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SB FINANCIAL GROUP, INC. - Quarter Report: 2016 September (Form 10-Q)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2016

 

OR

 

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

 

For the transition period from _______ to________

 

Commission file number 1-36785

 

SB FINANCIAL GROUP, INC.

(Exact name of registrant as specified in its charter)

 

Ohio   34-1395608
(State or other jurisdiction of   (I.R.S. Employer Identification No.)
incorporation or organization)    

 

401 Clinton Street, Defiance, Ohio 43512

 

(Address of principal executive offices)

(Zip Code)

 

(419) 783-8950

 

(Registrant’s telephone number, including area code)

 

N/A

 

(Former name, former address and former fiscal year, if changed since last report.)

 

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

 

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

 

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.

 

Large Accelerate Filer ☐    Accelerated Filer ☐    Non-Accelerated Filer ☐    Smaller Reporting Company   ☒

 

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

 

Title of each class   Name of each exchange on which registered
Common Shares, No Par Value   The NASDAQ Stock Market, LLC

4,852,551 Outstanding at November 14, 2016

  (NASDAQ Capital Market)

 

 

 

 

 

 

SB FINANCIAL GROUP, INC.

 

FORM 10-Q

 

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION  
     
Item 1. Financial Statements 1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29
Item 3. Quantitative and Qualitative Disclosures About Market Risk 41
Item 4. Controls and Procedures 41
     
PART II – OTHER INFORMATION  
     
Item 1. Legal Proceedings 42
Item 1A. Risk Factors 42
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 42
Item 3. Defaults Upon Senior Securities 42
Item 4. Mine Safety Disclosures 42
Item 5. Other Information 42
Item 6. Exhibits 42
    42
Signatures 43

 

 

 

 

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

SB Financial Group, Inc.

Condensed Consolidated Balance Sheets
September 30, 2016 and December 31, 2015

 

   September   December 
($ in Thousands)  2016   2015 
ASSETS  (Unaudited)     
Cash and due from banks  $25,167   $20,459 
Securities available for sale, at fair value   92,689    89,789 
Other securities - FRB and FHLB Stock   3,748    3,748 
Total investment securities   96,437    93,537 
           
Loans held for sale   5,865    7,516 
Loans, net of unearned income   619,352    557,659 
Allowance for loan losses   (7,320)   (6,990)
Net loans   612,032    550,669 
           
Premises and equipment, net   18,673    19,010 
Cash surrender value of life insurance   13,653    13,437 
Goodwill & other intangibles   16,426    16,435 
Foreclosed assets held for sale, net   73    286 
Mortgage servicing rights   6,887    7,152 
Accrued interest receivable   1,641    1,260 
Other assets   4,946    3,310 
Total assets  $801,800   $733,071 
           
LIABILITIES AND EQUITY          
Deposits          
Non interest bearing demand  $116,976   $113,113 
Interest bearing demand   135,729    126,443 
Savings   89,265    83,447 
Money market   126,501    104,412 
Time deposits   193,673    159,038 
Total deposits   662,144    586,453 
           
Advances from Federal Home Loan Bank   23,000    35,000 
Repurchase agreements   11,363    12,406 
Trust preferred securities   10,310    10,310 
Accrued interest payable   427    264 
Other liabilities   8,293    7,397 
Total liabilities   715,537    651,830 
           
Commitments & Contingent Liabilities   -    - 
           
Stockholders' Equity          
Preferred stock, Series A   13,983    13,983 
Common stock   12,569    12,569 
Additional paid-in capital   15,370    15,438 
Retained earnings   44,933    40,059 
Accumulated other comprehensive income   1,237    650 
Treasury stock, at cost   (1,829)   (1,458)
Total equity   86,263    81,241 
Total liabilities and equity  $801,800   $733,071 

 

See notes to condensed consolidated financial statements (unaudited)

 

Note: The balance sheet at December 31, 2015 has been derived from the audited consolidated financial statements at that date

 1 
 

 

SB FINANCIAL GROUP, INC.  

CONDENSED CONSOLIDATED STATEMENTS OF INCOME - (Unaudited)

 

($ in thousands, except share data)  Three Months Ended   Nine Months Ended 
   September   September   September   September 
Interest income  2016   2015   2016   2015 
Loans                
Taxable  $6,954    6,152    19,862    17,606 
Nontaxable   22    10    55    25 
Securities                    
Taxable   378    382    1,172    1,149 
Nontaxable   145    173    450    525 
Total interest income   7,499    6,717    21,539    19,305 
                     
Interest expense                    
Deposits   677    492    1,869    1,487 
Repurchase Agreements & Other   5    5    14    14 
Federal Home Loan Bank advances   83    94    266    280 
Trust preferred securities   63    53    184    157 
Total interest expense   828    644    2,333    1,938 
                     
Net interest income   6,671    6,073    19,206    17,367 
                     
Provision for loan losses   -    100    250    950 
                     
Net interest income after provision for loan losses   6,671    5,973    18,956    16,417 
                     
Noninterest income                    
Wealth Management Fees   695    636    1,971    1,961 
Customer service fees   692    734    2,052    2,068 
Gain on sale of mtg. loans & OMSR's   2,503    1,687    6,170    4,892 
Mortgage loan servicing fees, net   205    98    (514)   642 
Gain on sale of non-mortgage loans   327    296    927    872 
Data service fees   223    294    733    917 
Net gain on sale of securities   59    -    262    - 
Gain/(loss) on sale/disposal of assets   (31)   -    177    (20)
Other income   342    207    983    659 
Total non-interest income   5,015    3,952    12,761    11,991 
                     
Noninterest expense                    
Salaries and employee benefits   4,672    3,650    12,765    11,062 
Net occupancy expense   523    481    1,612    1,464 
Equipment expense   649    568    1,883    1,657 
Data processing fees   352    286    996    796 
Professional fees   380    416    1,022    1,282 
Marketing expense   123    146    493    437 
Telephone and communication   101    96    302    284 
Postage and delivery expense   154    198    513    633 
State, local and other taxes   170    130    440    387 
Employee expense   117    126    363    417 
Intangible amortization expense   3    54    9    163 
Other expenses   686    475    1,834    1,506 
Total non-interest expense   7,930    6,626    22,232    20,088 
                     
Income before income tax expense   3,756    3,299    9,485    8,320 
Income tax expense   1,209    1,035    3,018    2,569 
Net income  $2,547    2,264    6,467    5,751 
                     
Preferred Stock Dividends   244    244    731    712 
                     
Net income available to common shareholders   2,303    2,020    5,736    5,039 
                     
Basic earnings per common share  $0.47    0.41    1.17    1.03 
Diluted earnings per common share  $0.40    0.35    1.01    0.89 
                     
Dividends per common share  $0.060    0.050    0.175    0.145 
                     
Average common shares outstanding (in thousands):                    
Basic:   4,874    4,884    4,888    4,882 
Diluted:   6,376    6,390    6,384    6,422 

  

See notes to condensed consolidated financial statements (unaudited)

 2 
 

 

SB Financial Group, Inc.

Condensed Consolidated Statements of Comprehensive Income (unaudited)

 

   Three Months Ended
Sep. 30,
   Nine Months Ended
Sep. 30,
 
($'s in thousands)  2016   2015   2016   2015 
Net income  $2,547   $2,264   $6,467   $5,751 
Other comprehensive income:                    
Available-for-sale investment securities:                    
Gross unrealized holding gain (loss) arising in the period   (418)   617    1,151    362 
Related tax (expense)/benefit   142    (210)   (391)   (123)
Less: Reclassification for gain realized in income   (59)   -    (262)   - 
Related tax expense   20    -    89    - 
Net effect on other comprehensive income   (315)   407    587    239 
Total comprehensive income  $2,232   $2,671   $7,054   $5,990 

 

See notes to condensed consolidated financial statements (unaudited)

 

 3 
 

 

SB Financial Group, Inc.

Condensed Consolidated Statements of Shareholders’ Equity (unaudited)

 

   Preferred   Common   Additional Paid-in   Retained   Accumulated Other Comprehensive   Treasury     
($'s in thousands)  Stock   Stock   Capital   Earnings   Income   Stock   Total 
                             
Balance, January 1, 2016  $13,983   $12,569   $15,438   $40,059   $650   $(1,458)  $81,241 
Net Income                  6,467              6,467 
Other Comprehensive Income                       587         587 
Dividends on Common Stk., $0.175 per share                  (862)             (862)
Dividends on Preferred Stk., $0.4875 per share                  (731)             (731)
Issuance of Restricted Stock and Stock Options             (154)             253    99 
Stock Repurchase                            (624)   (624)
Share based compensation expense             86                   86 
Balance, September 30, 2016  $13,983   $12,569   $15,370   $44,933   $1,237   $(1,829)  $86,263 
                                    
Balance, January 1, 2015  $13,983   $12,569   $15,461   $34,379   $918   $(1,627)  $75,683 
Net Income                  5,751              5,751 
Other Comprehensive Income                       239         239 
Dividends on Common Stk., $0.145 per share                  (713)             (713)
Dividends on Preferred Stk., $0.475 per share                  (712)             (712)
Issuance of Restricted Stock and Stock Options             (78)             96    18 
Stock Repurchase                            (2)   (2)
Share based compensation expense             61                   61 
Balance, September 30, 2015  $13,983   $12,569   $15,444   $38,705   $1,157   $(1,533)  $80,325 

  

See notes to condensed consolidated financial statements (unaudited)

  

 4 
 

 

SB Financial Group, Inc.

Condensed Consolidated Statements of Cash Flows (Unaudited)

 

   Nine Months Ended
Sep. 30,
 
($'s in thousands)  2016   2015 
Operating Activities        
Net Income  $6,467   $5,751 
Items providing/(using) cash          
Depreciation and amortization   892    795 
Provision for loan losses   250    950 
Expense of share-based compensation plan   86    61 
Amortization of premiums and discounts on securities   688    744 
Amortization of intangible assets   9    163 
Amortization of originated mortgage servicing rights   879    725 
Recapture of originated mortgage servicing rights impairment   (71)   (269)
Impairment of mortgage servicing rights   1,236    218 
Proceeds from sale of loans held for sale   249,159    224,090 
Originations of loans held for sale   (241,732)   (216,963)
Gain from sale of loans   (7,098)   (5,764)
(Gain)/loss on sale of assets   (150)   20 
Changes in          
Interest receivable   (381)   (471)
Other assets   (2,848)   (8,276)
Interest payable and other liabilities   1,059    3,535 
Net cash provided by operating activities   8,445    5,309 
           
Investing Activities          
Purchases of available-for-sale securities   (17,572)   (25,456)
Proceeds from maturities of available-for-sale securities   11,923    14,830 
Proceeds from sales of available-for-sale-securities   2,950    - 
Net change in loans   (61,932)   (25,233)
Purchase of premises and equipment and software   (517)   (4,846)
Proceeds from sales or disposal of premises and equipment   96    36 
Proceeds from sale of foreclosed assets   785    110 
Net cash used in investing activities   (64,267)   (40,559)
           
Financing Activities          
Net  increase in demand deposits, money market, interest checking and savings accounts   41,056    27,018 
Net increase (decrease) in certificates of deposit   34,635    (4,356)
Net increase in securities sold under agreements to repurchase   (1,043)   4,171 
Repayment of Federal Home Loan Bank advances   (14,000)   (4,000)
Proceeds from Federal Home Loan Bank advances   2,000    4,000 
Net proceeds from share based compensation plans   99    18 
Repurchase of common stock   (624)   (2)
Dividends on common stock   (862)   (713)
Dividends on preferred stock   (731)   (712)
Net cash provided by financing activities   60,530    25,425 
           
Increase in Cash and Cash Equivalents   4,708    (9,825)
           
Cash and Cash Equivalents, Beginning of Year   20,459    28,197 
Cash and Cash Equivalents, End of Period  $25,167   $18,372 
           
Supplemental Cash Flows Information          
           
Interest paid  $2,170   $1,861 
Income taxes paid  $3,479   $1,650 
Transfer of loans to foreclosed assets  $319   $35 

 

See notes to condensed consolidated financial statements (unaudited)

 

 5 
 

 

SB FINANCIAL GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

NOTE 1—BASIS OF PRESENTATION

 

SB Financial Group, Inc., an Ohio corporation (the “Company”) is a bank holding company whose principal activity is the ownership and management of its wholly-owned subsidiaries, The State Bank and Trust Company (“State Bank”), RFCBC, Inc. (“RFCBC”), Rurbanc Data Services, Inc. dba RDSI Banking Systems (“RDSI”), and Rurban Statutory Trust II (“RST II”). In addition, State Bank owns all of the outstanding stock of Rurban Mortgage Company (“RMC”) and State Bank Insurance, LLC (“SBI”).

 

The consolidated financial statements include the accounts of the Company, State Bank, RFCBC, RDSI, RMC, and SBI. All significant intercompany accounts and transactions have been eliminated in consolidation.

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The financial statements reflect all adjustments that are, in the opinion of management, necessary to fairly present the financial position, results of operations and cash flows of the Company. Those adjustments consist only of normal recurring adjustments. Results of operations for the nine months ended September 30, 2016, are not necessarily indicative of results for the complete year.

 

The condensed consolidated balance sheet of the Company as of December 31, 2015 has been derived from the audited consolidated balance sheet of the Company as of that date.

 

For further information, refer to the consolidated financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

 

The following paragraphs summarize the impact of new accounting pronouncements:

 

Accounting Standards Update (ASU) No. 2016-13: Financial Instruments – Credit Losses (Topic 326)

 

This ASU replaces the current GAAP incurred impairment methodology regarding credit losses with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments in this update affect an entity to varying degrees depending on the credit quality of the assets held by the entity, their duration, and how the entity applies current GAAP. The amendments in this ASU are effective for reporting periods beginning after December 15, 2019, and management will need further study to determine the impact on the Company’s consolidated financial statements.

 

ASU No. 2016-09: Stock Compensation (Topic 718)

 

This ASU affects all entities that issue share-based payment awards to their employees. The update is intended to simplify the accounting for these transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and management will need further study to determine the impact on the Company’s consolidated financial statements.

 

ASU No. 2016-06: Derivatives and Hedging (Topic 815)

 

This ASU clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. An entity performing the assessment under the amendments in this Update is required to assess the embedded call (put) options solely in accordance with the four-step decision sequence. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and management does not believe this ASU will have a material impact on the Company’s consolidated financial statements.

 

 6 
 

 

ASU No. 2016-05: Derivatives and Hedging (Topic 815)

 

This ASU clarifies that a change in the counterparty to a derivative instrument that has been designated as the hedging instrument under Topic 815 does not, in and of itself, require dedesignation of that hedging relationship provided that all other hedging accounting criteria continue to be met. The amendments in this ASU are effective for reporting periods beginning after December 15, 2016, and management does not believe this ASU will have a material impact on the Company’s consolidated financial statements.

 

ASU No. 2016-02: Leases (Topic 842)

 

This ASU is intended to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The amendments in this ASU are effective for reporting periods beginning after December 15, 2019, and management will need further study to determine the impact on the Company’s consolidated financial statements.

 

ASU No. 2016-01: Financial Instruments – Recognition and measurement of financial assets and financial liabilities (Subtopic 825-10)

 

This ASU makes targeted improvements to generally accepted accounting principles. Specifically, the amendments require equity securities with readily determinable fair values be classified into different categories and require equity securities to be measured at fair value with changes in the fair value recognized through net income. The amendments in this ASU are effective for reporting periods beginning after December 15, 2017, and management does not believe this ASU will have a material impact on the Company’s consolidated financial statements.

 

ASU No. 2015-16: Business Combinations (Topic 805)

 

This ASU requires an acquirer to recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. Further, an entity must present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings that would have been recorded previously if the provisional amounts had been recorded as of the acquisition date. The amendments in this ASU are in effect, and they did not have a material impact on the Company’s consolidated financial statements.

 

ASU No. 2015-15: Interest – Imputation of Interest (Subtopic 835-30)

 

This ASU requires entities to present debt issuance costs related to a recognized debt liability as a direct deduction from the carrying amount of that debt liability. The amendments in this ASU are in effect, and they did not have a material impact on the Company’s consolidated financial statements.

 

ASU No. 2015-14: Revenue from Contracts with Customers (Subtopic 606)

 

This ASU defers by one year the effective date of the guidance in ASU 2014-09. The amendments in this ASU are now effective for reporting periods beginning after December 15, 2017, and management still does not believe this ASU will have a material impact on the Company’s consolidated financial statements.

  

 7 
 

  

NOTE 2—EARNINGS PER SHARE

 

Earnings per share (EPS) have been computed based on the weighted average number of common shares outstanding during the periods presented. For the period ended September 30, 2016, share-based awards totaling 0 common shares were not considered in computing diluted EPS as they were anti-dilutive. For the period ended September 30, 2015, share-based awards totaling 50,424 common shares were not considered in computing diluted EPS as they were anti-dilutive. Included in the diluted EPS for September 30, 2016 are the impact of the full conversion of the Company’s depository shares issued in December of 2014. Based upon the current conversion ratio, the 1,500,000 outstanding depository shares are convertible into an aggregate of 1,454,702 common shares. The average number of common shares used in the computation of basic and diluted earnings per share were:

 

   Three Months Ended
Sep. 30,
 
($ in thousands - except per share data)  2016   2015 
Distributed earnings allocated to common shares  $295   $246 
Undistributed earnings allocated to common shares   2,005    1,773 
Net earnings allocated to common shares   2,300    2,019 
Net earnings allocated to participating securities   3    1 
Dividends on convertible preferred shares   244    244 
Net Income allocated to common shares and participating securities  $2,547   $2,264 
           
Weighted average shares outstanding for basic earnings per share   4,874    4,884 
Dilutive effect of stock compensation   47    55 
Dilutive effect of convertible shares   1,455    1,451 
Weighted average shares outstanding for diluted earnings per share   6,376    6,390 
           
Basic earnings per common share  $0.47   $0.41 
Diluted earnings per common share  $0.40   $0.35 

 

   Nine Months Ended
Sep. 30,
 
($ in thousands - except per share data)  2016   2015 
Distributed earnings allocated to common shares  $862   $713 
Undistributed earnings allocated to common shares       4,868    4,322 
Net earnings allocated to common shares   5,730    5,035 
Net earnings allocated to participating securities   6    4 
Dividends on convertible preferred shares       731    712 
Net Income allocated to common shares and participating securities  $6,467   $5,751 
           
Weighted average shares outstanding for basic earnings per share   4,888    4,882 
Dilutive effect of stock compensation   41    89 
Dilutive effect of convertible shares   1,455    1,451 
Weighted average shares outstanding for diluted earnings per share   6,384    6,422 
           
Basic earnings per common share  $1.17   $1.03 
Diluted earnings per common share  $1.01   $0.89 

 

 8 
 

 

Note 3 - Securities

 

The amortized cost and appropriate fair values, together with gross unrealized gains and losses, of securities at September 30, 2016 and December 31, 2015 were as follows:

 

       Gross   Gross     
($ in thousands)  Amortized   Unrealized   Unrealized     
   Cost   Gains   Losses   Fair Value 
Available-for-Sale Securities:                
September 30, 2016                
U.S. Treasury and Government agencies  $13,920   $115   $(2)  $14,033 
Mortgage-backed securities   61,882    905    (27)   62,760 
State and political subdivisions   14,990    884    (1)   15,873 
Equity securities   23    -    -    23 
                     
   $90,815   $1,904   $(30)  $92,689 

 

       Gross   Gross     
($ in thousands)  Amortized   Unrealized   Unrealized     
   Cost   Gains   Losses   Fair Value 
Available-for-Sale Securities:                
December 31, 2015:                
U.S. Treasury and Government agencies  $10,804   $101   $-   $10,905 
Mortgage-backed securities   61,459    311    (427)   61,343 
State and political subdivisions   16,519    999    -    17,518 
Equity securities   23    -    -    23 
                     
   $88,805   $1,411   $(427)  $89,789 

 

 9 
 

 

The amortized cost and fair value of securities available for sale at September 30, 2016, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Available for Sale 
   Amortized   Fair 
($ in thousands)  Cost   Value 
         
Within one year  $442   $447 
Due after one year through five years   7,473    7,696 
Due after five years through ten years   6,836    7,143 
Due after ten years   14,159    14,620 
    28,910    29,906 
           
Mortgage-backed securities & equity securities   61,905    62,783 
           
Totals  $90,815   $92,689 

 

The fair value of securities pledged as collateral, to secure public deposits and for other purposes, was $76.6 million at September 30, 2016 and $42.6 million at December 31, 2015. The fair value of securities delivered for repurchase agreements were $15.8 million at September 30, 2016 and $15.8 million at December 31, 2015.

 

For the nine months ended September 30, 2016, there were gross gains of $0.26 million resulting from sales of available-for-sale securities, which was a reclassification from accumulated other comprehensive income (OCI) and was included in the net gain on sale of securities. The related $0.09 million in tax expense was a reclassification from OCI and was included in the income tax expense line item in the income statement. There were no realized gains and losses from sales of available-for-sale securities for the nine months ended September 30, 2015.

 

Certain investments in debt securities are reported in the financial statements at an amount less than their historical cost. Total fair value of these investments was $8.3 million at September 30, 2016, and $37.2 million at December 31, 2015, which was approximately 9 and 34 percent, respectively, of the Company’s available-for-sale investment portfolio at such dates. Based on evaluation of available evidence, including recent changes in market interest rates, credit rating information and information obtained from regulatory filings, management believes the declines in fair value for these securities are temporary. Should the impairment of any of these securities become other than temporary, the cost basis of the investment will be reduced and the resulting loss recognized in net income in the period the other-than-temporary impairment is identified.

 

 10 
 

 

Securities with unrealized losses, aggregated by investment class and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2016 and December 31, 2015 are as follows:

 

($ in thousands)  Less than 12 Months   12 Months or Longer   Total 
September 30, 2016  Fair Value   Unrealized Losses   Fair Value   Unrealized Losses   Fair Value   Unrealized Losses 
Available-for-Sale Securities:                        
U.S. Treasury and Government agencies  $2,598   $(2)  $-   $-   $2,598   $(2)
Mortgage-backed securities  $882   $(16)  $4,011   $(11)  $4,893   $(27)
State and Political subdivisions  $796   $(1)  $0   $0   $796   $(1)
                               
   $4,276   $(19)  $4,011   $(11)  $8,287   $(30)

 

($ in thousands)  Less than 12 Months   12 Months or Longer   Total 
December 31, 2015  Fair Value   Unrealized Losses   Fair Value   Unrealized Losses   Fair Value   Unrealized Losses 
Available-for-Sale Securities:                        
Mortgage-backed securities  $30,184   $(253)  $7,061   $(174)  $37,245   $(427)
                               
   $30,184   $(253)  $7,061   $(174)  $37,245   $(427)

  

The total potential unrealized loss as of September 30, 2016 in the securities portfolio was $0.03 million, which was down from the $0.43 million unrealized loss at December 31, 2015. Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concern warrants such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent of the Company to not sell the investment and whether it is more likely than not that the Company will be required to sell the security before recovery of its amortized cost. Management has determined there is no other-than-temporary-impairment on these securities.

 

NOTE 4 – LOANS AND ALLOWANCE FOR LOAN LOSSES

 

Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoffs, are reported at their outstanding principal balances adjusted for any charge-offs, the allowance for loan losses, any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans. Interest income is reported on the interest method and includes amortization of net deferred loan fees and costs over the loan term. Generally, all loan classes are placed on non-accrual status not later than 90 days past due, unless the loan is well-secured and in the process of collection. All interest accrued, but not collected, for loans that are placed on non-accrual or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income. Loan losses are charged against the allowance when management believes the non-collectability of a loan balance is probable. Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as new information becomes available.

 

The allowance consists of allocated and general components. The allocated component relates to loans that are classified as impaired. For those loans that are classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical charge-off experience and expected loss given default derived from the Company’s internal risk rating process. Other adjustments may be made to the allowance for pools of loans after an assessment of internal or external influences on credit quality that are not fully reflected on the historical loss or risk rating data.

 

 11 
 

 

A loan is considered impaired when, based on current information and events, it is probable that State Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration each 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 the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis for commercial, agricultural, and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price or the fair value of the collateral if the loan is collateral dependent.

 

When State Bank moves a loan to non-accrual status, total unpaid interest accrued to date is reversed from income. Subsequent payments are applied to the outstanding principal balance with the interest portion of the payment recorded on the balance sheet as a contra-loan. Interest received on impaired loans may be realized once all contractual principal amounts are received or when a borrower establishes a history of six consecutive timely principal and interest payments. It is at the discretion of management to determine when a loan is placed back on accrual status upon receipt of six consecutive timely payments.

 

Large groups of smaller balance homogenous loans are collectively evaluated for impairment. Accordingly, State Bank does not separately identify individual consumer and residential loans for impairment measurements, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

  

Categories of loans at September 30, 2016 and December 31, 2015 include:

 

   Total Loans   Non-Accrual Loans 
($ in thousands)  Sept. 2016   Dec. 2015   Sept. 2016   Dec. 2015 
                 
Commercial & Industrial  $100,951   $86,542    146    188 
Commercial RE & Construction   268,408    242,208    1,393    5,670 
Agricultural & Farmland   54,609    43,835    5    7 
Residential Real Estate   139,757    130,806    1,152    749 
Consumer & Other   55,333    54,224    193    32 
                     
Total Loans  $619,058   $557,615   $2,889   $6,646 
                     
Unearned Income  $294   $44           
                     
Total Loans, net of unearned income  $619,352   $557,659           
                     
Allowance for loan losses  $(7,320)  $(6,990)          

  

 12 
 

 

The following tables present the activity in the allowance for loan losses and the recorded investment in loans based on portfolio segment and impairment method as of September 30, 2016, December 31, 2015 and September 30, 2015.

 

   Commercial   Commercial
RE &
   Agricultural   Residential   Consumer     
   & Industrial   Construction   & Farmland   Real Estate   & Other   Total 
                         
ALLOWANCE FOR LOAN AND LEASE LOSSES    
For the Three Months Ended - September 30, 2016            
                         
Beginning balance  $1,137   $4,126   $189   $1,342   $656   $7,450 
Charge Offs   (42)   (30)   -    -    (64)  $(136)
Recoveries   1    -    1    1    3    6 
Provision   155    (960)   142    460    203    - 
Ending Balance  $1,251   $3,136   $332   $1,803   $798   $7,320 
                               
For the Nine Months Ended - September 30, 2016                 
                               
Beginning balance  $914   $3,886   $204   $1,312   $674   $6,990 
Charge Offs   (134)   (30)   -    -    (68)  $(232)
Recoveries   248    6    2    1    55    312 
Provision   223    (726)   126    490    137    250 
Ending Balance  $1,251   $3,136   $332   $1,803   $798   $7,320 
                               
Loans Receivable at September 30, 2016           
Allowance:                              
Ending balance:                              
individually evaluated for impairment  $-   $127   $-   $148   $19   $294 
Ending balance:                              
collectively evaluated for impairment  $1,251   $3,009   $332   $1,655   $779   $7,026 
Loans:                              
Ending balance:                              
individually evaluated for impairment  $-   $1,772   $-   $1,874   $346   $3,992 
Ending balance:                              
collectively evaluated for impairment  $100,951   $266,636   $54,609   $137,883   $54,987   $615,066 

  

 13 
 

 

   Commercial   Commercial
RE &
   Agricultural   Residential   Consumer     
($'s in thousands)  & Industrial   Construction   & Farmland   Real Estate   & Other   Total 
                         
Loans Receivable at December 31, 2015                
Allowance:                        
Ending balance:                        
individually evaluated for impairment  $-   $1,759   $-   $167   $37   $1,963 
Ending balance:                              
collectively evaluated for impairment  $914   $2,127   $204   $1,145   $637   $5,027 
Loans:                              
Ending balance:                              
individually evaluated for impairment  $126   $5,754   $-   $1,713   $464   $8,057 
Ending balance:                              
collectively evaluated for impairment  $86,416   $236,454   $43,835   $129,093   $53,760   $549,558 

 

   Commercial   Commercial RE &   Agricultural   Residential   Consumer     
($'s in thousands)  & Industrial   Construction   & Farmland   Real Estate   & Other   Total 
                         
ALLOWANCE FOR LOAN AND LEASE LOSSES    
For the Three Months Ended - September 30, 2015            
                         
Beginning balance  $1,488   $3,066   $261   $1,410   $781   $7,006 
Charge Offs   -    (53)   -    (4)   (1)  $(58)
Recoveries   1    -    1    23    4    29 
Provision   (621)   997    (40)   (154)   (82)   100 
Ending Balance  $868   $4,010   $222   $1,275   $702   $7,076 
                               
For the Nine Months Ended - September 30, 2015                        
                               
Beginning balance  $1,630   $2,857   $208   $1,308   $768   $6,771 
Charge Offs   (309)   (303)   -    (65)   (34)  $(711)
Recoveries   22    3    3    28    10    66 
Provision   (475)   1,453    11    4    (43)   950 
Ending Balance  $868   $4,010   $222   $1,275   $701   $7,076 

  

The risk characteristics of each loan portfolio segment are as follows:

 

Commercial and Agricultural

 

Commercial and agricultural loans are primarily based on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. The cash flows of borrowers, however, may not be as expected and the collateral securing these loans may fluctuate in value. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and may include a personal guarantee. Short-term loans may be made on an unsecured basis. In the case of loans secured by accounts receivable, the availability of funds for the repayment of these loans may be substantially dependent on the ability of the borrower to collect amounts due from its customers.

 

 14 
 

 

Commercial Real Estate including Construction

 

Commercial real estate loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Commercial real estate lending typically involves higher loan principal amounts and the repayment of these loans is generally dependent on the successful operation of the property securing the loan or the business conducted on the property securing the loan. Commercial real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The characteristics of properties securing the Company’s commercial real estate portfolio are diverse, but with geographic location almost entirely in the Company’s market area. Management monitors and evaluates commercial real estate loans based on collateral, geography and risk grade criteria. In general, the Company avoids financing single purpose projects unless other underwriting factors are present to help mitigate risk. In addition, management tracks the level of owner-occupied commercial real estate versus non-owner-occupied loans.

 

Construction loans are underwritten utilizing feasibility studies, independent appraisal reviews and financial analysis of the developers and property owners. Construction loans are generally based on estimates of costs and value associated with the completed project. These estimates may be inaccurate. Construction loans often involve the disbursement of substantial funds with repayment substantially dependent on the success of the ultimate project. Sources of repayment for these types of loans may be pre-committed permanent loans from approved long-term lenders, sales of developed property or an interim loan commitment from the Company until permanent financing is obtained. These loans are closely monitored by on-site inspections and are considered to have higher risks than other real estate loans due to their ultimate repayment being sensitive to interest rate changes, governmental regulation of real property, general economic conditions and the availability of long-term financing.

 

Residential and Consumer

 

Residential and consumer loans consist of two segments – residential mortgage loans and personal loans. Residential mortgage loans are secured by 1-4 family residences and are generally owner-occupied, and the Company generally establishes a maximum loan-to-value ratio and requires private mortgage insurance if that ratio is exceeded. Home equity loans are typically secured by a subordinate interest in 1-4 family residences, and consumer personal loans are secured by consumer personal assets, such as automobiles or recreational vehicles. Some consumer personal loans are unsecured, such as small installment loans and certain lines of credit. Repayment of these loans is primarily dependent on the personal income of the borrowers, which can be impacted by economic conditions in their market areas, such as unemployment levels. Repayment can also be impacted by changes in property values on residential properties. Risk is mitigated by the fact that these loans are of smaller individual amounts and spread over a large number of borrowers.

  

 15 
 

  

The following tables present the credit risk profile of the Company’s loan portfolio based on rating category and payment activity as of September 30, 2016 and December 31, 2015.

 

September 30, 2016  Commercial   Commercial
RE &
   Agricultural   Residential   Consumer     
($ in thousands)  & Industrial   Construction   & Farmland   Real Estate   & Other   Total 
                         
1-2  $1,207   $44   $40   $338   $4   $1,633 
3   27,841    84,276    9,661    111,581    52,185    285,544 
4   71,312    176,270    44,908    25,801    2,824    321,115 
Total Pass (1 - 4)   100,360    260,590    54,609    137,720    55,013    608,292 
                               
Special Mention (5)   -    4,419    -    566    62    5,047 
Substandard (6)   150    2,006    -    408    64    2,628 
Doubtful (7)   441    1,394    -    1,063    193    3,091 
Loss (8)   -    -    -    -    -    - 
Total Loans  $100,951   $268,408   $54,609   $139,757   $55,333   $619,058 

 

December 31, 2015  Commercial   Commercial RE &   Agricultural   Residential   Consumer     
($ in thousands)  & Industrial   Construction   & Farmland   Real Estate   & Other   Total 
                         
1-2  $709   $767   $47   $-   $15   $1,538 
3   23,362    79,915    8,195    118,463    50,745    280,680 
4   61,799    149,473    35,593    10,418    3,223    260,506 
Total Pass (1 - 4)   85,870    230,155    43,835    128,881    53,983    542,724 
                               
Special Mention (5)   330    5,260    -    756    70    6,416 
Substandard (6)   110    1,072    -    420    139    1,741 
Doubtful (7)   232    5,721    -    749    32    6,734 
Loss (8)   -    -    -    -    -    - 
Total Loans  $86,542   $242,208   $43,835   $130,806   $54,224   $557,615 

  

The Company evaluates the loan risk grading system definitions and allowance for loan loss methodology on an ongoing basis.

 

Credit Risk Profile

The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes loans with an outstanding balance greater than $100 thousand and non-homogeneous loans, such as commercial and commercial real estate loans. This analysis is performed on a quarterly basis. The Company uses the following definitions for risk ratings:

 

Pass (grades 1 – 4): Loans which management has determined to be performing as expected and in agreement with the terms established at the time of loan origination.

 

Special Mention (5): Assets have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date. Special mention assets are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification. Ordinarily, special mention credits have characteristics which corrective management action would remedy.

 

Substandard (6): Loans are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

 

 16 
 

 

Doubtful (7): Loans classified as doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of current known facts, conditions and values, highly questionable and improbable.

 

Loss (8): Loans are considered uncollectable and of such little value that continuing to carry them as assets on the Company’s financial statement is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

 

The following tables present the Company’s loan portfolio aging analysis as of September 30, 2016 and December 31, 2015.

 

($ in thousands)  30-59 Days   60-89 Days   Greater Than   Total Past       Total Loans 
September 30, 2016  Past Due   Past Due   90 Days   Due   Current   Receivable 
                         
Commercial & Industrial  $-   $-   $110   $110   $100,841   $100,951 
Commercial RE & Construction   56    909    1,135    2,100    266,308    268,408 
Agricultural & Farmland   -    -    -    -    54,609    54,609 
Residential Real Estate   -    55    233    288    139,469    139,757 
Consumer & Other   17    51    181    249    55,084    55,333 
Total Loans  $73   $1,015   $1,659   $2,747   $616,311   $619,058 

 

($ in thousands)  30-59 Days   60-89 Days   Greater Than   Total Past       Total Loans 
December 31, 2015  Past Due   Past Due   90 Days   Due   Current   Receivable 
                         
Commercial & Industrial  $-   $60   $188   $248   $86,294   $86,542 
Commercial RE & Construction   99    -    5,280    5,379    236,829    242,208 
Agricultural & Farmland   -    -    -    -    43,835    43,835 
Residential Real Estate   98    198    156    452    130,354    130,806 
Consumer & Other   64    -    2    66    54,158    54,224 
Total Loans  $261   $258   $5,626   $6,145   $551,470   $557,615 

  

All loans past due 90 days are systematically placed on nonaccrual status.

 

A loan is considered impaired, in accordance with the impairment accounting guidance (ASC 310-10-35-16), when based on current information and events, it is probable State Bank will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming commercial loans but also include loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in the interest rate on the loan, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collection.

  

 17 
 

 

The following tables present impaired loan information as of and for the three and nine months ended September 30, 2016 and 2015, and for the twelve months ended December 31, 2015:

 

Nine Months Ended
September 30, 2016
  Recorded   Unpaid Principal   Related   Average Recorded   Interest Income 
($'s in thousands)  Investment   Balance   Allowance   Investment   Recognized 
With no related allowance recorded:                    
Commercial & Industrial  $-   $-   $-   $-   $- 
Commercial RE & Construction   637    637    -    658    16 
Agricultural & Farmland   -    -    -    -    - 
Residential Real Estate   987    1,031    -    1,195    51 
Consumer & Other   20    78    -    94    6 
All Impaired Loans < $100,000   398    398    -    398    - 
With a specific allowance recorded:                         
Commercial & Industrial   -    -    -    -    - 
Commercial RE & Construction   1,135    1,385    127    1,404    - 
Agricultural & Farmland   -    -    -    -    - 
Residential Real Estate   887    887    148    957    29 
Consumer & Other   268    268    19    272    11 
Totals:                         
Commercial & Industrial  $-   $-   $-   $-   $- 
Commercial RE & Construction  $1,772   $2,022   $127   $2,062   $16 
Agricultural & Farmland  $-   $-   $-   $-   $- 
Residential Real Estate  $1,874   $1,918   $148   $2,152   $80 
Consumer & Other  $346   $346   $19   $366   $17 
All Impaired Loans < $100,000  $398   $398   $-   $398   $- 

 

Three Months Ended
September 30, 2016
  Average Recorded   Interest Income 
($'s in thousands)  Investment   Recognized 
With no related allowance recorded:        
Commercial & Industrial  $-   $- 
Commercial RE & Construction   647    6 
Agricultural & Farmland   -    - 
Residential Real Estate   1,186    17 
Consumer & Other   89    2 
All Impaired Loans < $100,000   438    - 
With a specific allowance recorded:          
Commercial & Industrial   -    - 
Commercial RE & Construction   1,404    - 
Agricultural & Farmland   -    - 
Residential Real Estate   945    10 
Consumer & Other   267    2 
Totals:          
Commercial & Industrial  $-   $- 
Commercial RE & Construction  $2,051   $6 
Agricultural & Farmland  $-   $- 
Residential Real Estate  $2,131   $27 
Consumer & Other  $356   $4 
All Impaired Loans < $100,000  $438   $- 

 

 18 
 

 

Twelve Months Ended
December 31, 2015
  Recorded   Unpaid Principal   Related   Average Recorded   Interest Income 
($'s in thousands)  Investment   Balance   Allowance   Investment   Recognized 
With no related allowance recorded:                    
Commercial & Industrial  $126   $1,214   $-   $1,388   $- 
Commercial RE & Construction   1,110    1,110    -    1,206    27 
Agricultural & Farmland   -    -    -    -    - 
Residential Real Estate   657    657    -    862    52 
Consumer & Other   90    90    -    107    9 
All Impaired Loans < $100,000   131    131    -    131    - 
With a specific allowance recorded:                         
Commercial & Industrial   -    -    -    -    - 
Commercial RE & Construction   4,644    4,893    1,759    5,006    90 
Agricultural & Farmland   -    -    -    -    - 
Residential Real Estate   1,056    1,013    167    1,084    45 
Consumer & Other   374    374    37    385    22 
Totals:                         
Commercial & Industrial  $126   $1,214   $-   $1,388   $- 
Commercial RE & Construction  $5,754   $6,003   $1,759   $6,212   $117 
Agricultural & Farmland  $-   $-   $-   $-   $- 
Residential Real Estate  $1,713   $1,670   $167   $1,946   $97 
Consumer & Other  $464   $464   $37   $492   $31 
All Impaired Loans < $100,000  $131   $131   $-   $131   $- 

 

   Nine Months Ended   Three Months Ended 
   Average Recorded   Interest Income   Average Recorded   Interest Income 
September 30, 2015  Investment   Recognized   Investment   Recognized 
With no related allowance recorded:                
Commercial & Industrial  $316   $-   $316   $- 
Commercial RE & Construction   704    25    797    6 
Agricultural & Farmland   -    -    -    - 
Residential Real Estate   673    38    859    8 
Consumer & Other   114    7    125    3 
All Impaired Loans < $100,000   344    -    344    - 
With a specific allowance recorded:                    
Commercial & Industrial   19    -    1,080    - 
Commercial RE & Construction   4,949    13    1,954    3 
Agricultural & Farmland   -    -    -    - 
Residential Real Estate   1,025    33    1,080    10 
Consumer & Other   337    17    362    5 
Totals:                    
Commercial & Industrial  $335   $-   $1,396   $- 
Commercial RE & Construction  $5,653   $38   $2,751   $9 
Agricultural & Farmland  $-   $-   $-   $- 
Residential Real Estate  $1,698   $71   $1,939   $18 
Consumer & Other  $451   $24   $487   $8 
All Impaired Loans < $100,000  $344   $-   $344   $- 

 

Impaired loans less than $100,000 are included in groups of homogenous loans. These loans are evaluated based on delinquency status.

 

Interest income recognized on a cash basis does not materially differ from interest income recognized on an accrual basis.

 

Troubled Debt Restructured (TDR) Loans

 

TDRs are modified loans where a concession was provided to a borrower experiencing financial difficulties. Loan modifications are considered TDRs when the concessions provided are not available to the borrower through either normal channels or other sources. However, not all loan modifications are TDRs.

  

 19 
 

 

TDR Concession Types

 

The Company’s standards relating to loan modifications consider, among other factors, minimum verified income requirements, cash flow analysis, and collateral valuations. Each potential loan modification is reviewed individually and the terms of the loan are modified to meet a borrower’s specific circumstances at a point in time. All loan modifications, including those classified as TDRs, are reviewed and approved. The types of concessions provided to borrowers include:

 

Interest rate reduction: A reduction of the stated interest rate to a nonmarket rate for the remaining original life of the loan. The Company also may grant interest rate concessions for a limited timeframe on a case by case basis.

 

Amortization or maturity date change: A change in the amortization or maturity date beyond what the collateral supports, including a concession that does any of the following:

 

(1)Lengthens the amortization period of the amortized principal beyond market terms. This concession reduces the minimum monthly payment and increases the amount of the balloon payment at the end of the term of the loan. Principal is generally not forgiven.

 

(2)Reduces the amount of loan principal to be amortized. This concession also reduces the minimum monthly payment and increases the amount of the balloon payment at the end of the term of the loan. Principal is generally not forgiven.

 

(3)Extends the maturity date or dates of the debt beyond what the collateral supports. This concession generally applies to loans without a balloon payment at the end of the term of the loan. In addition, there may be instances where renewing loans potentially require non-market terms and would then be reclassified as TDRs.

 

Other: A concession that is not categorized as one of the concessions described above. These concessions include, but are not limited to: principal forgiveness, collateral concessions, covenant concessions, and reduction of accrued interest. Principal forgiveness may result from any TDR modification of any concession type.

 

 20 
 

 

The following presents the activity of TDRs during the three and nine months ended September 30, 2016 and 2015.

 

   Three Months ended Sep. 30, 2016 
($ in thousands)  Number of Loans   Pre- Modification
Recorded Balance
   Post Modification
Recorded Balance
 
             
Residential Real Estate   -   $-   $- 
Commercial   1    309    309 
Consumer & Other   -    -    - 
                
Total Modifications   1   $309   $309 

 

   Interest           Total 
   Only   Term   Combination   Modification 
                 
Residential Real Estate  $            -   $-   $                 -   $   - 
Commercial   -    309    -    309 
Consumer & Other   -    -    -    - 
                     
Total Modifications  $-   $309   $-   $309 

 

There was no increase in the allowance for loan losses due to TDR's in the three month period ended Sep. 30, 2016.

 

   Nine Months ended Sep. 30, 2016 
($ in thousands)  Number of Loans   Pre- Modification
Recorded Balance
   Post Modification
Recorded Balance
 
             
Residential Real Estate          -   $-   $- 
Commercial   1    309    309 
Consumer & Other   1    221    221 
                
Total Modifications   2   $530   $530 

 

   Interest           Total 
   Only   Term   Combination   Modification 
                 
Residential Real Estate  $              -   $-   $                 -   $- 
Commercial   -    309    -    309 
Consumer & Other   -    221    -    221 
                     
Total Modifications  $-   $530   $-   $530 

 

 21 
 

 

There was no increase in the allowance for loan losses due to TDR's in the nine month period ended Sep. 30, 2016.

 

    Three Months ended Sep. 30, 2015
($ in thousands)   Number of Loans    Pre- Modification
Recorded Balance
    Post Modification
Recorded Balance
 
                
Residential Real Estate   -   $    -   $  - 
Commercial   -    -    - 
Consumer & Other   -    -    - 
                
Total Modifications   -   $-   $- 

 

    Interest              Total 
    Only    Term    Combination    Modification 
                     
Residential Real Estate  $-   $-   $  -   $    - 
Consumer & Other   -    -    -    - 
                     
Total Modifications  $-   $-   $-   $- 

 

There was no increase in the allowance for loan losses due to TDR's in the three month period ended Sep. 30, 2015.

 

   Nine Months ended Sep. 30, 2015 
($ in thousands)  Number of Loans   Pre- Modification
Recorded Balance
   Post Modification
Recorded Balance
 
             
Residential Real Estate   1   $24   $24 
Consumer & Other   -    -    - 
                
Total Modifications   1   $24   $24 

 

   Interest           Total 
   Only   Term   Combination   Modification 
                 
Residential Real Estate  $            -   $24   $                  -   $24 
Consumer & Other   -    -    -    - 
                     
Total Modifications  $-   $24   $-   $24 

 

There was no increase in the allowance for loan losses due to TDR's in the nine month period ended Sep. 30, 2015. TDR's modified in 2016 that have subsequently defaulted

 

   Number of   Recorded 
($ in thousands)  Contracts   Balance 
         
Consumer & Other   1   $221 
           
         1        221 

 

There were no TDR's modified during 2015 that have subsequently defaulted.

 

 22 
 

 

NOTE 5 – DERIVATIVE FINANCIAL INSTRUMENTS AND REPURCHASE AGREEMENTS

 

Risk Management Objective of Using Derivatives

 

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company manages its exposures to a wide variety of business and operational risks primarily through management of its core business activities. The Company manages economic risks, including interest rate, liquidity and credit risk, primarily by managing the amount, sources and duration of its assets and liabilities and through the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing and duration of the Company’s known or expected cash payments principally related to certain variable-rate assets.

 

Non-designated Hedges

 

The Company does not use derivatives for trading or speculative purposes. Derivatives not designated as hedges are not speculative and result from a service the Company provides to certain customers. The Company executes interest rate swaps with commercial banking customers to facilitate their respective risk management strategies. Those interest rate swaps are simultaneously offset by interest rate swaps that the Company executes with a third party, such that the Company minimizes its net risk exposure resulting from such transactions. As the interest rate swaps associated with this program do not meet the strict hedge accounting requirements, changes in the fair value of both the customer swaps and the offsetting swaps are recognized directly in earnings. As of September 30, 2016 and December 31, 2015, the notional amount of customer-facing swaps was approximately $30.1 million and $17.6 million, respectively. The same amounts were offset with third party counterparties, as described above.

 

The Company has minimum collateral posting thresholds with its derivative counterparties. As of September 30, 2016 and December 31, 2015, the Company had posted cash as collateral in the amount of $1.6 million and $0.7 million, respectively.

 

The table below presents the fair value of the Company’s derivative financial instruments, as well as their classification on the Balance Sheet, as of September 30, 2016 and December 31, 2015.

 

   Asset Derivatives  Liability Derivatives
   September 30, 2016  September 30, 2016
($ in thousands)  Balance Sheet  Fair   Balance Sheet  Fair 
   Location  Value   Location  Value 
Derivatives not designated as hedging instruments:              
Interest rate contracts  Other Assets  $1,396   Other Liabilities  $1,396 

 

   Asset Derivatives  Liability Derivatives
   December 31, 2015  December 31, 2015
($ in thousands)  Balance Sheet  Fair   Balance Sheet  Fair 
   Location  Value   Location  Value 
Derivatives not designated as hedging instruments:              
Interest rate contracts  Other Assets  $490   Other Liabilities  $490 

 

The Company’s derivative financial instruments had no net effect on the Income Statements for the three and nine months ended September 30, 2016 and 2015.

 

Securities Sold Under Repurchase Agreements

 

State Bank has retail repurchase agreements to facilitate cash management transactions with commercial customers. These obligations are secured by agency and mortgage-backed securities and such collateral is held by the Federal Home Loan Bank. The agreements mature within one month. These repurchase agreements are secured by agency securities and mortgage-backed securities with corresponding liabilities of $5.7 million and of $14.9 million. These securities have various maturity dates beyond 2017.

 

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NOTE 6 – FAIR VALUE OF ASSETS AND LIABILITIES

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. A fair value measurement must maximize the use of observable inputs and minimize the use of unobservable inputs. There is a hierarchy of three levels of inputs that may be used to measure fair value:

 

  Level 1 Quoted prices in active markets for identical assets or liabilities

 

  Level 2 Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities

 

  Level 3 Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities

 

Following is a description of the valuation methodologies and inputs used for assets measured at fair value on a recurring basis, recognized in the accompanying balance sheets, as well as the general classifications of such assets pursuant to the valuation hierarchy.

  

Available-for-Sale Securities

 

The fair values of available-for-sale securities are determined by various valuation methodologies. Level 1 securities include money market mutual funds. Level 1 inputs include quoted prices in an active market. Level 2 securities include U.S. treasury and government agencies, mortgage-backed securities, obligations of political and state subdivisions and equity securities. Level 2 inputs do not include quoted prices for individual securities in active markets; however, they do include inputs that are either directly or indirectly observable for the individual security being valued. Such observable inputs include interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, credit risks and default rates. Also included are inputs derived principally from or corroborated by observable market data by correlation or other means.

 

Interest Rate Contracts

 

The fair values of interest rate contracts are based upon the estimated amount the Company would receive or pay to terminate the contracts or agreements, taking into account underlying interest rates, creditworthiness of underlying customers for credit derivatives and, when appropriate, the creditworthiness of the counterparties.

 

 24 
 

 

The following table presents the fair value measurements of assets measured at fair value on a recurring basis and the level within the fair value hierarchy in which the fair value measurements fall at September 30, 2016 and December 31, 2015.

 

Fair Value Measurements Using:

 

($ in thousands)
Available-for-Sale Securities:
  Fair Values at
9/30/16
   (Level 1)   (Level 2)   (Level 3) 
                 
U.S. Treasury and Government Agencies  $14,033   $          -   $14,033   $          - 
Mortgage-backed securities   62,760    -    62,760    - 
State and political subdivisions   15,873    -    15,873    - 
Equity securities   23    -    23    - 
Interest rate contracts - assets   1,396    -    1,396    - 
Interest rate contracts - liabilities   (1,396)   -    (1,396)   - 

 

Fair Value Measurements Using:

 

($ in thousands)
Available-for-Sale Securities:
  Fair Values at
12/31/2015
   (Level 1)   (Level 2)   (Level 3) 
                 
U.S. Treasury and Government Agencies  $10,905   $          -   $10,905   $          - 
Mortgage-backed securities   61,343    -    61,343    - 
State and political subdivisions   17,518    -    17,518    - 
Equity securities   23         23    - 
Interest rate contracts - assets   490         490    - 
Interest rate contracts - liabilities   (490)        (490)   - 

 

Level 1 – Quoted Prices in Active Markets for Identical Assets

Level 2 – Significant Other Observable Inputs

Level 3 – Significant Unobservable Inputs

 

The following is a description of the valuation methodologies and inputs used for assets measured at fair value on a nonrecurring basis and recognized in the accompanying balance sheets, as well as the general classification of such assets pursuant to the valuation hierarchy.

 

Collateral-dependent Impaired Loans, NET of ALLL

 

Loans for which it is probable the Company will not collect all principal and interest due according to contractual terms are measured for impairment. The estimated fair value of collateral-dependent impaired loans is based on the appraised value of the collateral, less estimated cost to sell. Collateral-dependent impaired loans are classified within Level 3 of the fair value hierarchy. This method requires obtaining an independent appraisal of the collateral, which is reviewed for accuracy and consistency by Credit Administration. These appraisers are selected from the list of approved appraisers maintained by management. The appraised values are reduced by applying a discount factor to the value based on the Company’s loan review policy. All impaired loans held by the Company were collateral dependent at June 30, 2016 and December 31, 2015.

 

Mortgage Servicing Rights

 

Mortgage servicing rights do not trade in an active, open market with readily observable prices. Accordingly, fair value is estimated using discounted cash flow models associated with the servicing rights and discounting the cash flows using discount market rates, prepayment speeds and default rates. The servicing portfolio has been valued using all relevant positive and negative cash flows including servicing fees; miscellaneous income and float; marginal costs of servicing; the cost of carry of advances; and foreclosure losses; and applying certain prevailing assumptions used in the marketplace. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy. These mortgage servicing rights are tested for impairment on a quarterly basis.

 

 25 
 

 

Unobservable (Level 3) Inputs

 

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements.

  

($ in thousands)
Description
  Fair Values at
9/30/2016
   (Level 1)   (Level 2)   (Level 3) 
Impaired loans  $1,188   $-   $-   $1,188 
Mortgage Servicing Rights   7,125   $-   $-    7,125 

 

($ in thousands)

Description

  Fair Values at
12/31/2015
   (Level 1)   (Level 2)   (Level 3) 
Impaired loans  $3,011   $-   $-   $3,011 
Mortgage Servicing Rights   2,585   $-   $-    2,585 

  

Level 1 - Quoted Prices in Active Markets for Identical Assets

Level 2 - Significant Other Observable Inputs

Level 3 - Significant Unobservable Inputs

 

($'s in thousands)  Fair Value at
9/30/2016
   Valuation
Technique
  Unobservable Inputs  Range
(Weighted Average)
 
Collateral-dependent impaired loans  $1,188   Market comparable properties  Comparability adjustments (%)   Not available 
                 
Mortgage servicing rights   7,125   Discounted cash flow  Discount Rate   9.03%
           Constant prepayment rate   14.45%
           P&I earnings credit   0.53%
           T&I earnings credit   1.14%
           Inflation for cost of servicing   1.50%

 

($'s in thousands)  Fair Value at
12/31/2015
   Valuation Technique  Unobservable Inputs  Range
(Weighted
Average)
 
Collateral-dependent impaired loans  $3,011   Market comparable properties  Comparability adjustments (%)   Not available 
                 
Mortgage servicing rights   2,585   Discounted cash flow  Discount Rate   9.75%
           Constant prepayment rate   8.90%
           P&I earnings credit   0.42%
           T&I earnings credit   1.54%
           Inflation for cost of servicing   1.50%

  

There were no changes in the inputs or methodologies used to determine fair value at September 30, 2016 as compared to December 31, 2015.

 

The following methods were used to estimate the fair value of all other financial instruments recognized in the accompanying balance sheets at amounts other than fair value.

 

Cash and Due From Banks, Federal Reserve and Federal Home Loan Bank Stock and Accrued Interest Receivable and Payable

 

The carrying amount approximates the fair value.

  

 26 
 

 

Loans Held for Sale

 

The fair value of loans held for sale is based upon quoted market prices, where available, or is determined by discounting estimated cash flows using interest rates approximating the Company’s current origination rates for similar loans and adjusted to reflect the inherent credit risk.

 

Loans

 

The estimated fair value for loans receivable is based on estimates of the rate State Bank would charge for similar loans at September 30, 2016 and December 31, 2015, applied for the time period until the loans are assumed to re-price or be paid.

 

Mortgage Servicing Rights

 

Mortgage servicing rights do not trade in an active, open market with readily observable prices. Accordingly, fair value is estimated using discounted cash flow models associated with the servicing rights and discounting the cash flows using discount market rates, prepayment speeds and default rates. The servicing portfolio has been valued using all relevant positive and negative cash flows including servicing fees, miscellaneous income and float; marginal costs of servicing; the cost of carry of advances; and foreclosure losses; and applying certain prevailing assumptions used in the marketplace. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the hierarchy. These mortgage servicing rights are tested for impairment on a quarterly basis.

 

Deposits, FHLB advances & Repurchase agreements

 

Deposits include demand deposits, savings accounts, NOW accounts and certain money market deposits. The carrying amount approximates the fair value. The estimated fair value for fixed-maturity time deposits, as well as borrowings, is based on estimates of the rate State Bank could pay on similar instruments with similar terms and maturities at September 30, 2016 and December 31, 2015.

 

Loan Commitments

 

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. The estimated fair values for other financial instruments and off-balance-sheet loan commitments approximate cost at September 30, 2016 and December 31, 2015 and are not considered significant to this presentation.

 

Trust Preferred Securities

 

The fair value for Trust Preferred Securities is estimated by discounting the cash flows using an appropriate discount rate.

 

 27 
 

 

The following table presents estimated fair values of the Company’s other financial instruments carried at other than fair value. The fair values of certain of these instruments were calculated by discounting expected cash flows, which involves significant judgments by management and uncertainties. Fair value is the estimated amount at which financial assets or liabilities could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Because no market exists for certain of these financial instruments, and because management does not intend to sell these financial instruments, the Company does not know whether the fair values shown below represent values at which the respective financial instruments could be sold individually or in the aggregate.

 

   September 30,
2016
Carrying
   Fair Value Measurements Using 
   Amount   (Level 1)   (Level 2)   (Level 3) 
Financial assets                
Cash and cash equivalents  $25,167   $25,167   $-   $- 
Loans held for sale   5,865    -    6,053    - 
Loans, net of allowance for loan losses   612,032    -    -    612,961 
Federal Reserve and FHLB Bank stock   3,748    -    3,748    - 
Mortgage Servicing Rights   6,887    -    -    6,947 
Accrued interest receivable   1,641    -    1,641    - 
                     
Financial liabilities                    
Deposits  $662,144   $116,976   $548,360   $- 
FHLB Advances   23,000    -    23,143    - 
Short-term borrowings   11,363    -    11,363    - 
Trust preferred securities   10,310    -    8,015    - 
Accrued interest payable   427    -    427    - 

 

   December 31,
2015
Carrying
   Fair Value Measurements Using 
   Amount   (Level 1)   (Level 2)   (Level 3) 
Financial assets                
Cash and due from banks  $20,459   $20,459   $-   $- 
Loans held for sale   7,516    -    7,779    - 
Loans, net of allowance for loan losses   550,669    -    -    548,154 
Federal Reserve and FHLB Bank stock, at cost   3,748    -    3,748    - 
Mortgage Servicing Rights   7,152    -    -    7,760 
Accrued interest receivable   1,260    -    1,260    - 
                     
Financial liabilities                    
Deposits  $586,453   $113,113   $475,468   $- 
FHLB advances   35,000    -    34,870    - 
Short-term borrowings   12,406    -    12,406    - 
Trust preferred securities   10,310    -    7,165    - 
Accrued interest payable   264    -    264    - 

 

NOTE 7 – GENERAL LITIGATION

 

The Company is subject to claims and lawsuits that arise primarily in the ordinary course of business. Additionally, the Company is subject to periodic examinations by various regulatory agencies. It is the opinion of management that the disposition or ultimate resolution of such claims, lawsuits and examinations will not have a material adverse effect on the consolidated financial position, results of operations and cash flow of the Company.

 

 28 
 

 

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

 

Cautionary Statement Regarding Forward-Looking Information

 

This Quarterly Report on Form 10-Q, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains certain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance. Examples of forward-looking statements include: (a) projections of income or expense, earnings per share, the payment or non-payment of dividends, capital structure and other financial items; (b) statements of plans and objectives of the Company or our management or Board of Directors, including those relating to products or services; (c) statements of future economic performance; (d) statements regarding future customer attraction or retention; and (e) statements of assumptions underlying such statements. Words such as “anticipates”, “believes”, “plans”, “intends”, “expects”, “projects”, “estimates”, “should”, “may”, “would be”, “will allow”, “will likely result”, “will continue”, “will remain”, or other similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying those statements. Forward-looking statements are based on management’s expectations and are subject to a number of risks and uncertainties. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements. Risks and uncertainties that could cause actual results to differ materially include, without limitation, risks and uncertainties inherent in the national and regional banking industry, changes in economic conditions in the market areas in which the Company and its subsidiaries operate, changes in policies by regulatory agencies, changes in accounting standards and policies, changes in tax laws, fluctuations in interest rates, demand for loans in the market areas in which the Company and its subsidiaries operate, increases in FDIC insurance premiums, changes in the competitive environment, losses of significant customers, geopolitical events and the loss of key personnel. Additional detailed information concerning a number of important factors which could cause actual results to differ materially from the forward-looking statements contained in Management’s Discussion and Analysis of Financial Condition and Results of Operations is available in the Company’s filings with the Securities and Exchange Commission, including the risks identified under the heading “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015. Undue reliance should not be placed on the forward-looking statements, which speak only as of the date hereof. Except as may be required by law, the Company undertakes no obligation to update any forward-looking statement to reflect unanticipated events or circumstances after the date on which the statement is made.

 

Overview of SB Financial

 

SB Financial Group, Inc. (“SB Financial” or the “Company”) is a bank holding company registered with the Federal Reserve Board. SB Financial’s wholly-owned subsidiary, The State Bank and Trust Company (“State Bank”), is an Ohio-chartered bank engaged in commercial banking. SB Financial’s technology subsidiary, Rurbanc Data Services, Inc. dba RDSI Banking Systems (“RDSI”), provides item processing services to community banks and businesses.

 

 29 
 

 

Rurban Statutory Trust II (“RST II”) was established in August 2005. In September 2005, RST II completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures of the Company with terms substantially similar to the Trust Preferred Securities. The sole assets of RST II are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of RST II.

 

RFCBC, Inc. (“RFCBC”) is an Ohio corporation and wholly-owned subsidiary of the Company that was incorporated in August 2004. RFCBC operates as a loan subsidiary in servicing and working out problem loans.

 

State Bank Insurance, LLC (“SBI”) is an Ohio corporation and a wholly-owned subsidiary of State Bank that was incorporated in June of 2010. SBI is an insurance company that engages in the sale of insurance products to retail and commercial customers of State Bank.

 

Unless the context indicates otherwise, all references herein to “we”, “us”, “our”, or the “Company” refer to SB Financial Group, Inc. and its consolidated subsidiaries.

 

Recent Regulatory Developments

 

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

 

The Dodd-Frank Act was enacted into law on July 21, 2010. The Dodd-Frank Act is significantly changing the regulation of financial institutions and the financial services industry. Because the Dodd-Frank Act requires various federal agencies to adopt a broad range of regulations with significant discretion, many of the details of the new law and the effects they will have on the Company will not be known for months and even years.

 

Among the provisions already implemented pursuant to the Dodd-Frank Act, the following provisions have or may have an effect on the business of the Company and its subsidiaries:

 

the CFPB has been formed with broad powers to adopt and enforce consumer protection regulations;
   
the federal law prohibiting the payment of interest on commercial demand deposit accounts was eliminated effective July 21, 2011;
   
the standard maximum amount of deposit insurance per customer was permanently increased to $250,000;
   
the assessment base for determining deposit insurance premiums has been expanded from domestic deposits to average assets minus average tangible equity;
   
public companies in all industries are or will be required to provide shareholders the opportunity to cast a non-binding advisory vote on executive compensation;
   
new capital regulations for bank holding companies have been adopted, which will impose stricter requirements, and any new trust preferred securities issued after May 19, 2010, will no longer constitute Tier I capital; and
   
new corporate governance requirements applicable generally to all public companies in all industries require new compensation practices and disclosure requirements, including requiring companies to “claw back” incentive compensation under certain circumstances, to consider the independence of compensation advisors and to make additional disclosures in proxy statements with respect to compensation matters.

 

Many provisions of the Dodd-Frank Act have not yet been implemented and will require interpretation and rule making by federal regulators. As a result, the full effect of the Dodd-Frank Act on the Company cannot yet be determined. However, it is likely that the implementation of these provisions will increase compliance costs and fees paid to regulators, along with possibly restricting the operations of the Company and its subsidiaries.

 

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The Volcker Rule

 

In December 2013, five federal agencies adopted a final regulation implementing the Volcker Rule provision of the Dodd-Frank Act (the “Volcker Rule”). The Volcker Rule places limits on the trading activity of insured depository institutions and entities affiliated with a depository institution, subject to certain exceptions. The trading activity includes a purchase or sale as principal of a security, derivative, commodity future or option on any such instrument in order to benefit from short-term price movements or to realize short-term profits. The Volcker Rule exempts specified U.S. Government, agency and/or municipal obligations, and it excepts trading conducted in certain capacities, including as a broker or other agent, through a deferred compensation or pension plan, as a fiduciary on behalf of customers, to satisfy a debt previously contracted, repurchase and securities lending agreements and risk-mitigating hedging activities.

 

The Volcker Rule also prohibits a banking entity from having an ownership interest in, or certain relationships with, a hedge fund or private equity fund, with a number of exceptions. The Company does not engage in any of the trading activities or have any ownership interest in or relationship with any of the types of funds regulated by the Volcker Rule.

 

Executive and Incentive Compensation

 

In June 2010, the Federal Reserve Board, the OCC and the FDIC issued joint interagency guidance on incentive compensation policies (the “Joint Guidance”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. This principles-based guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (a) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (b) be compatible with effective internal controls and risk management and (c) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

 

Pursuant to the Joint Guidance, the Federal Reserve Board will review as part of a regular, risk-focused examination process, the incentive compensation arrangements of financial institutions such as the Company. Such reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination and deficiencies will be incorporated into the institution’s supervisory ratings, which can affect the institution’s ability to make acquisitions and take other actions. Enforcement actions may be taken against an institution if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and prompt and effective measures are not being taken to correct the deficiencies.

 

On February 7, 2011, federal banking regulatory agencies jointly issued proposed rules on incentive-based compensation arrangements under applicable provisions of the Dodd-Frank Act (the “Proposed Rules”). The Proposed Rules generally apply to financial institutions with $1.0 billion or more in assets that maintain incentive-based compensation arrangements for certain covered employees. The Proposed Rules (i) prohibit covered financial institutions from maintaining incentive-based compensation arrangements that encourage covered persons to expose the institution to inappropriate risk by providing the covered person with “excessive” compensation; (ii) prohibit covered financial institutions from establishing or maintaining incentive-based compensation arrangements for covered persons that encourage inappropriate risks that could lead to a material financial loss, (iii) require covered financial institutions to maintain policies and procedures appropriate to their size, complexity and use of incentive-based compensation to help ensure compliance with the Proposed Rules and (iv) require covered financial institutions to provide enhanced disclosure to regulators regarding their incentive-based compensation arrangements for covered person within 90 days following the end of the fiscal year.

 

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Pursuant to rules adopted by the stock exchanges and approved by the SEC in January 2013 under the Dodd-Frank Act, public companies are required to implement “clawback” procedures for incentive compensation payments and to disclose the details of the procedures which allow recovery of incentive compensation that was paid on the basis of erroneous financial information necessitating a restatement due to material noncompliance with financial reporting requirements. This policy is intended to apply to compensation paid within a three-year look-back window of the restatement and would cover all executives who received incentive awards. Public company compensation committee members are also required to meet heightened independence requirements and to consider the independence of compensation consultants, legal counsel and other advisors to the compensation committee. The compensation committees must have the authority to hire advisors and to have the company fund reasonable compensation of such advisors.

 

Effect of Environmental Regulation

 

Compliance with federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has not had a material effect upon the capital expenditures, earnings or competitive position of the Company and its subsidiaries. The Company believes that the nature of the operations of its subsidiaries has little, if any, environmental impact. The Company, therefore, anticipates no material capital expenditures for environmental control facilities for its current fiscal year or for the foreseeable future. The Company’s subsidiaries may be required to make capital expenditures for environmental control facilities related to properties which they may acquire through foreclosure proceedings in the future; however, the amount of such capital expenditures, if any, is not currently determinable.

 

Regulatory Capital

 

The FRB has adopted risk-based capital guidelines for bank holding companies and for state member banks, such as State Bank. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk weighted assets by assigning assets and off-balance-sheet items to broad risk categories. Prior to January 1, 2015, the minimum ratio of total capital to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) was 8%. Of that 8%, at least 4% was required to be comprised of common shareholders’ equity (including retained earnings but excluding treasury stock), non-cumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock, and minority interests in equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets (“Tier 1 capital”). The remainder of total risk-based capital (“Tier 2 capital”) may consist, among other things, of certain amounts of mandatory convertible debt securities, subordinated debt, preferred stock not qualifying as Tier 1 capital, allowance for loan and lease losses and net unrealized gains, after applicable taxes, on available-for-sale equity securities with readily determinable fair values, all subject to limitations established by the guidelines. Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of four risk weights (0%, 20%, 50% and 100%) is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

In July 2013, the FRB and the federal banking agencies published final rules that substantially amend the regulatory risk-based capital rules applicable to the Company and State Bank. These rules implement the “Basel III” regulatory capital reforms and changes required by the Dodd-Frank Act. “Basel III” refers to various documents released by the Basel Committee on Banking Supervision.

 

Effective January 1, 2015, State Bank and the Company became subject to new capital regulations under BASEL III (with some provisions transitioned into full effectiveness over two to four years). The new requirements create a new required ratio for common equity Tier 1 (“CET1”) capital, increases the leverage and Tier 1 capital ratios, changes the risk-weights of certain assets for purposes of the risk-based capital ratios, creates an additional capital conservation buffer over the required capital ratios and changes what qualifies as capital for purposes of meeting these various capital requirements. These new capital requirements are as follows: leverage ratio of 4% of adjusted total assets, total capital ratio of 8% of risk-weighted assets and the Tier 1 capital ratio of 6.5% of risk-weighted assets. In addition, the Company will have to meet the new minimum CET1 capital ratio of 4.5% of risk-weighted assets. CET1 consists generally of common stock, retained earnings and accumulated other comprehensive income (AOCI), subject to certain adjustments. Beginning in 2016, failure to maintain the required capital conservation buffer will limit the ability of the Company to pay dividends, repurchase shares or pay discretionary bonuses.

 

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Mortgage servicing rights, certain deferred tax assets and investments in unconsolidated subsidiaries over designated percentages of common stock will be deducted from capital, subject to a two-year transition period. In addition, Tier 1 capital will include AOCI, which includes all unrealized gains and losses on available for sale debt and equity securities, subject to a two-year transition period. State Bank decided in the first quarter of 2015 to permanently opt-out of the inclusion of AOCI in its capital calculations to reduce the impact of market volatility on its regulatory capital levels.

 

The new requirements under BASEL III also include changes in the risk-weights of certain assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and for non-residential mortgage loans that are 90 days past due or otherwise in nonaccrual status; a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less; a 250% risk weight (up from 100%) for mortgage servicing and deferred tax assets that are not deducted from capital; and increased risk-weights (0% to 600%) for equity exposures.

 

In addition to the minimum CET1, Tier 1 and total capital ratios, State Bank will have to maintain a capital conservation buffer consisting of additional CET1 capital equal to 2.5% of risk-weighted assets above each of the required minimum capital levels in order to avoid limitations on paying dividends, engaging in share repurchases and paying certain discretionary bonuses. This new capital conservation buffer requirement is phased in beginning in January 2016 at 0.625% of risk-weighted assets and increasing each year until fully implemented in January 2019.

 

The FRB’s prompt corrective action standards will change when these new capital ratios become effective. Under the new standards, in order to be considered well-capitalized, State Bank will be required to have at least a CET1 ratio of 6.5% (new), a Tier 1 ratio of 8% (increased from 6%), a total capital ratio of 10% (unchanged) and a leverage ratio of 5% (unchanged) and not be subject to specified requirements to meet and maintain a specific capital ratio for a capital measure.

 

State Bank conducted a proforma analysis of the application of these new capital requirements as of June 30, 2016. Based on that analysis, State Bank determined that it meets all these new requirements, including the full 2.5% capital conservation buffer, and would remain well capitalized if these new requirements had been in effect on that date. (see Note 13) In addition, as noted above, beginning in 2016, if State Bank does not have the required capital conservation buffer, its ability to pay dividends to the Company would be limited.

 

In April 2015, the Federal Reserve Board issued a final rule which increased the size limitation for qualifying bank holding companies under the Federal Reserve Board’s Small Bank Holding Company Policy Statement from $500 million to $1 billion of total consolidated assets. As a result, the Company now qualifies under the Small Bank Holding Company Policy Statement for exemption from the Federal Reserve Board’s consolidated risk-based capital and leverage rules at the holding company level.

 

Federal Deposit Insurance Corporation (“FDIC”)

 

The FDIC is an independent federal agency which insures the deposits of federally-insured banks and savings associations up to certain prescribed limits and safeguards the safety and soundness of financial institutions. State Bank’s deposits are subject to the deposit insurance assessments of the FDIC. Under the FDIC’s deposit insurance assessment system, the assessment rate for any insured institution may vary according to regulatory capital levels of the institution and other factors such as supervisory evaluations.

 

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In addition, the FDIC has proposed changing the deposit insurance premium assessment method for banks with less than $10 billion in assets that have been insured by the FDIC for at least five years. The proposed changes would revise the financial ratios method so that it would be based on a statistical model estimating the probability of failure of a bank over three years; update the financial measures used in the financial ratios method consistent with the statistical model; and eliminate risk categories for established small banks and use the financial ratios method to determine assessment rates for all such banks (subject to minimum or maximum initial assessment rates based upon a bank’s composite examination rating).

 

The FDIC is authorized to prohibit any insured institution from engaging in any activity that poses a serious threat to the insurance fund and may initiate enforcement actions against a bank, after first giving the institution’s primary regulatory authority an opportunity to take such action. The FDIC may also terminate the deposit insurance of any institution that has engaged in or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, order or condition imposed by the FDIC.

 

Critical Accounting Policies

 

Note 1 to the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015 describes the significant accounting policies used in the development and presentation of the Company’s financial statements. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company’s financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company’s financial condition and results, and they require management to make estimates that are difficult, subjective, and/or complex.

 

Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company’s loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management’s estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs.

 

The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan’s observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan’s effective interest rate.

 

Regardless of the extent of the Company’s analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer’s financial condition or changes in their unique business conditions, the subjective nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are also factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company’s evaluation of imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. To the extent that actual results differ from management’s estimates, additional loan loss provisions may be required that could adversely impact earnings for future periods.

 

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Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required. Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line or accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. A decrease in earnings resulting from these or other factors could lead to an impairment of goodwill that could adversely impact earnings for future periods.

 

Three Months Ended September 30, 2016 compared to Three Months Ended September 30, 2015

 

Net Income: Net income for the third quarter of 2016 was $2.5 million compared to net income of $2.3 million for the third quarter of 2015, an increase of 13 percent. Earnings per diluted share (EPS) of $0.40 were up 14 percent from the $0.35 for the third quarter of 2015.

 

Provision for Loan Losses: The third quarter provision for loan losses was $0.0 million compared to $0.1 million for the year-ago quarter. Net charge-offs for the quarter were $0.13 million compared to net charge-offs of $0.30 million for the year-ago quarter. Total delinquent loans ended the quarter at $2.8 million, which is down $3.7 million from the prior year or 0.17 percent of average loans.

 

Asset Quality Review – For the Period Ended

($’s in Thousands)

  Sep. 30,
2016
   Sep. 30,
2015
 
Net charge-offs  $130   $29 
Non-accruing loans   2,889    6,742 
Accruing Trouble Debt Restructures   1,588    1,576 
Non-accruing and restructured loans   4,477    8,318 
OREO / OAO   73    188 
Non-performing assets   4,550    8,506 
Non-performing assets/Total assets   0.57%   1.18%
Allowance for loan losses/Total loans   1.18%   1.31%
Allowance for loan losses/Non-performing loans   163.5%   85.1%

 

Consolidated Revenue: Total revenue, consisting of net interest income and noninterest income, was $11.7 million for the third quarter of 2016, an increase of $1.7 million, or 16.6 percent, from the $10.0 million generated during the 2015 third quarter.

 

Net interest income was $6.7 million, which is up $0.7 million from the prior year third quarter’s $6.0 million. The Company’s earning assets increased $69.4 million, coupled with a 2 basis point increase in the yield on earning assets. The net interest margin for the third quarter of 2016 was 3.82 percent compared to 3.87 percent for the third quarter of 2015. Funding cost for interest bearing liabilities for the third quarter of 2016 were 0.56 percent compared to 0.49 percent for the prior year third quarter.

 

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Noninterest income was $5.0 million for the 2016 third quarter, which is up $1.1 million from the prior year third quarter’s $4.0 million. In addition to the mortgage revenue detailed below, gains from the sale of non-mortgage loans was $0.3 million and gain on sale of securities was $0.1 million. Noninterest income as a percentage of average assets for the third quarter of 2016 was 2.52 percent compared to 2.20 percent for the prior year third quarter.

 

State Bank originated $117.2 million of mortgage loans for the third quarter of 2016, of which $101.1 million was sold with the remainder in loans held for investment. This compares to $87.0 million for the third quarter of 2015, of which $70.1 million was sold with the remainder in loans held for investment. These third quarter 2016 originations and subsequent sales resulted in $2.5 million of gains, up 48 percent from the gains for the third quarter of 2015. Net mortgage banking revenue was $2.7 million for the third quarter of 2016 compared to $1.8 million for the third quarter of 2015 due to the positive adjustment in servicing rights and higher volume. The 2016 third quarter included an $0.1 million valuation recapture on our mortgage servicing rights, due to increased prepayment speeds in the portfolio.

 

Consolidated Noninterest Expense: Noninterest expense for the third quarter of 2016 was $7.9 million, which is up $1.3 million compared to $6.6 million in the prior-year third quarter. The increase in noninterest expenses compared to the prior year was the result of higher staffing costs for our new branch facilities, merit increases, as well as additional staffing in compliance and mortgage administration.

 

Income Taxes: Income taxes for the third quarter of 2016 were $1.2 million (effective rate 32.2 percent) compared to $1.0 million (effective rate 31.4 percent) for the third quarter of 2015. This increase was driven by the increase in pretax income for the Company.

 

Nine Months Ended September 30, 2016 compared to Nine Months Ended September 30, 2015

 

Net Income: Net income for the first nine months of 2016 was $6.5 million compared to net income of $5.8 million for the first nine months of 2015, an increase of 12 percent. Earnings per diluted share (EPS) for the period of $1.01 were up 13 percent from the $0.89 for the prior year nine month period.

 

Provision for Loan Losses: The provision for loan losses for the first nine months of 2016 was $0.25 million compared to $0.95 million for the prior year first nine months. Net recoveries for the period were $0.08 million compared to net charge-offs of $0.65 million for the prior year nine month period.

 

Consolidated Revenue: Total revenue, consisting of net interest income and noninterest income, was $32.0 million for the first nine months of 2016, an increase of $2.6 million, or 8.9 percent, from the $29.4 million generated during the 2015 first nine months.

 

Net interest income was $19.2 million, which is up $1.8 million from the prior year first nine months $17.4 million. The Company’s earning assets increased $65.7 million, coupled with a 2 basis point increase in the yield on earning assets. The net interest margin for the first nine months of 2016 was 3.77 percent compared to 3.78 percent for the first nine months of 2015. Funding cost for interest bearing liabilities for the first nine months of 2016 were 0.54 percent compared to 0.49 percent for the prior year first nine months.

 

Noninterest income was $12.8 million for the 2016 first nine months, which is up $0.8 million from the prior year first nine month’s $12.0 million. In addition to the mortgage revenue detailed below, gains from the sale of non-mortgage loans was $0.9 million and gain on sale of securities was $0.3 million.

 

State Bank originated $299.4 million of mortgage loans for the first nine months of 2016, of which $255.57 million was sold with the remainder in loans held for investment. These levels were up 17 and 19 percent respectively for the prior year first nine months. The 2016 first nine months included a $1.2 million valuation impairment on our mortgage servicing rights, due to increased prepayment speeds in the portfolio.

 

Consolidated Noninterest Expense: Noninterest expense for the first nine months of 2016 was $22.2 million, which is up $2.1 million compared to $20.1 million in the prior-year first nine months. The increase in noninterest expenses compared to the prior year was the result of higher staffing costs for our new branch facilities and mortgage administration. In addition, higher occupancy costs related to our new branch facilities in Dublin and Findlay, Ohio have been realized.

 

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Income Taxes: Income taxes for the first nine months of 2016 were $3.0 million (effective rate 31.8 percent) compared to $2.6 million (effective rate 30.9 percent) for the first nine months of 2015. This increase was driven by the increase in pretax income for the Company.

 

Changes in Financial Condition

 

Total assets at September 30, 2016 were $801.8 million, an increase of $68.7 million or 9.4 percent since 2015 year end. Total loans, net of unearned income, were $619.4 million as of September 30, 2016, up $61.7 million from year end, an increase of 11.1 percent.

 

Total deposits at September 30, 2016 were $662.1 million, an increase of $75.7 million or 12.9 percent since 2015 year end. Borrowed funds (consisting of FHLB advances, and REPOs) totaled $34.4 million at September 30, 2016. This is down from year end when borrowed funds totaled $47.4 million due to a decrease in FHLB advances of $12.0 million. Total equity for the Company of $86.3 million now stands at 10.8 percent of total assets, which is up from the December 31, 2015 level of $81.2 million. Total equity to assets was 11.1 percent at December 31, 2015.

 

The allowance for loan loss of $7.3 million is up from the 2015 year end by 4.7 percent. This increase combined with the loan growth of 11.1 percent results in an allowance to loans of 1.18 percent. The 1.18 percent level is considered appropriate by management given the risk profile of the portfolio. The allowance to loan loss level at September 30, 2015 was 1.34 percent. The decline from the prior year was due to higher loan growth and improved asset quality.

 

Capital Resources

 

As of September 30, 2016, based on the computations for the call report the Bank is classified as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain capital ratios as set forth in the table below. There are no conditions or events since September 30, 2016 that management believes have changed the Bank’s capital classification.

 

The Bank’s actual capital levels and ratios as of September 30, 2016 and December 31, 2015 are presented in the following table. Capital levels are presented for the Bank only as the Company is now exempt from quarterly reporting on capital levels at the holding company level ($’s in thousands):

 

           For Capital Adequacy   To Be Well Capitalized Under Prompt Corrective 
   Actual   Purposes   Action Procedures 
($ in thousands)  Amount   Ratio   Amount   Ratio   Amount   Ratio 
As of September 30, 2016                        
Tier I Capital to average assets  $72,308    9.28%  $31,160    4.0%  $38,950    5.0%
Tier I Common equity capital to risk-weighted assets   72,308    10.36%   35,055    4.5%   50,635    6.5%
Tier I Capital to risk-weighted assets   72,308    10.36%   41,878    6.0%   55,837    8.0%
Total Risk-based capital to risk-weighted assets   79,628    11.41%   55,837    8.0%   69,796    10.0%
                               
As of December 31, 2015                              
Tier I Capital to average assets  $64,914    9.10%  $28,534    4.0%  $35,668    5.0%
Tier I Common equity capital to risk-weighted assets   64,914    10.23%   28,545    4.5%   41,231    6.5%
Tier I Capital to risk-weighted assets   64,914    10.23%   38,059    6.0%   50,746    8.0%
Total Risk-based capital to risk-weighted assets   71,904    11.34%   50,746    8.0%   63,432    10.0%

 

Effective January 1, 2015 new regulatory capital requirements, commonly referred to as “Basel III” were implemented and are reflected in the September 30, 2016 capital table above. Management opted out of the accumulated other comprehensive income treatment under the new requirements and, as such unrealized gains and losses from available-for-sale securities will continue to be excluded from Bank regulatory capital.

 

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LIQUIDITY

 

Liquidity relates primarily to the Company’s ability to fund loan demand, meet deposit customers’ withdrawal requirements and provide for operating expenses. Assets used to satisfy these needs consist of cash and due from banks, federal funds sold, interest-earning deposits in other financial institutions, securities available-for-sale and loans held for sale. These assets are commonly referred to as liquid assets. Liquid assets were $123.7 million at September 30, 2016, compared to $117.8 million at December 31, 2015.

 

Liquidity risk arises from the possibility that the Company may not be able to meet the Company’s financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Board of Directors of the Company has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates the Asset/Liability Committee (“ALCO”) as the body responsible for meeting these objectives. The ALCO reviews liquidity regularly and evaluates significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company’s Chief Financial Officer and Asset Liability Manager.

 

The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolio of $462.8 million at September 30, 2016 and $416.8 million at December 31, 2015, which can and has been used to collateralize borrowings, is an additional source of liquidity. Management believes the Company’s current liquidity level, without these borrowings, is sufficient to meet its liquidity needs. At September 30, 2016, all eligible commercial real estate, first mortgage residential and multi-family mortgage loans were pledged under an FHLB blanket lien.

 

The cash flow statements for the periods presented provide an indication of the Company’s sources and uses of cash, as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for the nine months ended September 30, 2016 and 2015 follows.

 

The Company experienced positive cash flows from operating activities for the nine months ended September 30, 2016 and September 30, 2015. Net cash provided by operating activities was $8.4 million for the nine months ended September 30, 2016 and $5.3 million for the nine months ended September 30, 2015. Highlights for the current year include $249.2 million in proceeds from the sale of loans, which is up $25.1 million from the prior year. Originations of loans held for sale was a use of cash of $241.7 million, which is also up from the prior year, by $24.8 million. For the nine months ended September 30, 2016, there was a gain on sale of loans of $7.1 million, and depreciation and amortization of $0.9 million.

 

The Company experienced negative cash flows from investing activities for the nine months ended September 30, 2016 and September 30, 2015. Net cash flows used in investing activities was $64.3 million for the nine months ended September 30, 2016 and $40.6 million for the nine months ended September 30, 2015. Highlights for the nine months ended September 30, 2016 include $17.6 million in purchases of available-for-sale securities. These cash payments were offset by $11.9 million in proceeds from maturities and sales of securities, which is down $2.9 million from the prior year nine-month period. The Company experienced a $61.9 million increase in loans, which is up $36.7 million from the prior year nine-month period.

 

The Company experienced positive cash flows from financing activities for the nine months ended September 30, 2016 and September 30, 2015. Net cash flow provided by financing activities was $60.5 million for the nine months ended September 30, 2016 and $25.4 million for the nine months ended September 30, 2015. Highlights for the current period include a $41.1 million increase in transaction deposits for the nine months ended September 30, 2016, which is up from the $27.0 million increase for the prior year nine-month period. Certificates of deposit increased by $34.6 million in the current year compared to a decrease of $4.4 million for the prior year.

 

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ALCO uses an economic value of equity (“EVE”) analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company’s assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a decrease in rates as of September 30, 2016 and December 31, 2015 was considered unlikely given the current interest rate environment and therefore, only the minus 100 basis point rate change was included in this analysis. The results of this analysis are reflected in the following tables for September 30, 2016 and December 31, 2015.

 

September 30, 2016

Economic Value of Equity

($’s in thousands)

Change in Rates  $ Amount   $ Change   % Change 
+400 basis points  $142,748   $25,778    22.04%
+300 basis points   138,075    21,105    18.04 
+200 basis points   131,940    14,971    12.80 
+100 basis points   125,166    8,197    7.01 
Base Case   116,969    -    - 
-100 basis points   107,970    (9,000)   (7.69)

 

December 31, 2015

Economic Value of Equity

($’s in thousands)

Change in Rates  $ Amount   $ Change   % Change 
+400 basis points  $137,575   $16,287    13.43%
+300 basis points   135,269    13,981    11.53 
+200 basis points   131,535    10,247    8.45 
+100 basis points   127,022    5,734    4.73 
Base Case   121,288    -    - 
-100 basis points   114,630    (6,657)   (5.49)

 

Off-Balance-Sheet Borrowing Arrangements:

 

Significant additional off-balance-sheet liquidity is available in the form of FHLB advances and unused federal funds lines from correspondent banks. Management expects the risk of changes in off-balance-sheet arrangements to be immaterial to earnings.

 

The Company’s commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolios in the aggregate amount of $462.8 million have been pledged to meet FHLB collateralization requirements as of September 30, 2016. Based on the current collateralization requirements of the FHLB, the Company had approximately $51.4 million of additional borrowing capacity at September 30, 2016. The Company also had $15.9 million in unpledged securities that may be used to pledge for additional borrowings.

 

The Company’s contractual obligations as of September 30, 2016 were comprised of long-term debt obligations, other debt obligations, operating lease obligations and other long-term liabilities. Long-term debt obligations are comprised of FHLB Advances of $23.0 million, and Trust Preferred Securities of $11.4 million. Total time deposits at September 30, 2016 were $193.7 million, of which $107.1 million matures beyond one year.

 

Also, as of September 30, 2016, the Company had commitments to sell mortgage loans totaling $26.9 million. The Company believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If the Company requires funds beyond its internal funding capabilities, advances from the FHLB of Cincinnati and other financial institutions are available.

 

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ASSET LIABILITY MANAGEMENT

 

Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available for sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company’s financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company’s primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure.

 

Interest rate risk is the exposure of a banking institution’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company’s earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company’s safety and soundness.

 

Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization’s quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate).

 

The Federal Reserve Board together with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Company adopted a Joint Agency Policy Statement on interest rate risk effective June 26, 1996. The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in prior Federal Reserve guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk.

 

Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution’s assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution’s interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution’s profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment.

 

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There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management’s expertise to be effective. The Company does not currently utilize any derivative financial instruments to manage interest rate risk. As market conditions warrant, the Company may implement various interest rate risk management strategies, including the use of derivative financial instruments.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Management believes there has been no material change in the Company’s market risk from the information contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 2015.

 

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

With the participation of the President and Chief Executive Officer (the principal executive officer) and the Executive Vice President and Chief Financial Officer (the principal financial officer) of the Company, the Company’s management has evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the quarterly period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Company’s President and Chief Executive Officer and the Company’s Executive Vice President and Chief Financial Officer have concluded that:

 

  information required to be disclosed by the Company in this Quarterly Report on Form 10-Q and other reports which the Company files or submits under the Exchange Act would be accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure;

 

  information required to be disclosed by the Company in this Quarterly Report on Form 10-Q and other reports which the Company files or submits under the Exchange Act would be recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms; and

 

  the Company’s disclosure controls and procedures were effective as of the end of the quarterly period covered by this Quarterly Report on Form 10-Q.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the Company’s fiscal quarter ended September 30, 2016, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

 

In the ordinary course of our business, the Company and its subsidiaries are parties to various legal actions which we believe are incidental to the operation of our 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 not likely to have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.

 

Item 1A. Risk Factors

 

There are certain risks and uncertainties in our business that could cause our actual results to differ materially from those anticipated. A detailed discussion of our risk factors is included in “Item 1A. Risk Factors” of Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. There have been no material changes to the risk factors as presented in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

(a)Not Applicable

 

(b)Not Applicable

 

(c)Repurchases of Common Shares

 

During the three and nine months ended September 30, 2016, the Company purchased shares of its common stock as detailed in the table below:

 

   Common Shares Repurchased   Average Price 
Three months ended        
9/30/2016   39,258   $11.77 
           
Nine months ended          
9/30/2016   54,756   $11.41 

 

Item 3. Defaults Upon Senior Securities

 

Not applicable

 

Item 4. Mine Safety Disclosures

 

Not applicable

 

Item 5. Other Information

 

Not applicable

 

Item 6. Exhibits

 

Exhibits

 

31.1 Rule 13a-14(a)/15d-14(a) Certification (Principal Executive Officer)
31.2 Rule 13a-14(a)/15d-14(a) Certification (Principal Financial Officer)
32.1 Section 1350 Certification (Principal Executive Officer)
32.2 Section 1350 Certification (Principal Financial Officer)

  

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

 

  SB FINANCIAL GROUP, INC.
     
Date:  November 14, 2016 By: /s/ Mark A. Klein
    Mark A. Klein
    Chairman, President & CEO
     
  By: /s/ Anthony V. Cosentino
    Anthony V. Cosentino
    Executive Vice President &
Chief Financial Officer

 

 

 

 

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