UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2003
[ ] TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from___________to__________
Commission File Number 2-91196(1)
NORTHERN EMPIRE BANCSHARES
----------------------------------------------------
(Exact name of registrant as specified in its charter)
CALIFORNIA 94-2830529
- ------------------------------- -------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
801 Fourth Street
Santa Rosa, California 95404
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(Address of principal executive offices)
(707) 579-2265
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Exchange Act: NONE
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 X
No_____.
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes X No ___
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which
the common equity was last sold, or the average bid and asked price of such
common equity, as of the last business day of the registrant's most
recently completed second fiscal quarter. $87,553,000 as of June 30, 2003.
Shares held by directors and executive officers have been excluded in that
such persons may be deemed to be "affiliates." Such determination of
affiliate status is not necessarily a conclusive determination for other
purposes.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date. 9,104,180
shares, as of February 15, 2004.
DOCUMENTS INCORPORATED BY REFERENCE:
Not Applicable.
(1) Registrant filed a registration statement, on Form S-1, under File
Number 2-91196, and the Post Effective Amendment No. 8 to the registration
statement was declared effective on November 23, 1988.
TABLE OF CONTENTS
Part I
Page
Item 1. Business 4
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 14
Part II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters 15
Item 6. Selected Financial Data 18
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operation 19
Item 7A. Quantitative and Qualitative Disclosures about
Market Risk 45
Item 8. Financial Statements and Supplementary Data 47
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 48
Item 9 A. Controls and Procedures 48
Part III
Item 10. Directors and Executive Officers of the Registrant 49
Item 11. Executive Compensation 50
Item 12. Security Ownership of Certain Beneficial Owners and
Management 52
Item 13. Certain Relationships and Related Transactions 53
Item 14. Principal Accounting Fees and Services 54
Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports
on Form 8-K 55
PART 1
Forward-Looking Statements
The discussion of certain matters in this report may constitute
"forward-looking statements" as defined in section 27A of the Securities
Act of 1933, and section 21E of the Securities Exchange Act of 1934, which
includes statements such as projections, plans and objectives and
assumptions about the future, and such forward looking statements are
subject to the safe harbor created by these sections. Although the
Corporation and the Bank have based their plans and projections on certain
assumptions, there can be no assurances that such assumptions will be
correct, or that their plans and projections can be achieved. Many
factors, risks and uncertainties could cause the actual results, amounts or
events to differ materially from those the Corporation and the Bank expect
to achieve or occur. Such factors, risks and uncertainties include, but
are not limited to the following:
Changes in the market interest rates and volatility of rate
sensitive loans and deposits. Changes in interest rates impact the
demand for new loans, the rates received on loans and securities
and the rates paid on deposits and borrowings. Significant
fluctuations in interest rates may have an adverse effect on the
business, financial condition and results of operations of the
Corporation and the Bank.
Competitive pressures in the banking industry. The banking
business is highly competitive, and competition among financial
institutions for all types of financial products and services is
expected to increase. The ability of the Bank to compete in the
future will depend on the nature and level of future competition.
Changes in the legislative and regulatory environment.
Banks and bank holding companies are subject to extensive
supervision and regulation. The banking business is also affected
by the monetary and fiscal policies of the United States government
and the Federal Reserve Board. The future regulatory environment
may significantly affect the Bank's business.
Declines in the national or regional economy. A worsening
of economic conditions could reduce the demand for loans, cause
credit quality deterioration and/or result in a decline in the
value of real estate collateral securing a substantial portion of
the Bank's loans. Any of these factors could have an adverse
impact on the Bank's financial condition.
Changes in accounting standards by the Financial Accounting
Standards Board, the Securities and Exchange Commission (SEC) or
other standard-setting bodies. Such changes could affect the
manner in which the Corporation and the Bank are required to
account for and report income, expenses, reserves, or a merger or
acquisition, if any and could materially affect the Corporation's
business and financial statements
Changes in the U.S. Small Business Administration (SBA)
program. The Bank makes a significant portion of its commercial
loans through the U.S. Small Business Administration program,
which guarantees a portion of such loans, and the Bank generates
income through the sale of such loans. Changes in the Small
Business Administration program could have an adverse effect on
the Bank's business, such changes are a possibility because of
current budget constraints at the SBA.
Changes in Federal Home Loan Bank (FHLB) borrowing policies.
The Bank relies upon the FHLB for a large portion of the funding
which is collateralized by loan assets. Based upon the current
policies of the FHLB we believe the advances are renewable.
Changes in the requirements of the FHLB could materially affect
the Bank's business and financial statements.
Investors are cautioned to consider these and other risks
and uncertainties. The Corporation specifically disclaims any
obligation to update any such factors or to publicly announce the
results of any revisions to any forward-looking statements in this
report to reflect future events or developments.
ITEM 1. Business
Available Information
The Corporation electronically files the following reports with the SEC:
Form 10-K (annual report), Form 10-Q (quarterly report, and Form 8-K
(current report). The Corporation may also file additional reports and/or
forms with the SEC. The SEC maintains an internet website, WWW.sec.gov.,
at which all electronic filings can be accessed. Information regarding the
Corporation and the Bank may be found at the Bank's website,
www.snbank.com. A direct link to Northern Empire Bancshares' reports filed
with the SEC is located under "Investor Info" section on the website.
Paper copies of the reports filed with the SEC may also be obtained by
contacting Jane M. Baker at the Corporation at 801 Fourth Street, Santa
Rosa, California or by telephone (707) 579-2265.
History and General
Northern Empire Bancshares (the "Corporation") was incorporated as a
California corporation on June 8, 1982 for the purpose of becoming a bank
holding company of Sonoma National Bank (the "Bank"). On April 27, 2000,
the Corporation made an election to become a financial holding company
pursuant to the Gramm-Leach-Bliley Act of 1999. The Corporation's executive
offices are located at 801 Fourth Street, Santa Rosa, California, and its
telephone number is (707) 579-2265.
The Corporation's sole subsidiary is the Bank and its activities are the
commercial banking activities engaged in through the Bank and some lending
through loan participations with the Bank. As a financial holding company,
the Corporation may in the future invest in subsidiaries which are
permissible for a financial holding company, subject to the required
approvals of the Federal Reserve Board. However, the Corporation has no
present plans to make any such additional investments and there can be no
assurance that it will do so in the future.
The Bank was organized as a national banking association on March 27, 1984
and commenced operations on January 25, 1985. It currently has the
following seven banking offices operating in Sonoma County, California:
1. Main Office located at 801 Fourth Street, in the central
business district of Santa Rosa, California,
2. Oakmont Branch located in the Oakmont area of Santa Rosa,
approximately 5 miles east of the main office,
3. West College Branch office in west Santa Rosa,
4. Windsor Branch located in Windsor, approximately 5 miles
north of the main office,
5. Sebastopol Branch office located in Sebastopol,
approximately 5 miles west of the main office,
6. Petaluma Branch located in Petaluma, approximately 15 miles
south of the main office, and
7. Sonoma Branch located in Sonoma, approximately 20 miles east
of the main office.
The Bank will be opening its first branch outside of Sonoma County in San
Rafael, California this summer, approximately 45 miles south of Santa Rosa.
The Bank also has loan production offices in the following locations:
1. Santa Rosa Loan Center located at 815 Fifth Street, in the
central business district of Santa Rosa, California,
2. Sacramento Office located at 1851 Heritage Lane, Suite 128,
Sacramento, California,
3. San Rafael Office located at 901 Tamalpais Avenue, Suite
200, San Rafael, California,
4. Walnut Creek Office located at 2910 Camino Diablo, Suite
215C, Walnut Creek, California, and
5. Phoenix Office located in the Biltmore Financial Center at
2398 East Camelback Road, Suite 615, Phoenix, Arizona.
As a national bank, the Bank is subject to supervision, regulation and
regular examination by the Comptroller of the Currency ("Comptroller").
The deposits of the Bank are insured by the Bank Insurance Fund, which is
administered by the Federal Deposit Insurance Corporation. The Bank is a
member of the Federal Reserve System and, as such, is subject to applicable
provisions of the Federal Reserve Act and the regulations thereunder. See,
"Supervision and Regulation."
The Bank engages in the general commercial banking business. It accepts
checking and savings deposits, offers money market deposit accounts and
certificates of deposit, makes secured and unsecured commercial,
construction, other installment and term loans, and offers other customary
banking services. The Bank makes commercial loans guaranteed by the Small
Business Administration (SBA), which may be sold in the secondary market.
The Bank does not offer trust services directly, and does not presently
intend to do so, but offers such services, when requested, through its
correspondent banks.
Within the Loan Department are groups of lenders which specialize in
commercial, construction and SBA lending. SBA loans are funded by the Bank
and then the Bank may, at its option, sell the portion of the loan
guaranteed by the SBA (generally 75% to 85% of the total loan amount,
depending on the purpose and term of the loan). When a SBA loan is sold,
the Bank retains the unguaranteed portion of that loan and the right to
service the loan. Income from loan sales is recorded in non-interest
income. The SBA program is subject to budgetary restrictions and other
revisions by the government which could have a negative impact on the
Bank's profit. See, "Management's Discussion and Analysis of Financial
Condition and results of Operation, Non-Interest Income." The Bank is
designated as a "Preferred Lender" by the SBA. This means that it may fund
a loan without credit review and underwriting performed by the SBA.
Market Area
The Bank's primary market area and source of most of its loan business is
Sonoma County and the greater Bay Area in California and Arizona. The Bank
has expanded its lending territory for construction loans, commercial real
estate loans and loans made under the programs of the SBA. The Bank has
loan production facilities in Phoenix, Arizona and San Rafael, Sacramento,
and Walnut Creek, California. The primary market area for deposit business
is Sonoma County.
Competition
The banking business in California generally, and specifically in the
market area served by the Bank, is highly competitive with respect to both
loans and deposits, and is dominated by major banks which have offices
operating throughout California. Among the advantages such major banks
have over the Bank are their ability to finance wide-ranging advertising
campaigns and to allocate their investment assets to regions of highest
yield and demand. In addition, many of the major banks operating in the
Bank's service area offer specialized services, such as trust and
international banking services, which the Bank does not offer directly. By
virtue of their greater total capitalization, the major banks also have
substantially higher lending limits than the Bank has. The Bank competes
for loans and deposits with these major banks, as well as with other
independent banks, savings and loan associations, credit unions, mortgage
companies, insurance companies and other lending institutions. The entry
of other independent banks in the Bank's service area may adversely affect
the Bank's ability to compete.
Savings and loans, credit unions and money market funds have provided
significant competition for banks with respect to deposits. Other
entities, both governmental and private, seeking to raise capital through
the issuance and sale of debt or equity securities, also provide
competition for the Bank in the acquisition of deposits. The trend of
federal and state legislation has significantly increased competition
between banks and other financial institutions for both loans and deposits
and is expected to continue to do so in the future. In particular, the
Gramm-Leach-Bliley Act enacted in 1999 authorizes affiliations among banks,
insurance companies and securities firms and is expected to significantly
increase competition among financial institutions with respect to all types
of financial products and services.
The earnings and growth of the Bank are affected not only by local market
conditions and general economic conditions, but also by government monetary
and fiscal policies. Such policies influence the growth of loans,
investments and deposits and also affect interest rates charged on loans
and paid on deposits. The nature and impact of future changes in such
policies on the business and earnings of the Bank cannot be predicted.
At present, there are approximately 122 banking offices and offices of
savings and loan associations in the Sonoma County market area and a
substantially greater number of such offices in the greater Bay Area,
including offices of major chain banks, of smaller independent banks and
savings and loan associations. The Bank attempts to compete by offering
personalized and specialized services to its customers. In the Sonoma
County market area, the Bank's promotional activities emphasize the
advantages of doing business with a locally owned, independent institution
attuned to the particular needs of the community.
The Bank has experienced increased competition from major banks and local
community banks in making SBA loans, especially in California. Most of our
local SBA competitors also have Preferred Lender status from the SBA, and
they often offer more attractive rates on SBA loans than the Bank can. We
expect this trend to continue. There can be no assurance that the Bank will
continue to increase its SBA loan portfolio or continue to make a
significant number of SBA loans.
Certain statistical information concerning the Bank and the Corporation is
provided at "Item 7-Management's Discussion and Analysis of Financial
Condition and Results of Operation".
Employees
At December 31, 2003 the Bank had 131 full-time and 29 part-time employees.
Supervision and Regulation
Banks and bank holding companies are subject to extensive supervision and
regulation under both federal and state laws and regulations. The primary
purpose of these laws and regulations is the protection of depositors,
consumers and the federal deposit insurance fund, and not the protection of
shareholders. The following description summarizes the regulatory
environment and some of the laws to which the Corporation and the Bank are
subject. The summary is not intended to be a discussion of all applicable
laws and regulations and is qualified in its entirety by reference to
specific statutes and regulations. The laws and regulations applicable to
banks and bank holding companies are constantly changing and evolving and
new laws and regulations are frequently introduced. The banking business
is also affected by the policies and interpretations of regulatory
authorities. It is not possible to predict the impact of future changes in
the regulatory environment on the business and operations of the
Corporation and the Bank.
The Corporation
The Corporation is a bank holding company registered under the Bank Holding
Company Act of 1956 and is subject to supervision by the Board of Governors
of the Federal Reserve System ("Board"). As a bank holding company, the
Corporation must obtain the approval of the Board before it may acquire all
or substantially all of the assets of any bank, or ownership or control of
the voting shares of any bank if, after giving effect to such acquisition
of shares, the Corporation would own or control more than 5% of the voting
shares of such bank. Prior approval of the Board is also required for the
merger or consolidation of the Corporation and another bank holding
company. Effective April 27, 2000, the Corporation made an election to
become a "financial holding company" pursuant to the Gramm-Leach-Bliley
Act. See "Financial Services Modernization," below.
The Board has the authority to examine the Corporation and the Bank
periodically. The Board has a policy for risk-focused supervision of small
bank holding companies that do not engage in significant non-banking
activities. The focus of examinations under the policy is on whether the
Corporation has in place systems to manage the risks it takes on in its
business. In analyzing risk, the Board looks at the financial condition of
the Corporation and the Bank, management, compliance with laws and
regulations, inter-company transactions and any new or contemplated
activities.
The Corporation and any subsidiary which it may acquire or organize in the
future are deemed to be affiliates of the Bank within the meaning set forth
in the Federal Reserve Act and are subject to that Act. This means, for
example, that there are limitations on loans by the Bank to affiliates, on
investments by the Bank in any affiliate's stock and on the Bank's taking
any affiliate's stock as collateral for loans to any borrower. All
affiliate transactions must satisfy certain limitations and otherwise be on
terms and conditions that are consistent with safe and sound banking
practices. In this regard, the Bank generally may not purchase from any
affiliate a low-quality asset (as that term is defined in the Federal
Reserve Act). Also, transactions by the Bank with an affiliate must be on
substantially the same terms as would be available for non-affiliates.
The Corporation and the Bank are prohibited from engaging in certain tie-in
arrangements in connection with the extension of credit. For example, the
Bank generally may not extend credit on the condition that the customer
obtain some additional service from the Bank or the Corporation, or refrain
from obtaining such service from a competitor.
The Corporation is subject to the periodic reporting requirements of the
Securities Exchange Act of 1934 ("Exchange Act"), and it files annual,
quarterly and current reports with the Securities and Exchange Commission.
At this time the Corporation's common shares are not registered under the
Exchange Act, and it is therefore not subject to the proxy and tender offer
rules or the director, executive officer and principal shareholder
reporting requirements of the Exchange Act.
(a) Sarbanes-Oxley Act of 2002. President Bush signed the Sarbanes-Oxley
Act of 2002 into law on July 30, 2002. This new legislation establishes a
comprehensive framework that affects the corporate governance and reporting
requirements of companies that file reports with the Securities and
Exchange Commission and provides accounting oversight of the accounting
firms that audit them. Among other things, the Sarbanes-Oxley Act
limits the scope of consulting services that auditors can offer their
reporting company audit clients;
imposes a range of new criminal penalties for fraud and other
wrongful acts and extends the period during which certain types of
lawsuits can be brought against a company or its insiders;
expands certain disclosure requirements for reporting companies and
requires the maintenance of internal controls and procedures and
disclosures regarding those controls and procedures;
requires officer certifications of a reporting company's financial
statements in quarterly, annual and other reports to the Securities
and Exchange Commission; and
creates an accounting oversight board that is empowered to set
auditing quality control and ethics standards.
The Sarbanes-Oxley Act requires the Securities and Exchange Commission to
adopt regulations to implement certain of its requirements. Numerous
regulations have been adopted to date and others are expected to be adopted
in the future.
(b) USA Patriot Act of 2001. The USA Patriot Act of 2001 contains new
anti-money laundering and financial transparency laws, in addition to the
laws and regulations theretofore in effect. The USA Patriot Act requires,
among other things, certain additional due diligence and record keeping
practices for financial institutions that administer or maintain private
bank accounts for non-U.S. persons and imposes standards for verifying
customer identification at account opening. The statutory requirements are
to be implemented by regulations issued by the U.S. Department of the
Treasury.
(c) Financial Services Modernization. Major financial services
modernization legislation was enacted in 1999, known as the
Gramm-Leach-Bliley Act ("1999 Act"). This legislation removed barriers
that theretofore separated banks, securities firms and other types of
financial institutions. Effective March 11, 2000, the 1999 Act established
a new type of holding company, a "financial holding company," that may
engage in "financial activities" not permitted to bank holding companies
and that have the authority to affiliate with companies engaged in such
activities. "Financial activities" are to be determined by the Board in
coordination with the Secretary of the Treasury, and may include activities
that are financial in nature, incidental to an activity that is financial
in nature, or complimentary to a financial activity and that do not pose a
safety and soundness risk. The 1999 Act enumerates activities considered
financial in nature (in addition to those already permitted to bank holding
companies), including underwriting insurance or annuities, or acting as an
insurance or annuity principal, agent or broker; providing investment or
financial advice; underwriting, dealing in or making markets in securities;
and merchant banking (subject to certain limitations).
A holding company may elect to be treated as a financial holding company,
and engage in these activities, provided that its subsidiary depository
institutions are well-capitalized, well-managed and have received at least
a satisfactory rating in the last Community Reinvestment Act examination.
National banks may also engage in many of these activities through a new
structure, the "financial subsidiary," subject to substantially the same
capital, management and CRA requirements, and state-chartered banks are
given similar authority.
The Act also provides for functional regulation of financial services
firms, which means that securities activities are to be regulated by the
Securities and Exchange Commission, insurance activities by state insurance
regulators, and banking activities by the appropriate bank regulatory
agencies.
The 1999 Act has resulted or is expected to result in new or revised
regulations for such matters as (1) newly authorized activities for bank
holding companies and financial holding companies, (2) financial privacy,
(3) customer protections for bank insurance sales, (4) the Community
Reinvestment Act, (5) overseas activities of bank holding companies, (6)
bank derivatives transactions and intra-day credit, (7) activities allowed
in national bank operating subsidiaries, and (8) broker-dealer registration
requirements for bank sales of new hybrid products.
(d) Dividends Payable by the Corporation Holders of Common Stock of the
Corporation are entitled to receive dividends as and when declared by the
Board of Directors out of funds legally available therefore under the laws
of the State of California. Under California law, the Corporation is
prohibited from paying dividends unless: (a) the amount of its retained
earnings immediately prior to the dividend payment equals or exceeds the
amount of the dividend; or (b) immediately after giving effect to the
dividend (i) the sum of its assets would be at least equal to 125 percent
of its liabilities and (ii) its current assets would be at least equal to
its current liabilities, or, if the average of its earnings before taxes on
income and before interest expense for the two preceding fiscal years was
less than the average of its interest expense for the two preceding fiscal
years, at least equal to 125 percent of its current liabilities.
The Board of Governors has advised bank holding companies that it believes
that payment of cash dividends in excess of current earnings from
operations is inappropriate and may be cause for supervisory action. As a
result of this policy, banks and their holding companies may find it
difficult to pay dividends out of retained earnings from historical periods
prior to the most recent fiscal year or to take advantage of earnings
generated by extraordinary items such as sales of buildings or other large
assets in order to generate profits to enable payment of future dividends.
Further, the Board of Governors' position that holding companies are
expected to provide a source of managerial and financial strength to their
subsidiary banks potentially restricts a bank holding company's ability to
pay dividends.
The Corporation's ability to pay dividends on its Common Stock is subject
to the rights of senior security holders and lenders, which will include
the holders of preferred stock in the future if preferred stock is issued.
Dividend payments will also be dependent upon its separate liquidity needs.
See Item 7, "Management's Discussion and Analysis of Financial Condition."
In that regard, Federal and state statutes, regulations and policies impose
restrictions on the payment of management fees and cash dividends by the
Bank to the Corporation.
The Bank
As a national banking association, the Bank is subject to the National Bank
Act and to supervision, regulation and regular examination by the
Comptroller of the Currency ("Comptroller"). It is also a member of the
Federal Reserve System and, as such, is subject to applicable provisions of
the Federal Reserve Act and regulations issued pursuant thereto. The
deposits of the Bank are insured up to the maximum legal limits by the Bank
Insurance Fund ("BIF"), which is managed by the Federal Deposit Insurance
Corporation ("FDIC"), and the Bank is therefore subject to applicable
provisions of the Federal Deposit Insurance Act and regulations of the
FDIC. The Bank is also subject to applicable provisions of California law,
insofar as they do not conflict with or are not pre-empted by Federal law.
The statutes and regulations administered by these agencies govern most
aspects of the Bank's business, including required reserves against
deposits, loans, investments, dividends, deposit insurance premiums mergers
and acquisitions, the establishment of new branches and other banking
facilities, disclosure obligations to depositors and borrower and customer
privacy.
(a) Supervision and Examinations. Federal law mandates frequent
examinations of all banks, with the costs of examinations to be assessed
against the bank being examined. In the case of the Bank, its primary
regulator is the Comptroller.
The Comptroller has a community bank risk-assessment system, which consists
of examination procedures that focus on the various types of risks that
national banks face. The Comptroller measures each individual bank's
exposure to certain risks, assesses the controls the bank has adopted in
response to the risks it faces and the measures it takes to monitor those
risks. The Comptroller evaluates nine categories of risk: credit, interest
rate, liquidity, price, foreign exchange, transaction, compliance,
strategic and reputation. These nine risks are measured and the direction
of the risk is also analyzed.
The FDIC has "back up" enforcement power over the Bank under Federal law.
The FDIC is authorized to conduct examinations of insured institutions that
represent a heightened risk to the deposit insurance funds when the FDIC
determines that such an examination is necessary. By agreement with other
federal regulatory agencies, the FDIC is also given access to supervisory
information held by the federal agencies and the right to participate in
examinations.
The Federal banking regulatory agencies have substantial enforcement powers
over the depository institutions that they regulate. Civil and criminal
penalties may be imposed on such institutions and persons associated with
those institutions for violations of any law or regulation. The penalties
can be up to $ 5,000 per day that a violation continues when the violation
is unintentional, or up to $1 million per day that a violation continues
when the violation is willful. The amount of the penalty also depends on
whether the violation is part of a pattern or causes a loss to the
financial institution. Enforcement powers also include the power to enjoin
"unsafe or unsound practices," the issuance of a cease-and-desist order
that can be judicially enforced, the issuance of directives to increase
capital and the issuance of formal and informal agreements.
(b) Prompt Corrective Action. The Federal Deposit Insurance Corporation
Improvement Act of 1991 ("FDICIA") requires the banking agencies to take
corrective action against certain financial institutions, based upon the
financial institutions' compliance with the various capital measurements.
The capital requirements and the definitions of the various measures of
capital are described below under the heading "Capital Regulations and
Dividends." The following chart sets forth the various categories of
capital compliance. In order to be considered in the well or adequately
capitalized categories, a financial institution must meet all the
requirements for that category. An institution will be considered
undercapitalized or significantly or critically undercapitalized if it
meets any of the requirements for that category.
Total Tier 1
Ratio Category Risk-Based Risk-Based Leverage
- -------------- ------------ ----------- -----------
Well Capitalized* 10% or above 6% or above 5% or above
Adequately Capitalized 8% or above 4% or above 4% or above**
Undercapitalized Less than 8% Less than 4% Less than 4%
Significantly Undercapitalized Less than 6% Less than 3% Less than 3%
Critically Undercapitalized - - 2% or less
* In addition, the institution must not be subject to any written
capital order or directive to meet and maintain a specific capital
level.
** 3% instead of 4% if the institution has the highest rating under
the CAMEL rating system.
FDICIA also permits the banking agencies essentially to downgrade an
institution to the next lower category (but not into the category of
critically undercapitalized) if it determines that the institution is in an
unsafe or unsound condition, or is engaging in an unsafe or unsound
practice. An institution that has received a less-than-satisfactory rating
in its most recent examination report for assets, management, earnings or
liquidity may be deemed to be engaged in an unsafe and unsound practice.
Except for a finding based on a less-than-satisfactory rating, the
institution is entitled to prior written notice and an opportunity to
respond to its regulator's finding that it is in an unsafe or unsound
condition or is engaging in such practices.
Based on its capital position at December 31, 2003, the Bank is considered
well capitalized.
As noted above, an undercapitalized financial institution is subject to
certain corrective action by the appropriate agency, depending on the
category it falls into. All undercapitalized institutions are required to
submit a capital plan within 45 days after the institution becomes
undercapitalized. Also, such an institution's asset growth is restricted
and it must obtain the prior approval of its federal regulator before it
acquires any company, sets up any new branch or engages in any new line of
business. The banking agency is required to monitor closely the condition
of the bank and its compliance with its plan, and to review periodically
the plan and the supervisory restrictions on the bank to assure they are
appropriate. In addition, the regulator is authorized by statute to take
the certain corrective actions and order certain limitations on the bank's
activities if necessary to carry out the purposes of the statute.
If an institution is categorized as being significantly undercapitalized,
or is undercapitalized and fails to submit a capital plan, its banking
regulator is required to take increasingly severe enforcement actions
against such institution. The regulator must require recapitalization
through a sale of stock or a merger, restrict affiliate transactions and
restrict the interest rates the bank may offer on deposits, (unless it
finds that doing so would not further the purpose of the section). In
addition, such an institution may not pay a bonus to a senior executive
officer or increase the pay of any executive officer without the prior
written approval of its federal regulator.
An institution that is critically undercapitalized is subject to mandatory
restrictions that are even more severe, and seizure within time limits
designated by statute. In general, the federal regulator is required to
seize an institution within 90 days of its becoming critically
undercapitalized, unless the regulator can document that another course of
action will better achieve the purposes of this section. The FDIC is
required to restrict the activities of a critically undercapitalized
institution, beyond the degree of limitations specified above for
institutions that are significantly undercapitalized.
(c) Brokered Deposits. FDICIA places limits on brokered deposits and
extends the limits to any bank that is not "well capitalized" or is
notified that it is in "troubled condition." Previously, the limitations
applied only to troubled banks. A well capitalized institution (which
generally includes an institution that is considered well capitalized for
purposes of the prompt corrective action regulations discussed above) may
still accept brokered deposits without restriction, unless it has been
informed by its appropriate Federal regulatory agency that it is in
"troubled condition." All other insured depository institutions are
prohibited from accepting brokered deposits unless a waiver is obtained
from the FDIC. If a waiver is obtained, the interest paid on such deposits
may not exceed the rate paid for deposits in its normal market area, or the
national rate as determined in the FDIC's regulation.
If a depository institution solicits deposits by offering interest rates
significantly higher than rates being offered in its market area, it is
deemed under FDICIA to be a deposit broker. Therefore, depending on its
capital category, it may be prohibited from such practice, or need a prior
waiver from the FDIC in order to offer such rates. The FDIC's regulations
specify that an institution that is not well capitalized may offer rates
that exceed the prevailing effective rates offered in the normal market
area only if the institution obtains a waiver, but the institution may not
offer rates more than 75 basis points above such prevailing rates.
The Bank is at this time considered well capitalized and not in a "troubled
condition," and it is not, therefore, subject to the brokered deposit
limitations.
(d) Risk-Based Deposit Insurance Assessments. In addition, FDICIA
requires the FDIC to develop and implement a system to account for risks
attributable to different categories and concentrations of assets and
liabilities in assessing deposit insurance premiums. Under this system,
each bank's deposit insurance premium assessment is calculated based on a
risk-based assessment program and the FDIC may increase or decrease the
assessment rate schedule on a semi-annual basis.
Capital Regulations and Dividends
The Board requires member banks and bank holding companies to maintain
adequate capital and has adopted capital leverage guidelines for evaluating
the capital adequacy of bank holding companies. The Comptroller has also
adopted a similar minimum leverage regulation, requiring national banks to
maintain at least a minimum capital to asset ratio. The Board's guidelines
and the Comptroller's regulations require the banks and bank holding
companies subject to them to achieve and maintain a Tier 1 capital to total
asset ratio of at least three percent (3.0%) to five percent (5.0%),
depending on the condition and rate of growth of the bank or holding
company. Tier 1 or core capital is defined to consist primarily of common
equity, retained earnings, and certain qualified perpetual preferred stock.
These minimum leverage ratio requirements limit the ability of the banking
industry, including the Corporation and the Bank, to leverage assets.
The Federal Reserve Board also uses risk-based capital guidelines to
evaluate the capital adequacy of member banks and bank holding companies.
Under these guidelines, assets are categorized according to risk and the
various categories are assigned risk weightings. Assets considered to
present less risk than others require allocation of less capital. In
addition, off-balance sheet and contingent liabilities and commitments must
be categorized and included as assets for this purpose. Under these
guidelines, the Corporation is required to maintain total capital of at
least 8.00% of risk-adjusted assets, and half of that minimum total capital
must consist of Tier 1 capital as defined above.
The Comptroller has also adopted risk-based capital guidelines applicable
to national banks, such as the Bank, that are similar to the Federal
Reserve's risk-based capital guidelines. At this time, the Bank is
required to maintain total capital of at least 8.00% of risk-adjusted
assets.
The capital totals of the Corporation and the Bank, as of December 31,
2003, exceeded the amounts of capital required under the regulatory
guidelines to be well capitalized as shown in Footnote 13 of the Financial
Statements, entitled Regulatory Capital Requirements, Item 8.
Under the risk-based capital rules, when the agencies assess the capital
adequacy of a bank, they must take into account the effect on that bank's
capital that would occur if interest rates moved up or down. The purpose of
this requirement is to ensure that banks with high levels of interest rate
risk have enough capital to cover the loss exposure.
The risk-based guidelines and the leverage ratio do not have a significant
effect on the Corporation and the Bank at this time because both the
Corporation and the Bank meet their respective required ratios. The effect
the requirements may have in the future is uncertain, but management does
not believe they will have an adverse effect on the Corporation or the
Bank. The risk-based capital guidelines may affect the allocation of the
Bank's assets between various types of loans and investments. If the Bank
continues to grow with its present asset composition, it may be required to
raise additional capital.
The required capital ratios have increased in significance under FDICIA, as
described above. The ratios now affect the Bank's ability to utilize
brokered deposits and its deposit insurance premium rates, and they can
result in regulatory enforcement action. See, above, "The Bank."
As required by FDICIA, the Federal banking agencies now take credit risk
concentrations and an individual institution's ability to manage such
concentrations into account when they assess a bank's capital adequacy.
Non-traditional investments and activities, such as the use of derivatives,
are also taken into account in assessing capital requirements. The
agencies can adjust the standards for risk-based capital on a case by case
basis to take such risks into account, but there is no formula that a bank
can use prior to evaluation by the agency to determine how credit
concentration or nontraditional activities will affect its capital
requirements.
Regulatory restrictions and other information guidelines with respect to
the payment of dividends by the Bank are contained in Item 5, "Market for
Registrant's Common Equity and Related Stockholder Matters.", below.
Impact of Monetary Policies
Banking is a business in which profitability depends on rate differentials.
In general, the difference between the interest rate received by the Bank
on loans extended to its customers and securities held in the Bank's
investment portfolio and the interest rate paid by the Bank on its deposits
and its other borrowings comprise the major portion of the Bank's earnings.
To the extent that the Bank is not able to compensate for increases in the
cost of deposits and other borrowings with greater income from loans,
securities and fees, the net earnings of the Bank will be reduced. The
interest rates paid and received by the Bank are highly sensitive to many
factors which are beyond the control of the Bank, including the influence
of domestic and foreign economic conditions.
The earnings and growth of the Bank are also affected by the monetary and
fiscal policy of the United States government and its agencies,
particularly the Board. These agencies can and do implement national
monetary policy, which is used in part to curb inflation and combat
recession. Among the instruments of monetary policy used by these agencies
are open market transactions in United States Government securities,
changes in the discount rates of member bank borrowings and changes in
reserve requirements. The actions of the Board have had a significant
effect on lending by banks, investments and deposits, and such actions are
expected to continue to have a substantial effect in the future. However,
the nature and timing of any further changes in such polices and their
impact on the Bank cannot be predicted.
Public Interest Laws, Consumer and Lending Laws
In addition to the other laws and regulations discussed herein, the Bank is
subject to numerous consumer and public interest laws and regulations that
are designed to protect customers in transactions with banks. While the
list set forth below is not exhaustive, these laws and regulations include
the Community Reinvestment Act, Truth in Lending Act, the Truth in Savings
Act, the Electronic Funds Transfer Act, the Expedited Funds Availability
Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Real
Estate Settlement Procedures Act, the Home Mortgage Disclosure Act, the
Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Bank
Secrecy Act, the Right to Financial Privacy Act and the Americans with
Disabilities Act.
These laws and regulations mandate certain disclosure requirements and
regulate the manner in which financial institutions must deal with
customers when taking deposits, making loans, collecting loans and
providing other services. The Bank must comply with the applicable
provisions of these laws and regulations as part of its ongoing customer
relations. Failure to comply with these laws and regulations can subject
the Bank to various penalties, including but not limited to enforcement
actions, injunctions, fines or criminal penalties, punitive damages to
consumers and the loss of certain contractual rights.
Environmental Regulation
Federal, state and local regulations regarding the discharge of materials
into the environment may have an impact on the Corporation and the Bank.
Under Federal law, liability for environmental damage and the cost of
cleanup may be imposed upon any person or entity who is an owner or
operator of contaminated property. State law provisions, which were
modeled after Federal law, impose substantially similar requirements. Both
Federal and state laws were amended in 1996 to provide generally that a
lender who is not actively involved in operating the contaminated property
will not be liable to clean up the property, even if the lender has a
security interest in the property or becomes an owner of the property
through foreclosure.
The Economic Growth and Regulatory Paperwork Reduction Act of 1996 (the
"Economic Growth Act"), discussed in more detail below, includes protection
for lenders from liability under the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 ("CERCLA"). The Economic Growth Act
adds a new section to CERCLA to specify the actions a lender may take with
respect to lending and foreclosure activities without incurring
environmental clean-up liability or responsibility. Typical contractual
provisions regarding environmental issues in the loan documentation and due
diligence inspections will not lead to lender liability for clean-up, and a
lender may foreclose on contaminated property, so long as it merely
maintains the property and moves to divest it at the earliest possible
time. Under California law, a lender generally will not be liable to the
State Attorney General for the cost associated with cleaning up
contaminated property unless the lender realized some benefit from the
property, failed to divest the property promptly, caused or contributed to
the release of the hazardous materials or made the loan primarily for
investment purposes. This amendment to California law became effective
with respect to judicial proceedings filed and orders issued after January
1, 1997.
The extent of the protection provided by both the Federal and state lender
protection statutes will depend on their interpretation by the
administrative agencies and courts, and the Corporation cannot predict
whether it will be adequately protected for the types of loans made by the
Bank.
In addition, the Corporation and the Bank are still subject to the risks
that a borrower's financial position will be impaired by liability under
the environmental laws and that property securing a loan made by the Bank
may be environmentally impaired and not provide adequate security for the
Bank. California law provides some protection against the second risk, by
establishing certain additional, alternative remedies for a lender in the
situation where the property securing a loan is later found to be
environmentally impaired. Primarily, the law permits the lender in such a
case to pursue remedies against the borrower other than foreclosure under
the deed of trust.
The Bank attempts to protect its position against the remaining
environmental risks by performing prudent due diligence. Environmental
questionnaires and information on use of toxic substances are requested as
part of its underwriting procedures. The Bank lends based upon its
evaluation of the collateral, net worth of the borrower and the borrower's
capacity for unforeseen business interruptions or risks.
New and Pending Legislation
Certain legislative and regulatory proposals that could affect the
Corporation, the Bank and the banking business in general are pending or
have been introduced, before the United States Congress, the California
State Legislature, and Federal, state and local government agencies. Such
legislative and regulatory proposals include proposals regarding expansion
of consumer protection, privacy and disclosure requirements, increases in
the premiums for deposit insurance, restructuring of the bank regulatory
agencies, and expansion of the powers of other financial institutions that
compete with banks, among others.
It is not known to what extent, if any, these proposals will be enacted or
remain in force or what effect such legislation would have on the
structure, regulation and competitive relationship of financial
institutions. It is likely, however, that many of these proposals would
subject the Corporation and the Bank to increased regulation, disclosure
and reporting requirements and would increase competition to the Bank and
its cost of doing business.
In addition to pending legislative changes, the various banking regulatory
agencies frequently propose rules and regulations to implement and enforce
already existing legislation. It cannot be predicted whether or in what
form any such legislation or regulations will be enacted or the effect that
such legislation or regulations may have on the Bank's business. It is
likely, however, that many of these proposals would subject the Corporation
and the Bank to increased regulation, disclosure and reporting requirements
and would increase competition to the Bank and its cost of doing business.
ITEM 2. Properties
The Corporation and the Bank share common quarters at 801 Fourth Street, in
the central business district of Santa Rosa. The Bank leases a total of
approximately 9,335 square feet of ground floor and second floor office
space at that location.
The SBA and Commercial Lending and Loan Administration offices are located
less than a block away from the main office at 815 Fifth Street, Santa
Rosa. The Bank leases 8,047 square feet from Mr. James Ratto, a major
shareholder of the Corporation. The Bank has entered into a new lease for
approximately 17,000 square feet located at 3558 Round Barn Boulevard,
Santa Rosa. Upon the completion of the contracted leasehold improvements,
the Bank will relocate the majority of its' lending staff and executive
management and abandon the Fifth Street location when the lease term
expires in August 2004.
The Bank's data processing, client services and personnel departments are
located at 1650 Northpoint Parkway, Santa Rosa. The Bank currently
occupies 7,122 square feet and will be adding 5,000 square feet adjacent to
the current space in the second quarter of 2004 to provide for projected
growth in staff in the operations areas of the Bank.
The Corporation leases facilities for its seven branch offices (both stand
alone offices and supermarket branches) in Sonoma County under various
leases which expire under various dates, including options to renew through
the year 2022. In January 2004 the Bank leased space for a new branch in
Marin County which is schedule to open this summer upon completion of
leasehold improvements.
The Bank also leases other properties for its loan production offices in
California and Arizona.
Management believes that the Bank has outgrown its current facilities and
has taken the actions noted above to expand the premises to accommodate
projected growth in specific areas of the Bank. Additional facilities may
be needed as and when the Bank continues to grow.
The Bank has invested in loans secured by real property collateral. The
Bank's policies with respect to such loans are described under the caption
"Item 7, Management's Discussion and Analysis of Financial Condition and
Results of Operation - Loan Portfolio."
ITEM 3. Legal Proceedings
Neither the Corporation nor the Bank is a party to any material pending
legal proceedings, other than proceedings arising in the ordinary course of
the Bank's business. None of these are expected to have a material adverse
impact on the financial position or results of operations of the
Corporation or Bank.
ITEM 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of shareholders during the fourth
quarter of 2003.
Part II
ITEM 5. Market for Registrant's Common Equity and Related Stockholder
Matters
On December 31, 2003, the Corporation had 9,039,450 shares of common stock
outstanding, held by approximately 274 shareholders of record.
At December 31, 2003, the directors and executive officers of the
Corporation and the Bank held 1,524,818 shares, or 14.0% of the outstanding
shares. These shares do not include shares that may be acquired upon the
exercise of outstanding stock options. See "Item 12, Security Ownership of
Certain Beneficial Owners and Management," herein. Under SEC rules, the
directors and officers are restricted in the amount of securities they may
sell without registration under the Securities Act of 1933, as amended. In
general, directors and officers each may offer up to 90,394 shares in any
three month period without such registration.
As of December 31, 2003, the directors, officers and staff have the right
to acquire 2,213,202 additional shares upon the exercise of options granted
pursuant to the Corporation's Stock Option Plans. Should several directors
and officers choose to exercise options and sell their shares on the
market, such that a large number of shares are offered at one time, the
price of the common stock could be adversely affected.
The Corporation's common stock is not listed on any securities exchange or
on the National Association of Securities Dealers Automated Quotations
(NASDAQ) System. The firms SmithBarney and Brookstreet Securities, located
in Santa Rosa, and Hoefer & Arnett and First Security Van Kasper, located
in San Francisco, are presently making a market in the stock. The
Corporation's trading symbol is NREB.
The following chart shows the high and low bid quotations and the volume of
transactions in the Corporation's stock for the periods indicated. The
price and volume information se forth below does not reflect
privately-negotiated transactions. The trading volume was obtained from the
OTC bulletin board web site. The prices were obtained from the business
section of the Press Democrat (the local newspaper in Santa Rosa,
California). The bid prices and numbers of shares in this table have been
adjusted for the impact of the stock dividends issued during 2003 and 2002
and the two for one stock split in December 2003.
Bid Quotations for the Corporation's Common Stock
Approximate
Quarter Ended High Low Trading Volume
- ------------- ---- -- --------------
March 31, 2002 $11.93 $10.23 202,003
June 30, 2002 13.93 12.45 437,945
September 30, 2002 13.40 12.38 220,456
December 31, 2002 12.88 12.17 197,171
March 31, 2003 13.33 11.93 257,706
June 30, 2003 12.86 11.93 233,287
September 30, 2003 14.05 11.70 707,092
December 31, 2003 18.50 14.00 463,449
Due to the lack of any significant trading and no established public
market, the prices indicated above should not be considered an indication
of the market value of the shares. There is no assurance that any
significant trading market for the shares will develop in the future and
there are no assurances as to the price at which shares may be traded in
the future. The bid and asked prices of the Corporation's common stock
were $17.30 and $17.70, respectively, on December 31, 2003.
Dividends and Stock Split
On October 21, 2003, the Corporation declared a two for one stock split to
shareholders of record on December 1, 2003. On April 1, 2003, the
Corporation declared a 5% stock dividend to shareholders of record on May
9, 2003. On March 26, 2002, the Corporation declared a 5% stock dividend
to shareholders of record on April 30, 2002.
The Corporation has not paid any cash dividends since 1995. There is no
assurance that dividends will be paid, or, if paid, what the amount of any
such dividends will be. The future dividend policy of the Corporation is
subject to the discretion of the Board of Directors and will depend upon a
number of factors, including earnings, financial condition, cash needs and
general business conditions. In addition, the Board of Directors may
declare dividends only out of funds legally available therefore. See
"Supervision and Regulation - Dividends Payable by the Corporation."
The Corporation's primary source of income (other than interest income
earned on the Corporation's other investments) is the receipt of dividends
from the Bank. The Bank's ability to pay dividends is subject to the
restrictions of the national banking laws and, under certain circumstances,
the approval of the Comptroller of the Currency. A national bank may not
pay dividends from its capital. All dividends must be paid out of net
profits then on hand, after deducting for expenses, including losses and
bad debts. A national bank is also prohibited from declaring a dividend
until its surplus fund equals the amount of its capital stock or, if the
surplus fund does not equal the amount of its capital stock, until
one-tenth of the bank's net profits for the preceding half year, in the
case of quarterly or semiannual dividends, or the preceding two consecutive
half-year periods, in the case of an annual dividend, are transferred to
the surplus fund each time dividends are declared.
The approval of the Comptroller is required if the total of all dividends
declared by a bank in any calendar year will exceed the total of its net
profits of that year combined with its retained net profits of the two
preceding years, less any required transfers to surplus or a fund for the
retirement of any preferred stock which may be outstanding. Moreover, the
Comptroller may prohibit the payment of dividends which would constitute an
unsafe and unsound banking practice. As of December 31, 2003, $28,766,000
of retained earnings of the Bank was available for the payment of dividends
to the parent company under this requirement.
Securities Authorized for Issuance Under Equity Compensation Plans
The Corporation's 1997 Stock Option Plan ("1997 Plan") was approved by the
Corporation's shareholders at the May 19, 1998 annual shareholders'
meeting. The 1997 Plan was adopted by the Board of Directors to replace the
Corporation's earlier stock option plan (the "1984 Plan") which was
approved by the Corporation's shareholders on June 4, 1995 and expired by
its terms on February 26, 1994. Options to purchase shares are still
outstanding under the 1984 Plan, and these options will remain outstanding
until they are exercised or expire. However, no new options may be granted
under the 1984 Plan. Other than options outstanding under its stock option
plans, the Corporation does not have any outstanding rights or warrants to
purchase shares of its common stock.
The purpose of the 1997 Plan is to provide a means whereby employees and
directors of the Corporation and the Bank and any other corporation that
may become a subsidiary of the Corporation, may be given an opportunity to
purchase shares of common stock of the Corporation. The Plan is intended
to advance the interests of the Corporation and the Bank by enhancing their
ability to attract and retain the best available personnel for positions of
substantial responsibility and to attract and retain the best available
persons to serve as directors of the Corporation and the Bank, to provide
additional incentive to employees and directors, and to promote the success
of the Corporation's business.
The Plan provides for the grant of both non-statutory options and options
which are intended to qualify as "incentive stock options" as defined in
Section 422 of the Internal Revenue Code (the "Code").
The following table shows the number of shares that may be issued upon the
exercise of options outstanding as of December 31, 2003, the weighted
average exercise price of such options and the number of shares remaining
for option grants under the 1997 Plan. The numbers of shares and the
exercise prices have been adjusted, pursuant to the terms of the 1997 Plan,
for stock dividends and the 2003 two-for-one stock split.
Equity Compensation Plan Information
Number of securities
remaining available for
Number of securities to Weighted-average future issuance under
be issued upon exercise exercise price of equity compensation plans
of outstanding options, outstanding options, (excluding securities
warrants and rights warrants and rights reflected in column (a)
----------------------- ------------------- -------------------------
Equity compensation plans
approved by security holders 2,213,202 $6.57 492,262
Equity compensation plans not
approved by security holders 0 0 0
--------- ----- -------
Total 2,213,202 $6.57 492,262
========= ===== =======
ITEM 6. Selected Financial Data
(Dollars in thousands) 2003 2002 2001 2000 1999
---------- --------- --------- --------- ---------
Year ended December 31:
Interest income $44,732 $41,456 $44,345 $39,894 $29,824
Interest expense 13,924 15,841 20,803 19,495 12,836
Net interest income 30,808 25,615 23,542 20,399 16,988
Provision for loan losses 900 840 960 960 800
Non-interest income 2,894 2,334 1,677 1,456 1,572
Non-interest expense 14,165 11,678 10,521 9,530 8,428
Income before income taxes 18,637 15,431 13,738 11,365 9,332
Provision for income taxes 7,366 6,096 5,651 4,513 3,754
Net Income 11,271 9,335 8,087 6,852 5,578
Earnings per share:
Basic* $1.28 $1.07 $0.93 $0.79 $0.65
Diluted* $1.12 $0.94 $0.85 $0.76 $0.61
Per Share:
Cash Dividends paid $0.00 $0.00 $0.00 $0.00 $0.00
Book value at December 31* $7.47 $6.12 $5.31 $4.56 $3.89
Average common shares outstanding* 8,812,882 8,768,569 8,746,032 8,705,873 8,610,767
Average diluted common shares outstanding* 10,082,552 9,963,744 9,529,632 9,066,152 9,149,471
Shares outstanding at December 31 (Actual) 9,039,450 8,779,919 8,343,852 7,909,402 7,476,622
At December 31:
Loans, net 733,857 586,461 466,529 432,446 357,225
Total assets 848,226 689,380 561,004 494,390 397,928
Total deposits 658,320 577,585 502,137 453,437 357,867
Borrowed funds 119,211 54,776 11,802 1,828 9,050
Shareholders' equity 67,533 53,738 44,297 36,103 29,062
* Prior years have been adjusted for stock split and stock dividends
issued.
Financial Ratios: 2003 2002 2001 2000 1999
- ----------------- ---- ---- ---- ---- ----
For the year:
Return on average assets 1.52% 1.50% 1.54% 1.54% 1.59%
Return on average equity 18.80% 18.86% 19.83% 20.87% 21.62%
Net interest margin 4.25% 4.23% 4.61% 4.71% 5.03%
Net loan losses to
average loans 0.00% 0.01% 0.01% 0.02% 0.01%
Efficiency ratio (1) 42.03% 41.78% 41.72% 43.60% 45.41%
At December 31:
Equity to assets 7.80% 7.80% 7.90% 7.30% 7.30%
Total capital to risk
adjusted assets 11.74% 11.56% 12.14% 10.69% 10.54%
Nonperforming assets to
total loans & OREO 0.17% 0.51% 0.45% 0.51% 0.52%
Nonperforming assets to
total assets 0.15% 0.44% 0.38% 0.46% 0.47%
Allowance for loan losses
to total loans 0.98% 1.07% 1.18% 1.06% 1.04%
Allowance for loan losses to
non-performing assets 572.9% 210.5% 260.48% 207.58% 200.58%
(1) Efficiency ratio is the percentage of noninterest expenses to the sum
of net interest income plus noninterest income.
ITEM 7. Management's Discussion and Analysis of Financial
Condition and Results of Operation
Critical Accounting Policies
The Corporation and Bank's accounting policies are fundamental to
understanding management's discussion and analysis of results of operations
and financial condition. Accounting policies are described in detail in
Note 1 of the Notes to Consolidated Financial Statements presented in Item
8. One policy, Allowance for Loan Losses, has been identified as being
critical because it requires management to make difficult and subjective
judgments about matters that are inherently uncertain and because of the
likelihood that materially different amounts might be reported under
different conditions or using different assumptions. This policy is
reviewed by Loan Committee and approved by the Board of Directors.
The Allowance for Loan Losses represents management's estimate of probable
losses inherent in the loan portfolio at the balance sheet date. The
allowance for loan losses is reviewed monthly and is based on allocations
for each loan category (e.g. Real Estate, Commercial), an allocation for
undisbursed commitments, plus an allocation for any outstanding loans which
have been classified and are on the "Watch List." Each loan that has been
classified is individually analyzed for the risk involved and an allowance
provided according to the risk assessment. In addition to the allocated
component there is an unallocated component. The unallocated component
incorporates management's judgment of the inherent risks in the portfolio
based on: historical loan loss experience, loan concentrations, evaluations
made by regulatory agencies and our outside accountants, and assessment of
economic conditions The allocated and unallocated components represent the
total allowance for loan losses that management believes is adequate to
cover losses inherent in the loan portfolio.
Changes in the estimate related to the allowance for loan losses can
materially affect net income. The process of determining the allowance
requires us to make assumptions regarding the inherent losses which are
highly uncertain, requires a high degree of judgment, and is impacted by
regional, national and global economic trends. Different assumptions
regarding possible future economic conditions could have been used and may
have had a material impact on the provision for loan losses and on the
consolidated results of operations.
Balance Sheet - Summary
The Corporation's sole subsidiary is the Bank, and its primary activities
are the commercial banking activities engaged in through the Bank. The
following discussion of financial condition as of December 31, 2003 and
2002 and results of operations for the years ended December 31, 2003, 2002
and 2001 focuses primarily on the Bank.
During 2003, total consolidated assets grew 23.0% to $848,226,000 at
December 31, 2003. Total consolidated assets grew 22.9% during 2002 to
$689,380,000 at December 31, 2002. The growth in 2003 results from strong
loan demand during the year. See "Loan Portfolio."
Total deposits increased 14.0% to $658,320,000 when comparing December 31,
2003 to December 31, 2002. For the year ended December 31, 2002, total
deposits increased 15.0% to $577,585,000. Deposits increased to fund the
loan growth mentioned above. See "Deposits."
Federal Home Loan Bank Advance increased very substantially to $119,211,000
at December 31, 2003 from $54,776,000 at December 31, 2002. Advances
increased to fund loan growth at a lower cost than term deposits. See "Mix
of Deposits and Other Funding Sources" and "FHLB Advances."
Results of Operations - Summary
The Corporation's consolidated net income for the year ended December 31,
2003 was $11,271,000 as compared to $9,335,000 for the year ended December
31, 2002, an increase of 20.7%. The Corporation's consolidated net income
for the year ended December 31, 2002, increased 15.4% over the year ended
December 31, 2001.
Net interest income before provision for loan losses increased $5,193,000,
or 20.3%, when comparing the year of 2003 to 2002. This increase results
from the growth in the volume of loans on which the Bank earns a net
interest margin and the lower cost of advances from FHLB versus term
deposits. The interest margin for 2003 equaled 4.25% compared to 4.23% in
2002 and 4.61% in 2001. See, "Net Interest Income."
The provision for loan losses of $900,000 in 2003 compared to $840,000 in
2002. See, "Allowance for Loan Losses." Non-interest income increased
$560,000 primarily due to higher premiums on SBA loan sales and an increase
in loan referral fees. See, "Non-Interest Income." Operating expenses
increased by $2,487,000 primarily because of rapid growth of the Bank. It
was the first full year of operation of the Bank's new branch office in
Sonoma, California and its new loan production office in San Rafael; both
opened in the fourth quarter of 2002.
When comparing 2002 to 2001 the provision for loan losses was decreased to
$840,000 in 2002 from $960,000 in 2001 and other income increased $657,000
to $2,334,000 in 2002 from $1,677,000 in 2001. Operating expenses
increased $1,157,000 during 2002 primarily due to increases in personnel
costs, a new branch office and the move of central services to a new
location.
Net Interest Income
The primary source of the Bank's income is the difference between (1) the
interest earned on its loan and investment portfolios, interest bearing
deposits with other banks, and federal funds sold, and (2) the interest
paid on deposits and other borrowed funds. This difference is referred to
as net interest income, and it is one of the primary factors that affect
the Corporation's profitability. Interest income earned on loans, which
includes loan fee income, is primarily a function of the amount of loans
outstanding and the rates prevailing on these loans. Interest paid on
deposits depends on the composition of the deposit base and the rates paid
to attract deposits. See, "Deposits."
For the year ended December 31, 2003, net interest income before the
provision for loan losses totaled $30,808,000 as compared to $25,615,000
for the year ended December 31, 2002, representing an increase of 20.3%.
The majority of this increase results from the net interest margin earned
on growth in the loan portfolio, largely as a result of the increase in
real estate loans. See, "Loan Portfolio." During 2002, net interest
income before the provision for loan losses totaled $25,615,000 as compared
to $23,542,000 in 2001 representing an increase of 8.8%. The majority of
this increase resulted from the net interest margin earned on growth in the
loan portfolio.
The Bank's net interest margin (expressed as a percentage, the yield on
average interest earning assets less the rate paid on average interest
bearing liabilities) moved to 4.25% in 2003 from 4.23% in 2002 and 4.61%
in 2001. Several factors impact the Bank's net interest margin. These
include changes in market interest rates, level of loans relative to
deposits, mix of loans and earning assets, non-accrual loan balances and
mix of deposits and other funding sources.
Changes in Market Interest Rates
Changes in economic conditions, and the actions of the Federal Reserve
Board to reduce the Fed Funds and Discount rates have a direct impact on
the Bank's net interest margin since prime rate generally moves with
Federal Reserve Board changes. During 2003 prime rate equaled 4.25% until
June when it declined to 4.00% where it remains. During 2002 prime rate
equaled 4.75% until November 7 when it declined to 4.25% (40 year lows).
Prime rate has remained fairly stable during the last two years following
2001 when the Fed Funds and prime rates also declined 11 times moving to
4.75% at December 31, 2001 from 9.50% at December 31, 2000. The majority of
SBA loans are tied to prime rate and reprice on a quarterly basis. Other
loan indexes also declined; however, not as immediately as prime rate. The
declines in market rates have a negative impact on the Bank's interest
margin depending upon their repricing schedule and index. There are no
assurances that earnings will not be adversely impacted by future actions
of the Federal Reserve Board and changes in market interest rates.
The Bank is considered asset sensitive, meaning more assets are immediately
adjustable than liabilities. The Bank's net interest margin tends to
increase when interest rates increase and tends to decrease in a declining
rate environment.
The full impact of rate changes on the Bank's earnings are not realized for
several months, since not all loans or deposits reprice immediately. The
majority of SBA loans are tied to the prime rate and reprice on a calendar
quarter basis. The Bank has adjustable rate loans, mainly commercial real
estate loans, which are tied to indexes which adjust at a slower pace, such
as the Eleventh District Cost of Funds Index (COFI). The COFI index moved
to 1.90% for December 2003 from 2.38% for December 2002 and 3.07% for
December 2001. The Bank also has a fixed rate loan portfolio which
generally reduces net interest margin as interest rates rise and benefits
net interest margin as rates decline.
Market rates also impact the Bank's ability to attract deposits and grow
the loan portfolio. The current low rates offered on deposits make them
less attractive to depositors. The Bank has also experienced an increase
in loan payoffs as borrowers have refinanced to other loans tied to indexes
which bear lower rates than loans tied to the COFI index.
Level of Loans Relative to Deposits
The net interest margin is also affected by the level of loans relative to
deposits. The Bank's ratio of loans-to-deposits increased during 2003,
when it averaged 107.5%, as compared to 99.6% in 2002 and 97.3% in 2001.
An increase in the loan-to-deposit ratio generally results in an increase
in net interest margin.
Mix of Loan and Earning Assets
Changes in the mix of loans also impact the Bank's interest margin. The
Bank grew average loans by $112.8 million in 2003 and $72.4 million in
2002. In both those years the majority of the growth in average loans
occurred in commercial real estate loans. There were increases of $89.1
million and $55.2 million in average commercial real estate loans,
respectively, which bear a lower average interest yield of 7.21% in 2003
and 8.03% in 2002. The majority of commercial real estate loan rates is
tied to COFI and generally adjusts every six months. There is a
significant lag in the repricing of these loans since first the COFI index
needs to reflect the decline in the cost of funds in the 11th District
before it is factored into the repricing rate on the COFI loans. In a
declining rate environment, COFI based loans help interest margin; however,
in an increasing rate environment they lag other indexes and have a
negative impact on net interest margin.
Average commercial loans yields (the majority of these loans are SBA loans)
for 2003 decreased 63 basis points from 2002. Most of these loans reprice
to prime rate on a quarterly repricing schedule. This average decline
results from the quarterly repricing of SBA loans to reflect the drop in
prime rate to 4.00% in June 2003 from 4.25% since November 2002 and 4.75%
from December 2001 to November 2002. Average construction loans declined
by $12.0 million during 2003. The average yield was 8.50% during 2003
compared to 9.01% in 2002. These loans have short maturity dates
(approximately one year). Economic conditions and rate competition for
construction loans resulted in less volume in construction loans during
2003.
Interest income increased to $44.7 million in 2003 from $41.5 million in
2002 and $44.3 million in 2001. The increase in 2003 results from an
increase in the average balance of loans outstanding during the year, with
declining rates continuing to have a negative impact on interest yields.
In 2002 the decline in interest income is a direct result of the lower
interest rate environment. Average loans increased to $648.7 million in
2003 from $535.9 million in 2002 and $463.5 million in 2001. The yield on
loans equaled 6.74% in 2003, 7.52% in 2002 and 9.20% in 2001. The 78 basis
point decline during 2003 resulted primarily from the impact of declining
rates and the Bank's competitive loan pricing. The lag in repricing COFI
loans continued to mitigate the impact of the declining market rates, with
the majority of COFI loan yields at rate floors.
The economic conditions and competition have impacted the mix of loans.
COFI loans were less attractive to borrowers when rates were rapidly
declining since loan products tied to prime rate, U.S. Treasury rates or
LIBOR had lower interest rates. As a result many COFI loans were refinanced
resulting in higher loan prepayments. Construction loans generally decline
when economic conditions worsen and the Bank has experienced less demand
for constructions loans during 2003. The Bank continues to experience
increased competition for loans, which has resulted in lower loan pricing.
Overall loan portfolio yields are affected by deferred loan fees and
discounts on loans. These fees and discounts are amortized to income over
the life, or estimated life, of the loan with which they are associated and
serve to increase loan portfolio yields. Interest income on loans includes
loan fee income of $1,346,000 for the year ended December 31, 2003,
$1,537,000 for the year ended December 31, 2002, and $1,658,000 for the
year ended December 31, 2001. This fee income increased yields on average
loans by 18 basis points in 2003, as compared to 22 basis points in 2002.
Deferred loan fees are a product of origination and commitment fees net of
certain direct loan origination costs. The deferred fee amounts equaled
$838,000 at December 31, 2003 and $1,464,000 at December 31, 2002. The
decline in fee income and the deferred fee balance in 2003 results from new
loan pricing on some products which did not include charging fees ("par
pricing") due to competition in the area. Deferred fees are netted against
total loans in the balance sheet.
Discounts on the unguaranteed portion of SBA loans are recorded as an asset
when the guaranteed portion of the SBA loan is sold. These discounts are
amortized as an adjustment to the loan yields over the estimated life of
the SBA loan. As of December 31, 2003, $1,414,000 was recorded as
discounts compared to $933,000 at December 31, 2002. The increase results
from loan sales during 2003 and the structure of the loans sales, which
includes premium and servicing values. These discounts are netted against
total loans in the balance sheet.
Non-Accrual Loan Balances
Loans carried as non-accrual reduce the portfolio yield, since the balance
of a non-accrual loan is maintained in the loan total but no interest is
accrued. Non-accrual loans are included in the loan amounts in the average
balance sheets below. Interest foregone on non-accrual loans equaled
$154,000 during 2003 compared to $228,000 during 2002 and $143,000 during
2001 which had a negative impact on net interest margin. The allowance for
loan losses has no direct effect on yield. For further discussion see
"Allowance for Loan Losses."
Mix of Deposits and Other Funding Sources
Interest expense decreased to $13.9 million compared to $15.8 million in
2002 and $20.8 million in 2001. This decline results from the current low
interest rate environment. Interest bearing deposits increased $66.2
million during 2003; however, the average cost of interest paid on interest
bearing deposits for the year ended December 31, 2003 was 2.34% versus
3.14% for the year ended December 31, 2002 and 4.88% for the year ended
December 31, 2001. Deposit costs decreased 80 basis points during 2003 and
174 basis points during 2002.
The Bank's money market rate account, the Sonoma Investors Reserve Account
remained competitive and average balances grew by $7.6 million during 2003.
Balances held in Sonoma Investors Reserve accounts equaled $ 142.6 at
December 31, 2003 moving from $144.6 million at December 31, 2002. Average
balances for savings and money market accounts at the Bank were $145.7
million for 2003, $138.1 million for 2002 and $129.7 million for 2001. The
rate offered on the Sonoma Investors Reserve account is repriced on a
weekly basis. This rate is a discretionary rate which provides management
with flexibility in controlling interest costs and reacting to changes in
market rates. Due to the weekly repricing, changes in rates on the Sonoma
Investors Reserve Account have a more immediate impact on the Bank's cost
of funds than changes in offering rates on time certificates. The cost of
funds on savings and money market accounts equaled 1.17% in 2003 compared
to 1.75% in 2002 and 3.23% in 2001.
Time deposits reprice at a slower pace, since certificates of deposits
usually do not reprice until their maturity dates, which generally range
from six to twenty-four months. Time deposits have increased to $404.0
million at December 31, 2003 from $352.1 million at December 31, 2002.
During both 2003 and 2002, the Bank ran several time deposit campaigns at
rates slightly higher than its local competitors. These higher priced
deposits were used to fund loan growth. The cost of time deposits averaged
2.94% in 2003 and 3.92% in 2002 compared to savings and money market rate
accounts which averaged 1.17% in 2003 and 1.75% in 2002. Growth in time
deposits which bear the highest cost, has a negative impact on the Bank's
cost of funds and net interest margin.
Average non-interest bearing deposits were relatively unchanged at $56.7
million in 2003 compared to $57.6 million in 2002. Growth in non-interest
bearing deposits has a positive impact on the interest margin.
The majority of the Bank's growth has been and continues to be funded by
time certificates and money market accounts. The Bank has the ability to
borrow from the Federal Home Loan Bank (FHLB) at a cost which is lower than
market rates on deposits. Due to the restructuring of the FHLB, the Bank's
borrowing capacity was significantly increased, and the Bank's borrowing
limit is now a maximum of 25% of its total assets with acceptable
collateral. During 2003, the Bank increased the funds borrowed to $119.2
million compared to $54.8 million at December 31, 2002. The borrowings
during 2003 are generally for a term of one year and are at fixed or
variable rates. The Bank has also borrowed from the FHLB to match fund
longer term loans totaling $1.9 million. The Bank has used this line as a
both a contingency source of funds and a source of funds for future loan
growth. At December 31, 2003, the Bank had pledged loan collateral to the
FHLB totaling $202.2 million which increased our borrowing capacity to
$163.1 million and had borrowed $119.2 million against that line.
Borrowing costs with the FHLB are lower than the cost of attracting new
deposits of similar duration. Therefore, expanding the Bank borrowings at
the FHLB has had a positive impact on net interest margins.
The tables on the following pages (i) summarize the distribution, by
amount, of the average assets, liabilities and shareholders' equity of the
Corporation for the periods indicated and (ii) set forth the yields on
earning assets and the rates paid for interest bearing liabilities during
the periods indicated. Non-accrual loans are included in the average loan
balances even though they are no longer accruing interest. Averages are
computed primarily from daily balances.
AVERAGE BALANCE SHEET
Year Ended
December 31, 2003
(dollars in thousands)
Average Interest Average
Balance Income/Expense Yield/Rate
------- -------------- ----------
Certificates of deposit
with other banks $546 $7 1.28%
Investments 4,704 196 4.18%
Federal funds sold 70,564 779 1.10%
Loans:
Commercial (including SBA loans) 200,518 11,172 5.57%
Installment loans to individuals 6,330 341 5.38%
Real estate - Construction 28,135 2,392 8.50%
Real estate - Other 413,667 29,845 7.21%
-------- ------- -----
Total Loans 648,650 43,750 6.74%
-------- ------- -----
Total earning assets 724,464 44,732 6.17%
-------
Non-earning assets:
Allowance for loan losses (6,894)
Deferred Loan Fees & Discounts (1,142)
Cash and due from banks 15,789
Other assets 11,850
--------
TOTAL ASSETS $744,067
========
Deposits:
Demand - interest bearing $27,377 $105 0.38%
Savings & money market 145,717 1,699 1.17%
Time certificates 373,546 10,983 2.94%
-------- ------- -----
Total interest bearing deposits 546,640 12,787 2.34%
Other Interest bearing liabilities 76,720 1,137 1.48%
-------- ------- -----
Total Interest bearing deposits &
liabilities 623,360 13,924 2.23%
-------
Non-interest bearing liabilities:
Non-interest bearing deposits 56,708
Other liabilities 4,051
Shareholders' equity 59,948
--------
TOTAL LIABILITIES
AND SHAREHOLDERS' EQUITY $744,067
========
Net interest income $30,808
=======
Net interest margin 4.25%
=======
AVERAGE BALANCE SHEET
Year Ended
December 31, 2002
(dollars in thousands)
Average Interest Average
Balance Income/Expense Yield/Rate
------- -------------- ----------
Certificates of deposit
with other banks $849 $17 2.01%
Investments 2,475 95 3.84%
Federal funds sold 65,926 1,029 1.56%
Loans:
Commercial (including SBA loans) 167,841 10,403 6.20%
Installment loans to individuals 3,341 229 6.85%
Real estate - Construction 40,117 3,615 9.01%
Real estate - Other 324,595 26,068 8.03%
-------- ------- -----
Total Loans 535,894 40,315 7.52%
-------- ------- -----
Total earning assets 605,144 41,456 6.85%
-------
Non-earning assets:
Allowance for loan losses (5,913)
Deferred Loan Fees & Discounts (1,688)
Cash and due from banks 15,028
Other assets 10,175
--------
TOTAL ASSETS $622,746
========
Deposits:
Demand - interest bearing $21,979 $130 0.59%
Savings & money market 138,105 2,414 1.75%
Time certificates 320,333 12,557 3.92%
-------- ------- -----
Total interest bearing deposits 480,417 15,101 3.14%
Other Interest bearing liabilities 31,906 740 2.32%
-------- ------- -----
Total Interest bearing deposits &
liabilities 512,323 15,841 3.09%
-------
Non-interest bearing liabilities:
Non-interest bearing deposits 57,642
Other liabilities 3,280
Shareholders' equity 49,501
--------
TOTAL LIABILITIES
AND SHAREHOLDERS' EQUITY $622,746
========
Net interest income $25,615
=======
Net interest margin 4.23%
=======
AVERAGE BALANCE SHEET
Year Ended
December 31, 2001
(dollars in thousands)
Average Interest Average
Balance Income/Expense Yield/Rate
------- -------------- ----------
Certificates of deposit
with other banks $490 $22 4.39%
Investments 2,073 123 5.95%
Federal funds sold 44,285 1,556 3.51%
Loans:
Commercial (including SBA loans) 139,902 12,300 8.79%
Installment loans to individuals 2,239 229 10.20%
Real estate - Construction 52,031 5,175 9.95%
Real estate - Other 269,358 24,940 9.25%
-------- ------- -----
Total Loans 463,530 42,644 9.20%
-------- ------- -----
Total earning assets 510,378 44,345 8.69%
-------
Non-earning assets:
Allowance for loan losses (5,135)
Deferred Loan Fees & Discounts (2,490)
Cash and due from banks 12,663
Other assets 9,481
--------
TOTAL ASSETS $524,897
========
Deposits:
Demand - interest bearing $18,861 $192 1.02%
Savings & money market 129,696 4,194 3.23%
Time certificates 273,550 16,232 5.93%
-------- ------- -----
Total interest bearing deposits 422,107 20,618 4.88%
Other Interest bearing liabilities 4,729 185 3.91%
-------- ------- -----
Total Interest bearing deposits &
liabilities 426,836 20,803 4.87%
Non-interest bearing liabilities:
Non-interest bearing deposits 54,302
Other liabilities 3,071
Shareholders' equity 40,688
--------
TOTAL LIABILITIES
AND SHAREHOLDERS' EQUITY $524,897
========
Net interest income $23,543
========
Net interest margin 4.61%
========
The following tables set forth the changes in net interest income due to
changes in interest rates and the volume of assets and liabilities between
years. Variances attributable to simultaneous rate and volume changes are
all allocated to volume change amount.
ANALYSIS OF VOLUME AND RATE CHANGES
ON NET INTEREST INCOME AND EXPENSE
2003 OVER 2002
(dollars in thousands)
Volume Yield/Rate Total
------ ---------- -----
Increase/(decrease) in interest income:
Certificates of deposit with other banks $(6) $(4) $(10)
Investments 86 15 101
Federal funds sold 72 (322) (250)
Loans:
Commercial (incl. SBA loans) 2,025 (1,256) (769)
Installment loans to individuals 205 (93) 112
Real estate - Construction (1,080) (143) (1,223)
Real estate - Other 7,153 (3,376) 3,777
------ ------ ------
Total 8,456 (5,180) 3,276
------ ------ ------
Increase/(decrease) in interest expense:
Deposits & other interest bearing liabilities:
Demand - interest bearing 32 (57) (25)
Savings & money market 133 (848) (715)
Time certificates 2,086 (3,660) (1,574)
Other interest bearing liabilities 1,039 (642) 397
------ ------ ------
Total 3,290 (5,207) (1,917)
------ ------ ------
Increase/(decrease) in net interest income $5,165 $28 $5,193
====== ====== ======
ANALYSIS OF VOLUME AND RATE CHANGES
ON NET INTEREST INCOME AND EXPENSE
2002 OVER 2001
(dollars in thousands)
Volume Yield/Rate Total
------ ---------- -----
Increase/(decrease) in interest income:
Certificates of deposit with other banks $16 $(21) $(5)
Investments 24 (52) (28)
Federal funds sold 760 (1,287) (527)
Loans:
Commercial (incl. SBA loans) 2,456 (4,353) (1,897)
Installment loans to individuals 113 (113) 0
Real estate - Construction (1,185) (375) (1,560)
Real estate - Other 5,115 (3,987) 1,128
------ ------ ------
Total 7,299 (10,188) (2,889)
------ ------ ------
Increase/(decrease) in interest expense:
Deposits & other interest bearing liabilities:
Demand - interest bearing 32 (94) (62)
Savings & money market 272 (2,052) (1,780)
Time certificates 2,776 (6,451) (3,675)
Other interest bearing liabilities 1,063 (508) 555
------ ------ ------
Total 4,143 (9,105) (4,962)
------ ------ ------
Increase/(decrease) in net interest income $3,156 $(1,083) $2,073
====== ====== ======
Provision for Loan Losses
The provision for loan losses was $900,000 for 2003 compared to $840,000
for 2002 and $960,000 for 2001. The provision reflects continued growth in
loans and the level of non-accrual loans during this year. For further
discussion see "Allowance for Loan Losses."
Non-Interest Income
The following table sets forth non-interest income by category for the
years indicated.
Year end December 31,
(Dollars in thousands) 2003 2002 2001
---- ---- ----
Gain on loan sales $1,387 $1,015 $545
Service charges on deposits 556 546 430
Loan servicing fees 326 298 288
Merchant and other service fees 184 189 181
Referral fees 227 72 36
Income on insurance policies 133 119 123
Gain on OREO sales 0 36 0
Other 81 59 74
------ ------ ------
Total Other Income $2,894 $2,334 $1,677
====== ====== ======
Non-interest income is derived primarily from gains on sales of SBA loans,
service charges on deposit accounts, earnings on life insurance and SBA
loan servicing fees. Non-interest income increased 24.0% to $2,894,000
when comparing the year ended December 31, 2003 to the previous year, which
resulted mainly from increased gains on the sale of SBA loans due to the
higher volume of SBA loan sales. When comparing the year ended December 31,
2002 to December 31, 2001, non-interest income increased 39.2% to
$2,334,000 compared to $1,677,000. This increase resulted mostly from
higher premiums on SBA loan sales and increased loan referral fees service
charges on deposit accounts.
Gains on SBA Loan Sales
Gains on the sale of the guaranteed portion of SBA loans increased to
$1,387,000 in 2003 compared to $1,015,000 in 2002 and $545,000 in 2001.
This increase in gains on sales resulted from higher premiums on the loan
sales. The volume of SBA loans sold was $14.1 million in 2003 with
$14,790,000 sold in 2002 and $8,514,000 in 2001. The Bank's premiums
averaged 9.9% in 2003 compared to 6.6% in 2002 and 5.7% in 2001. The
higher premiums are reflective of lower prepayment rates on SBA 7(a) loans
due to the lower prime rate during 2003 and 2002. The SBA implemented a
prepayment penalty on SBA 7(a) loans in 2000 which has also had a positive
impact on rate of prepayments.
Service Charges on Deposits
Non-interest income includes service charges on deposit accounts. During
2003, service charges totaled $556,000 versus $546,000 in 2002 and $430,000
in 2001. Service charges vary depending upon the type of account. Fees
charged to "analysis customers'" vary depending upon the customers' use of
various Bank services. Analysis customers' charges are reduced by an
earnings credit which is calculated by applying an interest rate (earnings
credit rate) to the average balance maintained by the customer. During the
last few years, the earnings credit rate declined due to the lower interest
rate environment. This means that account holders' earnings were lower to
cover the cost of services, and therefore, service charges were higher than
previous years. While the earnings credit rate does impact the service
charges, our business account holders continue to manage their accounts
activity to minimize their service charges. In addition to the lower
earnings credit rate, the Bank has continued to market this deposit product
and has added new business accounts which have increased revenues.
Loan Servicing Fees
SBA servicing fees equaled $326,000 in 2003 compared to $298,000 in 2003
and $288,000 in 2001. Service fee income is based on loan payments and
payoffs received on the sold portion of SBA loans, and therefore, vary from
year to year. During 2003, the Bank's average SBA loan portfolio serviced
was $43.9 million versus $35.2 million in 2002 and $31.6 million in 2001.
The serviced portfolio reflects SBA loan payoffs and volume of new sales
during the period.
There can be no assurance that the SBA program will continue to generate
significant amounts of other non-interest income in the future. The Bank
continues to experience additional competition with more financial
institutions making SBA loans. The governmental actions may alter the SBA
program at any time, which could have a negative impact on the Bank's
profit. See, "Item 1, The Corporation, Business of the Bank."
Income on Insurance Policies
Non-interest income also includes earnings on life insurance policies held
for certain directors and senior officers which totaled $133,000 in 2003
versus $119,000 in 2002 and $123,000 in 2001.
Gain on Other Real Estate Owned (OREO) Sales
The Bank did not have any other real estate owned during 2003. In 2002
there was one OREO sold for a gain of $36,000 on the only OREO property
held by the Bank during the year. See, "Other Real Estate Owned."
Non-Interest Expense
Non-interest expenses include salaries and employee benefits, occupancy,
equipment and the general expenses required for the operation of the
Corporation and the Bank. For the year ended December 31, 2003,
non-interest expenses totaled $14,165,000, an increase of 21.3% over the
previous year. The following table outlines the components of non-interest
expense for the periods indicated:
(In thousands) Year Ended December 31,
2003 2002 2001
---- ---- ----
Expense Item
Salaries & Employee Benefits $8,837 $6,981 $6,154
Occupancy 1,223 1,114 957
Equipment 760 606 604
Advertising/Business Development/Donations 619 519 487
Outside Customer Services 342 399 469
Director & Shareholder expenses 382 360 295
Deposit and Other Insurance 352 329 299
Postage & courier expenses 304 271 244
Professional Fees 394 360 247
Stationery & Supplies 248 228 196
Telephone expense 184 158 174
Loan expenses 168 93 94
Other 352 260 301
------- ------- -------
TOTAL $14,165 $11,678 $10,521
======= ======= =======
Salaries and Employee Benefits
A portion of the 26.6% increase in salaries and benefits resulted from
staff increases associated with the opening of the Sonoma Branch in October
2002 and the addition of loan officers in San Rafael and Sacramento, CA and
new support staff to process the increased loan volume. The Bank's full
time equivalent (FTE) staff positions averaged 130 in 2003, 114 in 2002 and
105 in 2001. During 2003 incentive compensation increased due to higher
level of loan production. It is expected that staff will continue to
increase in 2004 due to the opening of the Bank's new branch in San Rafael
and the hiring of additional staff for loan processing.
Salaries also included pay increases for performance and promotions during
the year. The Bank also experienced higher benefit costs during the year.
Additional increases in Employee benefit costs are expected in 2004.
Occupancy
Occupancy costs increased from 2002 to 2003 by 9.8% due to the full year of
operation of both the Sonoma Branch and the loan office in San Rafael. In
addition, there were annual increases in the rents charged on most
facilities as called for in the lease agreements. Occupancy expenses will
increase in 2004 when the Bank opens a new branch in San Rafael this
summer, expands the operation center and relocates the Loan Department and
Executive Offices to a larger facility this summer. For further discussion
see Item 2 "Properties."
Equipment
Equipment expenses increased to $760,000 in 2003 from $606,000 in 2002 and
$604,000 in 2001. During 2003, the Bank continued to upgrade and expand
our technology. The Bank's central processing system was replaced with new
equipment. This upgrade will make it possible to do such things as imaging
statements for customers and has other operational advantages. The Bank
also implemented signature card imaging and will be proceeding with a new
teller system. There is also a significant investment in equipment with
each new branch and staff addition. Equipment costs are expected to
continue to increase during 2004 with the planned expansion referred to
above.
Advertising/Business Development/Donations
Advertising and business development costs vary from year to year depending
on the various promotions that have occurred during the year. These costs
include promotion of various Bank services (I Banc, Telebanc, SBA,
commercial and construction lending and deposit campaigns) and promoting
new locations. The Bank continued its strong support of the local
community through contributions to local charitable agencies and matched
staff contributions to the United Way Campaign during 2003.
Outside Customer Services
Outside customer services decreased to $342,000 in 2003 from $399,000 in
2002 and $469,000 in 2001. Analysis charges accounts for the majority of
this expense category. Analysis charges are customer expenses for title
and escrow services, check charges, courier and payroll services incurred
on behalf of customers who maintain non-interest bearing deposit balances
sufficient to compensate for these costs. See, "Deposits." While some
non-interest expense is incurred, management feels the contribution of the
non-interest bearing demand accounts toward lowering the overall cost of
funds more than offsets this cost.
Director and Shareholder Expenses
Director and shareholder expenses equaled $382,000 in 2003 compared to
$360,000 in 2002 and $295,000 in 2001. See "Compensation of Directors."
Director fees vary depending upon the number of meetings during the year
and director attendance at those meetings. In addition, shareholder costs
have increased due to regulatory reporting changes and are expected to
continue to increase due to new and expanded regulatory requirements.
Deposit and Other Insurance
Included in Deposit and Other Insurance are regulatory assessments which
have been increasing over the last several years to $252,000 in 2003 from
$225,000 in 2002 and $200,000 in 2001. The Bank's deposit insurance premium
is currently based upon the lowest cost category of zero cents per $100 of
insured deposits. There can be no assurance that the deposit insurance
rates will remain at this low level; a rate increase is expected because of
the low ratio of federal reserves to insured deposits. The Bank is also
charged a "Financing Corporation" (FICO) assessment. The annual rate varies
and is calculated per $100 of insured deposits. This cost equaled $91,000
in 2003 compared to $87,000 in 2002 and $85,000 in 2001. Also included is
the fee (based upon total assets) assessed by the Office of the Comptroller
of the Currency which equaled $161,000 in 2003, $138,000 in 2002 and
$115,000 in 2001. See, "Description of Business-Supervision and
Regulation."
Professional Fees
Professional fees increased to $394,000 in 2003 from $360,000 in 2002 and
$247,000 in 2001. The Bank's legal costs vary depending upon the volume of
past due and non-accrual loans and OREO which required legal assistance.
Professional fees have also increased due to implementing changes in
financial reporting requirements which significantly impacted the cost of
audit services. Other professional fees include accounting services,
outside data processing review, intrusion testing, loan review services,
SBA audit fees and other consulting services.
Loan Expenses
Loan expenses increased to $168,000 in 2003 from $93,000 in 2002 and
$94,000 in 2001. These costs tend to vary depending on problem loan
expenses where the Bank is not reimbursed for these expenses. During 2003
the Bank contracted loan inspections and appraisal reviews services to
handle the increased volume of loan activity. Included in this category are
credit reports, appraisals, foreclosure expenses, inspection costs and
other loan related expenses. The Bank generally charges for direct costs
associated with loan originations. Broker fees are included as a part of
cost recovery and recorded in deferred fees on loans and amortized as an
adjustment to interest income in accordance with generally accepted
accounting principles.
The other expense categories increased to $352,000 in 2003 from $260,000 in
2002 and $301,000 in 2001. These miscellaneous expenses, while they do
vary, are expected to increase in 2004
When comparing 2002 to 2001, the increase in total non-interest expenses of
11.0% to $11,678,000 from $10,521,000 was due primarily to increased salary
expenses resulting from increases in branch, lending and other staff
additions throughout the Bank, salary increases and staff incentives
associated with increased volume of loan and deposit activity. In addition,
costs associated with occupancy and equipment also increased due to the
branch expansion. Most expense categories were higher as a result of the
loan and deposit growth and the new facilities.
Loan Portfolio
The following table shows the composition of the loan portfolio, by type of
loan, as of the dates indicated.
(In thousands)
December 31,
Type of Loan 2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
Real Estate - Other $495,538 $382,134 $284,782 $273,298 $210,119
Real Estate Construction 26,271 32,412 49,604 46,244 39,523
Commercial 214,000 173,325 137,711 118,134 112,277
Installment Loans to
Individuals 6,185 6,445 2,052 2,412 1,783
Total, gross 741,994 594,316 474,149 440,088 363,702
Deferred fees and
discounts, net (838) (1,466) (2,004) (2,961) (2,690)
Total loans net of deferred
fees and discounts 741,156 592,850 472,145 437,126 361,012
Allowance for loan losses (7,299) (6,389) (5,616) (4,681) (3,787)
-------- -------- -------- -------- --------
TOTAL LOANS, NET $733,857 $586,461 $466,529 $432,446 $357,225
======== ======== ======== ======== ========
The table above illustrates the Bank's emphasis on commercial and real
estate lending. At December 31, 2003 and 2002 commercial loans comprised
28.8% and 29.2%, respectively, of the Bank's total loan portfolio.
Construction and other real estate loans (combined) comprised 70.3% and
69.8% on those same dates. Management is aware of the risk factors in
making commercial and real estate loans and is continuously monitoring the
local marketplace as well as performing annual reviews of this portfolio.
The Bank makes commercial loans primarily to small and medium sized
businesses and to professionals located within Northern California and
Arizona. While the Bank emphasizes commercial lending, management does not
believe that there is any significant concentration of commercial loans to
any specific type of business or industry.
At December 31, 2003, 97.1% or $719.8 million of the Bank's loans were
secured by real estate as the principal source of collateral. A worsening
of economic conditions, a decline of real estate values and/or rising
interest rates could have an effect on the value of real estate securing
these loans and could have an adverse impact on the financial condition of
the Bank.
Most of the security for the Bank's loans is located in the area where the
loan is generated. A significant natural disaster impacting those
locations, such as a severe earthquake or widespread flooding, could
disrupt the business of these borrowers and impair the security for the
Bank's loans. Although some of the Bank's borrowers carry insurance to
cover some of the losses that might arise from such an event, the Bank does
not require all its borrowers to carry earthquake insurance coverage since
such insurance typically provides a large deductible amount. If a large
earthquake occurs in the Bank's market area, the Bank would probably have
to restructure some of its loans and may suffer loan losses related to the
earthquake.
The Bank originates loans guaranteed by the U.S. Small Bus