<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended June 30, 1998
OR
[_] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from _____________________ to ________________
Commission File No. 0-20899
FIRST LANCASTER BANCSHARES, INC.
--------------------------------
(Name of small business issuer in its charter)
Delaware 61-1297318
--------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
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: None.
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par
-----------------
value $0.01 per share
---------------------
(Title of Class)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports) and (2) has been
subject to such filing requirements for the past 90 days. Yes X No __
---
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained herein, and no disclosure will 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. [ ]
Issuer's revenues for the fiscal year ended June 30, 1998: $4,034,741
As of September 23, 1998, the aggregate market value of the 827,310 shares of
Common Stock of the registrant issued and outstanding held by non-affiliates on
such date was approximately $10.5 million based on the average bid and asked
price of $12.625 per share of the registrant's Common Stock on September 23,
1998. 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 23, 1998: 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
this Form 10-KSB into which the document is incorporated:
1. Portions of the Annual Report to Stockholders for the fiscal year ended
June 30, 1998 (Parts I and II)
2. Portions of Proxy Statement for 1998 Annual Meeting of Stockholders
(Part III)
<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
serving Garrard, Jessamine and Fayette Counties, Kentucky and which operates a
full-service office in Lancaster, Kentucky and a loan production office in
Nicholasville, 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 of the Bank."
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.
PROPOSED REGULATORY AND LEGISLATIVE CHANGES
On May 13, 1998, the U.S. House of Representatives by one vote passed H.R.
10 (the "Act"), the "Financial Services Competition Act of 1998," which calls
for a sweeping modernization of the banking system that would permit
affiliations between commercial banks, securities firms, insurance companies
and, subject to certain limitations, other commercial enterprises. The stated
purposes of the Act are to enhance consumer choice in the financial services
marketplace, level the playing field among providers of financial services and
increase competition.
H.R. 10 would remove the restrictions contained in the Glass-Steagall Act
of 1933 and the Bank Holding Company Act of 1956, thereby allowing qualified
financial holding companies to control banks, securities firms, insurance
companies, and other financial firms. Conversely, securities firms, insurance
companies and financial firms would be allowed to own or affiliate with a
commercial bank. Under the new framework, the Federal Reserve would serve as an
umbrella regulator to oversee the new financial holding company structure.
Securities affiliates would be required to comply with all applicable federal
securities laws, including registration and other requirements applicable
<PAGE>
to broker-dealers. The Act also provides that insurance affiliates be subject to
applicable state insurance regulations and supervision. The Act preserves the
thrift charter and all existing thrift powers, but restricts the activities of
new unitary thrift holding companies.
The Senate is now considering the legislation but may further modify the
Act. At this time, it is unknown whether the Act will be enacted, or if
enacted, what form the final version of such legislation might take.
LENDING ACTIVITIES
GENERAL. The Bank's loan portfolio totaled $47.6 million at June 30,1998,
representing 88.6% of total assets at that date. It is the Bank's policy to
concentrate its lending within its market area. At June 30, 1998, $35.4
million, or 66.2% of the Bank's gross loan portfolio, consisted of single-
family, residential mortgage loans. Other loans secured by real estate include
multi-family residential, commercial, construction and nonresidential loans,
which amounted to $17.6 million, or 32.9% of the Bank's gross loan portfolio at
June 30, 1998. To a lesser extent, the Bank originates consumer loans, which
consist of loans secured by deposits. At June 30, 1998, consumer loans totaled
$490,000, or 0.9% of the Bank's gross loan portfolio.
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, 1998, the Bank had no concentrations of loans
exceeding 10% of gross loans other than as disclosed below.
<TABLE>
<CAPTION>
At June 30,
--------------------------------------
1998 1997
--------------------- ---------------
Amount % Amount %
------------ ------- -------- -----
(Dollars in thousands)
<S> <C> <C> <C> <C>
Real estate loans:
Single-family residential................ $35,422 66.2% $30,996 73.4%
Multi-family residential and commercial.. 1,953 3.7 997 2.3
Construction............................. 10,864 20.3 6,632 15.7
Nonresidential /(1)/..................... 4,768 8.9 3,355 7.9
------- ------ ------- -----
Total real estate loans................. 53,007 99.1 41,980 99.3
Consumer loans............................ 490 0.9 276 0.7
------- ------ ------- -----
53,497 100.0% 42,256 100.0%
====== =====
Less:
Loans in process......................... 5,657 3,828
Unearned loan origination fees........... 47 19
Allowance for loan losses................ 200 125
------- -------
Total................................... $47,593 $38,284
======= =======
</TABLE>
- -------------------------
/(1)/ Consists of loans secured by first liens on residential lots and loans
secured by first mortgages on commercial real property.
2
<PAGE>
LOAN MATURITY SCHEDULE. The following table sets forth certain information
at June 30, 1998 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, 1999 June 30, 1998 June 30, 1998 Total
--------------- ------------- ------------- -------
(In thousands)
<S> <C> <C> <C> <C>
Single-family residential.. $26,558 $4,267 $4,597 $35,422
Multi-family residential... 875 20 1,058 1,953
Construction............... 10,570 260 34 10,864
Nonresidential............. 1,274 3,227 267 4,768
Consumer................... 324 166 -- 490
------- ------ ------ -------
Total................. $39,601 $7,940 $5,956 $53,497
======= ====== ====== =======
</TABLE>
The following table sets forth at June 30, 1998, 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
------------- ----------------
(In thousands)
<S> <C> <C>
Single-family residential.. $ 6,859 $28,563
Multi-family residential... 1,159 794
Construction............... 10,830 34
Nonresidential............. 4,551 217
Consumer................... 463 27
------- -------
Total.................. $23,862 $29,635
======= =======
</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.
3
<PAGE>
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.
<TABLE>
<CAPTION>
Year Ended June 30,
-------------------
1998 1997
--------- --------
(In thousands)
<S> <C> <C>
Loans originated:
Real estate loans:
Single-family residential /(1)/.. $ 8,457 $ 7,539
Construction /(2)/................ 13,976 7,063
Nonresidential /(3)/.............. 4,619 1,980
Consumer loans...................... 1,029 117
------- -------
Total loans originated........... $28,081 $16,699
======= =======
</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 the Federal Home Loan Mortgage
Corporation ("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.
4
<PAGE>
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 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 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 10% of the institution's unimpaired capital and surplus. Under this
general law, the Bank's loans to one borrower were limited to $1.38 million at
June 30, 1998. 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,
1998. At that date, the Bank had no lending relationships in excess of the
loans-to-one-borrower limit. At June 30, 1998, the Bank's largest lending
relationship was a $3.2 million loan to develop property for single-family
residences. The loan was current and performing in accordance with its terms at
June 30, 1998.
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, 1998, single-family residential mortgage
loans, totaled approximately $35.4 million, or 66.2% of the Bank's gross loan
portfolio. 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 ("ARM's"). As of June 30, 1998, 80.6% 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.
5
<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. At June 30,
1998, $23.9 million, or 44.6%, 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 Federal Home Loan Bank ("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, Jessamine and
Fayette Counties, Kentucky. At June 30, 1998, the Bank's loan portfolio
included $10.9 million of 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,
Jessamine and Fayette Counties, 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 and economic conditions. The Bank has sought to minimize this risk by
limiting construction lending to qualified borrowers in the Bank's market area
and by requiring the involvement of qualified builders.
6
<PAGE>
MULTI-FAMILY RESIDENTIAL AND COMMERCIAL AND NONRESIDENTIAL 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 currently range in size from $25,000 to
$160,000. The Bank's 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, Jessamine and
Fayette Counties, Kentucky. At June 30, 1998, the Bank had $2.0 million of
multi-family residential and commercial real estate loans, which amounted to
3.7% of the Bank's gross loan portfolio at such date. The Bank's nonresidential
loan portfolio consists of loans secured by first liens on residential lots and
loans secured by first mortgages on commercial real property. At June 30, 1998,
the Bank had approximately $4.8 million of such loans, which comprised 8.9% of
its loan portfolio. Multi-family residential, commercial and nonresidential
real estate loans are originated either 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, commercial and nonresidential real estate lending
entails significant additional risks as compared with single-family residential
property lending. Multi-family residential, commercial and nonresidential 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, commercial or nonresidential real estate loans are
made.
CONSUMER LENDING. The majority of 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, 1998, loans on deposit accounts totaled $170,000, or 3.2% of
the Bank's gross loan portfolio. The remaining $320,000 in consumer loans
includes loans secured by automobiles.
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 fee on loan originations ranging from 0.5% to 1.0% of the principal
balance. 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 a 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 contracted 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 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 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
7
<PAGE>
capitalized until a salable 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
Consolidated 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 Statement of Financial Accounting
Standards ("SFAS") No. 15 at the dates indicated.
<TABLE>
<CAPTION>
At June 30,
------------------------
1998 1997
-------- --------
(Dollars in thousands)
<S> <C> <C>
Loans accounted for on a non-accrual basis: (1)
Real estate:
Single-family residential.......................... $ 480 $ 808
Nonresidential..................................... -- 20
Consumer................................................. 20 --
Accruing loans which are contractually past due 90 days
or as to which repayment is in doubt.................. 88 --
----- -----
Total nonperforming loans.......................... $ 588 $ 828
===== =====
Percentage of real estate loans.......................... 1.11% 1.97%
===== =====
Other non-performing assets (2).......................... $ 270 $ --
===== =====
</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, 1998, gross interest accrued but not recognized
of approximately $18,000, would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current.
At June 30, 1998, nonaccrual loans consisted of 13 single-family
residential real estate loans aggregating $480,000 and one equipment loan
totaling $20,000 and represented a decrease of $328,000, or 39.6% from
nonaccrual loans of $828,000 at June 30, 1997. Accruing loans which are 90 days
past due totaled $88,000 or 0.2% of total loans at June 30, 1998 compared to the
accruing loans contractually past due 90 days at June 30, 1997. At June 30,
1998, $270,000 of real estate acquired through foreclosure, consisting of one
single-family residence, was held by the Bank.
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
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
8
<PAGE>
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, 1998, the Bank had $1.4
million in assets classified as special mention, $588,000 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 $112,254 at June 30, 1998 and was 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 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 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.
9
<PAGE>
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,
------------------------
1998 1997
------------ ----------
(Dollars in Thousands)
<S> <C> <C>
Balance at beginning of period.......... $ 125 $ 100
----- -----
Loans charged off:
Real estate mortgage:
Single-family residential......... 40 14
----- -----
Total charge-offs....................... 40 14
----- -----
Recoveries.............................. -- --
Net loans charged off................... (40) (14)
Provision for loan losses............... 115 39
----- -----
Balance at end of period................ $ 200 $ 125
===== =====
Ratio of net charge-offs to average
loans outstanding during the period.. .08% 0.04%
===== =====
</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,
--------------------------------------------------------
1998 1997
--------------------------- --------------------------
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:
Single-family residential.......... $ 150 66.2% $125 73.4%
Construction....................... 50 20.3 -- 15.7
----- -------------
Total allowance for loan losses.. $ 200 $125
===== =============
</TABLE>
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 of the Bank -- Liquidity
Requirements."
10
<PAGE>
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 review 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 $1.2 million at June 30, 1998 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 will 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 the Government National Mortgage Association ("GNMA"), which guarantee or
insure 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 collateralize borrowings or other obligations of the Bank.
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
11
<PAGE>
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 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,
----------------------
1998 1997
-------- --------
(Dollars in thousands)
<S> <C> <C>
Securities available for sale:
U.S. government and agency securities.. $1,161 $ 864
Securities held to maturity:
Mortgage-backed securities............. 435 540
------ ------
Total investment securities......... $1,596 $1,404
====== ======
</TABLE>
12
<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, 1998.
<TABLE>
<CAPTION>
One Year or Less One to Five Years Five to ten Years More than Ten Years
--------------------- --------------------- ----------------------- ---------------------
Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield
-------- -------- -------- -------- ---------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Securities available for
sale:
U.S. government and agency
securities............... $ 1,161 33.3% $ -- --% $ -- --% $ -- --%
Securities held to maturity:
Mortgage-backed
securities............... -- 6 8.5 17 8.5 412 7.6
-------- -------- ---------- --------
Total................. $ 1,161 33.3% $ 6 8.5% $ 17 8.5 $ 412 7.6
======== ======== ========== ========
<CAPTION>
Total Investment Portfolio
--------------------------------
Carrying Market Average
Value Value Yield
-------- ------ --------
<S> <C> <C> <C>
Securities available for
sale:
U.S. government and agency
securities............ $1,161 $1,161 33.3%
Securities held to maturity:
Mortgage-backed
securities.............. 435 446 8.4
------
Total................. $1,596 $1,627 26.6%
====== ======
</TABLE>
13
<PAGE>
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 average balances and average interest
rates based on daily balances for deposits for the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------
1998 1997
------------------ ------------------
Average Average Average Average
Deposits Rate Deposits Rate
-------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Non-interest bearing demand deposits.. $ 461 --% $ 3 --%
Savings deposits...................... 3,544 3.23 3,180 3.13
Time deposits......................... 21,550 5.96 19,023 5.64
------- -------
Total deposits................... $25,555 $22,203
======= =======
</TABLE>
14
<PAGE>
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,
1998.
<TABLE>
<CAPTION>
Certificates
Maturity Period of Deposits
--------------- -----------
(In thousands)
<S> <C>
Three months or less........... $ 611
Over three through six months.. 203
Over six through 12 months..... 1,537
Over 12 months................. 1,135
------
Total....................... $3,486
======
</TABLE>
BORROWINGS. Savings deposits historically have been the source of funds
for the Bank's lending, investments and general activities. The Bank is
authorized, however, to use advances from the of Cincinnati to supplement its
supply of lendable funds and to 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, 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 50% of assets (approximately $27.0 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, 1998, the Bank had $13.5 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, 1998,
the Bank was authorized to invest up to approximately $1.6 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, Fayette and Jessamine Counties, Kentucky, which are located around
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.
15
<PAGE>
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.
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, 1998, the latest date for which information was
available, it had 19.8% of deposits held by all banks and thrifts in its market
area.
EMPLOYEES
As of June 30, 1998, the Bank had 10 full-time and two part-time employees.
REGULATION OF THE COMPANY
GENERAL. The Company is a savings and loan holding company as defined by
the Home Owners' Loan Act (the "HOLA") and, as such, is subject to OTS
regulation, supervision and examination. In addition, the OTS has enforcement
authority over the Company and its non-savings institution subsidiaries and may
restrict or prohibit activities that are determined to represent a serious risk
to the safety, soundness or stability of the Bank or any other subsidiary
savings institution. 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 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
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 Qualified
Thrift Lender ("QTL") Test, then within one year after the institution ceased to
be a QTL, such unitary savings and loan holding company shall register as and be
deemed to be a bank holding company and will become subject to the activities
restrictions applicable to a bank holding company. See "Regulation of the Bank
- -- Qualified Thrift Lender Test."
16
<PAGE>
Legislation currently pending in the United States Congress would, if
enacted, restrict the business activities of unitary savings and loan holding
companies; however, the legislation in its present form would grandfather the
current absence of restriction on business activities for unitary savings and
loan holding companies in existence on the bill's date of enactment. Since the
Company currently is a unitary savings and loan holding company, it would
qualify for such grandfathered treatment under the current form of the
legislation. See " -- Proposed Regulatory and Legislative Changes."
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. The HOLA provides that, among other things, no multiple
savings and loan holding company or subsidiary thereof which is not a savings
institution may 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 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 previously authorized by regulation as of March 5, 1987 to be
directly engaged in by multiple savings and loan holding companies or (vii)
those activities authorized by the Federal Reserve Board as permissible for bank
holding companies, unless the Director of OTS by regulation prohibits or limits
such activities for savings and loan holding companies. Those activities
described in (vii) above must also be approved by the Director of OTS prior to
being engaged in by a multiple savings and loan holding company.
TRANSACTIONS WITH AFFILIATES. Transactions between savings institutions
and any affiliate are governed by Sections 23A and 23B of the Federal Reserve
Act. An affiliate of a savings institution is any company or entity which
controls, is controlled by or is under common control with the savings
institution. In a holding company context, the parent holding company of a
savings institution (such as the Company) and any companies which are controlled
by such parent holding company are affiliates of the savings institution.
Generally, Sections 23A and 23B (i) limit the extent to which the savings
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 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. Section 106 of the Bank
Holding Company Act of 1956, as amended ("BHCA") which also applies to the Bank,
prohibits the Bank from extending credit to or offering any other services, or
fixing or varying the consideration for such extension of credit or service, on
condition that the customer obtain some additional services from the institution
or certain of its affiliates or not obtain services of a competitor of the
institution, subject to certain exceptions.
Savings institutions are also subject to the restrictions contained in
Section 22(h) and Section 22(g) of the Federal Reserve Act on loans to executive
officers, directors and principal stockholders. Under Section 22(h), loans to a
director, executive officer or to a greater than 10% stockholder of a savings
institution, and certain affiliated entities of the foregoing, may not exceed,
together with all other outstanding loans to such person and affiliated entities
the institution's loan to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus and an additional 10% of such
capital and surplus for loans fully secured by certain readily marketable
collateral). 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
17
<PAGE>
approved in advance by a majority of the board of directors of the institution
with any "interested" director not participating in the voting. The Federal
Reserve Board has prescribed 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 $500,000). Further, the Federal Reserve Board pursuant to 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.
Section 22(g) of the Federal Reserve Act requires that loans to executive
officers of depository institutions not be made on terms more favorable than
those afforded to other borrowers, requires approval for such extensions of
credit by the board of directors of the institution, and imposes reporting
requirements for and additional restrictions on the type, amount and terms of
credits to such officers. In addition, Section 106 of the BHCA 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.
RESTRICTIONS ON ACQUISITIONS. The HOLA generally prohibits savings and
loan holding companies, without prior approval of the Director of OTS, from
acquiring (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
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 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 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 laws 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).
OTS regulations permit federal savings institutions to branch in any state
or states of the United States and its territories. Except in supervisory cases
or when interstate branching is otherwise permitted by state law or other
statutory provision, a federal savings institution may not establish an out-of-
state branch unless (i) the institution qualifies as a QTL or as a "domestic
building and loan association" under (S)7701(a)(19) of the Code and the total
assets attributable to all branches of the institution in the state would
qualify such branches taken as a whole for treatment as a QTL or as a domestic
building and loan association and (ii) such branch would not result in (a)
formation of a prohibited multi-state multiple savings and loan holding company
or (b) a violation of certain statutory restrictions on branching by savings
institution subsidiaries of banking holding companies. Federal savings
institutions generally may not establish new branches unless the institution
meets or exceeds minimum regulatory capital requirements. The OTS
18
<PAGE>
will also consider the institution's record of compliance with the Community
Reinvestment Act of 1977 in connection with any branch application.
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 Savings Association Insurance Fund (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.
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. OTS capital adequacy regulations require savings
institutions such as the Bank to meet three minimum capital standards: a "core"
capital requirement of 3% of adjusted total assets, a "tangible" capital
requirement of 1.5% of adjusted total assets, and a "risk-based" capital
requirement of 8% of total risk-based capital to total risk-weighted assets.
In addition, the OTS has adopted regulations imposing certain restrictions on
savings institutions that have a total risk-based capital ratio of 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 total assets of less than 4% (or 3% if the institution is
rated Composite 1 CAMELS under the OTS examination rating system). See "--
Prompt Corrective Regulatory Action."
The core capital, or "leverage ratio," requirement mandates that a savings
institution maintain core capital equal to at least 3% of its adjusted total
assets. "Core capital" includes 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
institution's intangible assets for which no market exists. Limited exceptions
to the reduction of intangible assets include permissible mortgage servicing
rights, purchased credit card relationships, qualifying supervisory goodwill and
certain intangible assets arising from prior regulatory accounting practices.
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 purchased mortgage servicing rights. Both core and tangible
capital are further reduced by an amount equal to the savings institution's debt
and equity investments in subsidiaries engaged in activities not permissible to
national banks (other than subsidiaries engaged in activities undertaken as
agent for customers or in mortgage banking activities and subsidiary depository
institutions or their holding companies). At June 30, 1998, the Bank had no
such investments.
Adjusted total assets are a savings institution's total assets as
determined under generally accepted accounting principles, adjusted for certain
goodwill amounts and increased by a pro rated portion of the assets of
unconsolidated includable subsidiaries in which the savings institution holds a
minority interest. Adjusted total assets are reduced by
19
<PAGE>
the amount of assets that have been deducted from capital, the portion of the
savings institution's investments in unconsolidated includable subsidiaries and,
for purposes of the core capital requirement, qualifying supervisory goodwill.
In determining compliance with the risk-based capital requirement, a
savings institution is allowed to use both core capital and supplementary
capital in its total capital provided the amount of supplementary capital
included does not exceed the savings institution'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 institution's general loss allowances. Total core and supplementary
capital are reduced by the amount of capital instruments held by other
depository institutions pursuant to reciprocal arrangements and by that portion
of the savings institution's land loans and non-residential construction loans
in excess of 80% loan-to-value ratio and all equity investments, other than
those deducted from core and tangible capital. At June 30, 1998, the Bank had
no high ratio land or nonresidential construction loans and had no equity
investments for which OTS regulations require a 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 loan-to-value ratios under 80% 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 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, 1998.
<TABLE>
<CAPTION>
Percent of
Amount Assets (1)
--------- ------------
(Dollars in thousands)
<S> <C> <C>
Tangible capital................ $12,826 24.0%
Tangible capital requirement.... 800 1.5
------- ----
Excess (deficit)............. $12,026 22.5%
======= ====
Core capital (2)................ $12,826 24.0%
Core capital requirement........ 1,600 3.0
------- ----
Excess (deficit)............. $11,226 21.0%
======= ====
Risk-based capital.............. $13,026 38.0%
Risk-based capital requirement.. 2,759 8.0
------- ----
Excess (deficit)............. $10,276 30.0%
======= ====
</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, to conform to the more stringent leverage ratio adopted by
the Office of the Comptroller of the Currency for national banks.
The 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 is 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
20
<PAGE>
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 is 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 estimated economic value of its assets. A savings institution with a
greater than normal interest rate risk is 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. Savings
institutions with less than $300 million in assets and a risk-based capital
ratio above 12% are generally exempt from filing the interest rate risk schedule
with their Thrift Financial Reports. However, the OTS requires any exempt
savings institution that it determines may have a high level of interest rate
risk exposure to file such schedule on a quarterly basis. The Bank has
determined that, on the basis of current financial data, it will not be deemed
to have more than normal level of interest rate risk under the rule and believes
that it will not be required to increase its total capital as a result of the
rule.
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. Such circumstances
would include a high degree of exposure of interest rate risk, prepayment risk,
credit risk and concentration of credit risk and certain risks arising from non-
traditional activities. 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,
including the OTS, 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 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
21
<PAGE>
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.
Under regulations jointly adopted by the federal banking regulators,
including the OTS, a depository institution's capital adequacy for purposes of
the prompt corrective action rules is determined 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, a savings institution
that is not subject to an order or written directive 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% or greater; and (iii) a leverage ratio of 5% or greater. An
"adequately capitalized" savings institution is a savings institution that does
not meet the definition of well capitalized and has: (i) a total risk-based
capital ratio of 8% or greater; (ii) a Tier 1 capital risk-based ratio of 4% or
greater; and (iii) a leverage ratio of 4% or greater (or 3% or greater if the
savings institution has a composite 1 CAMELS rating). An "undercapitalized
institution" is a savings institution that has (i) a total risk-based capital
ratio less than 8%; or (ii) a Tier 1 risk-based capital ratio of less than 4%;
or (iii) a leverage ratio of less than 4% (or 3% if the institution has a
composite 1 CAMELS rating). A "significantly undercapitalized" institution is
defined as a savings institution that has: (i) a total risk-based capital ratio
of less than 6%; or (ii) a Tier 1 risk-based capital ratio of less than 3%; or
(iii) a leverage ratio of less than 3%. A "critically undercapitalized" savings
institution is defined as a savings institution that has a ratio of "tangible
equity" to total assets of less than 2%. 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 OTS may reclassify a well capitalized savings
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 the OTS determines, after notice and an opportunity for a
hearing, that the savings institution is in an unsafe or unsound condition or
that the institution has received and not corrected a less-than-satisfactory
rating for any CAMELS rating category. The Bank is classified as "well
capitalized" under these regulations.
SAFETY AND SOUNDNESS STANDARDS. Under FDICIA, as amended by the Riegle
Community Development and Regulatory Improvement Act of 1994, each federal bank
regulatory agency is required to establish safety and soundness standards, by
regulation or guideline. The OTS and the other federal bank regulatory agencies
have adopted a set of guidelines prescribing safety and soundness standards
pursuant to the statute. The final rule and guidelines became effective August
9, 1995. The safety and soundness guidelines establish general standards
relating to internal controls and information systems, internal audit systems,
loan documentation, credit underwriting, interest rate exposure and asset
growth. The guidelines further provide that savings 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 OTS determines that a savings 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 savings institution must submit an acceptable compliance plan to
the OTS 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. 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 has materially
affected the Bank's operations.
Additionally under FDICIA, as amended by the CDRI Act, the Federal banking
agencies were 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, issued proposed guidelines relating
to asset quality and earnings.
22
<PAGE>
Under the proposed guidelines, a savings 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. Management believes that the asset
quality and earnings standards, in the form proposed by the banking agencies,
would not have a material effect on the Bank's operations.
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, 1998 of $710,300. 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, 1998, the Bank had $12.0 million in long-term advances and $1.5 million
in short-term advances outstanding from the FHLB of Cincinnati.
FEDERAL RESERVE SYSTEM. Pursuant to regulations of the Federal Reserve
Board, a thrift institution must maintain average daily reserves equal to 3% on
the first $47.8 million of transaction accounts, plus 10% on the amount over
$47.8 million. 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 non-interest 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. As of June 30, 1998, the Bank met its reserve requirements.
FEDERAL DEPOSIT INSURANCE. The Bank is required to pay assessments based on
a percentage of its insured deposits to the FDIC for insurance of its deposits
by the FDIC through the SAIF. Under the Federal Deposit Insurance Act, the FDIC
is required to set semi-annual assessments for SAIF-insured institutions at a
level necessary to maintain the designated reserve ratio of the SAIF at 1.25% of
estimated insured deposits or at a higher percentage of estimated insured
deposits that the FDIC determines to be justified for that year by circumstances
indicating a significant risk of substantial future losses to the SAIF.
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 under the prompt
corrective action regulations. See " -- Prompt Corrective Regulatory 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.
Historically, institutions with SAIF-assessable deposits, like the Bank,
were required to pay higher deposit insurance premiums than institutions with
deposits insured by the Bank Insurance Fund ("BIF") also administered by the
FDIC. In order to recapitalize the SAIF and address the premium disparity, in
November 1996 the FDIC imposed a one-time special assessment on institutions
with SAIF-assessable deposits based on the amount determined by the
23
<PAGE>
FDIC to be necessary to increase the reserve levels of the SAIF to the
designated reserve ratio of 1.25% of insured deposits. Institutions were
assessed at the rate of 65.7 basis points per $100 of each institution's SAIF-
assessable deposits as of March 31, 1995. Based on the foregoing, the Bank
recorded an accrual for the special assessment of $153,000 for the quarter ended
September 30, 1996. Net of related tax effects, this reduced reported earnings
by $101,000 for the year ended June 30, 1997.
The special assessment recapitalized the SAIF, and as a result, the FDIC
lowered the SAIF deposit insurance assessment rates to zero for well capitalized
institutions with the highest supervisory ratings and 0.31% of insured deposits
for institutions in the highest risk-based premium category. Since the BIF is
above its designated reserve ratio of 1.25% of insured deposits, "well-
capitalized" institutions in Subgroup A, numbering 95% of BIF-insured
institutions, pay no federal deposit insurance premiums, with the remaining 5%
of institutions paying a graduated range of rates up to 0.27% of insured
deposits for the highest risk-based premium category. Until December 31, 1999,
SAIF-insured institutions will be required to pay assessments to the FDIC at the
rate of 6.5 basis points to help fund interest payments on certain bonds issued
by the Financing Corporation ("FICO"), an agency of the federal government
established to finance takeovers of insolvent thrifts. During this period, BIF
members will be assessed for these obligations at the rate of 1.3 basis points.
After December 31, 1999, both BIF and SAIF members will be assessed at the same
rate for FICO payments.
LIQUIDITY REQUIREMENTS. The Bank generally is required to maintain average
daily balances of liquid assets (generally, cash, certain time deposits,
bankers' acceptances, highly rated corporate debt and commercial paper,
securities of certain mutual funds, and specified United States government,
state or federal agency obligations) in each calendar quarter that is equal or
greater than 4% of its net withdrawable accounts plus short-term borrowings
either at the end of the preceding calendar quarter or on the average daily
balance during the preceding quarter. The Bank also is required to maintain
sufficient liquidity to ensure its safe and sound operation. Monetary penalties
may be imposed for failure to meet liquidity requirements. The average daily
balance of liquid assets ratio of the Bank for June 30, 1998 was 8.2%.
QUALIFIED THRIFT LENDER TEST. The HOLA and OTS regulations require that
all savings institutions satisfy one of two Qualified Thrift Lender ("QTL")
tests or suffer a number of sanctions, including restrictions on activities. To
qualify as a QTL, a savings institution must either qualify as a "domestic
building and loan association" under the Internal Revenue Code or maintain at
least 65% of its "portfolio" assets in Qualified Thrift Investments. 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. All of the following may be included as Qualified Thrift
Investments: investments in mortgage-backed securities, residential mortgages,
home equity loans, loans made for educational purposes, small business loans,
credit card loans and shares of stock issued by a Federal Home Loan Bank.
Subject to a 20% of portfolio assets limit, savings institutions are also able
to treat the following as Qualified Thrift Investments: (i) 50% of the dollar
amount of residential mortgage loans subject to sale under certain conditions,
(ii) investments, both debt and equity, in the capital stock or obligations of
and any other security issued by a service corporation or operating subsidiary,
provided that such subsidiary derives at least 80% of its annual gross revenues
from activities directly related to purchasing, refinancing, constructing,
improving or repairing domestic residential housing or manufactured housing,
(iii) 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, (iv) loans
for the purchase, construction, development or improvement of community service
facilities, and (v) loans for personal, family, household or educational
purposes, provided that the dollar amount treated as Qualified Thrift
Investments may not exceed 10% of the savings institution's portfolio assets.
A savings institution must maintain its status as a QTL on a monthly basis
in at least nine out of every 12 months. An initial failure to qualify as a QTL
results in a number of sanctions, including the imposition of certain operating
restrictions and a restriction on obtaining additional advances from its Federal
Home Loan Bank. If a savings institution does not requalify under the QTL test
within the three-year period after it fails the QTL test, it would be required
to terminate any activity not permissible for a national bank and repay as
promptly as possible any outstanding
24
<PAGE>
advances from its Federal Home Loan Bank. In addition, the holding company of
such an institution, such as the Company, would similarly be required to
register as a bank holding company with the Federal Reserve Board. At June 30,
1998, the Bank qualified as a QTL.
RESTRICTIONS ON CAPITAL DISTRIBUTIONS. OTS regulations impose limitations
upon capital distributions by savings institutions, such as cash dividends,
payments to repurchase or otherwise acquire its shares, payments to stockholders
of another institution in a cash-out merger and other distributions charged
against capital. A savings institution must give notice to the OTS at least 30
days before declaration of a proposed capital distribution to its holding
company, and capital distributions in excess of specified earnings or by certain
institutions are subject to approval by the OTS. A savings institution that has
capital in excess of all regulatory capital requirements before and after a
proposed capital distribution (a "Tier 1 Association") and that is not otherwise
restricted in making capital distributions, may, after prior notice but without
the approval of the OTS, make capital distributions during a calendar year equal
to the greater of (a) 100% of its net income to date during the calendar year
plus the amount that would reduce by one-half its "surplus capital ratio" (the
excess capital over its fully phased-in capital requirements) at the beginning
of the calendar year, or (b) 75% of its net income for the previous four
quarters. Any additional capital distributions would require prior OTS
approval. A savings institution with total capital in excess of current minimum
capital requirements but not in excess of the fully phased-in requirements (a
"Tier 2 Association") is permitted, after notice, to make capital distributions
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. Tier 1 Associations that have been notified by the OTS that they
are in need of more than normal supervision will be treated as either a Tier 2
or Tier 3 Association. Unless the OTS determines that the Bank is an
institution requiring more than normal supervision, the Bank is authorized to
pay dividends in accordance with the provisions of the OTS regulations discussed
above as a Tier 1 Association. The Bank is a Tier 1 Association.
Under the OTS' prompt corrective action regulations, 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%; (ii) a Tier 1 risk-based capital ratio of less than 4%; or (iii) a
leverage ratio of less than 4%. The OTS, after consultation with the FDIC,
however, may permit an otherwise prohibited stock repurchase if made in
connection with the issuance of additional shares in an equivalent amount and
the repurchase will reduce the institution's financial obligations or otherwise
improve the institution's financial condition.
LOANS TO DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL STOCKHOLDERS. The
Bank's ability to extend credit to its directors, executive officers, and 10%
stockholders, as well as to entities controlled by such persons, is governed by
the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and
Regulation O of the Federal Reserve Board thereunder. Among other things, these
provisions require that an institution's extensions of credit to insiders (a) be
made on terms that are substantially the same as, and follow credit underwriting
procedures that are not less stringent than, those prevailing for comparable
transactions with unaffiliated persons and that do not involve more than the
normal risk of repayment or present other unfavorable features and (b) not
exceed certain limitations on the amount of credit extended to such persons,
individually and in the aggregate, which limits are based, in part, on the
amount of the institution's capital. In addition, extensions of credit in
excess of certain limits must be approved by the Bank's Board of Directors.
TAXATION
GENERAL. The Company and the Bank, together with the Bank's subsidiary,
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 inter-
company transactions and allowing companies included within the consolidated
return to offset income against losses under certain circumstances.
25
<PAGE>
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 requires 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, 1997 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.
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 money in hand, shares of stock, notes,
bonds, accounts, credits, and other intangible assets with certain deductions
allowed for amounts borrowed by depositors and for securities guaranteed by the
U.S. Government or certain of its agencies.
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, real and tangible
property taxes and utility-user taxes. Therefore, local taxing jurisdictions
still have the authority to impose a tax based on deposits.
26
<PAGE>
ITEM 2. DESCRIPTION OF PROPERTY
- --------------------------------
The Company's principal executive offices are located at 208 Lexington
Street, Lancaster, Kentucky in facilities owned by the Bank. At June 30, 1998,
the Company maintained a main office in Lancaster, Kentucky (located in Garrard
County) and a loan production office in Nicholasville, Kentucky (located in
Jessamine County). The Company owns its premises in Lancaster and leases the
premises in Nicholasville. This expiration date on the lease is May 31, 1999.
ITEM 3. LEGAL PROCEEDINGS.
- --------------------------
From time to time, the Company and its subsidiary are parties to various
legal proceedings incident to its business. At June 30, 1998, there were no
legal proceedings that management anticipates would have a material adverse
effect on the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
- ----------------------------------------------------
No matters were submitted to a vote of security holders of the Company
through a solicitation of proxies or otherwise during the fourth quarter of the
fiscal year covered by this report.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
- -----------------------------------------------------------------
The information contained under the section captioned "Market and Dividend
Information" in the Company's 1998 Annual Report to Stockholders (the "Annual
Report") filed as Exhibit 13 hereto is incorporated herein by reference.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
- -------------
The information contained in the section captioned "Management's Discussion
and Analysis of Financial Condition and Results of Operations" in the Annual
Report is incorporated herein by reference.
ITEM 7. FINANCIAL STATEMENTS
- -----------------------------
The consolidated financial statements of the Company in the Annual Report
are incorporated herein by reference.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
- ------------------------------------------------------------------------
FINANCIAL DISCLOSURE
- --------------------
None.
27
<PAGE>
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
- --------------------------------------------------------------------------------
For information concerning the Board of Directors of the Company, the
information contained under the section captioned "Proposal I -- Election of
Directors" in the Company's definitive proxy statement for the Company's 1998
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.
Information regarding the executive officers of the Company is set forth
under "Proposal I -- Election of Directors" in the Proxy Statement.
Information regarding delinquent Form 3, 4 or 5 filers is incorporated
herein by reference to the section entitled "Section 16(a) Beneficial Ownership
Reporting Compliance" in the Proxy Statement.
ITEM 10. EXECUTIVE COMPENSATION
- --------------------------------
The information contained under the section captioned "Proposal I --
Election of Directors -- Executive Compensation and Other Benefits" in the Proxy
Statement is incorporated herein by reference.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
- ---------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners
Information regarding this item in incorporated by reference to the section
captioned "Security Ownership of Certain Beneficial Owners and Management" in
the Proxy Statement.
(b) Security Ownership of Management
Information required by this item is incorporated herein by reference to
the sections captioned "Security Ownership of Certain Beneficial Owners and
Management" and "Proposal I -- "Election of Directors" in the Proxy Statement.
(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 Company.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- --------------------------------------------------------
The information required by this item is incorporated herein by reference
to the section captioned "Proposal I -- Election of Directors -- Transactions
with Management" in the Proxy Statement.
28
<PAGE>
ITEM 13. EXHIBITS, LISTS AND REPORTS ON FORM 8-K
- -------------------------------------------------
(a)(1) The following consolidated financial statements of the Company
included in the Annual Report are incorporated herein by reference from Item 7
of this Report. The remaining information appearing in the Annual Report to
Stockholders is not deemed to be filed as part of this Report, except as
expressly provided herein.
1. Report of Independent Auditors.
2. Consolidated Statements of Financial Condition as of June 30, 1998 and
1997.
3. Consolidated Statements of Income for the Years Ended June 30, 1998
and 1997.
4. Consolidated Statements of Changes in Stockholders' Equity for the
Years Ended June 30, 1998 and 1997.
5. Consolidated Statements of Cash Flows for the Years Ended June 30,
1998 and 1997.
6. Notes to Consolidated Financial Statements
(a)(2) Exhibits
--------
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>
No. Description
-- -----------
<S> <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 *
13 Annual Report to Stockholders
21 Subsidiaries of the Registrant
23 Consent of PricewaterhouseCoopers LLP
27 Financial Data Schedule
</TABLE>
_________________________
* Incorporated herein by reference from the Company's Registration Statement
on Form SB-2 (Registration No. 333-2468).
** Incorporated herein by reference from the Company's Annual Report on Form
10-KSB for the fiscal year ended June 30, 1997.
(b) Reports on Form 8-K. No Reports on Form 8-K were filed by the Company
-------------------
during the last quarter of the fiscal year covered by this report.
29
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
FIRST LANCASTER BANCSHARES, INC.
September 25, 1998 By: /s/ Virginia R. S. Stump
---------------------------------
Virginia R. S. Stump
Chairman of the Board, President and
Chief Executive Officer
(Duly Authorized Representative)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.
/s/ Virginia R. S. Stump September 25, 1998
- ------------------------------------
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, 1998
- ------------------------------------
Tony A. Merida
Vice Chairman of the Board and Executive
Vice President
/s/ David W. Gay September 25, 1998
- ------------------------------------
David W. Gay
Director
/s/ Jane G. Simpson September 25, 1998
- ------------------------------------
Jane G. Simpson
Director
/s/ Ronald L. Sutton September 25, 1998
- ------------------------------------
Ronald L. Sutton
Director
/s/ Jack C. Zanone September 25, 1998
- ------------------------------------
Jack C. Zanone
Director
30
<PAGE>
FIRST LANCASTER BANCSHARES, INC.
[LOGO]
1998 ANNUAL REPORT
<PAGE>
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.
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").
(i)
<PAGE>
LETTER TO STOCKHOLDERS
- --------------------------------------------------------------------------------
Dear Stockholders,
We have just completed our second year of operation as a public
company, and I am pleased to announce to you the favorable results our Company
has achieved.
For fiscal year 1998, the Company earned $512,000 in net income
compared to $448,000 in 1997, which is an increase of 14.3%. Per share earnings
increased in fiscal year 1998 to $0.58 from $0.51 in fiscal year 1997. The
assets of the Company have increased to $53.7 million as of June 30, 1998, which
is an increase of 25.5% from fiscal year 1997.
Most of the Company's growth has come from loan originations in Garrard
County and neighboring communities. Our loan production office, which opened in
Nicholasville, Kentucky in May 1997, continues to be a success in the Jessamine
and Fayette County area. Our loan portfolio grew $9.3 million, or 24.3%, in
fiscal year 1998 to bring our loans to $47.6 million as of June 30, 1998. We
hope for continued loan growth as the local economy continues to remain strong.
As a result of the increase in the Company's earnings, the Board of
Directors announced on July 6, 1998 an increase in our semi-annual dividends
from $0.25 to $0.30 to stockholders of record on July 17, 1998 and payable on
July 31, 1998.
While our Company continues to enjoy near record earnings, we are
continually monitoring the ever changing financial market as well as the overall
economy. According to SNL Securities, the thrift index price for all publicly
traded thrifts is down 26.46% for the same period last year ending August 31,
1998, a trend our Company has not escaped.
Management, is making every effort to see that growth will continue in
the Company to help make fiscal year 1999 another profitable year. The Board of
Directors and I appreciate your support of First Lancaster Bancshares and First
Lancaster Federal Savings Bank, and we welcome you to come in to see us at any
time. Our customers, shareholders and community are very important to us.
Sincerely,
/s/ Virginia R. S. Stump
Virginia R. S. Stump
Chairman of the Board, President
and Chief Executive Officer
<PAGE>
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
- --------------------------------------------------------------------------------
Selected Consolidated Financial Condition Data:
At June 30,
-------------------------
1998 1997
---- ----
(In thousands)
Assets......................................... $ 53,747 $ 42,808
Loans receivable, net.......................... 47,594 38,284
Cash and cash equivalents...................... 2,703 2,108
Investment securities:
Available for sale......................... 1,161 864
Held to maturity........................... -- --
Mortgage-backed securities..................... 435 540
Savings accounts............................... 25,417 22,128
FHLB advances.................................. 13,461 5,927
Total equity................................... 13,638 13,641
- --------------------------------------------------------------------------------
Selected Consolidated Operating Data:
Year Ended June 30,
-------------------------
1998 1997
---- ----
(In thousands)
Interest income................................ $ 4,035 $ 3,238
Interest expense............................... 1,960 1,321
-------- --------
Net interest income before provision for
loan losses................................. 2,075 1,917
Provision for loan losses...................... 115 38
-------- --------
Net interest income............................ 1,960 1,879
Noninterest expense............................ 1,166 1,182
-------- --------
Income before income taxes..................... 794 697
Provision for income taxes..................... 282 249
-------- --------
Net income..................................... $ 512 $ 448
======== ========
2
<PAGE>
Key Operating Ratios:
<TABLE>
<CAPTION>
At or for the
Year Ended June 30,
--------------------------
1998 1997
-------- --------
<S> <C> <C>
Performance Ratios:
Return on average assets (net income divided
by average total assets)............................... .94% 1.15%
Return on average total equity (net income
divided by average total equity)....................... 3.59 3.31
Interest rate spread (combined weighted average
interest rate earned less combined weighted
average interest rate cost)........................... 3.03 3.27
Ratio of average interest-earning assets to
average interest-bearing liabilities.................. 127.79 149.49
Ratio of noninterest expense to average
total assets.......................................... 2.15 3.02
Asset Quality Ratios:
Nonperforming assets to total assets...................... 1.09 1.93
Nonperforming loans to total loans........................ 1.24 2.16
Provision for loan losses to total loans.................. .24 .10
Allowance for loan losses to nonperforming
loans receivable, net................................... 34.02 15.10
Allowance for loan losses to total loans
receivable, net......................................... .42 .33
Net charge-offs to average loans outstanding.............. .08 .04
Capital Ratios:
Total equity to total assets.............................. 25.37 31.87
Average total equity to average assets.................... 23.15 34.64
Other:
Dividend payout ratio..................................... 88.60 .00
</TABLE>
3
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------
This discussion should be read in conjunction with the consolidated
financial statements, notes and tables included elsewhere in this report.
Management's discussion and analysis contains forward-looking statements that
are provided to assist in the understanding of anticipated future financial
performance. However, such performance are subject to risks, uncertainties and
other factors which could cause actual results to differ materially from future
results expressed or implied by such forward-looking statements. Potential risks
and uncertainties include, but are not limited to, economic conditions,
competition and other uncertainties detailed from time to time in the Company's
filings with the Securities and Exchange Commission.
General
First Lancaster Bancshares, Inc. (the "Company") was formed in 1996 and
serves as the savings and loan holding company for First Lancaster Federal
Savings Bank (the "Bank"), a federally chartered stock savings bank
headquartered in Lancaster, Kentucky and that conducts the principal business of
the Company. The Bank converted from a mutual savings bank to a
stockholder-owned savings bank in June 1996. At the same time, it became a
wholly owned subsidiary of the Company by selling its shares to the Company. The
Company funded its purchase of the Bank's stock using most of the net proceeds
from the Company's initial public offering of its common stock, which was
consummated at the same time as the Bank's conversion. Prior to its acquisition
of the Bank's stock, the Company had no material operations. All references in
this discussion are to the consolidated operations of the Company and the Bank.
The principal business of the Company consists of accepting deposits
from the general public and investing these funds primarily in loans and, to a
lesser extent, in investment securities and mortgage-backed securities. Loans
are originated by the Company within its primary market of Garrard, Jessamine
and Fayette counties located in central Kentucky and are comprised of
single-family residential first mortgage loans and, to a lesser extent,
single-family residential construction loans, nonresidential loans, loans
secured by multi-family residential property and loans secured by deposits.
The Company's net income is dependent primarily on its net interest
income, which is the difference between the interest income it earns on its
loans, investment securities and mortgage-backed securities and the interest it
pays on the savings accounts and certificates of deposits and on the advances
(i.e., borrowings) from the Federal Home Loan Bank of Cincinnati ("FHLB"). Net
interest income is affected by (i) the rates of interest earned or paid by the
Company and (ii) the volume of interest-earning assets and interest-bearing
liabilities that flow through the Company. Rates of interest earned or paid is
reflected in the Company's "interest rate spread," which is the difference
between the yields earned on interest-earning assets and the rates paid on
interest-bearing liabilities and is an indicator of the Company's profitability
in its core banking business. The Company's interest rate spread is affected by
regulatory, economic and competitive factors that influence interest rates, loan
demand and deposit flows. The Company's interest rate spread for the fiscal year
ended June 30, 1998 was 3.03% as compared to 3.27% for fiscal year 1997. The
volume of interest-earning assets and interest-bearing liabilities generally
increases profitability of the Company to the extent such assets exceed such
liabilities. The ratio of the Bank's average interest-earning assets to average
interest-bearing liabilities was 128.4% for fiscal year 1998 as compared to
149.49% for fiscal year 1997.
The overall operations of the Company are significantly affected by
prevailing economic conditions, competition and the monetary, fiscal and
regulatory policies of governmental agencies. Lending operations are influenced
in particular by the demand for and supply of housing, competition among
lenders, the level of interest rates and the availability of funds. Deposit
operations such as the amount of deposits and their related costs are influenced
in particular 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.
4
<PAGE>
Liquidity and Capital Resources.
Liquidity. Liquidity refers to the ability or the financial flexibility
to manage future cash flows to meet the needs of depositors and borrowers and
fund operations. Maintaining appropriate levels of liquidity allows the Company
to have sufficient funds available for reserve requirements, customer demand for
loans, withdrawal of deposit balances, maturities of deposits and timely
satisfaction of other commitments.
The Company's primary source of liquidity is dividends from the Bank,
the payment of which is subject to regulatory limitations on capital
distributions (such as dividends) and liquidity. Under capital distribution
regulations, the Bank must provide notice to the OTS before making any
distribution of its capital to its stockholder, the Company. Further, as a Tier
1 institution, which receives the most favorable treatment for capital
distribution purposes under OTS regulations, any capital distribution by the
Bank is limited to the greater of (i) 100% of its net earnings during a calendar
year plus 50% of its "surplus capital ratio" (the excess capital over its
capital requirements) determined as of the beginning of the calendar year, or
(ii) 75% of its net earnings for the four quarters preceding the payment. The
Bank's maximum aggregate amount of capital distributions that could be made
based upon financial results for fiscal year 1998 was $5.6 million.
The Bank generally is required to maintain average daily balances of
liquid assets (generally, cash, certain time deposits, bankers' acceptances,
highly rated corporate debt and commercial paper, securities of certain mutual
funds, and specified United States government, state or federal agency
obligations) equal to 4% of its net withdrawable accounts plus short-term
borrowings either at the end of the preceding calendar quarter or on an average
daily basis during the preceding quarter. The Bank also is required to maintain
sufficient liquidity to ensure its safe and sound operation. Monetary penalties
may be imposed for failure to meet liquidity requirements. The average daily
balance of liquid assets ratio of the Bank for June 1998 was 8.21%.
The cash flows of the Bank, and therefore of the Company, that serves
as the source of the Company's liquidity arise from operating, investing and
financing activities. Cash generated from the Company's operating activities
increased $1,209, or 0.2%, to $631,725 in fiscal year 1998 from $630,516 in
fiscal year 1997. This increase is attributable to an increase in net income of
$158,000 and a decrease in operating expense of $15,000 offset by an increase in
the provision for loan losses of $76,000 and income taxes of $33,000. This
increase was offset by changes in noncash operating activities as set forth in
the Company's cash flow statement.
Investing activities of the Company used more cash than they generated
as the Bank pursued its strategy of investing excess funds in residential
mortgage loans. The Company increased its net use of cash in investing
activities by $2.8 million in fiscal year 1998 as compared to 1997, reflecting a
$3.0 million net increase in the use of cash for loans receivable and the
purchase of $341,400 of FHLB stock.
Financing activities of the Company provided more cash than it used,
and the amount of cash provided increased from the prior year. During fiscal
year 1998, the net amount of cash generated by the Company's financing
activities increased by $8.9 million as compared to fiscal year 1997. A
principal component of this increase was an increase in FHLB advances of $7.0
million from fiscal year 1997. The amount of repayments to the FHLB increased by
$2.0 million in fiscal year 1998 from fiscal year 1997. Cash used in financing
activities also included purchases of treasury stock for $465,000 and payment of
cash dividends of $446,000.
The Company's use of FHLB advances reflects the flexibility in using
advances with repayment terms that approximate the anticipated lifetimes of
loans originated by the Company. As of June 30, 1998, the Company had a
borrowing capacity with the FHLB of $23.4 million, of which $13.5 million was
outstanding. See Note 9 of the Company's Notes to Consolidated Financial
Statements for more information on outstanding advances. This line is
collateralized with non-delinquent single-family residential mortgage loans.
5
<PAGE>
The Company anticipates that it will have sufficient funds available,
either from its operations or from outside funding sources, to satisfy its
funding commitments. At June 30, 1998, the Company had outstanding commitments
to originate loans totaling $1.2 million. Also at such date, the Company had
certificates of deposit scheduled to mature within one year of June 30, 1998
totaling $13.9 million
Capital Resources. The Company's capital position is reflected in its
stockholders' equity, subject to certain adjustments for regulatory purposes.
Stockholders' equity, or capital, is a measure of the Company's net worth,
soundness and viability. The Company continues to exhibit a strong capital
position, and its capital base allows it to take advantage of business
opportunities while maintaining the level of resources deemed appropriate by
management of the Company to address business risks inherent in the Company's
daily operations.
Stockholders' equity on June 30, 1998 was $13.6 million, a decrease of
$4,000, or 0.03%, from June 30, 1997. The decrease in stockholders' equity
reflects net income for fiscal year 1998 of $512,000 ($.58 per share), $465,000
purchase of treasury stock, $454,000 paid out in dividends, $196,000 in net
unrealized gain for the year from the Company's available-for-sale securities
and $100,000 in capital corresponding to the Bank's employee stock ownership
plan, which acquired Common Stock in the Company's initial public offering, and
$107,000 in capital corresponding to the Bank's Management Recognition Plan.
Federal regulations impose minimum capital requirements on the Bank but
not on savings and loan holding companies such as the Company. Among these
requirements that apply to the Bank are risk-based capital regulations, which
require all banks, including savings banks, to achieve and maintain specified
ratios of capital to risk-weighted assets. The risk-based capital rules are
designed to measure Tier 1 Capital (consisting of stockholders' equity, less
goodwill) and Total Capital in relation to the credit risk of both on- and
off-balance sheet items. Under the guidelines, one of four risk weights is
applied to the different on-balance sheet items. Off-balance sheet items, such
as loan commitments, are also subject to risk-weighting after conversion to
balance sheet equivalent amounts. All banks, including savings banks, must
maintain a minimum total capital to total risk-weighted assets ratio of 8.00%,
at least half of which must be in the form of Tier 1 Capital. For further
information regarding minimum regulatory capital levels, see Note 10 of the
Company's Notes to Consolidated Financial Statements. At June 30, 1998, the Bank
satisfied all minimum regulatory capital requirements and was considered
"well-capitalized" within the meaning of federal regulatory requirements.
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 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.
6
<PAGE>
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 allows the Bank to
respond to customer demand while minimizing interest rate and credit risk and
without any significant increase in operating expenses. At June 30, 1998,
mortgage loans with adjustable rates represented 53.40% of the Company's
mortgage loan portfolio. Approximately 98.0% of the Company's adjustable rate
mortgage loans have an annual adjustment limitation of two percent and a
lifetime limitation of five percent, and may not decline more than 1% below the
initial interest rate (the "floor"). These limitations on rate adjustments may
prevent the interest rates charged on loans from increasing at the same pace as
the Company's cost of funds. 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 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 the
same 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. 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. In contrast, 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.
At June 30, 1998, the Company's cumulative one-year interest rate gap
position was a positive $7.4 million, or 14.4% of total interest-earning assets.
A positive gap position indicates that the Company's net interest income would
be expected to increase in a period of increasing interest rates and decrease in
a period of decreasing interest rates. This is a one-day position which is
continually changing and is not necessarily indicative of the Company's position
at any other time. The Company's current one-year gap is within the guidelines
established by management and approved by the Board of Directors. Management
considers numerous factors when establishing these guidelines, including current
interest rate margins, capital levels and any guidelines provided by the OTS.
Different types of assets and liabilities with the same or similar
maturities may react differently to changes in overall market rates or
conditions, and thus changes in interest rates may affect net interest income
positively or negatively even if an institution were perfectly matched in each
maturity category. Additionally, the gap analysis does not consider the many
factors accompanying interest rate moves. While the interest rate sensitivity
gap is a useful measurement and contributes toward effective asset and liability
management, it is difficult to predict the effect of changing interest rates
solely on that measure, without accounting for alterations in the maturity or
repricing characteristics of the balance sheet that occur during changes in
market interest rates. For instance, while the retention of adjustable-rate
mortgage loans in the Company's portfolio helps reduce the Company's exposure to
changes in interest rates, these types of loans may give rise to unquantifiable
credit risks in a rising interest rate environment. As adjustable-rate loans
reprice to higher interest rates and therefore require higher loan payments,
they may become subject to a higher risk of default.
7
<PAGE>
The following table sets forth the amounts of interest-earning assets
and interest-bearing liabilities outstanding at June 30, 1998 which are expected
to mature or reprice in each of the time periods shown.
<TABLE>
<CAPTION>
Expected to Mature During the Year Ended June 30,
-----------------------------------------------------------------------------------------
1999 2000 2001 2002 2003 Thereafter Total Fair Value
-------- -------- -------- -------- -------- ---------- ----- ----------
(In thousands)
Interest-earning assets:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Loans:
Single-family................... $ 26,312 $ 1,122 $ 2,640 $ 271 $ 234 $ 4,597 $35,176 $35,126
Multi-family residential........ 875 -- -- 20 -- 1,058 1,953 1,949
Construction.................... 4,913 -- 260 -- -- 34 5,207 5,181
Nonresidential.................. 1,274 3,222 5 -- -- 267 4,768 4,753
Consumer........................ 324 78 18 32 38 -- 490 523
Interest bearing cash deposits in
other financial institutions....... 2,187 -- -- -- -- -- 2,187 2,187
Investment securities............... 1,161 -- -- -- -- -- 1,161 1,161
Mortgage-backed securities.......... -- -- 3 -- 3 429 435 446
-------- -------- -------- -------- -------- -------- ------- -------
Total............................ 37,046 4,422 2,926 323 275 6,385 51,377 51,326
-------- -------- -------- -------- -------- -------- ------- -------
Interest-bearing liabilities:
Deposits............................ 17,636 5,360 1,931 177 313 -- 25,417 25,643
Borrowings.......................... 12,033 536 38 42 45 767 13,461 13,390
-------- -------- -------- -------- -------- -------- ------- -------
Total............................ 29,669 5,896 1,969 219 358 767 38,878 39,033
-------- -------- -------- -------- -------- -------- ------- -------
Interest sensitivity gap............... $ 7,377 $ (1,474) $ 957 $ 104 $ (83) $ 5,618 $12,499 $12,293
======== ======== ======== ======== ======== ======== ======= =======
Cumulative interest sensitivity gap.... $ 7,377 $ 5,903 $ 6,860 $ 6,964 $ 6,881 $ 12,499 $12,499 $12,293
======== ======== ======== ======== ======== ======== ======= =======
Ratio of interest-earning assets to
interest-bearing liabilities........ 125.5% 75.0% 148.6% 147.5% 76.8% 832.5% 132.1% 131.5%
======== ======== ======== ======== ======== ======== ======= =======
Ratio of cumulative gap to total
interest-earning assets............. 14.4% 11.5% 13.4% 13.6% 13.4% 24.3% 24.3% 24.0%
======== ======== ======== ======== ======== ======== ======= =======
</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 Company does not believe that these assumptions will be
materially different from its actual experience. However, the actual interest
rate sensitivity of the Company's assets and liabilities could vary
significantly from the information set forth in the table due to market and
other factors.
Certain shortcomings are inherent in the method of analysis presented
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
differently to changes in market interest rates. The interest rates on certain
types of assets and liabilities may fluctuate in advance of or lag behind
changes in market interest rates. Additionally, certain assets, such as an
adjustable rate loan, which is the Company's primary loan product, may have
features that restrict changes in interest rates on a short-term basis and over
the life of the asset. The analysis could also be affected by changes in the
proportion of adjustable rate loans in the Company's portfolio. Further, in the
event of a change in interest rates, prepayment and early withdrawal levels
could deviate significantly from those assumed in the tables.
8
<PAGE>
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 indicated. Such yields and costs are derived by dividing income or
expense by the average daily balance of assets or liabilities, respectively, for
the periods presented.
The table also presents information for the periods 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.
9
<PAGE>
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------------------------------------------
1998 1997
------------------------------------- ----------------------------------
Average Average
Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost
------- -------- ---- ------- -------- ----
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Loans receivable (1)............................... $ 47,539 $ 3,869 8.14% $ 33,602 $ 3,009 8.95%
Investment securities.............................. 24 8 33.33 24 11 45.83
Non-marketable equity securities................... 723 41 5.67 332 22 6.63
Mortgage-backed securities......................... 441 37 8.39 501 40 7.98
Other interest-bearing cash deposits............... 1,397 80 5.73 2,998 156 5.20
---------- ---------- --------- ----------
Total interest-earning assets................... 50,124 4,035 8.05 37,457 3,238 8.64
---------- ----------
Unrealized gains on securities available
for sale............................................ 1,146 615
Non-interest-earning assets........................... 2,739 1,017
---------- ---------
Total assets.................................... $ 54,009 $ 39,089
========== =========
Interest-bearing liabilities:
Deposits........................................... $ 25,362 $ 1,279 5.04 $ 22,203 $ 1,151 5.18
Borrowings......................................... 13,670 681 4.98 2,854 170 5.96
---------- ---------- --------- ----------
Total interest-bearing liabilities.............. 39,032 1,960 5.02 25,057 1,321 5.27
---------- ----------
Non-interest-bearing liabilities...................... 1,675 490
---------- ---------
Total liabilities............................... 40,707 25,547
Retained earnings and capital......................... 12,546 13,136
Unrealized gain on securities available for sale...... 1,756 406
---------- ---------
Total liabilities and stockholders' equity...... $ 54,009 $ 39,089
========== =========
Net interest income................................... $ 2,075 $ 1,917
========== ==========
Interest rate spread.................................. 3.03% 3.27%
======== ========
Net yield on interest-earning assets.................. 4.14% 5.12%
======== ========
Ratio of average interest-earning assets
to average interest-bearing liabilities............ 128.42% 149.49%
======== ========
</TABLE>
- ---------------------
(1) Includes nonaccrual loans.
10
<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,
----------------------------------------------
1998 vs. 1997
----------------------------------------------
Increase (Decrease)
Due to
----------------------------------------------
Rate/
Volume Rate Volume Total
------ ---- ------ -----
(In thousands)
<S> <C> <C> <C> <C>
Interest income:
Loans receivable................................. $ 1,247 $ (272) $ (113) $ 860
Investment securities............................ -- (3) -- (3)
Nonmarketable equity securities.................. 26 (3) (4) 19
Mortgage-backed securities....................... (5) 2 -- (3)
Other (1)........................................ (83) 16 (8) (76)
-------- -------- -------- -------
Total interest-earning assets............... 1,185 (260) (125) 797
-------- -------- -------- -------
Interest expense:
Deposits......................................... 164 (31) (4) 128
Borrowings....................................... 645 (28) (106) 511
-------- -------- -------- -------
Total interest-bearing
liabilities.............................. 809 (59) (110) 639
-------- -------- -------- -------
Change in net interest income...................... $ 374 $ (201) $ (15) $ 158
======== ======== ======== =======
</TABLE>
- -----------
(1) Consists of overnight deposits, and cash deposits with the FHLB.
Changes in Financial Condition
General. The Company's total assets increased $10.9 million, or 25.5%,
from $42.8 million at June 30, 1997 to $53.7 million at June 30, 1998. The
increase was primarily attributable to the increase in net loans receivable
which was funded by the Company's increase in FHLB advances and by using cash
deposited in savings accounts and certificates of deposit.
Securities. The Company invests to a limited extent in investment
securities, including mortgage-backed securities. The Company's investment
securities available for sale consist solely of stock in the Federal Home Loan
Mortgage Corporation ("FHLMC"). The Company's investment in FHLMC stock
increased $298,000, or 34.5%, to $1.2 million at June 30, 1998 from $864,000 at
June 30, 1997. The increase in the Company's investment in FHLMC stock was due
solely to the increase in market value of $298,000 during fiscal year 1998.
The Company also holds investments in nonmarketable equity securities,
which increased $382,600, or 111.6%, to $725,300 at June 30, 1998 from $342,700
at June 30, 1997. These securities are comprised of FHLB stock, the ownership of
which is directly related to the amount of advances that may be obtained by the
Company, and stock in the Company's third party data processor, the ownership of
which is required as a condition to receive such service.
11
<PAGE>
Mortgage-backed securities of the Company decreased $105,773, or 19.6%,
to $434,635 at June 30, 1998 from $540,408 at June 30, 1997. The Company invests
in mortgage-backed securities on an occasional basis to take advantage of
favorable yields at desirable maturities if such characteristics may not be
otherwise obtained through loan originations in the then-current interest rate
environment.
To minimize its credit risk, the Company limits its purchases to those
mortgage-backed securities that are available through the purchase of
pass-through certificates offered by the FHLMC and by the Government National
Mortgage Association ("GNMA"). For the fiscal year ended June 30, 1998, the
Company's average balance of mortgage-backed securities was $441,136. For more
detailed information on mortgage-backed securities see Note 3 of the Company's
Notes to Consolidated Financial Statements.
Loans. Loans represent the Company's largest component of
interest-earning assets, providing 96.8% of interest income for the year ended
June 30, 1998 compared to 92.9% for the year ended June 30, 1997. Total loans
increased $9.3 million, or 24.3%, to $47.6 million at June 30, 1998 from $38.3
million at June 30, 1997. The Company's loans are predominantly to borrowers
residing in or doing business in Garrard, Jessamine and Fayette counties,
Kentucky.
The increase in loans arose primarily from increases in the Company's
origination of construction and single-family residential mortgage loans.
Single-family residential mortgage loans are the Company's principal loan
product, comprising 66.2% of its gross loan portfolio at June 30, 1998 and 73.4%
at June 30, 1997. The amount of such loans increased $4.4 million, or 14.2%, to
$35.4 million at June 30, 1998 from $31.0 million at June 30, 1997.
This increase is attributable to the Company's emphasis on loan
origination opportunities in Garrard, Jessamine and Fayette counties, Kentucky.
The Company opened a loan production office in Jessamine county in fiscal year
1997 which has allowed the Company to establish a presence in a previously
untapped market area. Management believes that loan growth reflects increased
marketing efforts and favorable economic conditions in the Company's market
area.
Net construction loans increased $3.4 million, or 64.3%, to $5.2
million at June 30, 1998 from $2.8 million at June 30, 1997. This increase
reflects the Company's focused sales efforts on construction loans, which are
primarily used for the construction of single-family residences. Such loans
generally have a term of six months and usually become single-family residential
mortgage loans upon completion of construction.
Allowance for Loan Losses. In the normal course of its business, the
Company must manage the risk that borrowers may default on their obligations to
the Company. The allowance for loan losses is a reserve established and
maintained by the Company to protect it against estimated losses inherent in the
loan portfolio. The allowance is increased by the provision for loan losses
(which is an expense on the income statement) and through recoveries of
previously written-off loans and is decreased by charged-off loans. Management
reviews the allowance at least quarterly to determine whether the level is
adequate to absorb estimated losses.
The allowance increased by $75,000, or 60.0%, to $200,000 at June 30,
1998 from $125,000 at June 30, 1997. This allowance comprised 0.42% of net loans
receivable at June 30, 1998 as compared to 0.33% of net loans receivable at June
30, 1997. The increase in the allowance reflects the Company's provision for
losses during fiscal year 1998 of $114,554, offset in part by loan charge-offs
of $39,554 which were principally due to residential mortgage loans.
Deposits. The Company relies upon its deposit base as the primary
source of funding for its operations. This deposit base, which is comprised of
demand deposit accounts, NOW accounts and money market demand accounts ("MMDA"),
and certificates of deposits, increased $3.3 million to $25.4 million at June
30, 1998 from $22.2 million at June 30, 1997. The average balance of deposits
also increased during fiscal year 1998 to $25.6 million from $22.2 million
during fiscal year 1997.
12
<PAGE>
The primary source of increase was the Company's time deposits which
increased $2.6 million, or 13.6%, to $21.7 million at June 30, 1998 from $19.1
million at June 30, 1997. The Company has established rates of interest for its
deposit products that management believes are sufficiently competitive to
attract deposits from new and existing customers. For more detail about the
Company's deposits, see Note 8 of the Company's Notes to the Consolidated
Financial Statements.
Other Borrowings. In addition to deposits, the Company utilizes
advances from the FHLB to fund its operations. These advances increased $7.6
million, or 128.8%, to $13.5 million at June 30, 1998 from $5.9 million at June
30, 1997. During fiscal year 1998, the Company's average amount of advances was
$13.7 million as compared to an average amount of $2.9 million during fiscal
year 1997.
Advances from the FHLB are usually fixed rate, with terms ranging from
six months to twenty years, and are collateralized by performing loans of the
Company with an aggregate unpaid principal balance equal to 150% of the
outstanding advances. The Company increased its use of advances during fiscal
year 1998 to help fund the Company's loan growth. Management anticipates that it
will continue to rely upon such advances to fund current loans and to facilitate
any asset growth.
Comparison of Operating Results for the Years Ended June 30, 1998 and 1997
Net Income. Net income for fiscal year 1998 was $512,000, an increase
of $64,000, or 14.3%, from fiscal year 1997. The increase in net income arose
from a $157,000, or 8.2%, increase in net interest income. The increase in net
interest income resulted principally from a 27.0% increase in interest-earning
assets that reflects strong growth of the Company's loan production volume,
offset by a decrease in the interest rate spread. The increase in net interest
income was offset by an increase in the provision for loan loss, increased
compensation and benefit expenses and increased legal, accounting and regulatory
filing fees associated with the Company's status as a public company.
Net Interest Income. Net interest income increased by $157,000, or
8.2%, to $2.1 million in fiscal year 1998 from $1.9 million in fiscal year 1997.
The increase reflects a $12.7 million, or 34.7%, increase in average
interest-earning assets, to $50.1 million in fiscal year 1998 from $37.5 million
in fiscal year 1997. This increase was due to the increase in loans receivable
and was funded by a $14.0 million increase in the Company's average
interest-bearing liabilities to $39.0 million during fiscal year 1998 from $25.0
million during fiscal year 1997. The increase in average interest-bearing
liabilities includes an increase in average deposits of $3.2 million, or 14.2%,
to $25.4 million during fiscal year 1998 from $22.2 million for fiscal year 1997
and an increase in average borrowings of $10.8 million, or 379.0%, to $13.7
million during fiscal year 1998 from $2.9 million for fiscal year 1997.
The Company's interest rate spread decreased to 3.03% for fiscal year
1998 from 3.27% for fiscal year 1997 as a result of an overall decline in the
interest rate environment occurring in the Company's market area.
Provision for Loan Losses. The Company's provision for loan losses
increased $76,000, or 197.0%, to $115,000 in fiscal year 1998 from $39,000 in
fiscal year 1997. The increase in the provision in fiscal year 1998 reflects the
overall potential loss associated with increases in loan production volume and
increases in construction type loans.
Other Expenses. The Company's other expenses decreased $16,000, or
1.3%, to $1,166,000 in fiscal year 1998 from $1,182,000 in fiscal year 1997.
Although the Company's total other expenses are similar between fiscal years
1998 and 1997, a decrease in the one-time SAIF assessment was offset by
increases in compensation and benefit expenses and higher legal, accounting and
regulatory filing fees associated with the Company's status as a public company.
Provision for Income Taxes. Income tax expense was $282,000 in fiscal
year 1998, a $33,000, or 13.3%, increase from $249,000 in fiscal year 1997. The
increase in the tax provision is associated with the Company's increased income
for fiscal year 1998.
13
<PAGE>
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 Company's operations. Unlike most
industrial companies, substantially all of the assets and liabilities of the
Company are monetary in nature. As a result, interest rates have a greater
impact on the Company'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.
Forward-Looking Statements
When used in this Annual Report to Stockholders, the words or phrases
"will likely result," "are expected to," "will continue," "is anticipated,"
"estimate," "project" or similar expressions are intended to identify
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such statements are subject to certain risks and
uncertainties including changes in economic conditions in the Company's market
area, changes in policies by regulatory agencies, fluctuations in interest
rates, demand for loans in the Company's market area, and competition that could
cause actual results to differ materially from historical earnings and those
presently anticipated or projected. The Company wishes to caution readers not to
place undue reliance on any such forward-looking statements, which speak only as
of the date made. The Company wishes to advise readers that the factors listed
above could affect the Company's financial performance and could cause the
Company's actual results for future periods to differ materially from any
opinions or statements expressed with respect to future periods in any current
statements.
The Company does not undertake, and specifically disclaims any
obligation, to publicly release the result of any revisions which may be made to
any forward-looking statements to reflect events or circumstances after the date
of such statements or to reflect the occurrence of anticipated or unanticipated
events.
Impact of Year 2000 Issue
A great deal of information has been disseminated about the global
computer crash that may occur in the year 2000. Many computer programs that can
only distinguish the final two digits of the year entered (a common programming
practice in earlier years) are expected to read entries for the year 2000 as the
year 1900 and compute payment, interest or delinquency based on the wrong date
or are expected to be unable to compute payment, interest or delinquency. Rapid
and accurate data processing is essential to the operations of the Company. Data
processing is also essential to most other financial institutions and many other
companies.
All of the material data processing of the Company that could be
affected by this problem is provided by a third party service bureau. The
service bureau of the Company has advised the Company that it expects to resolve
this potential problem before the year 2000. However, if the service bureau is
unable to resolve this potential problem in time, the Company would likely
experience significant data processing delays, mistakes or failures. These
delays, mistakes or failures could have a significant adverse impact on the
financial condition and results of operations of the Company. In the event that
the service bureau is unable to make the Company Year 2000 compliant by December
31,1998, the Company will seek out other third party data processing bureaus to
prevent interruption of the Company's data processing. The Company has developed
a contingency plan in the event there is an interruption of its on-line system,
whereby transaction processing will be done in a store and forward mode for
short-term interruptions, and for extended interruptions manual processing or
the use of a local database will be used.
The Company has also purchased a new teller computer network system,
which is anticipated to be installed by October of 1998. Based upon preliminary
analysis by the Company, the costs to purchase the computer network and for the
services of the third party service bureau will not exceed $150,000.
14
<PAGE>
Impact of New Accounting Standards
Accounting for Earnings Per Share. In February 1997, the Financial
Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share"
("EPS"). This statement specifies the computation, presentation, and disclosure
requirements for EPS. SFAS No. 128 is designated to improve the EPS information
provided in financial statements by simplifying the existing computational
guidelines, revising the disclosure requirements, and increasing the
comparability of EPS data on an international basis. Some of the changes made to
simplify the EPS computations include: (a) eliminating the presentation of
primary EPS and replacing it with basic EPS, with the principal difference being
that common stock equivalents are not considered in computing basic EPS, (b)
eliminating the modified treasury stock method and three percent materiality
provision, and (c) revising the contingent share provisions and the supplemental
EPS data requirements. SFAS No. 128 requires presentation of basic EPS amounts
from income for continuing operations and net income on the face of the income
statement for entities with simple capital structures and dual presentation of
basic and diluted EPS on the face of the income statement for all entities with
complex capital structures regardless of whether basic and diluted EPS are the
same. The statement also requires a reconciliation of the numerator and
denominator used on computing basic and diluted EPS and is applicable to all
entities with publicly held common stock or potential common stock. SFAS No. 128
was adopted as of January 1, 1998. The Company has restated the June 30, 1997
earnings per share computations in accordance with the provisions of SFAS No.
128.
Report of Comprehensive Income. In June 1997, the FASB issued SFAS No.
130, "Reporting Comprehensive Income." This statement establishes standards for
reporting and displaying comprehensive income and its components in a full set
of general-purpose financial statements. The purpose of reporting comprehensive
income is to present a measure of all changes in equity that result from
recognized transactions and other economic events of the period other than
transactions with owners in their capacity as owners. If used with related
disclosures and other information in the consolidated financial statements, the
FASB believes that the information provided by reporting comprehensive income
should help investors, creditors, and others in assessing an enterprise's
activities and the timing and magnitude of its future cash flows. The statement
requires that an enterprise classify items of other comprehensive income by
their nature in a financial statement and display the accumulated balance of
other comprehensive income separately from retained earnings and additional
paid-in capital in the equity section of the statement of financial condition.
This statement is effective for fiscal years beginning after December 31, 1997
and reclassification of financial statements for earlier periods provided for
comparative purposes is required. The only transactions that meet the definition
of comprehensive income for the Company include the unrealized gains on
securities available for sale. These unrealized gains are currently reported
separately in the equity section of the statement of financial condition.
The Company adopted the provision of SFAS No. 130 on July 1, 1998.
Disclosure About Segments of an Enterprise and Related Information. In
June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," which establishes standards for the manner
in which public business enterprises report information about operating segments
in annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to stockholders. This statement also establishes standards for related
disclosures about products and services, geographic areas, and major customers.
This statement requires the reporting of financial and descriptive information
about an enterprise's reportable operating segments. The statement is effective
for financial statements for periods beginning after December 15, 1997. In the
initial year of application, comparative information for earlier years is to be
restated. The Company does not anticipate that the adoption of SFAS No. 131 will
have a material effect on the Company.
Employer's Disclosures About Pensions and Other Postretirement
Benefits. In February 1998, the FASB issued SFAS No. 132, "Employer's
Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132
standardizes the disclosure requirements for pensions and other postretirement
benefits. This statement is effective for financial statements for periods
beginning after December 15, 1997. The Company's management plans to adopt the
appropriate provisions of the statements at January 1, 1999, and does not
currently believe that the future adoption of this statement will have a
material effect on the Company's financial position or operating results.
15
<PAGE>
Accounting for Derivative Instruments and Hedging Activities. On June
15, 1998, the FASB issued SFAS No. 133 "Accounting for Derivative Instruments
and Hedging Activities." SFAS No. 133 established a new model for accounting for
derivatives and hedging activities and supersedes and amends a number of
existing standards. SFAS No. 133 is effective for fiscal years beginning after
June 15, 1999, but earlier applications are permitted as of the beginning of any
fiscal quarter subsequent to June 15, 1998. Upon the statement's initial
application, all derivatives are required to be recognized in the statement of
financial position as either assets or liabilities and measured at fair value.
In addition, all hedging relationships must be designated, reassessed and
documented pursuant to the provisions of SFAS No. 133. Adoption of SFAS No. 133
is not expected to have a material financial statement impact on the Company.
16
<PAGE>
FIRST LANCASTER BANCSHARES, INC.
AND SUBSIDIARY
_______
REPORT ON AUDITS OF CONSOLIDATED FINANCIAL STATEMENTS
for the years ended June 30, 1998 and 1997
<PAGE>
C O N T E N T S
_______
Pages
-----
Report of Independent Accountants 19
Consolidated Financial Statements:
Consolidated Statements of Financial Condition 20
Consolidated Statements of Income 21
Consolidated Statements of Changes in Stockholders' Equity 22
Consolidated Statements of Cash Flows 23
Notes to Consolidated Financial Statements 24
<PAGE>
[LOGO OF PRICEWATERHOUSECOOPERS APPEARS HERE]
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
First Lancaster Bancshares, Inc.
Lancaster, Kentucky
In our opinion, the accompanying consolidated statements of financial condition
and the related consolidated statements of income, changes in stockholders'
equity and cash flows present fairly, in all material respects, the financial
position of First Lancaster Bancshares, Inc. and its subsidiary at June 30, 1998
and 1997, and the results of their operations and their cash flows for each of
the years then ended, in conformity with generally accepted accounting
principles. 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 of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
Lexington, Kentucky
August 5, 1998
19
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Financial Condition
June 30, 1998 and 1997
<TABLE>
<CAPTION>
Assets 1998 1997
------ ---- ----
<S> <C> <C>
Cash $ 516,199 $ 670,998
Interest-bearing cash deposits in other depository institutions 2,186,921 1,437,113
Investment securities available-for-sale at market value
(amortized cost $24,158 at June 30, 1998 and 1997) 1,161,126 863,520
Mortgage-backed securities, held to maturity (market value
of $448,000 and $546,000 at June 30, 1998 and
1997, respectively) 434,635 540,408
Investments in nonmarketable equity securities at cost 725,300 342,700
Loans receivable, net 47,593,855 38,283,591
Real estate acquired by foreclosure 270,200
Accrued interest receivable 465,527 260,227
Office property and equipment, at cost 379,490 400,523
Other assets 13,411 8,563
------------ ------------
Total Assets $ 53,746,664 $ 42,807,643
============ ============
Liabilities
-----------
Saving accounts and certificates $ 25,416,711 $ 22,127,687
Advance payments by borrowers for taxes and insurance 28,802 28,421
Accrued interest on savings accounts and certificates 70,974 35,583
Federal Home Loan Bank advances 13,461,167 5,926,928
Accounts payable and other liabilities 365,827 293,672
Income tax payable 997 70,849
Deferred income tax payable 278,821 216,416
------------ ------------
Total liabilities 39,623,299 28,699,556
------------ ------------
Common stock owned by ESOP subject to put option 485,988 466,616
------------ ------------
Stockholders' Equity
--------------------
Preferred stock, 500,000 shares authorized and unissued
Common stock, $.01 par value; 3,000,000 shares authorized;
872,656 and 888,500 shares issued and outstanding at
June 30, 1998 and 1997, respectively 9,588 9,588
Additional paid-in capital 9,152,891 9,110,683
Treasury stock (350,871)
Unearned employee stock ownership plan shares (626,221) (703,121)
Common stock owned by ESOP subject to put option (485,988) (466,616)
Unrealized gain on securities available-for-sale (net of
deferred tax liability of $386,569 and $285,383 at
June 30, 1998 and 1997, respectively) 750,399 553,979
Retained earnings, substantially restricted 5,187,579 5,136,958
------------ ------------
Total stockholders' equity 13,637,377 13,641,471
------------ ------------
Total liabilities and stockholders' equity $ 53,746,664 $ 42,807,643
============ ============
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
20
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Income
for the years ended June 30, 1998 and 1997
1998 1997
---- ----
Interest on loans and mortgage-backed securities $3,905,595 $3,048,777
Interest and dividends on investments and
deposits in other depository institutions 129,146 189,622
---------- ----------
Total interest income 4,034,741 3,238,399
---------- ----------
Interest on savings accounts and certificates 1,277,281 1,150,932
Interest on other borrowings 682,436 169,925
---------- ----------
Total interest expenses 1,959,717 1,320,857
---------- ----------
Net interest income 2,075,024 1,917,542
Provision for loan losses 114,554 38,560
---------- ----------
Net interest income after provision
for loan losses 1,960,470 1,878,982
---------- ----------
Other expenses:
Compensation 406,730 335,872
Employee retirement and other benefits 329,253 291,926
State franchise taxes 26,725 30,025
SAIF deposit insurance premium 29,220 200,082
Occupancy expense 81,807 76,393
Data Processing 45,321 50,126
Legal, accounting and filing fees 197,278 149,204
Other 50,083 48,459
---------- ----------
Total other expenses 1,166,417 1,182,087
---------- ----------
Income before income taxes 794,053 696,895
Provision for income taxes 282,200 249,057
---------- ----------
Net income $ 511,853 $ 447,838
========== ==========
Basic earnings per share .58 .51
Weighted average shares outstanding for basic
earnings per share
884,236 885,306
Diluted earnings per share .57 .49
Weighted average shares outstanding for fully
diluted earnings per share 904,144 907,151
The accompanying notes are an integral part of the consolidated financial
statements.
21
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statement of Changes in Stockholders' Equity
for the years ended June 30, 1998 and 1997
<TABLE>
<CAPTION>
Shares Common Additional Treasury Employee
Stock Paid In Stock Stock
Capital Ownership
---------- ------------ ------------ ------------ -----------
<S> <C> <C> <C> <C> <C>
Balance, June 30, 1996 882,108 $9,588 $9,149,403 $(767,040)
Conversion expenses from issuance of
common stock (69,576)
Employee Stock Ownership Plan (ESOP) 6,392 30,856 63,919
Market value adjustment
Net income
Change in unrealized gain on securities,
net of deferred tax liability of $114,293
----------- ----------- ----------- ----------- -----------
Balance, June 30, 1997 888,500 9,558 9,110,683 (703,121)
Purchase of treasury stock (30,817) (465,128)
Treasury stock issued to
Management Recognition Plan (MRP) 7,283 114,257
Employee Stock Ownership Plan (ESOP) 7,690 42,208 76,900
Market value adjustment
Net income
Dividends paid to shareholders
($.50 per share)
Change in unrealized gain on securities,
net of deferred tax liability of $101,186
----------- ----------- ----------- ----------- -----------
Balance, June 30, 1998 872,656 $9,558 $9,152,891 $(350,871) $(626,221)
=========== =========== =========== =========== ===========
<CAPTION>
Common Unrealized Retained Total
Stock Gains on Earnings Stockholders'
Owned By Securities Equity
ESOP
---------------- --------------- ----------------- ------------------
<S> <C> <C> <C> <C>
Balance, June 30, 1996 $(767,040) $332,116 $4,689,120 $12,646,147
Conversion expenses from issuance of
common stock (69,576)
Employee Stock Ownership Plan (ESOP) 63,919 158,694
Market value adjustment 236,505 236,505
Net income 447,838 447,838
Change in unrealized gain on securities,
net of deferred tax liability of $114,293 221,863 221,863
----------- ----------- ------------ -----------
Balance, June 30, 1997 (466,616) 553,979 5,136,958 13,641,471
Purchase of treasury stock (465,128)
Treasury stock issued to
Management Recognition Plan (MRP) (7,738) 106,519
Employee Stock Ownership Plan (ESOP) 76,900 196,008
Market value adjustment (96,272) (96,272)
Net income 511,853 511,853
Dividends paid to shareholders
($.50 per share) (453,494) (453,494)
Change in unrealized gain on securities,
net of deferred tax liability of $101,186 196,420 196,420
----------- ----------- ------------ -----------
Balance, June 30, 1998 $(485,988) $750,399 $5,187,579 $13,637,377
=========== =========== ============ ===========
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
22
<PAGE>
FIRST LANCASTER BANCSHARES, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
for the years ended June 30, 1998 and 1997
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Cash flows from operating activities:
Net income $ 511,853 $ 447,838
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation 30,841 35,451
Provision for loan losses 114,554 38,560
ESOP benefit expense 119,108 94,775
MRP benefit expense 89,472 67,309
Stock dividend, FHLB stock (41,200) (27,100)
Deferred income taxes (38,781) (61,340)
Net loan origination fees 27,787 (22,381)
(Gain) loss on sale of real estate acquired by foreclosure (18,917) (6,535)
Change in assets and liabilities:
Accrued interest receivable (205,300) (122,014)
Other assets (4,848) 15,307
Accrued interest on savings accounts and certificates 35,391 (10,378)
Accounts payable and other liabilities 81,617 112,405
Income tax payable (69,852) 68,619
------------ ------------
Net cash provided by operating activities 631,725 630,516
------------ ------------
Cash flows from investing activities:
Proceeds from sale of real estate acquired by foreclosure 187,500 175,500
Mortgage-backed securities principal repayments 105,774 77,571
Mortgage-backed securities purchases (503,000)
Net increase in loans receivable (9,891,548) (6,914,370)
Purchase of office property and equipment (9,808) (8,584)
Purchase of Federal Home Loan Bank stock (341,400)
------------ ------------
Net cash used in investing activities (9,949,482) (7,172,883)
------------ ------------
Cash flows from financing activities:
Net (decrease) increase in savings accounts and certificates 3,289,024 (1,354,902)
Net increase (decrease) in advance payments by borrowers for taxes and
insurance 381 3,581
Federal Home Loan Bank advances 12,087,830 5,000,000
Federal Home Loan Bank advances principal repayments (4,553,591) (2,553,482)
Purchase of treasury stock (465,128)
Dividends paid (445,750)
Stock conversion costs (69,576)
------------ ------------
Net cash provided by financing activities 9,912,766 1,025,621
------------ ------------
Net increase (decrease) in cash and cash equivalents 595,009 (5,516,746)
Cash and cash equivalents at beginning of year 2,108,111 7,624,857
------------ ------------
Cash and cash equivalents at end of year $ 2,703,120 $ 2,108,111
============ ============
Supplemental disclosure of cash flow information:
Interest paid $ 1,924,326 $ 1,322,932
Income taxes paid 320,618 249,000
Supplemental disclosure of non-cash investing and financing activities:
Unrealized gain on securities available for sale, net of deferred tax
liability of $101,186 and $114,293 196,420 221,863
Real estate acquired by foreclosure 485,327
</TABLE>
The accompanying notes are an integral part of the consolidated financial
statements.
23
<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 consolidated financial statements, management is required
to make estimates and assumptions that affect the reported amounts of
assets and liabilities as of the date of the 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 consolidated 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.
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.
The Corporation's purpose is to act as a holding company with the Bank as
its sole subsidiary. The Corporation's principal 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.
Lending activities are carried out from the main office in Lancaster,
Kentucky and the loan production office in Nicholasville, 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.
24
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
C. Cash and Cash Equivalents
-------------------------
For purposes of reporting consolidated cash flows, the Corporation
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.
D. Investment Securities and Mortgage-Backed Securities
----------------------------------------------------
All investments in debt securities and all investments in equity
securities that have readily determinable fair values are 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 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 are carried at amortized cost.
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. 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.
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. As a member of the Federal Home Loan Bank System, the Bank is
required to maintain an investment in FHLB capital stock in an amount
equal to at least 1% of outstanding residential mortgages, or 5% of
outstanding FHLB advances, whichever is greater. The Bank met this
requirement at June 30, 1998 and 1997.
Regulations require the Bank to maintain an amount of cash and U.S.
government and other approved securities equal to a prescribed percentage
(5% at June 30, 1998 and 1997) of deposits accounts (net of loans on
deposits) plus short-term borrowings. At June 30, 1998 and 1997, the Bank
met these requirements.
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. Loans
-----
Loans are stated at the principal amount outstanding. Interest income on
loans is recognized based on loan principal amounts outstanding during the
period. Interest earned on loans receivable is recorded in the period
earned.
25
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
G. Loan Fees
---------
Loan fees are accounted for in accordance with Statement of Financial
Accounting Standard (SFAS) No. 91. SFAS No. 91 requires that loan
origination fees and certain related direct loan origination costs be
offset and 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.
H. Provision for Loan Losses
-------------------------
The Bank has established an allowance for loan losses for the purpose of
absorbing losses associated with the Bank's loan portfolio. All actual
loan losses are charged to the related allowance and all recoveries are
credited to it. 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.
When a loan or portion of a loan is determined to be uncollectible, the
portion deemed uncollectible is charged against the allowance and
subsequent recoveries, if any, are credited to the allowance.
I. 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 cost or fair value minus estimated cost 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
noninterest expense.
J. 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.
26
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
J. Income Recognition on Impaired and Nonaccrual Loans, continued:
---------------------------------------------------------------
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.
K. Income Taxes
------------
Deferred income taxes are recognized for certain income and expenses that
are recognized in different periods for tax and financial statement
purposes.
L. Effect of Implementing New Accounting Standards
-----------------------------------------------
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share"
(EPS). This statement specifies the computation, presentation, and
disclosure requirements for EPS. SFAS No. 128 is designed to improve the
EPS information provided in financial statements by simplifying the
existing computational guidelines, revising the disclosure requirements,
and increasing the comparability of EPS data on an international basis.
Some of the changes made to simplify the EPS computations include: (a)
eliminating the presentation of primary EPS and replacing it with basic
EPS, with the principal difference being that common stock equivalents are
not considered in computing basic EPS, (b) eliminating the modified
treasury stock method and three percent materiality provision, and (c)
revising the contingent share provisions and the supplemental EPS data
requirements. SFAS No. 128 requires presentation of basic EPS amounts from
income for continuing operations and net income on the face of the income
statement for entities with simple capital structures and dual
presentation of basic and diluted EPS on the face of the income statement
for all entities with complex capital structures regardless of whether
basic and diluted EPS are the same. The statement also requires a
reconciliation of the numerator and denominator used on computing basic
and diluted EPS and is applicable to all entities with publicly held
common stock or potential common stock. SFAS No. 128 was adopted as of
January 1, 1998. The Corporation has restated the June 30, 1997 earnings
per share computations in accordance with the provisions of SFAS No. 128.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income". This statement establishes standards for reporting and displaying
comprehensive income and its components in a full set of general-purpose
financial statements. The purpose of reporting comprehensive income is to
present a measure of all changes in equity that result from recognized
transactions and other economic events of the period other than
transactions with owners in their capacity as owners. If used with related
disclosures and other information in the consolidated financial
statements, the FASB believes that the information provided by reporting
comprehensive income should help investors, creditors, and others in
assessing an enterprise's activities and the timing and magnitude of its
future cash flows. The statement requires that an enterprise classify
items of other comprehensive income by their nature in a financial
statement and display the accumulated balance of other comprehensive
income separately from retained earnings and additional paid-in capital in
the equity section of the statement of financial condition. This statement
is effective for fiscal years beginning after December 31, 1997 and
reclassification of financial statements for earlier periods provided for
comparative purposes is required. The only transactions that meet the
definition of comprehensive income for the Corporation include the
unrealized
27
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED:
L. Effect of Implementing New Accounting Standards, continued
-----------------------------------------------
gains on securities available for sale. These unrealized gains are
currently reported separately in the equity section of the statement of
financial condition. The Corporation adopted the provision of SFAS No.
130 on July 1, 1998.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information", which establishes standards for
the manner in which public business enterprises report information about
operating segments in annual financial statements and requires that those
enterprises report selected information about operating segments in
interim financial reports issued to stockholders. This statement also
establishes standards for related disclosures about products and services,
geographic areas, and major customers. This statement requires the
reporting of financial and descriptive information about an enterprise's
reportable operating segments. The statement is effective for financial
statements for periods beginning after December 15, 1997. In the initial
year of application, comparative information for earlier years is to be
restated. The Corporation does not anticipate that the adoption of SFAS
No. 131 will have a material effect on the Corporation.
In February, 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits." SFAS No. 132
standardizes the disclosure requirements for pensions and other
postretirement benefits. This statement is effective for financial
statements for periods beginning after December 15, 1997. The
Corporation's management plans to adopt the appropriate provisions of the
statements at January 1, 1999, and does not currently believe that the
future adoption of this statement will have a material effect on the
Corporation's financial position or operating results.
On June 15, 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". SFAS No. 133 established a new model
for accounting for derivatives and hedging activities and supersedes and
amends a number of existing standards. SFAS No. 133 is effective for
fiscal years beginning after June 15, 1999, but earlier applications is
permitted as of the beginning of any fiscal quarters subsequent to June
15, 1998. Upon the statement's initial application, all derivatives are
required to be recognized in the statement of financial position as either
assets or liabilities and measured at fair value. In addition, all
hedging relationships must be designated, reassessed and documented
pursuant to the provisions of SFAS No. 133. Adoption of SFAS No. 133 is
not expected to have a material financial statement impact on the
Corporation.
M. Reclassifications
-----------------
Certain presentations of accounts previously reported have been
reclassified in these consolidated financial statements. Such
reclassification had no material effect on net income or stockholders'
equity as previously reported.
28
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
2. Investment Securities:
Investment securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market Value
June 30, 1998 Cost Gains Losses
----------- ------------ ------------- --------------
<S> <C> <C> <C> <C>
Available for Sale Equity Securities:
Federal Home Loan
Mortgage Corporation
Common Stock - 24,672 shares $ 24,158 $ 1,136,968 $ -- $ 1,161,126
=========== ============ ============= ============
June 30, 1997
Available for Sale Equity Securities:
Federal Home Loan Mortgage Corporation
Common Stock - 24,672 shares $ 24,158 $ 839,362 $ -- $ 863,520
=========== ============ ============= ============
</TABLE>
3. Mortgaged-Backed Securities:
Mortgage-backed securities are summarized as follows:
<TABLE>
<CAPTION>
Gross Gross Estimated
Amortized Unrealized Unrealized Market Value
June 30, 1998 Cost Gains Losses
------------- ------------ ----------- -------------
<S> <C> <C> <C> <C>
FHLMC certificates $ 433,362 $ 11,038 $ -- $ 444,400
GNMA certificates 1,273 27 1,300
------------- ------------ ----------- -------------
$ 434,635 $ 11,065 $ -- $ 445,700
============= ============ =========== =============
June 30, 1997
FHLMC certificates $ 538,124 $ 5,546 $ -- $ 543,670
GNMA certificate 2,284 46 2,330
------------- ------------ ----------- -------------
$ 540,408 $ 5,592 $ -- $ 546,000
============= ============ =========== =============
</TABLE>
There were no sales of mortgage-backed securities during 1998 or 1997.
Accrued interest receivable on held to maturity mortgage-backed securities
totaled $3,430 and $4,291 at June 30, 1998 and 1997, respectively.
Expected maturities will differ from contractual maturities because
borrowers may prepay obligations without prepayment penalties.
29
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
4. Loans Receivable, Net:
The Bank's loan portfolio consists principally of long-term conventional
loans collateralized by first mortgages on single-family residences. Loans
receivable, net at June 30, 1998 and 1997 consist of the following:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Single-family residential $ 35,421,772 $ 30,995,488
Multi-family residential and commercial 1,953,114 996,920
Construction 10,864,305 6,632,056
Nonresidential 4,768,199 3,355,199
Consumer loans 489,928 276,182
------------------- -------------------
53,497,318 42,255,845
Less: Unearned loan origination fees 46,677 18,890
Undisbursed portion of construction loans 5,656,786 3,828,364
Allowance for loan losses 200,000 125,000
------------------- -------------------
$ 47,593,855 $ 38,283,591
=================== ===================
</TABLE>
Accrued interest receivable on loans totaled $462,097 and $255,956 at June
30, 1998 and 1997, respectively.
The following is a reconciliation of the allowance for loan losses:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Balance at beginning of year $ 125,000 $ 100,000
Provision charges to operations 114,554 38,560
Loans charged off (39,554) (13,560)
--------------- ----------------
Balance at end of year $ 200,000 $ 125,000
=============== ================
</TABLE>
The following is a summary of non-performing loans:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Accruing loan 90 days past due $ 87,627 $
Nonaccrual loans 500,268 828,000
---------------- ---------------
Total non-performing loans at year end $ 587,895 $ 828,000
================ ===============
Non-performing loans as a percentage of total loans 1.24% 2.16%
</TABLE>
At June 30, 1998 and 1997, 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 $18,000 and
$16,000, respectively.
At June 30, 1998 and 1997, the Bank did not have any loans outstanding to
directors and executive officers.
30
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
5. Investment in Nonmarketable Equity Securities:
<TABLE>
<CAPTION>
June 30,
--------------------------------
1998 1997
<S> <C> <C>
Federal Home Loan Bank of Cincinnati capital
stock, 7,103 and 3,277 shares in 1998 and 1997, respectively
$ 710,300 $ 327,700
Intrieve, Inc. capital stock, 10 shares 15,000 15,000
--------- ----------
725,300 342,700
========= ==========
</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
$1,200,500 and $2,061,500 at June 30, 1998 and 1997, respectively. These
instruments involve, to varying degrees, elements of credit and interest
rate risk in excess of the amount recognized in the consolidated statements
of financial condition.
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,
Jessamine and Fayette County, Kentucky market.
The Bank has $2,186,921 and $1,437,113 of cash on deposit with one financial
institution at June 30, 1998 and 1997, respectively.
7. Office Property and Equipment, at cost:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Land $ 30,000 $ 30,000
Office building and improvements 379,522 379,522
Furniture and equipment 191,747 191,412
----------------- -----------------
601,269 600,934
Less accumulated depreciation 221,779 200,411
----------------- -----------------
$ 379,490 $ 400,523
================= =================
</TABLE>
31
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
8. Deposits:
Deposit accounts are summarized as follows:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Demand deposit accounts $ 1,515,796 $ 1,289,161
NOW and MMDA deposit with a weighted average rate of
3.13% and 3.11% at June 30, 1998 and 1997, respectively
2,192,282 1,685,482
------------------------ ----------------------
Savings deposits 3,708,078 2,974,643
Certificates of deposit with a weighted average rate of
5.96% and 5.71% at June 30, 1998 and 1997 respectively
21,708,633 19,153,044
------------------------ ----------------------
Total deposits $ 25,416,711 $ 22,127,687
======================== ======================
<CAPTION>
Certificates of deposit by maturity at June 30, 1998 and 1997 are as
follows:
1998 1997
---- ----
<S> <C> <C>
1 year or less $ 13,928,382 $ 14,916,735
1 year - 3 years 7,290,588 3,175,555
Maturing in years thereafter 489,663 1,060,754
------------------------ ----------------------
$ 21,708,633 $ 19,153,044
======================== ======================
</TABLE>
Certificates of deposit by maturity and interest rate category at June 30,
1998 and 1997 are as follows:
<TABLE>
<CAPTION>
Amount due June 30, 1998
(In Thousands)
Less than one year 1-2 Years 2-3 Years After 3 Years Total
<S> <C> <C> <C> <C> <C>
2.00-3.99% $ 1 $ 20 $ - $ - $ 22
4.00-5.99% 11,520 999 94 71 12,684
6.00-7.99% 2,407 4,341 1,837 419 9,003
------------------- ------------------ ------------------ ---------------- --------------------
$ 13,928 $ 5,360 $ 1,931 $ 490 $ 21,709
=================== =================== ================== ================ ====================
<CAPTION>
Amount due June 30, 1997
(In Thousands)
Less than one year 1-2 Years 2-3 Years After 3 Years Total
<S> <C> <C> <C> <C> <C>
2.00-3.99% $ 26 $ 24 $ 3 $ $ 53
4.00-5.99% 13,018 1,480 253 165 14,916
6.00-7.99% 1,873 634 781 896 4,184
------------------- ------------------- ------------------ ---------------- --------------------
$ 14,917 $ 2,138 $ 1,037 $ 1,061 $ 19,153
=================== =================== ================== ================ ====================
</TABLE>
32
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
9. Federal Home Loan Bank Advances:
Federal Home Loan Bank advances at June 30, 1998 and 1997 are as follows:
<TABLE>
<CAPTION>
June 30, June 30,
-------- --------
1998 1997
---- ----
Date of Issue Year of Amount Amount Interest
Maturity Rate
<S> <C> <C> <C> <C>
10/27/94 11/01/04 $ 107,242 $ 136,155 8.45
1/31/95 1/30/15 650,000 650,000 5.75
5/09/95 6/01/05 116,095 140,773 7.35
3/14/97 3/13/98 750,000 6.05
3/25/97 3/24/00 500,000 500,000 6.75
3/25/97 3/25/98 2,000,000 6.20
5/01/97 10/28/97 1,750,000 6.00
7/31/97 7/31/98 1,000,000 5.88
8/14/97 8/14/98 500,000 5.95
10/22/97 10/22/98 250,000 6.05
1/27/98 1/22/99 1,000,000 5.75
1/28/98 2/01/08 87,830 6.37
2/17/98 8/14/98 500,000 5.61
2/20/98 2/20/99 500,000 5.67
3/03/98 3/03/99 1,000,000 5.75
3/13/98 3/12/99 1,250,000 5.74
3/20/98 3/19/99 750,000 5.77
3/25/98 3/25/99 2,000,000 5.81
3/31/98 9/25/98 500,000 5.71
4/24/98 4/23/99 1,750,000 5.84
4/28/98 10/23/98 250,000 5.74
5/13/98 11/09/98 500,000 5.72
5/22/98 11/18/98 250,000 5.72
------------- --------------
$13,461,167 $ 5,926,928
============= ==============
</TABLE>
The scheduled maturities of Federal Home Loan Bank advances for the five years
subsequent to June 30, 1998 are as follows:
1999 $12,033,057
2000 535,661
2001 38,473
2002 41,509
2003 44,788
Thereafter 767,679
-------------
$13,461,167
=============
33
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
9. Federal Home Loan Bank Advances, continued:
As collateral for the advance, the Bank has pledged $20,191,751 of one to
four family residential mortgages, which represents 150% of the amount of
the advance.
10. Regulatory Matters:
The Bank is subject to various regulatory capital requirements administered
by the OTS. Failure to meet minimum capital requirements can initiate
certain mandatory, and possibly additional discretionary, actions by the
OTS that, if undertaken, could have a direct material effect on the Bank's
financial statements. Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank's assets,
liabilities, and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgements by the OTS about
components, risk weightings, and other factors.
Quantative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the
table on the following page) of total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined), Tier I capital (as
defined) to adjusted total assets, and tangible capital to adjusted total
assets. Management believes, as of June 30, 1998, that the Bank meets all
capital adequacy requirements to which it is subject.
As of January, 1997, the most recent notification from the OTS categorized
the Bank as well capitalized under the regulatory framework for prompt
corrective action. To be categorized as well capitalized the Bank must
maintain minimum total risk-based, Tier I risk-based, and Tier I leverage
ratios as set forth in the table below. There have been no conditions or
events since that notification that management believes have changed the
institution's category.
34
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
10. Regulatory Matters:
Amounts are in the thousands.
<TABLE>
<CAPTION>
To Be Well
For Capital Capitalized Under
Adequacy Prompt Corrective
Actual Purposes Action Provisions
Amount Ratio Amount Ratio Amount Ratio
<S> <C> <C> <C> <C> <C> <C>
As of June 30, 1998:
Total Capital (to Risk
Weighted Assets) $ 13,026 38% $ 2,759 8% $ 3,499 10%
Tier I Capital (to Risk
Weighted Assets) $ 12,826 37% $ 1,380 4% $ 2,070 6%
Tier I Capital
(to Adjusted Total Assets) $ 12,826 24% $ 1,600 3% $ 1,600 3%
Tangible Capital (to
Adjusted Total Assets) $ 12,826 24% $ 800 1.5% $ 800 1.5%
As of June 30, 1997:
Total Capital (to Risk
Weighted Assets) $ 12,716 52% $ 1,977 8% $ 2,471 10%
Tier I Capital (to Risk
Weighted Assets) $ 12,591 51% $ 989 4% $ 1,483 6%
Tier I Capital (to
Adjusted Total Assets) $ 12,591 30% $ 1,269 3% $ 1,269 3%
Tangible Capital (to
Adjusted Total Assets) $ 12,591 30% $ 635 1.5% $ 635 1.5%
</TABLE>
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.
The provision for income taxes consists of:
June 30,
1998 1997
---- ----
------------ ------------
Current $ 320,981 $ 310,397
Deferred (38,781) (61,340)
------------ ------------
$ 282,200 $ 249,057
============ ============
35
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
11. Income Taxes, continued:
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:
June 30,
1998 1997
---- ----
Stock dividends on FHLB stock $ 14,008 $ 7,446
Provision for loan losses (25,500) (8,500)
Provision for uncollected interest (632) (1,914)
Depreciation (317) 3,967
Deferred fees (9,447) 7,610
Directors retirement expense (7,016) (27,708)
Supplemental executive retirement expense (10,204) (8,503)
Management recognition plan expense 5,141 (22,885)
ESOP expense 286 (2,353)
Bonus expense (5,100) (8,500)
------------ ------------
$ (38,781) $ (61,340)
============ ============
The following tabulation reconciles the federal statutory tax rate to the
effective rate of taxes provided for income before taxes:
<TABLE>
<CAPTION>
June 30,
1998 1997
------------------------ -----------------------
<S> <C> <C> <C> <C>
Tax at statutory rate $ 269,978 34.0 % $ 236,944 34.0%
Increases (decreases) in taxes resulting
From:
ESOP deduction 14,351 1.8 % 10,491 1.5%
Other, net (2,129) (0.3)% 1,622 0.2%
------------ --------- ------------ --------
Effective rate $ 282,200 35.5 % $ 249,057 35.7%
============ ========= ============ ========
</TABLE>
The tax effect of temporary differences giving rise to the Corporation's
consolidated deferred income tax asset (liability) at June 30, 1998 and
1997 are as follows:
1998 1997
---- ----
Deferred tax assets
Allowance for loan losses $ 68,000 $ 42,500
Uncollected interest 6,000 5,368
Deferred loan fees 15,870 6,423
Directors retirement expense 46,507 39,491
Supplemental executive retirement expense 22,515 12,311
Management recognition plan expense 17,744 22,885
ESOP expense 2,067 2,353
Bonus expense 13,600 8,500
------------ ------------
192,303 139,831
Deferred tax liabilities:
FHLB stock dividends (73,405) (59,397)
Depreciation on office property and (11,150) (11,467)
equipment
Unrealized gain on available for sale
securities (386,569) (285,383)
------------ ------------
Deferred income tax liability $ (278,821) $ (216,416)
============ ============
36
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
11. INCOME TAXES, CONTINUED:
In August 1996, the Small Business Job Protection Act was signed into law
which repeals the favorable tax bad debt deduction method available to
savings banks. Although the percentage of taxable income method bad debt
deduction will no longer be available to the Bank, the tax requirement to
invest in certain qualifying types of investments and loans has been
eliminated, thus providing greater freedom to the Bank in structuring its
statement of financial condition to maximize returns These tax-related
changes had no impact on the Bank's financial position or results of
operations.
As of June 30, 1998, the Bank's bad debt reserve for federal tax purposes
was approximately $816,000 which represents the base year amount. A deferred
tax liability has not been recognized for the base year amount. If the Bank
uses the base year reserve for any reason other than to absorb loan losses,
a tax liability could be incurred. It is not anticipated that the reserve
will be used for any other purpose.
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 to the plan amounted to $756 for the year
ended June 30, 1998, and to $3,752 for the year ended June 30, 1997.
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 of the Board of Directors and are computed as a percentage of
eligible employees' compensation. The Board of Directors authorized
contributions equal to 4% of eligible employees' compensation for 1998
and 1997, which amounted to $10,636 and $7,682 for 1998 and 1997,
respectively.
C. Employee Stock Ownership Plan
-----------------------------
The Corporation sponsors an employee stock ownership plan (ESOP) that
covers all employees. During 1996 the Corporation loaned $767,040 to the
ESOP for the purchase of 76,704 shares of the Corporation's stock. The
Corporation makes annual contributions to the ESOP equal to total debt
service less dividends received by the ESOP. All dividends on unallocated
shares are used to pay debt service. As the debt is repaid, First
Lancaster Bancshares, Inc. common shares are allocated to employees. The
Corporation accounts for its ESOP in accordance with Statement of
Position 93-6. Accordingly, the shares represented by outstanding debt
are reported as unearned ESOP shares in the statement of financial
condition. As shares are earned, the Corporation reports compensation
expense
37
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
C. Employee Stock Ownership Plan, Continued
----------------------------------------
equal to the current market price of the shares, and the shares become
outstanding for earnings per share computations. Dividends on allocated
ESOP shares are recorded as a reduction of retained earnings; dividends
on unallocated ESOP shares are recorded as a reduction of debt and
accrued interest.
Contribution expense for the ESOP was $119,108 and $94,775 for the years
ended June 30, 1998 and 1997, respectively. Interest on the debt is not
considered compensation expense by the Corporation. The ESOP shares were
as follows as of June 30:
1998 1997
---- ----
Allocated Shares 14,078 6,392
Unearned Shares 62,626 70,312
------------ -----------
Total ESOP Shares 76,704 76,704
============ ===========
Fair Value of Unearned Shares at June 30 $908,077 $1,072,258
Market Price per share $ 14.50 $ 15.25
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 490(h) of the Internal Revenue Code. The Corporation has
classified outside of permanent equity the fair value of earned and
unearned ESOP shares (net of the debit balance representing unearned ESOP
shares) subject to the put option in accordance with the Securities and
Exchange Commission Accounting Series Release #268.
D. Stock Award Plans
-----------------
Management Recognition Plan (MRP)
---------------------------------
In connection with the conversion, the Corporation adopted the First
Lancaster Bancshares, Inc. Management Recognition Plan, the objective of
which is to enable the Corporation to retain personnel of experience and
ability in key positions of responsibility. Those eligible to receive
benefits under the MRP include certain directors and executive officers
of the Corporation and Lancaster Federal Savings Bank as determined by
members of a committee appointed by the Board of Directors. On
January 9, 1997, 28,761 shares were awarded. The fair market value of
the common stock at that date was $14.625 and there is no exercise price
for the stock. Awards to directors and eligible employees will vest 20%
on each anniversary date of the award. On July 3, 1997, 231 additional
shares were granted. Shares are held by the trustee and are voted by the
MRP trustee in the same proportion as the trustee of the Corporation's
ESOP plan vote shares held therein. Assets of the trust are subject to
the general creditors of the Corporation. All shares vest immediately if
there is a change in control or in the case of a participant's death or
disability. The Corporation applied APB Opinion 25 and related
Interpretations in accounting for the MRP.
38
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
Compensation cost charged to operations for the MRP totaled $89,472 and
$67,309 for the years ended June 30, 1998 and 1997, respectively.
Stock Option Plan
-----------------
The Corporation granted stock options under the 1996 Stock Option and
Incentive Plan. Under the plan the Corporation is authorized to issue
shares of common stock pursuant to "Awards" granted in various forms,
including incentive stock options (intended to qualify under Section 422
of the Internal Revenue Code of 1986, as amended), non-qualified stock
options, and other similar stock-based awards. The Corporation granted
stock options to employees and directors in 1997 under the plan in the
form of incentive and non-qualified stock options. The stock options
granted in 1997 have contractual terms of 10 years. All options granted
to the employees and directors have an exercise price no less than the
fair market value of the stock at grant date. The option price is equal
to 110% of the fair market value on the grant date in the case of
Incentive Stock Options (ISO) granted to persons owning more than 10% of
the outstanding common shares. Each option will become exercisable with
respect to 20% of the optioned shares upon an optionee's completion of
each of five years of future service as an employee, director or
advisory or emeritus director, provided that an option shall become 100%
exercisable immediately if an optionee's continuous service terminates
due to death or disability. The options expire ten years after the date
of grant. The Corporation granted 71,910 options in 1997. In accordance
with APB 25, the Corporation has not recognized any compensation cost
for these plans in 1998.
A summary of the status of the Corporation's stock options as of
June 30, 1998 and the charges during the year ended on that date is
presented below.
# Shares of Weighted
Underlying Average
Options Exercise
Prices
------------ -----------
Outstanding, January 1, 1998 71,910 $ 14.625
Granted during the year 0
Exercised during the year 0
------------
Outstanding, June 30, 1998 71,910 $ 14.625
------------
Eligible for exercise at year-end 0
============
Weighted average fair value of options
granted at a discount $3.55
39
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
Stock Option Plan
-----------------
The Corporation applies APB Opinion 25 and related Interpretations in
accounting for the Plan. In 1995, the FASB issued FASB Statement No. 123,
"Accounting for Stock-Based Compensation" (SFAS 123) which, if fully adopted
by the Corporation, would change the methods the Corporation applies in
recognizing the cost of the plan. Adoption of the cost recognition
provisions of SFAS 123 is optional and the Corporation has decided not to
elect these provisions of SFAS 123. However, pro forma disclosures as if the
Corporation adopted the cost recognition provisions of SFAS 123 in 1996 are
required by SFAS 123 and are presented below.
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions for grants in 1997: dividend yield of 3.42%;
risk-free interest rate of 6.25%; expected life of options of 6 years; and a
volatility of 21.69% for all grants.
As of June 30, 1998, 71,910 options are outstanding with a weighted-average
remaining contractual life of all stock options being 8.5 years.
Had the compensation cost for the Corporation's stock-based compensation
plan been determined consistent with SFAS 123, the Corporation's net income
and net income per common share for 1998 would approximate the pro forma
amounts below:
AS REPORTED 6/30/98 PRO FORMA 6/30/98
----------------------- ---------------------
Net Income $ 511,853 $ 489,197
Earnings per share $ .57 $ .54
The effects of applying SFAS 123 in this pro forma disclosure are not
indicative of future amounts.
E. 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 $54,714 and $81,494 for the years ended
June 30, 1998 and 1997, respectively.
F. 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 of 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.
40
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
12. EMPLOYEE BENEFIT PLANS, CONTINUED:
F. Supplemental Executive Retirement Plan (SERP), Continued
--------------------------------------------------------
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 $30,011 and $25,009 for the years ended June 30, 1998 and 1997,
respectively.
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.
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.
41
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
13. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED:
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 bear interest at fixed rates. The carrying value of these
borrowings is estimated using the current rates at which similar loans would
be made to borrowers for the same maturities.
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 creditworthiness 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, 1998.
The estimated fair values of the Corporation's financial instruments are as
follows:
<TABLE>
<CAPTION>
JUNE 30, JUNE 30,
1998 1997
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
------------ ----------- ---------- ----------
(in thousands)
<S> <C> <C> <C> <C>
Financial Assets:
Cash $ 516 $ 516 $ 671 $ 671
Interest-bearing deposits in other depository
Institutions 2,187 2,187 1,437 1,437
Investment securities 1,161 1,161 864 864
Investment in nonmarketable equity
Securities 725 725 343 343
Mortgage-backed securities 435 448 540 546
Loans receivable, net allowance for loan
losses of $200 for 1998 and $125 for
1997 47,594 47,532 38,284 38,440
Financial Liabilities:
Savings accounts and certificates 25,417 25,643 22,128 22,349
Federal Home Loan Bank advances 13,461 13,390 5,927 5,927
</TABLE>
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 $69,576 in 1997.
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.
42
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
14. CONVERSION TO STOCK SAVINGS BANK, FORMATION OF HOLDING COMPANY AND SALE OF
COMMON STOCK, CONTINUED:
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, 1998 and
1997, 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, 1998, approximately $5,596,000 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 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.
43
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
15. Earnings Per Share:
<TABLE>
<CAPTION>
For the year ended June 30, 1998 For the year ended June 30, 1997
------------------------------------------- ---------------------------------------------
Income Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
------------- --------------- ----------- ------------ --------------- ----------
<S> <C> <C> <C> <C> <C> <C>
Basic earnings per
share
Income available to
common shareholders $ 511,853 884,236 $ 0.58 $ 447,838 885,306 $ 0.51
Effect of dilutive
securities
Stock Options 3,588 2,863
Management
recognition plan 16,320 18,982
Diluted earnings per
share
Income available to
common
shareholders plus
assumed
conversions $ 511,853 904,144 $ 0.57 $ 447,838 907,151 $ 0.49
</TABLE>
There were no preferred dividends or antidilutive securities that would affect
the computation of earnings per share.
44
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
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,
1998 1997
------------- -------------
<S> <C> <C>
Assets
Cash and balances with bank $ 192,914 $ 241,920
Investment in subsidiary 14,206,703 13,854,525
Income tax receivable 43,807 17,294
Accrued interest receivable 31,705 34,267
------------ ------------
$ 14,475,129 $ 14,148,006
============ ============
Liabilities and Stockholders' Equity
Accounts payable $ 3,444 $ 39,919
Common stock owned by ESOP subject to put option 485,988 466,616
Stockholders' equity 13,985,697 13,641,471
------------ ------------
$ 14,475,129 $ 14,148,006
============ ============
<CAPTION>
Condensed Statement of Income For the Year Ended June 30,
1998 1997
------------ ------------
Dividend from bank subsidiary $ 564,829
Interest income 64,473 $ 77,491
Legal, accounting and filing fees (140,840) (128,647)
------------ ------------
Net income (loss) before income taxes 488,462 (51,156)
Income tax benefit 26,513 17,294
------------ ------------
Net loss before equity in undistributed net income of
subsidiary 514,975 33,862
Equity in undistributed net income of subsidiary (3,122) 481,700
------------ ------------
Net income $ 511,853 $ 447,838
============ ============
<CAPTION>
Condensed Statement of Cash Flows June 30,
1998 1997
------------ ------------
Operating activities:
Net income $ 511,853 $ 447,838
Adjustment to reconcile net income to cash provided
by operating activities:
Equity in undistributed net income of subsidiary 3,122 (481,700)
Increase in income tax receivable (26,513) (17,294)
Decrease (increase) in accrued interest receivable 2,562 (34,267)
(Decrease) increase in accounts payable (36,475) 39,919
------------ ------------
Net cash provided by (used in) operating activities 454,549 (45,504)
Investing activities:
Payment on ESOP loan 32,120 57,000
------------ ------------
Net cash provided by investing activities 32,120 57,000
------------ ------------
</TABLE>
45
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, Continued
16. Condensed Financial Information (Parent Company Only):
Financing activities:
Purchase of treasury stock (118,440)
Dividends paid (445,750)
Cash received for treasury stock 28,515
Proceeds from stock conversion, net of expenses (69,576)
-------- --------
Net cash used in financing activities (535,675) (69,576)
-------- --------
Net decrease in cash (49,006) (58,080)
Cash, beginning of year 241,920 300,000
-------- --------
Cash, end of year $192,914 $241,920
======== ========
17. Subsequent Events:
On July 6, 1998 the Corporation declared a dividend of $0.30 per share or
$287,644, to shareholders of record as of July 17, 1998.
Other real estate owned at June 30, 1998 was sold on July 15, 1998 for
$280,000.
46
<PAGE>
CORPORATE INFORMATION
BOARD OF DIRECTORS
Virginia R. S. Stump
Chairman of the Board, President
and Chief Executive Officer of the
Company and the Bank
Tony A. Merida
Vice Chairman of the Board and
Executive Vice President of the
Company and the Bank
David W. Gay
Self-Employed
Jane G. Simpson
Retired
Ronald L. Sutton
Pharmacist
Jack C. Zanone
Self-Employed
EXECUTIVE OFFICERS
Virginia R. S. Stump
President and Chief Executive
Officer
Tony A. Merida
Executive Vice President
Kathy G. Johnica
Secretary and Treasurer
OFFICE LOCATIONS
208 Lexington Street 713 Edgewood Drive
Lancaster, Kentucky 40444-1131 Nicholasville, Kentucky
(Loan Production Office)
OTHER INFORMATION
Independent Certified Accountants
PricewaterhouseCoopers LLP
201 East Main Street, Suite 1400
Lexington, Kentucky 40507
Transfer Agent
Illinois Stock Transfer Company
209 W. Jackson Boulevard, Suite 903
Chicago, Illinois 60606
Special Counsel
Housley Kantarian & Bronstein, P.C.
1220 19th Street, N.W., Suite 700
Washington, D.C. 20036
Annual Meeting
The 1998 Annual Meeting of Stockholders
will be held on October 26, 1998 at 4:00 p.m.
at the Bank's office located at 208
Lexington Street, Lancaster, Kentucky.
Annual Report on Form 10-KSB
A copy of the Company's Annual Report on Form 10-KSB for the fiscal year ended
June 30, 1998 as filed with the Securities and Exchange Commission will be
furnished without charge to stockholders as of the record date for the 1998
Annual Meeting upon written request to the Corporate Secretary, First Lancaster
Bancshares, Inc., 208 Lexington Street, Lancaster, Kentucky 40444- 1131.
<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 (2) Kentucky 100%
</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.
<PAGE>
[LETTERHEAD OF PRICEWATERHOUSECOOPERS APPEARS HERE]
Consent of Independent Accountants
We consent to the incorporation by reference in the registration statement on
Form S-8 of our report dated August 5, 1998, on our audits of the consolidated
financial statements of First Lancaster Bancshares, Inc. and Subsidiary as of
June 30, 1998 and 1997, and the related consolidated statements of income,
changes in stockholders' equity, and cash flows for each of the years then
ended, which report is included in First Lancaster Bancshares, Inc. Annual
Report on Form 10-KSB for the year ended June 30, 1998. We also consent to the
reference to our firm under the caption "Experts".
/s/ PricewaterhouseCoopers LLP
Lexington, Kentucky
September 24, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 9
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-START> JUL-01-1997
<PERIOD-END> JUN-30-1998
<CASH> 516,199
<INT-BEARING-DEPOSITS> 2,186,921
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 1,161,126
<INVESTMENTS-CARRYING> 434,635
<INVESTMENTS-MARKET> 448,000
<LOANS> 47,593,855
<ALLOWANCE> 200,000
<TOTAL-ASSETS> 53,746,664
<DEPOSITS> 25,416,711
<SHORT-TERM> 0
<LIABILITIES-OTHER> 745,421
<LONG-TERM> 13,461,167
0
0
<COMMON> 9,588
<OTHER-SE> 13,627,789
<TOTAL-LIABILITIES-AND-EQUITY> 53,746,664
<INTEREST-LOAN> 3,905,595
<INTEREST-INVEST> 129,146
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 4,034,741
<INTEREST-DEPOSIT> 1,277,281
<INTEREST-EXPENSE> 1,959,717
<INTEREST-INCOME-NET> 2,075,024
<LOAN-LOSSES> 114,554
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 1,166,417
<INCOME-PRETAX> 794,053
<INCOME-PRE-EXTRAORDINARY> 794,053
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 511,853
<EPS-PRIMARY> 0.58
<EPS-DILUTED> 0.57
<YIELD-ACTUAL> 2.70
<LOANS-NON> 500,268
<LOANS-PAST> 87,627
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 125,000
<CHARGE-OFFS> 39,554
<RECOVERIES> 0
<ALLOWANCE-CLOSE> 200,000
<ALLOWANCE-DOMESTIC> 200,000
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
