FIRST OF LONG ISLAND CORP - Annual Report: 2013 (Form 10-K)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

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FORM 10-K

(Mark One)

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

 

For the fiscal year ended

December 31, 2013

 

OR

 

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

For the transition period from ________ to _________

Commission file number 001-32964

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

Securities registered pursuant to Section 12(g) of the Act:

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

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

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

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

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

 

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

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

The aggregate market value of the Corporation’s voting common stock held by nonaffiliates as of June 28, 2013, the last business day of the Corporation’s most recently completed second fiscal quarter, was $287,310,297.  This value was computed by reference to the price at which the stock was last sold on June 28, 2013 and excludes $14,172,595 representing the market value of common stock beneficially owned by directors and executive officers of the registrant.

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held April 22, 2014 are incorporated by reference into Part III.

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TABLE OF CONTENTS

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PART I

 

ITEM 1.

BUSINESS

 

General

 

The First of Long Island Corporation (“Registrant” or “Corporation”), a one-bank holding company, was incorporated on February 7, 1984, for the purpose of providing financial services through its wholly-owned subsidiary, The First National Bank of Long Island (“Bank”).

 

The Bank was organized in 1927 as a national banking association under the laws of the United States of America.  The Bank has two wholly owned subsidiaries: The First of Long Island Agency, Inc. (“Agency”), a licensed insurance agency under the laws of the State of New York; and, FNY Service Corp., an investment company.  The Bank and FNY Service Corp. jointly own another subsidiary, The First of Long Island REIT, Inc., a real estate investment trust.

 

All of the financial operations of the Corporation are aggregated in one reportable operating segment.  All revenues are attributed to and all long-lived assets are located in the United States.

 

The Bank’s revenues are derived principally from interest on loans and investment securities, service charges and fees on deposit accounts and income from investment management and trust services.

 

The Bank did not commence, abandon or significantly change any of its lines of business during 2013.

 

Markets Served and Products Offered

 

The Bank has historically served the financial needs of privately owned businesses, professionals, consumers, public bodies and other organizations primarily in Nassau and Suffolk Counties, Long Island, New York.  Additionally, the Bank has two commercial banking branches in Manhattan.  The Bank’s main office is located in Glen Head, New York, and the Bank has twenty-three other full service offices, eleven commercial banking offices and two select service banking centers which serve the needs of both businesses and consumers.  The Bank continues to evaluate potential new branch sites on Long Island and in the boroughs of New York City.

 

The Bank’s loan portfolio is primarily comprised of loans to borrowers on Long Island and in the boroughs of New York City, and its real estate loans are principally secured by properties located in those areas.  The Bank’s investment securities portfolio is primarily comprised of direct obligations of the U.S. government and its agencies and highly rated obligations of states and political subdivisions.  The Bank has an Investment Management Division that provides investment management, pension trust, personal trust, estate and custody services.

 

In addition to its loan and deposit products, the Bank offers other services to its customers including the following:

 

·	Account Reconciliation Services	·	Online Banking
·	ATM Banking	·	Payroll Services
·	Bank by Mail	·	Personal Money Orders
·	Bill Payment	·	Remote Deposit
·	Cash Management Services	·	Safe Deposit Boxes
·	Collection Services	·	Securities Transactions
·	Controlled Disbursement Accounts	·	Signature Guarantee Services
·	Drive-Through Banking	·	Telephone Banking
·	Lock Box Services	·	Travelers Checks
·	Merchant Credit Card Services	·	Investment Management and Trust Services
·	Mutual Funds, Annuities and Life Insurance	·	Wire Transfers and Foreign Cables
·	Night Depository Services	·	Withholding Tax Depository Services

 

Competition

 

The Bank encounters substantial competition in its banking business from numerous other financial services organizations that have offices located in the communities served by the Bank.  Principal competitors are money center, large regional and community banks located within the market area, as well as mortgage brokers, brokerage firms and credit unions.  The Bank competes for loans based on the quality of service it provides, loan structure, competitive pricing and branch locations, and competes for deposits by offering a high level of customer service, paying competitive rates and through the geographic distribution of its branch system.

 

Investment Activities

 

The investment policy of the Bank, as approved by the Board Asset Liability Committee (“BALCO”) and supervised by both the BALCO and the Management Investment Committee, is intended to promote investment practices which are both safe and sound and in full compliance with applicable regulations.  Investment authority will be granted and amended as is necessary by the Board of Directors or BALCO.

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The Bank's investment decisions seek to optimize income while keeping both credit and interest rate risk at acceptable levels, provide for the Bank's liquidity needs and provide securities that can be pledged, as needed, to secure deposits and borrowings.

 

The Bank’s investment policy generally limits individual maturities to twenty years and average lives on collateralized mortgage obligations (“CMOs”) and other mortgage-backed securities to 10 years.  At the time of purchase, bonds of states and political subdivisions must generally be rated AA or better, notes of states and political subdivisions must generally be rated MIG-1 (or equivalent), commercial paper must be rated A-1 or P-1, and corporate bonds must be rated AA or better.  In addition, management periodically reviews issuer credit ratings for all securities in the Bank’s portfolio other than those issued by the U.S. government or its agencies.  Any significant deterioration in the creditworthiness of an issuer will be analyzed and action will be taken if deemed appropriate.

 

At year-end 2013 and 2012, there were no holdings of securities of any one issuer, other than the U.S. Government and its agencies, in an amount greater than 10% of stockholders’ equity.

 

At December 31, 2013, $382.6 million of the Corporation’s municipal securities were rated AA or better, $1.1 million were rated A and $.8 million were non-rated bonds of local municipalities.  The Corporation’s pass-through mortgage securities portfolio at December 31, 2013 is comprised of $79.3 million, $73.0 million and $1.4 million of securities issued by the Government National Mortgage Association (“GNMA”), the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), respectively.  Each issuer’s pass-through mortgage securities are backed by residential mortgages conforming to the issuer’s underwriting guidelines and each issuer guarantees the timely payment of principal and interest on its securities.  All of the Corporation’s CMOs were issued by GNMA and such securities are backed by GNMA residential pass-through mortgage securities.  GNMA guarantees the timely payment of principal and interest on its CMOs and the underlying pass-through mortgage securities.  Obligations of GNMA, a U.S. government agency, represent full faith and credit obligations of the U.S. government, while obligations of Fannie Mae and Freddie Mac, which are U.S. government-sponsored agencies, do not.

 

The Bank has not engaged in the purchase and sale of securities for the primary purpose of producing trading profits and its current investment policy does not allow such activity.

 

Lending Activities

 

General.  The Bank’s lending is subject to written underwriting standards and loan origination procedures, as approved by the Board Loan Committee and contained in the Bank’s loan policies.  The loan policies allow for exceptions and set forth specific exception approval requirements.  Decisions on loan applications are based on, among other things, the borrower’s credit history, the financial strength of the borrower, estimates of the borrower’s ability to repay the loan, and the value of the collateral, if any.  All real estate appraisals must meet the requirements of the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) and banking agency guidance and, for those loans in excess of $250,000, be reviewed by the Bank’s appraisal review officer who is independent of the loan underwriting and origination process.

 

The Bank conducts its lending activities out of its main office in Glen Head, New York and its Suffolk County regional office in Hauppauge, New York.  The Bank’s loan portfolio is primarily comprised of loans to small and medium-sized privately owned businesses, professionals and consumers on Long Island and in the boroughs of New York City.  The Bank offers a full range of lending services including commercial and residential mortgage loans, home equity lines, commercial and industrial loans, small business credit scored loans, construction and land development loans, consumer loans, and commercial and standby letters of credit.  The Bank makes both fixed and variable rate loans.  Variable rate loans are primarily tied to and reprice with changes in the prime interest rate of the Bank, the prime interest rate as published in The Wall Street Journal, U.S. Treasury rates, or the Federal Home Loan Bank of New York advance rates.

 

Residential mortgage loans generally in excess of $500,000 and other loans in excess of $400,000 require the approval of the Management Loan Committee.  Loans in excess of $8.5 million also require the approval of two non-management members of the Board Loan Committee.  Loans in excess of $12 million require the recommendation of the Management Loan Committee and the approval of a majority of the Board of Directors.

 

Commercial and Industrial Loans.  Commercial and industrial loans include, among other things, short-term business loans; term and installment loans; revolving credit term loans; and loans secured by marketable securities, the cash surrender value of life insurance policies, deposit accounts or general business assets.  The Bank makes commercial and industrial loans on a demand basis, short-term basis, or installment basis.  Short-term business loans are generally due and payable within one year and should be self-liquidating during the normal course of the borrower’s business cycle.  Term and installment loans are usually due and payable within five years.  Generally, it is the policy of the Bank to request personal guarantees of principal owners on loans made to privately-owned businesses.

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Small Business Credit Scored Loans.  The Bank makes small business credit scored loans to businesses that generally have annual sales at the time of application of less than $2 million.  These loans take the form of credit lines usually in the amount of $100,000 or less and installment loans.  Installment loans are generally made to finance business automobiles, trucks and equipment and can be secured by the asset financed and/or deposit accounts with the Bank.  Both term loans and revolving credit commitments generally have maturities up to sixty months.  Business profile reports are used in conjunction with credit reports and FICO (Fair Isaac Corporation) small business score cards for loan underwriting and decision making purposes.  Credit and FICO small business risk scores enable the Bank to quickly and efficiently identify and approve loans to low-risk business applicants and decline loans to high-risk business applicants.  Moderate risk applicants may require further evaluation before a decision to approve or decline is made.

 

Real Estate Mortgage Loans and Home Equity Lines.  The Bank makes residential and commercial mortgage loans and establishes home equity lines of credit.  Applicants for residential mortgage loans and home equity lines will be considered for approval provided they have satisfactory credit history and collateral and the Bank believes that there is sufficient monthly income to service both the loan or line applied for and existing debt.  Applicants for commercial mortgage loans will be considered for approval provided they, as well as any guarantors, have satisfactory credit history and can demonstrate, through financial statements and otherwise, the ability to repay.  Commercial and residential mortgage loans are made with terms not in excess of thirty years.  Fixed rate residential mortgage loans with terms greater than twenty years are generally not maintained in the Bank’s portfolio.  Many of the residential mortgage loans made by the Bank in recent years are jumbo mortgages that reprice in five or seven years and then every year thereafter.  Commercial mortgage loans generally reprice within five years and home equity lines generally mature within ten years.  Depending on the type of property, the Bank’s usual practice is to lend no more than 70% to 75% of appraised value on residential mortgage loans, 65% on home equity lines, and 80% on commercial mortgage loans.  The lending limitations with regard to appraised value are more stringent for loans on co-ops and condominiums.

 

In processing requests for commercial mortgage loans, the Bank generally requires an environmental assessment to identify the possibility of environmental contamination.  The extent of the assessment procedures varies from property to property and is based on factors such as whether or not the subject property is an industrial building or has a suspected environmental risk based on current or past use.

 

Construction Loans.  From time to time, the Bank makes loans to finance the construction of both residential and commercial properties.  The maturity of such loans is generally one year or less and advances are made as the construction progresses.  The advances can require the submission of bills by the contractor, verification by a Bank-approved inspector that the work has been performed, and title insurance updates to ensure that no intervening liens have been placed.  Construction and land development loans are included in Commercial Mortgages on the Consolidated Balance Sheet and amounted to $973,000 at December 31, 2013.

 

Consumer Loans and Lines.  The Bank makes auto loans, home improvement loans and other consumer loans, establishes revolving overdraft lines of credit and issues VISA^® credit cards.  Consumer loans are generally made on an installment basis over terms not in excess of five years.  In reviewing loans and lines for approval, the Bank considers, among other things, the borrower’s ability to repay, stability of employment and residence, and past credit history.

 

Sources of Funds

 

The Corporation’s primary sources of cash are deposits, maturities and amortization of loans and investment securities, operations and borrowings.  The Corporation uses cash from these and other sources to fund loan growth, purchase investment securities, repay borrowings, expand and improve its physical facilities, pay cash dividends and for general operating purposes.

 

The Bank offers checking and interest-bearing deposit products.  In addition to business and small business checking, the Bank has a variety of personal checking products that differ in minimum balance requirements, monthly maintenance fees, and per check charges, if any.  The interest-bearing deposit products, which have a wide range of interest rates and terms, consist of checking accounts, including negotiable order of withdrawal (“NOW”) accounts and IOLA, escrow service accounts, rent security accounts, a variety of personal and nonpersonal money market accounts, a variety of personal and nonpersonal savings products, time deposits, holiday club accounts, and a variety of individual retirement accounts.

 

The Bank relies primarily on customer service, calling programs, lending relationships, referral sources, competitive pricing and advertising to attract and retain deposits.  Currently, the Bank solicits deposits only from its local market area and does not have any deposits that qualify as brokered deposits under applicable Federal regulations.  The flow of deposits is influenced by general economic conditions, changes in interest rates and competition.

 

Employees

 

As of December 31, 2013, the Bank had 260 full-time equivalent employees and considers employee relations to be good.  Employees of the Bank are not represented by a collective bargaining unit.

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Supervision and Regulation

 

General.  The banking industry is highly regulated.  Statutory and regulatory controls are designed primarily for the protection of depositors and the banking system, and not for the purpose of protecting shareholders.  The following discussion is not intended to be a complete list of all the activities regulated by banking laws or of the impact of such laws and regulations on the Corporation and the Bank.  Changes in applicable laws or regulations, and in their interpretation and application by regulatory agencies, cannot be predicted, but may have a material effect on our business and results of operations.

 

As a registered bank holding company, the Corporation is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and subject to inspection, examination and supervision by the Federal Reserve Board.  In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks, performing servicing activities for subsidiaries, and engaging in activities that the Federal Reserve has determined, by order or regulation, are so closely related to banking as to be a proper incident thereto under the BHC Act.  The Corporation is also subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the Securities and Exchange Commission (“SEC”).  Our common stock is listed on the Capital Market tier of the NASDAQ Stock Market (“NASDAQ”) under the symbol “FLIC” and is subject to NASDAQ rules for listed companies.

 

As a national bank, the Bank is subject to regulation and examination by the Office of the Comptroller of the Currency (“OCC”), as well as the Federal Deposit Insurance Corporation (“FDIC”).  Insured banks, such as the Bank, are subject to extensive regulation of many aspects of their business.  These regulations relate to, among other things: (i) the nature and amount of loans that may be made by the Bank and the rates of interest that may be charged; (ii) types and amounts of other investments; (iii) branching; (iv) permissible activities; (v) reserve requirements; and (vi) dealings with officers, directors and affiliates.

 

The Dodd-Frank Act made extensive changes in the regulation of depository institutions and their holding companies.  Certain provisions of the Dodd-Frank Act are having an impact on the Corporation and the Bank.  For example, the Dodd-Frank Act created a new Consumer Financial Protection Bureau as an independent bureau of the Federal Reserve Board.  The Consumer Financial Protection Bureau has assumed responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations, a function currently assigned to principal federal banking regulators, and will have authority to impose new requirements.  However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the enforcement authority of, their primary federal regulator, although the Consumer Financial Protection Bureau will have limited back-up authority to examine such institutions.

 

Bank Holding Company Regulation.  The BHC Act requires the prior approval of the Federal Reserve for the acquisition by a bank holding company of 5% or more of the voting stock or substantially all of the assets of any bank or bank holding company.  Also, under the BHC Act, bank holding companies are prohibited, with certain exceptions, from engaging in, or from acquiring 5% or more of the voting stock of any company engaging in, activities other than (i) banking or managing or controlling banks, (ii) furnishing services to or performing services for their subsidiaries or (iii) activities that the Federal Reserve has determined to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

 

Payment of Dividends.  The principal source of the Corporation’s liquidity is dividends from the Bank.  The prior approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year would exceed the sum of the bank’s net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus.  Under the foregoing dividend restrictions, and while maintaining its “well-capitalized” status and absent affirmative governmental approvals, during 2014 the Bank could declare dividends of approximately $32.5 million plus any 2014 net profits retained to the date of the dividend declaration.

 

In addition, the Corporation and the Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimum capital levels.  The appropriate Federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank holding company or a bank that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof.  The appropriate Federal regulatory authorities have stated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings.  In addition, in the current financial and economic environment, the Federal Reserve has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.

 

Transactions with Affiliates.  Federal laws strictly limit the ability of banks to engage in transactions with their affiliates, including their bank holding companies.  Regulations promulgated by the Federal Reserve Board limit the types and amounts of these transactions (including loans due and extensions of credit from their U.S. bank subsidiaries) that may take place and generally require those transactions to be on an arm’s-length basis.  In general, these regulations require that any “covered transactions” between a subsidiary bank and its parent company or the nonbank subsidiaries of the bank holding company be limited to 10% of the bank subsidiary’s capital and surplus and, with respect to such parent company and all such nonbank subsidiaries, to an aggregate of 20% of the bank subsidiary’s capital and surplus.  Further, loans and extensions of credit to affiliates generally are required to be secured by eligible collateral in specified amounts.

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Source of Strength Doctrine.  Federal Reserve policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks.  The Dodd-Frank Act codifies this policy as a statutory requirement.  Under this requirement, the Corporation is expected to commit resources to support the Bank, including at times when the Corporation may not be in a financial position to provide such resources.  Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks.  In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a Federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.

 

Capital Requirements.  As a bank holding company, the Corporation is subject to consolidated regulatory capital requirements administered by the Federal Reserve.  Our Bank is subject to similar capital requirements administered by the OCC.  The Federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (“Basel Committee”).  The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply.  The requirements are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments.  Under the requirements, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit).  For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk-weight categories defined by the Federal regulatory authorities.

 

A depository institution’s or holding company’s capital, in turn, is classified in one of two tiers, depending on type:

 

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Core Capital (Tier 1).  Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual stock at the holding company level, minority interests in equity accounts of consolidated subsidiaries, and qualifying trust preferred securities, less goodwill, most intangible assets and certain other assets.

 

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Supplementary Capital (Tier 2).  Subject to limitations, Tier 2 capital includes, among other things, the allowance for loan and lease losses, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, and qualifying subordinated debt.

 

Like other bank holding companies, the Corporation is currently required to maintain Tier 1 capital and “Total capital” (the sum of Tier 1 and Tier 2 capital) equal to at least 4.0% and 8.0%, respectively, of total risk-weighted assets (including various off-balance-sheet items, such as letters of credit).  Our Bank, like other depository institutions, is required to maintain similar capital levels under capital adequacy guidelines.  In addition, for a depository institution to be considered “well-capitalized” under the regulatory framework for prompt corrective action, its Tier 1 and total capital ratios must be at least 6.0% and 10.0% on a risk-adjusted basis, respectively.

 

Bank holding companies and banks are also required to comply with minimum leverage ratio requirements.  The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes).  The requirements necessitate a minimum Tier 1 leverage ratio of 3.0% for bank holding companies and national banks that either have the highest supervisory rating or have implemented the relevant Federal regulatory authority’s risk-adjusted measure for market risk.  All other bank holding companies and national banks are required to maintain a minimum Tier 1 leverage ratio of 4.0%, unless a different minimum is specified by a relevant regulatory authority.  In addition, for a depository institution to be considered “well-capitalized” under the regulatory framework for prompt corrective action, its Tier 1 leverage ratio must be at least 5.0%.  The Federal Reserve has not advised the Corporation, and the OCC has not advised the Bank, of any specific minimum Tier 1 leverage ratio applicable to either entity.

 

Prompt Corrective Action Regulations.  The Federal Deposit Insurance Act, as amended (“FDIA”), requires among other things, the Federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements.  The FDIA sets forth the following five capital tiers: “well-capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation.  The relevant capital measures are the total risk-based capital ratio, the Tier 1 risk-based capital ratio and the Tier 1 leverage ratio.

 

A bank will be (i) “well-capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a Tier 1 leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a Tier 1 leverage ratio of 4.0% or greater and is not “well-capitalized” (iii) “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a Tier 1 leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a Tier 1 leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if its tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters.  A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.

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The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.”  “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan to the appropriate banking agencies.  The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital.  In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan.  The bank holding company must also provide appropriate assurances of performance.  The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan.  If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”

 

“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks.  “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.

 

The appropriate Federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized.  The FDIA provides that an institution may be reclassified if the appropriate Federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.

 

The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.

 

As of December 31, 2013, the Bank was “well-capitalized” based on the aforementioned ratios.

 

Regulatory Capital Rulemaking.   In July 2013, the Federal Reserve Board and the OCC approved a final rule that changes the regulatory capital framework and revises the prompt corrective action categories discussed above for all banking organizations.  For a discussion of regulatory capital rulemakings, see “Regulatory Rulemakings” included in Part II, Item 7 of this Form 10-K.

 

Deposit Insurance.  The FDIC imposes an assessment on financial institutions for deposit insurance.  The assessment is based on the risk category of the institution, the institution’s average total assets and average tangible equity.  The FDIC periodically adjusts the deposit insurance assessment rates which may raise or lower the cost to an institution of maintaining FDIC insurance coverage.

 

In 2009, the FDIC required depository institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  Beginning with the first quarter of 2010, and on a quarterly basis thereafter, the Corporation was recording an expense for its regular FDIC assessment with an offsetting credit to the prepaid asset.  During 2013, the Bank received a refund from the FDIC of its remaining prepaid balance of $1.6 million.

 

During 2008, the FDIC temporarily increased the amount of deposit insurance available on all deposit accounts to a maximum of $250,000.  Additionally, certain non-interest-bearing transaction accounts maintained with financial institutions participating in the FDIC’s Temporary Liquidity Guarantee Program (“TLG Program”) were fully insured regardless of the dollar amount until June 30, 2010.  The Dodd-Frank Act made the $250,000 deposit insurance coverage permanent and extended unlimited coverage for certain noninterest-bearing transaction accounts until December 31, 2012. Beginning January 1, 2013, non-interest bearing transaction accounts are no longer eligible for unlimited deposit insurance coverage and are no longer insured separately from depositors’ other accounts at the same insured institution.

 

The FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.  Management is not aware of any practice, condition or violation that might lead to termination of the Bank’s deposit insurance.

 

Safety and Soundness Standards.  The FDIA requires the Federal bank regulatory agencies to prescribe standards, through regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate.  Guidelines adopted by the Federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees and benefits.  In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines.  The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder.  In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan.  If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of the FDIA.  See “Prompt Corrective Action Regulations” above.  If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.

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Community Reinvestment Act and Fair Lending Laws.  The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice.  Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low and moderate income individuals and communities.  Depository institutions are periodically examined for compliance with the CRA and are assigned ratings.  Banking regulators take into account CRA ratings when considering approval of proposed acquisition transactions.  Our Bank received a “Satisfactory” CRA rating on its most recent Federal examination.  The Bank and the Corporation are firmly committed to the practice of fair lending and maintaining strict adherence to all federal and state fair lending laws which prohibit discriminatory lending practices.

 

Federal Home Loan Bank System.  The Bank is a member of the Federal Home Loan Bank System (“FHLB System”), which consists of 12 regional Federal Home Loan Banks (each a “FHLB”).  The FHLB System provides a central credit facility primarily for member banks.  As a member of the FHLB of New York, the Bank is required to acquire and hold shares of capital stock in the FHLB in an amount equal to 4.5% of its borrowings from the FHLB plus 0.2% of the total principal amount at the beginning of the year of the Bank’s unpaid residential real estate loans, commercial real estate loans, home equity loans, CMOs, and other similar obligations.  At December 31, 2013, the Bank was in compliance with the FHLB’s capital stock ownership requirement.

 

Financial Privacy.  Federal regulations require the Bank to disclose its privacy policy, including identifying with whom it shares “nonpublic personal information,” to its customers at the time the customer establishes a relationship with the Bank and annually thereafter.  In addition, we are required to provide our customers with the ability to “opt-out” of having the Bank share their nonpublic personal information with nonaffiliated third parties before we can disclose that information, subject to certain exceptions.

 

The Federal banking agencies adopted guidelines establishing standards for safeguarding our customer information.  The guidelines describe the agencies’ expectation that regulated entities create, implement and maintain an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity and the nature and scope of our activities.  The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of customer records, and protect against unauthorized access to records or information that could result in substantial harm or inconvenience to customers.  Additionally, the guidance states that banks, such as the Bank, should develop and implement a response program to address security breaches involving customer information, including customer notification procedures.  The Bank has developed such a program.

 

Anti-Money Laundering and the USA PATRIOT Act.  A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing.  The USA PATRIOT Act of 2001 (“Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States.  The United States Treasury Department (“Treasury”) has issued and, in some cases, proposed a number of regulations that apply various requirements of the Patriot Act to financial institutions such as the Bank.  These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers.  Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons.  Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal, financial and reputational consequences for the institution. The Bank and the Corporation are firmly committed to maintaining strong policies, procedures and controls to ensure compliance with anti-money laundering laws and regulations and to combat money laundering and terrorist financing.

 

The Fair and Accurate Credit Transactions Act of 2003.  The Fair and Accurate Credit Transactions Act of 2003 (“FACT Act”) includes many provisions concerning national credit reporting standards, and permits consumers to opt out of information sharing among affiliated companies for marketing purposes.  The FACT Act also requires the Bank to notify its customers if it reports negative information about them to credit bureaus or if the credit that the Bank grants to them is on less favorable terms than are generally available.  The Bank also must comply with guidelines established by the Federal banking regulators to help detect identity theft.

 

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

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Availability of Reports

 

The First National Bank of Long Island maintains a website at www.fnbli.com.  The Corporation’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to these reports filed with or furnished to the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through the Bank’s website as soon as reasonably practicable after they are electronically filed with or furnished to the SEC.  To access these reports go to the homepage of the Bank’s website and click on “Investor Relations,” then click on “SEC Filings,” and then click on “Corporate SEC Filings.”  This will bring you to a listing of the Corporation’s reports maintained on the SEC’s EDGAR website.  You can then click on any report to view its contents.

 

You may also read and copy any document we file with the SEC at the SEC’s public reference room at 100 F Street, N.E., Washington, DC 20549.  You should call 1-800-SEC-0330 for more information on the public reference room.  Our SEC filings are also available on the SEC’s website at www.sec.gov.

 

ITEM 1A.

RISK FACTORS

 

The Corporation is exposed to a variety of risks, some of which are inherent in the banking business.  The more significant of these are addressed by the Corporation’s written policies and procedures.  While management is responsible for identifying, assessing and managing risk, the Board of Directors is responsible for risk oversight.  The Board fulfills its risk oversight responsibilities largely through its committees.  The risks faced by the Corporation include, among others, credit risk, allowance for loan loss risk, interest rate risk, liquidity risk, market risk for its common stock, economic conditions risk, operational risk, technology risk, key personnel risk, regulatory and legislative risk, income tax risk, external events risk and competitive risk.  Additional risks and uncertainties not currently known to the Corporation, or that the Corporation currently deems to be immaterial, could also have a material impact on the Corporation’s business, financial condition, or results of operations.

 

Credit Risk

 

For both investment securities and loans, there is always the risk that the Bank will be unable to collect all amounts due according to the contractual terms.  Credit risk in the Bank’s securities portfolio has been addressed by adopting a board committee approved investment policy that, among other things, limits terms and types of holdings, and specifies minimum required credit ratings.  Allowable investments include direct obligations of the U.S. government and its agencies, highly rated obligations of states and political subdivisions, and highly rated corporate obligations.  At the time of purchase, bonds of states and political subdivisions must generally be rated AA or better, notes of states and political subdivisions must generally be rated MIG-1 (or equivalent), commercial paper must be rated A-1 or P-1, and corporate bonds must be rated AA or better.  In addition, management periodically reviews the creditworthiness of all securities in the Bank’s portfolio other than those issued by the U.S. government or its agencies.  Any significant deterioration in the creditworthiness of an issuer will be analyzed and action taken if deemed appropriate.

 

Credit risk in the Bank’s loan portfolio has been addressed by adopting board committee approved commercial, consumer and mortgage loan policies and by maintaining independent loan review and appraisal review functions and an independent credit department.  The loan policies contain what the Corporation believes to be prudent underwriting guidelines, which include, among other things, specific loan approval requirements, maximum loan terms, loan to appraised value and debt service coverage limits for mortgage loans, credit score minimums and environmental study requirements.

 

The credit risk within the Bank’s loan portfolio primarily stems from factors such as borrower size, geographic concentration, industry concentration, real estate values, local and national general economic conditions and environmental contamination.  The Bank’s commercial loans, including those secured by mortgages, are primarily made to small and medium-sized businesses.  Such loans sometimes involve a higher degree of risk than those to larger companies because such businesses may have shorter operating histories, higher debt-to-equity ratios and may lack sophistication in internal record keeping and financial and operational controls.  In addition, most of the Bank’s loans are made to businesses and consumers on Long Island and in the boroughs of New York City, and a large percentage of these loans are mortgage loans secured by properties located in those areas.  At December 31, 2013, multifamily loans amounted to approximately $469 million and comprised approximately 66% of the Bank’s total commercial mortgage portfolio and approximately 34% of the Bank’s total loans secured by real estate.  The primary source of repayment for multifamily loans is cash flows from the underlying properties, a substantial portion of which are rent stabilized or rent controlled.  Such cash flows are dependent on the strength of the local economy.  Although economic conditions improved somewhat during 2013, general economic conditions have been unfavorable as characterized by high levels of unemployment and underemployment, suppressed commercial and residential real estate values, and elevated commercial real estate vacancies.  These conditions have caused some of the Bank’s borrowers to be unable to make the required contractual payments on their loans and could cause the Bank to be unable to realize the full carrying value of such loans through foreclosure or other collection efforts.  Environmental impairment of properties securing mortgage loans is also a risk.  However, at the present time, the Bank is not aware of any existing loans in the portfolio where there is environmental pollution originating on or near the mortgaged properties that would materially affect the value of the portfolio.

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Allowance for Loan Loss Risk

 

The Bank maintains an allowance for loan losses in an amount believed to be adequate to absorb probable incurred losses in its loan portfolio.  The maintenance of the allowance for loan losses is governed by a board committee approved allowance for loan and lease losses policy.  In arriving at the allowance for loan losses, an impairment analysis is performed on each loan where it is probable that the borrower will not be able to make all required principal and interest payments according to contractual terms.  In addition, losses for all other loans in the Bank’s portfolio are determined on a pooled basis taking into account, among other things, historical loss experience, delinquencies, economic conditions, trends in nature and volume of loans, concentrations of credit, changes in lending policies and procedures, experience, ability and depth of lending staff, changes in quality of the loan review function, environmental risks and loan risk ratings.  Because estimating the allowance for loan losses is highly subjective in nature and involves a variety of estimates and assumptions that are inherently uncertain, there is the risk that management’s estimate may not accurately capture probable incurred losses in the loan portfolio.  The Bank’s allowance at any point in time may need to be adjusted upward based on, among other things, additional information that comes to light after the estimate is made, changes in circumstances, or a recommendation by bank regulators based on their review of the Bank’s loan portfolio.  Such an adjustment could result in the need for a significant increase in the Bank’s provision for loan losses and have a material adverse impact on the Bank’s financial condition and results of operations.

 

Interest Rate Risk

 

The Bank’s results of operations are subject to risk resulting from interest rate fluctuations generally and having assets and liabilities that have different maturity, repricing and prepayment/withdrawal characteristics.  The Bank defines interest rate risk as the risk that the Bank's net interest income and/or economic value of equity (“EVE”) will change when interest rates change.  The Bank has addressed interest rate risk by adopting a board committee approved interest rate risk policy which sets forth quantitative risk limits and calls for monitoring and controlling interest rate risk through a variety of techniques including the use of interest rate sensitivity models and traditional repricing gap analysis.  Management utilizes a consultant with expertise in bank asset liability management to aid them in these efforts.

 

A sustained period of low interest rates could adversely affect the Bank’s earnings.  When interest rates are relatively low, as they currently are, borrowers tend to refinance higher rate loans at lower rates and prepayments on mortgages and mortgage securities are elevated.  Under those circumstances, the Bank may not be able to reinvest the resulting cash flows in new interest-earning assets with rates as high as those on the prepaid loans or investment securities.  In addition, subject to the floors contained in many of the Bank’s loan agreements, the Bank’s loans at variable interest rates adjust to lower rates at their reset dates.  The positive impact of lower interest rates on the Bank’s cost of funds is currently constrained because many of the Bank’s deposit products are at historically low rates with little if any room for further reductions, and because the Bank funds a significant portion of its average interest-earning assets with noninterest bearing checking deposits and capital.

 

In a period of rising interest rates, the Bank’s loans and investment securities could reprice slower than its interest-bearing liabilities, which could initially have a negative effect on net interest income.  Over a longer period of time, the effect on the Bank’s earnings should be positive primarily because with the passage of time more loans and investment securities will reprice at the higher rates and there will be no offsetting increase in interest expense for those interest-earning assets funded by noninterest-bearing checking deposits and capital.

 

Liquidity Risk

 

Liquidity risk is the risk that the Bank will not have sufficient funds to accommodate loan growth, meet deposit outflows or make contractual payments on borrowing arrangements.  The Bank has addressed liquidity risk by adopting a board committee approved Liquidity Policy and Liquidity Contingency Plan that set forth quantitative risk limits and a protocol for responding to liquidity stress conditions should they arise.  The Bank encounters significant competition in its market area from branches of larger banks, various community banks, credit unions and other financial services organizations.  This, in addition to renewed consumer confidence in the equity markets, could cause deposit outflows, and such outflows could be significant.

 

The Bank has both internal and external sources of liquidity that can be used to fund loan growth and accommodate deposit outflows. The Bank’s primary internal sources of liquidity are its overnight investments, investment securities designated as available-for-sale, maturities and monthly payments on its investment securities and loan portfolios and operations.

 

The Bank is a member of the Federal Reserve Bank of New York (“FRB”) and the FHLB of New York, has repurchase agreements in place with a number of brokerage firms and commercial banks and has federal funds lines with several commercial banks.  In addition to customer deposits, the Bank’s primary external sources of liquidity are secured borrowings from the FRB, FHLB of New York and repurchase agreement counterparties.  In addition, the Bank can purchase overnight federal funds under its existing lines.  However, the Bank’s FRB membership, FHLB of New York membership, repurchase agreements and federal funds lines do not represent legal commitments to extend credit to the Bank.  The amount that the Bank can potentially borrow is currently dependent on, among other things, the amount of unencumbered eligible securities and loans that the Bank can use as collateral and the collateral margins required by the lenders.

 

Market Risk for the Corporation’s Common Stock

 

The Corporation’s common stock is included in the Russell 3000 and Russell 2000 Indexes, which are reconstituted annually.  Upon reconstitution in May 2013, the average market capitalization of companies in the Russell 2000 Index was $1.4 billion, the median market capitalization was $594 million, the capitalization of the largest company in the index was $3.3 billion and the capitalization of the smallest company in the index was $129 million.  The Corporation’s market capitalization on December 31, 2013 was approximately $392 million.  The Corporation believes that inclusion in the Russell indexes has positively impacted the price, trading volume and liquidity of its common stock.  Conversely, if the Corporation’s market capitalization falls below the minimum necessary to be included in the indexes at any future reconstitution date, the opposite could occur.

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Economic Conditions Risk

 

Although national and local economic conditions improved somewhat in 2013, they still remain unfavorable.  This poses significant risks to both the Corporation’s business and the banking industry as a whole.  Specific risks include reduced loan demand from quality borrowers; increased competition for loans; increased loan loss provisions resulting from deterioration in loan quality caused by, among other things, depressed real estate values and high levels of unemployment and underemployment; reduced net interest income and net interest margin caused by a sustained period of low interest rates; interest rate volatility; price competition for deposits due to liquidity concerns or otherwise; and volatile equity markets.

 

In addition to the significant risks posed by unfavorable economic conditions, the Corporation could experience deposit outflows as national and local economic conditions improve and investors pursue alternative investment opportunities.

 

Operational Risk

 

The Corporation relies on its system of internal controls and the internal controls of its third-party service providers (“TPSPs”) to ensure that transactions are captured, recorded, processed and reported properly; confidential customer information is safeguarded; and fraud by employees and persons outside the Corporation is detected and prevented.  The Corporation’s internal controls and/or those of its TPSPs may prove to be ineffective or employees of the Corporation and/or its TPSPs may fail to comply with or override the controls, either of which could result in significant financial loss to the Corporation, adverse action by bank regulatory authorities or the SEC, and damage to the Corporation’s reputation.

 

Technology Risk

 

The delivery of financial products and services has become increasingly technology-driven.  The Bank’s ability to meet the needs of its customers competitively, and in a cost-efficient manner, is dependent on its ability to keep pace with technological advances and to invest in new technology as it becomes available.  The ability to keep pace with technological change is important, and failure to do so could have a material adverse impact on the Corporation’s business, financial condition and results of operations.

 

In addition, the Bank outsources certain of its data processing to TPSPs.  If TPSPs encounter difficulties, or if the Bank has difficulty communicating with them, the Bank’s ability to adequately process and account for customer transactions could be affected, and the Bank’s business operations could be adversely impacted.  Threats to information security also exist in the processing of customer information through TPSPs.  The Bank’s website and online banking products have been the target of cyber attacks in the past.  While the Bank and its TPSPs have successfully blocked attempts to infiltrate our systems, there is no guarantee that such attempts will be unsuccessful in the future.

 

The Bank has established board committee approved policies to prevent or limit the impact of systems failures, interruptions and security breaches and relies on commonly used security and processing systems to provide the security and authentication necessary for the processing of data.  The Bank makes use of logon and user access controls, transaction limits, firewalls, antivirus software, intrusion protection monitoring and vulnerability scans.  Systems failures or interruptions are addressed in a disaster recovery and contingency plan.  In addition, for TPSPs of data processing and other significant services, the Bank obtains and reviews audit reports prepared by independent registered public accounting firms regarding their financial condition and the effectiveness of their internal controls.

 

These precautions may not protect our systems from all compromises or breaches of security and there can be no assurance that such events will not occur or that they will be adequately addressed if they do.  The Bank carries a cyber liability insurance policy to mitigate the amount of any financial loss.  However, the occurrence of any systems failure, interruption or breach of security could damage the Bank’s reputation and result in a loss of customers and business, could subject the Bank to additional regulatory scrutiny, or could expose the Bank to civil litigation and possible financial liability beyond any insurance coverage.  Any of these occurrences could have a material adverse effect on the Corporation’s financial condition and results of operations.

 

Key Personnel Risk

 

The Corporation’s future success depends in part on the continued service of its executive officers and other key members of management and its staff, as well as its ability to continue to attract, motivate and retain additional highly qualified employees.  The loss of services of key personnel could have an adverse effect on the Bank’s business, operating results and financial condition because their skills, knowledge of the Bank’s market and years of industry experience may be difficult to replace.

 

Regulatory and Legislative Risk

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Income Tax Risk

The Corporation is subject to income tax under Federal, New York State and New York City laws and regulations.  Changes in such laws and regulations could increase the Corporation’s tax burden and such increase could have a material negative impact on its results of operations.

 

The governor of the State of New York State recently announced his budget proposal for the 2014-2015 fiscal year.  The governor’s proposal includes, among other things: (1) a merger of the current bank tax provisions under Article 32 of New York State tax law into the corporate tax provisions under Article 9A; (2) a reduction in the corporate income tax rate from 7.1% to 6.5%; (3) a reduction in income subject to tax resulting from small business and residential mortgage lending activities; (4) an increase in the MTA surcharge from 17% to 24.5% of the corporate tax; and (5) the elimination of captive REITs for institutions that have less than $8 billion in total assets.  Pursuant to the governor’s proposal, these changes would be effective for tax years beginning on or after January 1, 2015.

 

The Corporation currently avails itself of certain benefits under New York State tax law including the benefit associated with having a captive REIT.  If the tax reform elements contained in the governor’s budget proposal become law, the Corporation would lose the tax benefit associated with its REIT and could lose other tax benefits as well.  Other provisions in the governor’s proposal would benefit the Bank such as the reduction in the corporate tax rate from 7.1% to 6.5% and the aforementioned benefit that would be derived from small business and residential mortgage lending activities.  The Corporation is continuing to analyze the governor’s budget proposal and has not yet determined the full impact that the proposal, if enacted into law, could have on its tax burden.

 

External Events Risk – Weather and Terrorism

 

Weather-related events have adversely impacted our market area, especially areas located near coastal waters and flood prone areas.  Significant flooding and other storm-related damage may become more common in the future.  Financial institutions have been, and continue to be, targets of terrorist threats aimed at compromising operating and communication systems, and the metropolitan New York area remains a central target for potential acts of terrorism.  Weather-related and terrorist events could cause significant damage, impact the stability of our facilities and result in additional expenses, impair the ability of our borrowers to repay their loans, reduce the value of collateral securing repayment of our loans, and result in the loss of revenue.  While we have established and regularly test disaster recovery procedures, the occurrence of any such event could have a material adverse effect on our business, results of operations and financial condition.

As of December 31, 2013, the Bank owns a total of eighteen buildings in fee simple and leases twenty-seven other facilities, all of which are in Nassau and Suffolk Counties, Long Island and Manhattan.  The Corporation believes that the physical facilities of the Bank are suitable and adequate at present and are being fully utilized.

 

ITEM 3.

LEGAL PROCEEDINGS

 

In the ordinary course of business, the Corporation is party to various legal actions which are incidental to the operation of its business.  Although the ultimate outcome and amount of liability, if any, with respect to these legal actions cannot presently be ascertained with certainty, in the opinion of management, based upon information currently available to us, any resulting liability is believed to be immaterial to the Corporation's consolidated financial position, results of operations and cash flows.

 

ITEM 4.

MINE SAFETY DISCLOSURES - Not applicable.

PART II

 

ITEM 5.

MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER  PURCHASE OF EQUITY SECURITIES

The Corporation’s common stock trades on the NASDAQ Capital Market tier of the NASDAQ Stock Market under the symbol “FLIC.”  At December 31, 2013, there were 628 stockholders of record of the Corporation’s Common Stock.  The number of stockholders of record includes banks and brokers who act as nominees, each of whom may represent more than one stockholder.  The following table sets forth high and low sales prices and dividends declared, by quarter, for the years ended December 31, 2013 and 2012.

 

There are various legal limitations with respect to the Bank’s ability to pay dividends to the Corporation and the Corporation’s ability to pay dividends to its shareholders.  Under the New York Business Corporation Law, the Corporation may pay dividends on its outstanding shares except when the Corporation is insolvent or would be made insolvent by the dividend.  See Item 1, “Business – Supervision and Regulation - Payment of Dividends,” for a discussion of the limitations on the ability of the Bank and the Corporation under federal banking laws and regulations to pay dividends.

 

Equity Compensation Plan Information

 

Information regarding securities authorized for issuance under equity compensation plans is provided in Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” of this Form 10-K.

 

Performance Graph

 

Issuer Purchase of Equity Securities

 

The Corporation did not repurchase any shares of its own common stock in the fourth quarter of 2013.

ITEM 6.

SELECTED FINANCIAL DATA

 

The following is selected consolidated financial data for the past five years.  This data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the accompanying consolidated financial statements and related notes.

 

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview – 2013 Versus 2012

 

Analysis of 2013 Earnings.  Net income and earnings per share for 2013 were $21.3 million and $2.32, respectively, representing increases over the comparable 2012 amounts of 4.4% and 2.2%, respectively.  Dividends per share increased by 6.3% from $.96 for 2012 to $1.02 for 2013.  Returns on average assets and average equity for 2013 were .95% and 10.49%, respectively, as compared to .99% and 10.19%, respectively, for 2012.

 

Net income for 2013 increased by $907,000 over 2012.  The increase is primarily attributable to an increase in net interest income of $2.4 million, or 4.0%, a decrease in the provision for loan losses of $631,000, or 17.4%, and an increase in noninterest income (excluding securities gains) of $454,000, or 6.9%.  Partially offsetting these items were increases in noninterest expense (excluding debt extinguishment costs) of $2.1 million, or 5.5%, and income tax expense of $718,000, or 14.3%.  Results for 2012 include a net loss of $338,000 on a deleveraging transaction, comprised of $3.8 million of debt extinguishment costs partially offset by $3.5 million of securities gains.

 

The increase in net interest income resulted from an increase in average interest-earning assets of $177.4 million, or 8.9%, as partially offset by a 16 basis point decline in net interest margin.  The increase in average interest-earning assets is primarily attributable to increases in the average balances of loans outstanding of $213.2 million, or 19.9%, as partially offset by a decrease in the average balance of taxable securities of $46.2 million, or 8.5%.  From a yield perspective, the shift from lower yielding taxable securities to better yielding loans resulted in an improvement in the mix of the Bank’s interest-earning assets.  Partially offsetting these items was a 16 basis point decline in net interest margin from 3.34% in 2012 to 3.18% in 2013.  Net interest margin declined year-over-year as loans were repriced and cash flows were deployed in a low interest rate environment.

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Loan growth, to the extent not funded by the decline in taxable securities, was funded by growth in the average balances of noninterest-bearing checking deposits of $99.9 million, or 21.3%, interest-bearing deposits of $69.8 million, or 6.3%, and short-term borrowings of $30.5 million, or 53.2%.

 

The $631,000 decrease in the provision for loan losses is due to a reduction in historical losses, a change in management’s estimate of the impact of current economic conditions on the required allowance for loan losses and a decrease in net chargeoffs.  The impact of these items in reducing the provision was partially offset by more loan growth in 2013 than 2012 and a smaller decrease in 2013 than 2012 in reserves on loans individually deemed to be impaired.

 

The increase in noninterest income (excluding securities gains) of $454,000 is largely attributable to increases in Investment Management Division income and other noninterest income.  The $2.1 million increase in noninterest expense (excluding debt extinguishment costs) is comprised of increases in salaries, employee benefits expense, occupancy and equipment expense, and other noninterest expense.

 

  Analysis of Fourth Quarter 2013 Earnings.  Net income for the fourth quarter of 2013 was $5.2 million, an increase of 2.5% over $5.1 million for the fourth quarter of 2012.  The increase in net income is attributable to increases in net interest income of $1.2 million, or 8.2%, and noninterest income of $188,000, or 11.4%, as largely offset by increases in noninterest expense of $747,000, or 7.8%, the provision for loan losses of $437,000 and income tax expense of $104,000.

 

The changes in net interest income, noninterest income and noninterest expense occurred for substantially the same reasons discussed with respect to the full year periods.  The provision for loan losses increased in the fourth quarter largely because of more loan growth and a partial chargeoff on a loan transferred to held-for-sale, as partially offset by a decrease during the current quarter in specific reserves on loans individually deemed to be impaired.  Earnings per share remained unchanged at $.56 in each quarter.

 

Asset Quality.  The Bank’s allowance for loan losses to total loans (reserve coverage ratio) was 1.41% at December 31, 2013 compared to 1.62% at year-end 2012.  The reserve coverage ratio decreased due to a reduction in the portion of the allowance attributable to historical losses and management’s assessment of current economic conditions.  The $3.0 million provision for loan losses for 2013 is primarily attributable to loan growth and net chargeoffs, as partially offset by a decrease in specific reserves on loans individually deemed to be impaired and a decrease in the reserve coverage ratio.  The $3.6 million provision for loan losses for 2012 was mostly attributable to loan growth and net chargeoffs.

 

The credit quality of the Bank’s loan portfolio remains excellent, with nonaccrual loans, including a $900,000 loan held-for-sale, amounting to $4.5 million, or .3% of total loans outstanding at December 31, 2013.  The held-for-sale loan was sold in January 2014 for its carrying value of $900,000.  Additionally, loans past due 30 through 89 days amounted to only $184,000, or .01% of total loans outstanding.  Troubled debt restructurings declined during 2013 amounting to $3.1 million at the end of the year compared to $4.4 million at year-end 2012.  Of the $3.1 million in troubled debt restructurings outstanding at December 31, 2013, which includes the $900,000 loan held-for-sale, $541,000 are performing in accordance with their modified terms and $2.5 million are nonaccrual and included in the aforementioned amount of nonaccrual loans.  The credit quality of the Bank’s securities portfolio also remains excellent.  The Bank’s mortgage securities are backed by mortgages underwritten on conventional terms, with 83% of these securities being full faith and credit obligations of the U.S. government and the balance being obligations of U.S. government sponsored entities.  The remainder of the Bank’s securities portfolio principally consists of high quality, general obligation municipal securities rated AA or better by major rating agencies.  In selecting municipal securities for purchase, the Bank uses credit agency ratings for screening purposes only and then performs its own credit analysis.  On an ongoing basis, the Bank periodically assesses the credit strength of the municipal securities in its portfolio and makes decisions to hold or sell based on such assessments.

 

Capital Ratios and Book Value Per Share. The Corporation’s Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios were 8.62%, 15.77% and 17.02%, respectively, at December 31, 2013.  The strength of the Corporation’s balance sheet from both a capital and asset quality perspective positions the Corporation for continued growth in a measured and disciplined fashion.

 

Despite net income for 2013 of $21.3 million, book value per share decreased from $22.81 at year-end 2012 to $22.59 at year-end 2013.  The decrease resulted from an increase in intermediate and long-term interest rates during 2013 and a resulting reduction in unrealized gains on available-for-sale securities.  Unrealized gains on available-for-sale securities, net of tax, decreased by $19.9 million from $22.7 million at year-end 2012 to $2.8 million at year-end 2013.  Additionally, without the decrease in unrealized gains on available-for-sale securities, net of tax, return on average equity for 2013 would have been 66 basis points lower.

 

Key Strategic Initiatives.  Key strategic initiatives will continue to include loan and deposit growth through effective relationship management, targeted solicitation efforts, new product offerings and continued expansion of the Bank’s branch distribution system.  Additionally, with respect to loan growth, the Bank recently established a correspondent lending relationship and will continue to develop its existing broker relationships.  All loans originated through correspondent and broker relationships are underwritten by Bank personnel. During 2013, the Bank opened full service branches in Massapequa Park and Sayville, Long Island and expects to open branches in Oceanside and Manhasset, Long Island in the latter part of 2014.  The Bank is continuing to pursue additional sites for future branch expansion.

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Challenges We Face.  Although intermediate and long-term interest rates are significantly higher than they were at year-end 2012, they are still relatively low and could remain so for the foreseeable future.  In addition, there is significant price competition for loans in the Bank’s marketplace and there is little room for the Bank to further reduce its deposit rates.  The persistence of these factors could result in a decline in net interest margin from its current level.  If that were to occur, and management is unable to offset the resulting negative impact by increasing the volume of the Bank’s interest-earning assets, effecting a favorable change in the mix of the Bank’s interest-earning assets or interest-bearing liabilities, reducing expenses or the employment of other measures, the Bank’s profitability could decline.

 

Commercial and residential real estate values have been negatively impacted by persistently high levels of unemployment and underemployment, the erosion of household disposable income, foreclosures and commercial vacancies.  Although economic conditions improved somewhat during 2013, these factors still present meaningful threats to the maintenance of loan quality.

 

The banking industry is currently faced with an ever-increasing number of new and complex regulatory requirements which are putting downward pressure on revenues and upward pressure on required capital levels and the cost of doing business.

 

Overview – 2012 Versus 2011

 

Analysis of 2012 Earnings.  Net income and earnings per share for 2012 were $20.4 million and $2.27, respectively, representing increases over 2011 net income and earnings per share of 4.8% and 3.2%, respectively. Dividends per share were $.96 for 2012, or 6.7% more than the $.90 per share declared in 2011.  ROA and ROE for 2012 were .99% and 10.19%, respectively, versus 1.05% and 11.15%, respectively, for 2011.  An increase in average unrealized gains on available-for-sale securities accounts for a significant portion of the decline in ROE.

 

The increase in net income for 2012 was primarily attributable to an increase in net interest income of $1.4 million, or 2.3%, a decrease in the provision for loan losses of $433,000, and an increase in noninterest income (excluding securities gains) of $287,000, or 4.6%.  Partially offsetting the positive earnings impact of these items was a net loss of $338,000 on a deleveraging transaction executed in the second quarter of 2012, an increase in noninterest expense (before debt extinguishment costs) of $731,000, or 2.0%, and an increase in income tax expense of $73,000.  Despite a $1.0 million increase in income before income taxes in 2012, income tax expense only increased by $73,000 largely because of a $869,000 increase in tax-exempt income on municipal securities.

 

The increase in net interest income resulted from an increase in average interest-earning assets of $204.8 million, or 11.4%, as partially offset by a 29 basis point decline in net interest margin. The growth in average interest-earning assets was principally comprised of increases in average loans outstanding of $125.7 million, or 13.3%, nontaxable securities of $61.5 million, or 20.2%, and taxable securities of $24.1 million, or 4.7%.  Although net interest margin declined year-over-year as loans repriced and cash flows were deployed in a very low interest rate environment, it was relatively stable throughout 2012 at 3.37%, 3.36%, 3.35% and 3.30% for the first, second, third and fourth quarters of 2012, respectively.  Management’s efforts to make loans a larger portion of total assets and reduce deposit and borrowing costs contributed to this stabilization.

 

The most significant sources of funding for the growth in the average balances of loans and securities were growth in the average balances of savings, NOW and money market deposits of $93.2 million, or 12.5%, noninterest-bearing checking deposits of $48.3 million, or 11.5%, and borrowings of $31.0 million, or 13.7%.

 

The decrease in the provision for loan losses for 2012 was due to a reduction in specific reserves on loans individually deemed to be impaired and the stabilization of historical loss rates.  The impact of these items in reducing the provision was partially offset by an increased level of loan growth.

 

The $287,000 increase in noninterest income (excluding securities gains) for 2012 was primarily attributable to an increase in Investment Management Division income, an increase in mortgage assignment and other loan related fees, and a decrease in losses on loans held-for-sale.  The positive impact on earnings of these items was partially offset by a decrease in return check charges incurred by the Bank’s customers. The increase in noninterest expense (before debt extinguishment costs) largely resulted from increases in salaries, depreciation and certain loan related costs, as partially offset by a reduction in amounts expensed for the settlement of pending litigation.

 

 

The decline in net interest income occurred because the negative impact of a 20 basis point decline in net interest margin for the quarter more than offset the positive impact of quarterly growth in average interest-earnings assets of 4.7%.  The provision for loan losses decreased for the current quarter largely because of a reduction in specific reserves on loans individually deemed to be impaired.  The impact of these items in reducing the provision was partially offset by an increased level of loan growth.

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Asset Quality.  The Bank’s allowance for loan losses to gross loans (reserve coverage ratio) was 1.62% at December 31, 2012 compared to 1.68% at December 31, 2011.  The reduction in the reserve coverage ratio was largely due to a reduction in specific reserves on loans individually deemed to be impaired.  The $3.6 million provision for loan losses for 2012 was mostly attributable to loan growth and $1.3 million of chargeoffs on three loans.  The $4.1 million provision for loan losses for 2011 was mostly attributable to loan growth, $1.5 million of chargeoffs on two loans and a 13 basis point increase in the reserve coverage ratio.

 

The credit quality of the Bank’s loan portfolio remained excellent, with nonaccrual loans amounting to $4.1 million, or .36% of total loans, at December 31, 2012.  Additionally, loans past due 30 to 89 days amounted to only $884,000, or .08% of total loans.  Troubled debt restructurings declined from $5.4 million at the beginning of 2012 to $4.4 million at the end of the year primarily due to the sale of one such loan.  Of the $4.4 million in troubled debt restructurings outstanding at December 31, 2012, $1.8 million were performing in accordance with their modified terms and $2.6 million were delinquent and included in the aforementioned amounts for delinquent and nonaccrual loans.  The credit quality of the Bank’s securities portfolio also remained excellent.  The Bank’s mortgage securities were backed by mortgages underwritten on conventional terms, and almost all of these securities were full faith and credit obligations of the U.S. government.  The remainder of the Bank’s securities portfolio consisted principally of high quality, general obligation municipal securities rated AA or better by major rating agencies.

 

Capital.  The Corporation’s Tier 1 leverage capital, Tier 1 risk-based capital and total risk-based capital ratios were 9.29%, 19.01% and 20.26%, respectively, at December 31, 2012.

 

Balance Sheet.  In the second quarter of 2012, the Bank executed a deleveraging transaction and also refinanced a portion of its overnight borrowings with long-term debt.  These transactions were undertaken to bolster the Bank’s Tier 1 leverage capital ratio and potentially reduce the negative impact that an eventual increase in interest rates could have on the Bank’s earnings.  Absent the deleveraging transaction, total asset growth during 2012 would have been slightly more than double the reported growth of 4.2%.

 

The deleveraging transaction involved using the proceeds from the sale of investment securities with a market value of $97.1 million to extinguish long-term debt with a redemption value of $68.8 million.  The excess proceeds on this transaction were initially used to repay short-term borrowings and eventually used to fund a combination of loan originations and securities purchases. The net loss of $338,000 on the deleveraging transaction resulted from the combination of $3.8 million in debt extinguishment costs and $3.5 million in securities gains.  The refinancing strategy involved the repayment of $50 million of overnight borrowings with approximately equal amounts of six and seven year term borrowings.

 

Application of Critical Accounting Policies

 

In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported asset and liability balances and revenue and expense amounts.  Our determination of the allowance for loan losses is a critical accounting estimate because it is based on our subjective evaluation of a variety of factors at a specific point in time and involves difficult and complex judgments about matters that are inherently uncertain.  In the event that management’s estimate needs to be adjusted based on, among other things, additional information that comes to light after the estimate is made or changes in circumstances, such adjustment could result in the need for a significantly different allowance for loan losses and thereby materially impact, either positively or negatively, the Bank’s results of operations.

 

The Bank’s Allowance for Loan and Lease Losses Committee (“ALLL Committee”), which is chaired by the Chief Credit Officer, meets on a quarterly basis and is responsible for determining the allowance for loan losses after considering, among other things, the results of credit reviews performed by the Bank’s independent loan review consultants and the Bank’s credit department.  In addition, and in consultation with the Bank’s Chief Financial Officer and Chief Risk Officer, the ALLL Committee is responsible for implementing and maintaining policies and procedures surrounding the calculation of the required allowance.  The Board Loan Committee reviews and approves the Bank’s Allowance for Loan and Lease Losses Policy at least once each calendar year. The Bank’s allowance for loan losses is reviewed and ratified by the Board Loan Committee on a quarterly basis and is subject to periodic examination by the OCC whose safety and soundness examination includes a determination as to its adequacy to absorb probable incurred losses.

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The first step in determining the allowance for loan losses is to identify loans in the Bank’s portfolio that are individually deemed to be impaired and then measure impairment losses based on either the fair value of collateral or the discounted value of expected future cash flows.  For all collateral dependent impaired loans, impairment losses are measured based on the fair value of the collateral.  A loan is considered to be impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled principal and interest payments when due and according to the contractual terms of the loan agreement.  Loans that experience insignificant payment delays and payment shortfalls are not automatically considered to be impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and financial condition, and the amount of the shortfall in relation to the principal and interest owed.  In estimating the fair value of real estate collateral, management utilizes appraisals and also makes qualitative judgments based on, among other things, its knowledge of the local real estate market and analyses of current economic conditions and trends.  Estimating the fair value of collateral other than real estate is also subjective in nature and sometimes requires difficult and complex judgments.  Determining expected future cash flows can be more subjective than determining fair values.  Expected future cash flows could differ significantly, both in timing and amount, from the cash flows actually received over the loan’s remaining life.

 

In addition to estimating losses for loans individually deemed to be impaired, management also estimates collective impairment losses for pools of loans that are not specifically reviewed.  Statistical information regarding the Bank’s loss experience over a period of 24 to 60 months is the starting point in making such estimates.  Management believes that this loss period appropriately reflects losses from the current economic cycle and incurred losses in the Bank’s loan portfolio.  However, future losses could vary significantly from those experienced in the past, and accordingly on a quarterly basis management adjusts its historical loss experience to reflect current conditions.  In doing so, management considers a variety of general qualitative factors and then subjectively determines the weight to assign to each in estimating losses.  The factors include, among others: (1) delinquencies, (2) economic conditions as judged by things such as median home prices and commercial vacancy rates in the Bank’s service area and national and local unemployment levels, (3) trends in the nature and volume of loans, (4) concentrations of credit, (5) changes in lending policies and procedures, (6) experience, ability and depth of lending staff, (7) changes in the quality of the loan review function, (8) environmental risks, and (9) loan risk ratings.  Because of the nature of the factors and the difficulty in assessing their impact, management’s resulting estimate of losses may not accurately reflect actual losses in the portfolio.

 

The allowance for loan losses is comprised of impairment losses on loans specifically reviewed and estimated losses on the pools of loans that are collectively reviewed.  Although the allowance for loan losses has two separate components, one for impairment losses on individual loans and one for collective impairment losses on pools of loans, the entire allowance for loan losses is available to absorb realized losses as they occur whether they relate to individual loans or pools of loans.

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Net Interest Income

 

Average Balance Sheet; Interest Rates and Interest Differential.  The following table sets forth the average daily balances for each major category of assets, liabilities and stockholders’ equity as well as the amounts and average rates earned or paid on each major category of interest-earning assets and interest-bearing liabilities.  The average balances of investment securities include unrealized gains and losses on available-for-sale securities.

 

(1)

Tax-equivalent basis.  Interest income on a tax-equivalent basis includes the additional amount of interest income that would have been earned if the Corporation's investment in tax-exempt loans and investment securities had been made in loans and investment securities subject to Federal income taxes yielding the same after-tax income.  The tax-equivalent amount of $1.00 of nontaxable income was $1.52 in each period presented, based on a Federal income tax rate of 34%.

 

(2)	For the purpose of these computations, nonaccruing loans are included in the daily average loan amounts outstanding.

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Rate/Volume Analysis.  The following table sets forth the effect of changes in volumes, rates and rate/volume on tax-equivalent interest income, interest expense and net interest income.

 

(1)	Represents the change not solely attributable to change in rate or change in volume but a combination of these two factors.  The rate/volume variance could be allocated between the volume and rate variances shown in the table based on the absolute value of each to the total for both.

 

Net Interest Income – 2013 Versus 2012

 

Net interest income on a tax-equivalent basis was $69.1 million in 2013, an increase of $2.4 million, or 3.6%, from $66.7 million in 2012.  The increase resulted from an increase in average interest-earning assets of $177.4 million, or 8.9%, as partially offset by a 16 basis point decline in net interest margin.

 

The growth in average interest-earning assets is primarily attributable to increases in the average balances of loans outstanding of $213.2 million, or 19.9%, as partially offset by a decrease in the average balance of taxable securities of $46.2 million, or 8.5%.  Although most of the loan growth occurred in residential and commercial mortgage loans, commercial and industrial loans grew as well.  The Bank’s continued ability to grow loans is attributable to a variety of factors including, among others, competitive pricing, superior customer service, targeted solicitation efforts, advertising campaigns, and broker relationships for both residential and commercial mortgages.

 

Loan growth, to the extent not funded by the decline in taxable securities, was funded by growth in the average balances of noninterest-bearing checking deposits of $99.9 million, or 21.3%, interest-bearing deposits of $69.8 million, or 6.3%, and short-term borrowings of $30.5 million, or 53.2%.  The Bank’s ability to continue to grow deposits is attributable to, among other things, expansion of the Bank’s branch distribution system, targeted solicitation of local commercial businesses and municipalities, new and expanded lending relationships, and the Bank’s positive reputation in its marketplace.

 

Intermediate and long-term interest rates moved up significantly in 2013, but they are still relatively low.  In this low rate environment, despite significant growth in the average balances of loans and noninterest-bearing checking deposits, the Bank’s net interest income only increased by $2.4 million over 2012.  In addition, net interest margin declined by 16 basis points from 3.34% in 2012 to 3.18% in 2013.  A low interest rate environment negatively impacts net interest income and net interest margin primarily because: (1) the benefit of no cost funding in the form of noninterest-bearing checking deposits and capital is reduced; (2) cash received from payments and prepayments of higher yielding loans and securities is often used to originate or purchase lower yielding loans and securities; (3) the rates on some loans are modified downward, while other loans prepay in full resulting in the immediate writeoff of deferred costs; and (4) prepayment speeds on mortgage securities are elevated, thereby necessitating faster amortization of purchase premiums.

 

During 2013, long-term borrowings increased $140 million, from $145 million at December 31, 2012 to $285 million at December 31, 2013.  The increase in long-term borrowings resulted from management’s desire to better match the duration of the Bank’s assets and liabilities and thereby hedge against an eventual increase in interest rates.

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Net Interest Income – 2012 Versus 2011

 

Net interest income on a tax-equivalent basis was $66.7 million in 2012, an increase of $1.8 million, or 2.8%, from $64.9 million in 2011.  The increase resulted from an increase in average interest-earning assets of $204.8 million, or 11.4%, as partially offset by a 29 basis point decline in net interest margin.  The growth in average interest-earning assets was principally comprised of increases in average loans outstanding of $125.7 million, or 13.3%, nontaxable securities of $61.5 million, or 20.2%, and taxable securities of $24.1 million, or 4.7%.  While the average balance of the Bank’s taxable securities portfolio grew moderately when comparing 2012 to 2011, the size of the portfolio declined by $106.9 million, or 17.8%, when comparing year-end 2012 to 2011.  The decline occurred because of the deleveraging transaction and the deployment of funds, when possible, into loans rather than securities.

 

The most significant sources of funding for the growth in the average balances of loans and securities were growth in the average balances of savings, NOW and money market deposits of $93.2 million, or 12.5%, noninterest-bearing checking deposits of $48.3 million, or 11.5%, and borrowings of $31.0 million, or 13.7%.

 

Net interest margin declined from 3.63% in 2011 to 3.34% in 2012 as loans repriced and cash flows were deployed in a very low interest rate environment.  Also contributing to the decline in the net interest margin was the aforementioned refinancing transaction involving the repayment of overnight borrowings with six and seven year term borrowings.

 

Noninterest Income

 

Noninterest income includes service charges on deposit accounts, Investment Management Division income, gains or losses on sales of securities, and all other items of income, other than interest, resulting from the business activities of the Corporation.  Noninterest income (excluding securities gains) increased $454,000, or 6.9%, when comparing 2013 to 2012.  The increase is largely attributable to increases in Investment Management Division income of $248,000, or 15.3%, and other noninterest income of $240,000, or 12.6%.  The increase in Investment Management Division income is due to appreciation in the market value of assets under management and new business.  The $240,000 increase in other noninterest income includes increases in debit and credit card fees of $120,000, or 33.9%, and mortgage assignment and other loan related fees of $82,000, or 29.6%.  Gains on sales of securities decreased by $3.6 million when comparing 2013 to 2012 as a result of the deleveraging transaction in 2012.

 

Noninterest income (excluding securities gains) increased $287,000, or 4.6%, when comparing 2012 to 2011.  The increase was primarily attributable to an increase in Investment Management Division income of $85,000, an increase in mortgage assignment and other loan related fees of $195,000, and a decrease in losses on loans held-for-sale of $103,000.  The positive impact on earnings of these items was partially offset by a decrease in return check charges incurred by the Bank’s customers of $157,000.  Gains on sales of securities increased $3.5 million when comparing 2012 to 2011 as a result of the 2012 deleveraging transaction.

 

Noninterest Expense

 

Noninterest expense is comprised of salaries, employee benefits, occupancy and equipment expense and other operating expenses incurred in supporting the various business activities of the Corporation.  Noninterest expense (excluding debt extinguishment costs) increased $2.1 million, or 5.5%, when comparing 2013 to 2012.  The increase is comprised of increases in salaries of $800,000, or 4.9%, employee benefits expense of $482,000, or 9.6%, occupancy and equipment expense of $404,000, or 5.6%, and other noninterest expense of $374,000, or 4.3%.  The increase in salaries is primarily due to normal annual salary adjustments and additions to staff, as partially offset by a decrease in stock-based compensation expense.  Stock-based compensation expense declined because of a reduction in the estimated number of shares to be issued upon the vesting of restricted stock units and forfeitures of some outstanding awards.  The increase in employee benefits expense is primarily attributable to increases in incentive compensation cost, payroll tax expense and group health insurance expense, as partially offset by a decrease in pension expense.  The increase in occupancy and equipment expense is largely due to increases in general maintenance and repairs expense, snow removal costs, rent expense and the cost of servicing equipment.  The increase in other noninterest expense includes increases in consulting expense and marketing expense and growth-related increases in FDIC insurance expense and the Bank’s OCC assessment.  Debt extinguishment costs of $3.8 million in 2012 resulted from the deleveraging transaction.  Management continues to maintain a strong focus on expense control measures and enhancements in operating efficiency.

 

Noninterest expense (excluding debt extinguishment costs) increased $731,000, or 2.0%, when comparing 2012 to 2011.  The largest components of the increase were increases in salaries of $575,000, depreciation of $148,000, and certain loan related costs of $203,000, as partially offset by a reduction in amounts expensed for the settlement of pending litigation of $448,000.  Salaries increased primarily because of normal annual salary adjustments and additions to both branch and back-office staff.  Depreciation expense increased due to new branch facilities, investments in technology, and the expansion and restoration of existing branch and back-office facilities.  Certain loan related costs increased due to an increased volume of lending.

 

Income Taxes

 

Income tax expense as a percentage of book income (“effective tax rate”) was 21.2% in 2013, 19.7% in 2012 and 20.3% in 2011.  The effective tax rate increased in 2013 as compared to 2012 and 2011 largely because interest income on tax-exempt securities became a smaller percentage of income before income taxes.

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Financial Condition

 

Total assets were $2.4 billion at December 31, 2013, an increase of $291.6 million, or 13.8%, from the previous year-end.  The increase was primarily attributable to growth in loans of $330.6 million, or 28.8%, partially offset by a reduction in investment securities of $44.7 million, or 5.2%.  The increase in volume and change in the mix of the Bank’s interest-earning assets benefited earnings and financial condition by offsetting the decline in net interest margin caused by the persistently low interest rate environment.

 

Asset growth during 2013 was largely funded by deposit growth and an increase in long-term debt. Total deposits grew $149.1 million, or 9.1%, to $1.8 billion, and long-term debt grew $140.0 million, or 96.6%, to $285.0 million, at December 31, 2013.  For the year, noninterest-bearing checking deposits increased $70.2 million, or 13.3%, and savings, NOW and money market deposits increased $73.4 million, or 8.7%.  Stockholders’ equity at year-end 2013 totaled $206.6 million, an increase of $1.2 million from year-end 2012.

 

Investment Securities.  The following table presents the estimated fair value of available-for-sale securities and amortized cost of held-to-maturity securities at December 31, 2013, 2012 and 2011.

 

The following table presents the maturities and weighted average yields of the Bank’s investment securities at December 31, 2013.

 

(1)

Maturities shown are stated maturities, except in the case of municipal securities, which are shown at the earlier of their stated maturity or pre-refunded dates.  Securities backed by mortgages, which include the pass-through mortgage securities and collateralized mortgage obligations shown above, are expected to have substantial periodic repayments resulting in weighted average lives considerably shorter than would be surmised from the above table.

 

(2)	Yields on tax-exempt state and municipal securities have been computed on a tax-equivalent basis.

 

(3)	Yields on available-for-sale securities have been computed based on amortized cost.

 

During 2013, the Bank received cash dividends totaling $507,000 on its Federal Reserve Bank and Federal Home Loan Bank of New York stock, representing an average yield of 3.70%.

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Loans.  The composition of the Bank’s loan portfolio over the past five years is set forth below.

 

Commercial mortgage loans outstanding at December 31, 2013 include $973,000 of variable rate construction loans due within one year.

Maturity and rate information for the Bank’s commercial and industrial loans outstanding at December 31, 2013 is set forth below.

 

 

Asset Quality.  The Corporation has identified certain assets as risk elements.  These assets include nonaccrual loans, other real estate owned, loans that are contractually past due 90 days or more as to principal or interest payments and still accruing and troubled debt restructurings.  These assets present more than the normal risk that the Corporation will be unable to eventually collect or realize their full carrying value.  Information about the Corporation’s risk elements is set forth below.

 

(1)	Includes loans held-for-sale

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The past due status of a loan is based on the contractual terms in the loan agreement.  Unless a loan is well secured and in the process of collection, the accrual of interest income is discontinued when a loan becomes 90 days past due as to principal or interest payments.  The accrual of interest income on a loan is also discontinued when it is determined that the borrower will not be able to make principal and interest payments according to the contractual terms of the current loan agreement.  When the accrual of interest income is discontinued on a loan, any accrued but unpaid interest is reversed against current period income.

 

In addition to the Bank’s past due, nonaccrual and restructured loans, the disclosure of other potential problem loans can be found in “Note C – Loans” to the Corporation’s consolidated financial statements of this Form 10-K.

 

Loan Risk Ratings.  Risk ratings of the Corporation’s commercial and industrial loans and commercial real estate loans are set forth in the tables below.  Risk ratings are defined in “Note C – Loans” to the Corporation’s consolidated financial statements of this Form 10-K.

 

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Risk ratings of the Corporation’s residential mortgage loans, home equity lines and other consumer loans are set forth in the tables below.  Risk ratings are defined in “Note C – Loans” to the Corporation’s consolidated financial statements of this Form 10-K.