Back to GetFilings.com

#

ARROW FINANCIAL CORPORATION

FORM 10-Q

September 30, 2004

INDEX

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands) (Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In Thousands, Except Per Share Amounts)(Unaudited)

Share and Per Share amounts have been restated for the September 2004 three percent stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

Share and Per Share amounts have been restated for the September 2004 three percent stock dividend.

Included in shares issued for the 3% stock dividend in 2004 were treasury shares of 95,683 and unallocated ESOP shares of 3,539.

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY, Continued

(In Thousands, Except Share and Per Share Amounts) (Unaudited)

Share and Per Share amounts have been restated for the September 2004 three percent stock dividend.

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)(Unaudited)

See Notes to Unaudited Consolidated Interim Financial Statements.

#

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

FORM 10-Q

September 30, 2004

1.   Financial Statement Presentation   

In the opinion of the management of Arrow Financial Corporation (the "Company"), the accompanying unaudited consolidated interim financial statements contain all of the adjustments necessary to present fairly the financial position as of September 30, 2004 and December 31, 2003; the results of operations for the three-month and nine-month periods ended September 30, 2004 and 2003; the changes in shareholders’ equity for the nine-month periods ended September 30, 2004 and 2003; and the cash flows for the nine-month periods ended September 30, 2004 and 2003.  All such adjustments are of a normal recurring nature.  The unaudited consolidated interim financial statements should be read in conjunction with the annual consolidated financial statements of the Company for the year ended December 31, 2003, included in the Company’s 2003 Form 10-K.

2.   Accumulated Other Comprehensive Income (In Thousands)

The following table presents the components, net of tax, of accumulated other comprehensive income as of September 30, 2004 and December 31, 2003.  Share and per share amounts have been restated for the September 2004 three percent stock dividend.

3.   Earnings Per Common Share (In Thousands, Except Per Share Amounts)

The following table presents a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per common share (EPS) for the three-month and nine-month periods ended September 30, 2004 and 2003:

#

4.   Stock-Based Compensation Plans

The Company accounts for its stock-based compensation plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations.  No stock-based employee compensation cost has been reflected in net income for stock awards granted under these plans (other than for certain stock appreciation rights attached to options granted in 1992 and earlier, all of which had been exercised as of January 2002), as all awards granted under these plans have been options having an exercise price equal to the market value of the underlying common stock on the date of grant.  However, options granted do generally impact diluted earnings per share by increasing the weighted average diluted shares outstanding and thereby decreasing diluted earnings per share as compared to basic earnings per share.

There were no options granted in the first nine months of 2004.  The Company historically has granted compensatory stock options, when options have been granted, in the fourth quarter of the calendar year.  The weighted-average fair value of options granted during 2003 was $6.30 per option.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 2003: dividend yield of 3.28%; expected volatility of 27.2%; risk free interest rate of 3.76%; and expected lives of 7.0 years.  The Company also sponsors an Employee Stock Purchase Plan (ESPP) under which employees purchase the Company’s common stock at a 15% discount below market price at the time of purchase.  Under APB 25, a plan with a discount of 15% or less is not considered compensatory and expense is not recognized.  Under SFAS No. 123, however, “Accounting for Stock-Based Compensation,” the ESPP is considered a compensatory plan and the entire discount is considered to be a compensation expense in the pro forma disclosures set forth below.    The effects of applying SFAS No. 123 on pro forma net income for prior periods may not be representative of the effects on pro forma net income for future periods.  

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation plans.

5.   Guarantees

The Company does not issue any guarantees that would require liability-recognition or disclosure, other than its standby letters of credit.  Standby and other letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party.  Those guarantees are primarily issued to support public and private borrowing arrangements, including bond financing and similar transactions.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Typically, these instruments have terms of twelve months or less.  Some expire unused, and therefore, the total amounts do not necessarily represent future cash requirements.  Some have automatic renewal provisions.

For letters of credit, the amount of the collateral obtained, if any, is based on management’s credit evaluation of the counter-party.   The Company had approximately $2.6 million of standby letters of credit on September 30, 2004, most of which will expire within one year and some of which were not collateralized.  At that date, all the letters of credit were for private borrowing arrangements.  The fair value of the Company’s standby letters of credit at September 30, 2004 was insignificant.

#

6.   Retirement Plans (In Thousands)

The following table provides the components of net periodic benefit costs for the three months ended September 30:

The following table provides the components of net periodic benefit costs for the nine months ended September 30:

The Company previously disclosed in its financial statements for the year ended December 31, 2003 that it did not expect to make a contribution to the qualified defined benefit pension plan during 2004, but did expect to contribute $375 to its other postretirement benefit plans in 2004.  There has been no change in the Company’s expectations as of September 30, 2004.

On May 19, 2004, the FASB released FASB Staff Position No. FAS 106-2 “Accounting and for Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.”  Net periodic benefit costs for postretirement benefits in the tables above do not reflect any amount associated with the subsidy because the Company was unable to conclude whether the benefits provided by the plan are actuarially equivalent to Medicare Part D under the Act.

7.   Recently Issued Accounting Pronouncements

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities”.  The objective of this interpretation is to provide guidance on how to identify a variable interest entity (“VIE”) and determine when the assets, liabilities, non-controlling interests, and results of operations of a VIE need to be included in a company’s consolidated financial statements.  FIN 46 was effective for all VIE’s created after January 31, 2003.  However, the FASB postponed that effective date to December 31, 2003.  In December 2003, the FASB issued a revised FIN 46 (FIN 46 R), which further delayed this effective date until March 31, 2004 for VIE’s created prior to February 1, 2003, except for special purpose entities, which must adopt either FIN 46 or FIN 46 R as of December 31, 2003.  The requirements of FIN 46 R resulted in the deconsolidation of the Com pany’s wholly-owned subsidiary trusts, formed to issue redeemable preferred securities (“trust preferred securities”).  The deconsolidation, as of December 31, 2003, resulted in the derecognition of the trust preferred securities and the recognition of junior subordinated debentures of $15,000 in the Company’s consolidated balance sheet.  The assets of the trusts include cash held at the Company’s subsidiary banks, which aggregate approximately $465 at September 30, 2004 and December 31, 2003, offset by an identical amount representing the Company’s investment, which are included in deposits and other assets, respectively.  

Currently, banking regulators allow trust preferred securities, although derecognized under FIN 46 R, to continue to be included in regulatory capital as a component of Tier 1 capital.  The Company cannot predict whether trust preferred securities will continue to be allowed as a component of Tier 1 capital in future periods.

#

8.   Management’s Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expenses during the reporting period.  Actual results could differ from those estimates.

A material estimate that is particularly susceptible to significant change in the near term is the allowance for loan losses.  In connection with the determination of the allowance for loan losses, management obtains appraisals for properties.  The allowance for loan losses is management’s best estimate of probable loan losses incurred as of the balance sheet date.  While management uses available information to recognize losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses.  Such agencies may require the Company to recognize adjustments to the allowance for loan losses based on their judgments about information available to them at the time of their examination, which may not be currently availab le to management.

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Arrow Financial Corporation:

We have reviewed the accompanying consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of September 30, 2004, the related consolidated statements of income for the three-month and nine-month periods ended September 30, 2004 and 2003, and the related consolidated statements of changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2004 and 2003.  These consolidated financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Arrow Financial Corporation and subsidiaries as of December 31, 2003, and the related consolidated statements of income, changes in shareholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated January 21, 2004, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2003, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ KPMG LLP

Albany, New York

October 15, 2004

#

Item 2.

ARROW FINANCIAL CORPORATION AND SUBSIDIARIES

MANAGEMENT'S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SEPTEMBER 30, 2004

Cautionary Statement under Federal Securities Laws: The information contained in this Quarterly Report on Form 10-Q includes statements that are not historical in nature but rather are based on management’s beliefs, assumptions, expectations, estimates and projections about the future.  These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk.  Words such as “expects,” “believes,” “anticipates,” “should,” “plans,” “likely,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements.  Some of these statements are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulati on models.  Others are based on management’s general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.

Examples of forward-looking statements in this Report are:

Forward-looking statements in this Report are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify.  In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.  Factors that could cause or contribute to such differences include, but are not limited to, unexpected changes in economic and market conditions, including unanticipated fluctuations in interest rates, new developments in state and federal regulation, enhanced competition from unforeseen sources, new emerging technologies, sharp fluctuations in capital markets and similar risks inherent in the business of banking.  Significant geopolitical developments, whether or not anticipated, also may cause differences between expected future outcomes as expressed in forward-looking statements and actual outcomes.  Re aders are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Except as expressly required under applicable laws and regulations, the Company undertakes no obligation to revise or update forward-looking statements contained in this Report to reflect future occurrences, including unanticipated events.  This Quarterly Report should be read in conjunction with the Company's Annual Report on Form 10-K for December 31, 2003.

Arrow Financial Corporation (the "Company") is a two-bank holding company headquartered in Glens Falls, New York.  Its banking subsidiaries are Glens Falls National Bank and Trust Company (“GFNB”) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (“SNB”) whose main office is located in Saratoga Springs, New York.  The Company’s principal banking operations are located in the eastern section of New York State, north of Albany.

Peer Group Comparisons: At certain points in the ensuing discussion and analysis, the Company's performance is compared with that of its peer group of financial institutions. Unless otherwise specifically stated, this peer group is the group of 206 domestic bank holding companies with $1 to $3 billion in total consolidated assets identified in the Federal Reserve Board's "Bank Holding Company Performance Report" dated June 30, 2004.  Peer group data presented in this report was obtained from the Federal Reserve's Bank Holding Company Performance Report.

#

Use of Non-GAAP Financial Measures: In 2002, the Securities and Exchange Commission (SEC) adopted rules that apply to all public disclosures, including SEC filings, made by registered companies that contain “non-GAAP financial measures.”  GAAP is generally accepted accounting principles in the United States of America.  Under these rules, if companies include non-GAAP financial measures in their filings they must also disclose, along with the non-GAAP financial measures, certain additional information, including a reconciliation of the non-GAAP financial measures to the closest comparable GAAP financial measures and a statement of management's reasons for utilizing the non-GAAP financial measures.  The SEC has exempted from the definition of “non-GAAP financial measures” certain specific types of commonly used financial measures that are not based on GAAP.  When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required.  The following financial measures, which are commonly used by banks in presenting their financial results, are also used by the Company in its public disclosures and SEC filings, including this Report.  However, management is unable to predict whether the SEC will regard these or certain other financial measures used by the Company as "non-GAAP financial measures" within the meaning of the SEC's rules.

Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented on a tax-equivalent basis.  That is, to the extent that some component of the institution's net interest income will be exempt from taxation (e.g., was received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.  This adjustment is considered helpful in comparing one financial institution's net interest income (pre-tax) to that of another institution, as each will have a different proportion of tax-exempt items in their portfolios.  Moreover, net interest income is itself a component of a second financial measure commonly use d by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets.  For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution.  The Company follows these practices.

The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control.  The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income.  As in the case of net interest income generally, net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis.  Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income).  The Company follows these practices.

#

OVERVIEW

Selected Quarterly Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share and per share amounts have been restated for the September 2004 three percent stock dividend.

#

Selected Quarterly Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 13.

Selected Nine Month Period Information:

(Dollars In Thousands, Except Per Share Amounts)

Per share and per share amounts have been restated for September 2004 three percent stock dividend.

#

Selected Nine Month Period Information, Continued:

¹ See “Use of Non-GAAP Financial Measures” on page 13.

#

Average Consolidated Balance Sheets and Net Interest Income Analysis

(see “Use of Non-GAAP Financial Measures” on page 13)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

#

Average Consolidated Balance Sheets and Net Interest Income Analysis

(see “Use of Non-GAAP Financial Measures” on page 13)

(Fully Taxable Basis using a marginal tax rate of 35%)

(Dollars In Thousands)

#

OVERVIEW

The Company reported earnings of $4.968 million for the third quarter of 2004, an increase of $399 thousand, or 8.7%, as compared to $4.569 million for the third quarter of 2003.  Diluted earnings per share were $.48 and $.44 for the respective quarters.  For the first nine months of 2004 the Company reported earnings of $14.531 million, an increase of $401 thousand, or 2.8%, as compared to $14.130 million for the first nine months of 2003.  Diluted earnings per share were $1.40 and $1.36 for the respective periods.

The returns on average assets were 1.42% and 1.35% for the third quarters of 2004 and 2003, respectively, an increase of 7 basis points, or 5.2%.  The returns on average equity were 17.87% and 17.61% for the third quarters of 2004 and 2003, respectively, an increase of 26 basis points, or 1.5%.  For the first nine months of 2004 and 2003 the returns on average assets were 1.40% and 1.44%, respectively, a decrease of 4 basis points, or 2.8%.  The returns on average equity were 17.70% and 18.36% for the first nine months of 2004 and 2003, respectively, a decrease of 66 basis points, or 3.6%.

The principal reason for the declining returns between the two nine-month periods was the decrease in the net interest margin.  For the first nine months of 2004, the net interest margin was 3.93%, down 16 basis points, or 3.9%, from the 4.09% margin for the first nine months of 2003.  In the third quarter comparison, however, net interest margin for the 2004 quarter at 3.96% was 6 basis points higher than the margin of 3.90% for the third quarter of 2003 and this was the primary reason for the increase in the returns on average assets and equity between the two quarters.

Total assets were $1.385 billion at September 30, 2004, which represented an increase of $10.9 million, or 0.8%, from December 31, 2003, but was virtually unchanged from the level at September 30, 2003.

During the first nine months of 2004 shareholders' equity increased $7.3 million to $113.2 million.  The Company's risk-based capital ratios and Tier 1 leverage ratio increased during the period and continued to exceed regulatory minimum requirements at period-end.  At September 30, 2004 both Company banks qualified as "well-capitalized" under federal bank guidelines.  Efficient utilization of capital remains a high priority of the Company.

CHANGE IN FINANCIAL CONDITION

Summary of Selected Consolidated Balance Sheet Data

(Dollars in Thousands)

(1) Includes Nonaccrual Loans

#

Changes in Sources of Funds:  Total deposits, the Company’s primary source of funds, increased $4.0 million from the balance at year-end 2003.  Significant developments within the deposit portfolio included the following items:

•

Municipal deposits comprised 18.4% of all deposits at September 30, 2004.  Compared to year-end 2003, municipal deposits were down $10.2 million, reflecting the seasonal variation in municipal deposit balances and the outflow of funds due to the expiration of two contractual relationships involving certain municipal deposits.  Compared to the September 30, 2003 level, municipal deposits were up $3.0 million, or 1.6%.  The relatively flat level of municipal deposits compared to the year-earlier total was influenced, in part, by management’s decision to take a less aggressive posture in bidding for certain municipal deposits.  The renewal of two large, high-cost accounts totaling $30.7 million was not aggressively pursued by the Company in the beginning of the third quarter of 2004.

•

Demand deposits continued a pattern of strong growth, increasing $18.1 million, or 12.0% from December 31, 2003.  This increase was attributable to the Company’s existing branch network.

Since December 31, 2003, other short-term borrowings (primarily repurchase agreements) increased $9.1 million and retained earnings during the period added another $7.9 million to the Company’s sources of funds.  During the nine-month period, the balance of FHLB borrowings decreased $10.2 million.

Deployment of Funds into Earning Assets:  In addition to deposits, borrowings and shareholders’ equity as sources of funds, the Company also received during the nine-month period, as usual, a steady stream of maturing loans and investments.  After deployment or redeployment of funds received, the Company experienced a shift in the mix of earning assets during the period from the investment portfolio to the loan portfolio.  The balance of securities available-for-sale decreased $25.7 million while loan balances outstanding increased $21.8 million.  

The Company’s largest loan segment, indirect automobile financing, continued a trend by decreasing $5.9 million during the period.  This decrease was more than offset by a $14.1 million increase in commercial loan balances and a $15.4 million increase in residential real estate loan balances compared to year-end 2003.

Deposit Trends

The following two tables provide information on trends in the balance and mix of the Company’s deposit portfolio by presenting, for each of the last five quarters, the quarterly average balances by deposit type and the percentage of total deposits represented by each deposit type.

Quarterly Average Deposit Balances

(Dollars in Thousands)

Percentage of Average Quarterly Deposits

#

For a variety of reasons, including the seasonality of municipal deposits, the Company typically experiences little net deposit growth in the first quarter of the year, but more significant growth in the second and third quarters.  Deposit balances followed this pattern for the first two quarters of 2004, but due primarily to the adoption of a more conservative approach to certain municipal deposits, discussed above, average deposit balances fell from the second quarter of 2004 to the third quarter of 2004.

In the comparison of average balances between the third quarter of 2004 and the third quarter of 2003, growth in demand deposits and savings accounts more than offset decreases in NOW and time deposits.

The average balances of time deposits of $100,000 or more decreased by $4.2 million, or 5.6%, (primarily municipal balances) and the average balances of other time deposits decreased by $19.2 million, or 10.1%.  The steady decrease in the average balance of other time deposits over the September 2003 to September 2004 period continues a trend that the Company and other financial institutions have experienced in low-rate environments where depositors reallocate maturing time deposits to non-maturity accounts, presumably until rates start to increase.

In June 2003, the Company opened a new branch in Queensbury, New York.  Otherwise, the increase in deposits between the two periods was achieved through the Company's existing base of branches.

Quarterly Average Rate Paid on Deposits

Key Interest Rate Changes 1999 - 2004

#

The Company’s net interest margin has traditionally been sensitive to and impacted by changes in prevailing market interest rates.  Generally, there has been a negative correlation between changes in prevailing interest rates and the Company’s net interest margin in immediately ensuing periods.  When prevailing rates have declined, net interest margin generally has increased, in immediately ensuing periods, and vice versa.  The following analysis of the relationship between prevailing rates and the Company’s net interest margin and net interest income covers the period from 1999 to the present.  As indicated in the preceding table, prevailing interest rates economy-wide increased in the second half of 1999 and throughout 2000, following a long period of flat or slowly-declining prevailing interest rates.  The 1999 rate hikes had a moderately negative impact on financial results for 1999, as the Company experienced decreases in net interest spread and net interest margin.  However, the full negative impact of rising rates was felt more sharply in 2000, when the decrease in net interest margin due to rising rates was significant.

In the first quarter of 2001, after an extended period of stable interest rates and six months of moderate rate increases, the Federal Reserve Board began decreasing short-term interest rates rapidly and significantly in response to perceived weakening in the economy.  By December 2001, the total decrease in prevailing short-term interest rates for the year was 425 basis points.  After eleven months with no rate changes, the Federal Reserve Board decreased rates another 50 basis points in November 2002 and followed with an additional 25 basis point decrease in September 2003.  As a result, the Company experienced a decrease in the cost of deposits in all quarters of 2001, which continued throughout 2002, 2003 and into 2004.  However, although decreases in deposit rates began to be experienced in the first quarter of 2001, the Company did not experience a decrease in the average yield in its loan portfolio until the second quarter of 2 001.  More importantly, although yields on the loan portfolio continued to decrease through the remainder of 2001 and through all of 2002, 2003 and into 2004 as well, the decrease in loan yield trailed, or lagged behind, the decrease in the cost of deposits throughout the 2001-2003 period.

During 2003 and 2004, the effect of the Federal Reserve’s rate decreases on the Company’s deposit rates began to diminish, because rates on several of the Company’s deposit products, such as savings and NOW accounts, were already priced at such low levels that further significant decreases in the rates for such products was not practical or sustainable.  Yields on the loan portfolio, however, continued to fall significantly in 2003 and 2004, putting serious pressure on the net interest margin.  Thus the decreasing rate environment had a positive impact on net interest income during 2001 and 2002, as net interest margins increased both years, but for 2003 and 2004 the low rate environment had a negative impact on net interest margin.

The net interest margin for the full year of 2003 was 4.05%, a decrease of 45 basis points, or 10.0%, from the prior year.  During 2003 the yields on earning assets fell 91 basis points, while the cost of paying liabilities fell only 57 basis points.

The net interest margin for the first quarter of 2004 was 3.97%, an increase of 2 basis points from the net interest margin for the fourth quarter of 2003.  However, in the first quarter of 2004, both the yields on average earning assets and the cost of paying liabilities decreased slightly from the fourth quarter of 2003.

The net interest margin for the second quarter of 2004 was 3.86%, a decrease of 11 basis points from the net interest margin for the first quarter of 2004.  Yields on average earning assets decreased 14 basis points from the first quarter, while the cost of paying liabilities only decreased 4 basis points.

As the table above indicates, the Federal Reserve reversed direction in the second and third quarters of 2004 and began to increase prevailing rates with three successive 25 basis point increases in the federal funds rate.  This change in direction did not immediately impact either the Company’s cost of paying liabilities or its yield on earning assets, both because of normal time-lag in the responsiveness of such rates and for reasons unique to the Company’s portfolios.  The change in the mix of the Company’s total deposits in the third quarter of 2004, reflecting the de-emphasis on certain high cost municipal deposits discussed above, had an impact on net interest margin for the third quarter of 2004, which increased by 6 basis points to 3.96% from the second quarter of 2004.  The cost of all NOW accounts fell from 1.21% for the second quarter of 2004 to .80% for the third quarter of 2004.  The yield on earning assets , meanwhile, only decreased 3 basis points from the prior quarter.

#

Generally however, by the end of the third quarter 2004, the three 25 basis point increases in the target federal funds rate between June 2004 and September 2004, started to have the expected impact on net interest margin.  Rates paid on new time deposits, by the end of the quarter, were higher than the rates on maturing time deposits.  Also, the Company increased the rates paid on the high tiers of money market checking and savings accounts in the third quarter of 2004.  Putting further pressure on net interest margin was the fact that increases in yields on earning assets, expected to lag behind deposit rate increases, in fact were not increasing by quarter-end.  Yields on loan originations were below yields on maturing loans resulting in a decreased yield on earning assets.  Management is not able to predict how long it will be before an increase in prevailing rates will result in an increase in the Company’s yield on its earning assets, or whether or for how long the Company’s net interest margin may continue to decrease, adversely affecting earnings.

In both rising and falling rate environments, the Company faces significant competitive pricing pressures in its marketplace for both deposits and loans, and thus ultimately both assets and liabilities may be expected to reprice proportionately in response to changes in market rates.

Non-Deposit Sources of Funds

The Company has borrowed funds from the Federal Home Loan Bank ("FHLB") under a variety of programs, including fixed and variable rate short-term borrowings and borrowings in the form of "convertible advances."  These convertible advances have maturities of 2 - 10 years and are callable by the FHLB at certain dates beginning no earlier than one year from the issuance date.  If the advances are called (typically in a rising rate environment), the Company may elect to receive replacement advances from the FHLB at the then prevailing FHLB rates of interest.  

Management continues to explore and evaluate new non-deposit sources of funds.  In 1999, the Company established a financing vehicle, Arrow Capital Trust I ("ACT I").  ACT I issued so-called trust preferred securities, that is, 30 year guaranteed preferred beneficial interests in ACT I’s assets ("capital securities") in the aggregate amount of $5.0 million at a fixed rate of 9.5%.  ACT I then used the proceeds from the sale of the capital securities to acquire as its primary asset junior subordinated debentures issued by the Company, bearing the same interest rate as the capital securities (9.5%) and similar in aggregate amount ($5.0 million).  The debentures and capital securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning December 31, 2004.  In July 2003, the Company established a second financing vehicle, Arrow Capital Statutory Trust II ("A CST II") also for the purpose of issuing trust preferred securities.  ACST II issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company ("capital securities") in the aggregate amount of $10.0 million at a fixed rate of 6.53% until September 30, 2008 (afterwards the rate is variable, set at the three month LIBOR rate plus 3.15%). ACST II then used the proceeds from the sale of the capital securities to acquire as its primary asset junior subordinated debentures issued by the Company, bearing the same interest rate as the ACST II capital securities and similar in aggregate amount ($10 million).  These securities are redeemable (subject to any required regulatory approval) at the option of the Company beginning September 30, 2008.

Currently, the Company’s ACT I and ACST II capital securities, with associated expense that is tax deductible, qualify as Tier I capital of the Company under regulatory definitions, despite recent changes in the accounting for such securities under GAAP (See Note 7 to the Notes to Unaudited Consolidated Interim Financial Statements, above).  The Company cannot predict whether trust preferred securities will continue to be allowed as a component of Tier 1 capital in future periods.  

Both the ACT I and ACST II capital securities are subject to early redemption by the Company if the proceeds cease to qualify as Tier 1 capital of the Company, which would only happen if bank regulatory authorities were to reverse their current position that trust preferred securities issued by subsidiaries of bank holding companies, up to certain threshold levels, qualify for such treatment.

#

Loan Trends

The following two tables present, for each of the last five quarters, the quarterly average balances by loan type and the percentage of total loans represented by each loan type.

Quarterly Average Loan Balances

(Dollars in Thousands)

Percentage of Quarterly Average Loans