SB FINANCIAL GROUP, INC. Cautionary Statement Regarding Forward-Looking Information
This Quarterly Report on Form 10-Q, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains certain forward-looking statements that are provided to assist in the understanding of anticipated future financial performance. Forward-looking statements provide current expectations or forecasts of future events and are not guarantees of future performance. Examples of forward-looking statements include: (a) projections of income or expense, earnings per share, the payment or non-payment of dividends, capital structure and other financial items; (b) statements of plans and objectives of the Company or our management or Board of Directors, including those relating to products or services; (c) statements of future economic performance; (d) statements regarding future customer attraction or retention; and (e) statements of assumptions underlying such statements. Words such as "anticipates", "believes", "plans", "intends", "expects", "projects", "estimates", "should", "may", "would be", "will allow", "will likely result", "will continue", "will remain", or other similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying those statements. Forward-looking statements are based on management's expectations and are subject to a number of risks and uncertainties. Although management believes that the expectations reflected in such forward-looking statements are reasonable, actual results may differ materially from those expressed or implied in such statements. Risks and uncertainties that could cause actual results to differ materially include, without limitation:
? the ever-changing effects of the novel coronavirus (COVID-19) pandemic - the
duration, extent and severity of which are impossible to predict, including the
possibility of further resurgence of the spread of COVID-19 and variants
thereof -- on national, regional and local economies, supply chains, labor
markets and on our customers, counterparties, employees and third-party service
providers, as well as the effects of various responses of governmental and
nongovernmental authorities to the COVID-19 pandemic, including public health
actions directed toward the containment of the COVID-19 pandemic (such as
quarantines, shut downs and other restrictions on travel and commercial, social
or other activities), the development, availability and effectiveness of vaccines, and the implementation of fiscal stimulus packages;
? current and future economic and financial market conditions, either nationally
or in the states in which we do business, including the effects of inflation,
conflict in
to the continuing impact of the COVID-19 pandemic on our customers' operations
and financial condition, any of which may result in adverse impacts on our
deposit levels and composition, the quality of investment securities available
for purchase, demand for loans, the ability of our borrowers to repay their
loans, and the value of the collateral securing loans;
? changes in interest rates resulting from national and local economicconditions and the policies of regulatory authorities, including monetary
policies of the
adversely affect interest rates, interest margins, loan demand and interest
rate sensitivity;
? the volatility of mortgage banking income, whether due to interest rates,
demand, the fair value of mortgage loans, or other factors;
? factors that can impact the performance of our loan portfolio, including
changes in real estate values and liquidity in our primary market areas, the
financial health of our borrowers and the success of construction projects
that we finance;
? the transition away from LIBOR as a reference rate for financial contracts,
which could negatively impact our income and expenses and the value of various
financial contracts;
? changes in customers', suppliers', and other counterparties' performance and
creditworthiness may be different than anticipated due to the continuing
impact of and the various responses to the COVID-19 pandemic;
? operational risks, reputational risks, legal and compliance risks, and other
risks related to potential fraud or theft by employees or outsiders,
unauthorized transactions by employees or operational errors, or failures,
disruptions or breaches in security of our systems, including those resulting
from computer viruses or cyber-attacks;
30
? our ability to secure sensitive or confidential client information against
unauthorized disclose or access through computer systems and telecommunication
networks, including those of our third-party vendors and other service
providers, which may prove inadequate;
? a failure in or breach of our operational or security systems or
infrastructure, or those of our third-party vendors and other service
providers, resulting in failures or disruptions in customer accountmanagement, general ledger, deposit, loan, or other systems, including as a
result of cyber-attacks;
? competitive pressures and factors among financial services organizations could
increase significantly, including product and pricing pressures, changes to
third-party relationships and our ability to recruit and retain qualified
management and banking personnel;
? unexpected losses of services of our key management personnel, or the inability
to recruit and retain qualified personnel in the future;
? risks inherent in pursuing strategic growth initiatives, including integration
and other risks involved in past and possible future acquisitions;
? uncertainty regarding the nature, timing, cost and effect of legislative or
regulatory changes in the banking industry or otherwise affecting the Company,
including major reform of the regulatory oversight structure of the financial
services industry and changes in laws and regulations concerning taxes,
insurance premium levels, pensions, bankruptcy, consumer protection, rent
regulation and housing, financial accounting and reporting, environmental
protection, insurance, bank products and services, bank and bank holding
company capital and liquidity standards, fiduciary standards, securities and
other aspects of the financial services industry, as well as the reforms
provided for in the Coronavirus Aid, Relief and Economic Security (CARES) Act
and the follow-up legislation in the Consolidated Appropriations Act, 2021 and
the American Rescue Plan Act of 2021;
? the effect of changes in federal, state and/or local tax laws may adversely
affect our reported financial condition or results of operations;
? the effect of changes in accounting policies and practices may adversely
affect our reported financial condition or results of operations;
? litigation and regulatory compliance exposure, including the costs and effects
of any adverse developments in legal proceedings or other claims and the costs
and effects of unfavorable resolution of regulatory and other governmental
examinations or inquiries;
? continued availability of earnings and dividends from
capital sufficient for us to service our debt and pay dividends to our
shareholders in compliance with applicable legal and regulatory requirements;
? our ability to anticipate and successfully keep pace with technological
changes affecting the financial services industry; and
? other risks identified from time to time in the Company's other filings with
the
the heading "Item 1A. Risk Factors" of Part I of the Company's Annual Report on
Form 10-K for the fiscal year endedDecember 31, 2021 . Undue reliance should not be placed on the forward-looking statements, which speak only as of the date hereof. Except as may be required by law, the Company undertakes no obligation to update any forward-looking statement to reflect unanticipated events or circumstances after the date on which the statement
is made. Overview ofSB Financial SB Financial Group, Inc. ("SB Financial") is anOhio corporation and a financial holding company registered with theFederal Reserve Board .SB Financial's wholly-owned subsidiary,The State Bank and Trust Company ("State Bank "), is anOhio -chartered bank engaged in commercial banking. Rurban Statutory Trust II ("RST II") was established inAugust 2005 . InSeptember 2005 , RST II completed a pooled private offering of 10,000 Trust Preferred Securities with a liquidation amount of$1,000 per security. The proceeds of the offering were loaned toSB Financial in exchange for junior subordinated debentures ofSB Financial with terms substantially similar to the Trust Preferred Securities. The sole assets of RST II are the junior subordinated debentures, and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee bySB Financial of the obligations of RST II. 31
Unless the context indicates otherwise, all references herein to "we", "us",
"our", or the "Company" refer to
Critical Accounting Policies
Note 1 to the Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the fiscal year endedDecember 31, 2021 describes the significant accounting policies used in the development and presentation of the Company's financial statements. The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted inthe United States and conform to general practices within the banking industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions. The Company's financial position and results of operations can be affected by these estimates and assumptions and are integral to the understanding of reported results. Critical accounting policies are those policies that management believes are the most important to the portrayal of the Company's financial condition and results, and they require management to make estimates that are difficult, subjective, and/or complex. Allowance for Loan Losses - The allowance for loan losses provides coverage for probable losses inherent in the Company's loan portfolio. Management evaluates the adequacy of the allowance for loan losses each quarter based on changes, if any, in underwriting activities, loan portfolio composition (including product mix and geographic, industry or customer-specific concentrations), trends in loan performance, regulatory guidance and economic factors. This evaluation is inherently subjective, as it requires the use of significant management estimates. Many factors can affect management's estimates of specific and expected losses, including volatility of default probabilities, rating migrations, loss severity and economic and political conditions. The allowance is increased through provisions charged to operating earnings and reduced by net charge-offs. The Company determines the amount of the allowance based on relative risk characteristics of the loan portfolio. The allowance recorded for commercial loans is based on reviews of individual credit relationships and an analysis of the migration of commercial loans and actual loss experience. The allowance recorded for homogeneous consumer loans is based on an analysis of loan mix, risk characteristics of the portfolio, fraud loss and bankruptcy experiences, and historical losses, adjusted for current trends, for each homogeneous category or group of loans. The allowance for credit losses relating to impaired loans is based on the loan's observable market price, the collateral for certain collateral-dependent loans, or the discounted cash flows using the loan's effective interest rate. Regardless of the extent of the Company's analysis of customer performance, portfolio trends or risk management processes, certain inherent but undetected losses are probable within the loan portfolio. This is due to several factors, including inherent delays in obtaining information regarding a customer's financial condition or changes in their unique business conditions, the subjective nature of individual loan evaluations, collateral assessments and the interpretation of economic trends. Volatility of economic or customer-specific conditions affecting the identification and estimation of losses for larger non-homogeneous credits and the sensitivity of assumptions utilized to establish allowances for homogenous groups of loans are also factors. The Company estimates a range of inherent losses related to the existence of these exposures. The estimates are based upon the Company's evaluation of imprecise risk associated with the commercial and consumer allowance levels and the estimated impact of the current economic environment. To the extent that actual results differ from management's estimates, additional loan loss provisions may be required that could adversely impact earnings for future periods. 32Goodwill and Other Intangibles - The Company records all assets and liabilities acquired in purchase acquisitions, including goodwill and other intangibles, at fair value as required.Goodwill is subject, at a minimum, to annual tests for impairment. Other intangible assets are amortized over their estimated useful lives using straight-line or accelerated methods, and are subject to impairment if events or circumstances indicate a possible inability to realize the carrying amount. The initial goodwill and other intangibles recorded and subsequent impairment analysis requires management to make subjective judgments concerning estimates of how the acquired asset will perform in the future. Events and factors that may significantly affect the estimates include, among others, customer attrition, changes in revenue growth trends, specific industry conditions and changes in competition. A decrease in earnings resulting from these or other factors could lead to an impairment of goodwill that could adversely impact earnings for future periods.
Three Months Ended
Net Income: Net income for the first quarter of 2022 was$2.8 million compared to net income of$7.1 million for the first quarter of 2021, a decrease of 60.3 percent. Earnings per diluted share (EPS) of$0.40 were down 58.8 percent from EPS of$0.97 for the first quarter of 2021. Net income for the first quarters of 2022 and 2021 were both positively impacted by the recapture of the Company's temporary mortgage servicing rights impairment in the amounts of$0.9 million and$2.7 million , respectively. Net income for the first quarter of 2022 was negatively impacted by the significant decline in mortgage loan volume and loan sales during the first quarter of 2022, as compared to the first quarter of 2021, as rising rates reduced refinance activity and compressed inventories of available housing constrained new purchase volume. Mortgage loan volume was down over 37 percent from the prior year and a lower percentage of originated volume was sold on the secondary market. Loan growth was positive in the quarter and remaining balances on the Paycheck Protection Program ("PPP") initiative were down to$0.8 million atMarch 31, 2022 .
Provision for Loan Losses: The first quarter provision for loan losses was$0.0 million , compared to$0.75 million for the year-ago quarter. The total reserve level of$13.8 million is up 3.6 percent from the prior year. The Company had net charge-offs of$.01 million for the quarter compared to net recoveries of$0.02 million for the year-ago quarter. Total delinquent loans ended the quarter at$5.1 million , or 0.59 percent of total loans, which increased$0.1 million from the prior year.
Asset Quality Review - For the Period Ended
2022 2021
Net charge-offs (recoveries) $ 1 $ (2 )
Nonaccruing loans 4,293 5,635
Accruing Trouble Debt Restructures 762 794
Nonaccruing and restructured loans 5,055 6,429
OREO / OAO 527 43
Nonperforming assets 5,582 6,472
Nonperforming assets/Total assets 0.42 % 0.49 %
Allowance for loan losses/Total loans 1.62 % 1.57 %
Allowance for loan losses/Nonperforming loans 273.1 % 207.3 %
33
Consolidated Revenue: Total revenue, consisting of net interest income and
noninterest income, was $14.3 million for the first quarter of 2022, a decrease
of $6.3 million , or 30.5 percent, from the $20.5 million generated during the
first quarter of 2021.
Net interest income ("NII") was $8.5 million for the first quarter of 2022,
which was down $1.1 million from the prior year first quarter's $9.6 million .
Included in NII was $0.1 million in fees and interest from PPP loans compared to
$0.8 million for the prior year quarter. The Company's earning assets increased
$66.9 million , coupled with a 60 basis point decrease in the yield on earning
assets. The net interest margin (FTE) for the first quarter of 2022 was 2.68
percent compared to 3.21 percent for the first quarter of 2021. Funding costs
(interest paid to consumers and other entities) for interest bearing liabilities
for the first quarter of 2022 were 0.39 percent compared to 0.50 percent for the
prior year first quarter.
Noninterest income was $5.8 million for the first quarter of 2022, which was
down $5.1 million from the prior year first quarter's $10.9 million . In addition
to the mortgage revenue detailed below, wealth management revenue was $1.0
million . Recapture of mortgage servicing rights impairment increased noninterest
income by $0.9 million in the quarter, compared to an increase of $2.7 million
in the prior year. During the quarter, we sold $1.6 million in Small Business
Administration ("SBA") loans, with gains on sale of $0.17 million . Our title
agency contributed revenue of $0.6 million in the first quarter of 2022.
Noninterest income as a percentage of average assets for the first quarter of
2022 was 1.72 percent compared to 3.41 percent for the prior year first quarter.
State Bank originated $97.4 million of mortgage loans for the first quarter of
2022, which resulted in $72.2 million in loan proceeds, with the remainder of
loans held for investment. This compares to $155.8 million originated for the
first quarter of 2021, of which $136.7 million of loans were sold with the
remainder of loans held for investment. The Company is experiencing stronger
competition for new purchase volume due to the compressed inventory levels of
homes available for sale. In addition, the rise in rates has reduced the
economic advantage for clients to refinance existing mortgage loans. These first
quarter 2022 originations and subsequent sales resulted in $1.7 million of
gains, compared to $5.9 million of gains for the first quarter of 2021. Net
mortgage banking revenue was $2.9 million for the first quarter of 2022 compared
to $8.2 million for the first quarter of 2021. The 2022 first quarter included a
$0.9 million recapture of mortgage servicing rights compared to a $2.7 million
recapture for the first quarter of 2021.
Consolidated Noninterest Expense:Noninterest expense for the first quarter of
2022 was $10.9 million , which was down slightly compared to the $10.9 million in
the prior-year first quarter. The first quarter of 2022 included lower
incentives on mortgage activity and higher unfilled salaried positions
throughout the Company, which was offset by higher data processing and
professional fee expense due to expanded implementation of technology solutions.
Income Taxes: Income taxes for the first quarter of 2022 were $0.6 million
(effective rate of 17.7 percent) compared to $1.8 million (effective rate of
20.3 percent) for the first quarter of 2021. In addition to the impact of the
lower pretax income, this quarter was impacted by having additional earning
assets that are tax free in nature.
Changes in Financial Condition
Total assets atMarch 31, 2022 were$1.34 billion , an increase of$4.3 million , or 0.3 percent, sinceDecember 31, 2021 . Total loans, net of unearned income, were$850.7 million as ofMarch 31, 2022 , up$28.0 million , or 3.4 percent, from year-end. PPP loan balances of$0.8 million and$2.0 million were included in our total loans atMarch 31, 2022 andDecember 31, 2021 , respectively. Total deposits atMarch 31, 2022 were$1.14 billion , an increase of$25.0 million or 2.2 percent since 2021 year end. Borrowed funds (consisting of FHLB advances, retail repurchase agreements, trust preferred securities and subordinated debt) totaled$54.4 million atMarch 31, 2022 . This is up from year-end 2021 when borrowed funds totaled$50.7 million due to an increase in REPOs. Total equity for the Company of$132.6 million now stands at 9.9 percent of total assets compared to theDecember 31, 2021 level of$144.9 million and 10.9 percent of total assets. The reduction was due to an$11.8 million increase in the unrealized loss on the Company's investment portfolio.
The allowance for loan loss of
34
Capital Resources
As of March 31, 2022 , based on the computations for the FFIEC 041 Consolidated
Reports of Condition and Income filed by State Bank with the Federal Reserve
Board , State Bank was classified as well capitalized under the regulatory
framework for prompt corrective action. To be categorized as well capitalized,
State Bank must maintain capital ratios as set forth in the table below. There
are no conditions or events since March 31, 2022 that management believes have
changed State Bank's capital classification.
State Bank's actual capital levels and ratios as of March 31, 2022 and December
31, 2021 are presented in the following table. Capital levels are presented for
State Bank only as the Company is exempt from quarterly reporting on capital
levels at the holding company level:
To Be Well Capitalized
Under Prompt Corrective
For Capital Adequacy Action
Actual Purposes Procedures($ in thousands) Amount Ratio Amount Ratio Amount Ratio As ofMarch 31, 2022 Tier I Capital to average assets$ 136,243 10.35 %$ 52,651 4.0 %$ 65,814 5.0 % Tier I Common equity capital to risk-weighted assets 136,243 13.71 % 44,716 4.5 % 64,590 6.5 % Tier I Capital to risk-weighted assets 136,243 13.71 % 59,621 6.0 % 79,495 8.0 % Total Risk-based capital to risk-weighted assets 148,681 14.96 % 79,495 8.0 % 99,369 10.0 % As of December 31, 2021 Tier I Capital to average assets$ 133,202 10.18 %$ 52,324 4.0 %$ 65,405 5.0 % Tier I Common equity capital to risk-weighted assets 133,202 13.94 % 42,986 4.5 % 62,090 6.5 % Tier I Capital to risk-weighted assets 133,202 13.94 % 57,314 6.0 % 76,419 8.0 % Total Risk-based capital to risk-weighted assets 145,165 15.20 % 76,419
8.0 % 95,523 10.0 % New regulatory capital requirements commonly referred to as "Basel III" were fully phased in as ofJanuary 1, 2019 and are reflected in theMarch 31, 2022 capital table above. Management opted out of the accumulated other comprehensive income treatment under the new requirements and, as such, unrealized gains and losses from available-for-sale securities will continue to be excluded fromState Bank's regulatory capital. LIQUIDITY Liquidity relates primarily to the Company's ability to fund loan demand, meet deposit customers' withdrawal requirements and provide for operating expenses. Assets used to satisfy these needs consist of cash and due from banks, federal funds sold, interest-earning deposits in other financial institutions, securities available-for-sale and loans held for sale. These assets are commonly referred to as liquid assets. Liquid assets totaled$401.9 million atMarch 31, 2022 , compared to$422.9 million atDecember 31, 2021 . Liquidity risk arises from the possibility that the Company may not be able to meet the Company's financial obligations and operating cash needs or may become overly reliant upon external funding sources. In order to manage this risk, the Board of Directors of the Company has established a Liquidity Policy that identifies primary sources of liquidity, establishes procedures for monitoring and measuring liquidity and quantifies minimum liquidity requirements. This policy designates the Asset/Liability Committee ("ALCO") as the body responsible for meeting these objectives. The ALCO reviews liquidity regularly and evaluates significant changes in strategies that affect balance sheet or cash flow positions. Liquidity is centrally managed on a daily basis by the Company's Chief Financial Officer and Asset Liability Manager. The Company's commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolio of$669.8 million atMarch 31, 2022 and$645.1 million atDecember 31, 2021 , which can and has been used to collateralize borrowings, is an additional source of liquidity. Management believes the Company's current liquidity level, without these borrowings, is sufficient to meet its liquidity needs. AtMarch 31, 2022 , all eligible commercial real estate, first mortgage residential and multi-family mortgage loans were pledged under an FHLB blanket lien. 35
The cash flow statements for the periods presented provide an indication of the Company's sources and uses of cash, as well as an indication of the ability of the Company to maintain an adequate level of liquidity. A discussion of the cash flow statements for the three months endedMarch 31, 2022 and 2021 follows. The Company experienced negative cash flows from operating activities for the three months endedMarch 31, 2022 andMarch 31, 2021 . Net cash used by operating activities was$1.5 million for the three months endedMarch 31, 2022 and$0.9 million for the three months endedMarch 31, 2021 . Highlights for the current year include$73.9 million in proceeds from the sale of loans, which is down$62.8 million from the prior year. Originations of loans held for sale was a use of cash of$70.1 million , which is down from the prior year by$63.4 million . For the three months endedMarch 31, 2022 , there was a gain on sale of loans of$1.9 million , and depreciation and amortization of$0.6 million . The Company experienced negative cash flows from investing activities for the three months endedMarch 31, 2022 andMarch 31, 2021 . Net cash used in investing activities was$43.3 million for the three months endedMarch 31, 2022 and$5.6 million for the three months endedMarch 31, 2021 . Highlights for the current year include purchases of available-for-sale securities of$30.6 million . These cash payments were offset by$13.3 million in proceeds from maturities and sales of securities, which is up$1.3 million from the prior year three-month period. The Company experienced a$28.0 million increase in loans, which is up$52.5 million from the prior year three-month period. The Company experienced positive cash flows from financing activities for the three months endedMarch 31, 2022 andMarch 31, 2021 . Net cash provided by financing activities was$25.3 million for the three months endedMarch 31, 2022 and$71.8 million for the three months endedMarch 31, 2021 . Highlights for the current period include a$33.0 million increase in transaction deposits for the three months endedMarch 31, 2022 , which is down$79.5 million from the prior year. Certificates of deposit decreased by$8.0 million in the current year compared to$41.3 million for the prior year three-month period. ALCO uses an economic value of equity ("EVE") analysis to measure risk in the balance sheet incorporating all cash flows over the estimated remaining life of all balance sheet positions. The EVE analysis calculates the net present value of the Company's assets and liabilities in rate shock environments that range from -400 basis points to +400 basis points. The likelihood of a significant decrease in rates as ofMarch 31, 2022 andDecember 31, 2021 was considered unlikely given the current interest rate environment and therefore, only the minus 100 basis point rate change was included in this analysis. The results are reflected in the following tables forMarch 31, 2022 andDecember 31, 2021 .
36
Economic Value of Equity
March 31, 2022
($ in thousands)
Change in rates $ Amount $ Change % Change
+400 basis points $ 287,682 $ 24,404 9.27 %
+300 basis points 284,476 21,198 8.05 %
+200 basis points 278,814 15,536 5.90 %
+100 basis points 272,118 8,840 3.36 %
Base Case 263,278 - -
-100 basis points 249,230 (14,048 ) -5.34 %
Economic Value of Equity
December 31, 2021
($ in thousands)
Change in rates $ Amount $ Change % Change
+400 basis points $ 278,254 $ 35,684 14.71 %
+300 basis points 273,190 30,620 12.62 %
+200 basis points 265,711 23,142 9.54 %
+100 basis points 256,110 13,540 5.58 %
Base Case 242,570 - -
-100 basis points 217,281 (25,289 ) -10.43 %
Off-Balance-Sheet Borrowing Arrangements:
Significant additional off-balance-sheet liquidity is available in the form of FHLB advances and unused federal funds lines from correspondent banks. Management expects the risk of changes in off-balance-sheet arrangements to
be immaterial to earnings. The Company's commercial real estate, first mortgage residential, agricultural and multi-family mortgage portfolios in the total amount of$669.8 million were pledged to meet FHLB collateralization requirements as ofMarch 31, 2022 . Based on the current collateralization requirements of the FHLB, the Company had approximately$108.9 million of additional borrowing capacity atMarch 31, 2022 . The Company also had$173.6 million in unpledged securities available to pledge for additional borrowings. The Company's contractual obligations as ofMarch 31, 2022 were comprised of long-term debt obligations, other debt obligations, operating lease obligations and other long-term liabilities. Long-term debt obligations were comprised of FHLB advances of$5.5 million , trust preferred securities of$10.3 million , and subordinated debt of$20.0 million , or$19.5 million , net of issuance costs. Total time deposits atMarch 31, 2022 were$148.6 million , of which$62.5 million mature beyond one year. In addition, as ofMarch 31, 2022 , the Company had commitments to sell mortgage loans totaling$16.2 million . The Company believes that it has adequate resources to fund commitments as they arise and that it can adjust the rate on savings certificates to retain deposits in changing interest rate environments. If the Company requires funds beyond its internal funding capabilities, advances from the FHLB ofCincinnati and other financial institutions are available.
ASSET LIABILITY MANAGEMENT Asset liability management involves developing, executing and monitoring strategies to maintain appropriate liquidity, maximize net interest income and minimize the impact that significant fluctuations in market interest rates would have on current and future earnings. The business of the Company and the composition of its balance sheet consist of investments in interest-earning assets (primarily loans, mortgage-backed securities, and securities available for sale) which are primarily funded by interest-bearing liabilities (deposits and borrowings). With the exception of specific loans which are originated and held for sale, all of the financial instruments of the Company are for other than trading purposes. All of the Company's transactions are denominated inU.S. dollars with no specific foreign exchange exposure. In addition, the Company has limited exposure to commodity prices related to agricultural loans. The impact of changes in foreign exchange rates and commodity prices on interest rates are assumed to be insignificant. The Company's financial instruments have varying levels of sensitivity to changes in market interest rates resulting in market risk. Interest rate risk is the Company's primary market risk exposure; to a lesser extent, liquidity risk also impacts market risk exposure. 37 Interest rate risk is the exposure of a banking institution's financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of interest rate risk could pose a significant threat to the Company's earnings and capital base. Accordingly, effective risk management that maintains interest rate risks at prudent levels is essential to the Company's safety
and soundness.
Evaluating a financial institution's exposure to changes in interest rates includes assessing both the adequacy of the management process used to control interest rate risk and the organization's quantitative level of exposure. When assessing the interest rate risk management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain interest rate risks at prudent levels of consistency and continuity. Evaluating the quantitative level of interest rate risk exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity and asset quality (when appropriate). TheFederal Reserve Board together with theOffice of the Comptroller of the Currency and theFederal Deposit Insurance Company adopted a Joint Agency Policy Statement on interest rate risk effectiveJune 26, 1996 . The policy statement provides guidance to examiners and bankers on sound practices for managing interest rate risk, which will form the basis for ongoing evaluation of the adequacy of interest rate risk management at supervised institutions. The policy statement also outlines fundamental elements of sound management that have been identified in priorFederal Reserve Board guidance and discusses the importance of these elements in the context of managing interest rate risk. Specifically, the guidance emphasizes the need for active board of director and senior management oversight and a comprehensive risk management process that effectively identifies, measures and controls interest rate risk. Financial institutions derive their income primarily from the excess of interest collected over interest paid. The rates of interest an institution earns on its assets and owes on its liabilities generally are established contractually for a period of time. Since market interest rates change over time, an institution is exposed to lower profit margins (or losses) if it cannot adapt to interest rate changes. For example, assume that an institution's assets carry intermediate or long-term fixed rates and that those assets are funded with short-term liabilities. If market interest rates rise by the time the short-term liabilities must be refinanced, the increase in the institution's interest expense on its liabilities may not be sufficiently offset if assets continue to earn at the long-term fixed rates. Accordingly, an institution's profits could decrease on existing assets because the institution will either have lower net interest income or possibly, net interest expense. Similar risks exist when assets are subject to contractual interest rate ceilings, or rate-sensitive assets are funded by longer-term, fixed-rate liabilities in a declining rate environment. There are several ways an institution can manage interest rate risk including: 1) matching repricing periods for new assets and liabilities, for example, by shortening or lengthening terms of new loans, investments, or liabilities; 2) selling existing assets or repaying certain liabilities; and 3) hedging existing assets, liabilities, or anticipated transactions. An institution might also invest in more complex financial instruments intended to hedge or otherwise change interest rate risk. Interest rate swaps, futures contracts, options on futures contracts, and other such derivative financial instruments can be used for this purpose. Because these instruments are sensitive to interest rate changes, they require management's expertise to be effective. The Company does not currently utilize any derivative financial instruments to manage interest rate risk. As market conditions warrant, the Company may implement various interest rate risk management strategies, including the use of derivative financial instruments. 38
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