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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB/A
(Amendment No. 1)
(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.
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(Name of small business issuer in its charter)
Delaware 61-1297318
- ------------------------------ -----------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
208 Lexington Street, Lancaster, Kentucky 40444-1131
- ------------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code:
(606) 792-3368
Securities registered pursuant to Section 12(b) of the Act:
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. [X]
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 approxi-
mately $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)
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
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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
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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
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Total. . . . . . . . . . . . . . . . $ 47,593 $ 38,284
========= ========
<FN>
______________
(1) Consists of loans secured by first liens on residential lots and loans
secured by first mortgages on commercial real property.
</FN>
</TABLE>
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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 substan-
tially higher than rates on existing mortgage loans and, con-
versely, 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
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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
======== ========
<FN>
__________________
(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.
</FN>
</TABLE>
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 under-
writing 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.
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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 origi-
nated. 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
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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 construc-
tion. 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 con-
struction. 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.
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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 other-
wise 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
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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 $ --
====== ======
<FN>
_______________
(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.
</FN>
</TABLE>
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>
<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 deter-
mining 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>
<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 . . . .09% 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 limita-
tions, 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>
<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>
<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>
<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
------------------- -------------------- --------------------
Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Securities available for sale:
U.S. government and agency
securities $ 1,161 (1) 33.3% $ --% $ --%
Securities held to maturity:
Mortgage-backed securities -- 6 8.5 17 8.5
-------- ------ -------
Total $ 1,161 33.3% $ 6 8.5% $ 17 8.5
======== ====== =======
<CAPTION>
More than Ten Years Total Investment Portfolio
-------------------- ---------------------------------
Carrying Average Carrying Market Average
Value Yield Value Value Yield
-------- ------- -------- -------- -------
(Dollars in thousands)
<S> <C> <C> <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 412 7.6 435 448 7.6
------ -------- --------
Total $ 412 7.6 $ 1,596 $ 1,609 8.8%
====== ======== ========
<FN>
_____________________
(1) Amortized cost of $24,000 - average yield is based on amortized cost.
</FN>
</TABLE>
13
<PAGE>
<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 certifi-
cates 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 characteris-
tics 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 . . $ 290 -- % $ 3 -- %
Savings deposits . . . . . . . . . . . . 3,127 3.27 3,180 3.13
Time deposits. . . . . . . . . . . . . . 20,095 5.85 19,023 5.64
------- -------
Total deposits. . . . . . . . . . . . $23,512 $22,203
======= =======
</TABLE>
14
<PAGE>
<PAGE>
The following table indicates the amount of the Bank's
certificates of deposit of $100,000 or more by time remaining
until maturity as of June 30, 1998.
Certificates
Maturity Period of Deposits
--------------- ------------
(In thousands)
Three months or less . . . . . . . . . . . .$ 611
Over three through six months . . . . .. . . 203
Over six through 12 months . . . . . . . . . 1,537
Over 12 months . . . . . . . . . . . . . . . 1,135
--------
Total. . . . . . . . . . . . . . . . . . $ 3,486
========
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>
<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 6.6% 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>
<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 insti-
tution or its subsidiaries may engage in "covered transactions"
with any one affiliate to an amount equal to 10% of such insti-
tution'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 trans-
action" 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
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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
Section 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
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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 excep-
tions 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 activi-
ties not permissible to national banks (other than subsidiaries
engaged in activities undertaken as agent for customers or in
mortgage banking activities and subsidiary depository institu-
tions 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
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the amount of assets that have been deducted from capital, the
portion of the savings institution's investments in unconsoli-
dated 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, nonwith-
drawable 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%
======== ====
<FN>
_______________
(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.
</FN>
</TABLE>
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
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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 concentra-
tion 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
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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.
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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 institu-
tion 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 supervi-
sory 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
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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 institu-
tions 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
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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 distribu-
tions 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 distribu-
tions without the prior approval of the OTS. Tier 1 Associa-
tions 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 institu-
tion's extensions of credit to insiders (a) be made on terms
that are substantially the same as, and follow credit under-
writing 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
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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, institu-
tions 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 stock-
holders (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 distri-
buted. 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
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PART II
ITEM 6. 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 2.91% 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 liabili-
ties. The ratio of the Bank's average interest-earning assets
to average interest-bearing liabilities was 135.54% 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.
27
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<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.
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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.
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
29
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<PAGE>
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.
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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)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
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.
31
<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.
32
<PAGE>
<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). . . . . . . . . . . . . $ 44,630 $ 3,869 8.67% $ 33,602 $ 3,009 8.95%
Investment securities . . . . . . . . . . . . 24 8 33.33 24 11 45.83
Non-marketable equity securities. . . . . . . 588 41 6.97 332 22 6.63
Mortgage-backed securities. . . . . . . . . . 487 37 7.60 501 40 7.98
Other interest-bearing cash deposits. . . . . 1,549 80 5.16 2,998 156 5.20
-------- -------- -------- --------
Total interest-earning assets. . . . . . . 47,278 4,035 8.53 37,457 3,238 8.64
Unrealized gains on securities available -------- --------
for sale . . . . . . . . . . . . . . . . . . . 961 615
Non-interest-earning assets. . . . . . . . . . . 1,556 1,017
-------- --------
Total assets . . . . . . . . . . . . . . . $ 49,795 $ 39,089
======== ========
Interest-bearing liabilities:
Deposits. . . . . . . . . . . . . . . . . . . $ 23,512 $ 1,279 5.44 $ 22,203 $ 1,151 5.18
Borrowings. . . . . . . . . . . . . . . . . . 11,370 681 5.99 2,854 170 5.96
-------- -------- -------- --------
Total interest-bearing liabilities . . . . 34,882 1,960 5.62 25,057 1,321 5.27
Non-interest-bearing liabilities . . . . . . . . 804 -------- 490 -------
-------- -------
Total liabilities. . . . . . . . . . . . . 35,686 25,547
Retained earnings and capital. . . . . . . . . . 13,475 13,136
Unrealized gain on securities available
for sale . . . . . . . . . . . . . . . . . . . 634 406
------- ------
Total liabilities and
stockholders' equity . . . . . . . . . $ 49,795 $ 39,089
======== ========
Net interest income. . . . . . . . . . . . . . . $ 2,075 $ 1,917
======== ========
Interest rate spread . . . . . . . . . . . . . . 2.91% 3.27%
====== ======
Net yield on interest-earning assets . . . . . . 4.39% 5.12%
====== ======
Ratio of average interest-earning assets
to average interest-bearing liabilities . . . . . . 135.54% 149.49%
====== ======
<FN>
_____________________
(1) Includes nonaccrual loans.
</FN>
</TABLE>
33
<PAGE>
<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 . . . . . . . . . . $ 988 $ (96) $ (32) $ 860
Investment securities. . . . . . . . . . . -- (3) - (3)
Nonmarketable equity securities. . . . . . 17 1 1 19
Mortgage-backed securities . . . . . . . . (1) (2) (3)
Other (1). . . . . . . . . . . . . . . . . (76) (1) 1 (76)
------ ------ ------ -----
Total interest-earning assets . . . . 928 (101) (30) 797
------ ------ ------ -----
Interest expense:
Deposits . . . . . . . . . . . . . . . . . 68 57 3 128
Borrowings . . . . . . . . . . . . . . . . 507 1 3 511
------ ------ ------ -----
Total interest-bearing
liabilities. . . . . . . . . . . . 575 58 6 639
------ ------ ------ -----
Change in net interest income. . . . . . . . $ 353 $ (159) $ (36) $ 158
====== ====== ====== =====
<FN>
______________
(1) Consists of overnight deposits, and cash deposits with the FHLB.
</FN>
</TABLE>
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 attri-
butable 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.
34
<PAGE>
<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 pur-
chases 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
$487,000. 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 95.9% 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 $23.5 million from $22.2 million during fiscal year
1997.
35
<PAGE>
<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 $11.4
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 $9.8
million, or 26.2%, increase in average interest-earning assets,
to $47.3 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 $9.8 million increase in
the Company's average interest-bearing liabilities to $34.9
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 $1.3 million, or
5.9%, to $23.5 million during fiscal year 1998 from $22.2
million for fiscal year 1997 and an increase in average
borrowings of $8.5 million, or 298.4%, to $11.4 million during
fiscal year 1998 from $2.9 million for fiscal year 1997.
The Company's interest rate spread decreased to 2.91%
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.
36
<PAGE>
<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.
37
<PAGE>
<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 computa-
tions 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 compre-
hensive 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.
38
<PAGE>
<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 appli-
cations 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.
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.
39
<PAGE>
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
FIRST LANCASTER BANCSHARES, INC.
September 9, 1999 By:/s/ Virginia R. S. Stump
----------------------------------
Virginia R. S. Stump
Chairman of the Board, President and
Chief Executive Officer
(Duly Authorized Representative)
