustable rate advance.

 

At December 31, 2012 interest rates on the fixed rate long-term FHLB advances ranged from 0.39% to 7.22% with a weighted average rate of 2.07%. Of the $51.5 million, $30.0 million or 58% of the advances contained options whereby the FHLB may convert the fixed rate advance to an adjustable rate advance, at which time the Company may prepay the advance without penalty. The options on these advances are subject to a variety of terms including LIBOR based strike rates.

 

At December 31, 2013, the Company had an outstanding term loan with the balance of $7 million of which the original principal amount was $10 million and borrowed by the parent company in January 2013. At December 31, 2013 interest on the term loan is based upon 90-day LIBOR plus 2.875%. This term loan matures December 31, 2015. At December 31, 2013, the parent company had a $10 million line of credit with no outstanding balance. The line of credit matures December 30, 2014. Interest on the line of credit is based upon 90-day LIBOR plus 2.875% and includes an unused commitment fee of 0.25%.

 

As of December 31, 2012 long-term borrowings included a $1.5 million outstanding balance on a term loan of which was paid off in January 2013 by the parent company. At December 31, 2012 interest on the term loan was based upon 90-day LIBOR plus 3.00%.

 

64
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 7 – FHLB Advances and Other Borrowings (continued)

 

At December 31, 2012, the long-term borrowings shown above included an aggregate of $29.3 million of indebtedness represented by subordinated debentures issued by the Company’s parent company in two separate transactions. A $10 million subordinated debenture issued by the parent company to another bank bore interest based upon 90-day LIBOR plus 1.35%. 20% of the subordinated debenture was treated as Tier 2 capital for regulatory capital purposes as of December 31, 2012. This subordinated debenture was paid off in January 2013. The parent company issued $19.3 million principal amount of 8% redeemable subordinated debentures to the Company’s shareholders in April 2009. The entire principal amount of these debentures was treated as Tier 2 capital for regulatory capital purposes as of December 31, 2012. These debentures were redeemed on April 1, 2013.

 

At December 31, 2013, scheduled principal payments on long-term borrowings, excluding the capitalized lease obligation and acquired subordinated debentures (which are discussed below) are as follows:

 

2014  $43,039 
2015   24,042 
2016   45 
2017   749 
2018   10,027 
Thereafter   581 
Total  $78,483 

 

The Company assumed the obligations of junior subordinated debentures through the acquisition of American Community Bancorp, Inc. The junior subordinated debentures were issued to ACB Capital Trust I and Capital Trust II. The trusts are wholly owned by the Company. In accordance with accounting guidelines, the trusts are not consolidated with the Company’s financials, but rather the subordinated debentures are shown as borrowings. The Company guarantees payment of distributions on the trust preferred securities issued by ACB Trust I and ACB Trust II. Interest is payable on a quarterly basis. These securities qualify as Tier 1 capital (with certain limitations) for regulatory purposes. $4,871 of the junior subordinated debentures were treated as Tier 1 capital for regulatory capital purposes as of December 31, 2013. $4,725 of the junior subordinated debentures were treated as Tier 1 capital for regulatory capital purposes as of December 31, 2012. As a result of the acquisition of American Community these liabilities were recorded at fair value at the acquisition date with the discount amortizing into interest expense over the life of the liability, ultimately accreting to the issuance amount disclosed below.

 

The following table summarizes the terms of each issuance:

 

                Carrying                        
    Date of     Issuance     Amount at         Rate as of     Rate as of     Maturity  
    Issuance     Amount     December 31, 2013     Variable Rate   December 31, 2013     December 31, 2012     Date  
                                         
ACB Trust I   5/6/2005   $ 5,155   $ 3,186     90 day LIBOR + 2.15%   2.40%     2.46%     May 2035  
ACB Trust II   7/15/2005     3,093     1,838     90 day LIBOR + 1.85%   2.09%     2.16%     July 2035  

 

See also Note 5 regarding the capital lease obligation.

 

65
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 8 – Shareholders’ Equity

 

The Company and affiliate bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators about components, risk weightings, and other factors, and the regulators can lower classifications in certain cases. Failure to meet various capital requirements can initiate regulatory action that could have a direct material effect on the financial statements. Management believes as of December 31, 2013, the Company and Bank meet all capital adequacy requirements to which they are subject.

 

The prompt corrective action regulations provide five classifications, including well-capitalized, adequately capitalized, under-capitalized, significantly under-capitalized, and critically under-capitalized, although these terms are not used to represent overall financial condition. If only adequately capitalized, regulatory approval is required to accept brokered deposits. If under-capitalized, capital distributions are limited, as is asset growth and expansion, and plans for capital restoration are required.

 

At December 31, 2013, consolidated and affiliate bank actual capital and minimum required levels are presented below:

 

                   Minimum Required 
                   To Be Well- 
           Minimum Required   Capitalized Under 
           For Capital   Prompt Corrective 
   Actual   Adequacy Purposes:   Action Regulations: 
   Amount   Ratio   Amount   Ratio   Amount  Ratio 
Total Capital (to Risk Weighted Assets)                             
Consolidated  $201,233    13.07%  $123,189    8.00%    N/A   N/A 
Bank   191,714    12.46    123,099    8.00 $ 153,874   10.00%
                             
Tier 1 Capital (to Risk Weighted Assets)                             
Consolidated  $186,649    12.12%  $61,594    4.00%  N/A   N/A 
Bank   177,130    11.51    61,550    4.00 $ 92,324   6.00%
                             
Tier 1 Capital (to Average Assets)                             
Consolidated  $186,649    8.78%  $85,005    4.00%  N/A   N/A 
Bank   177,130    8.37    84,686    4.00 $ 105,857   5.00%

 

At December 31, 2012, consolidated and affiliate bank actual capital and minimum required levels are presented below:

 

                   Minimum Required 
                   To Be Well- 
           Minimum Required   Capitalized Under 
           For Capital   Prompt Corrective 
   Actual   Adequacy Purposes:   Action Regulations: 
   Amount   Ratio   Amount   Ratio   Amount  Ratio 
Total Capital (to Risk Weighted Assets)                             
Consolidated  $194,990    13.70%  $113,859    8.00%    N/A   N/A 
Bank   167,904    11.83    113,523    8.00 $ 141,904   10.00%
                             
Tier 1 Capital (to Risk Weighted Assets)                             
Consolidated  $158,198    11.12%  $56,930    4.00%  N/A   N/A 
Bank   152,384    10.74    56,762    4.00 $ 85,142   6.00%
                             
Tier 1 Capital (to Average Assets)                             
Consolidated  $158,198    8.18%  $77,317    4.00%  N/A   N/A 
Bank   152,384    7.91    77,025    4.00 $ 96,281   5.00%

 

66
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 8 – Shareholders’ Equity (continued)

 

The Company and the affiliate bank at year end 2013 and 2012 were categorized as well-capitalized. There have been no conditions or events that management believes have changed the classification of the Company or affiliate bank under the prompt corrective action regulations since the last notification from regulators. Regulations require the maintenance of certain capital levels at the affiliate bank, and may limit the dividends payable by the affiliate to the holding company, or by the holding company to its shareholders. At December 31, 2013, the affiliate bank had $39,000 in retained earnings available for payment of dividends to the parent company without prior regulatory approval.

 

Equity Plans and Equity Based Compensation

 

The Company maintains three equity incentive plans under which stock options, restricted stock, and other equity incentive awards can be granted. At December 31, 2013, the Company has reserved 438,813 shares of Common Stock (as adjusted for subsequent stock dividends and subject to further customary anti-dilution adjustments) for the purpose of issuance pursuant to outstanding and future grants of options, restricted stock, and other equity awards to officers, directors and other employees of the Company.

 

Stock Options

 

Options may be designated as “incentive stock options” under the Internal Revenue Code of 1986, or as nonqualified options. While the date after which options are first exercisable is determined by the appropriate committee of the Board of Directors of the Company or, in the case of options granted to directors, by the Board of Directors, no stock option may be exercised after ten years from the date of grant (twenty years in the case of nonqualified stock options). The exercise price of stock options granted pursuant to the plans must be no less than the fair market value of the Common Stock on the date of the grant.

 

The plans authorize an optionee to pay the exercise price of options in cash or in common shares of the Company or in some combination of cash and common shares. An optionee may tender already-owned common shares to the Company in exercise of an option. Certain of these plans authorize an optionee to surrender the value of an unexercised option in payment of an equivalent amount of the exercise price of the option. The Company typically issues authorized but unissued common shares upon the exercise of options.

 

The following table presents activity for stock options under the Company’s equity incentive plan for 2013:

 

   Year Ended December 31, 2013 
       Weighted   Weighted Average   Aggregate 
   Number of   Average Price   Life of Options   Intrinsic 
   Options   of Options   (in years)   Value 
                 
Outstanding at Beginning of Period   79,917   $16.73           
Granted   —    —           
Exercised   (8,300)   17.35           
Forfeited   —    —           
Expired   (2,100)   18.19           
Outstanding and Exercisable at End of Period   69,517   $16.61    3.43   $821 

 

The following table presents information related to stock options under the Company’s equity incentive plan during the years ended 2013, 2012 and 2011:

 

   2013   2012   2011 
Intrinsic Value of Options Exercised  $49   $203   $28 
Cash Received from Option Exercises  $—   $—   $— 
Tax Benefit of Option Exercises  $20   $78   $12 
Weighted Average Fair Value of Options Granted  $—   $—   $— 

 

The intrinsic value for stock options is calculated based on the exercise price of the underlying awards and the market price of common stock as of the reporting date.

 

67
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 8 – Shareholders’ Equity (continued)

 

During 2013, 2012 and 2011, the Company granted no options, and accordingly, recorded no stock compensation expense related to option grants. The Company recorded no other stock compensation expense applicable to options during the years ended December 31, 2013, 2012 and 2011 because all outstanding options were fully vested prior to 2007. As of December 31, 2013 and 2012, there was no unrecognized option expense as all outstanding options were fully vested.

 

Restricted Stock

 

During the periods presented, awards of long-term incentives were granted in the form of restricted stock. Awards that were granted to management under a management incentive plan were granted in tandem with cash credit entitlements (typically in the form of 50% restricted stock grants and 50% cash credit entitlements). The management restricted stock grants and tandem cash credit entitlements awarded in 2013 will vest in three equal installments of 33.3% with the first annual vesting on December 5th of the year of the grant and on December 5th of the next two succeeding years. The management restricted stock grants and tandem cash credit entitlements awarded in 2012 were subject to forfeiture in the event that the recipient of the grant did not continue employment with the Company through December 5th of the year of grant, at which time they generally vest 100 percent. Awards that were granted to directors as additional retainer for their services in December 2012 do not include any cash credit entitlement. These director restricted stock grants are subject to forfeiture in the event that the recipient of the grant does not continue in service as a director of the Company through December 5th of the year after grant or do not satisfy certain meeting attendance requirements, at which time they generally vest 100 percent. For measuring compensation costs, restricted stock awards are valued based upon the market value of the common shares on the date of grant.

 

The following table presents expense recorded for restricted stock and cash entitlements as well as the related tax effect for the years ended 2013, 2012 and 2011:

 

   2013   2012   2011 
             
Restricted Stock Expense  $329   $628   $636 
Cash Entitlement Expense   217    588    564 
Tax Effect   (221)   (493)   (475)
Net of Tax  $325   $723   $725 

 

Unrecognized expense associated with the restricted stock grants and cash entitlements totaled $942 and $101 as of December 31, 2013 and 2012. There was no unrecognized expense associated with the restricted stock grants as of December 31, 2011.

 

The following table presents information on restricted stock grants outstanding for the period shown:

 

   Year Ended 
   December 31, 2013 
       Weighted 
   Restricted   Average Market 
   Shares   Price at Grant 
         
Outstanding at Beginning of Period   4,983   $22.07 
Granted   33,031    23.41 
Issued and Vested   (14,620)   22.57 
Forfeited   (453)   22.07 
Outstanding at End of Period   22,941    23.68 

 

68
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 8 – Shareholders’ Equity (continued)

 

Employee Stock Purchase Plan

 

The Company maintains an Employee Stock Purchase Plan whereby eligible employees have the option to purchase the Company’s common stock at a discount. The purchase price of the shares under this Plan has been set at 95% of the fair market value of the Company’s common stock as of the last day of the plan year. The plan provided for the purchase of up to 500,000 shares of common stock, which the Company may obtain by purchases on the open market or from private sources, or by issuing authorized but unissued common shares. Funding for the purchase of common stock is from employee and Company contributions.

 

The Employee Stock Purchase Plan is not considered compensatory. There was no expense recorded for the employee stock purchase plan in 2013, 2012, and 2011 nor was there any unrecognized compensation expense as of December 31, 2013 and 2012 for the Employee Stock Purchase Plan.

 

Stock Repurchase Plan

 

On April 26, 2001, the Company announced that its Board of Directors approved a stock repurchase program for up to 607,754 of the outstanding Common Shares of the Company. Shares may be purchased from time to time in the open market and in large block privately negotiated transactions. The Company is not obligated to purchase any shares under the program, and the program may be discontinued at any time before the maximum number of shares specified by the program are purchased. The Board of Directors established no expiration date for this program. As of December 31, 2013, the Company had purchased 334,965 shares under the program. No shares were purchased under the program during the years ended December 31, 2013 and 2012.

 

NOTE 9 – Employee Benefit Plans

 

The Company provides a contributory trusteed 401(k) deferred compensation and profit sharing plan, which covers substantially all employees. The Company agrees to match certain employee contributions under the 401(k) portion of the plan, while profit sharing contributions are discretionary and are subject to determination by the Board of Directors. Company contributions were $882, $777, and $717 for 2013, 2012, and 2011, respectively.

 

The Company self-insures employee health benefits. Stop loss insurance covers annual losses exceeding $125 per covered family. Management’s policy is to establish a reserve for claims not submitted by a charge to earnings based on prior experience. Charges to earnings were $2,599, $1,799, and $1,620 for 2013, 2012, and 2011, respectively.

 

The Company maintains deferred compensation plans for the benefit of certain directors and officers. Under the plans, the Company agrees in return for the directors and officers deferring the receipt of a portion of their current compensation, to pay a retirement benefit computed as the amount of the compensation deferred plus accrued interest at a variable rate. Accrued benefits payable totaled $1,857 and $2,003 at December 31, 2013 and 2012. Deferred compensation expense was $173, $170, and $183 for 2013, 2012, and 2011, respectively. In conjunction with the plans, the Company purchased life insurance on certain directors and officers.

 

The Company entered into early retirement agreements with certain officers of the Company during 2008, 2009, 2010, and 2013. Accrued benefits payable as a result of the agreements totaled $337 and $298 at December 31, 2013 and 2012, respectively. Expense associated with these agreements totaled $166, $0, and $72 during 2013, 2012, and 2011, respectively. The benefits under the agreements will be paid through 2017.

 

The Company acquired through previous bank mergers a noncontributory defined benefit pension plan with benefits based on years of service and compensation prior to retirement. The benefits under the plan were suspended in 1998. This defined benefit plan was terminated in 2013 with all benefits of the plan distributed to the plan’s participants prior to December 31, 2013. The costs to terminate the defined benefit plan totaled $378 in 2013.

 

69
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 9 – Employee Benefit Plans (continued)

 

Accumulated plan benefit information for the Company’s plan as of December 31, 2013 and 2012 was as follows:

 

Changes in Benefit Obligation:  2013   2012 
Obligation at Beginning of Year  $837   $734 
Interest Cost   25    27 
Benefits Paid   (33)   (33)
Lump Sum Benefits Paid   (809)   — 
Actuarial (Gain) Loss   (62)   109 
Effect of Settlement/Curtailment   42    — 
Obligation at End of Year  $—   $837 
           
Changes in Plan Assets:          
Fair Value at Beginning of Year   399    353 
Actual Return on Plan Assets   —    1 
Employer Contributions   443    78 
Periodic Benefits Paid   (33)   (33)
Lump Sum Benefits Paid   (809)   — 
Fair Value at End of Year  $—   $399 
           
Funded Status:          
Funded Status at End of Year  $—   $(438)
           
Amounts recognized in accumulated other comprehensive income at December 31 consist of:          
    2013    2012 
Net Loss (Gain)  $—   $360 
Prior Service Cost   —    13 
   $—   $373 

 

The accumulated benefit obligation was $0 and $837 at year-end 2013 and 2012, respectively.

 

Components of Net Periodic Benefit Cost and Other Amounts Recognized in Other Comprehensive Income

 

   2013   2012   2011 
Interest Cost  $25   $27   $32 
Expected Return on Assets   (1)   (1)   (2)
Amortization of Prior Service Cost   1    1    1 
Recognition of Net Loss   46    30    31 
Net Periodic Benefit Cost  $71   $57   $62 
                
Net Loss (Gain) During the Period   (19)   110    24 
Amortization of Unrecognized Loss   (341)   (30)   (30)
Amortization of Prior Service Cost   (13)   (1)   (1)
Total Recognized in Other Comprehensive Income (Loss)   (373)   79    (7)
                
Total Recognized in Net Periodic Benefit Cost and Other Comprehensive
Income (Loss)		  $(302)  $136   $55 

 

70
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 9 – Employee Benefit Plans (continued)

 

The estimated net loss, prior service costs, and net transition obligation (asset) for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next fiscal year will be $0 as the defined benefit pension plan terminated in the current year.

 

Assumptions

 

Weighted-average assumptions used to determine benefit obligations at year-end:

   2013   2012   2011 
Discount Rate   N/A    3.25%   3.75%
Rate of Compensation Increase (1)   N/A    N/A    N/A 

 

Weighted-average assumptions used to determine net periodic pension cost:

   2013   2012   2011 
Discount Rate   3.25%   3.75%   4.60%
Expected Return on Plan Assets   0.25%   0.25%   0.50%
Rate of Compensation Increase (1)   N/A    N/A    N/A 

 

(1)Benefits under the plan were suspended in 1998; therefore, the weighted-average rate of increase in future compensation levels was not applicable for all years presented.

 

The expected return on plan assets was determined based upon rates that are expected to be available for future reinvestment of earnings and maturing investments along with consideration given to the current mix of plan assets.

 

Postretirement Medical and Life Benefit Plan

 

The Company has an unfunded postretirement benefit plan covering substantially all of its employees. The medical plan is contributory with the participants’ contributions adjusted annually; the life insurance plans are noncontributory.

 

Changes in Accumulated Postretirement Benefit Obligations:  2013   2012     
Obligation at the Beginning of Year  $691   $624      
Unrecognized Loss (Gain)   (33)   43      
                
Components of Net Periodic Postretirement Benefit Cost               
Service Cost   40    35      
Interest Cost   23    24      
                
Net Expected Benefit Payments   (50)   (35)     
Obligation at End of Year  $671   $691      
                
Components of Postretirement Benefit Expense  2013   2012   2011 
Service Cost  $40   $35   $28 
Interest Cost   23    24    25 
Amortization of Unrecognized Net (Gain) Loss   4    —    — 
Net Postretirement Benefit Expense   67    59    53 
                
Net Gain (Loss) During Period Recognized in Other Comprehensive Income   (37)   42    57 
                
Total Recognized in Net Postretirement Benefit Expense and Other Comprehensive Income  $30   $101   $110 

 

71
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 9 – Employee Benefit Plans (continued)

 

Assumptions Used to Determine Net Periodic Cost and Benefit Obligations:  2013   2012   2011 
Discount Rate   4.31%   3.41%   3.98%

 

Assumed Health Care Cost Trend Rates at Year-end:  2013   2012     
Health Care Cost Trend Rate Assumed for Next Year   8.00%   8.00%     
Rate that the Cost Trend Rate Gradually Declines to   5.00%   4.50%     
Year that the Rate Reaches the Rate it is Assumed to Remain at   2019    2019      

 

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects as of December 31, 2013:

 

   One-Percentage-Point   One-Percentage-Point 
   Increase   Decrease 
Effect on Total of Service and Interest Cost  $6   $(5)
Effect on Postretirement Benefit Obligation  $41   $(37)

 

Contributions

The Company expects to contribute $39 to its postretirement medical and life insurance plan in 2014.

 

Estimated Future Benefits

The following postretirement benefit payments, which reflect expected future service, are expected to be paid:

 

2014  $39 
2015   49 
2016   49 
2017   60 
2018   63 
2019-2023   383 

 

72
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 10 – Income Taxes

 

The provision for income taxes consists of the following:  2013   2012   2011 
             
Current Federal  $9,103   $9,649   $3,333 
Current State   648    568    184 
Deferred Federal   1,090    260    4,241 
Deferred State   623    192    (32)
Total  $11,464   $10,669   $7,726 

 

Income tax expense is reconciled to the 35% statutory rate applied to the pre-tax income for the years presented in the table below:

 

   2013   2012   2011 
             
Statutory Rate Times Pre-tax Income  $12,907   $12,153   $9,791 
Add (Subtract) the Tax Effect of:               
Income from Tax-exempt Loans and Investments   (1,157)   (1,007)   (780)
State Income Tax, Net of Federal Tax Effect   826    494    99 
General Business Tax Credits   (556)   (547)   (370)
Company Owned Life Insurance   (338)   (341)   (385)
Gain on United Commerce Bancorp Stock   (120)   —    — 
Gain on American Community Bancorp, Inc. Stock   —    —    (366)
Other Differences   (98)   (83)   (263)
Total Income Taxes  $11,464   $10,669   $7,726 

 

The net deferred tax liability at December 31 consists of the following:

 

   2013   2012     
Deferred Tax Assets:               
Allowance for Loan Losses  $4,871   $5,845      
Unrealized Loss on Securities   2,809    —      
Deferred Compensation and Employee Benefits   1,136    1,282      
Other-than-temporary Impairment   388    443      
Accrued Expenses   601    646      
Business Combination Fair Value Adjustments   847    —      
Pension and Postretirement Plans   35    195      
Other Real Estate Owned   288    140      
Non-Accrual Loan Interest Income   269    254      
Net Operating Loss Carryforward   224    —      
Other   313    279      
Total Deferred Tax Assets   11,781    9,084      
Deferred Tax Liabilities:               
Depreciation   (1,465)   (1,419)     
Leasing Activities, Net   (7,797)   (7,753)     
Unrealized Gain on Securities   —    (5,915)     
FHLB Stock Dividends   (343)   (336)     
Prepaid Expenses   (492)   (516)     
Intangibles   (804)   (359)     
Deferred Loan Fees   (460)   (394)     
Business Combination Fair Value Adjustments   —    (333)     
General Business Tax Credits   (23)   (7)     
Other   (330)   (255)     
Total Deferred Tax Liabilities   (11,714)   (17,287)     
Valuation Allowance   —    (45)     
Net Deferred Tax Asset (Liability)  $67   $(8,248)     

 

73
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 10 – Income Taxes (continued)

 

The Company held a valuation allowance at December 31, 2012 of $45. During 2013, the Company reversed the valuation allowance as the statute of limitations expired on this item. The Company has federal and state net operating loss carryforwards (acquired in the United Commerce Bancorp acquisition – See Note 17 for further discussion) of $609 (federal) and $1,420 (state). These carryforwards expire in 2032 and 2026 for federal and state purposes, respectively. The use of these federal and state carryforwards are each limited under IRC Section 382 to $538 annually.

 

Under the Internal Revenue Code, through 1996 two acquired banking companies, which are now a part of the Company’s single banking subsidiary, were allowed a special bad debt deduction related to additions to tax bad debt reserves established for the purpose of absorbing losses. The acquired banks were formerly known as Peoples Community Bank (acquired in October 2005) and First American Bank (acquired in January 1999). Subject to certain limitations, these Banks were permitted to deduct from taxable income an allowance for bad debts based on a percentage of taxable income before such deductions or actual loss experience. The Banks generally computed its annual addition to its bad debt reserves using the percentage of taxable income method; however, due to certain limitations in 1996, the Banks were only allowed a deduction based on actual loss experience.

 

Retained earnings at December 31, 2013, include approximately $2,995 for which no provision for federal income taxes has been made. This amount represents allocations of income for allowable bad debt deductions. Reduction of amounts so allocated for purposes other than tax bad debt losses will create taxable income, which will be subject to the then current corporate income tax rate. It is not contemplated that amounts allocated to bad debt deductions will be used in any manner to create taxable income. The unrecorded deferred income tax liability on the above amount at December 31, 2013 was approximately $1,048.

 

Unrecognized Tax Benefits

 

The Company had no unrecognized tax benefits as of December 31, 2013, 2012, and 2011, and did not recognize any increase in unrecognized benefits during 2013 relative to any tax positions taken in 2013. Should the accrual of any interest or penalties relative to unrecognized tax benefits be necessary, it is the Company’s policy to record such accruals in its income tax expense accounts; no such accruals existed as of December 31, 2013, 2012, and 2011. The Company and its corporate subsidiaries file a consolidated U.S. Federal income tax return, which is subject to examination for all years after 2009. The Company and its corporate subsidiaries doing business in Indiana file a combined Indiana unitary return, which is subject to examination for all years after 2009.

 

NOTE 11 – Per Share Data

 

The computation of Basic Earnings per Share and Diluted Earnings per Share are provided below:

 

   2013   2012   2011 
Basic Earnings per Share:               
Net Income  $25,413   $24,055   $20,249 
Weighted Average Shares Outstanding   12,786,065    12,622,049    12,581,646 
                
Basic Earnings per Share  $1.99   $1.91   $1.61 
                
Diluted Earnings per Share:               
Net Income  $25,413   $24,055   $20,249 
                
Weighted Average Shares Outstanding   12,786,065    12,622,049    12,581,646 
Stock Options, Net   21,613    15,694    6,102 
Diluted Weighted Average Shares Outstanding   12,807,678    12,637,743    12,587,748 
                
Diluted Earnings per Share  $1.98   $1.90   $1.61 

 

Stock options for 89,276 shares of common stock were not considered in computing diluted earnings per common share for 2011 because they were anti-dilutive. There were no anti-dilutive shares at December 31, 2013 and 2012.

 

74
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 12 – Lease Commitments

 

The total rental expense for all operating leases for the years ended December 31, 2013, 2012 and 2011 was $558, $486 and $413, respectively, including amounts paid under short-term cancelable leases.

 

The following is a schedule of future minimum lease payments for premises and equipment at year end 2013:

 

2014  $608 
2015   511 
2016   446 
2017   259 
2018   154 
Thereafter   1,508 
Total  $3,486 

 

NOTE 13 – Commitments and Off-balance Sheet Items

 

In the normal course of business, there are various commitments and contingent liabilities, such as commitments to extend credit and commitments to sell loans, which are not reflected in the accompanying consolidated financial statements. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to make loans and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policy to make commitments as it uses for on-balance sheet items.

 

The Company’s exposure to credit risk for commitments to sell loans is dependent upon the ability of the counter-party to purchase the loans. This is generally assured by the use of government sponsored entity counterparts. These commitments are subject to market risk resulting from fluctuations in interest rates. Commitments to sell loans are not mandatory (i.e., do not require net settlement with the counter-party to cancel the commitment).

 

Commitments and contingent liabilities are summarized as follows, at December 31:

 

   2013   2012 
   Fixed   Variable   Fixed   Variable 
   Rate   Rate   Rate   Rate 
Commitments to Fund Loans:                    
Consumer Lines  $8,940   $145,064   $6,013   $137,668 
Commercial Operating Lines   23,717    199,231    13,444    187,829 
Residential Mortgages   11,249    930    33,004    676 
Total Commitments to Fund Loans  $43,906   $345,225   $52,461   $326,173 
                     
Commitments to Sell Loans  $20,672   $—   $52,511   $— 
                     
Standby Letters of Credit  $1,515   $5,262   $1,408   $4,279 

 

The fixed rate commitments to fund loans have interest rates ranging from 2.15% to 18.00% and maturities ranging from less than 1 year to 32 years. Since many commitments to make loans expire without being used, these amounts do not necessarily represent future cash commitments. Collateral obtained upon exercise of the commitment is determined using management’s credit evaluation of the borrower, and may include accounts receivable, inventory, property, land, and other items.

 

75
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value

 

Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair values:

 

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:

 

Investment Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Level 3 pricing is obtained from a third-party based upon similar trades that are not traded frequently without adjustment by the Company. At December 31, 2013, the Company held $11.2 million in Level 3 securities which consist of $10.8 million of non-rated Obligations of State and Political Subdivisions and $353 thousand of equity securities that are not actively traded. Absent the credit rating, significant assumptions must be made such that the credit risk input becomes an unobservable input and thus these securities are reported by the Company in a Level 3 classification.

 

Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).

 

Impaired Loans: Fair values for impaired collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value in the cost to replace the current property. Value of market comparison approach evaluates the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Comparable sales adjustments are based on known sales prices of similar type and similar use properties and duration of time that the property has been on the market to sell. Such adjustments made in the appraisal process are typically significant and result in a Level 3 classification of the inputs for determining fair value.

 

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Company’s Risk Management Area reviews the assumptions and approaches utilized in the appraisal. In determining the value of impaired collateral dependent loans and other real estate owned, significant unobservable inputs may be used which include: physical condition of comparable properties sold, net operating income generated by the property and investor rates of return.

 

Other Real Estate: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate (ORE) 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 utilizing similar techniques as discussed above for Impaired Loans, resulting in a Level 3 classification. In cases where the carrying amount exceeds the fair value, less costs to sell, impairment loss is recognized.

 

76
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value (continued)

 

Loans Held-for-Sale: The fair values of loans held for sale are determined by using quoted prices for similar assets, adjusted for specific attributes of that loan resulting in a Level 2 classification.

 

Assets and Liabilities Measured on a Recurring Basis

 

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:

 

   Fair Value Measurements at December 31, 2013 Using 
   Quoted Prices in             
   Active Markets for   Significant Other   Significant     
   Identical Assets   Observable Inputs   Unobservable Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
Assets:                    
U.S. Treasury and Agency Securities  $—   $18,952   $—   $18,952 
Corporate Securities   —    —    —    — 
Obligations of State and Political Subdivisions   —    102,665    10,832    113,497 
Mortgage-backed Securities-Residential   —    473,230    —    473,230 
Equity Securities   —    —    353    353 
Total Securities  $ —   $594,847   $11,185   $606,032 
                     
Loans Held-for-Sale  $—   $9,265   $—   $9,265 
                     
Derivative Assets  $—   $866   $—   $866 
                     
Derivative Liabilities  $—   $737   $—   $737 

 

   Fair Value Measurements at December 31, 2012 Using 
   Quoted Prices in             
   Active Markets for   Significant Other   Significant     
   Identical Assets   Observable Inputs   Unobservable Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
Assets:                    
U.S. Treasury and Agency Securities  $—   $23,472   $—   $23,472 
Corporate Securities   —    —    —    — 
Obligations of State and Political Subdivisions   —    64,316    12,169    76,485 
Mortgage-backed Securities-Residential   —    486,912    —    486,912 
Equity Securities   380    —    353    733 
Total Securities  $380   $574,700   $12,522   $587,602 
                     
Loans Held-for-Sale  $—   $16,641   $—   $16,641 
                     
Derivative Assets  $—   $187   $—   $187 
                     
Derivative Liabilities  $—   $178   $—   $178 

 

There were no transfers between Level 1 and Level 2 for the periods ended December 31, 2013 and 2012.

 

At December 31, 2013, the aggregate fair value of the Loans Held-for-Sale was $9,265, aggregate contractual principal balance was $9,129 with a difference of $136. At December 31, 2012, the aggregate fair value of the Loans Held-for-Sale was $16,641, aggregate contractual principle balance was $16,413 with a difference of $228.

 

77
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value (continued)

 

The table below presents a reconciliation of all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2013 and 2012:

 

   Obligations of State                 
   and Political                 
   Subdivisions   Equity Securities   Corporate Securities 
   2013   2012   2013   2012   2013   2012 
                         
Beginning Balance of Recurring Level 3 Assets at January 1  $12,169   $4,075   $353   $353   $—   $1,005 
Total Gains or Losses (realized/unrealized) Included in earnings   (332)   156    —    —    —    — 
Maturities / Calls   (1,005)   —    —    —    —    (1,005)
Purchases   —    7,938    —    —    —    — 
Ending Balance of Recurring Level 3 Assets at December 31  $10,832   $12,169   $353   $353   $—   $— 

 

Of the total gain/loss included in earnings for the year ended December 31, 2013, $0 was attributable to interest income on securities and ($332) was attributable to other changes in fair value. Of the total gain/loss included in earnings for the year ended December 31, 2012, $1 was attributable to interest income on securities and $155 was attributable to other changes in fair value.

 

Assets and Liabilities Measured on a Non-Recurring Basis

 

Assets and liabilities measured at fair value on a non-recurring basis are summarized below:

 

   Fair Value Measurements at December 31, 2013 Using 
   Quoted Prices in             
   Active Markets for   Significant Other   Significant     
   Identical Assets   Observable Inputs   Unobservable Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
Assets:                    
Impaired Loans with Specific Allocations                    
Commercial and Industrial Loans  $—   $—   $—   $— 
Commercial Real Estate Loans   —    —    1,346    1,346 
Agricultural Loans   —    —    —    — 
Other Real Estate                    
Commercial Real Estate   —    —    20    20 

 

   Fair Value Measurements at December 31, 2012 Using 
   Quoted Prices in             
   Active Markets for   Significant Other   Significant     
   Identical Assets   Observable Inputs   Unobservable Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
Assets:                    
Impaired Loans with Specific Allocations                    
Commercial and Industrial Loans  $—   $—   $1,231   $1,231 
Commercial Real Estate Loans   —    —    1,497    1,497 
Agricultural Loans   —    —    135    135 
Other Real Estate                    
Commercial Real Estate   —    —    150    150 

 

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $4,449 with a valuation allowance of $3,103, resulting in an additional provision for loan losses of $1,024 for the year ended December 31, 2013. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $8,274 with a valuation allowance of $5,411, resulting in an additional provision for loan losses of $2,230 for the year ended December 31, 2012.

 

78
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value (continued)

 

Other Real Estate which is measured at the lower of carrying or fair value less costs to sell had a carrying value of $20 at December 31, 2013. A charge to earnings through Other Operating Income of $321 was included in the year ended December 31, 2013. Other Real Estate which is measured at the lower of carrying or fair value less costs to sell had a carrying value of $150 at December 31, 2012. A charge to earnings through Other Operating Income of $100 was included in the year ended December 31, 2012.

 

The following table presents quantitative information about Level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at December 31, 2013 and 2012:

 

                  Range
          Valuation       (Weighted
December 31, 2013   Fair Value     Technique(s)   Unobservable Input(s)   Average)
Impaired Loans - Commercial Real Estate Loans   $ 1,346    

Sales comparison approach

Income approach

Cost approach

  

Adjustment for physical condition of comparable properties sold

Adjustment for net operating income generated by the property

Adjustment for investor rates of return

   12%-80%
(53%)
Other Real Estate - Commercial Real Estate Loans   $ 20    

Sales comparison approach

Income approach

Cost approach

  

Adjustment for physical condition of comparable properties sold

Adjustment for net operating income generated by the property

Adjustment for investor rates of return

   50%
(50%)

 

 

                  Range
          Valuation       (Weighted
December 31, 2012   Fair Value     Technique(s)   Unobservable Input(s)   Average)
Impaired Loans - Commercial and Industrial Loans   $ 1,231     Sales comparison approach   Adjustment for differences between the comparable sales  

4%-68%

(8%)

Impaired Loans - Commercial Real Estate Loans   $ 1,497    

Sales comparison approach

Income approach

Cost approach

  

Adjustment for physical condition of comparable properties sold

Adjustment for net operating income generated by the property

Adjustment for investor rates of return

  

15%-78%

(48%)

Impaired Loans – Agricultural Loans   $ 135    

Sales comparison approach

Income approach

  

Adjustment for physical condition of comparable properties sold

Adjustment for net operating income generated by the property

  

76%

(76%)

Other Real Estate - Commercial Real Estate Loans   $ 150    

Sales comparison approach

Income approach

Cost approach

  

Adjustment for physical condition of comparable properties sold

Adjustment for net operating income generated by the property

Adjustment for investor rates of return

  

70%

(70%)

 

 

79
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value (continued)

 

The carrying amounts and estimated fair values of the Company’s financial instruments not previously presented are provided in the table below for the periods ending December 31, 2013 and 2012. Not all of the Company’s assets and liabilities are considered financial instruments, and therefore are not included in the table. Because no active market exists for a significant portion of the Company’s financial instruments, fair value estimates were based on subjective judgments, and therefore cannot be determined with precision.

 

       Fair Value Measurements at 
       December 31, 2013 Using 
   Carrying Value   Level 1   Level 2   Level 3   Total 
Financial Assets:                         
Cash and Short-term Investments  $60,232   $37,370   $22,862   $—   $60,232 
Securities Held-to-Maturity   268    —    271    —    271 
FHLB Stock and Other Restricted Stock   9,004    N/A    N/A    N/A    N/A 
Loans, Net   1,366,452    —    —    1,370,339    1,370,339 
Accrued Interest Receivable   7,470    —    1,918    5,552    7,470 
Financial Liabilities:                         
Demand, Savings, and Money Market Deposits   (1,463,122)   (1,463,122)   —    —    (1,463,122)
Time Deposits   (349,034)   —    (351,707)   —    (351,707)
Short-term Borrowings   (53,533)   —    (53,533)   —    (53,533)
Long-term Debt   (87,237)   —    (83,329)   (5,311)   (88,640)
Accrued Interest Payable   (777)   —    (732)   (45)   (777)
Unrecognized Financial Instruments:                         
Commitments to Extend Credit   —    —    —    —    — 
Standby Letters of Credit   —    —    —    —    — 
Commitments to Sell Loans   —    —    —    —    — 

 

       Fair Value Measurements at 
       December 31, 2012 Using 
   Carrying Value   Level 1   Level 2   Level 3   Total 
Financial Assets:                         
Cash and Short-term Investments  $51,794   $41,624   $10,170   $—   $51,794 
Securities Held-to-Maturity   346    —    351    —    351 
FHLB Stock and Other Restricted Stock   8,340    N/A    N/A    N/A    N/A 
Loans, Net   1,186,483    —    —    1,199,566    1,199,566 
Accrued Interest Receivable   7,419    —    1,893    5,526    7,419 
Financial Liabilities:                         
Demand, Savings, and Money Market Deposits   (1,311,748)   (1,311,748)   —    —    (1,311,748)
Time Deposits   (329,183)   —    (333,170)   —    (333,170)
Short-term Borrowings   (71,534)   —    (71,534)   —    (71,534)
Long-term Debt   (89,472)   —    (66,892)   (28,872)   (95,764)
Accrued Interest Payable   (1,275)   —    (829)   (446)   (1,275)
Unrecognized Financial Instruments:                         
Commitments to Extend Credit   —    —    —    —    — 
Standby Letters of Credit   —    —    —    —    — 
Commitments to Sell Loans   —    —    —    —    — 

 

Cash and Short-Term Investments:

The carrying amount of cash and short-term investments approximate fair values and are classified as Level 1 or Level 2.

 

Securities Held-to-Maturity:

The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2).

 

80
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 14 – Fair Value (continued)

 

FHLB Stock and Other Restricted Stock:

It is not practical to determine the fair values of FHLB stock and other restricted stock due to restrictions placed on their transferability.

 

Loans:

Fair values of loans, excluding loans held for sale and collateral dependent impaired loans having a specific allowance allocation, are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued as described previously. The methods utilized to estimate fair value of loans do not necessarily represent an exit price.

 

Accrued Interest Receivable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the asset they are associated with.

 

Deposits:

The fair values disclosed for demand deposits (e.g., interest and non-interest checking, savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amount) resulting in a Level 1 classification. Fair values for fixed rate time deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

 

Short-term Borrowings:

The carrying amounts of federal funds purchased, borrowings under repurchase agreements, and other short-term borrowings, generally maturing within ninety days, approximate their fair values resulting in a Level 2 classification.

 

Long-Term Debt:

The fair values of the Company’s long-term borrowings are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 2 classification.

 

The fair values of the Company’s subordinated debentures are estimated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

 

Accrued Interest Payable:

The carrying amount of accrued interest approximates fair value resulting in a Level 2 or Level 3 classification consistent with the liability they are associated with.

 

Off-balance Sheet Instruments:

Commitments to extend credit and standby letters of credit are generally short-term or variable rate with minimal fees charged. These instruments have no carrying value, and the fair value is not material. The fair value of commitments to sell loans is the cost or benefit of settling the commitments with the counter-party at the reporting date. At December 31, 2013 and 2012, none of the Company’s commitments to sell loans were mandatory, and there is no cost or benefit to settle these commitments.

 

NOTE 15 – Segment Information

 

The Company’s operations include three primary segments: core banking, trust and investment advisory services, and insurance operations. The core banking segment involves attracting deposits from the general public and using such funds to originate consumer, commercial and agricultural, commercial and agricultural real estate, and residential mortgage loans, primarily in the Company’s local markets. The core banking segment also involves the sale of residential mortgage loans in the secondary market. The trust and investment advisory services segment involves providing trust, investment advisory, and brokerage services to customers. The insurance segment offers a full range of personal and corporate property and casualty insurance products, primarily in the Company’s banking subsidiary’s local markets.

 

81
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 15 – Segment Information (continued)

 

The core banking segment is comprised by the Company’s banking subsidiary, German American Bancorp, which operated through 36 banking offices at December 31, 2013. Net interest income from loans and investments funded by deposits and borrowings is the primary revenue for the core-banking segment. The trust and investment advisory services segment’s revenues are comprised primarily of fees generated by German American Financial Advisors & Trust Company. These fees are derived by providing trust, investment advisory, and brokerage services to its customers. The insurance segment primarily consists of German American Insurance, Inc., which provides a full line of personal and corporate insurance products. Commissions derived from the sale of insurance products are the primary source of revenue for the insurance segment.

 

The following segment financial information has been derived from the internal financial statements of German American Bancorp, Inc., which are used by management to monitor and manage the financial performance of the Company. The accounting policies of the three segments are the same as those of the Company. The evaluation process for segments does not include holding company income and expense. Holding company amounts are the primary differences between segment amounts and consolidated totals, and are reflected in the column labeled “Other” below, along with amounts to eliminate transactions between segments.

 

       Trust and             
       Investment             
   Core   Advisory           Consolidated 
   Banking   Services   Insurance   Other   Totals 
Year Ended December 31, 2013                         
Net Interest Income  $69,634   $21   $17   $(1,155)  $68,517 
Net Gains on Sales of Loans   2,645    —    —    —    2,645 
Net Gains on Securities   2,065    —    —    364    2,429 
Trust and Investment Product Fees   6    3,355    —    (3)   3,358 
Insurance Revenues   39    31    6,147    —    6,217 
Noncash Items:                         
Provision for Loan Losses   350    —    —    —    350 
Depreciation and Amortization   3,944    28    339    150    4,461 
Income Tax Expense (Benefit)   12,387    (32)   320    (1,211)   11,464 
Segment Profit (Loss)   25,389    (70)   425    (331)   25,413 
Segment Assets at December 31, 2013   2,171,837    11,663    5,636    (25,309)   2,163,827 

 

       Trust and             
       Investment             
   Core   Advisory           Consolidated 
   Banking   Services   Insurance   Other   Totals 
Year Ended December 31, 2012                         
Net Interest Income  $68,311   $21   $34   $(2,118)  $66,248 
Net Gains on Sales of Loans   3,234    —    —    —    3,234 
Net Gains on Securities   1,667    —    —    —    1,667 
Trust and Investment Product Fees   5    2,657    —    (5)   2,657 
Insurance Revenues   23    36    5,465    —    5,524 
Noncash Items:                         
Provision for Loan Losses   2,412    —    —    —    2,412 
Depreciation and Amortization   4,099    24    415    150    4,688 
Income Tax Expense (Benefit)   11,999    (187)   181    (1,324)   10,669 
Segment Profit (Loss)   25,118    (298)   250    (1,015)   24,055 
Segment Assets at December 31, 2012   2,006,992    11,551    8,333    (20,576)   2,006,300 

 

82
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 15 – Segment Information (continued)

 

       Trust and             
       Investment             
   Core   Advisory           Consolidated 
   Banking   Services   Insurance   Other   Totals 
Year Ended December 31, 2011                         
Net Interest Income  $66,099   $16   $22   $(2,156)  $63,981 
Net Gains on Sales of Loans   2,381    —    —    —    2,381 
Net Gains on Securities   2,089    —    —    935    3,024 
Trust and Investment Product Fees   3    2,147    —    (5)   2,145 
Insurance Revenues   67    13    5,755    (16)   5,819 
Noncash Items:                         
Provision for Loan Losses   6,800    —    —    —    6,800 
Depreciation and Amortization   4,481    26    482    150    5,139 
Income Tax Expense (Benefit)   9,171    (353)   272    (1,364)   7,726 
Segment Profit (Loss)   20,855    (545)   352    (413)   20,249 
Segment Assets at December 31, 2011   1,875,417    11,801    7,948    (21,399)   1,873,767 

 

NOTE 16 – Parent Company Financial Statements

 

The condensed financial statements of German American Bancorp, Inc. are presented below:

 

CONDENSED BALANCE SHEETS

 

   December 31, 
   2013   2012 
ASSETS          
Cash  $9,721   $29,499 
Securities Available-for-Sale, at Fair Value   353    733 
Investment in Subsidiary Bank   195,480    184,093 
Investment in Non-banking Subsidiaries   3,650    4,064 
Other Assets   6,271    6,245 
Total Assets  $215,475   $224,634 
           
LIABILITIES          
Borrowings  $12,024   $35,624 
Other Liabilities   3,354    3,984 
Total Liabilities   15,378    39,608 
           
SHAREHOLDERS’ EQUITY          
Common Stock   13,174    12,637 
Additional Paid-in Capital   108,022    95,617 
Retained Earnings   84,164    66,421 
Accumulated Other Comprehensive Income (Loss)   (5,263)   10,351 
Total Shareholders’ Equity   200,097    185,026 
Total Liabilities and Shareholders’ Equity  $215,475   $224,634 

 

83
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 16 – Parent Company Financial Statements (continued)

 

CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

 

   Years Ended December 31, 
   2013   2012   2011 
INCOME               
Dividends from Subsidiaries               
Bank  $14,000   $17,500   $22,500 
Non-bank   1,500    —    1,350 
Interest Income   31    50    38 
Net Gain on Securities   343    —    935 
Other Income   75    70    71 
Total Income   15,949    17,620    24,894 
                
EXPENSES               
Salaries and Employee Benefits   824    458    444 
Professional Fees   485    352    379 
Occupancy and Equipment Expense   7    7    8 
Interest Expense   1,246    2,221    2,239 
Other Expenses   615    359    357 
Total Expenses   3,177    3,397    3,427 
INCOME BEFORE INCOME TAXES AND EQUITY IN UNDISTRIBUTED INCOME OF SUBSIDIARIES   12,772    14,223    21,467 
Income Tax Benefit   1,235    1,338    1,364 
INCOME BEFORE EQUITY IN UNDISTRIBUTED INCOME OF SUBSIDIARIES   14,007    15,561    22,831 
Equity in Undistributed (Excess Distributed) Income of Subsidiaries   11,406    8,494    (2,582)
NET INCOME   25,413    24,055    20,249 
                
Other Comprehensive Income:               
Changes in Unrealized Gain (Loss) on Securities, Available-for-Sale   (15,874)   (124)   5,677 
Changes in Unrecognized Amounts in Pension, Net   231    (47)   4 
Changes in Unrecognized Loss on Postretirement Benefit Obligation, Net   29    (21)   (38)
TOTAL COMPREHENSIVE INCOME  $9,799   $23,863   $25,892 

 

84
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 16 – Parent Company Financial Statements (continued)

 

CONDENSED STATEMENTS OF CASH FLOWS

 

   Years Ended December 31, 
   2013   2012   2011 
CASH FLOWS FROM OPERATING ACTIVITIES               
Net Income  $25,413   $24,055   $20,249 
Adjustments to Reconcile Net Income to Net Cash from Operations               
Loss (Gain) on Securities, Net   (343)   —    (935)
Change in Other Assets   283    33    3,656 
Change in Other Liabilities   (510)   203    (2,191)
Equity Based Compensation   329    628    635 
Excess Tax Benefit from Restricted Share Grant   (28)   (23)   (37)
Equity in Excess Distributed (Undistributed) Income of Subsidiaries   (11,406)   (8,494)   2,582 
Net Cash from Operating Activities   13,738    16,402    23,959 
                
CASH FLOWS FROM INVESTING ACTIVITIES               
Capital Contribution to Subsidiaries   —    (150)   — 
Acquire Banking Entities   (2,135)   —    (1,995)
Net Cash from Investing Activities   (2,135)   (150)   (1,995)
                
CASH FLOWS FROM FINANCING ACTIVITIES               
Proceeds from Issuance of Long-term Debt   10,000    —    — 
Repayment of Long-term Debt   (33,750)   (1,500)   (1,500)
Issuance of Common Stock   20    37    12 
Income Tax Benefit from Restricted Share Grant   28    23    37 
Employee Stock Purchase Plan   (9)   (67)   (25)
Dividends Paid   (7,670)   (7,068)   (7,047)
Net Cash from Financing Activities   (31,381)   (8,575)   (8,523)
                
Net Change in Cash and Cash Equivalents   (19,778)   7,677    13,441 
Cash and Cash Equivalents at Beginning of Year   29,499    21,822    8,381 
Cash and Cash Equivalents at End of Year  $9,721   $29,499   $21,822 

 

NOTE 17 – Business Combinations, Goodwill and Intangible Assets

 

Business Combinations

 

Effective October 1, 2013, the Company acquired United Commerce Bancorp and its subsidiary, United Commerce Bank. The acquisition was accomplished by the merger of United Commerce Bancorp into the German American Bancorp, Inc., immediately followed by the merger of United Commerce Bank into German American Bancorp, Inc.’s bank subsidiary (German American Bancorp). The United Commerce Bank operated two banking offices in Bloomington, Indiana. United Commerce’s consolidated assets and equity (unaudited) as of October 1, 2013 totaled $119.7 million and $13.7 million, respectively. The Company accounted for the transaction under the acquisition method of accounting which means that the acquired assets and liabilities were recorded at fair value at the date of acquisition. See Note 4 for additional information related to the fair value of loans acquired. The Company determined the fair value of core deposit intangibles, securities and deposits with the assistance of third party valuations. The estimated fair values over loans are subject to refinement as additional information relative to the closing date fair values becomes available through the measurement period.

 

In accordance with ASC 805, the Company has expensed approximately $251 of direct acquisition costs and recorded $1.7 million of goodwill and $2.1 million of intangible assets. The intangible assets are related to core deposits and are being amortized on an accelerated basis over 8 years. For tax purposes, goodwill totaling $1.7 million is non-deductible. The following table summarizes the fair value of the total consideration transferred as a part of the United Commerce acquisition as well as the fair value of identifiable assets acquired and liabilities assumed as of the effective date of the transaction.

 

85
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 17 – Business Combinations, Goodwill and Intangible Assets (continued)

 

October 1, 2013

 

Consideration     
Cash for Options and Fractional Shares  $643 
Cash Consideration   1,391 
Equity Instruments   13,348 
      
Fair Value of Total Consideration Transferred  $15,382 

 

Recognized Amounts of Identifiable Assets Acquired and Liabilities Assumed:

 

Cash and Due From Banks  $430 
Federal Funds Sold, Other Short-term Investments   7,362 
Interest-bearing Time Deposits with Banks   100 
Securities   25,644 
Loans   79,575 
Premises, Furniture & Equipment   1,718 
Core Deposit Intangible   2,052 
Accrued Interest Receivable & Other Assets   3,638 
Deposits   (106,633)
Accrued Interest Payable and Other Liabilities   (175)
      
Total Identifiable Net Assets  $13,711 
      
Goodwill  $1,671 

 

Under the terms of the merger agreement, the Company issued approximately 503,000 shares of its common stock to the former shareholders of United Commerce. Each United Commerce common shareholder of record at the effective time of the merger became entitled to receive 0.5456 shares of common stock of the Company for each of their former shares of United Commerce common stock.

 

The Company at the effective time of the merger owned 44,100 shares of United Commerce’s outstanding common stock (approximately 4.6% of United Commerce’s common shares then outstanding). All of these shares were cancelled at the effective time of the merger and were not exchanged for shares of the Company in the merger.

 

In connection with the closing of the merger, the Company paid to United Commerce’s shareholders of record at the close of business on September 30, 2013, cash consideration of $1.51 per United Commerce share (an aggregate of $1,391 to shareholders other than the Company) and the Company paid approximately $643 to persons who held options to purchase United Commerce common stock (all of which rights were cancelled at the effective time of the merger and were not assumed by the Company).

 

This acquisition was consistent with the Company’s strategy to build a regional presence in Southern Indiana. The acquisition offers the Company the opportunity to increase profitability by introducing existing products and services to the acquired customer base as well as add new customers in the expanded region.

 

Goodwill

 

The changes in the carrying amount of goodwill for the periods ended December 31, 2013, 2012 and 2011 were classified as follows:

 

   2013   2012   2011 
             
Beginning of Year  $18,865   $18,865   $9,835 
Acquired Goodwill   1,671    —    9,030 
Impairment   —    —    — 
End of Year  $20,536   $18,865   $18,865 

 

86
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 17 – Business Combinations, Goodwill and Intangible Assets (continued)

 

Of the $20,536 carrying amount of goodwill, $19,204 is allocated to the core banking segment and $1,332 is allocated to the insurance segment for the period ended December 31, 2013. Of the $18,865 carrying amount of goodwill, $17,533 is allocated to the core banking segment and $1,332 is allocated to the insurance segment for the periods ended December 31, 2012 and 2011.

 

Impairment exists when a reporting unit’s carrying value of goodwill exceeds its fair value. At December 31, 2013, the Company’s reporting units had positive equity and the Company elected to perform a qualitative assessment to determine if it was more likely than not that the fair value of the reporting units exceeded its carrying value, including goodwill. The qualitative assessment indicated that it was more likely than not that the fair value of the reporting unit exceeded its carrying value.

 

Acquired Intangible Assets

 

Acquired intangible assets were as follows as of year end:  2013 
   Gross   Accumulated 
   Amount   Amortization 
Core Banking          
Core Deposit Intangible  $9,004   $5,815 
Unidentified Branch Acquisition Intangible   257    257 
Insurance          
Customer List   5,199    5,060 
Total  $14,460   $11,132 
           
Acquired intangible assets were as follows as of year end:  2012 
    Gross    Accumulated 
    Amount    Amortization 
Core Banking          
Core Deposit Intangible  $6,952   $4,665 
Unidentified Branch Acquisition Intangible   257    257 
Insurance          
Customer List   5,199    4,794 
Total  $12,408   $9,716 

 

Amortization Expense was $1,416, $1,655 and $1,956, for 2013, 2012 and 2011.

 

Estimated amortization expense for each of the next five years is as follows:

 

  2014  $1,254   
  2015   790   
  2016   493   
  2017   323   
  2018   235   

 

87
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 18 – Other Comprehensive Income (Loss)

 

The table below summarizes the changes in accumulated other comprehensive income (loss) by component for the year ending December 31, 2013, net of tax:

 

   Unrealized             
   Gains and   Defined         
   Losses on   Benefit         
   Available-for-   Pension   Postretirement     
   Sale Securities   Items   Benefit Items   Total 
                 
Beginning Balance  $10,643   $(231)  $(61)  $10,351 
Other Comprehensive Income (Loss) Before                    
Reclassification   (14,295)   453    51    (13,791)
Amounts Reclassified from Accumulated                    
Other Comprehensive Income   (1,579)   (222)   (22)   (1,823)
Net Current Period Other                    
Comprehensive Income (Loss)   (15,874)   231    29    (15,614)
Ending Balance  $(5,231)  $—   $(32)  $(5,263)

 

The table below summarizes the classifications out of accumulated other comprehensive income (loss) by component for the year ending December 31, 2013:

 

   Amount Reclassified From    
Details about Accumulated Other  Accumulated Other   Affected Line Item in the Statement
Comprehensive Income (Loss) Components    Comprehensive Income (Loss)     Where Net Income is Presented
        
Unrealized Gains and Losses on        
Available-for-Sale Securities  $(2,429)  Net (Gain) Loss on Securities
    850   Income Tax Expense
    (1,579)  Net of Tax
Amortization of Defined Benefit Pension Items        
Prior Service Costs  $(13)  Salaries and Employee Benefits
Actuarial Gains (Losses)   (360)  Salaries and Employee Benefits
    151   Income Tax Expense
    (222)  Net of Tax
Amortization of Post Retirement Plan Items        
Actuarial Gains (Losses)  $(37)  Salaries and Employee Benefits
    15   Income Tax Expense
    (22)  Net of Tax
         
Total Reclassifications for the Period  $(1,823)   

 

88
 

 

Notes to the Consolidated Financial Statements
Dollars in thousands, except per share data

 

NOTE 19 – Quarterly Financial Data (Unaudited)

 

The following table represents selected quarterly financial data for the Company:

 

   Interest   Net Interest   Net   Earnings per Share 
   Income   Income   Income   Basic   Diluted 
                     
2013                         
First Quarter  $18,370   $16,225   $5,809   $0.46   $0.46 
Second Quarter   18,458    16,712    6,532    0.52    0.52 
Third Quarter   18,812    17,192    6,483    0.51    0.51 
Fourth Quarter   20,032    18,388    6,589    0.50    0.50 
                          
2012                         
First Quarter  $19,727   $16,612   $5,602   $0.44   $0.44 
Second Quarter   19,563    16,649    5,967    0.47    0.47 
Third Quarter   18,953    16,393    6,292    0.50    0.50 
Fourth Quarter   18,917    16,594    6,194    0.49    0.49 

 

89
 

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

Not Applicable.

 

Item 9A. Controls and Procedures.

 

Disclosure Controls and Procedures

As of December 31, 2013, the Company carried out an evaluation, under the supervision and with the participation of its principal executive officer and principal financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures. Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be included in the Company’s periodic reports filed with the Securities and Exchange Commission. There are inherent limitations to the effectiveness of systems of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective systems of disclosure controls and procedures can provide only reasonable assurances of achieving their control objectives.

 

Changes in Internal Control Over Financial Reporting in Most Recent Fiscal Quarter

There was no change in the Company’s internal control over financial reporting that occurred during the Company’s fourth fiscal quarter of 2013 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Management’s Report on Internal Control Over Financial Reporting

The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the 1992 Internal Control-Integrated Framework. Based on our assessment and those criteria, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2013.

 

The Company’s independent registered public accounting firm has issued their report on the Company’s internal control over financial reporting. That report is included in Item 8. Financial Statements and Supplementary Data of this Report under the heading, Report of Independent Registered Public Accounting Firm.

 

Item 9B. Other Information.

 

Not applicable.

 

90
 

 

PART III

 

Item 10. Directors, Executive Officers, and Corporate Governance.

 

Information relating to directors and executive officers of the Company will be included under the captions “Election of Directors” and “Our Executive Officers” in the Company’s Proxy Statement for the Annual Meeting of Shareholders to be held in May 2014, which will be filed within 120 days of the end of the fiscal year covered by this Report (the “2014 Proxy Statement”), which sections are incorporated herein in partial response to this Item’s informational requirements.

 

Section 16(a) Compliance. Information relating to Section 16(a) compliance will be included in the 2014 Proxy Statement under the caption of “Section 16(a): Beneficial Ownership Reporting Compliance” and is incorporated herein by reference.

 

Code of Business Conduct. The Company’s Board of Directors has adopted a Code of Business Conduct, which constitutes a “code of ethics” as that term is defined by SEC rules adopted under the Sarbanes-Oxley Act of 2002 (“SOA”). The Company has posted a copy of the Code of Business Conduct on its Internet website (www.germanamerican.com). The Company intends to satisfy its disclosure requirements under Item 5.05 of Form 8-K regarding certain amendments to, or waivers of, the Code of Business Conduct, by posting such information on its Internet website, except that waivers that must under NASDAQ rules be filed with the SEC on Form 8-K will be so filed.

 

Audit Committee Identification. The Board of Directors of the Company has a separately-designated standing audit committee established in accordance with Section 3(a) (58) (A) of the Securities Exchange Act of 1934. The description of the Audit Committee of the Board of Directors, and the identification of its members, will be set forth in the 2014 Proxy Statement under the caption “ELECTION OF DIRECTORS”, which section is incorporated herein by reference.

 

Audit Committee Financial Expert. The Board of Directors has determined that M. Darren Root, a director who serves on the Audit Committee of the Board of Directors and who is an independent director as defined by NASDAQ listing standards, is an “audit committee financial expert” as that term is defined by SEC rules adopted under SOA.

 

Lack of Changes in Nominating/Governance Committee Procedures re Shareholder Recommendations of Nominees. There has been no material change in the procedures by which the Company’s shareholders may recommend nominees for election to the Board of Directors of the Company that have been implemented since the last disclosure of such procedures in the Company’s Proxy Statement for the Annual Meeting of Shareholders that was held in May 2013.

 

Item 11. Executive Compensation.

 

Information relating to compensation of the Company’s executive officers and directors (including the required disclosures under the subheadings “Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report”) will be included under the caption “Executive and Director Compensation” in the 2014 Proxy Statement of the Company, which section is incorporated herein by reference.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

Information relating to security ownership of certain beneficial owners and the directors and executive officers of the Company will be included under the captions “Ownership of Our Common Shares by Our Directors and Executive Officers” and “Principal Owners of Common Shares” of the 2014 Proxy Statement of the Company, which sections are incorporated herein by reference.

 

Equity Compensation Plan Information

 

The Company maintains four plans under which it has authorized the issuance of its Common Shares to employees and non-employee directors as compensation: its 1992 Stock Option Plan (under which no new grants may be made), its 1999 Long-Term Equity Incentive Plan (under which no new grants may be made), its 2009 Long-Term Equity Incentive Plan, and its 2009 Employee Stock Purchase Plan. Each of these four plans was approved by the requisite vote of the Company’s common shareholders in the year of adoption by the Board of Directors. The Company is not a party to any individual compensation arrangement involving the authorization for issuance of its equity securities to any single person, other than option agreements and restricted stock award agreements that have been granted under the terms of one of the four plans identified above. The following table sets forth information regarding these plans as of December 31, 2013:

 

91
 

 

           Number of Securities 
           Remaining Available for 
           Future Issuance under 
   Number of Securities   Weighted Average   Equity Compensation 
   to be Issued upon Exercise   Exercise Price of   Plans (Excluding 
   of Outstanding Options,   Outstanding Options,   Securities Reflected in 
Plan Category  Warrants or Rights   Warrants and Rights   First Column) 
             
Equity compensation plans approved by security holders   69,517(a)  $16.61    800,747(b)
Equity compensation plans not approved by security holders   —    —    — 
Total   69,517   $16.61    800,747 

 

(a)Does not include any shares that employees may have the right to purchase under the Employee Stock Purchase Plan in August 2014 in respect of employee payroll deductions of participating employees that had accumulated as of December 31, 2013 during the plan year that commenced in August 2013. Although these employees have the right under this Plan to have their accumulated payroll deductions applied to the purchase of Common Shares at a discounted price in August 2014, the price at which such shares may be purchased and the number of shares that may be purchased under that Plan at that time is not presently determinable.

 

(b)Represents 431,451 shares that the Company may in the future issue to employees under the Employee Stock Purchase Plan (although the Company typically purchases the shares needed for sale to participating employees on the open market rather than issuing new issue shares to such employees) and 369,296 shares that were available for grant or issuance at December 31, 2013 under the 2009 Long-Term Equity Incentive Plan. Under the Long-Term Equity Incentive Plan, the aggregate number of Common Shares available for the grant of awards (subject to customary anti-dilution adjustment provisions) cumulatively following the adoption of the Plan in 2009 through the expiration of the Plan in 2019 may not exceed the sum of the following: (a) 500,000 shares, plus (b) any shares exchanged by a participant as full or partial payment to the Company of the exercise price of an option granted to the participant under the Plan; plus (c) at the beginning of each calendar year, an additional number of shares (if any) equal to the number of shares that would result in the number of shares available for awards as of such date being equal to one percent (1%) of the total number of the Company’s shares outstanding as of the immediately preceding December 31, on a fully-diluted basis.

 

For additional information regarding the Company’s equity incentive plans and employee stock purchase plan, see Note 8 to the consolidated financial statements in Item 8 of this Report.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence.

 

Information responsive to this Item 13 will be included under the captions “Election of Directors” and “Transactions with Related Persons” of the 2014 Proxy Statement of the Company, which sections are incorporated herein by reference.

 

Item 14. Principal Accounting Fees and Services.

 

Information responsive to this Item 14 will be included in the 2014 Proxy Statement under the caption “Principal Accountant Fees and Services”, which section is incorporated herein by reference.

 

92
 

 

PART IV

 

Item 15. Exhibits, Financial Statement Schedules.

 

(a)(1) Financial Statements

 

The following items are included in Item 8 of this Report:

   
German American Bancorp, Inc. and Subsidiaries:   Page #
     
Report of Independent Registered Public Accounting Firm   39
     
Consolidated Balance Sheets at December 31, 2013 and 2012   40
     
Consolidated Statements of Income, years ended December 31, 2013, 2012 and 2011   41
     
Consolidated Statements of Comprehensive Income, years ended December 31, 2013, 2012 and 2011   42
     
Consolidated Statements of Changes in Shareholders’ Equity, years ended December 31, 2013, 2012 and 2011   43
     
Consolidated Statements of Cash Flows, years ended December 31, 2013, 2012 and 2011   44
     
Notes to the Consolidated Financial Statements   45-89

 

(a)(2) Financial Statement Schedules

 

None.

 

(a)(3) Exhibits

 

The Exhibit Index, which index follows the signature page to this report and is hereby incorporated herein by reference, sets forth a list of those exhibits filed herewith, and includes and identifies management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K by Item 601 (b)(10)(iii) of Regulation S-K.

 

In reviewing any agreements included as exhibits to this report, please remember that they are included to provide you with information regarding their terms and are not intended to provide any other factual or disclosure information about us or the other parties to the agreements. The agreements may contain representations and warranties by the parties to the agreements, including us. These representations and warranties have been made solely for the benefit of the other parties to the applicable agreement and:

 

·should not in all instances be treated as categorical statements of fact, but rather as a way of allocating the risk to one of the parties if those statements prove to be inaccurate;
·may have been qualified by disclosures that were made to the other party in connection with the negotiation of the applicable agreement, which disclosures are not necessarily reflected in the agreement;
·may apply standards of materiality in a way that is different from what may be viewed as material to you or other investors; and
·were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments.

 

Accordingly, these representations and warranties may not describe the actual state of affairs as of the date they were made or at any other time.

 

93
 

 

Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

    GERMAN AMERICAN BANCORP, INC.
    (Registrant)
     
Date: March 12, 2014 By/s/Mark A. Schroeder
    Mark A. Schroeder, Chairman and  
    Chief Executive Officer

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

 

Date: March 12, 2014 By/s/Mark A. Schroeder
    Mark A. Schroeder, Chairman and  
    Chief Executive Officer
     
Date: March 12, 2014 By/s/Douglas A. Bawel
    Douglas A. Bawel, Director
     
Date: March 12, 2014 By/s/Christina M. Ernst
    Christina M. Ernst, Director
     
Date: March 12, 2014 By/s/Marc D. Fine
    Marc D. Fine, Director
     
Date: March 12, 2014 By/s/U. Butch Klem
    U. Butch Klem, Director
     
Date: March 12, 2014 By/s/J. David Lett
    J. David Lett, Director
     
Date: March 12, 2014 By/s/Gene C. Mehne
    Gene C. Mehne, Director
     
Date: March 12, 2014 By/s/Chris A. Ramsey
    Chris A. Ramsey, Director
     
Date: March 12, 2014 By/s/M. Darren Root
    M. Darren Root, Director
     
Date: March 12, 2014 By/s/Thomas W. Seger
    Thomas W. Seger, Director
     
Date: March 12, 2014 By/s/Raymond W. Snowden
    Raymond W. Snowden, Director
     
Date: March 12, 2014 By/s/Michael J. Voyles
    Michael J. Voyles, Director
     
Date: March 12, 2014 By/s/Bradley M. Rust
    Bradley M. Rust, Executive Vice President and
    Chief Financial Officer (principal accounting officer
    and principal financial officer)

 

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INDEX OF EXHIBITS

 

Exhibit No.   Description
2.1   Agreement and Plan of Reorganization among German American Bancorp, Inc., United Commerce Bancorp, German American Bancorp, and United Commerce Bank, dated July 23, 2013.  The copy of this exhibit filed as Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed July 24, 2013 is incorporated herein by reference. Schedules identified in the list of Schedules to this Agreement are not filed as part of this Exhibit, but the Registrant agrees to furnish to the Commission supplementally any omitted schedule upon request.
3.1   Restatement of the Articles of Incorporation of the Registrant is incorporated by reference from Exhibit 3.1 to the Registrant’s Current  Report on 8-K filed July 1, 2011.
3.2   Restated Bylaws of German American Bancorp, Inc., as amended and restated July 27, 2009.  The copy of this exhibit filed as Exhibit 3 to the current report on Form 8-K of the Registrant filed July 31, 2009 is incorporated herein by reference.
4.1   No long-term debt instrument issued by the Registrant exceeds 10% of consolidated total assets or is registered.  In accordance with paragraph 4 (iii) of Item 601(b) of Regulation S-K, the Registrant will furnish the Securities and Exchange Commission copies of long-term debt instruments and related agreements upon request.
4.2   Terms of Common Shares and Preferred Shares of the Registrant (included in Restatement of Articles of Incorporation) are incorporated by reference from Exhibit 3.1 to the Registrant’s Current  Report on 8-K filed July 1, 2011.
4.3   Specimen stock certificate for Common Shares of the Registrant is incorporated by reference from Exhibit 99.1 to the Registrant’s Current Report on Form 8-K filed October 21, 2010.
10.1*   The Registrant’s 1992 Stock Option Plan, as amended, is incorporated by reference from Exhibit 10.1 to the Registrant’s Registration Statement on Form S-4 filed October 14, 1998.
10.2*   Amendment to 1992 Stock Option Plan effective April 1, 2012, is incorporated by reference from Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2012.
10.3*   Form of Director Deferred Compensation Agreement between The German American Bank and certain of its Directors is incorporated herein by reference from Exhibit 10.4 to the Registrant’s Registration Statement on Form S-4 filed January 21, 1993 (the Agreement entered into by former director George W. Astrike, a copy of which was filed as Exhibit 10.4 to the Registrant’s Registration Statement on Form S-4 filed January 21, 1993, is substantially identical to the Agreements entered into by the other Directors, some of whom remain directors of the Registrant). The schedule following such Exhibit 10.4 lists the Agreements with the other Directors and sets forth the material detail in which such Agreements differ from the Agreement filed as such Exhibit 10.4.
   10.4*+   The Registrant’s 1999 Long-Term Equity Incentive Plan, as amended through February 22, 2008.
10.5*   Basic Plan Document for the Registrant’s Nonqualified Savings Plan is incorporated by reference from Exhibit 10.5 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010.

 

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10.6*   Adoption Agreement for the Registrant’s Nonqualified Savings Plan dated August 17, 2004, is incorporated by reference from Exhibit 10.6 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010.
10.7*   First Amendment to the Registrant’s Nonqualified Savings Plan dated August 17, 2004, is incorporated by reference from Exhibit 10.7 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010.
10.8*   Form of Non-Employee Director Stock Option Agreement (new grant, ten year expiration, no vesting) that in prior periods was typically issued to non-employee members of the Board of Directors as part of annual director fee retainer (not Incentive Stock Option for tax purposes), is incorporated by reference from Exhibit 10.10 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010.
10.9*   Form of Employee Director Stock Option Agreement (new grant, ten year expiration, no vesting) that in prior periods was typically issued to employee members of the Board of Directors as part of annual director fee retainer (intended to be Incentive Stock Option for tax purposes), is incorporated by reference from Exhibit 10.11 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2010.
10.10*   Description of Director Compensation Arrangements for the 12 month period ending at 2012 Annual Reorganization Meeting of the Board of Directors is incorporated by reference from the description included in Exhibit 10.1 to the Registrant’s Quarterly Report for the quarter ended June 30, 2011.
10.11*   Descriptions of Director Compensation Arrangements for the 12 month period ending at 2013 Annual Reorganization Meeting of the Board of Directors are incorporated by reference from the descriptions included in Item 5.02 of the Registrant’s Current Report on Form 8-K filed June 29, 2012, and in Item 5.02 of the Registrant’s Current Report on Form 8-K filed December 21, 2012.
10.12*   Description of Director Compensation Arrangements for the 12 month period ending at the 2014 Annual Reorganizational Meeting of the Board of Directors is incorporated by reference from the description included in Item 5.02 of the Registrant’s Current Report on Form 8-K filed June 27, 2013, and in Item 5.02 of the Registrant’s Current Report on Form 8-K filed December 18, 2013.
10.13*   Description of Executive Management Incentive Plan for 2011 (awards payable in 2012) is incorporated by reference from the description contained in Item 5.02 of the Registrant’s Current Report on Form 8-K filed March 5, 2011.
10.14*   Description of Executive Management Incentive Plan for 2012 (awards payable in 2013) is incorporated by reference from the description included in Item 5.02 of the Registrant’s Current Report on Form 8-K filed May 4, 2012.
10.15*   Description of Executive Management Incentive Plan for 2013 (awards payable in 2014) adopted by the Board of Directors on March 25, 2013, is incorporated by reference from the description included in Item 5.02 of the Registrant’s Current Report on Form 8-K filed March 29, 2013.
10.16*   Executive Supplemental Retirement Income Agreement dated October 1, 1996, between First Federal Bank, F.S.B. and Bradley M. Rust, as amended by a First Amendment between Bradley M. Rust and the Registrant dated December 30, 2008, is incorporated by reference to Exhibit 10.18 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2009.

 

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10.17*   Form of Restricted Stock Award Agreement that evidences the terms of awards of restricted stock grants and related cash entitlements granted under the 2009 Long-Term Equity Incentive Plan prior to 2013, is incorporated by reference from Exhibit 10.18 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2011.
10.18*   Form of Restricted Stock Award Agreement that evidences the terms of awards of restricted stock grants granted under the 2009 Long-Term Equity Incentive Plan to certain Directors in December 2012 is incorporated by reference from Exhibit 10.20 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2012.
  10.19*+   Form of Restricted Stock Award Agreement that evidences the terms of awards of restricted stock grants granted under the 2009 Long-Term Equity Incentive Plan to certain Directors in December 2013.
10.20*   Resolutions of Stock Option Committee of Board of Directors of the Registrant amending outstanding stock options by accelerating in full all vesting periods and exercise date restrictions and terminating replacement stock option privileges in connection with future option exercises, adopted by written consent effective December 29, 2005, is incorporated by reference to Exhibit 10.19 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2011.
10.21   Loan Agreement between Stock Yards Bank & Trust Company and German American Bancorp, Inc. dated January 25, 2013.  The copy of this exhibit filed as Exhibit 99.1 to the Company’s Current Report on Form 8-K filed January 29, 2013, is incorporated herein by reference.
10.22   Promissory Note (Term Note) made by German American Bancorp, Inc., to Stock Yards Bank & Trust Company dated January 25, 2013. The copy of this exhibit filed as Exhibit 99.2 to the Company’s Current Report on Form 8-K filed January 29, 2013, is incorporated herein by reference.
10.23   Promissory Note (Revolving Note) made by German American Bancorp, Inc., to Stock Yards Bank & Trust Company dated January 25, 2013.  The copy of this exhibit filed as Exhibit 99.3 to the Company’s Current Report on Form 8-K filed January 29, 2013, is incorporated herein by reference.
10.24   Stock Pledge Agreement between Stock Yards Bank & Trust Company and German American Bancorp, Inc. dated January 25, 2013. The copy of this exhibit filed as Exhibit 99.4 to the Company’s Current Report on Form 8-K filed January 29, 2013, is incorporated herein by reference.
  10.25+   Omnibus Amendment to Loan Documents between Stock Yards Bank & Trust Company and German American Bancorp, Inc. dated as of December 31, 2013.
 10.26*   German American Bancorp, Inc., 2009 Long Term Equity Incentive Plan. This exhibit is incorporated by reference from Exhibit 99.1 to the Registrant’s Registration Statement on Form S-8 (No. 333-160749) filed July 23, 2009.
 10.27*   German American Bancorp, Inc., 2009 Employee Stock Purchase Plan. This exhibit is incorporated by reference from Exhibit 99.2 to the Registrant’s Registration Statement on Form S-8 (No. 333-160749) filed July 23, 2009.
10.28   Agreement and Plan of Reorganization among German American Bancorp, Inc., United Commerce Bancorp, German American Bancorp, and United Commerce Bank, dated July 23, 2013.  The copy of this exhibit filed as Exhibit 2.1 to Registrant’s Current Report on Form 8-K filed July 24, 2013 is incorporated herein by reference.

 

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10.29*   Form of LTI Restricted Stock Award Agreement that evidences the terms of awards of restricted stock grants and related cash entitlements that were granted to executive officers during March 2013 pursuant to the Management Long-Term Incentive Plan component of the 2012 Executive Management Incentive Plan with respect to the performance period ended December 31, 2012. This exhibit is incorporated by reference from Exhibit 10.6 to the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2013.
21+   Subsidiaries of the Registrant
23+   Consent of Crowe Horwath LLP
31.1+   Sarbanes-Oxley Act of 2002, Section 302 Certification for Chairman and Chief Executive Officer.
31.2+   Sarbanes-Oxley Act of 2002, Section 302 Certification for Executive Vice President (Principal Financial Officer).
32.1+   Sarbanes-Oxley Act of 2002, Section 906 Certification for Chairman and Chief Executive Officer.
32.2+   Sarbanes-Oxley Act of 2002, Section 906 Certification for Executive Vice President (Principal Financial Officer).
101++   The following materials from German American Bancorp, Inc.’s Form 10-K Report for the annual period ended December 31, 2013, formatted in XBRL: (i) the Consolidated Balance Sheets, (ii) the Consolidated Statements of Income, (iii) the Consolidated Statements of Comprehensive Income, (iv) the Consolidated Statements of Cash Flows, (v) the Consolidated Statements of Changes in Shareholders’ Equity and (vi) the Notes to the Consolidated Financial Statements.

 

* Exhibits that describe or evidence all management contracts or compensatory plans or arrangements required to be filed as exhibits to this Report are indicated by an asterisk.

+ Exhibits that are filed with this Report (other than through incorporation by reference to other disclosures or exhibits) are indicated by a plus sign.

++ Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are furnished and not deemed filed or part of a registration statement or prospectus for purposes of Sections 11 and 12 of the Securities Act of 1933, as amended, and are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

 

GERMAN AMERICAN BANCORP, INC. WILL FURNISH TO ANY SHAREHOLDER AS OF MARCH 1, 2014 A COPY OF ANY OF THE ABOVE-LISTED EXHIBITS UPON THE PAYMENT OF A CHARGE OF $.50 PER PAGE IN ORDER TO DEFRAY ITS EXPENSES IN PROVIDING SUCH EXHIBIT. SUCH REQUEST SHOULD BE ADDRESSED TO GERMAN AMERICAN BANCORP, INC., ATTN: TERRI A. ECKERLE, SHAREHOLDER RELATIONS, P.O. BOX 810, JASPER, INDIANA, 47546.

 

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