<PAGE>
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
--------------------
(Mark One) FORM 10-KSB
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended June 30, 1996
[_] TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from ______________ to _______________
Commission File No. 0-20899
-------
FIRST LANCASTER BANCSHARES, INC.
--------------------------------
(Exact name of registrant as specified in its charter)
Delaware 61-1297318
-------------------------------------- --------------------
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
208 Lexington Street, Lancaster, Kentucky 40444-1131
- ----------------------------------------- ---------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (606) 792-3368
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Common stock, par value $.01 per share
--------------------------------------
(Title of Class)
Check whether the registrant (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or such
shorter period that the registrant was required to file such reports) and (2)
has been subject to such filing requirements for the past
90 days. Yes X No
------- -------
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-B 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-KSB or any amendment to
this Form 10-KSB. [ X ]
Registrant's revenues for the fiscal year ended June 30, 1996: $2,909,429
As of September 25, 1996, the aggregate market value of the 805,940 shares of
Common Stock of the registrant issued and outstanding held by non-affiliates on
such date was approximately $11,182,417 based on the closing sales price of
$13 7/8 per share of the registrant's Common Stock on September 25, 1996 as
listed on the NASDAQ SmallCap Market. For purposes of this calculation, it is
assumed that directors, officers and beneficial owners of more than 5% of the
registrant's outstanding voting stock are affiliates.
Number of shares of Common Stock outstanding as of September 25, 1996: 958,812
Transitional Small Business Disclosure Format Yes No X
------- -------
DOCUMENTS INCORPORATED BY REFERENCE
The following lists the documents incorporated by reference and the Part of the
Form 10-K into which the document is incorporated:
None.
Exhibit Index at Sequentially Numbered Page 51
<PAGE>
PART I
Item 1. Description of Business
--------------------------------
General
First Lancaster Bancshares, Inc. First Lancaster Bancshares, Inc. (the
"Company"), a Delaware corporation, was organized at the direction of the
Board of Directors of First Lancaster Federal Savings Bank, Lancaster,
Kentucky (the "Bank"), in February 1996 to acquire all of the capital stock
to be issued by the Bank in its conversion from mutual to stock form (the
"Conversion"). The Conversion was completed June 28, 1996. Prior to the
Conversion, the Company did not engage in any material operations. The
Company does not have any significant assets other than the outstanding
capital stock of the Bank, a portion of the net proceeds of the Conversion
and a note receivable from the ESOP. The Company's principal business is
the business of the Bank.
First Lancaster Federal Savings Bank. The Bank is a federal savings
bank which operates a single office located in Lancaster, Kentucky serving
Garrard and Jessamine Counties, Kentucky. The Bank was chartered by the
Commonwealth of Kentucky in 1873 under the name Lancaster Building and Loan
Association. The Bank adopted a federal charter and received federal
insurance of its deposit accounts in 1966, at which time it adopted the
name First Lancaster Federal Savings and Loan Association. In 1988 the
Bank converted from a federally chartered mutual savings and loan
association to a federally chartered mutual savings bank and adopted its
present name.
The principal business of the Bank consists of attracting deposits from
the general public and investing these deposits in loans secured by first
mortgages on single-family residences in the Bank's market area. The Bank
derives its income principally from interest earned on loans and, to a
lesser extent, interest earned on mortgage-backed securities and investment
securities and noninterest income. Funds for these activities are provided
principally by operating revenues, deposits and repayments of outstanding
loans and investment securities and mortgage-backed securities.
As a federally chartered savings institution, the Bank is subject to
extensive regulation by the Office of Thrift Supervision (the "OTS"). The
lending activities and other investments of the Bank must comply with
various federal regulatory requirements, and the OTS periodically examines
the Bank for compliance with various regulatory requirements. The Federal
Deposit Insurance Corporation ("FDIC") also has the authority to conduct
special examinations. The Bank must file reports with OTS describing its
activities and financial condition and is also subject to certain reserve
requirements promulgated by the Board of Governors of the Federal Reserve
System ("Federal Reserve Board"). For additional information, see " --
Regulation."
The Company's and the Bank's executive offices are located at 208
Lexington Street, Lancaster, Kentucky 40444-1131, and their telephone
number is (606) 792-3368.
Recent Developments
The Bank's savings deposits are insured by the Savings Association
Insurance Fund ("SAIF"), which is administered by the FDIC. The assessment
rate currently ranges from 0.23% of deposits for well capitalized
institutions to 0.31% of deposits for undercapitalized institutions. The
FDIC also administers the Bank Insurance Fund ("BIF"), which has the same
designated reserve ratio as the SAIF (currently 1.25%). The FDIC has
lowered the deposit insurance assessment rate for most commercial banks
insured by the BIF to the statutory minimum of $2,000 per year. The FDIC
has indicated that the assessment rate for SAIF-insured institutions will
not fall below 0.23% of insured deposits until approximately the year 2002.
The decrease in BIF rates created a substantial disparity in the deposit
insurance premiums paid by savings institutions, such as the Bank, which
are insured by SAIF and institutions insured by the BIF. The lower rates
paid by BIF-insured institutions are likely to give them a significant
competitive advantage over SAIF-insured savings institutions such as the
Bank.
To alleviate this disparity, one proposal being considered by the U.S.
Department of Treasury, the FDIC, and the U.S. Congress provides that a
one-time assessment of as much as 80 basis points be imposed on all SAIF-
insured deposits to cause the SAIF insurance fund to reach its designated
reserve ratio. Once this occurs, the two
2
<PAGE>
funds would be merged into one fund. There can be no assurance that this
proposal or any other proposal will be implemented or that premiums for
either fund will not be adjusted in the future by the FDIC or legislative
action.
The payment of a special assessment would severely and negatively impact
the Bank's results of operations, resulting in a net charge of up to
approximately $124,000, after adjusting for tax benefits. However, if such
a special assessment is imposed and the SAIF is recapitalized, it could
have the effect of reducing the Bank's insurance premiums in the future,
thereby creating equal competition between BIF-insured and SAIF-insured
institutions.
Legislation has also been introduced in Congress that provides for the
elimination of the distinctions between banks and thrifts under federal
law. In its current form, the legislation would require the automatic
conversion of all federally chartered savings associations such as the Bank
into national banks effective January 1, 1998. It would impose activities
restrictions and restrictions on branches, and it would also compel the
holding companies of such institutions to be subject to the more
restrictive regulations that govern holding companies of banks rather than
thrifts. If enacted in its present form, this legislation could restrict
the current or contemplated activities of the Bank and the Company, and it
could also increase regulatory compliance costs because of the new
regulatory structure to which the Bank and the Company would be subject.
Legislation that is effective for tax years beginning after December 31,
1995 would require savings associations to recapture into taxable income
the portion of the tax loan reserve that exceeds the 1987 tax loan loss
reserve. All of the Bank's tax loan loss reserves at June 30, 1996 were
pre 1987 loan loss reserves and therefore this provision should not affect
future operations. The Bank will no longer be allowed to use the reserve
method for tax loan loss provisions, but would be allowed to use either the
experience method or the specific charge-off method of accounting for bad
debts.
Lending Activities
General. The Bank's loan portfolio totaled $31.4 million at June 30,
1996, representing 77.1% of total assets at that date. It is the Bank's
policy to concentrate its lending within its market area. At June 30,
1996, $27.7 million, or 86.6% of the Bank's gross loan portfolio, consisted
of single-family, residential mortgage loans. Other loans secured by real
estate include residential construction loans, which amounted to $2.1
million, or 6.7% of the Bank's gross loan portfolio at June 30, 1996. To a
lesser extent, the Bank originates consumer loans, which consist of loans
secured by deposits. At June 30, 1996, consumer loans totaled $344,000, or
1.1% of the Bank's gross loan portfolio.
3
<PAGE>
Loan Portfolio Composition. The following table sets forth selected
data relating to the composition of the Bank's loan portfolio by type of
loan at the dates indicated. At June 30, 1996, the Bank had no
concentrations of loans exceeding 10% of gross loans other than as
disclosed below.
<TABLE>
<CAPTION>
At June 30,
-----------------------------------
1996 1995
----------------- ----------------
Amount % Amount %
-------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Real estate loans:
Single-family residential................ $27,709 86.6% $26,447 86.9%
Multi-family residential and commercial.. 579 1.8 473 1.6
Construction............................. 2,135 6.7 2,240 7.4
Nonresidential (1)....................... 1,222 3.8 957 3.1
------- ------ ------- ------
Total real estate loans................. 31,645 98.9 30,117 99.0
Consumer loans:
Savings account.......................... 344 1.1 329 1.0
------- ------ ------- ------
31,989 100.0% 30,446 100.0%
====== ======
Less:
Loans in process......................... 462 387
Unearned loan origination fees........... 42 31
Allowance for loan losses................ 100 70
------- -------
Total................................... $31,385 $29,958
======= =======
</TABLE>
- --------------------
(1) Consists of loans secured by first liens on residential lots and loans
secured by first mortgages on commercial real property.
4
<PAGE>
Loan Maturity Schedule. The following table sets forth certain
information at June 30, 1996 regarding the dollar amount of loans maturing
in the Bank's portfolio based on their contractual terms to maturity,
including scheduled repayments of principal. Demand loans, loans having no
stated schedule of repayments and no stated maturity, and overdrafts are
reported as due in one year or less. The table does not include any
estimate of prepayments which significantly shorten the average life of all
mortgage loans and may cause the Bank's repayment experience to differ from
that shown below.
<TABLE>
<CAPTION>
Due after
Due during 1 through Due after
the year ending 5 years after 5 years after
June 30, 1997 June 30, 1996 June 30, 1996 Total
--------------- ------------- ------------- -------
(In thousands)
<S> <C> <C> <C> <C>
Single-family residential.. $ 202 $1,655 $25,852 $27,709
Multi-family residential... -- -- 579 579
Construction............... 513 802 820 2,135
Nonresidential............. 145 419 658 1,222
Consumer................... 290 54 -- 344
------ ------ ------- -------
Total................. $1,150 $2,930 $27,909 $31,989
====== ====== ======= =======
</TABLE>
The following table sets forth at June 30, 1996, the dollar
amount of all loans which have predetermined interest rates and have
floating or adjustable interest rates.
<TABLE>
<CAPTION>
Predetermined Floating or
Rate Adjustable Rates
------------- ----------------
<S> <C> <C>
(In thousands)
Singe-family residential.. $4,470 $23,239
Multi-family residential.. 124 455
Construction.............. 1,339 796
Nonresidential............ 860 362
Consumer.................. -- 344
------ -------
Total.................... $6,793 $25,196
====== =======
</TABLE>
Scheduled contractual principal repayments of loans do not
reflect the actual life of such assets. The average life of loans is
substantially less than their contractual terms because of prepayments. In
addition, due-on-sale clauses on loans generally give the Bank the right to
declare a loan immediately due and payable in the event, among other
things, that the borrower sells the real property subject to the mortgage
and the loan is not repaid. The average life of mortgage loans tends to
increase when current mortgage loan market rates are substantially higher
than rates on existing mortgage loans and, conversely, decrease when
current mortgage loan market rates are substantially lower than rates on
existing mortgage loans.
Originations, Purchases and Sales of Loans. The Bank generally
has authority to originate and purchase loans secured by real estate
located throughout the United States. Consistent with its emphasis on
being a community-oriented financial institution, the Bank concentrates its
lending activities in its market area.
The following table sets forth certain information with respect
to the Bank's loan origination activity for the periods indicated. The
Bank has not purchased or sold any loans in the periods presented.
5
<PAGE>
<TABLE>
<CAPTION>
Year Ended June 30,
-------------------
1996 1995
--------- --------
(In thousands)
<S> <C> <C>
Loans originated:
Real estate loans:
Single-family residential (1).. $ 6,551 $6,186
Construction (2)............... 3,193 3,140
Nonresidential (3)............. 241 157
Consumer loans......................... 194 233
------- ------
Total loans originated........ $10,179 $9,716
======= ======
</TABLE>
- --------------------
(1) Includes home equity loans.
(2) Loans are for six months and must be converted to permanent loans.
(3) Includes loans secured by first liens on residential lots.
The Bank's loan originations are derived from a number of sources,
including referrals by realtors, depositors and borrowers and advertising,
as well as walk-in customers. The Bank's solicitation programs consist of
advertisements in local media, in addition to occasional participation in
various community organizations and events. Real estate loans are
originated by the Bank's loan personnel. All of the Bank's loan personnel
are salaried, and the Bank does not compensate loan personnel on a
commission basis for loans originated. Loan applications are accepted at
the Bank's office.
Loan Underwriting Policies. The Bank's lending activities are subject
to the Bank's written, non-discriminatory underwriting standards and to
loan origination procedures prescribed by the Bank's Board of Directors and
its management. Detailed loan applications are obtained to determine the
borrower's ability to repay, and the more significant items on these
applications are verified through the use of credit reports, financial
statements and confirmations. All loans must be reviewed by the Bank's
loan committee, which is comprised of President Stump and Directors David
W. Gay and Jack C. Zanone and two loan personnel. In addition, the full
Board of Directors reviews and approves all loans on a monthly basis.
Applications for single-family real estate loans are underwritten and
closed in accordance with the standards of FHLMC and Federal National
Mortgage Association ("FNMA") except that, consistent with banking practice
in Kentucky, title opinions rather than title insurance are obtained.
Generally, upon receipt of a loan application from a prospective borrower,
a credit report and verifications are ordered to confirm specific
information relating to the loan applicant's employment, income and credit
standing. If a proposed loan is to be secured by a mortgage on real
estate, an appraisal of the real estate is usually undertaken by an
appraiser approved by the Bank's Board of Directors and licensed or
certified (as necessary) by the Commonwealth of Kentucky. In the case of
single-family residential mortgage loans, except when the Bank becomes
aware of a particular risk of environmental contamination, the Bank
generally does not obtain a formal environmental report on the real estate
at the time a loan is made. A formal environmental report may be required
in connection with nonresidential real estate loans.
It is the Bank's policy to record a lien on the real estate securing a
loan and to obtain a title opinion from Kentucky counsel which provides
that the property is free of prior encumbrances and other possible title
defects. Borrowers must also obtain hazard insurance policies prior to
closing and, when the property is in a flood plain as designated by the
Department of Housing and Urban Development, pay flood insurance policy
premiums.
The Bank is permitted to lend up to 100% of the appraised value of the
real property securing a mortgage loan. The Bank is required by federal
regulations to obtain private mortgage insurance on that portion of the
6
<PAGE>
principal amount of any loan that is greater than 90% of the appraised
value of the property. The Bank will make a single-family residential
mortgage loan for owner-occupied property with a loan-to-value ratio of up
to 89.9% on such loans. For residential properties that are not owner-
occupied, the Bank generally does not lend more than 80% of the appraised
value. For construction loans, the Bank limits the loan-to-value ratio to
85%. The Bank generally limits the loan-to-value ratio on multi-family
residential or commercial real estate mortgage loans to 80%. The federal
banking agencies, including the OTS, have adopted regulations that would
establish new loan-to-value ratio requirements for specific categories of
real estate loans. See "Regulation -- Regulation of the Bank -- Uniform
Lending Standards."
Under applicable law, with certain limited exceptions, loans and
extensions of credit by a savings institution to a person outstanding at
one time shall not exceed 15% of the institution's unimpaired capital and
surplus. Under this general law, the Bank's loans to one borrower were
limited to $2.0 million at June 30, 1996. Loans and extensions of credit
fully secured by readily marketable collateral may comprise an additional
10% of unimpaired capital and surplus. Applicable law additionally
authorizes savings institutions to make loans to one borrower, for any
purpose, in an amount not to exceed $500,000 or in an amount not to exceed
the lesser of $30,000,000 or 30% of unimpaired capital and surplus to
develop residential housing, provided: (i) the purchase price of each
single-family dwelling in the development does not exceed $500,000; (ii)
the savings institution is and continues to be in compliance with its fully
phased-in regulatory capital requirements; (iii) the loans comply with
applicable loan-to-value requirements; (iv) the aggregate amount of loans
made under this authority does not exceed 150% of unimpaired capital and
surplus; and (v) the Director of OTS, by order, permits the savings
institution to avail itself of this higher limit. Under these limits, the
Bank's loans to one borrower to develop residential housing were limited to
$4.0 million at June 30, 1996. At that date, the Bank had no lending
relationships in excess of the loans-to-one-borrower limit. At June 30,
1996, the Bank's largest lending relationship was a $639,000 relationship
consisting of loans to develop single-family residences. All loans within
this relationship were current and performing in accordance with their
terms at June 30, 1996.
Interest rates charged by the Bank on loans are affected principally by
competitive factors, the demand for such loans and the supply of funds
available for lending purposes. These factors are, in turn, affected by
general economic conditions, monetary policies of the federal government,
including the Federal Reserve Board, legislative tax policies and
government budgetary matters.
Single-Family Residential Real Estate Lending. The Bank historically
has been and continues to be an originator of single-family, residential
real estate loans in its market area. At June 30, 1996, single-family
residential mortgage loans, totaled approximately $27.7 million, or 86.6%
of the Bank's gross loan portfolio. Of such loans, $7.5 million were
secured by nonowner-occupied investment properties consisting of single-
family and duplex residential properties. All loans originated by the
Bank are maintained in its portfolio rather than sold in the secondary
market.
The Bank primarily originates residential mortgage loans with adjustable
rates. As of June 30, 1996, 83.9% of single-family mortgage loans in the
Bank's loan portfolio carried adjustable rates. Such loans are primarily
for terms of 30 years, although the Bank does occasionally originate ARM's
for 20 year and 25 year terms, in each case amortized on a monthly basis
with principal and interest due each month. The interest rates on these
mortgages are adjusted once a year, with a maximum adjustment of 2% per
adjustment period and a maximum aggregate adjustment of 5% over the life of
the loan. Further, the interest rates on such loans may not be decreased
by more than 1% below the interest rate at which the loan was originated.
Rate adjustments on the Bank's adjustable-rate loans are indexed to a rate
which adjusts annually based upon changes in an index based on the weekly
average yield on U.S. Treasury securities adjusted to a constant comparable
maturity of one year, as made available by the Federal Reserve Board, and
the adjusted interest rate is equal to such Treasury rate plus 2.75%. The
adjustable-rate mortgage loans offered by the Bank do not provide for
initial rates of interest below the rates that would prevail when the index
used for repricing is applied.
7
<PAGE>
The retention of adjustable-rate loans in the Bank's portfolio helps
reduce the Bank's exposure to increases in prevailing market interest
rates. However, there are unquantifiable credit risks resulting from
potential increases in costs to borrowers in the event of upward repricing
of adjustable-rate loans. It is possible that during periods of rising
interest rates, the risk of default on adjustable-rate loans may increase
due to increases in interest costs to borrowers. Further, although
adjustable-rate loans allow the Bank to increase the sensitivity of its
interest-earning assets to changes in interest rates, the extent of this
interest sensitivity is limited by the initial fixed-rate period before the
first adjustment and the lifetime interest rate adjustment limitations.
Accordingly, there can be no assurance that yields on the Bank's
adjustable-rate loans will fully adjust to compensate for increases in the
Bank's cost of funds. Finally, adjustable-rate loans increase the Bank's
exposure to decreases in prevailing market interest rates, although
decreases in the Bank's cost of funds and the limitations on decreases in
the ARM's interest rate tend to offset this effect.
The Bank also originates, to a limited extent, fixed-rate loans for
terms of 15 years and 20 years. In each case, such loans are secured by
first mortgages on single-family, owner-occupied residential real property
located in the Bank's market area. Because of the Bank's policy to
mitigate its exposure to interest rate risk through the use of adjustable-
rate rather than fixed-rate products, the Bank does not emphasize fixed-
rate mortgage loans. The Bank's Board voted at its August meeting to set
up a 30 year fixed rate loan that would be made available to sell in the
secondary market. The initial loan package to sell will be limited to $1
million. At June 30, 1996, only $6.8 million, or 21.2%, of the Bank's loan
portfolio consisted of fixed-rate mortgage loans. To further reduce its
interest rate risk associated with such loans, the Bank relies upon FHLB
advances with similar maturities to fund such loans. See "-- Deposit
Activity and Other Sources of Funds -- Borrowings."
The Bank engages in construction lending involving loans to individuals
for construction of one- to four-family residential housing located within
the Bank's market area, with such loans converting to permanent financing
upon completion of construction. Such loans are generally made to
individuals for construction primarily in established subdivisions within
Garrard and Jessamine Counties, Kentucky. At June 30, 1996, the Bank's
loan portfolio included $2.1 million of net loans secured by properties
under construction, all of which were construction/permanent loans
structured to become permanent loans upon the completion of construction
and none of which was an interim construction loan structured to be repaid
in full upon completion of construction and receipt of permanent financing.
The Bank also makes a limited amount of loans to qualified builders for the
construction of one- to four-family residential housing located in
established subdivisions in Garrard County, Kentucky. Because such homes
are intended for resale, such loans are generally not converted to
permanent financing at the Bank. All construction loans are secured by a
first lien on the property under construction. Loan proceeds are disbursed
in increments as construction progresses and as inspections warrant.
Construction/permanent loans may have adjustable or fixed interest rates
and are underwritten in accordance with the same terms and requirements as
the Bank's permanent mortgages, except the loans generally provide for
disbursement in stages during a construction period of up to six months,
during which period the borrower is required to make interest-only monthly
payments. The permanent loans are typically 30-year ARM's, with the same
terms and conditions otherwise offered by the Bank. Monthly payments of
principal and interest commence one month from the date the loan is
converted to permanent financing. Borrowers must satisfy all credit
requirements that would apply to the Bank's permanent mortgage loan
financing prior to receiving construction financing for the subject
property and must execute a Construction Loan Agreement with the Bank.
Construction financing generally is considered to involve a higher
degree of risk of loss than long-term financing on improved, occupied real
estate. Risk of loss on a construction loan is dependent largely upon the
accuracy of the initial estimate of the property's value at completion of
construction or development and the estimated cost (including interest) of
construction. During the construction phase, a number of factors could
result in delays and cost overruns. If the estimate of construction costs
proves to be inaccurate, the Bank may be required to advance funds beyond
the amount originally committed to permit completion of the development.
If the estimate of value proves to be inaccurate, the Bank may be
confronted, at or prior to the maturity of the loan, with a project having
a value which is insufficient to assure full repayment. The ability of a
developer to sell developed lots or completed dwelling units will depend
on, among other things, demand, pricing, availability of comparable
properties
8
<PAGE>
and economic conditions. The Bank has sought to minimize this risk by
limiting construction lending to qualified borrowers in the Bank's market
area, by requiring the involvement of qualified builders, and by limiting
the aggregate amount of outstanding construction loans.
Multi-Family Residential and Commercial Real Estate Lending. The Bank's
multi-family residential loan portfolio generally consists of both fixed-
rate and ARM loans secured by small (i.e., fewer than sixteen units)
apartment buildings. Such loans generally range in size from $150,000 to
$285,000. At June 30, 1996, the Bank had $579,000 of multi-family
residential loans and commercial real estate loans, which amounted to 1.8%
of the Bank's gross loan portfolio at such date. The Bank's commercial
real estate portfolio generally consists of fixed-rate or adjustable-rate
loans secured by first mortgages on residential lots upon which single-
family homes will be constructed or upon a business's building and real
property. In each case, such property is located in Garrard or Jessamine
Counties, Kentucky. At June 30, 1996, the Bank had approximately $1.2
million of such loans, which comprised 3.8% of its loan portfolio. Multi-
family and commercial real estate loans either are originated on an
adjustable-rate basis with terms of up to 15 years or on a fixed rate for a
ten-year term and are underwritten with loan-to-value ratios of up to 80%
of the lesser of the appraised value or the purchase price of the property.
Multi-family residential and commercial real estate lending entails
significant additional risks as compared with single-family residential
property lending. Multi-family residential and commercial real estate
loans typically involve larger loan balances to single borrowers or groups
of related borrowers. The payment experience on such loans typically is
dependent on the successful operation of the real estate project, retail
establishment or business. These risks can be significantly impacted by
supply and demand conditions in the market for office, retail and
residential space, and, as such, may be subject to a greater extent to
adverse conditions in the economy generally. To minimize these risks, the
Bank generally limits itself to its market area or to borrowers with which
it has prior experience or who are otherwise known to the Bank. It has
been the Bank's policy to obtain annual financial statements of the
business of the borrower or the project for which multi-family residential
real estate or commercial real estate loans are made.
Consumer and Other Lending. The consumer loans currently in the Bank's
loan portfolio consist of loans secured by savings deposits. Such savings
account loans are usually made for up to 90% of the depositor's savings
account balance. The interest rate is normally 1.25% above the rate paid
on such deposit account serving as collateral, and the account must be
pledged as collateral to secure the loan. Interest generally is billed on
a semi-annual basis. At June 30, 1996, loans on deposit accounts totaled
$344,000, or 1.1% of the Bank's gross loan portfolio.
Loan Fees and Servicing. The Bank receives fees in connection with late
payments and for miscellaneous services related to its loans. The Bank
also charges a 1% fee on all loan originations. The Bank does not service
loans for others.
Nonperforming Loans and Other Problem Assets. It is management's policy
to continually monitor its loan portfolio to anticipate and address
potential and actual delinquencies. When a borrower fails to make a
payment on a loan, the Bank takes immediate steps to have the delinquency
cured and the loan restored to current status. Loans which are delinquent
45 days incur a late fee of 5.0% of principal and interest due. As a
matter of policy, the Bank will contact the borrower after the loan has
been delinquent 30 days. If payment is not promptly received, the borrower
is contacted again, and efforts are made to formulate an affirmative plan
to cure the delinquency. Generally, after any loan is delinquent 90 days
or more, formal legal proceedings are commenced to collect amounts owed.
Loans are placed on nonaccrual status if the loan becomes past due more
than 90 days unless such loans are well-secured and in the process of
collection. Loans are charged off when management concludes that they are
uncollectible. See Note 1 of Notes to Consolidated Financial Statements.
Real estate acquired by the Bank as a result of foreclosure is
classified as real estate acquired through foreclosure until such time as
it is sold. When such property is acquired, it is initially recorded at
estimated fair
9
<PAGE>
value and subsequently at the lower of book value or fair value, less
estimated costs to sell. Costs relating to holding such real estate are
charged against income in the current period, while costs relating to
improving such real estate are capitalized until a saleable condition is
reached. Any required write-down of the loan to its fair value less
estimated selling costs upon foreclosure is charged against the allowance
for loan losses. See Note 1 of Notes to Financial Statements.
The following table sets forth information with respect to the Bank's
nonperforming assets at the dates indicated. Further, no loans were
recorded as restructured loans within the meaning of SFAS No. 15 at the
dates indicated.
<TABLE>
<CAPTION>
At June 30,
---------------------
1996 1995
-------- ---------
(Dollars in thousands)
<S> <C> <C>
Loans accounted for on a non-accrual basis: (1)
Real estate:
Residential................................ $ 231 $ 316
Accruing loans which are contractually past
due 90 days................................... 76 90
----- -----
Total nonperforming loans.................. $ 307 $ 406
===== =====
Percentage of real estate loans.................. 0.97% 1.35%
===== =====
Other non-performing assets (2).................. $ 169 $ 10
===== =====
</TABLE>
- --------------------
(1) Loans, including impaired loans, are generally classified as
nonaccrual if they are past due as to maturity or payment of principal
or interest for a period of more than 90 days, unless such loans are
well-secured and in the process of collection. 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/or
interest is in doubt.
(2) Other nonperforming assets represent property acquired by the Bank
through foreclosure or repossession. This property is carried at fair
market value.
For the year ended June 30, 1996, gross interest accrued but not
recognized of $10,160, would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current.
At June 30, 1996, nonaccrual loans consisted of nine single-family
residential real estate loans totalling $231,000 and represented a decrease
of $85,000, or 26.9%, from nonaccrual loans of $316,000 at June 30, 1995.
At June 30, 1996, the Bank had $76,000 of loans 90 days or more delinquent
but still accruing. The balance was either subsequently paid off or
brought current, except $12,000 of loans which are still delinquent.
At June 30, 1996, other non-performing assets consisted of one single-
family residence with a carrying value of $169,000. The property was
transferred from nonaccrual loans to real estate owned in April 1996. For
further information regarding this property, see "Item 6. Management's
Discussion and Analysis of Financial Condition and Results of Operations --
Comparison of Financial Condition at June 30, 1996 and June 30, 1995."
At June 30, 1996, the Bank had no loans outstanding that were not
classified as non-accrual, 90 days past due or restructured but as to which
known information about possible credit problems of borrowers caused
management to have serious concerns as to the ability of the borrowers to
comply with present loan repayment terms and may result in disclosure as
non-accrual, 90 days past due or restructured.
Federal regulations require savings institutions to classify their
assets on the basis of quality on a regular basis. An asset meeting one of
the classification definitions set forth below may be classified and still
be a performing loan. An asset is classified as substandard if it is
determined to be inadequately protected by the current retained earnings
and paying capacity of the obligor or of the collateral pledged, if any.
An asset is classified as
10
<PAGE>
doubtful if full collection is highly questionable or improbable. An asset
is classified as loss if it is considered uncollectible, even if a partial
recovery could be expected in the future. The regulations also provide for
a special mention designation, described as assets which do not currently
expose a savings institution to a sufficient degree of risk to warrant
classification but do possess credit deficiencies or potential weaknesses
deserving management's close attention. Such assets designated as special
mention may include nonperforming loans consistent with the above
definition. Assets classified as substandard or doubtful require a savings
institution to establish general allowances for loan losses. If an asset
or portion thereof is classified loss, a savings institution must either
establish a specific allowance for loss in the amount of the portion of the
asset classified loss, or charge off such amount. Federal examiners may
disagree with a savings institution's classifications. If a savings
institution does not agree with an examiner's classification of an asset,
it may appeal this determination to the OTS Regional Director. The Bank
regularly reviews its assets to determine whether any assets require
classification or re-classification. At June 30, 1996, the Bank had
$449,000 in assets classified as special mention, $521,000 in assets
classified as substandard, no assets classified as doubtful and no assets
classified as loss. Special mention assets consist primarily of
residential real estate loans secured by first mortgages. This
classification is primarily used by management as a "watch list" to monitor
loans that exhibit any potential deviation in performance from the
contractual terms of the loan. Substandard assets are also primarily
residential real estate loans, the highest balance to a single borrower, of
which was $60,393 at June 30, 1996 secured by a single-family residence.
Allowance for Loan Losses. In originating loans, the Bank recognizes
that credit losses will be experienced and that the risk of loss will vary
with, among other things, the type of loan being made, the creditworthiness
of the borrower over the term of the loan, general economic conditions and,
in the case of a secured loan, the quality of the security for the loan.
It is management's policy to maintain an adequate allowance for loan losses
based on, among other things, the Bank's and the industry's historical loan
loss experience, evaluation of economic conditions, regular reviews of
delinquencies and loan portfolio quality and evolving standards imposed by
federal bank examiners. The Bank increases its allowance for loan losses
by charging provisions for possible loan losses against the Bank's income.
Management will continue to actively monitor the Bank's asset quality
and allowance for loan losses. Management will charge off loans and
properties acquired in settlement of loans against the allowances for
losses on such loans and such properties when appropriate and will provide
specific loss allowances when necessary. Although management believes it
uses the best information available to make determinations with respect to
the allowances for loan losses and believes such allowances are adequate,
future adjustments may be necessary if economic conditions differ
substantially from the economic conditions in the assumptions used in
making the initial determinations.
The Bank's methodology for establishing the allowance for loan losses
takes into consideration probable losses that have been identified in
connection with specific assets as well as losses that have not been
identified but can be expected to occur. Management conducts regular
reviews of the Bank's assets and evaluates the need to establish allowances
on the basis of this review. Allowances are established by the Board of
Directors on a quarterly basis based on an assessment of risk in the Bank's
assets taking into consideration the composition and quality of the
portfolio, delinquency trends, current charge-off and loss experience, loan
concentrations, the state of the real estate market, regulatory reviews
conducted in the regulatory examination process and economic conditions
generally. Specific reserves will be provided for individual assets, or
portions of assets, when ultimate collection is considered improbable by
management based on the current payment status of the assets and the fair
value of the security. At the date of foreclosure or other repossession,
the Bank would transfer the property to real estate acquired in settlement
of loans initially at estimated fair value and subsequently at the lower of
book value or fair value less estimated selling costs. Any portion of the
outstanding loan balance in excess of fair value less estimated selling
costs would be charged off against the allowance for loan losses. If, upon
ultimate disposition of the property, net sales proceeds exceed the net
carrying value of the property, a gain on sale of real estate would be
recorded.
Banking regulatory agencies, including the OTS, have adopted a policy
statement regarding maintenance of an adequate allowance for loan and lease
losses and an effective loan review system. This policy includes an
arithmetic formula for determining the reasonableness of an institution's
allowance for loan loss estimate compared
11
<PAGE>
to the average loss experience of the industry as a whole. Examiners will
review an institution's allowance for loan losses and compare it against
the sum of: (i) 50% of the portfolio that is classified doubtful; (ii) 15%
of the portfolio that is classified as substandard; and (iii) for the
portions of the portfolio that have not been classified (including those
loans designated as special mention), estimated credit losses over the
upcoming 12 months given the facts and circumstances as of the evaluation
date. This amount is considered neither a "floor" nor a "safe harbor" of
the level of allowance for loan losses an institution should maintain, but
examiners will view a shortfall relative to the amount as an indication
that they should review management's policy on allocating these allowances
to determine whether it is reasonable based on all relevant factors.
The following table sets forth an analysis of the Bank's allowance for
loan losses for the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
------------------------
1996 1995
------------ ----------
(Dollars in Thousands)
<S> <C> <C>
Balance at beginning of period.......... $ 70 $ 70
----- -----
Loans charged off:
Real estate mortgage:
Residential....................... 11 6
----- -----
Total charge-offs....................... 11 6
----- -----
Recoveries.............................. -- --
----- -----
Net loans charged off................... 11 6
----- -----
Provision for loan losses............... 41 6
----- -----
Balance at end of period................ $ 100 $ 70
===== =====
Ratio of net charge-offs to average
loans outstanding during the period.. .04% .02%
===== =====
</TABLE>
The following table allocates the allowance for loan losses by
loan category at the dates indicated. The allocation of the allowance to
each category is not necessarily indicative of future losses and does not
restrict the use of the allowance to absorb losses in any category.
<TABLE>
<CAPTION>
At June 30,
----------------------------------------------
1996 1995
---------------------- -----------------------
Percent of Percent of
Loans in Each Loans in Each
Category to Category to
Amount Total Loans Amount Total Loans
------ -------------- ------ --------------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Real estate - mortgage:
Residential........................ $100 88.4% $70 88.5%
---- ------
Total allowance for loan losses.. $100 $70
==== ======
</TABLE>
12
<PAGE>
Investment Activities
General. The Bank is permitted under federal law to make certain
investments, including investments in securities issued by various federal
agencies and state and municipal governments, deposits at the FHLB of
Cincinnati, certificates of deposit in federally insured institutions,
certain bankers' acceptances and federal funds. It may also invest,
subject to certain limitations, in commercial paper rated in one of the two
highest investment rating categories of a nationally recognized credit
rating agency, and certain other types of corporate debt securities and
mutual funds. Federal regulations require the Bank to maintain an
investment in FHLB stock and a minimum amount of liquid assets which may be
invested in cash and specified securities. From time to time, the OTS
adjusts the percentage of liquid assets which savings banks are required to
maintain. See " -- Regulation -- Regulation of the Bank Liquidity
Requirements."
The Bank makes investments in order to maintain the levels of
liquid assets required by regulatory authorities and manage cash flow,
diversify its assets, obtain yield and to satisfy certain requirements for
favorable tax treatment. The investment activities of the Bank consist
primarily of investments in mortgage-backed securities and other investment
securities, consisting primarily of securities issued or guaranteed by the
U.S. government or agencies thereof. Typical investments include federally
sponsored agency mortgage pass-through and federally sponsored agency and
mortgage-related securities. Investment and aggregate investment
limitations and credit quality parameters of each class of investment are
prescribed in the Bank's investment policy. The Bank performs analyses of
mortgage-related securities prior to purchase and on an ongoing basis to
determine the impact on earnings and market value under various interest
rate and prepayment conditions. Under the Bank's current investment
policy, securities purchases must be approved by the Bank's President and
Executive Vice President, both of whom also serve as directors of the Bank.
The Board of Directors reviews all securities transactions on a monthly
basis.
The Bank adopted SFAS No. 115 as of July 1, 1994. Pursuant to
SFAS No. 115, the Bank has classified securities with an aggregate cost of
$24,158 and an approximate market value of $527,364 at June 30, 1996 as
available for sale. Management of the Bank presently does not intend to
sell such securities and, based on the Bank's current liquidity level and
the Bank's access to borrowings through the FHLB of Cincinnati, management
currently does not anticipate that the Bank will be placed in a position of
having to sell securities with material unrealized losses.
Securities designated as "held to maturity" are those assets
which the Bank has the ability and intent to hold to maturity. Upon
acquisition, securities are classified as to the Bank's intent, and a sale
would only be effected due to deteriorating investment quality. The held
to maturity investment portfolio is not used for speculative purposes and
is carried at amortized cost. In the event the Bank sells securities from
this portfolio for other than credit quality reasons, all securities within
the investment portfolio with matching characteristics may be reclassified
as assets available for sale. Securities designated as "available for
sale" are those assets which the Bank may not hold to maturity and thus are
carried at market value with unrealized gains or losses, net of tax effect,
recognized in retained earnings.
Mortgage-Backed and Related Securities. Mortgage-backed
securities represent a participation interest in a pool of single-family or
multi-family mortgages, the principal and interest payments on which are
passed from the mortgage originators through intermediaries that pool and
repackage the participation interest in the form of securities to investors
such as the Bank. Such intermediaries may include quasi-governmental
agencies such as FHLMC, FNMA and GNMA which guarantee the payment of
principal and interest to investors. Mortgage-backed securities generally
increase the quality of the Bank's assets by virtue of the guarantees that
back them, are more liquid than individual mortgage loans and may be used
to collaterize borrowings or other obligations of the Bank.
13
<PAGE>
Mortgage-backed securities typically are issued with stated
principal amounts and the securities are backed by pools of mortgages that
have loans with interest rates that are within a range and have similar
maturities. The underlying pool of mortgages can be composed of either
fixed-rate or adjustable-rate mortgage loans. Mortgage-backed securities
generally are referred to as mortgage participation certificates or pass-
through certificates. As a result, the interest rate risk characteristics
of the underlying pool of mortgages, i.e., fixed-rate or adjustable-rate,
as well as prepayment risk, are passed on to the certificate holder. The
life of a mortgage-backed pass-through security is equal to the life of the
underlying mortgages.
The actual maturity of a mortgage-backed security varies,
depending on when the mortgagors prepay or repay the underlying mortgages.
Prepayments of the underlying mortgages may shorten the life of the
investment, thereby adversely affecting its yield to maturity and the
related market value of the mortgage-backed security. The yield is based
upon the interest income and the amortization of the premium or accretion
of the discount related to the mortgage-backed security. Premiums and
discounts on mortgage-backed securities are amortized or accredited over
the estimated term of the securities using a level yield method. The
prepayment assumptions used to determine the amortization period for
premiums and discounts can significantly affect the yield of the mortgage-
backed security, and these assumptions are reviewed periodically to reflect
the actual prepayment. The actual prepayments of the underlying mortgages
depend on many factors, including the type of mortgage, the coupon rate,
the age of the mortgages, the geographical location of the underlying real
estate collateralizing the mortgages and general levels of market interest
rates. The difference between the interest rates on the underlying
mortgages and the prevailing mortgage interest rates is an important
determinant in the rate of prepayments. During periods of falling mortgage
interest rates, prepayments generally increase, and, conversely, during
periods of rising mortgage interest rates, prepayments generally decrease.
If the coupon rate of the underlying mortgage significantly exceeds the
prevailing market interest rates offered for mortgage loans, refinancing
generally increases and accelerates the prepayment of the underlying
mortgages. Prepayment experience is more difficult to estimate for
adjustable-rate mortgage-backed securities.
The Bank's mortgage-backed and related securities portfolio
consists primarily of seasoned fixed-rate and adjustable-rate, mortgage-
backed and related securities. The Bank makes such investments in order to
manage cash flow, diversify assets, obtain yield, to satisfy certain
requirements for favorable tax treatment and to satisfy the qualified
thrift lender test. See " -- Regulation -- Regulation of the Bank --
Qualified Thrift Lender Test."
The following table sets forth the carrying value of the Bank's
investment securities at the dates indicated.
<TABLE>
<CAPTION>
At June 30,
--------------------
1996 1995
---- ----
<S> <C> <C>
(Dollars in thousands)
Securities available for sale:
U.S. government and agency securities.. $ 527 $ 424
Securities held to maturity:
Mortgage-backed securities............. 115 144
----- -----
Total investment securities......... $ 642 $ 568
===== =====
</TABLE>
14
<PAGE>
The following table sets forth information in the scheduled
maturities, amortized cost, market values and average yields for the Bank's
investment portfolio at June 30, 1996.
<TABLE>
<CAPTION>
One Year or Less One to Five Years Five to Ten Years More than Ten Years Total Investment Portfolio
------------------- ------------------ ------------------ ------------------- --------------------------
Carrying Average Carrying Average Carrying Average Carrying Average Carrying Market Average
Value Yield Value Yield Value Yield Value Yield Value Value Yield
--------- ------- --------- ------- -------- -------- -------- --------- -------- ------ --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Securities available
for sale:
U.S. government
and agency
securities........ $ 527 31.9%(1) $ -- --% $ -- --% $ -- --% $ 527 $ 527 31.9%(1)
Securities held to
maturity:
Mortgage-backed
securities........ $ -- -- 9 9.4% 32 8.3% 74 12.0% 115 125 10.8%
-------- -------- -------- -------- ------- -----
Total............. $ 527 31.9% $ 9 9.4% $ 32 8.3% $ 74 12.0% $ 642 $ 652 10.8%
======== ======== ======== ======== ======= =====
</TABLE>
- --------------
(1) Based on historical cost of $24,000.
15
<PAGE>
The Bank is required to maintain average daily balances of liquid
assets (cash, deposits maintained pursuant to Federal Reserve Board
requirements, time and savings deposits in certain institutions,
obligations of state and political subdivisions thereof, shares in mutual
funds with certain restricted investment policies, highly rated corporate
debt, and mortgage loans and mortgage-backed securities with less than one
year to maturity or subject to repurchase within one year) equal to a
monthly average of not less than a specified percentage (currently 5%) of
its net withdrawable savings deposits plus short-term borrowings. Monetary
penalties may be imposed for failure to meet liquidity requirements. The
average liquidity ratio of the Bank for the month of June 30, 1996 was
31.4%. See "Item 6. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Liquidity and Capital Resources."
Deposit Activity and Other Sources of Funds
General. Deposits are the primary source of the Bank's funds for
lending, investment activities and general operational purposes. In
addition to deposits, the Bank derives funds from loan principal and
interest repayments, maturities of investment securities and mortgage-
backed securities and interest payments thereon. Although loan repayments
are a relatively stable source of funds, deposit inflows and outflows are
significantly influenced by general interest rates and money market
conditions. Borrowings may be used on a short-term basis to compensate for
reductions in the availability of funds, or on a longer term basis for
general operational purposes. The Bank has access to borrow from the FHLB
of Cincinnati. See " -- Borrowings".
Deposits. The Bank attracts deposits principally from within its
market area by offering competitive rates on its deposit instruments,
including money market accounts, passbook savings accounts, Individual
Retirement Accounts, and certificates of deposit which range in maturity
from 91 days to five years. Deposit terms vary according to the minimum
balance required, the length of time the funds must remain on deposit and
the interest rate. Maturities, terms, service fees and withdrawal
penalties for its deposit accounts are established by the Bank on a
periodic basis. The Bank reviews its deposit mix and pricing on a weekly
basis. In determining the characteristics of its deposit accounts, the Bank
considers the rates offered by competing institutions, lending and
liquidity requirements, growth goals and federal regulations. The Bank
does not accept brokered deposits.
The Bank attempts to compete for deposits with other institutions
in its market area by offering competitively priced deposit instruments
that are tailored to the needs of its customers. Additionally, the Bank
seeks to meet customers' needs by providing convenient customer service to
the community, efficient staff and convenient hours of service.
Substantially all of the Bank's depositors are Kentucky residents who
reside in the Bank's market area.
The following table sets forth the change in dollar amount of
deposits in the various types of accounts offered by the Bank between the
dates indicated.
<TABLE>
<CAPTION>
Increase
Balance at (Decrease) Balance at
June 30, % of from June 30, June 30, % of
1996 Deposits 1995 1995 Deposits
---------- --------- -------------- ---------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Passbook and regular savings.. $ 2,218 9.4% $ 714 $ 1,504 6.2%
Money market deposit.......... 1,916 8.2 (554) 2,470 10.2
Certificates of deposit....... 19,349 82.4 (863) 20,212 83.6
------- ----- ----- ------- -----
Total.................... $23,483 100.0% $(703) $24,186 100.0%
======= ===== ===== ======= =====
</TABLE>
16
<PAGE>
The following table sets forth the time deposits in the Bank
classified by rates at the dates indicated.
<TABLE>
<CAPTION>
At June 30,
--------------------
1996 1995
----------- -------
(In thousands)
<S> <C> <C>
2.00 - 3.99%..................... $ 254 $ 299
4.00 - 5.99%..................... 12,137 11,575
6.00 - 7.99%..................... 6,958 8,339
------- -------
$19,349 $20,213
======= =======
</TABLE>
The following table sets forth the amount and maturities of time
deposits at June 30, 1996.
<TABLE>
<CAPTION>
Amount Due
------------------------------------------------
After
Rate 0-1 Year 1-2 Years 2-3 Years 3 Years Total
- ---------------- -------- --------- --------- ------- -------
(In thousands)
<S> <C> <C> <C> <C> <C>
2.00 - 3.99%.. $ 79 $ 138 $ 37 $ -- $ 254
4.00 - 5.99%.. 10,338 1,256 435 108 12,137
6.00 - 7.99%.. 3,476 2,026 67 1,389 6,958
------- ------ ------ ------- -------
$13,893 $ 3,420 $ 539 $1,497 $19,349
======= ======= ====== ====== =======
</TABLE>
The following table indicates the amount of the Bank's
certificates of deposit of $100,000 or more by time remaining until
maturity as of June 30, 1996.
<TABLE>
<CAPTION>
Certificates
Maturity Period of Deposits
--------------- --------------
(In thousands)
<S> <C>
Three months or less........... $ 512
Over three through six months.. 310
Over six through 12 months..... 715
Over 12 months................. 945
------
Total........................ $2,482
======
</TABLE>
The following table sets forth the savings activities of the Bank
for the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
---------------------
1996 1995
---------- ---------
(In thousands)
<S> <C> <C>
Deposits........................................... $22,938 $6,058
Withdrawals........................................ 24,856 6,268
------- ------
Net decrease before interest credited.............. (1,918) (210)
Interest credited.................................. 1,214 879
------- ------
Net increase (decrease) in savings deposits.... $ (704) $ 669
======= ======
</TABLE>
17
<PAGE>
Borrowings. Savings deposits historically have been the primary
source of funds for the Bank's lending, investments and general operating
activities. The Bank is authorized, however, to use advances from the FHLB
of Cincinnati to supplement its supply of lendable funds and to meet
deposit withdrawal requirements. The FHLB of Cincinnati functions as a
central reserve bank providing credit for savings institutions and certain
other member financial institutions. As a member of the FHLB System, the
Bank is required to own stock in the FHLB of Cincinnati and is authorized
to apply for advances. Advances are pursuant to several different
programs, each of which has its own interest rate and range of maturities.
The Bank has a Blanket Agreement for advances with the FHLB under which the
Bank may borrow up to 25% of assets (approximately $10.2 million), subject
to normal collateral and underwriting requirements. Advances from the FHLB
of Cincinnati are secured by the Bank's stock in the FHLB of Cincinnati and
first mortgage loans.
As of June 30, 1996, the Bank had $3.5 million in advances
outstanding. For further information, see Note 9 of Notes to Consolidated
Financial Statements. Further asset growth may be funded through
additional advances. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."
Subsidiary Activities
As a federally chartered savings bank, the Bank is permitted to invest
an amount equal to 2% of its assets in subsidiaries, with an additional
investment of 1% of assets where such investment serves primarily
community, inner-city and community development purposes. Under such
limitations, as of June 30, 1996, the Bank was authorized to invest up to
approximately $1.2 million in the stock of or loans to subsidiaries,
including the additional 1% investment for community inner-city and
community development purposes. Institutions meeting their applicable
minimum regulatory capital requirements may invest up to 50% of their
regulatory capital in conforming first mortgage loans to subsidiaries in
which they own 10% or more of the capital stock.
The Bank has one subsidiary service corporation, First Lancaster
Corporation, which it formed in 1978 to hold stock in Intrieve, Inc., a
data processing service.
Market Area
The Bank's market area for gathering deposits and making loans
consists of Garrard and Jessamine Counties, Kentucky, which are located
south of Lexington, Kentucky. The economy in the Bank's market area is
based upon a variety of manufacturing and service industries within a one-
hour drive from its office in Lancaster Kentucky rather than a single large
employer or a single industry. Such industries include an automobile and
truck manufacturer, a computer printer manufacturer, an electrical
equipment manufacturer, a printing company and a heating and air
conditioning equipment manufacturer. Other significant employers include
the Garrard County school system and the Christian Appalachian Project, a
nonprofit organization with over 300 employees.
Competition
The Bank faces strong competition both in originating real estate and
consumer loans and in attracting deposits. The Bank competes for real
estate and other loans principally on the basis of interest rates, the
types of loans it originates, the deposit products it offers and the
quality of services it provides to borrowers. The Bank also competes by
offering products which are tailored to the local community. Its
competition in originating real estate loans comes primarily from other
savings institutions, commercial banks and mortgage bankers making loans
secured by real estate located in the Bank's market area. Commercial
banks, credit unions and finance companies provide vigorous competition in
consumer lending. Competition may increase as a result of the continuing
reduction of restrictions on the interstate operations of financial
institutions.
18
<PAGE>
The Bank attracts its deposits through its sole office primarily from
the local community. Consequently, competition for deposits is principally
from other savings institutions, commercial banks and brokers in the local
community as well as from the corporate credit unions sponsored by the
large private employers in the Bank's market area. The Bank competes for
deposits and loans by offering what it believes to be a variety of deposit
accounts at competitive rates, convenient business hours, a commitment to
outstanding customer service and a well-trained staff. The Bank believes it
has developed strong relationships with local realtors and the community in
general.
Management considers its market area for gathering deposits to be
Garrard and Jessamine Counties in Kentucky. The Bank estimates that it
competes with two banks for deposits and loans. Based on data provided by
the FHLB, the Bank estimates that at June 30, 1996, the latest date for
which information was available, it had 20.2% of deposits held by all banks
and thrifts in its market area.
Employees
As of June 30, 1996, the Bank had eight full-time and two part-time
employee(s), none of whom were represented by a collective bargaining
agreement. Management considers the Bank's relationships with its
employees to be good.
Regulation
Regulation of the Company
General. The Company is a savings and loan holding company as defined
by the Home Owners' Loan Act. As such, the Company is subject to OTS
regulation, examination, supervision and reporting requirements. As a
subsidiary of a savings and loan holding company, the Bank is subject to
certain restrictions in its dealings with the Company and affiliates
thereof.
Activities Restrictions. The Board of Directors of the Company
presently operates the Company as a unitary savings and loan holding
company. There are generally no restrictions on the activities of a
unitary savings and loan holding company. However, if the Director of the
OTS determines that there is reasonable cause to believe that the
continuation by a savings and loan holding company of an activity
constitutes a serious risk to the financial safety, soundness or stability
of its subsidiary savings institution, the Director of the OTS may impose
such restrictions as deemed necessary to address such risk including
limiting: (i) payment of dividends by the savings institution; (ii)
transactions between the savings institution and its affiliates; and (iii)
any activities of the savings institution that might create a serious risk
that the liabilities of the holding company and its affiliates may be
imposed on the savings institution. Notwithstanding the above rules as to
permissible business activities of unitary savings and loan holding
companies, if the savings institution subsidiary of such a holding company
fails to meet the QTL test, then such unitary holding company shall also
presently become subject to the activities restrictions applicable to
multiple holding companies and, unless the savings institution requalifies
as a QTL within one year thereafter, register as, and become subject to,
the restrictions applicable to a bank holding company. See "Regulation of
the Bank -- Qualified Thrift Lender Test."
If the Company were to acquire control of another savings institution,
other than through merger or other business combination with the Bank, the
Company would thereupon become a multiple savings and loan holding company.
Except where such acquisition is pursuant to the authority to approve
emergency thrift acquisitions and where each subsidiary savings institution
meets the QTL test, the activities of the Company and any of its
subsidiaries (other than the Bank or other subsidiary savings institutions)
would thereafter be subject to further restrictions. Among other things,
no multiple savings and loan holding company or subsidiary thereof which is
not a savings institution shall commence or continue for a limited period
of time after becoming a multiple savings and loan holding company or
subsidiary thereof, any business activity, upon prior notice to, and no
objection by, the OTS, other than: (i) furnishing or performing management
services for a subsidiary savings institution; (ii) conducting an
19
<PAGE>
insurance agency or escrow business; (iii) holding, managing, or
liquidating assets owned by or acquired from a subsidiary savings
institution; (iv) holding or managing properties used or occupied by a
subsidiary savings institution; (v) acting as trustee under deeds of trust;
(vi) those activities authorized by regulation as of March 5, 1987 to be
engaged in by multiple holding companies; or (vii) unless the Director of
the OTS by regulation prohibits or limits such activities for savings and
loan holding companies, those activities authorized by the Federal Reserve
Board as permissible for bank holding companies. Those activities described
in (vii) above must also be approved by the Director of the OTS prior to
being engaged in by a multiple holding company.
Legislation has been passed by the U.S. House of Representatives which
would subject all unitary holding companies to the same restrictions on
activities as are currently applied to multiple holding companies. If such
legislation is enacted in its current form, the ability of the Company to
engage in certain activities that are currently permitted to a unitary
holding company may be restricted. Since the Company does not and has no
current plans to engage in any business activity impermissible for a
multiple holding company, such legislation would not require the Company to
discontinue any current activity. No prediction can be made at this time
as to whether such legislation will be enacted or whether it will be
enacted in its current form.
Restrictions on Acquisitions. Savings and loan holding companies are
prohibited from acquiring, without prior approval of the Director of OTS,
(i) control of any other savings institution or savings and loan holding
company or substantially all the assets thereof or (ii) more than 5% of the
voting shares of a savings institution or holding company thereof which is
not a subsidiary. Under certain circumstances, a registered savings and
loan holding company is permitted to acquire, with the approval of the
Director of the OTS, up to 15% of the voting shares of an under-capitalized
savings institution pursuant to a "qualified stock issuance" without that
savings institution being deemed controlled by the holding company. In
order for the shares acquired to constitute a "qualified stock issuance,"
the shares must consist of previously unissued stock or treasury shares,
the shares must be acquired for cash, the savings and loan holding
company's other subsidiaries must have tangible capital of at least 6-1/2%
of total assets, there must not be more than one common director or officer
between the savings and loan holding company and the issuing savings
institution, and transactions between the savings institution and the
savings and loan holding company and any of its affiliates must conform to
Sections 23A and 23B of the Federal Reserve Act. Except with the prior
approval of the Director of the OTS, no director or officer of a savings
and loan holding company or person owning or controlling by proxy or
otherwise more than 25% of such company's stock, may also acquire control
of any savings institution, other than a subsidiary savings institution, or
of any other savings and loan holding company.
The Director of the OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls
savings institutions in more than one state if: (i) the multiple savings
and loan holding company involved controls a savings institution which
operated a home or branch office in the state of the institution to be
acquired as of March 5, 1987; (ii) the acquiror is authorized to acquire
control of the savings institution pursuant to the emergency acquisition
provisions of the Federal Deposit Insurance Act; or (iii) the statutes of
the state in which the institution to be acquired is located specifically
permit institutions to be acquired by state-chartered institutions or
savings and loan holding companies located in the state where the acquiring
entity is located (or by a holding company that controls such state-
chartered savings institutions).
Regulation of the Bank
General. The Bank is a federally chartered savings institution, is a
member of the FHLB of Cincinnati and its deposits are insured by the FDIC
through the SAIF. As a federal savings institution, the Bank is subject to
regulation and supervision by the OTS and the FDIC and to OTS regulations
governing such matters as capital standards, mergers, establishment of
branch offices, subsidiary investments and activities and general
investment authority. The OTS periodically examines the Bank for
compliance with various regulatory requirements and for safe and sound
operations. The FDIC also has the authority to conduct special
examinations of the Bank because its deposits are insured by the SAIF. The
Bank must file reports with the OTS describing its activities and financial
condition and must obtain the approval of the OTS prior to entering into
certain transactions, such as mergers with or acquisitions of other
depository institutions.
20
<PAGE>
As a federally insured depository institution the Bank is subject to
various regulations promulgated by the Federal Reserve Board, including
Regulation B (Equal Credit Opportunity), Regulation D (Reserve
Requirements), Regulations E (Electronic Fund Transfers), Regulation Z
(Truth in Lending), Regulation CC (Availability of Funds and Collection of
Checks) and Regulation DD (Truth in Savings).
The system of regulation and supervision applicable to the Bank
establishes a comprehensive framework for the operations of the Bank and is
intended primarily for the protection of the depositors of the Bank.
Changes in the regulatory framework could have a material effect on the
Bank and its operations that in turn, could have a material adverse effect
on the Company.
Capital Requirements. Under OTS capital standards, savings
associations must maintain "tangible" capital equal to 1.5% of adjusted
total assets, "core" capital equal to 3% of adjusted total assets, and a
combination of core and "supplementary" capital equal to 8% of "risk-
weighted" assets. In addition, the OTS has adopted regulations which
impose certain restrictions on savings associations that have a total risk-
based capital ratio that is less than 8%, a ratio of Tier 1 capital to
risk-weighted assets of less than 4% or a ratio of Tier 1 capital to
adjusted total assets of less than 4% (or 3% if the institution is rated
CAMEL 1 under the OTS examination rating system). See "--Prompt Corrective
Regulatory Action." The Bank is in compliance with all currently
applicable capital requirements. For purposes of this regulation, Tier 1
capital has the same definition as core capital which is defined as common
stockholders' equity (including retained earnings), noncumulative perpetual
preferred stock and related surplus, minority interests in the equity
accounts of fully consolidated subsidiaries, certain nonwithdrawable
accounts and pledged deposits and "qualifying supervisory goodwill." Core
capital is generally reduced by the amount of the savings association's
intangible assets for which no market exists. Limited exceptions to the
deduction of intangible assets are provided for mortgage servicing rights,
purchased credit card relationships and qualifying supervisory goodwill
held by an eligible savings association. Tangible capital is given the
same definition as core capital but does not include an exception for
qualifying supervisory goodwill and is reduced by the amount of all the
savings association's intangible assets with only a limited exception for
mortgage servicing rights and purchased credit card relationships.
Both core and tangible capital are further reduced by an amount equal
to a gradually increasing percentage of the savings association's debt and
equity investments in subsidiaries engaged in activities not permissible
for national banks, other than subsidiaries engaged in activities
undertaken as agent for customers or in mortgage banking activities and
subsidiary depository institutions or holding companies. At June 30, 1996,
the Bank had no such investments.
Adjusted total assets are a savings association's total assets as
determined under generally accepted accounting principles, increased for
certain goodwill amounts and increased by a prorated portion of the assets
of subsidiaries in which the savings association holds a minority interest
and which are not engaged in activities for which the capital rules require
the savings association to net its debt and equity investments in such
subsidiaries against capital, as well as a prorated portion of the assets
of other subsidiaries for which netting is not fully required under phase-
in rules. Adjusted total assets are reduced by the amount of assets that
have been deducted from capital, the portion of savings association's
investments in subsidiaries that must be netted against capital under the
capital rules and, for purposes of the core capital requirement, qualifying
supervisory goodwill. At June 30, 1996, the Bank's adjusted total assets
for purposes of the core and tangible capital requirements totalled $40.7
million.
In determining compliance with the risk-based capital requirement, a
savings association is allowed to use both core capital and supplementary
capital, provided the amount of supplementary capital used does not exceed
the savings association's core capital. Supplementary capital is defined
to include certain preferred stock issues, nonwithdrawable accounts and
pledged deposits that do not qualify as core capital, certain approved
subordinated debt, certain other capital instruments and a portion of the
savings association's general loan and lease loss allowances.
21
<PAGE>
Total core and supplementary capital are reduced by the amount of
capital instruments held by other depository institutions pursuant to
reciprocal arrangements and by an increasing percentage of the savings
association's high loan-to-value ratio land loans, non-residential
construction loans and equity investments other than those deducted from
core and tangible capital. As of June 30, 1996, the Bank had no high ratio
land or non-residential construction loans and no equity investments for
which OTS regulations require a phased deduction from total capital.
The risk-based capital requirement is measured against risk-weighted
assets which equal the sum of each asset and the credit-equivalent amount
of each off-balance sheet item after being multiplied by an assigned risk
weight. Under the OTS risk-weighting system, one-to-four family first
mortgages not more than 90 days past due with original loan-to-value ratios
under 80%, multi-family mortgages (maximum 36 dwelling units) with loan-to-
value ratios under 80% and average annual occupancy rates of at least 80%,
and certain qualifying loans for the construction of one- to four-family
residences pre-sold to home purchasers are assigned a risk weight of 50%.
Consumer and residential construction loans are assigned a risk weight of
100%. Mortgage-backed securities issued, or fully guaranteed as to
principal and interest, by the FNMA or FHLMC are assigned a 20% risk
weight. Cash and U.S. Government securities backed by the full faith and
credit of the U.S. Government (such as mortgage-backed securities issued by
GNMA) are given a 0% risk weight.
The table below provides information with respect to the Bank's
compliance with its regulatory capital requirements at June 30, 1996.
<TABLE>
<CAPTION>
Percent of
Amount Assets (1)
--------- ------------
(Dollars in thousands)
<S> <C> <C>
Tangible capital................ $12,015 29.5%
Tangible capital requirement.... 606 1.5
------- ----
Excess (deficit).............. $11,409 28.0%
======= ====
Core capital (2)................ $12,015 29.8%
Core capital requirement........ 1,212 3.0
------- ----
Excess (deficit).............. $10,803 26.8%
======= ====
Risk-based capital.............. $12,115 60.9%
Risk-based capital requirement.. 1,592 8.0
------- ----
Excess (deficit).............. $10,523 52.9%
======= ====
</TABLE>
- ------------------------
(1) Based on adjusted total assets for purposes of the tangible capital
and core capital requirements and risk-weighted assets for purpose of
the risk-based capital requirement.
(2) Reflects the capital requirement which the Bank must satisfy to avoid
regulatory restrictions that may be imposed pursuant to prompt
corrective action regulations. The core requirement applicable to the
Bank may increase to 4.0% or 5.0% if the OTS amends its capital
regulations, as it has proposed, in response to the more stringent
leverage ratio adopted by the Office of the Comptroller of the
Currency for national banks.
OTS risk-based capital requirements require savings institutions with
more than a "normal" level of interest rate risk to maintain additional
total capital. A savings institution's interest rate risk will be measured
in terms of the sensitivity of its "net portfolio value" to changes in
interest rates. Net portfolio value is defined, generally, as the present
value of expected cash inflows from existing assets and off-balance sheet
contracts less the present value of expected cash outflows from existing
liabilities. A savings institution will be considered to have a "normal"
level of interest rate risk exposure if the decline in its net portfolio
value after an immediate 200 basis point increase or decrease in market
interest rates (whichever results in the greater decline) is less than two
percent of the current
22
<PAGE>
estimated economic value of its assets. A savings institution with a
greater than normal interest rate risk will be required to deduct from
total capital, for purposes of calculating its risk-based capital
requirement, an amount (the "interest rate risk component") equal to one-
half the difference between the institution's measured interest rate risk
and the normal level of interest rate risk, multiplied by the economic
value of its total assets.
The OTS calculates the sensitivity of a savings institution's net
portfolio value based on data submitted by the institution in a schedule to
its quarterly Thrift Financial Report and using the interest rate risk
measurement model adopted by the OTS. The amount of the interest rate risk
component, if any, to be deducted from a savings institution's total
capital is based on the institution's Thrift Financial Report filed two
quarters earlier. Institutions with less than $300 million in assets and a
risk-based capital ratio above 12%, like the Bank, generally are exempt
from filing the interest rate risk schedule with their Thrift Financial
Reports. However, the OTS will require any exempt institution that it
determines may have a high level of interest rate risk exposure to file
such schedule on a quarterly basis and may be subject to an additional
capital requirement based upon its level of interest rate risk as compared
to its peers.
The OTS has proposed an amendment to its capital regulations
establishing a minimum core capital ratio of 3.00% for savings institutions
rated composite 1 under the OTS CAMEL examination rating system. For all
other savings associations, the minimum core capital ratio would be 3.00%
plus at least an additional 100 to 200 basis points. In determining the
amount of additional core capital, the OTS would assess both the quality of
risk management systems and the level of overall risk in each individual
savings institution through the supervisory process on a case-by-case
basis.
In addition to requiring generally applicable capital standards for
savings institutions, the OTS is authorized to establish the minimum level
of capital for a savings institution at such amount or at such ratio of
capital-to-assets as the OTS determines to be necessary or appropriate for
such institution in light of the particular circumstances of the
institution. The OTS may treat the failure of any savings institution to
maintain capital at or above such level as an unsafe or unsound practice
and may issue a directive requiring any savings institution which fails to
maintain capital at or above the minimum level required by the OTS to
submit and adhere to a plan for increasing capital. Such an order may be
enforced in the same manner as an order issued by the FDIC.
Prompt Corrective Regulatory Action. Under the Federal Deposit
Insurance Corporation Improvement Act of 1991 ("FDICIA"), the federal
banking regulators are required to take prompt corrective action if an
insured depository institution fails to satisfy certain minimum capital
requirements. All institutions, regardless of their capital levels, are
restricted from making any capital distribution or paying any management
fees if the institution would thereafter fail to satisfy the minimum levels
for any of its capital requirements. An institution that fails to meet the
minimum level for any relevant capital measure (an "undercapitalized
institution") may be: (i) subject to increased monitoring by the
appropriate federal banking regulator; (ii) required to submit an
acceptable capital restoration plan within 45 days; (iii) subject to asset
growth limits; and (iv) required to obtain prior regulatory approval for
acquisitions, branching and new lines of businesses. The capital
restoration plan must include a guarantee by the institution's holding
company that the institution will comply with the plan until it has been
adequately capitalized on average for four consecutive quarters, under
which the holding company would be liable up to the lesser of 5% of the
institution's total assets or the amount necessary to bring the institution
into capital compliance as of the date it failed to comply with its capital
restoration plan. A "significantly undercapitalized" institution, as well
as any undercapitalized institution that did not submit an acceptable
capital restoration plan, may be subject to regulatory demands for
recapitalization, broader application of restrictions on transactions with
affiliates, limitations on interest rates paid on deposits, asset growth
and other activities, possible replacement of directors and officers, and
restrictions on capital distributions by any bank holding company
controlling the institution. Any company controlling the institution could
also be required to divest the institution or the institution could be
required to divest subsidiaries. The senior executive officers of a
significantly undercapitalized institution may not receive bonuses or
increases in compensation without prior approval and the institution is
prohibited from making payments of principal or interest on its
subordinated debt. In their discretion, the federal banking regulators may
also impose the
23
<PAGE>
foregoing sanctions on an undercapitalized institution if the regulators
determine that such actions are necessary to carry out the purposes of the
prompt corrective action provisions. If an institution's ratio of tangible
capital to total assets falls below a "critical capital level," the
institution will be subject to conservatorship or receivership within 90
days unless periodic determinations are made that forbearance from such
action would better protect the deposit insurance fund. Unless appropriate
findings and certifications are made by the appropriate federal bank
regulatory agencies, a critically undercapitalized institution must be
placed in receivership if it remains critically undercapitalized on average
during the calendar quarter beginning 270 days after the date it became
critically undercapitalized.
Federal banking regulators have adopted regulations implementing the
prompt corrective action provisions of FDICIA. Under these regulations,
the federal banking regulators will generally measure a depository
institution's capital adequacy on the basis of the institution's total
risk-based capital ratio (the ratio of its total capital to risk-weighted
assets), Tier 1 risk-based capital ratio (the ratio of its core capital to
risk-weighted assets) and leverage ratio (the ratio of its core capital to
adjusted total assets). Under the regulations, an institution that is not
subject to an order or written directive by its primary federal regulator
to meet or maintain a specific capital level will be deemed "well
capitalized" if it also has: (i) a total risk-based capital ratio of 10% or
greater; (ii) a Tier 1 risk-based capital ratio of 6.0% or greater; and
(iii) a leverage ratio of 5.0% or greater. An "adequately capitalized"
depository institution is an institution that does not meet the definition
of well capitalized and has: (i) a total risk-based capital ratio of 8.0%
or greater; (ii) a Tier 1 risk-based capital ratio of 4.0% or greater; and
(iii) a leverage ratio of 4.0% or greater (or 3.0% or greater if the
depository institution has a composite 1 CAMEL rating). An
"undercapitalized institution" is a depository institution that has (i) a
total risk-based capital ratio less than 8.0%; or (ii) a Tier 1 risk-based
capital ratio of less than 4.0%; or (iii) a leverage ratio of less than
4.0% (or less than 3.0% if the institution has a composite 1 CAMEL rating).
A "significantly undercapitalized" institution is defined as a depository
institution that has: (i) a total risk-based capital ratio of less than
6.0%; or (ii) a Tier 1 risk-based capital ratio of less than 3.0%; or (iii)
a leverage ratio of less than 3.0%. A "critically undercapitalized"
institution is defined as a depository institution that has a ratio of
"tangible equity" to total assets of less than 2.0%. Tangible equity is
defined as core capital plus cumulative perpetual preferred stock (and
related surplus) less all intangibles other than qualifying supervisory
goodwill and certain purchased mortgage servicing rights. The appropriate
federal banking agency may reclassify a well capitalized depository
institution as adequately capitalized and may require an adequately
capitalized or undercapitalized institution to comply with the supervisory
actions applicable to institutions in the next lower capital category (but
may not reclassify a significantly undercapitalized institution as
critically under-capitalized) if it determines, after notice and an
opportunity for a hearing, that the institution is in an unsafe or unsound
condition or that the institution has received and not corrected a less-
than-satisfactory rating for any CAMEL rating category. At June 30, 1996,
the Bank was classified as "well capitalized" under OTS regulations.
Safety and Soundness Guidelines. Under FDICIA, as amended by the
Riegle Community Development and Regulatory Improvement Act of 1994 (the
"CDRI Act"), each Federal banking agency is required to establish safety
and soundness standards for institutions under its authority. On July 10,
1995, the federal banking agencies, including the OTS and the Federal
Reserve Board, released Interagency Guidelines Establishing Standards for
Safety and Soundness and published a final rule establishing deadlines for
submission and review of safety and soundness compliance plans. The final
rule and the guidelines went into effect on August 9, 1995. The guidelines
require depository institutions to maintain internal controls and
information systems and internal audit systems that are appropriate for the
size, nature and scope of the institution's business. The guidelines also
establish certain basic standards for loan documentation, credit
underwriting, interest rate risk exposure, and asset growth. The
guidelines further provide that depository institutions should maintain
safeguards to prevent the payment of compensation, fees and benefits that
are excessive or that could lead to material financial loss, and should
take into account factors such as comparable compensation practices at
comparable institutions. If the appropriate federal banking agency
determines that a depository institution is not in compliance with the
safety and soundness guidelines, it may require the institution to submit
an acceptable plan to achieve compliance with the guidelines. A depository
institution must submit an acceptable compliance plan to its primary
federal regulator within 30 days of receipt of a request for such a plan.
Failure to submit or implement a compliance plan may subject the
institution to regulatory sanctions.
24
<PAGE>
Management believes that the Bank already meets substantially all the
standards adopted in the interagency guidelines, and therefore does not
believe that implementation of these regulatory standards will materially
affect the operations of the Bank.
Additionally under FDICIA, as amended by the CDRI Act, the federal
banking agencies are required to establish standards relating to the asset
quality and earnings that the agencies determine to be appropriate. On
July 10, 1995, the federal banking agencies, including the OTS and the
Federal Reserve Board, issued proposed guidelines relating to asset quality
and earnings. Under the proposed guidelines, an FDIC insured depository
institution should maintain systems, commensurate with its size and the
nature and scope of its operations, to identify problem assets and prevent
deterioration in those assets as well as to evaluate and monitor earnings
and ensure that earnings are sufficient to maintain adequate capital and
reserves.
Federal Home Loan Bank System. The FHLB System consists of 12
district FHLBs subject to supervision and regulation by the Federal Housing
Finance Board ("FHFB"). The FHLBs provide a central credit facility
primarily for member institutions. As a member of the FHLB of Cincinnati,
the Bank is required to acquire and hold shares of capital stock in the
FHLB of Cincinnati in an amount at least equal to 1% of the aggregate
unpaid principal of its home mortgage loans, home purchase contracts, and
similar obligations at the beginning of each year, or 1/20 of its advances
(borrowings) from the FHLB of Cincinnati, whichever is greater. The Bank
was in compliance with this requirement with investment in FHLB of
Cincinnati stock at June 30, 1996 of $300,600. The FHLB of Cincinnati
serves as a reserve or central bank for its member institutions within its
assigned district. It is funded primarily from proceeds derived from the
sale of consolidated obligations of the FHLB System. It offers advances to
members in accordance with policies and procedures established by the FHFB
and the Board of Directors of the FHLB of Cincinnati. Long-term advances
may only be made for the purpose of providing funds for residential housing
finance. At June 30, 1996, the Bank had $3.45 million in long-term
advances and $31,000 in short-term advances outstanding from the FHLB of
Cincinnati.
Federal Reserve System. Pursuant to regulations of the Federal
Reserve Board, all FDIC-insured depository institutions must maintain
average daily reserves equal to 3% on the first $52.0 million of
transaction accounts, plus 10% on the remainder. This percentage is
subject to adjustment by the Federal Reserve Board. Because required
reserves must be maintained in the form of vault cash or in a noninterest
bearing account at a Federal Reserve Bank, the effect of the reserve
requirement is to reduce the amount of the institution's interest-earning
assets. At June 30, 1996, the Bank met its reserve requirements.
The monetary policies and regulations of the Federal Reserve Board
have a significant effect on the operating results of banks. The Federal
Reserve Board's policies affect the levels of bank loans, investments and
deposits through its open market operation in United States government
securities, its regulation of the interest rate on borrowings of member
banks from Federal Reserve Banks and its imposition of non-earning reserve
requirements on all depository institutions, such as the Bank, that
maintain transaction accounts or non-personal time deposits.
Deposit Insurance. The Bank is required to pay assessments based on a
percent of its insured deposits to the FDIC for insurance of its deposits
by the SAIF. Through December 31, 1997, the assessment rate shall not be
less than 0.23%. After December 31, 1997, the SAIF assessment rate will be
a rate determined by the FDIC to be appropriate to increase the reserve
ratio of the SAIF to 1.25% of insured deposits or such higher percentage as
the FDIC determines to be appropriate but not less than 0.15%.
Under the FDIC's risk-based deposit insurance assessment system, the
assessment rate for an insured depository institution depends on the
assessment risk classification assigned to the institution by the FDIC,
which is determined by the institution's capital level and supervisory
evaluations. Based on the data reported to regulators for the date closest
to the last day of the seventh month preceding the semi-annual assessment
period, institutions are assigned to one of three capital groups -- well
capitalized, adequately capitalized or undercapitalized -- using the same
percentage criteria as in the prompt corrective action regulations. See
"-- Prompt Corrective Regulatory
25
<PAGE>
Action." Within each capital group, institutions are assigned to one of
three subgroups on the basis of supervisory evaluations by the
institution's primary supervisory authority and such other information as
the FDIC determines to be relevant to the institution's financial condition
and the risk posed to the deposit insurance fund. Subgroup A consists of
financially sound institutions with only a few minor weaknesses. Subgroup
B consists of institutions that demonstrate weaknesses which, if not
corrected, could result in significant deterioration of the institution and
increased risk of loss to the deposit insurance fund. Subgroup C consists
of institutions that pose a substantial probability of loss to the deposit
insurance fund unless effective corrective action is taken.
The Bank's savings deposits are insured by the SAIF, which is
administered by the FDIC. The assessment rate currently ranges from 0.23%
of deposits for well capitalized institutions to 0.31% of deposits for
undercapitalized institutions. The FDIC also administers the Bank
Insurance Fund ("BIF"), which has the same designated reserve ratio as the
SAIF (currently 1.25%). On August 8, 1995, the FDIC adopted an amendment
to the BIF risk-based assessment schedule which lowered the deposit
insurance assessment rate for most commercial banks and other depository
institutions with deposits insured by the BIF to a range of from 0.31% of
insured deposits for undercapitalized BIF-insured institutions to 0.04% of
deposits for well-capitalized institutions, which constitute over 90% of
BIF-insured institutions. The FDIC amendment became effective for the
quarter ended September 30, 1995. Subsequently, the BIF assessment rate
has been lowered to the statutory minimum of $2,000 per year. The FDIC has
indicated that the assessment rate for SAIF-insured institutions will not
fall below 0.23% of insured deposits until approximately the year 2002.
To alleviate this disparity, one proposal being considered by the U.S.
Department of Treasury, the FDIC, and the U.S. Congress provides that a
one-time assessment of as much as 80 basis points be imposed on all SAIF-
insured deposits to cause the SAIF insurance fund to reach its designated
reserve ratio. Once this occurs, the two funds would be merged into one
fund. There can be no assurance that this proposal or any other proposal
will be implemented or that premiums for either fund will not be adjusted
in the future by the FDIC or legislative action.
The payment of a special assessment would severely and negatively
impact the Bank's results of operations, resulting in a net charge of up to
approximately $124,000, after adjusting for tax benefits. However, if such
a special assessment is imposed and the SAIF is recapitalized, it could
have the effect of reducing the Bank's insurance premiums in the future,
thereby creating equal competition between BIF-insured and SAIF-insured
institutions.
The Bank is prohibited under current federal law from converting from
SAIF to BIF insurance. Under federal statute, the prohibition on
conversion from SAIF to BIF insurance will continue until such time as the
SAIF's ratio of reserves to insured deposits (the "reserve ratio") equals
1.25%. Based on projections published by the FDIC, absent a special
assessment, the SAIF reserve ratio is not expected to reach 1.25% for a
number of years.
FDIC regulations provide that any insured depository institution with
a ratio of Tier 1 capital to total assets of less than 2% will be deemed to
be operating in an unsafe or unsound condition, which would constitute
grounds for the initiation of termination of deposit insurance proceedings.
The FDIC, however, would not initiate termination of insurance proceedings
if the depository institution has entered into and is in compliance with a
written agreement with its primary regulator, and the FDIC is a party to
the agreement, to increase its Tier 1 capital to such level as the FDIC
deems appropriate. Tier 1 capital is defined as the sum of common
stockholders' equity, noncumulative perpetual preferred stock (including
any related surplus) and minority interests in consolidated subsidiaries,
minus all intangible assets other than mortgage servicing rights and
qualifying supervisory goodwill eligible for inclusion in core capital
under OTS regulations and minus identified losses and investments in
certain securities subsidiaries. Insured depository institutions with Tier
1 capital equal to or greater than 2% of total assets may also be deemed to
be operating in an unsafe or unsound condition notwithstanding such capital
level. The regulation further provides that in considering applications
that must be submitted to it by savings associations, the FDIC will take
into account whether the savings association is meeting with the Tier 1
capital requirement for state non-member banks of 4% of total assets for
all but the most highly rated state non-member banks.
Liquidity Requirements. The Bank is required under OTS regulations to
maintain average daily balances of liquid assets (cash, deposits maintained
pursuant to Federal Reserve Board reserve requirements, time and savings
26
<PAGE>
deposits in certain institutions, obligations of the United States and
states and political subdivisions thereof, shares in mutual funds with
certain restricted investment policies, highly rated corporate debt, and
mortgage loans and mortgage-related securities with less than one year to
maturity or subject to pre-arranged sale within one year) equal to the
monthly average of not less than a specified percentage (currently 5%) of
its net withdrawable savings deposits plus short-term borrowings. The Bank
is also required to maintain average daily balances of short-term liquid
assets at a specified percentage (currently 1%) of the total of its net
withdrawable savings accounts and borrowings payable in one year or less.
Monetary penalties may be imposed for failure to meet liquidity
requirements. The average daily and short-term liquidity ratios of the
Bank for the month of June 1996 were approximately 31.4%.
Qualified Thrift Lender Test. A savings institution that does not
meet the Qualified Thrift Lender ("QTL") test must either convert to a bank
charter or comply with the following restrictions on its operations: (i)
the institution may not engage in any new activity or make any new
investment, directly or indirectly, unless such activity or investment is
permissible for a national bank; (ii) the branching powers of the
institution shall be restricted to those of a national bank; (iii) the
institution shall not be eligible to obtain any advances from its FHLB; and
(iv) payment of dividends by the institution shall be subject to the rules
regarding payment of dividends by a national bank. Upon the expiration of
three years from the date the institution ceases to be a QTL, it must cease
any activity and not retain any investment not permissible for a national
bank and immediately repay any outstanding FHLB advances (subject to safety
and soundness considerations).
To meet the QTL test, an institution's "Qualified Thrift Investments"
must total at least 65% of "portfolio assets." Under OTS regulations,
portfolio assets are defined as total assets less intangibles, property
used by a savings institution in its business and liquidity investments in
an amount not exceeding 20% of assets. Qualified Thrift Investments
consist of (i) loans, equity positions or securities related to domestic,
residential real estate or manufactured housing and (ii) 50% of the dollar
amount of residential mortgage loans subject to sale under certain
conditions. In addition, subject to a 20% of portfolio assets limit,
savings institutions are able to treat as Qualified Thrift Investments 200%
of their investments in loans to finance "starter homes" and loans for
construction, development or improvement of housing and community service
facilities or for financing small businesses in "credit-needy" areas.
In addition, a savings institution must maintain its status as a QTL
on a monthly basis in nine out of every 12 months. A savings institution
that fails to maintain Qualified Thrift Lender status will be permitted to
requalify once, and if it fails the QTL test a second time, it will become
immediately subject to all penalties as if all time limits on such
penalties had expired. Failure to qualify as a QTL results in a number of
sanctions, including the imposition of certain operating restrictions
imposed on national banks and a restriction on obtaining additional
advances from the Federal Home Loan Bank System. Upon failure to qualify
as a QTL for two years, a savings association must convert to a commercial
bank. At June 30, 1996, the Bank qualified as a QTL.
Dividend Restrictions. Under OTS regulations, the Bank may not pay
dividends on its capital stock if its regulatory capital would thereby be
reduced below the amount then required for the liquidation account
established for the benefit of certain depositors of the Bank at the time
of the Conversion. In addition, savings institution subsidiaries of
savings and loan holding companies are required to give the OTS 30 days
prior notice of any proposed declaration of dividends to the holding
company.
OTS regulations impose additional limitations on the payment of
dividends and other capital distributions (including stock repurchases and
cash mergers) by the Bank. Under these regulations, a savings institution
that, immediately prior to, and on a pro forma basis after giving effect
to, a proposed capital distribution, has total capital (as defined by OTS
regulation) that is equal to or greater than the amount of its fully
phased-in capital requirements (a "Tier 1 Association") is generally
permitted, without OTS approval after notice, to make capital distributions
during a calendar year in the amount equal to the greater of: (i) 75% of
its net income for the previous four quarters; or (ii) up to 100% of its
net income to date during the calendar year plus an amount that would
reduce by one-half the amount by which its capital-to-assets ratio exceeded
regulatory requirements at the beginning of the calendar year. A savings
institution with total capital in excess of current minimum capital ratio
requirements, but not in excess of its fully phased-in requirements (a
"Tier 2 Association") is permitted, after notice, to make capital
distributions
27
<PAGE>
without OTS approval of up to 75% of its net income for the previous four
quarters, less dividends already paid for such period. A savings
institution that fails to meet current minimum capital requirements (a
"Tier 3 Association") is prohibited from making any capital distributions
without the prior approval of the OTS. A Tier 1 Association that has been
notified by the OTS that its is in need of more than normal supervision
will be treated as either a Tier 2 or Tier 3 Association. The Bank is a
Tier 1 Association. The Bank is also prohibited from making any capital
distributions if after making the distribution, the Bank would have: (i) a
total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based
capital ratio of less than 4.0%; or (iii) a leverage ratio of less than
4.0%. See "-- Prompt Corrective Regulatory Action."
Uniform Lending Standards. Under OTS and Federal Reserve Board
regulations, savings banks and state member banks must adopt and maintain
written policies that establish appropriate limits and standards for
extensions of credit that are secured by liens or interests in real estate
or are made for the purpose of financing permanent improvements to real
estate. These policies must establish loan portfolio diversification
standards, prudent underwriting standards, including loan-to-value limits,
that are clear and measurable, loan administration procedures and
documentation, approval and reporting requirements. The real estate
lending policies of savings associations and state member banks must
reflect consideration of the Interagency Guidelines for Real Estate Lending
Policies (the "Interagency Guidelines") that have been adopted by the
federal banking agencies.
The Interagency Guidelines, among other things, call upon depository
institutions to establish internal loan-to-value limits for real estate
loans that are not in excess of the following supervisory limits: (i) for
loans secured by raw land, the supervisory loan-to-value limit is 65% of
the value of the collateral; (ii) for land development loans (i.e., loans
for the purpose of improving unimproved property prior to the erection of
structures), the supervisory limit is 75%; (iii) for loans for the
construction of commercial, multifamily or other nonresidential property,
the supervisory limit is 80%; (iv) for loans for the construction of one-
to-four family properties, the supervisory limit is 85%; and (v) for loans
secured by other improved property (e.g., farmland, completed commercial
property and other income-producing property including non-owner-occupied,
one-to-four family property), the limit is 85%. Although no supervisory
loan-to-value limit has been established for owner-occupied, one-to-four
family and home equity loans, the Interagency Guidelines state that for any
such loan with a loan-to-value ratio that equals or exceeds 90% at
origination, an institution should require appropriate credit enhancement
in the form of either mortgage insurance or readily marketable collateral.
The Interagency Guidelines state that it may be appropriate in
individual cases to originate or purchase loans with loan-to-value ratios
in excess of the supervisory loan-to-value limits, based on the support
provided by other credit factors. The aggregate amount of loans in excess
of the supervisory loan-to-value limits, however, should not exceed 100% of
total capital and the total of such loans secured by commercial,
agricultural, multifamily and other non-one-to-four family residential
properties should not exceed 30% of total capital. The supervisory loan-
to-value limits do not apply to certain categories of loans including loans
insured or guaranteed by the U.S. government and its agencies or by
financially capable state, local or municipal governments or agencies,
loans backed by the full faith and credit of a state government, loans that
are to be sold promptly after origination without recourse to a financially
responsible party, loans that are renewed, refinanced or restructured
without the advancement of new funds, loans that are renewed, refinanced or
restructured in connection with a workout, loans to facilitate sales of
real estate acquired by the institution in the ordinary course of
collecting a debt previously contracted and loans where the real estate is
not the primary collateral.
Management believes that the Bank's current lending policies conform
to the Interagency Guidelines.
Limits on Loans to One Borrower. Savings institutions generally are
subject to the lending limits applicable to national banks. With certain
limited exceptions, the maximum amount that a savings institution may lend
to any borrower (including certain related entities of the borrower) at one
time may not exceed 15% of the unimpaired capital and surplus of the
institution, plus an additional 10% of unimpaired capital and surplus for
loans fully secured by readily marketable collateral. Savings institutions
are additionally authorized to make loans to one borrower, for any purpose,
in an amount not to exceed $500,000 or, by order of the Director of OTS, in
an amount not to exceed the lesser of $30,000,000 or 30% of unimpaired
capital and surplus to develop residential housing, provided: (i) the
28
<PAGE>
purchase price of each single-family dwelling in the development does not
exceed $500,000; (ii) the savings institution is and continues to be in
compliance with its fully phased-in capital requirements; (iii) the loans
comply with applicable loan-to-value requirements, and; (iv) the aggregate
amount of loans made under this authority does not exceed 150% of
unimpaired capital and surplus. The lending limits generally do not apply
to purchase money mortgage notes taken form the purchaser of real property
acquired by the institution in satisfaction of debts previously contracted
if no new funds are advanced to the borrower and the institution is not
placed in a more detrimental position as a result of the sale. Certain
types of loans are excepted from the lending limits, including loans
secured by savings deposits. At June 30, 1996, the maximum amount that the
Bank could have loaned to any one borrower without prior OTS approval was
$4.0 million. At such date, the largest aggregate amount of loans that the
Bank had outstanding to any one borrower was $639,000.
Transactions with Related Parties. Transactions between a savings
institution or a state member bank and any affiliate are governed by
Sections 23A and 23B of the Federal Reserve Act. An affiliate of a savings
institution or state member bank is any company or entity which controls,
is controlled by or is under common control with the savings institution or
state member bank. In a holding company context, the parent holding
company of a savings institution or state member bank (such as the Company)
and any companies which are controlled by such parent holding company are
affiliates of the savings institution or state member bank. Generally,
Sections 23A and 23B (i) limit the extent to which an institution or its
subsidiaries may engage in "covered transactions" with any one affiliate to
an amount equal to 10% of such institution's capital stock and surplus, and
contain an aggregate limit on all such transactions with all affiliates to
an amount equal to 20% of such capital stock and surplus and (ii) require
that all such transactions be on terms substantially the same, or at least
as favorable, to the institution or subsidiary as those provided to a non-
affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and similar other types of
transactions. In addition to the restrictions imposed by Sections 23A and
23B, no savings institution or state member bank may (i) loan or otherwise
extend credit to an affiliate, except for any affiliate which engages only
in activities which are permissible for bank holding companies, or (ii)
purchase or invest in any stocks, bonds, debentures, notes or similar
obligations of any affiliate, except for affiliates which are subsidiaries
of the savings institution or state member bank.
Savings institutions and state member banks also are subject to the
restrictions contained in Section 22(h) of the Federal Reserve Act and the
Federal Reserve's Regulation O thereunder on loans to executive officers,
directors and principal stockholders. Under Section 22(h), loans to a
director, executive officer and to a greater than 10% stockholder of a
savings institution or state member bank and certain affiliated interests
of such persons, may not exceed, together with all other outstanding loans
to such person and affiliated interests, the institution's loans-to-one-
borrower limit (generally equal to 15% of the institution's unimpaired
capital and surplus) and all loans to such persons may not exceed the
institution's unimpaired capital and unimpaired surplus. Section 22(h)
also prohibits loans, above amounts prescribed by the appropriate federal
banking agency, to directors, executive officers and greater than 10%
stockholders of a savings institution, and their respective affiliates,
unless such loan is approved in advance by a majority of the board of
directors of the institution with any "interested" director not
participating in the voting. Regulation O prescribes the loan amount
(which includes all other outstanding loans to such person) as to which
such prior board of director approval is required as being the greater of
$25,000 or 5% of capital and surplus (up to $671,000). Further, Section
22(h) requires that loans to directors, executive officers and principal
stockholders be made on terms substantially the same as offered in
comparable transactions to other persons. Section 22(h) also generally
prohibits a depository institution from paying the overdrafts of any of its
executive officers or directors.
Savings institutions and state member banks also are subject to the
requirements and restrictions of Section 22(g) of the Federal Reserve Act
on loans to executive officers and the restrictions of 12 U.S.C. (S) 1972
on certain tying arrangements and extensions of credit by correspondent
banks. Section 22(g) of the Federal Reserve Act requires loans to executive
officers of depository institutions not be made on terms more favorable
than those afforded to other borrowers, requires approval by the board of
directors of a depository institution for extension of credit to executive
officers of the institution, and imposes reporting requirements for and
additional restrictions on the type, amount and terms of credits to such
officers. Section 1972 (i) prohibits a depository institution from
extending credit to or offering any other services, or fixing or varying
the consideration for such extension of credit
29
<PAGE>
or service, on the condition that the customer obtain some additional
service from the institution or certain of its affiliates or not obtain
services of a competitor of the institution, subject to certain exceptions,
and (ii) prohibits extensions of credit to executive officers, directors,
and greater than 10% stockholders of a depository institution by any other
institution which has a correspondent banking relationship with the
institution, unless such extension of credit is on substantially the same
terms as those prevailing at the time for comparable transactions with
other persons and does not involve more than the normal risk of repayment
or present other unfavorable features.
Taxation
General
In prior years, the Bank filed its consolidated federal income tax
return based on the calendar year. As of June 30, 1996, the Company and
the Bank, together with the Bank's subsidiary, will file a consolidated
federal income tax return based on a fiscal year ending June 30.
Consolidated returns have the effect of eliminating gain or loss on
intercompany transactions and allowing companies included within the
consolidated return to offset income against losses under certain
circumstances.
Federal Income Taxation
Savings institutions such as the Bank are subject to the provisions of
the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code")
in the same general manner as other corporations. However, institutions
such as the Bank which meet certain definitional tests and other conditions
prescribed by the Internal Revenue Code may benefit from certain favorable
provisions regarding their deductions from taxable income for annual
additions to their bad debt reserve. For purposes of the bad debt reserve
deduction, loans are separated into "qualifying real property loans," which
generally are loans secured by interests in certain real property, and
"nonqualifying loans", which are all other loans. The bad debt reserve
deduction with respect to nonqualifying loans must be based on actual loss
experience. The amount of the bad debt reserve deduction with respect to
qualifying real property loans may be based upon actual loss experience
(the "experience method") or a percentage of taxable income determined
without regard to such deduction (the "percentage of taxable income
method"). Under the experience method, the bad debt deduction for an
addition to the reserve for qualifying real property loans is an amount
determined under a formula based generally on the bad debts actually
sustained by a savings institution over a period of years. Under the
percentage of taxable income method, the bad debt reserve deduction for
qualifying real property loans is computed as 8% of a savings institution's
taxable income, with certain adjustments. The Bank generally has elected
to use the method which has resulted in the greatest deductions for federal
income tax purposes in any given year.
Recapture of the Bad Debt Reserve. To the extent (i) a savings
institution's reserve for losses on qualifying real property loans under
the percentage of income method exceeds the amount that would have been
allowed under the experience method and (ii) a savings institution makes
distributions to stockholders (including distributions in redemption,
dissolution or liquidation) that are considered to result in withdrawals
from that excess bad debt reserve, then the amounts considered withdrawn
will be included in the savings institution's taxable income. The amount
that would be deemed withdrawn from such reserves upon such distribution
and which would be subject to taxation at the savings institution level at
the normal corporate tax rate would be an amount that, when reduced by
taxes on such amount, would equal the amount actually distributed.
Dividends paid out of a savings institution's current or accumulated
earnings and profits as calculated for federal income tax purposes,
however, will not be considered to result in withdrawals from its bad debt
reserves to the extent of such earnings and profits. Dividends in excess
of a savings institution's current and accumulated earnings and profits,
distributions in redemption of stock and distributions in partial or
complete liquidation of a savings institution will be considered to come
from its bad debt reserve.
Legislation that is effective for tax years beginning after December
31, 1995 would require savings associations to recapture into taxable
income the portion of the tax loan reserve that exceeds the 1987 tax loan
loss reserve. All of the Bank's tax loan loss reserves at June 30, 1996
were pre-1987 loan loss reserves and therefore this provision should not
affect future operations. The Bank will no longer be allowed to use the
reserve method
30
<PAGE>
for tax loan loss provisions, but would be allowed to use either the
experience method or the specific charge-off method of accounting for bad
debts.
The Bank's federal income tax returns have not been audited for the
last five years.
State Income Taxation
The State of Delaware imposes no income or franchise taxes on savings
institutions. The Bank is subject to an annual Kentucky ad valorem tax
based on a calendar year and due before the following July 1. This tax is
0.1% of the Bank's savings accounts, common stock, capital and retained
income with certain deductions allowed for amounts borrowed by depositors
and for securities guaranteed by the U.S. Government or certain of its
agencies. For the calendar year ended June 30, 1996, the amount of such
expense for the Bank was $28,583.
Stockholders of the Company who are residents of the Commonwealth of
Kentucky may be subject to a Kentucky tax on intangible property, defined
for this purpose to include shares of stock in a corporation. The tax is
an ad valorem tax based upon the fair market value of the shares held by
the individual, and is assessed at a rate of $0.25 per $100 in value.
Kentucky has replaced its bank shares tax with a franchise-based tax
on financial institutions. A tax of 1.1% is imposed annually on the
average value of net capital over the last five years. This franchise-
based tax is in lieu of all city, county and local taxes except transfer
taxes, property taxes and utility-user taxes. Therefore, local taxing
jurisdictions still have the authority to impose a tax based on deposits.
Item 2. Description of Property
--------------------------------
The following table sets forth information regarding the Bank's sole
office at June 30, 1996.
<TABLE>
<CAPTION>
Book Value at
Year Owned or June 30, Approximate
Opened Leased 1996 Square Footage
------ ------------- -------- --------------
<S> <C> <C> <C> <C>
Main office 1989 Owned $351,000 4,163
</TABLE>
The book value of the Bank's investment in premises and equipment
totaled approximately $427,000 at June 30, 1996. See Note 7 of Notes to
Financial Statements.
Item 3. Legal Proceedings.
-------------------------
From time to time, the Bank is a party to various legal
proceedings incident to its business. At June 30, 1996, there were no
legal proceedings to which the Company or the Bank was a party, or to which
any of their property was subject, which were expected by management to
result in a material loss to the Company or the Bank. There are no pending
regulatory proceedings to which the Company, the Bank or its subsidiaries
is a party or to which any of their properties is subject which are
currently expected to result in a material loss.
Item 4. Submission of Matters to a Vote of Security Holders
------------------------------------------------------------
No matters were submitted to a vote of security holders during
the fourth quarter of the fiscal year ended June 30, 1996.
31
<PAGE>
PART II
Item 5. Market for the Registrant's Common Equity and Related
--------------------------------------------------------------
Stockholders' Matters
---------------------
The Company's common stock began trading under the symbol "FLKY"
on the Nasdaq SmallCap Market on July 1, 1996. As of September 25, 1996
there were 958,812 shares of the common stock outstanding and approximately
285 holders of record of common stock. No dividends have been paid on
the common stock as of September 25, 1996.
Item 6. Management's Discussion and Analysis of Financial Condition and
------------------------------------------------------------------------
Results of Operations
---------------------
General
Prior to the Conversion, the Company had no material operations.
The Company's principal business since June 28, 1996 has been that of the
Bank. As a result, this discussion for periods ended and as of dates on or
prior to June 28, 1996 relates to the financial condition and results of
operations of the Bank. The principal business of the Company consists of
accepting deposits from the general public and investing these funds
primarily in loans and in investment securities and mortgage-backed
securities. The Company's loans presently consist primarily of loans
secured by residential real estate located in its market area, with a
limited amount of loans secured by consumer loans.
The Company's net income is dependent primarily on its net
interest income, which is the difference between interest income earned on
its loan, investment securities and mortgage-backed securities portfolio
and interest paid on interest-bearing liabilities. Net interest income is
determined by (i) the difference between yields earned on interest-earning
assets and rates paid on interest-bearing liabilities ("interest rate
spread") and (ii) the relative amounts of interest-earning assets and
interest-bearing liabilities. The Company's interest rate spread is
affected by regulatory, economic and competitive factors that influence
interest rates, loan demand and deposit flows. To a lesser extent, the
Company's net income also is affected by the level of noninterest expenses
such as compensation and employee benefits and FDIC insurance premiums.
The operations of the Company are significantly affected by
prevailing economic conditions, competition and the monetary, fiscal and
regulatory policies of governmental agencies. Lending activities are
influenced by the demand for and supply of housing, competition among
lenders, the level of interest rates and the availability of funds.
Deposit flows and costs of funds are influenced by prevailing market rates
of interest, primarily on competing investments, account maturities and the
levels of personal income and savings in the Company's market area.
Asset/Liability Management
The Company has sought to reduce its exposure to changes in
interest rates by matching more closely the effective maturities or
repricing characteristics of its interest-earning assets and interest-
bearing liabilities. The matching of the Company's assets and liabilities
may be analyzed by examining the extent to which its assets and liabilities
are interest rate sensitive and by monitoring the expected effects of
interest rate changes on the Company's net interest income.
An asset or liability is interest rate sensitive within a
specific time period if it will mature or reprice within that time period.
If the Company's assets mature or reprice more quickly or to a greater
extent than its liabilities, the Company's net portfolio value and net
interest income would tend to increase during periods of rising interest
rates but decrease during periods of falling interest rates. If the
Company's assets mature or reprice more slowly or to a lesser extent than
its liabilities, the Company's net portfolio value and net interest income
would tend to decrease during periods of rising interest rates but increase
during periods of falling interest rates. As a result of the interest rate
risk inherent in the historical savings institution business of originating
long-term loans funded by
32
<PAGE>
short-term deposits, the Company has pursued certain strategies designed to
decrease the vulnerability of its earnings to material and prolonged
changes in interest rates.
In accordance with the Company's interest rate risk policy,
management has emphasized the origination of adjustable rate mortgage loans
with rate adjustments indexed to the one-year Treasury bill, adjusted for
constant maturity, and has also used FHLB advances to better match
maturities of funding sources with the terms of fixed-rate mortgage loans
originated by the Bank. Management believes that this approach to loan
originations allow the Bank to respond to customer demand while minimizing
interest rate and credit risk and without increasing operating expenses.
At June 30, 1996, mortgage loans with adjustable rates represented 78.8% of
the Company's mortgage loan portfolio. Approximately 98.0% of the
Company's adjustable rate mortgage loans have an annual adjustment cap of
two percent and a lifetime cap of five percent, and may not decline more
than 1% below the initial interest rate. These caps may restrict the
interest rates from increasing at the same pace that the Company's cost of
funds increase. However, some of the rates on adjustable rate mortgages
may already be at their lifetime floor, which would also restrict future
downward adjustments and thereby eliminate the Company's interest rate risk
associated with a declining interest rate environment.
Interest Rate Sensitivity Analysis
The matching of assets and liabilities may be analyzed by
examining the extent to which such assets and liabilities are "interest
rate sensitive" and by monitoring an institution's interest rate
sensitivity "gap." An asset or liability is said to be interest rate
sensitive within a specific period if it will mature or reprice within that
period. The interest rate sensitivity gap is defined as the difference
between the amount of interest-earning assets maturing or repricing within
a specific time period and the amount of interest-bearing liabilities
maturing or repricing within that time period. A gap is considered
positive when the amount of interest rate sensitive assets exceeds the
amount of interest rate sensitive liabilities, and is considered negative
when the amount of interest rate sensitive liabilities exceeds the amount
of interest rate sensitive assets. At June 30, 1996, the Bank had an
excess of interest-earning assets over interest-bearing liabilities
maturing or repricing within one year of approximately $11.5 million,
resulting in a positive one-year interest rate sensitivity gap of 28.2%.
Generally, for institutions with a positive gap, net interest income would
be expected to be adversely affected by declining interest rates and
positively affected by rising interest rates. Generally, during a period
of rising interest rates, a negative gap would be expected to adversely
affect net interest income while a positive gap would be expected to result
in an increase in net interest income, while conversely during a period of
declining interest rates, a negative gap would be expected to result in an
increase in net interest income and a positive gap would be expected to
adversely affect net interest income.
33
<PAGE>
The following table sets forth the amounts of interest-earning
assets and interest-bearing liabilities outstanding at June 30, 1996 which
are expected to mature or reprice in each of the time periods shown.
<TABLE>
<CAPTION>
Over One Over Five Over Ten Over
One Year Through Through Through Twenty
or Less Five Years Ten Years Twenty Years Years Total
--------- ----------- ---------- ------------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Single-family mortgage loans............. $20,752 $ 3,609 $ 813 $ 2,473 $ 62 $27,709
Multi-family residential mortgage loans.. -- -- 304 275 -- 579
Construction............................. 513 802 -- 110 710 2,135
Nonresidential........................... 145 419 354 238 66 1,222
Consumer................................. 290 54 -- -- -- 344
Interest bearing cash deposits in other
institutions............................ 7,285 -- -- -- -- 7,285
Investment securities.................... 527 -- -- -- -- 527
Mortgage-backed securities............... -- 9 32 74 -- 115
------- ------- ------- ------- ------- -------
Total.................................. 29,512 4,893 1,503 3,170 838 39,916
------- ------- ------- ------- ------- -------
Interest-bearing liabilities:
Deposits................................. 18,027 5,437 19 -- -- 23,483
Borrowings............................... -- -- 330 3,150 -- 3,480
------- ------- ------- ------- ------- -------
Total.................................. 18,027 5,437 349 3,150 -- 26,963
------- ------- ------- ------- ------- -------
Interest sensitivity gap.................. $11,485 $ (544) $ 1,154 $ 20 $ 838 $12,953
======= ======= ======= ======= ======= =======
Cumulative interest sensitivity gap....... $11,485 $10,441 $12,095 $12,115 $12,953 $12,953
======= ======= ======= ======= ======= =======
Ratio of interest-earning assets
to interest-bearing liabilities.......... 163.7% (90.0)% 430.7% 100.6% 100.0% 148.0%
======= ======= ======= ======= ======= =======
Ratio of cumulative gap to total assets... 28.2% 26.9% 29.7% 29.7% 31.8% 31.8%
======= ======= ======= ======= ======= =======
</TABLE>
The preceding table was prepared based upon the assumption that
loans will not be repaid before their respective contractual maturity
except for adjustable rate loans, which are classified based upon their
next repricing date. Further, it is assumed that fixed maturity deposits
are not withdrawn prior to maturity and that other deposits are withdrawn
or repriced within one year. Management of the Bank does not believe that
these assumptions will be materially different from the Bank's actual
experience. However, the actual interest rate sensitivity of the Bank's
assets and liabilities could vary significantly from the information set
forth in the table due to market and other factors.
The retention of adjustable-rate mortgage loans in the Bank's
portfolio helps reduce the Bank's exposure to changes in interest rates.
However, there are unquantifiable credit risks resulting from potential
increased costs to borrowers as a result of repricing of adjustable-rate
mortgage loans. It is possible that during periods of rising interest
rates, the risk of default on adjustable-rate mortgage loans may increase
due to the upward adjustment of interest cost to the borrower. See "Item
1. Description of Business -- Lending Activities -- Single-Family
Residential Real Estate Lending."
Net Portfolio Value. In recent years, the Company has measured
its interest rate sensitivity by computing the "gap" between the assets and
liabilities which were expected to mature or reprice within certain
periods, based on assumptions regarding loan prepayment and deposit decay
rates formerly provided by the OTS. However, the OTS now requires the
computation of amounts by which the net present value of an institution's
cash flows from assets, liabilities and off balance sheet items (the
institution's net portfolio value, or "NPV") would change in the event of a
range of assumed changes in market interest rates. The OTS also requires
the computation of estimated changes in net interest income over a four-
quarter period. These computations estimate the effect of an institution's
NPV and net interest income of instantaneous and permanent 1% to 4%
increases and decreases in market interest
34
<PAGE>
rates. In the Company's interest rate sensitive policy, the Board of
Directors has established a maximum decrease in net interest income and
maximum decreases in NPV given these instantaneous changes in interest
rates.
The following table sets forth the interest rate sensitivity of
the Company's net portfolio value as of June 30, 1996 in the event of 1%,
2%, 3% and 4% instantaneous and permanent increases and decreases in market
interest rates, respectively. These changes are set forth below as basis
points, where 100 basis points equals one percentage point.
<TABLE>
<CAPTION>
Net Portfolio Value NPV as % of Portfolio Value of Assets
Change -------------------------------- ---------------------------------------
in Rates $ Amount $ Change % Change NPV Ratio Basis Point Change
-------- -------- ---------- --------- ---------------- ---------------------
<S> <C> <C> <C> <C> <C>
(Dollars in thousands)
+ 400 bp 11,995 (1,386) (10) 30.27% (176) bp
+ 300 bp 12,534 (846) (6) 31.06% (96) bp
+ 200 bp 12,967 (413) (3) 31.65% (37) bp
+ 100 bp 13,253 (128) (1) 31.97% (5) bp
0 bp 13,381 32.02%
- 100 bp 13,390 10 0 31.88% (15) bp
- 200 bp 13,361 (19) 0 31.66% (36) bp
- 300 bp 13,418 38 0 31.59% (44) bp
- 400 bp 13,545 164 +1 31.62% (41) bp
</TABLE>
OTS regulations incorporate an interest rate risk ("IRR") component
into the risk-based capital rules. The new rule became effective January
1, 1994, with institutions first required to meet the new standards at July
1, 1994. The IRR component is a dollar amount that will be deducted from
total capital for the purpose of calculating an institution's risk-based
capital requirement and is measured in terms of the sensitivity of its NPV
to changes in interest rates. An institution's IRR is measured as the
change to its NPV as a result of a hypothetical 200 basis point change in
market interest rates. A resulting change in NPV of more than 2% of the
estimated market value of its assets will require the institution to deduct
from its capital 50% of that excess change.
Computations of prospective effects of hypothetical interest rate
changes are based on numerous assumptions, including relative levels of
market interest rates, loan prepayments and deposit run-offs, and should
not be relied upon as indicative of actual results. Further, the
computations do not contemplate any actions the Company may undertake in
response to changes in interest rates.
Certain shortcomings are inherent in the method of analysis presented
in both the computation of NPV and in the analysis presented in prior
tables setting forth the maturing and repricing of interest-earning assets
and interest-bearing liabilities. For example, although certain assets and
liabilities may have similar maturities or periods to repricing, they may
react in differing degrees to changes in market interest rates. The
interest rates on certain types of assets and liabilities may fluctuate in
advance of changes in market interest rates, while interest rates on other
types may lag behind changes in market rates. Additionally, certain
assets, such as adjustable rate loans, which represent the Company's
primary loan product, have features which restrict changes in interest
rates on a short-term basis and over the life of the asset. In addition,
the proportion of adjustable rate loans in the Company's portfolio could
decrease in future periods if market interest rates remain at or decrease
below current levels due to refinance activity. Further, in the event of a
change in interest rates, prepayment and early withdrawal levels would
likely deviate significantly from those assumed in the tables. Finally,
the ability of many borrowers to service their adjustable-rate debt may
decrease in the event of an interest rate increase.
Average Balance, Interest and Average Yields and Rates
The following table sets forth certain information relating to the
Company's average interest-earning assets and interest-bearing liabilities
and reflects the average yield on assets and average cost of liabilities
for the periods and at the date indicated. Such yields and costs are
derived by dividing income or expense by the average
35
<PAGE>
monthly balance of assets or liabilities, respectively, for the periods
presented. Average balances are derived from month-end balances. Management
does not believe that the use of month-end balances instead of daily
balances has caused any material difference in the information presented.
The table also presents information for the periods and at the
date indicated with respect to the difference between the average yield
earned on interest-earning assets and average rate paid on interest-bearing
liabilities, or "interest rate spread," which savings institutions have
traditionally used as an indicator of profitability. Another indicator of
an institution's net interest income is its "net yield on interest-earning
assets," which is its net interest income divided by the average balance of
interest-earning assets. Net interest income is affected by the interest
rate spread and by the relative amounts of interest-earning assets and
interest-bearing liabilities. When interest-earning assets approximate or
exceed interest-bearing liabilities, any positive interest rate spread will
generate net interest income.
36
<PAGE>
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------------------------
1996 1995
---------------------------- ---------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
------- -------- -------- ------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
(Dollars in thousands)
Interest-earning assets:
Loans receivable (1)..................... $30,442 $2,692 8.84% $28,369 $2,454 8.65%
Investment securities.................... 24 8 31.91 24 7 27.57
Non-marketable equity securities......... 308 21 6.74 257 16 6.32
Mortgage-backed securities............... 130 14 10.78 160 17 10.66
Other interest-bearing cash deposits..... 3,203 175 5.46 1,566 82 5.25
------- ------ ------- ------
Total interest-earning assets........... 34,107 2,909 8.53 30,376 2,576 8.48
------ ------
Unrealized gains on securities available
for sale.................................. 451 374
Non-interest-earning assets................ 1,062 749
------- -------
Total assets............................ $35,620 $31,499
======= =======
Interest-bearing liabilities:
Deposits................................. $25,502 $1,460 5.73 $23,326 $1,075 4.61
Borrowings............................... 4,299 275 6.39 3,437 223 6.50
------- ------ ------- ------
Total interest-bearing liabilities...... 29,801 1,735 5.82 26,763 1,298 4.85
------ ------
Non-interest-bearing liabilities........... 388 271
------- -------
Total liabilities....................... 30,189 27,034
Retained earnings and capital.............. 5,133 4,218
Unrealized gain on securities
available for sale....................... 298 247
------- -------
Total liabilities and retained
earnings............................... $35,620 $31,499
======= =======
Net interest income........................ $1,174 $1,278
====== ======
Interest rate spread....................... 2.71% 3.63%
===== ======
Net yield on interest-earning assets....... 3.44% 4.21%
===== ======
Ratio of average interest-earning assets
to average interest-bearing liabilities.. 114.45% 113.50%
====== ======
- --------------------
</TABLE>
(1) Includes nonaccrual loans.
37
<PAGE>
Rate/Volume Analysis
The following table sets forth certain information regarding
changes in interest income and interest expense of the Company for the
periods indicated. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable
to: (i) changes in volume (changes in volume multiplied by old rate); (ii)
changes in rate (changes in rate multiplied by old volume); and (iii)
changes in rate/volume (changes in rate multiplied by changes in volume).
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------
1996 vs. 1995
--------------------------------
Increase (Decrease)
Due to
--------------------------------
Rate/
Volume Rate Volume Total
------- ------ ------- ------
(In thousands)
<S> <C> <C> <C> <C>
Interest income:
Loans receivable.................... $ 179 55 4 238
Investment securities............... -- 1 -- 1
Nonmarketable equity securities..... 3 1 -- 4
Mortgage-backed securities.......... (3) -- -- (3)
Other (1)........................... 86 3 3 92
----- ----- ---- -----
Total interest-earning assets.. 265 60 7 332
----- ----- ---- -----
Interest expense:
Deposits............................ 100 261 24 385
Borrowings.......................... 56 (4) (1) 51
----- ----- ---- -----
Total interest-bearing
liabilities................. $ 156 $ 257 $ 23 $ 436
===== ===== ==== =====
Change in net interest income......... $ 109 $(197) $(16) $(104)
===== ===== ==== =====
</TABLE>
- --------------------
(1) Consists of overnight deposits, and cash deposits with the FHLB.
Comparison of Financial Condition at June 30, 1996 and June 30, 1995
The Bank's total assets increased by approximately $6.9 million, or
20.4% from $33.8 million at June 30, 1995 to $40.7 million at June 30,
1996. The increase results primarily from an increase in interest-bearing
cash deposits in other depository institutions of approximately $5.3
million, or 265.0%, to $7.3 million at June 30, 1996 from approximately
$2.0 million at June 30, 1995. This increase reflects the influx of cash
deposits for investment in the equity of the Bank.
Available-for-sale securities increased approximately $103,000, or
24.3%, to $527,000 at June 30, 1996 from $424,000 at June 30, 1995. The
increase was due to an increase in the value of the Bank's investment in
Federal Home Loan Mortgage Corporation ("FHLMC") stock, which increased to
$85.50 per share at June 30, 1996 from $68.75 per share at June 30, 1995.
The recognition of such gain in the carrying value of the FHLMC stock is
consistent with the Bank's adoption in fiscal year 1995 of Statement of
Financial Accounting Standard ("SFAS") No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," which requires that securities
classified as "available-for-sale" be recorded at market value rather than
at cost. See Note 1 of Notes to Consolidated Financial Statements.
38
<PAGE>
The Bank's total loans receivable increased $1.4 million, or 4.7% to
$31.4 million at June 30, 1996 from $30.0 million at June 30, 1995. As
rates decrease, consumers tend to favor fixed-rate loans rather than
adjustable-rate loans that would later give rise to increased rates.
Because of the declining interest rate environment during the year ended
June 30, 1996, the amount of loan originations during such period declined.
The majority of the increase in interest-bearing cash deposits in
other depository institutions and in stockholder's equity was due to the
capital infusion from the initial public offering of stock. Savings
accounts and certificates decreased $0.7 million from $24.2 million at June
30, 1995 to $23.5 million at June 30, 1996. Certificates of deposit with
maturities of 12 months to 36 months decreased $1.5 million from $16.3
million at June 30, 1995 to $14.8 million at June 30, 1996. The decrease
in certificates was offset by an increase in long term deposits which
increased $824,000 for the period. The Bank depends primarily upon deposit
growth rather than borrowings for its funding source and therefore actively
competes for deposits in its market area. The Bank offered higher rates
on its deposit funding sources prior to the initial public offering of
stock to increase liquidity for lending purposes. The Bank anticipates
funding future loan originations from its balance of cash and interest-
bearing deposits in other depository institutions.
Real estate owned increased from $10,000 at June 30, 1995 to $169,000
at June 30, 1996. In October 1995, the Bank sold its $10,000 real estate
owned. Also in October 1995, the Bank transferred a $118,000 residential
real estate loan to real estate owned. The property was sold in 1996. In
April 1996, the Bank transferred a $169,000 nonaccruing single-family
residential real estate loan to real estate owned following the acquisition
of the single-family residence securing the loan through a deed in lieu of
foreclosure. In June 1996, the Bank entered into a contract for the sale
of the property. If this sale is completed, there will be an immaterial
loss. If the sale is not completed, the Bank will seek another buyer for
this property.
Federal Home Loan Bank advances declined $1.2 million from $4.7
million at June 30, 1995 to $3.5 million at June 30, 1996. The Bank used
cash on hand to reduce such advances.
Comparison of Operating Results for the Years Ended June 30, 1996 and 1995
Net Income. The Bank's net income decreased $164,000, or 34.6%, from
$474,000 for the year ended June 30, 1995 to $310,000 for the year ended
June 30, 1996. The decrease was due to a $104,000 decline in net interest
income, an increase in the provision for loan loss of approximately
$35,000, and an increase in other expenses of $116,000 offset in part by a
$92,000 decline in tax expense.
Net Interest Income. Net interest income decreased $104,000, or 8.0%,
to $1.2 million for the year ended June 30, 1996 from $1.3 million for the
year ended June 30, 1995, due primarily to the decrease in the Bank's
interest rate spread to 2.71% for the year ended June 30, 1996 from 3.63%
for the year ended June 30, 1995, which resulted in the decrease in the
Bank's net yield on interest-earning assets to 3.44% for the year ended
June 30, 1996 from 4.21% for the year ended June 30, 1995.
Interest Income. Total interest and dividend income increased
approximately $333,000, or 12.8%, to $2.9 million for the year ended June
30, 1996 from $2.6 million for the year ended June 30, 1995. The increase
primarily reflects an increase in interest income on loans and an increase
in interest on deposits in other depository institutions. Interest income
on loans increased approximately $235,000, or 9.4%, to $2.7 million for the
year ended June 30, 1996 from $2.5 million for the year ended June 30,
1995. Such increase reflects a $2.1 million increase in the average
balance of loans outstanding during the year ended June 30, 1996 from the
year ended June 30, 1995 as the Bank continued its policy during 1996 of
loan growth through originations. Interest income on deposits in other
depository institutions increased $98,000, or 93.3%, to $203,000 for the
year ended June 30, 1996 from $105,000 for the year ended June 30, 1995.
The increase primarily reflects a $2.2 million increase in the average
balance of such deposits during the year ended June 30, 1996 from the same
period in 1995 as the Bank increased its liquidity through deposit growth
and contributed capital for use in originating loans.
39
<PAGE>
Interest Expense. Total interest expense increased approximately
$437,000, or 52.9%, to $1.7 million for the year ended June 30, 1996 from
$1.3 million for the year ended June 30, 1995. Of such amount, interest on
savings accounts and certificates increased approximately $385,000, or
38.5%, to $1.5 million for the year ended June 30, 1996 from $1.1 million
for the year ended June 30, 1995. This increase is primarily attributable
to the Bank's increase in deposit rates to maintain its deposit base to
fund loan originations. The average cost of deposits increased by 1.12%
(i.e., 112 basis points) to 5.73% for the year ended June 30, 1996 from
4.61% for the year ended June 30, 1995. Interest on other borrowings also
increased $51,000, or 22.8%, to $275,000 for the year ended June 30, 1996
from $224,000 for the year ended June 30, 1995, primarily reflecting a
26.5% increase in the average balance of FHLB advances outstanding to $4.3
million for the year ended June 30, 1996 from $3.4 million for the year
ended June 30, 1995.
Provision for Loan Losses. For a discussion of management's
methodology for establishing the provision for loan losses and the Bank's
historical experience in this regard, see " -- Comparison of Results for
the Years Ended June 30, 1996 and 1995." The Bank established provisions
for loan losses of approximately $41,000 and $6,000 in the year ended June
30, 1996 and 1995, respectively. Management's determination to increase
the reserve was based in part on the general increases in loans outstanding
of $1.4 million, or 4.7%, during 1996. The Bank's provision for loan
losses is based upon management's assessment of the general risk inherent
in the loan portfolio based on all relevant factors and conditions. See
"Business of the Bank -- Lending Activities -- Allowance for Loan Losses."
Noninterest Expense. Total noninterest expense increased $116,000, or
20.9% from $555,000 for the year ended June 30, 1995 to $671,000 for the
year ended June 30, 1996. This increase was caused primarily by an
increase of $72,000 in compensation and benefits as a result of general
salary increases, the addition of one loan officer and two tellers and
initial accrual of retirement plan expense.
Income Tax. The effective tax rate for the year ended June 30, 1996
and 1995 was 33% and 34%, respectively. The expense decreased
approximately $92,000, or 37.7%, from $244,000 for the year ended June 30,
1995 to $152,000 for the year ended June 30, 1996. The decrease was due to
the decrease in the Bank's income before income taxes.
Performance Ratios
<TABLE>
<CAPTION>
Year ended June 30,
------------------
1996 1995
-------- --------
<S> <C> <C>
Return on average assets 0.87% 1.50%
Return on average equity 5.71% 10.61%
Dividend payout ratio 0.00% 0.00%
Average total equity to 15.24% 14.18%
average total assets
</TABLE>
40
<PAGE>
Liquidity and Capital Resources
The Company's primary source of liquidity, in addition to the
$8.4 million in net proceeds retained by the Company from the Conversion,
will be dividends paid by the Bank and earnings on that portion of the net
proceeds retained by the Company. The Bank, as a stock savings bank, is
subject to certain regulatory limitations with respect to the payment of
dividends to the Company. See "Item 1. Regulation -- Regulation of the
Bank -- Dividend Restrictions."
The Bank's capital ratios are substantially in excess of current
regulatory capital requirements. At June 30, 1996, the Bank's tangible and
core capital amounted to 29.5% of adjusted total assets, or 28.0% and
26.8%, respectively, in excess of the Bank's current 1.5% tangible and 3.0%
core capital requirements. Additionally, the Bank's risk-based capital
ratio was 60.9% at June 30, 1996, or 52.9% in excess of the Bank's 8.0%
risk-based capital requirement.
The Bank's principal sources of funds for operations are deposits
from its primary market area, principal and interest payments on loans and
proceeds from maturing investment securities, as well as the net proceeds
from the Conversion of approximately $8.4 million. In addition, as a
member of the FHLB of Cincinnati, the Bank is eligible to borrow funds from
the FHLB of Cincinnati in the form of advances.
The Bank is required to maintain minimum levels of liquid assets
as defined by OTS regulations. This requirement, which may be changed at
the direction of the OTS depending upon economic conditions and deposit
flows, is based upon a percentage of deposits and short-term borrowings.
The required minimum ratio is currently 5.0%. The Bank's liquidity ratio
averaged 31.4% for the month of June 1996. Historically, management of the
Bank has sought to maintain a relatively high level of liquidity in order
to retain flexibility to take advantage of investment opportunities. The
Company intends to continue its practice of investing available funds in
loan originations, especially residential real estate loans with adjustable
rates. The Company also intends to continue its origination of fixed-rate
residential real estate loans, but expects to fund such loans with FHLB
advances or certificates of deposit with similar maturities. While
management believes that a higher liquidity ratio would allow for certain
flexibility in making investments, including mortgage loans, management
believes that the Company's liquidity is adequate to meet current needs.
The Company may, however, elect to increase its borrowings from the FHLB of
Cincinnati or increase its rates on deposits in order to generate
additional funds. Because liquid assets generally provide for lower rates
of return, the Company's relatively higher liquidity will, to a certain
extent, result in a lower rate of return on assets.
The Company's most liquid asset is cash held in an interest-
bearing overnight interest account at the FHLB of Cincinnati. The level of
cash is dependent on the Company's operating, financing and investing
activities during any given period. Such cash totaled $7.3 million at June
30, 1996.
Another source of liquidity is the Bank's ability to obtain
advances from the FHLB of Cincinnati. In addition, the Company maintains a
significant portion of its investments in FHLB overnight funds that will be
available when needed.
Management believes that the Company will have sufficient funds
available to meet its current commitments. At June 30, 1996, the Company
had commitments to originate loans of $454,000. Certificates of deposit
which were scheduled to mature in less than one year at June 30, 1996,
totaled $13.9 million. On the basis of historical experience, management
believes that a significant portion of such deposits will remain with the
Company.
Impact of Inflation and Changing Prices
The Financial Statements and Notes thereto presented herein have
been prepared in accordance with generally accepted accounting principles,
which require the measurement of financial position and operating results
in terms of historical dollars without considering the change in the
relative purchasing power of money over time and due to inflation. The
impact of inflation is reflected in the increased cost of the Bank's
operations. Unlike most industrial companies, nearly all the assets and
liabilities of the Bank are monetary in nature. As a result, interest
41
<PAGE>
rates have a greater impact on the Bank's performance than do the effects
of general levels of inflation. Interest rates do not necessarily move in
the same direction or to the same extent as the price of goods and
services.
Impact of New Accounting Standards
Accounting for ESOP. The Accounting Standards Division of the
American Institute of Certified Public Accountants approved Statement of
Position ("SOP") 93-6, "Employers' Accounting for Employee Stock Ownership
Plans," which is effective for fiscal years beginning after December 15,
1993. SOP 93-6 changed, among other things, the measure of compensation
recorded by employers from the cost of ESOP shares to the fair value of
ESOP shares. To the extent that the fair value of the Common Stock held by
the ESOP that are committed to be released directly to compensate
employees, differs from the cost of such shares, compensation expenses and
a related charge or credit to additional paid-in capital will be reported
in the Company's financial statements. The adoption of the ESOP by the
Bank and the application of SOP 93-6 is likely to result in fluctuations in
compensation expense as a result of changes in the fair value of the Common
Stock. However, any such compensation expense fluctuations will result in
an offsetting adjustment to paid-in capital, and therefore, total capital
will not be affected.
Impairment of Long-Lived Assets. In March 1995, the Financial
Accounting Standards Board ("FASB") issued Statement of Financial
Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of." This
Statement establishes accounting standards for the impairment of long-lived
assets, certain identifiable intangibles, and goodwill related to those
assets to be held and used and for long-lived assets and certain
identifiable intangibles to be disposed of. This Statement requires that
long-lived assets and certain identifiable intangibles to be held and used
by an entity be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. In performing the review for recoverability, the entity
should estimate the future cash flows expected to result from the use of
the asset and its eventual disposition. If the sum of the expected future
cash flows (undiscounted and without interest charges) is less than the
carrying amount of the asset, an impairment loss is recognized. Otherwise,
an impairment loss is not recognized. Measurement of an impairment loss
for long-lived assets and identifiable intangibles that an entity expects
to hold and use should be based on the fair value of the asset. The impact
on the financial statements for implementation of the statement is not
expected to be material.
Mortgage Servicing Rights. In May 1995, the FASB issued SFAS No.
122, "Accounting for Mortgage Servicing Rights." This Statement amends
FASB Statement No. 65, "Accounting for Certain Mortgage Banking Activities"
to require that a mortgage banking enterprise recognize as separate asset
rights to service mortgage loans for others, however those servicing rights
are acquired. The total cost of the mortgage loans to be sold should be
allocated between the mortgage servicing rights and the loans based on
their relative fair values if it is practicable to estimate those fair
values. If not, the entire cost should be allocated to the mortgage loans.
This statement applies prospectively in fiscal years beginning after
December 15, 1995. The impact on the financial statements for
implementation of the Statement is not expected to be material.
Accounting for Stock-Based Compensation. In October 1995, the
FASB issued SFAS No. 123, "Accounting for Stock-Based Compensation to
Employees." This Statement encourages entities to adopt the fair value
based method of accounting for employee stock options or other stock
compensation plans. However, it allows an entity to measure compensation
cost for those plans using the intrinsic value based method of accounting
prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees." Under the fair value based method, compensation cost is
measured at the grant date based on the value of the award and is
recognized over the service period, which is usually the vesting period.
Under the intrinsic value based method, compensation cost is the excess of
the quoted market price of the stock at grant date over the amount an
employee must pay to acquire the stock. Most fixed stock option plans --
the most common type of stock compensation plan -- have no intrinsic value
at grant date, and under Opinion No. 25 no compensation cost is recognized
for them. Compensation cost is recognized for other types of stock based
compensation plans under Opinion No. 25, including plans with variable,
usually performance-based, features. This Statement requires that an
employer's financial statements include certain
42
<PAGE>
disclosures about stock-based employee compensation arrangements regardless
of the method used to account for them. This statement is effective for
transactions entered into in fiscal years that begin after December 15,
1995. The Company will adopt the Statement on the date the Company
authorizes the issuance of stock options as contemplated in the Company's
prospectus dated May 13, 1996. The Company has determined it will use the
accounting provisions prescribed by APB Opinion No. 25.
In June 1996, the FASB issued SFAS No. 125 "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities." Under this standard, accounting for transfers and servicing
of financial assets and extinguishments of liabilities is based on control.
After a transfer of financial assets, an entity recognizes the financial
and servicing assets it controls and the liabilities it has incurred,
derecognizes financial assets when control has been surrendered and
derecognizes liabilities when extinguished. This statement applies
prospectively in fiscal years beginning after December 31, 1996. The
Corporation does not expect the implementation of this statement to have a
material affect on the financial statements.
43
<PAGE>
Item 7. Financial Statements
-----------------------------
44
<PAGE>
FIRST LANCASTER BANCSHARES, INC.
AND SUBSIDIARY
_______
REPORT ON AUDITS OF
CONSOLIDATED
FINANCIAL STATEMENTS
FOR THE YEARS ENDED
JUNE 30, 1996 AND 1995
<PAGE>
C O N T E N T S
--------
<TABLE>
<CAPTION>
Pages
-----
<S> <C>
Report of Independent Accountants 1
Consolidated Financial Statements:
Balance Sheets 2
Statements of Income 3
Statements of Changes in Stockholders' Equity 4
Statements of Cash Flows 5
Notes to Financial Statements 6-26
</TABLE>
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
First Lancaster Bancshares, Inc.
Lancaster, Kentucky
We have audited the accompanying consolidated balance sheets of First Lancaster
Bancshares, Inc. and Subsidiary (the Corporation) as of June 30, 1996 and 1995,
and the related consolidated statements of income, changes in stockholders'
equity, and cash flows for the years then ended. These financial statements are
the responsibility of the Corporation's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of First Lancaster
Bancshares, Inc. and Subsidiary as of June 30, 1996 and 1995, and the
consolidated results of their operations and their cash flows for the years then
ended in conformity with generally accepted accounting principles.
As discussed in Note 1 to the financial statements, the Bank changed its method
of accounting for certain investments in debt and equity securities in 1995.
/s/ Coopers & Lybrand L.L.P.
Lexington, Kentucky
July 29, 1996
1
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
June 30, 1996 and 1995
<TABLE>
<CAPTION>
ASSETS 1996 1995
<S> <C> <C>
Cash $ 339,445 $ 357,713
Interest-bearing cash deposits in other depository institutions 7,285,412 1,994,181
Investment securities available-for-sale, at market value (amortized
cost $24,158 at June 30, 1996 and 1995) 527,364 424,050
Mortgage-backed securities, held to maturity (market value of
$125,000 and $154,442 at June 30,1996 and 1995, respectively) 114,979 144,056
Investments in nonmarketable equity securities, at cost 315,600 300,400
Loans receivable, net 31,385,400 29,958,452
Real estate acquired by foreclosure 168,965 10,000
Income tax receivable 30,987
Accrued interest receivable 138,213 108,046
Office property and equipment, at cost, less accumulated depreciation 427,390 464,676
Other assets 23,870 19,733
------------ ------------
Total assets $ 40,726,638 $ 33,812,294
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Savings accounts and certificates $ 23,482,589 $ 24,186,523
Advance payments by borrowers for taxes and insurance 24,840 26,083
Accrued interest on savings accounts and certificates 45,961 54,831
Federal Home Loan Bank advances 3,480,410 4,675,317
Accounts payable and other liabilities 113,958 72,886
Income tax payable 2,230
Deferred income tax payable 163,463 153,606
------------ ------------
Total liabilities 27,313,451 29,169,246
------------ ------------
Commitments and contingencies (Notes 5 and 10)
Preferred stock, 500,000 shares authorized
Common stock, $.01 par value; 9,588,120 shares authorized;
882,108 shares issued and outstanding at June 30, 1996 9,588
Additional paid-in capital 9,149,403
Employee stock ownership plan (767,040)
Unrealized gain on securities available-for-sale (net of deferred tax
liability of $171,090 and $135,963, respectively) 332,116 263,929
Retained earnings, substantially restricted 4,689,120 4,379,119
------------ ------------
Total stockholders' equity 13,413,187 4,643,048
------------ ------------
Total liabilities and stockholders' equity $ 40,726,638 $ 33,812,294
============ ============
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
2
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
for the years ended June 30, 1996 and 1995
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Interest on loans and mortgage-backed securities $ 2,706,214 $ 2,471,281
Interest and dividends on investments and deposits in other
depository institutions 203,215 105,243
------------ ------------
Total interest income 2,909,429 2,576,524
------------ ------------
Interest on savings accounts and certificates 1,460,215 1,074,699
Interest on other borrowings 274,818 223,656
------------ ------------
Total interest expense 1,735,033 1,298,355
------------ ------------
Net interest income 1,174,396 1,278,169
Provision for loan losses 41,328 5,832
------------ ------------
Net interest income after provision for loan losses 1,133,068 1,272,337
------------ ------------
Other expenses:
Compensation 281,122 255,592
Employee retirement and other benefits 69,092 22,689
State franchise taxes 28,584 26,460
SAIF deposit insurance premium 67,866 63,076
Depreciation 37,286 25,597
Data processing 40,651 36,330
Other 146,651 125,103
------------ ------------
Total other expenses 671,252 554,847
------------ ------------
Income before income taxes 461,816 717,490
Provision for income taxes 151,815 243,900
------------ ------------
Net income $ 310,001 $ 473,590
============ ============
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
3
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
for the years ended June 30, 1996 and 1995
<TABLE>
<CAPTION>
Unrealized
Employee Gains on
Additional Stock Securities Total
Common Paid-In Ownership Available Retained Stockholders'
Shares Stock Capital Plan for Sale Earnings Equity
------------ ------------- ------------- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, June 30, 1994 $3,905,529 $ 3,905,529
Net income 473,590 473,590
Cumulative effect as of
July 1, 1994 of
unrealized gain
on securities
available-for-sale,
net of deferred tax
liability of $118,662 $230,344 230,344
Change in unrealized
gain on securities
available-for-sale,
net of deferred tax
liability of $17,301 33,585 33,585
------------ ------------- ------------- ------------- ------------- ------------- -------------
Balance, June 30, 1995 263,929 4,379,119 4,643,048
Proceeds from issuance
of common stock,
net of conversion
expense of $429,129 958,812 $9,588 $9,149,403 9,158,991
Employee Stock
Ownership Plan
(ESOP) (76,704) $(767,040) (767,040)
Net income 310,001 310,001
Change in unrealized
gain on securities
available-for-sale,
net of deferred tax
liability of $35,127 68,187 68,187
------------ ------------- ------------- ------------- ------------- ------------- -------------
Balance, June 30, 1996 882,108 $9,588 $9,149,403 $(767,040) $332,116 $4,689,120 $13,413,187
============ ============= ============= ============= ============= ============= =============
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
4
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the years ended June 30, 1996 and 1995
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Cash flows from operating activities:
Net income $ 310,001 $ 473,590
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 37,286 25,597
Provision for loan losses 41,328 5,832
Stock dividend, FHLB stock (15,200) (15,200)
Deferred income taxes (25,270) 12,267
Net loan origination fees deferred 29,430 31,423
Amortization of deferred loan fees (18,893) (18,042)
Accretion of discount on mortgage-backed
securities (150) (1,198)
Loss on sale of real estate acquired by
foreclosure 8,579
Change in assets and liabilities:
Income tax receivable 30,987 (30,987)
Accrued interest receivable (30,167) (47,352)
Other assets (4,137) (12,582)
Accrued interest on savings accounts and
certificates (8,870) 15,373
Accounts payable and other liabilities 41,072 32,077
Income tax payable 2,230 (853)
------------ ------------
Net cash provided by operating activities 398,226 469,945
------------ ------------
Cash flows from investing activities:
Purchase of Federal Home Loan Bank stock (49,300)
Proceeds from sale of real estate acquired by
foreclosure 119,421
Mortgage-backed securities principal repayments 29,227 37,655
Net (increase) decrease in loans receivable (1,765,778) (4,367,165)
Purchase of office property and equipment (242,626)
------------ ------------
Net cash used in investing activities (1,617,130) (4,621,436)
------------ ------------
Cash flows from financing activities:
Net (decrease) increase in savings accounts and
certificates 2,993,959 669,400
Net (decrease) increase in advance payments by
borrowers for taxes and insurance (1,243) 4,440
Federal Home Loan Bank advances 4,714,846
Federal Home Loan Bank advance principal repayments (1,194,907) (39,529)
Proceeds from stock conversion 5,123,187
Stock conversion costs (429,129)
------------ ------------
Net cash provided by financing activities 6,491,867 5,349,157
------------ ------------
Net increase in cash and cash equivalents 5,272,963 1,197,666
Cash and cash equivalents at beginning of year 2,351,894 1,154,228
------------ ------------
Cash and cash equivalents at end of year $ 7,624,857 $ 2,351,894
============ ============
Supplemental disclosure of cash flow information:
Interest paid $ 1,751,530 $ 1,257,727
Income taxes paid $ 176,421 $ 263,473
Supplemental disclosure of non-cash investing and
financing activities:
Unrealized gain on securities available for sale,
net of deferred tax liability of $35,127 and
$135,963, respectively $ 68,187 $ 263,929
Real estate acquired by foreclosure $ 286,965
Conversion proceeds transferred from savings deposits $ 3,697,893
The accompanying notes are an integral part of the consolidated financial statements.
</TABLE>
5
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
The following is a description of the more significant accounting policies
which First Lancaster Bancshares, Inc. (the Corporation) and its wholly owned
subsidiary, First Lancaster Federal Savings Bank (the Bank), follow in
preparing and presenting the consolidated financial statements.
A. Basis of Presentation
---------------------
The consolidated financial statements include the accounts of the
Corporation, the Bank and the Bank's wholly-owned subsidiary, First
Lancaster Corporation. All significant intercompany accounts and
transactions have been eliminated.
In preparing the financial statements, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the statements of financial condition and
income and expenses for the period. Actual results could differ
significantly from those estimates. Estimates used in the preparation of
the financial statements are based on various factors including the
current interest rate environment and the general strength of the local
economy. Changes in the overall interest rate environment can
significantly affect the Bank's net interest income and the value of its
recorded assets and liabilities. Material estimates that are particularly
susceptible to significant change in the near-term relate to the
determination of the allowance for loan losses. In connection with this
determination, management obtains independent appraisals for significant
properties and prepares fair value analyses as appropriate.
Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize such losses, future
additions to the allowance may be necessary based on changes in economic
conditions, particularly in Lancaster and the State of Kentucky. In
addition, various regulatory agencies, as an integral part of their
examination process, periodically review the Bank's allowance for loan
losses. Such agencies may require the Bank to recognize additions to the
allowance based on their judgments about information available to them at
the time of their examination.
The Federal Deposit Insurance Corporation ("FDIC") has lowered the deposit
insurance assessment rate for most commercial banks insured by the Bank
Insurance Fund ("BIF") to 0.04% of insured deposits. The FDIC has
indicated that the assessment rate for SAIF-insured institutions will not
fall below .23% of insured deposits until approximately the year 2002.
This decrease in BIF rates has resulted in a substantial disparity in
deposit insurance premiums paid by savings institutions, such as the Bank,
which are insured by the Savings Association Insurance Fund ("SAIF") and
institutions insured by the BIF. The lower rates paid by BIF-insured
institutions are likely to give them a significant competitive advantage
over SAIF-insured institutions such as the Bank.
6
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
A. Basis of Presentation, continued
--------------------------------
To alleviate this disparity, one proposal being considered by the U.S.
Department of Treasury, the FDIC, and the U.S. Congress provides that a
one-time assessment of as much as 80 basis points be imposed on all SAIF-
insured deposits to cause the SAIF insurance fund to reach its designated
reserve ratio (currently 1.25%). Once this occurs, the two funds would be
merged into one fund. There can be no assurance that this proposal or any
other proposal will be implemented or that premiums for either fund will
not be adjusted in the future by the FDIC or legislative action.
The payment of a special assessment would severely and negatively impact
the Bank's results of operations, resulting in a net charge of up to
approximately $124,000, after adjusting for tax benefits. However, if such
a special assessment is imposed and the SAIF is recapitalized, it could
have the effect of reducing the Bank's insurance premiums in the future,
thereby creating equal competition between BIF-insured and SAIF-insured
institutions.
In addition, legislation that is effective for tax years beginning after
December 31, 1995 would require savings associations to recapture into
taxable income the portion of the tax loan reserve that exceeds the 1987
tax loan loss reserve. All of the Bank's tax loan loss reserves at June
30, 1996 were pre 1987 loan loss reserves and therefore this provision
should not affect future operations. The Bank will no longer be allowed to
use the reserve method for tax loan loss provisions, but would be allowed
to use either the experience method or the specific charge-off method of
accounting for bad debts.
B. Organization
------------
The Bank is a federally chartered savings bank and a member of the Federal
Home Loan Bank System. As a member of this system, the Bank is required to
maintain an investment in capital stock of the Federal Home Loan Bank of
Cincinnati in an amount equal to at least 1% of its outstanding
residential mortgage loans, 3% of its total assets or 5% of its
outstanding advances from the bank, whichever is greater. No ready market
exists for the stock and it has no quoted market value.
The Corporation's purpose is to act as a holding company with the Bank as
its sole subsidiary. The Corporation's principle business is the business
of the Bank, and the Bank is predominately engaged in the business of
receiving deposits from and making first mortgage loans to borrowers on
one to four family residential properties domiciled in Central Kentucky.
Savings deposits of the Bank are insured by the Federal Deposit Insurance
Corporation ("FDIC") up to certain limitations. The Bank pays a premium to
the FDIC for the insurance of such savings deposits.
C. Cash and Cash Equivalents
-------------------------
For purposes of reporting consolidated cash flows, the Bank considers
cash, balances with banks and interest-bearing cash deposits in other
depository institutions with maturities of three months or less to be cash
equivalents.
7
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
D. Investment Securities and Mortgage-Backed Securities
----------------------------------------------------
In May 1993, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting
for Certain Investments in Debt and Equity Securities." SFAS No. 115
requires that all investments in debt securities and all investments in
equity securities that have readily determinable fair values be classified
into three categories. Debt securities that management has the positive
intent and ability to hold until maturity are classified as held to
maturity. Securities that are bought and held specifically for the purpose
of selling them in the near future are classified as trading securities.
All other securities are classified as available for sale. Securities
classified as trading and available for sale are carried at market value.
Unrealized holding gains and losses for trading securities are included in
current income. Unrealized holding gains and losses for available for sale
securities are reported as a net amount in a separate component of
stockholders' equity until realized. Investments classified as held to
maturity will be carried at amortized cost. The statement was adopted
effective July 1, 1994.
The Bank has analyzed its debt securities portfolio, and based on this
analysis, the Bank has determined to classify all debt securities as held
to maturity due to management's intent and ability to hold all debt
securities so classified until maturity. Equity securities are classified
as available for sale.
No active market exists for Federal Home Loan Bank capital stock. The
carrying value is estimated to be fair value, since if the Bank withdraws
membership in the Federal Home Loan Bank, the stock must be redeemed for
face value. Premiums and discounts on investment and mortgage-backed
securities are amortized over the term of the security using the interest
method. Gain or loss on sale of investments available-for-sale is
reflected in income at the time of sale using the specific identification
method.
E. Depreciation
------------
Depreciation of office property and equipment is calculated using
straight-line and accelerated methods over the estimated useful lives of
such property. The gain or loss on the sale of office property and
equipment is recorded in the year of disposition.
F. Loan Fees
---------
Loan fees are accounted for in accordance with SFAS No. 91. SFAS No. 91
requires that loan origination fees and certain related direct loan
origination costs be offset and that the resulting net amount be deferred
and amortized over the contractual life of the related loans as an
adjustment to the yield of such loans.
8
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
G. Provision for Loan Losses
-------------------------
The Bank has established an allowance for loan losses for the purpose of
absorbing losses associated with the Bank's real estate mortgage loan
portfolio. All actual loan losses are charged to the related allowance and
all recoveries are credited to it when management deems the ultimate
collectibility of the loan is readily determinable. Additions to the
allowance for loan losses are provided by charges to operations based on
various factors, including the market value of the underlying collateral,
growth and composition of the loan portfolios, the relationship of the
allowance for loan losses to outstanding loans, historical loss
experience, delinquency trends and prevailing and projected economic
conditions. Management evaluates the carrying value of loans periodically
in order to evaluate the adequacy of the allowance. While management uses
the best information available to make these evaluations, future
adjustments to the allowance may be necessary if the assumptions used in
making the evaluations require material revision.
In May 1993 the FASB issued SFAS No. 114 "Accounting by Creditors for
Impairment of a Loan" (SFAS No. 114), which is effective for fiscal years
beginning after December 15, 1994. The Statement addresses the accounting
by creditors for impairment of certain loans. It is generally applicable
for all loans except large groups of smaller balance homogenous loans that
are collectively evaluated for impairment including residential mortgage
loans and consumer installment loans.
SFAS No. 114 requires that impaired loans be measured based on the present
value of expected future cash flows discounted at the loan's effective
interest rate, or at the loan's observable market price or the fair value
of the collateral if the loan is collateral dependent. A loan is
considered impaired when, based on current information and events, it is
probable that a creditor will be unable to collect all amounts due
according to the contractual terms of the loan agreements.
In October 1994, the FASB issued SFAS No. 118, which is effective
concurrent with the effective date of SFAS No. 114. This Statement amends
SFAS No. 114 to allow a creditor to use existing methods for recognizing
interest income on impaired loans. Also, this statement requires the
disclosure about the recorded investment in certain impaired loans and how
the creditor recognizes interest income related to those impaired loans.
The Bank adopted the provisions of SFAS Nos. 114 and 118 as of July 1,
1995 and the impact of the adoption of SFAS Nos. 114 and 118 was
immaterial.
H. Real Estate Acquired by Foreclosure
-----------------------------------
Real estate properties acquired through, or in lieu of, loan foreclosure
are initially recorded at fair value at the date of foreclosure
establishing a new cost basis. After foreclosure, valuations are
periodically performed by management and the real estate is carried at the
lower of (1) cost or (2) fair value minus estimated costs to sell. Any
reduction to fair value from the new cost basis recorded at the time of
acquisition is accounted for as a valuation reserve. Revenue and expenses
from operations and additions to the valuation allowance are included in
loss on foreclosed real estate.
9
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
I. Income Recognition on Impaired and Nonaccrual Loans
---------------------------------------------------
Loans, including impaired loans, are generally classified as nonaccrual if
they are past due as to maturity or payment of principal or interest for a
period of more than 90 days, unless such loans are well-secured and in the
process of collection. 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/or interest is in doubt.
Loans may be returned to accrual status when all principal and interest
amounts contractually due (including arrearages) are reasonably assured of
repayment within an acceptable period of time, and there is a sustained
period of repayment performance by the borrower, in accordance with the
contractual terms of interest and principal.
Payments received on a nonaccrual loan are either applied to the
outstanding principal balance or recorded as interest income, depending on
management's assessment of the collectibility of the loan.
J. Income Taxes
------------
Deferred income taxes are recognized for certain income and expenses that
are recognized in different periods for tax and financial statement
purposes.
K. Effect of Implementing New Accounting Standards
-----------------------------------------------
The Accounting Standards Division of the American Institute of Certified
Public Accountants approved Statement of Position ("SOP") 93-6,
"Employers' Accounting for Employee Stock Ownership Plans," which is
effective for fiscal years beginning after December 15, 1993. SOP 93-6
changed, among other things, the measure of compensation recorded by
employers from the cost of ESOP shares to the fair value of ESOP shares.
To the extent that the fair value of First Lancaster Federal's ESOP
shares, committed to be released directly to compensate employees, differs
from the cost of such shares, compensation expenses and a related charge
or credit to additional paid-in capital will be reported in the Company's
financial statements. The adoption of the ESOP by the Bank and the
application of SOP 93-6 is likely to result in fluctuations in
compensation expense as a result of changes in the fair value of the
Common Stock; however, any such compensation expense fluctuations will
result in an offsetting adjustment to paid-in capital. Therefore, total
capital will not be affected.
10
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
K. Effect of Implementing New Accounting Standards, continued
----------------------------------------------------------
In March 1995, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed of." This Statement establishes accounting standards for the
impairment of long-lived assets, certain identifiable intangibles, and
goodwill related to those assets to be held and used and for long-lived
assets and certain identifiable intangibles to be disposed of. This
Statement requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for impairment
whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. In performing the review for
recoverability, the entity should estimate the future cash flows expected
to result from the use of the asset and its eventual disposition. If the
sum of the expected future cash flows (undiscounted and without interest
charges) is less than the carrying amount of the asset, an impairment loss
is recognized. Otherwise, an impairment loss is not recognized.
Measurement of an impairment loss for long-lived assets and identifiable
intangibles that an entity expects to hold and use should be based on the
fair value of the asset. The impact on the financial statements for
implementation of the statement is not expected to be material.
In May 1995, the FASB issued SFAS No. 122, "Accounting for Mortgage
Servicing Rights". This Statement amends FASB Statement No. 65,
"Accounting for Certain Mortgage Banking Activities" to require that a
mortgage banking enterprise recognize as separate assets rights to service
mortgage loans for others, however those servicing rights are acquired.
The total cost of the mortgage loans to be sold should be allocated
between the mortgage servicing rights and the loans based on their
relative fair values if it is practicable to estimate those fair values.
If not, the entire cost should be allocated to the mortgage loans. This
statement applies prospectively in fiscal years beginning after December
15, 1995. The impact on the financial statements for implementation of the
Statement is not expected to be material.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation". This Statement encourages entities to adopt the fair value
based method of accounting for employee stock options or other stock
compensation plans. However, it allows an entity to measure compensation
cost for those plans using the intrinsic value based method of accounting
prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees". Under the fair value based method, compensation cost is
measured at the grant date based on the value of the award and is
recognized over the service period, which is usually the vesting period.
Under the intrinsic value based method, compensation cost is the excess of
the quoted market price of the stock at grant date over the amount an
employee must pay to acquire the stock. This statement is effective for
transactions entered into in fiscal years that begin after December 15,
1995. The Company will adopt the Statement on the date the Company
authorizes the issuance of stock options as contemplated in the Company's
prospectus dated May 13, 1996. The Company has determined it will use the
accounting prescribed by APB Opinion No. 25.
11
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
K. Effect of Implementing New Accounting Standards, continued
----------------------------------------------------------
In June 1996, the FASB issued SFAS No. 125 "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities". Under
this standard, accounting for transfers and servicing of financial assets
and extinguishments of liabilities is based on control. After a transfer
of financial assets, an entity recognizes the financial and servicing
assets it controls and the liabilities it has incurred, derecognizes
financial assets when control has been surrendered and derecognizes
liabilities when extinguished. This statement applies prospectively in
fiscal years beginning after December 31, 1996. The Corporation does not
expect the implementation of this statement to have a material affect on
the financial statements.
2. INVESTMENT SECURITIES:
Investment securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market
June 30, 1996 Cost Gains Losses Value
<S> <C> <C> <C> <C>
Available-for-Sale Equity Securities:
Federal Home Loan Mortgage Corporation
Common stock - 6,168 shares $ 24,158 $ 503,206 $ $ 527,364
========= ========= ========= =========
June 30, 1995
Available-for-Sale Equity Securities:
Federal Home Loan Mortgage Corporation
Common stock - 6,168 shares $ 24,158 $ 399,892 $ $ 424,050
========= ========= ========= =========
</TABLE>
3. MORTGAGED-BACKED SECURITIES:
Mortgage-backed securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market
June 30, 1996 Cost Gains Losses Value
<S> <C> <C> <C> <C>
FHLMC certificates $ 111,228 $ 9,699 $ 120,927
GNMA certificate 3,751 322 4,073
--------- --------- --------- ---------
$ 114,979 $ 10,021 $ 125,000
========= ========= ========= =========
June 30, 1995
FHLMC certificates $ 138,385 $ 10,259 $ 148,644
GNMA certificate 5,671 127 5,798
--------- --------- --------- ---------
$ 144,056 $ 10,386 $ 154,442
========= ========= ========= =========
</TABLE>
12
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
3. MORTGAGED-BACKED SECURITIES, CONTINUED:
Accrued interest receivable on held-to-maturity mortgage-backed securities
totaled $2,128 and $2,630 at June 30, 1996 and 1995, respectively.
Expected maturities will differ from contractual maturities because borrowers
may prepay obligations without prepayment penalties.
4. LOANS RECEIVABLE, NET:
The Bank's loan portfolio consists principally of long-term conventional
loans collateralized by first mortgages on single-family residences. All
loans are carried at their unpaid principal balance. Loans receivable, net,
at June 30, 1996 and 1995 consist of the following:
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Single-family residential $ 27,708,600 $ 26,446,811
Multi-family residential 579,000 473,000
Construction 2,135,000 2,240,000
Non-residential 1,222,000 957,000
Loans to depositors, secured by savings 344,077 328,974
------------- -------------
31,988,677 30,445,785
Less: Unearned loan origination fees 41,271 30,734
Undisbursed portion of mortgage loans 462,006 386,599
Allowance for loan losses 100,000 70,000
------------- -------------
$ 31,385,400 $ 29,958,452
============= =============
</TABLE>
Accrued interest receivable on loans totaled $136,085 and $105,416 at June
30, 1996 and 1995, respectively.
The following is a reconciliation of the allowance for loan losses:
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Balance at beginning of year $ 70,000 $ 70,000
Provision charged to operations 41,328 5,832
Loans charged off (11,328) (5,832)
------------- -------------
Balance at end of year $ 100,000 $ 70,000
============= =============
</TABLE>
Nonaccrual loans amounted to approximately $231,221 and $315,838 at June 30,
1996 and 1995, respectively. At June 30, 1996 and 1995, the amount of interest
income that would have been recorded on loans in nonaccrual status, had such
loans performed in accordance with their terms, would have been approximately
$10,160 and $5,658 respectively.
13
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
5. INVESTMENT IN NONMARKETABLE EQUITY SECURITIES:
<TABLE>
<CAPTION>
JUNE 30,
-------------------------------
1996 1995
<S> <C> <C>
Federal Home Loan Bank of Cincinnati
capital stock 2,904 and 2,854 shares
in 1996 and 1995, respectively $ 300,600 $ 285,400
Intrieve, Inc.
capital stock 10 shares 15,000 15,000
---------- ----------
$ 315,600 $ 300,400
========== ==========
</TABLE>
6. Financial Instruments with Off-Balance Sheet Risk and Concentrations of
Credit Risk:
The Bank is party to financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers.
These financial instruments include mortgage commitments which amounted to
$454,000 and $625,000 at June 30, 1996 and 1995, respectively. These
instruments involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the consolidated balance sheets.
The Bank's exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for loan commitments is represented
by the contractual amount of those commitments. The Bank uses the same
credit policies in making commitments and conditional obligations as it does
for on-balance sheet instruments. The Bank evaluates each customer's credit
worthiness on a case-by-case basis. The amount of collateral obtained upon
extension of credit is based on management's credit evaluation of the
counterparty. Collateral held varies but primarily includes residential real
estate.
The Bank has no significant concentrations of credit risk with any individual
counterparty to originate loans. The Bank's lending is concentrated in
residential real estate mortgages in the local Garrard and Jessamine County,
Kentucky market.
7. OFFICE PROPERTY AND EQUIPMENT:
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Land $ 30,000 $ 30,000
Office building and improvements 379,522 379,522
Furniture and equipment 185,552 185,552
---------- ----------
595,074 595,074
Less accumulated depreciation 167,684 130,398
---------- ----------
$ 427,390 $ 464,676
========== ==========
</TABLE>
14
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
8. DEPOSITS:
<TABLE>
<CAPTION>
1996 1995
BALANCES BY INTEREST RATE
<S> <C> <C> <C> <C>
Passbook, (3.00-3.75% in 1996;
3.25-3.75% in 1995) $ 2,217,829 9.4% $ 1,503,688 6.2%
Money market deposit accounts
(2.75%-4.00% in 1996; 3.99% in 1995) 1,916,155 8.2 2,470,255 10.2
Certificates:
1 year (4.50-6.75% in 1996; 4.25-6.75%
in 1995) 7,489,407 31.9 7,461,916 30.9
18 months (3.0-7.0% in 1996;
3.25-7.0% in 1995) 3,573,153 15.2 4,480,507 18.5
30 months (3.0-7.0% in 1996;
3.75-7.0% in 1995) 3,708,206 15.8 4,346,174 18.0
4-8 years (5.0-8.0% in 1996;
6.0-8.0% in 1995) 1,564,677 6.7 740,448 3.0
Money market:
3 months (4.0% in 1996; 5.25% in 1995) 64,162 0.3 114,288 0.5
6 months (4.25-5.0% in 1996;
5.25-5.75% in 1995) 2,949,000 12.5 3,069,247 12.7
------------ ----- ------------ -----
19,348,605 82.4 20,212,580 83.6
------------ ----- ------------ -----
$ 23,482,589 100.0% $ 24,186,523 100.0%
============ ===== ============ =====
</TABLE>
Interest expense for certificates was $1,295,941 and $894,048 for the years
ended June 30, 1996 and 1995, respectively. Interest expense for passbook
and money market accounts was $164,274 and $180,651 for the years ended June
30, 1996 and 1995, respectively.
<TABLE>
<CAPTION>
1996 1995
CERTIFICATE CONTRACTUAL MATURITIES
<S> <C> <C> <C> <C>
Money market:
3 months $ 64,162 0.3% $ 114,288 0.6%
6 months 2,949,000 15.2 3,069,247 15.2
Others:
12 - 36 months 14,770,766 76.4 16,288,597 80.6
Over 36 months 1,564,677 8.1 740,448 3.6
------------ ----- ------------ -----
$ 19,348,605 100.0% $ 20,212,580 100.0%
============ ===== ============ =====
</TABLE>
15
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
9. FEDERAL HOME LOAN BANK ADVANCES:
Federal Home Loan Bank advances at June 30, 1996 and 1995 are as follows:
<TABLE>
<CAPTION>
JUNE 30, 1996 JUNE 30, 1995
----------------------- -----------------------
DATE OF YEAR OF INTEREST INTEREST
ISSUE MATURITY AMOUNT RATE AMOUNT RATE
<S> <C> <C> <C> <C> <C>
7/08/94 7/07/95 $ $ 650,000 5.90%
7/28/94 7/28/95 500,000 6.00
8/11/94 8/11/14 1,500,000 6.23% 1,500,000 6.03
10/27/94 11/01/04 177,160 8.45 210,471 8.45
11/18/94 11/18/14 1,000,000 5.89 1,000,000 7.10
1/31/95 1/30/15 650,000 5.46 650,000 7.27
5/09/95 6/01/05 153,250 7.35 164,846 7.35
----------- -----------
$ 3,480,410 $ 4,675,317
=========== ===========
</TABLE>
The scheduled maturities of Federal Home Loan Bank advances for the five
years subsequent to June 30, 1996 are as follows:
<TABLE>
<S> <C>
1997 $ 30,686
1998 33,235
1999 35,996
2000 38,988
2001 42,229
Thereafter $ 3,299,276
-----------
$ 3,480,410
===========
</TABLE>
As collateral for the advance the Bank has pledged $5,220,615 of one to four
family residential mortgages, which represents 150% of the amount of the
advance.
10. RETAINED EARNINGS:
In connection with the insurance of savings accounts, $558,222 of the Bank's
retained income at June 30, 1996 is restricted and may be used only for the
absorption of losses. This restriction does not represent a valuation
allowance and was not created by charges against earnings.
The Office of Thrift Supervision ("OTS") imposes regulations which provide
that insured depository institutions must maintain certain levels of
capital. The regulations include a leverage limit, a tangible capital
requirement and a risk-based capital requirement. Specifically, the
regulations provide that insured depository institutions must maintain
tangible capital equal to 1.5% of adjusted total assets, core capital equal
to 3% of adjusted total assets and a combination of core and supplementary
capital equal to 8% of risk weighted assets.
Pursuant to Federal Deposit Insurance Corporation Improvement Act (FDICIA) of
1991 regulations implementing the prompt corrective action provisions became
effective on December 19, 1992. FDICIA also includes significant changes to
the legal and regulatory environment for insured depository institutions,
including reduction in insurance coverage for certain kinds of deposits,
increased supervision by the federal regulatory agencies, increased reporting
requirements for insured institutions, and new regulations concerning
internal controls, accounting and operations.
16
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
10. RETAINED EARNINGS, CONTINUED:
The prompt corrective action regulations define specific capital categories
based on an institution's capital ratios. The capital categories, in
declining order, are "well capitalized," "adequately capitalized,"
"undercapitalized," "significantly undercapitalized," and "critically
undercapitalized." Institutions categorized as "undercapitalized" are
subject to certain restrictions, including the requirement to file a capital
plan with its primary federal regulator, prohibitions on the payment of
dividends and management fees, restrictions on executive compensation, and
increased supervisory monitoring, among other things.
To be considered "well capitalized," an institution must generally have a
leverage capital ratio of at least 5%, a tier one risk-based capital ratio
of at least 6% and a total risk-based capital ratio of at least 10%. At
December 31, 1995 the Bank met the criteria required to be considered "well-
capitalized" under this regulation.
The following summarizes the Bank's capital requirements and position at
June 30, 1996 and 1995. Amounts are in thousands.
<TABLE>
<CAPTION>
JUNE 30,
--------------------------------------
1996 1995
----------------- ----------------
AMOUNT % AMOUNT %
-------- ----- -------- -----
<S> <C> <C> <C> <C>
Tangible capital $ 12,015 29.5% $ 4,379 13.0%
Tangible capital requirement 606 1.5 507 1.5
-------- ----- -------- -----
Excess $ 11,409 28.0% $ 3,872 11.5%
======== ===== ======== =====
Core capital $ 12,015 29.8% $ 4,379 13.0%
Core capital requirement 1,212 3.0 1,014 3.0
-------- ----- -------- -----
Excess $ 10,803 26.8% $ 3,365 10.0%
======== ===== ======== =====
Tangible capital $ 12,015 $ 4,379
Allowance for loan losses 100 70
-------- --------
Total capital (core and supplemental) 12,115 60.9% 4,449 25.2%
Risk-based requirement 1,592 8.0 1,411 8.0
-------- ----- -------- -----
Excess $ 10,523 52.9% $ 3,038 17.2%
======== ===== ======== =====
</TABLE>
The general valuation allowance may be included in risk-based capital up to
a maximum of 1.25% of risk-weighted assets. In addition, the OTS has
proposed a ruling affecting the amounts and composition of required
regulatory capital. This proposal would require institutions accorded less
than the highest rating by the OTS to maintain core capital of between 4%
and 5% of assets, an increase from the present 3% requirement.
17
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
11. INCOME TAXES:
Under the asset and liability method, deferred income taxes are recognized
for the tax consequences of temporary differences by applying future
statutory tax rates to differences between the financial statements carrying
amounts and the tax basis of existing assets and liabilities.
<TABLE>
<CAPTION>
The provision for income taxes consists of:
YEARS ENDED JUNE 30,
-----------------------
1996 1995
<S> <C> <C>
Current $ 177,085 $ 231,633
Deferred (25,270) 12,267
--------- ---------
$ 151,815 $ 243,900
========= =========
</TABLE>
Deferred income taxes result from temporary differences in the recognition of
income and expenses for tax and financial statement purposes. The source of
these temporary differences and the tax effect of each are as follows:
<TABLE>
<CAPTION>
YEARS ENDED JUNE 30,
-----------------------
1996 1995
<S> <C> <C>
Stock dividends on FHLB stock $ 6,902 $ 5,168
Provision for loan losses (10,370) (1,949)
Depreciation (1,098) 12,330
Loan fees deferred (3,583) (4,550)
Provision for uncollected interest (1,530) 1,268
Directors retirement expense (11,783)
Supplemental executive retirement expense (3,808)
--------- ---------
$ (25,270) $ 12,267
========= =========
</TABLE>
The following tabulation reconciles the federal statutory tax rate to the
effective rate of taxes provided for income before taxes:
<TABLE>
<CAPTION>
YEARS ENDED JUNE 30,
------------------------------------
1996 1995
<S> <C> <C> <C> <C>
Tax at statutory rate $ 157,187 34.0% $ 243,947 34.0%
Increases (decreases) in taxes
resulting from:
Other, net (5,372) (1.2) (47) 0.0
--------- ----- --------- ----
$ 151,815 32.8% $ 243,900 34.0%
========= ===== ========= ====
</TABLE>
18
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
11. INCOME TAXES, CONTINUED:
The tax effect of temporary differences giving rise to the Corporation's
consolidated deferred income tax asset (liability) at June 30, 1996 and
1995 are as follows:
<TABLE>
<CAPTION>
1996 1995
<S> <C> <C>
Deferred tax assets:
Allowance for loan losses $ 34,000 $ 23,630
Deferred loan fees 14,033 10,450
Directors retirement expense 11,783
Supplemental executive retirement expense 3,808
Allowance for uncollected interest 3,454 1,924
---------- ----------
67,078 36,004
Deferred tax liabilities:
FHLB stock dividends (51,951) (45,049)
Depreciation on office property and
equipment (7,500) (8,598)
Unrealized gain on available for sale
securities (171,090) (135,963)
----------- -----------
Deferred income tax liability $ (163,463) $ (153,606)
=========== ===========
</TABLE>
The bad debt deduction determined for tax purposes through December 31,
1987 was not charged to earnings in the financial statements, but resulted
in an appropriation to restricted retained earnings for tax purposes. The
accumulated appropriation of bad debts in restricted retained earnings at
June 30, 1996 and 1995 is approximately $816,000. Reductions of such
amounts for other than bad debt losses create income for tax purposes. The
bank did not receive a bad debt deduction for 1996 or for 1995 under the
reserve method as a result of the 12% withdrawable savings limitation.
12. EMPLOYEE BENEFIT PLANS:
A. Retirement Plan
---------------
The Bank is a participant in the Financial Institution's Retirement
Fund, a multi-employer defined benefit retirement plan. The Plan is
noncontributory and covers all employees who meet certain requirements
as to age and length of service. The Bank's policy is to fund
retirement costs accrued. Contributions were not required for the year
ended June 30, 1996 due to the full funding limitation under the
Internal Revenue Code. The Bank was not required to make a contribution
in 1996. Contributions to the plan amounted to $11,737 for the year
ended June 30, 1995.
Because the Bank participates in a multi-employer plan, the actuarial
present value of accumulated plan benefits and plan net assets
available for benefits are not determinable and therefore not
disclosed.
B. Profit-Sharing Plan
-------------------
Effective January 1, 1990, the Bank became a participant in the profit-
sharing feature of the Financial Institutions Thrift Plan. The Plan is
noncontributory and covers all salaried employees who meet certain
requirements as to age and length of service. Employees become vested
upon completion of five years of service. Contributions are at the
discretion
19
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
B. Profit-Sharing Plan
-------------------
of the Board of Directors and are computed as a percentage of eligible
employees' compensation. The Board of Directors authorized contributions
equal to 4% for 1996 and 1995 of eligible employees' compensation which
amounted to $8,860 and $8,256 for 1996 and 1995, respectively.
C. Employee Stock Ownership Plan
-----------------------------
As a part of conversion to stock, the Bank formed the First Lancaster
Bancshares, Inc. Employee Stock Ownership Plan (ESOP). Generally, all
employees of the Bank are eligible to participate in the ESOP upon
attainment of age 21 and completion of two years of service.
Participants are 100% vested in their right to ESOP benefits at all
times. In the case of a distribution of ESOP shares which are not
readily tradable on an established securities market, the Plan provides
the Participant with a put option that complies with the requirements of
Section 409(h) of the Internal Revenue Code.
On June 28, 1996, the plan borrowed $767,040 from the Corporation to
purchase 76,740 shares of the Corporation's common stock. The obligation
of the ESOP to repay the debt is guaranteed by the Bank.
In November 1993, the AICPA issued Statement of Position 93-6
"Employers' Accounting for Employee Stock Ownership Plans." The
statement was adopted by the Bank on June 28, 1996, the effective date
of the Bank's conversion to a stock company. The Statement requires,
among other things, that: (1) for ESOP shares committed to be released
in a period to compensate employees directly, employers should recognize
compensation cost equal to the average fair value (as determined on a
monthly basis) of the shares committed to be released, (2) dividends on
unallocated shares used to repay ESOP loans are not considered dividends
for financial reporting purposes, (3) for an internally leveraged ESOP,
the Corporation loan receivable and the ESOP note payable as well as the
interest income/expense is not reflected in the consolidated financial
statement and (4) for earnings per share computations, ESOP shares that
have been committed to be released should be considered outstanding.
ESOP shares that have not been committed to be released should not be
considered outstanding.
<TABLE>
<CAPTION>
The following table shows ESOP shares as of June 30, 1996.
<S> <C>
Allocated shares 0
Shares released for allocation 0
Unreleased shares 767,040
---------
Total ESOP shares 767,040
=========
Fair value of unreleased shares 767,040
=========
</TABLE>
20
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
D. Retirement Plan for Non-Employee Directors
------------------------------------------
Effective December 7, 1995, the Board of Directors of the Bank adopted
the First Lancaster Federal Savings Bank Directors' Retirement Plan for
Non-Employee Directors. A participant in the Plan will receive on each
of the ten annual anniversary dates of leaving the Board, an amount
equal to the product of his "Benefit Percentage," "Vested Percentage,"
(as defined) and 75% of the total fee he received for service on the
Board during the calendar year preceding his retirement. The amount
charged to operations under the plan totaled $16,921 for the year ended
June 30, 1996.
E. Supplemental Executive Retirement Plan (SERP)
---------------------------------------------
Effective December 7, 1995 the Bank entered into supplemental
retirement agreements with two key executives of the Bank. Upon the
executive's termination of employment with the Bank, the executive will
be entitled to receive annual payments equal to the product to the
executive's "Vested Percentage" and "Average Annual Compensation", less
the "Annual Offset Amount", as defined in the plan. Vesting occurs at
10% per full year of service with the Bank following December 31, 1995.
The Bank has established an irrevocable grantor trust to hold assets in
order to provide itself with a source of funds to assist the Bank in
the meeting of the SERP liability. The amount charged to operations
under the plan totaled $11,200 for the year ended June 30, 1996.
13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
In December 1991, the FASB issued SFAS No. 107, "Disclosures About Fair
Value of Financial Instruments." This statement extends the existing fair
value disclosure practices for some instruments by requiring all entities
to disclose the fair value of financial instruments (as defined), both
assets and liabilities recognized and not recognized in the statements of
financial condition, for which it is practicable to estimate fair value.
There are inherent limitations in determining fair value estimates as they
relate only to specific data based on relevant information at that time. As
a significant percentage of the Bank's financial instruments do not have an
active trading market, fair value estimates are necessarily based on future
expected cash flows, credit losses and other related factors. Such
estimates are accordingly, subjective in nature, judgmental and involve
imprecision. Future events will occur at levels different from that in the
assumptions, and such differences may significantly affect the estimates.
The statement excludes certain financial instruments and all nonfinancial
instruments from its disclosure requirements. Accordingly, the aggregate
fair value amounts presented do not represent the underlying value of the
Corporation.
Additionally, the tax impact of the unrealized gains or losses has not been
presented or included in the estimates of fair value.
21
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, continued
The following methods and assumptions were used by the Corporation in
estimating its fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS: The carrying amounts reported in the statements
of financial condition for cash and short-term instruments approximate
those assets' fair values.
INVESTMENT SECURITIES AND MORTGAGE-BACKED SECURITIES: Fair values for
investment securities are based on quoted market prices, where available.
If quoted market prices are not available, fair values are based on quoted
market prices of comparable instruments. No active market exists for the
Federal Home Loan Bank capital stock. The carrying value is estimated to be
fair value, since if the Bank withdraws membership in the Federal Home Loan
Bank, the stock must be redeemed for face value.
LOANS RECEIVABLE: For certain homogeneous categories of loans, such as
residential mortgages and other consumer loans, fair value is estimated
using the quoted market prices for securities backed by similar loans,
adjusted for differences in loan characteristics. The fair value of other
types of loans is estimated by discounting the future cash flows using the
current rates at which similar loans would be made to borrowers with
similar credit ratings and for the same remaining maturities.
DEPOSITS: The fair value of savings deposits and certain money market
deposits is the amount payable on demand at the reporting date. The fair
value of fixed-maturity certificates of deposit is estimated using the
rates currently offered for deposits of similar remaining maturities.
ADVANCES FROM THE FEDERAL HOME LOAN BANK: Advances from the Federal Home
Loan Bank are short term obligations that primarily bear interest at
current variable rates, therefore their carrying value approximates their
fair value.
LOAN COMMITMENTS: The fair value of loan commitments is estimated to
approximate the contract values, as the related loan will have a current
market rate, the credit worthiness of the counterparties is presently
considered in the commitments, and the original fees charged do not vary
significantly from the fee structure at June 30, 1996.
The estimated fair values of the Corporation's financial instruments are as
follows:
<TABLE>
<CAPTION>
1996
CARRYING FAIR
AMOUNT VALUE
------------ ----------
<S> <C> <C>
(IN THOUSANDS)
Financial Assets
Cash $ 339 $ 339
Interest-bearing deposits in other depository
institutions 7,285 7,285
Investment securities 527 527
Investment in nonmarketable equity securities 316 316
Mortgage-backed securities 115 125
Loans receivable, net of allowance for loan
losses of $100 for 1996 31,385 31,347
Financial Liabilities:
Savings accounts and certificates 23,482 24,035
Federal Home Loan Bank advances 3,480 3,480
</TABLE>
22
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
14. Conversion to Stock Savings Bank, Formation of Holding Company and Sale of
Common Stock:
On June 28, 1996, the Bank converted from a mutual savings bank to a
capital stock savings bank. The Bank issued all of its outstanding capital
stock to First Lancaster Bancshares, Inc., a holding company for First
Lancaster Federal Savings Bank. First Lancaster Bancshares, Inc.
consummated a public offering of 958,812 shares of common stock which
generated proceeds of $8,821,080 net of conversion costs totaling $429,129.
This conversion transaction has been accounted for as a pooling of
interests. The 1995 financial statements of First Lancaster Federal Savings
Bank have been presented for comparative purposes.
At the time of conversion, the Bank established a liquidation account in an
amount of the Bank's net worth as of the latest practicable date prior to
conversion. The liquidation account is maintained for the benefit of
eligible deposit account holders who maintain their deposit accounts in the
Bank after conversion.
In the event of a complete liquidation (and only in such an event), each
eligible deposit account holder will be entitled to receive a liquidation
distribution from the liquidation account, in the proportionate amount of
the then current adjusted balance for deposit accounts held, before any
liquidation may be made with respect to capital stock. The Bank may not
declare or pay a cash dividend on or repurchase any of its common stock if
the effect thereof would cause its regulatory capital to be reduced below
the amount required for the liquidation account.
The Bank may not declare or pay a cash dividend on or repurchase any of its
stock if the effect would be to reduce retained earnings of the Bank below
the capital requirements of the OTS. Federal regulations adopted by the OTS
impose certain limitations on the payment of dividends and other capital
distributions, including stock repurchases by the Bank. OTS regulations
utilize a tiered approach which permits various levels of distributions
based primarily upon an institution's capital level and net income. Based
upon current OTS regulations and its capital structure at June 30, 1996,
the Bank may make capital distributions during a year up to the greater of
(i) 100% of its net earnings to date during the calendar year plus an
amount equal to one-half of the amount by which its total capital-to-assets
ratio exceeded its fully phased-in capital-to-assets ratio at the beginning
of the calendar year or (ii) 75% of its net income during the most recent
four-quarter period. The amount computed under these OTS regulations cannot
reduce the Bank's capital below the liquidation account as discussed above.
At June 30, 1996, approximately $1,830,000 was available for payment of
dividends from the Bank to the Corporation under the above mentioned OTS
restrictions.
The Corporation's Certificate of Incorporation authorizes 500,000 shares of
preferred stock of the Corporation, of $.01 par value. The consideration
for the issuance of the shares shall be paid in full before their issuance
and shall not be less than the par value. Neither promissory notes nor
future services shall constitute payment or part payment for the issuance
of shares of the Corporation. The consideration for the shares shall be
cash, tangible or intangible property (to the extent direct investment in
such property would be permitted), labor or services actually performed for
the Corporation, or any combination of the foregoing. The preferred stock,
and any series of preferred stock, as established by the Board of
Directors, the Corporation shall file
23
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
14. Conversion to Stock Savings Bank, Formation of Holding Company and Sale of
Common Stock, continued:
articles of amendment to the Corporate Certificate of Incorporation with
the Delaware Secretary of State establishing and designating the series and
fixing and determining the relative rights and preferences thereof. The
Corporation's Certificate of Incorporation expressly vests in the Board of
Directors of the Corporation the authority to issue the preferred stock in
one or more series and to determine, to the extent permitted by law prior
to the issuance of the preferred stock (or any series of the preferred
stock), the relative rights, limitations and preferences of the preferred
stock or any such series.
15. Earnings Per Share
The conversion from a mutual savings bank to a stock institution was
completed June 28, 1996 (see Note 14). The computation of earnings per
share is based on the net income earned from the date of conversion to the
end of the fiscal year divided by the weighted-average number of shares
issued from the date of the conversion until the end of the fiscal year.
Since the date of conversion was on the last day of the fiscal year,
earnings per share is zero.
Employee Stock Ownership Plan (see Note 11) shares not committed to be
released to participants are not considered outstanding for the purposes of
computing earnings per share.
16. Condensed Financial Information (Parent Company Only)
The following condensed statements summarize the financial position,
operating results and cash flows of First Lancaster Bancshares, Inc.
(Parent Company only).
<TABLE>
<CAPTION>
Condensed Statement of Financial Condition JUNE 30,
1996
------------
<S> <C>
Assets
Cash and balances with bank $ 300,000
Investment in subsidiary 12,346,147
Loan receivable from bank 767,040
------------
$ 13,413,187
============
Liabilities and Stockholders' Equity
Stockholders' equity $ 13,413,187
------------
$ 13,413,187
============
</TABLE>
<TABLE>
<CAPTION>
Condensed Statement of Income For the Year
Ended
June 30
1996
------------
<S> <C>
Equity in undistributed net income
of subsidiary $ 310,001
============
</TABLE>
24
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
16. CONDENSED FINANCIAL INFORMATION (Parent Company Only), continued
<TABLE>
<CAPTION>
Condensed Statement of Cash Flows FOR THE YEAR
ENDED
JUNE 30, 1996
-------------
<S> <C>
OPERATING ACTIVITIES:
Net income $ 310,001
Adjustment to reconcile net income to cash
provided by operating activities:
Equity in undistributed net income of subsidiary (310,001)
------------
Net cash provided by operating activities 0
INVESTING ACTIVITIES:
Investment in subsidiary (8,091,951)
------------
Net cash used in investment activities (8,091,951)
------------
FINANCIAL ACTIVITIES:
Proceeds from stock conversion net of expenses 8,391,951
------------
Net cash provided by financing activities 8,391,951
------------
Net increase in cash 300,000
------------
Cash, beginning of period 0
Cash, end of year $ 300,000
============
</TABLE>
25
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
17. Service Corporation Subsidiary:
The following balance sheets of First Lancaster Corporation, a wholly-owned
subsidiary of the Bank, are presented in accordance with requirements of
the OTS. The Bank formed First Lancaster Corporation in 1978 for the
purpose of purchasing approximately 0.5% of the outstanding stock of
Intrieve, Inc. (formerly Savings and Loan Data Corporation), which provides
data processing services to the Bank.
Intrieve is a nonprofit corporation owned entirely by user savings and loan
associations and savings banks in its geographical area and transacts
business solely with its member associations and banks.
FIRST LANCASTER CORPORATION
Balance Sheets
June 30, 1996 and 1995
<TABLE>
<CAPTION>
ASSETS 1996 1995
<S> <C> <C>
Investment - Intrieve, at cost $15,000 $15,000
Cash 342 374
------- -------
$15,342 $15,374
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Common stock $16,000 $16,000
Deficit (658) (626)
------- -------
$15,342 $15,374
======= =======
</TABLE>
18. CONCENTRATION OF CREDIT RISK:
The Bank has $7,285,412 and $1,994,181 of cash on deposit with one
financial institution at June 30, 1996 and 1995, respectively.
26
<PAGE>
Item 8. Changes in and Disagreements With Accountants on Accounting and
------------------------------------------------------------------------
Financial Disclosure
--------------------
None.
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act
------------------------------------------------------------------------
The Board of Directors of the Company is divided into three classes.
Directors of the Company serve for three year terms or until their
successors are elected and qualified, with approximately one-third of the
directors being elected at each annual meeting of stockholders, beginning
with the first annual meeting of stockholders following Conversion. The
following table sets forth information regarding the directors of the
Company all of whom also serve as directors of the Bank.
<TABLE>
<CAPTION>
Age at
Name June 30, 1996 Director Since(1) Term to Expire
- ----------------------------------------- ------------- ----------------- --------------
<S> <C> <C> <C>
David W. Gay 58 1992 1996
Director
Jane G. Simpson 69 1985 1996
Director
Virginia R. S. Stump 41 1983 1997
Chairman of the Board, President
and Chief Executive Officer
Ronald L. Sutton 50 1992 1997
Director
Roger S. Grubbs 79 1979 1998
Director
Tony A. Merida 38 1991 1998
Executive Vice President
Jack C. Zanone 75 1978 1998
Director
</TABLE>
- --------------------
(1) All directors were appointed as directors in 1996 in connection with
the incorporation and organization of the Company. The information
shown is the year each director was elected as a director of the Bank.
Presented below is certain information concerning the directors of the
Bank. Unless otherwise stated, all directors have held the positions
indicated for at least the past five years.
David W. Gay has been self-employed since 1993 as a residential
property appraiser certified by the Commonwealth of Kentucky and in which
capacity he performs appraisals at the request of financial institutions,
including the Bank. From 1992 to 1993, Mr. Gay was a systems analyst with
Lexmark, a manufacturer of printers and printer supplies. Mr. Gay retired
in 1992 from IBM Corporation after 35 years of employment and last served
as a systems analyst. Mr. Gay is currently serving on the Ethics Committee
for the City of Lancaster and the Finance Committee for the Lancaster
Christian Church. He has also served as the past president of the Dix
River Country Club.
Jane G. Simpson has been retired since 1977. Ms. Simpson was a school
teacher for over thirty years in the Boyle, Mercer and Garrard County
School Systems.
45
<PAGE>
Virginia R.S. Stump is President and Chief Executive Officer of the
Bank, a position in which she has served since 1985, and has been a member
of the Board of Directors since 1983 and Chairman of the Board since 1993.
Ms. Stump also is President and Chief Executive Officer of the Company.
Ms. Stump joined the Bank in 1973 and, prior to assuming her current
position, served as Secretary/Treasurer of the Bank from 1980 to 1985.
Prior to 1980, Ms. Stump served in various other positions in the Bank.
Ms. Stump is also an owner in Garrard County's Bestway, a family-owned
grocery store and flower shop. Ms. Stump is currently a member of the
Garrard County Literacy Council and the Garrard County Community Education
Board, and has previously served on the Housing Authority of Lancaster and
the Garrard County Industrial Board and has served as co-chair of the
Garrard County Tobacco Festival.
Ronald L. Sutton has practiced as a pharmacist since 1968 and has been
employed in such capacity by Garrard County Memorial Hospital since 1987.
He was a member of the Advisory Board for the Family Resources Center of
Garrard County and has previously served as its chairman. Mr. Sutton has
also participated in the Drug Education Awareness programs in the Garrard
County Middle School and has served as the pharmacist preceptor and advisor
for two local pharmacy students. In addition to serving as a pharmacist,
he owns and operates a cattle and tobacco farm in Garrard County.
Roger S. Grubbs has been retired since 1980 from Camp Nelson Stone
Company, which he owned and served as its president. He is a member and
past president of the Lancaster Rotary Club and has previously served as a
board member for the Lancaster Baptist Church, Finance Committee, and the
Lancaster/Garrard County Industrial Board.
Tony A. Merida is Executive Vice President of the Bank, a position in
which he has served since February 1995, and has been a member of the Board
of Directors since 1991. Mr. Merida also is Executive Vice President of
the Company. Mr. Merida joined the Bank in 1980 and served as the
Secretary and Treasurer of the Bank from 1985 to 1995. Mr. Merida serves
on the Board of Directors of the Garrard County Habitat for Humanity and on
the Board of Directors of the Institute of Financial Education. In
addition, he also serves on the Board of Directors for the Bluegrass Area
Development District and previously served on the Lancaster/Garrard County
Industrial Board.
Jack C. Zanone has been self-employed as a residential appraiser since
1978. Prior to that time, Mr. Zanone was co-owner of the Lancaster
Department Store for over thirty years. He previously served on the
Garrard County Industrial Board and the Lancaster City Council. Mr. Zanone
is an elder of the Lancaster Christian Church.
Item 10. Executive Compensation
--------------------------------
The following table sets forth the cash and noncash compensation for
the fiscal years indicated awarded to or earned by the Chief Executive
Officer. No executive officer of the Company earned salary and bonus in
fiscal year 1996 exceeding $100,000 for services rendered in all capacities
to the Company and the Bank.
<TABLE>
<CAPTION>
Annual Compensation
----------------------------------------------
Other Annual All Other
Name Year Salary Bonus Compensation(1) Compensation(2)
- ----------------------------------- --------- ------- ------ --------------- ---------------
<S> <C> <C> <C> <C> <C>
Virginia R.S. Stump 1996 $55,500 $8,100 $ -- $17,300
Chairman of the Board of 1995 51,500 7,400 -- 9,200
the Bank and President and
Chief Executive Officer of
the Company and the Bank
</TABLE>
- --------------------
(1) Executive officers of the Company and the Bank receive indirect
compensation in the form of certain perquisites and other personal
benefits. The amount of such benefits received by the named executive
officer in fiscal 1996 did not exceed 10% of each of the executive
officer's salary and bonus.
(2) Consists of director's fees, insurance commissions and nonqualified
retirement benefit accruals.
46
<PAGE>
Supplemental Executive Retirement Agreement. In order to secure the
continuing services of Ms. Virginia R.S. Stump (the "Executive"), the Bank
has entered into supplemental executive retirement agreement (the "SERA")
with her effective December 7, 1995. Pursuant to the terms of the SERA,
upon the Executive's termination of employment with the Bank, for reasons
other than death or removal for "just cause," the Executive will be
entitled to receive annual payments from the Bank in an amount for life
equal to (i) the product of the Executive's "Vested Percentage" and 70% of
"Average Annual Compensation," less (ii) the Executive's "Annual Offset
Amount." Under the SERA, "Vested Percentage" means 10% per full year of an
Executive's service with the Bank following December 31, 1995, up to a
maximum Vested Percentage of 100% (accelerated to 100% upon termination of
employment due to the Executive's death or disability or upon a change in
control of the Bank). "Average Annual Compensation" means the average of
the Executive's highest annual compensation for three of the five calendar
years preceding her termination of employment. "Annual Offset Amount" means
the sum of (i) the Executive's primary social security benefits, (ii) the
annual benefits which the Executive would receive under the Bank's Pension
Plan in the form of a 50% joint and survivor annuity, and (iii) the annual
amount payable to the Executive if that portion of her account under the
Bank's 401(k) Plan which would be attributable to the Bank's contributions
were paid to her in the form of a 50% joint and survivor annuity,
commencing upon termination of employment.
In the event the Executive dies before retirement benefit payments
commence, the Executive's surviving spouse will receive an annual payment
for the remainder of the surviving spouse's life (up to a maximum of 20
years) in an amount equal to 50% of the annual retirement benefit the
Executive would have received if she had terminated employment on the date
of her death and then had a vested percentage equal to 100%. In the event
the Executive dies after retirement benefits commence, the Executive's
surviving spouse will receive an annual payment for the remainder of the
surviving spouse's life in an amount equal to 50% of the annual retirement
benefits the Executive would have received had she survived to collect
them. Termination for "just cause" (as defined in the SERA) would result
in the Executive's forfeiture of all retirement benefits under the SERA.
The Bank intends to establish an irrevocable grantor trust to hold assets
in order to provide itself with a source of funds to assist the Bank in the
meeting of its liabilities under the SERA.
Employment Agreements. The Company and the Bank entered into a
separate employment agreement (the "Employment Agreements") pursuant to
which Ms. Virginia R.S. Stump serves as President and Chief Executive
Officer of the Company and the Bank. In such capacities, Ms. Stump (the
"Executive") is responsible for overseeing all operations of the Bank and
the Company and for implementing the policies adopted by the Boards of
Directors. Such Boards believe that the Employment Agreements assure fair
treatment of the Executive in relation to her career with the Company and
the Bank by assuring her some financial security. In the event that the
Executive prevails over the Company or the Bank in a legal dispute as to
the Employment Agreements she will be reimbursed for her legal and other
expenses.
The Employment Agreements became effective on June 28, 1996 and
provide for a term of three years, with an annual base salary equal to the
Executive's existing base salary rate in effect on the date of Conversion.
The Executive's base rate currently is $57,000. On each anniversary date
from the date of commencement of the Employment Agreements, the term of the
Executive's employment under the Employment Agreements will be extended for
an additional one-year period beyond the then effective expiration date,
upon a determination by the Board of Directors that the performance of the
Executive has met the required performance standards and that such
Employment Agreements should be extended. The Employment Agreements
provide the Executive with a salary review by the Board of Directors not
less often than annually, as well as with inclusion in any discretionary
bonus plans, retirement and medical plans, customary fringe benefits,
vacation and sick leave. The Employment Agreements will terminate upon the
Executive's death or disability, and are terminable by the Company or the
Bank for "just cause" as defined in the Employment Agreements. In the
event of termination for just cause, no severance benefits are available.
If the Company or the Bank terminates the Executive without just cause, the
Executive will be entitled to a continuation of her salary and benefits
from the date of termination through the remaining term of the Employment
Agreements, plus an additional 12-month period, and, at the Executive's
election, either cash in an amount equal to the cost to the Executive of
obtaining health, life, disability, and other benefits which the Executive
47
<PAGE>
would have been eligible to participate in through the Employment
Agreements' expiration date or continued participation in such benefit
plans through the Employment Agreements' expiration date, provided the
Executive continues to qualify for participation therein. If the
Employment Agreements are terminated due to the Executive's "disability"
(as defined in the Employment Agreements), the Executive will be entitled
to a continuation of her salary and benefits for up to 180 days following
such termination. In the event of the Executive's death during the term of
the Employment Agreement, her estate will be entitled to receive her salary
through the last day of the calendar month in which the Executive's death
occurred. The Executive is able to voluntarily terminate her Employment
Agreement by providing 90 days' written notice to the Boards of Directors
of the Bank and the Company, in which case the Executive is entitled to
receive only her compensation, vested rights and benefits up to the date of
termination.
The Employment Agreements contain provisions stating that in the event
of the Executive's involuntary termination of employment in connection
with, or within one year after, any change in control of the Bank or the
Company, other than for "just cause," the Executive will be paid within 10
days of such termination an amount equal to the difference between (i) 2.99
times her "base amount," as defined in Section 280G(b)(3) of the Internal
Revenue Code, and (ii) the sum of any other parachute payments, as defined
under Section 280G(b)(2) of the Internal Revenue Code, that the Executive
receives on account of the change in control. "Control" generally refers
to the acquisition, by any person or entity, of the ownership or power to
vote more than 25% of the Bank's or Company's voting stock, the control of
the election of a majority of the Bank's or the Company's directors, or the
exercise of a controlling influence over the management or policies of the
Bank or the Company. In addition, under the Employment Agreements, a
change in control occurs when, during any consecutive two-year period,
directors of the Company or the Bank at the beginning of such period cease
to constitute at least a majority of the Board of Directors of the Company
or the Bank. The same amount would be paid (i) in the event of an
Executive's voluntary termination of employment within 30 days following a
change in control, or (ii) in the event of the Executive's voluntary
termination of employment within one year following a change in Control,
upon the occurrence, or within 90 days thereafter, of certain specified
events following the change in Control, which have not been consented to in
writing by the Executive. Such events generally relate to a reduction in
the Employee's salary, benefits or duties. The Employment Agreement with
the Bank provides that within five business days of a change in control,
the Bank shall fund, or cause to be funded, a trust in the amount of 2.99
times the Executive's base amount, that will be used to pay the Executive
amounts owed to him upon termination, other than for just cause, within one
year of the change in control. The aggregate payments that would be made
to the Executive, assuming that termination of employment under the
foregoing circumstances at June 30, 1996, would have been approximately
$170,000. These provisions may have an anti-takeover effect by making it
more expensive for a potential acquiror to obtain control of the Company.
Director Compensation
The Bank's directors receive fees of $600 per monthly meeting
attended. No fees are paid for serving on committees of the Board of
Directors.
Director Retirement Plan. The Bank's Board of Directors has adopted
the First Lancaster Federal Savings Bank Directors' Retirement Plan (the
"Directors' Plan"), effective December 7, 1995, for its directors (i) who
are members of the Bank's Board of Directors (the "Board") at some time on
or after the plan's effective date, and (ii) who are not employees on the
date of being both nominated and elected (or re-elected) to the Board.
Directors who become participants will remain participants even if they
later become employees of the Bank. A participant in the Directors' Plan
will receive, at no cost to the participant, on each of the ten annual
anniversary dates of leaving the Board, an amount equal to the product of
his or her "Benefit Percentage," "Vested Percentage," and 75% of the annual
fee for service on the Board during the calendar year preceding retirement.
A participant's "Benefit Percentage" is based on years of service on the
Board as a non-employee director, and increases in increments of 25%, from
0% for less than five years of service to 25% for five to nine years of
service, to 50% for 10 to 14 years of service, to 75% for 15 to 19 years of
service, to 100% for 20 or more years of service. A participant's "Vested
Percentage" is based on years of service on the Board after December 31,
1995 (excluding service as an employee-
48
<PAGE>
director) and increases in increments of 25%, from 50% for less than one
year of service, to 75% for one year of service, to 100% for two or more
years of service. However, in the event a participant terminates service
on the Board due to "disability" (as defined in the Directors' Plan), the
participant's Vested Percentage becomes 100% regardless of his or her years
of service.
If a participant dies, his or her beneficiary will receive an amount
equal to the retirement benefits that would have been paid to the
participant under the Directors' Plan if the participant (i) had terminated
service on the Board on the date of his or her death, and (ii) had a Vested
Percentage equal to 100%. If a participant dies after commencing to
receive retirement benefits under the plan, his or her beneficiary will
receive monthly payments for a number of months equal to the difference
between 120 and the number of monthly retirement benefits payments made
under the plan on or before the participant's death. These payments will
equal 100% of the monthly amount of retirement benefits that the
participant had been collecting under the plan. Any benefits accrued under
the Directors' Plan will be paid from the Bank's general assets. The Bank
expects to establish a trust in order to hold assets with which to pay
benefits. Trust assets will be subject to the claims of the Bank's general
creditors. In the event a participant prevails over the Bank in a legal
dispute as to the terms or interpretation of the Directors' Plan, he or she
will be reimbursed for his or her legal and other expenses.
Item 11. Security Ownership of Certain Beneficial Owners
---------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners
Persons and groups owning in excess of 5% of the Company's common
stock, par value $.01 per share ("Common Stock"), are required to file
certain reports regarding such ownership pursuant to the Securities
Exchange Act of 1934 with the Company and the Securities and Exchange
Commission. Based on such reports (and certain other written information
received by the Company), management knows of no persons other than those
set forth below who owned more than 5% of the outstanding shares of Common
Stock as of September 24, 1996. The following table sets forth, as of
September 24, 1996, certain information as to those persons who were the
beneficial owners of more than five percent (5%) of the Company's
outstanding shares of Common Stock.
<TABLE>
<CAPTION>
Percent of Shares
Name and Address Amount and Nature of of Common Stock
of Beneficial Owner Beneficial Ownership (1) Outstanding
------------------- ------------------------- ----------------
<S> <C> <C>
First Lancaster Bancshares, Inc.
Employee Stock Ownership Plan 76,704 (2) 8.0%
208 Lexington Street
Lancaster, Kentucky 40444-1131
</TABLE>
- --------------------
(1) In accordance with Rule 13d-3 under the Securities Exchange Act of
1934, as amended (the "Exchange Act"), a person is deemed to be the
beneficial owner, for purposes of this table, of any shares of Common Stock
if he or she has or shares voting or investment power with respect to such
Common Stock or has a right to acquire beneficial ownership at any time
within 60 days from September 24, 1996. As used herein, "voting power" is
the power to vote or direct the voting of shares and "investment power" is
the power to dispose or direct the disposition of shares.
(2) These shares are held in a suspense account for future allocation
among participating employees as the loan used to purchase the shares is
repaid. The ESOP trustees, currently Directors Gay, Sutton and Zanone, vote
all allocated shares in accordance with instructions of the participants.
Unallocated shares and shares for which no instructions have been received
are voted by the ESOP trustees in the same ratio as participants direct the
voting of allocated shares or, in the absence of such direction, in the
ESOP trustees' best judgment. As of September 24, 1996, no shares had been
allocated.
49
<PAGE>
(b) Security Ownership of Management
The following table sets forth information as of September 24, 1996
with respect to the shares of Common Stock beneficially owned by each
director of the Company, the sole executive officer named in the Summary
Compensation Table and by all directors and executive officers of Company
as a group.
<TABLE>
<CAPTION>
Amount and Percent of
Nature of Beneficial Common Stock
Name Ownership (1) Outstanding
---- -------------------- -------------
<S> <C> <C>
Virginia R. S. Stump 10,036 (2) 1.0%
Tony A. Merida 11,000 1.1
David W. Gay 15,000 (3) 1.6
Roger S. Grubbs 15,000 1.6
Jane G. Simpson 15,000 1.6
Ronald L. Sutton 7,735 *
Jack C. Zanone 2,400 *
All directors and executive
officers as a group (7 persons) 76,171 7.9
</TABLE>
- --------------------
(1) For the definition of beneficial ownership, see footnote 1 to the
table in "Securities Ownership of Certain Beneficial Owners." Unless
otherwise indicated, ownership is direct and the named individuals and
group exercise sole voting and investment power over the shares listed
as beneficially owned by such persons or group. The amounts shown do
not include 76,704 unallocated shares held by the ESOP, the voting of
which is directed by the ESOP trustees, consisting of Directors Gay,
Sutton and Zanone, in the same ratio as ESOP participants direct the
voting of allocated shares or, in the absence of such direction, in
the ESOP trustees' best judgment.
(2) The amount shown includes 1,032 shares of Common Stock owned by Ms.
Stump's husband.
(3) The amount shown includes 100 shares of Common Stock owned by Mr.
Gay's son and 549 shares of Common Stock owned by Mr. Gay's wife.
* The percentage owned is less than 1% of the outstanding Common Stock.
(c) Changes in Control
Management of the Company knows of no arrangements, including any
pledge by any person of securities of the Company, the operation of which
may at a subsequent date result in a change in control of the registrant.
Item 12. Certain Relationships and Related Transactions
--------------------------------------------------------
The Bank offers loans to its directors and officers. These loans are
made in the ordinary course of business with the same collateral, interest
rates and underwriting criteria as those of comparable transactions
prevailing at the time and do not involve more than the normal risk of
collectibility or present other unfavorable features. Under law, the
Bank's loans to directors and executive officers are required to be made on
substantially the same terms, including interest rates, as those prevailing
for comparable transactions and must not involve more than the normal risk
of repayment or present other unfavorable features. Furthermore, all loans
to such persons must be approved in advance by a disinterested majority of
the Board of Directors. At June 30, 1996, the Bank did not have any loans
outstanding to directors and executive officers.
50
<PAGE>
Item 13. Exhibits, Lists and Reports on Form 8-K.
-------------------------------------------------
(a) List of Documents Filed as Part of this Report
----------------------------------------------
The following is a list of exhibits filed as part of this Annual
Report on Form 10-KSB and is also the Exhibit Index.
<TABLE>
<CAPTION>
Page in
Sequentially
No. Description Numbered Copy
--- ----------- -------------
<S> <C> <C>
3.1 Certificate of Incorporation of First Lancaster Bancshares, Inc. *
3.2 Bylaws of First Lancaster Bancshares, Inc. *
4 Form of Common Stock Certificate of First Lancaster Bancshares, Inc. *
10.1 First Lancaster Bancshares, Inc. 1996 Stock Option and Incentive Plan *
10.2 First Lancaster Federal Savings Bank Management Recognition Plan *
10.3(a) Employment Agreements by and between First Lancaster Federal Savings
Bank and Virginia R. S. Stump *
10.3(b) Employment Agreements by and between First Lancaster Bancshares, Inc.
and Virginia R. S. Stump *
10.4 First Lancaster Federal Savings Bank Directors' Retirement Plan *
10.5 First Lancaster Federal Savings Bank Incentive Compensation Plan *
10.6 Supplemental Executive Retirement Agreements between First Lancaster
Federal Savings Bank and Virginia R. S. Stump *
21 Subsidiaries of the Registrant
27 Financial Data Schedule
</TABLE>
- --------------------
(*) Incorporated herein by reference from the Company's Registration
Statement on Form SB-2 (Registration No. 333-2468).
(b) Reports on Form 8-K. During the quarter ended June 30, 1996, the
-------------------
Registrant did not file any current reports on Form 8-K.
51
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
FIRST LANCASTER BANCSHARES, INC.
September 25, 1996 By: /s/ Virginia R. S. Stump
-------------------------------------
Virginia R. S. Stump
Chairman of the Board, President and
Chief Executive Officer
(Duly Authorized Representative)
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed below by the following persons on behalf
of the Registrant and in the capacities and on the dates indicated.
<TABLE>
<S> <C>
/s/ Virginia R. S. Stump September 25, 1996
- -------------------------------
Virginia R. S. Stump
Chairman of the Board, President and
Chief Executive Officer
(Principal Executive, Financial and
Accounting Officer)
/s/ Tony A. Merida September 25, 1996
- -------------------------------
Tony A. Merida
Vice Chairman of the Board and Executive
Vice President
/s/ David W. Gay September 25, 1996
- -------------------------------
David W. Gay
Director
/s/ Roger S. Grubbs September 25, 1996
- -------------------------------
Roger S. Grubbs
Director
/s/ Jane G. Simpson September 25, 1996
- -------------------------------
Jane G. Simpson
Director
/s/ Ronald L. Sutton September 25, 1996
- -------------------------------
Ronald L. Sutton
Director
/s/ Jack C. Zanone September 25, 1996
- -------------------------------
Jack C. Zanone
Director
</TABLE>
52
<PAGE>
Exhibit 21
Subsidiaries of the Registrant
Parent
------
First Lancaster Bancshares, Inc.
<TABLE>
<CAPTION>
State or Other
Jurisdiction of Percentage
Subsidiaries (1) Incorporation Ownership
- ---------------- --------------- -----------
<S> <C> <C>
First Lancaster Federal Savings Bank United States 100%
First Lancaster Corporation Kentucky 100% (2)
</TABLE>
- --------------------
(1) The assets, liabilities and operations of the subsidiaries are
included in the consolidated financial statements contained in the
financial statements attached hereto as an exhibit.
(2) First Lancaster Corporation is a wholly-owned subsidiary of First
Lancaster Federal Savings Bank.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 9
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JUN-30-1996
<PERIOD-START> JUL-01-1995
<PERIOD-END> JUN-30-1996
<CASH> 339,445
<INT-BEARING-DEPOSITS> 7,285,412
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 527,364
<INVESTMENTS-CARRYING> 114,979
<INVESTMENTS-MARKET> 125,000
<LOANS> 31,988,677
<ALLOWANCE> 100,000
<TOTAL-ASSETS> 40,726,638
<DEPOSITS> 23,482,589
<SHORT-TERM> 0
<LIABILITIES-OTHER> 350,452
<LONG-TERM> 3,480,410
0
0
<COMMON> 9,588
<OTHER-SE> 13,403,599
<TOTAL-LIABILITIES-AND-EQUITY> 40,726,638
<INTEREST-LOAN> 2,706,214
<INTEREST-INVEST> 203,215
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 2,907,429
<INTEREST-DEPOSIT> 1,406,215
<INTEREST-EXPENSE> 1,735,033
<INTEREST-INCOME-NET> 1,174,396
<LOAN-LOSSES> 41,328
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 671,252
<INCOME-PRETAX> 461,816
<INCOME-PRE-EXTRAORDINARY> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 310,001
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
<YIELD-ACTUAL> 7.29
<LOANS-NON> 231,221
<LOANS-PAST> 76,000
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 70,000
<CHARGE-OFFS> 11,328
<RECOVERIES> 0
<ALLOWANCE-CLOSE> 100,000
<ALLOWANCE-DOMESTIC> 100,000
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
