SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
Or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
For the transition period from_____________________ to ___________________
Commission file number 0-13222
CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2265045
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
15 South Main Street, Mansfield, Pennsylvania 16933
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (570) 662-2121
Indicate by checkmark whether the registrant (1) has filed all reports
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes__X___ No_____
The number of shares outstanding of the Registrant's Common Stock, as of
August 1, 2002, 2,826,908 shares of Common Stock, par value $1.00.
Citizens Financial Services, Inc.
Form 10-Q
INDEX
Page
Part I FINANCIAL INFORMATION (UNAUDITED)
Item 1-Financial Statements
Consolidated Balance Sheet as of June 30, 2002, and
December 31, 2001 1
Consolidated Statement of Income for the
Three Months and Six Months Ended June 30, 2002 and 2001 2
Consolidated Statement of Comprehensive Income for the
Three Months and Six Months Ended June 30, 2002 and 2001 3
Consolidated Statement of Cash Flows for the Six Months Ended
June 30, 2002 and 2001 4
Notes to Consolidated Financial Statements 5-6
Item 2-Management's Discussion and Analysis of Financial Condition
and Results of Operations 7-19
Item 3-Quantitative and Qualitative Disclosure About Market Risk 20
Part II OTHER INFORMATION
Item 1-Legal Proceedings 21
Item 2-Changes in Securities and Use of Proceeds 21
Item 3-Defaults upon Senior Securities 21
Item 4-Submission of Matters to a Vote of Security Holders 21
Item 5-Other Information 21
Item 6-Exhibits and Reports on Form 8-K 22
SIGNATURES 23
The accompanying notes are an integral part of these unaudited financial statements
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 - Basis of Presentation
Citizens Financial Service, Inc., (individually and collectively, the "Company") is a Pennsylvania corporation organized as the holding company of its wholly owned subsidiary, First Citizens National Bank (the "Bank"), and its subsidiary, First Citizens Insurance Agency, Inc. Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary's financial conditions and results of operations. All material inter-company balances and transactions have been eliminated in consolidation.
The accompanying interim financial statements have been prepared by the Company without audit and, in the opinion of management, reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the Company's financial position as of June 30, 2002, and the results of operations for the interim periods presented. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. For further information refer to the consolidated financial statements and footnotes thereto incorporated by reference in the Company's Annual Report on Form 10-K for the year ended December 31, 2001.
Note 2 - Earnings per Share
Earnings per share calculations give retroactive effect to stock dividends declared by the Company. The number of shares used in the earnings per share and dividends per share calculation was 2,799,420 for 2002 and 2001.
Note 3 - Income Tax Expense
Income tax expense is less than the amount calculated using the statutory tax rate, primarily the result of tax-exempt income earned from state and municipal securities and loans and investment in tax credits.
Note 4 - Recent Accounting Pronouncements
In April 2002, the FASB issued FAS No. 145, "Rescission of FASB Statement No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections". FAS No. 145 rescinds FAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. As a result, the criteria in Opinion 30 will now be used to classify those gains and losses. This statement also amends FAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This statement also makes technical corrections to existing pronouncements, which are not substantive but in some cases may change accounting practice. FAS No. 145 is effective for transactions occurring after May 15, 2002. The adoption of FAS No. 145 did not have a material effect on the Company's financial position or results of operations.
In January 2002, the Company adopted FAS No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. The statement changes the accounting for goodwill from an amortization method to an impairment-only approach. Thus, amortization of goodwill, including goodwill recorded in past business combinations, will cease upon adoption of this statement. However, this new statement did not amend FAS 72, Accounting forCertain Acquisitions of Banking or Thrift Institutions, which requires recognition and amortization of unidentified intangible assets relating to the acquisition of financial institutions or branches thereof. The FASB has undertaken a limited scope project to reconsider the provisions of FAS 72 in 2002 and has issued an exposure draft of a proposed statement,Acquisitions of Certain Financial Institutions, that would remove acquisitions of financial institutions from the scope of FAS No. 72. The adoption of this proposed statement would require all goodwill originating from acquisitions that meet the definition of a business combination as defined in Emerging Issues Task Force Issue ("EITF") No. 98-3 to be discontinued. At June 30, 2002 the Company's Consolidated Balance Sheet reflected total goodwill assets of $6.6 million from acquisitions currently accounted for under FAS No. 72. The Company has determined that such assets meet the requirements of a business combination in EITF No. 98-3. The adoption of this proposed statement and retroactive application would subject such assets to the non-amortization provisions of FAS No. 142 and would result in an increase in net income of $169,000, or $.06 per share, for the first half of 2002.
Item 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of Citizens Financial Services, Inc., First Citizens National Bank, First Citizens Insurance Agency, Inc. or the combined company. When we use such words as "believes," "expects," "anticipates," or similar expressions, we are making forward-looking statements. For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
The following is management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Citizens Financial Service, Inc., a bank holding company and its subsidiary (the Company). Our Company's consolidated financial condition and results of operations consist almost entirely of our wholly owned subsidiary's (First Citizens National Bank) financial conditions and results of operations. Management's discussion and analysis should be read in conjunction with the preceding June 30, 2002 financial information. The results of operations for the six months ended June 30, 2002 and 2001 are not necessarily indicative of the results you may expect for the full year.
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. Our lending and deposit products and investment services are offered primarily within the vicinity of our service area.
Risk identification and management are essential elements for the successful management of the Company. In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, and liquidity risk.
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates. Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company. The Company uses its asset/liability management policy to control and manage interest rate risk.
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms. Credit risk results from loans with customers and purchasing of securities. The Company's primary credit risk is in the loan portfolio. The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses. Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors. The Company has established guidelines within its asset/liability policy to manage liquidity risk. These guidelines include contingent funding alternatives.
Readers should carefully review the risk factors described in other documents our Company files, from time to time, with the Securities and Exchange Commission, including the Annual Report on Form 10-K for the year ended December 31, 2001, filed by our Company and any Current Reports on Form 8-K filed by our Company.
We face strong competition in the communities we serve from other commercial banks, savings banks, and savings and loan associations, some of which are substantially larger institutions than our subsidiary. In addition, insurance companies, investment-counseling firms, and other business firms and individuals offer personal and corporate trust services. We also compete with credit unions, issuers of money market funds, securities brokerage firms, consumer finance companies, mortgage brokers and insurance companies. These entities are strong competitors for virtually all types of financial services.
In recent years, the financial services industry has experienced tremendous change to competitive barriers between bank and non-bank institutions. We not only must compete with traditional financial institutions, but also with other business corporations that have begun to deliver competing financial services. Competition for banking services is based on price, nature of product, quality of service, and in the case of certain activities, convenience of location.
TRUST AND INVESTMENT SERVICES
Our Trust Department services range from professional estate settlement services through management of complex trust accounts to investment management and custody of securities. Our expanded Employee Benefits Department manages retirement accounts for many area companies and individuals. We also manage many individual IRAs, both rollover and contributory.
The Trust Department offers full service brokerage services in selected locations throughout the Bank's market area and appointments can be made in any First Citizens National Bank branch.
Effective October 2001, the Bank began offering annuities and life insurance through our new insurance subsidiary, First Citizens Insurance Agency, Inc. We plan on adding long term care insurance and other consumer insurance products in 2002.
Total assets (shown in the Consolidated Balance Sheet) have grown 2.3% since year-end 2001 to $430.6 million. Total loans increased 5.0% to $281.8 million and investment securities decreased 6.8% to $105.8 million since year-end 2001. Total deposits increased 1.9% to $377.5 million since year-end 2001. Explanations of variances will be described with in the following appropriate sections.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents totaled $16,146,000 at June 30, 2002 compared to $11,480,000 on December 31, 2001. Noninterest-bearing cash decreased $1,064,000 since year-end 2001, while interest-bearing cash increased $5,730,000 during that same period.
We believe the liquidity needs of the Company, are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, and the portion of the investment and loan portfolios that mature within one year. These sources of funds will enable the Company to meet cash obligations and off-balance sheet commitments as they come due.
INVESTMENTS
Our investment portfolio decreased by $7,765,000 or 6.8% from December 31, 2001 to June 30, 2002. Our investment portfolio has decreased primarily as result of mortgage-backed securities monthly principal payments, allowing excess funds to fund loan growth. During the first six months, we sold approximately $3,251,000 of Municipal Bonds along with $1,023,000 of Corporate Bonds and $5,751,000 of U.S. Government Agency Mortgage-backed securities. Proceeds from the fore mentioned sales were re-invested into Agency Mortgage-backed securities, Corporate Bonds and Agencies.
Management monitors the earnings performance and the effectiveness of the liquidity of the investment portfolio on a regular basis. Through active balance sheet management and analysis of the securities portfolio, the Company maintains sufficient liquidity to satisfy depositor requirements and various credit needs of its customers.
LOANS
The Company's loan demand increased during the first six months of 2002. We anticipate loan demand will continue during the remainder of 2002 as a result of continued re-financings that will be taking place due to the current lower interest rate environment and our continued efforts to grow the new offices that we acquired in 2000. The Company's lending is focused in the north central Pennsylvania market and the southern tier of New York. The composition of our loan portfolio consists principally of retail lending, which includes single-family residential mortgages and other consumer lending, and commercial lending primarily to locally owned small businesses. New loans are generated primarily from direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.
As shown in the following tables (dollars in thousands), the change in net loans increased by $13,302,000 or 5.0% for the period compared to the December 31, 2001. Residential mortgage lending is a principal business activity and one our Company expects to continue by providing a full complement of competitively priced conforming, nonconforming and home equity mortgages.
During the current period Residential loans increased 5.0% or $8,213,000 when compared to December 31, 2001. The result of this increase is primarily due to our home equity loan promotion during the first six months of 2002 in an effort to grow loans, especially in the new offices. During the current period State & political subdivision loans increased 21.5% or $4,939,000 when compared to December 31, 2001. The result of this increase is primarily due to our increased effort to grow our commercial loan portfolio.
The reduction of interest rates during 2001, continue to have a positive impact on loan originations through the second quarter of 2002. We expect that loan growth will continue for the rest of the year.
Our focus on commercial lending continues to be expanded over the past several years with the establishment of a core group of commercial lenders to handle a higher volume of small business loans.
ALLOWANCE FOR LOAN LOSSES
As shown in the following table (dollars in thousands), the Allowance for Loan Losses as a percentage of loans remained stable at 1.20%, at December 31, 2001 and June 30, 2002. The dollar amount of the reserve increased $159,000, since year-end 2001. The increase is a result of the provision of $210,000 expensed during the first six months less net charge-offs. Gross charge-offs for the first six months of 2002 were $69,000, while recoveries were $18,000.
The adequacy of the allowance for loan losses is subject to a formal analysis by management of the Company. Management deems the allowance to be adequate to absorb probable losses in the portfolio, as of June 30, 2002. The Company has disclosed in its annual report on Form 10-K the process and methodology supporting the loan loss provision.
DEPOSITS
Traditional deposits continue to be the most significant source of funds for the Company. As shown in the following tables (dollars in thousands), deposits increased $6,994,000 or 1.9%, since December 31, 2001. Non-interest-bearing deposits increased $3,112,000 along with a $3,858,000 increase in savings deposits, at June 30, 2002.
BORROWED FUNDS
Borrowed funds increased $561,000 during the first six months of 2002. The Company's daily cash requirements or short-term investments are met by using the financial instruments available through the Federal Home Loan Bank.
In November 2000, the holding company borrowed $2,000,000 to invest in the bank subsidiary. This increased the Bank's capital and improved the negative impact on the regulatory capital ratios as a result of the branches acquired in 2000 (approximately $9.7 million in intangibles).
STOCKHOLDERS' EQUITY
We evaluate stockholders' equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the more likely a corporation is to meet its cash obligations and absorb unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.
Total Stockholders' Equity was $35,713,000, at June 30, 2002 compared to $33,389,000, at December 31, 2001, an increase of $2,324,000 or 7.0%. In the first six months, the Company earned $2,606,000 and paid dividends of $938,000, a dividend payout ratio of 36.0% of net income.
All of the Company's investment securities are classified as available-for-sale making this portion of the Company's balance sheet sensitive to the changing market value of investments. Short-term interest rates in the first six months of 2002 have remained consistent with a slight decline in longer-term rates since the end of 2001. This situation has caused an increase in the accumulated other comprehensive income which is included in stockholders' equity of $656,000 since December 31, 2001.
On July 30, 1999, our Company began a plan to purchase, in open market or privately negotiated transactions, up to 135,000 shares of its outstanding common stock. This stock repurchase program was suspended, in April 2000, because of the acquisition. However, a total of 55,162 shares were repurchased at a cost of approximately $1 million as of June 30, 2002.
The Company has also complied with standards of capital adequacy mandated by the banking regulators. The Company's primary regulators have established "risk-based" capital requirements designed to measure capital adequacy. Risk-based capital ratios reflect the relative risks associated with various assets, entities hold in their portfolios. A weight category of 0% (lowest risk assets), 20%, 50%, or 100% (highest risk assets), is assigned to each asset on the balance sheet. The Company's computed risk-based capital ratios are as follows (dollars in thousands):
On April 4, 2001, our Company filed a Registration Statement on Form S-3 establishing a Dividend Re-Investment Plan (DRIP), which was effective for the second quarter dividend in 2001. As of June 30, 2002 we have 297 shareholders participating representing 241,523 shares and the total number of shares purchased is 5,954.
RESULTS OF OPERATIONS
OVERVIEW OF THE INCOME STATEMENT
The Company had net income of $1,331,000 and $2,606,000 for the second quarter and first six months of 2002, respectively. Earnings per share, for the respective periods were $0.48 and $0.93. Net income was $1,037,000 and $1,828,000 for the second quarter and first six months of 2001, which equates to earnings per share of $0.37 and $0.65, respectively. The return on average assets and the return on average equity, for the six months of 2002, were 1.24% and 15.79%. Details of the reasons for this change are discussed on the following pages.
Operating cash earnings (net income before amortization of intangible assets, net of tax) was $1,491,000 and $2,934,000 for the second quarter and first six months of 2002, respectively, an increase of $287,000 and $771,000, from the $1,204,000 and $2,163,000 for the 2001 related period. Operating cash earnings per share was $0.53 and $1.05, during the second quarter and first six months of 2002, compared with $0.43 and $0.77, during the comparable 2001 period.
NET INTEREST INCOME
Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on interest-bearing liabilities.
Net interest income, after provision for loan losses, totaled $4,103,000 in the second quarter, an increase of $652,000 or 18.9%, over the second quarter of 2001 and totaled $8,127,000 for the six months of 2002, an increase of $1,402,000 or 20.9% over the prior year. The Bank experienced an increase in earning assets in the past six months of 1.4%, which came primarily from our continued efforts to grow the new offices.
The following table sets forth the average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders' equity, the related rates, net interest income and rate "spread" created:
We continue to experience an increasing interest margin percentage during the first six months of 2002, compared to the narrowing margin that we have experienced in the last few years. When the flat yield curve became inverted in 2000, interest rates began to rise resulting in our higher volume of short-term liabilities re-pricing faster than our short-term assets. Currently the yield curve is extremely steep beyond 3 months. Most of the Company's investments, loans, deposits and borrowings are priced or re-priced along the three month to five-year portion of the yield curve and a more normal yield curve should enable us to maintain our current favorable net interest margin. We continue to review various pricing and investment strategies to enhance deposit growth while maintaining or expanding the current interest margin.
The following table shows the effect of changes in volume and rate on interest income and expense. Tax-exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory federal income tax rate of 34%, for the six month period ended June 30 (dollars in thousands):
As can be seen from the preceding tables, tax equivalent net interest income rose from $6,404,000, in 2000, to $7,500,000, in 2001, and increased to $8,859,000, in 2002. In the period ending June 30, 2002, net interest income increased $1,359,000, while overall spread increased from 3.59% to 4.24%. The increased volume of interest-earning assets generated an increase in interest income of $258,000 while increased volume of interest-bearing liabilities produced $7,000 of interest expense. The change in volume resulted in an increase of $251,000 in net interest income. The net change in rate was a positive $1,108,000, resulting in a total positive net change of $1,359,000, when combined with change in volume. The yield on interest-earning assets declined 68 basis points to 7.35% and the average interest rate on interest-bearing liabilities decreased 133 basis points, from 4.44% to 3.11%, because of the previously described changes to the yield curve.
The Company recorded a provision for loan losses in the second quarter of $90,000 compared to the second quarter of 2001 at $120,000 and $210,000 for the six months of 2002 compared to $195,000 in 2001.
This provision was appropriate given management's quarterly review of the allowance for loan losses that is based on the following information: migration analysis of delinquent and non-accrual loans, estimated future losses on loans, recent review of large problem credits, local and national economic conditions, historical loss experience, regulatory qualitative adjustments and peer comparisons.
NON-INTEREST INCOME
Non-interest income, as detailed below, increased $119,000 or 9.7% and $499,000 or 24.1% in the second quarter and the first six months of 2002,respectively, when compared to the same periods in 2001. Service charge income continues to be the primary source of growth in other operating income. For the first six months, account service charges totaled $1,512,000 up $374,000 or 32.9% over last year. These increases in fee income were mainly the result of the checking account acquisition strategy we put into place in the latter half of 2001. Other income increased $290,000 for the first six months of 2002, when compared to the same period in 2001. This increase is due to $99,000 from our insurance agency along with a $58,000 increase in Master card/Visa and loan insurance commissions, a $48,000 insurance claim on one of our corporate buildings and $83,000 related to loans sold on the secondary market.
The following table shows the breakdown of other operating income for the three months ended June 30, 2002 and 2001(dollars in thousands):
The following table shows the breakdown of other operating income for the six months ended June 30, 2002 and 2001(dollars in thousands):
In an effort to accelerate the improvement of our capital ratios and take advantage of current market conditions, we elected to sell and reinvest approximately $10,646,000 of investment securities in the first six months of 2002, which resulted in $216,000 of security gains.
We continue to evaluate means of increasing non-interest income. Our approach is to apply service charges on business transaction accounts by charging fees on transaction activity (reduced by earnings credit based on customers' balances) to more equitably recover costs. We expect to continue this analysis for our other products.
NON-INTEREST EXPENSES
Total non-interest expense, as detailed below, increased $305,000 or 8.9% during the second quarter of 2002 and $708,000 or 10.7% in the first six months of 2002 when compared to the same period in 2001. The increase in salaries and employee benefits is a result of the filling of some corporate positions related to the growth strategies that we have implemented, along with annual salary increases and adjustments. The increase in other expense is primarily the result of increased foreclosure expense of $55,000 and abnormally high operational charge-offs of $39,000 associated with fraud scams that hit our market place.
The following tables reflect the breakdown of other operating expense and professional fees for the three months ended June 30, 2002 and 2001(dollars in thousands):
The following tables reflect the breakdown of other operating expense and professional fees for the six months ended June 30, 2002 and 2001(dollars in thousands):
The professional fees increase in 2002 reflects management's efforts to implement strategic income initiatives where we share a portion of the revenue over a stated time period as a result of the account acquisition strategy.
PROVISION FOR INCOME TAXES
The provision for income taxes was $391,000 for the second quarter of 2002 compared to $219,000 in the second quarter of 2001. For the six-month period comparisons, the provision for income taxes was $772,000 in 2002 and $357,000 in 2001. The increase was primarily a result of increased levels of taxable income.
We have entered into two limited partnership agreements to establish low-income housing projects in our market area. As a result of these agreements for tax purposes, we have recognized $123,000 out of a total $911,000 from one project and expect to begin recognition of an additional $385,000 over ten years on the second project, which was completed in November 2001. A total of approximately $1,290,000 of tax credits is anticipated over a ten-year period.
LIQUIDITY
Liquidity is a measure of our Company's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders. Liquidity is needed to meet depositors' withdrawal demands, extend credit to meet borrowers' needs, provide funds for normal operating expenses and cash dividends, and fund other capital expenditures.
Our Company's historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities.
Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements our Company's availability of funds.
Our Company's use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is presented. Other significant uses of funds include capital expenditures. Surplus funds are then invested in investment securities.
Capital expenditures during the first six months of 2002 were $362,000, $975,000 less than the same period in 2001. The large decrease is primarily the result of the building projects completed during 2001 (described below):
Major capital expenditures for 2002 were:
Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital.
CREDIT QUALITY RISK
The following table identifies amounts of loan losses and non-performing loans. Past due loans are those that were contractually past due 90 days or more as to interest or principal payments (dollars in thousands).
Interest does not accrue on non-accrual loans. Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.
INTEREST RATE AND MARKET RISK MANAGEMENT
The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.
Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since our Company has no trading portfolio, it is not subject to trading risk.
Currently, our Company has equity securities that represent only 4.7% of our investment portfolio and, therefore, equity risk is not significant.
The primary components of interest-sensitive assets include adjustable-rate loans and investments, loan repayments, investment maturities and money market investments. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor accounts which are paid current market interest rates).
Gap analysis, one of the methods used by us to analyze interest rate risk, does not necessarily show the precise impact of specific interest rate movements on our Company's net interest income because the re-pricing of certain assets and liabilities is discretionary and is subject to competitive and other pressures. In addition, assets and liabilities within the same period may, in fact, be repaid at different times and at different rate levels. We have not experienced the kind of earnings volatility that might be indicated from gap analysis.
Our Company currently uses a computer simulation model to better measure the impact of interest rate changes on net interest income. We use the model as part of our risk management process that will effectively identify, measure, and monitor our Company's risk exposure.
We use numerous interest rate simulations employing a variety of assumptions to evaluate our interest rate risk exposure. A shock analysis at June 30, 2002, indicated that a 200 basis point movement in interest rates in either direction would have a minor impact on our Company's anticipated net interest income over the next twenty-four months.
GENERAL
The majority of assets and liabilities of a financial institution are monetary in nature and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. However, inflation does have an important impact on the growth of total assets and on non-interest expenses, which tend to rise during periods of general inflation.
Various congressional bills have been passed and other proposals have been made for significant changes to the banking system, including provisions for: limitation on deposit insurance coverage; changing the timing and method financial institutions use to pay for deposit insurance; and tightening the regulation of bank derivatives' activities.
Aside from those matters described above, we do not believe that there are any trends, events or uncertainties, which would have a material adverse impact on future operating results, liquidity or capital resources. We are not aware of any current recommendations by the regulatory authorities (except as described herein) which, if they were to be implemented, would have such an effect, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on our Company's results of operations.
In the normal course of conducting business activities, the Company is exposed to market risk, principally interest rate risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments and was discussed previously in this Form 10-Q. Management and a committee of the board of directors manage interest rate risk.
No material changes in market risk strategy occurred during the current period. A detailed discussion of market risk is provided in the SEC Form 10-K for the period ended December 31, 2001.
PART II - OTHER INFORMATION AND SIGNATURES
Item 1 - Legal Proceedings
Management is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Company. Any pending proceedings are ordinary, routine litigation incidental to the business of the Company and its subsidiary. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Company and its subsidiary by government authorities.
Item 2 - Changes in Securities and use of Proceeds - Note applicable.
Item 3 - Defaults Upon Senior Securities - Not applicable.
Item 4 - Submission of Matters to a Vote of Security Holders
Item 5 - Other Information - None.
Item 6 -Exhibits and Reports on Form 8-K.
(a) Exhibits.
(3)(ii)- By-laws of the Corporation, as amended. (Incorporated by Reference to Exhibit (3)(ii) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1995, as filed with the Commission on March 26, 1996.)
(10) - Material Contracts. Employment Agreement between our Company and Richard E. Wilber. (Incorporated by Reference to Exhibit (10) to the Annual Report of Form 10-K for the fiscal year ended December 31, 1998, as filed with the Commission on March 17, 1998.)
(99.1) - Independent accountant's review of financial statements for the period ended June 30, 2002.
(99.2) - Certfication of Principal Executive Officer
(99.3) - Certification of Chief Financial Officer
(b) Reports on Form 8-K - Earnings release entitled "Financial Results for the First Quarter 2002" filed July 18, 2002.
Pursuant to the requirements of the Securities Exchange Act of 1934, the undersigned Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.
(Registrant)
August 8, 2002 /s/ Richard E. Wilber
By: Richard E. Wilber
President
(Principal Executive Officer)
August 8, 2002 /s/ Randall E Black
By: Randall E. Black
Assistant Treasurer
(Principal Financial Officer &
Principal Accounting Officer)
EXHIBITS INDEX
(99.2) - Certification of Principal Executive Officer