(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $1.00 Par Value
Name of exchange where registered:
The NASDAQ Stock Market, LLC
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the of the Securities Act.
Yes ¨ No ý
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes ¨ No ý
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No ¨
Indicate by check 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 and post such files).
Yes ý 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, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨
Accelerated filer x
Non-accelerated filer ¨
Smaller reporting company x
Emerging Growth Company ¨
If emerging growth company, indicate by check market 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. ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No ý
As of June 30, 2018, the aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates was approximately $294.2 million. As of March 6, 2019, there were 13,946,283 shares outstanding of the registrant’s common stock, $1.00 par value.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s Proxy Statement for the Annual Meeting of Shareholders to be held on May 2, 2019, are incorporated by reference in Part III of this Form 10-K.
SmartFinancial, Inc. (“SmartFinancial”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). Any statements that do not relate to historical or current facts or matters are forward-looking statements. You can identify some of the forward-looking statements by the use of forward-looking words, such as “may,” “will,” “could,” “project,” “believe,” “anticipate,” “expect,” “estimate,” “continue,” “potential,” “plan,” “forecast,” and the like, the negatives of such expressions, or the use of the future tense. Statements concerning current conditions may also be forward-looking if they imply a continuation of a current condition. These forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, financial condition, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, but are not limited to:
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weakness or a decline in the U.S. economy, in particular in Tennessee, and other markets in which we operate;
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the possibility that our asset quality would decline or that we experience greater loan losses than anticipated;
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the impact of liquidity needs on our results of operations and financial condition;
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competition from financial institutions and other financial service providers;
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the impact of negative developments in the financial industry and U.S. and global capital and credit markets;
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the impact of recently enacted and future legislation and regulation on our business;
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negative changes in the real estate markets in which we operate and have our primary lending activities, which may result in an unanticipated decline in real estate values in our market area;
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risks associated with our growth strategy, including a failure to implement our growth plans or an inability to manage our growth effectively;
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claims and litigation arising from our business activities and from the companies we acquire, which may relate to contractual issues, environmental laws, fiduciary responsibility, and other matters;
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expected revenue synergies and cost savings from our recently completed acquisition of Foothills Bancorp, Inc. (“Foothills”) and the proposed acquisition of Entegra Financial (“Entegra”) may not be fully realized or may take longer than anticipated to be realized;
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disruption from these merger with customers, suppliers or employees or other business partners’ relationships;
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the risk of successful integration of the targets’ businesses with our business;
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lower than expected revenue following these mergers;
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SmartFinancial’s ability to manage the combined company’s growth following the mergers;
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the possibility that the Entegra merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events;
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the dilution caused by SmartFinancial’s issuance of additional shares of its common stock in connection with the Foothills merger and the Entegra merger;
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cyber attacks, computer viruses or other malware that may breach the security of our websites or other systems we operate or rely upon for services to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage our systems and negatively impact our operations and our reputation in the market;
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results of examinations by our primary regulators, the Tennessee Department of Financial Institutions (the “TDFI”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”), and other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for credit losses, write-down assets, require us to reimburse customers, change the way we do business, or limit or eliminate certain other banking activities;
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government intervention in the U.S. financial system and the effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve;
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our inability to pay dividends at current levels, or at all, because of inadequate future earnings, regulatory restrictions or limitations, and changes in the composition of qualifying regulatory capital and minimum capital requirements (including those resulting from the U.S. implementation of Basel III requirements);
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the relatively greater credit risk of commercial real estate loans and construction and land development loans in our loan portfolio;
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unanticipated credit deterioration in our loan portfolio or higher than expected loan losses within one or more segments of our loan portfolio;
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unexpected significant declines in the loan portfolio due to the lack of economic expansion, increased competition, large prepayments, changes in regulatory lending guidance or other factors;
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unanticipated loan delinquencies, loss of collateral, decreased service revenues, and other potential negative effects on our business caused by severe weather or other external events;
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changes in expected income tax expense or tax rates, including changes resulting from revisions in tax laws, regulations and case law;
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our ability to retain the services of key personnel; and
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the impact of Tennessee’s anti-takeover statutes and certain of our charter provisions on potential acquisitions of us.
For a more detailed discussion of some of the risk factors, see the section entitled “Risk Factors” below. We do not intend to update any factors, except as required by SEC rules, or to publicly announce revisions to any of our forward-looking statements. Any forward-looking statement speaks only as of the date that such statement was made. You should consider any forward looking statements in light of this explanation, and we caution you about relying on forward-looking statements.
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PART I
ITEM 1. BUSINESS
OVERVIEW
SmartFinancial, Inc. (“SmartFinancial” or the “Company”) was incorporated on September 19, 1983, under the laws of the State of Tennessee. SmartFinancial is a bank holding company registered under the Bank Holding Company Act of 1956, as amended.
The primary activity of SmartFinancial currently is, and is expected to remain for the foreseeable future, the ownership and operation of SmartBank (the "Bank"). As a bank holding company, SmartFinancial intends to facilitate SmartBank’s ability to serve its customers’ requirements for financial services. The holding company structure also provides flexibility for expansion through the possible acquisition of other financial institutions and the provision of additional banking-related services, as well as certain non-banking services, which a traditional commercial bank may not provide under present laws.
SmartBank
SmartBank is a Tennessee-chartered commercial bank established in 2007 which has its principal office in Pigeon Forge, Tennessee. The principal business of the Bank consists of attracting deposits from the general public and investing those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial and residential real estate loans, consumer loans and residential and commercial construction loans. Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, and various states and their political subdivisions. In addition to deposits, sources of funds for the Bank’s loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowings from other financial institutions. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses and other overhead expenses. At December 31, 2018, SmartBank had 29 full-service branches located in Tennessee, Alabama, and Florida, two loan production offices, two mortgage loan production offices, and two service centers.
Foothills Merger
On June 28, 2018, the Company along with the Bank entered into an agreement and plan of merger with Foothills Bancorp, Inc., a Tennessee corporation and Foothills Bank, a Tennessee-chartered commercial bank and wholly owned subsidiary of Foothills Bancorp. The merger was consummated on November 1, 2018, with Foothills Bancorp stockholders receiving stock of the Company. After the merger, original stockholders of SmartFinancial owned approximately 91 percent of the outstanding common stock of the combined entity on a fully diluted basis while the previous Foothills Bancorp stockholders owned approximately 9 percent. The assets and liabilities of Foothills Bancorp, as of the effective date of the merger, were recorded at their respective estimated fair values and combined with those of the Company. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was approximately $7.5 million. As a result of the merger the Company assets increased approximately $218 million and liabilities increased approximately $196 million.
Tennessee Bancshares Merger
On December 12, 2017, the Company along with the Bank entered into an agreement and plan of merger with Tennessee Bancshares, Inc., a Tennessee corporation and Southern Community Bank, a Tennessee-chartered commercial bank and wholly owned subsidiary of Tennessee Bancshares. The merger was consummated on May 1, 2018, with Tennessee Bancshares stockholders receiving stock of the Company. After the merger, original stockholders of SmartFinancial owned approximately 89 percent of the outstanding common stock of the combined entity on a fully diluted basis while the previous Tennessee Bancshares stockholders owned approximately 11 percent. The assets and liabilities of Tennessee Bancshares, as of the effective date of the merger, were recorded at their respective estimated fair values and combined with those of the Company. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was approximately $16 million. As a result of the merger the Company assets increased approximately $226 million and liabilities increased approximately $207 million.
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Capstone Merger
On May 22, 2017, the stockholders of the Company approved a merger with Capstone Bancshares, Inc. ("Capstone"), the one bank holding company of Capstone Bank, which was consummated on November 1, 2017. Capstone stockholders received either stock, cash, or a combination of stock and cash. After the merger, stockholders of SmartFinancial owned approximately 74 percent of the outstanding common stock of the combined entity on a fully diluted basis. The assets and liabilities of Capstone, as of the effective date of the merger, were recorded at their respective estimated fair values and combined with those of SmartFinancial. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was approximately $38 million. As a result of the merger Company assets increased approximately $536 million and liabilities increased approximately $466 million. The merger had a significant impact on all aspects of the Company's financial statements, and as a result, financial results after the merger may not be comparable to financial results prior to the merger.
Purchase of Cleveland, Tennessee branch
On December 8, 2016, the Bank entered into a purchase and assumption agreement with Atlantic Capital Bank, N.A. on a branch in Cleveland, Tennessee. The purchase was completed on May 19, 2017 for a total of $1.2 million in cash. The assets and liabilities as of the effective date of the transaction were recorded at their respective estimated fair values. The excess of the purchase price over the net estimated fair values of the acquired assets and liabilities was allocated to identifiable intangible assets with the remaining excess allocated to goodwill, which was $660 thousand. In the periods following the acquisition, the financial statements include the results attributable to the Cleveland branch purchase beginning on the date of purchase. As a result of the transaction the Company acquired approximately $27 million in assets and assumed $27 million in liabilities.
SBLF Preferred Stock
On March 6, 2017, the Company redeemed its $12 million of Senior Non-Cumulative Perpetual Preferred Stock, Series A (“SmartFinancial SBLF Stock”), to the United States Secretary of the Treasury and paid $195 thousand in accrued dividends. More details about the SBLF Preferred Stock can be found in Note 16 in the “Notes to Consolidated Financial Statements.”
Employees
As of December 31, 2018, SmartFinancial and SmartBank had 387 full-time equivalent employees. The employees are not represented by a collective bargaining unit. SmartFinancial believes that its relationship with its employees is good.
Merger and Acquisition Strategy
Our strategic plan involves growing a high performing community bank through organic loan and deposit growth as well as disciplined merger and acquisition activity. We are continually evaluating business combination opportunities and may conduct due diligence activities in connection with these opportunities. As a result, business combination discussions and, in some cases, negotiations, may take place, and transactions involving cash, debt or equity securities could be expected. Any future business combinations or series of business combinations that we might undertake may be material in terms of assets acquired, liabilities assumed, or equity issued.
Competition
We compete in the highly competitive banking and financial services industry. Our profitability depends principally on our ability to effectively compete in the markets in which we conduct business. We expect competition in the industry to continue to increase mainly as a result of the improvement in financial technology used by both existing and new banking and financial services firms. Competition may further intensify as additional companies enter the markets where we conduct business and we enter mature markets in accordance with our expansion strategy.
We experience strong competition from both bank and non-bank competitors. Broadly speaking, we compete with national banks, super-regional banks, smaller community banks and non-traditional internet-based banks. In addition, we compete with other financial intermediaries and investment alternatives such as mortgage companies, credit card issuers, leasing companies, finance companies, money market mutual funds, brokerage firms, governmental and corporation bond issuers, and other securities firms. Many of these non-bank competitors are not subject to the same regulatory oversight, affording them a competitive advantage in some instances. In many cases, our competitors have substantially greater resources and offer certain services that we are unable to provide to our customers.
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We encounter strong pricing competition in providing our services. Additionally, other banks offer different products or services from those that we provide. The larger national and super-regional banks may have significantly greater lending limits and may offer additional products than we are capable of providing. We attempt to compete successfully with our competitors, regardless of their size, by emphasizing customer service while continuing to provide a wide variety of services.
Supervision and Regulation
General
The U.S. banking industry is highly regulated under federal and state law. The following is a general summary of the material aspects of certain statutes and regulations applicable to SmartFinancial and SmartBank. This supervisory framework could materially impact the conduct and profitability of SmartFinancial’s and SmartBank’s activities. A change in applicable laws or regulations, or in the manner such laws or regulations are interpreted by regulatory agencies or courts, may have a material effect on SmartFinancial’s and SmartBank’s business, operations, and earnings.
SmartFinancial is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (which we refer to as the “BHC Act”). As a result, SmartFinancial is subject to supervision, regulation, and examination by the Federal Reserve and is required to file with the Federal Reserve annual reports and such additional information as the Federal Reserve may require pursuant to the BHC Act and applicable regulations. SmartFinancial is also under the jurisdiction of the SEC for matters relating to the offering and sale of SmartFinancial’s securities and is subject to the SEC’s rules and regulations relating to periodic reporting, reporting to stockholders, proxy solicitations, and insider-trading.
SmartBank is a Tennessee-chartered commercial bank and is a member of the Federal Reserve System. As a Tennessee-chartered bank, SmartBank is subject to supervision, regulation, and examination by the Tennessee Department of Financial Institutions ("TDFI"). As a member of the Federal Reserve System, SmartBank is also subject to supervision, regulation, and examination by the Federal Reserve. In addition, SmartBank’s deposit accounts are insured up to applicable limits by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation ("FDIC"), and SmartBank is subject to regulation by the FDIC as the insurer of its deposits.
The bank and bank holding company regulatory scheme has two primary goals: to maintain a safe and sound banking system and to facilitate the conduct of sound monetary policy. This comprehensive system of supervision and regulation is intended primarily for the protection of the FDIC’s Deposit Insurance Fund, bank depositors, and the public, rather than SmartFinancial’s stockholders or creditors. To this end, federal and state banking laws and regulations control, among other things, the types of activities in which SmartFinancial and SmartBank may engage, permissible investments that SmartFinancial and SmartBank may make, the level of reserves that SmartBank must maintain against deposits, minimum equity capital levels, the nature and amount of collateral required for loans, maximum interest rates that can be charged, the ability of SmartFinancial and SmartBank to pay dividends and the amount of dividends paid, and corporate activities regarding mergers, acquisitions, and the establishment and closing of branch offices. In addition, federal and state laws impose substantial requirements on SmartBank in the areas of consumer protection and detection and reporting of potential or suspected money laundering and terrorist financing activities.
The sections below summarize certain elements of the bank holding company and bank regulatory framework applicable to SmartFinancial and SmartBank. This summary is not, however, intended to describe all laws, regulations, and policies applicable to SmartFinancial and SmartBank, and you should refer to the full text of the referenced statutes, regulations, and corresponding guidance for more information. These statutes and regulations are subject to change, and additional statutes, regulations, and corresponding guidance may be adopted. Proposals to change the laws and regulations governing the banking industry are frequently raised at both the state and federal level. We are unable to predict any such future changes or the effects, if any, that any such changes could have on SmartFinancial’s business, revenues, and financial results.
Regulation of SmartFinancial
As a regulated bank holding company, SmartFinancial is subject to various laws and regulations that affect SmartFinancial’s business. These laws and regulations, among other things, prescribe minimum capital requirements, limit transactions with affiliates, impose limitations on the business activities in which SmartFinancial can engage, restrict SmartFinancial’s ability to pay dividends to its stockholders, restrict the ability of institutions to guarantee its debt, and impose certain specific accounting requirements on SmartFinancial that may be more restrictive and may result in greater or earlier charges to earnings or reductions in its capital than generally accepted accounting principles.
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Permitted Activities
Under the BHC Act, a bank holding company that is not a financial holding company (as discussed below) is generally permitted to engage in, or acquire direct or indirect control of more than 5 percent of any class of the voting shares of any company that is not a bank or bank holding company and that is engaged in, the following activities (in each case subject to certain conditions and restrictions and prior approval of the Federal Reserve):
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banking or managing or controlling banks;
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furnishing services to or performing services for its subsidiaries; and
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any activity that the Federal Reserve determines by regulation or order to be so closely related to banking as to be a proper incident to the business of banking, including, for example, factoring accounts receivable, making, acquiring, brokering, or servicing loans and usual related activities, leasing personal or real property, operating a nonbank depository institution, such as a savings association, performing trust company functions, conducting financial and investment advisory activities, underwriting and dealing in government obligations and money market instruments, performing selected insurance underwriting activities, issuing and selling money orders and similar consumer-type payment instruments, and engaging in certain community development activities.
While the Federal Reserve has in the past found these activities acceptable for other bank holding companies, the Federal Reserve may not allow SmartFinancial to conduct any or all of these activities, which are reviewed by the Federal Reserve on a case by case basis upon application by a bank holding company.
Acquisitions Subject to Prior Regulatory Approval
The BHC Act generally requires the prior approval of the Federal Reserve for a bank holding company to acquire substantially all the assets of a bank or to acquire direct or indirect ownership or control of more than 5 percent of any class of the voting shares of any bank, bank holding company, savings and loan holding company, or savings association, or to increase any such non-majority ownership or control of any bank, bank holding company, savings and loan holding company, or savings association, or to merge or consolidate with any bank holding company.
Under the BHC Act, a bank holding company that is located in Tennessee and is “well capitalized” and “well managed”, as such terms are defined under the BHC Act and implementing regulations, may purchase a bank located outside of Tennessee. Conversely, a well-capitalized and well-managed bank holding company located outside of Tennessee may purchase a bank located inside Tennessee. In each case, however, restrictions may be placed on the acquisition of a bank that has only been in existence for a limited amount of time or will result in concentrations of deposits exceeding limits specified by statute.
Federal and state laws, including the BHC Act and the Change in Bank Control Act, impose additional prior notice or approval requirements and ongoing regulatory requirements on any investor that seeks to acquire direct or indirect “control” of an FDIC-insured depository institution or bank holding company. “Control” of a depository institution or bank holding company is a facts and circumstances analysis, but generally an investor is deemed to control a depository institution or bank holding company if the investor owns or controls 25 percent or more of any class of voting securities. Ownership or control of 10 percent or more of any class of voting securities, where either the depository institution or bank holding company is a public company, like SmartFinancial, or no other person will own or control a greater percentage of that class of voting securities after the acquisition, is also presumed to result in the investor controlling the depository institution or bank holding company, although this is subject to rebuttal.
The BHC Act was substantially amended through the Financial Services Modernization Act of 1999, commonly referred to as the Gramm-Leach Bliley Act, or the GLBA. The GLBA eliminated long-standing barriers to affiliations among banks, securities firms, insurance companies, and other financial services providers. A bank holding company whose subsidiary deposit institutions are “well capitalized” and “well managed” may elect to become a “financial holding company” and thereby engage without prior Federal Reserve approval in certain banking and non-banking activities that are deemed to be financial in nature or incidental to financial activity. These “financial in nature” activities include securities underwriting, dealing, and market making; organizing, sponsoring, and managing mutual funds; insurance underwriting and agency; merchant banking activities; and other activities that the Federal Reserve has determined to be closely related to banking. Generally, no regulatory approval is required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve. SmartFinancial has not elected to become a financial holding company.
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A dominant theme of the GLBA is functional regulation of financial services, with the primary regulator of a company or its subsidiaries being the agency which traditionally regulates the activity in which the company or its subsidiaries wish to engage. For example, the SEC regulates bank holding company securities transactions, and the various banking regulators oversee banking activities.
Bank Holding Company Obligations to Bank Subsidiaries
Under current law and Federal Reserve policy, a bank holding company is expected to act as a source of financial and managerial strength to its depository institution subsidiaries and to maintain resources adequate to support such subsidiaries, which could require SmartFinancial to commit resources to support SmartBank in situations where additional investments may not otherwise be warranted. As a result of these obligations, a bank holding company may be required to contribute additional capital to its subsidiaries.
Bank Holding Company Dividends
The Federal Reserve’s policy regarding dividends generally is that a bank holding company should not declare or pay a cash dividend which would impose undue pressure on the capital of any bank subsidiary or would be funded only through borrowing or other arrangements that might adversely affect a bank holding company’s financial position. As a general matter, the Federal Reserve has indicated that the board of directors of a bank holding company should consult with the Federal Reserve and eliminate, defer, or significantly reduce the bank holding company’s dividends if:
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the company’s net income available to stockholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;
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the company’s prospective rate of earnings retention is not consistent with its capital needs and overall current and prospective financial condition; or
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the company will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.
If an insured member bank controlled by a bank holding company becomes “significantly undercapitalized” under the applicable federal bank capital ratios, or if the bank is “undercapitalized” and has failed to submit an acceptable capital restoration plan or has materially failed to implement such a plan, the Federal Reserve may require prior approval for any capital distribution by the bank holding company. For more information, see “Capitalization Levels and Prompt Corrective Action” below.
In addition, because SmartFinancial is a legal entity separate and distinct from SmartBank and does not conduct stand-alone operations, the company’s ability to pay dividends largely depends on the ability of SmartBank to pay dividends to SmartFinancial, which is also subject to regulatory restrictions as described below in “Bank Dividends.”
Under Tennessee law, SmartFinancial is not permitted to pay cash dividends if, after giving effect to the payment of such dividends, the company would not be able to pay its debts as they become due in the usual course of business or its total assets would be less than the sum of its total liabilities plus any amounts needed to satisfy any preferential rights if it were dissolving.
Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (which we refer to as the “Dodd-Frank Act”) significantly changed the regulatory structure for financial institutions like SmartBank and their holding companies with respect to lending, deposit, investment, trading, and operating activities. Although the Dodd-Frank Act is primarily aimed at the activities of investment banks and large commercial banks, many of the provisions of the legislation impact the operations of community banks like SmartBank. The following aspects of the Dodd-Frank Act are, or may be, applicable to SmartFinancial’s or SmartBank’s operations:
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Tier 1 capital treatment for certain “hybrid” capital items such as trust preferred securities was eliminated, subject to various grandfathering and transition rules.
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The deposit insurance assessment base calculation now equals a depository institution’s average consolidated total assets minus its average tangible equity during the assessment period. Previously, the deposit insurance assessment was calculated based on the insured deposits held by the institution.
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The ceiling on the size of the Deposit Insurance Fund was removed and the minimum designated reserve ratio of the Deposit Insurance Fund increased 20 basis points to 1.35 percent of estimated annual insured deposits or assessment base. The FDIC also was directed to offset the effect of the increased reserve ratio for insured depository institutions with total consolidated assets of less than $10 billion.
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Bank holding companies and banks must be “well capitalized” and “well managed” in order to acquire banks located outside of their home state, which codified longstanding Federal Reserve policy. Any bank holding
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company electing to be treated as a financial holding company must be and remain “well capitalized” and “well managed.”
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Capital requirements for insured depository institutions are now countercyclical, such that capital requirements increase in times of economic expansion and decrease in times of economic contraction.
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The Federal Reserve established interchange transaction fees for electronic debit transactions under a restrictive “reasonable and proportional cost” per transaction standard.
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The “opt in” provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1997 have been eliminated, which allows a state bank to establish de novo branches in a state other than the bank’s home state if the law of such other state would permit a bank chartered in that state to open a branch at that location.
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The Durbin Amendment limits interchange fees payable on debit card transactions for financial institutions with more than $10 billion in assets. While the Durbin Amendment does not directly apply to SmartBank, competitive market forces related to the reduction mandated by the Durbin Amendment may result in a decrease in revenue from interchange fees for smaller financial institutions.
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The prohibition on the payment of interest on demand deposit accounts was repealed effective one year after enactment, thereby permitting depository institutions to pay interest on business checking and other accounts.
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A new federal agency was created, the Bureau of Consumer Financial Protection (also known as the Consumer Financial Protection Bureau, or CFPB), which has broad rulemaking, supervisory, and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans, and credit cards. The CFPB is also responsible for examining large financial institutions (i.e., those with more than $10 billion in assets) for, and enforcing, compliance with federal consumer financial protection laws and regulations.
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The regulation of consumer protections relative to mortgage originations, addressing loan originator compensation, minimum repayment standards, including restrictions on variable-rate lending by requiring the ability to repay be determined based on the maximum rate that will apply during the first five years of a variable-rate loan term, prepayment considerations, and new disclosures, has been expanded.
Economic Growth, Regulatory Relief, and Consumer Protection Act
On May 24, 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act (which we refer to as the “Regulatory Relief Act”) was enacted to modify or remove certain financial reform rules and regulations, including some of those implemented under the Dodd-Frank Act. While it maintains the majority of the regulatory structure established by the Dodd-Frank Act, the Regulatory Relief Act amends certain aspects for smaller depository institutions with less than $10 billion in assets, such as SmartBank. Portions of the Regulatory Relief Act address access to mortgage credit; consumer access to credit; protections for veterans, consumers, and homeowners; rules for certain bank holding companies; capital access; and protections for student borrowers. SmartFinancial and SmartBank will focus on the implementing rules, regulations, and guidance for the various provisions of the Regulatory Relief Act that impact their operations and activities.
Among other things, the Regulatory Relief Act simplifies the regulatory capital rules for financial institutions and their holding companies with total consolidated assets of less than $10 billion. The Regulatory Relief Act requires federal banking agencies to develop a community bank leverage ratio (defined as the ratio of tangible equity capital to average total consolidated assets) for banks and holding companies with total consolidated assets of less than $10 billion and an appropriate risk profile. The required regulations must specify a minimum community bank leverage ratio of not less than 8 percent and not more than 10 percent, as well as procedures for treatment of a qualifying banking organization that has a community bank leverage ratio that falls below the required minimum. Qualifying banking organizations that exceed the minimum community bank leverage ratio will be deemed to be in compliance with all other capital and leverage requirements. On November 21, 2018, pursuant to the Regulatory Relief Act, the federal banking agencies issued a notice of proposed rulemaking proposing a community bank leverage ratio of 9 percent. The comment period for the proposed rule has since closed, but the regulation is not yet finalized. The final minimum community bank leverage ratio is not known at this time.
The Regulatory Relief Act also expands the universe of holding companies that are permitted to rely on the “Small Bank Holding Company and Savings and Loan Holding Company Policy Statement” (which we refer to as the “Small BHC Policy Statement”). The asset size of a qualifying holding company was increased from $1 billion to $3 billion on August 30, 2018, thus excluding holding companies with less than $3 billion in total consolidated assets from consolidated capital requirements.
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Further, the Regulatory Relief Act decreased the burden for community banks in regards to call reports, the Volcker Rule (which generally restricts banks from engaging in certain investment activities and limits involvement with hedge funds and private equity firms), mortgage disclosures, and risk weights for some high-risk commercial real estate loans. On December 28, 2018, the federal banking agencies issued a final rule under the Regulatory Relief Act increasing the asset threshold to qualify for an 18-month on-site examination cycle from $1 billion to $3 billion for qualifying institutions that are well capitalized, well managed, and meet certain other requirements.
As of December 31, 2018, SmartFinancial had total consolidated assets of approximately $2.3 billion, meaning that it could qualify to rely on the Small BHC Policy Statement and qualify for an 18-month on-site examination cycle. However, in the event the Entegra merger is completed, SmartFinancial would have total consolidated assets of more than $3 billion and would not qualify for these regulatory relief measures.
The Dodd-Frank Act, even despite the regulatory relief afforded by the Regulatory Relief Act, or any number of the provisions of the Regulatory Relief Act itself, may have the effect of increasing SmartFinancial’s and SmartBank’s expenses, decreasing their revenues, and changing the activities in which they choose to engage. The environment in which banking organizations operate is ever-evolving and any number of changes, whether legal, regulatory, social, economic, or otherwise, may have long-term effects on the profitability of banking organizations that cannot now be foreseen. It is particularly difficult at this time to determine or predict the impact of the Regulatory Relief Act on SmartFinancial and SmartBank, in part because various implementing rules and regulations are required and many of these have not yet been written or finalized.
U.S. Basel III Capital Rules
The U.S. Basel III capital rules, which were effective January 1, 2015, currently apply to all national and state banks and savings associations and certain, generally larger, bank holding companies (which we refer to collectively as “covered banking organizations”). The requirements in the U.S. Basel III capital rules started to phase in on January 1, 2015, for many covered banking organizations, including SmartFinancial and SmartBank, and were fully phased in on January 1, 2019.
In recent years, bank holding companies with less than $1 billion in total consolidated assets and that are not engaged in significant nonbanking activities, do not conduct significant off-balance sheet activities, and do not have a material amount of debt or equity securities registered with the SEC have been exempt from the Federal Reserve’s consolidated capital requirements under the Small BHC Policy Statement. As discussed above, the Regulatory Relief Act increased the asset threshold for bank holding companies to qualify for the Small BHC Policy Statement from $1 billion to $3 billion. Accordingly, SmartFinancial currently is not subject to the Federal Reserve’s consolidated capital requirements (as of December 31, 2018, SmartFinancial had total consolidated assets of approximately $2.3 billion), but will become subject to these requirements if and when it reaches $3 billion in total consolidated assets. Despite SmartFinancial currently being exempt from these requirements, SmartBank remains subject to minimum capital requirements. In the event the Entegra merger is completed, however, SmartFinancial would have total consolidated assets of more than $3 billion and would become subject to the Federal Reserve’s consolidated capital requirements.
The U.S. Basel III capital rules impose the following minimum capital requirements:
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a common equity Tier 1 risk-based capital ratio of 4.5 percent;
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a Tier 1 risk-based capital ratio of 6 percent;
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a total risk-based capital ratio of 8 percent;
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a leverage ratio of 4 percent; and
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for a very small number of the largest financial institutions in the United States, an enhanced supplementary leverage ratio of 3 percent.
Under the U.S. Basel III capital rules, Tier 1 capital is defined to include two components: common equity Tier 1 capital and additional Tier 1 capital. The highest form of capital, common equity Tier 1 capital, or CET1 capital, consists solely of common stock (plus related surplus), retained earnings, accumulated other comprehensive income, and limited amounts of minority interests that are in the form of common stock. Additional Tier 1 capital includes other perpetual instruments historically included in Tier 1 capital, such as non-cumulative perpetual preferred stock.
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The rules permit bank holding companies with less than $15.0 billion in total consolidated assets, such as SmartFinancial, to continue to include trust-preferred securities and cumulative perpetual preferred stock issued before May 19, 2010, in Tier 1 capital, but not in CET1 capital, subject to certain restrictions. Tier 2 capital consists of an institution’s allowance for loan and lease losses, up to 1.25 percent of risk-weighted assets; qualifying perpetual preferred stock (and related surplus); certain qualifying hybrid capital instruments, perpetual debt, and mandatory convertible debt; certain qualifying subordinated debt instruments and intermediate-term preferred stock (and related surplus), subject to limitations; and a percentage of pretax net unrealized gains on available-for-sale equity securities with readily determinable fair values.
In addition, in order to avoid restrictions on capital distributions or discretionary bonus payments to executives, a covered banking organization must maintain a capital conservation buffer on top of its minimum risk-based capital requirements. This buffer must consist solely of Tier 1 common equity, but the buffer applies to all three risk-based capital measurements (common equity Tier 1 capital, Tier 1 capital, and total capital). The capital conservation buffer, which was phased in incrementally over time and became fully phased in on January 1, 2019, consists of an additional amount of common equity Tier 1 capital equal to 2.5 percent of risk-weighted assets.
The U.S. Basel III capital standards require certain deductions from or adjustments to capital. Deductions from CET1 capital are required for goodwill (net of associated deferred tax liabilities); intangible assets such as non-mortgage servicing assets and purchased credit card relationships (net of associated deferred tax liabilities); deferred tax assets that arise from net operating loss and tax credit carryforwards (net of any related valuation allowances and net of deferred tax liabilities); any gain on sale in connection with a securitization exposure; any defined benefit pension fund net asset (net of any associated deferred tax liabilities) held by a bank holding company (this provision does not apply to a bank or savings association); the aggregate amount of outstanding equity investments (including retained earnings) in financial subsidiaries; and identified losses. Other deductions are necessary from different levels of capital. The U.S. Basel III capital rules generally also increased the risk weight for certain assets, meaning that more capital must be held against those assets. For example, under Basel III, commercial real estate loans that do not meet certain underwriting requirements must be risk-weighted at 150 percent, rather than at 100 percent which was the case prior to the U.S. Basel III capital rules becoming effective; however, the Regulatory Relief Act has reversed this for community banks with respect to some commercial real estate loans.
Additionally, the U.S. Basel III capital standards provide for the deduction of three categories of assets: (i) deferred tax assets arising from temporary differences that cannot be realized through net operating loss carrybacks (net of related valuation allowances and of deferred tax liabilities), (ii) mortgage servicing assets (net of associated deferred tax liabilities), and (iii) investments in more than 10 percent of the issued and outstanding common stock of unconsolidated financial institutions (net of associated deferred tax liabilities). The amount in each category that exceeds 10 percent of CET1 capital must be deducted from CET1 capital. The remaining, non-deducted amounts are then aggregated, and the amount by which this total amount exceeds 15 percent of CET1 capital must be deducted from CET1 capital. Amounts of minority investments in consolidated subsidiaries that exceed certain limits and investments in unconsolidated financial institutions may also have to be deducted from the category of capital to which such instruments belong.
Accumulated other comprehensive income, or AOCI, is presumptively included in CET1 capital and often would operate to reduce this category of capital. The U.S. Basel III capital rules provided a one-time opportunity at the end of the first quarter of 2015 for covered banking organizations to opt out of much of this treatment of AOCI, and SmartFinancial elected to opt out. The rules also have had the effect of increasing capital requirements by increasing the risk weights on certain assets, including high volatility commercial real estate (as discussed above), mortgage servicing rights not includable in CET1 capital, equity exposures, and claims on securities firms, which are used in the denominator of the three risk-based capital ratios.
As discussed above under “Economic Growth, Regulatory Relief, and Consumer Protection Act,” pursuant to the Regulatory Relief Act, federal banking agencies have proposed a new minimum community bank leverage ratio (defined as the ratio of tangible equity capital to average total consolidated assets) of 9 percent for banks and holding companies with total consolidated assets of less than $10 billion and an appropriate risk profile. Qualifying banking organizations that exceed the minimum community bank leverage ratio would be deemed to be in compliance with all other risk-based and leverage capital requirements. At the same time, the agencies proposed corresponding capital adequacy levels. As proposed, a qualifying banking organization with a community bank leverage ratio of greater than 9 percent would be considered “well capitalized”; a qualifying banking organization with a community bank leverage ratio of 7.5 percent or greater would be considered “adequately capitalized”; a qualifying banking organization with a community bank leverage ratio of less than 7.5 percent would be considered “undercapitalized”; and a qualifying banking organization with a community bank leverage ratio of less than 6 percent would be considered “significantly capitalized” and would be required to provide its primary regulator with additional information in order to determine whether such organization would be classified as “critically undercapitalized.” The comment period for these proposed rules has closed, but the regulation is not yet finalized.
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SmartFinancial management believes that SmartFinancial and SmartBank would meet all capital adequacy requirements under the community bank leverage ratio capital rules if such rules were currently effective.
The Regulatory Relief Act also makes important changes to the “prompt corrective action” framework discussed below in “Regulation of SmartBank-Capitalization Levels and Prompt Corrective Action.”
Anti-Tying Restrictions
Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other nonbanking services offered by a bank holding company or its affiliates.
Executive Compensation and Corporate Governance
The Dodd-Frank Act generally requires public companies to include, at least once every three years, a separate non-binding “say on pay” vote in their proxy statement to allow stockholders the opportunity to vote on the compensation of the company’s named executive officers. In addition, if such public companies are involved in a merger, acquisition, or consolidation, or if they propose to sell or dispose of all or substantially all of their assets, stockholders generally have a right to an advisory vote on any golden parachute arrangements in connection with such transaction (frequently referred to as “say-on-golden parachute” vote). Other provisions of the Dodd-Frank Act may also impact SmartFinancial’s corporate governance. For instance, the Dodd-Frank Act required the SEC to adopt rules directing the national securities exchanges to prohibit the listing of any equity security of a company that does not have an independent compensation committee and requiring all exchange-traded companies to adopt clawback policies for incentive compensation paid to executive officers in the event of accounting restatements based on material non-compliance with financial reporting requirements.
Regulation of SmartBank
As a Tennessee-chartered commercial bank, SmartBank is subject to supervision, regulation, and examination by the TDFI, and, as a member of the Federal Reserve System, SmartBank is also subject to supervision, regulation, and examination by the Federal Reserve. Federal and state laws and regulations affect virtually all aspects of SmartBank’s operations, including its capital requirements, its ability to pay dividends, mergers and acquisitions, limitations on the amount that it can loan to a single borrower and related interests, permissible investments, and geographic and new product expansion, among other things. SmartBank generally must submit an application to, and receive the approval of, the TDFI and Federal Reserve before opening a new branch office or merging with another financial institution. The Commissioner of the TDFI and the Federal Reserve have the authority to enforce laws and regulations by ordering SmartBank, or a director, officer, or employee of SmartBank, to cease and desist from violating a law or regulation or from engaging in unsafe or unsound banking practices and by imposing other sanctions, including civil money penalties.
Tennessee law contains limitations on the interest rates that may be charged on various types of loans and restrictions on the nature and amount of loans that may be granted. and on the type of investments which may be made, by Tennessee-chartered banks. Tennessee-chartered banks are also subject to regulation by the TDFI with regard to capital requirements and the payment of dividends.
Tennessee has adopted the provisions of the Federal Reserve’s Regulation O with respect to restrictions on loans and other extensions of credit to bank “insiders.” Further, under Tennessee law, state banks are prohibited from lending to any one person, firm, or corporation amounts more than 15 percent of the bank’s equity capital accounts, except, (i) in the case of certain loans secured by negotiable title documents covering readily marketable nonperishable staples or (ii) with the prior approval of the bank’s board of directors or finance committee (however titled), the bank may make a loan to any person, firm, or corporation of up to 25 percent of its equity capital accounts.
Various state and federal consumer laws and regulations also affect the operations of SmartBank, including state usury laws, consumer credit and equal credit opportunity laws, and fair credit reporting laws. In addition, the Federal Deposit Insurance Corporation Improvement Act of 1991, generally prohibits insured state-chartered banks from conducting activities as principal that are not permitted for national banks.
SmartBank’s deposits are insured by the FDIC under the Federal Deposit Insurance Act.
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Current Expected Credit Loss
A new accounting standard changing the current method for providing allowances for loan losses has been adopted by the Financial Accounting Standards Board. This new standard is referred to as Current Expected Credit Loss (or “CECL”) and becomes effective for SmartBank in 2020. The use of this standard will increase the types of data required to determine the appropriate level of SmartBank’s allowance for loan losses.
The use of this standard may increase SmartBank’s allowance for loan losses. Any increase in SmartBank’s allowance for loan losses or expenses incurred in order to make the determination for such allowance for loan losses could have a material adverse effect on SmartBank’s financial condition and results of operations. The direct effects of CECL on SmartBank are further discussed in Note 1-Summary of Significant Accounting Policies to our audited consolidated financial statements.
Capitalization Levels and Prompt Corrective Action
Federal law and regulations establish a capital-based regulatory framework designed to promote early intervention for troubled banks and require the FDIC to choose the least expensive method of resolution in the event of bank failures. The capital-based regulatory framework contains five categories of regulatory capital requirements, including “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” and “critically undercapitalized.” Generally, to qualify as a “well capitalized” institution, a bank (i) must have a Tier 1 leverage capital ratio of no less than 5 percent, a common equity Tier 1 risk-based capital ratio of no less than 6.5 percent, a Tier 1 risk-based capital ratio of no less than 8 percent, and a total risk-based capital ratio of no less than 10 percent and (ii) must not be subject to any order or written directive to meet and maintain a specific capital level for any capital measure. Generally, a bank is considered “adequately capitalized” if it maintains a Tier 1 leverage capital ratio of at least 4 percent, a common equity Tier 1 risk-based capital ratio of at least 4.5 percent, a Tier 1 risk-based capital ratio of at least 6 percent, and a total risk-based capital ratio of at least 8 percent.
Immediately upon becoming “undercapitalized” (i.e., a Tier 1 leverage capital ratio of less than 4 percent, a common equity Tier 1 risk-based capital ratio of less than 4.5 percent, a Tier 1 risk-based capital ratio of less than 6 percent, or a total risk-based capital ratio of less than 8 percent), a depository institution becomes subject to the provisions of Section 38 of the Federal Deposit Insurance Act, which: (i) restrict payment of capital distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require submission of a capital restoration plan; (iv) restrict the growth of the institution’s assets; and (v) require prior approval of certain expansion proposals. Additionally, bank holding companies controlling financial institutions can be called upon to boost the institutions’ capital and to partially guarantee the institutions’ performance under their capital restoration plans. The appropriate federal banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the Deposit Insurance Fund, subject in certain cases to specified procedures. These discretionary supervisory actions include: (i) requiring the institution to raise additional capital; (ii) restricting transactions with affiliates; (iii) requiring divestiture of the institution or the sale of the institution to a willing purchaser; (iv) requiring the institution to change and improve its management; (iv) prohibiting the acceptance of deposits from correspondent banks; (v) requiring prior Federal Reserve approval for any capital distribution by a bank holding company controlling the institution; and (vi) any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.
It should be noted that the minimum capital ratios referred to above in this section are merely guidelines, and federal and state bank regulators possess the discretionary authority to require higher capital ratios.
As previously discussed above, the Regulatory Relief Act simplifies the regulatory capital rules for financial institutions and their holding companies with total consolidated assets of less than $10 billion. The Regulatory Relief Act requires federal banking agencies to develop a community bank leverage ratio (defined as the ratio of tangible equity capital to average total consolidated assets) for banks and holding companies with total consolidated assets of less than $10 billion and an appropriate risk profile. The required regulations must specify a minimum community bank leverage ratio of not less than 8 percent and not more than 10 percent, as well as procedures for treatment of a qualifying community bank that has a community bank leverage ratio that falls below the required minimum. Qualifying banks that exceed the minimum community bank leverage ratio will be deemed to be in compliance with all other capital and leverage requirements. On November 21, 2018, pursuant to the Regulatory Relief Act, the federal banking agencies issued a notice of proposed rulemaking proposing a community bank leverage ratio of 9 percent. The comment period for the proposed rule has since closed, but the regulation is not yet finalized and, therefore, the final minimum community bank leverage ratio is not known at this time.
Bank Reserves
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The Federal Reserve requires all depository institutions, even if not members of the Federal Reserve System, to maintain reserves against some transaction accounts (primarily demand deposit and negotiable order of withdrawal (NOW) accounts). The balances maintained to meet the reserve requirements imposed by the Federal Reserve may be used to satisfy liquidity requirements. An institution may borrow from the Federal Reserve Bank “discount window” as a secondary source of funds, provided that the institution meets the Federal Reserve Bank’s credit standards.
Bank Dividends
Under federal law, an insured depository institution may not pay a dividend if it is undercapitalized or if paying the dividend would cause the institution to become undercapitalized. Tennessee law also places restrictions on the declaration and payment of dividends by state-chartered banks. For example, under Tennessee law, the board of directors of a Tennessee-chartered bank may only declare dividends from the surplus profits arising from the business of the bank and may not declare dividends in any calendar year that exceed the total of the bank’s retained net income of that year combined with its retained net income of the preceding two years without the prior approval of the Commissioner of the TDFI. Tennessee law also requires certain charges against and transfers from an institution’s undivided profits account before undivided profits can be made available for the payment of dividends. Furthermore, the TDFI also has the authority to prohibit the payment of dividends by a Tennessee-chartered bank when it determines payment of those dividends to be an unsafe and unsound banking practice.
Insurance of Accounts and Other Assessments
SmartBank pays deposit insurance assessments to the Deposit Insurance Fund, which are determined through a risk-based assessment system. SmartBank’s deposit accounts are currently insured by the Deposit Insurance Fund, generally up to a maximum of $250,000 per separately insured depositor. SmartBank pays assessments to the FDIC for such deposit insurance. Under the current assessment system, the FDIC assigns an institution to a risk category based on the institution’s most recent supervisory and capital evaluations, which are designed to measure risk. Under the Federal Deposit Insurance Act, the FDIC may terminate a bank’s deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order, agreement, or condition imposed by the FDIC.
In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation, or FICO, a federal government corporation established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the last of the FICO bonds mature in 2019.
Restrictions on Transactions with Affiliates
SmartBank is also subject to federal laws that restrict certain transactions between it and its nonbank affiliates. An affiliate of a bank generally is any company or entity that controls, is controlled by, or is under common control with the bank, including, in the case of SmartBank, SmartFinancial. Under Sections 23A and 23B of the Federal Reserve Act (which we refer to as the “FRA”) and the Federal Reserve’s Regulation W, covered transactions by SmartBank with a single nonbank affiliate are generally limited to 10 percent of SmartBank’s capital and surplus and 20 percent of capital and surplus for all covered transactions with all nonbank affiliates. The definition of “covered transactions” includes transactions such as a loan by a bank to an affiliate, an investment by a bank in an affiliate, or a purchase by a bank of assets from an affiliate. A loan by a bank to a nonbank affiliate must be secured by collateral valued at 100 percent to 130 percent of the loan amount, depending on the type of collateral, and certain low quality assets and securities of an affiliate may not serve as collateral.
All such transactions must generally be consistent with safe and sound banking practices and must be on terms that are no less favorable to the bank than those that would be available from nonaffiliated third parties. Moreover, state banking laws impose restrictions on affiliate transactions similar to those imposed by federal law. Federal Reserve policies also prohibit the payment by bank subsidiaries of management fees which are unreasonable in amount or exceed the fair market value of the services rendered or, if no market exists, actual costs plus a reasonable profit.
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Loans to Insiders
Loans to executive officers or directors of a bank, or to any person who directly or indirectly, or acting through or in concert with one or more persons, owns, controls, or has the power to vote more than 10 percent of any class of voting securities of a bank, or to any related interest of those persons, including any company controlled by such persons, are subject to Sections 22(g) and 22(h) of the FRA and their corresponding regulations, which are commonly referred to as “Regulation O.” Among other things, these loans must be made on terms substantially the same as those prevailing in transactions made to unaffiliated individuals and certain extensions of credit to these persons must first be approved in advance by a disinterested majority of the bank’s entire board of directors. Regulation O generally prohibits loans to any of these persons where the aggregate amount exceeds an amount equal to 15 percent of an institution’s unimpaired capital and surplus plus an additional 10 percent of unimpaired capital and surplus in the case of loans that are fully secured by certain readily marketable collateral, or when the aggregate amount on all of the extensions of credit outstanding to all of these persons would exceed the bank’s unimpaired capital and unimpaired surplus. Section 22(g) identifies limited circumstances in which a bank is permitted to extend credit to its executive officers.
Community Reinvestment Act
The Community Reinvestment Act (which we refer to as the “CRA”) and its corresponding regulations are intended to encourage banks to help meet the credit needs of their service areas, including low- and moderate-income neighborhoods, consistent with safe and sound operations. The CRA and its regulations provide for regulatory assessment of a bank’s record in meeting the credit needs of its service area. Federal banking agencies are required to make public the rating of a bank’s performance under the CRA. The federal banking agencies consider a bank’s CRA rating when a bank submits an application to establish banking centers, merge, or acquire the assets and assume the liabilities of another bank. In the case of an application by a bank holding company for approval of a merger or acquisition, the CRA performance record of all banks involved in the merger or acquisition are reviewed in connection with the application filing. An unsatisfactory record of CRA compliance can substantially delay, block, or result in the imposition of conditions in connection with expansionary activities. SmartBank’s last CRA performance evaluation was in August 2016, and SmartBank was assigned a rating of “Satisfactory.”
Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (which we refer to as the “Riegle-Neal Act”) provides that adequately capitalized and managed bank holding companies are permitted to acquire banks in any state. Previously, under the Riegle-Neal Act, a bank’s ability to branch into a particular state was largely dependent upon whether that state “opted in” to de novo interstate branching. Many states did not “opt-in,” which resulted in branching restrictions in those states. The Dodd-Frank Act amended the Riegle-Neal Act legal framework for interstate branching to permit national banks and state banks to establish de novo branches in any state if that state would permit the establishment of the branch by a state bank chartered in that state. Under current Tennessee law, SmartBank may open branch offices throughout Tennessee with the prior approval of the TDFI and adherence to applicable legal requirements.
Bank Secrecy Act
The Currency and Foreign Transactions Reporting Act of 1970, better known as the “Bank Secrecy Act,” requires all United States financial institutions to assist United States government agencies to detect and prevent money laundering. Specifically, the Bank Secrecy Act requires financial institutions to keep records of cash purchases of negotiable instruments, file reports of cash transactions exceeding a daily aggregate amount of $10,000, and to report suspicious activity that might signify money laundering, tax evasion, or other criminal activities, and to obtain and retain information regarding the identify and verification of the beneficial owners of business customers.
Anti-Money Laundering and Economic Sanctions
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (better known as the “USA PATRIOT Act”) provides the federal government with additional powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, the USA PATRIOT Act imposed new requirements that obligate financial institutions, such as banks, to take certain steps to control the risks associated with money laundering and terrorist financing.
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Among other requirements, the USA PATRIOT Act and its implementing regulations require banks, such as SmartBank, to establish anti-money laundering programs that include, at a minimum:
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internal policies, procedures, and controls designed to implement and maintain the bank’s compliance with all of the requirements of the USA PATRIOT Act, the Bank Secrecy Act, and related laws and regulations;
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systems and procedures for monitoring and reporting suspicious transactions and activities;
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a designated compliance officer;
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employee training;
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an independent audit function to test the anti-money laundering program;
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procedures to verify the identity of each customer upon the opening of accounts;
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heightened due diligence policies, procedures, and controls applicable to certain foreign accounts and relationships; and
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ongoing due diligence and monitoring of customer relationships, including the beneficial owners of business customers.
Additionally, the USA PATRIOT Act requires each financial institution to develop a customer identification program, or CIP, as part of the bank’s anti-money laundering program. The key components of the CIP are identification, verification, government list comparison, notice, and record retention. The purpose of the CIP is to enable the financial institution to determine the true identity and anticipated account activity of each customer. To make this determination, among other things, the financial institution must collect certain information from customers at the time they enter into the customer relationship with the financial institution. This information must be verified within a reasonable time through documentary and non-documentary methods. Furthermore, all customers must be screened against any CIP-related government lists of known or suspected terrorists. Information regarding the identity and verification of the beneficial owners of business customers must also be obtained and retained. Furthermore, financial institutions are also required to comply with various reporting and recordkeeping requirements. Federal banking regulators consider an applicant’s effectiveness in combating money laundering, among other factors, in connection with an application to approve a bank merger or the acquisition of control of a bank or bank holding company.
The U.S. Department of the Treasury’s Office of Foreign Assets Control (which we refer to as “OFAC”) is responsible for helping to ensure that United States entities do not engage in transactions with the subjects of U.S. sanctions, as defined by various executive orders and acts of Congress. Currently, OFAC administers and enforces comprehensive U.S. economic sanctions programs against certain specified countries/regions. In addition to the country/region-wide sanctions programs, OFAC also administers complete embargoes against individuals and entities identified on OFAC’s list of Specially Designated Nationals and Blocked Persons, or “SDN List.” The SDN List includes thousands of parties that are located in many jurisdictions throughout the world, including in the United States and Europe. SmartBank is responsible for determining whether any potential and/or existing customers appear on the SDN List or are owned or controlled by a person on the SDN List. If any customer appears on the SDN List or is owned or controlled by a person or entity on the SDN List, such customer’s account must be placed on hold and a blocking or rejection report, as appropriate and if required, must be filed within 10 business days with OFAC. In addition, if a customer is a citizen of, has provided an address in, or is organized under the laws of any country or region for which OFAC maintains a comprehensive sanctions program, SmartBank must take certain actions with respect to such customer as dictated under the relevant OFAC sanctions program. SmartBank must maintain compliance with OFAC by implementing appropriate policies and procedures and by establishing a recordkeeping system that is reasonably appropriate to administer SmartBank’s compliance program. SmartBank has adopted policies, procedures, and controls to comply with the Bank Secrecy Act, the USA PATRIOT Act, and OFAC regulations.
Privacy and Data Security
Under the GLBA, federal banking regulators adopted rules limiting the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. The rules require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to nonaffiliated third parties. The GLBA also directed federal regulators to prescribe standards for the security of consumer information. SmartBank is subject to these standards, as well as standards for notifying customers in the event of a security breach. Laws, regulations, and guidance related to data protection, consumer privacy, third party vendor management, disaster recovery, and information security continue to develop and change as a result of the rapid increase in and evolution of electronic bank products and services. The federal banking agencies are likely to spend time developing additional rules, regulations, and guidance on the subject of cyber security in response to recent cyber-attacks against financial institutions and continued development of electronic and online banking products and services.
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Consumer Laws and Regulations
SmartBank is also subject to other federal and state consumer-related laws and regulations that are designed to protect consumers in transactions with banks. These laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Check Clearing for the 21st Century Act, the Fair Credit Reporting Act, the Fair Debt Collection Practices Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act, the Fair and Accurate Transactions Act, the Servicemembers Civil Relief Act, the Military Lending Act, the Mortgage Disclosure Improvement Act, and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with consumers when offering consumer financial products and services.
Rulemaking authority for these and other consumer financial protection laws transferred from the prudential regulators to the CFPB on July 21, 2011. In some cases, regulators such as the Federal Trade Commission, the U.S. Department of Housing and Urban Development, and the U.S. Department of Justice also retain certain rulemaking or enforcement authority. The CFPB also has broad authority to prohibit unfair, deceptive, and abusive acts and practices and to investigate and penalize financial institutions that violate this prohibition. While the statutory language of the Dodd-Frank Act sets forth the standards for acts and practices that violate the prohibition on unfair, deceptive, and abusive acts and practices, certain aspects of these standards are untested and it is currently not possible to predict how the CFPB will exercise this authority. In addition, consumer compliance examination authority remains with the prudential regulators for smaller depository institutions (i.e., those with $10 billion or less in total assets).
Pursuant to the Dodd-Frank Act, the CFPB established certain minimum standards for the origination of residential mortgages, including a requirement to determine the borrower’s ability to repay. The Dodd-Frank Act generally prohibits a financial institution from making a residential mortgage loan unless the institution makes a “reasonable and good faith determination” that the consumer has a “reasonable ability” to repay the loan. The Dodd-Frank Act allows borrowers to raise certain defenses to a foreclosure action if a financial institution has not complied with the ability to repay requirements, but also provides a full or partial safe harbor from such defenses for loans that are “qualified mortgages.” The CFPB’s implementing rules define a “qualified mortgage” to have certain specified characteristics, and generally prohibit loans with negative amortization, interest-only payments, balloon payments, or terms exceeding 30 years from being qualified mortgages. The rules also establishes general underwriting criteria for qualified mortgages, including that monthly payments be calculated based on the highest payment that will apply in the first five years of the loan and that the borrower have a total debt-to-income ratio that is less than or equal to 43 percent. The Regulatory Relief Act has expanded the qualified mortgage safe harbor for financial institutions with total consolidated assets of less than $10 billion to generally include loans that the institution retains in portfolio and that comply with existing limits on prepayment penalties, that comply with existing limits on total points and fees of 3 percent of the loan amount, that do not have negative amortization or interest-only features, and for which the institution has considered and documented the consumer’s debt, income, and financial resources.
FIRREA and FDICIA
Far-reaching legislation, including the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (which we refer to as “FIRREA”) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (which we refer to as “FDICIA”), has impacted the business of banking for years. FIRREA primarily affected the regulation of savings institutions, rather than the regulation of commercial banks and bank holding companies like SmartBank and SmartFinancial, but did include provisions affecting deposit insurance premiums, acquisitions of thrifts by banks and bank holding companies, liability of commonly controlled depository institutions, and receivership and conservatorship rights and procedures, and substantially increased penalties for violations of banking laws, regulations, and orders.
FDICIA resulted in extensive changes to the federal banking laws. The primary purpose of FDICIA was to authorize additional borrowings by the FDIC in order to assist in the resolution of failed and failing financial institutions. However, the law also instituted certain changes to the supervisory process and contained various provisions affecting the operations of banks and bank holding companies.
The additional supervisory powers and regulations mandated by FDICIA include a “prompt corrective action” program based upon five regulatory zones for banks, in which banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place a bank in receivership or require the sale of a bank to another depository institution when the bank’s ratio of tangible equity to total assets reaches 2 percent. Better capitalized institutions are generally subject to less onerous regulation and supervision than banks with lesser amounts of capital. The Federal Reserve has adopted regulations implementing the prompt corrective action provisions of
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FDICIA, which place financial institutions into one of the following five categories based upon capitalization ratios (as these ratios have been revised following the implementation of Basel III):
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a “well capitalized” institution has a total risk-based capital ratio of at least 10 percent, a Tier 1 risk-based capital ratio of at least 8 percent, a common equity Tier 1 risk-based capital ratio of at least 6.5 percent, and a Tier 1 leverage capital ratio of at least 5 percent;
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an “adequately capitalized” institution has a total risk-based capital ratio of at least 8 percent, a Tier 1 risk-based capital ratio of at least 6 percent, a common equity Tier 1 risk-based capital ratio of at least 4.5 percent, and a Tier 1 leverage capital ratio of at least 4 percent;
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an “undercapitalized” institution has a total risk-based capital ratio of less than 8 percent, a Tier 1 risk-based capital ratio of less than 6 percent, a common equity Tier 1 risk-based capital ratio of less than 4.5 percent, or a Tier 1 leverage capital ratio of less than 4 percent;
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a “significantly undercapitalized” institution has a total risk-based capital ratio of less than 6 percent, a Tier 1 risk-based capital ratio of less than 4 percent, a common equity Tier 1 risk-based capital ratio of less than 3 percent, or a Tier 1 leverage capital ratio of less than 3 percent; and
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a “critically undercapitalized” institution has a ratio of tangible equity to total assets of 2 percent or less.
Institutions in any of the three undercapitalized categories would generally be prohibited from declaring dividends or making capital distributions. The regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital.
These levels will differ for community banks such as SmartBank who qualify for and elect to use the new community bank leverage ratio pursuant to the requirements of the Regulatory Relief Act. As previously discussed, the Regulatory Relief Act requires federal banking agencies to develop a community bank leverage ratio (defined as the ratio of tangible equity capital to average total consolidated assets) for banks and holding companies with total consolidated assets of less than $10 billion and an appropriate risk profile. The required regulations must specify a minimum community bank leverage ratio of not less than 8 percent and not more than 10 percent, as well as procedures for treatment of a qualifying banking organization that has a community bank leverage ratio that falls below the required minimum. Qualifying banking organizations that exceed the minimum community bank leverage ratio will be deemed to be in compliance with all other risk-based and leverage capital requirements. On November 21, 2018, the federal banking agencies issued a notice of proposed rulemaking proposing a community bank leverage ratio of 9 percent and corresponding capital adequacy levels. As proposed, a qualifying banking organization with a community bank leverage ratio of greater than 9 percent would be considered “well capitalized”; a qualifying banking organization with a community bank leverage ratio of 7.5 percent or greater would be considered “adequately capitalized”; a qualifying banking organization with a community bank leverage ratio of less than 7.5 percent would be considered “undercapitalized”; and a qualifying banking organization with a community bank leverage ratio of less than 6 percent would be considered “significantly capitalized” and would be required to provide its primary regulator with additional information in order to determine whether such organization would be classified as “critically undercapitalized.” The comment period for the proposed rule has closed, but the regulation is not yet finalized.
SmartFinancial's management believes that SmartBank and SmartFinancial would meet all capital adequacy requirements under the community bank leverage ratio capital rules if such rules were currently effective.
Various other sections of FDICIA impose substantial audit and reporting requirements and increase the role of independent accountants and outside directors. Set forth below is a list of certain other significant requirements under or provisions of FDICIA:
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annual on-site examinations by regulators (except for smaller, well-capitalized banks with high management ratings, which must be examined every 18 months);
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mandated annual independent audits by independent public accountants and an independent audit committee of outside directors for institutions with more than $500 million in assets;
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uniform disclosure requirements for interest rates and terms of deposit accounts;
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a requirement that the FDIC establish a risk-based deposit insurance assessment system;
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authorization for the FDIC to impose one or more special assessments on insured banks to recapitalize the bank insurance fund (now called the Deposit Insurance Fund);
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a requirement that each institution submit to its primary regulators an annual report on its financial condition and management, which report is available to the public;
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a ban on the acceptance of brokered deposits except by well capitalized institutions and by adequately capitalized institutions with the permission of the FDIC, and the regulation of the brokered deposit market by the FDIC;
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restrictions on the activities engaged in by state banks and their subsidiaries as principal, including insurance underwriting, to the same activities permissible for national banks and their subsidiaries unless the state bank is
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well capitalized and a determination is made by the FDIC that the activities do not pose a significant risk to the insurance fund;
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a review by each regulatory agency of accounting principles applicable to reports or statements required to be filed with federal banking agencies and a mandate to devise uniform requirements for all such filings;
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the institution by each regulatory agency of noncapital safety and soundness standards for each institution it regulates which cover (i) internal controls, (ii) loan documentation, (iii) credit underwriting, (iv) interest rate exposure, (v) asset growth, (vi) compensation, fees, and benefits paid to employees, officers, and directors, (vii) operational and managerial standards, and (viii) asset quality, earnings, and stock valuation standards for preserving a minimum ratio of market value to book value for publicly traded shares (if feasible);
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uniform regulations regarding real estate lending; and
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a review by each regulatory agency of the risk-based capital rules to ensure they take into account adequate interest rate risk, concentration of credit risk, and the risks of non-traditional activities.
Future Legislative Developments
Legislation that could impact SmartFinancial and/or SmartBank is routinely introduced in Congress and the Tennessee legislature. Any such legislation could change current banking laws and the environment in which SmartFinancial and SmartBank operate in significant and unpredictable ways. SmartFinancial cannot now determine the effects (if any) that any such legislation, if enacted, or the regulations implementing the legislation or interpretations of such legislation or regulations, would have on SmartFinancial’s or SmartBank’s business, financial condition, or results of operations.
ITEM 1A. RISK FACTORS
Investing in our common stock involves various risks which are particular to SmartFinancial, its industry, and its market area. Several risk factors regarding investing in our securities are discussed below. This listing should not be considered as all-inclusive. If any of the following risks were to occur, we may not be able to conduct our business as currently planned and our financial condition or operating results could be negatively impacted. These matters could cause the trading price of our securities to decline in future periods.
Risks Related to Our Industry
Our net interest income could be negatively affected by interest rate adjustments by the Federal Reserve Board.
As a financial institution, our earnings are dependent upon our net interest income, which is the difference between the interest income that we earn on interest-earning assets, such as investment securities and loans, and the interest expense that we pay on interest-bearing liabilities, such as deposits and borrowings. Therefore, any change in general market interest rates, including changes resulting from changes in the Federal Reserve Board’s policies, affects us more than non-financial institutions and can have a significant effect on our net interest income and total income. Our assets and liabilities may react differently to changes in overall market rates or conditions because there may be mismatches between the repricing or maturity characteristics of our assets and liabilities. As a result, an increase or decrease in market interest rates could have a material adverse effect on our net interest margin and results of operations. Actions by monetary and fiscal authorities, including the Federal Reserve Board, could have an adverse effect on our deposit levels, loan demand, business and results of operations.
The Federal Reserve Board raised interest rates by 200 basis points since December 2016 after having held interest rates at almost zero over recent years. However, the consistently low rate environment has negatively impacted our net interest margin, notwithstanding decreases in nonperforming loans and improvements in deposit mix. Any reduction in net interest income will negatively affect our business, financial condition, liquidity, results of operations, and/or cash flows.
Changes in the level of interest rates also may negatively affect our ability to originate loans, the value of our assets, and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings. A decline in the market value of our assets may limit our ability to borrow additional funds. As a result, we could be required to sell some of our loans and investments under adverse market conditions, upon terms that are not favorable to us, in order to maintain our liquidity. If those sales are made at prices lower than the amortized costs of the investments, we will incur losses.
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The primary tool that management uses to measure short-term interest rate risk is a net interest income simulation model prepared by an independent third party provider. As of December 31, 2018, SmartFinancial is considered to be in an asset-sensitive position, meaning income is generally expected to increase with an increase in short-term interest rates and, conversely, to decrease with a decrease in short-term interest rates. Based on the results of this simulation model, which assumed a static environment with no contemplated asset growth or changes in our balance sheet management strategies, if short-term interest rates immediately increased by 200 basis points, we could expect net income to increase by approximately $2.0 million over a 12-month period. This result is primarily due to the floating rate securities and loans which we anticipate would reprice at a quicker rate than our interest bearing liabilities. The actual amount of any increase or decrease may be higher or lower than predicted by our simulation model.
The final Basel III capital rules generally require insured depository institutions and their holding companies to hold more capital, which could adversely affect our financial condition and operations.
In July 2013, the federal banking agencies published new regulatory capital rules based on the international standards, known as Basel III, that had been developed by the Basel Committee on Banking Supervision. The new rules raised the risk-based capital requirements and revised the methods for calculating risk-weighted assets, usually resulting in higher risk weights. The new rules became effective on January 1, 2015, with a phase in period that generally extends from January 1, 2015 through January 1, 2019.
The Basel III-based rules increase capital requirements and include two new capital measurements that will affect us, a risk-based common equity Tier 1 ratio and a capital conservation buffer. As an example, the Tier 1 capital ratio minimum requirement of 4 percent from January 1, 2015 is increasing to 8.5 percent by 2019. SmartBank has approximately $235.5 million of Tier 1 capital. Under the previous standard, we could have grown SmartBank's total asset size to approximately $5.9 billion with our current capital but will be limited to $2.8 billion in assets under the new Basel III standards to be fully phased in by 2019. In 2018, 89 percent of our average assets were earning assets and over 92 percent of our revenue was generated from net interest income. Therefore, a future reduction of potential earning assets by approximately 53 percent could drastically reduce our future income. More details about the new capital requirements can be found in Note 13-Regulatory Matters to our audited consolidated financial statements.
We are dependent on our information technology and telecommunications systems and third-party servicers, and systems failures, interruptions or breaches of security could have an adverse effect on our financial condition and results of operations.
Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify these systems as circumstances warrant, the security of our computer systems, software and networks may be vulnerable to breaches, unauthorized access, misuse, computer viruses or other malicious code and other events that could have a security impact. We outsource many of our major systems, such as data processing, loan servicing and deposit processing systems. The failure of these systems, or the termination of a third-party software license or service agreement on which any of these systems is based, could interrupt our operations. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to process new and renewal loans, gather deposits and provide customer service, compromise our ability to operate effectively, damage our reputation, result in a loss of customer business and/or subject us to additional regulatory scrutiny and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
In addition, we provide our customers the ability to bank remotely, including over the Internet or through their mobile device. The secure transmission of confidential information is a critical element of remote and mobile banking. Our network could be vulnerable to unauthorized access, computer viruses, phishing schemes, spam attacks, human error, natural disasters, power loss and other security breaches. We may be required to spend significant capital and other resources to protect against the threat of security breaches and computer viruses, or to alleviate problems caused by security breaches or viruses. To the extent that our activities or the activities of our customers involve the storage and transmission of confidential information, security breaches (including breaches of security of customer systems and networks) and viruses could expose us to claims, litigation and other possible liabilities. Any inability to prevent security breaches or computer viruses could also cause existing customers to lose confidence in our systems and could adversely affect our reputation, results of operations and ability to attract and maintain customers and businesses. In addition, a security breach could also subject us to additional regulatory scrutiny, expose us to civil litigation and possible financial liability and cause reputational damage.
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Risks Related to Our Company
If our allowance for loan losses and fair value adjustments with respect to acquired loans is not sufficient to cover actual loan losses, our earnings will be adversely affected.
Our success depends significantly on the quality of our assets, particularly loans. Like other financial institutions, we are exposed to the risk that our borrowers may not repay their loans according to their terms, and the collateral securing the payment of these loans may be insufficient to fully compensate us for the outstanding balance of the loan plus the costs to dispose of the collateral. As a result, we may experience significant loan losses that may have a material adverse effect on our operating results and financial condition.
We maintain an allowance for loan losses with respect to our loan portfolio, in an attempt to cover loan losses inherent in our loan portfolio. In determining the size of the allowance, we rely on an analysis of our loan portfolio, our experience and our evaluation of general economic conditions. We also make various assumptions and judgments about the collectability of our loan portfolio, including the diversification in our loan portfolio, the effect of changes in the economy on real estate and other collateral values, the results of recent regulatory examinations, the effects on the loan portfolio of current economic conditions and their probable impact on borrowers, the amount of charge-offs for the period and the amount of nonperforming loans and related collateral security.
The application of the acquisition method of accounting in our acquisitions has impacted our allowance for loan losses. Under the acquisition method of accounting, all acquired loans were recorded in our consolidated financial statements at their fair values at the time of acquisition and the related allowance for loan losses was eliminated because credit quality, among other factors, was considered in the determination of fair value. To the extent that our estimates of fair values are too high, we will incur losses associated with the acquired loans. The allowance, if any, associated with our purchased credit impaired loans reflects deterioration in cash flows since acquisition resulting from our quarterly re-estimation of cash flows which involves complex cash flow projections and significant judgment on timing of loan resolution.
If our analysis or assumptions prove to be incorrect, our current allowance may not be sufficient, and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to the allowance for loan losses would materially decrease our net income and adversely affect our general financial condition. As an example, an increase in the amount of the reserve to organic loans of 0.05 percent in 2018 would have resulted in a reduction of approximately 3 percent to pre-tax income.
In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our allowance for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our allowance for loan losses or loan charge-offs required by these regulatory agencies could have a material adverse effect on our operating results and financial condition.
Our success depends significantly on economic conditions in our market areas.
Unlike larger organizations that are more geographically diversified, our branches are currently concentrated in Eastern Tennessee and the Florida Panhandle. As a result of this geographic concentration, our financial results will depend largely upon economic conditions in these market areas. If the communities in which we operate do not grow or if prevailing economic conditions, locally or nationally, deteriorate, this may have a significant impact on the amount of loans that we originate, the ability of our borrowers to repay these loans and the value of the collateral securing these loans. A return to economic downturn conditions caused by inflation, recession, unemployment, government action, natural disasters or other factors beyond our control would likely contribute to the deterioration of the quality of our loan portfolio and reduce our level of deposits, which in turn would have an adverse effect on our business. As an example, the Florida Panhandle area has been and will continue to be susceptible to major hurricanes, floods, and tropical storms including Hurricane Michael in 2018. In 2016, certain of our markets in Eastern Tennessee were disrupted by wildfires which damaged homes and businesses. In addition, some portions of our target market are in areas which a substantial portion of the economy is dependent upon tourism. The tourism industry tends to be more sensitive than the economy as a whole to changes in unemployment, inflation, wage growth, and other factors which affect consumer’s financial condition and sentiment.
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Our organic loan growth may be limited by regulatory constraints
During 2018 many of the regulatory agencies, including ours, increased their focus on the application of an interagency guidance issued in 2006, titled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices.” The 2006 interagency guidance focuses on the risks of high levels of concentration in CRE lending at banking institutions, and specifically addresses two supervisory criteria:
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Construction concentration criterion: Loans for construction, land, and land development (CLD or “construction”) represent 100 percent or more of a banking institution’s total risk-based capital, commonly referred to as the "100 ratio"
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Total CRE concentration criterion: Total nonowner-occupied CRE loans (including CLD loans), as defined in the 2006 guidance (“total CRE”), represent 300 percent or more of the institution’s total risk-based capital, and growth in total CRE lending has increased by 50 percent or more during the previous 36 months, commonly referred to as the "300 ratio"
The guidance states that banking institutions exceeding the concentration levels mentioned in the two supervisory criteria should have in place enhanced credit risk controls, including stress testing of CRE portfolios. The guidance also states that institutions with CRE concentration levels above those specified in the two supervisory criteria may be identified for further supervisory analysis. Under the guidance for every $1 in increased capital only $1 can be leveraged to construction lending and only $3 can be lent to total CRE lending. In comparison $1 of capital can be leveraged into about $10 other types of lending. At the end of 2018 our loan portfolio was below both the 100 and 300 ratio as laid out in the guidance, but given the guidance our ability to grow those loan types could well be constrained by the amount we are also able to grow capital.
To the extent that we are unable to identify and consummate attractive acquisitions, or increase loans through organic loan growth, we may be unable to successfully implement our growth strategy, which could materially and adversely affect us.
A substantial part of our historical growth has been a result of acquisitions and we intend to continue to grow our business through strategic acquisitions of banking franchises coupled with organic loan growth. Previous availability of attractive acquisition targets may not be indicative of future acquisition opportunities, and we may be unable to identify any acquisition targets that meet our investment objectives. To the extent that we are unable to find suitable acquisition candidates, an important component of our strategy may be lost. If we are able to identify attractive acquisition opportunities, we must generally satisfy a number of conditions prior to completing any such transaction, including certain bank regulatory approvals, which have become substantially more difficult, time-consuming and unpredictable as a result of the recent financial crisis. Additionally, any future acquisitions may not produce the revenue, earnings or synergies that we anticipated. As our purchased credit impaired loan portfolio, which produces substantially higher yields than our organic and purchased non-credit impaired loan portfolios, is paid down, we expect downward pressure on our income. If we are unable to replace our purchased credit impaired loans and the related accretion with a significantly higher level of new performing loans and other earning assets due to our inability to identify attractive acquisition opportunities, a decline in loan demand, competition from other financial institutions in our markets, stagnation or continued deterioration of economic conditions, or other conditions, our financial condition and earnings may be adversely affected.
Our strategic growth plan contemplates additional acquisitions, which could expose us to additional risks.
We periodically evaluate opportunities to acquire additional financial institutions. As a result, we may engage in negotiations or discussions that, if they were to result in a transaction, could have a material effect on our operating results and financial condition, including short and long-term liquidity. Our acquisition activities could be material and could require us to use a substantial amount of common stock, cash, other liquid assets, and/or incur debt.
Our acquisition activities could involve a number of additional risks, including the risks of:
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incurring time and expense associated with identifying and evaluating potential acquisitions and negotiating potential transactions, resulting in management's attention being diverted from the operation of our existing business;
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using inaccurate estimates and judgments to evaluate credit, operations, management and market risks with respect to the target institution or assets;
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incurring time and expense required to integrate the operations and personnel of the combined businesses, creating an adverse short-term effect on results of operations; and
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losing key employees and customers as a result of an acquisition that is poorly received.
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Our recent acquisition and future expansion may result in additional risks.
Over the last two years we have completed the acquisitions of Capstone, Tennessee Bancshares, and Foothills Bancorp and we anticipate consummating our proposed merger with Entegra Financial in mid-2019, subject to customary closing conditions. We expect to continue to expand in our current markets and in other select markets through additional branches or through additional acquisitions of all or part of other financial institutions. These types of expansions involve various risks, including the risks detailed below.
Growth. As a result of our merger activity, we may be unable to successfully:
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maintain loan quality in the context of significant loan growth;
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obtain regulatory and other approvals;
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attract sufficient deposits and capital to fund anticipated loan growth;
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maintain adequate common equity and regulatory capital;
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avoid diversion or disruption of our existing operations or management as well as those of the acquired institution;
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maintain adequate management personnel and systems to oversee and support such growth;
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maintain adequate internal audit, loan review and compliance functions; and
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implement additional policies, procedures and operating systems required to support such growth.
Results of Operations. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits. Our growth strategy necessarily entails growth in overhead expenses as we routinely add new offices and staff. Our historical results may not be indicative of future results or results that may be achieved as we continue to increase the number and concentration of our branch offices in our newer markets.
Development of offices. There are considerable costs involved in opening branches, and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, any new branches we establish can be expected to negatively impact our earnings for some period of time until they reach certain economies of scale. The same is true for our efforts to expand in these markets with the hiring of additional seasoned professionals with significant experience in that market. Our expenses could be further increased if we encounter delays in opening any of our new branches. We may be unable to accomplish future branch expansion plans due to a lack of available satisfactory sites, difficulties in acquiring such sites, failure to receive any required regulatory approvals, increased expenses or loss of potential sites due to complexities associated with zoning and permitting processes, higher than anticipated merger and acquisition costs or other factors. Finally, we have no assurance any branch will be successful even after it has been established or acquired, as the case may be.
Regulatory and economic factors. Our growth and expansion plans may be adversely affected by a number of regulatory and economic developments or other events. Failure to obtain required regulatory approvals, changes in laws and regulations or other regulatory developments and changes in prevailing economic conditions or other unanticipated events may prevent or adversely affect our continued growth and expansion. Such factors may cause us to alter our growth and expansion plans or slow or halt the growth and expansion process, which may prevent us from entering into or expanding in our targeted markets or allow competitors to gain or retain market share in our existing markets.
Failure to successfully address these and other issues related to our expansion could have a material adverse effect on our financial condition and results of operations, and could adversely affect our ability to successfully implement our business strategy. Also, if our growth occurs more slowly than anticipated or declines, our results of operations and financial condition could be materially adversely affected.
Integrating Foothills Bank and, if our pending merger with Entegra Financial is completed, Entegra Bank into SmartBank’s may be more difficult, costly, or time-consuming than anticipated.
We are still in the process of integrating Foothills Bank’s business with that of SmartBank, and if the merger with Entegra Financial is completed as planned, we will begin the process of integrating Entegra Bank with that of SmartBank as well. A successful integration of these businesses with ours will depend substantially on our ability to consolidate operations, corporate cultures, systems and procedures and to eliminate redundancies and costs. We may not be able to combine our business with one or both of the targets’ businesses without encountering difficulties, such as:
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the loss of key employees;
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disruption of operations and business;
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inability to maintain and increase competitive presence;
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loan and deposit attrition, customer loss and revenue loss, including as a result of any decision we may make to close one or more locations;
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possible inconsistencies in standards, control procedures and policies;
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unexpected problems with costs, operations, personnel, technology and credit; and/or
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problems with the assimilation of new operations, sites or personnel, which could divert resources from regular banking operations.
Additionally, general market and economic conditions or governmental actions affecting the financial industry generally may inhibit our successful integration of one or both of the targets’ businesses. Further, we acquired Foothills and intend to acquire Entegra Financial with the expectation that the acquisitions will result in various benefits including, among other things, benefits relating to enhanced revenues, a strengthened market position for the combined company, cross selling opportunities, technological efficiencies, cost savings and operating efficiencies. Achieving the anticipated benefits of this acquisition is subject to a number of uncertainties, including whether we integrate Foothill's and/or Entegra Bank’s businesses, including its organizational culture, operations, technologies, services and products, in an efficient and effective manner, our ability to achieve the estimated noninterest expense savings we believe we can achieve, and general competitive factors in the marketplace. Failure to achieve these anticipated benefits on the anticipated timeframe, or at all, could result in a reduction in the price of our shares as well as in increased costs, decreases in the amount of expected revenues and diversion of management’s time and energy and could materially and adversely affect our business, results of operations and financial condition. Additionally, we made fair value estimates of certain assets and liabilities in recording our acquisition of Foothills and will make fair value estimates of certain assets and liabilities in recording our acquisition of Entegra Bank. Actual values of these assets and liabilities could differ from our estimates, which could result in our not achieving the anticipated benefits of the acquisition. Finally, any cost savings that are realized may be offset by losses in revenues or other charges to earnings.
We may face risks with respect to future acquisitions.
When we attempt to expand our business through mergers and acquisitions (as we have done over the last three years), we seek targets that are culturally similar to us, have experienced management and possess either market presence or have potential for improved profitability through economies of scale or expanded services. In addition to the general risks associated with our growth plans which are highlighted above, in general acquiring other banks, businesses or branches, particularly those in markets with which we are less familiar, involves various risks commonly associated with acquisitions, including, among other things:
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the time and costs associated with identifying and evaluating potential acquisition and merger targets;
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inaccuracies in the estimates and judgments used to evaluate credit, operations, management and market risks with respect to the target institution;
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the time and costs of evaluating new markets, hiring experienced local management, including as a result of de novo expansion into a market, and opening new bank locations, and the time lags between these activities and the generation of sufficient assets and deposits to support the significant costs of the expansion that we may incur, particularly in the first 12 to 24 months of operations;
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our ability to finance an acquisition and possible dilution to our existing shareholders;
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the diversion of our management’s attention to the negotiation of a transaction and integration of an acquired company’s operations with ours;
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the incurrence of an impairment of goodwill associated with an acquisition and adverse effects on our results of operations;
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entry into new markets where we have limited or no direct prior experience;
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closing delays and increased expenses related to the resolution of lawsuits filed by our shareholders or shareholders of companies we may seek to acquire;
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the inability to receive regulatory approvals timely or at all, including as a result of community objections, or such approvals being restrictively conditional; and
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risks associated with integrating the operations, technologies and personnel of the acquired business.
We expect to continue to evaluate merger and acquisition opportunities that are presented to us in our current markets, as well as other markets, throughout the region and conduct due diligence activities related to possible transactions with other financial institutions. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash or equity securities and related capital raising transactions may occur at any time. Generally, acquisitions of financial institutions involve the payment of a premium over book and market values, and, therefore, some dilution of our book value and fully diluted earnings per share may occur in connection with any future transaction. Failure to realize the expected revenue increases, cost savings, increases in product presence and/or other projected benefits from an acquisition could have a material adverse effect on our financial condition and results of operations.
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In addition, we may face significant competition from numerous other financial services institutions, many of which may have greater financial resources than we do, when considering acquisition opportunities. Accordingly, attractive acquisition opportunities may not be available to us. There can be no assurance that we will be successful in identifying or completing any potential future acquisitions.
Our concentration in loans secured by real estate, particularly commercial real estate and construction and development, is subject to risks that could adversely affect our results of operations and financial condition.
We offer a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of our loans are secured by real estate (both residential and commercial) in our market areas. Consequently, declines in economic conditions in these market areas may have a greater effect on our earnings and capital than on the earnings and capital of larger financial institutions whose real estate loan portfolios are more geographically diverse.
At December 31, 2018, approximately 82 percent of our loans had real estate as a primary or secondary component of collateral, which includes 11 percent of our loans secured by construction and development collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Real estate values declined significantly during the recent economic crisis and may decline similarly in future periods. Although real estate prices in most of our markets have stabilized or are improving, a renewed decline in real estate values would expose us to further deterioration in the value of the collateral for all loans secured by real estate and may adversely affect our results of operations and financial condition.
Commercial real estate loans are generally viewed as having more risk of default than residential real estate loans, particularly when there is a downturn in the business cycle. They are also typically larger than residential real estate loans and consumer loans and depend on cash flows from the owner’s business or the property to service the debt. Cash flows may be affected significantly by general economic conditions and a downturn in the local economy or in occupancy rates in the local economy where the property is located, each of which could increase the likelihood of default on the loan. Because our loan portfolio contains a number of commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in the percentage of nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses and an increase in charge-offs, all of which could have a material adverse effect on our results of operations and financial condition, which could negatively affect our stock price.
If a commercial real estate loan did default there would be legal expenses associated with obtaining the real estate which is typically collateral for the loan. In the last several years the amount of these legal expenses has been low, compared to periods when the defaults of commercial real estate loans have been higher. Once we obtain the collateral for the commercial real estate loan it is put into foreclosed assets. Foreclosed assets generally do not produce income but do have the costs associated with the ownership of real estate, principally real estate taxes and maintenance costs. Since these assets have a cost to maintain our goal is to keep costs at a minimum by liquidating the assets as soon as possible. Generally, in spite of our best efforts and intentions, foreclosed assets are sold at a loss. Among other reasons the rate of loan defaults increase as the economy worsens and declining economic environment and political turmoil generally results in downward pressure on foreclosed asset values and increased marketing periods. In simple terms for banks like ours who have a large amount of commercial real estate loans a worsening economy will typically lead to higher loan delinquencies, followed by increases in loan defaults and greater legal expenses, leading to higher foreclosed asset levels with an increased expense to maintain the properties, ending in a sale of the foreclosed assets - most likely at a loss.
Our largest loan relationships currently make up a significant percentage of our total loan portfolio.
As of December 31, 2018, our 10 largest borrowing relationships totaled approximately $180 million in commitments (including unfunded commitments), or approximately 10 percent of our total loan portfolio. The concentration risk associated with having a small number of relatively large loan relationships is that, if one or more of these relationships were to become delinquent or suffer default, we could be at risk of material losses. The allowance for loan losses may not be adequate to cover losses associated with any of these relationships, and any loss or increase in the allowance could have a material adverse effect on our business, financial condition, results of operations and prospects.
26
Our corporate structure provides for decision-making authority by our regional presidents and banking teams. Our business, financial condition, results of operations and prospects could be negatively affected if our employees do not follow our internal policies or are negligent in their decision-making.
We attract and retain our management talent by empowering them to make certain business decisions on a local level. Lending authorities are assigned to relationship managers, regional and presidents and regional credit officers to make credit decisions based on their experience. Additionally, all loans not in full compliance with the bank’s loan policy must be approved by an additional level of authority with adequate credit authority for the exposure and any exposure in excess of $2.8 million in Total Relationship Exposure with some sample loans below this amount are reviewed by our Chief Credit Officer in Knoxville, Tennessee. Moreover, for decisions that fall outside of the assigned individual authorities at every level, our teams are required to obtain approval from our. Officer Loan Committee and/or Directors Loan Committee. Our local bankers may not follow our internal procedures or otherwise act in our best interests with respect to their decision-making. A failure of our employees to follow our internal policies, or actions taken by our employees that are negligent could have a material adverse effect on our business, financial condition, results of operations and prospects.
Declines in the businesses or industries of our customers could cause increased credit losses and decreased loan balances, which could adversely affect our financial results.
The small to medium-sized businesses that we lend to may have fewer resources to weather adverse business developments, which may impair a borrower’s ability to repay a loan, and such impairment could have an adverse effect on our business, financial condition and results of operations. A substantial focus of our marketing and business strategy is to serve small to medium-sized businesses in our market areas. As a result, a relatively high percentage of our loan portfolio consists of commercial loans to such businesses. We further anticipate an increase in the amount of loans to small to medium-sized businesses during 2018.
Small to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management skills, talents and efforts of one or two people or a small group of people, and the death, disability or resignation of one or more of these people could have an adverse impact on the business and its ability to repay its loan. If general economic conditions negatively impact the markets in which we operate and small to medium-sized businesses are adversely affected or our borrowers are otherwise harmed by adverse business developments, this, in turn, could have an adverse effect on our business, financial condition and results of operations.
Certain of our deposits and other funding sources may be volatile and impact our liquidity.
We bank several large depository clients including three customers totaling approximately $160.6 million in deposits at December 31, 2018. Should those clients reduce their balances we would be forced to find other funding sources. In addition to the traditional core deposits, such as demand deposit accounts, interest checking, money market savings and certificates of deposits less than $250,000, we utilize or in the past have utilized several noncore funding sources, such as brokered certificates of deposit, Federal Home Loan Bank (FHLB) of Cincinnati advances, federal funds purchased and other sources. We utilize these noncore funding sources to fund the ongoing operations and growth of SmartBank. The availability of these noncore funding sources is subject to broad economic conditions and to investor assessment of our financial strength and, as such, the cost of funds may fluctuate significantly and/or be restricted, thus impacting our net interest income, our immediate liquidity and/or our access to additional liquidity. We have somewhat similar risks to the extent high balance core deposits exceed the amount of deposit insurance coverage available.
We impose certain internal limits as to the absolute level of noncore funding we will incur at any point in time. Should we exceed those limitations, we may need to modify our growth plans, liquidate certain assets, participate loans to correspondents or execute other actions to allow for us to return to an acceptable level of noncore funding within a reasonable amount of time.
27
We face additional risks due to our increase in mortgage banking activities that have and could negatively impact our net income and profitability.
We have established mortgage banking operations which expose us to risks that are different from our retail and commercial banking operations. During higher and rising interest rate environments, the demand for mortgage loans and the level of refinancing activity tends to decline, which can lead to reduced volumes of business and lower revenues, which could negatively impact our earnings. While we have been experiencing historically low interest rates, the low interest rate environment likely will not continue indefinitely. Because we sell a substantial portion of the mortgage loans we originate, the profitability of our mortgage banking operations also depends in large part on our ability to aggregate a high volume of loans and sell them in the secondary market at a gain. Thus, in addition to our dependence on the interest rate environment, we are dependent upon (a) the existence of an active secondary market and (b) our ability to profitably sell loans into that market. Our mortgage banking operations incurred additional expenses over $3.0 million in 2018 and generated noninterest income of $1.4 million. Profitability of our mortgage operations will depend upon our ability to increase production and thus income while holding or reducing costs. In addition, mortgages sold to third-party investors are typically subject to certain repurchase provisions related to borrower refinancing, defaults, fraud or other reasons stipulated in the applicable third-party investor agreements. If the fair value of a loan when repurchased is less than the fair value when sold, we may be required to charge such shortfall to earnings.
Any expansion into new lines of business might not be successful.
As part of our ongoing strategic plan, we will continue to consider expansion into new lines of business through the acquisition of third parties, or through organic growth and development. There are substantial risks associated with such efforts, including risks that (a) revenues from such activities might not be sufficient to offset the development, compliance, and other implementation costs, (b) competing products and services and shifting market preferences might affect the profitability of such activities, and (c) our internal controls might be inadequate to manage the risks associated with new activities. Furthermore, it is possible that our unfamiliarity with new lines of business might adversely affect the success of such actions. If any such expansions into new product markets are not successful, there could be an adverse effect on our financial condition and results of operations.
We may need additional access to capital, which we may be unable to obtain on attractive terms or at all.
We may need to incur additional debt or equity financing in the future to make strategic acquisitions or investments, for future growth or to fund losses or additional provision for loan losses in the future. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, we may be unable to raise additional capital, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to further expand our operations through internal growth and acquisitions could be materially impaired and our stock price negatively affected.
Any deficiencies in our financial reporting or internal controls could materially and adversely affect us, including resulting in material misstatements in our financial statements, and could materially and adversely affect the market price of our common stock.
If we fail to maintain effective internal controls over financial reporting, our operating results could be harmed and it could result in a material misstatement in our financial statements in the future. Inferior controls and procedures or the identification of accounting errors could cause our investors to lose confidence in our internal controls and question our reported financial information, which, among other things, could have a negative impact on the trading price of our common stock. Additionally, we could become subject to increased regulatory scrutiny and a higher risk of shareholder litigation, which could result in significant additional expenses and require additional financial and management resources.
We incur increased costs as a result of being a public company.
As a public company, we incur significant legal, accounting and other expenses, including costs associated with public company reporting requirements. We also incur costs associated with the Sarbanes-Oxley Act, the Dodd-Frank Act and related rules implemented or to be implemented by the SEC and the NASDAQ Stock Market. In addition, changing laws, regulations and standards relating to corporate governance and public disclosure are creating uncertainty for public companies, increasing legal and financial compliance costs and making some activities more time consuming. These laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and, as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We intend to continue to invest resources to comply with evolving laws, regulations and standards and this continued investment may result in increased general and administrative expenses and a diversion of management's time and attention from revenue-generating
28
activities to compliance activities. If our efforts to comply with new laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to their application and practice, regulatory authorities may initiate legal proceedings against us and our business may be adversely affected. In 2018, we incurred over $840 thousand in direct external costs associated with being a public company, which does not include the increased internal costs of the personnel needed to comply with being a public company.
Inability to retain senior management and key employees or to attract new experienced financial services professionals could impair our relationship with our customers, reduce growth and adversely affect our business.
We have assembled a senior management team which has substantial background and experience in banking and financial services. Moreover, much of historical loan growth was the result of our ability to attract experienced financial services professionals who have been able to attract customers from other financial institutions. Inability to retain these key personnel or to continue to attract experienced lenders with established books of business could negatively impact our growth because of the loss of these individuals' skills and customer relationships and/or the potential difficulty of promptly replacing them.
We may be subject to losses due to fraudulent and negligent conduct of our loan customers, deposit customers, third party service providers and employees.
When we make loans to individuals or entities, we rely upon information supplied by borrowers and other third parties, including information contained in the applicant’s loan application, property appraisal reports, title information and the borrower’s net worth, liquidity and cash flow information. While we attempt to verify information provided through available sources, we cannot be certain all such information is correct or complete. Our reliance on incorrect or incomplete information could have a material adverse effect on our financial condition or results of operations.
The value of our goodwill and other intangible assets may decline in the future.
As of December 31, 2018, we had $79.0 million of goodwill and other intangible assets. A significant decline in our financial condition, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of our common stock may necessitate taking charges in the future related to the impairment of our goodwill and other intangible assets. If we were to conclude that a future write-down of goodwill and other intangible assets is necessary, we would record the appropriate charge, which could have a material adverse effect on our financial condition and results of operations. Future acquisitions could result in additional goodwill.
Risks Related to Our Stock
Our ability to declare and pay dividends is limited.
There can be no assurance of whether or when we may pay dividends on our common stock in the future. Future dividends, if any, will be declared and paid at the discretion of our board of directors and will depend on a number of factors. Our principal source of funds used to pay cash dividends on our common stock will be dividends that we receive from SmartBank. Although the Bank’s asset quality, earnings performance, liquidity and capital requirements will be taken into account before we declare or pay any future dividends on our common stock, our board of directors will also consider our liquidity and capital requirements and our board of directors could determine to declare and pay dividends without relying on dividend payments from the Bank.
Federal and state banking laws and regulations and state corporate laws restrict the amount of dividends we may declare and pay. For example, Federal Reserve Board regulations implementing the capital rules required under Basel III do not permit dividends unless capital levels exceed certain higher levels applying capital conservation buffers that began to apply on January 1, 2016 and are being phased in over three years.
Even though our common stock is currently traded on the Nasdaq Capital Market, it has less liquidity than many other stocks quoted on a national securities exchange.
The trading volume in our common stock on the Nasdaq Capital Market has been relatively low when compared with larger companies listed on the Nasdaq Capital Market or other stock exchanges. Although we have experienced increased liquidity in our stock, we cannot say with any certainty that a more active and liquid trading market for our common stock will continue to develop. Because of this, it may be more difficult for stockholders to sell a substantial number of shares for the same price at which stockholders could sell a smaller number of shares.
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We cannot predict the effect, if any, that future sales of our common stock in the market, or the availability of shares of common stock for sale in the market, will have on the market price of our common stock. We can give no assurance that sales of substantial amounts of common stock in the market, or the potential for large amounts of sales in the market, would not cause the price of our common stock to decline or impair our future ability to raise capital through sales of our common stock.
The market price of our common stock has fluctuated significantly, and may fluctuate in the future. These fluctuations may be unrelated to our performance. General market or industry price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices.
We may issue additional shares of stock or equity derivative securities, including awards to current and future executive officers, directors and employees, which could result in the dilution of shareholders’ investment.
Our authorized capital includes 40,000,000 shares of common stock and 2,000,000 shares of preferred stock. As of December 31, 2018, we had 13,933,504 shares of common stock and no shares of preferred stock outstanding, and had reserved or otherwise set aside for issuance 170,625 shares underlying outstanding options and 2,479,055 shares that are available for future grants of stock options, restricted stock or other equity-based awards pursuant to our equity incentive plans. Subject to NASDAQ rules, our board of directors generally has the authority to issue all or part of any authorized but unissued shares of common stock or preferred stock for any corporate purpose. We anticipate that we will issue additional equity in connection with the acquisition of other strategic partners and that in the future we likely will seek additional equity capital as we develop our business and expand our operations, depending on the timing and magnitude of any particular future acquisition. These issuances would dilute the ownership interests of existing shareholders and may dilute the per share book value of the common stock. New investors also may have rights, preferences and privileges that are senior to, and that adversely affect, our then existing shareholders.
In addition, the issuance of shares under our equity compensation plans will result in dilution of our shareholders’ ownership of our Common Stock. The exercise price of stock options could also adversely affect the terms on which we can obtain additional capital. Option holders are most likely to exercise their options when the exercise price is less than the market price for our Common Stock. They may profit from any increase in the stock price without assuming the risks of ownership of the underlying shares of Common Stock by exercising their options and selling the stock immediately.
We are subject to Tennessee’s anti-takeover statutes and certain charter provisions that could decrease our chances of being acquired even if the acquisition is in the best interest of our shareholders.
As a Tennessee corporation, we are subject to various legislative acts that impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire us and increase the difficulty of consummating any such offers, even if the acquisition would be in our shareholders’ best interests. Our charter also contains provisions which may make it difficult for another entity to acquire us without the approval of a majority of the disinterested directors on our board of directors. Secondly, the amount of common stock owned by, and other compensation arrangements with, certain of our officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Agreements with our senior management also provide for significant payments under certain circumstances following a change in control. These compensation arrangements, together with the common stock and option ownership of our board of directors and management, could make it difficult or expensive to obtain majority support for shareholder proposals or potential acquisition proposals that the board of directors and officers oppose.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
As of December 31, 2018, the principal offices of SmartFinancial are located at 5401 Kingston Pike, #600, Knoxville, Tennessee 37919. This property is owned by SmartBank and also serves as a branch location for the Bank’s customers. The Bank provides services or performs operational functions at 35 locations, of which 23 are owned and 12 that are leased. Although the properties owned and leased are generally considered adequate, we have a continuing program of modernization, expansion, and when necessary, occasional replacement of facilities. For additional information relating to the Company’s premises, equipment and lease commitments, see Note 5—Premises and Equipment to our audited consolidated financial statements.
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ITEM 3. LEGAL PROCEEDINGS
As of the end of 2018, neither SmartFinancial nor SmartBank was involved in any material litigation. SmartBank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business. Management believes that any claims pending against SmartFinancial or its subsidiary are without merit or that the ultimate liability, if any, resulting from them will not materially affect SmartBank’s financial condition or SmartFinancial’s consolidated financial position.
ITEM 4. MINE SAFETY DICLOSURES
Not applicable.
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PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
On December 31, 2018, SmartFinancial had 13,933,504 shares of common stock outstanding. SmartFinancial’s common stock is listed on NASDAQ under the symbol “SMBK”.
There were approximately 3,338 holders of record of the common stock as of March 6, 2019.
During the fourth quarter of 2018 the Board of Directors of SmartFinancial approved a common stock repurchse program. There were no shares purchased under this program in 2018.
For information relating to compensation plans under which our equity securities are authorized for issuance, see Part III Items 11 and 12.
ITEM 6. SELECTED FINANCIAL DATA
This item is not applicable to smaller reporting companies.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion of our financial condition at December 31, 2018 and 2017 and our results of operations for each of the years in the three-year period ended December 31, 2018. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from our consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included
Business Overview
The Company’s business model consists of leveraging capital into assets funded by liabilities. As a general rule capital can be leveraged approximately ten times. The primary source of revenue is interest income from earning assets, namely loans and securities. These liabilities used to fund the assets are primarily deposits. The Company seeks to maximize net interest income, the difference between interest received on earning assets and the amount of interest paid on liabilities. Net interest income to average assets is a key ratio that measures the profitability of the earning assets of the company. Noninterest income is the second source of revenue and primarily consists of customer service fees, gains on the sales of securities and loans, and other noninterest income. Noninterest income to average assets is a ratio that reflects our effectiveness in generating these other forms of revenue. The Company incurs noninterest expenses as result of the operations of its business. Primary expenses are those of employees, occupancy and equipment, professional services, and data processing. The Company seeks to minimize the amount of noninterest expense relative to the amount of total assets; noninterest expense to assets is a key ratio that measures the efficiency of the costs incurred to operate the business.
Executive Summary
The following is a summary of the Company’s financial highlights and significant events during 2018:
•
Completed two acquisitions during the year which increased assets by approximately $444 million : Tennessee Bancshares the second quarter and Foothills Bancorp in the fourth quarter.
•
Earnings available to common shareholders increased to $18.1 million and earnings per share increased to $1.46.
•
Ended 2018 with record high total assets of $2.3 billion, net loans of $1.8 billion, and deposits of $1.9 billion.
•
Net interest margin, taxable equivalent, increased to 4.43 percent 2018 compared to 4.29 percent in 2017.
•
Efficiency ratio, which is equal to noninterest expense divided by the sum of net interest income and noninterest income, decreased to 70.7 percent in 2018, compared to 76.0 percent in 2017.
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Analysis of Results of Operations
2018 compared to 2017
Net income was $18.1 million in 2018, compared to $5.0 million in 2017. Net income available to common shareholders was $18.1 million, or $1.45 per diluted common share, in 2018, compared to $4.8 million, or $0.55 per diluted common share, in 2017. Net interest income to average assets of 3.90 percent in 2018 held steady from in 2017. Noninterest income to average assets of 0.34 percent decreased from 0.42 percent in 2017 as growth in assets exceeded increases in noninterest income. Noninterest expense to average assets decreased from 3.29 percent in 2017 to 3.00 percent in 2018 as the company continued to capture economies of scale following the mergers. The resulting pretax income to average assets was 1.19 percent in 2018 compared to 1.00 percent in 2017. Finally, in 2018 the effective tax rate was 15.2 percent, which was lower than normal due to a tax benefit from options exercised while the rate of 56.2 percent in 2017 was elevated due to a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017.
2017 compared to 2016
Net income was $5.0 million in 2017 a decrease from $5.8 million in 2016 primarily due to a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017. Net income available to common shareholders was $4.8 million, or $0.55 per diluted common share, in 2017 compared to $4.8 million, or $0.78 per diluted common share, in 2016. Net interest income to average assets of 3.90 percent in 2017 increased from 3.77 percent in 2016 as a result of a higher percentage of average earning assets to average total assets. Noninterest income to average assets of 0.42 percent in 2017 increased slightly from 0.41 percent in 2016 due to higher customer service fees, higher interchange and debit cards fees, and higher other noninterest income. Noninterest expense to average assets increased from 3.20 percent in 2016 to 3.29 percent in 2017 primarily due to $2.4 million in merger expenses. The resulting pretax income to average assets was 1.00 percent in 2017 compared to 0.95 percent in 2016. Finally, the effective tax rate of 56.2 percent in 2017 was elevated due to a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017 while in 2016 the effective tax rate was 36.70 percent..
Net Interest Income and Yield Analysis
2018 compared to 2017
Net interest income, taxable equivalent, increased to $76.8 million in 2018 from $46.4 million in 2017. The increase in net interest income, taxable equivalent, was the result of a significant increase in earning assets primarily from the mergers but also from organic business activity. Average earning assets increased from $1.1 billion in 2017 to $1.7 billion in 2018. Over this period, average loan balances increased by $592.1 million and average securities balances increased by $33.0 million. In addition, total average interest-bearing deposits increased by $543.1 million. Net interest income to average assets of 3.90 percent in 2018 was unchanged from 3.90 percent in 2017. Net interest margin, taxable equivalent, was 4.43 percent in 2018, compared to 4.29 percent in 2017, with the increase due to higher yields on earning assets. Net interest margin, taxable equivalent, was slightly negatively impacted by an increase in the cost of interest bearing liabilities from 0.66 percent in 2017 to 1.10 percent in 2018. In 2019 we expect net interest income to average assets and net interest margin, taxable equivalent, to experience pressure as there is the potential for pressure to increase deposit rates as short term rates have continued to increase but do anticipate the effect of rate increases will be mitigated on the income side by increases in yields of our floating rate earning assets.
2017 compared to 2016
Net interest income, taxable equivalent, increased to $46.4 million in 2017 from $38.3 million in 2016. The increase in net interest income, taxable equivalent, was the result of a significant increase in earning assets primarily from the merger but also from organic business activity. Average earning assets increased from $944.6 million in 2016 to $1.1 billion in 2017 . Over this period, average loan balances increased by $149.6 million and average securities and interest bearing balances decreased by $17.3 million. In addition, total average interest-bearing deposits increased by $113.8 million. Net interest income to average assets of 3.90 percent in 2017 increased from 3.77 percent in 2016 . Net interest margin, taxable equivalent, was 4.29 percent in 2017 4.06 percent in 2016, with the increase due to higher yields on earning assets.. Net interest margin, taxable equivalent, was slightly negatively impacted by an increase in the cost of interest bearing liabilities from 0.56 percent in 2016 to 0.66 percent in 2017.
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The following table summarizes the major components of net interest income and the related yields and costs for the periods presented.
2018
2017
2016
(Dollars in thousands)
Average
Yield/
Average
Yield/
Average
Yield/
Balance
Interest *
Cost*
Balance
Interest *
Cost*
Balance
Interest *
Cost*
Assets
Loans (1)
$
1,511,724
$
86,479
5.72
%
$
919,603
$
48,834
5.31
%
$
769,990
$
39,779
5.18
%
Taxable Securities
143,281
3,512
2.46
%
123,741
2,369
1.92
%
142,271
2,358
1.66
%
Tax-exempt securities (2)
19,734
767
3.90
%
6,260
214
3.43
%
4,996
162
3.25
%
Federal funds and other earning assets
65,244
1,642
2.52
%
36,754
723
1.97
%
25,828
336
1.30
%
Total interest-earning assets
1,739,983
92,400
5.32
%
1,086,358
52,140
4.81
%
943,085
42,635
4.53
%
Noninterest-earning assets
222,734
102,231
69,147
Total assets
$
1,962,717
$
1,188,589
$
1,012,232
Liabilities and Stockholders’ Equity
Interest-bearing demand deposits
$
242,859
1,290
0.53
%
$
166,382
539
0.32
%
$
150,649
286
0.19
%
Money market and savings deposits
601,808
5,579
0.93
%
342,637
1,759
0.51
%
258,092
1,172
0.46
%
Time deposits
536,964
7,419
1.39
%
329,524
3,221
0.98
%
316,046
2,647
0.84
%
Total interest-bearing deposits
1,381,631
14,288
1.04
%
838,543
5,519
0.66
%
724,787
4,105
0.57
%
Federal funds purchased and other borrowings
16,940
155
0.92
%
20,771
90
0.43
%
23,015
84
0.37
%
Federal Home Loan Bank advances
6,939
118
1.71
%
2,260
16
0.71
%
15,360
93
0.61
%
Long-term debt
18,855
1,005
5.34
%
1,699
68
4.01
%
448
17
3.81
%
Total interest-bearing liabilities
1,424,365
15,566
1.10
%
863,273
5,693
0.66
%
763,610
4,299
0.56
%
Noninterest-bearing deposits
285,729
172,842
139,652
Other liabilities
10,172
6,670
5,492
Total liabilities
1,720,266
1,042,785
908,754
Stockholders’ equity
242,451
145,804
103,478
Total liabilities and stockholders’ equity
$
1,962,717
$
1,188,589
$
1,012,232
Net interest income, taxable equivalent
$
76,834
$
46,447
$
38,336
Interest rate spread (3)
4.22
%
4.15
%
3.95
%
Tax equivalent net interest margin (4)
4.43
%
4.29
%
4.06
%
Percentage of average interest-earning assets to average interest-bearing liabilities
122.2
%
125.8
%
123.7
%
Percentage of average equity to average assets
12.4
%
12.3
%
10.2
%
* Taxable equivalent basis
(1)
Loans include nonaccrual loans. Yields related to loans exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 21.0 percent in 2018 and 34.0 percent in 2017 and 2016. The taxable-equivalent adjustment was $10 thousand for 2018, $28 thousand for 2017 and $16 thousand for 2016. Loan fees included in loan income was $2.7 million, $2.5 million, and $2.6 million for 2018, 2017 and 2016, respectively.
(2)
Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 21.0 percent in 2018 and 34.0 percent in 2017 and 2016. The taxable-equivalent adjustment was $180 thousand, $90 thousand and $55 thousand for 2018, 2017 and 2016, respectively.
(3)
Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(4)
Net interest margin represents net interest income divided by average interest-earning assets.
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Rate and Volume Analysis
Net interest income, taxable equivalent, increased by $30.4 million between the years ended December 31, 2018 and 2017 and by $8.1 million between the years ended December 31, 2017 and 2016. The following is an analysis of the changes in net interest income comparing the changes attributable to rates and those attributable to volumes (in thousands):
2018 Compared to 2017
Increase (decrease) due to
2017 Compared to 2016
Increase (decrease) due to
Rate
Volume
Net
Rate
Volume
Net
Interest-earning assets:
Loans (1)
$
6,203
$
31,442
$
37,645
$
1,284
$
7,771
$
9,055
Taxable Securities
768
375
1,143
319
(308
)
11
Tax-exempt securities (2)
91
462
553
11
41
52
Federal funds and other earning assets
358
561
919
245
142
387
Total interest-earning assets
7,420
32,840
40,260
1,859
7,646
9,505
Interest-bearing demand deposits
506
245
751
223
30
253
Money market and savings deposits
2,498
1,322
3,820
197
390
587
Time deposits
2,165
2,033
4,198
460
114
574
Total interest-bearing deposits
5,169
3,600
8,769
880
534
1,414
Federal funds purchased and other borrowings
81
(16
)
65
14
(8
)
6
Federal Home Loan Bank advances
69
33
102
3
(80
)
(77
)
Long-term debt
249
688
937
3
48
51
Total interest-bearing liabilities
5,568
4,305
9,873
948
446
1,394
Net interest income
$
1,852
$
28,535
$
30,387
$
911
$
7,200
$
8,111
(1)
Loans include nonaccrual loans. Yields related to loans exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of 21.0 percent in 2018 and 34.0 percent in 2017 and 2016. The taxable-equivalent adjustment was $10 thousand for 2018, $28 thousand for 2017 and $16 thousand for 2016. Loan fees included in loan income was $2.7 million, $2.5 million, and $2.6 million for 2018, 2017 and 2016, respectively.
(2)
Yields related to investment securities exempt from income taxes are stated on a taxable-equivalent basis assuming a federal income tax rate of of 21.0 percent in 2018 and 34.0 percent in 2017 and 2016. The taxable-equivalent adjustment was $180 thousand, $90 thousand and $55 thousand for 2018, 2017 and 2016, respectively.
Changes in net interest income are attributed to either changes in average balances (volume change) or changes in average rates (rate change) for earning assets and sources of funds on which interest is received or paid.. Volume change is calculated as change in volume times the previous rate while rate change is change in rate times the previous volume. The change attributed to rates and volumes (change in rate times change in volume) is considered above as a change in volume.
35
Noninterest Income
The following table provides a summary of noninterest income for the periods presented.
Year ended December 31,
(Dollars in thousands)
2018
2017
2016
Customer service fees
$
2,416
$
1,374
$
1,128
Interchange and debit card transaction fees
573
952
732
Gain on sale of securities
1
144
199
Gain on sale of loans and other assets
1,433
1,276
1,139
Other noninterest income
2,161
1,281
986
Total noninterest income
$
6,584
$
5,027
$
4,183
2018 compared to 2017
Noninterest income totaled $6.6 million in 2018, which was an increase from $5.0 million in 2017. Noninterest income to average assets of 0.34 percent decreased from 0.42 percent in 2017. Primary drivers of the decrease were a change in the accounting treatment form interchange and debit card transaction fees, which starting in 2018 are shown net of direct costs. In 2018, there were gains of $1.4 million on the sale of mortgage loans, SBA loans and other assets compared to $1.3 million in 2017. Other noninterest income of $2.2 million in 2018 increased from $1.3 million in 2017 primarily due to higher income from bank owned life insurance and higher income from investment operations. In 2018, we expect noninterest income to average assets to increase as a result of increased loan sales from the mortgage unit, higher service charges on deposit accounts, increases in income from investment services, and greater other noninterest income.
2017 compared to 2016
Noninterest income totaled $5.0 million in 2017, which was an increase from $4.2 million in 2016. Noninterest income to average assets of 0.42 percent in 2017 increased slightly from 0.41 percent in 2016. Primary drivers of the increase were higher gains higher customer service fees, higher interchange and debit cards fees, and higher other noninterest income. In 2017, there were $1.4 million in customer service fees compared to $1.1 million in 2016 due to higher volumes. Interchange an debit card fees increased from$732 thousand in 2016 to $952 thousand in 2017 due to higher volumes. Other noninterest income of $1.3 million in 2017 increased from $986 thousand in 2016 primarily due to increased revenue as a result of the merger.
Noninterest Expense
The following table provides a summary of noninterest expense for the periods presented.
Year ended December 31,
(Dollars in thousands)
2018
2017
2016
Salaries and employee benefits
$
30,630
$
20,743
$
17,715
Net occupancy and equipment expense
6,303
4,271
3,996
FDIC insurance
786
466
606
Foreclosed assets
776
132
236
Advertising
873
638
616
Data processing
1,906
1,875
1,893
Professional services
3,647
2,085
2,123
Amortization of other intangible assets
976
346
305
Software as services contracts
2,054
1,398
1,154
Merger expenses
3,781
2,417
—
Other operating expenses
7,224
4,758
3,856
Total noninterest expense
$
58,956
$
39,130
$
32,500
36
2018 compared to 2017
Noninterest expense totaled $59.0 million in 2018 compared to $39.1 million in 2017. Noninterest expense to average assets decreased from 3.29 percent in 2017 to 3.00 percent in 2018. Salaries and employee benefits, occupancy and equipment, and other noninterest expense categories in 2018 were all higher as a result of post-merger expenses including ten additional months of Capstone expenses, seven additional months of Tennessee Bancshares expenses, and two additional months of Foothills expenses. In 2019, we expect noninterest expense to average assets to increase as anticipated increases in merger expenses offset reductions in core operating expenses.
2017 compared to 2016
Noninterest expense totaled $39.1 million in 2017 compared to $32.5 million in 2016 . Noninterest expense to average assets increased from 3.20 percent in 2016 to 3.29 percent in 2017. Salaries and employee benefits, occupancy and equipment, data processing, and other noninterest expense categories in 2017 were all higher as a result of two full months of post-merger expense. In 2017 noninterest expense was also elevated by $2.4 million of merger expenses, compared to none in 2016.
Income Taxes
2018 compared to 2017
In 2018, income tax expense totaled $3.2 million compared to $6.4 million in 2017. In 2018 the effective tax rate was 15.2 percent, which was lower than normal due to a tax benefit from options exercised in the prior period while the rated of 56.2 percent in 2017 was elevated due to a $2.4 million after-tax charge to write down the Company's deferred tax assets as a result of the Tax Cuts and Jobs Act of 2017. In 2019, we expect our effective tax rate to be in the range of 25 percent.
2017 compared to 2016
In 2017, income tax expense totaled $6.4 million compared to $3.4 million in 2016. The effective tax rate of 56.2 percent in 2017 was elevated due to a $2.4 million after-tax charge to reduce the value of the Company's deferred tax assets as a result of the tax law signed in December compared to 36.7 percent in 2016
Loan Portfolio Composition
The Company had total net loans outstanding, including organic and purchased loans, of approximately $1.8 billion at December 31, 2018 and $1.3 billion at December 31, 2017. Loans secured by real estate, consisting of commercial or residential property, are the principal component of our loan portfolio. We do not generally originate traditional long-term residential mortgages for our portfolio but we do originate and hold traditional second mortgage residential real estate loans, adjustable rate mortgages and home equity lines of credit. Even if the principal purpose of the loan is not to finance real estate, when reasonable, we attempt to obtain a security interest in the real estate in addition to any other available collateral to increase the likelihood of ultimate repayment or collection of the loan.
Organic Loans
Our net organic loans increased $356.6 million, or 44.9 percent to $1.2 billion at December 31, 2018, from December 31, 2017, primarily as a result of the mergers. Our goal of streamlining the credit process has improved our efficiency and is a competitive advantage in many of our markets. In addition, continued training and recruiting of experienced loan officers has provided us with the opportunity to close larger and more complex deals than we historically have. Finally, the overall business environment continues to rebound from recessionary conditions. Organic loans include loans which were originally purchased non-credit impaired loans but have been renewed.
Purchased Loans
Purchased non-credit impaired loans of $584.5 million at December 31, 2018 increased by $93.6 million from December 31, 2017 as a result of the mergers. Also during 2018, our purchased credit impaired (“PCI”) loans increased by $1.4 million to $34.2 million at December 31, 2018. The activity within the purchased credit impaired loans will be impacted by how quickly these loans are resolved and/or our future acquisition activity.
37
The following tables summarize the composition of our loan portfolio for the periods presented (dollars in thousands):
2018
Organic
Loans
Purchased
Non-Credit
Impaired
Loans
Purchased
Credit
Impaired
Loans
Total
Amount
% of
Gross
Total
Commercial real estate-mortgage
$
555,915
$
286,430
$
17,682
$
860,027
48.4
%
Consumer real estate-mortgage
224,958
173,584
8,712
407,254
22.9
%
Construction and land development
134,232
49,061
4,602
187,895
10.6
%
Commercial and industrial
234,877
70,820
2,557
308,254
17.3
%
Consumer and other
8,627
4,577
605
13,809
0.8
%
Total gross loans receivable, net of deferred fees
1,158,609
584,472
34,158
1,777,239
100.0
%
Allowance for loan losses
(8,275
)
—
—
(8,275
)
Total loans, net
$
1,150,333
$
584,473
$
34,158
$
1,768,964
2017
Organic
Loans
Purchased
Non-Credit
Impaired
Loans
Purchased
Credit
Impaired
Loans
Total
Amount
% of
Gross
Total
Commercial real estate-mortgage
$
387,313
$
237,772
$
17,903
$
642,988
48.6
%
Consumer real estate-mortgage
173,988
112,019
7,450
293,457
22.2
%
Construction and land development
97,116
33,173
5,120
135,409
10.2
%
Commercial and industrial
135,271
101,958
858
238,087
18.0
%
Consumer and other
5,925
5,929
1,463
13,317
1.0
%
Total gross loans receivable, net of deferred fees
799,613
490,851
32,794
1,323,258
100.0
%
Allowance for loan losses
(5,844
)
—
(16
)
(5,860
)
Total loans, net
$
793,769
$
490,851
$
32,778
$
1,317,398
2016
Organic
Loans
Purchased
Non-Credit
Impaired
Loans
Purchased
Credit
Impaired
Loans
Total
Amount
% of
Gross
Total
Commercial real estate-mortgage
$
297,689
$
102,576
$
14,943
$
415,208
51.0
%
Consumer real estate-mortgage
135,923
42,875
9,004
187,802
23.1
%
Construction and land development
108,390
7,801
1,678
117,869
14.5
%
Commercial and industrial
68,235
15,219
1,568
85,022
10.5
%
Consumer and other
6,786
689
—
7,475
0.9
%
Total gross loans receivable, net of deferred fees
617,023
169,160
27,193
813,376
100.0
%
Allowance for loan losses
(5,105
)
—
—
(5,105
)
Total loans, net
$
611,918
$
169,160
$
27,193
$
808,271
38
2015
Organic Loans
Purchased Non-Credit Impaired Loans
Purchased Credit Impaired Loans
Total Amount
% of
Gross
Total
Commercial real estate-mortgage
$
229,203
$
120,524
$
20,050
$
369,777
50.8
%
Consumer real estate-mortgage
95,233
53,697
12,764
161,694
22.2
%
Construction and land development
73,028
29,755
2,695
105,478
14.5
%
Commercial and industrial
53,761
28,422
2,768
84,951
11.7
%
Consumer and other
4,692
1,123
—
5,815
0.8
%
Total gross loans receivable, net of deferred fees
455,917
233,521
38,277
727,715
100.0
%
Allowance for loan losses
(4,354
)
—
—
(4,354
)
Total loans, net
$
451,563
$
233,521
$
38,277
$
723,361
2014
Organic Loans
Purchased Non-Credit Impaired Loans
Purchased Credit Impaired Loans
Total Amount
% of
Gross
Total
Commercial real estate-mortgage
$
186,444
$
3,905
$
3,102
$
193,451
53.2
%
Consumer real estate-mortgage
75,066
1,968
4,380
81,414
22.4
%
Construction and land development
52,421
48
36
52,505
14.5
%
Commercial and industrial
33,716
—
3
33,719
9.3
%
Consumer and other
2,314
—
—
2,314
0.6
%
Total gross loans receivable, net of deferred fees
349,961
5,921
7,521
363,403
100.0
%
Allowance for loan losses
(3,880
)
—
—
(3,880
)
Total loans, net
$
346,081
$
5,921
$
7,521
$
359,523
Loan Portfolio Maturities
The following table sets forth the maturity distribution of our loans, including the interest rate sensitivity for loans maturing after one year (dollars in thousands).
Rate Structure for Loans
Maturing Over One Year
One Year
or Less
One through
Five Years
Over Five
Years
Total
Fixed
Rate
Floating
Rate
Commercial real estate-mortgage
$
119,165
$
430,911
$
309,951
$
860,027
$
484,199
$
256,663
Consumer real estate-mortgage
46,742
172,854
187,658
407,254
133,332
227,180
Construction and land development
84,855
70,949
32,091
187,895
43,704
59,336
Commercial and industrial
107,826
127,006
73,422
308,254
164,744
35,684
Consumer and other
6,286
6,314
1,209
13,809
6,308
1,215
Total Loans
$
364,874
$
808,034
$
604,331
$
1,777,239
$
832,287
$
580,078
Nonaccrual, Past Due, and Restructured Loans
Loans are considered past due when the contractual amounts due with respect to principal and interest are not received within 30 days of the contractual due date. Loans are generally classified as nonaccrual if they are past due for a period of 90 days or more, unless such loans are well secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or as partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance of interest and principal by the borrower in accordance with the contractual terms.
39
PCI loans with common risk characteristics are grouped in pools at acquisition. These loans are evaluated for accrual status at the pool level rather than the individual loan level and performance is based on our ability to reasonably estimate the amount and timing of future cash flows rather than a borrower's ability to repay contractual loan amounts. Since we are able to reasonably estimate the amount and timing of future cash flows on the Company's PCI loan pools, none of these loans have been identified as nonaccrual. However, PCI loans included in pools are identified as nonperforming if they are past due 90 days or more at acquisition or become 90 days or more past due after acquisition. The past due status is determined based on the contractual terms of the individual loans.
While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to the principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered.
Assets acquired as a result of foreclosure are recorded at estimated fair value in foreclosed assets. Any excess of cost over estimated fair value at the time of foreclosure is charged to the allowance for loan losses. Valuations are periodically performed on these properties, and any subsequent write-downs are charged to earnings. Routine maintenance and other holding costs are included in noninterest expense.
Loans, excluding pooled PCI loans, are classified as troubled debt restructurings (“TDR”) by the Company when certain modifications are made to the loan terms and concessions are granted to the borrowers due to financial difficulty experienced by those borrowers. The Company grants concessions by (1) reduction of the stated interest rate for the remaining original life of the debt or (2) extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk. The Company does not generally grant concessions through forgiveness of principal or accrued interest. The Company’s policy with respect to accrual of interest on loans restructured in a TDR follows relevant supervisory guidance. That is, if a borrower has demonstrated performance under the previous loan terms and shows capacity to perform under the restructured loan terms, continued accrual of interest at the restructured interest rate is likely. If a borrower was materially delinquent on payments prior to the restructuring but shows the capacity to meet the restructured loan terms, the loan will likely continue as nonaccrual until there is demonstrated performance under new terms. Lastly, if the borrower does not perform under the restructured terms, the loan is placed on non-accrual status. The Company closely monitors these loans and ceases accruing interest on them if we believe that the borrowers may not continue performing based on the restructured note terms.
PCI loans that were classified as TDRs prior to acquisition are not classified as TDRs by the Company after the acquisition date. Subsequent modification of a PCI loan accounted for in a pool that would otherwise meet the definition of a TDR is not reported, or accounted for, as a TDR since pooled PCI loans are excluded from the scope of TDR accounting. A PCI loan not accounted for in a pool would be reported, and accounted for, as a TDR if modified in a manner that meets the definition of a TDR after the acquisition date.
Nonperforming loans as a percentage of gross loans, net of deferred fees, was 0.18 percent as of December 31, 2018, compared to 0.25 percent as of December 31, 2017. Total nonperforming assets as a percentage of total assets as of December 31, 2018 totaled 0.25 percent compared to 0.34 percent as of December 31, 2017. Acquired PCI loans that are included in loan pools are reclassified at acquisition to accrual status and thus are not included as nonperforming assets unless they are 90 days or greater past due. In 2018, there was $124 thousand in interest income recognized on nonaccrual and restructured loans compared to the $222 thousand in gross interest income that would have been recognized if the loans had been current in accordance with their original terms.
The following table summarizes the Company's nonperforming assets as of December 31 for the periods presented.
(Dollars in thousands)
2018
2017
2016
2015
2014
Nonaccrual loans
$
2,696
$
1,764
$
1,415
$
2,252
$
5,067
Accruing loans past due 90 days or more (1)
584
1,509
699
502
—
Total nonperforming loans
3,280
3,273
2,114
2,754
5,067
Foreclosed assets
2,495
3,254
2,386
5,358
4,983
Total nonperforming assets
$
5,775
$
6,527
$
4,500
$
8,112
$
10,050
Restructured loans not included above
$
116
$
41
$
166
$
3,693
$
1,937
(1)
Balances include PCI loans past due 90 days or more that are grouped in pools which accrue interest based on pool yields.
40
Potential Problem Loans
At December 31, 2018 problem loans amounted to approximately $784.0 thousand or 0.04 percent of total loans outstanding. Potential problem loans, which are not included in nonperforming loans, represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have doubts about the borrower's ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the Bank's primary regulators, for loans classified as substandard or worse, but not considered nonperforming loans.