| FIRST FINANCIAL SERVICE CORP In addition to the matters described under “Item 1A Risk Factors,” factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to: (i) the strength of the US economy in general and the strength of the local economies in the markets in which we operate; (ii) the effects of and changes in trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board; (iii) inflation, prevailing interest rates, market and monetary fluctuations; (iv) the timely development of and acceptance of new products and services and perceived overall value of these products and services by users; (v) changes in consumer spending, borrowing, and savings habits; (vi) technological changes; (vii) acquisitions; (viii) our ability to increase our market share and control expenses; (ix) the effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, and securities) with which we must comply; (x) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies as well as the Financial Accounting Standards Board, (xi) changes in our organization, compensation, and benefits plans; (xii) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; and (xiii) our success at managing these and other risks |
| Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date of the statement to reflect the occurrence of unanticipated events |
| Business First Financial Service Corporation was incorporated in August 1989 under the laws of the Commonwealth of Kentucky and became the holding company for First Federal Savings Bank of Elizabethtown, effective on June 1, 1990 |
| Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating the business activities of the Bank |
| Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries |
| In 2004 we amended our articles of incorporation to change our name from First Federal Financial Corporation of Kentucky to First Financial Service Corporation |
| We are headquartered in Elizabethtown, Kentucky |
| We were originally founded in 1923 as a state-chartered institution and became federally chartered in 1940 |
| In 1987, we converted to a federally chartered savings bank and converted from mutual to stock form |
| We are a member of the FHLB of Cincinnati and, since converting to a state charter in 2003, have been subject to regulation, examination and supervision by the Federal Deposit Insurance Corporation (“FDIC”) and Kentucky Office of Financial 2 ______________________________________________________________________ Institutions (“KOFI”) |
| Our deposits are insured by the Savings Association Insurance Fund (“SAIF”) and administered by the FDIC On January 8, 2003, we converted to a Kentucky chartered commercial bank from a federally chartered savings bank |
| In connection with the conversion, we changed to a fiscal year ending on December 31 |
| This report covers the year ended December 31, 2005 |
| General Business Overview We serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service |
| We offer a variety of financial services to our retail and commercial banking customers |
| These services include personal and corporate banking services and personal investment financial counseling services |
| Our full complement of lending services includes: · a broad array of residential mortgage products, both fixed and adjustable rate; · consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans; · specialized financing programs to support community development; · mortgages for multi-family real estate; · commercial real estate loans; · commercial loans to businesses, including revolving lines of credit and term loans; · real estate development; · construction lending; and · agricultural lending |
| We also provide a broad selection of deposit instruments |
| These include: · multiple checking and NOW accounts for both personal and business accounts; · various savings accounts, including those for minors; · money market accounts; · tax qualified deposit accounts such as Individual Retirement Accounts; and · a broad array of certificate of deposit products |
| We also support our customers by providing services such as: · functioning as a federal tax depository; · providing access to merchant bankcard services; · supplying various forms of electronic funds transfer; · providing debit cards and credit cards; and · providing telephone and Internet banking |
| Through our personal investment financial counseling services, we offer a wide variety of mutual funds, equity investments, and fixed and variable annuities |
| 3 ______________________________________________________________________ We invest in the wholesale capital markets through the management of our security portfolio and use various forms of wholesale funding |
| The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations |
| Our operations are also affected by non-interest income, such as service charges, insurance agency revenue, loan fees, gains and losses from the sale of mortgage loans and gains from the sale of real estate held for development |
| Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense and provisions for loan losses |
| Market Area Served We conduct operations in 14 full-service banking centers in six contiguous counties in Central Kentucky along the Interstate 65 corridor |
| Our markets range from the major metropolitan area of Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown |
| Our markets are supported by a diversified industry base and have a regional population of over 1 million |
| Louisville is the 16th largest city in the United States |
| Our core markets have experienced a compound annual growth rate of 5prca in deposits for the past four years |
| Management anticipates a similar growth rate of our markets for the next few years and believes it is well positioned to benefit from this continued growth |
| The counties we operate in include Hardin, Nelson, Hart, Bullitt, Meade and Jefferson |
| Excluding Jefferson County, we control in the aggregate over 22prca of the deposit market share with the next largest competitor controlling just 8prca of the market |
| Over the past four years, these counties have demonstrated an average growth rate in deposits of 5prca |
| According to the most recent census data, our core markets have experienced a population increase of 4prca, a 26prca increase in the median home price, and a growth in median family income of 22prca over the past four census reporting years |
| We expanded our presence into the Louisville market, primarily through our commercial lending operations |
| At December 31, 2005, over 21prca of our total loan portfolio resides in this market |
| In an effort to better serve these customers and to enhance our retail branch network in this market, we opened two new full-service state of the art retail facilities in the second quarter of 2004 |
| These facilities represent our state of the art prototype branch with a retail-focused design |
| This design features an internet cafe with access to online banking and bill payment services |
| Large plasma screens in the lobby provide customers with current news and information about bank products and services as well as upcoming community events |
| The facilities are staffed to offer a full range of financial services to the growing retail and commercial customer base |
| We have a combined dlra30 million in deposits in these two new facilities, representing a 71prca increase in deposits in this market during 2005 |
| Our current deposit market share in Louisville remains under 1prca of the current dlra13dtta7 billion deposit base |
| Based on our service-focused operating strategy, we believe we can increase our presence in Louisville, where six large out-of-state holding companies hold the largest deposit market shares |
| General and Operating Strategies Our operating strategy is to serve the needs and cater to the economic strengths of the local communities in which we operate and strive to provide a high level of personal and professional customer service |
| We offer a variety of financial services to our retail and commercial banking customers |
| Our growth strategy is focused on a combination of acquisitions and expansion in our existing markets through internal growth as well as establishing new branches |
| 4 ______________________________________________________________________ Branch Expansion |
| Management continues to consider markets for branch expansion |
| Because of the economic growth in our markets over the past several years, we may consider further branch expansion in our current or surrounding market areas |
| However, we do not rule out branch expansion in other areas experiencing economic growth |
| While no new banking centers were opened in Louisville during 2005, we continued to identify future branch sites |
| Negotiations continue on several locations, contingent upon successful rezoning efforts |
| Our expectation is to complete rezoning and begin construction on at least one facility in the first quarter of 2006 with an anticipated opening date in early 2007 |
| During 2005, we completed a major renovation of our Mt |
| Washington location in Bullitt County |
| We have also started construction on a new full service-banking center in Elizabethtown with plans of opening in early 2006 |
| We are also considering other possible locations within our core market area |
| Our goal is to protect and grow our 22prca market share as our core market is becoming increasingly competitive |
| Acquisitions |
| Management believes that the consolidation in the banking industries, along with the easing of restrictions on bank branching, as well as increased regulatory burdens, concerns about technology and marketing, are likely to lead owners of community banks and agencies within the Bank’s market areas to explore the possibility of sale or combination with a broader-based financial service companies such as ourselves |
| In addition, branching opportunities have arisen from time to time as a result of divestiture of branches by large national and regional bank holding companies of certain overlapping branches resulting from consolidations |
| Management’s strategy in assimilating acquisitions is to emphasize revenue growth as well as to continuously review the operations of the acquired entities and streamline operations where feasible |
| Management does not believe that implementing wholesale administrative cost reductions in acquired institutions, particularly reducing customer focused personnel, is beneficial to our long-term growth, because significant administrative changes in community banks can have an adverse impact on customer satisfaction in the acquired institution’s community |
| However, management has determined that certain human resource, and accounting functions can be consolidated immediately upon acquisition to achieve higher productivity levels without compromising customer service |
| Increases in revenue growth are emphasized by offering customers a broader product line consistent with full service banking |
| Management is very selective when evaluating a potential acquisition based upon factors such as the operating strategy, market, financial condition, and the culture of the acquisition candidate |
| The last acquisition we made was in July 1998 with the acquisition of three bank branches |
| Internal Growth |
| Management believes that its largest source of internal growth is through our ongoing solicitation program conducted by branch managers and lending officers, followed by referrals from customers |
| The primary reason for referrals is positive customer feedback regarding our customer service and response time |
| Our goal in continuing our expansion is to maintain a profitable, customer-focused financial institution |
| We believe that our existing structure, management, data and operational systems are sufficient to achieve further internal growth in asset size, revenues and capital without proportionate increases in operating costs |
| This growth should also allow us to increase the lending limits, thereby enabling us to increase our ability to serve the needs of existing and new customers |
| Our operating strategy has always been to provide high quality community banking services to our customers and increase market share through active solicitation of new business, repeat business and referrals from customers, and continuation of selected promotional strategies |
| 5 ______________________________________________________________________ We believe that our banking customers seek a banking relationship with a service-oriented community banking organization |
| Our operational systems have been designed to facilitate personalized service |
| Management believes our banking locations have an atmosphere that encourages personalized services and decision-making, while we are of sufficient financial size to offer broad product lines to meet customers’ needs |
| We also believe that economic expansion in our market areas will continue to contribute to internal growth |
| Through our primary emphasis on customer service and our management’s banking experience, we intend to continue internal growth by attracting customers and primarily focusing on the following: · Products Offered—We offer personal and corporate banking services, mortgage origination, mortgage servicing, personal investment, and financial counseling services as well as internet and telephone banking |
| We offer a full range of commercial banking services, checking accounts, ATM’s, checking accounts with interest, savings accounts, money market accounts, certificates of deposit, NOW accounts, Individual Retirement Accounts, brokerage and residential mortgage services, branch banking, and debit and credit cards |
| We also offer installment loans, including auto, recreational vehicle, and other secured and unsecured loans sourced directly by our branches |
| See “Lending Activities” below for a discussion of products we provide to commercial accounts |
| · Operational Efficiencies—We seek to maximize operational and support efficiencies consistent with maintaining high quality customer service |
| Where feasible, we share a common information system designed to enhance customer service and improve efficiencies by providing system-wide voice and data communication connections |
| We have consolidated loan processing, bank balancing, financial reporting, investment management, information systems, payroll and benefit management, loan review, and audits |
| · Marketing Activities—We focus on a proactive solicitation program for new business, as well as identifying and developing products and services that satisfy customer needs |
| We actively sponsor community events within our branch areas |
| We believe that active community involvement contributes to our long-term success |
| The largest portion of our lending activity is the origination of commercial loans that are primarily secured by real estate, including construction loans |
| These loans are generated primarily in our market area |
| In recent years, we have put greater emphasis on small business lending, originating loans for small and medium-sized businesses from our various locations |
| We make commercial loans to a variety of industries |
| Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less |
| At December 31, 2005, we had dlra353dtta6 million outstanding in commercial real estate loans |
| The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels |
| In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally |
| Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to dlra18dtta5 million of the loan portfolio at December 31, 2005 |
| These loans are included in the dlra353dtta6 million outstanding in commercial real estate loans discussed above |
| We generally do not lend above 75prca of the appraised values of multi-family residences on first mortgage loans |
| The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 25 years or less |
| 6 ______________________________________________________________________ Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction |
| The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, make it relatively difficult to evaluate accurately the total loan funds required to complete a project, and related loan-to-value ratios |
| The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending |
| At December 31, 2005 we had dlra13dtta6 million outstanding in construction loans |
| Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan |
| Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower’s equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower |
| Commercial Business Lending |
| The commercial business loan portfolio has grown in recent years as a result of our focus on small business lending |
| We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities |
| Commercial loans generally are made to small-to-medium size businesses located within our defined market area |
| Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans |
| Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel |
| Commercial business loans outstanding at December 31, 2005 totaled dlra36dtta0 million |
| Residential Real Estate |
| Residential mortgage loans are secured primarily by single-family homes |
| The majority of our mortgage loan portfolio is secured by real estate in Hardin, Nelson, Hart, Meade, and Bullitt counties |
| Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years |
| Interest rates are competitively priced within the primary geographic lending market, and vary according to the term for which they are fixed |
| At December 31, 2005 we had dlra142dtta7 million in residential mortgage loans outstanding |
| We generally emphasize the origination of adjustable-rate mortgage loans (“ARMs”) when possible |
| We offer six ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2prca annually, and a lifetime maximum adjustment cap of 6prca |
| As of December 31, 2005, approximately 43dtta7prca of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to five years and balloon loans of seven years or less |
| The origination of these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages |
| We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90prca of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90prca |
| Consumer Lending |
| Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit |
| These loans involve a higher risk of default than loans secured by one-to-four-family residential loans |
| We believe, however, that the shorter term and the normally higher interest rates available on various types of consumer loans help maintain a profitable spread between the average loan yield and cost of funds |
| Home equity lines of credit as of December 31, 2005, totaled dlra41dtta1 million |
| 7 ______________________________________________________________________ Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending |
| Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate |
| The Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans |
| Loans beyond individual authorities must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan |
| We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records |
| Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards |
| Adequate collateral is required on the majority of consumer loans |
| The Executive Loan Committee monitors and evaluates unsecured lending activity by each loan officer |
| The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area |
| Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things: borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly |
| To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates |
| All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision |
| Aggressive collection procedures encourage more timely recovery of late payments |
| At December 31, 2005, total loans under the indirect consumer loan program totaled dlra31dtta6 million |
| Subsidiary Activities First Service Corporation of Elizabethtown (“First Service”) acts as a broker for the purpose of selling investment services to our customers in the area of tax-deferred annuities, government securities, mutual funds, and stocks and bonds |
| First Service employs four full-time employees to perform these services |
| This investment function operates under licenses held by First Service |
| The net income of First Service was dlra11cmam000 for the year ended December 31, 2005 |
| First Heartland Mortgage Company of Elizabethtown (“First Heartland”), through which our secondary market lending department originates qualified VA, KHC, RHC and conventional secondary market loans on the behalf of the investors provides necessary liquidity to us and needed loan products to our customers |
| The net income of First Heartland Mortgage was dlra119cmam000 for the year ended December 31, 2005 |
| First Federal Office Park, LLC, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale |
| During the year ended December 31, 2005 lot sales resulted in a dlra143cmam000 gain |
| We are holding three lots for sale in this subsidiary, of the initial nine lots held for sale |
| We provide title insurance coverage for mortgage borrowers through two subsidiaries: First Heartland Title, LLC, and First Federal Title Services, LLC First Heartland Title is a joint venture with a local title insurance company and First Federal Title Services is a joint venture with a title insurance company in Louisville |
| We hold a 48prca interest in First Heartland Title and a 49prca interest in First Federal Title Services |
| The subsidiaries generated dlra157cmam000 in net income for the year ended December 31, 2005, of which our portion was dlra75cmam360 |
| 8 ______________________________________________________________________ Competition We face substantial competition both in attracting and retaining deposits and in lending |
| Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky, and less directly from money market mutual funds and from sellers of corporate and government debt securities |
| The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions |
| Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies |
| Retail establishments effectively compete for loans by offering credit cards and retail installment contracts for the purchase of goods and merchandise |
| We believe that we have been able to compete effectively in our primary market area |
| We have offices in nine cities in six central Kentucky counties |
| In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have |
| These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations |
| In addition, Kentucky’s interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us |
| We believe that competition from both bank and non-bank entities will continue to remain strong in the near future |
| The following table sets forth our market share and rank in terms of deposits in each Kentucky county where we have offices |
| We have two offices in Jefferson County, which is Louisville, Kentucky |
| The Louisville metropolitan area has a population of more than one million |
| County Number of Offices FFKY Market Share % FFKY Rank Hardin 4 21dtta0 1 Nelson 2 8dtta0 5 Hart 1 17dtta0 3 Bullitt 2 27dtta0 1 Meade 3 56dtta0 1 Jefferson 2 <1dtta0 N/M Employees As of December 31, 2005, we had 262 employees, of which 247 were full-time and 15 part-time |
| None of our employees are subject to a collective bargaining agreement, and we believe that we enjoy good relations with our personnel |
| On January 8, 2003, we converted from a federally chartered savings bank to a Kentucky chartered commercial bank |
| Before the conversion, we were subject to the regulation of the Office of Thrift Supervision |
| As a Kentucky chartered commercial bank, we are now subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KOFI Our deposits are insured by the FDIC Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky banking corporation to engage in any banking activity in which a national bank operating in any state, a state bank, 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 it first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity |
| 9 ______________________________________________________________________ In connection with the conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) |
| As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding its business operations and the business operations of its 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 and Change in Control |
| As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5prca of the voting stock of a bank, and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities |
| In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices |
| The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources |
| It also evaluates compliance by the holding company’s financial institution subsidiaries and the target institution with the Community Reinvestment Act |
| The Community Reinvestment Act generally requires each financial institution to take affirmative action to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods |
| 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 only 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 10prca or more of the voting stock of a bank holding company with a class of securities registered under the Securities Exchange Act of 1934 would constitute an acquisition of control of the bank holding company |
| In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25prca (5prca 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 |
| The Gramm-Leach-Bliley Act |
| The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”), signed into law on November 12, 1999, amended a number of Federal banking laws that affect the Corporation and First Federal |
| The provisions of the GLB Act believed to be of most significance to us are discussed below |
| In particular, the GLB Act permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature |
| ” To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating |
| Other Holding Company Regulations |
| Federal law substantially restricts transactions between financial institutions and their affiliates |
| As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower |
| Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable 10 ______________________________________________________________________ transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies |
| 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 |
| Capital Requirements |
| The Federal Reserve Board and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise |
| Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8prca |
| At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”) |
| The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”) |
| To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10prca and a Tier 1 risk-weighted ratio of 6prca or greater |
| The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized |
| ” FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed |
| Failure to meet capital requirements can also cause an institution to be directed to raise additional capital |
| FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards |
| In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy |
| The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy |
| The agencies also jointly adopted a regulation, effective January 1, 2002, amending their regulatory capital standards to change the treatment of certain recourse obligations, direct credit subsidies, residual interest and other positions in securitized transactions that expose banking organizations to credit risk |
| The regulation amends the agencies’ regulatory capital standards to align more closely the risk-based capital treatment of recourse obligations and direct credit subsidies, to vary the capital requirements for positions in securitized transactions (and certain other credit exposures) according to their relative risk, and to require capital commensurate with the risks associated with residual interests |
| 11 ______________________________________________________________________ In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver |
| Our deposits are insured by the FDIC up to the statutory maximum limit of dlra100cmam000 per depositor through the Savings Association Insurance Fund |
| For this protection, we must pay semiannual assessments to the FDIC The assessment rate for an insured depository institution depends on the assessment risk classification assigned to the institution by the FDIC, which will be determined by the institution’s capital level and supervisory evaluations |
| The Corporation is a legal entity separate and distinct from the Bank |
| The majority of our revenue is from dividends paid to it by the Bank |
| The Bank is subject to laws and regulations that limit the amount of dividends they 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 and desist from 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 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 |
| Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits |
| Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10prca of the net profits of the bank for the period until the bank’s capital surplus equals the amount of its stated capital attributable to its common stock |
| Moreover, the KOFI Commissioner 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 |
| 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 if becoming unable to pay debts as they come due |
| Consumer Protection Laws |
| We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population |
| These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts |
| Federal law currently contains extensive customer privacy protections 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 |
| 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 12 ______________________________________________________________________ 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 branch office or to relocate an office |
| The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in connection with an application to acquire a bank or other bank holding company, and such records may be the basis for denying the application |
| 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, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering, and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations |
| 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 |
| Available Information We file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports with the Securities and Exchange Commission |
| These reports are available at the SEC’s website at http://www |
| The reports are also available on our website at http://www |
| You may obtain electronic or paper copies of our reports free of charge by contacting Rebecca Bowling, Corporate Secretary-Treasurer, First Federal Savings Bank, 2323 Ring Road, Elizabethtown, Kentucky 42701 (telephone) 270-765-2131 |
| 13 ______________________________________________________________________ Item 1A Risk Factors We, like other financial companies, are subject to a number of risks, many of which are outside of management’s control, though we strive to manage those risks while optimizing returns |
| These risks include: (a) credit risk, which is the risk that loan and lease customers or other counterparties will be unable to perform their contractual obligations, (b) market risk, which is the risk that changes in market rates and prices will adversely affect our financial condition or results of operation, (c) liquidity risk, which is the risk that we will have insufficient cash or access to cash to meet our operating needs, and (d) operational risk, which is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events |
| In addition to the other information included readers should consider that the following important factors, among others, could materially impact our business, future results of operations, and future cash flows |
| (a) Credit Risk We extend credit to a variety of customers based on internally set standards and the judgment of management |
| We manage the credit risk it takes through a program of underwriting standards that we follow, the review of certain credit decisions, and an on-going process of assessment of the quality of the credit we have already extended |
| If our credit standards and our on-going process of credit assessment do not function as intended, we could incur significant credit losses |
| Adverse economic conditions in that region, in particular, could harm our results from operations, cash flows, and financial condition |
| Adverse economic conditions and other factors, such as political or business development or natural hazards that may affect Kentucky, may reduce demand for credit or fee-based products and could negatively affect real estate and other collateral values, interest rate levels, and the availability of credit to refinance loans at or before maturity |
| (b) Market Risk 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 and international economic and political conditions |
| Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates |
| If our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, as a result of decreasing interest rates, 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 would be subject to repricing before assets become subject to repricing |
| 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 interests 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 |
| 14 ______________________________________________________________________ (c) Liquidity Risk If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation to fund corporate expansion or other activities |
| Liquidity policies and limits are established by the board of directors, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits, the percentage of assets funded with non-core or wholesale funding |
| ALCO regularly monitors the overall liquidity position of the Bank and holding company to ensure that various alternative strategies exist to cover 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 don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers |
| The ALCO establishes 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, non-core brokered deposits, and medium and long-term debt, which includes 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 the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions |
| If we were unable to access any of these funding sources when needed, we might be unable 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 |
| For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations |
| (d) Operational Risk We have significant competition in both attracting and retaining deposits and in originating loans |
| Competition is intense in most of the markets we serve |
| We compete on price and service with other banks and financial companies such as savings and loans, credit unions, finance companies, mortgage banking companies, and brokerage firms |
| Competition could intensify in the future as a result of industry consolidation, the increasing availability of products and services from non-banks, greater technological developments in the industry, and banking reform |
| If our competition prices deposits or loans at rates significantly more favorable than ours, then we may have difficulty in both attracting and retaining deposits and loans |
| Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions |
| However, there can be no assurance that we will 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 operation 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 |
| 15 ______________________________________________________________________ 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 |
| From time to time, we experience loss from operational risk, including the effects of operational errors, and these losses may be substantial |
| While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer such losses in the future |
| New, or changes in existing tax, accounting, are regulatory laws, regulations, rules, standards, policies, and interpretations could significantly impact strategic initiatives, results of operations, cash flows, and financial condition |
| The financial services industry is extensively regulated |
| Federal and state banking regulations are designed primarily to protect deposit insurance funds and consumers, not to benefit a financial company’s shareholders |
| These regulations may sometimes impose significant limitations on operations |
| The significant federal and state banking regulations that affect us are described in this report under the heading “Regulation” |
| These regulations, along with currently existing tax, accounting, and monetary laws, regulations, rules, standards, policies and interpretations control the methods by which financial institutions conduct business, implement strategic initiatives and tax compliance, and govern financial reporting and disclosures |
| These laws, regulations, rules, standards, policies, and interpretations are constantly evolving and may change significantly over time |
| Events that may not have a direct impact on us, such as the bankruptcy of US companies, can cause legislators, regulators, and authoritative bodies, such as the Financial Accounting Standards Board, the Securities and Exchange Commission, the Public Company Accounting Oversight Board, and other 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 |