PART I

 

Preliminary Note Concerning Forward-Looking Statements

 

This report contains statements about the future expectations, activities and events that constitute forward-looking statements. Forward-looking statements express our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

 

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we expressed or implied in any forward-looking statements. These risks and uncertainties can be difficult to predict and may be beyond our control. Factors that could contribute to differences in our results include, but are not limited to deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses; changes in the interest rate environment, which may reduce our margins or impact the value of securities, loans, deposits and other financial instruments; changes in loan underwriting, credit review or loss reserve policies associated with economic conditions, examination conclusions, or regulatory developments; general economic or business conditions, either nationally, regionally or locally in the communities we serve, may be worse than expected, resulting in, among other things, a deterioration in credit quality or a reduced demand for credit; the results of regulatory examinations; any matter that would cause us to conclude that there was impairment of any asset, including intangible assets; the continued service of key management personnel; our ability to attract, motivate and retain qualified employees; factors that increase the competitive pressure among depository and other financial institutions, including product and pricing pressures; the ability of our competitors with greater financial resources to develop and introduce products and services that enable them to compete more successfully than us; inability to comply with regulatory capital requirements and to secure any required regulatory approvals for capital actions; legislative or regulatory developments, including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial services industry; and fiscal and governmental policies of the United States federal government.

 

Other risks are detailed in Item 1A. “Risk Factors” of this Form 10-K all of which are difficult to predict and many of which are beyond our control.

 

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include the assumptions or bases underlying the forward-looking statement. We have made our assumptions and bases in good faith and believe they are reasonable. We caution you however, that estimates based on such assumptions or bases frequently differ from actual results, and the differences can be material. The forward-looking statements included in this report speak only as of the date of the report. We do not intend to update these statements unless applicable laws require us to do so.

 

Item 1.

Business Overview

 

As used in this report, references to “the Company,” “we,” “our,” “us,” and similar terms refer to the consolidated entity consisting of Porter Bancorp, Inc. and its wholly-owned subsidiary. The “Bank” refers to Porter Bancorp, Inc.’s bank subsidiary, Limestone Bank, Inc.

 

The Company is a bank holding company headquartered in Louisville, Kentucky. The Company’s common stock is traded on Nasdaq’s Capital Market under the symbol PBIB. We operate the Bank, our wholly owned subsidiary and the fifteenth largest bank domiciled in the Commonwealth of Kentucky based on total assets (formerly known as PBI Bank). We operate banking offices in twelve counties in Kentucky. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products. As of December 31, 2017, we had total assets of $970.8 million, total loans of $712.1 million, total deposits of $847.0 million and stockholders’ equity of $72.7 million.

 

 

Our Markets

 

We operate in markets that include the four largest cities in Kentucky – Louisville, Lexington, Bowling Green and Owensboro – and in other communities along the I-65, Western Kentucky Parkway, and Natcher Parkway corridors.

 

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Louisville/Jefferson, Bullitt and Henry Counties: Our headquarters are in Louisville, the largest city in Kentucky. We also have banking offices in Bullitt County, south of Louisville, and Henry County, east of Louisville. Our banking offices in these counties also serve the contiguous counties of Spencer, Shelby and Oldham to the east and northeast of Louisville. The area’s major employers are diversified across many industries and include the air hub for United Parcel Service (“UPS”), two Ford assembly plants, GE Appliances and Lighting, Humana, Norton Healthcare, Brown-Forman, YUM! Brands, Papa John’s Pizza, and Texas Roadhouse.

 

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Lexington/Fayette County: Lexington, located in Fayette County, is the second largest city in Kentucky. Lexington is the financial, educational, retail, healthcare and cultural hub for Central and Eastern Kentucky. It is known worldwide for its horse farms and Keeneland Race Track, and proudly boasts of itself as “The Horse Capital of the World”. It is also the home of the University of Kentucky and Transylvania University. The area’s major employers include Toyota, Lexmark, IBM Global Services and Valvoline.

 

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Southern Kentucky: This market includes Bowling Green, the third largest city in Kentucky, located about 60 miles north of Nashville, Tennessee. Bowling Green, located in Warren County, is the home of Western Kentucky University and is the economic hub of the area. This market also includes communities in the contiguous Barren County, including the city of Glasgow. Major employers in Barren and Warren Counties include GM’s Corvette plant, automotive supply chain manufacturers, and R.R. Donnelley’s regional printing facility.

 

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Owensboro/Daviess County: Owensboro, located on the banks of the Ohio River, is Kentucky’s fourth largest city. The city is called a festival city, with over 20 annual community celebrations that attract visitors from around the world, including its world famous Bar-B-Q Festival which attracts over 80,000 visitors. It is an industrial, medical, retail and cultural hub for Western Kentucky and the area employers include Owensboro Medical System, US Bank Home Mortgage, Titan Contracting and Specialty Food Group.

 

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South Central Kentucky: South of the Louisville metropolitan area, we have banking offices in Butler, Edmonson, Green, Hart, and Ohio Counties. This region includes stable community markets comprised primarily of agricultural and service-based businesses. Each of our banking offices in these markets has a stable customer and core deposit base.

 

Our Products and Services 

 

We meet our customers’ banking needs with a broad range of financial products and services. Our lending services include real estate, commercial, mortgage, agriculture, and consumer loans to those in our communities and to small to medium-sized businesses, the owners and employees of those businesses, as well as other executives and professionals. We complement our lending operations with an array of retail and commercial deposit products. In addition, we offer our customers drive-through banking facilities, automatic teller machines, night depository, personalized checks, credit cards, debit cards, internet banking, mobile banking, treasury management services, remote deposit services, electronic funds transfers through ACH services, domestic and foreign wire transfers, cash management, and vault services, along with loan and deposit sweep accounts.

 

Employees

 

At December 31, 2017, the Company had 217 full-time equivalent employees. Our employees are not subject to a collective bargaining agreement, and management considers the Company’s relationship with employees to be good.

 

Competition 

 

The banking business is highly competitive, and we experience competition from many other financial institutions. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans, other credit and service charges relating to loans, the quality and scope of the services offered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions that operate offices within our market area and beyond.

 

 

Supervision and Regulation  

 

Written Agreement. On September 21, 2011, we entered into a written agreement (“Written Agreement”) with the Federal Reserve Bank of St. Louis. The Company made formal commitments in the Written Agreement to use its financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without written approval, and to submit an acceptable plan to maintain sufficient capital.

 

Bank and Holding Company Laws, Rules and Regulations. The following is a summary description of the relevant laws, rules and regulations governing banks and bank holding companies. The descriptions of, and references to, the statutes and regulations below are brief summaries and do not purport to be complete. The descriptions are qualified in their entirety by reference to the specific statutes and regulations discussed.

 

The Dodd-Frank Act. On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was signed into law. The Dodd-Frank Act imposed new restrictions and an expanded framework of regulatory oversight for financial institutions, including depository institutions.

 

The Dodd-Frank Act represents a comprehensive overhaul of the financial services industry within the United States. There are a number of reform provisions that significantly impact the ways in which banks and bank holding companies, including the Company and the Bank, do business. For example, regulations issued under the Dodd-Frank Act changed the assessment base for federal deposit insurance premiums by modifying the assessment base calculation to be based on a depository institution’s consolidated assets less tangible capital instead of deposits, and permanently increased the standard maximum amount of deposit insurance per customer to $250,000. The Dodd-Frank Act also imposed more stringent capital requirements on bank holding companies by, among other things, imposing leverage ratios on bank holding companies and prohibiting new trust preferred security issuances from counting as Tier I capital. The Dodd-Frank Act also repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. The Dodd-Frank Act codified and expanded the Federal Reserve’s source of strength doctrine, which requires that all bank holding companies serve as a source of financial strength for its subsidiary banks. Other provisions of the Dodd-Frank Act include, but are not limited to: (i) the creation of a financial consumer protection agency that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer protection; (ii) enhanced regulation of financial markets, including derivatives and securitization markets; (iii) reform related to the regulation of credit rating agencies; (iv) the elimination of certain trading activities by banks; and (v) new disclosure and other requirements relating to executive compensation and corporate governance.

 

Many provisions of the Dodd-Frank Act require interpretation and rule-making by federal agencies. The Company monitors all relevant sections of the Dodd-Frank Act to ensure continued compliance with laws and regulations, which results in greater compliance costs and higher fees paid to regulators. Future implementation of the Dodd-Frank Act may result in restrictions on the Company’s operations.

 

Porter Bancorp. The Company is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). As such, we must file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries. We are also subject to examination by the Federal Reserve Board and to operational guidelines established by the Federal Reserve Board. We are subject to the Bank Holding Company Act and other federal laws on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

 

Acquisitions. A bank holding company must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock or all or substantially all of the assets of a bank, merging or consolidating with any other bank holding company and before engaging, or acquiring a company that is not a bank and is engaged in certain non-banking activities. Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then may only do so if the Federal Reserve Board does not object to the proposed transaction. The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company would constitute an acquisition of control of the bank holding company. In addition, approval of the Federal Reserve Board is required before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

 

Permissible Activities. A bank holding company is generally permitted under the Bank Holding Company Act to engage in or acquire direct or indirect control of more than 5% of the voting shares of any bank, bank holding company or company engaged in any activity that the Federal Reserve Board determines to be so closely related to banking as to be a proper incident to the business of banking.

 

 

Under current federal law, a bank holding company may elect to become a financial holding company, which enables the holding company to conduct activities that are “financial in nature,” incidental to financial activity, or complementary to financial activity that do not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Activities that are “financial in nature” include securities underwriting, dealing and market making in securities; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Federal Reserve Board has determined to be closely related to banking. No regulatory approval is required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. We have not filed an election to become a financial holding company.

 

Capital Adequacy Requirements. Both the Company and the Bank are required to comply with capital adequacy guidelines. Guidelines are established by the Federal Reserve Board for the Company and the FDIC for the Bank. Both the Federal Reserve Board and the FDIC have substantially similar risk based and leverage ratio guidelines for banking organizations, which are intended to ensure that banking organizations have adequate capital related to the risk levels of assets and off-balance sheet instruments. The capital adequacy guidelines are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria, assuming they have the highest regulatory rating. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. Federal Reserve Board guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

 

In July 2013, the Federal Reserve Board and the FDIC approved final rules that substantially amended the regulatory risk-based capital rules applicable to the Company and Bank. The final rules implement the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” (“Basel III”) and changes required by the Dodd-Frank Act. The final rules implementing the Basel III regulatory capital reforms became effective for the Company and Bank on January 1, 2015, and include new minimum risk-based capital and leverage ratios. These rules refine the definition of what constitutes “capital” for purposes of calculating the capital ratios.

  

The Basel III minimum capital level requirements applicable to bank holding companies and banks subject to the rules are  a common equity Tier 1 capital ratio of 4.5%, a Tier 1 risk-based capital ratio of 6%, a total risk-based capital ratio of 8%, and a Tier 1 leverage ratio of 4% for all institutions. The rules also establish a “capital conservation buffer” of 2.5%, to be phased in over three years, above the regulatory minimum risk-based capital ratios. Once the capital conservation buffer is fully phased in, the minimum ratios area common equity Tier 1 risk-based capital ratio of 7.0%, a Tier 1 risk-based capital ratio of 8.5%, and a total risk-based capital ratio of 10.5%.

  

The phase-in of the capital conservation buffer requirement began in January 2016 at 0.625% of risk-weighted assets and increases each year until fully implemented in January 2019. An institution is subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if capital levels fall below minimum levels plus the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

Under these new rules, Tier 1 capital generally consists of common stock (plus related surplus) and retained earnings, limited amounts of minority interest in the form of additional Tier 1 capital instruments, and non-cumulative preferred stock and related surplus, subject to certain eligibility standards, less goodwill and other specified intangible assets and other regulatory deductions. Tier 2 capital may consist of subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the allowance for loan losses. Proceeds of trust preferred securities are excluded from Tier 1 capital unless issued before 2010 by an institution with less than $15 billion of assets. Total capital is the sum of Tier 1 and Tier 2 capital.

 

 

Prompt Corrective Action. Pursuant to the Federal Deposit Insurance Act (“FDIA”), the FDIC must take prompt corrective action to resolve the problems of undercapitalized institutions. FDIC regulations define the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized”. A bank is “undercapitalized” if it fails to meet any one of the ratios required to be adequately capitalized. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The degree of regulatory scrutiny increases and the permissible activities of a bank decrease, as the bank moves downward through the capital categories. Depending on a bank’s level of capital, the FDIC’s corrective powers include:

 

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requiring a capital restoration plan;

 

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placing limits on asset growth and restriction on activities;

 

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requiring the bank to issue additional voting or other capital stock or to be acquired;

 

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placing restrictions on transactions with affiliates;

 

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restricting the interest rate the bank may pay on deposits;

 

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ordering a new election of the bank’s board of directors;

 

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requiring that certain senior executive officers or directors be dismissed;

 

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prohibiting the bank from accepting deposits from correspondent banks;

 

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requiring the bank to divest certain subsidiaries;

 

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prohibiting the payment of principal or interest on subordinated debt; and

 

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ultimately, appointing a receiver for the bank.

 

If an institution is required to submit a capital restoration plan, the institution’s holding company must guarantee the subsidiary’s compliance with the capital restoration plan up to a certain specified amount. Any such guarantee from a depository institution’s holding company is entitled to a priority of payment in bankruptcy. The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior Federal Reserve Board approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

 

Dividends. Under Federal Reserve Board policy, bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not declare a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.

 

The Company is a legal entity separate and distinct from the Bank. Historically, the majority of the Company’s revenue has been from dividends paid to it by the Bank. The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and hearing, that the institution cease such practice. The federal banking agencies have indicated that paying dividends that deplete an institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act (“FDICIA”), an insured institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings. A bank holding company may still declare and pay a dividend if it does not have current operating earnings if the bank holding company expects profits for the entire year and the bank holding company obtains the prior consent of the Federal Reserve.

 

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits. The KDFI must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank’s total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. Additionally, retained earnings must be positive. We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or in the corporation becoming unable to pay its debts as they come due. The Bank did not pay any dividends in 2017 or 2016 and cannot currently pay any dividends without prior regulatory approval.

 

With respect to the payment of dividends, Porter Bancorp’s issued and outstanding Series E and Series F Preferred Shares rank senior to its common shares and non-voting common shares.

 

 

Source of Financial Strength. Under Federal Reserve policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment. The Federal Reserve’s “Source of Financial Strength” policy was codified in the Dodd-Frank Act.

 

Limestone Bank. The Bank, a Kentucky chartered commercial bank, is subject to regular bank examinations and other supervision and regulation by both the FDIC and the KDFI. Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky banking corporation to engage in any banking activity which could be engaged in by a national bank operating in Kentucky; a state bank, a thrift or savings bank operating in any other state; or a federal chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

 

Capital Requirements. Please see capital adequacy requirements discussion above.

 

Deposit Insurance Assessments. The deposits of the Bank are insured by the Deposit Insurance Fund (“DIF”) of the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance premium assessments of the DIF. The FDIC imposes a risk-based deposit premium assessment system, which was amended pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”). Under this system, as amended, the assessment rates for an insured depository institution vary according to the level of risk incurred in its activities. To arrive at an assessment rate for a banking institution, the FDIC places it in one of four risk categories determined by reference to its capital levels and supervisory ratings. The assessment rate schedule can change from time to time, at the discretion of the FDIC, subject to certain limits.

 

The Dodd-Frank Act imposed additional assessments and costs with respect to deposits. Under the Dodd-Frank Act, the FDIC imposes deposit insurance assessments based on total assets rather than total deposits. Pursuant to the Dodd-Frank Act, the FDIC revised the deposit insurance assessment system and implemented a revised assessment rate process with the goal of differentiating insured depository institutions who pose greater risk to the DIF.

 

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

 

Branching. Kentucky law permits Kentucky chartered banks to establish a banking office in any county in Kentucky. A Kentucky bank may also establish a banking office outside of Kentucky. Well capitalized Kentucky banks that have been in operation at least three years and satisfy certain criteria relating to, among other things, their composite and management ratings, may establish a banking office in Kentucky without the approval of the KDFI upon notice to the KDFI and any other state bank with its main office located in the county where the new banking office will be located. Otherwise, branching requires the approval of the KDFI, which must ascertain and determine that the public convenience and advantage will be served and promoted and that there is reasonable probability of the successful operation of the banking office. The transaction must also be approved by the FDIC, which considers a number of factors, including financial history, capital adequacy, earnings prospects, character of management, needs of the community and consistency with corporate powers.

 

Section 613 of the Dodd-Frank Act effectively eliminated the interstate branching restrictions set forth in the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. Banks located in any state may now de novo branch in any other state, including Kentucky. Such unlimited branching power may increase competition within the markets in which the Company and the Bank operate.

 

 

Insider Credit Transactions. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured depository institutions and their subsidiaries. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests, which may not exceed the institution’s total unimpaired capital and surplus.

 

Consumer Protection Laws. The Bank is subject to federal consumer protection statues and regulations promulgated under those laws, including, but not limited to, the:

 

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Truth-In-Lending Act and Regulation Z, governing disclosures of credit terms to consumer borrowers;

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Home Mortgage Disclosure Act and Regulation C, requiring financial institutions to provide certain information about home mortgage and refinanced loans;

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Real Estate Settlement Procedures Act (“RESPA”), requiring lenders to provide borrowers with disclosures regarding the nature and cost of real estate settlements and prohibiting certain abusive practices;

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Secure and Fair Enforcement for Mortgage Licensing Act (“S.A.F.E. Act”), requiring residential loan originators who are employees of financial institutions to meet registration requirements;

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Fair Credit Reporting Act and Regulation V, governing the provision of consumer information to credit reporting agencies and the use of consumer information;

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Equal Credit Opportunity Act and Regulation B, prohibiting discrimination on the basis of race, religion or other prohibited factors in the extension of credit;

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Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

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Truth in Savings Act, which requires disclosure of deposit terms to consumers;

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Regulation CC, which relates to the availability of deposit funds to consumers;

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Right to Financial Privacy Act, which imposes a duty to maintain the confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;

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Electronic Funds Transfer Act, governing automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services;

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Automated Overdraft Payment Regulations and Regulation E, requiring financial institutions to provide customer notices, monitor overdraft payment programs, and prohibiting financial institutions from charging consumer fees for paying overdrafts on automated teller machine and one time debit card transactions unless a consumer consents, or opts in to the service for those types of transactions.

 

The Dodd-Frank Act created the Consumer Financial Protection Bureau, which is granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller institutions are subject to rules promulgated by the CFPB, but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive or abusive acts or practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower’s ability to repay. In addition, the Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB.

 

The Dodd-Frank Act also permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations. Federal preemption of state consumer protection law requirements, traditionally an attribute of the federal savings association charter, has also been modified by the Dodd-Frank Act and now requires a case-by-case determination of preemption by the Office of the Comptroller of the Currency (“OCC”) and eliminates preemption for subsidiaries of a bank. Depending on the implementation of this revised federal preemption standard, the operations of the Bank could become subject to additional compliance burdens in the states in which it operates.

 

Loans to One Borrower. Under current limits, loans and extensions of credit outstanding at one time to a single borrower and not fully secured generally may not exceed 20% of an institution’s unimpaired capital and unimpaired surplus. Loans and extensions of credit fully secured by collateral may represent an additional 10% of unimpaired capital and unimpaired surplus.

 

 

Volcker Rule. On December 10, 2013, the final Volcker Rule under the Dodd-Frank Act was approved and implemented by the Federal Reserve Board, the FDIC, the Securities and Exchange Commission (“SEC”), and the Commodity Futures Trading Commission. The Volcker Rule attempts to reduce risk and banking system instability by restricting U.S. banks from investing in or engaging in proprietary trading and speculation and imposing a strict framework to justify exemptions for underwriting, market-making and hedging activities. U.S. banks are restricted from investing in funds with collateral comprised of less than 100% loans that are not registered with the SEC and from engaging in hedging activities that do not hedge a specific identified risk. The Volcker Rule does not have a significant effect on the Bank’s operations.

 

Privacy. Federal law currently contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.

 

Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons. The FDIC’s assessment of our record is made available to the public. The assessment also is part of the Federal Reserve Board’s consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new banking office or to relocate an office.

 

Bank Secrecy Act. The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities. In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices. Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

 

USA Patriot Act. The USA Patriot Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism. This includes standards for verifying customer identification at account opening, as well as rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. It grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on the operations of financial institutions. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

 

Effect on Economic Environment. The policies of regulatory authorities, including the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and bank subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits. Their use may affect interest rates charged on loans or paid for deposits.

 

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings and those of our subsidiaries cannot be predicted.

 

Legislative and Regulatory Initiatives. From time to time various laws, regulations and governmental programs affecting financial institutions and the financial industry are introduced in Congress or otherwise promulgated by regulatory agencies. Such measures may change the environment in which the Company and its subsidiaries operate in substantial and unpredictable ways. The nature and extent of future legislative, regulatory or other changes affecting financial institutions are unpredictable at this time. Future legislation, policies and the effects thereof might have a significant influence on overall growth and distribution of loans, investments and deposits. They also may affect interest rates charged on loans or paid on time and savings deposits. New legislation and policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

 

 

Available Information

 

The Company files periodic reports with the SEC including its annual report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K and proxy statements. The public may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Our SEC reports are accessible at no cost on our web site at http://www.limestonebank.com, under the Investors Relations section of the About Us tab, once they have been electronically filed with the SEC. A shareholder may also request a copy of our Annual Report on Form 10-K free of charge upon written request to: Chief Financial Officer, Porter Bancorp, Inc., 2500 Eastpoint Parkway, Louisville, Kentucky 40223.

 

Item 1A. Risk Factors

 

An investment in the Company’s common stock involves a number of risks. Realization of any of the risks described below could have a material adverse effect on the Company’s business, financial condition, results of operations, cash flow and/or future prospects.

 

The Company is subject to a Written Agreement with the Federal Reserve that restricts the conduct of the Company’s operations and may have a material adverse effect on its business.

 

In a Written Agreement with the Federal Reserve Bank of St. Louis, the Company made formal commitments in the agreement to use its financial and management resources to serve as a source of strength for the Bank and to assist the Bank in addressing weaknesses identified by the FDIC and the KDFI, to pay no dividends without prior written approval, to pay no interest or principal on subordinated debentures or trust preferred securities without written approval, and to submit an acceptable plan to maintain sufficient capital.

 

Bank regulatory agencies can exercise discretion when an institution does not meet minimum regulatory capital levels and the other terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by regulatory agencies could damage our reputation and have a material adverse effect on the Company’s business.

 

As a bank holding company, we depend on dividends and distributions paid to us by our banking subsidiary.

 

The Company is a legal entity separate and distinct from the Bank and our other subsidiaries. Our principal source of cash flow, from which we would fund any dividends paid to our shareholders, has historically been dividends the Company receives from the Bank. Regulations of the FDIC and the KDFI govern the ability of the Bank to pay dividends and other distributions to the Company, and regulations of the Federal Reserve govern our ability to pay dividends or make other distributions to shareholders. Since the Bank is unlikely to be in a position to pay dividends to the Company without prior regulatory approval until retained earnings are positive, cash inflows for the Company are limited to common stock or debt issuances. See the “Item 1. Business” “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities – Dividends.”

 

We are currently precluded from paying any dividends.

 

Our agreement with the holders of our trust preferred securities provides that we cannot pay dividends until we pay all deferred distributions in full and resume paying quarterly distributions. We have also agreed with the Federal Reserve to obtain its written consent prior to declaring or paying any future dividends. In addition, the dividend preferences of our Series E and Series F Preferred Shares entitle our preferred shareholders to receive an annual, noncumulative 2% dividend before we can pay a dividend on our non-voting common shares and voting common shares.

 

Interest on junior subordinated debt is in deferral.

 

At December 31, 2017, we had an aggregate obligation of $22.2 million relating to the principal and accrued unpaid interest on our four issues of junior subordinated debentures, which has resulted in a deferral of distributions on our trust preferred securities. Although we are permitted to defer payments on these securities for up to five years (and we commenced doing so in 2016), the deferred interest payments continue to accrue until paid in full. Our deferral period expires after the second quarter of 2021.

 

 

The Company’s senior debt is secured by the Bank’s common stock and contains financial covenants that must be maintained to avoid default.

 

The Company’s senior secured loan agreement is with a commercial bank. The loan matures on June 30, 2022. Interest is payable quarterly at a rate of three-month LIBOR plus 250 basis points through June 30, 2020, at which time quarterly principal payments of $250,000 plus interest will commence. The loan is secured by a first priority pledge of 100% of the issued and outstanding stock of the Bank. The Company may prepay any amount due under the promissory note at any time without premium or penalty.

 

The loan agreement contains customary representations, warranties, covenants and events of default, including the following financial covenants: (i) the Company must maintain minimum cash on hand of not less than $750,000 through June 30, 2018, and not less than $2,500,000 thereafter, (ii) the Company must maintain a total risk based capital ratio at least equal to 9% of risk-weighted assets to June 30, 2018, and 10% thereafter, (iii) the Bank must maintain a total risk based capital ratio at least equal to 10% of risk-weighted assets to June 30, 2018, and 11% thereafter, and (iv) non-performing assets of the Bank may not exceed 2.5% of the Bank’s total assets. Both the Company and Bank were in compliance with the covenants as of December 31, 2017.

 

We are defendants in various legal proceedings.

 

The Company and the Bank are involved in judicial proceedings and regulatory investigations concerning matters arising from our business activities. Although we believe we have a meritorious defense in all significant litigation pending against us, we cannot predict the ultimate outcome. Litigation is subject to inherent uncertainties and unfavorable rulings could occur. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain. Accruals are not made in cases where liability is not probable or the amount cannot be reasonably estimated. We provide disclosure of matters where we believe liability is reasonably possible and which may be material to our consolidated financial statements. If we do not prevail, the ultimate outcome of litigation matters could have a material adverse effect on our financial condition, results of operations, or cash flows. For more information about ongoing legal proceedings, see the Notes to Consolidated Financial Statements.

 

In the past, the Bank served as trustee for employee stock ownership plans (“ESOPs”) which engaged in transactions that are under review by the U. S. Department of Labor (“DOL”), subjecting us to certain legal risks.

 

From 2007 until the first quarter of 2013, the Bank served as trustee for certain ESOPs that purchased the stock of companies from prior owners in purchase transactions. Stock purchase transactions by ESOPs are subject to regular and routine reviews by the DOL for compliance with ERISA. Failure to fulfill fiduciary duties under ERISA with respect to any such plan would subject the Bank to certain financial risks such as claims for damages as well as fines and penalties assessable under ERISA. The Bank was a defendant in legal proceedings initiated by the DOL with respect to two stock purchase transactions by ESOPs for which the Bank served as trustee. Both matters were settled. A ruling in any future litigation that the Bank failed to fulfill its fiduciary duties under ERISA with respect to an ESOP, including stock purchases by the ESOP, could subject the Bank to claims for damages as well as fines and penalties assessable under ERISA.

 

Investigations into and heightened scrutiny of our operations could result in additional costs and damage our reputation.

 

In October 2014, the Department of Justice (“DOJ”) initiated an investigation concerning possible violations of federal laws, including, among other things, possible violations related to false bank entries, bank fraud and securities fraud. The investigation concerns allegations that Bank personnel engaged in practices intended to delay or avoid disclosure of the Bank’s asset quality at the time of and following the United States Treasury’s purchase of preferred shares from the Company in November 2008. The Bank has cooperated with all requests for information from the DOJ. At this time, the DOJ has not indicated whether it intends to pursue any action in the matter. Heightened scrutiny of the operations of the Company and the Bank by federal officials may subject us to governmental or regulatory inquiries, investigations, actions, penalties and fines, which could adversely affect our reputation and result in costs to us in excess of current reserves and management’s estimate of the aggregate range of possible loss for such matters.

 

 

Our business may be adversely affected by conditions in the financial markets and by economic conditions generally.

 

Weakness in business and economic conditions generally or specifically in our markets may have one or more of the following adverse effects on our business:

 

●

A decrease in the demand for loans and other products and services we offer;

●

A decrease in the value of collateral securing our loans; and

●

An increase in the number of customers who become delinquent, file for protection under bankruptcy laws or default on their loans.

 

Adverse conditions in the general business environment have had an adverse effect on our business in the past. Although the general business environment has improved, we cannot predict how long such improvement can be sustained. In addition, the improvement of certain economic indicators, such as real estate asset values, rents, and unemployment, may vary between geographic markets and may continue to lag behind improvement in the overall economy. These economic indicators typically affect the real estate and financial services industries, in which we have a significant number of customers, more significantly than other economic sectors. Furthermore, we have a substantial lending business that depends upon the ability of borrowers to make debt service payments on loans. Should economic conditions worsen, our business, financial condition or results of operations could be adversely affected.

 

A large percentage of our loans are collateralized by real estate, and prolonged weakness in the real estate market may result in losses and adversely affect our profitability.

 

Approximately 73.7% of our loan portfolio as of December 31, 2017, was comprised of commercial and residential loans collateralized by real estate. Adverse economic conditions could decrease demand for real estate and depress real estate values in our markets. Persistent weakness in the real estate market could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If real estate values decline, it will become more likely that we would be required to increase our allowance for loan losses. If during a period of depressed real estate values, we were required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

 

We offer real estate construction and development loans, which carry a higher degree of risk than other real estate loans. Weakness in the residential construction and commercial development real estate markets has in the past increased the non-performing assets in our loan portfolio and our provision for loan loss expense. These impacts have had, and could have in the future, a material adverse effect on capital, financial condition and results of operations.

 

Approximately 8.1% of our loan portfolio as of December 31, 2017 consisted of real estate construction and development loans, up from 5.7% at December 31, 2016 and 5.4% at December 31, 2015. These loans generally carry a higher degree of risk than long-term financing of existing properties because repayment depends on the ultimate completion of the project and permanent financing or sale of the property. If the Bank is forced to foreclose on a project prior to its completion, it may not be able to recover the entire unpaid portion of the loan or it may be required to fund additional money to complete the project, or hold the property for an indeterminate period of time. Any of these outcomes may result in losses and adversely affect profitability and financial condition.

 

Residential construction and commercial development real estate activity in our markets were affected by the challenging economic conditions that followed the financial crisis of 2008. Weakness in these sectors could lead to valuation adjustments to the loan portfolios and real estate owned. A weak real estate market could reduce demand for residential housing, which, in turn, could adversely affect real estate development and construction activities. Consequently, the longer challenging economic conditions persist, the more likely they are to adversely affect the ability of residential real estate development borrowers to repay loans and the value of property used as collateral for such loans.

 

Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.

 

The Bank maintains an allowance for loan losses at a level we believe is adequate to absorb probable incurred losses in the loan portfolio based on historical loan loss experience, economic and environmental factors, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual future loan losses, which would adversely affect operating results. Management’s estimates are subjective, and their accuracy depends on the outcome of future events. Changes in economic, operating, and other conditions that are generally beyond our control could cause actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses. Regulatory agencies may require an increase in provision for loan losses or to recognize additional loan charge-offs when their judgment differed from ours. Any of these events could have a material negative impact on our operating results.

 

 

Our levels of classified loans and non-performing assets may increase in the foreseeable future if economic conditions cause borrowers to default. Further, the value of the collateral underlying a given loan, and the realizable value of such collateral in a foreclosure sale, may decline, making it less likely to realize a full recovery if a borrower defaults on a loan. Any additional increases in the level of our non-performing assets, loan charge-offs or provision for loan losses, or our inability to realize the estimated net value of underlying collateral in the event of a loan default, could negatively affect our business, financial condition, results of operations and the trading price of our securities.

 

If we experience greater credit losses than anticipated, our operating results would be adversely affected.

 

As a lender, the Bank is exposed to the risk that borrowers will be unable to repay their loans according to their terms and that any collateral securing the payment of their loans may not be sufficient to assure repayment. Credit losses are inherent in the business of making loans and could have a material adverse effect on our operating results. Our credit risk with respect to our real estate and construction loan portfolio will relate principally to the creditworthiness of borrowers and the value of the real estate serving as security for the repayment of loans. Our credit risk with respect to our commercial and consumer loan portfolio will relate principally to the general creditworthiness of businesses and individuals within our local markets.

 

We make various assumptions and judgments about the collectability of our loan portfolio and provide an allowance for estimated loss losses based on a number of factors. We believe that our allowance for loan losses is adequate. However, if our assumptions or judgments are wrong, our allowance for loan losses may not be sufficient to cover our actual loan losses. We may have to increase our allowance in the future at the request of one of our primary banking regulators, to adjust for changing conditions and assumptions, or as a result of any deterioration in the quality of our loan portfolio. The actual amount of future provisions for loan losses cannot be determined at this time and may vary from the amounts of past provisions.

 

We continue to hold and from time to time acquire OREO properties, which could increase operating expenses and result in future losses to the Company.

 

During recent years, the Bank has acquired and disposed of a significant amount of real estate as a result of foreclosure or by deed in lieu of foreclosure that is listed on our balance sheet as other real estate owned (“OREO”). An increase in our OREO portfolio increases the expenses incurred to manage and dispose of these properties, which sometimes includes funding construction required to facilitate sale.

 

Properties in our OREO portfolio are recorded at fair value, which represents the estimated sales price of the properties on the date acquired less estimated selling costs. Generally, in determining “fair value” an orderly disposition of the property is assumed, except where a different disposition strategy is expected. Significant judgment is required in estimating the fair value of OREO, and the period of time within which such estimates can be considered current may change during periods of market volatility. Any decreases in market prices of real estate in our market areas may lead to additional OREO write downs, with a corresponding expense in our statement of operations. We evaluate OREO property values periodically and write down the carrying value of the properties if and when the results of our analysis require it.

 

In response to market conditions and other economic factors, we may utilize alternative sale strategies other than orderly disposition as part of our OREO disposition strategy, such as auctions or bulk sales. In this event, as a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from such sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of our OREO properties. In addition, our disposition of OREO through alternative sales strategies could impact the fair value of comparable OREO properties remaining in our portfolio.

 

Our profitability depends significantly on local economic conditions.

 

Most of our business activities are conducted in central Kentucky and most of our credit exposure is in that region. We are at risk from adverse economic or business developments affecting this area, including declining regional and local business and employment activity, a downturn in real estate values and agricultural activities and natural disasters. To the extent the central Kentucky economy weakens, delinquency rates, foreclosures, bankruptcies and losses in our loan portfolio will likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by the economic downturn or a localized natural disaster. Events that adversely affect business activity and real estate values in central Kentucky have had and may continue to have a negative impact on our business, financial condition, results of operations and future prospects.

 

 

Our small to medium-sized business portfolio may have fewer resources to weather a downturn in the economy.

 

Our portfolio includes loans to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need additional capital to expand or compete and may experience variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small or medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons. The death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn may have a more pronounced negative impact on our target market, causing us to incur substantial credit losses that could materially harm our operating results.

 

Our profitability is vulnerable to fluctuations in interest rates.

 

Changes in interest rates could harm our financial condition or results of operations. Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings). Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic or international economic or political conditions. Factors beyond our control, such as inflation, recession, unemployment and money supply may also affect interest rates. If, as a result of decreasing interest rates, our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, our net interest income may decrease. Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

 

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities may be subject to repricing before assets become subject to repricing. Fixed rate investment securities are subject to fair value declines as interest rates rise. Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment. At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates. In a declining interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

 

If we cannot obtain adequate funding, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Company.

 

Our liquidity policies and limits are established by the Board of Directors of the Bank, with operating limits managed and monitored by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits and the percentage of assets funded with non-core or wholesale funding. The ALCO regularly monitors the overall liquidity position of the Bank and the Company to ensure that various alternative strategies exist to meet unanticipated events that could affect liquidity. Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost. If our liquidity policies and strategies do not work as well as intended, we may be unable to make loans and repay deposit liabilities as they become due or are demanded by customers. The ALCO follows established board approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source. Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, and Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets.

 

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common shares in public or private transactions. If we are unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.

 

We may not be able to realize the value of our tax losses and deductions.

 

Due to historic losses, we have a net operating loss carry-forward of $25.6 million, credit carry-forwards of $900,000, and other net deferred tax assets of $4.8 million. In order to realize the benefit of these tax losses, credits and deductions, we will need to generate substantial taxable income in future periods. Our deferred tax assets are calculated using a federal corporate tax rate of 21%. Changes in tax laws and rates may affect our deferred tax assets in the future. If lower federal corporate tax rates are enacted, our net deferred tax assets would be reduced commensurate with the rate reduction. Additionally, should the Company need to raise additional capital by issuing new common shares or securities convertible into common shares, then depending on the number of common share equivalents issued, it could trigger a “change in control,” as defined by Section 382 of the Internal Revenue Code. Such an event could negatively impact or limit the ability to utilize our net operating loss carry-forwards, credit loss carry-forwards, and other net deferred tax assets.

 

 

We may sell capital stock in the future to raise additional capital or for additional liquidity at the holding company. Future sales or other dilution of our equity may adversely affect the market price of our common shares.

 

Our issuance of additional common shares or securities convertible into common shares would dilute the ownership interest of our existing common shareholders. The market price of our common shares could decline as a result of such an offering as well as other sales of a large block of shares of our common shares or similar securities in the market after such an offering, or the perception that such sales could occur. Our common shares have traded from time-to-time at a price below our book value per share. A sale of common shares at or below our book value would be dilutive to current shareholders. The sale of shares at a price below market value could negatively impact the market price of our common shares.

 

Higher FDIC deposit insurance premiums and assessments could significantly increase our non-interest expense.

 

Our deposits are insured by the FDIC up to legal limits and, accordingly, we are subject to FDIC deposit insurance premiums and assessments. FDIC assessments for deposit insurance are based on the average total consolidated assets of the insured institution during the assessment period, less the average tangible equity of the institution during the assessment period. Any increase in assessment rates may adversely affect our business, financial condition or results of operations.

 

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

 

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from other commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds, and other mutual funds. Our competition in making loans comes principally from other commercial banks, credit unions, savings and loan associations, mortgage banking firms, and consumer finance companies. In addition, competition for business in the Louisville and Lexington metropolitan areas has grown in recent years as changes in banking law have allowed banks to enter those markets by establishing new branches.

 

Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete. Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:

 

●

offer higher interest rates on deposits and lower interest rates on loans than we can;

●

offer a broader range of services than we do;

●

maintain more branch locations than we do; and

●

mount extensive promotional and advertising campaigns.

 

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

 

We depend on our senior management team, and the unexpected loss of one or more of our senior executives could impair our relationship with customers and adversely affect our business and financial results.

 

Our future success significantly depends on the continued services and performance of our key management personnel. Our future performance will depend on our ability to motivate and retain these and other key officers. The Dodd-Frank Act, and the policies of bank regulatory agencies have placed restrictions on executive compensation practices. Such restrictions and standards may further impact our ability to compete for talent with other businesses that are not subject to the same limitations as we are. The loss of the services of members of senior management or other key officers or our inability to attract additional qualified personnel as needed could materially harm our business.

 

Our reported financial results depend on management’s selection of accounting methods and certain assumptions and estimates.

 

Accounting policies and assumptions are fundamental to the reported financial condition and results of operations. Management must exercise judgment in selecting and applying many of these accounting policies and methods so they comply with generally accepted accounting principles and reflect management’s judgment of the most appropriate manner in which to report our financial condition and results. In some cases, management must select the accounting policy or method to apply from two or more alternatives, any of which may be reasonable under the circumstances, yet may result in reporting materially different results than would have been reported under a different alternative.

 

 

Certain accounting policies are critical to presenting our reported financial condition and results. They require management to make difficult, subjective or complex judgments about matters that are uncertain. Materially different amounts could be reported under different conditions or using different assumptions or estimates. These critical accounting policies include the valuation of securities, allowance for loan losses, valuation of OREO, valuation of stock based compensation, valuation of net deferred income tax asset, assessing and estimating contingencies, and revenue recognition. Because of the uncertainty of estimates involved in these matters, we may be required, among other things, to significantly increase the allowance for credit losses, sustain credit losses that are significantly higher than the reserve provided, recognize significant impairment on OREO, or permanently impair deferred tax assets.

 

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, we may suffer losses from operational risk in the future.

 

Management maintains internal operational controls, and we have invested in technology to help us process large volumes of transactions. However, we may not be able to continue processing at the same or higher levels of transactions. If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

 

We process large volumes of transactions on a daily basis and are exposed to numerous types of operational risk, which could cause us to incur substantial losses. Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements. This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

 

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk. While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels. We have also established procedures that are designed to ensure that policies relating to conduct, ethics and business practices are followed. Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

 

Our information systems may experience an interruption or security breach.

 

Failure in or breach of our operational or security systems or infrastructure, or those of our third party vendors and other service providers, including as a result of cyber attacks, could disrupt our businesses, result in the disclosure or misuse of confidential or proprietary information, damage our reputation, increase our costs and cause losses. As a financial institution, we depend on our ability to process, record and monitor a large number of customer transactions on a continuous basis. As customer, public and regulatory expectations regarding operational and information security have increased, our operational systems and infrastructure must continue to be safeguarded and monitored for potential failures, disruptions, and breakdowns. Our business, financial, accounting, data processing systems or other operating systems and facilities may stop operating properly or become disabled or damaged as a result of a number of factors including events that are wholly or partially beyond our control. For example, there could be sudden increases in customer transaction volume, electrical or telecommunications outages, natural disasters such as earthquakes, tornadoes, and hurricanes; disease pandemics, events arising from local or larger scale political or social matters, including terrorist acts, and, as described below, cyber attacks. Although we have business continuity plans and other safeguards in place, our business operations may be adversely affected by significant and widespread disruption to our physical infrastructure or operating systems that support our businesses and customers.

 

Information security risks for financial institutions have generally increased in recent years in part because of the proliferation of new technologies, the use of the Internet and telecommunications technologies to conduct financial transactions, and the increased sophistication and activities of organized crime, hackers, terrorists, activists, and other external parties. As noted above, our operations rely on the secure processing, transmission and storage of confidential information in our computer systems and networks. In addition, to access our products and services, our customers may use personal smartphones, tablet PC’s, and other mobile devices that are beyond our control systems. Although we believe we have appropriate information security procedures and controls, our technologies, systems, networks, and our customers’ devices may become the target of cyber attacks or information security breaches. These events could result in the unauthorized release, gathering, monitoring, misuse, loss or destruction of our customers’ confidential, proprietary and other information or that of our customers, or otherwise disrupt the business operations of ourselves, our customers or other third parties.

 

 

Third parties with which we do business or that facilitate our business activities, could also be sources of operational and information security risk to us, including from breakdowns or failures of their own systems or capacity constraints. Although to date we have not experienced any material losses relating to cyber attacks or other information security breaches, we can give no assurance that we will not suffer such losses in the future. Our risk and exposure to these matters remains heightened because of, among other things, the evolving nature of these threats and the prevalence of Internet and mobile banking. As cyber threats continue to evolve, we may be required to expend significant additional resources to continue to modify or enhance our protective measures or to investigate and remediate any information security vulnerabilities. Disruptions or failures in the physical infrastructure or operating systems that support our businesses and customers, or cyber attacks or security breaches of the networks, systems or devices that our customers use to access our products and services could result in customer attrition, regulatory fines, penalties or intervention, reputational damage, reimbursement or other compensation costs, and/or additional compliance costs, any of which could materially adversely affect our business, results of operations or financial condition.

 

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect financial performance and ability to implement growth and operating strategies.

 

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, as described under “Item 1 – Business-Supervision and Regulation.” Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, and not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.

 

Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks, and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations, and policies or to maintain required capital could affect our ability to pay dividends on common shares, our ability to grow through the development of new offices, make acquisitions, and remain independent. These limitations may prevent us from successfully implementing our growth and operating strategies.

 

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans. Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Consumer Financial Protection Bureau, the SEC, the Public Company Accounting Oversight Board and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations. Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.

 

Changes in banking laws could have a material adverse effect on us.

 

We are subject to changes in federal and state laws as well as changes in banking and credit regulations, and governmental economic and monetary policies. We cannot predict whether any of these changes could adversely and materially affect us. The current regulatory environment for financial institutions entails significant potential increases in compliance requirements and associated costs. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on our activities that could have a material adverse effect on our business and profitability.

 

Recent legislation regarding the financial services industry may have a significant adverse effect on operations. 

 

Enacted in July 2010, the Dodd-Frank Act has had a significant impact the U.S. financial system, including among other things:

 

●

new requirements on banking, derivative and investment activities, including the repeal of the prohibition on the payment of interest on business demand accounts, and debit card interchange fee requirements;

●

the creation of the Consumer Financial Protection Bureau with supervisory authority, including the power to conduct examinations and take enforcement actions with respect to financial institutions with assets of $10 billion or more and implement regulations that will affect all financial institutions;

●

provisions affecting corporate governance and executive compensation of all companies subject to the reporting requirements of the Securities and Exchange Act of 1934, as amended; and

●

a provision requiring bank regulators to set minimum capital levels for bank holding companies that are as strong as those required for their insured depository subsidiaries, subject to a grandfather clause for holding companies with less than $15 billion in assets as of December 31, 2009.

 

 

Some provisions in the Dodd-Frank Act remain subject to regulatory rule-making, implementation, and interpretation, the effects of which are not yet known. As a result, it is difficult to gauge the ultimate impact of certain provisions of the Dodd-Frank Act because the implementation of many concepts is left to regulatory agencies. For example, the CFPB is given the power to adopt new regulations to protect consumers and is given control over existing consumer protection regulations adopted by federal banking regulators. The CFPB has already adopted a number of regulations but it is not known at this time when additional rules will be finalized and implemented.

 

The provisions of the Dodd-Frank Act and any rules adopted to implement those provisions, as well as any additional legislative or regulatory changes may impact the profitability of our business activities and costs of operations, require that we change certain of our business practices, materially affect our business model or affect retention of key personnel, require us to raise additional regulatory capital, including additional Tier 1 capital, and could expose us to additional costs (including increased compliance costs). These and other changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.

 

 

Item 1B.

Unresolved Staff Comments

 

Not applicable.

 

Item 2.

Properties

 

The Bank operates 15 banking offices in Kentucky. The following table shows the location, square footage and ownership of each property. We believe that each of these locations is adequately insured. Support operations are located in our main office in Louisville and in Glasgow.

 

Markets		Square Footage			Owned/Leased
Louisville/Jefferson, Bullitt and Henry Counties
Main Office: 2500 Eastpoint Parkway, Louisville		30,000			Owned
Eminence Office: 646 Elm Street, Eminence		1,500			Owned
Hillview Office: 6890 North Preston Highway, Hillview		3,500			Owned
Pleasureville Office: 5440 Castle Highway, Pleasureville		10,000			Owned
Conestoga Office: 155 Conestoga Parkway, Shepherdsville		3,900			Owned
Lexington/Fayette County
Lexington Office: 2424 Harrodsburg Road, Suite 100, Lexington		8,500			Leased
South Central Kentucky
Brownsville Office: 113 East Main Cross Street, Brownsville		8,500			Owned
Greensburg Office: 202 North Main Street, Greensburg		11,000			Owned
Horse Cave Office: 201 East Main Street, Horse Cave		5,000			Owned
Morgantown Office: 112 West G.L. Smith Street, Morgantown		7,500			Owned
Munfordville Office: 949 South Dixie Highway, Munfordville		9,000			Owned
Beaver Dam Office: 1300 North Main Street, Beaver Dam		3,200			Owned
Owensboro/Daviess County
Owensboro Office: 1819 Frederica Street, Owensboro		3,000			Owned
Southern Kentucky
Campbell Lane Office: 751 Campbell Lane, Bowling Green		7,500			Owned
Glasgow Office: 1006 West Main Street, Glasgow		12,000			Owned
Other Properties
Office Building: 701 Columbia Avenue, Glasgow		19,000			Owned

 

 

Item 3.

Legal Proceedings

We are defendants in various legal proceedings. Litigation is subject to inherent uncertainties and unfavorable outcomes could occur. See Note 16, “Off Balance Sheet Risks, Commitments, and Contingent Liabilities” in the Notes to our consolidated financial statements for detail regarding ongoing legal proceedings and other matters.

 

Item 4.

Mine Safety Disclosure

 

Not applicable.

 

 

PART II

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Information

 

Our common shares are traded on the Nasdaq Capital Market under the ticker symbol “PBIB”. The following table presents the high and low market closing prices per share for our common shares reported on the Nasdaq Capital Market for the periods indicated. The per share prices shown in the table have been adjusted for the 1-for-5 reverse stock split of our common shares that took effect on December 16, 2016.

 

		2017
		Market Value
Quarter Ended		High				Low				Dividend
Fourth Quarter		$	15.45			$	11.42			$	0.00
Third Quarter			11.81				9.98				0.00
Second Quarter			10.49				8.73				0.00
First Quarter			12.75				9.14				0.00

 

		2016
		Market Value
Quarter Ended		High				Low				Dividend
Fourth Quarter		$	12.90			$	8.05			$	0.00
Third Quarter			8.55				7.70				0.00
Second Quarter			11.25				5.95				0.00
First Quarter			7.10				5.45				0.00

 

As of January 31, 2018, we had approximately 1,664 shareholders, including 470 shareholders of record and approximately 1,194 beneficial owners whose shares are held in “street” name by securities broker-dealers or other nominees.

 

Dividends 

 

As a bank holding company, our ability to declare and pay dividends depends on various federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.

 

Our principal source of revenue with which to pay dividends on our common shares are dividends the Bank may declare and pay out of funds legally available for payment of dividends. Currently, the Bank must obtain the prior written consent of its primary regulators prior to declaring or paying any dividends until retained earnings are positive. A Kentucky chartered bank may declare a dividend of an amount of the bank’s net profits as the board deems appropriate. The approval of the KDFI is required if the total of all dividends declared by a bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt. Under our Written Agreement, the prior approval of the Federal Reserve Bank of St. Louis is also required for the payment of any Bank dividends.

 

Effective with the third quarter of 2016, the Company resumed deferring interest payments on the junior subordinated notes underlying our trust preferred securities. Deferring interest payments on the junior subordinated notes resulted in the deferral of distributions on our trust preferred securities. If we defer interest payments on our trust preferred securities for 20 consecutive quarters, we must pay all deferred interest or we will be in default. Our deferral period expires after the second quarter of 2021.

 

We will not be able to pay cash dividends on our common shares until we have paid all deferred distributions on our trust preferred securities. Deferred distributions on trust preferred securities are cumulative, and distributions accrue and compound on each subsequent payment date. If we become subject to any liquidation, dissolution or winding up of affairs, holders of the trust preferred securities and then holders of our preferred shares will be entitled to receive the liquidation amounts to which they are entitled including the amount of any accrued and unpaid distributions and dividends, before any distribution can be made to the holders of common shares or preferred shares. Series E and Series F Preferred Shares have priority over our common shares and non-voting common shares with respect to any payment of dividends.

 

Purchase of Equity Securities by Issuer

 

During the fourth quarter of 2017, the Company did not repurchase any of its common shares, which is its only registered class of equity securities.

 

 

Item 6.

Selected Financial Data

 

The following table summarizes our selected historical consolidated financial data from 2013 to 2017. You should read this information in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”

 

Selected Consolidated Financial Data 

 

		As of and for the Years Ended December 31,
(Dollars in thousands except per share data)		2017				2016				2015				2014				2013
Income Statement Data:
Interest income		$	37,522			$	35,602			$	36,574			$	39,513			$	43,228
Interest expense			6,405				5,981				7,023				9,795				11,143
Net interest income			31,117				29,621				29,551				29,718				32,085
Provision (negative provision) for loan losses			(800	)			(2,450	)			(4,500	)			7,100				700
Non-interest income			4,855				4,764				7,695				4,079				5,919
Non-interest expense			30,218				39,567				44,959				39,435				38,890
Income (loss) before income taxes			6,554				(2,732	)			(3,213	)			(12,738	)			(1,586	)
Income tax expense (benefit)			(31,899	)			21				—				(1,583	)			—
Net income (loss)			38,453				(2,753	)			(3,213	)			(11,155	)			(1,586	)
Less:
Dividends and accretion on preferred stock			—				—				—				2,362				2,079
Effect of exchange of preferred stock for common stock			—				—				—				(36,104	)			—
Earnings (loss) allocated to participating securities			967				(88	)			(336	)			3,159				(267	)
Net income (loss) attributable to common		$	37,486			$	(2,665	)		$	(2,877	)		$	19,428			$	(3,398	)
Common Share Data: (1)
Basic earnings (loss) per common share		$	6.15			$	(0.46	)		$	(0.62	)		$	7.94			$	(1.44	)
Diluted earnings (loss) per common share			6.15				(0.46	)			(0.62	)			7.94				(1.44	)
Cash dividends declared per common share			—				—				—				—				—
Book value per common share (2)			11.17				4.81				5.43				8.37				(0.92	)
Tangible book value per common share (2)			11.17				4.79				5.33				8.05				(1.46	)
Balance Sheet Data (at period end):
Total assets		$	970,801			$	945,177			$	948,722			$	1,017,989			$	1,076,121
Debt obligations:
FHLB advances			11,797				22,458				3,081				15,752				4,492
Junior subordinated debentures			21,000				21,000				21,000				25,000				25,000
Subordinated capital note			2,250				3,150				4,050				4,950				5,850
Senior debt			10,000				—				—				—				—
Average Balance Data:
Average assets		$	947,961			$	929,140			$	984,419			$	1,049,232			$	1,098,400
Average loans			667,474				621,275				635,948				662,442				788,176
Average deposits			864,278				852,717				907,785				961,671				1,004,052
Average FHLB advances			9,184				2,967				3,473				4,473				4,990
Average junior subordinated debentures			21,000				21,000				23,981				25,000				25,000
Average subordinated capital note			2,805				3,708				4,608				5,508				6,404
Average senior debt			5,068				—				—				—				—
Average stockholders’ equity			37,851				39,423				33,083				33,881				42,631

 

---

(1)

On December 16, 2016, the Company completed a 1-for-5 reverse stock split of its issued and outstanding common and non-voting common shares. As a result of the reverse stock split, all share and per share data has been adjusted in the accompanying tables. Preferred shares were not impacted by the 1-for-5 reverse stock split.

(2)	After shareholder approval on February 25, 2015, our two series of mandatorily convertible preferred shares converted into a total of 810,720 common shares and 1,291,600 non-voting common shares.

  

 

Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operation

 

Management’s discussion and analysis of financial condition and results of operations analyzes the consolidated financial condition and results of operations of Porter Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, Limestone Bank, Inc. (the “Bank”). The Bank completed a name change from PBI Bank to Limestone Bank on February 20, 2018. The Company is a Louisville, Kentucky-based bank holding company that operates banking offices of the Bank in twelve Kentucky counties. Our markets include metropolitan Louisville in Jefferson County and the surrounding counties of Henry and Bullitt. We serve south central Kentucky and southern Kentucky from banking offices in Butler, Green, Hart, Edmonson, Barren, Warren, Ohio, and Daviess Counties. We also have an office in Lexington, the second largest city in Kentucky. The Bank is a community bank with a wide range of commercial and personal banking products.

 

Historically, we have focused on commercial and commercial real estate lending, both in markets where we have banking offices and other growing markets in our region. Commercial, commercial real estate and real estate construction loans accounted for 58.4% of our total loan portfolio as of December 31, 2017, and 55.6% as of December 31, 2016. Commercial lending generally produces higher yields than residential lending, but involves greater risk and requires more rigorous underwriting standards and credit quality monitoring.

 

The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes and other schedules presented elsewhere in the report.

 

Overview

 

For the year ended December 31, 2017, the Company reported net income of $38.5 million compared with net loss of $2.8 million for the year ended December 31, 2016 and a net loss of $3.2 million for the year ended December 31, 2015. After allocating earnings to participating securities, net income attributable to common shareholders was $37.5 million for the year ended December 31, 2017, compared with net loss attributable to common shareholders of $2.7 million for the year ended December 31, 2016, and a net loss attributable to common shareholders of $2.9 million for the year ended December 31, 2015. Basic and diluted income per common share were $6.15 for the year ended December 31, 2017, compared with net loss per common share of ($0.46) for 2016, and net loss per common share of ($0.62) for 2015.

 

The following significant items are of note for the year ended December 31, 2017:

 

●

The Company has had a full valuation allowance against its net deferred tax asset since 2011. The ability to utilize the net deferred tax asset depends upon generating sufficient future levels of taxable income. The determination to restore a deferred tax asset and eliminate a valuation allowance depends upon the evaluation of both positive and negative evidence regarding the likelihood of achieving sufficient future taxable income levels. During the fourth quarter of 2017, management concluded it was more-likely-than-not the asset would be utilized to reduce future taxes payable related to the future taxable income of the Company, and as such, reversed the valuation allowance. As a result of the conclusion to reverse the valuation allowance, the Company recorded an income tax benefit of $54.0 million for the year ended December 31, 2017. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 was signed into law. Among other significant changes to the tax code, the new law lowered the federal corporate tax rate from 35% to 21% beginning in 2018. As a result, the Company revalued its net deferred tax asset at the new 21% rate. Due to this revaluation, the Company recorded a $20.3 million charge to income tax expense for the year ended December 31, 2017. The combination of the reversal of the valuation allowance and the change in federal corporate tax rates, as well as income tax expense for the year, resulted in an income tax benefit of $31.9 million for the year ended December 31, 2017.

 

●

The Bank is no longer subject to a consent order with the Federal Deposit Insurance Corporation and Kentucky Department of Financial Institutions. We were notified that the Bank’s prior consent order was terminated, effective October 31, 2017.

 

●

Loan growth outpaced paydowns during the period. Average loans receivable increased approximately $46.2 million or 7.4% to $667.5 million for the year ended December 31, 2017, compared with $621.3 million for the year ended December 31, 2016. This resulted in an increase in interest revenue volume of approximately $2.2 million, which was offset by rate decreases of $895,000 for the year ended December 31, 2017, compared with the year ended December 31, 2016.

 

●

Net interest margin increased six basis points to 3.48% for the year ended 2017 compared with 3.42% in the year ended December 31, 2016. The increase in margin between periods was primarily due to an increase in the rate of interest earned on interest earning assets from 4.11% in 2016 to 4.18% in 2017.

 

 

●

Negative provision for loan losses expense was $800,000 in 2017, compared to a negative provision for loan losses expense of $2.5 million for 2016, because of declining historical loss rates, improvements in loan quality, and management’s assessment of risk in the loan portfolio. Net loan recoveries were $35,000 for 2017, compared to net loan charge-offs of $624,000 for 2016 and $2.8 million for 2015. In the following paragraphs, we discuss the improving trends in non-performing loans, past due loans, and loan risk categories during the period, factors that led to the negative provision expense.

 

●

Non-performing loans decreased $3.8 million to $5.5 million at December 31, 2017, compared with $9.2 million at December 31, 2016. The decrease in non-performing loans was due to $5.0 million in paydowns, $665,000 in charge-offs, $199,000 in loans returned to accrual status, and $270,000 in transfers to OREO, offset by $2.3 million in loans placed on non-accrual.

 

●

Loans past due 30-59 days decreased from $2.3 million at December 31, 2016 to $1.5 million at December 31, 2017, and loans past due 60-89 days decreased from $315,000 at December 31, 2016 to $171,000 at December 31, 2017. Loans past due 90 days or more totaled $1,000 at December 31, 2017, compared to no loans past due 90 days or more at December 31, 2016. Total loans past due and nonaccrual loans decreased to $7.1 million at December 31, 2017 from $11.8 million at December 31, 2016.

 

●

All loan risk categories (other than pass loans) have decreased since December 31, 2016. Pass loans represent 94.5% of the portfolio at December 31, 2017, compared to 91.7% at December 31, 2016 and 83.6% at December 31, 2015. During 2017, the pass category increased approximately $86.6 million, the watch category declined approximately $4.7 million, the special mention category declined approximately $333,000, and the substandard category declined approximately $8.7 million. The $8.7 million decrease in loans classified as substandard was driven by $6.8 million in principal payments received, $270,000 in migration to OREO, $4.6 million in loans upgraded from substandard, and $790,000 in charge-offs, offset by $3.7 million in loans moved to substandard during 2017.

 

●

Foreclosed properties were $4.4 million at December 31, 2017, compared with $6.8 million at December 31, 2016. During the year ended December 31, 2017, the Company acquired $270,000 and sold $793,000 of OREO. We incurred OREO losses totaling $2.0 million during the year ended December 31, 2017, reflecting fair value write-downs for updated appraisals, changes in marketing strategies, and reductions in listing prices for certain properties, offset by $74,000 in net gain on sales of OREO.

 

●

Non-performing assets decreased to $9.9 million or 1.02% of total assets at December 31, 2017, compared with $16.0 million or 1.70% of total assets at December 31, 2016. In addition, accruing troubled debt restructurings declined to $1.2 million at December 31, 2017 from $5.4 million at December 31, 2016.

 

●

Non-interest income increased by $91,000 in 2017 to $4.9 million compared with $4.8 million for the year ended December 31, 2016. This increase was primarily attributable to a $295,000 increase in service charges on deposit accounts, a $123,000 increase in bank card interchange fees, and a $72,000 increase in net gain on sale of securities partially offset by no OREO income during 2017, compared to $456,000 during 2016.

 

●

Non-interest expense for the year ended December 31, 2017 of $30.2 million represented a 23.6% decrease from $39.6 million for 2016. The decrease in non-interest expense was attributable primarily to a decrease in litigation and loan collection expense, which decreased $8.6 million. Litigation expense was negatively impacted in 2016 by a ruling from the Kentucky Court of Appeals against the Bank that approximated $8.0 million. Non-interest expense also benefited from a $590,000 decrease in professional fees, a $418,000 decrease in salaries and employee benefits, and a $248,000 decrease in FDIC insurance.

 

●

Deposits decreased $2.9 million or 0.3% to $847.0 million at December 31, 2017 compared with $849.9 million at December 31, 2016. Certificate of deposit balances decreased $20.4 million during 2017 to $424.2 million at December 31, 2017, from $444.6 million at December 31, 2016. Non-interest bearing demand deposits increased $13.0 million or 10.4% during 2017 to $137.4 million compared with $124.4 million at December 31, 2016. Money market accounts increased $8.9 million or 6.2% during 2017 to $151.4 million compared with $142.5 million at December 31, 2016.

 

 

●

On June 30, 2017, the Company entered into a $10.0 million senior secured loan agreement with a commercial bank. The loan matures on June 30, 2022. Interest is payable quarterly at a rate of three-month LIBOR plus 250 basis points through June 30, 2020, at which time quarterly principal payments of $250,000 plus interest will commence. The loan is secured by a first priority pledge of 100% of the issued and outstanding stock of the Bank. The Company may prepay any amount due under the promissory note at any time without premium or penalty. The Company contributed $9.0 million of the borrowing proceeds to the Bank as common equity Tier 1 capital. The remaining $1.0 million of the borrowing proceeds was retained by the lender in escrow to service quarterly interest payments. At December 31, 2017, the escrow account had a balance of $806,000.

 

These items are discussed in further detail throughout this Item 7.

 

Application of Critical Accounting Policies

 

The Company’s accounting and reporting policies comply with GAAP and conform to general practices within the banking industry. We believe that the following significant accounting policies may involve a higher degree of management assumptions and judgments that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

 

Allowance for Loan Losses – The Bank maintains an allowance for loan losses believed to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. The Board of Directors evaluates the adequacy of the allowance for loan losses on a quarterly basis. We evaluate the adequacy of the allowance using, among other things, historical loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral and current economic conditions and trends. The allowance may be allocated for specific loans or loan categories, but the entire allowance is available for any loan. The allowance consists of specific and general components. The specific component relates to loans that are individually evaluated and measured for impairment. The general component is based on historical loss experience adjusted for qualitative environmental factors. We develop allowance estimates based on actual loss experience adjusted for current economic conditions and trends. Allowance estimates are a prudent measurement of the risk in the loan portfolio applied to individual loans based on loan type. If the mix and amount of future charge-off percentages differ significantly from the assumptions used by management in making its determination, we may be required to materially increase our allowance for loan losses and provision for loan losses, which could adversely affect our results.

 

Other Real Estate Owned – OREO is real estate acquired as a result of foreclosure or by deed in lieu of foreclosure. It is classified as real estate owned until such time as it is sold. OREO is recorded at its fair market value less estimated cost to sell. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Costs incurred in order to perfect the lien prior to foreclosure may be capitalized if the fair value less the cost to sell exceeds the balance of the loan at the time of transfer to OREO. Examples of eligible costs to be capitalized are payments of delinquent property taxes to clear tax liens or payments to contractors and subcontractors to clear mechanics’ liens. Fair value of OREO is determined on an individual property basis. To determine the fair value of OREO for smaller dollar single family homes, we consult with staff from the Bank’s special assets group as well as external realtors and appraisers. If the internally evaluated market price is below our underlying investment in the property, appropriate write-downs are taken. For larger dollar residential and commercial real estate properties, we obtain a new appraisal of the subject property or have staff from our special assets group evaluate the latest in-file appraisal in connection with the transfer to OREO. We typically obtain updated appraisals within five quarters of the anniversary date of ownership unless a sale is imminent. Subsequent reductions in fair value are recorded as non-interest expense when a new appraisal indicates a decline in value or in cases where a listing price is lowered below the appraised amount. 

 

Stock-based Compensation – Compensation cost is recognized for restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. The market price of the Company’s common shares at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. For awards with graded vesting, compensation cost is recognized on a straight-line basis over the requisite service period for the entire award.

 

Valuation of Deferred Tax Asset – We evaluate deferred tax assets for impairment on a quarterly basis. We established a 100% deferred tax valuation allowance in December 2011 based upon the analysis of our past performance and our expected future performance. The Company’s ability to utilize the net deferred tax asset depends upon generating suffient future levels of taxable income. The determination to restore a deferred tax asset and eliminate a valuation allowance depends upon the evaluation of both positive and negative evidence regarding the likelihood of achieving future taxable income levels. In 2017, management concluded it was more-likely-than-not the asset would be utilized to reduce future taxes payable related to the future taxable income of the Company, and as such, reversed the valuation allowance.

 

 

Contingencies – We are defendants in various legal proceedings. We record contingent liabilities resulting from claims against us when a loss is assessed to be probable and the amount of the loss is reasonably estimable. Assessing probability of loss and estimating probable losses requires analysis of multiple factors, including in some cases judgments about the potential actions of third party claimants and courts. Recorded contingent liabilities are based on the best information available and actual losses in any future period are inherently uncertain.

 

Results of Operations 

 

The following table summarizes components of income and expense and the change in those components for 2017 compared with 2016:

 

		For the Years Ended December 31,								Change from Prior Period
		2017				2016				Amount				Percent
		(dollars in thousands)
Gross interest income		$	37,522			$	35,602			$	1,920				5.4	%
Gross interest expense			6,405				5,981				424				7.1
Net interest income			31,117				29,621				1,496				5.1
Provision (negative provision) for loan losses			(800	)			(2,450	)			1,650				67.3
Non-interest income			4,567				4,548				19				0.4
Gains on sale of securities, net			288				216				72				33.3
Non-interest expense			30,218				39,567				(9,349	)			(23.6	)
Net income (loss) before taxes			6,554				(2,732	)			9,286				339.9
Income tax expense (benefit)			(31,899	)			21				(31,920	)			NM
Net income (loss)			38,453				(2,753	)			41,206				NM
Earnings (losses) attributable to participating securities			967				(88	)			1,055				NM
Net income (loss) attributable to common shareholders			37,486				(2,665	)			40,151				NM

NM: Not Meaningful

 

Net income of $38.5 million for the year ended December 31, 2017 increased by $41.2 million from a net loss of $2.8 million for 2016. During the period, improving trends in non-performing loans, past due loans, and loan risk categories continued. In addition, net income for 2017 was impacted by the reversal of the Company’s deferred tax asset valuation allowance and the change in federal corporate tax rates in connection with the enactment of the Tax Cuts and Jobs Act of 2017. The net result of these two items, as well as income tax expense for the year, was an income tax benefit of $31.9 million for 2017. A negative provision for loan losses expense of $800,000 was recorded during 2017, compared to $2.5 million negative provision for loan losses expense for 2016. Non-interest income increased $19,000 during 2017. There was an increase of $295,000 in service charges on deposit accounts, $123,000 in bank card interchange fees, and $62,000 in other non-interest income which was offset by no OREO income during 2017, compared to $456,000 during 2016. Non-interest expense decreased $9.3 million during 2017 due primarily to a decrease in litigation and loan collection expense of $8.6 million as 2016 was negatively impacted by a ruling from the Kentucky Court of Appeals against the Bank that approximated $8.0 million. After consideration of earnings attributable to participating securities, net income attributable to common shareholders was $37.5 million for the year ended December 31, 2017, as compared to net loss attributable to common shareholders of $2.7 million for 2016.

 

 

The following table summarizes components of income and expense and the change in those components for 2016 compared with 2015:

 

		For the Years Ended December 31,								Change from Prior Period
		2016				2015				Amount				Percent
		(dollars in thousands)
Gross interest income		$	35,602			$	36,574			$	(972	)			(2.7	)%
Gross interest expense			5,981				7,023				(1,042	)			(14.8	)
Net interest income			29,621				29,551				70				0.2
Provision (negative provision) for loan losses			(2,450	)			(4,500	)			(2,050	)			(45.6	)
Non-interest income			4,548				5,929				(1,381	)			(23.3	)
Gains on sale of securities, net			216				1,766				(1,550	)			(87.8	)
Non-interest expense			39,567				44,959				(5,392	)			(12.0	)
Net loss before taxes			(2,732	)			(3,213	)			481				15.0
Income tax expense			21				—				21				100.0
Net loss			(2,753	)			(3,213	)			(460	)			(14.3	)
Earnings (losses) attributable to participating securities			(88	)			(336	)			248				(73.8	)
Net loss attributable to common shareholders			(2,665	)			(2,877	)			(212	)			(7.4	)

 

Net loss of $2.8 million for the year ended December 31, 2016 decreased by $460,000 from a net loss of $3.2 million for 2015. A negative provision for loan losses expense of $2.5 million was recorded for 2016 due to improvements in loan quality and management’s assessment of risk within the portfolio as compared to $4.5 million negative provision for loan losses expense for 2015. Non-interest income decreased $2.9 million during 2016 due primarily to a decrease in OREO rental income of $890,000 driven by the sale of income producing properties and a $1.6 million decrease in gains on the sale of securities compared to 2015. Non-interest expense decreased $5.4 million during 2016. OREO expense decreased by $10.8 million, but was offset by a $7.7 million increase in litigation and loan collection expense primarily resulting from the adverse Kentucky Court of Appeals ruling. After consideration of losses attributable to participating securities, net loss attributable to common shareholders was $2.7 million for the year ended December 31, 2016, as compared to net loss attributable to common shareholders of $2.9 million for 2015.

 

Net Interest Income – Net interest income was $31.1 million for the year ended December 31, 2017, an increase of $1.5 million, or 5.1%, compared with $29.6 million for the same period in 2016. Net interest spread and margin were 3.35% and 3.48%, respectively, for 2017, compared with 3.32% and 3.42%, respectively, for 2016. Average nonaccrual loans were $7.1 million and $11.4 million in 2017 and 2016, respectively.

 

Average interest-earning assets were $904.1 million for 2017, compared with $875.3 million for 2016, a 3.3% increase, primarily attributable to higher average loans and investment securities, partially offset by a decrease in interest bearing deposits with financial institutions. Average loans were $667.5 million for 2017, compared with $621.3 million for 2016, a 7.4% increase. Average investment securities were $193.1 million for 2017, compared with $183.7 million for 2016, a 5.1% increase. Average interest bearing deposits with financial institutions and fed funds sold were $36.2 million in 2017, compared with $62.9 million in 2016, a 42.4% decrease. Total interest income increased 5.4% to $37.5 million for 2017, compared with $35.6 million for 2016.

 

Average interest-bearing liabilities increased by 1.7% to $773.2 million for 2017, compared with $760.7 million for 2016. Our total interest expense increased by 7.1% to $6.4 million for 2017, compared with $6.0 million during 2016, due primarily to the completion of a $10.0 million senior debt transaction during 2017 as well as an increase in FHLB advances outstanding during 2017. Average volume of certificates of deposit decreased 2.9% to $452.4 million for 2017, compared with $466.0 million for 2016. The average interest rate paid on certificates of deposit increased to 0.93% for 2017, compared with 0.88% for 2016. Average volume of interest checking and money market deposit accounts increased 6.2% to $247.3 million for 2017, compared with $232.7 million for 2016. The average interest rate paid on interest checking and money market deposit accounts decreased to 0.38% for 2017, compared with 0.40% for 2016.

 

Net interest income was $29.6 million for the year ended December 31, 2016, an increase of $70,000, or 0.2%, compared with $29.6 million for the same period in 2015. Net interest spread and margin were 3.32% and 3.42%, respectively, for 2016, compared with 3.18% and 3.27%, respectively, for 2015. Average nonaccrual loans were $11.4 million and $29.0 million in 2016 and 2015, respectively.

 

Average interest-earning assets were $875.3 million for 2016, compared with $917.5 million for 2015, a 4.6% decrease, primarily attributable to lower average loans, investment securities and interest bearing deposits with financial institutions. Average loans were $621.3 million for 2016, compared with $635.9 million for 2015, a 2.3% decrease. Average investment securities were $183.7 million for 2016, compared with $194.1 million for 2015, a 5.3% decrease. Average interest bearing deposits with financial institutions were $62.3 million in 2016, compared with $78.9 million in 2015, a 21.0% decrease. Our total interest income decreased 2.7% to $35.6 million for 2016, compared with $36.6 million for 2015.

 

 

Average interest-bearing liabilities decreased by 8.0% to $760.7 million for 2016, compared with $826.9 million for 2015. Total interest expense decreased by 14.8% to $6.0 million for 2016, compared with $7.0 million during 2015, due primarily to lower interest rates paid on and lower volume of certificates of deposit. Average volume of certificates of deposit decreased 16.4% to $466.0 million for 2016, compared with $557.4 million for 2015. The average interest rate paid on certificates of deposit decreased to 0.88% for 2016, compared with 0.96% for 2015, as the result of continued re-pricing of certificates of deposit at maturity to lower interest rates. The average volume of interest checking and money market deposit accounts increased 15.7% to $232.7 million for 2016, compared with $201.2 million for 2015. The average interest rate paid on interest checking and money market deposit accounts increased to 0.40% for 2016, compared with 0.38% for 2015.

 

 

Average Balance Sheets

 

The following table sets forth the average daily balances, the interest earned or paid on such amounts, and the weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities for the periods indicated. Dividing income or expense by the average daily balance of assets or liabilities, respectively, derives such yields and costs for the periods presented.

 

		For the Years Ended December 31,
		2017												2016
		Average Balance				Interest Earned/Paid				Average Yield/Cost				Average Balance				Interest Earned/Paid				Average Yield/Cost
		(dollars in thousands)
ASSETS
Interest-earning assets:
Loans receivables (1)(2)
Real estate		$	509,133			$	24,544				4.82	%		$	493,068			$	24,486				4.97	%
Commercial			107,188				4,403				4.11				81,110				3,471				4.28
Consumer			10,790				843				7.81				9,818				826				8.41
Agriculture			39,839				2,047				5.14				36,811				1,733				4.71
Other			524				29				5.53				468				21				4.49
U.S. Treasury and agencies			31,440				694				2.21				34,049				757				2.22
Mortgage-backed securities			94,451				2,240				2.37				101,249				2,240				2.21
Collateralized loan obligations			20,242				541				2.67				802				28				3.49
State and political subdivision securities (non-taxable) (3)			19,617				571				4.48				21,041				620				4.53
State and political subdivision securities (taxable)			23,689				757				3.20				23,921				768				3.21
Corporate bonds			3,651				167				4.57				2,656				93				3.50
FHLB stock			7,323				366				5.00				7,323				293				4.00
Federal funds sold			960				10				1.04				639				3				0.47
Interest-bearing deposits in other financial institutions			35,222				310				0.88				62,307				263				0.42
Total interest-earning assets			904,069				37,522				4.18	%			875,262				35,602				4.11	%
Less: Allowance for loan losses			(8,961	)											(10,719	)
Non-interest-earning assets			52,853												64,597
Total assets		$	947,961											$	929,140
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Certificates of deposit and other time deposits		$	452,443			$	4,191				0.93	%		$	466,007			$	4,111				0.88	%
Interest checking and money market deposits			247,261				940				0.38				232,717				921				0.40
Savings accounts			35,486				59				0.17				34,257				61				0.18
FHLB advances			9,184				120				1.31				2,967				70				2.36
Junior subordinated debentures			23,805				901				3.78				24,708				818				3.31
Senior debt			5,068				194				3.83				—				—				—
Total interest-bearing liabilities			773,247				6,405				0.83	%			760,656				5,981				0.79	%
Non-interest-bearing liabilities
Non-interest-bearing deposits			129,088												119,736
Other liabilities			7,775												9,325
Total liabilities			910,110												889,717
Stockholders’ equity			37,851												39,423
Total liabilities and stockholders’ equity		$	947,961											$	929,140
Net interest income						$	31,117											$	29,621
Net interest spread											3.35	%											3.32	%
Net interest margin											3.48	%											3.42	%
Ratio of average interest-earning assets to average interest-bearing liabilities											116.92	%											115.07	%

 

 

---

(1)	Includes loan fees in both interest income and the calculation of yield on loans.

(2)	Calculations include non-accruing loans of $7.1 million and $11.4 million in average loan amounts outstanding.

(3)	Taxable equivalent yields are calculated assuming a 35% federal income tax rate.

 

 

 

		For the Years Ended December 31,
		2016												2015
		Average Balance				Interest Earned/Paid				Average Yield/Cost				Average Balance				Interest Earned/Paid				Average Yield/Cost
		(dollars in thousands)
ASSETS
Interest-earning assets:
Loans receivables (1)(2)
Real estate		$	493,068			$	24,486				4.97	%		$	516,605			$	25,423				4.92	%
Commercial			81,110				3,471				4.28				78,993				3,475				4.40
Consumer			9,818				826				8.41				10,432				856				8.21
Agriculture			36,811				1,733				4.71				29,395				1,470				5.00
Other			468				21				4.49				523				27				5.16
U.S. Treasury and agencies			34,049				757				2.22				31,269				684				2.19
Mortgage-backed securities			101,249				2,240				2.21				107,277				2,420				2.26
Collateralized loan obligations			802				28				3.49				—				—				—
State and political subdivision securities (non-taxable) (3)			21,041				620				4.53				25,354				764				4.64
State and political subdivision securities (taxable)			23,921				768				3.21				24,059				774				3.22
Corporate bonds			2,656				93				3.50				6,116				155				2.53
FHLB stock			7,323				293				4.00				7,323				293				4.00
Other debt securities			—				—				—				544				43				7.90
Federal funds sold			639				3				0.47				752				1				0.13
Interest-bearing deposits in other financial institutions			62,307				263				0.42				78,904				189				0.24
Total interest-earning assets			875,262				35,602				4.11	%			917,546				36,574				4.03	%
Less: Allowance for loan losses			(10,719	)											(17,154	)
Non-interest-earning assets			64,597												84,027
Total assets		$	929,140											$	984,419
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities
Certificates of deposit and other time deposits		$	466,007			$	4,111				0.88	%		$	557,441			$	5,329				0.96	%
Interest checking and money market deposits			232,717				921				0.40				201,164				756				0.38
Savings accounts			34,257				61				0.18				35,604				75				0.21
Federal funds purchased and repurchase agreements			—				—				—				587				1				0.17
FHLB advances			2,967				70				2.36				3,473				95				2.74
Junior subordinated debentures			24,708				818				3.31				28,589				767				2.68
Total interest-bearing liabilities			760,656				5,981				0.79	%			826,858				7,023				0.85	%
Non-interest-bearing liabilities
Non-interest-bearing deposits			119,736												113,576
Other liabilities			9,325												10,902
Total liabilities			889,717												951,336
Stockholders’ equity			39,423												33,083
Total liabilities and stockholders’ equity		$	929,140											$	984,419
Net interest income						$	29,621											$	29,551
Net interest spread											3.32	%											3.18	%
Net interest margin											3.42	%											3.27	%
Ratio of average interest-earning assets to average interest-bearing liabilities											115.07	%											110.97	%

 

 

---

(1)	Includes loan fees in both interest income and the calculation of yield on loans.

(2)	Calculations include non-accruing loans of $11.4 million and $29.0 million in average loan amounts outstanding.

(3)	Taxable equivalent yields are calculated assuming a 35% federal income tax rate.

 

 

Rate/Volume Analysis 

 

The table below sets forth information regarding changes in interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (changes in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume). Changes in rate-volume are proportionately allocated between rate and volume variance.

 

		Year Ended December 31, 2017 vs. 2016												Year Ended December 31, 2016 vs. 2015
		Increase (decrease) due to change in												Increase (decrease) due to change in
		Rate				Volume				Net Change				Rate				Volume				Net Change
		(in thousands)
Interest-earning assets:
Loan receivables		$	(895	)		$	2,224			$	1,329			$	7			$	(721	)		$	(714	)
U.S. Treasury and agencies			(5	)			(58	)			(63	)			11				62				73
Mortgage-backed securities			155				(155	)			—				(46	)			(134	)			(180	)
Collateralized loan obligations			(9	)			522				513				—				28				28
State and political subdivision securities			(9	)			(51	)			(60	)			(13	)			(137	)			(150	)
Corporate bonds			33				41				74				126				(188	)			(62	)
FHLB stock			73				—				73				—				—				—
Other debt securities			—				—				—				—				(43	)			(43	)
Federal funds sold			4				3				7				2				—				2
Interest-bearing deposits in other financial institutions			196				(149	)			47				102				(28	)			74
Total increase (decrease) in interest income			(457	)			2,377				1,920				189				(1,161	)			(972	)
Interest-bearing liabilities:
Certificates of deposit and other time deposits			202				(122	)			80				(390	)			(828	)			(1,218	)
Interest checking and money market accounts			(37	)			56				19				42				123				165
Savings accounts			(4	)			2				(2	)			(11	)			(3	)			(14	)
Federal funds purchased and repurchase agreements			—				—				—				—				(1	)			(1	)
FHLB advances			(42	)			92				50				(12	)			(13	)			(25	)
Junior subordinated debentures			114				(31	)			83				164				(113	)			51
Senior debt			—				194				194				—				—				—
Total increase (decrease) in interest expense			233				191				424				(207	)			(835	)			(1,042	)
Increase (decrease) in net interest income		$	(690	)		$	2,186			$	1,496			$	396			$	(326	)		$	70

 

Non-interest Income – The following table presents for the periods indicated the major categories of non-interest income:

 

		For the Years Ended December 31,
		2017				2016				2015
		(in thousands)
Service charges on deposit accounts		$	2,253			$	1,958			$	1,851
Bank card interchange fees			972				849				839
Income from bank owned life insurance			412				417				295
Net gain on sales and calls of securities			288				216				1,766
Other real estate owned rental income			—				456				1,346
Gain on extinguishment of junior subordinated debt			—				—				883
Other			930				868				715
Total non-interest income		$	4,855			$	4,764			$	7,695

 

Non-interest income increased by $91,000 in 2017 to $4.9 million compared with $4.8 million for the year ended December 31, 2016. This increase was primarily attributable to a $295,000 increase in service charges on deposit accounts, a $123,000 increase in bank card interchange fees, and a $72,000 increase in net gain on sale of securities partially offset by no OREO income during 2017, compared to $456,000 during 2016.

 

 

Non-interest income decreased by $2.9 million in 2016 to $4.8 million compared with $7.7 million for the year ended December 31, 2015 driven primarily by a decline in gains on the sales of securities from $1.8 million in 2015 to $216,000 in 2016, as well as a decrease in OREO rental income of $890,000 between the two periods as a result of income producing properties being sold. Non-interest income for 2015 was also positively impacted by an $883,000 gain on extinguishment of junior subordinated debt.

 

Non-interest Expense – The following table presents the major categories of non-interest expense:

 

		For the Years Ended December 31,
		2017				2016				2015
		(in thousands)
Salary and employee benefits		$	15,090			$	15,508			$	15,857
Occupancy and equipment			3,420				3,517				3,449
FDIC insurance			1,412				1,660				2,212
Data processing expense			1,256				1,185				1,128
Marketing expense			1,098				973				560
State franchise and deposit tax			956				965				1,120
Professional fees			978				1,568				2,885
Communications			722				706				663
Insurance expense			540				565				589
Postage and delivery			395				359				400
Litigation and loan collection expense			179				8,805				1,141
Other real estate owned expense			1,973				1,541				12,302
Other			2,199				2,215				2,653
Total non-interest expense		$	30,218			$	39,567			$	44,959

 

Non-interest expense for the year ended December 31, 2017 of $30.2 million represented a 23.6% decrease from $39.6 million for 2016. The decrease in non-interest expense was attributable primarily to a decrease in litigation and loan collection expense, which decreased $8.6 million. Litigation expense was negatively impacted in 2016 by a ruling from the Kentucky Court of Appeals against the Bank that approximated $8.0 million. Non-interest expense also benefited from a $590,000 decrease in professional fees, a $418,000 decrease in salaries and employee benefits, and a $248,000 decrease in FDIC insurance. As shown below, expenses related to OREO trended higher due to higher valuation adjustment writedowns during 2017 compared to 2016.

 

		2017				2016
		(in thousands)
Net gain on sales		$	(74	)		$	(222	)
Provision to allowance for declining market values			1,963				1,180
Operating expense			84				583
Total		$	1,973			$	1,541

 

During the year ended December 31, 2017, fair value write-downs of $2.0 million were recorded compared with $1.2 million for the year ended December 31, 2016. The 2017 write-downs reflect declines in the fair value due to updated appraisals, changes in marketing strategies, and reductions in listing prices for certain properties. We were successful in selling OREO totaling $793,000 and $12.7 million during 2017 and 2016, respectively.

 

 

Non-interest Expense Comparison – 2016 to 2015

 

Non-interest expense for the year ended December 31, 2016 of $39.6 million represented a 12.0% decrease from $45.0 million for 2015. The decrease in non-interest expense was attributable primarily to decreases in OREO expenses and professional fees, offset by increases in litigation and loan collection expense as a result of the Kentucky Court of Appeals ruling against the Bank. As shown below, expenses related to OREO trended lower as the size of the portfolio significantly declined.

 

		2016				2015
		(in thousands)
Net (gain) loss on sales		$	(222	)		$	74
Provision to allowance for declining market values			1,180				9,855
Operating expense			583				2,373
Total		$	1,541			$	12,302

 

During the year ended December 31, 2016, fair value write-downs of $1.2 million were recorded compared with $9.9 million for the year ended December 31, 2015. The write-downs reflect declines in the fair value and include reductions in listing prices for certain properties, updated appraisals, and sales of certain properties through auctions. We were successful in selling OREO totaling $12.7 million and $22.6 million during 2016 and 2015, respectively.

 

Income Tax Expense and Benefit – Effective tax rates differ from the federal statutory rate of 35% applied to income (loss) before income taxes due to the following:

 

		2017				2016				2015
		(in thousands)
Federal statutory rate times financial statement income (loss)		$	2,294			$	(956	)		$	(1,125	)
Effect of:
Valuation allowance			(54,049	)			1,238				717
Tax-exempt income			(196	)			(211	)			(264	)
Non-taxable life insurance income			(144	)			(146	)			(103	)
Restricted stock vesting			(121	)			—				—
Change in federal statutory rate			20,274				—				—
Other, net			43				96				775
Total		$	(31,899	)		$	21			$	—

 

The Company has had a full valuation allowance against its net deferred tax asset since 2011. The Company’s ability to utilize the net deferred tax asset depends upon generating sufficient future levels of taxable income. The determination to restore a deferred tax asset and eliminate a valuation allowance depends upon the evaluation of both positive and negative evidence regarding the likelihood of achieving sufficient future taxable income levels. During the fourth quarter of 2017, management concluded it was more-likely-than-not the asset would be utilized to reduce future taxes payable related to the future taxable income of the Company, and as such, reversed the valuation allowance. As a result of the conclusion to reverse the valuation allowance, the Company recorded an income tax benefit of $54.0 million for the year ended December 31, 2017.

 

On December 22, 2017, the Tax Cuts and Jobs Act of 2017 was signed into law. Among other significant changes to the tax code, the new law lowered the federal corporate tax rate from 35% to 21% beginning in 2018. As a result, the Company revalued its net deferred tax asset at the new 21% rate. Due to this revaluation, the Company recorded a $20.3 million charge to income tax expense for the year ended December 31, 2017.

 

The combination of the reversal of the valuation allowance and the change in federal corporate tax rates, as well as income tax expense for the year, resulted in an income tax benefit of $31.9 million for the year ended December 31, 2017.

 

See Note 12, “Income Taxes”, for additional discussion of our income taxes.

 

Income tax expense of $21,000 was recorded for 2016, with no income tax expense or benefit recorded for 2015. Our deferred tax valuation allowance increased to $54.0 million at December 31, 2016. Our statutory federal tax rate was 35% in both 2016 and 2015. The effective tax rate for 2016 and 2015 is not meaningful due to the reduction of income tax benefit as the result of the deferred tax valuation allowance.

 

 

Analysis of Financial Condition 

 

Total assets at December 31, 2017 were $970.8 million compared with $945.2 million at December 31, 2016, an increase of $25.6 million or 2.7%. This increase was primarily attributable to an increase in net loans of $73.6 million as well as the restoration of a net deferred tax asset of $31.3 million. These increases were partially offset by a decrease in investment securities of $41.9 million as well as a $30.9 million decrease in interest bearing deposits in banks.

 

Total assets at December 31, 2016 were $945.2 million compared with $948.7 million at December 31, 2015, a decrease of $3.5 million or 0.4%. This decrease was primarily attributable to a decrease in cash and cash equivalents of $27.0 million which funded the redemption of deposits of $28.1 million. There was also a decrease in OREO of $12.4 million offset by an increase in net loans of $23.6 million, an increase in available for sale securities of $7.8 million, and an increase in FHLB advances of $19.4 million.

 

Reversal of Deferred Tax Asset Valuation Allowance and Change in Federal Tax Rate – The Company had a full valuation allowance against its net deferred tax asset since 2011. The Company’s ability to utilize the net deferred tax asset depends upon generating sufficient future levels of taxable income. The determination to restore a deferred tax asset and eliminate a valuation allowance depends upon the evaluation of both positive and negative evidence regarding the likelihood of achieving sufficient future taxable income levels. During the fourth quarter of 2017, management concluded it was more-likely-than-not the asset would be utilized to reduce future taxes payable related to the future taxable income of the Company, and as such, reversed the valuation allowance.

 

As a result of the conclusion to reverse the valuation allowance and the reduction of the federal tax rate from 35% to 21%, the Company has a net deferred tax asset of $31.3 million at December 31, 2017.

 

Loans Receivable – Loans receivable increased $72.9 million, or 11.4%, during the year ended December 31, 2017, to $712.1 million. Our commercial, commercial real estate and real estate construction portfolios increased by an aggregate of $61.0 million, or 17.2%, during 2017 and comprised 58.4% of the total loan portfolio at December 31, 2017.

 

Loans receivable increased $20.6 million, or 3.3%, during the year ended December 31, 2016, to $639.2 million. Our commercial, commercial real estate and real estate construction portfolios increased by an aggregate of $18.8 million, or 5.6%, during 2016 and comprised 55.6% of the total loan portfolio at December 31, 2016.

 

Loan Portfolio Composition – The following table presents a summary of the loan portfolio at the dates indicated, net of deferred loan fees, by type. There are no foreign loans in our portfolio and other than the categories noted, there is no concentration of loans in any industry exceeding 10% of total loans.

 

		As of December 31,
		2017								2016
		Amount				Percent				Amount				Percent
		(dollars in thousands)
Commercial		$	113,771				15.98	%		$	97,761				15.29	%
Commercial Real Estate:
Construction			57,342				8.05				36,330				5.68
Farmland			88,320				12.40				71,507				11.19
Nonfarm nonresidential			156,724				22.01				149,546				23.39
Residential Real Estate:
Multi-family			56,588				7.94				48,197				7.54
1-4 Family			179,222				25.17				188,092				29.42
Consumer			18,439				2.59				9,818				1.54
Agriculture			41,154				5.78				37,508				5.87
Other			555				0.08				477				0.08
Total loans		$	712,115				100.00	%		$	639,236				100.00	%

 

 

		As of December 31,
		2015								2014								2013
		Amount				Percent				Amount				Percent				Amount				Percent
		(dollars in thousands)
Commercial		$	86,176				13.93	%		$	60,936				9.75	%		$	52,878				7.45	%
Commercial Real Estate:
Construction			33,154				5.36				33,173				5.31				43,326				6.11
Farmland			76,412				12.35				77,419				12.39				71,189				10.04
Nonfarm nonresidential			140,570				22.72				175,452				28.07				232,026				32.71
Residential Real Estate:
Multi-family			44,131				7.13				41,891				6.70				46,858				6.61
1-4 Family			201,478				32.57				197,278				31.56				228,505				32.21
Consumer			10,010				1.62				11,347				1.82				14,365				2.03
Agriculture			26,316				4.25				26,966				4.31				19,199				2.71
Other			419				0.07				537				0.09				980				0.13
Total loans		$	618,666				100.00	%		$	624,999				100.00	%		$	709,326				100.00	%

 

Lending activities are subject to a variety of lending limits imposed by state and federal law. The Bank’s secured legal lending limit to a single borrower or guarantor was approximately $31.4 million at December 31, 2017.

 

At December 31, 2017, we had 12 loan relationships each with aggregate extensions of credit in excess of $10.0 million, all of which were classified as pass by the Bank’s internal loan review process. In 2016, we had four loan relationships each with aggregate extensions of credit in excess of $10.0 million.

 

As of December 31, 2017, we had $46.2 million of loan participations purchased from, and $19.1 million of loan participations sold to, other banks. As of December 31, 2016, we had $33.4 million of loan participations purchased from, and $26.0 million of loan participations sold to, other banks.

 

 

Loan Maturity Schedule – The following table sets forth at December 31, 2017, the dollar amount of loans, net of deferred loan fees, maturing in the loan portfolio based on their contractual terms to maturity:

 

		As of December 31, 2017
		Maturing Within One Year				Maturing 1 through 5 Years				Maturing Over 5 Years				Total Loans
		(dollars in thousands)
Loans with fixed rates:
Commercial		$	4,509			$	25,481			$	4,707			$	34,697
Commercial Real Estate:
Construction			5,602				17,765				10,177				33,544
Farmland			5,273				16,985				21,075				43,333
Nonfarm nonresidential			14,801				77,138				22,287				114,226
Residential Real Estate:
Multi-family			5,038				28,337				15,449				48,824
1-4 Family			14,028				27,730				58,034				99,792
Consumer			1,172				5,951				1,275				8,398
Agriculture			3,143				5,582				779				9,504
Other			90				316				59				465
Total fixed rate loans		$	53,656			$	205,285			$	133,842			$	392,783
Loans with floating rates:
Commercial		$	10,169			$	45,673			$	23,232			$	79,074
Commercial Real Estate:
Construction			9,790				13,976				32				23,798
Farmland			1,127				5,665				38,195				44,987
Nonfarm nonresidential			1,598				7,170				33,730				42,498
Residential Real Estate:
Multi-family			208				4,956				2,600				7,764
1-4 Family			1,885				5,096				72,449				79,430
Consumer			10,013				—				28				10,041
Agriculture			22,087				9,349				214				31,650
Other			—				—				90				90
Total floating rate loans		$	56,877			$	91,885			$	170,570			$	319,332

 

Loan Portfolio by Risk Category – The following table presents a summary of the loan portfolio at the dates indicated, by risk category.

 

			As of December 31,
			2017				2016				2015				2014				2013
			(in thousands)
Pass			$	673,033			$	586,430			$	517,484			$	461,126			$	369,529
Watch				25,715				30,431				63,363				68,200				144,316
Special Mention				164				497				1,395				4,189				5,865
Substandard				13,203				21,878				36,424				91,484				189,616
Doubtful				—				—				—				—				—
Total			$	712,115			$	639,236			$	618,666			$	624,999			$	709,326

 

Loans receivable increased $72.9 million, or 11.4%, during the year ended December 31, 2017. All loan risk categories have decreased since December 31, 2016, with the exception of pass graded loans. The pass category increased approximately $86.6 million, the watch category declined approximately $4.7 million, the special mention category declined approximately $333,000, and the substandard category declined approximately $8.7 million.

 

 

Loan Delinquency – The following table presents a summary of loan delinquencies at the dates indicated.

 

			As of December 31,
			2017				2016				2015				2014				2013
			(in thousands)
Past Due Loans:
30-59 Days			$	1,478			$	2,302			$	3,133			$	3,960			$	10,696
60-89 Days				171				315				241				980				775
90 Days and Over				1				—				—				151				232
Total Loans Past Due 30-90+ Days				1,650				2,617				3,374				5,091				11,703
Nonaccrual Loans				5,457				9,216				14,087				47,175				101,767
Total Past Due and Nonaccrual Loans			$	7,107			$	11,833			$	17,461			$	52,266			$	113,470

 

Loans past due 30-59 days decreased from $2.3 million at December 31, 2016 to $1.5 million at December 31, 2017, and loans past due 60-89 days decreased from $315,000 at December 31, 2016 to $171,000 at December 31, 2017. This represents a $968,000 decrease in loans past due 30-89 days. We considered this trend in delinquency levels during the evaluation of qualitative trends in the portfolio when establishing the general component of the allowance for loan losses.

 

Nonaccrual loans decreased $3.8 million from December 31, 2016 to December 31, 2017. The $3.8 million decrease in nonaccrual loans was primarily driven by $5.0 million in paydowns, $665,000 in charge-offs, $270,000 in transfers to OREO, and $199,000 in loans returned to accrual status, offset by $2.3 million in loans placed on non-accrual. The $5.5 million in nonaccrual loans at December 31, 2017, and $9.2 million at December 31, 2016, were generally secured by farmland, other commercial real estate, and other residential real estate loans. Management believes it has established adequate loan loss reserves for these credits.

 

Non-Performing Assets – Non-performing assets consist of certain restructured loans for which interest rate or other terms have been renegotiated, loans past due 90 days or more still on accrual, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets. Loans, including impaired loans, are placed on nonaccrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection. Loans are considered impaired if full principal or interest payments are not anticipated in accordance with the contractual loan terms. Impaired loans are carried at the present value of expected future cash flows discounted at the loan’s effective interest rate or at the fair value of the collateral less cost to sell if the loan is collateral dependent. Loans are reviewed on a regular basis and normal collection procedures are implemented when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 120 days and is not cured through normal collection procedures or an acceptable arrangement is not agreed to with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. Consumer loans generally are charged off when a loan is deemed uncollectible and often before any available collateral has been disposed. Commercial business and real estate loan delinquencies are handled on an individual basis with the advice of legal counsel.

 

Interest income on loans is recognized on the accrual basis except for those loans placed on nonaccrual status. The accrual of interest on impaired loans is discontinued when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, which typically occurs after the loan becomes 90 days delinquent. When interest accrual is discontinued, existing accrued interest is reversed and interest income is subsequently recognized only to the extent cash payments are received on well-secured loans.

 

Real estate acquired as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until such time as it is sold. New and used automobiles and other motor vehicles acquired as a result of foreclosure are classified as repossessed assets until they are sold. When such property is acquired it is recorded at its fair market value less cost to sell. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. Subsequent gains and losses are included in non-interest expense.

 

 

The following table sets forth information with respect to non-performing assets as of the dates indicated:

 

		As of December 31,
		2017				2016				2015				2014				2013
		(dollars in thousands)
Past due 90 days or more still on accrual		$	1			$	—			$	—			$	151			$	232
Loans on nonaccrual status			5,457				9,216				14,087				47,175				101,767
Total non-performing loans			5,458				9,216				14,087				47,326				101,999
Real estate acquired through foreclosure			4,409				6,821				19,214				46,197				30,892
Other repossessed assets			—				—				—				—				—
Total non-performing assets		$	9,867			$	16,037			$	33,301			$	93,523			$	132,891
Non-performing loans to total loans			0.77	%			1.44	%			2.28	%			7.57	%			14.38	%
Non-performing assets to total assets			1.02	%			1.70	%			3.51	%			9.19	%			12.35	%
Allowance for non-performing loans		$	108			$	241			$	295			$	1,253			$	2,285
Allowance for non-performing loans to non-performing loans			1.98	%			2.62	%			2.09	%			2.65	%			2.24	%

 

Troubled Debt Restructuring – A troubled debt restructuring (TDR) occurs when the Bank has agreed to a loan modification in the form of a concession to a borrower who is experiencing financial difficulty. The Bank’s TDRs typically involve a reduction in interest rate, a deferral of principal for a stated period of time, or an interest only period. All TDRs are considered impaired, and the Bank has allocated reserves for these loans to reflect the present value of the concessionary terms granted to the borrower. If the loan is considered collateral dependent, it is reported net of allocated reserves, at the fair value of the collateral less cost to sell.

 

The Bank does not have a formal loan modification program. If a borrower is unable to make contractual payments, we review the particular circumstances of that borrower’s situation and determine whether or not to negotiate a revised payment stream. The goal when restructuring a credit is to afford the borrower a reasonable period of time to remedy the issue causing cash flow constraints so that they may return to performing status over time.

 

Loan modifications have taken the form of a reduction in interest rate and/or curtailment of scheduled principal payments for a short-term period, usually three to six months, but in some cases until maturity of the loan. In some circumstances we may restructure real estate secured loans in a bifurcated fashion whereby there is a fully amortizing “A” loan at a market interest rate and an interest-only “B” loan at a reduced interest rate. The majority of restructured loans are collateral secured loans. If a borrower fails to perform under the modified terms, the loan(s) are placed on nonaccrual status and collection actions are intiated.

 

We consider any loan that is restructured for a borrower experiencing financial difficulties due to a borrower’s potential inability to pay in accordance with contractual terms of the loan to be a troubled debt restructuring. Specifically, we consider a concession involving a modification of the loan terms, such as (i) a reduction of the stated interest rate, (ii) a reduction or deferral of principal, or (iii) a reduction or deferral of accrued interest at a stated interest rate lower than the current market rate for new debt with similar risk all to be troubled debt restructurings. When a modification of terms is made for a competitive reason, we do not consider it to be a troubled debt restructuring. A primary example of a competitive modification would be an interest rate reduction for a performing customer’s loan to a market rate as the result of a market decline in rates.

 

Management periodically reviews renewals and modifications of previously identified TDRs for which there was no principal forgiveness, to consider if it is appropriate to remove the TDR classification. If the borrower is no longer experiencing financial difficulty and the renewal/modification did not contain a concessionary interest rate or other concessionary terms, management considers the potential removal of the TDR classification. If deemed appropriate based upon current underwriting, the TDR classification is removed as the borrower has complied with the terms of the loan at the date of renewal/modification and there was a reasonable expectation that the borrower would continue to comply with the terms of the loan after the date of the renewal/modification. Additionally, the TDR classification may be removed in circumstances in which the Company performs a non-concessionary re-modification of the loan at terms that were considered to be at market for loans with comparable risk. Management expects the borrower will continue to perform under the re-modified terms based on the borrower’s past history of performance.

 

If the borrower fails to perform, we place the loan on nonaccrual status and seek to liquidate the underlying collateral. The nonaccrual policy for restructured loans is identical to the nonaccrual policy for all loans. The policy calls for a loan to be reported as nonaccrual if it is maintained on a cash basis because of deterioration in the financial condition of the borrower, payment in full of principal and interest is not expected, or principal or interest is past due 90 days or more unless the assets are both well secured and in the process of collection. Changes in value for impairment, including the amount attributed to the passage of time, are recorded entirely within the provision for loan losses. Upon determination that a loan is collateral dependent, the loan is charged down to the fair value of collateral less estimated costs to sell.

 

 

At December 31, 2017, we had six restructured loans totaling $3.0 million with borrowers who experienced deterioration in financial condition compared with nine restructured loans totaling $8.7 million at December 31, 2016. In general, these loans were granted interest rate reductions to provide cash flow relief to borrowers experiencing cash flow difficulties. At December 31, 2017, two loans totaling approximately $1.8 million had been granted principal payment deferrals until maturity. There were no concessions made to forgive principal relative to these loans, although we have recorded partial charge-offs for certain restructured loans. In general, these loans are secured by first liens on 1-4 residential or commercial real estate properties, or farmland. Restructured loans also included $467,000 of commercial loans at December 31, 2017. At December 31, 2017, $1.2 million of TDRs were performing according to their modified terms.

 

There were no modifications granted during 2017 or 2016 that resulted in loans being identified as TDRs. During the twelve months ended December 31, 2017, TDRs were reduced as a result of $1.6 million in payments. In addition, the TDR classification was removed from two loans that met the requirements discussed above in 2017. These loans totaled $4.1 million at December 31, 2016, and are no longer evaluated individually for impairment.

 

The following table sets forth information with respect to TDRs, non-performing loans, real estate acquired through foreclosure, and other repossessed assets.

 

		As of December 31,
		2017				2016				2015				2014				2013
		(dollars in thousands)
Total non-performing loans		$	5,458			$	9,216			$	14,087			$	47,326			$	101,999
TDRs on accrual			1,217				5,350				17,440				21,985				44,346
Total non-performing loans and TDRs on accrual		$	6,675			$	14,566			$	31,527			$	69,311			$	146,345
Real estate acquired through foreclosure			4,409				6,821				19,214				46,197				30,892
Other repossessed assets			—				—				—				—				—
Total non-performing assets and TDRs on accrual		$	11,084			$	21,387			$	50,741			$	115,508			$	177,237
Total non-performing loans and TDRs on accrual to total loans			0.94	%			2.28	%			5.10	%			11.09	%			20.63	%
Total non-performing assets and TDRs on accrual to total assets			1.14	%			2.26	%			5.35	%			11.35	%			16.47	%

 

See Footnote 3, “Loans”, to the financial statements for additional disclosure related to troubled debt restructuring.

 

Interest income that would have been earned on non-performing loans was $465,000, $738,000, and $1.7 million for the years ended December 31, 2017, 2016, and 2015, respectively. Interest income recognized on accruing non-performing loans was $135,000, $445,000, and $710,000 for the years ended December 31, 2017, 2016, and 2015, respectively.

 

Allowance for Loan Losses – The allowance for loan losses is based on management’s continuing review and evaluation of individual loans, loss experience, current economic conditions, risk characteristics of various categories of loans and such other factors that, in management’s judgment, require current recognition in estimating loan losses.

 

Management has established loan grading procedures that result in specific allowance allocations for any estimated inherent risk of loss. For loans not individually evaluated, a general allowance allocation is computed using factors developed over time based on actual loss experience. Prior to June 2017, the look-back period for historical losses was 12 quarters, weighted 40% for the most recent eight quarters and 20% for the previous four quarter period. Effective June 30, 2017, the Company extended the look-back period to 16 quarters on a prospective basis, weighted 40% for the most recent four quarters, then declining one tenth for each of the remaining annual periods. Management determined the four-year look-back period was appropriate as the four-year period more appropriately correlates to the period in which the current portfolio was underwritten and originated. The specific and general allocations plus consideration of qualitative factors represent management’s estimate of probable losses contained in the loan portfolio at the evaluation date. Although the allowance for loan losses is comprised of specific and general allocations, the entire allowance is available to absorb any credit losses.

 

 

The following table sets forth an analysis of loan loss experience as of and for the periods indicated:

 

		As of December 31,
		2017				2016				2015				2014				2013
		(dollars in thousands)
Balances at beginning of period		$	8,967			$	12,041			$	19,364			$	28,124			$	56,680
Loans charged-off:
Real estate			750				2,157				5,050				17,943				28,879
Commercial			5				276				696				1,099				2,828
Consumer			51				178				268				354				773
Agriculture			95				18				118				30				128
Total charge-offs			901				2,629				6,132				19,426				32,608
Recoveries:
Real estate			714				1,189				2,338				2,726				1,622
Commercial			59				334				723				614				1,212
Consumer			130				368				240				213				266
Agriculture			33				114				8				13				252
Total recoveries			936				2,005				3,309				3,566				3,352
Net charge-offs (recoveries)			(35	)			624				2,823				15,860				29,256
Provision (negative provision) for loan losses			(800	)			(2,450	)			(4,500	)			7,100				700
Balance at end of period		$	8,202			$	8,967			$	12,041			$	19,364			$	28,124
Allowance for loan losses to period-end loans			1.15	%			1.40	%			1.95	%			3.10	%			3.96	%
Net charge-offs (recoveries) to average loans			(0.01	%)			0.10	%			0.44	%			2.39	%			3.71	%
Allowance for loan losses to non-performing loans			150.27	%			97.30	%			85.48	%			40.92	%			27.57	%
Allowance for loan losses for loans individually evaluated for impairment		$	219			$	399			$	428			$	752			$	3,471
Loans individually evaluated for impairment			7,173				15,131				31,776				71,993				149,883
Allowance for loan losses to loans individually evaluated for impairment			3.05	%			2.64	%			1.35	%			1.04	%			2.32	%
Allowance for loan losses for loans collectively evaluated for impairment		$	7,983			$	8,568			$	11,613			$	18,612			$	24,653
Loans collectively evaluated for impairment			704,942				624,105				586,890				553,006				559,443
Allowance for loan losses to loans collectively evaluated for impairment			1.13	%			1.37	%			1.98	%			3.37	%			4.41	%

 

The allowance for loan losses is a reserve established through charges to earnings in the form of a provision for loan losses. The allowance for loan losses is comprised of general reserves and specific reserves. The loan loss reserve, as a percentage of total loans at December 31, 2017, decreased to 1.15% from 1.40% at December 31, 2016. The change in loan loss reserve as a percentage of total loans between periods is attributable to growth in the portfolio driven by new loans underwritten with lower loss expectations, improving historical loss experience, improvement in risk grade classification metrics, improved charge-off levels, and improved past due trends. The allowance for loan losses to non-performing loans was 150.27% at December 31, 2017, compared with 97.30% at December 31, 2016. Net recoveries in 2017 totaled $35,000.

 

 

The following table sets forth the net charge-offs (recoveries) for the periods indicated:

 

 

		Year Ended December 31, 2017				Year Ended December 31, 2016				Year Ended December 31, 2015
		(in thousands)
Commercial		$	(54	)		$	(58	)		$	(27	)
Commercial Real Estate			(361	)			(339	)			1,225
Residential Real Estate			397				1,307				1,487
Consumer			(64	)			(200	)			37
Agriculture			62				(96	)			110
Other			(15	)			10				(9	)
Total net charge-offs (recoveries)		$	(35	)		$	624			$	2,823

 

A general reserve is maintained for each loan type in the loan portfolio. In determining the amount of the general reserve portion of the allowance for loan losses, management considers factors such as our historical loan loss experience, the growth, composition and diversification of our loan portfolio, current delinquency levels, loan quality grades, the results of recent regulatory examinations and general economic conditions. Based on these factors, we apply estimated percentages to the various categories of loans, not including any loan that has a specific allowance allocated to it, based on our historical experience, portfolio trends and economic and industry trends. This information is used by management to set the general reserve portion of the allowance for loan losses at a level it deems prudent.

 

Generally, all loans identified as impaired are reviewed on a quarterly basis in order to determine whether a specific allowance is required. A loan is considered impaired when, based on current information, it is probable that we will not receive all amounts due in accordance with the contractual terms of the loan agreement. Once a loan has been identified as impaired, management measures impairment in accordance with ASC 310-10, “Impairment of a Loan.” When management’s measured value of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve or charged-off if the loan is deemed collateral dependent. These specific reserves are determined on an individual loan basis based on management’s current evaluation of our loss exposure for each credit given the payment status, financial condition of the borrower and value of any underlying collateral. Loans for which specific reserves have been provided are excluded from the general reserve calculations described below. Changes in specific reserves from period to period are the result of changes in the circumstances of individual loans such as charge-offs, pay-offs, changes in collateral values or other factors.

 

The allowance for loan losses represents management’s estimate of the amount necessary to provide for probable losses in the loan portfolio in the normal course of business. Due to the uncertainty of risks in the loan portfolio, management’s judgment of the amount of the allowance necessary to absorb loan losses is approximate. The allowance for loan losses is also subject to regulatory examinations and may be adjusted in response to a determination by the regulatory agencies as to its adequacy in comparison with peer institutions.

 

We make specific allowances for each impaired loan based on its type and risk classification as discussed above. At year-end 2017, the allowance for loan losses to total non-performing loans increased to 150.27% from 97.30% at year-end 2016. It is important to look more closely at this ratio as a significant portion of impaired loans are collateral dependent and have been charged down to the estimated fair value of the underlying collateral less cost to sell. Please see the next table for comparison and disclosure of recorded investment less allocated allowance relative to the unpaid principal balance. Impaired loans have been assessed for collectability which considered, among other things, the borrower’s ability to repay, the value of the underlying collateral, and other market conditions to ensure that the allowance for loan losses is adequate to absorb probable incurred losses.

 

 

The following table presents the unpaid principal balance, recorded investment and allocated allowance related to loans individually evaluated for impairment in the commercial real estate and residential real estate portfolios as of December 31, 2017 and 2016.

 

		December 31, 2017								December 31, 2016
		Commercial Real Estate				Residential Real Estate				Commercial Real Estate				Residential Real Estate
		(in thousands)
Unpaid principal balance		$	4,734			$	5,456			$	10,985			$	10,439
Prior charge-offs			(2,099	)			(1,506	)			(5,131	)			(1,818	)
Recorded investment			2,635				3,950				5,854				8,621
Allocated allowance			—				(206	)			(35	)			(350	)
Recorded investment, less allocated allowance		$	2,635			$	3,744			$	5,819			$	8,271
Recorded investment, less allocated allowance/ Unpaid principal balance			55.66	%			68.62	%			52.97	%			79.23	%

 

Based on prior charge-offs, the current recorded investments in loans individually evaluated for impairment in the commercial real estate and residential real estate segments of the portfolio are significantly below the unpaid principal balances of those loans. The recorded investment net of the allocated allowance was 55.66% and 68.62% of the unpaid principal balance in the commercial real estate and residential real estate segments, respectively, at December 31, 2017.

 

The following table illustrates recent trends in loans collectively evaluated for impairment and the related allowance for loan losses by portfolio segment:

 

		December 31, 2017												December 31, 2016
		Loans				Allowance				% to Total				Loans				Allowance				% to Total
		(dollars in thousands)
Commercial		$	113,184			$	879				0.78	%		$	97,166			$	462				0.48	%
Commercial real estate			299,751				4,032				1.35				251,529				4,859				1.93
Residential real estate			231,860				2,694				1.16				227,668				3,076				1.35
Consumer			18,438				64				0.35				9,817				8				0.08
Agriculture			41,154				313				0.76				37,448				161				0.43
Other			555				1				0.18				477				2				0.42
Total		$	704,942			$	7,983				1.13	%		$	624,105			$	8,568				1.37	%

 

The allowance for those loan losses related to loans collectively evaluated for impairment trended downward from 1.37% at December 31, 2016 to 1.13% at December 31, 2017 as a result of declining historical charge-off levels and improving trends in loan category risk ratings. The residential real estate segment constitutes approximately 32.9% of total loans collectively evaluated for impairment. The related allowance for the residential real estate segment trended downward from 1.35% at December 31, 2016 to 1.16% at December 31, 2017 as net charge-offs declined from approximately $1.3 million in 2016 to $397,000 in 2017. The commercial real estate segment constitutes approximately 42.5% of total loans collectively evaluated for impairment. The related allowance for the commercial real estate segment trended downward from 1.93% at December 31, 2016 to 1.35% at December 31, 2017. This is consistent with the decline in historical rates and improvement in loan quality within the commercial real estate segment. The overall decrease in the allowance also reflects improving historical loss experience, qualitative factors, improvement in risk grade classification metrics, improved charge-off levels, improved past due trends, and the negative provision.  

 

A significant portion of the portfolio is comprised of loans secured by real estate. A decline in the value of the real estate serving as collateral for loans may impact our ability to collect those loans. In general, we obtain updated appraisals on property securing our loans when circumstances are warranted such as at the time of renewal or when market conditions have significantly changed. We use qualified licensed appraisers approved by our Board of Directors. These appraisers possess prerequisite certifications and knowledge of the local and regional marketplace.

 

Based on its assessment of the loan portfolio, management presents a quarterly review of the allowance for loan losses to the Bank’s Board of Directors, indicating any change in the allowance for loan losses since the last review and any recommendations as to adjustments in the allowance for loan losses.

 

 

This assessment is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or as events change. The allowance for loan losses has decreased as a percentage of loans outstanding to 1.15% at December 31, 2017 from 1.40% at December 31, 2016. This decline is the result of growth in the portfolio driven by new loans underwritten with lower loss expectations, improving historical loss experience, improvement in risk grade classification metrics, improved charge-off levels, and improved past due trends. The level of the allowance is based on estimates, and losses may ultimately vary from these estimates.

 

The Bank follows a loan grading program designed to evaluate the credit risk in the loan portfolio. Through this loan grading process, an internally classified watch list is maintained which helps management assess the overall quality of the loan portfolio and the adequacy of the allowance for loan losses. Loans categorized as watch list loans show warning elements where the present status exhibits one or more deficiencies that require attention in the short-term or where pertinent ratios of the loan account have weakened to a point where more frequent monitoring is warranted. These loans do not have all of the characteristics of a classified loan (substandard or doubtful) but show weakened elements as compared with those of a satisfactory credit. These loans are reviewed to assist in assessing the adequacy of the allowance for loan losses.

 

In establishing the appropriate risk rating for specific assets, management considers, among other factors, the borrower’s ability to repay, the borrower’s repayment history, the current delinquency status, the estimated value of the underlying collateral, and the capacity and willingness of a guarantor to satisfy the obligation. As a result of this process, loans are categorized as special mention, substandard or doubtful.

 

Loans classified as “special mention” do not have all of the characteristics of substandard or doubtful loans. They have one or more deficiencies that warrant special attention and which corrective action, such as accelerated collection practices, may remedy.

 

Loans classified as “substandard” are those loans with clear and defined weaknesses such as a highly leveraged position, unfavorable financial ratios, uncertain repayment sources or poor financial condition that may jeopardize the repayment of the debt as contractually agreed. They are characterized by the distinct possibility that we will sustain some losses if the deficiencies are not corrected.

 

Loans classified as “doubtful” are those loans which have characteristics similar to substandard loans but with an increased risk that collection or liquidation in full is highly questionable and improbable.

 

Specific reserves may be carried for accruing TDRs in compliance with restructured terms. Once a loan is deemed impaired or uncollectible as contractually agreed (other than performing TDRs), the loan is charged-off either partially or in-full against the allowance for loan losses, based upon the expected future cash flows discounted at the loan’s effective interest rate, or the fair value of collateral less estimated cost to sell with respect to collateral-based loans if collateral dependent.

 

As of December 31, 2017, $13.2 million of loans were classified as substandard, $164,000 classified as special mention and no loans classified as doubtful or loss. This compares with $21.9 million of loans classified as substandard, $497,000 classified as special mention and no loans classified as doubtful or loss as of December 31, 2016. The $8.7 million decrease in loans classified as substandard was primarily driven by $6.8 million in principal payments received, $270,000 in migration to OREO, $4.6 million in loans upgraded from substandard, and $790,000 in charge-offs, offset by $3.7 million in loans moved to substandard during 2017. Substandard loans are primarily concentrated in the residential real estate portfolio. As of December 31, 2017, $418,000 of the allowance for loan losses was allocated to substandard loans. This compares to allocations of $600,000 in the allowance for loan losses related to substandard loans at December 31, 2016.

 

 

The following table depicts management’s allocation of the allowance for loan losses by loan type. Allowance funding and allocation is based on management’s current evaluation of risk in each category, economic conditions, past loss experience, loan volume, past due history and other factors. Since these factors and management’s assumptions are subject to change, the allocation is not necessarily predictive of future portfolio performance. The allocation is made for analytical purposes and is not necessarily indicative of the categories in which future losses may occur. The total allowance is available to absorb losses from any segment of loans.  

 

		As of December 31,
		2017								2016
		Amount of Allowance				Percent of Loans to Total Loans				Amount of Allowance				Percent of Loans to Total Loans
		(dollars in thousands)
Commercial		$	892				15.98	%		$	475				15.29	%
Commercial Real Estate:
Construction			301				8.05				470				5.68
Farmland			449				12.40				288				11.19
Nonfarm nonresidential			3,282				22.01				4,136				23.39
Residential Real Estate:
Multi-family			627				7.94				610				7.54
1-4 Family			2,273				25.17				2,816				29.42
Consumer			64				2.59				8				1.54
Agriculture			313				5.78				162				5.87
Other			1				0.08				2				0.08
Total		$	8,202				100.0	%		$	8,967				100.0	%

  

 

		As of December 31,
		2015								2014								2013
		Amount of Allowance				Percent of Loans to Total Loans				Amount of Allowance				Percent of Loans to Total Loans				Amount of Allowance				Percent of Loans to Total Loans
		(dollars in thousands)
Commercial		$	818				13.93	%		$	2,046				9.75	%		$	3,221				7.45	%
Commercial Real Estate:
Construction			424				5.36				739				5.31				2,149				6.11
Farmland			364				12.35				1,094				12.39				1,623				10.04
Nonfarm nonresidential			6,205				22.72				9,098				28.07				12,642				32.71
Residential Real Estate:
Multi-family			422				7.13				886				6.70				1,449				6.61
1-4 Family			3,562				32.57				4,901				31.56				6,313				32.21
Consumer			122				1.62				274				1.82				416				2.03
Agriculture			122				4.25				319				4.31				305				2.71
Other			2				0.07				7				0.09				6				0.13
Total		$	12,041				100.0	%		$	19,364				100.0	%		$	28,124				100.00	%

 

Provision for Loan Losses – A negative provision for loan losses of $800,000 was recorded for the year ended December 31, 2017, compared with a negative provision for loan losses of $2.5 million for 2016 and a negative provision for loan losses of $4.5 million for 2015. The negative provision in 2017 was driven by declining historical loss rates, improvements in loan quality, and management’s assessment of risk within the portfolio. The total allowance for loan losses was $8.2 million, or 1.15% of total loans, at December 31, 2017, compared with $9.0 million, or 1.40% of total loans, at December 31, 2016, and $12.0 million, or 1.95% of total loans, at December 31, 2015. The decreased allowance is consistent with the overall trends within the portfolio. Substandard loans decreased by $8.7 million or 39.7% during 2017, net recoveries were $35,000 for 2017 compared to net charge-offs of $624,000 in 2016 and $2.8 million in 2015, and nonaccrual loans decreased by $3.8 million or 40.8% during 2017. Charge-offs for 2017 were concentrated in the loans secured by the residential real estate category of the portfolio. These net charge-offs consisted of $397,000 of residential real estate loans. We consider the size and volume of our portfolio as well as the credit quality of our loan portfolio based upon risk category classification when determining the loan loss provision for each period and the allowance for loan losses at period end.

 

 

Foreclosed Properties – Foreclosed properties at December 31, 2017 were $4.4 million compared with $6.8 million at December 31, 2016. See Note 5, “Other Real Estate Owned”, to the financial statements. During 2017, we acquired $270,000 of OREO properties and sold properties totaling approximately $793,000. We value foreclosed properties at fair value less estimated cost to sell when acquired and expect to liquidate these properties to recover our investment in the due course of business.

 

OREO is recorded at fair market value less estimated cost to sell at time of acquisition. Any write-down of the property at the time of acquisition is charged to the allowance for loan losses. When foreclosed properties are acquired, management obtains a new appraisal or has staff from the Bank’s special assets group evaluate the latest in-file appraisal in connection with the transfer to OREO. We typically obtain updated appraisals within five quarters of the anniversary date of ownership unless a sale is imminent. Subsequent reductions in fair value are recorded as non-interest expense when a new appraisal indicates a decline in value or in cases where a listing price is lowered below the appraisal amount.

 

The following table presents the major categories of OREO at the year-ends indicated:

		2017				2016				2015
		(in thousands)
Commercial Real Estate:
Construction, land development, and other land		$	4,335			$	6,571			$	12,344
Farmland			74				—				—
Nonfarm nonresidential			—				—				6,746
Residential Real Estate:
1-4 Family			—				250				124
		$	4,409			$	6,821			$	19,214

 

Net activity relating to other real estate owned during the years indicated is as follows:

		2017				2016				2015
		(in thousands)
OREO Activity
OREO as of January 1		$	6,821			$	19,214			$	46,197
Real estate acquired			270				1,273				5,513
Valuation adjustment write-downs			(1,963	)			(1,180	)			(9,855	)
Net gain (loss) on sale			74				222				(74	)
Proceeds from sale of properties			(793	)			(12,708	)			(22,567	)
OREO as of December 31		$	4,409			$	6,821			$	19,214

 

Net gain on sales, write-downs, and operating expenses for OREO totaled $2.0 million for the year ended December 31, 2017, compared with $1.5 million in 2016 and $12.3 million in 2015.

 

During the year ended December 31, 2017, fair value write-downs of $2.0 million were recorded compared with $1.2 million for 2016 and $9.9 million for 2015. The write-downs recorded in each year reflect fair value write-downs due to updated appraisals, changes in marketing strategies, and reductions in listing prices for certain properties. OREO sales totaled $793,000, $12.7 million, and $22.6 million during 2017, 2016, and 2015, respectively. We expect to resolve certain nonaccrual loans through the acquisition and sale of the underlying real estate collateral.

 

Investment Securities – The securities portfolio serves as a source of liquidity and earnings and contributes to the management of interest rate risk. Investments are made in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, collateralized loan obligations, certificates of deposit at insured savings and loans and banks, bankers’ acceptances and federal funds. The investment policy also authorizes investment in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The investment portfolio decreased by $41.9 million, or 21.5%, to $152.7 million at December 31, 2017, compared with $194.6 million at December 31, 2016 as the Bank sold selected securities to manage liquidity and interest rate risk.

 

 

The following table sets forth the carrying value of our securities portfolio at the dates indicated.

 

		December 31, 2017																December 31, 2016
		Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value				Amortized Cost				Gross Unrealized Gains				Gross Unrealized Losses				Fair Value
		(dollars in thousands)
Securities available for sale
U.S. Government and federal agencies		$	22,105			$	2			$	(483	)		$	21,624			$	34,757			$	50			$	(708	)		$	34,099
Agency mortgage-backed: residential			65,935				117				(1,087	)			64,965				103,390				455				(1,492	)			102,353
Collateralized loan obligations			25,343				182				(20	)			25,505				11,203				—				—				11,203
State and municipal			33,303				508				(101	)			33,710				2,028				25				(8	)			2,045
Corporate bonds			6,838				78				—				6,916				3,069				24				(3	)			3,090
Total available for sale		$	153,524			$	887			$	(1,691	)		$	152,720			$	154,447			$	554			$	(2,211	)		$	152,790

 

		Amortized Cost				Gross Unrecognized Gains				Gross Unrecognized Losses				Fair Value				Amortized Cost				Gross Unrecognized Gains				Gross Unrecognized Losses				Fair Value
Securities held to maturity
State and municipal		$	—			$	—			$	—			$	—			$	41,818			$	1,272			$	(18	)		$	43,072
Total held to maturity		$	—			$	—			$	—			$	—			$	41,818			$	1,272			$	(18	)		$	43,072

 

In 2013, the Bank transferred a portion of its tax-free municipal and taxable municipal bond portfolios from available for sale (AFS) to held to maturity (HTM). At that time, the transfer occurred at fair value with the unrealized loss of $1.3 million remaining in other comprehensive income. That unrealized loss has subsequently been amortized on the level yield method out of other comprehensive income with an offsetting entry reducing interest income as a yield adjustment through earnings. No gain or loss was recorded at the time of transfer in 2013. Given the Bank’s current balance sheet composition, interest rate risk profile, the current tax environment, and the Bank’s strategic plan, management reassessed the classification of the held to maturity securities and, effective December 1, 2017, transferred $41.4 million of tax-free municipals and taxable municipals from HTM to AFS. As a result, the $702,000 in remaining unamortized loss from the 2013 transfer was reclassified through a book value adjustment of these securities. At December 31, 2017, these securities were carried at fair value with unrealized holding gains and losses reported in other comprehensive income, net of tax, with the remaining securities classified as AFS.

 

The following table sets forth the contractual maturities, fair values and weighted-average yields for our available for sale securities held at December 31, 2017:

 

		Due Within One Year								After One Year But Within Five Years								After Five Years But Within Ten Years								After Ten Years								Total
		Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield				Amount				Yield
Available for sale
U.S. Government and federal agencies		$	—				—	%		$	—				—	%		$	5,788				2.19	%		$	15,836				2.18	%		$	21,624				2.18	%
Agency mortgage-backed: residential			—				—				2,956				2.64				9,415				2.31				52,594				2.46				64,965				2.45
Collateralized loan obligations			—				—				—				—				10,631				0.28				14,874				2.59				25,505				1.63
State and municipal			145				2.10				19,612				3.31				11,539				3.27				2,414				5.19				33,710				3.42
Corporate bonds			—				—				—				—				3,160				4.54				3,756				5.11				6,916				4.86
Total available for sale		$	145				2.10	%		$	22,568				3.22	%		$	40,533				2.20	%		$	89,474				2.61	%		$	152,720				2.59	%

 

---

Average yields in the table above were calculated on a tax equivalent basis using a federal income tax rate of 35%. Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages. These securities are issued by federal agencies such as Ginnie Mae, Fannie Mae and Freddie Mac, as well as non-agency company issuers. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest. Cash flows from agency backed mortgage-backed securities are guaranteed by the issuing agencies.

 

Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities that are purchased at a premium will generally return decreasing net yields as interest rates drop because home owners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Therefore, those securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal and consequently, average life will not be shortened. If interest rates begin to fall, prepayments will generally increase. Non-agency issuer mortgage-backed securities do not carry a government guarantee. We limit our purchases of these securities to bank qualified issues with high credit ratings. We regularly monitor the performance and credit ratings of these securities and evaluate these securities, as we do all of our securities, for other-than-temporary impairment on a quarterly basis. At December 31, 2017, 81.0% of the agency mortgage-backed securities we held had contractual final maturities of more than ten years with a weighted average life of 23.9 years.

 

 

Deposits – We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years, we have been required by market conditions to rely increasingly on short to mid-term certificate accounts and other deposit alternatives, which are more responsive to market interest rates.

 

We primarily rely on our banking office network to attract and retain deposits in our local markets and have in the past leveraged the online channel to attract out-of-market deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits. During 2017, total deposits decreased $2.9 million compared with 2016. During 2016, total deposits decreased $28.1 million compared with 2015. The decrease in deposits for 2017 and 2016 was primarily in higher cost certificates of deposit balances.

 

To evaluate our funding needs in light of deposit trends resulting from continually changing conditions, we evaluate simulated performance reports that forecast changes in margins along with other pertinent economic data. We continue to offer attractively priced deposit products along our product line to allow us to retain deposit customers and reduce interest rate risk during various rising and falling interest rate cycles.

 

We offer savings accounts, interest checking accounts, money market accounts and fixed rate certificates with varying maturities. The flow of deposits is influenced significantly by general economic conditions, changes in interest rates and competition. Management adjusts interest rates, maturity terms, service fees and withdrawal penalties on the Bank’s deposit products periodically. The variety of deposit products allows the Bank to compete more effectively in obtaining funds and to respond with more flexibility to the flow of funds away from depository institutions into outside investment alternatives. However, the ability to attract and maintain deposits and the cost of these funds have been, and will continue to be, significantly affected by market conditions.

 

The following table sets forth the average daily balances and weighted average rates paid for our deposits for the periods indicated:

 

		For the Years Ended December 31,
		2017								2016								2015
		Average Balance				Average Rate				Average Balance				Average Rate				Average Balance				Average Rate
		(dollars in thousands)
Demand		$	129,088							$	119,736							$	113,576
Interest Checking			101,980				0.13	%			96,294				0.13	%			88,814				0.13	%
Money Market			145,281				0.55				136,423				0.58				112,350				0.57
Savings			35,486				0.17				34,257				0.18				35,604				0.21
Certificates of Deposit			452,443				0.93				466,007				0.88				557,441				0.96
Total Deposits		$	864,278							$	852,717							$	907,785
Weighted Average Rate							0.60	%							0.60	%							0.68	%

 

The following table sets forth the average daily balances and weighted average rates paid for our certificates of deposit for the periods indicated:

 

		For the Years Ended December 31,
		2017								2016								2015
		Average Balance				Average Rate				Average Balance				Average Rate				Average Balance				Average Rate
		(dollars in thousands)
Certificates of Deposit
Less than $250,000		$	419,816				1.01	%		$	437,955				0.88	%		$	524,279				0.95	%
$250,000 or more			32,627				0.92				28,052				0.97				33,162				1.12
Total		$	452,443				0.93	%		$	466,007				0.88	%		$	557,441				0.96	%

 

 

The following table shows at December 31, 2017 the amount of our time deposits of $250,000 or more by time remaining until maturity:

 

Maturity Period
(in thousands)
Three months or less		$	5,276
Three months through six months			1,995
Six months through twelve months			3,497
Over twelve months			20,963
Total		$	31,731

 

The Bank maintains competitive pricing on its deposit products, which we believe allows it to retain a substantial percentage of our customers when their time deposits mature.

 

Borrowing – Deposits are the primary source of funds for lending and investment activities and for general business purposes. We can also use advances (borrowings) from the FHLB of Cincinnati to supplement the pool of lendable funds, meet deposit withdrawal requirements and manage the terms of liabilities. Advances from the FHLB are secured by the Bank’s stock in the FHLB, and substantially all of its first mortgage residential loans. At December 31, 2017, the Bank had $11.8 million in advances outstanding from the FHLB and the capacity to increase borrowings by an additional $79.0 million. The FHLB of Cincinnati functions as a central reserve bank providing credit for savings banks and other member financial institutions. As a member, the Bank is required to own capital stock in the FHLB and is authorized to apply for advances on the security of such stock and certain of our home mortgages and other assets (principally, securities that are obligations of, or guaranteed by, the United States) provided that it meets certain standards related to creditworthiness.

 

The following table sets forth information about our FHLB advances as of and for the periods indicated:

 

		December 31,
		2017				2016				2015
		(dollars in thousands)
Average balance outstanding		$	9,184			$	2,967			$	3,473
Maximum amount outstanding at any month-end during the period			26,830				22,458				8,705
End of period balance			11,797				22,458				3,081
Weighted average interest rate:
At end of period			1.48	%			0.85	%			2.65	%
During the period			1.31	%			2.34	%			2.73	%

 

Subordinated Capital Note – At December 31, 2017, the Bank had a subordinated capital note outstanding in the principal amount of $2.3 million. The note is unsecured, bears interest at three-month LIBOR plus 300 basis points adjusting quarterly, and qualifies as Tier 2 capital until five years before the note matures on July 1, 2020. Beginning on July 1, 2015, one-fifth of the principal amount of the subordinated note was excluded from Tier 2 capital each year until fully excluded during the year before maturity. At December 31, 2017, a total of $1.7 million of the outstanding balance was included in Tier 2 capital. The note requires quarterly principal payments of $225,000 plus interest. At December 31, 2017, the interest rate on this note was 4.34%.

 

 

Junior Subordinated Debentures – At December 31, 2017, the Company had four issues of junior subordinated debentures outstanding totaling $21.0 million as shown in the table below.

 

Description

Liquidation Amount Trust Preferred Securities

Issuance Date

Interest Rate (1)

Junior Subordinated Debt and Investment in Trust

Maturity Date

(dollars in thousands)

Porter Statutory Trust II

$

5,000

2/13/2004

3-month LIBOR + 2.85%

$

5,155

2/13/2034

Porter Statutory Trust III

3,000

4/15/2004

3-month LIBOR + 2.79%

3,093

4/15/2034

Porter Statutory Trust IV

10,000

12/14/2006

3-month LIBOR + 1.67%

10,433

3/1/2037

Ascencia Statutory Trust I

3,000

2/13/2004

3-month LIBOR + 2.85%

3,093

2/13/2034

$

21,000

$

21,774

 

---

(1)

As of December 31, 2017, the 3-month LIBOR was 1.69%.

 

The trust preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the subordinated debentures at maturity or their earlier redemption at the liquidation preference. The subordinated debentures are redeemable before the maturity date at our option at their principal amount plus accrued interest.

 

On April 15, 2016, the Company completed the private placement of 580,000 common shares and 220,000 non-voting common shares to accredited investors resulting in total proceeds of $5.0 million. The investors in the private placement directed a portion of the purchase price to pay all deferred interest payments on junior subordinated debentures, bringing interest payments current through the second quarter of 2016.

 

The Company has the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed 20 consecutive quarters. Since the third quarter of 2016, we have been deferring interest payments on the junior subordinated debentures held by our trust subsidiaries, requiring the trust subsidiaries to defer distributions on the trust preferred securities held by investors. Deferred distributions on the $21.0 million of trust preferred securities outstanding totaled $1.2 million as of December 31, 2017. The deferral period expires after the second quarter of 2021, at which time we will be required to pay all accrued interest or be in default. A deferral period may begin at the Company’s discression so long as interest payments are current. We are prohibited from paying cash dividends on our preferred and common shares until such time as we have paid all deferred distributions on our trust preferred securities. So long as the Written Agreement remains in effect, we will be required to obtain the approval of the Federal Reserve Bank of St. Louis before making any interest payments on the subordinated debentures.

 

The Federal Reserve Board rules allow trust preferred securities to be included in Tier 1 capital, subject to quantitative and qualitative limits. Currently, no more than 25% of our Tier 1 capital can consist of trust preferred securities and qualifying perpetual preferred stock. To the extent the amount of our trust preferred securities exceeds the 25% limit, the excess would be includable in Tier 2 capital. As of December 31, 2017, the Company’s trust preferred securities totaled 22% of its Tier 1 capital and 40% of its Tier 2 capital.

 

Each of the trusts issuing the trust preferred securities holds junior subordinated debentures issued with an original maturity of 30 years. In the last five years before the junior subordinated debentures mature, the associated trust preferred securities are excluded from Tier 1 capital and included in Tier 2 capital. In addition, the trust preferred securities during this five-year period are amortized out of Tier 2 capital by one-fifth each year and excluded from Tier 2 capital completely during the year before maturity.

 

Senior Debt – On June 30, 2017, the Company entered into a $10.0 million senior secured loan agreement with a commercial bank. The loan matures on June 30, 2022. Interest is payable quarterly at a rate of three-month LIBOR plus 250 basis points through June 30, 2020, at which time quarterly principal payments of $250,000 plus interest will commence. The loan is secured by a first priority pledge of 100% of the issued and outstanding stock of the Bank. The Company may prepay any amount due under the promissory note at any time without premium or penalty.

 

 

The Company contributed $9.0 million of the borrowing proceeds to the Bank as common equity Tier 1 capital. The remaining $1.0 million of the borrowing proceeds were retained by the lender in escrow to service quarterly interest payments. At December 31, 2017, the escrow account had a balance of $806,000.

 

The loan agreement contains customary representations, warranties, covenants and events of default, including the following financial covenants: (i) the Company must maintain minimum cash on hand of not less than $750,000 through June 30, 2018, and not less than $2,500,000 thereafter, (ii) the Company must maintain a total risk based capital ratio at least equal to 9% of risk-weighted assets to June 30, 2018, and 10% thereafter, (iii) the Bank must maintain a total risk based capital ratio at least equal to 10% of risk-weighted assets to June 30, 2018, and 11% thereafter, and (iv) non-performing assets of the Bank may not exceed 2.5% of the Bank’s total assets. Both the Company and Bank were in compliance with the covenants as of December 31, 2017.

 

Liquidity

 

Liquidity risk arises from the possibility the Company may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we meet the cash flow requirements of depositors and borrowers, as well as operating cash needs, taking into account all on- and off-balance sheet funding demands. Liquidity risk management also involves ensuring that we meet our cash flow needs at a reasonable cost. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Asset Liability Committee regularly monitors and reviews our liquidity position.

 

Funds are available to the Bank from a number of sources, including the sale of securities in the available for sale investment portfolio, principal pay-downs on loans and mortgage-backed securities, customer deposit inflows, and other wholesale funding.

 

The Bank also borrows from the FHLB to supplement funding requirements. At December 31, 2017, the unused borrowing capacity with the FHLB was $79.0 million. Advances are collateralized by first mortgage residential loans and borrowing capacity is based on the underlying book value of eligible pledged loans.

 

The Bank also has available on an unsecured basis federal funds borrowing lines from a correspondent bank totaling $5.0 million. Management believes the sources of liquidity are adequate to meet expected cash needs for the foreseeable future. However, the availability of these lines could be affected by our financial position.

 

Historically, we have also utilized brokered and wholesale deposits to supplement our funding strategy. At December 31, 2017, we had no brokered deposits.

 

The Company uses cash on hand to service senior debt and to provide for operating cash flow needs. The Company also may issue common equity preferred equity, and debt to support cash flow needs and liquidity requirements. At December 31, 2017, cash on hand totaled $2.0 million, of which, $806,000 is held in escrow by the Company’s senior debt holder to service interest payments.

 

Capital 

 

Stockholders’ equity increased $39.9 million to $72.7 million at December 31, 2017, compared with $32.7 million at December 31, 2016. The increase was due primarily to current year net income $38.5 million.

 

The Company had a full valuation allowance against its net deferred tax asset since 2011. During the fourth quarter of 2017, management concluded it was more-likely-than-not the asset would be utilized to reduce future taxes payable related to the future taxable income of the Company, and as such, reversed the valuation allowance. On December 22, 2017, the Tax Cuts and Jobs Act of 2017 was signed into law. Among other significant changes to the tax code, the new law lowered the federal corporate tax rate from 35% to 21% beginning in 2018. As a result, the Company revalued its net deferred tax asset at the new 21% rate. The combination of the reversal of the valuation allowance and the change in federal corporate tax rates, as well as income tax expense for the year, resulted in an income tax benefit of $31.9 million for the year ended December 31, 2017.

 

On June 30, 2017, the Company entered into a $10.0 million senior secured loan agreement with a commercial bank. The loan matures on June 30, 2022. Interest is payable quarterly at a rate of three-month LIBOR plus 250 basis points through June 30, 2020, at which time quarterly principal payments of $250,000 plus interest will commence. The loan is secured by a first priority pledge of 100% of the issued and outstanding stock of the Bank. The Company may prepay any amount due under the promissory note at any time without premium or penalty. A total of $9.0 million of loan proceeds was injected to the Bank as common equity Tier 1 capital.

 

On December 16, 2016, the Company completed a 1-for-5 reverse stock split of its issued and outstanding common and non-voting common shares. The reverse stock split was intended to increase the trading price per share of the common shares, with the objective to make the common shares a more attractive and cost effective investment and enhance liquidity for shareholders. All share and per share data in this annual report has been adjusted to reflect the reverse stock split. Preferred shares were not affected by the 1-for-5 reverse stock split.

 

 

On April 15, 2016, the Company completed the private placement of 580,000 common shares and 220,000 non-voting common shares to accredited investors, raising total proceeds of $5.0 million. The investors in the private placement directed a portion of purchase price to pay all deferred interest payments on our junior subordinated debentures, bringing interest payments current through the second quarter of 2016. The remaining proceeds were retained for general corporate purposes and to support the Bank.

 

Each of the federal bank regulatory agencies has established risk-based capital requirements for banking organizations. The Basel III regulatory capital reforms became effective for the Company and Bank on January 1, 2015, and include new minimum risk-based capital and leverage ratios. These rules refine the definition of what constitutes “capital” for purposes of calculating those ratios, including the definitions of Tier 1 capital and Tier 2 capital. The final rules allowed banks and their holding companies with less than $250 billion in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in accumulated other comprehensive income in their capital calculation. The Company and the Bank opted out of this requirement. The rules also establish a “capital conservation buffer” of 2.5% above the regulatory minimum risk-based capital ratios. Once the capital conservation buffer is fully phased in, the minimum ratios are a common equity Tier 1 risk-based capital ratio of 7.0%, a Tier 1 risk-based capital ratio of 8.5%, and a total risk-based capital ratio of 10.5%. The phase-in of the capital conservation buffer requirement began in January 2016 at 0.625% of risk-weighted assets and increases each year until fully implemented in January 2019. An institution is subject to limitations on paying dividends, engaging in share repurchases and paying discretionary bonuses if capital levels fall below minimum levels plus the buffer amounts. These limitations establish a maximum percentage of eligible retained income that could be utilized for such actions.

 

The following table shows the ratios of Tier 1 capital, common equity Tier 1, and total capital to risk-adjusted assets and the leverage ratios (excluding the capital conservation buffer) for the Bank at December 31, 2017:

 

		Regulatory Minimums				Well-Capitalized Minimums				Limestone Bank
Tier 1 capital			6.0	%			8.0	%			10.35	%
Common equity Tier 1 capital			4.5				6.5				10.35
Total risk-based capital			8.0				10.0				11.61
Tier 1 leverage ratio			4.0				5.0				8.70

 

Failure to meet minimum capital requirements could result in additional discretionary actions by regulators that, if taken, could have a materially adverse effect on our financial condition.

 

Off Balance Sheet Arrangements 

 

In the normal course of business, we enter into various transactions, which, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and standby letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in the consolidated balance sheets.

 

The commitments associated with outstanding standby letters of credit and commitments to extend credit as of December 31, 2017 are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect our actual future cash funding requirements:

 

		One year or less				More than 1 year but less than 3 years				3 years or more but less than 5 years				5 years or more				Total
		(dollars in thousands)
Commitments to extend credit		$	37,862			$	36,699			$	19,542			$	33,419			$	127,522
Standby letters of credit			2,588				—				1				—				2,589
Total		$	40,450			$	36,699			$	19,543			$	33,419			$	130,111

 

Standby Letters of Credit – Standby letters of credit are written conditional commitments we issue to guarantee the performance of a borrower to a third party. If the borrower does not perform in accordance with the terms of the agreement with the third party, we may be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the borrower. Our policies generally require that standby letter of credit arrangements be underwritten in a manner consistent with a loan of similar characteristics.

 

 

Commitments to Extend Credit – We enter into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of our commitments to extend credit are contingent upon borrowers maintaining specific credit standards at the time of loan funding. We minimize our exposure to loss under these commitments by subjecting them to credit approval and monitoring procedures.

 

Risk Participation Agreements – In connection with the purchase of loan participations, the Bank has entered into risk participation agreements, which had notional amounts totaling $19.8 million at December 31, 2017 and $14.6 million at December 31, 2016.

 

Contractual Obligations 

 

The following table summarizes our contractual obligations and other commitments to make future payments as of December 31, 2017:

		One year or less				More than 1 year but less than 3 years				3 years or more but less than 5 years				5 years or more				Total
		(dollars in thousands)
Time deposits		$	204,018			$	205,986			$	14,231			$	—			$	424,235
FHLB borrowing (1)			10,200				665				836				96				11,797
Subordinated capital note			900				1,350				—				—				2,250
Junior subordinated debentures			—				—				—				21,000				21,000
Senior debt			—				500				2,000				7,500				10,000
Total		$	215,118			$	208,501			$	17,067			$	28,596			$	469,282

 

---

(1)	Fixed rate borrowings with rates ranging from 0% to 5.24%, and maturities ranging from 2018 through 2033, averaging 1.48%.

 

Impact of Inflation and Changing Prices

 

The financial statements and related data presented herein have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of financial position and operating results in historical dollars without considering changes in the relative purchasing power of money over time due to inflation.

 

We have an asset and liability structure that is essentially monetary in nature. As a result, interest rates have a more significant impact on performance than the effects of general levels of inflation. Periods of high inflation are often accompanied by relatively higher interest rates, and periods of low inflation are accompanied by relatively lower interest rates. As market interest rates rise or fall in relation to the rates earned on loans and investments, the value of these assets decreases or increases respectively.

 

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”). The ALCO, which is comprised of senior officers, has the responsibility for approving and ensuring compliance with asset/liability management policies. Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates. The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies. Management considers interest rate risk to be our most significant market risk.

 

The Company utilizes an earnings simulation model to analyze net interest income sensitivity. It then evaluates potential changes in market interest rates and their subsequent effects on net interest income. The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points that are sustained for one year. Assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates are also incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income. Actual results may differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

 

Given an instantaneous 100 basis point increase in interest rates, the base net interest income would increase by an estimated 0.9% at December 31, 2017 compared with an decrease of 2.5% at December 31, 2016. The following table indicates the estimated impact on net interest income under various interest rate scenarios for the year ended December 31, 2017, as calculated using the static shock model approach:

 

		Change in Future Net Interest Income
		Dollar Change				Percentage Change
		(dollars in thousands)
+ 200 basis points		$	545				1.7	%
+ 100 basis points			271				0.9
-  100 basis points			(1,061	)			(3.3	)
-  200 basis points			(2,384	)			(7.5	)

 

 

Implementation of strategies to mitigate the risk of changing interest rates in the future, could lessen our forecasted “base case” net interest income in the event of no interest rate changes. Interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities as well as their relative pricing schedules. It is also influenced by market interest rates, deposit growth, loan growth, deposit decay rates and asset prepayment speed assumptions.

 

The following table sets forth the amounts of our interest-earning assets and interest-bearing liabilities outstanding at December 31, 2017, which we anticipate, based upon certain assumptions, to reprice or mature in each of the future time periods shown. The projected repricing of assets and liabilities anticipates prepayments and scheduled rate adjustments, as well as contractual maturities under an interest rate unchanged scenario within the selected time intervals. While we believe such assumptions are reasonable, we cannot provide assurance that assumed repricing rates will approximate actual future activity.

 

 

		Volume Subject to Repricing Within
		0 – 90 Days				91 – 181 Days				182 – 365 Days				1 – 5 Years				Over 5 Years				Non- Interest Sensitive				Total
		(dollars in thousands)
Assets:
Federal funds sold and short-term investments		$	25,966			$	—			$	—			$	—			$	—			$	—			$	25,966
Investment securities			46,712				2,726				7,649				58,131				37,056				516				152,790
FHLB stock			7,323				—				—				—				—				—				7,323
Loans held for sale			70				—				—				—				—				—				70
Loans, net of allowance			272,599				48,677				84,009				260,961				45,869				(8,202	)			703,913
Fixed and other assets			—				—				—				—				—				80,739				80,739
Total assets		$	352,670			$	51,403			$	91,658			$	319,092			$	82,925			$	73,053			$	970,801
Liabilities and Stockholders’ Equity
Interest-bearing checking, savings, and money market accounts		$	285,403			$	—			$	—			$	—			$	—			$	—			$	285,403
Certificates of deposit			74,560				52,197				76,126				221,184				168				—				424,235
Borrowed funds			43,274				208				233				1,187				145				—				45,047
Other liabilities			—				—				—				—				—				143,443				143,443
Stockholders’ equity			—				—				—				—				—				72,673				72,673
Total liabilities and stockholders’ equity		$	403,237			$	52,405			$	76,359			$	222,371			$	313			$	216,116			$	970,801
Period gap		$	(50,567	)		$	(1,002	)		$	15,299			$	96,721			$	82,612
Cumulative gap		$	(50,567	)		$	(51,569	)		$	(36,270	)		$	60,451			$	143,063
Period gap to total assets			(5.21	)%			(0.10	)%			1.58	%			9.96	%			8.51	%
Cumulative gap to total assets			(5.21	)%			(5.31	)%			(3.74	)%			6.23	%			14.74	%
Cumulative interest-earning assets to cumulative interest-bearing liabilities			87.46	%			88.68	%			93.18	%			108.01	%			118.96	%

 

The one-year cumulative gap position as of December 31, 2017 was negative $36.3 million or 3.7% of total assets. This is a one-day position that is continually changing and is not necessarily indicative of the Company’s position at any other time. Any gap analysis has inherent shortcomings because certain assets and liabilities may not move proportionally as interest rates change.

 

 

Item 8.

Financial Statements and Supplementary Data

 

The following consolidated financial statements and reports are included in this section:

 

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2017 and 2016

Consolidated Statements of Operations for the Years Ended December 31, 2017, 2016, and 2015

Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2017, 2016, and 2015

Consolidated Statements of Change in Stockholders’ Equity for the Years Ended December 31, 2017, 2016, and 2015

Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016, and 2015

Notes to Consolidated Financial Statements

 

 

Crowe Horwath LLP Independent Member Crowe Horwath International

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 

Shareholders and the Board of Directors of Porter Bancorp, Inc.

Louisville, Kentucky

 

Opinion on the Financial Statements

 

We have audited the accompanying consolidated balance sheets of Porter Bancorp, Inc. (the "Company") as of December 31, 2017 and 2016, the related consolidated statements of operations, comprehensive income (loss), changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the "financial statements").  In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.

 

Basis for Opinion

 

These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) ("PCAOB") and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

 

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting in accordance with the standards of the PCAOB. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion in accordance with the standards of the PCAOB.

 

Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

 

 

/s/ Crowe Horwath, LLP

 

We have served as the Company's auditor since 1998.

 

Louisville, Kentucky

February 28, 2018

 

 

PORTER BANCORP, INC.

CONSOLIDATED BALANCE SHEETS

December 31,

(Dollar amounts in thousands except share data) 

 

 

See accompanying notes.

 

 

PORTER BANCORP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31,

(Dollar amounts in thousands except per share data)

 

 

See accompanying notes.

 

 

PORTER BANCORP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Years Ended December 31,

(in thousands)

 

 

 

See accompanying notes.

 

 

PORTER BANCORP, INC. 

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

Years Ended December 31,

(Dollar amounts in thousands except share and per share data)

 

 

See accompanying notes.

 

 

PORTER BANCORP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS 

Years Ended December 31,

(in thousands)

 

 

See accompanying notes.

 

 

PORTER BANCORP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2017, 2016 and 2015

 

Item 9.     Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

 

None

 

Item 9A.

Controls and Procedures

 

Disclosure Controls and Procedures

Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. Our management, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2017. Based on that evaluation, management believes that our disclosure controls and procedures were effective to collect, process, and disclose the information required to be disclosed in the reports filed with the SEC within the required time periods as of the end of the period covered by this report.

 

There was no change in the internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Management’s Report on Internal Control Over Financial Reporting

 

The management of Porter Bancorp, Inc. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of; the principal executive and principal financial officers and effected by the board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles and includes those policies and procedures that:

 

Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

 

Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and

 

Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2017. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO") in the 2013 Internal Control-Integrated Framework. Based on that assessment, management believes that, as of December 31, 2017, our internal control over financial reporting is effective based on those criteria.

 

This annual report does not include an attestation report of our registered public accounting firm regarding internal controls over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report.

 

/s/ John T. Taylor

John T. Taylor

President and Chief Executive Officer

 

/s/ Phillip W. Barnhouse

Phillip W. Barnhouse

Chief Financial Officer

 

Item 9B.     Other Information

 

None

 

 

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance.

 

The Company has adopted a code of ethics applicable to the Chief Executive Officer and the senior financial officers, which is posted on the Bank’s website at http://www.limestonebank.com under the Investors Relations section of the About Us tab. If we amend or waive any of the provisions of the Code of Ethics applicable to our Chief Executive Officer or senior financial officers, we intend to disclose the amendment or waiver on our website. We will provide to any person without charge, upon request, a copy of this Code of Ethics. You can request a copy by contacting Porter Bancorp, Inc., Chief Financial Officer, 2500 Eastpoint Parkway, Louisville, Kentucky, 40223, (telephone) 502-499-4800.

 

Additional information required by this Item 10 is omitted because we are filing a definitive proxy statement pursuant to Regulation 14A on or before April 30, 2018, which includes the required information. The required information contained in our proxy statement is incorporated herein by reference.

 

Item 11. Executive Compensation.

 

The information required by this Item 11 is omitted because we are filing a definitive proxy statement pursuant to Regulation 14A on or before April 30, 2018, which includes the required information. The required information contained in our proxy statement is incorporated herein by reference.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

The information required by this Item 12 is omitted because we are filing a definitive proxy statement pursuant to Regulation 14A on or before April 30, 2018, which includes the required information. The required information contained in our proxy statement is incorporated herein by reference.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence.

 

The information required by this Item 13 is omitted because we are filing a definitive proxy statement pursuant to Regulation 14A on or before April 30, 2018, which includes the required information. The required information contained in our proxy statement is incorporated herein by reference.

 

Item 14. Principal Accounting Fees and Services.

 

The information required by this Item 14 is omitted because we are filing a definitive proxy statement pursuant to Regulation 14A on or before April 30, 2018, which includes the required information. The required information contained in our proxy statement is incorporated herein by reference.

 

 

PART IV

 

Item 15.	Exhibits and Financial Statement Schedules
(a) 1.	The following financial statements are included in this Form 10-K:
	Consolidated Balance Sheets as of December 31, 2017 and 2016
	Consolidated Statements of Operations for the Years Ended December 31, 2017, 2016, and 2015
	Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2017, 2016, and 2015
	Consolidated Statements of Change in Stockholders’ Equity for the Years Ended December 31, 2017, 2016, and 2015
	Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016, and 2015
	Notes to Consolidated Financial Statements
	Report of Independent Registered Public Accounting Firm
(a) 2.	List of Financial Statement Schedules
	Financial statement schedules are omitted because the information is not applicable.
(a) 3.	List of Exhibits
	The Exhibit Index of this report is incorporated by reference. The compensatory plans or arrangement required to be filed as exhibits to this Form 10-K pursuant to Item 15(c) are noted with an asterisk in the Exhibit Index.

 

 

EXHIBIT INDEX

Exhibit No. (1)			Description
3.1			Amended and Restated Articles of Incorporation, dated March 25, 2016. Exhibit 3.1 to Form 8-K filed May 26, 2016 is incorporated by reference.
3.2			Amendment to Articles of Incorporation, dated December 6, 2016, effecting reverse stock split.  Exhibit 3.1 to Form 8-K filed December 21, 2016 is incorporated by reference.
3.3			Amended and Restated Bylaws of Porter Bancorp, Inc. Exhibit 3.1 to Form 8-K filed May 22, 2013 is hereby incorporated by reference.
4.1			Warrant to purchase up to 299,829 shares.  Exhibit 4.1 to Form 8-K filed November 24, 2008 is incorporated by reference.
10.1			Loan Agreement between Porter Bancorp, Inc. and First Merchants Bank dated June 30, 2017.  Exhibit 1.1 to Form 8-K filed July 5, 2017 is incorporated by reference.
10.2			Promissory Note between Porter Bancorp, Inc. and First Merchants Bank dated June 30, 2017.  Exhibit 1.2 to Form 8-K filed July 5, 2017 is incorporated by reference.
10.3			Pledge Agreement between Porter Bancorp, Inc. and First Merchants Bank dated June 30, 2017.  Exhibit 1.3 to Form 8-K filed July 5, 2017 is incorporated by reference.
10.4+			Porter Bancorp, Inc. 2016 Omnibus Equity Compensation Plan.  Appendix A to Schedule 14A proxy statement (DEF 14A) filed April 25, 2016 is incorporated by reference.
10.5+			Form of Porter Bancorp, Inc. Restricted Stock Award Agreement. Exhibit 10.3 to 8-K filed June 22, 2016 is incorporated by reference.
10.6+			Porter Bancorp, Inc. 2006 Non-Employee Directors Stock Ownership Incentive Plan, as amended and restated as of March 26, 2014. Exhibit 10.1 to Form S-8 Registration Statement (Reg. No. 333-202746) filed March 13, 2015 is incorporated by reference.
10.7+			Non-Employee Director Stock Incentive Program.  Exhibit 10.1 to Form 8-K filed June 22, 2016 is incorporated by reference.
10.8+			Porter Bancorp, Inc. 2017 Incentive Compensation Bonus Plan.  Exhibit 10.1 to Form 10-Q filed May 4, 2017 is incorporated by reference.
10.9+			Form of Ascencia Bank (now Limestone Bank) Supplemental Executive Retirement Plan. Exhibit 10.5 to Form S-1 Registration Statement (Reg. No. 333-133198) filed April 11, 2006 is incorporated by reference.
10.10+			Form of Amendment to Supplemental Executive Retirement Plan.  Exhibit 10.7 to Form 10-K filed March 26, 2009 is incorporated by reference.
10.11+			Employment Agreement with John T. Taylor. Exhibit 10.1 to Form 8-K filed September 27, 2016 is incorporated by reference.
10.12+			Employment Agreement with John R. Davis.  Exhibit 10.2 to Form 8-K filed September 27, 2016 is incorporated by reference.
10.13+			Employment Agreement with Joseph C. Seiler.  Exhibit 10.3 to Form 8-K filed September 27, 2016 is incorporated by reference.
10.14+			Employment Agreement with Phillip W. Barnhouse.  Exhibit 10.4 to Form 8-K filed September 27, 2016 is incorporated by reference.
21.1			List of Subsidiaries of Porter Bancorp, Inc.
23.1			Consent of Crowe Horwath LLP, Independent Registered Public Accounting Firm.
31.1			Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14.
31.2			Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14.
32.1			Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350.

 

 

Exhibit No. (1)			Description
32.2			Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and U.S.C. Section 1350.
101			The following financial statements from the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, formatted in XBRL: (i) Consolidated Balance Sheets, (ii) Consolidated Statements of Operations, (iii) Consolidated Statements of Comprehensive Income, (iv) Consolidated Statements of Changes in Stockholders’ Equity, (v) Consolidated Statements of Cash Flows, (vi) Notes to Consolidated Financial Statements.

 

---

+	Management contract or compensatory plan or arrangement.

(1)	The Company has other long-term debt agreements that meet the exclusion set forth in Section 601(b)(4)(iii)(A) of Regulation S-K. The Company hereby agrees to furnish a copy of such agreements to the Securities and Exchange Commission upon request.

 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	PORTER BANCORP, INC.
February 28, 2018	By:	/s/ John T. Taylor
		John T. Taylor
		Chief Executive Officer

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated.

 

/s/ John T. Taylor	Chief Executive Officer	February 28, 2018
John T. Taylor
/s/ Phillip W. Barnhouse	Chief Financial Officer	February 28, 2018
Phillip W. Barnhouse
/s/ W. Glenn Hogan	Director	February 28, 2018
W. Glenn Hogan
/s/ Michael T. Levy	Director	February 28, 2018
Michael T. Levy
/s/ Bradford T. Ray	Director	February 28, 2018
Bradford T. Ray
/s/ W. Kirk Wycoff	Director	February 28, 2018
W. Kirk Wycoff
/s/ James M. Parsons	Director	February 28, 2018
James M. Parsons
/s/ Dr. Edmond J. Seifried	Director	February 28, 2018
Dr. Edmond J. Seifried

 

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