Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

Form 10-K

Annual Report Pursuant to Section 13
or 15(d) of the Securities Exchange Act of 1934

 

For the Fiscal Year Ended		Commission File Number
December 31, 2016		1-13661

 

STOCK YARDS BANCORP, INC.     

1040 East Main Street
Louisville, Kentucky 40206
(502) 582-2571

Incorporated in Kentucky

I.R.S. No. 61-1137529

 

Securities registered pursuant to Section 12(b) of the Act: 

Title of each class:		Name of each exchange on which registered:
Common Stock, no par value		NASDAQ

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act). Yes ☐          No ☑

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐          No ☑

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑          No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).           Yes ☑          No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Large accelerated filer	☐	Accelerated filer	☑
Non-accelerated filer (Do not check if a smaller reporting company)	☐	Smaller reporting company	☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐          No ☑

 

The aggregate market value of registrant’s voting stock (Common Stock, no par value) held by non-affiliates of the registrant as of June 30, 2016 (the last business day of the registrant’s most recently completed second fiscal quarter) was $577,350,743 .

 

The number of shares of the registrant’s Common Stock, no par value, outstanding as of February 24, 2017, was 22,641,525.

 

Documents Incorporated By Reference

 

Portions of Registrant’s definitive proxy statement related to Registrant’s Annual Meeting of Shareholders to be held on April 27, 2017 (the “Proxy Statement”), to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Form 10-K.

 

  

STOCK YARDS BANCORP, INC.
Form 10-K
Index

 

Part I:
Item 1.	Business	4
Item 1A.	Risk Factors	7
Item 1B.	Unresolved Staff Comments	11
Item 2.	Properties	11
Item 3.	Legal Proceedings	11
Item 4.	Mine Safety Disclosures	11
Part II:
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	13
Item 6.	Selected Financial Data	15
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	46
Item 8.	Financial Statements and Supplementary Data	46
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	97
Item 9A.	Controls and Procedures	97
Item 9B.	Other Information	100
Part III:
Item 10.	Directors, Executive Officers and Corporate Governance	100
Item 11.	Executive Compensation	100
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	100
Item 13.	Certain Relationships and Related Transactions, and Director Independence	101
Item 14.	Principal Accounting Fees and Services	101
Part IV:
Item 15.	Exhibits and Financial Statement Schedules	101
Signatures		105
Index to Exhibits		106

 

 

Glossary of Acronyms and Terms

 

The following listing provides a comprehensive reference of common acronyms and terms used throughout the document:

 

ASU	Accounting Standards Update
Bancorp	Stock Yards Bancorp, Inc.
Bank	Stock Yards Bank & Trust Company
BOLI	Bank Owned Life Insurance
BP	Basis Point = 1/100th of one percent
COSO	Committee of Sponsoring Organizations
CRA	Community Reinvestment Act of 1977
Dodd-Frank Act	Dodd-Frank Wall Street Reform and Consumer Protection Act
EPS	Earnings Per Share
FASB	Financial Accounting Standards Board
FDIC	Federal Deposit Insurance Corporation
FHA	Federal Housing Administration
FHC	Financial Holding Company
FHLB	Federal Home Loan Bank
FHLMC	Federal Home Loan Mortgage Corporation
FNMA	Federal National Mortgage Association
GLB Act	Gramm-Leach-Bliley Act
GNMA	Government National Mortgage Association
WM	Wealth management and trust
KSOP	Combined employee profit sharing and stock ownership plan
LIBOR	London Interbank Offered Rate
MSA	Metropolitan Statistical Area
MSR	Mortgage Servicing Right
OAEM	Other Assets Especially Mentioned
Oldham	THE BANCORP, Inc.
OREO	Other Real Estate Owned
OTTI	Other-Than-Temporary Impairment
PSU	Performance Stock Unit
RSU	Restricted Stock Unit
SAR	Stock Appreciation Right
SEC	Securities and Exchange Commission
TDRs	Troubled Debt Restructurings
US GAAP	United States Generally Accepted Accounting Principles
VA	U.S. Department of Veterans Affairs

  

                                                 

Part I

 

Item 1.

Business

 

Stock Yards Bancorp, Inc. (“Bancorp” or “Company”), headquartered in Louisville, Kentucky, is the holding company for Stock Yards Bank & Trust Company (“Bank”). Bancorp, which was incorporated in 1988 in Kentucky, is registered with, and subject to supervision, regulation and examination by, the Board of Governors of the Federal Reserve System. The Bank is wholly owned and is a state chartered bank. Because Bancorp has no significant operations of its own, its business and that of the Bank are essentially the same. The operations of the Bank are fully reflected in the consolidated financial statements of Bancorp.  Accordingly, references to “Bancorp” in this document may encompass both the holding company and the Bank.

 

Stock Yards Bank & Trust Company

 

Stock Yards Bank & Trust Company is the banking and sole subsidiary of Bancorp and was chartered in 1904.  The Bank is headquartered in Louisville, Kentucky and provides commercial and personal banking services in the Louisville, Kentucky, Indianapolis, Indiana and Cincinnati, Ohio metropolitan markets through 37 full service banking offices.  The Bank is chartered under the laws of the Commonwealth of Kentucky.  In addition to traditional commercial and personal banking activities, the Bank has a wealth management and trust department (WM&T) offering a wide range of investment management, trust, employee benefit plan, estate administration, and financial planning services.   The Bank also originates and sells single-family residential mortgages. Additionally, the Bank offers securities brokerage services via its branch network through an arrangement with a third party broker-dealer.  See Note 25 to Bancorp’s consolidated financial statements for information relating to the Bank’s business segments and “Item 2. Properties” for information regarding owned and leased properties.

 

At December 31, 2016, Stock Yards Bank & Trust Company had 578 full-time equivalent employees. Employees of Stock Yards Bank & Trust Company are entitled to participate in a variety of employee benefit programs including a combined employee profit sharing and stock ownership plan (“KSOP”). Management of Bancorp strives to be an employer of choice and considers the relationship with employees to be good.

 

Supervision and Regulation

 

Bank holding companies and commercial banks are extensively regulated under both federal and state laws. Changes in applicable laws or regulations may have a material effect on the business and prospects of Bancorp.

 

Bancorp, as a registered bank holding company, is subject to the supervision of and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956. In addition, Bancorp is subject to the provisions of Kentucky’s banking laws regulating bank acquisitions and certain activities of controlling bank shareholders.

 

Kentucky and federal banking statutes delineate permissible activities for Kentucky state-chartered banks. Kentucky’s statutes, however, contain a super parity provision for Kentucky chartered banks having one of the top two ratings in its most recent regulatory examination. This provision allows these state banks to engage in any banking activity in which a national bank in Kentucky, a state bank operating in any other state, or a federally chartered thrift could engage. The bank must first obtain a legal opinion specifying the statutory or regulatory provisions that permit the activity.

 

The Bank is subject to the supervision of the Kentucky Department of Financial Institutions and the Federal Deposit Insurance Corporation. The Federal Deposit Insurance Corporation (“FDIC”) insures the deposits of the Bank to the current maximum of $250,000 per depositor.

 

The Gramm-Leach-Bliley Act (the “GLB Act”) allows for affiliations among banks, securities firms and insurance companies by means of a financial holding company (“FHC”). The GLB Act requires that, at the time of establishment of an FHC, all depository institutions within that corporate group must be “well managed” and “well capitalized” and must have received a rating of “satisfactory” or better under its most recent Community Reinvestment Act examination. Further, non-banking financial firms (for example an insurance company or securities firm) may establish an FHC and acquire a depository institution. While the distinction between banks and non-banking financial firms has been blurring over recent years, the GLB Act makes it less cumbersome for banks to offer services “financial in nature” but beyond traditional commercial banking activities. Likewise, non-banking financial firms may find it easier to offer services that had, heretofore, been provided primarily by depository institutions.  In 2012, management of Bancorp chose to become an FHC after evaluating the benefits and costs.

 

  

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) was signed into law in 2010. Generally, the Dodd-Frank Act was effective the day after it was signed into law, but different effective dates apply to specific sections of the law. This extensive and complex legislation contained many provisions affecting the banking industry, including:

 

	●	Creation of a Bureau of Consumer Financial Protection overseeing banks with assets totaling $10 billion or greater while writing and maintaining several regulations that apply to all banks,
	●	Determination of debit card interchange rates by the Federal Reserve Board,
	●	New regulation over derivative instruments,
	●	Phase outs of certain forms of trust preferred debt and hybrids previously included as bank capital, and
	●	Increases to FDIC deposit coverage, revised calculations for assessing bank premiums, and numerous other provisions affecting financial institution regulation, oversight of certain non-banking organizations, investor protection, etc.

  

The ultimate impact of the Dodd-Frank Act remains uncertain and we expect it will have a continued adverse impact on the financial services industry as a whole and on Bancorp’s business, results of operations, and financial condition due to regulatory costs and increased regulatory scrutiny over products and practices.

 

The Community Reinvestment Act of 1977 (CRA) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA, and banking regulators take into account CRA ratings when considering approval of certain applications. An unsatisfactory CRA rating could, among other things, result in the denial or delay of corporate applications filed by Bancorp or the Bank for proposed activities such as branch openings or relocations and applications to acquire, merge or consolidate with another banking institution or holding company.

 

The federal banking regulators have adopted rules limiting the ability of banks and other financial institutions to disclose non-public information about consumers to unaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to an unaffiliated third party. These regulations affect how consumer information is conveyed to outside vendors. The Bank is also subject to regulatory guidelines establishing standards for safeguarding customer information. These guidelines describe the federal banking agencies’ expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities.

 

The Bank is subject to the Bank Secrecy Act and the USA Patriot Act. These statutes and related rules and regulations impose requirements and limitations on specified financial transactions and accounts and other relationships intended to guard against money laundering and terrorism financing. Financial institutions must take certain steps to assist government agencies in detecting and preventing money laundering and report certain types of suspicious transactions. Regulatory authorities routinely examine financial institutions for compliance with these obligations, and failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution, including causing applicable bank regulatory authorities not to approve merger or acquisition transactions when regulatory approval is required or to prohibit such transactions even if approval is not required.

 

  

In 2013, the Federal Reserve Board and the FDIC approved rules that substantially amended the regulatory risk-based capital rules applicable to Bancorp and Bank. The rules implemented the regulatory capital reforms of the Basel Committee on Banking Supervision reflected in "Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems" (“Basel III”) and changes required by the Dodd-Frank Act. The Basel III regulatory capital reforms became effective for Bancorp and Bank on January 1, 2015, and included new minimum risk-based capital and leverage ratios. The minimum capital level requirements applicable to bank holding companies and banks subject to the rules are:

 

	●	a common equity Tier 1 capital ratio of 4.5%,
	●	a Tier 1 risk-based capital ratio of 6% (increased from 4%),
	●	a total risk-based capital ratio of 8% (unchanged from previous rules), and
	●	a Tier 1 leverage ratio of 4% for all institutions.

  

The rules also established a "capital conservation buffer" of 2.5%, to be phased in over three years, above the regulatory minimum risk-based capital ratios, and will result in the following minimum ratios once the capital conservation buffer is fully phased in:

 

	●	a common equity Tier 1 risk-based capital ratio of 7.0%,
	●	a Tier 1 risk-based capital ratio of 8.5%, and
	●	a total risk-based capital ratio of 10.5%.

  

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

 

Under these rules, Tier 1 capital generally consists of common stock (plus related surplus) and retained earnings, limited amounts of minority interest in the form of additional Tier 1 capital instruments, and non-cumulative preferred stock and related surplus, subject to certain eligibility standards, less goodwill and other specified intangible assets and other regulatory deductions. The definition of Tier 2 capital is generally unchanged for most banking organizations, subject to certain new eligibility criteria.

 

Common equity Tier 1 capital generally consists of common stock, additional paid-in capital and retained earnings plus limited amounts of minority interest in the form of common stock, less goodwill and other specified intangible assets and other regulatory deductions.

 

The rules allowed banks and their holding companies with less than $250 billion in assets a one-time opportunity to opt-out of a requirement to include unrealized gains and losses in accumulated other comprehensive income in their capital calculation. Bancorp opted-out of this requirement.

 

As of December 31, 2016, Bancorp met the requirements to be considered well-capitalized and is not subject to limitations due to the capital conservation buffer.

 

From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the regulatory environment in which Bancorp operates in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. Bancorp cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of Bancorp. 

 

Available Information

 

Bancorp files reports with the SEC including the Annual Report on Form 10-K, quarterly reports on Form 10-Q, current event reports on Form 8-K, and proxy statements, as well as any amendments to those reports. The public may read and copy any materials the Registrant files with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. Bancorp’s Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to section 13(a) or 15(d) of the Exchange Act are also accessible at no cost on Bancorp’s web site at http://www.syb.com after they are electronically filed with the SEC.

 

  

Item 1A.

Risk Factors

 

Investment in Bancorp’s common stock involves risk, and Bancorp’s profitability and success may be affected by a number of factors including those discussed below.

 

Financial condition and profitability depend significantly on local and national economic conditions.

 

Our success depends on general economic conditions both locally and nationally. Most of Bancorp’s customers are in the Louisville, Indianapolis, and Cincinnati metropolitan areas. Compared to regional or national financial institutions, we are less able to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Some of Bancorp’s customers are directly impacted by the local economy while others have more national or global business dealings. Some of the factors influencing general economic conditions include tepid economic recovery, and government regulation. Poor economic conditions have an unfavorable impact on the demand of customers for loans and the ability of some borrowers to repay these loans. Deterioration in the quality of the credit portfolio could have a material adverse effect on financial condition, results of operations, and ultimately capital.

 

Financial condition and profitability depend on real estate values in our market area.

 

Bancorp offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Bancorp’s loans are secured by real estate (both residential and commercial) primarily in Bancorp’s market area. In instances where borrowers are unable to repay their loans from us and there has been deterioration in the value of the loan collateral, Bancorp could experience higher loan losses which could have a material adverse effect on financial condition, results of operations, and ultimately capital.

 

If actual loan losses are greater than Bancorp’s assumption for loan losses, earnings could decrease.

 

Bancorp’s loan customers may not repay their loans according to the terms of these loans, the collateral securing the payment of these loans may be insufficient to ensure repayment and the wealth of guarantors providing guarantees to support these loans may be insufficient to aid in the repayment of these loans. Accordingly, Bancorp might experience significant credit losses which could have a material adverse effect on operating results. Bancorp makes various assumptions and judgments about the collectability of the loan portfolio, including the creditworthiness of borrowers and the value of collateral for repayment of many loans. In determining the adequacy of the allowance for loan losses, Bancorp considers, among other factors, an evaluation of economic conditions and Bancorp’s loan loss experience. If Bancorp’s assumptions prove to be incorrect or economic problems are worse than projected, the current allowance may not be sufficient to cover loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in the loan portfolio. Such additions to the allowance, if necessary, could have a material adverse impact on financial results.

 

In addition, federal and state regulators annually review Bancorp’s allowance for loan losses and may require an increase in the provision for loan losses or loan charge-offs. If the regulatory agencies require any increase in the provision for loan losses or loan charge-offs for which Bancorp had not allocated, it would have a negative effect on net income.

 

If we are unable to remediate the material weakness in our internal control over financial reporting that we have reported in this Annual Report, or if other material weaknesses are identified in the future, our results of operations or financial condition could be materially adversely affected.

 

As disclosed elsewhere in this Annual Report on Form 10-K, during the fourth quarter of 2016, we determined that the Company has a material weakness in our internal control over financial reporting relating to the operating effectiveness of the Company’s control over the assessment of the appropriateness of loan grades used in the allowance for loan losses estimate, including the completeness and accuracy of the information used to assess the loan grades. No restatement of prior period financial statements, no change in previously released financial results, and no adjustments to the fourth quarter 2016 allowance for loan losses calculation were required as a result of this material weakness in internal control. Management is taking steps to remediate this material weakness by evaluating the Company’s allowance for loan losses policies and procedures for and resources allocated to the review control over the assessment of loan grades. If our remedial measures are insufficient to address this material weakness or if additional material weaknesses or significant deficiencies in our internal control are discovered or occur in the future, our results of operations or financial condition could be materially adversely affected.

 

Fluctuations in interest rates could reduce profitability.

 

Our primary source of income is from the net interest spread, the difference between interest earned on loans and investments and the interest paid on deposits and borrowings. Bancorp expects to periodically experience gaps in the interest rate sensitivities of Bancorp’s assets and liabilities, meaning that either interest-bearing liabilities will be more sensitive to changes in market interest rates than interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to Bancorp’s position, this gap will work against Bancorp and earnings will be negatively affected.

 

  

Many factors affect the fluctuation of market interest rates, including, but not limited to the following:

 

	●	inflation or deflation
	●	recession
	●	a rise in unemployment
	●	tightening money supply
	●	international disorder and instability in foreign financial markets
	●	the Federal Reserve’s actions to control interest rates

 

Bancorp’s interest rate sensitivity analysis indicates an increase in interest rates of up to 4% would decrease net interest income, primarily because the majority of Bancorp’s variable rate loans have floors of 4% or higher, and are indexed to the prime rate. Since the prime rate is currently 3.75%, rates would have to increase more than 25 bp before the rates on such loans will rise. This negatively impacts the effect of rising rates. Deposit rates generally do not reprice as quickly as loans which negatively affects earnings as rates decline. As rates rise this behavior could benefit the Bancorp short term, but might pose a risk to earnings in the longer term. Migration of deposits out of Bancorp, as customers pursue higher rates, could impact liquidity and earnings as Bancorp competes for deposits. Changes in the mix of deposits could result in increased average rates paid on deposits, and lower earnings to Bancorp. Bancorp’s asset-liability management strategy, which is designed to mitigate risk from changes in market interest rates, may not be able to prevent changes in interest rates from having a material adverse effect on Bancorp’s results of operations and financial condition. Bancorp’s most recent earnings simulation model estimated the impact of changing interest rates on earnings for the next 12 months indicates net interest income will decrease approximately 3.7% if interest rates immediately decrease 100 basis points and decrease approximately 0.9% if rates increase 100 basis points.

 

Significant stock market volatility could negatively affect Bancorp’s financial results.

 

Capital and credit markets experience volatility and disruption from time to time. These conditions place downward pressure on credit availability, credit worthiness and customers’ inclinations to borrow. Prolonged volatility or a significant disruption could negatively impact customers’ ability to seek new loans or to repay existing loans. The personal wealth of many borrowers and guarantors has historically added a source of financial strength to certain loans and would be negatively impacted by severe market declines. Sustained reliance on their personal assets to make loan payments would result in deterioration of their liquidity, and could result in loan defaults.

 

Income from wealth management and trust constitutes approximately 44% of non-interest income. Trust assets under management are expressed in terms of market value, and a significant portion of fee income is based upon those values. A large majority of wealth management and trust fees are based on market values which generally fluctuate with the overall stock market.

 

Competition with other financial institutions could adversely affect profitability.

 

Bancorp operates in a highly competitive industry that could become even more so as a result of earnings pressure of contending banks, legislative, regulatory and technological changes and continued consolidation. Bancorp faces vigorous competition in price and structure of financial products from banks and other financial institutions. Bancorp also competes with other non-traditional providers of financial services, such as brokerage firms and insurance companies. As internet-based financial services continue to grow in acceptance, Bancorp must remain relevant as a place where consumers and businesses value personal service while our competition offers these services without human interaction. The variety of sources of competition may reduce or limit margins on banking services, reduce market share and adversely affect results of operations and financial condition. Bancorp’s own growth and expansion may adversely affect customer perceptions of the community based, customer oriented service Bancorp provides, thus damaging Bancorp’s image in the market.

 

Credit unions continue to grow in popularity and size, and their expansion into business lending is growing. Because credit unions are not subject to federal income tax, and Bancorp pays federal income tax at a marginal rate of 35%, these companies have a significant competitive advantage over Bancorp. This advantage may have a negative impact on Bancorp’s growth and resultant financial results as these credit unions continue to expand.

 

Decreased residential mortgage origination, volume and pricing decisions of competitors could affect net income

 

Bancorp originates, sells and services residential mortgage loans. Changes in interest rates and pricing decisions by our loan competitors affect demand for Bancorp’s residential mortgage loan products, revenue realized on the sale of loans and revenues received from servicing such loans for others, ultimately reducing Bancorp’s net income. New regulations, increased regulatory reviews, and/or changes in structure of secondary mortgage markets which Bancorp utilizes to sell mortgage loans may be introduced and may increase costs and make it more difficult to operate a residential mortgage origination business.

 

  

An extended disruption of vital infrastructure or a security breach could negatively impact Bancorp’s business, results of operations, and financial condition.

 

Bancorp’s operations depend upon, among other things, infrastructure, including equipment and facilities. Extended disruption of vital infrastructure by fire, power loss, natural disaster, telecommunications failure, information systems breaches, terrorist activity or the domestic and foreign response to such activity, or other events outside of Bancorp’s control could have a material adverse impact on the financial services industry as a whole and on Bancorp’s business, results of operations and financial condition. Bancorp’s business continuity plan may not work as intended or may not prevent significant interruption of operations. Occurrence of any failures, interruptions, or security breaches of information systems could damage Bancorp’s reputation, result in loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have an adverse effect on Bancorp’s financial condition and results of operation.

 

Bancorp’s assets which are at risk for cyber-attacks include financial assets and non-public information belonging to customers. Cyber security risks include cyber espionage, blackmail, ransom, theft, and corporate account takeovers. Bancorp employs many preventive and detective controls to protect its assets, and provides mandatory recurring information security training to all employees. Bancorp has invested in multiple preventative tools in an attempt to protect our customers from cyber threats and corporate account takeover. Bancorp regularly provides educational information regarding cyber threats to our customers. Bancorp utilizes multiple third-party vendors who have access to our assets via electronic media. While Bancorp requires third parties, many of whom are small companies, to have similar or superior controls in place there is no guarantee that a breach of information could occur.

 

Bancorp’s credit metrics are at historically strong levels.

 

During 2016, Bancorp’s solid asset quality metrics trended within a narrow range and exceeded solid benchmarks of the past several years to reach historically strong levels. We realize that present asset quality metrics are exceptionally positive and, recognizing the cyclical nature of the lending business, we know they will normalize over the long term.

 

Bancorp’s accounting policies and methods are critical to how Bancorp reports its financial condition and results of operations. They require management to make estimates about matters that are uncertain.

 

Accounting policies and methods are fundamental to how Bancorp records and reports its financial condition and results of operations. Bancorp must exercise judgment in selecting and applying these accounting policies and methods so they comply with United States generally accepted accounting principles (“US GAAP”).

 

Bancorp has identified certain accounting policies as being critical because they require management’s judgment to ascertain the valuations of assets, liabilities, commitments and contingencies. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset, or reducing a liability. Bancorp has established detailed policies and control procedures intended to ensure these critical accounting estimates and judgments are well controlled and applied consistently.

 

The policies and procedures are intended to ensure that the process for changing methodologies occurs in an appropriate manner. Because of the uncertainty surrounding Bancorp’s judgments and the estimates pertaining to these matters, there can be no assurances that actual results will not differ from those estimates. See the “Critical Accounting Policies” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for more information.

 

 

Bancorp operates in a highly regulated environment and may be adversely affected by changes in federal, state and local laws and regulations.

 

Bancorp is subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or federal or state legislation could have a substantial impact on Bancorp and its operations. Additional legislation and regulations may be enacted or adopted in the future that could significantly affect Bancorp’s powers, authority and operations, which could have a material adverse effect on Bancorp’s financial condition and results of operations. The exercise of regulatory power may have a negative impact on Bancorp’s results of operations and financial condition.

 

The Bank is subject to numerous fair lending laws designed to protect consumers and failure to comply with these laws could lead to a wide variety of sanctions.

 

The CRA, the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations prohibit discriminatory lending practices by financial institutions. The U.S. Department of Justice, federal banking agencies and other federal agencies are responsible for enforcing these laws and regulations. A successful regulatory challenge to an institution’s compliance with fair lending laws and regulations could result in a wide variety of sanctions, including damages and civil money penalties, injunctive relief, restrictions on mergers and acquisitions activity, restrictions on expansion and restrictions on entering new lines of business. Private parties may also have the ability to challenge an institution’s performance under fair lending laws in private class action litigation. Such actions could have a material adverse effect on our assets, business, condition (financial or otherwise), liquidity, prospects and results of operations.  

 

The Bank faces a risk of noncompliance and enforcement action with the Bank Secrecy Act and other anti-money laundering statutes and regulations.

 

The Bank Secrecy Act, the USA Patriot Act and other laws and regulations require financial institutions, among other duties, to institute and maintain an effective anti-money laundering program and to file reports such as suspicious activity reports and currency transaction reports. We are required to comply with these and other anti-money laundering requirements. The federal banking agencies and Financial Crimes Enforcement Network are authorized to impose significant civil money penalties for violations of those requirements. We are also subject to increased scrutiny of compliance with the rules enforced by the Office of Foreign Assets Control, or OFAC. If our policies, procedures and systems are deemed deficient, we would be subject to liability, including fines and regulatory actions, which may include restrictions on our ability to pay dividends and the requirement to obtain regulatory approvals to proceed with certain aspects of our business plan, including our acquisition plans. Failure to maintain and implement adequate programs to combat money laundering and terrorist financing could also have serious reputational consequences for us. Any of these circumstances could have a material adverse effect on our assets, business, condition (financial or otherwise), liquidity, prospects and results of operations.  

 

Bancorp’s ability to stay current on technological changes in order to compete and meet customer demands is constantly being challenged.

 

The financial services industry is undergoing rapid technological changes, with frequent introductions of new technology-driven products and services. Future success of Bancorp will depend, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands for convenience, as well as to create additional operational efficiencies and greater privacy and security protection for customers and their personal information. Many of Bancorp’s competitors have substantially greater resources to invest in technological improvements. Bancorp may not be able to effectively implement new technology-driven products and services as quickly as competitors or be successful in marketing these products and services to its customers. Bancorp relies on third party providers for many of its technology-driven banking products and services. Some of these companies have limited financial resources and may be slow to respond with upgrades or enhancements to their products to keep pace with improvements in technology or the introduction of competing products. Failure to successfully keep pace with technological change affecting the financial services industry could impair Bancorp’s ability to effectively compete to retain or acquire new business and could have an adverse impact on its business, financial position, results of operations and liquidity.

 

  

Bancorp is dependent upon outside third parties for the processing and handling of our records and data.

 

We rely on software developed by third-party vendors to process various transactions. In some cases, we have contracted with third parties to run their proprietary software on our behalf. While we perform a review of controls instituted by the applicable vendors over these programs in accordance with industry standards and perform our own testing of user controls, we rely on the continued maintenance of controls by these third-party vendors, including safeguards over the security of client data. We may incur a temporary disruption in our ability to conduct business or process transactions, or incur damage to our reputation, if the third-party vendor fails to adequately maintain internal controls or institute necessary changes to systems. Such a disruption or breach of security could have a material adverse effect on our business. Further, if these third-party service providers experience difficulties, or should terminate their services, and we are unable to replace them with other providers, particularly on a timely basis, our business operations could be interrupted. If an interruption were to continue for a significant period of time, our business, financial condition and results of operations could be adversely affected.

  

Bancorp may not be able to attract and retain skilled people.

 

Bancorp’s success depends, in large part, on our ability to attract and retain key people. Competition for the best people in the industry and the markets in which we engage can be intense, and we may not be able to retain or hire the people we want or need. To attract and retain qualified employees, we must compensate them at market levels. If we are unable to continue to attract and retain qualified employees, or do so at rates necessary to maintain our competitive position, our performance, including our competitive position, could suffer, and, in turn, adversely affect our business, financial condition or results of operations.

 

Bancorp invests in partnerships that generate federal income tax savings and these may not continue.

 

Bancorp invests in certain partnerships that yield federal income tax credits resulting in higher net income for Bancorp. These transactions may also include lending to the counterparty, further enhancing the profitability of the transaction.  These transactions typically involve a very limited number of counterparties. The availability and suitability of these transactions are not particularly predictable and may not continue to be favorable to Bancorp. Therefore the positive effect on Bancorp’s net income may not continue.

 

 

Item 1B.

Unresolved Staff Comments

 

Bancorp has no unresolved SEC staff comments.

 

Item 2.

Properties

 

The principal offices of Bancorp are located at 1040 East Main Street, Louisville, Kentucky. Bancorp’s operations center is at a separate location. In addition to the main office complex and the operations center, Bancorp owned 20 branch properties at December 31, 2016, two of which are located on leased land.  At that date, Bancorp also leased 17 branch facilities as well as its wealth management and trust facility. Of the 37 banking locations, 28 are located in the Louisville Metropolitan Statistical Area (“MSA”), four are located in the Indianapolis MSA and five are located in the Cincinnati MSA. See Notes 6 and 19 to Bancorp’s consolidated financial statements for the year ended December 31, 2016, for additional information relating to amounts invested in premises and equipment and lease commitments.

 

Item 3.

Legal Proceedings

 

See Note 19 to Bancorp’s consolidated financial statements for the year ended December 31, 2016, for information relating to legal proceedings.

 

Item 4.

Mine Safety Disclosures

 

Not applicable.

 

 

Executive Officers of the Registrant 

 

The following table lists the names and ages as of December 31, 2016 of all current executive officers of Bancorp and the Bank. Each executive officer is appointed by Bancorp’s Board of Directors to serve at the discretion of the Board.

 

There is no arrangement or understanding between any executive officer of Bancorp or the Bank and any other person(s) pursuant to which he/she was or is to be selected as an officer.

 

Name and Age of Executive Officer		Position and Offices with Bancorp and/or the Bank
David P. Heintzman Age 57		Chairman of the Board of Directors and Chief Executive Officer of Bancorp and the Bank
James A. Hillebrand Age 48		President and Director of Bancorp and the Bank
Kathy C. Thompson Age 55		Senior Executive Vice President and Director of Bancorp and the Bank
Nancy B. Davis Age 61		Executive Vice President, Treasurer and Chief Financial Officer of Bancorp and the Bank
William M. Dishman III Age 53		Executive Vice President and Chief Risk Officer of the Bank
Philip S. Poindexter Age 50		Executive Vice President and Chief Lending Officer of the Bank
T. Clay Stinnett Age 43		Executive Vice President and Chief Strategic Officer of Bancorp and the Bank
Michael J. Croce Age 47		Executive Vice President and Director of Retail Banking of the Bank

 

Mr. Heintzman was appointed Chairman and Chief Executive Officer in January 2006. Prior thereto, he served as President of Bancorp and the Bank since 1992. Mr. Heintzman joined the Bank in 1985.

 

Mr. Hillebrand was appointed President in July 2008. Prior thereto, he served as Executive Vice President and Director of Private Banking of the Bank since 2005. From 2000 to 2004, he served as Senior Vice President of Private Banking. Mr. Hillebrand joined the Bank in 1996.

 

Ms. Thompson was appointed Senior Executive Vice President in January 2006.  Prior thereto, she served as Executive Vice President of Bancorp and the Bank. She joined the Bank in 1992 and is Manager of the Wealth Management and Trust Department.

 

Ms. Davis was appointed Executive Vice President of Bancorp and the Bank in 1999 and Chief Financial Officer in 1993. She joined the Bank in 1991.

 

Mr. Dishman joined the Bank and was appointed Executive Vice President and Chief Risk Officer in February 2009.

 

Mr. Poindexter was appointed Chief Lending Officer in July 2008. Prior thereto, he served as Executive Vice President and Director of Commercial Banking. Mr. Poindexter joined the Bank in 2004.

 

Mr. Stinnett was appointed Executive Vice President and Chief Strategic Officer in February 2011. Prior thereto, he served as Senior Vice President and Chief Strategic Officer since 2005. Mr. Stinnett joined the Bank in 2000.

 

Mr. Croce was appointed Executive Vice President and Director of Retail Banking in July 2014. Prior thereto, he served as Senior Vice President and Division Manager of Business Banking. Mr. Croce joined the Bank in 2004.

 

  

Part II

 

Item 5.

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

 

Bancorp’s common stock is traded on the NASDAQ Global Select Market under the ticker symbol SYBT. The table below sets forth the quarterly high and low market closing prices of Bancorp’s common stock and dividends declared per share. On April 29, 2016, Bancorp declared a 3 for 2 stock split to be effected as a 50% stock dividend to shareholders of record on May 13, 2016, payable May 27, 2016. Share and per share information has been adjusted for this split. The payment of dividends by the Bank to Bancorp is subject to the restriction described in Note 18 to the consolidated financial statements. Management believes that Bancorp will continue to generate adequate earnings to continue to pay dividends on a quarterly basis.  On December 31, 2016, Bancorp had approximately 1,585 shareholders of record, and approximately 4,000 beneficial owners holding shares in nominee or “street” name.

 

 

 

		2016												2015
										Cash Dividends												Cash Dividends
Quarter		High				Low				Declared				High				Low				Declared
First		$	26.09			$	23.27			$	0.17			$	23.21			$	20.31			$	0.15
Second			29.03				24.55				0.18				25.40				22.50				0.16
Third			33.25				27.52				0.18				25.62				22.63				0.16
Fourth			46.95				32.93				0.19				27.10				23.83				0.17

The following table shows information relating to the repurchase of shares of common stock by Bancorp during the three months ended December 31, 2016.

 

		Total number of shares purchased (1)				Average price paid per share				Total number of shares purchased as part of publicly announced plan				Maximum number of shares that may yet be purchased under the plan
October 1-October 31			5,455			$	34.04				-				-
November 1-November 30			3,484				38.56				-				-
December 1-December 31			1,400				45.85				-				-
Total			10,339			$	37.16				-				-

 

(1) Activity represents shares of stock withheld to pay taxes due upon the exercise of stock appreciation rights and on lapsed shares of restricted stock.

 

The following performance graphs and data shall not be deemed filed for purposes of Section 18 of the Securities Exchange Act of 1934 or otherwise subject to the liabilities of that section, nor shall it be deemed soliciting material or subject to Regulation 14A of the Exchange Act or incorporated by reference in any filing under the Exchange Act or the Securities Act of 1933, except as shall be expressly set forth by specific reference in such filing.

 

The first graph below compares the performance of Bancorp Common Stock to the Russell 2000 index, the SNL NASDAQ Bank index and the SNL Midwest Bank index for Bancorp’s last five fiscal years. The graph assumes the value of the investment in Bancorp Common Stock and in each index was $100 at December 31, 2011 and that all dividends were reinvested.

 

In addition to the five-year period required by the SEC, the ten-year period is presented because it provides additional perspective, and Bancorp management believes that longer-term performance is of greater interest. The ten-year graph assumes the value of the investment in Bancorp Common Stock and in each index was $100 at December 31, 2006 and that all dividends were reinvested.

 

  

 

		Period Ending
Index		12/31/11				12/31/12				12/31/13				12/31/14				12/31/15				12/31/16
Stock Yards Bancorp, Inc.			100.00				112.99				165.94				178.39				207.63				395.83
Russell 2000			100.00				116.35				161.52				169.43				161.95				196.45
SNL Midwest Bank			100.00				120.36				164.78				179.14				181.86				242.99
SNL Bank NASDAQ			100.00				119.19				171.31				177.42				191.53				265.56

 

 

		Period Ending
Index		12/31/06				12/31/07				12/31/08				12/31/09				12/31/10				12/31/11				12/31/12				12/31/13				12/31/14				12/31/15				12/31/16
Stock Yards Bancorp, Inc.			100.00				87.71				103.54				82.85				98.05				84.75				95.76				140.64				151.18				175.97				335.47
Russell 2000			100.00				98.43				65.18				82.89				105.14				100.75				117.23				162.74				170.70				163.17				197.93
SNL Midwest Bank			100.00				77.94				51.28				43.45				53.96				50.97				61.35				83.99				91.31				92.69				123.85
SNL Bank NASDAQ			100.00				78.51				57.02				46.25				54.57				48.42				57.71				82.95				85.91				92.74				128.58

  

  

Item 6.

Selected Financial Data

 

Selected Consolidated Financial Data 

 

		Years ended December 31
(Amounts in thousands except per share data and ratios)		2016				2015				2014				2013				2012
Income statement data
Interest income		$	102,172			$	93,170			$	89,087			$	86,464			$	86,901
Interest expense			4,918				4,852				5,330				9,166				12,951
Net interest income			97,254				88,318				83,757				77,298				73,950
Provision (credit) for loan losses			3,000				750				(400	)			6,550				11,500
Non-interest income			43,537				39,950				39,155				39,002				38,457
Non-interest expenses			81,520				73,398				73,209				71,352				65,472
Income before income taxes			56,271				54,120				50,103				38,398				35,435
Income tax expense			15,244				16,933				15,281				11,228				9,634
Net income		$	41,027			$	37,187			$	34,822			$	27,170			$	25,801
Per share data
Net income, basic		$	1.84			$	1.68			$	1.59			$	1.27			$	1.24
Net income, diluted			1.80				1.65				1.57				1.26				1.23
Cash dividends declared			0.72				0.64				0.59				0.54				0.51
Book value			13.88				12.80				11.75				10.47				9.83
Market value			46.95				25.19				22.23				21.28				14.95
Weighted average common and common equivalent shares - diluted			22,792				22,459				22,144				21,530				20,898
Balance sheet data
Total assets		$	3,039,481			$	2,816,801			$	2,563,868			$	2,389,262			$	2,148,262
Loans			2,305,375				2,033,007				1,868,550				1,721,350				1,584,594
Allowance for loan losses			24,007				22,441				24,920				28,522				31,881
Available for sale securities			570,074				565,876				513,056				490,031				386,440
Deposits			2,520,548				2,371,702				2,123,627				1,980,937				1,781,693
Federal Home Loan Bank advances			51,075				43,468				36,832				34,329				31,882
Subordinated debentures			-				-				-				-				30,900
Stockholders' equity			313,872				286,519				259,895				229,444				205,075
Average balances
Stockholders’ equity		$	304,151			$	274,451			$	245,425			$	220,107			$	197,551
Assets			2,886,396				2,573,901				2,398,430				2,232,868				2,070,967
Federal Home Loan Bank advances			45,455				41,041				35,709				32,518				60,113
Long-term debt			-				-				-				30,477				31,474
Selected ratios
Return on average assets			1.42	%			1.44	%			1.45	%			1.22	%			1.25	%
Return on average stockholders’ equity			13.49				13.55				14.19				12.34				13.06
Average stockholders’ equity to average assets			10.54				10.66				10.23				9.86				9.54
Net interest rate spread			3.51				3.59				3.67				3.59				3.74
Net interest rate margin, fully tax-equivalent			3.59				3.67				3.75				3.74				3.94
Efficiency ratio			57.56				56.81				59.09				60.82				57.38
Non-performing loans to total loans			0.29				0.44				0.64				1.33				1.90
Non-performing assets to total assets			0.39				0.48				0.70				1.19				1.74
Net charge offs to average loans			0.07				0.17				0.18				0.60				0.60
Allowance for loan losses to total loans			1.04				1.10				1.33				1.66				2.01

  

Share and per share information has been adjusted to reflect the 3 for 2 stock-split effected in the form of a 50% stock dividend in May 2016. 

 

  

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

  

 

Financial Section Summary

 

The financial section of this Form 10-K includes management’s discussion and analysis, consolidated financial statements, and the notes to those financial statements. Bancorp has prepared the following summary to assist in your review of the financial section. It is designed to give you an overview of Stock Yards Bancorp, Inc. and summarize some of the more important activities and events that occurred during 2016. Share and per share information has been adjusted to reflect the 3 for 2 stock-split which was effected in the form of a 50% stock dividend in May 2016.

 

The financial section includes the following:

 

Management’s discussion and analysis, or MD&A provides information as to analysis of the consolidated financial condition and results of operations of Bancorp. It contains management’s view about industry trends, risks, uncertainties, accounting policies that Bancorp views as critical in light of its business, results of operations including discussion of the key performance drivers, financial position, cash flows, commitments and contingencies, important events, transactions that have occurred over the last three years, and forward-looking information, as appropriate.

 

Financial statements include Consolidated Balance Sheets as of the end of the last two years, and Consolidated Statements of Income, Comprehensive Income, Changes in Stockholders’ Equity, and Cash Flows, for each of the last three years. Bancorp’s financial statements are prepared in accordance with US GAAP.

 

Notes to the financial statements provide insight into, and are an integral part of, the financial statements. These notes contain explanations of significant accounting policies, details about certain captions on the financial statements, information about significant events or transactions that have occurred, discussions about legal proceedings, commitments and contingencies, and selected financial information relating to business segments. The notes to the financial statements also are prepared in accordance with US GAAP.

 

Reports related to the financial statements and internal controls over financial reporting include the following:

	●	A report from KPMG LLP, an independent registered public accounting firm, which includes their opinion on the presentation of Bancorp’s consolidated financial statements in conformity with US GAAP based on their audits;
	●	A report from management indicating Bancorp’s responsibility for financial reporting and the financial statements;
	●	A report from management indicating Bancorp’s responsibility for the system of internal control over financial reporting, including an assessment of the effectiveness of those controls; and
	●	A report from KPMG LLP, which includes their opinion on the effectiveness of Bancorp’s internal control over financial reporting.

 

Our Business

 

Stock Yards Bancorp, Inc. was incorporated in 1988, and its business is substantially the same as that of its wholly owned subsidiary, Stock Yards Bank & Trust Company. The Bank has operated continuously since it opened in 1904. The Bank conducted business at one location for 85 years and began branching in 1989. At December 31, 2016, the Bank had 28 full service banking locations in the Louisville MSA, 4 full service banking locations in the Indianapolis MSA, and 5 full service banking locations in the Cincinnati MSA. Bancorp’s focus on flexible, attentive customer service has been key to its growth and profitability. The wide range of services provided by wealth management and trust, securities brokerage, and mortgage origination helps support the corporate philosophy of capitalizing on full service customer relationships.

 

 

Forward-Looking Statements

 

This report contains forward-looking statements under the Private Securities Litigation Reform Act that involve risks and uncertainties. These forward-looking statements may be identified by the use of words such as “expect”, “anticipate”, “plan”, “foresee”, “believe” or other words with similar meaning. Although Bancorp believes assumptions underlying forward-looking statements contained herein are reasonable, any of these assumptions could be inaccurate. Factors that could cause actual results to differ from results discussed in forward-looking statements include, but are not limited to: economic conditions both generally and more specifically in markets in which Bancorp and its subsidiary operate; competition for Bancorp’s customers from other providers of financial services; government legislation and regulation which change from time to time and over which Bancorp has no control; changes in interest rates; material unforeseen changes in liquidity, deterioration in the real estate market, results of operations or financial condition of Bancorp’s customers; or other risks detailed in Bancorp’s filings with the Securities and Exchange Commission and Item 1A of this Form 10-K, all of which are difficult to predict and many of which are beyond the control of Bancorp.

 

Critical Accounting Policies

 

Bancorp has prepared consolidated financial information in this report in accordance with US GAAP.  In preparing the consolidated financial statements in accordance with US GAAP, Bancorp makes estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  There can be no assurances that actual results will not differ from those estimates.

 

Management has identified the accounting policy related to the allowance and provision for loan losses as critical to the understanding of Bancorp’s results of operations and discussed this conclusion with the Audit Committee of the Board of Directors. Since the application of this policy requires significant management assumptions and estimates, it could result in materially different amounts to be reported if conditions or underlying circumstances were to change. The provision for loan losses reflects an allowance methodology driven by risk ratings, historical losses, specific loan loss allocations, and qualitative factors. Assumptions include many factors such as changes in borrowers’ financial condition which can change quickly or historical loss ratios related to certain loan portfolios which may or may not be indicative of future losses. In the second quarter of 2015, Bancorp extended the historical period used to capture Bancorp’s historical loss ratios from 12 quarters to 24 quarters. This extension of the historical period was applied to all classes and segments of our portfolio. The expansion of the look-back period for the quantitative historical loss rate caused us to review the overall methodology for the qualitative factors to ensure we were appropriately capturing the risk not addressed in the quantitative historical loss rate. Management believes the extension of the look-back period is appropriate to capture the impact of a full economic cycle and more accurately represents the current level of risk inherent in the loan portfolio. To the extent that management’s assumptions prove incorrect, results from operations could be materially affected by a higher or lower provision for loan losses. The accounting policy related to the allowance for loan losses is applicable to the commercial banking segment of Bancorp. The impact and any associated risks related to this policy on Bancorp’s business operations are discussed in the “Allowance for Loan Losses” section below.

 

The allowance for loan losses is management’s estimate of probable losses inherent in the loan portfolio as of the balance sheet date. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

 

Bancorp’s allowance calculation includes allocations to loan portfolio segments at December 31, 2016 for qualitative factors including, among other factors, local economic and business conditions in each of our primary markets, quality and experience of lending staff and management, exceptions to lending policies, levels of and trends in past due loans and loan classifications, concentrations of credit such as collateral type, trends in portfolio growth, changes in value of underlying collateral for collateral-dependent loans, effect of other external factors such as the national economic and business trends, quality and depth of the loan review function, and management’s judgement of current trends and potential risks. Bancorp utilizes the sum of all allowance amounts derived as described above as the appropriate level of allowance for loan and lease losses. Changes in criteria used in this evaluation or availability of new information could cause the allowance to be increased or decreased in future periods. In addition, bank regulatory agencies, as part of their examination process, may require adjustments to the allowance for loan and lease losses based on their judgments and estimates.

 

 

Overview of 2016   

 

The following discussion should be read in conjunction with Bancorp’s consolidated financial statements and accompanying notes and other schedules presented elsewhere in this report.

 

In 2016, Bancorp completed a record year of earnings, asset, and deposit growth with net income totaling $41.0 million, an increase of $3.8 million, or 10%, over 2015. Diluted earnings per share for 2016 increased 9% over 2015 to $1.80, marking the sixth consecutive year of record earnings per diluted share. Increased profitability was primarily due to increases in net interest income and non-interest income, and decreased income tax expense. These were partially offset by an increased provision for loan losses and higher non-interest expenses in 2016.

 

As is the case with most banks, the primary source of Bancorp’s revenue is net interest income and fees from various financial services provided to customers. Net interest income is the difference between interest income earned on loans, investment securities and other interest earning assets less interest expense on deposit accounts and other interest bearing liabilities. Loan volume and interest rates earned on those loans are critical to overall profitability. Similarly, deposit volume is crucial to funding loans and rates paid on deposits directly impact profitability. Business volumes are influenced by economic factors including market interest rates, business spending, consumer confidence and competitive conditions within the marketplace.

 

As a result of record loan production, lower levels of payments and prepayments, and higher utilization of available lines of credit, Bancorp’s loan portfolio increased $272 million, or 13%, to $2.3 billion as of December 31, 2016. Despite lower average rates on interest earning assets, the positive effect of increased volumes on loans and available-for-sale investments contributed to higher interest income for 2016, as interest income increased $9.0 million, or 10%, over the same period in 2015. Deposit growth during 2016, offset by lower funding costs on deposits and borrowings, resulted in only a slight increase in interest expense, year over year. Under the continuing pressure of a highly competitive lending environment, net interest margin in 2016 decreased to 3.59%, as compared to 3.67% in 2015.

 

Total non-interest income increased $3.6 million, or 9.0% in 2016, as compared to 2015, and remained consistent at 31% of total revenues. With the exception of a minimal decrease in income from bank-owned life insurance, all areas of non-interest income increased, 2016 over 2015, with the greatest dollar increase from the Bancorp’s wealth management and trust department (WM&T). WM&T represents an important part of the relationship focused philosophy of the Company and, accordingly, income from the department represents approximately 44% of total non-interest income for the Bancorp. The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size and although the 2016 increase was partially the result of a rising stock market during the year, it also represented the best year ever for WM&T in terms of new clients added.

 

Higher non-interest expenses for 2016 were primarily the result of increased personnel and technology costs, associated with growth and operational support, and increased amortization expense for investments in tax credit partnerships as the Bancorp increased its commitment to customers pursuing tax-advantaged projects, primarily involving historical redevelopment. Net gains on sales of other real estate owned totaled $409 thousand compared to net losses of $147 thousand for 2015. Bancorp's efficiency ratio for 2016 of 57.6% was up from 56.8% in 2015. 

 

For the twelve-month period ended December 31, 2016, Bancorp recorded a $3.0 million provision for loan losses, compared to $750 thousand for the same period in 2015.  The increase in the provision was primarily the result of loan growth. The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, is adequate to provide coverage for the inherent losses on outstanding loans. Bancorp's allowance for loan losses was 1.04% of total loans at December 31, 2016, compared to 1.10% of total loans at December 31, 2015.

 

Bancorp’s effective tax rate decreased to 27.1% in 2016 from 31.3% in 2015, primarily a result of the higher utilization of federal income tax credits in 2016. Bancorp invests in certain partnerships that yield federal income tax credits. The tax benefit of these investments exceeds amortization expense associated with them, resulting in a positive impact on net income.

 

  

Tangible common equity (TCE), a non-GAAP measure, is a measure of a company's capital which is useful in evaluating the quality and adequacy of capital. It is calculated by subtracting the value of intangible assets and any preferred equity from Bancorp’s stockholders’ equity. The ratio of tangible common equity to total tangible assets was 10.26% as of December 31, 2016, compared to 10.10% at December 31, 2015. See the Non-GAAP Financial Measures section for details on reconcilement to US GAAP measures.

 

Challenges for 2017 will include managing net interest margin, achieving continued loan growth, managing credit quality and adapting to changing regulatory requirements.

 

●	Considering the recent increase in short-term interest rates implemented by the Federal Open Market Committee and with the expectation of additional increases in 2017, management anticipates that net interest margins will increase during the coming year. However, competitive pressures on rates for new loans could result in a continued pressure on the net interest margin for 2017. Increased deposit rate competition could also negatively impact this expectation, as could an increase in longer term interest rates.
●	Bancorp’s goals for 2017 include net loan growth at a pace comparable to that experienced in 2014 and 2015. This will be impacted by competition, prevailing economic conditions, line of credit utilization and prepayments in the loan portfolio. Bancorp believes there is continued opportunity for loan growth in all three markets, and Bancorp’s ability to deliver attractive loan growth over the long-term is linked to Bancorp’s success.
●	Bancorp has been successful at gathering sufficient deposits to fund loan growth. While deposits in all market areas have grown, the most significant increases arose in the Louisville market. Bancorp will need to continue to increase deposits to support loan growth.
●	Bancorp is subject to extensive regulation, supervision and examination by federal and state banking authorities. While recent political developments indicate banking regulations may decrease, Bancorp believes regulation will continue to play a significant role in the banking industry.

  

The following sections provide more details on subjects presented in this overview.

 

Results of Operations

 

Net income was $41.0 million or $1.80 per share on a diluted basis for 2016 compared to $37.2 million or $1.65 per share for 2015 and $34.8 million or $1.57 per share for 2014.

 

Net income for 2016 was positively impacted by:

	●	an $8.9 million, or 10% increase in net interest income, and
	●	a $3.6 million, or 9% increase in non-interest income, and
	●	a $1.7 million, or 10% decrease in income tax expense.

  

Net income for 2016 was negatively impacted by:

	●	a $3.0 million provision for loan losses in 2016, compared to $750 thousand in 2015, and
	●	an $8.1 million, or 11% increase in non-interest expense

  

The following paragraphs provide a more detailed analysis of significant factors affecting operating results.

 

Net Interest Income

 

Net interest income, the most significant component of Bancorp’s earnings, represents total interest income less total interest expense.  Net interest spread is the difference between the taxable equivalent rate earned on average interest earning assets and the rate expensed on average interest bearing liabilities.  Net interest margin represents net interest income on a taxable equivalent basis as a percentage of average earning assets. Net interest margin is affected by both interest rate spread and the level of non-interest bearing sources of funds.  The level of net interest income is determined by the mix and volume of interest earning assets, interest bearing deposits and interest bearing liabilities and by changes in interest rates. The discussion that follows is based on tax-equivalent interest data. 

 

 

Comparative information regarding net interest income follows:

 

 

(Dollars in thousands)														2016/2015				2015/2014
		2016				2015				2014				Change				Change
Net interest income, tax- equivalent basis		$	98,088			$	89,246			$	84,730				9.9	%			5.3	%
Net interest spread			3.51	%			3.59	%			3.67	%			(8	) bp			(8	) bp
Net interest margin			3.59	%			3.67	%			3.75	%			(8	) bp			(8	) bp
Average earning assets		$	2,730,949			$	2,430,400			$	2,259,843				12.4	%			7.5	%
Five year Treasury bond rate at year end			1.93	%			1.76	%			1.65	%			17	bp			11	bp
Average five year Treasury bond rate			1.33	%			1.53	%			1.63	%			(20	) bp			(10	) bp
Prime rate at year end			3.75	%			3.50	%			3.25	%			25	bp			25	bp
Average prime rate			3.51	%			3.26	%			3.25	%			25	bp			1	bp

  

bp = basis point = 1/100th of a percent 

 

All references above to net interest margin and net interest spread exclude the sold portion of certain participation loans from calculations. Such loans remain on Bancorp's balance sheet as required by US GAAP because Bancorp retains some form of effective control; however, Bancorp receives no interest income on the sold portion of these loans. These participation loans sold are excluded in the calculation of margins, because Bancorp believes it provides a more accurate depiction of the performance of its loan portfolio.

 

Prime rate and the five year Treasury bond rate are included above to provide a general indication of the interest rate environment in which Bancorp operated. Approximately $869 million, or 38%, of Bancorp’s loans are variable rate; most of these loans are indexed to the prime rate and may reprice as that rate changes. However, approximately $287 million of variable rate loans, have reached their contractual floor of 4% or higher. Interest rates must rise above the level of the floors before these loans will begin to reprice. Approximately $154 million of variable rate loans have contractual floors below 4%. The remaining $428 million of variable rate loans have no contractual floor. Bancorp intends to establish floors whenever possible upon acquisition of new customers. Bancorp’s variable rate loans are primarily comprised of commercial lines of credit and real estate loans. At inception, most of Bancorp’s fixed rate loans are priced in relation to the five year Treasury bond.

 

Average loan balances increased $235 million or 12.3% in 2016. However, competition and the sustained low interest rate environment drove average loan yields lower by 9 basis points. Increased interest income from higher volumes was partially offset by these lower rates. Bancorp grew average interest bearing deposits $170 million or 10.6%. Average interest costs on interest bearing deposits decreased 1 basis point, reflecting a stabilization of the sustained low interest rate environment of recent years. Average Federal Home Loan Bank (“FHLB”) advances increased by $4.4 million or 10.8%, with average rates decreasing by 61 basis points.

 

Considering the recent increase in short-term interest rates implemented by the Federal Open Market Committee and with the expectation of additional increases in 2017, management anticipates that net interest margins will increase during the coming year. However, competitive pressures on rates for new loans could result in pressure on the net interest margin for 2017. The margin could be affected negatively if competition causes increases in deposit rates or a decline in loan pricing in Bancorp’s markets.

 

Asset/Liability Management and Interest Rate Risk

 

Managing interest rate risk is critical to Bancorp. The primary objective of interest rate risk management is to neutralize effects of interest rate changes on net income. By considering both on and off-balance sheet financial instruments, management evaluates interest rate sensitivity while attempting to optimize net interest income within the constraints of prudent capital adequacy, liquidity needs, market opportunities and customer requirements.

 

  

Interest Rate Simulation Sensitivity Analysis

 

Bancorp uses an earnings simulation model to estimate and evaluate the impact of an immediate change in interest rates on earnings in a one year forecast. The simulation model is designed to reflect dynamics of interest earning assets, interest bearing liabilities and off-balance sheet financial instruments. By estimating effects of interest rate increases and decreases, the model can reveal approximate interest rate risk exposure. This simulation model is used by management to gauge approximate results given a specific change in interest rates at a given point in time.  The model is therefore a tool to indicate earnings trends in given interest rate scenarios and may not indicate actual expected results. 

 

The December 31, 2016 simulation analysis, which shows little interest rate sensitivity, indicates that increases in interest rates of 100 to 200 basis points would have a negative effect on net interest income, and a decrease of 100 basis points in interest rates would also have a negative effect on net interest income.  In this scenario, if rates raise 200 bp, net interest income declines 1.18%, primarily due to the high percentage of non-maturity deposits, which reprice immediately, combined with the short duration of time deposits matched against the loan portfolio. These estimates are summarized below. The scenario of rates decreasing 200 bp is not reasonably possible given current low rates for short-term instruments and most deposits.

 

		Net interest income % change
Increase 200 bp			(1.18)
Increase 100 bp			(0.87)
Decrease 100 bp			(3.69)
Decrease 200 bp			N/A

 

Approximately 62% of its loan portfolio has fixed rates and 12% of its loan portfolio is priced at variable rates with floors of 4% or higher. Since the prime rate is currently 3.75%, a rise in rates would have to increase more than 25 bps before the rates on such loans will rise to compensate for higher interest costs. This effect is captured in the simulation analysis above.

 

Undesignated derivative instruments described in Note 22 to Bancorp’s consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value due to changes in prevailing interest rates, recorded in other non-interest income. Because of matching terms of offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings, and are therefore not included in the simulation analysis results above.

 

Derivatives designated as cash flow hedges described in Note 22 to Bancorp’s consolidated financial statements are recognized on the consolidated balance sheet at fair value, with changes in fair value due to changes in prevailing interest rates, recorded net of tax in other comprehensive income.

 

The following table presents the increases in net interest income due to changes in rate and volume computed on a tax-equivalent basis and indicates how net interest income in 2016 and 2015 was impacted by volume increases and the lower average interest rate environment. Tax-equivalent adjustments are based on a 35% federal tax rate. The change in interest due to both rate and volume has been allocated to the change due to rate and the change due to volume in proportion to the relationship of the absolute dollar amounts of the change in each. 

 

  

Taxable Equivalent Rate/Volume Analysis

 

		2016/2015												2015/2014
		Increase (decrease)												Increase (decrease)
		due to												due to
(In thousands)		Net change				Rate				Volume				Net change				Rate				Volume
Interest income
Loans		$	8,321			$	(1,804	)		$	10,125			$	3,444			$	(3,099	)		$	6,543
Federal funds sold			228				191				37				(29	)			2				(31	)
Mortgage loans held for sale			(12	)			10				(22	)			75				19				56
Securities
Taxable			331				(787	)			1,118				555				(113	)			668
Tax-exempt			40				12				28				(7	)			(33	)			26
Total interest income			8,908				(2,378	)			11,286				4,038				(3,224	)			7,262
Interest expense
Deposits
Interest bearing demand deposits			385				171				214				97				24				73
Savings deposits			4				(1	)			5				3				(1	)			4
Money market deposits			172				144				28				15				(10	)			25
Time deposits			(357	)			(166	)			(191	)			(697	)			(375	)			(322	)
Securities sold under agreements to repurchase			(13	)			(7	)			(6	)			9				1				8
Federal funds purchased and other short-term borrowings			51				33				18				(4	)			1				(5	)
Federal Home Loan Bank advances			(176	)			(269	)			93				99				(24	)			123
Total interest expense			66				(95	)			161				(478	)			(384	)			(94	)
Net interest income		$	8,842			$	(2,283	)		$	11,125			$	4,516			$	(2,840	)		$	7,356

Bancorp’s tax equivalent net interest income increased $8.8 million for the year ended December 31, 2016 compared to the same period of 2015, while 2015 increased $4.5 million compared to 2014.

 

As shown in the table above, net interest income for 2016 compared to 2015 was positively impacted, most significantly by an increase in loan volume and to a lesser extent by securities volume, a more favorable mix of deposits, and a decrease in rates of FHLB advances. Net interest income for the comparative periods was negatively impacted by a decline in the average rate earned on assets. The change in average rates on deposits was slight with only a minimal impact on earnings.

 

For the year 2015 compared to 2014, net interest income was positively impacted most significantly by an increase in loan and, to a lesser extent, securities volume, a decrease in deposit rates, a more favorable mix of deposits, and decreases in the rates of FHLB advances. Net interest income was negatively impacted by a decline in the average rate earned on assets and higher volume of FHLB advances.

 

  

Provision for Loan Losses

 

In determining the provision for loan losses, management considers many factors. Among these are the quality of the loan portfolio, underlying collateral, previous loss experience, the size and composition of the loan portfolio and an assessment of the impact of current economic conditions on borrowers’ ability to pay. The provision for loan losses and resulting ratios are summarized below:

 

(Dollars in thousands)		2016				2015				2014
Provision (credit) for loan losses		$	3,000			$	750			$	(400	)
Allowance to loans at year end			1.04	%			1.10	%			1.33	%
Allowance to average loans for year			1.11	%			1.17	%			1.41	%

  

The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, is adequate to provide coverage for inherent losses on outstanding loans. The allowance for loan losses is calculated after considering credit quality factors, and ultimately relies on an overall internal analysis of risk in the loan portfolio. Based on this analysis, the provision for loan losses is determined and recorded. The provision reflects the results of an allowance methodology that is driven by risk ratings, historical losses, specific loan loss allocations, and qualitative factors. The 2016 provision reflected a number of factors, including record loan growth and qualitative considerations. Key indicators of loan quality continued to show improvement during 2016, with levels of non-performing loans continuing a five year downward trend. Bancorp considers the present asset quality metrics to be exceptionally strong. Recognizing the cyclical nature of the lending business, this trend will most likely normalize over the long term. More information on this process can be found in the “Allowance for loan losses” section.

 

Non-performing loans decreased to $6.7 million at December 31, 2016 from $8.9 million at year-end 2015, primarily due to a decrease in non-accrual loans. Troubled debt restructurings (TDRs) currently accruing interest, decreased from $1.1 million at December 31, 2015 to $974 thousand at December 31, 2016, declining as a result of payments applied to principal on the three loans involved. The ratio of non-performing loans to total loans was 0.29% at December 31, 2016, down from 0.44% at December 31, 2015. Another key metric, net charge-offs, totaled 0.07% of average loans for 2016 compared to 0.17% for 2015. See “Financial Condition-Non-performing Loans and Assets” for further discussion of non-performing loans.  See “Financial Condition-Summary of Loan Loss Experience” for further discussion of loans charged off during the year.

 

Bancorp’s loan portfolio is diversified with no significant concentrations of credit. Geographically, most loans are extended to borrowers in the metropolitan areas of Louisville, Indianapolis and Cincinnati. The adequacy of the allowance is monitored on an ongoing basis and it is the opinion of management that the balance of the allowance for loan losses at December 31, 2016 is adequate to absorb probable losses inherent in the loan portfolio as of the financial statement date. See “Financial Condition-Allowance for Loan Losses” for more information on the allowance for loan losses. 

 

  

Non-Interest Income and Non-Interest Expenses

 

The following table provides a comparison of components of non-interest income for 2016, 2015 and 2014. Below the table is a discussion of significant changes and trends.

 

														2016/2015								2015/2014
(Dollars in thousands)		2016				2015				2014				Change				%				Change				%
Wealth management and trust services		$	19,155			$	18,026			$	18,212			$	1,129				6.3	%		$	(186	)			(1.0	)%
Service charges on deposit accounts			9,471				8,906				8,883				565				6.3				23				0.3
Bankcard transactions			5,655				4,876				4,673				779				16.0				203				4.3
Mortgage banking			3,897				3,488				2,653				409				11.7				835				31.5
Securities brokerage			2,145				1,994				2,060				151				7.6				(66	)			(3.2	)
Bank owned life insurance			871				889				927				(18	)			(2.0	)			(38	)			(4.1	)
Other			2,343				1,771				1,747				572				32.3				24				0.9
		$	43,537			$	39,950			$	39,155			$	3,587				9.0	%		$	795				2.0	%

 

 

Wealth Management and Trust

 

The largest component of non-interest income is wealth management and trust (“WM&T”) revenue. The magnitude of WM&T revenue distinguishes Bancorp from other community banks of similar asset size. Trust assets under management totaled $2.52 billion at December 31, 2016, a 13% increase compared to $2.24 billion at December 31, 2015. Assets under management are stated at market value and while the 2016 increase was partially the result of a rising stock market during the year, it also represented the best year ever for WM&T in terms of new clients added. WM&T revenue, which constitutes an average of 44% of non-interest income, increased $1.1 million, or 6.3%, for 2016 compared to 2015. Recurring fees, which generally comprise over 95% of the WM&T revenue, increased $856 thousand, or 4.9%, in 2016, compared to 2015. Recurring fees earned for managing accounts are based on a percentage of market value of the assets under management and are assessed on a monthly basis. Some revenues of the WM&T department, most notably executor, insurance, and some employee benefit plan-related fees, are non-recurring in nature and the timing of these revenues corresponds with the related administrative activities, and are also based on the market value of assets under management. Total non-recurring fees increased $273 thousand for 2016, compared to 2015. For 2016, 2015 and 2014 executor fees totaled approximately $549 thousand, $390 thousand and $739 thousand, respectively. Contracts between WM&T and their clients do not permit performance based fees and accordingly, none of the fees earned by WM&T are performance based. Management believes the WM&T department will continue to factor significantly in Bancorp’s financial results and provide strategic diversity to revenue streams. Management is optimistic that the WM&T department will deliver strong growth in 2017, but notes that increased market volatility could affect near-term results. The tables that follow present additional information on the assets under management and fees earned by WM&T.

 

The following table provides information regarding assets under management (AUM) by WM&T as of December 31, 2016 and 2015. This table demonstrates that:

 

●

Approximately 80% of our AUM are actively managed.

 

●

Non-managed employee benefit plan accounts consist primarily of participant directed assets.

 

●

The amount of custody and safekeeping accounts is insignificant, and

 

●

The majority of our managed assets are in personal trust, agency, and investment management accounts.

  

 

Assets Under Management by Account Type		December 31, 2016								December 31, 2015
		Assets								Assets
(in thousands)		Managed				Non-managed (1)				Managed				Non-managed (1)
Personal trust and agency accounts		$	548,132			$	92,880			$	555,649			$	2,093
Employee benefit and retirement related accounts
Defined contribution			39,082				355,150				36,837				304,112
Defined benefit			12,965				-				14,053				-
IRA's			306,496				8,150				290,251				9,349
Investment management and investment advisor agency accounts			847,587				18,356				770,194				-
Foundation and endowment trust and agency accounts			223,741				-				216,174				4,320
Total fiduciary accounts		$	1,978,003			$	474,536			$	1,883,158			$	319,874
Custody and safekeeping accounts			-				70,872				-				34,637
Totals		$	1,978,003			$	545,408			$	1,883,158			$	354,511
Total managed and non-managed assets		$	2,523,411							$	2,237,669

 

(1) Non-managed assets represent those for which WM&T does not have investment discretion.

 

The table below presents data regarding WM&T managed assets by class of investment as of December 31, 2016 and 2015. Managed assets are invested in instruments for which market values can be readily determined, the majority of which are sensitive to market fluctuations. This table demonstrates that:

 

●

Managed assets are invested in instruments for which market values can be readily determined.

 

●

The majority of these instruments are sensitive to market fluctuations.

 

●

The composition of our managed assets is divided approximately 60% in equities and 40% in fixed income, and this composition is relatively consistent from year to year, and

 

●

No Stock Yards Bank propriety mutual funds exist, and therefore no such investment options are available to our clients.

 

Managed Assets by Class of Investment
		As of December 31,
(in thousands)		2016				2015
Non-interest bearing deposits		$	145			$	357
Interest bearing deposits			148,751				118,692
US Treasury and government agency obligations			39,862				56,457
State, county and municipal obligations			120,576				133,887
Money market mutual funds			12,908				41,921
Equity mutual funds			452,593				416,646
Other mutual funds - fixed, balanced, and municipal			300,811				280,903
Other notes and bonds			92,338				77,584
Common and preferred stocks			708,782				654,208
Real estate mortgages			388				437
Real estate			45,502				45,297
Other miscellaneous assets (1)			55,347				56,769
Total managed assets		$	1,978,003			$	1,883,158

 

(1) Includes rights, warrants, annuities, insurance policies, unit investment trusts, and oil and gas rights.

 

  

The table below provides information regarding fee income earned by Bancorp’s WM&T department for the twelve-month periods ended December 31, 2016, 2015 and 2014. The table below demonstrates that fee revenue is earned most significantly from personal trust, agency, and investment management accounts. Fees are based on AUM and tailored for individual accounts and/or relationships. We use a fee structure that considers and tailors based on type of account and other factors. For example, fee structures are in place for investment management, irrevocable trusts, revocable trusts, IRA accounts, and accounts holding only fixed income securities. There are also fee structures for estate settlements, which are non-recurring, and retirement plan services which typically consist of a one-time conversion fee with recurring AUM fees to follow. All fees are based on the market value of each account and are tiered based on account size, with larger relationships paying a lower percentage of AUM in fees. Fees are agreed upon at the time the account is opened and these and any subsequent revisions are communicated in writing to the customer. Fees earned are not performance based nor are they based on investment strategy or transactions.

 

Fiduciary and Related Services Income
		Years Ended December 31,
(In thousands)		2016				2015				2014
Personal trust and agency		$	7,142			$	6,825			$	7,499
Employee benefits and related trust
Defined contribution			1,543				1,367				1,284
Defined benefit			106				125				119
IRA's			3,000				2,847				2,579
Corporate trust and agency			3				3				3
Investment management and investment advisory agency			6,521				6,087				5,639
Foundation and endowment trust and agency			491				433				535
Custody and safekeeping			104				90				87
Brokerage and insurance			45				132				202
Other			200				117				265
Total		$	19,155			$	18,026			$	18,212

 

Other Non-interest Income

 

Service charges on deposit accounts increased $565 thousand, or 6.3%, for 2016 compared to 2015. Service charge income is driven by transaction volume, which can fluctuate throughout the year. The increases for 2016 are primarily due to the introduction of a new checking account product during the year. This product provides ancillary services to customers, while carrying a monthly service charge. Another significant component of service charges is related to fees earned on checking account overdrafts. Management expects this source of revenue to slowly decline due to anticipated changes in customer behavior and ongoing regulatory restrictions.

 

Bankcard transaction revenue increased $779 thousand, or 16.0%, for 2016 compared to 2015. Bankcard revenue primarily represents income the Bank derives from customers’ use of debit and credit cards. The increase in 2016 reflected volume resulting from newly offered commercial credit cards. Volume, which is dependent on consumer behavior, is expected to continue to increase. However, interchange income is based on rates set by service providers in a competitive market. Bancorp expects a slight decrease in interchange rates as service providers gravitate to the lower cost options within the market, potentially decreasing revenue from this source.

 

Mortgage banking revenue primarily includes gains on sales of mortgage loans. Bancorp’s mortgage banking department originates residential mortgage loans to be sold in the secondary market. Interest rates on the loans sold are locked with the investor prior to closing the loans, thus Bancorp bears no interest rate risk related to these loans. The department offers conventional, VA and FHA financing, for purchases and refinances, as well as programs for first-time home buyers. Interest rates on mortgage loans directly impact the volume of business transacted by the mortgage banking division. Mortgage banking revenue increased $409 thousand, or 11.7%, in 2016 compared to 2015. Market rates for mortgage loans remained low during 2016, while economic conditions improved stimulating both purchase and refinance activity for the year. As interest rates rise Bancorp anticipates a slowing of refinancing activity.

 

In 2016 there were no securities sold. In 2015, Bancorp sold securities with total fair market value of $5.9 million, generating no gain or loss. These securities consisted of agency and mortgage-backed securities with small remaining balances. In 2014, Bancorp sold securities with total fair market value of $7.7 million, generating a net loss of $9 thousand. These securities consisted of mortgage-backed securities with small remaining balances, obligations of state and political subdivisions, and agency securities. Sales were made in the ordinary course of portfolio management. Management has the intent and ability to hold all remaining investment securities available-for-sale for the foreseeable future.

 

  

Securities brokerage commissions and fees increased $151 thousand, or 7.6%, in 2016 compared to 2015, corresponding to overall brokerage volume. Brokerage commissions and fees earned consist primarily of stock, bond and mutual fund sales as well as wrap fees on accounts. Wrap fees are charges for investment programs that bundle together a suite of services, such as brokerage, advisory, research and management, and are based on a percentage of assets. Bancorp deploys its brokers primarily through its branch network via an arrangement with a third party broker-dealer, while larger managed accounts are serviced in the Bank’s WM&T department.

 

Income related to bank-owned life insurance (“BOLI”) declined to $871 thousand in 2016 compared to $889 thousand for 2015, reflecting a lower interest crediting rate in 2016 due to the prevailing low interest rate environment.  BOLI assets represent the cash surrender value for life insurance policies on certain key employees who have provided consent for Bancorp to be the beneficiary of a portion of such policies. The related change in cash surrender value and any death benefits received under the policies are recorded as non-interest income. This income helps offset the cost of various employee benefits.

 

Other non-interest income increased $572 thousand, or 32.3%, during 2016 compared to 2015. Included in this category is swap fee income, which totaled $467 thousand and $60 thousand for 2016 and 2015, respectively. Opportunities to earn swap fee income are infrequent due to the specialized nature of the transactions.

 

The following table provides a comparison of components of non-interest expenses for 2016, 2015 and 2014. Below the table is a discussion of significant changes and trends.

 

														2016/2015								2015/2014
(Dollars in thousands)		2016				2015				2014				Change				%				Change				%
Salaries and employee benefits		$	49,185			$	44,709			$	44,687			$	4,476				10.0	%		$	22				0.0	%
Net occupancy expense			6,279				5,912				5,963				367				6.2				(51	)			(0.9	)
Data processing expense			7,073				6,348				6,393				725				11.4				(45	)			(0.7	)
Furniture and equipment expense			1,143				1,074				1,016				69				6.4				58				5.7
FDIC insurance			1,181				1,258				1,314				(77	)			(6.1	)			(56	)			(4.3	)
Loss (gain) on other real estate owned			(409	)			147				(271	)			(556	)			(378.2	)			418				(154.2	)
Amortization of investment in tax credit partnerships			4,458				634				1,095				3,824				603.2				(461	)			(42.1	)
Other			12,610				13,316				13,012				(706	)			(5.3	)			304				2.3
		$	81,520			$	73,398			$	73,209			$	8,122				11.1	%		$	189				0.3	%

                                                                         

Salaries and benefits, the largest component of non-interest expenses increased $4.5 million, or 10%, in 2016 compared to 2015. The increase reflected the addition of personnel associated with growth and operational support, higher incentive compensation related to accelerating loan and earnings growth, and increases in employee benefits. At December 31, 2016, Bancorp had 578 full-time equivalent employees compared to 555 at December 31, 2015 and 524 at December 31, 2014.

 

Net occupancy expense increased $367 thousand, or 6.2%, from 2015 to 2016. The increase was largely due to higher rent and depreciation for locations added during 2015 and increased maintenance costs company-wide. At December 31, 2016, Bancorp had 37 banking center locations, including the main office, and a separate operations center.

 

Data processing expense increased $725 thousand, or 11.4%, from 2015 to 2016, largely due to increases in computer costs resulting from system improvements and expenses related to the issuance and processing of business credit cards. This category includes computer software amortization, equipment depreciation, and expenditures related to investments in new technology needed to maintain and improve the quality of delivery channels and internal resources.

 

  

Furniture and equipment expense increased $69 thousand or 6.4% in 2016, as compared to 2015, due to a variety of factors, none of which is individually significant. Costs of capital asset additions flow through the statement of income over the lives of the assets in the form of depreciation expense. 

 

FDIC insurance expense decreased $77 thousand, or 6.1% for the year ended December 31, 2016, as compared to the same period in 2015. The assessment is calculated by the FDIC, and the decline in expense is due primarily to a change in assessment methodology. During 2016, the FDIC revised the assessment criteria to more closely align FDIC assessments with each financial institution’s risks. Bancorp benefited from this change.

 

Gains/losses from the sale of foreclosed assets decreased non-interest expense by $556 thousand, for 2016 compared to 2015. This occurred as Bancorp experienced a net gain of $409 thousand for 2016 as compared to a net loss of $147 thousand in 2015.

 

Amortization expense of investments in tax credit partnerships increased $3.8 million for the year ended December 31, 2016 compared to the same period of 2015. This expense reflects amortization of investments in partnerships which generate federal income tax credits and can vary widely depending upon the timing and magnitude of investments and related amortization. For each of Bancorp’s investments in tax credit partnerships, the tax benefit compared to the amortization results in a positive effect on net income. See the Income Taxes section below for details on amortization and income tax impact for these credits.

 

Other non-interest expenses, decreased $706 thousand, or 5.3% for the year ended December 31, 2016 compared to the same period of 2015. The decrease was primarily the result of the following:

 

●

A recovery of $588 thousand in 2016 of a 2008 impairment loss. In 2004, Bancorp invested $1.4 million in Indiana Business Bancorp (“IBB”), and included the investment in other assets. Due to a decline in the market value of the stock, Bancorp recorded an impairment charge totaling $866 thousand in 2008. In April 2016, IBB entered into an agreement to be acquired. The transaction was completed in October 2016, resulting in the $588 thousand pre-tax recovery, which was recorded in other expense in the fourth quarter of 2016.

●

A decrease in the provision expense for estimated losses on unfunded commitments; expense of $432 thousand for 2015 as compared to a net reduction of $82 thousand in 2016. This is based on evaluation of the credit risk related to available lines of credit in the loan portfolio and fluctuates based on borrower’s use or repayment of those lines.

●

A decrease of $366 thousand in amortization expense for mortgage servicing rights, 2016 compared to 2015, as pools of MSRs added several years ago were fully amortized in 2015.

 

These decreases were partially offset by higher state bank taxes and losses on asset disposals, 2016 over 2015. This category also includes legal and professional fees, donations, marketing, OREO maintenance, printing, and mail and telecommunications expenses, all of which experienced insignificant changes year to year.

 

Bancorp's efficiency ratio for 2016 of 57.6% increased from 56.8% in 2015. Excluding the amortization of the investments in tax credit partnerships, the adjusted efficiency ratio, a non-GAAP measure, would have been 54.4% and 56.3% for 2016 and 2015, respectively. See the Non-GAAP Financial Measures section for details on reconcilement to US GAAP measures.

 

 

Income Taxes

 

A three year comparison of income tax expense and effective tax rate follows:

 

(Dollars in thousands)		2016				2015				2014
Income tax expense		$	15,244			$	16,933			$	15,281
Effective tax rate			27.1	%			31.3	%			30.5	%

 

 

The decrease in the effective tax rate, 2015 to 2016, is largely the result of higher utilization of federal income tax credits in 2016. Bancorp invests in certain partnerships that yield federal income tax credits. For each of Bancorp’s investments in tax credit partnerships the tax benefit compared to the amortization results in a positive effect on net income.

 

The increase in the effective tax rate from 2014 to 2015 arose from proportionately lower nontaxable income from the increase in cash value of life insurance and municipal securities. For more information regarding income taxes and the effective tax rate see Note 8 to Bancorp’s consolidated financial statements.

 

Financial Condition

 

Earning Assets and Interest Bearing Liabilities

 

Summary information with regard to Bancorp’s financial condition follows:

 

														2016/2015								2015/2014
(Dollars in thousands)		2016				2015				2014				Change				%				Change				%
Average earning assets		$	2,730,949			$	2,430,400			$	2,259,843			$	300,549				12.4	%		$	170,557				7.5	%
Average interest bearing liabilities			1,895,258				1,715,584				1,664,406				179,674				10.5	%			51,178				3.1	%
Average total assets			2,886,396				2,573,901				2,398,430				312,495				12.1	%			175,471				7.3	%
Total year end assets			3,039,481				2,816,801				2,563,868				222,680				7.9	%			252,933				9.9	%

 

 

Bancorp has experienced growth in earning assets over the last several years primarily in the area of loans.  From 2015 to 2016, average loans increased 12.3%, or $235.2 million, compared to 8.4% or $147.5 million from 2014 to 2015. Growth has been all organic as each of Bancorp’s three markets continued to participate in accelerated lending activity. Loan growth during 2016 reflected ongoing expansion in key lending categories such as commercial and industrial lending, and non-owner occupied commercial real estate lending, which have remained well under regulatory guidelines for commercial investment real estate. Utilization rates on lines of credit were 52%, 48% and 52% as of December 31 2016, 2015 and 2014, respectively. Average securities available-for-sale increased $55.2 million, or 13.0% from 2015 to 2016, compared to $31.8 million, or 8.1% from 2014 to 2015.

 

The increase in average interest bearing liabilities from 2015 to 2016 occurred primarily in demand deposits as clients continued to have excess cash balances and few short-term investment alternatives in the current rate environment. Average total interest bearing deposit accounts increased 10.6% and non-interest bearing deposit accounts increased 16.5% in 2016. Time deposits decreased, 11.2%, or $31.9 million in 2016 as compared to 13.9% or $46.0 million in 2015, as Bancorp intentionally did not renew higher cost deposits. Bancorp continued to utilize fixed rate advances from the FHLB during 2016 as these rates compared favorably to similar term time deposits.  Bancorp had an average of $45.5 million in outstanding FHLB advances in 2016 compared to $41.0 million and $35.7 million in 2015 and 2014, respectively.  At December 31, 2016 and 2015, federal funds purchased from correspondent banks totaled $47.4 million and $22.5 million, respectively.

 

At December 31, 2016, Bancorp had excess cash balances resulting from seasonal deposits of approximately $100 million. These funds are invested in short-term investments, as the deposits are expected to return to normal levels during the first two quarters of 2016. While these accounts are profitable, the excess investment is expected to have a negative effect on net interest margin for the first six months of 2017 since short term rates are significantly lower than rates for longer term earning assets.

 

 

Average Balances and Interest Rates – Taxable Equivalent Basis

 

		Year 2016												Year 2015												Year 2014
(Dollars in thousands)		Average balances				Interest				Average rate				Average balances				Interest				Average rate				Average balances				Interest				Average rate
Earning assets
Federal funds sold		$	92,994			$	491				0.53	%		$	82,405			$	263				0.32	%		$	91,