Item 1A. Risk Factors.
FACTORS THAT MAY AFFECT FUTURE RESULTS
An investment in Bancorp’s common stock is subject to risks inherent in its business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included in this filing. In addition to the risks and uncertainties described below, other risks and uncertainties not currently known to Bancorp or that Bancorp currently deems to be immaterial also may materially and adversely affect its business, financial condition and results of operations in the future. The value or market price of Bancorp’s common stock could decline due to any of these identified or other risks, and an investor could lose all or part of their investment.
There are factors, many beyond Bancorp’s control, which may significantly change the results or expectations of Bancorp. Some of these factors are described below, however, many are described in the other sections of this Annual Report on Form 10-K.
Economic, Market and Credit Risks
The ongoing COVID-19 pandemic and measures intended to prevent its spread have adversely impacted our business and financial results, and the ultimate impact will depend on future developments, which are highly uncertain and cannot be predicted, including the scope and duration of the pandemic and actions taken by governmental authorities in response to the pandemic.
The COVID-19 pandemic has created and continues to create extensive disruptions to the global economy and to the lives of individuals throughout the world. Governments, businesses, and the public are taking unprecedented actions to contain the spread of COVID-19 and to mitigate its effects, including self-quarantines, travel bans, shelter-in-place orders, closures of businesses and schools, fiscal stimulus, and legislation designed to deliver monetary aid and other relief. While the scope, duration, and full effects of COVID-19 continue to evolve and are not fully known, the pandemic and related efforts to contain it have disrupted global economic activity, adversely affected the functioning of financial markets, impacted interest rates, increased economic and market uncertainty, and disrupted trade and supply chains. If these effects continue for a prolonged period, or result in sustained economic stress or recession, many of the risk factors identified in this Annual Report on Form-10-K could be exacerbated and such effects could have a material adverse impact on us in a number of ways related to credit, collateral, asset valuations, customer demand, funding, operations, interest rate risk, and human capital.
There are no comparable recent events that provide guidance as to the effect the spread of COVID-19 as a global pandemic may have, and, as a result, the ultimate impact of the outbreak is highly uncertain and subject to change. We do not yet know the full extent of the impact on our business, operations or the economy as a whole. However, the effects could have a material extended impact on our business and heighten many of its known risks described below.
Fluctuations in interest rates could reduce profitability.
Our primary source of income is from net interest spread, the difference between interest earned on loans and investments and interest paid on deposits and borrowings. We expect to periodically experience gaps in interest rate sensitivities of assets and liabilities, meaning that either interest-bearing liabilities may be more sensitive to changes in market interest rates than interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this gap will work against us and earnings will be negatively affected.
Many factors affect fluctuation of market interest rates, including, but not limited to the following:
● the FRB’s actions to control interest rates
● inflation or deflation
● recession
● a rise in unemployment
● tightening money supply
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The FRB has lowered the FFTR five times since the end of 2018, resulting in a combined 225 bps decrease in the FFTR through December 31, 2020, with Prime ending the year at 3.25%. The most recent of these cuts came in March 2020 when the FRB lowered the FFTR to a range of 0% - 0.25% in response to the global COVID-19 pandemic, the lowest level seen since late 2015.
Market expectations are for the FRB to hold rates at current levels in 2021 and possibly beyond. Beyond potential ongoing pricing pressure/competition and the absolute low level of rates, the current economic outlook and prospects of a sustained zero-rate environment continues to pose challenges regarding potential ongoing NIM compression. Deposit rates tend to be tied to the short end of the rate curve, while fixed-rate loans are largely priced based upon longer term rates, typically five-year offerings. A flattening or inverted yield curve may increase our funding costs while limiting rates that can be earned on loans and investments, thereby decreasing our net interest income and earnings. Migration of deposits out of Bancorp, as customers pursue higher rates, could impact liquidity and earnings, as we compete for deposits. Changes in the mix of deposits could result in increased average rates paid on deposits, and lower earnings. Our asset-liability management strategy, which is designed to mitigate risk from changes in market interest rates, may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition.
The CECL accounting standard resulted in a significant change in how we recognize credit losses.
In June 2016, the FASB issued ASC, “Financial Instruments-Credit Losses (Topic 326), Measurement of Credit Losses on Financial Instruments,”which replaced the “incurred loss” model for recognizing credit losses with an “expected loss” model and was adopted by Bancorp effective January 1, 2020. Whereas the incurred loss model delayed recognition of loss on financial instruments until it was probable a loss had occurred, the expected loss model recognizes a loss at the time the loan is first added to the balance sheet. Adoption of the CECL model has materially affected the determination of the ACL for loans and has resulted in a significant increase to the ACL. Assumptions made by management and material changes in economic factors could significantly influence the ACL. Any material increase to the required level of loan loss allowance could adversely affect our business, financial condition, and results of operations.
If actual loan losses are greater than our assumption for loan losses, earnings could decrease.
Our loan customers may not repay their loans according to the terms of these loans, collateral securing payment of these loans may be insufficient to ensure repayment and the wealth of guarantors providing guarantees to support these loans may be inadequate to aid in the repayment of these loans. Accordingly, we might experience significant credit losses which could have a material adverse effect on operating results. We make various assumptions and judgments about the collectability of our loan portfolio, including creditworthiness of borrowers and value of collateral for repayment. In determining the adequacy of the ACL for loans, we consider, among other factors, an evaluation of economic conditions, future national unemployment projections and our historical loan loss experience. If our assumptions prove to be incorrect or economic problems are worse than projected, the current allowance may be insufficient to cover loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio. Such additions to the allowance, if necessary, could have a material adverse impact on our financial results.
Federal and state regulators annually review our allowance and may require an adjustment in the ACL for loans. If regulatory agencies require any increase in the allowance for which we had not allocated, it would have a negative effect on our financial results.
Our credit metrics are currently at historically strong levels and this trend could normalize over time.
Over the past several years, our asset quality metrics have trended within a narrow range, exceeding benchmarks and reaching historically strong levels. We realize that present asset quality metrics are positive and, recognizing the cyclical nature of the lending business, we anticipate this trend will likely normalize over time.
Financial condition and profitability depend significantly on local and national economic conditions.
Our success depends on general economic conditions both locally, regionally and nationally. A portion of our customers’ ability to repay their obligations is directly tied to local, regional, national or global business dealings. Deterioration in the quality of the credit portfolio could have a material adverse effect on our financial condition, results of operations, and ultimately capital.
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Financial condition and profitability depend on real estate values in our market areas.
We offer a variety of secured loans, including C&I lines of credit, C&I term loans, real estate, C&D, HELOCs, consumer and other loans. Many of our loans are often secured by real estate primarily in our market areas. In instances where borrowers are unable to repay their loans and there has been deterioration in the value of loan collateral, we could experience higher loan losses which could have a material adverse effect on financial condition, and results of operations.
Significant stock market volatility could negatively affect our financial results.
Income from WM&T constitutes approximately 45% of non-interest income. Trust AUM are expressed in terms of market value, and a significant portion of fee income is based upon those values, which generally fluctuate consistent with overall capital markets.
Capital and credit markets experience volatility and disruption from time to time. These conditions may place downward pressure on credit availability, credit worthiness and customers’ inclinations to borrow. Prolonged volatility or a significant disruption could negatively impact customers’ ability to seek new loans or to repay existing loans. Personal wealth of many borrowers and guarantors has historically added a source of financial strength to certain loans and would be negatively impacted by severe market declines. Sustained reliance on personal assets to make loan payments would result in deterioration of their liquidity, and could result in loan defaults.
The value of our investment securities may be negatively affected by factors outside of our control and impairment of these securities could have an adverse impact on our financial condition and results of operations.
Factors beyond our control can significantly influence the fair value of our investment securities. These factors include, but are not limited to, rating agency actions, defaults by issuers or with respect to underlying securities, changes in market interest rates, volatility and liquidity within capital markets and changes in local, regional, national or international economic conditions. Impairment to the fair value of these securities can result in realized and/or unrealized losses in future periods and declines in other comprehensive income, which could have an adverse effect on our business, financial condition and results of operations.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services companies are interrelated as a result of trading, clearing, counterparty, or other relationships. We have exposure to different industries and counterparties and through transactions with counterparties in the bank and non-bank financial services industries, including broker-dealers, commercial banks, investment banks and other institutional customers. As a result, defaults by, or even rumors or questions about, one or more bank or non-bank financial services companies, or bank or non-bank financial services industries in general, could lead to market-wide liquidity problems and could result in losses or defaults by us or other institutions. These losses or defaults could have an adverse effect on our business, financial condition and results of operations.
The planned phasing out of LIBOR as a financial benchmark presents risks to the financial instruments we originate or hold.
LIBOR is the reference rate used for many of our transactions, including our lending and borrowing, as well as the derivatives that we use to manage risk related to such transactions. LIBOR will cease to exist as a published rate after 2021. The expected discontinuation of LIBOR could have a significant impact on the financial markets and market participants. As of December 31, 2020, we had approximately $440 million in variable rate loans with interest rates tied to LIBOR, of which approximately $330 million have maturity dates beyond December 31, 2021. Our derivative activities based upon LIBOR include interest rate swap transactions with maturities beyond 2021 with notional amounts totaling approximately $120 million.
The FRB, through the Alternative Reference Rate Committee, has recommended a replacement benchmark rate, the Secured Overnight Financing Rate. All loan and swap contracts extending beyond 2021 will need to be managed effectively to ensure appropriate benchmark rate replacements are provided for and adopted.
Failure to identify a replacement benchmark rate and/or update data processing systems could result in future interest rate changes not being correctly captured, which could result in interest rate risk not being mitigated as intended, or interest earned being miscalculated, which could adversely impact our business, financial condition, and results of operations. Uncertainty regarding LIBOR and discretionary actions or negotiations of fallback provisions could result in pricing volatility, adverse tax or accounting impacts, or additional compliance, legal and operational costs.
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Strategic Risks
Acquisitions could adversely affect our business, financial condition and results of operations.
An institution that we acquire may have asset quality issues or contingent liabilities that we did not discover or fully recognize in the due diligence process, thereby resulting in unanticipated losses. Acquisitions of other institutions also typically require integration of different corporate cultures, loan and deposit products, pricing strategies, data processing systems and other technologies, accounting, compliance, internal audit and financial reporting systems, operating systems and internal controls, marketing programs and personnel of the acquired institution. The integration process is complicated and time consuming and could divert our attention from other business concerns and may be disruptive to our customers and customers of the acquired institution. Our failure to successfully integrate an acquired institution could result in loss of key customers and employees, and prevent us from achieving expected synergies and cost savings. We may finance acquisitions with borrowed funds, thereby increasing our leverage and reducing liquidity, or with potentially dilutive issuances of equity securities.
Competition with other financial institutions could adversely affect profitability.
We operate in a highly competitive industry that could become even more so as a result of earnings pressure from peer organizations, legislative, regulatory and technological changes and continued consolidation. We face vigorous competition in price and structure of financial products from banks and other financial institutions. In recent years, credit unions have expanded their lending mix and now compete heavily with banks in the CRE lending market. Non-traditional providers’ high risk tolerance for fixed rate, long-term loans has adversely affected our net loan growth and results of operations. We also compete with other non-traditional providers of financial services, such as brokerage firms and insurance companies. As internet-based financial services continue to grow in acceptance, we must remain relevant as an institution where consumers and businesses value personal service while other institutions offer these services without human interaction. The variety of sources of competition may reduce or limit our margins on banking services, increase operational costs through expanded product offerings, reduce market share and adversely affect our financial condition and results of operations.
We may not be able to attract and retain skilled people.
Our success depends, in large part, on our ability to attract and retain key people. Competition for the best people in the industry and markets in which we engage can be intense, and we may not be able to retain or hire the people wanted or needed. To attract and retain qualified employees, we must compensate them at or above market levels. If we are unable to continue to attract and retain qualified employees, or do so at rates necessary to maintain the Company’s competitive position, our performance, including the Company’s competitive position, could suffer, and, in turn, adversely affect our business, financial condition or results of operations.
We are subject to liquidity risks.
Liquidity is essential to our business. We rely on our ability to generate deposits and effectively manage the repayment and maturity schedules of our loans and investment securities, respectively, to ensure we have adequate liquidity to fund our operations. An inability to raise funds through deposits, borrowings, sales of investment securities, FHLB advances, sales of loans and other sources could have a significant negative effect on our liquidity.
We are dependent on large commercial deposit relationships as a primary funding source. Approximately 49% of our total deposits are centralized in accounts with balances $500,000 or greater. We categorize these deposits as core funds, as they represent long-standing, full-service relationships and are a testament to our commitment to partner with business customers by providing exemplary service and competitive products. A sudden shift in customer behavior within these deposits resulting in balances being reduced or exiting Bancorp altogether could impact our ability to capitalize on growth opportunities and meet current obligations. We have secondary funding sources to draw upon as needed, but the cost of those funds would be higher than typical deposit accounts, which would negatively impact our financial condition and results of operations.
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Excess liquidity also poses a risk to our financial condition and results of operations. We have experienced record levels of liquidity over the past year, which is expected to continue in 2021and possibly beyond. Should loan demand not meet desired levels, excess liquidity must be invested in an effort to maximize return. The risks associated with such investment include the inability to find alternative options suitable to our risk profile, investing in alternatives that adversely impact our financial condition and results of operations, and liquidity risk associated with any specific investment. Further, holding elevated levels of liquidity can have a significant impact on our NIM and result in additional margin compression.
We invest in partnerships that generate federal income tax savings and these may not continue.
We invest in certain partnerships that yield federal income tax credits resulting in higher net income. These transactions may also include lending to developers, further enhancing profitability of the transaction. These transactions typically involve a very limited number of counterparties. Availability and suitability of these transactions are not particularly predictable and may not continue to be favorable to us. Current and future tax legislation could result in fewer transactions and the extent to which federal income tax credits favorably affect net income. Therefore, the positive effect on our net income may not continue at levels previously experienced.
Operational Risks
Our accounting policies and methods are critical to how we report our financial condition and results of operations. They require management to make estimates about matters that are uncertain.
Accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. Management must exercise judgment in selecting and applying these accounting policies and methods so they comply with GAAP.
We have identified certain accounting policies as being critical because they require management’s judgment to ascertain the valuations of assets, liabilities, commitments and contingencies. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or reducing a liability. We have established detailed policies and control procedures intended to ensure these critical accounting estimates and judgments are well-controlled and applied consistently.
Policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. Because of the uncertainty surrounding judgments and estimates pertaining to these matters, there can be no assurances that actual our results will not differ from those estimates. See the section titled “Critical Accounting Policies and Estimates” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for more information.
An extended disruption of vital infrastructure could negatively impact our business, results of operations, and financial condition.
Our operations depend upon, among other things, infrastructure, including equipment and facilities. Extended disruption of vital infrastructure by fire, power loss, natural disaster, telecommunications failure, information systems breaches, corporate account take-over, terrorist activity or the domestic and foreign response to such activity, or other events outside of our control could have a material adverse impact on the financial services industry, the economy as a whole or on our financial condition and results of operations. Our business continuity plan may not work as intended or may not prevent significant interruption of operations. Occurrence of any failures or interruptions of information systems could damage our reputation, result in loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have an adverse effect on our financial condition and results of operations.
Security breaches or incidences of fraud could negatively impact our business, results of operations, and financial condition.
Our assets, which are at risk for cyber-attacks, include financial assets and non-public information belonging to customers. Cyber security risks include cyber espionage, blackmail, ransom, theft, and corporate account takeovers. We employ many preventive and detective controls to protect our assets, and provide mandatory recurring information security training for all employees. We have invested in multiple preventative tools in an attempt to protect customers from cyber threats and corporate account takeover and regularly provide educational information regarding cyber threats to customers. We utilize multiple third-party vendors who have access to ours assets via electronic media. While we require third parties, many of whom are small companies, to have similar or superior controls in place, there is no guarantee that a breach of information could not occur. Activities of the Bank that subject Bancorp to risk of fraud by customers, employees, vendors, or members of the general public include ACH transactions, wire transactions, ATM/ITM transactions, checking transactions, credit card transactions and loan originations. Repeated incidences of fraud or a single large occurrence could adversely impact our reputation, financial condition and results of operations.
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We are dependent upon outside third parties for processing and handling of the Company’s records and data.
We rely on software developed by third-party vendors to process various transactions. In some cases, we have contracted with third parties to run their proprietary software on our behalf. While we perform a review of controls instituted by applicable vendors over these programs in accordance with industry standards and performs testing of user controls, we rely on continued maintenance of controls by these third-party vendors, including safeguards over security of client data. We may incur a temporary disruption in our ability to conduct business or process transactions, or incur reputational damage, if a third-party vendor fails to adequately maintain internal controls or institute necessary changes to systems. Such a disruption or breach of security could have a material adverse effect on our business. Further, if these third-party service providers experience difficulties, or should terminate their services, and we are unable to replace them on a timely basis, our business operations could be interrupted. If an interruption were to continue for a significant period of time, or if we incurred excessive costs involved with replacing third-party service provider, our business, financial condition and results of operations could be adversely affected.
Our ability to stay current on technological changes in order to compete and meet customer demands is constantly being challenged.
The financial services industry is constantly undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. Future success of Bancorp will depend, in part, upon our ability to address the needs of our customers by utilizing technology to provide products and services that will satisfy customer demands for convenience, as well as to create additional operational efficiencies and greater privacy and security protection for customers and their personal information. Many of our competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services as quickly as competitors or be successful in marketing these products and services to our customers. We rely on third party providers for many of our technology-driven banking products and services. Some of these companies may be slow to respond with upgrades or enhancements to their products to keep pace with improvements in technology or the introduction of competing products. Failure to successfully keep pace with technological change affecting the financial services industry could impair our ability to effectively compete to retain or acquire new business and could have an adverse impact on our business, financial position and results of operations.
Changes in customer use of banks could adversely affect our financial condition and results of operations.
The rapid evolution of non-bank alternatives for initiation and completion of financial transactions puts us at risk of losing sources of revenue and funding. The ability of customers to pay bills, deposit and transfer funds, and purchase assets without utilizing the banking system could result in loss of fee income, deposits, and loans. If we are unable to continue timely development of competitive new products and services, our financial condition and results of operations could be adversely affected.
Regulatory and Legal Risks
We operate in a highly regulated environment and may be adversely affected by changes to or lack of compliance with federal, state and local laws and regulations.
We are subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change to, or addition of, applicable regulations or federal or state legislation could have a substantial impact on our financial condition and results of operations. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on the ability to pay dividends and the requirement to obtain regulatory approvals to proceed with certain aspects of our business plan, including branching and acquisitions.
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Changes in tax laws and regulations may have an adverse impact on our financial condition and results of operations.
The Tax Cuts and Jobs Act, which was enacted in December 2017, reduced the federal tax rate for corporations from 35% to 21%. While this legislation resulted in a one-time charge to earnings associated with the revaluation of Bancorp’s DTAs at the date of enactment, it has since had a positive impact on earnings as federal income tax expense has been reduced. With the Biden Administration taking office in 2021, it is increasingly likely that the federal tax rate for corporations could be increased in 2021 or 2022. The potential enactment of such legislation, or changes in the interpretation of existing tax law, including provisions impacting tax rates, apportionment, consolidation or combination, income, expense, credits and exemptions may have a material adverse effect on our business, financial condition and results of operations.
Changes to state tax laws and regulations that go into effect in 2021 may have a negative impact on our financial condition and results of operations. In March 2019, the Kentucky Legislature passed HB354 requiring financial institutions to transition from a capital based franchise tax to the Kentucky corporate income tax beginning in 2021. The Kentucky corporate income tax will be assessed at 5% of Kentucky taxable income and will be included as a component of current and deferred state income tax expense.
We are subject to litigation risk and reputational risk pertaining to fiduciary responsibility.
From time to time, customers may make claims and take legal action pertaining to our fiduciary responsibilities. Whether customer claims and legal action related to our fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to us they may result in significant financial liability and/or adversely affect the market perception of us and our products and services, as well as impact customer demand for those products and services. Any financial liability or reputational damage could have a material adverse effect on our financial condition and results of operations.
Item 1B. Unresolved Staff Comments.
None.
Item 2. Properties.
The principal offices of Bancorp are located at 1040 East Main Street, Louisville, Kentucky. Bancorp’s operations center is at a separate location in Louisville. At December 31, 2020, in addition to the main office complex and the operations center, Bancorp owned 26 branch properties, three of which are located on leased land. At that date, Bancorp also leased 18 branch facilities including its WM&T facility. Of the 44 banking locations, 33 are located in the Louisville MSA, five are located in the Indianapolis MSA and six are located in the Cincinnati MSA.
Item 3. Legal Proceedings.
In the ordinary course of operations, Bancorp and the Bank are defendants in various legal proceedings. There is no proceeding pending or, to the knowledge of management, threatened in which an adverse decision could result in a material adverse change in the business or consolidated financial position of Bancorp or the Bank.
Item 4. Mine Safety Disclosures.
NA
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PART II
Bancorp’s common stock is traded on the NASDAQ under the ticker symbol SYBT. On December 31, 2020, Bancorp had approximately 1,600 shareholders of record, and approximately 8,200 beneficial owners holding shares in nominee or “street” name.
The following table shows information relating to the repurchase of shares of common stock by Bancorp during the three months ended December 31, 2020.
October 1 - October 31 — $ — — $ —
November 1 - November 30 — — — —
December 1 - December 31 — — — —
Effective May 22, 2019, Bancorp’s Board of Directors approved a share repurchase program authorizing the repurchase of 1 million shares, or approximately 4% of Bancorp’s total common shares outstanding at the time. Stock repurchases are expected to be made from time to time on the open market or in privately negotiated transactions, subject to applicable securities laws. The plan, which will expire in May 2021 unless otherwise extended or completed at an earlier date, does not obligate the Company to repurchase any specific dollar amount or number of shares prior to the plan’s expiration. Based on economic developments over the past year and the increased importance of capital preservation, no shares were repurchased in 2020. As of December 31, 2020, Bancorp had 741,196 shares that could be repurchased under its current share repurchase program.
There were no equity securities of the registrant sold without registration during the quarter covered by this report.
The following performance graphs and data shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed soliciting material or subject to Regulation 14A of the Exchange Act or incorporated by reference in any filing under the Exchange Act or the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.
The first graph compares performance of Bancorp’s Common Stock to the Russell 2000 Index, the SNL Midwest Bank Index, and the SNL Bank NASDAQ Index for the last five fiscal years. The graph assumes the value of the investment in Bancorp’s Common Stock and in each index was $100 at December 31, 2015 and that all dividends were reinvested.
In addition to the five-year period required by the SEC, the ten-year period is presented because it provides additional perspective, and Bancorp management believes that longer-term performance is of interest. The ten-year graph assumes the value of the investment in Bancorp’s Common Stock and in each index was $100 at December 31, 2010 and that all dividends were reinvested.
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Period Ending
Period Ending
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Item 6. Selected Financial Data.
As of and for the Years Ended December 31,
Operating Data:
Share and Per Share Data:
Financial Condition Data:
Performance Ratios:
Asset Quality:
Allowance for credit losses on loans to total loans 1.47 0.94 1.00 1.03 1.04
Capital Ratios:
Other Data:
Share and per share information has been adjusted to reflect the 3 for 2 stock-split in April 2016 effected in the form of a 50% stock dividend.
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Non-GAAP Financial Measures
The following table provides a reconciliation of total stockholders’ equity in accordance with GAAP to tangible stockholders’ equity (TCE), a non-GAAP disclosure. Bancorp provides the TCE per share, a non-GAAP measure, in addition to those defined by banking regulators, based on its widespread use by investors as a means to evaluate capital adequacy:
December 31, (dollars in thousands, except per share data) 2020 2019
Less: Core deposit intangible (1,962 ) (2,285 )
Less: Core deposit intangible (1,962 ) (2,285 )
Total stockholders' equity to total assets - GAAP (a/b) 9.56 % 10.91 %
Tangible common equity to tangible assets - Non-GAAP (c/d) 9.28 % 10.55 %
Book value per share - GAAP (a/e) $ 19.42 $ 17.97
Tangible common equity per share - Non-GAAP (c/e) 18.78 17.32
ACL to total non-PPP loans represents the ACL, divided by total loans less PPP loans. Non-performing loans to total non-PPP loans represents non-performing loans, divided by total loans less PPP loans. Delinquent loans to total non-PPP loans represents delinquent loans (consisting of all loans 30 days or more past due), divided by total loans less PPP loans. Bancorp believes these non-GAAP disclosures are important because they provide comparable ratios after eliminating PPP loans, which are fully guaranteed by the SBA and have not been allocated for within the ACL and are not at risk of non-performance.
Allowance for credit losses on loans (c) $ 51,920 $ 26,791
Allowance for credit losses on loans to total loans - GAAP (c/a) 1.47 % 0.94 %
Non-performing loans to total loans - GAAP (d/a) 0.37 % 0.42 %
Non-performing loans to total loans - Non-GAAP (d/b) 0.44 % 0.42 %
Delinquent loans to total loans - GAAP (e/a) 0.48 % 0.53 %
Delinquent loans to total loans - Non-GAAP (e/b) 0.57 % 0.53 %
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The efficiency ratio, a non-GAAP measure, equals total non-interest expenses divided by the sum of net interest income FTE and non-interest income. The ratio excludes net gains (losses) on sales, calls, and impairment of investment securities, if applicable. In addition to the efficiency ratio, Bancorp considers an adjusted efficiency ratio. Bancorp believes it is important because it provides a comparable ratio after eliminating the fluctuation in non-interest expenses related to amortization of investments in tax credit partnerships.
Net interest income on a FTE basis includes the additional amount of interest income that would have been earned if investments in certain tax-exempt interest earning assets had been made in assets subject to federal, state and local taxes yielding the same after-tax income.
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The consolidated financial statements include the accounts of Stock Yards Bancorp, Inc. its wholly-owned subsidiary, SYB, collectively referred to as “Bancorp” or the “Company.” All significant inter-company transactions and accounts have been eliminated in consolidation.
Stock Yards Bancorp, Inc. is a FHC headquartered in Louisville, Kentucky. SYB, chartered in 1904, is a state-chartered non-member financial institution that provides services in the Louisville, Kentucky, Indianapolis, Indiana and Cincinnati, Ohio MSAs through 44 full service banking center locations.
Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the consolidated financial statements and accompanying Footnotes presented in Part II Item 8 “Financial Statements and Supplementary Data.”
Cautionary Statement Regarding Forward-Looking Statements
This document contains statements relating to future results of Bancorp that are considered “forward-looking” as defined by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements are principally, but not exclusively, contained in Part II Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part I Item 1A “Risk Factors.”
Forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance, or achievements to be materially different from future results, performance, or achievements expressed or implied by the statement. These statements are often, but not always, made through the use of words or phrases such as “anticipate,” “believe,” “aim,” “can,” “conclude,” “continue,” “could,” “estimate,” “expect,” “foresee,” “goal,” “intend,” “may,” “might,” “outlook,” “possible,” “plan,” “predict,” “project,” “potential,” “seek,” “should,” “target,” “will,” “will likely,” “would,” or other similar expressions. These forward-looking statements are not historical facts and are based on current expectations, estimates and projections about our industry, management’s beliefs and certain assumptions made by management, many of which, by their nature, are inherently uncertain and beyond our control, particularly with regard to developments related to the COVID-19 pandemic. Forward-looking statements detail management’s expectations regarding the future and are based on information known to management only as of the date the statements are made and management undertakes no obligation to update forward-looking statements to reflect events or circumstances that occur after the date forward-looking statements are made, except as required by applicable law.
There is no assurance that any list of risks and uncertainties or risk factors is complete. Factors that could cause actual results to differ materially from those expressed or implied in forward-looking statements include, among other things:
● changes in or forecasts of future political and economic conditions;
● changes in laws and regulations or the interpretation thereof;
● changes in fiscal, monetary, and/or regulatory policies;
● ability to effectively manage capital and liquidity;
● competitive product and pricing pressures;
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● integration of acquired businesses or future acquisitions;
As previously noted, Bancorp executed a definitive Agreement and Plan of Merger (“agreement”) dated as of January 27, 2021, to acquire Kentucky Bancshares, Inc. and its subsidiary Kentucky Bank. This document also contains statements regarding the proposed acquisition transaction that are not statements of historical fact and are considered forward-looking statements within the criteria described above. These statements are likewise subject to various risks and uncertainties that may cause actual results and outcomes of the proposed transaction to differ, possibly materially, from the anticipated results or outcomes expressed or implied in these forward-looking statements. In addition to factors disclosed in reports filed by Stock Yards and Kentucky Bancshares with the SEC, risks and uncertainties for Stock Yards, Kentucky Bancshares and the combined company include, but are not limited to: the possibility that any of the anticipated benefits of the proposed merger will not be realized or will not be realized within the expected time period; the risk that integration of Kentucky Bancshares’ operations with those of Stock Yards will be materially delayed or will be more costly or difficult than expected; the parties’ inability to meet expectations regarding the timing, completion and accounting and tax treatments of the merger; the inability to complete the merger due to the failure of Kentucky Bancshares’ shareholders to adopt the merger agreement; the failure to satisfy other conditions to completion of the merger, including receipt of required regulatory and other approvals; the failure of the proposed transaction to close for any other reason; diversion of management's attention from ongoing business operations and opportunities due to the merger; the challenges of integrating and retaining key employees; the effect of the announcement of the merger on Stock Yards’, Kentucky Bancshares’ or the combined company's respective customer and employee relationships and operating results; the possibility that the merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events; dilution caused by Stock Yards’ issuance of additional shares of Stock Yards common stock in connection with the merger; the magnitude and duration of the COVID-19 pandemic and its impact on the global economy and financial market conditions and the business, results of operations and financial condition of Stock Yards, Kentucky Bancshares and the combined company; and general competitive, economic, political and market conditions and fluctuations.
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Effective January 27, 2021, Bancorp executed a definitive Share Purchase Agreement (“agreement”), pursuant to which Bancorp will acquire all of the outstanding common stock of publicly traded Kentucky Bancshares, Inc. Kentucky Bancshares, Inc., headquartered in Paris, Kentucky, is the holding company for Kentucky Bank, which operates 19 branches throughout the following central Kentucky cities: Paris (Bourbon County), Cynthiana (Harrison County), Georgetown (Scott County), Lexington (Fayette County), Morehead (Rowan County), Nicholasville (Jessamine County), Richmond (Madison County), Sandy Hook (Elliott County), Versailles (Woodford County), Wilmore (Jessamine County) and Winchester (Clark County).
Under the terms of the Agreement, the Company will acquire all of outstanding common stock in a combined stock and cash transaction, resulting in a total consideration to Kentucky Bancshares existing shareholders of approximately $190 million. Bancorp will fund the cash payment portion of the acquisition through existing resources on-hand.
The acquisition is expected to close during second quarter of 2021, subject to customary regulatory approval and completion of customary closing conditions. As of December 31, 2020, Kentucky Bancshares, Inc. had approximately $1.2 billion in assets, $767 million in loans, $979 million in deposits and $114 million in tangible common equity. Kentucky Bancshares also maintains a Wealth Management and Trust Department with total assets under management of $258 million at December 31, 2020. The combined franchise will serve customers through 63 branches with total assets of approximately $5.8 billion, $4.3 billion in gross loans, $5.0 billion in deposits and over $4.1 billion in trust assets under management.
In May 2019, Bancorp completed its acquisition of KSB for $28 million in cash. The acquisition expanded Bancorp’s market area into nearby Nelson County, Kentucky, and expanded the customer base in Louisville, Kentucky. At May 1, 2019, KSB reported approximately $192 million in total assets, approximately $164 million in loans, and approximately $126 million in deposits. As a result of the acquisition, goodwill totaling $12 million was recorded during the second quarter of 2019, with nominal recast adjustments posted during the third and fourth quarters of the same year.
As a result of the completion of the acquisition, Bancorp incurred pre-tax transaction charges totaling $1.3 million during the second quarter of 2019. Net income from the KSB acquisition was accretive to Bancorp’s overall operating results beginning with the third quarter of 2019. Effective March 31, 2020, management finalized the fair values of the acquired assets and assumed liabilities in advance of the 12-month post acquisition date, as allowed by GAAP.
In connection with the acquisition, Bancorp became the 100% successor owner of KBST, an unconsolidated finance subsidiary. As permitted under the terms of KBST’s governing documents, Bancorp redeemed the TPS at the par amount of approximately $4 million in June 2019.
Issued but Not Yet Effective Accounting Standards Updates
For disclosure regarding the impact to Bancorp’s financial statements of issued-but-not-yet-effective ASUs, see the Footnote titled “Summary of Significant Accounting Policies” of Part II Item 8 “Financial Statements and Supplementary Data.”
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Critical Accounting Policies and Estimates
Bancorp’s consolidated financial statements and accompanying footnotes have been prepared in accordance with GAAP. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported periods.
Management continually evaluates its accounting policies and estimates that it uses to prepare the consolidated financial statements. In general, management’s estimates and assumptions are based on historical experience, accounting and regulatory guidance, and information obtained from independent third-party professionals. Actual results may differ from those estimates made by management.
Critical accounting policies are those that management believes are the most important to the portrayal of Bancorp’s financial condition and operating results and require management to make estimates that are difficult, subjective and complex. Most accounting policies are not considered by management to be critical accounting policies. Several factors are considered in determining whether or not a policy is critical in the preparation of the financial statements. These factors include, among other things, whether the estimates have a significant impact on the financial statements, the nature of the estimates, the ability to readily validate the estimates with other information including independent third parties or available pricing, sensitivity of the estimates to changes in economic conditions and whether alternative methods of accounting may be utilized under GAAP. Management has discussed each critical accounting policy and the methodology for the identification and determination of critical accounting policies with Bancorp’s Audit Committee. Effective January 1, 2020 through December 31, 2020, the significant accounting policy considered the most critical in preparing Bancorp’s consolidated financial statements is the determination of the ACL on loans.
Allowance for Credit Losses on Loans and Provision for Credit Losses
On January 1, 2020, Bancorp adopted ASC 326 “Financial Instruments – Credit Losses,” which created material changes to Bancorp’s existing critical accounting policy that existed at December 31, 2019.
The ACL on loans is established through credit loss expense charged to current earnings. The amount maintained in the ACL reflects management’s estimate of the net amount not expected to be collected on the loan portfolio at the balance sheet date over the life of the loan. The ACL is comprised of specific reserves assigned to certain loans that do not share general risk characteristics and general reserves on pools of loans that do share general risk characteristics. Factors contributing to the determination of specific reserves include the creditworthiness of the borrower and more specifically, changes in the expected future receipt of principal and interest payments and/or in the value of pledged collateral. A reserve is recorded when the carrying amount of the loan exceeds the discounted estimated cash flows using the loan’s initial effective interest rate, an expected loss ratio based on historical losses adjusted as appropriate for qualitative factors, or the fair value of the collateral for certain collateral-dependent loans.
For purposes of establishing the general reserve, Bancorp stratifies the loan portfolio into homogeneous groups of loans that possess similar loss potential characteristics and calculates the net amount expected to be collected over the life of the loans to estimate the credit losses in the loan portfolio. Bancorp’s methodologies for estimating the ACL on loans consider available relevant information about the collectability of cash flows, including information about past events, current conditions, and reasonable and supportable forecasts.
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Business Segment Overview
Bancorp is divided into two reportable segments: Commercial Banking and WM&T:
Commercial Banking provides a full range of loan and deposit products to individual consumers and businesses in all its markets through retail lending, mortgage banking, deposit services, online banking, mobile banking, private banking, commercial lending, treasury management services, merchant services, international banking, correspondent banking and other banking services. The Bank also offers securities brokerage services via its banking center network through an arrangement with a third party broker-dealer in the Commercial Banking segment.
WM&T provides investment management, company retirement plan management, retirement planning, trust, estate and financial planning services in all markets in which Bancorp operates. The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size.
The COVID-19 pandemic in the U.S. and efforts to contain it have had a complex and significant adverse impact on the economy, the banking industry and Bancorp. The impact on future fiscal periods is subject to a high degree of uncertainty.
On March 11, 2020, the World Health Organization declared COVID-19 to be a global pandemic, indicating that almost all public commerce and related business activities must be, to varying degrees, curtailed with the goal of decreasing the rate of new infections. The spread of the virus has caused significant disruptions in the U.S. economy and has impacted banking and other financial activity in the markets in which Bancorp operates. While some industries have been impacted more severely than others, all businesses have been impacted to some degree. This disruption resulted in the initial shuttering of non-essential businesses across most of the country, significant job loss, and aggressive measures by the federal government. While phased-in re-opening of commerce that began towards the end of the second quarter has led to the easing of many initial restrictions, unemployment levels remain elevated and uncertainty regarding the effects of the pandemic on general economic behavior remains.
In response to the above, Congress, the President and regulatory agencies took action designed to lessen the economic fallout. Most notably, the CARES Act was signed into law at the end of March. The goal of the CARES Act was to prevent a severe economic downturn through various measures, including direct financial aid to American families and economic stimulus to impacted industry sectors.
The CARES Act established the SBA PPP to provide loans for eligible businesses/not-for-profits with the focus on job retention and assistance with certain operating expenses. Portions of these loans qualify for forgiveness when used for payroll costs, mortgage interest, rent and utilities during the 24-week period beginning with the date of the loan. Loans funded through the PPP are fully guaranteed by the U.S. government.
The first round of the PPP expired on August 8, 2020 and as of December 31, 2020, Bancorp had submitted 520 forgiveness applications to the SBA totaling $170 million and has received payment from the SBA for 333 borrowers. The SBA has 90 days to review and decision applications for forgiveness. On October 8, 2020, the SBA announced it would streamline loan forgiveness for loans of $50,000 or less with one or more employee other than the owner (representing approximately 48% of the PPP loans Bancorp originated). Bancorp has approximately $10.5 million in net unrecognized fees related to the PPP that would be recognized in income immediately once the loans are paid off or forgiven by the SBA. The timing of such forgiveness is expected to have a major impact on 2021 operating results.
Additional legislative stimulus action was signed into law at the end of December 2020 through the CAA, providing $900 billion in new COVID-19 stimulus relief as part of a broader government spending bill, including $284 billion for a second round of the PPP and an extension of the program to March 31, 2021. To qualify, borrowers must show a 25% decline in revenue over certain periods.
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The program offers “second draw” loans targeted at hard-hit businesses that employ 300 or fewer employees and that have used or will use the full amount of their initial PPP loan. The maximum loan under this program is $2 million, based on two and a half months of average annual payroll (three and a half months for hotels and restaurants). The measurement period for the payroll can either be calendar year 2019 or the one year period before the date the “second draw” originates. For any loan up to $150,000, the covered loan amount will be forgiven once the borrower submits a one page forgiveness application detailing the loan amount, the number of employees retained, and the amount of the loan spent on payroll. This will substantially reduce the burden on both borrowers and lenders. The lender review will be limited to whether the lender received a complete application with all fields completed, initialed, or signed as applicable. If the submission is complete, the lender is required to accept it and forward to the SBA. Bancorp is projecting to book approximately 1,300 of these “second draw” PPP loans totaling $220 million.
The CARES Act permits financial institutions to suspend requirements under GAAP for loan modifications to borrowers affected by COVID-19 and is intended to provide interpretive guidance as to conditions that would constitute a short-term modification that would not meet the definition of a TDR. This includes the following: (i) the loan modification is made between March 1, 2020 and the earlier of December 31, 2020 or 60 days after the end of the coronavirus emergency declaration, and (ii) the applicable loan was not more than 30 days past due as of December 31, 2019. Bancorp is applying this guidance to qualifying loan modifications and has implemented modifications meeting these conditions. Federal bank regulatory authorities also issued guidance to encourage banks to make loan modifications for borrowers affected by COVID-19 and to assure banks that they would not be criticized by examiners for doing so.
While the emergency-use approval and distribution of the COVID-19 vaccination is a promising development, the duration of the pandemic and its continued effects on local, national and global economic activity will continue to weigh on Bancorp’s financial condition and results of operations in 2021and possibly beyond.
The PPP directly impacted Bancorp’s financial condition and results of operations for the twelve months ended December 31, 2020 as follows:
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Other pandemic-related impacts to Bancorp’s financial condition and results of operations for the twelve months ended December 31, 2020 were as follows:
In tandem with the declaration of the global pandemic, Bancorp invoked its Board of Director-approved pandemic plan, which included timely communication to employees, implementing remote work arrangements to the full extent possible, separating individual departments, operating select branch lobbies by appointment only, fully staffing all branch drive-thru lanes, communicating with and encouraging customers to use Bancorp’s free self-service tools such as ITMs/ATMs, online banking, mobile banking and bill pay and actively promoting social distancing in all aspects of business.
Bancorp has maintained social distancing precautions for all employees in the office and customers visiting branches, preventative cleaning at offices/branches and restrictions on non-essential business related travel to the fullest extent possible and pursuant to guidance issued by the Centers for Disease Control and state and local authorities. Bancorp has implemented business continuity measures as necessary throughout the pandemic, including monitoring potential business interruptions.
Bancorp has taken measures both to support customers affected by the pandemic and to maintain strong asset quality, including:
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Management continues to meet to anticipate and respond to ongoing pandemic related developments. Bancorp has not incurred any significant challenges to its ability to maintain its systems and controls in light of the measures taken to prevent the spread of COVID-19 and has not incurred significant resource constraints through the implementation of its business continuity plans and does not anticipate incurring such in the future. Bancorp has not made, and at this time does not expect to make, any material staffing or compensation changes as a result of the pandemic.
Overview – Operating Results
The following table presents an overview Bancorp’s financial performance for the years ended December 31, 2020, 2019 and 2018:
Years Ended December 31, Variance
Additional discussion follows under the section titled “Results of Operations.”
General highlights for the year ended December 31, 2020 compared to December 31, 2019:
● In 2020, Bancorp set the following financial records:
o Record loan production in 2020 (excluding PPP)
o WM&T AUM of $3.85 billion at December 31, 2020
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Total stockholder’s equity to total assets was 9.56% as of December 31, 2020 compared to 10.91% at December 31, 2019, the decline driven by the outsized balance sheet growth attributed to PPP participation. Total equity increased $34.4 million in 2020, as net income of $58.9 million was offset by dividends declared of $24.5 million, changes in AOCI and various stock based compensation.
TCE is a measure of a company's capital which is useful in evaluating the quality and adequacy of capital. Bancorp’s ratio of TCE to total tangible assets was 9.28% as of December 31, 2020, compared with 10.55% at December 31, 2019, the decline driven by the significant balance sheet growth associated with PPP participation as noted above. See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.
General highlights for the year ended December 31, 2019 compared to December 31, 2018:
● In 2019, Bancorp set the following financial records:
o Net income of $66.1 million surpassing $55.5 million in 2018
o Total deposit growth of $340 million
o WM&T AUM of $3.3 billion at December 31, 2019
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● NIM declined 1 bp to 3.82% for 2019 compared to the prior year.
● Net interest income increased $10.8 million, or 9%, for 2019.
o Lower long-term interest rates boosted mortgage banking income.
o Card processing expenses trended upward consistent with revenue growth.
Total stockholder’s equity to total assets was 10.91% as of December 31, 2019 compared to 11.10% at December 31, 2018. Total equity increased $39.8 million in 2019, as record net income of $66.1 million was offset by dividends declared of $23.5 million, stock repurchases totaling $9.2 million, changes in AOCI and various stock based compensation.
TCE is a measure of a company's capital which is useful in evaluating the quality and adequacy of capital. Bancorp’s ratio of TCE to total tangible assets was 10.55% as of December 31, 2019, compared with 11.05% at December 31, 2018, with the decline attributable to the second quarter 2019 KSB acquisition. See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.
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Challenges for 2021:
Bancorp has identified the following challenges for fiscal year 2021:
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Results of Operations
Net Interest Income
As is the case with most banks, Bancorp’s primary revenue sources are net interest income and fee income from various financial services provided to customers. Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities. Loan volume and interest rates earned on those loans are critical to overall profitability. Similarly, deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability. New business volume is influenced by economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace. The discussion that follows is based on fully tax-equivalent interest data.
Comparative information regarding net interest income follows:
As of and for the Years Ended December 31, Variance
Five year Treasury note rate at year end 0.36 % 1.69 % 2.51 % (133 )bps (82 )bps
Average five year Treasury note rate 0.53 % 1.95 % 2.75 % (142 )bps (80 )bps
NIM and net interest spread calculations above exclude the sold portion of certain participation loans, which totaled $10 million, $8 million and $10 million for the years ended December 31, 2020, 2019 and 2018, respectively. These sold loans are on Bancorp’s balance sheet as required by GAAP because Bancorp retains some form of effective control; however, Bancorp receives no interest income on the sold portion. These participation loans sold are excluded, because Bancorp believes it provides a more accurate depiction of the performance of its loan portfolio.
Prime rate, the five year Treasury note rate and the one month LIBOR are included in the table above to provide a general indication of the interest rate environment in which Bancorp has operated during the past three years. Approximately $1 billion, or 31%, of Bancorp’s loans are variable rate (37% excluding the PPP portfolio), of which 99% are indexed to either Prime or one month LIBOR and generally reprice as those rates change. At inception, most of Bancorp’s fixed rate loans are priced in relation to the five year Treasury note.
The interest rate environment has declined drastically over the three year period as referenced in the table above. Rising rates in 2018 drove the FFTR to a range of 2.25-2.50%, resulting in Prime rising to 5.50% by the end of that year, representing the highest interest rates experienced post-Great Recession. Since hitting those marks, the FRB has lowered the FFTR five times, resulting in a combined 225 bps decrease in the FFTR through December 31, 2020. The most recent of these cuts came in mid-March 2020 when the FRB lowered the FFTR to a range of 0% - 0.25% in response to the COVID-19 pandemic, the lowest level since late 2015.
Discussion of 2020 vs 2019:
Net interest spread and NIM were 3.22% and 3.39% for 2020 compared to 3.50% and 3.82% for 2019. NIM was significantly impacted in 2020 by the following:
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● Strong average loan growth (excluding PPP loans).
● Excess balance sheet liquidity and elevated deposit balances.
As previously stated, Bancorp originated approximately 3,400 PPP loans, equating to $637 million (net of origination fees and costs) during the second quarter of 2020. Bancorp received $19.5 million in net origination fees from the SBA and recognized $9.1 million in net origination fee income associated with the PPP portfolio in 2020. While this had a positive impact on interest and fee income as well as net interest income, the 1% stated yield on the PPP portfolio negatively impacted the overall loan portfolio yield by 17 bps and NIM by 3 bps. With a heavy concentration of these loans originating in April, the average balance of the PPP portfolio ended at $443 million for the year ended December 31, 2020 with a yield of 3.08%, which was significantly below the 4.34% yield on the traditional loan portfolio (excluding PPP loans) for the same period.
Average FFS and interest bearing due from bank balances increased significantly for the year ended December 31, 2020 compared with the same period in 2019. Excess liquidity contributed to approximately 15 bps of NIM compression for the year ended December 31, 2020 compared to 9 bps for the year ended December 31, 2019.
Net interest income (FTE) increased $10.6 million, or 8%, for the year ended December 31, 2020 compared to the same period of 2019, primarily attributed to the deposit rate cuts implemented by Bancorp in response to the changing interest rate environment and the additional fee income associated with the PPP portfolio.
Total average interest earning assets increased $729 million, or 22%, to $4.0 billion for the year ended December 31, 2020, with the average rate earned on total interest earning assets contracting 82 bps to 3.68%.
Total interest income (FTE) was flat, down $32,000 to $148.1 million for the year ended December 31, 2020, as compared with the same period of 2019 despite the drastic decline in the interest rate environment.
Total average interest bearing liabilities increased $353 million, or 16%, to $2.6 billion for the year ended December 31, 2020, as compared with the same period of 2019, with the average cost decreasing 54 bps to 0.46%.
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Total interest expense decreased $10.6 million, or 47%, for the year ended December 31, 2020, compared to the same period of 2019, a direct result of strategic deposit rate reductions implemented in response to the changing interest rate environment.
Discussion of 2019 vs 2018:
During the third quarter of 2019, the FRB lowered the FFTR 25 bps twice; effective on August 1st and later during the quarter, effective September 19th. Effective October 31st, the FRB lowered the FFTR 25 bps once again with Prime ending at 4.75% as of December 31, 2019 compared to 5.50% at December 31, 2018.
In response to the August FFTR reduction, Bancorp immediately lowered the stated rate of most interest-bearing deposit account types, in addition to lowering all CD offering rates. With regard to the September FFTR reduction, Bancorp immediately lowered stated rates on most personal money market and larger sweep customers in addition to CD offering rates. Bancorp was able to fully offset the loss in revenue, with the first and second FFTR movements not impacting overall NIM. With the October 31st rate drop, the Bank lowered the stated rate of most interest-bearing deposit account types in addition to subsequently lowering all CD offering rates in early November. Unlike the previous two rate cuts by the FRB, the decline in loan yields associated with this cut was not fully offset by the reduction in deposit rates.
In the first half of 2018, Bancorp raised stated rates paid on money market accounts in addition to launching a targeted CD marketing campaign within its Louisville market to support loan growth and increase liquidity. The campaign generated over $100 million in CD growth in 2018. In addition, the deposit portfolio assumed from KSB in the second quarter of 2019 was concentrated in higher costing time deposits. While Bancorp had not aggressively pursued deposits since mid-2018, falling interest rates in 2019 drove an increase in non-interest bearing deposits.
In general, net interest income and NIM were favorably impacted by elevated loan prepayment fees collected in 2019 with a much lighter impact experienced in the prior year. Offsetting the fee impact, the KSB portfolio mix of interest earning assets and interest bearing liabilities added during 2019 had a slight negative impact on NIM.
Net interest spread (FTE) and NIM (FTE) were 3.50% and 3.82%, for the year ended December 31, 2019 compared to 3.60% and 3.83% for the same period in 2018. Net interest income (FTE) of $125.6 million for the year ended December 31, 2019 increased $10.7 million, or 9%, from $114.9 million for the same period in 2018, led by growth in average interest earning assets, primarily loans. Total average earning assets increased $292 million, or 10%, to $3.3 billion for the year ended December 31, 2019, as compared with the same period in 2018, with the average rate earned on earnings assets increasing 16 bps to 4.50%. Average loans increased $198 million, or 8%, for the year ended December 31, 2019 compared to the same period in 2018, with the KSB acquisition contributing $102 million, or 52% of the total average increase. The remaining increase stemmed from record annual organic loan production experienced across all markets. Average balances of FFS, interest bearing due from banks and AFS securities increased $91 million, or 19%, in total for the year ended December 31, 2019, as compared with 2018, as excess balance sheet liquidity was deployed into short-term investments.
Total interest income (FTE) increased $17.9 million, or 14%, for the year ended December 31, 2019, as compared with the same period in 2018, to $148.1 million. Approximately $15.8 million of this total increase related to loans (FTE), with the majority of this increase attributed to average balance growth.
Bancorp was successful in growing loans in 2019 despite elevated levels of commercial loan payoffs, resulting largely from construction and land development borrowers moving elsewhere for permanent financing or CRE loans for which collateral was sold. Loan growth during 2019 reflected ongoing expansion in key lending categories such as C&I and CRE owner-occupied lending.
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Total average interest bearing liabilities increased $202 million, or 10%, to $2.3 billion for the year ended December 31, 2019, as compared with the same period in 2018, with the average cost increasing 26 bps to 1.00%. Average interest bearing liabilities assumed in the KSB acquisition (deposits and FHLB advances) represented $78 million, or 39%, of the total increase. Average interest bearing deposits increased $237 million, or 12%, for the year ended December 31, 2019 compared to the same period in 2018, with approximately $58 million attributable to the KSB acquisition and concentrated in the time deposits category.
Total interest expense increased $7.2 million, or 47%, for the year ended December 31, 2019 compared to the same period in 2018 and was concentrated within interest bearing deposits. Approximately 62% of the total interest bearing deposit change was attributable to rate with fluctuations as follows:
The average balance of SSUAR decreased $24 million, or 38%, for the year ended December 31, 2019 compared to the same period in 2018, as a significant number of commercial customers migrated from lower yielding collateralized products to higher yielding non-collateralized deposits.
With higher levels of excess balance sheet liquidity in 2019, Bancorp maintained less reliance on short-term borrowing, leading to a $34 million decline in average balance of FFP and a favorable interest expense variance of $618,000.
Average FHLB advances increased $22 million, or 45%, for the year ended December 31, 2019 compared to 2018 based on advances assumed from the KSB acquisition. These advances were retained by Bancorp based upon favorable rates and terms at the time of acquisition and in relation to the overall execution of Bancorp’s asset liability management strategy. Also, as a result of the KSB acquisition, Bancorp assumed a $4 million subordinated note that was redeemed at par prior to the end of the second quarter of 2019.
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Average Balance Sheets and Interest Rates (FTE)
Interest earning assets:
Available for sale debt securities:
SBA Paycheck Protection Program (PPP) loans 442,510 13,636 3.08 — — — — — —
Non-interest earning assets:
Interest bearing liabilities:
Deposits:
Subordinated debt — — — 922 26 2.82 — — —
Non-interest bearing liabilities:
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Supplemental Information - Total Company Average Balance Sheets and Interest Rates (FTE)
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The following table illustrates the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities impacted Bancorp’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. Tax-equivalent adjustments are based on a federal income tax rate of 21%. The change in interest due to both rate and volume has been allocated to the change due to rate and the change due to volume in proportion to the relationship of the absolute dollar amounts of the change in each.
Rate/Volume Analysis (FTE)
Compared to Compared to
Total Net Increase (Decrease) Due to Total Net Increase (Decrease) Due to
(in thousands) Change Rate Volume Change Rate Volume
Interest income:
Securities available for sale:
SBA Paycheck Protection Program (PPP) loans 13,636 — 13,636 — — —
Interest expense:
Deposits:
Securities sold under agreements to repurchase (64 ) (69 ) 5 (56 ) 7 (63 )
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Asset/Liability Management and Interest Rate Risk
Managing interest rate risk is fundamental for the financial services industry. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity with the goal of optimizing net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.
Interest Rate Simulation Sensitivity Analysis
Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one-year forecast. The simulation model is designed to reflect dynamics of interest earning assets and interest bearing liabilities. By estimating effects of interest rate fluctuations, the model can approximate interest rate risk exposure. This simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time. The model is therefore a tool to indicate earnings trends in given interest rate scenarios and may not indicate actual or expected results.
The December 31, 2020 simulation reflects the FRB’s mid-March 2020 action to lower the FFTR to near zero. Bancorp’s interest rate simulation sensitivity analysis details that increases in interest rates of 100 bps would have a slightly positive effect on interest income, while an increase in rates of 200 bps would have a more positive effect on net interest income. These results are attributed to over half of the variable rate loan portfolio being currently at or near floor rates, as these yields will not increase until short-term rates exceed these floor rates. For example, a significant portion of the variable rate loan portfolio is tied to Prime, with floor rates of 4.00%. Given Prime is at 3.25% as of December 31, 2020, short-term rates would have to increase over 75 bps for these loans to move above their floor rates.
The overall increase in net interest income in the rising rate scenarios is primarily due to variable rate loans and short-term investments repricing more quickly than deposits and short-term borrowings. Asset balances subject to immediate repricing cause an estimated decline in net interest income in the down 100 bps scenario, as rates on non-maturity deposits cannot be lowered sufficiently to offset declining interest income. These estimates are summarized below:
Change in Rates
Basis Points Basis Points Basis Points Basis Points
Bancorp’s loan portfolio is currently composed of approximately 69% fixed and 31% variable rate loans, with the fixed rate portion pricing (excluding PPP loans) generally based on a spread to the five-year treasury curve at the time of origination and the variable portion pricing based on an on-going spread to Prime (approximately 60%) or one month LIBOR (approximately 40%). Bancorp’s loan portfolio (excluding PPPP loans) at December 31, 2020 was composed of approximately 63% fixed and 37% variable rate loans.
Periodically, Bancorp enters into interest rate swap transactions with borrowers who desire to hedge exposure to rising interest rates, while at the same time entering into an offsetting interest rate swap, with substantially matching terms, with another approved independent counterparty. These are undesignated derivative instruments and are recognized on the balance sheet at fair value, with changes in fair value recorded in other non-interest income as interest rates fluctuate. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above. For additional information see the Footnote titled “Assets and Liabilities Measured and Reported at Fair Value.”
In addition, Bancorp uses derivative financial instruments as part of its interest rate risk management, including interest rate swaps. These interest rate swaps are designated as cash flow hedges as described in the Footnote titled “Derivative Financial Instruments.” For these derivatives, the effective portion of gains or losses is reported as a component of OCI, and is subsequently reclassified into earnings as an adjustment to interest expense in periods in which the hedged forecasted transaction affects earnings.
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Provision for Credit Losses
Provision for credit losses for the year ended December 31, 2020 represents the amount of expense that, based on Management’s judgment, is required to maintain the ACL on loans at an appropriate level under the CECL model. Previous years were calculated under the incurred loss model. The determination of the amount of the ACL on loans is complex and involves a high degree of judgment and subjectivity. See the footnote titled “Summary of Significant Accounting Policies” for detailed discussion regarding Bancorp’s ACL methodology by loan segment.
An analysis of the changes in the ACL on loans, including provision, and selected ratios follow:
Impact of adopting ASC 326 8,221 — —
Initial ACL on loans purchased with credit deterioration 1,635 — —
Provision to average loans 0.51 % 0.04 % 0.11 %
Net loan (charge-offs) recoveries to average loans (0.05 )% 0.01 % (0.08 )%
ACL on loans to average loans 1.57 % 0.99 % 1.02 %
ACL on loans to total loans 1.47 % 0.94 % 1.00 %
ACL on loans to total loans (excluding PPP) 1.74 % — —
Discussion of 2020 vs 2019:
Upon adoption of ASC 326 on January 1, 2020, Bancorp recorded an increase of $8.2 million to the ACL on loans and a corresponding decrease to retained earnings, net of the DTA impact. In addition, non-accretable yield marks of $1.6 million related to formerly classified PCI loans were reclassed between the amortized cost basis of loans and corresponding ACL. The adjustment upon adoption of ASC 326 increased the ACL on loans balance to $37 million as of January 1, 2020.
The ACL on loans totaled $52 million at December 31, 2020 compared to $27 million at December 31, 2019, representing an ACL to total loans ratio of 1.47% and 0.94% for those periods, respectively. The ACL to total loans (excluding PPP loans) was 1.74% at December 31, 2020. Based on the 100% SBA guarantee of the PPP loan portfolio, which totaled $550 million (net of unamortized deferred fees) at December 31, 2020, Bancorp did not reserve for potential losses for this portfolio.
Despite overall strong credit metrics, Bancorp recorded provision for credit losses $16.9 million for the year ended December 31, 2020, as compared with $1.0 million for the same period of 2019, the latter of which was determined under the incurred loan loss model. Provisioning in 2020 was significantly impacted by the economic crisis, its corresponding impact on unemployment forecast adjustments within the CECL model, loan growth, specific reserve additions and qualitative factor adjustments. The forecasted change in the unemployment rate coupled with the qualitative factor adjustments resulted in approximately $12.4 million of the total provision expense recorded for the year ended December 31, 2020. In addition, Bancorp recorded $2.8 million in provision for credit losses in 2020 related to net loan growth which was heavily concentrated within the fourth quarter. During the second quarter of 2020, a large CRE relationship was placed on non-accrual status and allocated a $2 million specific reserve within the ACL on loans. An additional $1 million specific reserve was added to this relationship during the fourth quarter.
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During the third quarter of 2020, the Company recorded charge-offs totaling $1.6 million related to loans that were acquired in the prior year acquisition and fully allocated for through purchase accounting adjustments at the time of acquisition. While these are reflected as charge-offs, there was no impact to the provision for credit losses, nor to the income statement, associated with these loans and charge-off activity for the year ended December 31, 2020 was otherwise minimal.
Bancorp’s loan portfolio is diversified with no significant concentrations of credit. Geographically, most loans are extended to borrowers in the MSAs of Louisville, Indianapolis and Cincinnati. The adequacy of the allowance is monitored on an ongoing basis and it is the opinion of management that the balance of the allowance at December 31, 2020 is adequate to absorb probable losses inherent in the loan portfolio as of the financial statement date.
Discussion of 2019 vs 2018:
Bancorp recorded provision of $1.0 million and $2.7 million for the years ended December 31, 2019 and 2018, both years’ provision being determined under the incurred-loss methodology. Strong credit metrics and net recoveries of $257,000 in 2019 resulted in an allowance to total loans of 0.94% as of December 31, 2019, compared with 1.00% as December 31, 2018. The loans acquired in the 2019 KSB acquisition were marked to market on the acquisition date and as such, did not receive an allowance.
In 2019, key indicators of loan quality remained consistent, or compared to 2018 with the exception of increased classified balances, defined as OAEM, Substandard, and non-performing loans, which increased $4 million at December 31, 2019 compared to December 31, 2018.
The historical look-back period within Bancorp’s historical loan loss methodology was extended from 32 to 36 quarters in the first quarter of 2019 to all classes and segments of the portfolio. The expansion of the look-back period more accurately represented the level of risk in the loan portfolio in management’s view at that time and attempted to capture the effects of a full economic cycle. Based on the look-back period extension, the allowance level increased approximately $2.0 million during the first quarter of 2019.
See the “Financial Condition – Allowance for Credit Losses” section of this discussion for further details regarding the ACL for loans.
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Non-Interest Income
Variance
Discussion of 2020 vs 2019:
Total non-interest income increased $2.5 million, or 5%, for the year ended December 31, 2020 compared to the same period of 2019. Non-interest income comprised 28% of total revenues, defined as net interest income (FTE) and non-interest income, for the years ended December 31, 2020 and 2019. WM&T services comprised 45% of Bancorp’s total non-interest income for the year ended December 31, 2020 compared to 46% for the same period in 2019.
WM&T Services:
The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size. Trust AUM, stated at market value, ended 2020 at a record $3.85 billion, a 16% increase compared with $3.32 billion at December 31, 2019. WM&T revenue increased $763,000, or 3%, to $23.4 million for the year ended December 31, 2020, as compared with the same period of 2019. While stock market volatility associated with the COVID-19 pandemic has had a significant impact on the WM&T department, particularly in the second quarter of this year, strong market performance in the latter half of this year, record new business growth and a large non-recurring estate fee from the first quarter of 2020 led to record WM&T income of $23.4 million.
Recurring fees earned for managing accounts are based on a percentage of market value of AUM and are typically assessed on a monthly basis. Recurring fees, which generally comprise the vast majority of WM&T revenue, increased $660,000, or 3%, for the year ended December 31, 2020, as compared with the same period of 2019. A portion of WM&T revenue, most notably executor, insurance and some employee benefit plan-related fees, are nonrecurring in nature and the timing of these revenues corresponds with the related administrative activities. For this reason, such fees are subject to more period over period fluctuation. Total nonrecurring fees increased $103,000 or 15%, for the year ended December 31, 2020, as compared with the same period in 2019. Contracts between WM&T and their customers do not permit performance based fees and accordingly, none of the WM&T revenue is performance based. Management believes the WM&T department will continue to factor significantly in Bancorp’s financial results and provide strategic diversity to revenue streams.
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Detail of WM&T Service Income by Account Type:
Brokerage and insurance services 45 52 53
Total wealth management and trust services income $ 23,406 $ 22,643 $ 21,536
The preceding table demonstrates that WM&T fee revenue is concentrated within investment advisory and personal trust accounts. WM&T fees are predominantly based on AUM and tailored for individual/company accounts and/or relationships with fee structures customized based on account type and other factors with larger relationships paying a lower percentage of AUM in fees. For example, recurring AUM fee structures are in place for investment management, irrevocable trusts, revocable trusts, individual IRAs and accounts holding only fixed income securities. Company retirement plan services often consist of a one-time conversion fee with recurring AUM fees to follow. While there are also fee structures for estate settlements, income received is often non-recurring in nature. Fees are agreed upon at the time the account is opened and any subsequent revisions are communicated in writing to the customer. Fees earned are not performance-based nor are they based on investment strategy or transactions.
Assets Under Management by Account Type:
AUM (not included on balance sheet) grew from $3.32 billion at December 31, 2019 to $3.85 billion at December 31, 2020.
As of December 31, 2020 and 2019, approximately 80% and 81%, respectively, of AUM were actively managed. Company retirement plan accounts primarily consist of participant directed assets and the amount of custody and safekeeping accounts are insignificant.
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Managed Trust Assets Under Management by Class of Investment:
US Treasury and government agency obligations 31,719 46,950
Other mutual funds - fixed, balanced, and municipal 441,275 339,296
Managed assets are invested in instruments for which market values can be readily determined, the majority of which are sensitive to market fluctuations, and consist of approximately 64% in equities and 36% in fixed income securities at December 31, 2020. This composition is relatively consistent from period to period and WM&T has no proprietary mutual funds.
Additional Sources of Non-interest income:
Deposit service charges decreased $1.0 million, or 20%, for the year ended December 31, 2020, as compared with the same period in 2019. Deposit service charge income is primarily driven by changes in customer behavior and transaction volume, which can fluctuate from period to period. Consistent with the industry, Bancorp has experienced a steady decline in the volume of fees earned on overdrawn checking accounts over the last several years, a trend that was significantly exacerbated by the pandemic with significant declines in transaction volume and paper check presentments beginning in April 2020. Stimulus checks, extensions of tax payment due dates, more lucrative unemployment compensation, diminished pandemic spend and PPP funding all impacted consumer behavior in 2020. While Bancorp experienced a notable increase in deposit service charge income in the latter half of the year, Management is not able to predict when, or if, this revenue stream will return to pre-pandemic levels.
Debit and credit card income consists of interchange income, ancillary fees and incentives received from card processors. Debit and credit card revenue increased $357,000 or 4%, for the year ended December 31, 2020, as compared with the same period in 2019 despite pandemic-related hurdles, as Bancorp has seen continued growth in the customer bases. Total debit card income increased $85,000, or 1%, while total credit card income increased $272,000, or 11%.Similar to deposit service charges above, Bancorp saw significant improvement in transaction volume in the latter of half of 2020 as statewide activity restrictions due to the pandemic in Bancorp’s markets implemented earlier this year were eased and/or lifted.
Treasury management fees primarily consist of fees earned for cash management services provided to commercial customers. This revenue stream increased $415,000, or 8%, for the year ended December 31, 2020 compared to 2019 as Bancorp’s Treasury Management department was able to overcome the significant decline in pandemic related transaction volume with new product sales and expansion of its customer base (partially attributable to the PPP). The demand for Bancorp’s treasury products has increased during the pandemic, as these products allow customers to operate more efficiently in a decentralized environment. Bancorp anticipates this income category will continue to increase based on continued customer base growth and the expanding suite of services offered within Bancorp’s treasury management platform.
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Mortgage banking income primarily includes gains on sales of mortgage loans and loan servicing income offset by MSR amortization. Bancorp’s mortgage banking department predominantly originates residential mortgage loans to be sold in the secondary market, primarily to FNMA. Interest rates on the mortgage loans sold are locked with the borrower and investor prior to closing the loans, thus Bancorp bears no interest rate risk related to loans sold. Bancorp offers conventional, VA and FHA financing for purchases and refinances, as well as programs for first-time homebuyers. Interest rates on mortgage loans directly influence the volume of business transacted by the mortgage-banking department. Mortgage banking revenue increased $3.2 million, or 110%, for the year ended December 31, 2020 as compared with the same period of 2019, respectively, as sustained low long-term rates have incentivized refinancing activity and resulted in record mortgage banking income. The current pipeline of mortgage loans remains strong, however, volume could slow as underlying issues with the pandemic develop and the pool of potential customers who have yet to refinance shrinks.
In September 2020, the Bank elected to start retaining a portion of FNMA qualified secondary market single family residential real estate loan production from the mortgage banking department on balance sheet in an effort to deploy excess liquidity. Approximately $31 million in 15/30 year fixed rate loans yielding approximately 2.75% were retained through December 31, 2020, forgoing approximately $845,000 in gain on sales of loans that would typically have been recognized in mortgage banking income. The Bank aims to retain approximately $5 to $10 million per month of such production with a mix of 15/30 year maturities in the first part of 2021.
Net investment product sales commissions and fees are generated primarily on stock, bond and mutual fund sales, as well as wrap fees on brokerage accounts. Wrap fees represent charges for investment programs that bundle together a suite of services, such as brokerage, advisory, research and management and are based on a percentage of assets. Bancorp deploys its financial advisors primarily through its branch network via an arrangement with a third party broker-dealer, while larger managed accounts are serviced by Bancorp’s WM&T segment. Net investment product sales commissions and fees increased $277,000, or 18%, for the year December 31, 2020, as compared with the same period of 2019, as market volatility during 2020 led to increased customer trading activity.
BOLI assets represent the cash surrender value of life insurance policies on certain key employees who have provided consent for Bancorp to be the beneficiary for a portion of such policies. The related change in cash surrender value and any death benefits received under the policies are recorded as non-interest income. This income serves to offset the cost of various employee benefits. BOLI income decreased $338,000, for the year ended December 31, 2020, primarily as a result of a $296,000 death benefit received in the third quarter of 2019.
Other non-interest income decreased $1.2 million, or 40%, for the year ended December 31, 2020 as compared with the same period of 2019. This decrease was driven by a plethora of non-recurring activity that occurred in 2019 including swap fee income of $374,000, a $212,000 gain on the sale of VISA Class B stock originally acquired in a 2013 acquisition, proceeds of $142,000 associated with life insurance policies outside of the traditional BOLI program and a $126,000 banking center relocation incentive.
Discussion of 2019 vs 2018:
Total non-interest income increased $4.4 million, or 10%, for the year ended December 31, 2019 compared to the same period in 2018. Non-interest income comprised 28% of total revenue for both the year ended December 31, 2019 and 2018. WM&T services comprised 46% of Bancorp’s total non-interest income for the year ended December 31, 2019 compared to 48% for the same period in 2018.
Trust AUM, stated at market value, ended 2019 at a $3.32 billion, a 20% increase compared with $2.77 billion at December 31, 2018. AUM consisted of approximately 63% in equities and 37% in fixed income securities at December 31, 2019. WM&T revenue increased $1.1 million, or 5%, to a $22.6 million for the year ended December 31, 2019, as compared with the same period in 2018 consistent with increased new business generation, strong market returns and growth in company retirement plans. Recurring fees increased $973,000, or 5%, for the year ended December 31, 2019, as compared with the same period of 2018. Total non-recurring fees increased $134,000, or 23%, for the year ended December 31, 2019, as compared with the same period of 2018. As of December 31, 2019 and 2018, approximately 81% and 79% of AUM were actively managed.
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Deposit service charges decreased $238,000, or 4%, for the year ended December 31, 2019, as compared with the same period in 2018. Consistent with the industry, Bancorp has experienced a steady decline in volume and fees earned on overdrawn checking accounts.
Debit and credit card revenue increased $1.4 million, or 20%, for the year ended December 31, 2019, as compared with the same period in 2018 consistent with increased volume resulting from continued growth in the customer bases. Total debit card income increased $500,000, or 10%, for the year ended December 31, 2019, while credit card income increased $854,000, or 56%, for the same period. In 2019, credit card income included a $47,000 non-recurring fee from its card processor for reaching activity incentive thresholds. This was the first such payment received since the Bank launched this product in mid-2015. Also, 2019 debit card revenue included a similar non-recurring fee of $174,000. No similar non-recurring debit or credit card incentives were received in 2018.
Treasury management fees increased $421,000, or 9%, for the year ended December 31, 2019 compared to 2018, as a result of customer base growth and expansion in the portfolio of services offered.
Mortgage banking revenue increased $521,000, or 22%, for the year ended December 31, 2019 compared to 2018. Mortgage transaction volume began to increase in the second quarter and to a larger extent into the third quarter of 2019, as mortgage rates declined, spurring an increase in refinancing activity. During the third quarter of 2019, the ten year treasury rate/ yield curve, which mortgage rates closely follow, began a steep decline leading to the lowest mortgage rates in recent years.
Net investment product sales commissions and fees decreased $179,000, or 11%, for the year ended December 31, 2019, as compared with the same period in 2018. Advisor turnover in addition to regulatory changes that resulted in lower commissions on several product offerings negatively impacted the brokerage department throughout 2019.
BOLI income decreased $98,000, 9%, in 2019 compared to 2018, as a result of life insurance proceeds received in both periods reducing the related earning assets in addition to lower crediting rates on those investments.
Other non-interest income increased $1.5 million for the year ended December 31, 2019, as compared with the same period in 2018 primarily due non-recurring items that included swap fee income of $788,000, a $212,000 gain on the sale of VISA Class B stock originally acquired in a 2013 acquisition, proceeds of $142,000 associated with life insurance policies outside of the traditional BOLI program, receipt of a $130,000 historic tax-credit investment distribution and a $126,000 banking center relocation incentive.
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Non-interest expenses
Variance
Credit loss expense for off-balance sheet exposures 1,500 — — 1,500 100 — —
Discussion of 2020 vs 2019:
Total non-interest expenses increased $5.0 million, or 5%, in 2020 compared to 2019. Compensation and employee benefits comprised 61% and 62% of Bancorp’s total non-interest expenses for 2020 and 2019, respectively.
Compensation, which includes salaries, incentives, bonuses, and stock based compensation, increased $1.1 million, or 2%, for 2020 compared to 2019. The increase is attributed to annual merit-based salary increases, higher incentive-related compensation and an increase in full time equivalent employees, which grew from 591 at the beginning of 2019 to 641 at December 31, 2020 boosted by the 2019 KSB acquisition and the addition of sales professionals. Non-recurring severance and employee retention expense of nearly $500,000 was recorded in 2019 as a result of the KSB acquisition.
Employee benefits consists of all personnel related expense not included in compensation, with the most significant items being health insurance, payroll taxes, and retirement plan contributions. Employee benefits increased $373,000, or 3%, in 2020 compared with 2019. Growth in full time equivalent employees led to higher 401(k) matching contributions and employer payroll tax expense in 2020.
Net occupancy and equipment expense primarily includes depreciation, rent, property taxes, utilities and maintenance. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense. Net occupancy increased $35,000 for 2020 compared with 2019. Three new locations were added in the second quarter of 2019 as part of the KSB acquisition and an additional branch location was added in the third quarter of 2019. In 2020, Bancorp opened an additional branch in the Cincinnati MSA, as well as another location in Louisville. As of December 31, 2020, Bancorp has 44 full service banking center locations; 33 in the Louisville MSA, 6 in the Cincinnati MSA and 5 in the Indianapolis MSA.
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Technology and communications expense include ongoing computer software amortization, equipment depreciation and expenditures related to investments in technology needed to maintain and improve the quality of customer delivery channels, information security and internal resources. Technology expense increased $1.4 million, or 20%, in 2020 compared to 2019 consistent with expanding customer-facing software and system functionality, as well as increased licensing/maintenance expense, higher mortgage loan processing expenses, treasury management customer expansion and the migration to a hosted core environment during the third quarter of 2020. Non-recurring technology expenses associated with the 2019 acquisition totaled $104,000 for the prior year.
Bancorp outsources processing for debit and credit card operations, which generate significant revenue for the Company. These expenses fluctuate consistent with transaction volumes. Debit and credit card processing expense increased $113,000, or 5%, for 2020 as compared with 2019, consistent with the correlated increase experienced for debit and credit card income.
Marketing and business development expenses include all costs associated with promoting Bancorp, community support, retaining customers and acquiring new business.These expenses decreased $1.2 million, or 34%, for the year ended December 31, 2020, as compared to the same period of 2019. The sharp decline corresponds with less physical customer interaction as a result of the pandemic, which has led to less travel and entertainment expense in addition to lower advertising expense. Bancorp committed to pay $116,000 to the Bank’s foundation, established to support various community initiatives, as of December 31, 2020 compared to $600,000 as of December 31, 2019.
Postage, printing and supply expenses increased $126,000, or 8%, in 2020 compared to 2019, as a result of banking center/customer expansion over the past year and a half coupled with replacing transaction-based forms throughout the Bank associated with the migration to a hosted core environment, which occurred in the third quarter of 2020.
Legal and professional fees decreased $622,000, or 21%, for 2020 compared to 2019. The decrease is attributed to one-time costs associated with the prior year acquisition, which totaled $867,000 in 2019.
FDIC insurance increased $972,000 for the year ended December 31, 2020, as compared to the same period of 2019. As a result of the national FDIC Reserve Ratio reaching 1.38% in 2019, the FDIC released credits to small institutions (less than $10 billion in total consolidated assets) in the prior year. For this reason, Bancorp recorded no FDIC insurance expense for the third and fourth quarters of 2019, and incurred only a portion of the assessed expense in the first quarter of 2020, as these credits were depleted. FDIC insurance expense normalized in the second quarter of 2020 and ultimately increased in the third and fourth quarters as a result of a higher leverage ratio attributed to a PPP-driven larger balance sheet.
Tax credit partnerships generate federal income tax credits, and for each of Bancorp’s investments in tax credit partnerships, the tax benefit, net of related expenses, results in a positive effect on net income. Amounts of credits and corresponding expenses can vary widely depending upon timing and magnitude of the investments. Amortization of investments in tax credit partnership increased $2.0 million from 2020 to 2019 as a result of a large tax credit deal completed in the fourth quarter of 2020.
Capital and deposit based taxes increased $516,000, or 13%, in 2020 compared to 2019 consistent with overall balance sheet growth.
In connection with the adoption of ASC 326, Bancorp analyzed its unused lines of credit and recorded credit loss expense for off-balance sheet credit exposures totaling $1.5 million during the year ended December 31, 2020. The increase related to changes in the mix of unused lines and underlying CECL model factors. No such expense was incurred in 2019.
Other non-interest expenses decreased $1.2 million, or 21%, for 2020 compared to 2019 driven by the sale of a bank-owned property recorded as an off-set to non-interest expense in the second quarter of 2020 along with elevated 2019 expense that included the write off of assets totaling $347,000 in connection with signing the contract to migrate to the hosted core processing solution and elevated fraud and robbery-related losses.
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Bancorp’s efficiency ratio for 2020 of 54.86% improved from 56.07% in 2019. Excluding amortization of investments in tax credit partnerships, the adjusted efficiency ratio, a non-GAAP measure, would have been 53.22% and 55.45% for 2020 and 2019. See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.
Discussion of 2019 vs 2018:
Total non-interest expenses increased $8.8 million, or 10%, in 2019 compared to 2018. Compensation and employee benefits comprised 62% and 63% of Bancorp’s total non-interest expenses for 2019 and 2018.
Compensation expense increased $4.2 million, or 9%, for 2019 compared to 2018. Consistent with 2019 results, bonus expense of $5.8 million was recorded during 2019 compared to $4.5 million during 2018. Net full time equivalent employees increased from 591 at December 31, 2018 to 615 at December 31, 2019. While 25 employees were added in connection with the KSB acquisition, 2019 reflects a higher concentration of non-KSB related loan production personnel added. In addition, non-recurring severance and employee retention expense of nearly $500,000 was recorded in 2019 as a result of the KSB acquisition.
Employee benefits increased $816,000, or 8%, in 2019 compared with 2018. Growth in full time equivalent employees led to higher 401(k) matching contributions and employer payroll tax expense in 2019. Effective January 1, 2019, as a recruitment strategy, Bancorp amended its 401(k) plan to allow employer matching contribution eligibility following 30 days of employment.
Net occupancy increased $769,000, or 10%, for 2019 compared with 2018. Bancorp opened one branch location during the third quarter of 2019 in Mt. Washington, Kentucky and added five branch locations associated with the KSB acquisition during the second quarter. Bancorp closed three of the acquired branch locations in Louisville during the third quarter of 2019 due to their proximity to existing Bancorp branches. All three buildings and were sold in 2019 resulting in positive re-cast adjustments to goodwill. The KSB locations added $238,000 of additional occupancy and equipment expense for 2019.
Technology expense increased $529,000, or 8%, in 2019 compared to 2018 due largely to increases in computer infrastructure upgrades and maintenance costs. KSB related one-time non-recurring expenses totaled $104,000 for 2019.
Debit and credit card processing expense increased $165,000, or 7%, for 2019 as compared with 2018, as a result of a growing customer base and increased transaction volume.
Marketing and business development expenses increased $528,000, or 17%, for 2019 as compared with 2018 largely due to increased community support expenses. In connection with record operating results, Bancorp committed to pay $600,000 to the Bank’s foundation, established to support various community initiatives, as of December 31, 2019 compared to $125,000 as of December 31, 2018.
Postage, printing and supplies expenses increased $94,000, or 6%, in 2019 compared to 2018, primarily due to the KSB acquisition.
Legal and professional fees increased $400,000, or 15%, for 2019 compared to 2018. One-time costs associated with the KSB acquisition totaled nearly $867,000 in 2019 compared to $337,000 incurred in late 2018 in anticipation of the acquisition. Additional costs associated with consulting engagements also contributed to the period over period increase.
No FDIC insurance expense was recorded for the second half of 2019, as the FDIC released credits to small institutions. This change was announced in 2016 and it took approximately three years for the reserve threshold to be met and the corresponding credits issued.
Amortization of investments in tax credit partnership decreased $159,000, or 13%, from 2018 to 2019.
Capital and deposit based taxes increased $545,000, or 16%, in 2019 compared to 2018 in connection with general balance sheet growth and the KSB acquisition.
Other non-interest expenses increased $1.5 million, or 38%, for 2019 compared to 2018 primarily due to growth in Bancorp’s credit card rebates/rewards program, increased amortization associated with the core deposit intangible resulting from the KBS acquisition, elevated fraud/robbery related losses, increased Director compensation and the write off of assets in relation to signing a contract to move to a hosted core processing solution.
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Bancorp’s efficiency ratio for 2019 of 56.07% increased from 55.89% in 2018. Excluding amortization of investments in tax credit partnerships, the adjusted efficiency ratio, a non-GAAP measure, would have been 55.45% and 55.11% for 2019 and 2018. See the section titled “Non-GAAP Financial Measures” for reconcilement of non-GAAP to GAAP measures.
Income Taxes
A comparison of income tax expense and ETR follows:
Discussion of 2020 vs 2019:
Fluctuations in the ETR are primarily attributed to the following:
The CARES Act includes several significant provisions for corporations including increasing the amount of deductible interest under section 163(j), allowing companies to carryback certain net operating losses, and increasing the amount of net operating loss that corporations can use to offset income. These changes did not have a significant impact on Bancorp’s income taxes.
Bancorp invests in certain partnerships that yield federal income tax credits. Taken as a whole, the tax benefit of these investments exceeds amortization expense, resulting in a positive impact on net income. The timing and magnitude of these transactions may vary widely from period to period.
Discussion of 2019 vs 2018:
The decline in the ETR from 2018 to 2019 related primarily to the two Kentucky state tax law changes noted in the discussion above.
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Financial Condition – December 31, 2020 Compared to December 31, 2019
Overview
Total assets increased $884 million, or 24%, to $4.6 billion at December 31, 2020, from $3.7 billion at December 31, 2019. Average assets increased $737 million, or 21%, to $4.2 billion at December 31, 2020. The significant 2020 balance sheet expansion was directly attributable to the PPP, which drove $550 million of the $687 million increase in loans, the remaining growth being the result of record production in the traditional loan portfolio. In addition, virtually all interest-earning asset categories experienced year over prior year increases. The Company ended 2020 with significantly higher ACL on loans resulting from the adoption of ASC 326 and elevated pandemic-related provisioning during the year.
Total liabilities increased $850 million, or 26%, with record deposit growth of $855 million driven by the PPP. Partially off-setting the deposit growth and increases in SSUAR and other liabilities was a $48 million decline in FHLB borrowings, as advances matured without renewal or replacement.
Cash and Cash Equivalents.
Cash and cash equivalents increased $68 million, or 27%, to $318 million as of December 31, 2020. Bancorp maintained higher levels of liquidity in 2020 attributable to the PPP and growth in deposits.
AFS Debt Securities
The primary purpose of the securities portfolio is to provide another source of interest income, as well as liquidity management. In managing the composition of the balance sheet, Bancorp seeks a balance between earnings sources and credit and liquidity considerations.
AFS debt securities include securities that may be sold in response to changes in interest rates, resultant prepayment risk and other factors related to interest rate and prepayment risk changes and are carried at fair value with unrealized gains or losses, net of tax effect, included in stockholders’ equity.
All of Bancorp’s debt securities are classified as AFS. Carrying value is summarized as follows:
U.S. Treasury and other U.S. Government obligations $ — $ 49,897
Mortgage-backed securities – government agencies 437,585 193,861
Obligations of states and political subdivisions 11,315 17,036
AFS debt securities increased $116 million, or 25%, for December 31, 2020 as compared to December 31, 2019. Bancorp began strategically growing the AFS securities portfolio in the latter half of the year in an effort to invest excess balance sheet liquidity. In addition, the AFS securities portfolio also experienced market appreciation of $12 million in 2020 stemming from declines in the interest rate environment between December 31, 2020 and December 31, 2019. Bancorp expects the AFS debt securities portfolio to grow in 2021, as strategies associated with the investment of excess balance sheet liquidity continue to be implemented.
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Maturity distribution and weighted average interest rates of debt securities AFS follows:
After one but After five but
(dollars in thousands) Amount Rate Amount Rate Amount Rate Amount Rate
Actual maturities for mortgage-backed securities may differ from contractual maturities due to prepayments on underlying collateral.
Loans
Composition of loans, net of deferred fees and costs, by primary loan class as reported under ASC 326 follows:
Variance
December 31, (dollars in thousands) 2020 2019 $ Change % Change
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For historical comparative purposes, the composition of loans by class pre-ASC 326 adoption follows:
Real estate mortgage:
Total loans increased $687 million, or 24%, however, excluding the PPP loan portfolio, total loans grew $136 million, or 5%, as growth in the CRE portfolio offset contraction in the C&I lines of credit portfolio. Line of credit usage declined significantly after the first quarter of 2020 as a result of the pandemic, falling to 38% at December 31, 2020 compared to 47% at December 31, 2019. Further, the previously mentioned retention of a portion of FNMA qualified secondary market single family residential real estate loan production from the mortgage banking department predominantly drove the growth in the residential real estate portfolio.
As of December 31, 2020, PPP loans of $561 million ($550 million net of unamortized deferred fees and costs), were outstanding. PPP borrowers are eligible for forgiveness from the SBA for the portion of funding received utilized for job retention and certain other expenses, such as payroll costs, mortgage interest, rent and utilities during the 24-week period beginning with the date of the loan. With a significant portion of these loans potentially eligible for full forgiveness, there is high likelihood of early pay off prior to maturity (predominantly 24 months). On October 8, 2020, the SBA announced it would streamline loan forgiveness for loans of $50,000 or less with one or more employee other than the owner (representing approximately 48% of the PPP loans Bancorp originated). The Bank has approximately $10.5 million in net unrecognized fees related to the PPP that would be recognized in income immediately once the loans are paid off or forgiven by the SBA. The timing of such forgiveness is expected to have a major impact on operating results in 2021.
The initial round of the PPP expired on August 8, 2020 and as of December 31, 2020, the Bank has submitted 520 forgiveness applications to the SBA totaling $170 million and has received payment from the SBA for 333 borrowers. The SBA has 90 days to review and decision applications for forgiveness.
An additional round of the PPP was included in the CAA, which was signed into law on December 27, 2020 and extended the program to March 31, 2021. To qualify for the program, borrowers must show a 25% decline in revenue in the first, second, or third quarters in 2020, as compared to the same periods in 2019 (if the loan application is after December 31, 2020, then a fourth quarter comparison may be used as well). The bill allows borrowers to select the end date of their covered period, however, it must be greater than eight weeks from the date of disbursement of the PPP loan and cannot exceed 24 weeks.
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The program offers “second draw” loans targeted at hard-hit businesses that employ 300 or fewer employees and that have used or will use the full amount of their initial PPP loan. The maximum loan under this program is $2 million, based on two and a half months of average annual payroll (three and a half months for hotels and restaurants). The measurement period for the payroll can either be calendar year 2019 or the one year period before the date the “second draw” originates. For any loan up to $150,000, the covered loan amount will be forgiven once the borrower submits a one page form listing the loan amount, the number of employees retained, and the amount of the loan spent on payroll. This will substantially reduce the burden on both borrowers and lenders. The lender review will be limited to whether the lender received a complete application with all fields completed, initialed, or signed as applicable. If the submission is complete, the lender is required to accept it and forward to the SBA. Bancorp is projecting to book approximately 1,300 of these “second draw” PPP loans totaling $220 million.
During 2020 and as a result of the pandemic, Bancorp added a pass-rating category for loans that demonstrated significant exposure to industries impacted by the pandemic. This category was added to allow for the capture of a more detailed review of these loans if any broad economic trends or developments occurred related to the pandemic or the underlying performance of the borrowers. The vast majority of these loans are not in deferral as of December 31, 2020 and are performing according to their original terms. As a result of Bancorp’s review of these loans during the year, loans totaling $41 million were downgraded below a pass-rating as a result of pandemic-related business interruptions, $38 million of which were downgraded to OAEM and $3 million were downgraded to Substandard for the year ended December 31, 2020.
In accordance with Section 4013 of the CARES Act and in response to requests from borrowers who experienced business interruptions related to the pandemic, Bancorp extended payment deferrals for those affected borrowers. Depending on the demonstrated need of the customer, Bancorp deferred either the full loan payment or the principal-only portion of respective loan payments for 90 or 180 days for some borrowers directly impacted by the pandemic.
For the year ended December 31, 2020, Bancorp executed nearly 1,200 full payment deferrals. As of December 31, 2020 outstanding full payment loan deferrals totaled $37 million - representing 1.24% of the loan portfolio (excluding PPP loans). Pursuant to the CARES Act, these loan deferrals were not classified as TDRs and not included in non-performing loan statistics. While the modifications themselves did not trigger a loan risk rating downgrade beyond the “pass” rating, if the impact of COVID-19 continues and borrower’s operations do not improve or if other negative events occur, such modified loans could transition to potential problem loans or into problem loans. The CAA extended relief from TDR accounting to the earlier of 1) 60 days after the national emergency termination date or (2) January 1, 2022.
During the third and fourth quarters of 2020, a significant portion of the deferred loan portfolio returned to full or original paying status. Management continues to analyze the evolving economic conditions in its markets while closely monitoring credit metrics, particularly related to the following segments comprising deferrals in the Bank’s loan portfolio:
December 31, September 30,
Lodging / Hotels $ 16 $ 30
Residential real estate secured 2 18
Real estate/land development 1 12
Retail centers 2 12
Parking lot/parking garage/storage — 11
Tradeshows/events 8 10
Total deferrals $ 37 $ 120
Bancorp anticipates that a portion of the Bank’s borrowers in the above industry segments will continue to endure economic challenges, as long as the current COVID-19 related economic conditions persist. Among other things, this could cause them to draw on their existing lines of credit and/or affect their ability to repay existing indebtedness. These developments are also expected to partially impact the CRE portfolio, particularly with respect to real estate with exposure to these industries, and the value of certain collateral.
Bancorp’s credit exposure is diversified with secured and unsecured loans to individuals and businesses. No specific industry concentration exceeds 10% of loans outstanding. While Bancorp has a diversified loan portfolio, a customer’s ability to honor contracts is somewhat dependent upon the economic stability and/or industry in which that customer does business. Loans outstanding and related unfunded commitments are primarily concentrated within Bancorp’s current market areas, which encompass the Louisville, Indianapolis and Cincinnati MSAs.
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Bancorp occasionally enters into loan participation agreements with other banks to diversify credit risk. For certain participation loans sold, Bancorp has retained effective control of the loans, typically by restricting the participating institutions from pledging or selling their ownership share of the loan without permission from Bancorp. GAAP requires the participated portion of these loans to be recorded as secured borrowings. These participated loans are included in the C&I and CRE loan portfolio segments with a corresponding liability recorded in other liabilities. At December 31, 2020 and December 31, 2019, the total participated portion of loans of this nature totaled $10 million and $8 million, respectively.
LIBOR will cease to exist as a published rate after 2021. As of December 31, 2020, Bancorp had approximately $443 million in variable rate loans with interest rates tied to LIBOR, of which approximately $330 million have maturity dates beyond December 31, 2021. Bancorp’s derivative activities based upon LIBOR include interest rate swap transactions with maturities beyond 2021 with notional amounts totaling approximately $120 million. Bancorp has established a working group, consisting of key stakeholders from throughout the company, to monitor developments relating to LIBOR uncertainty and changes and to guide Bancorp’s response. This team is currently working to gain an understanding of the specific products, systems, borrowing arrangements and legal agreements that will be impacted by the change.
The following table details amounts of loans at December 31, 2020 which, based on remaining scheduled repayments of principal, are due in the periods indicated.
Maturing
Within one After one but
December 31, 2020 (in thousands) year within five years After five years Total
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The table below details C&I and C&D loans maturing after one year categorized by fixed and variable interest rate structures:
Commercial and industrial Construction and land development
In the event where Bancorp structures a loan with a maturity exceeding five years (typically CRE loans), an automatic rate adjustment will typically be set in place at five years from origination date to limit interest rate sensitivity.
Non-performing Loans and Assets
Information summarizing non-performing loans and assets follows:
Non-peforming loans to total loans (excluding PPP) 0.44 % — — — —
Non-performing loans to total loans were 0.37% at December 31, 2020 compared to 0.42% at December 31, 2019. Non-performing loans to total loans (excluding PPP loans) were 0.44% at December 31, 2020.
Non-performing loans increased $1.1 million to $13.2 million at December 31, 2020 compared to December 31, 2019. During the first quarter of 2020 a large non-accrual C&I relationship totaling $8 million paid off due to sale of the business. During the second quarter of 2020, a large CRE relationship was placed on non-accrual status and allocated a $2 million specific reserve within the ACL on loans. An additional $1 million specific reserve was added for this relationship during the fourth quarter of 2020.
In total, non-performing assets as of December 31, 2020 were comprised of 35 loans ranging in individual amounts up to $10 million, one nominal accruing TDR loan and foreclosed real estate held for sale. Foreclosed real estate held at December 31, 2020 included a residential real estate properties and a CRE property.
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The following table presents the major classifications of non-accrual loans by portfolio:
Commercial real estate - non-owner occupied $ 10,278 $ 740
Commercial real estate - owner occupied 1,403 2,278
Commercial and industrial - term 6 2,520
Commercial and industrial - lines of credit 88 5,682
Total commercial and industrial 94 8,202
Residential real estate - owner occupied 413 211
Residential real estate - non-owner occupied 101 63
Total residential real estate 514 274
Construction and land development — —
Home equity lines of credit 221 —
Consumer 4 —
Leases — —
Credit cards - commercial — —
Loans are placed in a non-accrual income status when prospects for recovering both principal and accrued interest are considered doubtful or when a default of principal or interest has existed for 90 days or more, unless such a loan is well- secured and in the process of collection or renewal. Interest income recorded on non-accrual loans as principal payments was $350,000, $552,000, and $93,000 for 2020, 2019, and 2018. Interest income that would have been recorded if non-accrual loans were on a current basis in accordance with their original terms was $457,000, $491,000, and $391,000 for 2020, 2019, and 2018.
In addition to non-performing loans discussed above, there were loans, which are accruing interest, for which payments were current or less than 90 days past due where borrowers are experiencing elevated financial difficulties. These potential problem loans totaled approximately $26 million and $37 million at December 31, 2020 and 2019. These relationships are monitored closely for possible future inclusion in non-performing loans. Management believes it has adequately reflected credit exposure in these loans in its determination of the allowance.
Loans accounted for as TDRs include modifications from original terms such as those due to bankruptcy proceedings, certain changes to amortization periods or extended suspension of principal payments due to customer financial difficulties. To the extent that Bancorp chooses to work with borrowers by providing reasonable concessions rather than initiating collection, this would result in an increase in loans accounted for as TDRs. TDRs that are in non-accrual status are reported as non-accrual loans. Loans accounted for as TDRs are individually evaluated for impairment and are reported as non-performing loans.
On March 27, 2020, the CARES Act was signed into law. Section 4013 of the CARES Act, “Temporary Relief from Troubled Debt Restructurings,” provides banks the option to temporarily suspend certain requirements under GAAP related to TDRs for a limited period of time to account for the effects of COVID-19. To qualify for Section 4013 of the CARES Act, borrowers must have been current at December 31, 2019. All modifications are eligible so long as they are executed between March 1, 2020 and the earlier of (i) December 31, 2020, or (ii) the 60th day after the end of the COVID-19 national emergency declared by the President of the United States. Multiple modifications of the same credits are allowed and there is no cap on the duration of the modification. On December 21, 2020, certain provisions of the CARES Act, including the temporary suspension of certain requirements related to TDRs, were extended through December 31, 2021.
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In March 2020, various regulatory agencies, including the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, issued an interagency statement on loan modifications and reporting for financial institutions working with customers affected by the pandemic. The interagency statement was effective immediately and impacted accounting for loan modifications. Under Accounting Standards Codification 310-40, “Receivables – Troubled Debt Restructurings by Creditors,” (“ASC 310-40”), a restructuring of debt constitutes a TDR if the creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise consider. The agencies confirmed with the staff of the FASB that short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief, are not to be considered TDRs. This includes short-term modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant. Borrowers considered current are those that are less than 30 days past due on their contractual payments at the time a modification program is implemented.
As of December 31, 2020, TDRs consisted of one loan totaling $16,000 compared to two loans totaling $34,000 at December 31, 2019.
The following table presents the amortized cost basis of non-performing loans and the amortized cost basis of loans on non-accrual status for which there were no related ACL losses:
Commercial real estate - non-owner occupied $ 186 $ 741
Commercial real estate - owner occupied 1,048 2,278
Commercial and industrial - term 6 1
Commercial and industrial - lines of credit 88 173
Total commercial and industrial 94 174
Residential real estate - owner occupied 413 212
Residential real estate - non-owner occupied 101 63
Total residential real estate 514 275
Construction and land development — —
Home equity lines of credit 221 —
Consumer 4 —
Leases — —
Credit cards - commercial — —
Delinquent Loans
Delinquent loans (consisting of all loans 30 days or more past due) totaled $17 million at December 31, 2020 compared to $15 million at December 31, 2019. Delinquent loans total loans were 0.48% and 0.53% at December 31, 2020 and December 31, 2019. Delinquent loans to total loans (excluding PPP loans) were 0.57% at December 31, 2020.
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Allowance for Credit Losses on Loans
The ACL is a valuation allowance for loans estimated at each balance sheet date in accordance with GAAP. When Bancorp deems all or a portion of a loan to be uncollectible, the appropriate amount is written off and the ACL is reduced by the same amount. Subsequent recoveries, if any, are credited to the ACL when received. See the footnote titled “Summary of Significant Accounting Policies”for discussion of Bancorp’s ACL methodology on loans. Allocations of the ACL may be made for specific loans, but the entire ACL on loans is available for any loan that, in Bancorp’s judgment, should be charged-off.
The following table sets forth the ACL by category of loan as reported under ASC 326:
Residential real estate - non-owner occupied 1,818 3 % 1.29 % 947 3 % 0.70 %
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For historical comparative purposes, the ACL by category of loan as reported pre-ASC 326 adoption follows:
Upon adoption of ASC 326 on January 1, 2020, Bancorp recorded an increase of $8.2 million to the ACL on loans and a corresponding decrease to retained earnings, net of the DTA impact. In addition, non-accretable yield marks of $1.6 million related to formerly classified PCI loans were reclassed between the amortized cost basis of loans and corresponding ACL. The adjustment upon adoption of ASC 326 raised the ACL on loans balance to $37 million on January 1, 2020. In addition to the CECL adoption, the ACL for 2020 was significantly impacted by unemployment rate forecast adjustments within the CECL model, loan growth and the addition of a large specific reserve for one relationship and qualitative factor adjustments. During the third quarter of 2020, the aforementioned $1.6 million included in the ACL as specific reserves were charged-off with no resulting impact to provision expense.
Bancorp measures expected credit losses of financial assets on a collective (pool) basis, when the financial assets share similar risk characteristics. Depending on the nature of the pool of financial assets with similar risk characteristics, Bancorp has measured its portfolio classes as follows:
Loan Portfolio Segment ACL Methodology
Commercial real estate - non-owner occupied Discounted cash flow
Commercial real estate - owner occupied Discounted cash flow
Commercial and industrial - term Static pool
Commercial and industrial - line of credit Static pool
Residential real estate - owner occupied Discounted cash flow
Residential real estate - non-owner occupied Discounted cash flow
Construction and land development Static pool
Home equity lines of credit Static pool
Consumer Static pool
Leases Static pool
Credit cards - commercial Static pool
The static pool methodology is utilized for the loan portfolio segments that typically have shorter durations. For each of these loan segments, Bancorp applies an expected loss ratio based on historical losses adjusted as appropriate for qualitative factors. Qualitative loss factors are based on management's judgment of company, market, industry or business specific data, changes in underlying loan composition of specific portfolios, trends relating to credit quality, delinquency, non-performing and adversely rated loans, and reasonable and supportable forecasts of economic conditions.
When developing the ACL CECL model for loan pools utilizing the DCF method, Bancorp utilized regression analysis of historical internal and peer data to identify a suitable loss driver to utilize when modeling lifetime probability of default and loss given default. Such regression analysis was used to measure how the expected probability of default and loss given default would react to changes in forecasted levels of the loss driver. Based on this regression analysis, management determined that the forecasted Seasonally Adjusted National Civilian Unemployment Rate best correlated to Bancorp’s historical losses and elected to use this rate as the primary loss driver to be consistently applied across all applicable loan segments over a reasonable and supportable forecast period.
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Upon adoption of ASC 326 on January 1, 2020, management determined that four quarters represented a reasonable and supportable national unemployment forecast period with reversion back to Bancorp’s historical loss rate over eight quarters on a straight-line basis. This resulted in an $8.2 million initial increase in the ACL on loans with the offset to retained earnings.
Subsequent to January 1, 2020, based on the economic crisis caused by COVID-19 and measures taken to protect public health such as stay-at-home orders and mandatory closures of businesses, economic activity halted significantly and job losses surged. As such, national unemployment has fluctuated widely in 2020 as follows:
As of March 31, 2020, based on the evolving pandemic, Bancorp elected to forecast for only one quarter of national unemployment (versus the four quarters used as of January 1, 2020) and modified its forecast to reflect a significant increase in unemployment (utilizing the highest unemployment rate in Bancorp’s observed history) reverting back to Bancorp’s long-term average in the third quarter of 2020, with the loss driver remaining significantly worse compared to recent trends. The impact of the increased unemployment rate forecast was muted by an adjustment in qualitative factors attributed to the massive federal stimulus programs enacted at the end of the first quarter in response to the pandemic. The forecasted increase in the unemployment rate coupled with the qualitative factor adjustments resulted in approximately $5.4 million of the total $5.5 million provision expense recorded for the first quarter of 2020.
During the second quarter, for the first time during 2020, the FRB released a forecasted Seasonally Adjusted National Civilian Unemployment Rate for the years ended December 31, 2020, 2021 and 2022. Based on this and the continuation of the economic crisis, as of June 30, 2020, Bancorp elected to forecast for four quarters of national unemployment utilizing actual June unemployment then stepping down to the FRB median forecast before reverting back to Bancorp’s long-term average in the fourth quarter of 2020. Similar to the first quarter of 2020, the impact of the increased unemployment forecast was muted by an adjustment in qualitative factors attributed to the massive federal stimulus programs that have been enacted. The forecasted increase in unemployment coupled with the qualitative factor adjustments resulted in approximately $4.8 million of the total $5.5 million provision expense recorded for the second quarter of 2020.
As of September 30, 2020, Bancorp elected to forecast for one quarter of the Seasonally Adjusted National Civilian Unemployment Rate utilizing the FRB’s 2020 median unemployment forecast released in September then stepping down to the FRB’s 2021 median unemployment forecast over the next three quarters before reverting back to Bancorp’s long-term average. In addition, Bancorp fully reversed the qualitative factor adjustment established in the first and second quarters of 2020 attributed to the massive federal stimulus programs. The forecasted changes in unemployment, coupled with the qualitative factor adjustments resulted in approximately $4.4 million in provision expense for the third quarter of 2020
During the fourth quarter of 2020, the FRB released its forecasted Seasonally Adjusted National Civilian Unemployment Rate for the 12 months ended December 31, 2020, 2021, 2022 and 2023 as follows:
Upper end of range 6.9 % 6.8 % 5.8 % 4.4 %
Lower end of range 6.6 % 4.0 % 3.5 % 3.5 %
As of December 31, 2020, Bancorp elected to forecast four quarters of the Seasonally Adjusted National Civilian Unemployment Rate utilizing the FRB’s 2020 median unemployment forecast released in December then stepping down to the FRB’s 2021 median unemployment forecast over the next three quarters before reverting back to Bancorp’s long-term average. The improvement within the unemployment forecast, coupled with minor qualitative factor adjustments, resulted in a credit of approximately $2.2 million in provision expense for the third quarter of 2020.
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Outstanding loans (excluding PPP loans) increased $92 million during the first three months of 2020 and contracted $103 million during the second quarter of 2020, as outstanding C&I lines of credit were reduced by $94 million. The overall net change in the loan mix contributed to $1.4 million of additional provision expense for the three months ended March 31, 2020. During the second quarter of 2020, loan contraction (mainly C&I lines of credit) led to a $1.5 million reduction in the required ACL on loans. In the third quarter, loan growth was essentially flat, as an increase the in CRE portfolio was offset by further contraction in the C&I portfolio, resulting in $133,000 of additional provision expense. In addition, the third quarter change in specific reserves offset net charge-offs by $116,000. Loan growth in the fourth quarter totaled $151 million, contributing to approximately $2.6 million in additional provision expense.
The pandemic has had a material impact on Bancorp’s quarterly ACL on loans calculations for 2020. While Bancorp has not yet experienced credit quality issues resulting in charge-offs related to the pandemic, the ACL calculation for loans and resulting provision were significantly impacted by changes in forecasted economic conditions. Should the forecast for economic conditions worsen, Bancorp could experience further increases in its required ACL and record additional provision expense. While the execution of payment deferrals under the CARES ACT has assisted credit quality ratios, it is possible that asset quality could worsen at future measurement periods if the effects of the pandemic are prolonged.
In connection with the adoption of ASC 326, Bancorp analyzed its unused lines of credit and recorded credit loss expense for off-balance sheet credit exposures (non-interest expense) totaling $375,000 and $1.5 million during the first and second quarters of 2020. The second quarter increase directly correlated to the increased availability due to C&I line of credit pay downs. Further declines in line of credit utilization resulted in an additional $550,000 of such expense in the third quarter. In the fourth quarter of 2020, the reserve was reduced by $900,000 to a balance of $5.4 million, with the majority of the decline attributed to an increase in C&I line of utilization.
During the second quarter of 2020, a large CRE relationship was placed on non-accrual status and received a $2 million specific reserve allocation within the ACL on loans. The borrower did not receive PPP funds, the loan was current at the time of non-accrual classification and each subsequent quarter end, and no payments related to the loan have been deferred. During the fourth quarter, an additional $1 million in specific reserve allocation was attributed to this relationship.
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