Arrow Financial Earnings 2018-12-31
AROW 10K Annual Report
| Balance Sheet | Income Statement | Cash Flow |
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 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 December 31, 2018
Commission File Number: 0-12507
ARROW FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
New York | 22-2448962 | |||
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |||
250 GLEN STREET, GLENS FALLS, NEW YORK 12801 | ||||
(Address of principal executive offices) (Zip Code) | ||||
Registrant’s telephone number, including area code: (518) 745-1000 | ||||
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE | ||||
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: | ||||
Common Stock, Par Value $1.00 | ||||
(Title of Class) | ||||
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x 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 x 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. x Yes No
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). x Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of 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 X | Non-accelerated filer | Smaller reporting company | Emerging growth company | ||||||||||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. Yes No
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes x No
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $510,085,420
Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date.
Class | Outstanding as of February 28, 2019 | |
Common Stock, par value $1.00 per share | 14,465,928 | |
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s Proxy Statement for the Annual Meeting of Stockholders to be held May 8, 2019 (Part III).
ARROW FINANCIAL CORPORATION
FORM 10-K
TABLE OF CONTENTS
Page | ||
Note on Terminology | 3 | |
The Company and Its Subsidiaries | 3 | |
Forward-Looking Statements | 3 | |
Use of Non-GAAP Financial Measures | 4 | |
PART I | ||
PART II | ||
PART III | ||
PART IV | ||
*These items are incorporated by reference to the Corporation’s Proxy Statement for the Annual Meeting of Stockholders to be held May 8, 2019.
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NOTE ON TERMINOLOGY
In this Annual Report on Form 10-K, the terms “Arrow,” “the registrant,” “the Company,” “we,” “us,” and “our,” generally refer to Arrow Financial Corporation and subsidiaries as a group, except where the context indicates otherwise. At certain points in this Report, our performance is compared with that of our “peer group” of financial institutions. Unless otherwise specifically stated, this peer group is comprised of the group of 68 domestic (U.S.-based) bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Board’s most recent “Bank Holding Company Performance Report” (which is the Performance Report for the most recently available period ending September 30, 2018), and peer group data has been derived from such Report. This peer group is not, however, identical to either of the peer groups comprising the two bank indices included in the stock performance graphs on pages 20 and 21 of this Report.
THE COMPANY AND ITS SUBSIDIARIES
Arrow is a two-bank holding company headquartered in Glens Falls, New York. Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National/GFNB) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National/SNB) whose main office is located in Saratoga Springs, New York. Active subsidiaries of Glens Falls National include Upstate Agency, LLC (an insurance agency that sells property and casualty insurance agency and also specializes in selling and servicing group health care policies and life insurance), North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds) and Arrow Properties, Inc. (a real estate investment trust, or REIT). Arrow also owns directly two subsidiary business trusts, organized in 2003 and 2004 to issue trust preferred securities (TRUPs), which are still outstanding.
FORWARD-LOOKING STATEMENTS
The information contained in this Annual Report on Form 10-K contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future. These statements are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and involve a degree of uncertainty and attendant risk. Words such as “expects,” “believes,” “anticipates,” “estimates” and variations of such words and similar expressions often identify such forward-looking statements. Some of these statements, such as those included in the interest rate sensitivity analysis in Item 7A of this Report, entitled “Quantitative and Qualitative Disclosures About Market Risk,” are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models. Other forward-looking statements are based on our general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.
These forward-looking statements may not be exhaustive, are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify. You should not place undue reliance on any such forward-looking statements. In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast. Factors that could cause or contribute to such differences include, but are not limited to:
• | rapid and dramatic changes in economic and market conditions; |
• | sharp fluctuations in interest rates, economic activity, or consumer spending patterns; |
• | sudden changes in the market for products we provide, such as real estate loans; |
• | significant changes in banking or other laws and regulations, including both enactment of new legal or regulatory measures (e.g., the Economic Growth, Regulatory Relief and Consumer Protection Act ("Economic Growth Act"), the Tax Cuts and Jobs Act of 2017 ("Tax Act") and the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank")) or the modification or elimination of pre-existing measures; |
• | significant changes in U.S. monetary or fiscal policy, including new or revised monetary programs or targets adopted or announced by the Federal Reserve ("monetary tightening or easing") or significant new federal legislation materially affecting the federal budget ("fiscal tightening or expansion"); |
• | competition from other sources (e.g., non-bank entities); |
• | similar uncertainties inherent in banking operations or business generally, including technological developments and changes; and |
• | other risks detailed from time to time within our filings with the Securities and Exchange Commission ("SEC"). |
We are under no duty to update any of the forward-looking statements after the date of this Annual Report on Form 10-K to conform such statements to actual results. All forward-looking statements, express or implied, included in this Report and the documents we incorporate by reference and that are attributable to the Company are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that the Company or any persons acting on our behalf may issue.
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USE OF NON-GAAP FINANCIAL MEASURES
The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Company’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them.
Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, as well as disclosures based on that tabular presentation, is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and from the fact that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. We follow these practices.
The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control. The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income. Net interest income as utilized in calculating the efficiency ratio is typically the same as the net interest income presented in Selected Financial Information table discussed in the preceding paragraph, i.e., it is expressed on a tax-equivalent basis. Moreover, many financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain recurring component elements of income and expense, such as intangible asset amortization (which is included in noninterest expense under GAAP but may not be included therein for purposes of calculating the efficiency ratio) and securities gains or losses (which are reflected in the calculation of noninterest income under GAAP but may be ignored for purposes of calculating the efficiency ratio). We make these adjustments.
Tangible Book Value per Share: Tangible equity is total stockholders’ equity less intangible assets. Tangible book value per share is tangible equity divided by total shares issued and outstanding. Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total stockholders’ equity including intangible assets divided by total shares issued and outstanding. Intangible assets includes many items, but in our case, essentially represents goodwill.
Adjustments for Certain Items of Income or Expense: In addition to our regular utilization in our public filings and disclosures of the various non-GAAP measures commonly utilized by financial institutions discussed above, we also may elect from time to time, in connection with our presentation of various financial measures prepared in accordance with GAAP, such as net income, earnings per share (i.e., EPS), return on average assets (i.e., ROA), and return on average equity (i.e., ROE), to provide as well certain comparative disclosures that adjust these GAAP financial measures, typically by removing therefrom the impact of certain transactions or other material items of income or expense that are unusual or unlikely to be repeated. We do so only if we believe that inclusion of the resulting non-GAAP financial measures may improve the average investor's understanding of our results of operations by separating out items that have a disproportional positive or negative impact on the particular period in question or by otherwise permitting a better comparison from period-to-period in our results of operations with respect to our fundamental lines of business, including the commercial banking business.
We believe that the non-GAAP financial measures disclosed by us from time-to-time are useful in evaluating our performance and that such information should be considered as supplemental in nature, and not as a substitute for or superior to, the related financial information prepared in accordance with GAAP. Our non-GAAP financial measures may differ from similar measures presented by other companies.
PART I
Item 1. Business
A. GENERAL
Our holding company, Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956. Arrow owns two nationally- chartered banks in New York (Glens Falls National and Saratoga National), and through such banks indirectly owns various non-
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bank subsidiaries, including an insurance agency, a registered investment adviser and a REIT. See "The Company and Its Subsidiaries," above.
Subsidiary Banks (dollars in thousands) | |||||||
Glens Falls National | Saratoga National | ||||||
Total Assets at Year-End | $ | 2,444,624 | $ | 542,244 | |||
Trust Assets Under Administration and Investment Management at Year-End (Not Included in Total Assets) | $ | 1,282,364 | $ | 103,388 | |||
Date Organized | 1851 | 1988 | |||||
Employees (full-time equivalent) | 462 | 54 | |||||
Offices | 30 | 10 | |||||
Counties of Operation | Warren, Washington, Saratoga, Essex & Clinton | Saratoga, Albany, Rensselaer, & Schenectady | |||||
Main Office | 250 Glen Street Glens Falls, NY | 171 So. Broadway Saratoga Springs, NY | |||||
The holding company’s business consists primarily of the ownership, supervision and control of our two banks, including the banks' subsidiaries. The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks. There were 516 full-time equivalent employees, including 58 employees within our insurance agency affiliate, at December 31, 2018.
We offer a broad range of commercial and consumer banking and financial products. Our deposit base consists of deposits derived principally from the communities we serve. We target our lending activities to consumers and small- and mid-sized companies in our regional geographic area. In addition, through an indirect lending program we acquire consumer loans from an extensive network of automobile dealers that operate in a larger area of upstate New York, and in central and southern Vermont. Through our banks' trust operations, we provide retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.
B. LENDING ACTIVITIES
Arrow engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing. We also maintain an active indirect lending program through our sponsorship of automobile dealer programs under which we purchase consumer auto loans, primarily from dealers that meet pre-established specifications. From time to time, we sell a portion of our residential real estate loan originations into the secondary market, primarily to the Federal Home Loan Mortgage Corporation ("Freddie Mac") and other governmental agencies. Normally, we retain the servicing rights on mortgage loans originated and sold by us into the secondary markets, subject to our periodic determinations on the continuing profitability of such activity.
Generally, we continue to implement lending strategies and policies that are intended to protect the quality of the loan portfolio, including strong underwriting and collateral control procedures and credit review systems. Loans are placed on nonaccrual status either due to the delinquency status of principal and/or interest or a judgment by management that the full repayment of principal and interest is unlikely. Home equity lines of credit, secured by real property, are systematically placed on nonaccrual status when 120 days past due, and residential real estate loans when 150 days past due. Commercial and commercial real estate loans are evaluated on a loan-by-loan basis and are placed on nonaccrual status when 90 days past due if the full collection of principal and interest is uncertain. (See Part II, Item 7.C.II.c. "Risk Elements.") Subsequent cash payments on loans classified as nonaccrual may be applied all to principal, although income in some cases may be recognized on a cash basis.
We lend almost exclusively to borrowers within our normal retail service area in northeastern New York State, with the exception of our indirect consumer lending line of business, where we acquire retail paper from an extensive network of automobile dealers that operate in a larger area of upstate New York, and in central and southern Vermont. The loan portfolio does not include any foreign loans or any other significant risk concentrations. We do not generally participate in loan syndications, either as originator or as a participant. However, from time to time, we buy participations in individual loans, typically commercial loans, originated by other financial institutions in New York and adjacent states. In recent periods, the total dollar amount of such participations has fluctuated, but generally represents less than 20% of commercial loans outstanding. Most of the portfolio is fully collateralized, and many commercial loans are further supported by personal guarantees.
We do not engage in subprime mortgage lending as a business line and we do not extend or purchase so-called "Alt A," "negative amortization," "option ARM's" or "negative equity" mortgage loans.
C. SUPERVISION AND REGULATION
The following generally describes the laws and regulations to which we are subject. Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law. To the extent that the following information summarizes statutory or regulatory law, it is qualified in its entirety by reference to the particular provisions of the various statutes and regulations. Any change in applicable law may have a material effect on our business operations, customers, prospects and investors.
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Bank Regulatory Authorities with Jurisdiction over Arrow and its Subsidiary Banks
Arrow is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 ("BHC Act") and as such is subject to regulation by the Board of Governors of the Federal Reserve System ("FRB"). As a "bank holding company" under New York State law, Arrow is also subject to regulation by the New York State Department of Financial Services. Our two subsidiary banks are both national banks and are subject to supervision and examination by the Office of the Comptroller of the Currency ("OCC"). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"). The BHC Act generally prohibits Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities. Under the BHC Act, a bank holding company generally must obtain FRB approval before acquiring, directly or indirectly, voting shares of another bank or bank holding company, if after the acquisition the acquiror would own 5 percent or more of a class of the voting shares of that other bank or bank holding company. Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states, subject to certain limitations. Bank holding companies that meet certain qualifications may choose to apply to the FRB for designation as "financial holding companies." If they obtain such designation, they will thereafter be eligible to acquire or otherwise affiliate with a much broader array of other financial institutions than "bank holding companies" are eligible to acquire or affiliate with, including insurance companies, investment banks and merchant banks. Arrow has not attempted to become, and has not been designated as, a financial holding company.
The FRB and the OCC have broad regulatory, examination and enforcement authority. The FRB and the OCC conduct regular examinations of the entities they regulate. In addition, banking organizations are subject to requirements for periodic reporting to the regulatory authorities. The FRB and OCC have the authority to implement various remedies if they determine that the financial condition, capital, asset quality, management, earnings, liquidity or other aspects of a banking organization's operations are unsatisfactory or if they determine the banking organization is violating or has violated any law or regulation. The authority of the federal bank regulators over banking organizations includes, but is not limited to, prohibiting unsafe or unsound practices; requiring affirmative action to correct a violation or unsafe or unsound practice; issuing administrative orders; requiring the organization to increase capital; requiring the organization to sell subsidiaries or other assets; restricting dividends, distributions and repurchases of the organization's stock; restricting the growth of the organization; assessing civil money penalties; removing officers and directors; and terminating deposit insurance. The FDIC may terminate a depository institution's deposit insurance upon a finding that the institution's financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices for certain other reasons.
Regulatory Supervision of Other Arrow Subsidiaries
The insurance agency subsidiary of Glens Falls National is subject to the licensing and other provisions of New York State Insurance Law and is regulated by the New York State Department of Financial Services. Arrow's investment adviser subsidiary is subject to the licensing and other provisions of the federal Investment Advisers Act of 1940 and is regulated by the SEC.
Regulation of Transactions between Banks and their Affiliates
Transactions between banks and their "affiliates" are regulated by Sections 23A and 23B of the Federal Reserve Act (FRA). Each of our organization's non-bank subsidiaries (other than the business trusts we formed to issue our TRUPs) is a subsidiary of one of our banks, and also is an "operating subsidiary" under Sections 23A and 23B. This means the non-bank subsidiary is considered to be part of the bank that owns it and thus is not an affiliate of that bank for purposes of Section 23A and 23B. However, each of our two banks is an affiliate of the other bank, under Section 23A, and Arrow, the holding company, is also an affiliate of each bank under both Sections 23A and 23B. Extensions of credit that a bank may make to affiliates, or to third parties secured by securities or obligations of the affiliates, are substantially limited by the FRA and the Federal Deposit Insurance Act (FDIA). Such acts further restrict the range of permissible transactions between a bank and any affiliate, including a bank affiliate. Furthermore, under the FRA, a bank may engage in certain transactions, including loans and purchases of assets, with a non-bank affiliate, only if certain special conditions, including collateral requirements for loans, are met and if the other terms and conditions of the transaction, including interest rates and credit standards, are substantially the same as, or at least as favorable to the bank as, those prevailing at the time for comparable transactions by the bank with non-affiliated companies or, in the absence of comparable transactions, on terms and conditions that would be offered by the bank to non-affiliated companies.
Regulatory Capital Standards
An important area of banking regulation is the federal banking system's promulgation and enforcement of minimum capitalization standards for banks and bank holding companies.
Bank Capital Rules. In July 2013, federal bank regulators, including the FRB and the OCC, approved their revised bank capital rules aimed at implementing capital requirements pursuant to Dodd-Frank. These rules were also intended to coordinate U.S. bank capital standards with the then-current drafts of the Basel III proposed bank capital standards for all of the developed world's banking organizations. The federal regulators' revised capital rules (the "Capital Rules"), which impose significantly higher minimum capital ratios on U.S. financial institutions than the rules they replaced, became effective for Arrow and its subsidiary banks on January 1, 2015, with full phase in by 2019.
These Capital Rules consist of two basic types of capital measures, a leverage ratio and set of risk-based capital measures. Within these two broad types of rules, however, significant changes were made in the revised Capital Rules, as discussed as follows.
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Leverage Ratio. The Capital Rules increased the minimum required leverage ratio from 3.0% to 4.0%. The leverage ratio continues to be defined as the ratio of the institution's "Tier 1" capital (as defined under the new leverage rule) to total tangible assets (again, as defined under the revised leverage rule).
Risk-Based Capital Measures. Risk-based capital measures assign various risk weightings to all of the institution's assets, by asset type, and to certain off balance sheet items, and then establish minimum levels of capital to the aggregate dollar amount of such risk-weighted assets. Under the risk-based Capital Rules, there are 8 major risk-weighted categories of assets (although there are several additional super-weighted categories for high-risk assets that are generally not held by community banking organizations like Arrow's). The Capital Rules include a measure called the "common equity tier 1 capital ratio" (CET1). For this ratio, only common equity (basically, common stock plus surplus plus retained earnings) qualifies as capital (i.e., CET1). Preferred stock and trust preferred securities, which qualified as Tier 1 capital under the old Tier 1 risk-based capital measure (and continue to qualify as capital under the revised Tier 1 risk-based capital measure), are not included in CET1 capital. Technically, under these rules, CET1 capital also includes most elements of accumulated other comprehensive income (AOCI), including unrealized securities gains and losses, as part of both total regulatory capital (numerator) and total assets (denominator). However, smaller banking organizations like Arrow's were given the opportunity to make a one-time irrevocable election to include or not to include certain elements of AOCI, most notably unrealized securities gains or losses. Arrow made such an election, i.e., not to include unrealized securities gains and losses in calculating our CET1 ratio under the Capital Rules. The minimum CET1 ratio under these rules, effective January 1, 2015, is 4.50%, which will remain constant throughout the phase-in period.
Consistent with the general theme of higher capital levels, the Capital Rules also increased the minimum ratio for Tier 1 risk-based capital from 4.0% to 6.0%, effective January 1, 2015. The minimum level for total risk-based capital under the Capital Rules remained at 8.0%.
The Capital Rules incorporate a capital concept, the so-called "capital conservation buffer" (set at 2.5%, after full phase-in), which must be added to each of the minimum required risk-based capital ratios (i.e., the minimum CET1 ratio, the minimum Tier 1 risk-based capital ratio and the minimum total risk-based capital ratio). The capital conservation buffer is being phased-in over four years beginning January 1, 2016 (see the table below). When, during economic downturns, an institution's capital begins to erode, the first deductions from a regulatory perspective would be taken against the conservation buffer. To the extent that such deductions should erode the buffer below the required level (2.5% of total risk-based assets after full phase-in), the institution will not necessarily be required to replace the buffer deficit immediately, but will face restrictions on paying dividends and other negative consequences until the buffer is fully replenished.
Also under the Capital Rules, and as required under Dodd-Frank, TRUPs issued by small- to medium-sized banking organizations (such as Arrow) that were outstanding on the Dodd-Frank grandfathering date for TRUPS (May 19, 2010) will continue to qualify as tier 1 capital, up to a limit of 25% of tier 1 capital, until the TRUPs mature or are redeemed, subject to certain limitations. See the discussion of grandfathered TRUPs in Section E ("CAPITAL RESOURCES AND DIVIDENDS") of Item 7.
The following is a summary of the definitions of capital under the various risk-based measures in the Capital Rules:
Common Equity Tier 1 Capital (CET1): Equals the sum of common stock instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income (AOCI), and qualifying minority interests, minus applicable regulatory adjustments and deductions. Such deductions will include AOCI, if the organization has exercised its irrevocable option not to include AOCI in capital (Arrow made such an election). Mortgage-servicing assets, deferred tax assets, and investments in financial institutions are limited to 15% of CET1 in the aggregate and 10% of CET1 for each such item individually.
Additional Tier 1 Capital: Equals the sum of noncumulative perpetual preferred stock, tier 1 minority interests, grandfathered TRUPs, and Troubled Asset Relief Program instruments, minus applicable regulatory adjustments and deductions.
Tier 2 Capital: Equals the sum of subordinated debt and preferred stock, total capital minority interests not included in Tier 1, and allowance for loan and lease losses (not exceeding 1.25% of risk-weighted assets) minus applicable regulatory adjustments and deductions.
The following table presents the transition schedule applicable to Arrow and its subsidiary banks under the Capital Rules:
Year, as of January 1 | 2016 | 2017 | 2018 | 2019 | ||||
Minimum CET1 Ratio | 4.500 | % | 4.500 | % | 4.500 | % | 4.500 | % |
Capital Conservation Buffer ("Buffer") | 0.625 | % | 1.250 | % | 1.875 | % | 2.500 | % |
Minimum CET1 Ratio Plus Buffer | 5.125 | % | 5.750 | % | 6.375 | % | 7.000 | % |
Minimum Tier 1 Risk-Based Capital Ratio | 6.000 | % | 6.000 | % | 6.000 | % | 6.000 | % |
Minimum Tier 1 Risk-Based Capital Ratio Plus Buffer | 6.625 | % | 7.250 | % | 7.875 | % | 8.500 | % |
Minimum Total Risk-Based Capital Ratio | 8.000 | % | 8.000 | % | 8.000 | % | 8.000 | % |
Minimum Total Risk-Based Capital Ratio Plus Buffer | 8.625 | % | 9.250 | % | 9.875 | % | 10.500 | % |
Minimum Leverage Ratio | 4.000 | % | 4.000 | % | 4.000 | % | 4.000 | % |
These minimum capital ratios, especially the CET1 ratio (4.5%) and the enhanced Tier 1 risk-based capital ratio (6.0%), which began to apply to the Company on January 1, 2015, represent a heightened and more restrictive capital regime than institutions previously had to meet, and the four year phase-in of the regulatory capital buffer, which began January 1, 2016, will add to the stress on the Company's profitability.
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At December 31, 2018, Arrow and its two subsidiary banks exceeded by a substantial amount each of the applicable minimum capital ratios established under the revised Capital Rules, including the minimum CET1 Ratio, the minimum Tier 1 Risk-Based Capital Ratio, the minimum Total Risk-Based Capital Ratio, and the minimum Leverage Ratio, and including in the case of each risk-based ratio, the phased-in portion of the capital buffer. See Note 19, Regulatory Matters, to the notes to our Consolidated Financial Statements for a presentation of our period-end ratios for 2018 and 2017.
In May 2018, the Economic Growth, Regulatory Relief and Consumer Protection Act (the "Economic Growth Act") , was enacted to modify or remove certain legal requirements, including some requirements related to capital standards implemented under Dodd-Frank. While the Economic Growth Act maintains much of the regulatory structure established by Dodd-Frank, it amends certain aspects of that regulatory framework, including certain capital requirements. These Economic Growth Act changes could result in meaningful regulatory relief regarding capital standards for community banking organizations, such as Arrow's. See the discussion of this item under "2018 Regulatory Reform."
Regulatory Capital Classifications. Under applicable banking law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. The regulators have established five capital classifications for banking institutions, ranging from the highest category of "well-capitalized" to the lowest category of "critically under-capitalized". Under the Capital Rules, a banking institution is considered "well-capitalized" if it meets the following capitalization standards on the date of measurement: a CET1 risk-based capital ratio of 6.50% or greater, a Tier 1 risk-based capital ratio of 8.00% or greater, and a total risk-based capital ratio of 10.00% or greater, provided the institution is not subject to any regulatory order or written directive regarding capital maintenance.
As of December 31, 2018, Arrow and its two subsidiary banks qualified as "well-capitalized" under the revised capital classification scheme.
2018 Regulatory Reform. The Economic Growth Act was signed into law May 24, 2018. Some of its provisions were written to take effect immediately; others have later specified effective dates and still others are open-ended, to be implemented by rule-making. This legislation includes a variety of provisions that are intended to affect community banking institutions such as Arrow, including the following:
• | The federal bank regulatory agencies are directed to establish a "community bank leverage ratio" ("CBLR") of between 8% and 10%, calculated by dividing tangible equity capital by average total consolidated assets of "qualifying community banks" that meet certain requirements to be set by those regulatory agencies. A qualifying community bank is a depository institution or bank holding company with less than $10 billion in total assets that meets other requirements to be established by the regulators. If a qualifying community bank exceeds the community bank leverage ratio, it will be deemed to have met all applicable capital and leverage requirements, including the generally applicable leverage capital requirements and risk-based capital requirements and (if the community bank is a depository institution) the "well capitalized" requirement under the federal "prompt corrective action" capital standards. This new community bank leverage ratio is intended to reduce the burden of compliance with regard to regulatory capital adequacy for qualifying community banks. However, this alternative capital standard will not be effective until the federal bank regulatory authorities adopt rules for its implementation. |
• | The definition of "high volatility commercial real estate" loans that trigger heightened risk-based capital requirements, has been modified and limited to ease the burden of those requirements. |
• | The total asset threshold for qualifying insured financial institutions eligible for an 18-month examination cycle has been increased from $1 billion to $3 billion. |
• | The new law provides that reciprocal deposits of certain institutions shall not be considered "brokered deposits," subject to certain limitations. |
• | Some community banks will be exempt from mortgage escrow requirements, and an expanded "qualified mortgage" exemption for community banks has been implemented to ease the burden of the "ability to repay" requirements in the Truth in Lending Act. |
• | Financial institutions with less than $10 billion in total assets that meet certain requirements will be exempt from the Volcker Rule proprietary trading requirements implemented under the Dodd Frank Act. |
On November 21, 2018, federal banking regulators issued a notice of proposed rulemaking which defines a qualifying “community bank” to include banks or bank holding companies with total consolidated assets of less than $10 billion in addition to other qualifications. The proposed rule would set the threshold for the Community Bank Leverage Ratio (CBLR) at greater than 9 percent, calculated as the ratio of “CBLR tangible equity” divided by “average total consolidated assets.” Based on the parameters of this proposed rulemaking, the CBLR for Arrow and both subsidiary banks is estimated to exceed the 9 percent threshold. However, these proposed rules are not yet final, and the terms of the rules may change before becoming final. Upon effectiveness, the final rules may impact Arrow’s capital options and requirements, although the potential impact of the final rules on Arrow will remain uncertain until those final rules are issued. Until those rules become final, the enhanced bank capital standards promulgated under Dodd-Frank will remain applicable to Arrow.
Dividend Restrictions; Other Regulatory Sanctions
A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business, including for example, through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if its capital falls below minimum regulatory capital ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations. In addition to these potential regulatory limitations on payment of dividends, our holding company's ability to pay dividends to our shareholders, and our subsidiary banks' ability to pay dividends to our holding
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company are also subject to various restrictions under applicable corporate laws, including banking laws (which affect our subsidiary banks) and the New York Business Corporation Law (which affects our holding company). The ability of our holding company and banks to pay dividends or repurchase shares in the future is, and is expected to continue to be, influenced by regulatory policies, the Capital Rules and other applicable law.
In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank holding company or one of its banks, the regulators may take enforcement action or impose enforcement orders, formal or informal, against the holding company or the particular bank. If the ratio of tangible equity to total assets of a bank falls to 2% or below, the bank will likely be closed and placed in receivership, with the FDIC as receiver.
Cybersecurity
In addition to the provisions in the Gramm-Leach-Bliley Act relating to data security (discussed below), Arrow and its subsidiaries are subject to many federal and state laws, regulations and regulatory interpretations which impose standards and requirements related to cybersecurity. For example, in February 2018, the Securities and Exchange Commission ("SEC") issued the "Commission Statement and Guidance on Public Company Cybersecurity Disclosures" to assist public companies in preparing disclosures about cybersecurity risks and incidents. With the increased frequency and magnitude of cybersecurity incidents, the SEC indicated that it is critical that public companies take all required actions to inform investors about material cybersecurity risks and incidents in a timely fashion. Additionally, in October 2018 the SEC issued the "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding Certain Cyber-Related Frauds Perpetrated Against Public Companies and Related Internal Controls Requirements" which cited business email compromises that led to the incidents and that internal accounting controls may need to be reassessed in light of these emerging risks.
In March 2015, federal regulators issued related statements regarding cybersecurity. One statement indicates that financial institutions should design multiple layers of security controls to establish lines of defense and to ensure that their risk management processes also address the risk posed by compromised customer credentials, including security measures to reliably authenticate customers accessing internet-based services of the financial institution. The other statement indicates that a financial institution’s management is expected to maintain sufficient business continuity planning processes to ensure the rapid recovery, resumption and maintenance of the institution’s operations after a cyber-attack involving destructive malware. A financial institution is also expected to develop appropriate processes to enable recovery of data and business operations and address rebuilding network capabilities and restoring data if the institution or its critical service providers fall victim to this type of cyber-attack. Financial institutions that fail to observe this regulatory guidance on cybersecurity may be subject to various regulatory sanctions, including financial penalties.
Anti-Money Laundering and OFAC
Under the Patriot Act and other federal anti-money laundering law, financial institutions must maintain anti-money laundering programs that include established internal policies, procedures, and controls. Financial institutions are also prohibited from entering into specified financial transactions and account relationships and must meet enhanced standards for due diligence and customer identification. Financial institutions must take reasonable steps to conduct enhanced scrutiny of account relationships to guard against money laundering and to report any suspicious transactions. Law enforcement authorities have been granted increased access to financial information maintained by financial institutions. Bank regulators routinely examine institutions for compliance with these obligations and they must consider an institution's compliance in connection with the regulatory review of applications, including applications for banking mergers and acquisitions. The U.S. Department of the Treasury's Office of Foreign Assets Control, or "OFAC," is responsible for helping to insure that U.S. entities do not engage in transactions with certain prohibited parties, as defined by various Executive Orders and Acts of Congress. OFAC publishes lists of persons, organizations, and countries suspected of aiding, harboring or engaging in terrorist acts, known as Specially Designated Nationals and Blocked Persons. If Arrow finds a name on any transaction, account or wire transfer that is on an OFAC list, Arrow must freeze or block such account or transaction, file a suspicious activity report and notify the appropriate authorities. The U.S. Treasury Department's Financial Crises Enforcement Network ("FinCEN") issued a final rule in 2016 increasing customer due diligence requirements for banks, including adding a requirement to identify and verify the identity of beneficial owners of customers that are legal entities, subject to certain exclusions and exemptions. The Company has established procedures for compliance with these requirements.
The USA Patriot Act
The USA Patriot Act, initially adopted in 2001 and re-adopted by the U.S. Congress in 2006 with certain changes (the "Patriot Act"), imposes substantial record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers. The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements. The Patriot Act requires all financial institutions, including banks, to maintain certain anti-money laundering compliance, customer identification and due diligence programs. Compliance with the provisions of the Patriot Act results in substantial costs on all financial institutions.
Reserve Requirements
Pursuant to regulations of the FRB, all banking organizations are required to maintain average daily reserves at mandated ratios against their transaction accounts and certain other types of deposit accounts. These reserves must be maintained in the form of vault cash or in an account at a Federal Reserve Bank.
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Community Reinvestment Act
Arrow's subsidiary banks are subject to the Community Reinvestment Act ("CRA") and implementing regulations. CRA regulations establish the framework and criteria by which the bank regulatory agencies assess an institution's record of helping to meet the credit needs of its community, including low and moderate-income individuals. CRA ratings are taken into account by regulators in reviewing certain applications made by Arrow and its bank subsidiaries.
Privacy and Confidentiality Laws
Arrow and its subsidiaries are subject to a variety of laws that regulate customer privacy and confidentiality. The Gramm-Leach-Bliley Act requires financial institutions to adopt privacy policies, to restrict the sharing of nonpublic customer information with nonaffiliated parties upon the request of the customer, and to implement data security measures to protect customer information. Certain state laws may impose additional privacy and confidentiality restrictions. The Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act of 2003, regulates use of credit reports, providing of information to credit reporting agencies and sharing of customer information with affiliates, and sets identity theft prevention standards.
The Dodd-Frank Act
Dodd-Frank significantly changed the regulatory structure for financial institutions and their holding companies, for example, through provisions requiring the Capital Rules. Among other provisions, Dodd-Frank implemented corporate governance revisions that apply to all public companies, not just financial institutions and permanently increased the FDIC’s standard maximum deposit insurance amount to $250,000, changed the FDIC insurance assessment base to assets rather than deposits and increased the reserve ratio for the deposit insurance fund to ensure the future strength of the fund. The federal prohibition on the payment of interest on certain demand deposits was repealed, thereby permitting depository institutions to pay interest on business transaction accounts. Dodd-Frank established a new federal agency, the Consumer Financial Protection Bureau (the “CFPB”), centralizing significant aspects of consumer financial protection under this agency. Limits were imposed for debit card interchange fees for issuers that have assets greater than $10 billion, which also could affect the amount of interchange fees collected by financial institutions with less than $10 billion in assets. Dodd-Frank also imposed new requirements related to mortgage lending, including prohibitions against payment of steering incentives and provisions relating to underwriting standards, disclosures, appraisals and escrows. The Volcker Rule prohibited banks and their affiliates from engaging in proprietary trading and investing in certain unregistered investment companies.
Federal banking regulators and other agencies including, among others, the FRB, the OCC and the CFPB, have been engaged in extensive rule-making efforts under Dodd-Frank, and the 2018 Economic Growth Act has impacted certain Dodd-Frank requirements, as explained above.
Sarbanes-Oxley Act
The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance, accounting and reporting requirements for companies that have securities registered under the Exchange Act. These requirements included: (1) requirements for audit committees, including independence and financial expertise; (2) certification of financial statements by the chief executive officer and chief financial officer of the reporting company; (3) standards for auditors and regulation of audits; (4) disclosure and reporting requirements for the reporting company and directors and executive officers; and (5) a range of civil and criminal penalties for fraud and other violations of securities laws.
Incentive Compensation
Dodd-Frank required the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities, such as the Company, having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements.
The federal bank regulators issued proposed rules to address incentive-based compensation arrangements in June 2016. Final rules have not yet been issued by the federal bank regulatory agencies under this Dodd-Frank provision.
In 2010, the FRB, OCC and FDIC issued comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Management believes the current and past compensation practices of the Company do not encourage excessive risk taking or undermine the safety and soundness of the organization.
The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Company, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation
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arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
Deposit Insurance Laws and Regulations
In February 2011, the FDIC finalized a new assessment system that took effect in the second quarter of 2011. The final rule changed the assessment base from domestic deposits to average assets minus average tangible equity, adopted a new large-bank pricing assessment scheme, and set a target size for the Deposit Insurance Fund. The changes went into effect in the second quarter of 2011. The rule (as mandated by Dodd-Frank) finalizes a target size for the Deposit Insurance Fund Reserve Ratio at 2.0% of insured deposits. It also implements a lower assessment rate schedule when the ratio reaches 1.15% (so that the average rate over time should be about 8.5 basis points) and, in lieu of dividends, provides for a lower rate schedule when the reserve ratio reaches 2.0% and 2.5%.
In August 2016, the FDIC announced that the reserve ratio reached 1.17% at the end of June 2016. This represents the highest level the ratio has reached in more than eight years. The reduction in assessment rates went into effect in the third quarter of 2016. We are unable to predict whether or to what extent the FDIC may elect to impose additional special assessments on insured institutions in upcoming years, if bank failures should once again become a significant problem.
In January 2019, both of the Company's banking subsidiaries received preliminary notification of eligibility for small bank assessment credits. These credits are related to the Deposit Insurance Recovery Fund Reserve Ratio reaching 1.36% and may reduce the banks' future quarterly assessments.
D. RECENT LEGISLATIVE DEVELOPMENTS
Economic Growth, Regulatory Relief and Consumer Protection Act (the “Economic Growth Act”)
In May 2018, the Economic Growth Act, was enacted to modify or remove certain legal requirements, including some requirements imposed under Dodd-Frank. While the Economic Growth Act maintains much of the regulatory structure established by Dodd-Frank, it amends certain aspects of that regulatory framework . Many of these changes could result in meaningful regulatory relief for community banking organizations, such as Arrow's.
Health Care Reform
Various proposals have been discussed for consideration that would substantially modify various health care laws. At present, we are not able to estimate the likelihood of adoption of any such provisions or the potential impact thereof if adopted.
The Tax Cuts and Jobs Act of 2017 ("Tax Act")
On December 22, 2017, Tax Act was enacted. A number of provisions have impacted us including the following:
• | Tax Rate. The Tax Act replaced the graduated corporate tax rates applicable under prior law, which imposed a maximum tax rate of 35%, with a reduced 21% tax rate. This reduction will generally result in future increased earnings and capital and reduced our net deferred tax liability. Generally accepted accounting principles ("GAAP") requires that the impact of the provisions of the Tax Act be accounted for in the period of enactment. Accordingly, a benefit of $1.1 million was recorded in the fourth quarter of 2017 which represents the impact of the re-measurement of net deferred tax liabilities. |
• | Employee Compensation. A publicly held corporation is not permitted to deduct compensation in excess of $1 million per year paid to certain employees. The Tax Act eliminates certain exceptions to the $1 million limit applicable under prior law related to performance-based compensation, such as equity grants and cash bonuses that are paid only on the attainment of performance goals. Based on our current compensation plans, we do not expect to be impacted by this limitation. |
• | Interest Expense. The Tax Act limits a taxpayer's annual deduction of business interest expense to the sum of (i) business interest income and (ii) 30% of "adjusted taxable income," defined as business's taxable income without taking into account business interest income or expense, net operating losses, and, for 2018 through 2021, depreciation, amortization and depletion. Because we generate significant amounts of net interest income, we do not expect to be impacted by this limitation. |
The foregoing description of the impact of the Tax Act on us should be read in conjunction with Note 15, Income Taxes, of the notes to our Consolidated Financial Statements.
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Other Legislative Initiatives
From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory authorities. These initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to change the financial institution regulatory environment. Such legislation could change banking laws and the operating environment of our Company in substantial, but unpredictable ways. We cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations would have on our financial condition or results of operations.
E. STATISTICAL DISCLOSURE – (GUIDE 3)
Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SEC’s industry guide for Bank Holding Companies.
Required Information | Location in Report |
Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential | Part II, Item 7.B.I. |
Investment Portfolio | Part II, Item 7.C.I. |
Loan Portfolio | Part II, Item 7.C.II. |
Summary of Loan Loss Experience | Part II, Item 7.C.III. |
Deposits | Part II, Item 7.C.IV. |
Return on Equity and Assets | Part II, Item 6. |
Short-Term Borrowings | Part II, Item 7.C.V. |
F. COMPETITION
We face intense competition in all markets we serve. Competitors include traditional local commercial banks, savings banks and credit unions, non-traditional internet-based lending alternatives, as well as local offices of major regional and money center banks. Like all banks, we encounter strong competition in the mortgage lending space from a wide variety of other mortgage originators, all of whom are principally affected in this business by the rate and terms set, and the lending practices established from time-to-time by the very large government sponsored enterprises ("GSEs") engaged in residential mortgage lending, most importantly, “Fannie Mae” and “Freddie Mac.” For many years, these GSEs have purchased and/or guaranteed a very substantial percentage of all newly-originated mortgage loans in the U.S.. Additionally, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market funds, mutual funds, credit card companies and wealth management enterprises offer substantive equivalents of the various other types of loan and financial products and services and transactional accounts that we offer, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to us. Under federal banking laws, such non-banking financial organizations not only may offer products and services comparable to those offered by commercial banks, but also may establish or acquire their own commercial banks.
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G. EXECUTIVE OFFICERS OF THE REGISTRANT
The names and ages of the executive officers of Arrow and positions held by each are presented in the following table. Officers are elected annually by the Board of Directors.
Name | Age | Positions Held and Years from Which Held |
Thomas J. Murphy | 60 | President and Chief Executive Officer of Arrow since January 1, 2013. Mr. Murphy has been a Director of Arrow since July 2012. In addition to his executive leadership role at Arrow, he has been the President of GFNB since July 1, 2011 and Chief Executive Officer of GFNB since January 1, 2013. Prior positions in the Company include: Senior Executive Vice President of Arrow (2011-2012), Vice President of Arrow (2009-2011), Senior Trust Officer of GFNB (2010-2011), Corporate Secretary (2009-2012), Assistant Corporate Secretary of Arrow (2008-2009), Senior Vice President of GFNB (2008-2011) and Manager of the Personal Trust Department of GFNB (2004-2011). Mr. Murphy started with the Company in 2004. |
Edward J. Campanella | 51 | Senior Vice President, Treasurer and Chief Financial Officer of Arrow since September 5, 2017. Mr. Campanella also serves as Executive Vice President, Treasurer and Chief Financial Officer of GFNB. Mr. Campanella joined the Company in 2017. Previously, he served as Chief Financial Officer for National Union Bank of Kinderhook in Kinderhook, NY (2016-2017). He was Senior Vice President, Treasurer and Director of Finance at Opus Bank in Irvine, CA (2013-2016). Prior to that he served as First Vice President and Treasurer of Cambridge Savings Bank in Cambridge, MA (2006-2013). |
David S. DeMarco | 57 | Senior Vice President and Chief Banking Officer of Arrow since February 1, 2018. Mr. DeMarco has been a Senior Vice President of Arrow since May 1, 2009. Additionally, Mr. DeMarco has been President and Chief Executive Officer of SNB since January 1, 2013. He is also Executive Vice President and Chief Banking Officer of GFNB. Previously, Mr. DeMarco served as Executive Vice President and Head of the Branch, Corporate Development, Financial Services & Marketing Division of GFNB (2003-2012). Mr. DeMarco started with the Company as a commercial lender in 1987. |
David D. Kaiser | 58 | Senior Vice President of Arrow since February 1, 2015. Mr. Kaiser has also served as Executive Vice President of GFNB since 2012 and as Chief Credit Officer of GFNB since 2011. Previously, he served as the Corporate Banking Manager for GFNB from 2005 to 2011. Mr. Kaiser started with the Company in 2000. |
Andrew J. Wise | 52 | Senior Vice President and Chief Operating Officer of Arrow Financial Corporation since February 1, 2018. Mr. Wise has also served as Executive Vice President and Chief Operating Officer of GFNB since October 2017. Previously, Mr. Wise served as Chief Administrative Officer of GFNB. He joined GFNB in May 2016 as Senior Vice President of Administration. Prior to that, he worked at Adirondack Trust Company for 12 years where he was Executive Vice President and Chief Operating Officer of the company’s insurance subsidiary. |
H. AVAILABLE INFORMATION
Our Internet address is www.arrowfinancial.com. We make available, free of charge on or through our internet website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we file or furnish them with the SEC pursuant to the Exchange Act. We also make available on our website various other documents related to corporate operations, including our Corporate Governance Guidelines, the charters of our principal board committees, and our codes of ethics. We have adopted a financial code of ethics that applies to Arrow’s chief executive officer, chief financial officer and principal accounting officer and a business code of ethics that applies to all directors, officers and employees of our holding company and its subsidiaries.
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Item 1A. Risk Factors
Our financial results and the market price of our stock are subject to risks arising from many factors, including the risks listed below, as well as other risks and uncertainties. Any of these risks could materially and adversely affect our business, financial condition or results of operations. (Please note that the discussion below regarding the potential impact on Arrow of certain of these factors that may develop in the future is not meant to provide predictions by Arrow's management that such factors will develop, but to acknowledge the possible negative consequences to our Company and business if certain conditions materialize.)
Market conditions could present significant challenges to the U.S. commercial banking industry and its core business of making and servicing loans and any substantial downturn in the regional markets in which we operate or in the U.S. economy generally could adversely affect our ability to maintain steady growth in our loan portfolio and our earnings. Our business is highly dependent on the business environment in the markets in which we operate as well as the United States as a whole. Our business is dependent upon the financial stability of our borrowers, including their ability to pay interest on and repay the principal amount of outstanding loans, the value of the collateral securing those loans, and the overall demand for loans and our other products and services, all of which impact our stability and future growth. Although our market area has experienced a stabilizing of economic conditions in recent years and even periods of modest growth, if unpredictable or unfavorable economic conditions unique to our market area should occur in upcoming periods, these conditions will likely have an adverse effect on the quality of our loan portfolio and financial performance. As a community bank, we are less able than our larger regional competitors to spread the risk of unfavorable local economic conditions over a larger market area. Further, if the overall U.S. economy deteriorates, then our business, results of operations, financial condition and prospects could be adversely affected. In particular, our financial performance may be adversely affected by short-term and long-term interest rates, the prevailing yield curve, inflation, monetary supply, fluctuations in the debt and equity capital markets, and the strength of the domestic economy and the local economies in the markets in which we operate, all of which are beyond our control.
We are subject to interest rate risk, which could adversely affect our profitability. Our profitability, like that of most financial institutions, depends to a large extent on our net interest income, which is the difference between our interest income on interest-earning assets, such as loans and investment securities, and our interest expense on interest-bearing liabilities, such as deposits and borrowings. Changes in monetary policy, including changes in interest rates, could influence not only the interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but also (1) our ability to originate loans and obtain deposits, (2) the fair value of our financial assets and liabilities, and (3) the average duration of our mortgage-backed securities portfolio. If the interest rates we pay on deposits and other borrowings increase at a faster rate than the interest rates received on loans, securities and other interest-earning investments, our net interest income, and therefore our earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings. Changes in interest rates, whether they are increases or decreases, can also trigger repricing and changes in the pace of payments for both assets and liabilities.
In addition, an increase in interest rates could have a negative impact on our results of operations by reducing the ability of borrowers to repay their current loan obligations. These circumstances could not only result in increased loan defaults, foreclosures and charge-offs, but also necessitate further increases to the allowance for loan losses which may materially and adversely affect our business, results of operations, financial condition and prospects.
Capital and liquidity standards require banks and bank holding companies to maintain more and higher quality capital and greater liquidity than has historically been the case. Capital standards, particularly those adopted as a result of Dodd-Frank, continue to have a significant effect on banks and bank holding companies, including Arrow. The need to maintain more and higher quality capital, as well as greater liquidity, and generally increased regulatory scrutiny with respect to capital levels, may at some point limit our business activities, including lending, and our ability to expand. It could also result in our being required to take steps to increase our regulatory capital and may dilute shareholder value or limit our ability to pay dividends or otherwise return capital to our investors through stock repurchases.
Certain of the capital requirements of Dodd-Frank and the related regulations will be impacted by the Economic Growth Act, which was enacted in 2018. The Economic Growth Act created a “community bank leverage ratio” standard for qualifying banking organizations as an alternative to the Dodd-Frank risk-based capital regime. However, this alternative capital standard will not be effective until the federal bank regulatory authorities adopt rules for its implementation. Such rules have been proposed, but are not yet final, and the terms of the rules may change before becoming final. Upon effectiveness, the final rules may impact Arrow’s capital options and requirements, although the potential impact of the final rules on Arrow will remain uncertain until those final rules are issued. Until these Economic Growth Act rules become final, the enhanced bank capital standards promulgated under Dodd-Frank will remain applicable to Arrow.
Any future economic or financial downturn, including any significant correction in the equity markets, may negatively affect the volume of income attributable to, and demand for, fee-based services of banks such as ours, including our fiduciary business, which could negatively impact our financial condition and results of operation. Revenues from our trust and wealth management business are dependent on the level of assets under management. Any significant downturn in the equity markets may lead our trust and wealth management customers to liquidate their investments, or may diminish account values for those customers who elect to leave their portfolios with us, in either case reducing our assets under management and thereby decreasing our revenues from this important sector of our business. Our other fee-based businesses are also susceptible to a sudden economic or financial downturn.
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In addition, our loan quality is affected by the condition of the economy. Like all financial institutions, we maintain an allowance for loan losses to provide for probable loan losses at the balance sheet date. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the portfolio, current economic conditions and geographic concentrations within the portfolio and other factors. While we have continued to enjoy a very high level of quality in our loan portfolio generally and very low levels of loan charge-offs and non-performing loans, if the economy in our geographic market area should deteriorate to the point that recessionary conditions return, or if the regional or national economy experiences a protracted period of stagnation, the quality of our loan portfolio may weaken so significantly that our allowance for loan losses may not be adequate to cover actual or expected loan losses. In such events, we may be required to increase our provisions for loan losses and this could materially and adversely affect financial results. Moreover, weak or worsening economic conditions often lead to difficulties in other areas of our business, including growth of our business generally, thereby compounding the negative effects on earnings.
We face continuing and growing security risks to our information base including the information we maintain relating to our customers, and any breaches in the security systems we have implemented to protect this information could have a material negative effect on our business operations and financial condition. In the ordinary course of business, Arrow relies on electronic communications and information systems to conduct our operations and to store sensitive data. Arrow employs an in-depth, layered, defensive approach that leverages people, processes and technology to manage and maintain cybersecurity controls. Arrow employs a variety of preventative and detective tools to monitor, block, and provide alerts regarding suspicious activity, as well as to report on any suspected advanced persistent threats. We have implemented and regularly review and update extensive systems of internal controls and procedures as well as corporate governance policies and procedures intended to protect our business operations, including the security and privacy of all confidential customer information. In addition, we rely on the services of a variety of vendors to meet our data processing and communication needs. No matter how well designed or implemented our controls are, we cannot provide an absolute guarantee to protect our business operations from every type of cybersecurity or other security problem in every situation, whether as a result of systems failures, human error or negligence, cyberattacks, security breaches, fraud or misappropriation. Any failure or circumvention of these controls could have a material adverse effect on our business operations and financial condition. Notwithstanding the strength of our defensive measures, the threat from cyberattacks is severe, attacks are sophisticated and increasing in volume, and attackers respond rapidly to changes in defensive measures. While to date, Arrow has not experienced a significant compromise, significant data loss or any material financial losses related to cybersecurity attacks or other security problems, our systems and those of our customers and third-party service providers are under constant threat. Risks and exposures related to cybersecurity attacks or other security problems are expected to remain high for the foreseeable future due to the rapidly evolving nature and sophistication of these threats and issues, as well as due to the expanding use of Internet banking, mobile banking and other technology-based products and services by us and our customers.
The computer systems and network infrastructure that we use are always vulnerable to unforeseen disruptions, including theft of confidential customer information (“identity theft”) and interruption of service as a result of fire, natural disasters, explosion, general infrastructure failure, cyberattacks or other security problems. These disruptions may arise in our internally developed systems, or the systems of our third-party service providers or may originate from the actions of our consumer and business customers who access our systems from their own networks or digital devices to process transactions. Information security and cyber security risks have increased significantly in recent years because of consumer demand to use the Internet and other electronic delivery channels to conduct financial transactions. Cybersecurity risk and other security problems are a major concern to financial services regulators and all financial service providers, including our Company. These risks are further exacerbated due to the increased sophistication and activities of organized crime, hackers, terrorists and other disreputable parties. We regularly assess and test our security systems and disaster preparedness, including back-up systems, but the risks are substantially escalating. As a result, cybersecurity and the continued enhancement of our controls and processes to protect our systems, data and networks from attacks or unauthorized access remain a priority. Accordingly, we may be required to expend additional resources to enhance our protective measures or to investigate and remediate any information security vulnerabilities or exposures. Any breach of our system security could result in disruption of our operations, unauthorized access to confidential customer information, significant regulatory costs, litigation exposure and other possible damages, loss or liability. Such costs or losses could exceed the amount of available insurance coverage, if any, and would adversely affect our earnings. Also, any failure to prevent a security breach or to quickly and effectively deal with such a breach could negatively impact customer confidence, damaging our reputation and undermining our ability to attract and keep customers. In addition, if we fail to observe any of the cybersecurity requirements in federal or state laws, regulations or regulatory guidance, we could be subject to various sanctions, including financial penalties.
The Company relies on the operations of our banking subsidiaries to provide liquidity which, if limited, could impact our ability to pay dividends to our shareholders or to repurchase our common stock. We are a bank holding company, a separate legal entity from our subsidiaries. Our bank holding company does not have significant operations of its own. The ability of our subsidiaries, including our bank and insurance subsidiaries, to pay dividends is limited by various statutes and regulations. It is possible, depending upon the financial condition of our subsidiaries and other factors, that our subsidiaries might be restricted at some point in their ability to pay dividends to the holding company, including by a bank regulator asserting that the payment of such dividends or other payments would constitute an unsafe or unsound practice. In addition, under federal banking law, we are subject to consolidated capital requirements at the holding company level. If our holding company or its bank subsidiaries are required to retain or increase capital, we may not be able to maintain our cash dividends or pay dividends at all, or to repurchase shares of our common stock.
Changes in federal, state or local tax laws may negatively impact our financial performance. As in the case of the Tax Act, we are subject to changes in tax law that could impact our effective tax rates. These law changes may be retroactive to previous
# 15
periods and as a result could negatively affect our current and future financial performance. Similarly, the bank's customers are likely to experience varying effects from both the individual and business tax provisions of changes in tax law and such effects, whether positive or negative, may have a corresponding impact on our business and the economy as a whole.
Changes in accounting standards may materially and negatively impact our financial statements. From time-to-time, the Financial Accounting Standards Board (“FASB”) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we may be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial statements. Specifically, changes in the fair value of our financial assets could have a significant negative impact on our asset portfolios and indirectly on our capital levels.
We rely on other companies to provide key components of our business infrastructure. Third-party vendors provide key components of our business infrastructure such as Internet connections, network access and mutual fund distribution. The financial health and operational capabilities of these third parties are for the most part beyond our control, and any problems experienced by these third parties, such that they may not be able to continue to provide services to us or to perform such services consistent with our expectations, could adversely affect our ability to deliver products and services to our customers and to conduct our business.
We operate in a highly competitive industry and market areas that could negatively affect our growth and profitability. Competition for commercial banking and other financial services is fierce in our market areas. In one or more aspects of business, our subsidiaries compete with other commercial banks, savings and loan associations, credit unions, finance companies, Internet-based financial services companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Additionally, due to their size and other factors, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services, as well as better pricing for those products and services, than we can. Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. In addition, many of our competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks. Failure to offer competitive services in our market areas could significantly weaken our market position, adversely affecting our growth, which, in turn, could have a material adverse effect on our financial condition and results of operations.
If economic conditions worsen and the U.S. financial markets should suffer a downturn, we may experience limited access to credit markets. As discussed under Part I, Item 7.D. “Liquidity,” we maintain borrowing relationships with various third parties that enable us to obtain from them, on relatively short notice, overnight and longer-term funds sufficient to enable us to fulfill our obligations to customers, including deposit withdrawals. If, in the context of a downturn in the U.S. economy or financial markets, these third parties should encounter difficulty in accessing their own credit markets, we may, in turn, experience a decrease in our capacity to borrow funds from them or other third parties traditionally relied upon by banks for liquidity.
Our business could suffer if we lose key personnel unexpectedly or if employee wages increase significantly. Our success depends, in large part, on our ability to retain our key personnel for the duration of their expected terms of service. On an ongoing basis, we prepare and review back-up plans, in the event key personnel are unexpectedly rendered incapable of performing or depart or resign from their positions. However, any sudden unexpected change at the senior management level may adversely affect our business. In addition, should our industry begin to experience a shortage of qualified employees, we, like other financial institutions, may have difficulty attracting and retaining entry level or higher bracket personnel and also may experience, as a result of such shortages or the enactment of higher minimum wage laws locally or nationwide, increased salary expense, which would likely negatively impact our results of operations.
Federal banking statutes and regulations could change in the future, which may adversely affect our Company and certain players in the financial industry as a whole. We are subject to extensive federal and state banking regulations and supervision. Banking laws and regulations are intended primarily to protect bank depositors’ funds (and indirectly the Federal Deposit Insurance Fund) as well as bank retail customers, who may lack the sophistication to understand or appreciate bank products and services. These laws and regulations generally are not, however, aimed at protecting or enhancing the returns on investment enjoyed by bank shareholders.
Our depositor/customer awareness of the changing regulatory environment is particularly true of the set of laws and regulations under Dodd-Frank, which were passed in the aftermath of the 2008-09 financial crisis and in large part were intended to better protect bank customers (and to some degree, banks) against a wide variety of lending products and aggressive lending practices that pre-dated the crisis and are seen as having contributed to its severity. Although not all banks offered such products or engaged in such practices, all banks are affected by these laws and regulations to some degree.
Dodd-Frank restricts our lending practices, requires us to expend substantial additional resources to safeguard customers, significantly increases our regulatory burden, and subjects us to significantly higher minimum capital requirements which, in the long run, may serve as a drag on our earnings, growth and ultimately on our dividends and stock price (the Dodd-Frank capital standards are separately addressed in a previous risk factor).
Although the Economic Growth Act and similar initiatives may mitigate the impact of Dodd-Frank, other statutory and regulatory changes could add to the existing regulatory burden imposed on banking organizations like ours resulting in a potential material adverse effect on our financial condition and results of operations.
# 16
Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, or other anti-money laundering laws and regulations could result in fines or sanctions and restrictions on conducting acquisitions or establishing new branches. The USA PATRIOT and Bank Secrecy Acts require financial institutions to develop programs to prevent financial institutions from being used for money laundering and terrorist activities. If such activities are suspected, financial institutions are obligated to file suspicious activity reports with the U.S. Treasury’s Office of Financial Crimes Enforcement Network. Federal anti-money laundering rules require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure to comply with these regulations could result in fines or sanctions, and restrictions on conducting acquisitions or establishing new branches. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. The policies and procedures we have adopted that are designed to assist in compliance with these laws and regulations may not be effective in preventing violations of these laws and regulations.
The Company is subject to the Community Reinvestment Act ("CRA") and fair lending laws, and failure to comply with these laws could lead to material penalties. CRA the Equal Credit Opportunity Act, the Fair Housing Act and other fair lending laws and regulations impose nondiscriminatory lending requirements on financial institutions. A successful regulatory challenge to an institution’s performance under the CRA or fair lending laws and regulations could result in a wide variety of sanctions, including the required payment of damages and civil money penalties, injunctive relief, imposition of restrictions on mergers and acquisitions activity and restrictions on expansion. 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 business, financial condition and results of operations.
Our industry is faced with technological advances and changes on a continuing basis, and failure to adapt to these advances and changes could have a material adverse impact on our business. Technological advances and changes in the financial services industry are pervasive and constant. The retail financial services sector, like many other retail goods and services sectors, is constantly evolving, involving new delivery and communications systems and technologies that are extraordinarily far-reaching and impactful. For us to remain competitive, we must comprehend and adapt to these systems and technologies. Proper implementation of new technologies can increase efficiency, decrease costs and help to meet customer demand. However, many of our competitors have greater resources to invest in technological advances and changes. We may not always be successful in utilizing the latest technological advances in offering our products and services or in otherwise conducting our business. Failure to identify, consider, adapt to and implement technological advances and changes could have a material adverse effect on our business.
Problems encountered by other financial institutions could adversely affect us. Our ability to engage in routine funding transactions could be adversely affected by financial or commercial problems confronting other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different counterparties in the normal course of our business, and we routinely execute transactions with counterparties in the financial services industry, including brokers and dealers, other commercial banks, investment banks, mutual and hedge funds, and other financial institutions. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, could lead to market-wide liquidity problems and losses or defaults by us or by other financial institutions on whom we rely or with whom we interact. Some of these transactions expose us to credit and other potential risks in the event of default of our counterparty or client. In addition, credit risk may be exacerbated when the collateral held by us cannot be liquidated or only may be liquidated at prices not sufficient to recover the full amount due us under the underlying financial instrument, held by us. There is no assurance that any such losses would not materially and adversely affect our results of operations.
The Company's allowance for possible loan and lease losses may be insufficient, and an increase in the allowance would reduce earnings. The allowance is established through a provision for loan and lease losses based on management’s evaluation of the risks inherent in our loan portfolio and the general economy. The allowance is based upon a number of factors, including the size of the loan and lease portfolio, asset classifications, economic trends, industry experience and trends, industry and geographic concentrations, estimated collateral values, management’s assessment of the credit risk inherent in the portfolio, historical loan and lease loss experience and loan underwriting policies. In addition, we evaluate all loans and leases identified as problem loans and augment the allowance based upon our estimation of the potential loss associated with those problem loans and leases. Additions to our allowance for loan and lease losses decrease our net income. If the evaluation we perform in connection with establishing loan and lease loss reserves is wrong, our allowance for loan and lease losses may not be sufficient to cover our losses, which would have an adverse effect on our operating results. Our regulators, in reviewing our loan and lease portfolio as part of a regulatory examination, may from time to time require us to increase our allowance for loan and lease losses, thereby negatively affecting our earnings, financial condition and capital ratios at that time. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans and leases, identification of additional problem loans and leases and other factors, both within and outside of our control. Additions to the allowance could have a negative impact on our results of operations.
The increasing complexity of our operations presents varied risks that could affect our earnings and financial condition. We process a large volume of transactions on a daily basis and are exposed to numerous types of risks related to internal processes, people and systems. These risks include, but are not limited to, the risk of fraud by persons inside or outside the Company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, breaches of data security, human error or negligence, and our internal control system and compliance with a complex array of consumer and safety and soundness regulations. We could also experience additional loss as a result of potential legal actions that could arise as a result of operational deficiencies or as a result of noncompliance with applicable laws and regulations.
# 17
We have established and maintain a system of internal controls that provides management with information on a timely basis and allows for the monitoring of compliance with operational standards. These systems have been designed to manage operational risks at an appropriate, cost effective level. Procedures exist that are designed to ensure that policies relating to conduct, ethics, and business practices are followed. Losses from operational risks may still occur, however, including losses from the effects of operational errors.
Natural disasters, acts of war or terrorism and other external events could negatively impact the Company. Natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on our ability to conduct business. In addition, such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Our management has established disaster recovery policies and procedures that are expected to mitigate events related to natural or man-made disasters; however, the occurrence of any such event and the impact of an overall economic decline resulting from such a disaster could have a material adverse effect on our financial condition and results of operations.
Item 1B. | Unresolved Staff Comments - None |
Item 2. Properties
Our main office is at 250 Glen Street, Glens Falls, New York. The building is owned by us and serves as the main office for Arrow and Glens Falls National, our principal subsidiary bank. The main office of our other banking subsidiary, Saratoga National, is in Saratoga Springs, New York. We own twenty-eight branch banking offices, lease twelve branch banking offices and lease two residential loan origination offices, all at market rates. Our insurance agency is co-located in eight bank-owned branches, three leased insurance offices and two owned stand-alone buildings. We also lease office space in buildings and parking lots near our main office in Glens Falls as well as a back-up site for business continuity purposes.
In the opinion of management, the physical properties of our holding company and our various subsidiaries are suitable and adequate. For more information on our properties, see Notes 2, Summary of Significant Accounting Policies, 6, Premises and Equipment, and 18, Leases, in the notes to our Consolidated Financial Statements contained in Part II, Item 8 of this Report.
Item 3. Legal Proceedings
We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business. On an ongoing basis, we typically are the subject of or a party to various legal claims, which arise in the normal course of our business. Although the outcome of the lawsuits or other proceedings cannot be predicated with certainty and the amount of any liability that may arise therefrom cannot be predicted accurately, in the opinion of management based upon consultation with counsel, the various legal claims currently pending against us will not result in a material adverse effect to our financial condition.
Item 4. Mine Safety Disclosures - None
# 18
PART II
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is traded on the Global Select Market of the National Association of Securities Dealers, Inc. ("NASDAQ®") Stock Market under the symbol AROW.
Based on information received from our transfer agent and various brokers, custodians and agents, we estimate there were approximately 7,700 beneficial owners of Arrow’s common stock at December 31, 2018. Arrow has no other class of stock outstanding.
Equity Compensation Plan Information
The following table sets forth certain information regarding Arrow's equity compensation plans as of December 31, 2018. These equity compensation plans were (i) our 2013 Long-Term Incentive Plan ("LTIP"), and its predecessors, our 2008 Long-Term Incentive Plan and our 1998 Long-Term Incentive Plan; (ii) our 2014 Employee Stock Purchase Plan ("ESPP"); and (iii) our 2013 Directors' Stock Plan ("DSP"). All of these plans have been approved by Arrow's shareholders.
Plan Category | (a) Number of Securities to be Issued Upon Exercise of Outstanding Options, Restricted Stock Units, Warrants and Rights | (b) Weighted-Average Exercise Price of Outstanding Options, Restricted Stock Units, Warrants and Rights | (c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) | |||||
Equity Compensation Plans Approved by Security Holders (1)(2) | 287,899 | 25.37 | 370,102 | |||||
Equity Compensation Plans Not Approved by Security Holders | — | — | ||||||
Total | 287,899 | 370,102 | ||||||
(1) | The total of 287,899 shares listed in column (a) includes 284,522 which are issuable pursuant to outstanding stock options and 3,377 which are issuable pursuant to restricted stock units all granted under the LTIP or its predecessor plans. |
(2) | The total of 370,102 shares listed in column (c) includes (i) 261,614 shares of common stock available for future award grants under the LTIP, (ii) 91,657 shares of common stock available for future issuance under the ESPP, and (iii) 16,831 shares of common stock available for future issuance under the DSP. |
# 19
STOCK PERFORMANCE GRAPHS
The following two graphs provide a comparison of the total cumulative return (assuming reinvestment of dividends) for the common stock of Arrow as compared to the Russell 2000 Index, the NASDAQ Banks Index and the Zacks $1B-$5B Bank Assets Index.
The first graph presents comparative stock performance for the five-year period from December 31, 2013 to December 31, 2018 and the second graph presents comparative stock performance for the fifteen-year period from December 31, 2003 to December 31, 2018.
The historical information in the graphs and accompanying tables may not be indicative of future performance of Arrow stock on the various stock indices.
TOTAL RETURN PERFORMANCE Period Ending | |||||||||||||||||
Index | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | |||||||||||
Arrow Financial Corporation | 100.00 | 109.59 | 114.57 | 181.56 | 161.42 | 161.33 | |||||||||||
Russell 2000 Index | 100.00 | 104.89 | 100.26 | 121.63 | 139.44 | 124.09 | |||||||||||
NASDAQ Banks Index | 100.00 | 105.08 | 114.45 | 154.96 | 165.08 | 137.07 | |||||||||||
Zacks $1B - $5B Bank Assets Index | 100.00 | 108.03 | 116.76 | 161.47 | 174.08 | 153.75 | |||||||||||
Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2019.
# 20
[TOTAL RETURN PERFORMANCE Period Ending | |||||||||||||||||||||||
Index | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |||||||||||||||
Arrow Financial Corporation | 100.00 | 118.58 | 106.58 | 108.20 | 101.28 | 123.94 | 132.30 | 156.43 | |||||||||||||||
Russell 2000 Index | 100.00 | 118.44 | 123.78 | 146.52 | 144.22 | 95.49 | 121.43 | 154.03 | |||||||||||||||
NASDAQ Banks Index | 100.00 | 114.52 | 111.86 | 125.60 | 99.40 | 72.47 | 60.30 | 71.71 | |||||||||||||||
Zacks $1B - $5B Bank Assets Index | 100.00 | 116.74 | 114.01 | 127.88 | 107.38 | 87.68 | 75.27 | 85.54 | |||||||||||||||
TOTAL RETURN PERFORMANCE (Cont'd.) Period Ending | |||||||||||||||||||||||
Index | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | |||||||||||||||
Arrow Financial Corporation | 143.40 | 162.12 | 182.92 | 200.46 | 209.58 | 332.12 | 295.27 | 295.11 | |||||||||||||||
Russell 2000 Index | 147.60 | 171.73 | 238.39 | 250.05 | 239.02 | 289.96 | 332.44 | 295.83 | |||||||||||||||
NASDAQ Banks Index | 64.14 | 76.73 | 109.82 | 115.40 | 125.69 | 170.18 | 181.29 | 150.53 | |||||||||||||||
Zacks $1B - $5B Bank Assets Index | 83.73 | 98.75 | 128.58 | 138.91 | 150.13 | 207.62 | 223.83 | 197.70 | |||||||||||||||
Source: Prepared by Zacks Investment Research, Inc. Used with permission. All rights reserved. Copyright 1980-2019.
The preceding stock performance graphs and tables shall not be deemed incorporated by reference, by virtue of any general statement contained herein or in any other filing incorporated by reference herein, into any other SEC filing by the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, except to the extent the Company specifically incorporates this information by reference into such filing, and shall not otherwise be deemed filed as part of any such other filing.
# 21
Unregistered Sales of Equity Securities
None.
Issuer Purchases of Equity Securities
The following table presents information about repurchases by Arrow during the three months ended December 31, 2018 of our common stock (our only class of equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934):
Fourth Quarter 2018 Calendar Month | (a) Total Number of Shares Purchased1 | (b) Average Price Paid Per Share1 | (c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs2 | (d) Maximum Approximate Dollar Value of Shares that May Yet be Purchased Under the Plans or Programs2 | |||||||||
October | 1,991 | $ | 36.78 | — | $ | 4,404,627 | |||||||
November | 10,410 | 35.03 | — | 4,404,627 | |||||||||
December | 14,865 | 33.00 | — | 4,404,627 | |||||||||
Total | 27,266 | 34.05 | — | ||||||||||
1The total number of shares purchased and the average price paid per share listed in columns (a) and (b) consist of (i) any shares purchased in such periods in open market or private transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the "DRIP") by the administrator of the DRIP, and (ii) shares surrendered or deemed surrendered to Arrow in such periods by holders of options to acquire Arrow common stock received by them under Arrow's long-term incentive plans ("LTIPs") in connection with their stock-for-stock exercise of such options, and shares repurchased by Arrow pursuant to its publicly-announced stock repurchase program. In the months indicated, the listed number of shares purchased included the following numbers of shares purchased by Arrow through such methods: October - DRIP purchases (1,991 shares); November - DRIP purchases (2,580 shares), stock-for-stock option exercises (7,830 shares); and December - DRIP purchases (14,865 shares).
2Includes only those shares acquired by Arrow pursuant to its publicly-announced stock repurchase programs. Our only publicly-announced stock repurchase program in effect for the fourth quarter of 2018 was the program approved by the Board of Directors and announced in October 2017, under which the Board authorized management, in its discretion, to repurchase from time to time during 2018, in the open market or in privately negotiated transactions, up to $5 million of Arrow common stock subject to certain exceptions (the "2018 Program"). Arrow had no repurchases of its shares in the fourth quarter of 2018 under the 2018 Program. In January 2019, the Board authorized a repurchase program for the period January 30, 2019 through December 31, 2019 similar to its 2018 program, which also authorizes management to repurchase up to $5 million of stock for the period January 30, 2019 through December 31, 2019.
# 22
Item 6. Selected Financial Data
FIVE YEAR SUMMARY OF SELECTED DATA
Arrow Financial Corporation and Subsidiaries
(Dollars In Thousands, Except Per Share Data)
Consolidated Statements of Income Data: | 2018 | 2017 | 2016 | 2015 | 2014 | ||||||||||||||
Interest and Dividend Income | 96,503 | $ | 84,657 | $ | 76,915 | $ | 70,738 | $ | 66,861 | ||||||||||
Interest Expense | 12,485 | 7,006 | 5,356 | 4,813 | 5,767 | ||||||||||||||
Net Interest Income | 84,018 | 77,651 | 71,559 | 65,925 | 61,094 | ||||||||||||||
Provision for Loan Losses | 2,607 | 2,736 | 2,033 | 1,347 | 1,848 | ||||||||||||||
Net Interest Income After Provision for Loan Losses | 81,411 | 74,915 | 69,526 | 64,578 | 59,246 | ||||||||||||||
Noninterest Income | 28,736 | 28,093 | 27,854 | 27,995 | 28,206 | ||||||||||||||
Net Gains (Losses) on Securities Transactions | 213 | (448 | ) | (22 | ) | 129 | 110 | ||||||||||||
Noninterest Expense | (65,055 | ) | (62,705 | ) | (59,609 | ) | (57,430 | ) | (54,028 | ) | |||||||||
Income Before Provision for Income Taxes | 45,305 | 39,855 | 37,749 | 35,272 | 33,534 | ||||||||||||||
Provision for Income Taxes | 9,026 | 10,529 | 11,215 | 10,610 | 10,174 | ||||||||||||||
Net Income | $ | 36,279 | $ | 29,326 | $ | 26,534 | $ | 24,662 | $ | 23,360 | |||||||||
Per Common Share: 1 | |||||||||||||||||||
Basic Earnings | $ | 2.52 | $ | 2.05 | $ | 1.87 | $ | 1.75 | $ | 1.66 | |||||||||
Diluted Earnings | 2.50 | 2.04 | 1.86 | 1.74 | 1.66 | ||||||||||||||
Per Common Share: 1 | |||||||||||||||||||
Cash Dividends | $ | 1.00 | $ | 0.95 | $ | 0.92 | $ | 0.90 | $ | 0.88 | |||||||||
Book Value | 18.63 | 17.40 | 16.28 | 15.13 | 14.29 | ||||||||||||||
Tangible Book Value 2 | 16.99 | 15.71 | 14.56 | 13.37 | 12.46 | ||||||||||||||
Consolidated Year-End Balance Sheet Data: | |||||||||||||||||||
Total Assets | $ | 2,988,334 | $ | 2,760,465 | $ | 2,605,242 | $ | 2,446,188 | $ | 2,217,420 | |||||||||
Securities Available-for-Sale | 317,535 | 300,200 | 346,996 | 402,309 | 366,139 | ||||||||||||||
Securities Held-to-Maturity | 283,476 | 335,907 | 345,427 | 320,611 | 302,024 | ||||||||||||||
Loans | 2,196,215 | 1,950,770 | 1,753,268 | 1,573,952 | 1,413,268 | ||||||||||||||
Nonperforming Assets 3 | 6,782 | 7,797 | 7,186 | 8,924 | 8,162 | ||||||||||||||
Deposits | 2,345,584 | 2,245,116 | 2,116,546 | 2,030,423 | 1,902,948 | ||||||||||||||
Federal Home Loan Bank Advances | 279,000 | 160,000 | 178,000 | 137,000 | 51,000 | ||||||||||||||
Other Borrowed Funds | 74,659 | 84,966 | 55,836 | 43,173 | 39,421 | ||||||||||||||
Stockholders’ Equity | 269,584 | 249,603 | 232,852 | 213,971 | 200,926 | ||||||||||||||
Selected Key Ratios: | |||||||||||||||||||
Return on Average Assets | 1.27 | % | 1.09 | % | 1.06 | % | 1.05 | % | 1.07 | % | |||||||||
Return on Average Equity | 13.96 | 12.14 | 11.79 | 11.86 | 11.79 | ||||||||||||||
Dividend Payout Ratio 4 | 40.00 | 46.57 | 49.46 | 51.72 | 53.01 | ||||||||||||||
Average Equity to Average Assets | 9.10 | 8.96 | 8.95 | 8.88 | 9.05 | ||||||||||||||
1Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September 27, 2018 3% stock dividend.
2Tangible book value excludes goodwill and other intangible assets from total equity.
3Nonperforming assets consist of nonaccrual loans, loans past due 90 or more days but still accruing interest, repossessed assets, restructured loans, other real estate owned and nonaccrual investments.
4Dividend Payout Ratio – cash dividends per share to fully diluted earnings per share.
# 23
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Selected Quarterly Information Dollars in thousands, except per share amounts Share and per share amounts have been restated for the September 2018 3% stock dividend | |||||||||||||||||||
Quarter Ended | 12/31/2018 | 9/30/2018 | 6/30/2018 | 3/31/2018 | 12/31/2017 | ||||||||||||||
Net Income | $ | 8,758 | $ | 9,260 | $ | 9,730 | $ | 8,531 | $ | 8,071 | |||||||||
Transactions Recorded in Net Income (Net of Tax): | |||||||||||||||||||
Net (Loss) Gain on Security Transactions | — | — | — | — | (278 | ) | |||||||||||||
Net Changes in Fair Value of Equity Investments | (106 | ) | 85 | 166 | 13 | — | |||||||||||||
Tax Benefit from Net Deferred Tax Liability Revaluation | — | — | — | — | 1,116 | ||||||||||||||
Share and Per Share Data: 1 | |||||||||||||||||||
Period End Shares Outstanding | 14,472 | 14,441 | 14,424 | 14,368 | 14,348 | ||||||||||||||
Basic Average Shares Outstanding | 14,451 | 14,431 | 14,394 | 14,354 | 14,322 | ||||||||||||||
Diluted Average Shares Outstanding | 14,514 | 14,520 | 14,480 | 14,436 | 14,426 | ||||||||||||||
Basic Earnings Per Share | $ | 0.61 | $ | 0.64 | $ | 0.68 | $ | 0.59 | $ | 0.56 | |||||||||
Diluted Earnings Per Share | 0.60 | 0.64 | 0.67 | 0.59 | 0.56 | ||||||||||||||
Cash Dividend Per Share | 0.260 | 0.252 | 0.243 | 0.243 | 0.243 | ||||||||||||||
Selected Quarterly Average Balances: | |||||||||||||||||||
Interest-Bearing Deposits at Banks | $ | 34,782 | $ | 30,522 | $ | 28,543 | $ | 27,978 | $ | 27,047 | |||||||||
Investment Securities | 637,341 | 636,847 | 647,913 | 642,442 | 660,043 | ||||||||||||||
Loans | 2,160,435 | 2,089,651 | 2,026,598 | 1,971,240 | 1,930,590 | ||||||||||||||
Deposits | 2,347,231 | 2,279,709 | 2,325,202 | 2,305,736 | 2,284,206 | ||||||||||||||
Other Borrowed Funds | 315,172 | 314,304 | 219,737 | 184,613 | 187,366 | ||||||||||||||
Shareholders’ Equity | 268,503 | 263,139 | 256,358 | 251,109 | 247,253 | ||||||||||||||
Total Assets | 2,954,031 | 2,879,854 | 2,823,061 | 2,763,706 | 2,744,180 | ||||||||||||||
Return on Average Assets, annualized | 1.18 | % | 1.28 | % | 1.38 | % | 1.25 | % | 1.17 | % | |||||||||
Return on Average Equity, annualized | 12.94 | % | 13.96 | % | 15.22 | % | 13.78 | % | 12.95 | % | |||||||||
Return on Average Tangible Equity, annualized 2 | 14.20 | % | 15.36 | % | 16.80 | % | 15.24 | % | 14.36 | % | |||||||||
Average Earning Assets | 2,831,438 | 2,757,020 | 2,703,054 | 2,641,660 | 2,617,680 | ||||||||||||||
Average Paying Liabilities | 2,189,233 | 2,110,924 | 2,100,085 | 2,050,661 | 2,029,811 | ||||||||||||||
Interest Income | 26,000 | 24,495 | 23,590 | 22,418 | 22,135 | ||||||||||||||
Tax-Equivalent Adjustment 3 | 376 | 376 | 468 | 491 | 980 | ||||||||||||||
Interest Income, Tax-Equivalent 3 | 26,376 | 24,871 | 24,058 | 22,909 | 23,115 | ||||||||||||||
Interest Expense | 4,343 | 3,498 | 2,628 | 2,016 | 1,821 | ||||||||||||||
Net Interest Income | 21,657 | 20,997 | 20,962 | 20,402 | 20,314 | ||||||||||||||
Net Interest Income, Tax-Equivalent 3 | 22,033 | 21,373 | 21,430 | 20,893 | 21,294 | ||||||||||||||
Net Interest Margin, annualized | 3.03 | % | 3.02 | % | 3.11 | % | 3.13 | % | 3.08 | % | |||||||||
Net Interest Margin, Tax-Equivalent, annualized 3 | 3.09 | % | 3.08 | % | 3.18 | % | 3.21 | % | 3.23 | % | |||||||||
Efficiency Ratio Calculation: 4 | |||||||||||||||||||
Noninterest Expense | $ | 16,881 | $ | 16,026 | $ | 16,192 | $ | 15,955 | $ | 16,045 | |||||||||
Less: Intangible Asset Amortization | 65 | 65 | 66 | 67 | 69 | ||||||||||||||
Net Noninterest Expense | $ | 16,816 | $ | 15,961 | $ | 16,126 | $ | 15,888 | $ | 15,976 | |||||||||
Net Interest Income, Tax-Equivalent | $ | 22,033 | $ | 21,373 | $ | 21,430 | $ | 20,893 | $ | 21,294 | |||||||||
Noninterest Income | 6,799 | 7,350 | 7,911 | 6,888 | 6,752 | ||||||||||||||
Less: Net (Loss) Gain on Security Transactions | — | — | — | — | (458 | ) | |||||||||||||
Less: Net Changes in Fair Value of Equity Investments | (142 | ) | 114 | 223 | 18 | — | |||||||||||||
Net Gross Income | 28,974 | 28,609 | 29,118 | 27,763 | $ | 28,504 | |||||||||||||
Efficiency Ratio | 58.04 | % | 55.79 | % | 55.38 | % | 57.23 | % | 56.05 | % | |||||||||
Period-End Capital Information: 5 | |||||||||||||||||||
Total Stockholders’ Equity (i.e. Book Value) | $ | 269,584 | $ | 264,810 | $ | 259,488 | $ | 252,734 | $ | 249,603 | |||||||||
Book Value per Share 1 | 18.63 | 18.34 | 17.99 | 17.59 | 17.40 | ||||||||||||||
Goodwill and Other Intangible Assets, net | 23,725 | 23,827 | 23,933 | 24,045 | 24,162 | ||||||||||||||
Tangible Book Value per Share 1,2 | 16.99 | 16.69 | 16.33 | 15.92 | 15.71 | ||||||||||||||
Tier 1 Leverage Ratio | 9.61 | % | 9.67 | % | 9.65 | % | 9.62 | % | 9.49 | % | |||||||||
Common Equity Tier 1 Capital Ratio | 12.89 | % | 12.89 | % | 13.01 | % | 12.97 | % | 12.89 | % | |||||||||
Tier 1 Risk-Based Capital Ratio | 13.87 | % | 13.90 | % | 14.04 | % | 14.03 | % | 13.97 | % | |||||||||
Total Risk-Based Capital Ratio | 14.86 | % | 14.90 | % | 15.06 | % | 15.04 | % | 14.99 | % | |||||||||
Assets Under Trust Administration & Investment Mgmt | $ | 1,385,752 | $ | 1,551,289 | $ | 1,479,753 | $ | 1,470,191 | $ | 1,452,994 | |||||||||
# 24
Selected Twelve-Month Information Dollars in thousands, except per share amounts Share and per share amounts have been restated for the September 2018 3% stock dividend | |||||||||||
2018 | 2017 | 2016 | |||||||||
Net Income | $ | 36,279 | $ | 29,326 | $ | 26,534 | |||||
Transactions Recorded in Net Income (Net of Tax): | |||||||||||
Net Loss on Security Transactions | $ | — | $ | (275 | ) | $ | (13 | ) | |||
Net Changes in Fair Value of Equity Investments | 158 | — | — | ||||||||
Period End Shares Outstanding1 | 14,472 | 14,348 | 14,304 | ||||||||
Basic Average Shares Outstanding1 | 14,408 | 14,310 | 14,206 | ||||||||
Diluted Average Shares Outstanding1 | 14,488 | 14,406 | 14,297 | ||||||||
Basic Earnings Per Share1 | $ | 2.52 | $ | 2.05 | $ | 1.87 | |||||
Diluted Earnings Per Share1 | 2.50 | 2.04 | 1.86 | ||||||||
Cash Dividends Per Share1 | 1.00 | 0.95 | 0.92 | ||||||||
Average Assets | $ | 2,855,753 | $ | 2,693,946 | $ | 2,513,645 | |||||
Average Equity | 259,835 | 241,466 | 224,969 | ||||||||
Return on Average Assets | 1.27 | % | 1.09 | % | 1.06 | % | |||||
Return on Average Equity | 13.96 | 12.14 | 11.79 | ||||||||
Average Earning Assets | $ | 2,734,160 | $ | 2,567,116 | $ | 2,388,042 | |||||
Average Interest-Bearing Liabilities | 2,113,102 | 2,006,575 | 1,896,351 | ||||||||
Interest Income | 96,503 | 84,657 | 76,915 | ||||||||
Interest Income, Tax-Equivalent* | 98,214 | 88,501 | 80,636 | ||||||||
Interest Expense | 12,485 | 7,006 | 5,356 | ||||||||
Net Interest Income | 84,018 | 77,651 | 71,559 | ||||||||
Net Interest Income, Tax-Equivalent* | 85,729 | 81,495 | 75,280 | ||||||||
Net Interest Margin | 3.07 | % | 3.02 | % | 3.00 | % | |||||
Net Interest Margin, Tax-Equivalent* | 3.14 | % | 3.17 | % | 3.15 | % | |||||
Efficiency Ratio Calculation*4 | |||||||||||
Noninterest Expense | 65,055 | $ | 62,705 | $ | 59,609 | ||||||
Less: Intangible Asset Amortization | 263 | 279 | 297 | ||||||||
Net Noninterest Expense | $ | 64,792 | $ | 62,426 | $ | 59,312 | |||||
Net Interest Income, Tax-Equivalent | $ | 85,729 | $ | 81,495 | $ | 75,280 | |||||
Noninterest Income | 28,949 | 27,645 | 27,832 | ||||||||
Less: Net (Loss) Gain on Security Transactions | — | (448 | ) | (22 | ) | ||||||
Less: Net Changes in Fair Value of Equity Investments | 213 | — | — | ||||||||
Net Gross Income, Adjusted | $ | 114,465 | $ | 109,588 | $ | 103,134 | |||||
Efficiency Ratio* | 56.60 | % | 56.96 | % | 57.51 | % | |||||
Period-End Capital Information: | |||||||||||
Tier 1 Leverage Ratio | 9.61 | % | 9.49 | % | 9.47 | % | |||||
Total Stockholders’ Equity (i.e. Book Value) | $ | 269,584 | $ | 249,603 | $ | 232,852 | |||||
Book Value per Share | 18.63 | 17.40 | 16.28 | ||||||||
Intangible Assets | 23,725 | 24,162 | 24,569 | ||||||||
Tangible Book Value per Share 2 | 16.99 | 15.71 | 14.56 | ||||||||
Asset Quality Information: | |||||||||||
Net Loans Charged-off as a Percentage of Average Loans | 0.05 | % | 0.06 | % | 0.06 | % | |||||
Provision for Loan Losses as a Percentage of Average Loans | 0.13 | % | 0.15 | % | 0.12 | % | |||||
Allowance for Loan Losses as a Percentage of Period-End Loans | 0.92 | % | 0.95 | % | 0.97 | % | |||||
Allowance for Loan Losses as a Percentage of Nonperforming Loans | 365.74 | % | 312.37 | % | 309.31 | % | |||||
Nonperforming Loans as a Percentage of Period-End Loans | 0.25 | % | 0.31 | % | 0.31 | % | |||||
Nonperforming Assets as a Percentage of Total Assets | 0.23 | % | 0.28 | % | 0.28 | % | |||||
*See "Use of Non-GAAP Financial Measures" on page 4.
# 25
Arrow Financial Corporation
Reconciliation of Non-GAAP Financial Information
(Dollars In Thousands, Except Per Share Amounts)
Footnotes: | ||||||||||||||||||||
1. | Share and per share data have been restated for the September 27, 2018, 3% stock dividend. | |||||||||||||||||||
2. | Non-GAAP Financial Measure Reconciliation: Tangible Book Value, Tangible Equity, and Return on Tangible Equity exclude goodwill and other intangible assets, net from total equity. These are non-GAAP financial measures which we believe provide investors with information that is useful in understanding our financial performance. | |||||||||||||||||||
12/31/2018 | 9/30/2018 | 6/30/2018 | 3/31/2018 | 12/31/2017 | ||||||||||||||||
Total Stockholders' Equity (GAAP) | $ | 269,584 | $ | 264,810 | $ | 259,488 | $ | 252,734 | $ | 249,603 | ||||||||||
Less: Goodwill and Other Intangible assets, net | 23,725 | 23,827 | 23,933 | 24,045 | 24,162 | |||||||||||||||
Tangible Equity (Non-GAAP) | $ | 245,859 | $ | 240,983 | $ | 235,555 | $ | 228,689 | $ | 225,441 | ||||||||||
Period End Shares Outstanding | 14,472 | 14,441 | 14,424 | 14,368 | 14,348 | |||||||||||||||
Tangible Book Value per Share (Non-GAAP) | $ | 16.99 | $ | 16.69 | $ | 16.33 | $ | 15.92 | $ | 15.71 | ||||||||||
Net Income | 8,758 | 9,260 | 9,730 | 8,531 | 8,071 | |||||||||||||||
Return on Tangible Equity (Net Income/Tangible Equity - Annualized) | 14.20 | % | 15.36 | % | 16.80 | % | 15.24 | % | 14.36 | % | ||||||||||
3. | Non-GAAP Financial Measure Reconciliation: Net Interest Margin is the ratio of our annualized tax-equivalent net interest income to average earning assets. This is also a non-GAAP financial measure which we believe provides investors with information that is useful in understanding our financial performance. | |||||||||||||||||||
12/31/2018 | 9/30/2018 | 6/30/2018 | 3/31/2018 | 12/31/2017 | ||||||||||||||||
Interest Income (GAAP) | $ | 26,000 | $ | 24,495 | $ | 23,590 | $ | 22,418 | $ | 22,135 | ||||||||||
Add: Tax Equivalent Adjustment (Non-GAAP) | 376 | 376 | 468 | 491 | 980 | |||||||||||||||
Interest Income - Tax Equivalent (Non-GAAP) | $ | 26,376 | $ | 24,871 | $ | 24,058 | $ | 22,909 | $ | 23,115 | ||||||||||
Net Interest Income (GAAP) | $ | 21,657 | $ | 20,997 | $ | 20,962 | $ | 20,402 | $ | 20,314 | ||||||||||
Add: Tax-Equivalent adjustment (Non-GAAP) | 376 | 376 | 468 | 491 | 980 | |||||||||||||||
Net Interest Income - Tax Equivalent (Non-GAAP) | $ | 22,033 | $ | 21,373 | $ | 21,430 | $ | 20,893 | $ | 21,294 | ||||||||||
Average Earning Assets | 2,831,438 | 2,757,020 | 2,703,054 | 2,641,660 | 2,617,680 | |||||||||||||||
Net Interest Margin (Non-GAAP) | 3.09 | % | 3.08 | % | 3.18 | % | 3.21 | % | 3.23 | % | ||||||||||
4. | Non-GAAP Financial Measure Reconciliation: Financial Institutions often use the "efficiency ratio", a non-GAAP ratio, as a measure of expense control. We believe the efficiency ratio provides investors with information that is useful in understanding our financial performance. We define our efficiency ratio as the ratio of our noninterest expense to our net gross income (which equals our tax-equivalent net interest income plus noninterest income, as adjusted). | |||||||||||||||||||
5. | For the current quarter, all of the regulatory capital ratios in the table above, as well as the Total Risk-Weighted Assets and Common Equity Tier 1 Capital amounts listed in the table below, are estimates based on, and calculated in accordance with bank regulatory capital rules. All prior quarters reflect actual results. The December 31, 2018 CET1 ratio listed in the tables (i.e., 12.89%) exceeds the sum of the required minimum CET1 ratio plus the fully phased-in Capital Conservation Buffer (i.e., 7.00%). | |||||||||||||||||||
12/31/2018 | 9/30/2018 | 6/30/2018 | 3/31/2018 | 12/31/2017 | ||||||||||||||||
Total Risk Weighted Assets | 2,046,495 | 1,999,849 | 1,934,890 | 1,889,719 | 1,856,242 | |||||||||||||||
Common Equity Tier 1 Capital | 283,913 | 257,852 | 259,488 | 265,066 | 259,378 | |||||||||||||||
Common Equity Tier 1 Ratio | 12.89 | % | 12.89 | % | 13.01 | % | 12.97 | % | 12.89 | % | ||||||||||
# 26
CRITICAL ACCOUNTING ESTIMATES
The significant accounting policies, as described in Note 2 - Summary of Significant Accounting Policies to the notes to the Consolidated Financial Statements are essential in understanding the Management Discussion and Analysis. Many of the significant accounting policies require complex judgments to estimate the values of assets and liabilities. The Company has procedures and processes in place to facilitate making these judgments. The more judgmental estimates are summarized in the following discussion. In many cases, there are numerous alternative judgments that could be used in the process of determining the inputs to the models. Where alternatives exist, the Company has used the factors that are believed to represent the most reasonable value in developing the inputs. Actual performance that differs from our estimates of the key variables could impact the results of operations.
Allowance for loan losses: The allowance for loan losses represents management’s estimate of probable losses inherent in the Company’s loan portfolio. The process for determining the allowance for loan losses is discussed in Note 2, Summary of Significant Accounting Policies and Note 5, Loans, to the notes to the Consolidated Financial Statements. The Company evaluates the allowance at the portfolio segment level and the portfolio segments are commercial, commercial real estate, residential real estate, and consumer loans. Due to the variability in the drivers of the assumptions used in this process, estimates of the portfolio’s inherent risks and overall collectability change with changes in the economy, individual industries, and borrowers’ ability and willingness to repay their obligations. The degree to which any particular assumption affects the allowance for loan losses depends on the severity of the change and its relationship to the other assumptions. Key judgments used in determining the allowance for loan losses for individual commercial loans include credit quality indicators, collateral values and estimated cash flows for impaired loans. For pools of loans the Company considers the historical net loss experience, and as necessary, adjustments to address current events and conditions, considerations regarding economic uncertainty, and overall credit conditions. The historical loss factors incorporate a rolling twelve quarter look-back period for each loan segment in order to reduce the volatility associated with improperly weighting short-term fluctuations. The process of determining the level of the allowance for loan losses requires a high degree of judgment. Any downward trend in the economy, regional or national, may require the Company to increase the allowance for loan losses resulting in a negative impact on the results of operations and financial condition.
# 27
A. OVERVIEW
The following discussion and analysis focuses on and reviews our results of operations for each of the years in the three-year period ended December 31, 2018 and our financial condition as of December 31, 2018 and 2017. The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the Consolidated Financial Statements and other financial data presented elsewhere in this Report. When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.
Summary of 2018 Financial Results: Net income for 2018 of $36.3 million increased 23.7% over the results for 2017. Diluted earnings per share ("EPS") for 2018 was $2.50, an increase of $0.46, or 22.5% from EPS in 2017. Financial performance ratios were strong for 2018, including the return on average equity ("ROE") of 13.96%, compared to 12.14% for 2017 year, and return on average assets ("ROA") for 2018 of 1.27% compared to 1.09% for 2017.
Factors contributing to the positive results for the current year compared to the comparable year are as follows:
Net interest income on a GAAP basis increased 8.2% to $84.0 million primarily due to the increase in total interest and dividend income of $11.8 million. Net interest margin on a GAAP basis improved to 3.07% for 2018 as compared to 3.02% for 2017. Interest and fees on loans increased $11.4 million for 2018 mainly due to strong loan growth and higher market rates. Interest expense increased $5.5 million as a result of 4.6% deposit growth, higher market rates and some shifting in the overall funding mix toward higher costing sources. Consistent with prior years, seasonal municipal deposits increased in the fourth quarter. Noninterest income, including net gains on securities, increased $1.3 million in 2018 mainly due to an $838 thousand increase in income from fiduciary activities, an increase of $543 thousand in service fee revenue, and the increase in the net gain on securities. Total noninterest expense increased by $2.4 million, in 2018 primarily due to the $1.1 million increase in salaries and employee benefits and $1.0 million increase in other operating expenses, which included increased loan costs combined with increased spending on technology. In addition to the above, the provision for income taxes decreased $1.5 million, or 14.3%, due to the reduction in tax rates as a result of the Tax Act.
The changes in net income, net interest income and net interest margin between the current and prior year are discussed in detail under the heading "RESULTS OF OPERATIONS," beginning on page 29.
2018 Regulatory Reform: The Economic Growth Act, was signed into law May 24, 2018. Some of its provisions were written to take effect immediately; others have later specified effective dates and still others are open-ended, to be implemented by rule-making. See the discussion of this item under C. SUPERVISION AND REGULATION, "2018 Regulatory Reform" for further details.
The Tax Act was enacted on December 22, 2017. The Company has recorded and reported the effects of the law’s impacts in its financial statements for the periods ended December 31, 2018 and December 31, 2017. See Note 15, Income Taxes, to the notes to our Consolidated Financial Statements for more information.
Regulatory Capital and Increase in Stockholders' Equity: As of December 31, 2018,we continued to exceed by a substantial amount all required minimum capital ratios under the bank regulatory capital rules at both the holding company and bank levels. At that date, both of our banks, as well as our holding company, continued to qualify as "well-capitalized" under the capital classification guidelines as defined by the current bank regulatory capital rules. Because of our continued profitability and strong asset quality, our regulatory capital levels throughout recent years have consistently remained well in excess of the various required regulatory minimums in effect from time to time, as they do at present. Pursuant to the Capital Rules under Dodd-Frank, required minimum regulatory capital levels for insured banks and their parent holding companies are scheduled to increase in 2019. As explained above, pursuant to Economic Growth Act, the federal bank regulators are required to implement a simplified community bank leverage ratio capital standard that may be applicable to Arrow and its subsidiary banks to allow them to satisfy all applicable capital and leverage requirements, including the currently applicable risk-based capital ratio requirements. The implementation of the new community bank leverage ratio standards will be subject to the notice and comment procedures of rulemaking. The Economic Growth Act does not impose a deadline for this rulemaking. The federal bank regulators have issued a proposed rule to implement the "community bank leverage ratio", but that rule is not final, and is subject to change. The Company anticipates that, when this new standard is implemented, it may simplify capital adequacy compliance requirements for community banks and holding companies such as Arrow.
Total Stockholders' equity was $269.6 million at December 31, 2018, an increase of $20.0 million, or 8.0%, from the year earlier level. The components of the change in stockholders' equity since year-end 2017 are presented in the Consolidated Statement of Changes in Stockholders' Equity on page 58. Total book value per share increased by 7.1% over the prior year level. At December 31, 2018, tangible book value per share, a non-GAAP financial measure calculated based on tangible book value (total stockholders' equity minus intangible assets including goodwill) was $16.99, an increase of $1.28, or 8.1%, over the December 31, 2017 amount. This increase in total stockholders' equity during 2018 principally reflected the following factors: (i) $36.3 million of net income for the period, plus (ii) $3.5 million of equity received from various stock-based compensation plans, plus (iii) $1.8 million of equity resulting from the dividend reinvestment plan, reduced by (iv) cash dividends of $14.4 million; (v) other comprehensive loss of $5.0 million and (vi) repurchases of our common stock of $2.1 million. As of December 31, 2018, our closing stock price was $32.02, resulting in a trading multiple of 1.88 to our tangible book value. The Board of Directors declared and the Company paid a cash dividend of $0.243 per share for the first two quarters of 2018 and $0.252 per share for the third quarter of 2018, as adjusted for a 3% stock dividend distributed September 27, 2018, a cash dividend of $0.26 per share for the fourth quarter of 2018, and has declared a $0.26 per share cash dividend for the first quarter of 2019.
# 28
Economic trends and loan quality: Economic growth has continued at a modest pace in the Company's market area, while labor markets remained exceptionally tight. Residential real estate revealed mixed results, with the growth in the median sales price slower than the national average. Nonperforming loans were $5.5 million at December 31, 2018, a decrease of $0.4 million, or 7.2%, from year-end 2017. The ratio of nonperforming loans to period-end loans at December 31, 2018 was .25%, a decrease from 0.31% at December 31, 2017 and less than the Company's peer group ratio of 0.61% at September 30, 2018. Loans charged-off (net of recoveries) against the allowance for loan losses was $1.0 million for 2018, a decrease of $165 thousand from 2017. The ratio of net charge-offs to average loans was 0.05% for 2018, compared to the peer group ratio of 0.08% for the period ended September 30, 2018. At December 31, 2018, the allowance for loan losses was $20.2 million, representing 0.92% of total loans, a decrease of 3 basis points from the December 31, 2017 ratio.
The Company's major loan segments are:
◦ | Commercial Loans: These loans comprised approximately 6% of the total loan portfolio at period-end. The business sector in the Company's service area, including small- and mid-sized businesses with headquarters in the area, continued to be in reasonably good financial condition at 2018 year-end. |
◦ | Commercial Real Estate Loans: These loans comprised approximately 22% of the total loan portfolio at period-end. Commercial property values in the Company's region have remained stable in recent periods. Appraisals on nonperforming and watched CRE properties are updated as deemed necessary, usually when the loan was downgraded or when there has been significant market deterioration since the last appraisal. |
◦ | Residential Real Estate Loans: These loans, including home equity loans, comprised approximately 39% of the total loan portfolio at period-end. The residential real estate market in the Company's service area has been stable in recent periods. The Company originated nearly all of the residential real estate loans currently held in the loan portfolio and applied conservative underwriting standards to loan originations. The Company typically sells a portion of residential real estate mortgage originations into the secondary market. The ratio of the sales of originations to total originations tends to fluctuate from period to period, although this ratio has generally declined somewhat in recent periods. |
◦ | Consumer Loans (Primarily Indirect Automobile Loans): These loans comprise approximately 33% of the total loan portfolio at period-end. Throughout the past three years, the Company did not experience any significant increase in the delinquency rate or in the percentage of nonperforming loans in this segment. |
Liquidity and access to credit markets: The Company did not experience any liquidity problems or special concerns during 2018, nor during the prior two years. The terms of the lines of credit with three correspondent banks, the Federal Home Loan Bank of New York ("FHLBNY") and the Federal Reserve Bank have not changed (see the general liquidity discussion on page 47). In general, the Company principally relies on asset-based liquidity (i.e., funds in overnight investments and cash flow from maturing investments and loans) with liability-based liquidity as a secondary source. The main liability-based sources are overnight borrowing arrangements with three correspondent banks, an arrangement for overnight borrowing and term credit advances from the FHLBNY, and an additional arrangement for short-term advances at the Federal Reserve Bank discount window. Regular liquidity stress tests are performed and the Company periodically tests the contingent liquidity plan to ensure that an adequate amount of available funds can be generated to meet a wide variety of potential liquidity crises, including a severe crisis.
Visa Class B Common Stock: Arrow's subsidiary bank, Glens Falls National, like other Visa member banks, bears some indirect contingent liability for Visa's direct liability arising out of certain antitrust claims involving merchant discounts to the extent that Visa's liability might exceed the amount funded in their litigation escrow account. On September 18, 2018, Visa issued a press release announcing that they and other defendants entered into a settlement agreement with class plaintiffs in the related litigation case, and they expect the damage class plaintiffs to file a motion for preliminary approval of the settlement with the court. If the settlement is approved and the balance in the litigation escrow account is sufficient to cover the litigation claims and related expenses, Arrow could potentially realize a gain on the receipt of Visa Class A common stock. At December 31, 2018, Glens Falls National held 27,771 shares of Visa Class B common stock, and utilizing the conversion ratio to Class A common stock at that time, these Class B shares would convert to 45,000 shares of Visa Class A common stock. Since the litigation settlement is not certain, the Company has not recognized any economic value for these shares.
B. RESULTS OF OPERATIONS
The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on our results of operations for December 31, 2018 and the prior two years.
I. NET INTEREST INCOME
Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds. Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate). Net interest margin is the ratio of net interest income to average earning assets. Net interest income may also be described as the product of average earning assets and the net interest margin. We will present net interest income in both a GAAP and tax-equivalent basis. As described in the section entitled “Use of Non-GAAP Financial Measures” on page 4 of this Report, for purposes of our presentation of Selected Financial Information in this Report, including in this Item 7, "Management's Discussion and Analysis
# 29
of Financial Conditions and Results of Operations," we include a calculation net interest income on a tax-equivalent basis, producing a non-GAAP financial measure. See the discussion and calculation of our 2018 tax equivalent net interest income and net interest margin on page 4 of this Report.
CHANGE IN NET INTEREST INCOME
(Dollars In Thousands) (GAAP Basis)
Years Ended December 31, | Change From Prior Year | ||||||||||||||||||||||||
2017 to 2018 | 2016 to 2017 | ||||||||||||||||||||||||
2018 | 2017 | 2016 | Amount | % | Amount | % | |||||||||||||||||||
Interest and Dividend Income | 96,503 | 84,657 | 76,915 | $ | 11,846 | 14.0 | % | $ | 7,742 | 10.1 | % | ||||||||||||||
Interest Expense | 12,485 | 7,006 | 5,356 | 5,479 | 78.2 | 1,650 | 30.8 | ||||||||||||||||||
Net Interest Income | $ | 84,018 | $ | 77,651 | $ | 71,559 | $ | 6,367 | 8.2 | % | $ | 6,092 | 8.5 | % | |||||||||||
CHANGE IN NET INTEREST INCOME
(Dollars In Thousands) (Tax-equivalent Basis)
Years Ended December 31, | Change From Prior Year | ||||||||||||||||||||||||
2017 to 2018 | 2016 to 2017 | ||||||||||||||||||||||||
2018 | 2017 | 2016 | Amount | % | Amount | % | |||||||||||||||||||
Interest and Dividend Income | 98,214 | 88,501 | 80,636 | $ | 9,713 | 11.0 | % | $ | 7,865 | 9.8 | % | ||||||||||||||
Interest Expense | 12,485 | 7,006 | 5,356 | 5,479 | 78.2 | 1,650 | 30.8 | ||||||||||||||||||
Net Interest Income | $ | 85,729 | $ | 81,495 | $ | 75,280 | $ | 4,234 | 5.2 | % | $ | 6,215 | 8.3 | % | |||||||||||
On a GAAP basis, net interest income was $84.0 million in 2018, an increase of $6.4 million, or 8.2%, from the $77.7 million in 2017. This compared to an increase of $6.1 million, or 8.5%, from 2016 to 2017. Factors contributing to the year-to-year changes in net interest income over the three-year period are discussed in the following portions of this Section B.I.
# 30
The following tables reflects the components of our net interest income, setting forth, for years ended December 31, 2018, 2017 and 2016: (i) average balances of assets, liabilities and stockholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets. Interest income, net interest income and interest rate information are presented on a GAAP and tax-equivalent basis (see the discussion under "Use of Non-GAAP Financial Measures" on page 4 of this Report). The yield on securities available-for-sale is based on the amortized cost of the securities. Nonaccrual loans are included in average loans.
Average Consolidated Balance Sheets and Net Interest Income Analysis
(GAAP basis)
(Dollars in Thousands)
Years Ended: | 2018 | 2017 | 2016 | |||||||||||||||||||||||||||||
Interest | Rate | Interest | Rate | Interest | Rate | |||||||||||||||||||||||||||
Average | Income/ | Earned/ | Average | Income/ | Earned/ | Average | Income/ | Earned/ | ||||||||||||||||||||||||
Balance | Expense | Paid | Balance | Expense | Paid | Balance | Expense | Paid | ||||||||||||||||||||||||
Interest-Bearing Deposits at Banks | $ | 30,475 | $ | 711 | 2.33 | % | $ | 25,573 | $ | 348 | 1.36 | % | $ | 24,950 | $ | 152 | 0.61 | % | ||||||||||||||
Investment Securities: | ||||||||||||||||||||||||||||||||
Fully Taxable | 382,703 | 8,582 | 2.24 | % | 390,641 | 7,884 | 2.02 | % | 420,885 | 7,934 | 1.89 | % | ||||||||||||||||||||
Exempt from Federal Taxes | 258,407 | 5,563 | 2.15 | % | 288,655 | 6,223 | 2.16 | % | 278,982 | 6,006 | 2.15 | % | ||||||||||||||||||||
Loans | 2,062,575 | 81,647 | 3.96 | % | 1,862,247 | 70,202 | 3.77 | % | 1,663,225 | 62,823 | 3.78 | % | ||||||||||||||||||||
Total Earning Assets | 2,734,160 | 96,503 | 3.53 | % | 2,567,116 | 84,657 | 3.30 | % | 2,388,042 | 76,915 | 3.22 | % | ||||||||||||||||||||
Allowance for Loan Losses | (19,278 | ) | (17,303 | ) | (16,449 | ) | ||||||||||||||||||||||||||
Cash and Due From Banks | 36,360 | 36,175 | 33,207 | |||||||||||||||||||||||||||||
Other Assets | 104,511 | 107,958 | 108,845 | |||||||||||||||||||||||||||||
Total Assets | $ | 2,855,753 | $ | 2,693,946 | $ | 2,513,645 | ||||||||||||||||||||||||||
Deposits: | ||||||||||||||||||||||||||||||||
Interest-Bearing Checking Accounts | $ | 849,626 | 1,618 | 0.19 | % | $ | 907,113 | 1,510 | 0.17 | % | $ | 912,461 | 1,279 | 0.14 | % | |||||||||||||||||
Savings Deposits | 753,198 | 3,457 | 0.46 | % | 685,782 | 1,371 | 0.20 | % | 616,208 | 931 | 0.15 | % | ||||||||||||||||||||
Time Deposits of $250,000 Or More | 78,159 | 1,183 | 1.51 | % | 32,089 | 282 | 0.88 | % | 69,489 | 453 | 0.65 | % | ||||||||||||||||||||
Other Time Deposits | 173,151 | 1,420 | 0.82 | % | 165,778 | |||||||||||||||||||||||||||