ITEM 1A. RISK FACTORS
RISK FACTORS
There are a number of factors, including those specified below, that may adversely affect the Corporation’s business, financial results or stock price. Additional risks that the Corporation currently does not know about or currently views as immaterial may also impair the Corporation’s business or adversely impact its financial results or stock price.
Operational Risks
•The ongoing COVID-19 pandemic and measures intended to prevent its spread have adversely impacted the Corporation’s business and financial results, and the continued impact will depend on future developments, which are highly uncertain and cannot be predicted, including the severity and duration of the pandemic and further actions taken by governmental authorities and other third parties to contain and treat the virus.
COVID-19, which has been identified as a pandemic by the World Health Organization and declared a national emergency in the United States, continues to significantly impact the global economy (including the states and local economies in which we operate) and create significant volatility and disruption in financial markets. The outbreak has resulted in authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter in place or total lock-down orders and business limitations and shutdowns. Such measures have significantly contributed to rising unemployment and negatively impacted consumer and business spending. As a result, the demand for the Corporation’s products and services has been, and will continue to be, significantly impacted. Furthermore, the pandemic has caused, and could continue to influence, the recognition of credit losses in the Corporation’s loan portfolios and increases in the Corporation’s allowance for credit losses as our customers are negatively impacted by the economic downturn. In addition, governmental actions have resulted in decreased interest rates and yields, which may lead to decreases in the Corporation’s net interest income.
As our banking regulators have encouraged us to work prudently with borrowers who are unable to meet their contractual payment obligations due to the effects of COVID-19, the Bank has implemented certain hardship relief programs (including payment deferrals, fee waivers, extensions of repayment terms, and other delays in payment). As a result, the Bank has made numerous short-term loan modifications for customers who are current and otherwise not past due. As provided under the CARES Act and extended by the 2021 Consolidated Appropriations Act, these qualified loan modifications are currently exempt by law from classification as troubled debt restructures as defined by GAAP. The potential adverse impact resulting from the inability of customers to repay loans on a timely basis cannot be determined at this time. However, the extent of such impact, as reflected in the Corporation's financial statements, may be muted by these loan modifications, which would have the effect of delaying loan loss recognition until after any applicable deferral period.
The spread of COVID-19 has caused the Corporation to modify its business practices (including developing work from home and social distancing plans for our employees), and we may take further actions as may be required by government authorities or as we determine are in the best interests of our employees, customers and business partners. There is no certainty that such measures will be sufficient to mitigate the risks posed by the virus or will otherwise be satisfactory to government authorities. Furthermore, the Corporation’s business operations have been, and may again in the future be, disrupted due to vendors and third-party service providers being unable to work or provide services effectively, including because of illness, quarantines, government actions, or other restrictions in connection with the pandemic.
COVID-19 has not yet been contained and the extent to which it continues to impact the Corporation’s business, results of operations and financial condition, as well as its regulatory capital and liquidity ratios, will depend on future developments, which are highly uncertain and are difficult to predict, including, but not limited to, the duration and severity of the outbreak, the potential for a seasonal or other resurgence, actions taken by governmental authorities and other third parties to contain and treat the virus, and how quickly and to what extent normal economic and operating conditions can resume. Moreover, the effects of the COVID-19 pandemic may heighten many of the other risks described in this “Risk Factors” section. While we do not yet know the full extent of the COVID-19 impact, the negative effects on the Corporation’s business, results of operations and financial condition could be material.
•As a participating lender in the Small Business Administration’s Paycheck Protection Program (the “PPP” or “program”), the Corporation and the Bank are subject to additional risks of litigation from the Bank’s clients or other parties in connection with the Bank’s processing of loans for the PPP and risks that the SBA may not fund some or all PPP loan guaranties.
On March 27, 2020, the CARES Act was enacted, which included a $349 billion loan program administered through the SBA referred to as the PPP. Under the PPP, small businesses, eligible nonprofits and certain others can apply for loans from existing SBA lenders and other approved regulated lenders that enroll in the program, subject to numerous limitations and eligibility criteria. Under the terms of the program, loans are to be fully guaranteed by the SBA. Congress has approved additional funding for the program since it began, most recently on December 27, 2020 as part of the 2021 Consolidated Appropriations Act, whereby authority to make loans under the program was extended through March 31, 2021. The Bank is participating as a lender in the PPP. Because of the short timeframe between the passing of the CARES Act and the April 3, 2020 opening of the PPP, there was some ambiguity in the laws, rules and guidance regarding the operation of the program, which exposes the Corporation to risks relating to noncompliance with the PPP.
Since the opening of the PPP, several larger banks have been subject to litigation relating to the policies and procedures that they used in processing applications for the program. The Corporation and the Bank may be exposed to the risk of litigation: (1) from both customers and non-customers that have approached the Bank in connection with PPP loans and its policies and procedures used in processing applications for the program; and (2) from agents of the PPP borrowers claiming they are entitled to a portion of the Bank's loan processing fees as a result of their assisting borrowers with their PPP loan applications. If any such litigation is filed against the Corporation or the Bank and is not resolved in a manner favorable to the Corporation or the Bank, it may result in significant financial liability or adversely affect the Corporation’s reputation. In addition, litigation can be costly, regardless of outcome. Any financial liability, litigation costs or reputational damage caused by PPP-related litigation could have a material adverse impact on our business, financial condition and results of operations.
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The Bank also has credit risk on PPP loans if a determination is made by the SBA that there is a deficiency in the manner in which the loan was originated, funded, or serviced by the Bank, such as an issue with the eligibility of a borrower to receive a PPP loan, which may or may not be related to the ambiguity in the laws, rules and guidance regarding the operation of the program. In the event of a loss resulting from a default on a PPP loan and a determination by the SBA that there was a deficiency in the manner in which the PPP loan was originated, funded, or serviced by the Corporation, the SBA may deny its liability under the guaranty, reduce the amount of the guaranty, or, if it has already paid under the guaranty, seek recovery of any loss related to the deficiency from the Bank.
•The Corporation’s allowance for loan losses may not be adequate to cover actual losses.
The Corporation maintains an allowance for loan losses to provide for loan defaults and non-performance. The allowance for loan losses represents management’s estimate of probable losses inherent in the Corporation’s loan portfolio. The Corporation’s allowance consists of three components: probable losses estimated from individual reviews of specific loans, probable losses estimated from historical loss rates, and probable losses resulting from economic, environmental, qualitative or other deterioration above and beyond what is reflected in the first two components of the allowance. The process for determining the adequacy of the allowance for loan losses is critical to the Corporation’s financial results. It requires management to make difficult, subjective and complex judgments, as a result of the need to make estimates about the effect of matters that are uncertain. Therefore, the allowance for loan losses, considering current factors at the time, including economic conditions and ongoing internal and external examination processes, will increase or decrease as deemed necessary to ensure the allowance for loan losses remains adequate. In addition, the allowance as a percentage of charge-offs and nonperforming loans will change at different points in time based on credit performance, loan mix and collateral values.
In addition, the adoption of Accounting Standards Update (ASU) No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments as amended, on January 1, 2021 will impact our methodology for estimating the allowance for credit losses and could increase volatility in the Corporation's financial results. See NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The Corporation recorded a one-time cumulative-effect adjustment to retained earnings, net of income taxes, on its consolidated balance sheet as of January 1, 2021. The allowance increased by 57 percent from December 31, 2020 because it covered expected credit losses over the life of the loan portfolio, which approximates four years, and it includes all purchased loans that were previously excluded from the allowance for loan losses calculation. CECL also requires the establishment of a reserve for potential losses from unfunded commitments that is recorded in other liabilities, separate from allowance for credit losses, which was approximately $21 million. The ongoing impact of adopting this ASU is dependent on various factors, including credit quality, macroeconomic forecasts and conditions, composition of our loans and securities portfolios, and other management judgments.
•The Corporation may suffer losses in its loan portfolio despite its underwriting practices.
The Corporation seeks to mitigate the risks inherent in its loan portfolio by adhering to specific underwriting practices. The Corporation’s strategy for credit risk management includes conservative credit policies and underwriting criteria for all loans, as well as an overall credit limit for each customer significantly below legal lending limits. The strategy also emphasizes diversification on a regional geographic, industry and customer level, regular credit quality reviews and management reviews of large credit exposures and loans experiencing deterioration of credit quality. There is a continuous review of the loan portfolio, including an internally administered loan “watch” list and an independent loan review. The evaluation takes into consideration identified credit problems, as well as the possibility of losses inherent in the loan portfolio that are not specifically identified. Although the Corporation believes that its underwriting criteria are appropriate for the various kinds of loans it makes, the Corporation may incur losses on loans due to the factors previously discussed.
•The Corporation's wholesale funding sources may prove insufficient to replace deposits or support future growth.
As part of the Corporation's liquidity management, a number of funding sources are used, including core deposits and repayments and maturities of loans and investments. Sources also include brokered certificates of deposit, repurchase agreements, federal funds purchased and FHLB advances. Negative operating results or changes in industry conditions could lead to an inability to replace these additional funding sources at maturity. The Corporation's financial flexibility could be constrained if we are unable to maintain access to funding or if adequate financing is not available to accommodate future growth at acceptable interest rates. Finally, if the Corporation is required to rely more heavily on more expensive funding sources to support future growth, revenues may not increase proportionately to cover the costs. In this case the Corporation's results of operations and financial condition would be negatively affected.
•The Corporation relies on dividends from its subsidiaries for its liquidity needs.
The Corporation is a separate and distinct legal entity from its bank and non-bank subsidiaries. The Corporation receives substantially all of its cash from dividends paid by its subsidiaries. These dividends are the principal source of funds to pay dividends on the Corporation’s stock and interest and principal on its debt. Various federal and state laws and regulations limit the amount of dividends that the bank subsidiaries may pay to the Corporation.
•Acquisitions may not produce revenue enhancements or cost savings at levels or within timeframes originally anticipated and may result in unforeseen integration difficulties.
The Corporation regularly explores opportunities to acquire banks, financial institutions, or other financial services businesses or assets. The Corporation cannot predict the number, size or timing of acquisitions. Difficulty in integrating an acquired business or company may cause the Corporation not to realize expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from the acquisition. The integration could result in higher than expected deposit attrition (run-off), loss of key employees, disruption of the Corporation’s business or the business of the acquired company, or otherwise adversely affect the Corporation’s ability to maintain relationships with customers and employees or achieve the anticipated benefits of the acquisition. Also, the negative effect of any divestitures required by regulatory authorities in acquisitions or business combinations may be greater than expected. The Corporation may also issue equity securities in connection with acquisitions, which could cause ownership and economic dilution to current stockholders.
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•The Corporation faces operational risks because the nature of the financial services business involves a high volume of transactions.
The Corporation operates in diverse markets and relies on the ability of its employees and systems to process a high number of transactions. Operational risk is the risk of loss resulting from the Corporation’s operations, including, but not limited to, the risk of fraud by employees or persons outside of the Corporation, the execution of unauthorized transactions by employees, errors relating to transaction processing and technology, breaches of the internal control system and compliance requirements and business continuation and disaster recovery. This risk of loss also includes the potential legal actions that could arise as a result of an operational deficiency or as a result of noncompliance with applicable regulatory standards, adverse business decisions or their implementation, and customer attrition due to potential negative publicity. In the event of a breakdown in the internal control system, improper operation of systems or improper employee actions, the Corporation could suffer financial loss, face regulatory action and suffer damage to its reputation.
•Cyber incidents and other security breaches at the Corporation, its service providers or counterparties, or in the business community or markets may negatively impact the Corporation’s business or performance.
In the ordinary course of its business, the Corporation collects, stores, and transmits sensitive, confidential, or proprietary data and other information, including intellectual property, business information, funds-transfer instructions, and the personally identifiable information of its customers and employees. The secure processing, storage, maintenance, and transmission of this information is critical to the Corporation’s operations and reputation, and if any of this information were mishandled, misused, improperly accessed, lost, or stolen or if the Corporation’s operations were disrupted, the Corporation could suffer significant financial, business, reputational, regulatory, or other damage.
The Corporation maintains a comprehensive Cyber and Information Security Program and significant resources are devoted to protecting the Corporation’s assets from threats. Despite security measures, the Corporation’s information technology and infrastructure may be breached through cyber-attacks, computer viruses or malware, pretext calls, electronic phishing, or other means. These risks and uncertainties are rapidly evolving and increasing in complexity, and the Corporation’s failure to effectively mitigate them could negatively impact its business and operations.
Service providers and counterparties also present a source of risk to the Corporation if their own security measures or other systems or infrastructure were to be breached or otherwise fail. Likewise, a cyber-attack or other security breach affecting the business community, the markets, or parts of them may cycle or cascade through the financial system and adversely affect the Corporation or its service providers or counterparties. Many of these risks and uncertainties are beyond the Corporation’s control.
Even when an attempted cyber incident or other security breach is successfully avoided or thwarted, the Corporation may need to expend substantial resources in doing so, may be required to take actions that could adversely affect customer satisfaction or behavior, and may be exposed to reputational damage. If a breach were to occur, moreover, the Corporation could be exposed to contractual claims, regulatory actions, and litigation by private plaintiffs, and would additionally suffer reputational harm. Despite the Corporation’s efforts to safeguard the integrity of systems and controls and to manage third-party risk, the Corporation may not be able to anticipate or implement effective measures to prevent all security breaches or all risks to the sensitive, confidential, or proprietary information that it or its service providers or counterparties collect, store, or transmit. In addition, the Corporation may not have adequate insurance coverage to compensate for losses from a cyber incident or other security breach.
The ongoing COVID-19 pandemic is introducing additional risk to our information systems and security procedures, controls and policies as a result of employees, contractors and other corporate partners working remotely. As a result of the increased remote workforce, we must increasingly rely on information technology systems that are outside our direct control, and these systems are also vulnerable to cyber-based attacks and security breaches. In addition, since the beginning of pandemic, there has been an increase in attacks by cyber criminals on businesses and individuals, utilizing interest in pandemic-related information and the fear and uncertainty caused by the pandemic to increase phishing, malware, and other cybersecurity attacks designed to trick victims into transferring sensitive data or funds, steal credentials or deploy malware that compromises information systems. If one of our employees were to fall victim to one of these attacks, or our information technology systems are compromised, our operations could be disrupted, or we may suffer financial loss, reputational loss, loss of customer business or other critical assets, or become exposed to regulatory fines and intervention or civil litigation.
•The Corporation continually encounters technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables the financial institutions to better serve customers to reduce costs. The Corporation's future success depends, in part, upon its ability to address customer needs by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation's operations. The Corporation may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological changes affecting the financial services industry could negatively affect the Corporation's growth, revenue and profit. In addition, the Corporation relies upon the expertise and support of third-party service providers to help implement, maintain and/or service certain of its core technology solutions. If the Corporation cannot effectively manage these service providers, the service parties fail to materially perform, or the Corporation was to falter in any of the other noted areas, its business or performance could be negatively impacted.
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•The Corporation is subject to environmental liability risk associated with our Bank branches and any real estate collateral we acquire upon foreclosure.
A significant portion of our loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. The costs associated with investigation and remediation activities could be substantial. If hazardous or toxic substances are found, we may be liable for remediation costs, as well as for personal injury and property damage, including damages and costs resulting from environmental contamination emanating from the property. Although we have policies and procedures to perform an environmental review before initiating foreclosure, these actions may not be sufficient to detect all potential environmental hazards.
We also have an extensive branch network, owning branch locations throughout the areas we serve that may be subject to similar environmental liability risks. Environmental laws may require us to incur substantial expenses and could materially reduce the affected property's value or limit our ability to use or sell the affected property. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on our business, financial condition or results of operations.
•Significant legal actions could subject the Corporation to substantial uninsured liabilities.
The Corporation is from time to time subject to claims related to its operations. These claims and legal actions, including supervisory actions by the Corporation’s regulators, could involve large monetary claims and significant defense costs. To protect itself from the cost of these claims, the Corporation maintains insurance coverage in amounts and with deductibles that it believes are appropriate for its operations. However, the Corporation’s insurance coverage may not cover all claims against the Corporation or continue to be available to the Corporation at a reasonable cost. As a result, the Corporation may be exposed to substantial uninsured liabilities, which could adversely affect the Corporation’s results of operations and financial condition.
•The Corporation’s controls and procedures may fail or be circumvented.
Management regularly reviews and updates the Corporation’s 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 the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our results of operations and financial condition.
•The Corporation’s methods of reducing risk exposure may not be effective.
The Corporation maintains a comprehensive risk management program designed to identify, quantify, manage, mitigate, monitor, aggregate, and report risks. However, instruments, systems and strategies used to hedge or otherwise manage exposure to various types of credit, market, liquidity, operational, compliance, financial reporting and strategic risks could be less effective than anticipated. As a result, the Corporation may not be able to effectively mitigate its risk exposures in particular market environments or against particular types of risk, which could have a material adverse effect on our results of operations and financial condition.
•The Corporation’s reported financial results depend on management’s selection of accounting methods and certain assumptions and estimates.
The Corporation’s accounting policies and methods are fundamental to how it records and reports its financial condition and results of operations. The Corporation’s management must exercise judgment in selecting and applying many of these accounting policies and methods, so they comply with GAAP and reflect management’s judgment of the most appropriate manner to report the Corporation’s financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which might be reasonable under the circumstances yet might result in the Corporation reporting materially different results than would have been reported under a different alternative. Certain accounting policies are critical to presenting the Corporation’s financial condition and results, and require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include: the allowance for loan losses; the valuation of investment securities; the valuation of goodwill and intangible assets; pension accounting; and the accounting related to acquisitions. Because of the uncertainty of estimates involved in these matters, the Corporation may be required to do one or more of the following: significantly increase the allowance for loan losses and/or sustain loan losses that are significantly higher than the reserve provided; recognize significant provision for impairment of its investment securities; recognize significant impairment on its goodwill and intangible assets; significantly increase its pension liability; or modify the purchase price allocation of an acquisition. As part of its function of assisting the Corporation’s Board of Directors in discharging its responsibility of ensuring all types of risk to the organization are properly being managed, mitigated and monitored by management, the Audit Committee of the Board of Directors oversees management’s accounting policies and
methods. For more information, refer to NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
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•A write-down of all or part of the Corporation’s goodwill could materially reduce its net income and net worth.
At December 31, 2020, the Corporation had goodwill of $543.9 million recorded on its consolidated balance sheet. Under ASC 350, Intangibles – Goodwill and Other, the Corporation is required to evaluate goodwill for impairment on an annual basis, as well as on an interim basis, if events or changes indicate that the asset may be impaired. An impairment loss must be recognized for any excess of carrying value over the fair value of goodwill. The fair value is determined based on internal valuations using management’s assumptions of future growth rates, future attrition, discount rates, multiples of earnings or other relevant factors. The resulting estimated fair value could result in material write-downs of goodwill and recording of impairment losses. Such a write-down could materially reduce the Corporation’s net income and overall net worth. The Corporation also cannot predict the occurrence of certain future events that might adversely affect the fair value of goodwill. Such events include, but are not limited to, strategic decisions made in response to economic and competitive conditions, the effect of the economic environment on the Corporation’s customer base, or a material negative change in its relationship with significant customers.
•Changes in accounting standards could materially impact the Corporation’s financial statements.
From time to time, the Financial Accounting Standards Board changes the financial accounting and reporting standards that govern the preparation of the Corporation’s financial statements. These changes can be hard to predict and can materially impact how the Corporation records and reports its financial condition and results of operations. In some cases, the Corporation could be required to apply a new or revised standard retroactively; resulting in the restatement of prior period financial statements.
•Negative publicity could damage the Corporation’s reputation and adversely impact its business and financial results.
Reputation risk, or the risk to the Corporation’s earnings and capital from negative publicity, is inherent in the Corporation’s business. Negative publicity can result from the Corporation’s actual or alleged conduct in any number of activities, including lending practices, corporate governance and acquisitions, and actions taken by government regulators and community organizations in response to those activities. Negative publicity can adversely affect the Corporation’s ability to keep and attract customers and can expose the Corporation to litigation and regulatory action. Although the Corporation takes steps to minimize reputation risk in dealing with customers and other constituencies, the Corporation is inherently exposed to this risk.
•The Corporation may not be able to pay dividends in the future in accordance with past practice.
The Corporation has traditionally paid a quarterly dividend to common stockholders. The payment of dividends is subject to legal and regulatory restrictions. Any payment of dividends in the future will depend, in large part, on the Corporation’s earnings, capital requirements, financial condition and other factors considered relevant by the Corporation’s Board of Directors.
•The Bank is operating under a Settlement Agreement and Agreed Order ("Settlement Agreement") with the United States Department of Justice ("DOJ"), and its failure to comply with the Agreement could materially and adversely affect our business.
The Bank is operating under a Settlement Agreement and Agreed Order with the DOJ. The Settlement Agreement and Agreed Order was effective August 8, 2019 and has a four year term. The Bank’s failure to comply with the Settlement Agreement could materially and adversely affect our business Our Board of Directors and executive management team have been working diligently to comply with the Settlement Agreement and believe that they have allocated sufficient resources to address the corrective actions required by the DOJ. Compliance with and resolution of the Settlement Agreement will ultimately be determined by the DOJ. The Bank’s failure to comply with the Settlement Agreement and to successfully implement its requirements or the general perception of the Settlement Agreement by other regulators with jurisdiction over the Corporation or the Bank could have a material and adverse effect on our business, results of operation, financial condition, plans for and timing of future acquisitions and expansion, cash flows and stock price.
Market and Industry Risks
•The Corporation’s business and financial results are significantly affected by general business and economic conditions.
The Corporation’s business activities and earnings are affected by general business conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, and the strength of the United States economy and the state and local economies in which the Corporation operates. The Corporation's offices are primarily located in Indiana, Illinois, Ohio and Michigan. Worsening economic conditions in our market areas could negatively impact the financial condition, results of operations and stock price of the Corporation. For example, a prolonged economic downturn, increases in unemployment, or other events that affect household and/or corporate incomes could result in deterioration of credit quality, an increase in the allowance for loan losses, or reduced demand for loan or fee-based products and services. Changes in the financial performance and condition of the Corporation’s borrowers could negatively affect repayment of those borrowers’ loans. In addition, changes in securities market conditions and monetary fluctuations could adversely affect the availability and terms of funding necessary to meet the Corporation’s liquidity needs.
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•Changes in the domestic interest rate environment could affect the Corporation’s net interest income as well as the valuation of assets and liabilities.
The operations of financial institutions, such as the Corporation, are dependent to a large degree on net interest income, which is the difference between interest income from loans and investments and interest expense on deposits and borrowings. An institution’s net interest income is significantly affected by market rates of interest, which in turn are affected by prevailing economic conditions, by the fiscal and monetary policies of the federal government and by the policies of various regulatory agencies. In addition to affecting profitability, changes in interest rates can impact the valuation of assets and liabilities. For example, changes in reference rates linked to financial instruments, such as the London Interbank Offered Rate (LIBOR), may adversely affect the value of financial instruments the Corporation holds or issues and related net interest income. Rate changes can also affect the ability of borrowers to meet obligations under variable or adjustable rate loans which in turn affect loss rates on those assets. Also, the demand for interest rate based products and services, including loans and deposit accounts, may decline resulting in the flow of funds away from financial institutions into direct investments. Direct investments, such as U.S. Government and corporate securities and other investment vehicles, including mutual funds, generally pay higher rates of return than financial institutions, because of the absence of federal insurance premiums and reserve requirements.
Governments have taken unprecedented steps to partially mitigate the adverse effects of their COVID-19 containment measures. For example, in late March 2020, the CARES Act was enacted to inject more than $2 trillion of financial assistance into the U.S. economy. The Federal Reserve has taken wide-ranging actions as well. Since March 15, 2020, the Federal Open Market Committee has reduced the target range for the federal funds rate to 0 percent to 0.25 percent. The Federal Reserve has also initiated a program to purchase an indeterminate amount of Treasury securities and agency mortgage-backed securities, corporate bonds and other investments, and numerous facilities to support the flow of credit to households and businesses. These activities have the effect of suppressing long-term interest rates and could lead to unforeseen consequences.
•The replacement of LIBOR with an alternative reference rate could have an adverse impact on the Corporation.
In July 2017, the U.K. Financial Conduct Authority, the authority regulating LIBOR, announced that LIBOR in its current state would be discontinued at the end of 2022. LIBOR is commonly referenced in financial contracts and the Corporation has exposure to the termination of this interest rate index in loans, derivatives, debt agreements, and other instruments. A cross functional project team has been established to determine the level of exposure, identify the appropriate replacement rate(s), and develop migration strategies. Industry groups, regulators and other various oversight bodies will be consulted throughout the transition. Any replacement interest rate(s) may perform differently and we may incur significant costs to transition both our borrowing arrangements and the loan agreements with our customers from LIBOR, which may have an adverse effect on our results of operations. In addition, amending certain contracts indexed to LIBOR may require consent from impacted counterparties which could be difficult to obtain. The financial and operational impact of the transition is unknown at this time.
•Changes in the laws, regulations and policies governing banks and financial services companies could alter the Corporation’s business environment and adversely affect operations.
The Board of Governors of the Federal Reserve System regulates the supply of money and credit in the United States. Its fiscal and monetary policies determine in a large part the Corporation’s cost of funds for lending and investing and the return that can be earned on those loans and investments, both of which affect the Corporation’s net interest margin. Federal Reserve Board policies can also materially affect the value of financial instruments that the Corporation holds, such as debt securities. The Corporation and the Bank are heavily regulated at the federal and state levels. This regulation is to protect depositors, federal deposit insurance funds and the banking system as a whole. Congress and state legislatures and federal and state agencies continually review banking laws, regulations and policies for possible changes. After the Great Recession, efforts to promote the safety and soundness of financial institutions, financial market stability, the transparency and liquidity of financial markets, and consumer and investor protection resulted in increased regulation in the financial services industry. Regulatory agencies have intensified their examination practices and enforcement of laws and regulations. Compliance with regulations and other supervisory initiatives could increase the Corporation’s expenses and reduce revenues by limiting the types of financial services and products that the Corporation offers and/or increasing the ability of non-banks to offer competing financial services and products. See a description of recent legislation in the “REGULATION AND SUPERVISION OF FIRST MERCHANTS CORPORATION AND SUBSIDIARIES” section of Item 1: Business of this Annual Report on Form 10-K.
The banking industry, as well as the broader economy, may be subject to new legislation, regulation, and government policy. Future legislation, regulation, and government policy could affect the banking industry as a whole, including our business and results of operations, in a way that cannot accurately be predicted. In addition, our financial condition and results of operations also could be adversely affected by changes in the way in which existing statutes and regulations are interpreted or applied by courts and government agencies.
Certain regulations require the Corporation to maintain certain capital ratios, such as the ratio of Tier 1 capital to risk-based assets. Both the Dodd-Frank Act, which reformed the regulation of financial institutions in a comprehensive manner, and the Basel III regulatory capital reforms, which increase both the amount and quality of capital that financial institutions must hold, impact capital requirements. If the Corporation is unable to satisfy these heightened regulatory capital requirements, due to a decline in the value of the loan portfolio or otherwise, raising additional capital or disposing of assets could be required. Additional capital could be raised by selling additional shares of common stock, or securities convertible into or exchangeable for common stock, which could significantly dilute the ownership percentages of stockholders and cause the market price of our common stock to decline. Events or circumstances in the capital markets generally may increase capital costs and impair the ability to raise capital at any given time. Disposal of assets cannot guarantee disposal at prices appropriate for the disposition, and future operating results could be negatively affected.
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•The Corporation is subject to heightened regulatory requirements as the Corporation's assets have exceeded $10 billion.
Based on the Corporation’s organic growth and recent acquisitions, the Corporation’s total consolidated assets exceeded $10 billion for four consecutive quarters as of December 31, 2019. As a result, the Corporation is subject to increased regulatory scrutiny and additional expectations imposed by the Dodd-Frank Act. The increased regulatory scrutiny comes from the examination of compliance with federal consumer protection laws by the CFPB. The CFPB’s examination practices continue to evolve and it is uncertain how they might impact the Corporation. The Durbin Amendment imposes limits on interchange fees paid by merchants to banks whose assets exceed $10 billion when debit cards are used as payment. These limits have materially reduced the Corporation’s fee income and that reduction is expected to continue. Compliance with the CFPB standards could increase the Corporation’s operational costs. Our other regulators may also consider our compliance with these requirements when examining our operations generally or considering any request for regulatory approval we may make.
•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 last recession, significantly increased losses to the Deposit Insurance Fund of the FDIC. Further, the Dodd-Frank Act mandated 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 the Bank’s financial condition or capital strength, and future conditions in the banking industry. As the Corporation's assets have exceeded $10 billion, the method for calculating the Bank’s FDIC assessment has changed. The calculation change materially increased the Corporation's FDIC assessment and the increase is expected to continue. See the “Deposit Insurance” section of “REGULATION AND SUPERVISION OF FIRST MERCHANTS CORPORATION AND SUBSIDIARIES” under this Item 1. Business for additional information.
•The banking and financial services industry is highly competitive, and competitive pressures could intensify and adversely affect the Corporation’s financial results.
The Corporation operates in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. The Corporation competes with other banks, savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions and investment companies. In addition, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Many of the Corporation’s competitors have fewer regulatory constraints, greater resources and lower cost structures allowing them to aggressively price their products. In December 2016, the OCC announced its intent to make special purpose national bank charters available to financial technology companies. The agency published a paper discussing issues related to chartering special purpose national banks and solicited public comment to help guide its approach to financial innovation. Such pressures make it more difficult for the Corporation to attract and retain customers across its business lines. Also, the demands of adapting to industry changes in technology and systems, on which the Corporation and financial services industry are highly dependent, could present operational issues and require capital spending.
Additionally, our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in many activities for which the Corporation is engaged is intense and we may not be able to hire people and retain them. The unexpected loss of services of key personnel could have a material adverse impact on our business, financial condition and results of operations because of their customer relationships, skills, knowledge of our markets, years of industry experience and the difficulty of promptly finding qualified replacement personnel. In addition, the scope and content of U.S. banking regulators' policies on incentive compensation, as well as changes to these policies, could adversely affect our ability to hire, retain and motivate our key employees.
•Changes in tax legislation could materially impact the Corporation’s business and financial results.
From time to time, the U.S government or State governments where the Corporation has tax nexus can enact tax legislation that may have a material effect on the Corporation's business and financial results. On December 22, 2017, the U.S. government enacted tax reform legislation commonly referred to as the Tax Cuts and Jobs Act ("TCJA") which made significant changes to the Internal Revenue Code of 1986, as amended. The legislation, among other things, made significant changes to the rules applicable to the taxation of corporations, such as changing the corporate tax rate to 21 percent, modifying the rules regarding limitations on certain deductions for executive compensation, introducing a capital investment deduction in certain circumstances, placing certain limitations on the interest deduction, and modifying the rules regarding the usability of net operating losses. ASC 740, Income Taxes, requires the impact of tax legislation to be recognized in the accounting period the legislation is signed into law. As such, the $5.1 million impact of revaluing the Corporation's deferred tax assets and liabilities has been recorded in income tax expense as of December 31, 2017.
While our earnings have been positively impacted by the rate reduction and the resulting increase in economic activity, the TCJA also enacted limitations on certain deductions that have had a negative impact on borrowers and the market for single-family residential real estate, and, as a result, on the banking industry. These limitations include (1) a lower limit on the deductibility of mortgage interest on single-family residential mortgage loans, (2) the elimination of interest deductions for certain home equity loans, (3) a limitation on the deductibility of business interest expense, and (4) a limitation on the deductibility of property taxes and state and local income taxes. Given the current economic and political environment and ongoing budgetary pressures, the enactment of further new federal or state tax legislation may occur. The enactment of such legislation, or changes in the interpretation of existing law, including provisions impacting tax rates, apportionment, consolidation or combination, income, expenses, credits and exemptions may have a material adverse effect on our business, financial condition and results of operations.
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PART I: ITEM 1A. AND ITEM 1B.
General Risk Factors
•A disaster, natural or otherwise, acts of terrorism and political or military actions taken by the United States or other governments could adversely affect the Corporation’s business, directly or indirectly.
Disasters (such as tornadoes, floods, and other severe weather conditions, pandemics, fires, and other catastrophic accidents or events) and terrorist activities and the impact of these occurrences cannot be predicted. Such occurences could harm the Corporation’s operations and financial condition directly through interference with communications and through the destruction of facilities and operational, financial and management information systems and/or indirectly by adversely affecting economic and industry conditions. These events could prevent the Corporation from gathering deposits, originating loans and processing and controlling its flow of business by affecting borrowers, depositors, suppliers or other counterparties. The Corporation’s ability to mitigate the adverse impact of these occurrences would depend in part on the Corporation’s business continuity planning, the ability to anticipate any such event occurring, the preparedness of national or regional emergency responders, and continuity planning of parties the Corporation deals with.
•The Corporation’s stock price can be volatile.
The Corporation’s stock price can fluctuate widely in response to a variety of factors, including: actual or anticipated variations in the Corporation’s quarterly operating results; recommendations by securities analysts; significant acquisitions or business combinations; strategic partnerships, joint ventures or capital commitments; operating and stock price performance of other companies that investors deem comparable to the Corporation; new technology used or services offered by the Corporation’s competitors; news reports relating to trends, concerns and other issues in the banking and financial services industry, and changes in government regulations. General market fluctuations, industry factors and general economic and political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, could also cause the Corporation’s stock price to decrease, regardless of the Corporation’s operating results.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
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PART I: ITEM 2., ITEM 3. AND ITEM 4.
ITEM 2. PROPERTIES.
The headquarters of the Corporation and the Bank are located at 200 East Jackson Street, Muncie, Indiana. The building is owned by the Bank.
The Bank conducts business through numerous facilities owned and leased. Of the 124 banking offices operated by the Bank, 109 are owned and 15 are leased from non-affiliated third parties.
None of the properties owned by the Corporation are subject to any major encumbrances. The net investment of the Corporation and subsidiaries in real estate and equipment at December 31, 2020 was $111,062,000.
ITEM 3. LEGAL PROCEEDINGS.
There are no pending legal proceedings, other than litigation incidental to the ordinary course of business of the Corporation and its subsidiaries, of a material nature to which the Corporation or its subsidiaries is a party, or of which any of their properties are subject. Further, there are no material legal proceedings in which any director, officer, principal shareholder, or affiliate of the Corporation, or any associate of any such director, officer or principal shareholder, is a party, or has a material interest, adverse to the Corporation or any of its subsidiaries.
None of the routine legal proceedings, individually or in the aggregate, in which the Corporation or its affiliates are involved are expected to have a material adverse impact on the financial position or the results of operations of the Corporation.
ITEM 4. MINE SAFETY DISCLOSURES.
Not applicable.
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SUPPLEMENTAL INFORMATION
SUPPLEMENTAL INFORMATION - INFORMATION ABOUT OUR EXECUTIVE OFFICERS
The names, ages, and positions with the Corporation and the Bank of all executive officers of the Corporation and all persons chosen to become executive officers are listed below. The officers are elected by the Board of Directors of the Corporation for a term of one year or until the election of their successors. There are no arrangements between any officer and any other person pursuant to which he or she was selected as an officer.
Mark K. Hardwick, 50, Chief Executive Officer, Corporation
Chief Executive Officer of the Corporation since January 2021; Executive Vice President and Chief Financial Officer and Chief Operating Officer of the Corporation from May 2016 to January 2021; Executive Vice President and Chief Financial Officer of the Corporation from December 2005 to May 2016; Senior Vice President and Chief Financial Officer of the Corporation from April 2002 to December 2005; Corporate Controller of the Corporation from November 1997 to April 2002.
Michael J. Stewart, 55, President, Corporation
President of the Corporation since January 2021; Executive Vice President and Chief Banking Officer of the Corporation from February 2008 to January 2021; Executive Vice President from December 2006 to February 2008 of National City Corp; Executive Vice President and Chief Credit Officer of National City Bank of Indiana from December 2002 to December 2006.
Michele M. Kawiecki, 48, Executive Vice President and Chief Financial Officer, Corporation
Executive Vice President and Chief Financial Officer of the Corporation since January 2021; Senior Vice President and Director of Finance of the Corporation from March 2015 to January 2021; Senior Vice President of Capital Management and Assistant Treasurer of UMB Financial Corporation from May 2011 to March 2015; Director of Corporate Development and Enterprise Project Management at UMB Financial Corporation from May 2008 to May 2011; Chief Risk Officer at UMB Financial Corporation from February 2004 to May 2008.
John J. Martin, 54, Executive Vice President and Chief Credit Officer, Corporation
Executive Vice President and Chief Credit Officer of the Corporation since March 2013; Senior Vice President and Chief Credit Officer of the Corporation from June 2009 to March 2013; First Vice President and Deputy Chief Credit Officer of the Corporation from July 2008 to June 2009; First Vice President and Senior Manager of Lending Process of the Corporation from January 2008 to July 2008; Senior Vice President and Regional Senior Credit Officer of National City Bank from May 2000 to December 2007.
Stephan H. Fluhler, 52, Senior Vice President, Chief Information Officer, Corporation
Senior Vice President and Chief Information Officer of the Corporation since May 2014; Chief Technology Officer of the Corporation from 2004 to May 2014; Director of Technology Services and Change Management of the Corporation from December 2003 to 2004.
Jeffrey B. Lorentson, 57, Senior Vice President and Chief Risk Officer, Corporation
Senior Vice President and Chief Risk Officer of the Corporation since June 2007; Corporate Controller of First Indiana Bank from June 2006 to June 2007; First Vice President and Corporate Controller of the Corporation from 2003 to 2006; Vice President and Corporate Controller of the Corporation from 2002 to 2003.
Steven C. Harris, 57, Senior Vice President and Director of Human Resources, Corporation
Senior Vice President and Director of Human Resources of the Corporation since November, 2016; First Vice President, Director of Talent Development of FMC from March 2016 to November 2016, Senior Vice President, Regional Retail Manager of PNC Bank from February 2015 to March 2016, Senior Vice President and Market Sales and Service Manager, PNC Bank from June 2009 to February 2015.
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PART II: ITEM 5. AND ITEM 6.
PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
PERFORMANCE GRAPH
The following graph compares the cumulative 5-year total return to shareholders on First Merchants Corporation’s common stock relative to the cumulative total returns of the Russell 2000 index and the KBW Nasdaq Regional Banking Index. The graph assumes that the value of the investment in the Corporation’s common stock and in each of the indexes (including reinvestment of dividends) was $100 on December 31, 2015 and tracks it through December 31, 2020.
Period Ending
The stock price performance included in this graph is not necessarily indicative of future stock price performance.
COMMON STOCK LISTING
First Merchants Corporation common stock is traded on the Nasdaq Global Select Market under the symbol FRME. At the close of business on February 23, 2021, the number of shares outstanding was 54,347,186. There were 4,426 stockholders of record on that date.
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PART II: ITEM 5. AND ITEM 6.
PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASES
The following table presents information relating to our purchases of equity securities during the three months ended December 31, 2020, as follows:
December, 2020 — $ — — —
(1) Includes shares repurchased pursuant to net settlement by employees in satisfaction of income tax withholding obligations incurred through the vesting of the Corporation's restricted stock awards.
(2) On January 27, 2021, the Board of Directors of the Corporation approved a stock repurchase program of up to 3,333,000 shares of the Corporation’s outstanding common stock; provided, however, that the total aggregate investment in shares repurchased under the program may not exceed $100,000,000. Details regarding the 2021 stock repurchase program are discussed in NOTE 27. SUBSEQUENT EVENTS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
EQUITY COMPENSATION PLAN INFORMATION
The following table provides information about the Corporation’s common stock that may be issued under equity compensation plans as of December 31, 2020.
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PART II: ITEM 5. AND ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA.
Operations (1) (2) (3)
Per Share Data
Diluted net income available to common stockholders 2.74 3.19 3.22 2.12 1.98
Average Balances (1) (2) (3)
Year-End Balances (1) (2) (3)
Financial Ratios (1) (2) (3)
(1) Effective May 19, 2017, the Corporation acquired 100 percent of Arlington Bank. Arlington Bank was headquartered in Columbus, Ohio and had 3 full service banking centers serving the Columbus, Ohio market. Pursuant to the merger agreement, each Arlington Bank shareholder received 2.7245 shares of the Corporation's common stock for each outstanding share of Arlington Bank common stock held. The Corporation issued approximately 2.1 million shares of common stock, which was valued at approximately $82.6 million.
(2) On November 21, 2016, the Corporation purchased 495,112 shares, or 12.1 percent, of IAB's outstanding common stock from an IAB shareholder for $19.8 million. Effective July 14, 2017, the Corporation acquired the remaining shares of IAB common stock. IAB was headquartered in Fort Wayne, Indiana and had 16 full service banking centers serving the Fort Wayne, Indiana market. Pursuant to the merger agreement, each IAB shareholder received 1.653 shares of the Corporation's common stock for each outstanding share of IAB common stock held. The Corporation issued approximately 6.0 million shares of common stock. The transaction value for the remaining shares of common stock, not owned by the Corporation, was approximately $238.8 million, resulting in a total purchase price of $258.6 million.
(3) On September 1, 2019, the Corporation acquired 100 percent of MBT. MBT was headquartered in Monroe, Michigan and had 20 banking centers serving the Monroe market. Pursuant to the merger agreement, each MBT shareholder received 0.275 shares of the Corporation's common stock for each outstanding share of MBT common stock held. The Corporation issued approximately 6.4 million shares of common stock, which was valued at approximately $229.9 million. The details of the acquisition can be found in NOTE 2. ACQUISITIONS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
(4) Non-GAAP reconciliation can be found in the “Capital” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations included as Item 7 of this Annual Report on Form 10-K.
(5) Includes loans held for sale.
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PART II: ITEM 7. AND ITEM 7A. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
CRITICAL ACCOUNTING POLICIES
Generally accepted accounting principles require management to apply significant judgment to certain accounting, reporting and disclosure matters. Management must use assumptions and estimates to apply those principles where actual measurement is not possible or practical. The judgments and assumptions made are based upon historical experience or other factors that management believes to be reasonable under the circumstances. Because of the nature of the judgments and assumptions, actual results could differ from estimates, which could have a material effect on our financial condition and results of operations. For a complete discussion of the Corporation’s significant accounting policies, see NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
The following policies materially affect our reported earnings and financial condition and require significant judgments and estimates.
Business Combinations
Business combinations are accounted for under the acquisition method of accounting. Under the acquisition method, assets and liabilities of the business acquired are recorded at their estimated fair values as of the date of acquisition with any excess of the cost of the acquisition over the fair value of the net tangible and intangible assets acquired recorded as goodwill. Results of operations of the acquired business are included in the income statement from the date of acquisition.
Investment Securities
Held to maturity securities are carried at amortized cost when the Corporation has the positive intent and ability to hold them until maturity. Available for sale securities are recorded at fair value on a recurring basis with the unrealized gains and losses, net of applicable income taxes, recorded in other comprehensive income. Realized gains and losses are recorded in earnings and the prior fair value adjustments are reclassified within stockholders' equity. Gains and losses on sales of securities are determined on the specific-identification method. Amortization of premiums and accretion of discounts are amortized to their earliest call date and are recorded as interest income from securities.
Available for sale and held to maturity securities are evaluated for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the Corporation 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 assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.
When OTTI occurs, the amount of OTTI recognized in the income statement depends on whether the Corporation intends to sell the security or it is more likely than not that the Corporation will be required to sell the security before recovery of its amortized cost basis, less any recognized credit loss. If the intent is to sell, or it is more likely than not that the Corporation will be required to sell the security before recovery of its amortized cost basis, less any recognized credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis, less any recognized credit loss, and its fair value at the balance sheet date. If the intent is not to sell the security and it is not more likely than not that the Corporation will be required to sell the security before the recovery of its amortized cost basis less any recognized credit loss, the OTTI has been separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income, net of applicable income taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
For held to maturity debt securities, the amount of an OTTI recorded in other comprehensive income for the noncredit portion of a previous other-than-temporary impairment is amortized prospectively over the remaining life of the security on the basis of the timing of future estimated cash flows of the security.
Loans
The Corporation’s loan portfolio is carried at the principal amount outstanding, net of unearned income and principal charge-offs. Certain loan fees and direct costs are being deferred and amortized as an adjustment of yield on the loans. Interest income is accrued on the principal balances of loans. The accrual of interest is discontinued on a loan when, in management’s opinion, the borrower may be unable to meet payments as they become due. When the interest accrual is discontinued, all unpaid accrued interest is reversed against earnings when considered uncollectible. Interest income accrued in the prior year, if any, is charged to the allowance for loan losses. Interest income is subsequently recognized only to the extent cash payments are received and the loan is returned to accruing status.
Certain non-accrual, substantially delinquent and renegotiated loans classified as troubled debt restructures may be considered to be impaired in accordance with ASC 310, Receivables. Under ASC 310-10, a loan is impaired when, based on current information or events, it is probable all amounts due (principal and interest) according to the contractual terms of the loan agreement are uncollectible. Renegotiated consumer loans classified as troubled debt restructures are considered to be impaired. In applying the provisions of ASC 310-10, the Corporation considers all other investments in one-to-four family residential loans and consumer installment loans to be homogeneous and therefore excluded from separate identification for evaluation of impairment. Impaired loans are carried at the fair value of collateral if the loan is collateral dependent, or the present value of estimated future cash flows using the loan’s existing rate. A portion of the allowance for loan losses is allocated to impaired loans if the value of such loans is deemed to be less than the unpaid balance. If these allocations cause the allowance for loan losses to increase, such increase is reported as a component of the provision for loan losses. Loan losses are charged against the allowance when management believes the uncollectability of the loan is confirmed. The valuation would be considered Level 3, consisting of appraisals of underlying collateral and discounted cash flow analysis.
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PART II: ITEM 7. AND ITEM 7A. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The CARES Act and the Interagency Statement on Loan Modifications encourage financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations due to the effects of COVID-19. Additionally, Section 4013 of the CARES Act further provides that a qualified loan modification is exempt by law from classification as a troubled debt restructure as defined by GAAP, from the period beginning March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the date on which the national emergency concerning the COVID-19 outbreak under the National Emergencies Act (50 U.S.C. 1601 et seq.) terminates. The 2021 Consolidated Appropriations Act extended the expiration date for COVID-related loan modifications exempt from troubled debt restructuring classification under GAAP until the earlier of January 1, 2022, or 60 days after the termination of the national emergency. Additional details of the Corporation's loan modifications under these programs are included in the "LOAN QUALITY" section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Purchased Loans
Loans acquired in a business combination with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be purchased credit impaired. Evidence of credit quality deterioration as of purchase dates may include information such as past-due and nonaccrual status, borrower credit risk grade and recent loan to value percentages. Purchased credit-impaired loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality (ASC 310-30). These loans are initially measured at fair value based upon expected cash flows without anticipation of prepayments and includes estimated future credit losses expected to be incurred over the life of the loans. As a result, related discounts are recognized subsequently through accretion based on the expected cash flows of the acquired loans. For purposes of applying ASC 310-30, loans acquired in business combinations are individually evaluated for the initial fair value measurement. Accordingly, allowances for credit losses related to these loans are not carried over at the acquisition date.
The difference between contractually required payments and the cash flows expected to be collected at acquisition is referred to as the nonaccretable portion of the fair value discount or premium. The accretable portion of the fair value discount or premium is the difference between the expected cash flows and the net present value of expected cash flows, with such difference accreted into income over the term of the loans. Acquired loans not accounted for under ASC 310-30 are accounted for under ASC 310-20, which allows the fair value adjustment to be accreted into income over the remaining life of the loans.
Allowance for Loan Losses
The allowance for loan losses is maintained to absorb losses inherent in the loan portfolio and is based on ongoing, quarterly assessments of the probable losses inherent in the loan portfolio. The allowance is increased by the provision for loan losses, which is charged against current operating results. Loan losses are charged against the allowance when management believes the uncollectability of a loan is confirmed. Subsequent recoveries, if any, are credited to the allowance. The Corporation’s strategy for credit risk management includes credit policies and underwriting criteria for all loans, as well as an overall credit limit for each customer significantly below legal lending limits. The strategy also emphasizes diversification on regional geographic and industry levels, regular credit quality reviews and management reviews of large credit exposures and loans experiencing deterioration of credit quality.
The Corporation’s methodology for assessing the appropriateness of the allowance consists of three key elements – the determination of the appropriate reserves for impaired loans accounted for under ASC 310-10, probable losses estimated from historical loss rates, and probable losses resulting from economic, environmental, qualitative or other deterioration above and beyond what is reflected in the first two components of the allowance.
Where appropriate, reserves are allocated to individual loans based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral, other sources of cash flow and legal options available to the Corporation. Loans individually evaluated for impairment are those deemed impaired in accordance with ASC 310-10, including commercial relationships greater than $500,000 that exhibit well defined credit weaknesses. Any allowances for impaired loans are measured based on the fair value of the underlying collateral, if collateral dependent, or the present value of expected future cash flows discounted at the loan’s effective interest rate. The Corporation evaluates the collectability of principal when assessing the need for a loss accrual. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations.
The historical allocation for commercial loans graded pass are established by loan segments using loss rates based on the Corporation’s migration analysis. This migration analysis shows the loss rates for each segment of loans based on the loan grades at the beginning of the twelve month period. This loss rate is then applied to the current portfolio of loans in each respective loan segment.
Homogenous loans, such as consumer installment and residential mortgage loans, are not individually risk graded. Reserves are established for each segment of loans using loss rates based on charge-offs for the same period as the migration analysis used for commercial loans.
Historical loss allocations for commercial and consumer loans may be adjusted for significant factors that, in management’s judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the national and local economies, trends in loan growth and charge-off rates, changes in mix, concentration of loans in specific industries, asset quality trends (delinquencies, charge-offs and non-accrual loans), risk management and loan administration, changes in the internal lending policies and credit standards, examination results from bank regulatory agencies and the Corporation’s internal loan review.
Effective January 1, 2021, the Corporation adopted ASU 2016-13, Financial Instruments - Measurement of Current Expected Credit Losses on Financial Instruments ("CECL"), which will modify the accounting for the allowance for loan losses from an incurred loss model to an expected loss model, as discussed more fully under NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
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PART II: ITEM 7. AND ITEM 7A. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Goodwill and Intangibles
For acquisitions, assets acquired, including identified intangible assets, and the liabilities assumed are required to be recorded at their fair value. These often involve estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques that may include estimates of attrition, inflation, asset growth rates, or other relevant factors. In addition, the determination of the useful lives over which the intangible asset will be amortized is subjective. Intangible Assets that are subject to amortization, including core deposit intangibles, are being amortized on both the straight-line and accelerated basis over two to ten years. Intangible assets are periodically evaluated as to the recoverability of their carrying value.
Under ASC 350, Intangibles – Goodwill and Other, the Corporation must review goodwill for impairment on an annual basis, as well as on an interim basis if events or changes indicate that the asset might be impaired. An impairment loss must be recognized for any excess of carrying value over fair value of the goodwill. The Corporation completed its most recent annual goodwill impairment test as of October 1, 2020 and concluded, based on current events and circumstances, goodwill is not impaired. Details of the Corporation's goodwill impairment test are included in NOTE 8. GOODWILL of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Derivative Instruments
Derivative instruments, which are recorded as assets or liabilities in the consolidated balance sheets, are carried at fair value of the derivatives and reflects the estimated amounts that would have been received to terminate these contracts at the reporting date based upon pricing or valuation models applied to current market information.
As part of the asset/liability management program, the Corporation will utilize, from time to time, interest rate floors, caps or swaps to reduce its sensitivity to interest rate fluctuations. Changes in the fair values of derivatives are reported in the consolidated statements of operations or AOCI depending on the use of the derivative and whether the instrument qualifies for hedge accounting. The key criterion for hedge accounting is that the hedged relationship must be highly effective in achieving offsetting changes in those cash flows that are attributable to the hedged risk, both at inception of the hedge and on an ongoing basis.
Derivatives that qualify for the hedge accounting treatment are designated as either: (1) a hedge of the fair value of the recognized asset or liability, or of an unrecognized firm commitment (a fair value hedge); or (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (a cash flow hedge). To date, the Corporation has only entered into a cash flow hedge. For cash flow hedges, changes in the fair values of the derivative instruments are reported in AOCI to the extent the hedge is effective. The gains and losses on derivative instruments that are reported in AOCI are reflected in the consolidated statements of income in the periods in which the results of operations are impacted by the variability of the cash flows of the hedged item. Generally, net interest income is increased or decreased by amounts receivable or payable with respect to the derivatives, which qualify for hedge accounting. At inception of the hedge, the Corporation establishes the method it uses for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The ineffective portion of the hedge, if any, is recognized in the consolidated statements of income. The Corporation excludes the time value expiration of the hedge when measuring ineffectiveness.
The Corporation offers interest rate derivative products (e.g. interest rate swaps) to certain of its high-quality commercial borrowers. This product allows customers to enter into an agreement with the Corporation to swap their variable rate loan to a fixed rate. These derivative products are designed to reduce, eliminate or modify the risk of changes in the borrower’s interest rate or market price risk. The extension of credit incurred through the execution of these derivative products is subject to the same approvals and rigorous underwriting standards as the related traditional credit product. The Corporation limits its risk exposure to these products by entering into a mirror-image, offsetting swap agreement with a separate, well-capitalized and rated counterparty previously approved by the Credit and Asset Liability Committee. By using these interest rate swap arrangements, the Corporation is also better insulated from the interest rate risk associated with underwriting fixed-rate loans. These derivative contracts are not designated against specific assets or liabilities under ASC 815, Derivatives and Hedging, and, therefore, do not qualify for hedge accounting. The derivatives are recorded on the balance sheet at fair value and changes in fair value of both the customer and the offsetting swap agreements are recorded (and essentially offset) in non-interest income. The fair value of the derivative instruments incorporates a consideration of credit risk (in accordance with ASC 820, Fair Value Measurements and Disclosures), resulting in some volatility in earnings each period.
Income Taxes
Income tax expense in the consolidated statements of income is the total of the current year income tax due or refundable and the change in deferred tax assets and liabilities. Deferred tax assets and liabilities are the expected future tax amounts from the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized. The Corporation files consolidated income tax returns with its subsidiaries. The Corporation is generally no longer subject to U.S. federal, state and local income tax examinations by tax authorities for tax years before 2017.
The Corporation adopted the provisions of the ASC 740, Income Taxes, which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the implementation of ASC 740, the Corporation did not identify any uncertain tax positions that it believes should be recognized in the financial statements. The Corporation reviews income tax expense and the carrying value of deferred tax assets and liabilities quarterly; as new information becomes available, the balances are adjusted, if applicable. The Corporation's policy is to recognize interest and penalties related to unrecognized tax benefits, if any, as a component of income tax expense.
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PART II: ITEM 7. AND ITEM 7A. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
COVID-19, THE CARES ACT, THE 2021 CONSOLIDATED APPROPRIATIONS ACT AND RELATED REGULATORY ACTIONS
Impact of COVID-19
On January 30, 2020, the World Health Organization (“WHO”) announced that the outbreak of COVID-19 constituted a public health emergency of international concern. On March 11, 2020, WHO declared COVID-19 to be a global pandemic and, on March 13, 2020, the President of the United States declared the COVID-19 outbreak a national emergency. The health concerns relating to the COVID-19 outbreak and related governmental actions taken to reduce the spread of the virus have significantly impacted the global economy (including the states and local economies in which the Corporation operates), disrupted supply chains, lowered equity market valuations, and created significant volatility and disruption in financial markets. The outbreak has resulted in authorities implementing numerous measures to try to contain the virus, such as travel bans and restrictions, quarantines, shelter in place or total lock-down orders and business limitations and shutdowns. As a result of the shelter in place mandates in effect beginning early in the second quarter of 2020, commercial activity throughout our geographic footprint, as well as nationally, decreased significantly during 2020. Most states have reopened, albeit under limited capacities and under other social distancing restrictions; however, commercial activity has not returned to the levels existing prior to the outbreak of the pandemic. Such measures have significantly contributed to rising unemployment and negatively impacted consumer and business spending. As a result, the demand for the Corporation’s products and services has been, and will continue to be, significantly impacted.
The continued impact of COVID-19 on the Corporation will depend on numerous factors and future developments that are highly uncertain and cannot be predicted with confidence. It is unknown how long the COVID-19 pandemic will last, or when restrictions on individuals and businesses will be fully lifted and businesses and their employees will be able to resume normal activities. Additional information may emerge regarding the severity of COVID-19 and additional actions may be taken by federal, state and local governments to contain COVID-19 or treat its impact. Changes in the behavior of customers, businesses and their employees as a result of COVID-19 pandemic, including social distancing practices, even after formal restrictions have been lifted and vaccination rates have increased, are also unknown. As a result of COVID-19 and the actions taken to contain it or reduce its impact, we may experience changes in the demand for our products and services, changes in the value of collateral securing outstanding loans, reductions in the credit quality of borrowers and the inability of borrowers to repay loans in accordance with their terms. Our commercial and consumer customers are experiencing varying degrees of financial distress, which is expected to continue in 2021, especially if positive cases increase and economic shutdowns continue. These and similar factors and events may have substantial negative effects on the business, financial condition and results of operations of the Corporation and its customers. While we expect nearly every industry to have some impact from COVID-19, some industries will be impacted more than others. In particular, senior living, hotel and accommodations, and restaurants and food service have been the most affected by COVID-19 and account for approximately 7 percent of total loans.
We have taken deliberate actions to ensure that we have the balance sheet strength to serve our clients and communities, including increases in liquidity and managing our assets and liabilities in order to maintain a strong capital position. Additionally, in response to the COVID-19 pandemic, we have taken a number of actions to offer various forms of support to our customers, employees and communities that have experienced impacts from this development. The Corporation contributed approximately $1 million to non-profit organizations in our communities on the front lines of fighting the COVID-19 pandemic. In response to social distancing protocols, we have modified office locations by installing protective barriers, required the use of personal protective equipment and incurred additional cleaning and janitorial expense to disinfect banking centers and office locations, which cost $1.5 million. Additionally, we have enhanced mobile and online services, such as increased mobile deposit limits, to allow more transactions to be completed outside the banking centers. We have also provided customer alerts focused on COVID-19 scams and fraud education and prevention.
Interest Rates
On March 3, 2020, the Federal Open Market Committee ("FOMC") reduced the target range for the federal funds rate by 50 basis points to 1.00 percent to 1.25 percent. This rate was further reduced to a target range of 0 percent to 0.25 percent on March 16, 2020. Additionally, there was a decline in one-month LIBOR from 1.76 percent as of December 31, 2019 to .14 percent on December 31, 2020. These reductions in interest rates and other effects of the COVID-19 outbreak are likely to negatively impact the Corporation’s net interest income.
The CARES Act and the Paycheck Protection Program
On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) was signed into law, providing an approximately $2 trillion stimulus package that includes direct payments to individual taxpayers, economic stimulus to significantly impacted industry sectors, emergency funding for hospitals and providers, small business loans, increased unemployment benefits, and a variety of tax incentives.
For small businesses, eligible nonprofits and certain others, the CARES Act established a Paycheck Protection Program (“PPP”), which is administered by the Small Business Administration (“SBA”). On April 24, 2020, the Paycheck Protection Program and Health Care Enhancement Act was enacted. Among other things, this legislation amends the initial CARES Act program by raising the appropriation level for PPP loans from $349 billion to $670 billion. The PPP was further modified on June 5, 2020 with the adoption of the Paycheck Protection Program Flexibility Act (the Flexibility Act), which extended the maturity date for PPP loans from two years to five years for loans disbursed on or after the date of enactment of the Flexibility Act. For PPP loans disbursed prior to such enactment, the Flexibility Act permits the borrower and lender to mutually agree to extend the term of the loan to five years. The Bank has actively participated in assisting its customers with applications for resources through the program. PPP loans earn interest at a fixed rate of 1 percent and primarily have a two-year term. The Bank anticipates that the majority of these loans will ultimately be forgiven, in whole or in part, by the SBA in accordance with the terms of the program. Under the terms of the PPP, the loans are fully guaranteed by the SBA. As of December 31, 2020, the Bank had over 4,400 PPP loans representing $667.1 million, which is net of $12.5 million of deferred processing fee income and costs. The weighted-average deferred processing fee on PPP loans was approximately 3.09 percent and is recognized over the term of the loan. If a loan is forgiven by the SBA or paid off by the borrower prior to maturity, any unamortized portion of the fee will be recognized immediately. During the year ended December 31, 2020, the Corporation recognized interest income on PPP loans of $6.2 million and $16.2 million of PPP loan related deferred processing fee income as a yield adjustment.
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The 2021 Consolidated Appropriations Act
On December 27, 2020, a $900 billion COVID-19 relief package, as passed by the U.S. Congress, was signed into law as part of the 2021 Consolidated Appropriations Act (“CAA”) that provides federal government funding through the end of its 2021 fiscal year. In addition to delivering direct stimulus payments to certain individuals, an increase in unemployment insurance benefits, an extension of the eviction moratorium, relief to the healthcare industry, and additional aid to various other businesses, the COVID-19-related provisions of the CAA provide for (i) an additional $284 billion in funding for the PPP, through March 31, 2021, (ii) an extension of the temporary delay for implementation of the CECL accounting standard, and (iii) further suspension of the troubled debt restructure assessment and reporting requirements for financial institutions under GAAP.
Main Street Business Lending Program
On April 9, 2020, the Federal Reserve announced its proposed Main Street emergency lending initiative as an additional measure to provide much-needed financial support to small and mid-sized businesses adversely impacted by the COVID-19 pandemic. The Main Street programs are intended to provide credit flows to financial institutions so that they can provide loans to eligible small and mid-sized businesses. The funds available through the Main Street programs amount to $600 billion. Under this initiative, which was modified and supplemented by the Federal Reserve on April 30, 2020, three loan facilities have been established for "for profit" entities: (i) the Main Street New Loan Facility (the “MSNLF), (ii) the Main Street Priority Loan Facility (the “MSPLF”); and (iii) the Main Street Expanded Loan Facility (the “MSELF”), each of which was authorized by the Federal Reserve under Section 13(3) of the Federal Reserve Act. All three facilities use the same eligible lender and eligible borrower criteria, and have many of the same features, including the same maturity, interest rate, deferral of principal and interest for one year, and ability of the borrower to prepay without penalty. As required by the CARES Act, Main Street loans are full-recourse to the borrower and are not forgivable. The loan types differ in amounts and other terms, including in how they interact with the eligible borrower’s existing outstanding debt. The proposed minimum loan amounts under the MSNLF and the MSPLF were initially set at $250,000, but were lowered to $100,000 by the Federal Reserve effective October 30, 2020. The minimum loan amount under the MSELF has been set at $10 million. The maximum loan amount under all three programs is dependent upon the borrower's financial position. The Bank was an approved lender for all three Main Street programs until the program's termination on January 8, 2021.
Paycheck Protection Program Liquidity Facility
To provide liquidity to small business lenders and the broader credit markets, to help stabilize the financial system, and to provide economic relief to small businesses nationwide, the Federal Reserve authorized each of the Federal Reserve Banks to participate in the Paycheck Protection Program Liquidity Facility (the “PPPL Facility”), pursuant to the Federal Reserve Act. Under the PPPL Facility, each of the Federal Reserve Banks will extend non-recourse loans to eligible financial institutions such as the Bank to fund loans guaranteed by the SBA under the PPP. The Bank has until March 31, 2021 to access funds under the PPPL Facility, unless further extended by the Federal Reserve and the Department of the Treasury. At December 31, 2020, the Corporation did not have an outstanding balance with the PPPL Facility.
Loan Modifications and Troubled Debt Restructures
On March 22, 2020, a statement was issued by the Bank's banking regulators and titled the “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus” (the "Interagency Statement") that encourages financial institutions to work prudently with borrowers who are or may be unable to meet their contractual payment obligations due to the effects of COVID-19. Additionally, Section 4013 of the CARES Act further provides that a qualified loan modification is exempt by law from classification as a troubled debt restructure as defined by GAAP, from the period beginning March 1, 2020 until the earlier of December 31, 2020 or the date that is 60 days after the date on which the national emergency concerning the COVID-19 outbreak under the National Emergencies Act (50 U.S.C. 1601 et seq.) terminates. The Interagency Statement was subsequently revised on April 7, 2020 to clarify the interaction of the original guidance with Section 4013 of the CARES Act, as well as setting forth the banking regulators’ views on consumer protection considerations. In accordance with such guidance, the Bank has offered short-term modifications made in response to COVID-19 to borrowers who were current and otherwise not past due. These included short-term, 180 days or less, modifications in the form of payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. The CAA, as described above, extended the expiration date for COVID-related loan modifications exempt from troubled debt restructuring classification until the earlier of January 1, 2022, or 60 days after the termination of the national emergency. As of December 31, 2020, $120.3 million in loan balances remained in deferral. Details of the modifications are included in the "LOAN QUALITY" section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Optional Delay of CECL Implementation
Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit losses on Financial Instruments ("CECL") had an original adoption date of January 1, 2020, which included a day 1 measurement date of January 1, 2020. The CARES Act, passed by Congress on March 27, 2020 in response to the COVID-19 pandemic, created an optional deferral of the CECL adoption date. Pursuant to the CARES Act and the related joint statement of federal banking regulators (which also became effective as of March 27, 2020), and consistent with guidance from the SEC and FASB, the Corporation elected to delay implementation of ASU No. 2016-13, which was set to expire on December 31, 2020. However, the CAA amended the CARES Act by extending the temporary relief from CECL compliance to the earlier of the first day of the fiscal year that begins after the date on which the national emergency concerning COVID-19 terminates, or January 1, 2022. The Corporation elected to delay implementation of CECL following the approval of the CARES Act and, with the enactment of the CAA, the Corporation has elected to further delay adoption of CECL to January 1, 2021. This will allow the Corporation to utilize the CECL standard for the entire year of adoption. As a result of the Corporation’s election, its 2020 financial statements have been prepared under the existing incurred loss model.
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Regulatory Capital
CECL Model. As part of the March 27, 2020 joint statement of federal banking regulators discussed above, an interim final rule that allows banking organizations to mitigate the effects of the CECL accounting standard on their regulatory capital was also announced. Banking organizations that are required under GAAP to adopt CECL during 2020 can elect to mitigate the estimated cumulative regulatory capital effects of CECL for up to two years. This two-year delay is in addition to the three-year transition period that federal banking regulators had already made available. While the Corporation has elected to delay implementation of ASU No. 2016-13 as described above, it expects to take advantage of the additional time permitted by this interim final rule, which will largely delay the effects of CECL on its regulatory capital through December 31, 2022. Beginning on January 1, 2023, the Corporation will be required to phase in 25 percent of the previously deferred estimated capital impact of CECL, with an additional 25 percent to be phased in at the beginning of each subsequent year until fully phased in by January 1, 2026. Under the interim final rule, the amount of adjustments to regulatory capital that can be deferred until the phase-in period includes both the initial impact of our adoption of CECL, and 25 percent of subsequent changes in our allowance for credit losses during each quarter following implementation of CECL until December 31, 2022.
PPP Loans and PPPL Facility. On April 9, 2020, federal banking regulators issued an interim final rule to modify the Basel III regulatory capital rules applicable to banking organizations to allow those organizations participating in the PPP to neutralize the regulatory capital effects of participating in the program. The interim final rule, which became effective on April 13, 2020, clarifies that PPP loans receive a zero percent risk weight for purposes of determining risk-weighted assets and the CET1, Tier 1 and Total Risk-Based capital ratios. At December 31, 2020, risk-weighted assets included $667.1 million of PPP loans at a zero risk weight. Additionally, in order to facilitate use of the PPPL Facility, the agencies have clarified that banking organizations, including the Corporation and the Bank, are allowed to neutralize the regulatory effects of PPP covered loans on the risk-based capital ratios, as well as PPP covered loans pledged under the PPPL Facility on the leverage capital ratios. At December 31, 2020, the Corporation did not have an outstanding balance with the PPPL Facility; therefore there were no adjustments to the leverage ratio for PPP loans.
RESULTS OF OPERATIONS - 2020
Net income available to stockholders for the year ended December 31, 2020 was $148.6 million compared to $164.5 million during the same period in 2019. Earnings per fully diluted common share for 2020 totaled $2.74 compared to $3.19 during the same period in 2019.
As of December 31, 2020, total assets equaled $14.1 billion, an increase of $1.6 billion, or 12.9 percent, from December 31, 2019. The Corporation's total loan portfolio increased $778.8 million, or 9.2 percent from December 31, 2019. At December 31, 2020, the Corporation's PPP loan portfolio totaled $667.1 million, net of $12.5 million of deferred processing fee income and costs, which were primarily included in the commercial and industrial loan class. Other loan segments that experienced large increases from December 31, 2019 were commercial real estate, non-owner occupied and public finance and other commercial loans. The largest loan segments that experienced a decrease were real estate construction and home equity loans. Additional details of the changes in the Corporation's loans are discussed within NOTE 5. LOANS AND ALLOWANCE of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, and the "LOAN QUALITY" section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Interest-bearing deposits increased $274.0 million from December 31, 2019 due to excess liquidity from deposit growth and an increase in wholesale funding. Additionally, total investment securities increased $550.7 million, or 21.2 percent, from December 31, 2019 as a portion of the excess liquidity from deposit growth and additional wholesale funding was used to invest in the bond portfolio. Also contributing to the increase in investment securities was a $62.1 million increase in net unrealized gains on the available for sale portfolio. The net increase in unrealized gains from December 31, 2019 to December 31, 2020 is primarily due to interest rate declines in 2020 as the longer term points on the yield curve have declined since year-end, which increases the fair value of securities in the portfolio. Additional details of the changes in the Corporation's investment securities portfolio are discussed within NOTE 4. INVESTMENT SECURITIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
The Corporation’s allowance for loan losses totaled $130.6 million as of December 31, 2020 and equaled 1.41 percent of total loans. For the year ended December 31, 2020, the Corporation's provision expense and net charge-offs were $58.7 million and $8.3 million, respectively, compared to provision expense and net charge-offs of $2.8 million and $3.1 million during the same period in 2019. For the year ended December 31, 2020, there were charge-offs greater than $500,000 on two commercial relationships, which totaled $7.3 million. The largest of the two charge-offs was $6.7 million for a university apparel relationship. For the same period in 2019, there were two commercial charge-offs greater than $500,000 which totaled $3.6 million. The increase in the allowance for loan losses and provision expense primarily reflects our view of increased credit risk related to the COVID-19 pandemic. Additional details of the changes in the Corporation's allowance for loan losses are discussed within NOTE 5. LOANS AND ALLOWANCE of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, and the "PROVISION EXPENSE AND ALLOWANCE FOR LOAN LOSSES" section of this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Accounting Standards Update No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit losses on Financial Instruments ("CECL") had an original adoption date of January 1, 2020, which included a day 1 measurement date of January 1, 2020. The CARES Act, passed by Congress on March 27, 2020 in response to the COVID-19 pandemic, created an optional deferral of the CECL adoption date. Pursuant to the CARES Act and the related joint statement of federal banking regulators (which also became effective as of March 27, 2020), and consistent with guidance from the SEC and FASB, the Corporation elected to delay implementation of ASU No. 2016-13. The 2021 Consolidated Appropriations Act, signed into law on December 27, 2020, provided the annual funding for the federal government and also contained several rules giving further COVID-19 relief, one of which was an extension of the adoption date for CECL to the earlier of January 1, 2022 or the first day of the fiscal year that begins after the termination of the national emergency. The Corporation elected to adopt CECL on January 1, 2021 with a day one measurement date of January 1, 2021. As a result of the Corporation’s election, its 2020 financial statements have been prepared under the existing incurred loss model.
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Non-accrual loans totaled $61.5 million at December 31, 2020, an increase of $45.6 million from the December 31, 2019 balance of $15.9 million. The increase in non-accrual loan balances during 2020 was primarily due to four non-owner occupied commercial real estate properties, in the senior and assisted living industry, moving to non-accrual. The total reported balance of these four loans was $40.0 million. Additional details of the Allowance for Loan Losses and non-performing loans are discussed within the “LOAN QUALITY" and "PROVISION EXPENSE AND ALLOWANCE FOR LOAN LOSSES” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The Corporation's other assets increased $45.9 million from December 31, 2019. The Corporation's derivative asset (recorded in other assets) and derivative liability (recorded in other liabilities) relating to interest rate contracts increased $46.5 million and $47.1 million, respectively, from December 31, 2019. The increases are primarily due to a $292.7 million increase in the related outstanding notional balance. Additionally, yield curve rates used for valuation purposes were lower at each term point as of December 31, 2020 compared to December 31, 2019. This was primarily the result of investors seeking the safety of U.S. Treasuries, coupled with Federal Reserve purchases of U.S. Treasuries, as containment efforts related to the COVID-19 outbreak began to significantly reduce economic activity.
As of December 31, 2020, total deposits equaled $11.4 billion, an increase of $1.5 billion, or 15.5 percent, from December 31, 2019. The Corporation experienced increases from December 31, 2019 in demand and savings accounts of $1.6 billion and $765.5 million, respectively. A portion of the increase is due to PPP loans that have remained on deposit, in addition to consumer Economic Impact Payments from the IRS that have also remained on deposit. Offsetting these increases were decreases in certificates of deposit and brokered deposits of $673.2 million and $141.2 million, respectively, from December 31, 2019. The low interest rate environment has resulted in customers migrating funds from maturing time deposit products into non-maturity products due to similar rates offered for both products.
Total borrowings decreased $47.8 million as of December 31, 2020, compared to December 31, 2019. The Corporation's Federal Funds purchased decreased $55 million from December 31, 2019. The excess liquidity generated from deposit growth reduced the Corporation's need for overnight funding. Additionally, subordinated debentures and term loans decreased $20.3 million as the Corporation redeemed $20.0 million of subordinated debentures. Of the redemptions, $10.0 million was for a partial redemption of debentures held by First Merchants Capital Trust II (“FMC Trust II”) and the remaining $10.0 million was for a complete redemption of debentures held by Grabill Capital Trust I ("Grabill Trust"). Both FMC Trust II and Grabill Trust used the proceeds from the redemptions to concurrently redeem like amounts of their capital (preferred) securities, each with an aggregate principal redemption price of $10.0 million. The common securities of FMC Trust II are, and the common securities of Grabill Trust were, held by the Corporation (recorded in other assets). Subsequent to the redemption of its capital securities, Grabill Trust was dissolved. Offsetting these decreases, Federal Home Loan Bank advances increased $38.4 million compared to December 31, 2019. The Corporation took advantage of the low interest rate environment to lock in longer term FHLB advances at low rates.
The Corporation's other liabilities as of December 31, 2020 increased $50.4 million compared to December 31, 2019. As noted above, the derivative hedge liability increased $47.1 million from December 31, 2019. Additionally, the Corporation accrued $6.2 million of trade date accounting related to investment securities purchases as of December 31, 2020, of which, there was no accrual at December 31, 2019.
The Corporation was able to maintain all regulatory capital ratios in excess of the regulatory definition of “well-capitalized.” Details of the Stock Repurchase Programs and regulatory capital ratios are discussed within the “CAPITAL” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
RESULTS OF OPERATIONS – 2019
Net income available to stockholders for the year ended December 31, 2019 was $164.5 million compared to $159.1 million during the same period in 2018. Earnings per fully diluted common share for 2019 totaled $3.19 compared to $3.22 during the same period in 2018. Included in the 2019 results were $13.7 million, or $0.21 per share, of acquisition-related expenses associated with the acquisition of MBT. Details of the MBT acquisition, which occurred on September 1, 2019, are included within NOTE 2. ACQUISITIONS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
As of December 31, 2019, total assets equaled $12.5 billion compared to $9.9 billion as of year end 2018, an increase of $2.6 billion, or 26.0 percent. The MBT acquisition resulted in $1.5 billion of the asset increase in 2019. The Corporation's total loan portfolio equaled $8.5 billion as of December 31, 2019, an increase of $1.2 billion, or 17.1 percent from December 31, 2018. Excluding the MBT loans acquired of $732.6 million, the Corporation's loan portfolio grew organically in 2019 by $506.5 million, or 7 percent.
The Corporation’s allowance for loan losses totaled $80.3 million as of December 31, 2019, a slight decrease compared to $80.6 million as of December 31, 2018, due to declines in delinquent, impaired and non-accrual loans during 2019. Non-accrual loans decreased $10.2 million, or 39 percent during 2019 and the allowance provides 503.4 percent coverage of all non-accrual loans and 0.95 percent of total loans at December 31, 2019. Details of the Allowance for Loan Losses and non-performing loans are discussed within the “LOAN QUALITY" and "PROVISION EXPENSE AND ALLOWANCE FOR LOAN LOSSES” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The Corporation's investment securities portfolio increased $963.5 million from December 31, 2018, and totaled $2.6 billion as of December 31, 2019. The MBT acquisition accounted for $212.2 million of the increase and excess liquidity from deposit growth was deployed in the investment portfolio, which also contributed to the increase from December 31, 2018. Details of the composition of the Corporation's investment securities portfolio are included within NOTE 4. INVESTMENT SECURITIES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
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The Corporation's other assets increased $52.4 million from December 31, 2018 due in part to implementation of new lease accounting guidance in ASU 2016-02, Leases (Topic 842), associated with the Corporation's leased banking center locations. As of December 31, 2019, the Corporation's right of use asset (recorded in other assets) was $20.7 million and the lease liability (recorded in other liabilities) was $21.4 million. The new lease accounting guidance and lease disclosures are discussed within NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES and NOTE 10. LEASES of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Additionally, the Corporation's derivative hedge asset (recorded in other assets) and derivative hedge liability (recorded in other liabilities), related to the Corporation's interest rate swaps with commercial banking customers, which are simultaneously hedged by offsetting interest rate swaps with a third party, increased $15.8 million and $16.7 million, respectively from December 31, 2018. The increases were primarily due to a $214.5 million increase in outstanding notional balance and yield curve rates used for valuation purposes were lower at each term point as of December 31, 2019 compared to December 31, 2018. Details of the Corporation's derivative activity is detailed in NOTE 14. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITY of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Total deposits of $9.8 billion increased $2.1 billion, or 26.9 percent, from December 31, 2018. The MBT acquisition on September 1, 2019 resulted in $1.1 billion of acquired deposits. Organic deposit growth of $979.4 million, or 12.6 percent, also contributed to the increase in 2019. Excluding deposits from the MBT acquisition, the largest increases were in demand, savings and time deposits. Total borrowings as of December 31, 2019 increased $61.7 million from December 31, 2018. FHLB advances increased $36.1 million, which included $10.9 million in FHLB advances from the MBT acquisition, while federal funds purchased decreased $49.0 million. Securities sold under repurchase agreements increased $74.4 million from December 31, 2018, as a result of the MBT acquisition, which accounted for a $94.8 million increase. Additional details related to the changes in deposits and borrowings are detailed within NOTE 11. DEPOSITS and NOTE 13. BORROWINGS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K and the “Deposits and Borrowings” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The Corporation continued to maintain all regulatory capital ratios in excess of the regulatory definition of “well-capitalized” as discussed in the “CAPITAL” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
NET INTEREST INCOME
Net interest income is the most significant component of the Corporation's earnings, comprising 78 percent of revenues for the year ended December 31, 2020. Net interest income and margin are influenced by many factors, primarily the volume and mix of earning assets, funding sources, and interest rate fluctuations. Loans typically generate more interest income than investment securities with similar maturities. Funding from customer deposits generally costs less than wholesale funding sources. Factors such as general economic activity, Federal Reserve Board monetary policy, and price volatility of competing alternative investments, can also exert significant influence on our ability to optimize the mix of assets and funding and the net interest income and margin.
Net interest income is the excess of interest received from earning assets over interest paid on interest-bearing liabilities. For analytical purposes, net interest income is also presented on an FTE basis in the table that follows to reflect what our tax-exempt assets would need to yield in order to achieve the same after-tax yield as a taxable asset. The federal statutory rate of 21 percent was used for 2020, 2019 and 2018, adjusted for the TEFRA interest disallowance applicable to certain tax-exempt obligations. The FTE analysis portrays the income tax benefits associated with tax-exempt assets and helps to facilitate a comparison between taxable and tax-exempt assets. Management believes that it is a standard practice in the banking industry to present net interest margin and net interest income on a fully taxable equivalent basis. Therefore, management believes these measures provide useful information for both management and investors by allowing them to make peer comparisons.
Net interest margin, on a tax equivalent basis, decreased 40 basis points to 3.29 percent for 2020 compared to 3.69 percent in 2019. For the year ended December 31, 2020, the increase in average earning assets of $2.1 billion was primarily attributable to an increase in loans and investment securities of $1.4 billion and $635.5 million, respectively. The earning assets from the September 1, 2019 MBT acquisition were included in the 2020 average balances for an entire year compared to only four months in 2019. Additionally, the Bank originated over $900 million of PPP loans which averaged $601.8 million for the year. The increase in the investment securities portfolio was the result of excess liquidity generated from growth in deposits and wholesale funding being used to invest in the bond portfolio.
Asset yields decreased 94 basis points FTE in 2020 compared to 2019. The decrease in asset yields was primarily a result of the FOMC's interest rate decreases of 50 basis points on March 3, 2020 and 100 basis points on March 16, 2020 at the Committee's special meetings related to COVID-19, and the decline in one-month LIBOR from December 31, 2019 to December 31, 2020 of 162 basis points. The PPP loans originated in 2020 were recorded at an interest rate of only 1 percent, but the Corporation also recognized fee income of $16.2 million during 2020, which is included in interest income and had a positive impact to net interest margin of 2 basis points for 2020.
The Corporation also recognized fair value accretion income on purchased loans, which is included in interest income, of $13.5 million, which accounted for 11 basis points of net interest margin for the year ended December 31, 2020. Comparatively, the Corporation recognized $12.0 million of fair value accretion income, which accounted for 12 basis points of net interest margin for the year ended December 31, 2019.
Interest costs decreased 67 basis points, and when coupled with the decline in asset yields of 94 basis points, resulted in a 27 basis point FTE decrease in net interest spread as compared to 2019. Interest costs have decreased as management aggressively moved deposit rates down in tandem with a decline in wholesale funding rates. The Corporation also took advantage of the low interest rate environment to lock in longer term FHLB advances at low rates. Interest-bearing deposit and borrowing costs decreased from 1.26 percent and 2.66, respectively, for the twelve months ended December 31, 2019, to .60 percent and 1.91 percent, respectively, for the twelve months ended December 31, 2020.
Additional details of the Corporation's acquisitions, remaining loan fair value discount, accretable and nonaccretable yield can be found in NOTE 2. ACQUISITIONS and NOTE 6. ACCOUNTING FOR CERTAIN LOANS ACQUIRED IN A PURCHASE of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
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In 2019, the increases in net interest income and average earning assets were primarily attributable to the September 2019 MBT acquisition, in addition to, core organic loan and deposit growth and an increase in the investment securities portfolio. Asset yields decreased 1 basis point FTE and interest costs increased 34 basis points, resulting in an 35 basis point FTE decrease in net interest spread as compared to 2018. Asset yields decreased in 2019 primarily as a result of the Federal Reserve's discount rate decrease of 25 basis points at each of the Board's August, September and October 2019 meetings. Average earning assets increased $1.3 billion in 2019 compared to 2018 primarily as a result of organic loan growth and the MBT acquisition. In 2019, organic loan growth was $506.5 million, or 7 percent. The Corporation recognized fair value accretion income on purchased loans, which is included in interest income, of $12.0 million and $14.1 million, respectively, for the twelve months ended December 31, 2019 and 2018. Net interest margin, on a tax equivalent basis, decreased to 3.69 percent for 2019 compared to 4.00 percent in 2018.
Net interest margin is a function of net interest income and the level of average earning assets. The following table presents the Corporation’s interest income, interest expense, and net interest income as a percent of average earning assets for the three-year period ending in 2020.
Assets:
Investment Securities: (1)
Loans: (3)
Liabilities:
Interest-bearing deposits:
Net Interest Margin (FTE):
Interest Income (FTE) / Average Earning Assets 3.84 % 4.78 % 4.79 %
Interest Expense / Average Earning Assets 0.55 % 1.09 % 0.79 %
(1) Average balance of securities is computed based on the average of the historical amortized cost balances without the effects of the fair value adjustment. Annualized amounts are computed using a 30/360 day basis.
(2) Tax-exempt securities and loans are presented on a fully taxable equivalent basis, using a marginal tax rate of 21 percent for 2020, 2019 and 2018. These totals equal $16,966, $13,085 and $10,732, respectively.
(3) Non-accruing loans have been included in the average balances.
(4) Net Interest Spread (FTE) is interest income expressed as a percentage of average earning assets minus interest expense expressed as a percentage of average interest-bearing liabilities.
(5) Net Interest Margin (FTE) is interest income expressed as a percentage of average earning assets minus interest expense expressed as a percentage of average earning assets.
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NON-INTEREST INCOME
Non-interest income increased $23.2 million, or 26.8 percent, in 2020 compared to 2019. The low mortgage interest rate environment and larger customer base resulting from the MBT acquisition on September 1, 2019 combined to produce an increase of $10.4 million in net gains and fees on sales of loans. Additionally, the larger customer base from the MBT acquisition, in addition to organic growth, resulted in increases in fiduciary and wealth management fees and derivative hedge fees totaling $6.2 million and $1.6 million, respectively. Details of the Corporation's 2019 acquisition can be found in NOTE 2. ACQUISITIONS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Finally, net realized gains on the sale of available for sale securities increased $7.5 million when compared to 2019.
These increases were partially offset by a decrease in service charges on deposit accounts of $2.0 million mainly due to higher than normal customer deposit balances as a result of stimulus funds received in response to the COVID-19 pandemic. This resulted in significantly lower non-sufficient funds and overdraft fees when compared to 2019. Additionally, card payment fee income decreased $741,000 when compared to 2019. While the larger customer base resulting from the MBT acquisition and organic growth resulted in increased transaction volume, the cap placed on interchange fee income as a result of the Durbin Amendment to the Dodd-Frank Act became effective for the Bank July 1, 2020 and resulted in less interchange revenue.
Non-interest income increased $10.2 million, or 13.4 percent, in 2019 compared to 2018. On September 1, 2019, the Corporation acquired MBT, which contributed $4.1 million to the 2019 increase in non-interest income. The increased customer base from the acquisition, in addition to organic growth, resulted in an increase in customer related line items of $10.4 million. The largest increases were recognized in derivative hedge fees, fiduciary and wealth management fees, card payment fees and service charges on deposit accounts which accounted for $9.7 million of the customer related line items increase.
NON-INTEREST EXPENSES
Non-interest expense increased $16.6 million, or 6.7 percent, in 2020 compared to 2019. The increase was driven by 2020 having a full-year of expense from the larger franchise and growth in customer base resulting from the MBT acquisition when compared to 2019 only containing four months of activity. While the Corporation experienced increases in several non-interest expense categories the largest increase was in salaries and employee benefits which increased by $11.9 million compared to 2019. Net occupancy and equipment expenses reflected increases of $7.2 million and $3.1 million, respectively. In addition to the full-year impact of the larger franchise, the Corporation recorded $4.5 million of expenses in these two categories related to the recent announcement of the consolidation of seventeen banking centers.
Additionally, FDIC assessment expense increased $5.1 million in 2020, when compared to 2019, due to a combination of 2019 reflecting assessment credits issued as a result of the FDIC insurance fund reaching the FDIC's target minimum reserve ratio coupled with increased expense in the current year resulting from the Corporation's FDIC assessment changing to the calculation applicable to banks over $10 billion in total assets. Finally, the Corporation incurred $2.5 million of additional expense in 2020, compared to 2019, related to actions taken in response to the COVID-19 pandemic which included approximately $1.5 million in net occupancy and equipment costs incurred to enhance social distancing and cleaning protocols and $1.0 million recorded in marketing expense for donations to non-profit organizations in our communities on the front lines of the COVID-19 pandemic efforts.
The increases noted above were partially offset by the Corporation having recorded $13.7 million of acquisition-related expenses in 2019 in connection with MBT, primarily consisting of $5.3 million of contract termination and core system conversion expenses, $5.2 million of employee severance and retention expenses and $1.6 million of professional and other outside services expense. Additionally, the decrease in outside data processing fees of $2.0 million in 2020, compared to 2019, is mainly related to the sunsetting of a debit rewards program. Finally, the Corporation also realized a decrease in other real estate owned and foreclosure expenses of $2.1 million when compared to 2019.
Non-interest expense increased $26.8 million, or 12.2 percent, in 2019 compared to 2018. The most significant factor contributing to the increase was the acquisition of MBT, as the Corporation recorded $13.7 million of acquisition-related expenses as noted above. In addition to the acquisition-related expenses, MBT operations, after the acquisition, resulted in non-interest expense of $6.2 million, of which $3.3 million was in salaries and employee benefits. Additionally, increases totaling $6.1 million were noted in equipment and software, outside data processing fees, and other real estate owned and foreclosure expense. Lastly, marketing expense increased $2.0 million, compared to 2018, primarily due to fair lending settlement expenses.
These increases were partially offset by a decrease in FDIC expense of $2.2 million in 2019 compared to 2018. The decrease was due to assessment credits being issued as a result of the FDIC insurance fund reaching the FDIC's target minimum reserve ratio.
INCOME TAX EXPENSE
Income tax expense in 2020 was $21.4 million on pre-tax income of $170.0 million, or 12.6 percent. For 2019, income tax expense was $29.3 million on pre-tax income of $193.8 million, or 15.1 percent. The lower effective tax rate in 2020 compared to 2019 is primarily a result of the significant increase in provision expense and non-interest expenses, which reduced taxable income, coupled with an increase in tax-exempt interest income, which increased the benefit of non-taxable income. Additionally, the net operating loss ("NOL") carryback provided in the CARES Act resulted in a favorable rate differential as noted in the effective tax rate reconciliation in NOTE 22. INCOME TAX of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Additional income tax expense details are discussed within the “INCOME TAXES” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. .
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CAPITAL
Stockholders' Equity
On September 1, 2019, the Corporation acquired 100 percent of MBT. Pursuant to the merger agreement, each MBT shareholder received 0.275 shares of the Corporation's common stock for each outstanding share of MBT common stock held. The Corporation issued approximately 6.4 million shares of common stock, which was valued at approximately $229.9 million. Details regarding the MBT acquisition are discussed in NOTE 2. ACQUISITIONS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Stock Repurchase Programs
On September 3, 2019, the Board of Directors of the Corporation approved a stock repurchase program of up to 3 million shares of the
Corporation's outstanding common stock; provided, however, that the total aggregate investment in shares repurchased under the program was not to exceed $75 million. On a share basis, the amount of common stock subject to the repurchase program represented approximately 5 percent of the Corporation's outstanding shares. During the first quarter of 2020, the Corporation repurchased 1,634,437 of its common shares for $55.9 million at an average price of $34.21, which resulted in the aggregate investment in share repurchases to equal $75.0 million, the maximum allowable under the plan.
On January 27, 2021, the Board of Directors of the Corporation approved a stock repurchase program of up to 3,333,000 shares of the Corporation's outstanding common stock; provided, however, that the total aggregate investment in shares repurchased under the program may not exceed $100,000,000. On a share basis, the amount of common stock subject to the repurchase program represents approximately 6 percent of the Corporation's outstanding shares. Details regarding the 2021 stock repurchase program are discussed in NOTE 27. SUBSEQUENT EVENTS of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.
Regulatory Capital
Capital adequacy is an important indicator of financial stability and performance. The Corporation and the Bank are subject to various regulatory
capital requirements administered by the federal banking agencies and are assigned to a capital category. The assigned capital category is
largely determined by four ratios that are calculated according to the regulations: total risk-based capital, tier 1 risk-based capital, CET1, and tier
1 leverage ratios. The ratios are intended to measure capital relative to assets and credit risk associated with those assets and off-balance sheet
exposures of the entity. The capital category assigned to an entity can also be affected by qualitative judgments made by regulatory agencies
about the risk inherent in the entity's activities that are not part of the calculated ratios.
There are five capital categories defined in the regulations, ranging from well capitalized to critically undercapitalized. Classification of a bank in
any of the undercapitalized categories can result in actions by regulators that could have a material effect on a bank's operations. Quantitative
measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios of total and tier 1
capital to risk-weighted assets, and of tier 1 capital to average assets, or leverage ratio, all of which are calculated as defined in the
regulations. Banks with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized,
depending on their actual levels. The appropriate federal regulatory agency may also downgrade a bank to the next lower capital category upon
a determination that the bank is in an unsafe or unsound practice. Banks are required to monitor closely their capital levels and to notify their
appropriate regulatory agency of any basis for a change in capital category.
Basel III was effective for the Corporation on January 1, 2015 and requires the Corporation and the Bank to maintain the minimum capital and
leverage ratios as defined in the regulation and as illustrated in the table below, which capital to risk-weighted asset ratios include a 2.5 percent capital conservation buffer. Under Basel III, in order to avoid limitations on capital distributions, including dividends, the Corporation must hold a 2.5 percent capital conservation buffer above the adequately capitalized CET1 to risk-weighted assets ratio (which buffer is reflected in the required ratios below). Under Basel III, the Corporation and Bank elected to opt-out of including accumulated other comprehensive income in regulatory capital. As of December 31, 2020, the Bank met all capital adequacy requirements to be considered well capitalized under the fully phased-in Basel III capital rules. There is no threshold for well capitalized status for bank holding companies.
The Corporation's and Bank's actual and required capital ratios as of December 31, 2020 and December 31, 2019 were as follows:
Prompt Corrective Action Thresholds
Actual Basel III Minimum Capital Required Well Capitalized
December 31, 2020 Amount Ratio Amount Ratio Amount Ratio
Total risk-based capital to risk-weighted assets
Tier 1 capital to risk-weighted assets
Common equity tier 1 capital to risk-weighted assets
Tier 1 capital to average assets
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Prompt Corrective Action Thresholds
Actual Basel III Minimum Capital Required Well Capitalized
December 31, 2019 Amount Ratio Amount Ratio Amount Ratio
Total risk-based capital to risk-weighted assets
Tier 1 capital to risk-weighted assets
Common equity tier 1 capital to risk-weighted assets
Tier 1 capital to average assets
On April 9, 2020, federal banking regulators issued an interim final rule to modify the Basel III regulatory capital rules applicable to banking
organizations to allow those organizations participating in the PPP to neutralize the regulatory capital effects of participating in the program. The
interim final rule, which became effective April 13, 2020, clarifies that PPP loans receive a zero percent risk weight for purposes of determining
risk-weighted assets and the CET1, Tier 1 and Total Risk-Based capital ratios. At December 31, 2020, risk-weighted assets included $667.1
million of PPP loans at a zero risk weight. Additionally, in order to facilitate use of the PPPL Facility, the agencies have clarified that banking
organizations, including the Corporation and the Bank, are allowed to neutralize the regulatory effects of PPP covered loans on the risk-based
capital ratios, as well as PPP covered loans pledged under the PPPL Facility on the leverage capital ratios. At December 31, 2020, the
Corporation did not have an outstanding balance with the PPPL Facility; therefore there were no adjustments to the leverage ratio for PPP loans.
Management believes that all of the above capital ratios are meaningful measurements for evaluating the safety and soundness of the Corporation. Traditionally, the banking regulators have assessed bank and bank holding company capital adequacy based on both the amount and the composition of capital, the calculation of which is prescribed in federal banking regulations. The Federal Reserve focuses its assessment of capital adequacy on a component of Tier 1 capital known as CET1. Because the Federal Reserve has long indicated that voting common shareholders' equity (essentially Tier 1 risk-based capital less preferred stock and non-controlling interest in subsidiaries) generally should be the dominant element in Tier 1 risk-based capital, this focus on CET1 is consistent with existing capital adequacy categories. Tier I regulatory capital consists primarily of total stockholders’ equity and subordinated debentures issued to business trusts categorized as qualifying borrowings, less non-qualifying intangible assets and unrealized net securities gains or losses.
Total Risk-Based Capital
Add: Qualifying Capital Securities 46,368 — 66,363 —
Qualifying Subordinated Debentures 65,000 — 65,000 —
Common Equity Tier 1 Capital Ratio
Less: Qualified Capital Securities (46,368) — (66,363) —
(1) Includes net unrealized gains or losses on available for sale securities, net gains or losses on cash flow hedges, and amounts resulting from the application of the applicable accounting guidance for defined benefit and other postretirement plans.
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Additionally, management believes the following tables are also meaningful when considering performance measures of the Corporation. Non-
GAAP financial measures such as tangible common equity to tangible assets, return on average tangible capital and return on average tangible
assets are important measures of the strength of the Corporation's capital and ability to generate earnings on tangible common equity invested
by our shareholders. These non-GAAP measures provide useful supplemental information and may assist investors in analyzing the
Corporation’s financial position without regard to the effects of intangible assets and preferred stock. Disclosure of these measures also allows
analysts and banking regulators to assess our capital adequacy on these same bases.
Because these measures are not defined in GAAP or federal banking regulations, they are considered non-GAAP financial measures. Non-
GAAP financial measures have inherent limitations, are not required to be uniformly applied, and are not audited. Although these non-GAAP
financial measures are frequently used by investors to evaluate a company, they have limitations as analytical tools, and should not be
considered in isolation, or as a substitute for analyses of results as reported under GAAP.
The Corporation had a strong capital position as evidenced by the tangible common equity to tangible assets ratio of 9.65 percent at December 31, 2020, and 10.16 percent at December 31, 2019.
Tangible Common Equity to Tangible Assets (non-GAAP)
Less: Cumulative preferred stock (GAAP) (125) (125)
Stockholders' Equity to Assets (GAAP) 13.33 % 14.34 %
Tangible common equity to tangible assets (non-GAAP) 9.65 % 10.16 %
Plus: Tax Benefit of intangibles (non-GAAP) 5,989 7,257
Tangible book value - common (non-GAAP) $ 24.27 $ 21.94
The following table details and reconciles tangible earnings per share, return on tangible capital and tangible assets to traditional GAAP measures for the periods ended December 31, 2020 and 2019.
Average core deposit intangible (GAAP) 32,106 27,067
Average deferred tax on CDI (GAAP) (6,648) (5,588)
Average cumulative preferred stock (GAAP) (125) (125)
Net income available to common stockholders (GAAP) $ 148,600 $ 164,460
CDI amortization, net of tax (GAAP) 4,730 4,736
Per Share Data:
Diluted net income available to common stockholders (GAAP) $ 2.74 $ 3.19
Ratios:
Return on average GAAP capital (ROE) 8.14 % 10.48 %
Return on average tangible capital 12.21 % 15.81 %
Return on average assets (ROA) 1.10 % 1.48 %
Return on average tangible assets 1.19 % 1.60 %
Return on average tangible capital is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible capital. Return on average tangible assets is tangible net income available to common stockholders (annualized) expressed as a percentage of average tangible assets.
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PART II: ITEM 7. AND ITEM 7A. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
LOAN QUALITY
The Corporation's primary lending focus is small business and middle market commercial, commercial real estate and residential real estate, which results in portfolio diversification. Commercial loans are individually underwritten and judgmentally risk rated. They are periodically monitored and prompt corrective actions are taken on deteriorating loans. Consumer loans are typically underwritten with statistical decision-making tools and are managed throughout their life cycle on a portfolio basis.
The quality of the loan portfolio and amount of non-performing loans may increase or decrease as a result of acquisitions, organic portfolio growth, problem loan recognition and resolution through collections, sales or charge-offs. The performance of any loan can be affected by external factors such as economic conditions, or internal factors specific to a particular borrower, such as the actions of a customer's internal management.
At December 31, 2020, non-performing loans totaled $64.7 million, an increase of $47.9 million from the December 31, 2019 balance of $16.8 million. Total loan delinquencies have increased $46.0 million during the twelve months ended December 31, 2020, compared to December 31, 2019. The primary categories leading to the increase in delinquencies were the 60-89 days past due commercial and industrial category, which increased $6.4 million due primarily to one relationship, and in the 90 days or more past due commercial real estate, non-owner occupied category, which increased $30.0 million due primarily to three relationships, totaling $14.1 million, $12.8 million, and $3.7 million, respectively. Loans not accruing interest income totaled $61.5 million at December 31, 2020, an increase of $45.6 million from the December 31, 2019 balance of $15.9 million. The increase in non-accrual loan balances during 2020 was primarily due to three relationships involving four non-owner occupied commercial real estate properties, in the senior and assisted living industry, moving to non-accrual. The total reported balance of these loans was $40.0 million. The Corporation's coverage ratio of allowance for loan losses to non-accrual loans decreased from 503.4 percent at December 31, 2019 to 212.5 percent at December 31, 2020. See additional information in the “PROVISION EXPENSE AND ALLOWANCE FOR LOAN LOSSES” section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Other real estate owned totaling $940,000 decreased $6.6 million during the twelve month period ending December 31, 2020 due primarily to the sale of a senior living commercial property with a carrying value of $5.9 million. Current appraisals are obtained to determine the fair value of other real estate owned. Management continues to aggressively market these real estate assets.
Accruing loans 90-days or more delinquent totaled $746,000 at December 31, 2020, an increase of $677,000 from the December 31, 2019 balance of $69,000. The increase was primarily in commercial and industrial loans.
Impaired loans include loans deemed impaired according to the guidance set forth in ASC 310-10. Commercial loans under $500,000 and consumer loans, with the exception of troubled debt restructures, are not individually evaluated for impairment. A loan is deemed impaired when, based on current information or events, it is probable that all amounts due of principal and interest according to the contractual terms of the loan agreement will not be collected substantially within the contractual terms of the note. At December 31, 2020, impaired loans totaled $56.2 million, an increase of $44.5 million from the December 31, 2019 balance of $11.7 million. At December 31, 2020, a specific allowance for losses was not deemed necessary for impaired loans totaling $7.8 million as there was no identified loss on these credits. An allowance of $12.9 million, which is discussed further in the "PROVISION EXPENSE AND ALLOWANCE FOR LOAN LOSSES" section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, was recorded for the remaining balance of these impaired loans totaling $48.4 million, and is included in the Corporation’s allowance for loan losses.
The Corporation's non-performing assets plus accruing loans 90-days or more delinquent and impaired loans are presented in the table below.
December 31, December 31,
Non-performing assets:
Loans 90-days or more delinquent and still accruing 746 69
The non-accrual balances in the above table include troubled debt restructures totaling $1.7 million and $709,000 as of December 31, 2020 and December 31, 2019, respectively.
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The composition of non-performing assets plus accruing loans 90-days or more delinquent is reflected in the following table.
December 31, December 31,
Non-performing assets and loans 90-days or more delinquent:
Commercial and industrial loans $ 2,923 $ 1,259
Agricultural land, production and other loans to farmers 1,012 1,180
Real estate loans
Commercial real estate, non-owner occupied 47,548 3,447
Commercial real estate, owner occupied 3,040 2,659
Individual's loans for household and other personal expenditures 55 45
Non-performing assets and loans 90-days or more delinquent $ 66,397 $ 24,386
In 2020, net charge-offs totaled $8.3 million, an increase of $5.2 million and $6.6 million from 2020 and 2019, respectively. In 2020, the corporation incurred charge-offs exceeding $500,000 on two commercial relationships, which combined to total $7.3 million. The largest of the two charge-offs was $6.7 million for a university apparel relationship. There were no recoveries above $500,000 recognized during the twelve month period ending December 31, 2020. In 2019, the corporation incurred charge-offs on two commercial relationships exceeding $500,000, which totaled $3.6 million, and had one recovery on a commercial relationship above $500,000, which amounted to $738,000.
The Corporation's loan loss experience is presented in the table below for the years indicated.
Allowance for loan losses:
Ratio of allowance to non-accrual loans 212.5 % 503.4 % 308.1 %
The distribution of the net charge-offs by collateral classification is provided in the following table for the years indicated.
Net charge-offs:
Commercial and industrial loans $ 7,794 $ 239 $ (257)
Agricultural land, production and other farm loans (2) 2 44
Real estate loans
Commercial real estate, non-owner occupied (148) 1,170 (714)
Commercial real estate, owner occupied 56 (2) 189
Individuals loans for household and other personal expenditures 383 168 447
Public finance and other commercial loans — 239 80
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