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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| [ X ] | Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
| For the fiscal year ended: | December 31, 2011 |
Or
| [ ] | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
| For the transition period from to |
| Commission file number: | 001-13221 |
CULLEN/FROST BANKERS, INC.
(Exact name of registrant as specified in its charter)
| Texas | 74-1751768 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
| 100 W. Houston Street, San Antonio, Texas | 78205 | |
| (Address of principal executive offices) | (Zip code) | |
(210) 220-4011
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Common Stock, $.01 Par Value, | The New York Stock Exchange, Inc. | |
| (Title of each class) | (Name of each exchange on which registered) |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ X ] No [ ]
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [ X ]
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ X ] No [ ]
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [ X ] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
| Large accelerated filer [ X ] | Accelerated filer [ ] | |
| Non-accelerated filer [ ] (Do not check if a smaller reporting company) | Smaller reporting company [ ] |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act.) Yes [ ] No [ X ]
As of June 30, 2011, the last business day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of the shares of common stock held by non-affiliates, based upon the closing price per share of the registrant’s common stock as reported on The New York Stock Exchange, Inc., was approximately $3.3 billion.
As of January 23, 2012, there were 61,281,714 shares of the registrant’s common stock, $.01 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the 2012 Annual Meeting of Shareholders of Cullen/Frost Bankers, Inc. to be held on April 26, 2012 are incorporated by reference in this Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.
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CULLEN/FROST BANKERS, INC.
ANNUAL REPORT ON FORM 10-K
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PART I
| ITEM 1. | BUSINESS |
The disclosures set forth in this item are qualified by Item 1A. Risk Factors and the section captioned “Forward-Looking Statements and Factors that Could Affect Future Results” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report and other cautionary statements set forth elsewhere in this report.
The Corporation
Cullen/Frost Bankers, Inc. (“Cullen/Frost”), a Texas business corporation incorporated in 1977, is a financial holding company and a bank holding company headquartered in San Antonio, Texas that provides, through its subsidiaries (collectively referred to as the “Corporation”), a broad array of products and services throughout numerous Texas markets. The Corporation offers commercial and consumer banking services, as well as trust and investment management, mutual funds, Section 1031 property exchange services, investment banking, insurance, brokerage, leasing, asset-based lending, treasury management and item processing services. At December 31, 2011, Cullen/Frost had consolidated total assets of $20.3 billion and was one of the largest independent bank holding companies headquartered in the State of Texas.
The Corporation’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards, and safe, sound assets. The Corporation operates as a locally oriented, community-based financial services organization, augmented by experienced, centralized support in select critical areas. The Corporation’s local market orientation is reflected in its regional management and regional advisory boards, which are comprised of local business persons, professionals and other community representatives that assist the Corporation’s regional management in responding to local banking needs. Despite this local market, community-based focus, the Corporation offers many of the products available at much larger money-center financial institutions.
The Corporation serves a wide variety of industries including, among others, energy, manufacturing, services, construction, retail, telecommunications, healthcare, military and transportation. The Corporation’s customer base is similarly diverse. The Corporation is not dependent upon any single industry or customer.
The Corporation’s operating objectives include expansion, diversification within its markets, growth of its fee-based income, and growth internally and through acquisitions of financial institutions, branches and financial services businesses. The Corporation generally seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction. During 2011, the Corporation announced the planned acquisition of Stone Partners, Inc., a Houston-based human resources consulting firm that specializes in compensation, benefits and outsourcing services. The acquisition became effective in January 2012. The Corporation acquired an insurance agency in the San Antonio market area during 2011 while the Corporation did not make any acquisitions during 2010 and acquired insurance agencies in both the Dallas and San Marcos market areas during 2009. None of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
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Although Cullen/Frost is a corporate entity, legally separate and distinct from its affiliates, bank holding companies such as Cullen/Frost are generally required to act as a source of financial strength for their subsidiary banks. The principal source of Cullen/Frost’s income is dividends from its subsidiaries. There are certain regulatory restrictions on the extent to which these subsidiaries can pay dividends or otherwise supply funds to Cullen/Frost. See the section captioned “Supervision and Regulation” for further discussion of these matters.
Cullen/Frost’s executive offices are located at 100 W. Houston Street, San Antonio, Texas 78205, and its telephone number is (210) 220-4011.
Subsidiaries of Cullen/Frost
The New Galveston Company
Incorporated under the laws of Delaware, The New Galveston Company is a wholly owned second-tier financial holding company and bank holding company, which directly owns all of Cullen/Frost’s banking and non-banking subsidiaries with the exception of Cullen/Frost Capital Trust II.
Cullen/Frost Capital Trust II
Cullen/Frost Capital Trust II (“Trust II”) is a Delaware statutory business trust formed in 2004 for the purpose of issuing $120.0 million in trust preferred securities and lending the proceeds to Cullen/Frost. Cullen/Frost guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities.
Trust II is a variable interest entity for which the Corporation is not the primary beneficiary. As such, the accounts of Trust II are not included in the Corporation’s consolidated financial statements. See the Corporation’s accounting policy related to consolidation in Note 1 - Summary of Significant Accounting Policies in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which is located elsewhere in this report.
Although the accounts of Trust II are not included in the Corporation’s consolidated financial statements, the $120.0 million in trust preferred securities issued by Trust II are included in the Tier 1 capital of Cullen/Frost for regulatory capital purposes. The aggregate amount of restricted core capital elements (which includes trust preferred securities, among other things) that may be included in the Tier 1 capital of most bank holding companies, including Cullen/Frost’s, is limited to 25% of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The quantitative limits do not currently preclude the Corporation from including the $120.0 million in trust preferred securities in Tier 1 capital. As further discussed below, provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act will apply the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, which, among other things, will require the Corporation to deduct, over three years beginning January 1, 2013, all trust preferred securities from the Corporation’s Tier 1 capital.
The Frost National Bank
The Frost National Bank (“Frost Bank”) is primarily engaged in the business of commercial and consumer banking through more than 115 financial centers across Texas in the Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio regions. Frost Bank was chartered as a national banking association in 1899, but its origin can be traced to a mercantile partnership organized in 1868. At December 31, 2011, Frost Bank had consolidated total assets of $20.3 billion and total deposits of $16.8 billion and was one of the largest commercial banks headquartered in the State of Texas.
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Significant services offered by Frost Bank include:
| ¨ | Commercial Banking. Frost Bank provides commercial banking services to corporations and other business clients. Loans are made for a wide variety of general corporate purposes, including financing for industrial and commercial properties and to a lesser extent, financing for interim construction related to industrial and commercial properties, financing for equipment, inventories and accounts receivable, and acquisition financing, as well as commercial leasing and treasury management services. |
| ¨ | Consumer Services. Frost Bank provides a full range of consumer banking services, including checking accounts, savings programs, automated teller machines, overdraft facilities, installment and real estate loans, home equity loans and lines of credit, drive-in and night deposit services, safe deposit facilities, and brokerage services. |
| ¨ | International Banking. Frost Bank provides international banking services to customers residing in or dealing with businesses located in Mexico. These services consist of accepting deposits (generally only in U.S. dollars), making loans (in U.S. dollars only), issuing letters of credit, handling foreign collections, transmitting funds, and to a limited extent, dealing in foreign exchange. |
| ¨ | Correspondent Banking. Frost Bank acts as correspondent for approximately 316 financial institutions, which are primarily banks in Texas. These banks maintain deposits with Frost Bank, which offers them a full range of services including check clearing, transfer of funds, fixed income security services, and securities custody and clearance services. |
| ¨ | Trust Services. Frost Bank provides a wide range of trust, investment, agency and custodial services for individual and corporate clients. These services include the administration of estates and personal trusts, as well as the management of investment accounts for individuals, employee benefit plans and charitable foundations. At December 31, 2011, the estimated fair value of trust assets was $25.2 billion, including managed assets of $10.3 billion and custody assets of $14.9 billion. |
| ¨ | Capital Markets - Fixed-Income Services. Frost Bank’s Capital Markets Division was formed to meet the transaction needs of fixed-income institutional investors. Services include sales and trading, new issue underwriting, money market trading, and securities safekeeping and clearance. |
Frost Insurance Agency, Inc.
Frost Insurance Agency, Inc. is a wholly owned subsidiary of Frost Bank that provides insurance brokerage services to individuals and businesses covering corporate and personal property and casualty insurance products, as well as group health and life insurance products.
Frost Brokerage Services, Inc.
Frost Brokerage Services, Inc. (“FBS”) is a wholly owned subsidiary of Frost Bank that provides brokerage services and performs other transactions or operations related to the sale and purchase of securities of all types. FBS is registered as a fully disclosed introducing broker-dealer under the Securities Exchange Act of 1934 and, as such, does not hold any customer accounts.
Frost Premium Finance Corporation
Frost Premium Finance Corporation is a wholly owned subsidiary of Frost Bank that makes loans to qualified borrowers for the purpose of financing their purchase of property and casualty insurance.
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Frost Investment Advisors, LLC
Frost Investment Advisors is a registered investment advisor entity and a wholly owned subsidiary of Frost Bank that provides investors access to various Frost-managed mutual funds.
Frost 1031 Exchange, LLC
Frost 1031 Exchange is a wholly owned subsidiary of Frost Bank that assists customers in structuring the exchange of property such that the transactions result in a tax-deferred exchange in compliance with Section 1031 of the Internal Revenue Code.
Frost Securities, Inc.
Frost Securities, Inc. is a wholly owned subsidiary of The New Galveston Company that provides advisory and private equity services to middle market companies in Texas.
Main Plaza Corporation
Main Plaza Corporation is a wholly owned non-banking subsidiary of The New Galveston Company that occasionally makes loans to qualified borrowers. Loans are funded with current cash or borrowings against internal credit lines.
Other Subsidiaries
Cullen/Frost has various other subsidiaries that are not significant to the consolidated entity.
Operating Segments
Cullen/Frost’s operations are managed along two reportable operating segments consisting of Banking and Frost Wealth Advisors (formerly Financial Management Group, or “FMG”). See the sections captioned “Results of Segment Operations” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 17 - Operating Segments in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
Competition
There is significant competition among commercial banks in the Corporation’s market areas. In addition, the Corporation also competes with other providers of financial services, such as savings and loan associations, credit unions, consumer finance companies, securities firms, insurance companies, insurance agencies, commercial finance and leasing companies, full service brokerage firms and discount brokerage firms. Some of the Corporation’s competitors have greater resources and, as such, may have higher lending limits and may offer other services that are not provided by the Corporation. The Corporation generally competes on the basis of customer service and responsiveness to customer needs, available loan and deposit products, the rates of interest charged on loans, the rates of interest paid for funds, and the availability and pricing of trust, brokerage and insurance services.
Supervision and Regulation
Cullen/Frost, Frost Bank and many of its non-banking subsidiaries are subject to extensive regulation under federal and state laws. The regulatory framework is intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole and not for the protection of shareholders and creditors.
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Significant elements of the laws and regulations applicable to Cullen/Frost and its subsidiaries are described below. The description is qualified in its entirety by reference to the full text of the statutes, regulations and policies that are described. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies. A change in statutes, regulations or regulatory policies applicable to Cullen/Frost and its subsidiaries could have a material effect on the business of the Corporation.
Regulatory Reforms
The events of the past few years have led to numerous new laws in the United States and internationally for financial institutions. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Dodd-Frank”), which was enacted in July 2010, significantly restructures the financial regulatory regime in the United States. Although the Dodd-Frank Act’s provisions that have received the most public attention generally have been those applying to or more likely to affect larger institutions, it contains numerous other provisions that will affect all bank holding companies and banks, including the Corporation and Frost Bank. Among other provisions affecting the Corporation’s businesses (some of which are discussed in more detail below):
| ¨ | Dodd-Frank changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible capital, eliminated the ceiling and the size of the Deposit Insurance Fund (the “DIF”), and increased the floor applicable to the size of the DIF. |
| ¨ | Dodd-Frank repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. |
| ¨ | Dodd-Frank centralized responsibility for consumer financial protection by creating a new agency, the Consumer Financial Protection Bureau (“CFPB”), and giving it responsibility for implementing, examining and enforcing compliance with federal consumer protection laws. |
| ¨ | Dodd-Frank provided that debit card interchange fees must be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. This provision is known as the “Durbin Amendment.” In June 2011, the Board of Governors of the Federal Reserve System (“Federal Reserve Board”) adopted regulations setting the maximum permissible interchange fee as the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction, with an additional adjustment of up to one cent per transaction if the issuer implements certain fraud-prevention standards. See further discussion regarding the impact of the Durbin Amendment on the Corporation’s 2011 financial statements in the sections captioned “Service Charges on Deposit Accounts” and “Other Non-Interest Income” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations elsewhere in this report. |
| ¨ | Dodd-Frank authorized the Federal Reserve Board to adopt enhanced supervision and prudential standards for, among others, bank holding companies with total consolidated assets of $50 billion or more (often referred to as “systemically important financial institutions” or “SIFI”), and authorized the Federal Reserve Board to establish such standards either on its own or upon the recommendations of the Financial Stability Oversight Council (“FSOC”), a new systemic risk oversight body created by Dodd-Frank. In December 2011, the Federal Reserve Board issued for public comment a notice of proposed rulemaking establishing enhanced prudential standards responsive to these provisions for (i) risk-based capital requirements and leverage limits, (ii) stress testing of capital, (iii) liquidity requirements (iv) overall risk management requirements (v) resolution plan and credit exposure reporting and (vi) concentration/credit exposure limits. Comments on these proposed rules (the “Proposed SIFI Rules”), are due by March 31, 2012. The Proposed SIFI Rules address a wide, diverse array of regulatory areas, each of which is highly complex. Most of the Proposed SIFI Rules will not |
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| apply to the Corporation for so long as its total consolidated assets remain below $50 billion. However, if organic growth or growth through acquisitions causes the Corporation to have total consolidated assets of $50 billion or more, these rules will apply. Two aspects of the Proposed SIFI Rules - requirements for annual stress testing of capital under one base and two stress scenarios and certain corporate governance provisions requiring, among other things, that each bank holding company establish a risk committee of its board of directors and that that committee include a “risk expert” - apply to bank holding companies with total consolidated assets of $10 billion or more, including the Corporation. |
The implications of the Dodd-Frank Act for the Corporation’s businesses will depend to a large extent on the manner in which rules adopted pursuant to the Dodd-Frank Act are implemented by the primary U.S. financial regulatory agencies as well as potential changes in market practices and structures in response to the requirements of the Dodd-Frank Act. The Corporation continues to analyze the impact of rules adopted under Dodd-Frank, including the Proposed SIFI Rules, on the Corporation’s businesses. However, the full impact will not be known until the rules, and other regulatory initiatives that overlap with the rules, are finalized and their combined impacts can be understood.
The Basel Committee on Banking Supervision (the “Basel Committee”) released in December 2010 revised final frameworks for the regulation of capital and liquidity of internationally active banking organizations. These new frameworks are generally referred to as “Basel III”. Although the U.S. banking agencies have not yet published a notice of proposed rulemaking to implement Basel III in the United States, they are likely to do so (at least with respect to the Basel III capital framework) during the first half of 2012. The Corporation anticipates that the Basel III capital framework as adopted in the United States will apply to the Corporation and will establish substantially higher capital requirements than currently apply. The application of the Basel III liquidity framework to bank holding companies with less than $50 billion of total consolidated assets is less certain. See the sections captioned “Capital Requirements” and “Liquidity Requirements” below.
Regulatory Agencies
Cullen/Frost is a legal entity separate and distinct from Frost Bank and its other subsidiaries. As a financial holding company and a bank holding company, Cullen/Frost is regulated under the Bank Holding Company Act of 1956, as amended (“BHC Act”), and its subsidiaries are subject to inspection, examination and supervision by the Federal Reserve Board. The BHC Act provides generally for “umbrella” regulation of financial holding companies such as Cullen/Frost by the Federal Reserve Board, and for functional regulation of banking activities by bank regulators, securities activities by securities regulators, and insurance activities by insurance regulators. Cullen/Frost is also under the jurisdiction of the Securities and Exchange Commission (“SEC”) and is subject to the disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. Cullen/Frost’s common stock is listed on the New York Stock Exchange (“NYSE”) under the trading symbol “CFR,” and is subject to the rules of the NYSE for listed companies.
Frost Bank is organized as a national banking association under the National Bank Act. It is subject to regulation and examination by the Office of the Comptroller of the Currency (“OCC”) and the Federal Deposit Insurance Corporation (“FDIC”).
Many of the Corporation’s non-bank subsidiaries also are subject to regulation by the Federal Reserve Board and other federal and state agencies. Frost Securities, Inc. and Frost Brokerage Services, Inc. are regulated by the SEC, the Financial Industry Regulatory Authority (“FINRA”) and state securities regulators. Frost Investment Advisors, LLC is subject to the disclosure and regulatory requirements of the Investment Advisors Act of 1940, as administered by the SEC. The Corporation’s insurance subsidiaries are subject to regulation by applicable state insurance regulatory agencies. Other non-bank subsidiaries are subject to both federal and state laws and regulations.
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On February 3, 2012, Frost Bank, the sole banking subsidiary of the Corporation, applied to the Texas Department of Banking to become a Texas state chartered bank and notified the Federal Reserve Bank of Dallas of its intention to become a state chartered bank and a member of the Federal Reserve System. If the applications are approved, the Texas Department of Banking and the Federal Reserve Bank of Dallas will become the primary regulators of Frost Bank, and Frost Bank will no longer be regulated by the OCC. Deposits at Frost Bank that are currently insured by the FDIC will continue to be so insured up to applicable limits. As a result of this change, Frost Bank expects to reduce its examination fees by approximately $1.3 million to $1.5 million on an annual basis.
Bank Holding Company Activities
In general, the BHC Act limits the business of bank holding companies to banking, managing or controlling banks and other activities that the Federal Reserve Board has determined to be so closely related to banking as to be a proper incident thereto. In addition, bank holding companies that qualify and elect to be financial holding companies may engage in any activity, or acquire and retain the shares of a company engaged in any activity, that is either (i) financial in nature or incidental to such financial activity (as determined by the Federal Reserve Board in consultation with the Secretary of the Treasury) or (ii) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally (as solely determined by the Federal Reserve Board), without prior approval of the Federal Reserve Board. Activities that are financial in nature include securities underwriting and dealing, insurance underwriting and making merchant banking investments.
To maintain financial holding company status, a financial holding company and all of its depository institution subsidiaries must be “well capitalized” and “well managed.” A depository institution subsidiary is considered to be “well capitalized” if it satisfies the requirements for this status discussed in the section captioned “Capital Adequacy and Prompt Corrective Action,” included elsewhere in this item. A depository institution subsidiary is considered “well managed” if it received a composite rating and management rating of at least “satisfactory” in its most recent examination. The Corporation’s financial holding company status will also depend upon it maintaining its status as “well capitalized” and “well managed’ under applicable Federal Reserve Board regulations. If a financial holding company ceases to meet these requirements, the Federal Reserve Board may impose corrective capital and/or managerial requirements on the financial holding company and place limitations on its ability to conduct the broader financial activities permissible for financial holding companies. In addition, the Federal Reserve Board may require divestiture of the holding company’s depository institutions if the deficiencies persist. Bank holding companies and banks must also be both well capitalized and well managed in order to acquire banks located outside their home state.
In order for a financial holding company to commence any new activity permitted by the BHC Act or to acquire a company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the Community Reinvestment Act. See the section captioned “Community Reinvestment Act” included elsewhere in this item.
The Federal Reserve Board has the power to order any bank holding company or its subsidiaries to terminate any activity or to terminate its ownership or control of any subsidiary when the Federal Reserve Board has reasonable grounds to believe that continuation of such activity or such ownership or control constitutes a serious risk to the financial soundness, safety or stability of any bank subsidiary of the bank holding company.
The Dodd-Frank Act requires the federal financial regulatory agencies to adopt rules that prohibit banks and their affiliates from engaging in proprietary trading and investing in and sponsoring certain unregistered investment companies (defined as hedge funds and private equity funds), with implementation starting as early as July 2012. The statutory provision is commonly called the “Volcker Rule”. In October 2011, federal regulators proposed rules to implement the Volcker Rule that included an extensive request for comments on the proposal,
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which are due by February 13, 2012. The proposed rules are highly complex, and many aspects of their application remain uncertain. Based on the proposed rules, the Corporation does not currently anticipate that the Volcker Rule will have a material effect on the operations of Cullen/Frost and its subsidiaries, as the Corporation does not engage in the businesses prohibited by the Volcker Rule. The Corporation may incur costs if it is required to adopt additional policies and systems to ensure compliance with the Volcker Rule, but any such costs are not expected to be material. Until a final rule is adopted, the precise financial impact of the rule on the Corporation, its customers or the financial industry more generally, cannot be determined.
The BHC Act, the Bank Merger Act, the Texas Banking Code and other federal and state statutes regulate acquisitions of commercial banks. The BHC Act requires the prior approval of the Federal Reserve Board for the direct or indirect acquisition by a bank holding company of more than 5.0% of the voting shares of a commercial bank or its parent holding company. Under the Bank Merger Act, the prior approval of the OCC or other appropriate federal bank regulatory authority is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities will consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the risks to the stability of the U.S. banking or financial system, the applicant’s performance record under the Community Reinvestment Act (see the section captioned “Community Reinvestment Act” included elsewhere in this item) and fair housing laws and the effectiveness of the subject organizations in combating money laundering activities.
Dividends
The principal source of Cullen/Frost’s liquidity is dividends from Frost Bank. The prior approval of the OCC is required if the total of all dividends declared by a national bank in any calendar year would exceed the sum of the bank’s net profits for that year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits national banks from paying dividends that would be greater than the bank’s undivided profits after deducting statutory bad debt in excess of the bank’s allowance for loan losses. Under the foregoing dividend restrictions, and while maintaining its “well capitalized” status, Frost Bank could pay aggregate dividends of approximately $299.8 million to Cullen/Frost, without obtaining affirmative governmental approvals, at December 31, 2011. This amount is not necessarily indicative of amounts that may be paid or available to be paid in future periods.
In addition, Cullen/Frost and Frost Bank are subject to other regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a bank holding company or a bank that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The appropriate federal regulatory authorities have stated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice and that banking organizations should generally pay dividends only out of current operating earnings. In addition, in the current financial and economic environment, the Federal Reserve Board has indicated that bank holding companies should carefully review their dividend policy and has discouraged payment ratios that are at maximum allowable levels unless both asset quality and capital are very strong.
Under rules adopted by the Federal Reserve Board in November 2011, known as the Comprehensive Capital Analysis and Review (“CCAR”) Rules, bank holding companies with $50 billion or more of total consolidated assets are required to submit annual capital plans to the Federal Reserve Board and generally may pay dividends and repurchase stock only under a capital plan as to which the Federal Reserve Board has not objected. The CCAR rules will not apply to the Corporation for so long as the Corporation’s total consolidated assets remain below $50 billion. However, it is anticipated that the Corporation’s capital ratios reflected in the stress test calculations required of the Corporation under the Proposed SIFI Rules (described above under “Regulatory Reforms”) will be an important factor considered by the Federal Reserve Board in evaluating whether proposed payments of dividends or stock repurchases may be an unsafe or unsound practice.
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Transactions with Affiliates
Transactions between Frost Bank, on the one hand, and Cullen/Frost and its other subsidiaries, on the other hand, are regulated by the Federal Reserve Board. These regulations limit the types and amounts of transactions (including loans due and extensions of credit from the U.S. bank subsidiaries) that may take place and generally require those transactions to be on an arm’s-length basis. In general, these regulations require that any “covered transaction” by Frost Bank (or its subsidiaries) with an affiliate must be secured by designated amounts of specified collateral and must be limited, as to any one of Cullen/Frost or its non-bank subsidiaries, to 10% of Frost Bank’s capital stock and surplus, and, as to Cullen/Frost and all such non-bank subsidiaries in the aggregate, to 20% of Frost Bank’s capital stock and surplus. The Dodd-Frank Act significantly expanded the coverage and scope of the limitations on affiliate transactions within a banking organization including, for example, the requirement that the 10% of capital limit on covered transactions apply to financial subsidiaries. “Covered transactions” are defined by statute to include a loan or extension of credit, as well as a purchase of securities issued by an affiliate, a purchase of assets (unless otherwise exempted by the Federal Reserve Board) from the affiliate, certain derivative transactions that create a credit exposure to an affiliate, the acceptance of securities issued by the affiliate as collateral for a loan, and the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate.
Source of Strength Doctrine
Federal Reserve Board policy has historically required bank holding companies to act as a source of financial and managerial strength to their subsidiary banks. The Dodd-Frank Act codified this policy as a statutory requirement. Under this requirement, Cullen/Frost is expected to commit resources to support Frost Bank, including at times when Cullen/Frost may not be in a financial position to provide such resources. Any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to depositors and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to priority of payment.
In addition, under the National Bank Act, if the capital stock of Frost Bank is impaired by losses or otherwise, the OCC is authorized to require payment of the deficiency by assessment upon Cullen/Frost. If the assessment is not paid within three months, the OCC could order a sale of the Frost Bank stock held by Cullen/Frost to make good the deficiency.
Capital Requirements
As a bank holding company, Cullen/Frost is subject to consolidated regulatory capital requirements administered by the Federal Reserve Board. Frost Bank is subject to similar capital requirements administered by the OCC. The federal regulatory authorities’ risk-based capital guidelines are based upon the 1988 capital accord (“Basel I”) of the Basel Committee on Banking Supervision (the “Basel Committee”). The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that develops broad policy guidelines for use by each country’s supervisors in determining the supervisory policies they apply. The requirements are intended to ensure that banking organizations have adequate capital given the risk levels of assets and off-balance sheet financial instruments. Under the requirements, banking organizations are required to maintain minimum ratios for Tier 1 capital and total capital to risk-weighted assets (including certain off-balance sheet items, such as letters of credit). For purposes of calculating the ratios, a banking organization’s assets and some of its specified off-balance sheet commitments and obligations are assigned to various risk categories. A depository institution’s or holding company’s capital, in turn, is classified in one of two tiers, depending on type:
| ¨ | Core Capital (Tier 1). Tier 1 capital includes common equity, retained earnings, qualifying non-cumulative perpetual preferred stock, minority interests in equity accounts of consolidated subsidiaries (and, under existing standards, a limited amount of qualifying trust preferred securities and qualifying cumulative perpetual preferred stock at the holing company level), less goodwill, most intangible assets and certain other assets. |
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| ¨ | Supplementary Capital (Tier 2). Tier 2 capital includes, among other things, perpetual preferred stock and trust preferred securities not meeting the Tier 1 definition, qualifying mandatory convertible debt securities, qualifying subordinated debt, and allowances for loan and lease losses, subject to limitations. |
The Dodd-Frank Act applies the same leverage and risk-based capital requirements that apply to insured depository institutions to bank holding companies such as the Corporation, which, among other things as applied to the Corporation, going forward will preclude the Corporation from including in Tier 1 capital trust preferred securities or cumulative preferred stock, if any, issued on or after May 19, 2010 and to deduct, over three years beginning January 1, 2013, all trust preferred securities from the Corporation’s Tier 1 capital.
Cullen/Frost, like other bank holding companies, currently is required to maintain Tier 1 capital and “total capital” (the sum of Tier 1 and Tier 2 capital) equal to at least 4.0% and 8.0%, respectively, of its total risk-weighted assets (including various off-balance-sheet items, such as letters of credit). Frost Bank, like other depository institutions, is required to maintain similar capital levels under capital adequacy guidelines. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its Tier 1 and total capital ratios must be at least 6.0% and 10.0% on a risk-adjusted basis, respectively.
Bank holding companies and banks are also required to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier 1 capital to its total adjusted quarterly average assets (as defined for regulatory purposes). The requirements necessitate a minimum leverage ratio of 3.0% for bank holding companies and national banks that either have the highest supervisory rating or have implemented the appropriate federal regulatory authority’s risk-adjusted measure for market risk. All other bank holding companies and national banks are required to maintain a minimum leverage ratio of 4.0%, unless a different minimum is specified by an appropriate regulatory authority. In addition, for a depository institution to be considered “well capitalized” under the regulatory framework for prompt corrective action, its leverage ratio must be at least 5.0%. The Federal Reserve Board has not advised Cullen/Frost, and the OCC has not advised Frost Bank, of any specific minimum leverage ratio applicable to either entity.
In 2004, the Basel Committee published a new capital accord (“Basel II”) to replace Basel I. Basel II provides two approaches for setting capital standards for credit risk – an internal ratings-based approach tailored to individual institutions’ circumstances and a standardized approach that bases risk weightings on external credit assessments to a much greater extent than permitted in existing risk-based capital guidelines. Basel II also sets capital requirements for operational risk and refines the existing capital requirements for market risk exposures. Basel II applies to bank holding companies and banks having $250 billion or more in total consolidated assets or $10 billion or more of foreign exposures (referred to as “core” banks) and, accordingly, currently does not apply either to the Corporation or Frost Bank.
In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation, now officially identified by the Basel Committee as “Basel III”. Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their bank subsidiaries to maintain substantially more capital, with a greater emphasis on common equity.
The Basel III final capital framework, among other things, (i) introduces as a new capital measure called “Common Equity Tier 1” (“CET1”), (ii) specifies that Tier 1 capital consist of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital and (iv) expands the scope of the adjustments as compared to existing regulations.
When fully phased in on January 1, 2019, Basel III will require banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5%, plus a 2.5% “capital
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conservation buffer” (which is added to the 4.5% CET1 ratio as that buffer is phased in, effectively resulting in a minimum ratio of CET1 to risk-weighted assets of at least 7% upon full implementation), (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer (which is added to the 6.0% Tier 1 capital ratio as that buffer is phased in, effectively resulting in a minimum Tier 1 capital ratio of 8.5% upon full implementation), (iii) a minimum ratio of Total capital (that is, Tier 1 plus Tier 2) to risk-weighted assets of at least 8.0%, plus the capital conservation buffer (which is added to the 8.0% total capital ratio as that buffer is phased in, effectively resulting in a minimum total capital ratio of 10.5% upon full implementation) and (iv) as a newly adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (as the average for each quarter of the month-end ratios for the quarter).
Basel III also provides for a “countercyclical capital buffer,” generally to be imposed when bank regulatory agencies determine that excess aggregate credit growth has become associated with a buildup of systemic risk, that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented (potentially resulting in total buffers of between 2.5% and 5%).
The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
The implementation of the Basel III capital framework will commence on January 1, 2013. On that date, banking institutions will be required to meet the following minimum capital ratios:
| ¨ | 3.5% CET1 to risk-weighted assets. |
| ¨ | 4.5% Tier 1 capital to risk-weighted assets. |
| ¨ | 8.0% Total capital to risk-weighted assets. |
Management believes, as of December 31, 2011, that Cullen/Frost and Frost Bank would meet all capital adequacy requirements under the Basel III capital framework on a fully phased-in basis if such requirements were currently effective.
The Basel III final framework provides for a number of deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1. Under current capital standards, the effects of accumulated other comprehensive income items included in capital are excluded for the purposes of determining regulatory capital ratios. Under the Basel III capital framework, the effects of accumulated other comprehensive items are not excluded, which could result in significant variations in level of capital depending upon the impact of interest rate fluctuations on the fair value of the Corporation’s securities portfolio.
Implementation of the deductions and other adjustments to CET1 will begin on January 1, 2014 and will be phased-in over a five-year period (20% per year). The implementation of the capital conservation buffer will begin on January 1, 2016 at the 0.625% level and be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019).
The timing for the federal banking agencies’ publication of proposed rules to implement the Basel III capital framework and the implementation schedule is uncertain, but the federal banking agencies have indicated
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informally that rules implementing the Basel III capital framework will be published for comment during the first half of 2012. The rules ultimately adopted and made applicable to the Corporation may be different from the Basel III final framework as published in December 2010. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets could adversely impact the Corporation’s net income and return on equity.
The Proposed SIFI Rules discussed above would require bank holding companies, such as the Corporation, with $10 billion or more but less than $50 billion in assets to perform internal annual stress tests to assess the potential impact on earnings and capital, taking into account the current condition of the company and its risks, exposures, business strategies and activities.
Liquidity Requirements
Historically, regulation and monitoring of bank and bank holding company liquidity has been addressed as a supervisory matter, without required formulaic measures. The Basel III liquidity framework requires banks and bank holding companies to measure their liquidity against specific liquidity tests that, although similar in some respects to liquidity measures historically applied by banks and regulators for management and supervisory purposes, going forward would be required by regulation. One test, referred to as the liquidity coverage ratio (“LCR”), is designed to ensure that the banking entity maintains an adequate level of unencumbered high-quality liquid assets equal to the entity’s expected net cash outflow for a 30-day time horizon (or, if greater, 25% of its expected total cash outflow) under an acute liquidity stress scenario. The other test, referred to as the net stable funding ratio (“NSFR”), is designed to promote more medium- and long-term funding of the assets and activities of banking entities over a one-year time horizon. These requirements will incent banking entities to increase their holdings of U.S. Treasury securities and other sovereign debt as a component of assets and increase the use of long-term debt as a funding source. The Basel III liquidity framework contemplates that the LCR will be subject to an observation period continuing through mid-2013 and, subject to any revisions resulting from the analyses conducted and data collected during the observation period, implemented as a minimum standard on January 1, 2015. Similarly, it contemplates that the NSFR will be subject to an observation period through mid-2016 and, subject to any revisions resulting from the analyses conducted and data collected during the observation period, implemented as a minimum standard by January 1, 2018. These new standards are subject to further rulemaking and their terms may well change before implementation.
Prompt Corrective Action
The Federal Deposit Insurance Act, as amended (“FDIA”), requires among other things, the federal banking agencies to take “prompt corrective action” in respect of depository institutions that do not meet minimum capital requirements. The FDIA includes the following five capital tiers: “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.” A depository institution’s capital tier will depend upon how its capital levels compare with various relevant capital measures and certain other factors, as established by regulation. The relevant capital measures are the total capital ratio, the Tier 1 capital ratio and the leverage ratio.
A bank will be (i) “well capitalized” if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure; (ii) “adequately capitalized” if the institution has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater and is not “well capitalized”; (iii) “undercapitalized” if the institution has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0% or a leverage ratio of less than 4.0%; (iv) “significantly undercapitalized” if the institution has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0% or a leverage ratio of less than 3.0%; and (v) “critically undercapitalized” if the institution’s tangible equity is equal to or less than 2.0% of average quarterly tangible assets. An institution may be downgraded to, or deemed to be in, a capital category that is lower than indicated by its capital ratios if it is
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determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. A bank’s capital category is determined solely for the purpose of applying prompt corrective action regulations, and the capital category may not constitute an accurate representation of the bank’s overall financial condition or prospects for other purposes.
The FDIA generally prohibits a depository institution from making any capital distributions (including payment of a dividend) or paying any management fee to its parent holding company if the depository institution would thereafter be “undercapitalized.” “Undercapitalized” institutions are subject to growth limitations and are required to submit a capital restoration plan. The agencies may not accept such a plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution’s capital. In addition, for a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The bank holding company must also provide appropriate assurances of performance. The aggregate liability of the parent holding company is limited to the lesser of (i) an amount equal to 5.0% of the depository institution’s total assets at the time it became undercapitalized and (ii) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it is “significantly undercapitalized.”
“Significantly undercapitalized” depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become “adequately capitalized,” requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. “Critically undercapitalized” institutions are subject to the appointment of a receiver or conservator.
The appropriate federal banking agency may, under certain circumstances, reclassify a well capitalized insured depository institution as adequately capitalized. The FDIA provides that an institution may be reclassified if the appropriate federal banking agency determines (after notice and opportunity for hearing) that the institution is in an unsafe or unsound condition or deems the institution to be engaging in an unsafe or unsound practice.
The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than the capital levels of the institution.
Cullen/Frost believes that, as of December 31, 2011, its bank subsidiary, Frost Bank, was “well capitalized” based on the aforementioned ratios. For further information regarding the capital ratios and leverage ratio of Cullen/Frost and Frost Bank see the discussion under the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 10 -Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, elsewhere in this report.
Deposit Insurance
Substantially all of the deposits of Frost Bank are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. On April 1, 2011, the deposit insurance assessment base changed from total domestic deposits to average total assets minus average tangible equity, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Act. Additionally, the deposit insurance assessment system was revised to create a two scorecard system, one for most large institutions, including Frost Bank, that have more than $10 billion in assets and another for “highly complex” institutions that have over $50 billion in assets and are fully owned by a parent with over $500 billion in assets. Each scorecard has a performance score and a loss-severity score that is combined to produce a total score, which is then translated into an initial assessment rate. In calculating these scores, the FDIC utilizes a bank’s capital
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level and supervisory ratings (it’s “CAMELS ratings”), certain financial measures to assess an institution’s ability to withstand asset-related stress and funding-related stress. The use of risk categories and long-term debt issuer ratings was eliminated. The FDIC has the ability to make discretionary adjustments to the total score, up or down, by a maximum of 15 points, based upon significant risk factors that are not adequately captured in the scorecard. The total score is constrained to be between 30 and 90 and translates to an initial base assessment rate on a non-linear, sharply-increasing scale.
For large institutions, including Frost Bank, the initial base assessment rate ranges from 5 to 35 basis points on an annualized basis (basis points representing cents per $100). After the effect of potential base-rate adjustments, the total base assessment rate could range from 2.5 to 45 basis points on an annualized basis. The potential adjustments to an institution’s initial base assessment rate include (i) a potential decrease of up to 5 basis points for certain long-term unsecured debt (“unsecured debt adjustment”) and (ii) (except for well-capitalized institutions with a CAMELS rating of 1 or 2) a potential increase of up to 10 basis points for brokered deposits in excess of 10% of domestic deposits (“brokered deposit adjustment”). As the DIF reserve ratio grows, the rate schedule will be adjusted downward. Additionally, the rule includes a new adjustment for depository institution debt whereby an institution will pay an additional premium equal to 50 basis points on every dollar (above 3% of an institution’s Tier 1 capital) of long-term, unsecured debt held that was issued by another insured depository institution (excluding debt guaranteed under the TLGP).
In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. As of December 31, 2011, $32.2 million in pre-paid deposit insurance is included in accrued interest receivable and other assets in the accompanying consolidated balance sheet.
In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.
In November 2010, the FDIC issued a final rule to implement provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for non-interest-bearing transaction accounts. The separate coverage for non-interest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012.
FDIC insurance expense totaled $12.7 million, $20.5 million and $25.8 million in 2011, 2010 and 2009, respectively. FDIC insurance expense includes deposit insurance assessments and Financing Corporation (“FICO”) assessments related to outstanding FICO bonds. The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.
Under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC.
Safety and Soundness Standards
The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits, and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate
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exposure, asset growth and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of the FDIA. See “Prompt Corrective Action” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Consumer Financial Protection Bureau Supervision
In July 2011, Frost Bank was notified that it will be supervised by the CFPB for certain consumer protection purposes. The CFPB will focus on:
| ¨ | Risks to consumers and compliance with the federal consumer financial laws, when it evaluates the policies and practices of a financial institution. |
| ¨ | The markets in which firms operate and risks to consumers posed by activities in those markets. |
| ¨ | Depository institutions that offer a wide variety of consumer financial products and services; depository institutions with a more specialized focus. |
| ¨ | Non-depository companies that offer one or more consumer financial products or services. |
Depositor Preference
The FDIA provides that, in the event of the “liquidation or other resolution” of an insured depository institution, the claims of depositors of the institution, including the claims of the FDIC as subrogee of insured depositors, and certain claims for administrative expenses of the FDIC as a receiver, will have priority over other general unsecured claims against the institution. If an insured depository institution fails, insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, non-deposit creditors, including depositors whose deposits are payable only outside of the United States and the parent bank holding company, with respect to any extensions of credit they have made to such insured depository institution.
Liability of Commonly Controlled Institutions
FDIC-insured depository institutions can be held liable for any loss incurred, or reasonably expected to be incurred, by the FDIC due to the default of another FDIC-insured depository institution controlled by the same bank holding company, or for any assistance provided by the FDIC to another FDIC-insured depository institution controlled by the same bank holding company that is in danger of default. “Default” means generally the appointment of a conservator or receiver. “In danger of default” means generally the existence of certain conditions indicating that default is likely to occur in the absence of regulatory assistance. Such a “cross-guarantee” claim against a depository institution is generally superior in right of payment to claims of the holding company and its affiliates against that depository institution. At this time, Frost Bank is the only insured depository institution controlled by Cullen/Frost for this purpose. However, if Cullen/Frost were to control other FDIC-insured depository institutions in the future, the cross-guarantee would apply to all such FDIC-insured depository institutions.
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Community Reinvestment Act
The Community Reinvestment Act of 1977 (“CRA”) requires depository institutions to assist in meeting the credit needs of their market areas consistent with safe and sound banking practice. Under the CRA, each depository institution is required to help meet the credit needs of its market areas by, among other things, providing credit to low- and moderate-income individuals and communities. Depository institutions are periodically examined for compliance with the CRA and are assigned ratings. In order for a financial holding company to commence any new activity permitted by the BHC Act, or to acquire any company engaged in any new activity permitted by the BHC Act, each insured depository institution subsidiary of the financial holding company must have received a rating of at least “satisfactory” in its most recent examination under the CRA. Furthermore, banking regulators take into account CRA ratings when considering approval of a proposed transaction. Frost Bank received a rating of “satisfactory” in its most recent CRA examination.
Financial Privacy
The federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. These regulations affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Anti-Money Laundering and the USA Patriot Act
A major focus of governmental policy on financial institutions in recent years has been aimed at combating money laundering and terrorist financing. The USA PATRIOT Act of 2001 (the “USA Patriot Act”) substantially broadened the scope of United States anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The United States Treasury Department has issued and, in some cases, proposed a number of regulations that apply various requirements of the USA Patriot Act to financial institutions such as Cullen/Frost’s bank and broker-dealer subsidiaries. These regulations impose obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing and to verify the identity of their customers. Certain of those regulations impose specific due diligence requirements on financial institutions that maintain correspondent or private banking relationships with non-U.S. financial institutions or persons. Failure of a financial institution to maintain and implement adequate programs to combat money laundering and terrorist financing, or to comply with all of the relevant laws or regulations, could have serious legal and reputational consequences for the institution.
Office of Foreign Assets Control Regulation
The United States has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These are typically known as the “OFAC” rules based on their administration by the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”). The OFAC-administered sanctions targeting countries take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial transactions relating to making investments in, or providing investment-related advice or assistance to, a sanctioned country; and (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons). Blocked assets (e.g., property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences.
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Incentive Compensation
The Dodd-Frank Act requires the federal bank regulatory agencies and the SEC to establish joint regulations or guidelines prohibiting incentive-based payment arrangements at specified regulated entities, such as the Corporation and Frost Bank, having at least $1 billion in total assets that encourage inappropriate risks by providing an executive officer, employee, director or principal shareholder with excessive compensation, fees, or benefits or that could lead to material financial loss to the entity. In addition, these regulators must establish regulations or guidelines requiring enhanced disclosure to regulators of incentive-based compensation arrangements. The agencies proposed such regulations in April 2011, which may become effective before the end of 2012. If the regulations are adopted in the form initially proposed, they will impose limitations on the manner in which the Corporation may structure compensation for its executives.
In June 2010, the Federal Reserve Board, OCC and FDIC issued a comprehensive final guidance on incentive compensation policies intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The guidance, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. These three principles are incorporated into the proposed joint compensation regulations under the Dodd-Frank Act, discussed above.
The Federal Reserve Board will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as the Corporation, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.
Legislative and Regulatory Initiatives
From time to time, various legislative and regulatory initiatives are introduced in Congress and state legislatures, as well as by regulatory agencies. Such initiatives may include proposals to expand or contract the powers of bank holding companies and depository institutions or proposals to substantially change the financial institution regulatory system. Such legislation could change banking statutes and the operating environment of the Corporation in substantial and unpredictable ways. If enacted, such legislation could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions, and other financial institutions. The Corporation cannot predict whether any such legislation will be enacted, and, if enacted, the effect that it, or any implementing regulations, would have on the financial condition or results of operations of the Corporation. A change in statutes, regulations or regulatory policies applicable to Cullen/Frost or any of its subsidiaries could have a material effect on the business of the Corporation.
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Employees
At December 31, 2011, the Corporation employed 3,848 full-time equivalent employees. None of the Corporation’s employees are represented by collective bargaining agreements. The Corporation believes its employee relations to be good.
Executive Officers of the Registrant
The names, ages as of December 31, 2011, recent business experience and positions or offices held by each of the executive officers of Cullen/Frost are as follows:
| Name and Position Held | Age | Recent Business Experience | ||||
| Richard W. Evans, Jr. |
65 | Officer of Frost Bank since 1973. Chairman of the Board and Chief Executive Officer of Cullen/Frost from October 1997 to present. | ||||
| Patrick B. Frost |
51 | Officer of Frost Bank since 1985. President of Frost Bank from August 1993 to present. Director of Cullen/Frost from May 1997 to present. | ||||
| Phillip D. Green |
57 | Officer of Frost Bank since July 1980. Group Executive Vice President, Chief Financial Officer of Cullen/Frost from October 1995 to present. | ||||
| David W. Beck |
61 | Officer of Frost Bank since July 1973. President, Chief Business Banking Officer of Frost Bank from February 2001 to present. | ||||
| Robert A. Berman |
49 | Officer of Frost Bank since January 1989. Group Executive Vice President, Internet Financial Services of Frost Bank from May 2001 to present. | ||||
| Paul H. Bracher |
55 | Officer of Frost Bank since January 1982. President, State Regions of Frost Bank from February 2001 to present. | ||||
| Richard Kardys |
65 | Officer of Frost Bank since January 1977. Group Executive Vice President, Executive Trust Officer of Frost Bank from May 2001 to present. | ||||
| Paul J. Olivier |
59 | Officer of Frost Bank since August 1976. Group Executive Vice President, Consumer Banking of Frost Bank from May 2001 to present. | ||||
| William L. Perotti |
54 | Officer of Frost Bank since December 1982. Group Executive Vice President, Chief Credit Officer of Frost Bank from May 2001 to present. Chief Risk Officer of Frost Bank from April 2005 to present. | ||||
| Emily A. Skillman |
67 | Officer of Frost Bank since January 1998. Group Executive Vice President, Human Resources of Frost Bank from October 2003 to present. | ||||
There are no arrangements or understandings between any executive officer of Cullen/Frost and any other person pursuant to which such executive officer was or is to be selected as an officer.
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Available Information
Under the Securities Exchange Act of 1934, Cullen/Frost is required to file annual, quarterly and current reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). You may read and copy any document Cullen/Frost files with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. The SEC maintains a website at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. Cullen/Frost files electronically with the SEC.
Cullen/Frost makes available, free of charge through its website, its reports on Forms 10-K, 10-Q and 8-K, and amendments to those reports, as soon as reasonably practicable after such reports are filed with or furnished to the SEC. Additionally, the Corporation has adopted and posted on its website a code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer. The Corporation’s website also includes its corporate governance guidelines and the charters for its audit committee, its compensation and benefits committee, and its corporate governance and nominating committee. The address for the Corporation’s website is http://www.frostbank.com. The Corporation will provide a printed copy of any of the aforementioned documents to any requesting shareholder.
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| ITEM 1A. | RISK FACTORS |
An investment in the Corporation’s common stock is subject to risks inherent to the Corporation’s business. The material risks and uncertainties that management believes affect the Corporation are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Corporation. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Corporation’s business operations. This report is qualified in its entirety by these risk factors.
If any of the following risks actually occur, the Corporation’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the market price of the Corporation’s common stock could decline significantly, and you could lose all or part of your investment.
Risks Related To The Corporation’s Business
The Corporation’s Business May Be Adversely Affected By Conditions In The Financial Markets and Economic Conditions Generally
From December 2007 through June 2009, the U.S. economy was in recession. Business activity across a wide range of industries and regions in the U. S. was greatly reduced. Although economic conditions have improved, certain sectors, such as real estate and manufacturing, remain weak and unemployment remains high. Local governments and many businesses are still in serious difficulty due to lower consumer spending and decreased liquidity in the credit markets.
Market conditions also led to the failure or merger of several prominent financial institutions and numerous regional and community-based financial institutions. These failures, as well as projected future failures, have had a significant negative impact on the capitalization level of the deposit insurance fund of the FDIC, which, in turn, has led to a significant increase in deposit insurance premiums paid by financial institutions.
The Corporation’s financial performance generally, and in particular the ability of borrowers to pay interest on and repay principal of outstanding loans and the value of collateral securing those loans, as well as demand for loans and other products and services the Corporation offers, is highly dependent upon on the business environment in the markets where the Corporation operates, in the State of Texas and in the United States as a whole. A favorable business environment is generally characterized by, among other factors, economic growth, efficient capital markets, low inflation, low unemployment, high business and investor confidence, and strong business earnings. Unfavorable or uncertain economic and market conditions can be caused by declines in economic growth, business activity or investor or business confidence; limitations on the availability or increases in the cost of credit and capital; increases in inflation or interest rates; high unemployment, natural disasters; or a combination of these or other factors.
Concerns about the European Union’s sovereign debt crisis have also caused uncertainty for financial markets globally. Such risks could indirectly affect the Corporation by affecting its hedging or other counterparties, as well as the Corporation’s customers with European businesses or assets denominated in the euro or companies in the Corporation’s market with European businesses or affiliates.
Overall, during 2011, the business environment has been adverse for many households and businesses in the United States and worldwide. While economic conditions in the State of Texas, the United States and worldwide have improved since the recession, there can be no assurance that this improvement will continue. Such conditions could adversely affect the credit quality of the Corporation’s loans, results of operations and financial condition.
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The Corporation Is Subject To Lending Risk
There are inherent risks associated with the Corporation’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Corporation operates as well as those across the State of Texas and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Corporation is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Corporation to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Corporation.
As of December 31, 2011, approximately 87% of the Corporation’s loan portfolio consisted of commercial and industrial, construction and commercial real estate mortgage loans. These types of loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because the Corporation’s loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Loans” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial and industrial, construction and commercial real estate loans.
The Corporation Is Subject To Interest Rate Risk
The Corporation’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Corporation’s control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Open Market Committee. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Corporation receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Corporation’s ability to originate loans and obtain deposits, (ii) the fair value of the Corporation’s financial assets and liabilities, and (iii) the average duration of the Corporation’s mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Corporation’s net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies, including the use of derivatives as hedging instruments, to reduce the potential effects of changes in interest rates on the Corporation’s results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Net Interest Income” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s management of interest rate risk.
The Corporation’s Allowance For Loan Losses May Be Insufficient
The Corporation maintains an allowance for loan losses, which is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to
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reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires the Corporation to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Continuing deterioration in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Corporation’s control, may require an increase in the allowance for loan losses. In addition, bank regulatory agencies periodically review the Corporation’s allowance for loan losses and may require an increase in the provision for loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. Furthermore, if charge-offs in future periods exceed the allowance for loan losses, the Corporation will need additional provisions to increase the allowance for loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and, possibly, capital, and may have a material adverse effect on the Corporation’s financial condition and results of operations. See the section captioned “Allowance for Loan Losses” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Corporation’s process for determining the appropriate level of the allowance for loan losses.
The Corporation’s Profitability Depends Significantly On Economic Conditions In The State Of Texas
The Corporation’s success depends primarily on the general economic conditions of the State of Texas and the specific local markets in which the Corporation operates. Unlike larger national or other regional banks that are more geographically diversified, the Corporation provides banking and financial services to customers across Texas through financial centers in the Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio regions. The local economic conditions in these areas have a significant impact on the demand for the Corporation’s products and services as well as the ability of the Corporation’s customers to repay loans, the value of the collateral securing loans and the stability of the Corporation’s deposit funding sources. Moreover, approximately 97% of securities in the Corporation’s municipal bond portfolio were issued by political subdivisions or agencies within the State of Texas. A significant decline in general economic conditions in Texas, whether caused by recession, inflation, unemployment, changes in securities markets, acts of terrorism, outbreak of hostilities or other international or domestic occurrences or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation May Be Adversely Affected By The Soundness Of Other Financial Institutions
Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships. The Corporation has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including commercial banks, brokers and dealers, investment banks, and other institutional clients. Many of these transactions expose the Corporation to credit risk in the event of a default by a counterparty or client. In addition, the Corporation’s credit risk may be exacerbated when the collateral held by the Corporation cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the credit or derivative exposure due to the Corporation. Any such losses could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Operates In A Highly Competitive Industry and Market Area
The Corporation faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets where the Corporation operates. The Corporation also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies
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and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Also, technology and other changes have lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. For example, consumers can maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. Further, many of the Corporation’s competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Corporation can.
The Corporation’s ability to compete successfully depends on a number of factors, including, among other things:
| ¨ | The ability to develop, maintain and build long-term customer relationships based on top quality service, high ethical standards and safe, sound assets. |
| ¨ | The ability to expand the Corporation’s market position. |
| ¨ | The scope, relevance and pricing of products and services offered to meet customer needs and demands. |
| ¨ | The rate at which the Corporation introduces new products and services relative to its competitors. |
| ¨ | Customer satisfaction with the Corporation’s level of service. |
| ¨ | Industry and general economic trends. |
Failure to perform in any of these areas could significantly weaken the Corporation’s competitive position, which could adversely affect the Corporation’s growth and profitability, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Extensive Government Regulation and Supervision
The Corporation, primarily through Cullen/Frost, Frost Bank and certain non-bank subsidiaries, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not security holders. These regulations affect the Corporation’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. The Dodd-Frank Act, enacted in July 2010, instituted major changes to the banking and financial institutions regulatory regimes in light of the recent performance of and government intervention in the financial services sector. Other changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Corporation in substantial and unpredictable ways. Such changes could subject the Corporation to additional costs, limit the types of financial services and products the Corporation may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations. See the sections captioned “Supervision and Regulation” included in Item 1. Business and Note 10 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
The Recent Repeal of Federal Prohibitions on Payment of Interest on Demand Deposits Could Increase the Corporation’s Interest Expense.
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act beginning on July 21, 2011. As a result, some financial institutions have commenced offering interest on demand deposits to compete for customers. The Corporation does not yet know
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what interest rates other institutions may offer as market interest rates begin to increase. The Corporation’s interest expense will increase and its net interest margin will decrease if it begins offering interest on demand deposits to attract additional customers or maintain current customers, which could have a material adverse effect on the Corporation’s business, financial condition and results of operations.
The Corporation May Need to Raise Additional Capital in the Future, and Such Capital May Not Be Available When Needed or at All
The Corporation may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs, particularly if its asset quality or earnings were to deteriorate significantly. The Corporation’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial performance. Economic conditions and the loss of confidence in financial institutions may increase the Corporation’s cost of funding and limit access to certain customary sources of capital, including inter-bank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve Board.
The Corporation cannot assure that such capital will be available on acceptable terms or at all. Any occurrence that may limit the Corporation’s access to the capital markets, such as a decline in the confidence of debt purchasers, depositors of Frost Bank or counterparties participating in the capital markets, or a downgrade of Cullen/Frost’s or Frost Bank’s debt ratings, may adversely affect the Corporation’s capital costs and its ability to raise capital and, in turn, its liquidity. Moreover, if the Corporation needs to raise capital in the future, it may have to do so when many other financial institutions are also seeking to raise capital and would have to compete with those institutions for investors. An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on the Corporation’s businesses, financial condition and results of operations.
The Value of the Corporation’s Goodwill and Other Intangible Assets May Decline in the Future.
As of December 31, 2011, the Corporation had $538.7 million of goodwill and other intangible assets. A significant decline in the Corporation’s expected future cash flows, a significant adverse change in the business climate, slower growth rates or a significant and sustained decline in the price of Cullen/Frost’s common stock may necessitate taking charges in the future related to the impairment of the Corporation’s goodwill and other intangible assets. If the Corporation were to conclude that a future write-down of goodwill and other intangible assets is necessary, the Corporation would record the appropriate charge, which could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation’s Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates the Corporation’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Corporation’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
New Lines of Business or New Products and Services May Subject The Corporation to Additional Risks
From time to time, the Corporation may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Corporation may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may
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not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Corporation’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Corporation’s business, results of operations and financial condition.
Cullen/Frost Relies On Dividends From Its Subsidiaries For Most Of Its Revenue
Cullen/Frost is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from its subsidiaries. These dividends are the principal source of funds to pay dividends on Cullen/Frost’s common stock and interest and principal on Cullen/Frost’s debt. Various federal and/or state laws and regulations limit the amount of dividends that Frost Bank and certain non-bank subsidiaries may pay to Cullen/Frost. Also, Cullen/Frost’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event Frost Bank is unable to pay dividends to Cullen/Frost, Cullen/Frost may not be able to service debt, pay obligations or pay dividends on the Corporation’s common stock. The inability to receive dividends from Frost Bank could have a material adverse effect on the Corporation’s business, financial condition and results of operations. See the section captioned “Supervision and Regulation” in Item 1. Business and Note 10—Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
Potential Acquisitions May Disrupt the Corporation’s Business and Dilute Stockholder Value
The Corporation generally seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale or expanded services. Acquiring other banks, businesses, or branches involves various risks commonly associated with acquisitions, including, among other things:
| ¨ | Potential exposure to unknown or contingent liabilities of the target company. |
| ¨ | Exposure to potential asset quality issues of the target company. |
| ¨ | Potential disruption to the Corporation’s business. |
| ¨ | Potential diversion of the Corporation’s management’s time and attention. |
| ¨ | The possible loss of key employees and customers of the target company. |
| ¨ | Difficulty in estimating the value of the target company. |
| ¨ | Potential changes in banking or tax laws or regulations that may affect the target company. |
The Corporation regularly evaluates merger and acquisition opportunities and conducts due diligence activities related to possible transactions with other financial institutions and financial services companies. As a result, merger or acquisition discussions and, in some cases, negotiations may take place and future mergers or acquisitions involving cash, debt or equity securities may occur at any time. Acquisitions typically involve the payment of a premium over book and market values, and, therefore, some dilution of the Corporation’s tangible book value and net income per common share may occur in connection with any future transaction. Furthermore, failure to realize the expected revenue increases, cost savings, increases in geographic or product presence, and/or other projected benefits from an acquisition could have a material adverse effect on the Corporation’s financial condition and results of operations.
During 2011, the Corporation announced the planned acquisition of Stone Partners, Inc. a Houston-based human resources consulting firm that specializes in compensation, benefits and outsourcing services. The acquisition became effective in January 2012. The Corporation acquired an insurance agency in the San Antonio
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market area during 2011 while the Corporation did not make any acquisitions during 2010 and acquired insurance agencies in both the Dallas and San Marcos market areas during 2009. None of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
The Corporation Is Subject To Liquidity Risk.
The Corporation requires liquidity to meet its deposit and debt obligations as they come due. The Corporation’s access to funding sources in amounts adequate to finance its activities or on terms that are acceptable to it could be impaired by factors that affect it specifically or the financial services industry or economy generally. Factors that could reduce its access to liquidity sources include a downturn in the Texas market, difficult credit markets or adverse regulatory actions against the Corporation. The Corporation’s access to deposits may also be affected by the liquidity needs of its depositors. In particular, a substantial majority of the Corporation’s liabilities are demand, savings, interest checking and money market deposits, which are payable on demand or upon several days’ notice, while by comparison, a substantial portion of its assets are loans, which cannot be called or sold in the same time frame. Although the Corporation historically has been able to replace maturing deposits and advances as necessary, it might not be able to replace such funds in the future, especially if a large number of its depositors sought to withdraw their accounts, regardless of the reason. A failure to maintain adequate liquidity could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation May Not Be Able To Attract and Retain Skilled People
The Corporation’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Corporation can be intense and the Corporation may not be able to hire people or to retain them. The Corporation does not currently have employment agreements or non-competition agreements with any of its senior officers. The unexpected loss of services of key personnel of the Corporation could have a material adverse impact on the Corporation’s business because of their skills, knowledge of the Corporation’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
The Corporation’s Information Systems May Experience An Interruption Or Breach In Security
The Corporation relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Corporation’s customer relationship management, general ledger, deposit, loan and other systems. While the Corporation has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Corporation’s information systems could damage the Corporation’s reputation, result in a loss of customer business, subject the Corporation to additional regulatory scrutiny, or expose the Corporation to civil litigation and possible financial liability, any of which could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Corporation’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Corporation’s operations. Many of the Corporation’s competitors have substantially greater resources to invest in technological improvements. The Corporation may not be able to effectively implement new
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technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Claims and Litigation Pertaining To Fiduciary Responsibility
From time to time, customers make claims and take legal action pertaining to the Corporation’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Corporation’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Corporation they may result in significant financial liability and/or adversely affect the market perception of the Corporation and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
The Corporation’s Operations Rely On Certain External Vendors
The Corporation is reliant upon certain external vendors to provide products and services necessary to maintain day-to-day operations of the Corporation. Accordingly, the Corporation’s operations are exposed to risk that these vendors will not perform in accordance with the contracted arrangements under service level agreements. The Corporation maintains a system of comprehensive policies and a control framework designed to monitor vendor risks including, among other things, (i) changes in the vendor’s organizational structure, (ii) changes in the vendor’s financial condition, (iii) changes in the vendor’s support for existing products and services and (iv) changes in the vendor’s strategic focus. While the Corporation believes these policies and procedures help to mitigate risk, the failure of an external vendor to perform in accordance with the contracted arrangements under service level agreements could be disruptive to the Corporation’s operations, which could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
The Corporation Is Subject To Environmental Liability Risk Associated With Lending Activities
A significant portion of the Corporation’s loan portfolio is secured by real property. During the ordinary course of business, the Corporation may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Corporation may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Corporation to incur substantial expenses and may materially reduce the affected property’s value or limit the Corporation’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Corporation’s exposure to environmental liability. Although the Corporation has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Corporation’s financial condition and results of operations.
Severe Weather, Natural Disasters, Acts Of War Or Terrorism and Other External Events Could Significantly Impact The Corporation’s Business
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Corporation’s ability to conduct business. In addition, such events could affect the stability of the Corporation’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the
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Corporation to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event in the future could have a material adverse effect on the Corporation’s business, which, in turn, could have a material adverse effect on the Corporation’s financial condition and results of operations.
Financial Services Companies Depend On The Accuracy and Completeness Of Information About Customers And Counterparties
In deciding whether to extend credit or enter into other transactions, the Corporation may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Corporation may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Corporation’s business and, in turn, the Corporation’s financial condition and results of operations.
Risks Associated With The Corporation’s Common Stock
The Corporation’s Stock Price Can Be Volatile
Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Corporation’s stock price can fluctuate significantly in response to a variety of factors including, among other things:
| ¨ | Actual or anticipated variations in quarterly results of operations. |
| ¨ | Recommendations by securities analysts. |
| ¨ | Operating and stock price performance of other companies that investors deem comparable to the Corporation. |
| ¨ | News reports relating to trends, concerns and other issues in the financial services industry. |
| ¨ | Perceptions in the marketplace regarding the Corporation and/or its competitors. |
| ¨ | New technology used, or services offered, by competitors. |
| ¨ | Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Corporation or its competitors. |
| ¨ | Failure to integrate acquisitions or realize anticipated benefits from acquisitions. |
| ¨ | Changes in government regulations. |
| ¨ | Geopolitical conditions such as acts or threats of terrorism or military conflicts. |
General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Corporation’s stock price to decrease regardless of operating results.
The Trading Volume In The Corporation’s Common Stock Is Less Than That Of Other Larger Financial Services Companies
Although the Corporation’s common stock is listed for trading on the New York Stock Exchange (NYSE), the trading volume in its common stock is less than that of other, larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Corporation’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Corporation has no control. Given the lower trading volume of the Corporation’s common stock, significant sales of the Corporation’s common stock, or the expectation of these sales, could cause the Corporation’s stock price to fall.
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Cullen/Frost May Not Continue To Pay Dividends On Its Common Stock In The Future
Holders of Cullen/Frost common stock are only entitled to receive such dividends as its board of directors may declare out of funds legally available for such payments. Although Cullen/Frost has historically declared cash dividends on its common stock, it is not required to do so and may reduce or eliminate its common stock dividend in the future. This could adversely affect the market price of Cullen/Frost’s common stock. Also, Cullen/Frost is a bank holding company, and its ability to declare and pay dividends is dependent on certain federal regulatory considerations, including the guidelines of the Federal Reserve Board regarding capital adequacy and dividends.
An Investment In The Corporation’s Common Stock Is Not An Insured Deposit
The Corporation’s common stock is not a bank deposit and, therefore, is not insured against loss by the Federal Deposit Insurance Corporation (FDIC), any other deposit insurance fund or by any other public or private entity. Investment in the Corporation’s common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the same market forces that affect the price of common stock in any company. As a result, if you acquire the Corporation’s common stock, you could lose some or all of your investment.
Certain Banking Laws May Have An Anti-Takeover Effect
Provisions of federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire the Corporation, even if doing so would be perceived to be beneficial to the Corporation’s shareholders. These provisions effectively inhibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Corporation’s common stock.
| ITEM 1B. | UNRESOLVED STAFF COMMENTS |
None
| ITEM 2. | PROPERTIES |
The Corporation’s headquarters are located in downtown San Antonio, Texas. These facilities, which are owned by the Corporation, house the Corporation’s executive and primary administrative offices, as well as the principal banking headquarters of Frost Bank. The Corporation also owns or leases other facilities within its primary market areas in the regions of Austin, Corpus Christi, Dallas, Fort Worth, Houston, Rio Grande Valley and San Antonio. The Corporation considers its properties to be suitable and adequate for its present needs.
| ITEM 3. | LEGAL PROCEEDINGS |
The Corporation is subject to various claims and legal actions that have arisen in the normal course of conducting business. Management does not expect the ultimate disposition of these matters to have a material adverse impact on the Corporation’s financial statements.
| ITEM 4. | MINE SAFETY DISCLOSURES |
None
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PART II
| ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
Common Stock Market Prices and Dividends
The Corporation’s common stock is traded on the New York Stock Exchange, Inc. (“NYSE”) under the symbol “CFR”. The tables below set forth for each quarter of 2011 and 2010 the high and low intra-day sales prices per share of Cullen/Frost’s common stock and the cash dividends declared per share.
| 2011 |
2010 |
|||||||||||||||
| Sales Price Per Share | High | Low | High | Low | ||||||||||||
| First quarter |
$ | 62.59 | $ | 56.75 | $ | 57.14 | $ | 49.55 | ||||||||
| Second quarter |
60.58 | 54.46 | 60.78 | 51.39 | ||||||||||||
| Third quarter |
57.67 | 44.04 | 56.65 | 50.04 | ||||||||||||
| Fourth quarter |
53.51 | 43.57 | 62.13 | 51.20 | ||||||||||||
| Cash Dividends Per Share | 2011 | 2010 | ||||||
| First quarter |
$ | 0.45 | $ | 0.43 | ||||
| Second quarter |
0.46 | 0.45 | ||||||
| Third quarter |
0.46 | 0.45 | ||||||
| Fourth quarter |
0.46 | 0.45 | ||||||
| Total |
$ | 1.83 | $ | 1.78 | ||||
As of December 31, 2011, there were 61,263,963 shares of the Corporation’s common stock outstanding held by 1,479 holders of record. The closing price per share of common stock on December 30, 2011, the last trading day of the Corporation’s fiscal year, was $52.91.
The Corporation’s management is currently committed to continuing to pay regular cash dividends; however, there can be no assurance as to future dividends because they are dependent on the Corporation’s future earnings, capital requirements and financial condition. See the section captioned “Supervision and Regulation” included in Item 1. Business, the section captioned “Capital and Liquidity” included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 10 - Regulatory Matters in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, all of which are included elsewhere in this report.
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Stock-Based Compensation Plans
Information regarding stock-based compensation awards outstanding and available for future grants as of December 31, 2011, segregated between stock-based compensation plans approved by shareholders and stock-based compensation plans not approved by shareholders, is presented in the table below. Additional information regarding stock-based compensation plans is presented in Note 11 - Employee Benefit Plans in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data located elsewhere in this report.
| Plan Category | Number of Shares to be Issued Upon Exercise of Outstanding Awards |
Weighted-Average Price of |
Number of Shares Available for Future Grants |
|||||||||
| Plans approved by shareholders |
4,968,822 | $ | 51.49 | 1,963,455 | ||||||||
| Plans not approved by shareholders |
- | - | - | |||||||||
| Total |
4,968,822 | $ | 51.49 | 1,963,455 | ||||||||
Stock Repurchase Plans
From time to time, the Corporation has maintained several stock repurchase plans authorized by the Corporation’s board of directors. In general, stock repurchase plans allow the Corporation to proactively manage its capital position and return excess capital to shareholders. Shares purchased under such plans also provide the Corporation with shares of common stock necessary to satisfy obligations related to stock compensation awards.
The following table provides information with respect to purchases made by or on behalf of the Corporation or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Corporation’s common stock during the fourth quarter of 2011.
| Period | Total Number of Shares Purchased |
Average Price Paid Per Share |
Total Number of Shares Purchased as Part of Publicly Announced Plans |
Maximum Number of Shares That May Yet Be Purchased Under the Plans at the End of the Period |
||||||||||||
| October 1, 2011 to October 31, 2011 |
7,641 | (1) | $ | 48.65 | - | - | ||||||||||
| November 1, 2011 to November 30, 2011 |
- | - | - | |||||||||||||
| December 1, 2011 to December 31, 2011 |
- | - | - | |||||||||||||
| Total |
7,641 | $ | 48.65 | - | - | |||||||||||
| (1) | Represents repurchases made in connection with the vesting of certain share awards. |
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Performance Graph
The performance graph below compares the cumulative total shareholder return on Cullen/Frost Common Stock with the cumulative total return on the equity securities of companies included in the Standard & Poor’s 500 Stock Index and the Standard and Poor’s 500 Bank Index, measured at the last trading day of each year shown. The graph assumes an investment of $100 on December 31, 2006 and reinvestment of dividends on the date of payment without commissions. The performance graph represents past performance and should not be considered to be an indication of future performance.
Cumulative Total Returns
on $100 Investment Made on December 31, 2006
| 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | |||||||||||||||||||
| Cullen/Frost |
$ | 100.00 | $ | 93.50 | $ | 96.49 | $ | 98.59 | $ | 124.44 | $ | 111.48 | ||||||||||||
| S&P 500 |
100.00 | 105.48 | 66.52 | 84.07 | 96.71 | 98.76 | ||||||||||||||||||
| S&P 500 Banks |
100.00 | 81.22 | 65.18 | 61.66 | 73.91 | 65.89 | ||||||||||||||||||
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Table of Contents
| ITEM 6. | SELECTED FINANCIAL DATA |
The following consolidated selected financial data is derived from the Corporation’s audited financial statements as of and for the five years ended December 31, 2011. The following consolidated financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and related notes included elsewhere in this report. All of the Corporation’s acquisitions during the five years ended December 31, 2011 were accounted for using the purchase method. Accordingly, the operating results of the acquired companies are included with the Corporation’s results of operations since their respective dates of acquisition. Dollar amounts, except per share data, and common shares outstanding are in thousands.
| Year Ended December 31, |
||||||||||||||||||||
| 2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
| Consolidated Statements of Income |
||||||||||||||||||||
| Interest income: |
||||||||||||||||||||
| Loans, including fees |
$ | 397,855 | $ | 409,651 | $ | 432,222 | $ | 504,680 | $ | 573,039 | ||||||||||
| Securities |
218,744 | 202,713 | 188,446 | 167,044 | 165,517 | |||||||||||||||
| Interest-bearing deposits |
6,357 | 4,901 | 2,161 | 429 | 396 | |||||||||||||||
| Federal funds sold and resell agreements |
61 | 74 | 207 | 3,498 | 29,895 | |||||||||||||||
| Total interest income |
623,017 | 617,339 | 623,036 | 675,651 | 768,847 | |||||||||||||||
| Interest expense: |
||||||||||||||||||||
| Deposits |
22,179 | 29,973 | 56,015 | 104,871 | 190,237 | |||||||||||||||
| Federal funds purchased and repurchase agreements |
312 | 437 | 1,052 | 12,954 | 31,951 | |||||||||||||||
| Junior subordinated deferrable interest debentures |
6,783 | 6,982 | 7,231 | 6,972 | 11,283 | |||||||||||||||
| Subordinated notes payable and other borrowings |
11,967 | 16,488 | 22,059 | 16,829 | 16,639 | |||||||||||||||
| Total interest expense |
41,241 | 53,880 | 86,357 | 141,626 | 250,110 | |||||||||||||||
| Net interest income |
581,776 | 563,459 | 536,679 | 534,025 | 518,737 | |||||||||||||||
| Provision for loan losses | 27,445 | 43,611 | 65,392 | 37,823 | 14,660 | |||||||||||||||
| Net interest income after provision for loan losses |
554,331 | 519,848 | 471,287 | 496,202 | 504,077 | |||||||||||||||
| Non-interest income: |
||||||||||||||||||||
| Trust fees |
73,233 | 68,428 | 67,268 | 74,554 | 70,359 | |||||||||||||||
| Service charges on deposit accounts |
94,367 | 98,796 | 102,474 | 87,566 | 80,718 | |||||||||||||||
| Insurance commissions and fees |
35,421 | 34,015 | 33,096 | 32,904 | 30,847 | |||||||||||||||
| Other charges, commissions and fees |
34,005 | 30,452 | 27,699 | 35,557 | 32,558 | |||||||||||||||
| Net gain (loss) on securities transactions |
6,414 | 6 | (1,260 | ) | (159 | ) | 15 | |||||||||||||
| Other |
46,562 | 50,336 | 64,429 | 56,900 | 53,734 | |||||||||||||||
| Total non-interest income |
290,002 | 282,033 | 293,706 | 287,322 | 268,231 | |||||||||||||||
| Non-interest expense: |
||||||||||||||||||||
| Salaries and wages |
252,028 | 239,589 | 230,643 | 225,943 | 209,982 | |||||||||||||||
| Employee benefits |
52,939 | 52,352 | 55,224 | 47,219 | 47,095 | |||||||||||||||
| Net occupancy |
46,968 | 46,166 | 44,188 | 40,464 | 38,824 | |||||||||||||||
| Furniture and equipment |
51,469 | 47,651 | 44,223 | 37,799 | 32,821 | |||||||||||||||
| Deposit insurance |
12,714 | 20,451 | 25,812 | 4,597 | 1,220 | |||||||||||||||
| Intangible amortization |
4,387 | 5,125 | 6,537 | 7,906 | 8,860 | |||||||||||||||
| Other |
137,593 | 124,207 | 125,611 | 122,717 | 123,644 | |||||||||||||||
| Total non-interest expense |
558,098 | 535,541 | 532,238 | 486,645 | 462,446 | |||||||||||||||
| Income before income taxes |
286,235 | 266,340 | 232,755 | 296,879 | 309,862 | |||||||||||||||
| Income taxes |
68,700 | 57,576 | 53,721 | 89,624 | 97,791 | |||||||||||||||
| Net income |
$ | 217,535 | $ | 208,764 | $ | 179,034 | $ | 207,255 | $ | 212,071 | ||||||||||
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Selected Financial Data (continued)
| As of or for the Year Ended December 31, |
||||||||||||||||||||
| 2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
| Per Common Share Data |
||||||||||||||||||||
| Net income - basic |
$ | 3.55 | $ | 3.44 | $ | 3.00 | $ | 3.51 | $ | 3.59 | ||||||||||
| Net income - diluted |
3.54 | 3.44 | 3.00 | 3.50 | 3.57 | |||||||||||||||
| Cash dividends declared and paid |
1.83 | 1.78 | 1.71 | 1.66 | 1.54 | |||||||||||||||
| Book value |
37.27 | 33.74 | 31.55 | 29.68 | 25.18 | |||||||||||||||
| Common Shares Outstanding |
||||||||||||||||||||
| Period-end |
61,264 | 61,108 | 60,038 | 59,416 | 58,662 | |||||||||||||||
| Weighted-average shares - basic |
61,101 | 60,411 | 59,456 | 58,846 | 58,952 | |||||||||||||||
| Dilutive effect of stock compensation |
177 | 175 | 58 | 324 | 645 | |||||||||||||||
| Weighted-average shares - diluted |
61,278 | 60,586 | 59,514 | 59,170 | 59,597 | |||||||||||||||
| Performance Ratios |
||||||||||||||||||||
| Return on average assets |
1.17 | % | 1.21 | % | 1.14 | % | 1.51 | % | 1.63 | % | ||||||||||
| Return on average equity |
10.01 | 10.30 | 9.78 | 13.11 | 15.20 | |||||||||||||||
| Net interest income to average earning assets |
3.88 | 4.08 | 4.23 | 4.67 | 4.69 | |||||||||||||||
| Dividend pay-out ratio |
51.58 | 51.75 | 57.05 | 47.36 | 42.83 | |||||||||||||||
| Balance Sheet Data |
||||||||||||||||||||
| Period-end: |
||||||||||||||||||||
| Loans |
$ | 7,995,129 | $ | 8,117,020 | $ | 8,367,780 | $ | 8,844,082 | $ | 7,769,362 | ||||||||||
| Earning assets |
18,497,987 | 15,806,350 | 14,437,267 | 13,001,103 | 11,556,385 | |||||||||||||||
| Total assets |
20,317,245 | 17,617,092 | 16,288,038 | 15,034,142 | 13,485,014 | |||||||||||||||
| Non-interest-bearing demand deposits |
6,672,555 | 5,360,436 | 4,645,802 | 4,152,348 | 3,597,903 | |||||||||||||||
| Interest-bearing deposits |
10,084,193 | 9,118,906 | 8,667,508 | 7,356,589 | 6,931,770 | |||||||||||||||
| Total deposits |
16,756,748 | 14,479,342 | 13,313,310 | 11,508,937 | 10,529,673 | |||||||||||||||
| Long-term debt and other borrowings |
223,738 | 373,757 | 392,646 | 392,661 | 400,323 | |||||||||||||||
| Shareholders’ equity |
2,283,537 | 2,061,680 | 1,894,424 | 1,763,527 | 1,477,088 | |||||||||||||||
| Average: |
||||||||||||||||||||
| Loans |
$ | 8,042,968 | $ | 8,125,150 | $ | 8,652,563 | $ | 8,314,265 | $ | 7,464,140 | ||||||||||
| Earning assets |
16,769,028 | 15,333,348 | 13,803,919 | 11,868,262 | 11,339,876 | |||||||||||||||
| Total assets |
18,568,967 | 17,186,572 | 15,701,960 | 13,684,531 | 13,041,682 | |||||||||||||||
| Non-interest-bearing demand deposits |
5,738,982 | 5,023,780 | 4,258,484 | 3,614,747 | 3,524,132 | |||||||||||||||
| Interest-bearing deposits |
9,483,633 | 9,023,839 | 8,161,143 | 6,916,372 | 6,688,509 | |||||||||||||||
| Total deposits |
15,222,615 | 14,047,619 | 12,419,627 | 10,531,119 | 10,212,641 | |||||||||||||||
| Long-term debt and other borrowings |
310,870 | 382,651 | 576,161 | 394,763 | 413,700 | |||||||||||||||
| Shareholders’ equity |
2,172,096 | 2,027,699 | 1,831,133 | 1,580,311 | 1,395,022 | |||||||||||||||
| Asset Quality |
||||||||||||||||||||
| Allowance for loan losses |
$ | 110,147 | $ | 126,316 | $ | 125,309 | $ | 110,244 | $ | 92,339 | ||||||||||
| Allowance for losses to period-end loans |
1.38 | % | 1.56 | % | 1.50 | % | 1.25 | % | 1.19 | % | ||||||||||
| Net loan charge-offs |
$ | 43,614 | $ | 42,604 | $ | 50,327 | $ | 19,918 | $ | 18,406 | ||||||||||
| Net loan charge-offs to average loans |
0.54 | % | 0.52 | % | 0.58 | % | 0.24 | % | 0.25 | % | ||||||||||
| Non-performing assets |
$ | 120,946 | $ | 164,950 | $ | 180,179 | $ | 78,040 | $ | 29,849 | ||||||||||
| Non-performing assets to: |
||||||||||||||||||||
| Total loans plus foreclosed assets |
1.51 | % | 2.03 | % | 2.14 | % | 0.88 | % | 0.38 | % | ||||||||||
| Total assets |
0.60 | 0.94 | 1.11 | 0.52 | 0.22 | |||||||||||||||
| Consolidated Capital Ratios |
||||||||||||||||||||
| Tier 1 risk-based capital ratio |
14.38 | % | 13.82 | % | 11.91 | % | 10.30 | % | 9.96 | % | ||||||||||
| Total risk-based capital ratio |
16.24 | 15.91 | 14.19 | 12.58 | 12.59 | |||||||||||||||
| Leverage ratio |
8.66 | 8.68 | 8.50 | 8.80 | 8.37 | |||||||||||||||
| Average shareholders’ equity to average total assets |
11.70 | 11.80 | 11.66 | 11.55 | 10.70 | |||||||||||||||
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The following tables set forth unaudited consolidated selected quarterly statement of operations data for the years ended December 31, 2011 and 2010. Dollar amounts are in thousands, except per share data.
| Year Ended December 31, 2011 |
||||||||||||||||
| 4th Quarter |
3rd Quarter |
2nd Quarter |
1st Quarter |
|||||||||||||
| Interest income |
$ | 158,512 | $ | 154,779 | $ | 156,133 | $ | 153,593 | ||||||||
| Interest expense |
8,189 | 9,418 | 11,800 | 11,834 | ||||||||||||
| Net interest income |
150,323 | 145,361 | 144,333 | 141,759 | ||||||||||||
| Provision for loan losses |
- | 9,010 | 8,985 | 9,450 | ||||||||||||
| Non-interest income (1) |
67,660 | 79,217 | 70,792 | 72,333 | ||||||||||||
| Non-interest expense |
143,833 | 137,407 | 136,797 | 140,061 | ||||||||||||
| Income before income taxes |
74,150 | 78,161 | 69,343 | 64,581 | ||||||||||||
| Income taxes |
18,736 | 23,654 | 13,657 | 12,653 | ||||||||||||
| Net income |
$ | 55,414 | $ | 54,507 | $ | 55,686 | $ | 51,928 | ||||||||
| Net income per common share: |
||||||||||||||||
| Basic |
$ | 0.90 | $ | 0.89 | $ | 0.91 | $ | 0.85 | ||||||||
| Diluted |
0.90 | 0.89 | 0.91 | 0.85 | ||||||||||||
| Year Ended December 31, 2010 |
||||||||||||||||
| 4th Quarter |
3rd Quarter |
2nd Quarter |
1st Quarter |
|||||||||||||
| Interest income |
$ | 154,176 | $ | 155,688 | $ | 155,314 | $ | 152,161 | ||||||||
| Interest expense |
12,613 | 13,272 | 13,418 | 14,577 | ||||||||||||
| Net interest income |
141,563 | 142,416 | 141,896 | 137,584 | ||||||||||||
| Provision for loan losses |
11,290 | 10,100 | 8,650 | 13,571 | ||||||||||||
| Non-interest income (2) |
70,278 | 70,430 | 69,932 | 71,393 | ||||||||||||
| Non-interest expense |
133,741 | 132,552 | 134,654 | 134,594 | ||||||||||||
| Income before income taxes |
66,810 | 70,194 | 68,524 | 60,812 | ||||||||||||
| Income taxes |
13,759 | 15,199 | 15,624 | 12,994 | ||||||||||||
| Net income |
$ | 53,051 | $ | 54,995 | $ | 52,900 | $ | 47,818 | ||||||||
| Net income per common share: |
||||||||||||||||
| Basic |
$ | 0.87 | $ | 0.90 | $ | 0.87 | $ | 0.79 | ||||||||
| Diluted |
0.87 | 0.90 | 0.87 | 0.79 | ||||||||||||
| (1) | Includes net gains on securities transactions of $6.4 million during the third quarter and $5 thousand during the first quarter of 2011 |
| (2) | Includes net gains on securities transactions of $1 thousand during the second quarter and $5 thousand during the first quarter of 2010. |
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Table of Contents
| ITEM 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Forward-Looking Statements and Factors that Could Affect Future Results
Certain statements contained in this Annual Report on Form 10-K that are not statements of historical fact constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Act”), notwithstanding that such statements are not specifically identified as such. In addition, certain statements may be contained in the Corporation’s future filings with the SEC, in press releases, and in oral and written statements made by or with the approval of the Corporation that are not statements of historical fact and constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenues, expenses, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure and other financial items; (ii) statements of plans, objectives and expectations of Cullen/Frost or its management or Board of Directors, including those relating to products or services; (iii) statements of future economic performance; and (iv) statements of assumptions underlying such statements. Words such as “believes”, “anticipates”, “expects”, “intends”, “targeted”, “continue”, “remain”, “will”, “should”, “may” and other similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to:
| ¨ | Local, regional, national and international economic conditions and the impact they may have on the Corporation and its customers and the Corporation’s assessment of that impact. |
| ¨ | Volatility and disruption in national and international financial markets. |
| ¨ | Government intervention in the U.S. financial system. |
| ¨ | Changes in the mix of loan geographies, sectors and types or the level of non-performing assets and charge-offs. |
| ¨ | Changes in estimates of future reserve requirements based upon the periodic review thereof under relevant regulatory and accounting requirements. |
| ¨ | The effects of and changes in trade and monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board. |
| ¨ | Inflation, interest rate, securities market and monetary fluctuations. |
| ¨ | The effect of changes in laws and regulations (including laws and regulations concerning taxes, banking, securities and insurance) with which the Corporation and its subsidiaries must comply. |
| ¨ | The soundness of other financial institutions. |
| ¨ | Political instability. |
| ¨ | Impairment of the Corporation’s goodwill or other intangible assets. |
| ¨ | Acts of God or of war or terrorism. |
| ¨ | The timely development and acceptance of new products and services and perceived overall value of these products and services by users. |
| ¨ | Changes in consumer spending, borrowings and savings habits. |
| ¨ | Changes in the financial performance and/or condition of the Corporation’s borrowers. |
| ¨ | Technological changes. |
| ¨ | Acquisitions and integration of acquired businesses. |
| ¨ | The ability to increase market share and control expenses. |
| ¨ | The Corporation’s ability to attract and retain qualified employees. |
| ¨ | Changes in the competitive environment in the Corporation’s markets and among banking organizations and other financial service providers. |
| ¨ | The effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Public Company Accounting Oversight Board, the Financial Accounting Standards Board and other accounting standard setters. |
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| ¨ | Changes in the reliability of the Corporation’s vendors, internal control systems or information systems. |
| ¨ | Changes in the Corporation’s liquidity position. |
| ¨ | Changes in the Corporation’s organization, compensation and benefit plans. |
| ¨ | The costs and effects of legal and regulatory developments including the resolution of legal proceedings or regulatory or other governmental inquiries and the results of regulatory examinations or reviews. |
| ¨ | Greater than expected costs or difficulties related to the integration of new products and lines of business. |
| ¨ | The Corporation’s success at managing the risks involved in the foregoing items. |
Forward-looking statements speak only as of the date on which such statements are made. The Corporation undertakes no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made, or to reflect the occurrence of unanticipated events.
Application of Critical Accounting Policies and Accounting Estimates
The accounting and reporting policies followed by the Corporation conform, in all material respects, to accounting principles generally accepted in the United States and to general practices within the financial services industry. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. While the Corporation bases estimates on historical experience, current information and other factors deemed to be relevant, actual results could differ from those estimates.
The Corporation considers accounting estimates to be critical to reported financial results if (i) the accounting estimate requires management to make assumptions about matters that are highly uncertain and (ii) different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on the Corporation’s financial statements.
Accounting policies related to the allowance for loan losses are considered to be critical, as these policies involve considerable subjective judgment and estimation by management. The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for loan loss methodology includes allowance allocations calculated in accordance with Accounting Standards Codification (ASC) Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio, as well as trends in the foregoing. Portions of the allowance may be allocated for specific credits; however, the entire allowance is available for any credit that, in management’s judgment, should be charged off. While management utilizes its best judgment and information available, the ultimate adequacy of the allowance is dependent upon a variety of factors beyond the Corporation’s control, including the performance of the Corporation’s loan portfolio, the economy, changes in interest rates and the view of the regulatory authorities toward loan classifications. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion and Note 3 - Loans in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data elsewhere in this report for further details of the risk factors considered by management in estimating the necessary level of the allowance for loan losses.
39
Table of Contents
Overview
The following discussion and analysis presents the more significant factors affecting the Corporation’s financial condition as of December 31, 2011 and 2010 and results of operations for each of the years in the three-year period ended December 31, 2011. This discussion and analysis should be read in conjunction with the Corporation’s consolidated financial statements, notes thereto and other financial information appearing elsewhere in this report. The Corporation acquired insurance agencies in the San Antonio market area in 2011 and in both the Dallas and San Marcos market areas during 2009. All of the Corporation’s acquisitions during the reported periods were accounted for as purchase transactions, and as such, their related results of operations are included from the date of acquisition, though none of these acquisitions had a significant impact on the Corporation’s financial statements during their respective reporting periods.
Taxable-equivalent adjustments are the result of increasing income from tax-free loans and investments by an amount equal to the taxes that would be paid if the income were fully taxable based on a 35% federal tax rate, thus making tax-exempt yields comparable to taxable asset yields.
Dollar amounts in tables are stated in thousands, except for per share amounts.
Results of Operations
Net income totaled $217.5 million, or $3.54 diluted per common share, in 2011 compared to $208.8 million, or $3.44 diluted per common share, in 2010 and $179.0 million, or $3.00 diluted per common share, in 2009.
Selected income statement data, returns on average assets and average equity and dividends per share for the comparable periods were as follows:
| 2011 | 2010 | 2009 | ||||||||||
| Taxable-equivalent net interest income |
$ | 642,066 | $ | 616,319 | $ | 577,716 | ||||||
| Taxable-equivalent adjustment |
60,290 | 52,860 | 41,037 | |||||||||
| Net interest income |
581,776 | 563,459 | 536,679 | |||||||||
| Provision for loan losses |
27,445 | 43,611 | 65,392 | |||||||||
| Non-interest income |
290,002 | 282,033 | 293,706 | |||||||||
| Non-interest expense |
558,098 | 535,541 | 532,238 | |||||||||
| Income before income taxes |
286,235 | 266,340 | 232,755 | |||||||||
| Income taxes |
68,700 | 57,576 | 53,721 | |||||||||
| Net income |
$ | 217,535 | $ | 208,764 | $ | 179,034 | ||||||
| Earnings per common share: |
||||||||||||
| Basic |
$ | 3.55 | $ | 3.44 | $ | 3.00 | ||||||
| Diluted |
3.54 | 3.44 | 3.00 | |||||||||
| Return on average assets |
1.17 | % | 1.21 | % | 1.14 | % | ||||||
| Return on average equity |
10.01 | 10.30 | 9.78 | |||||||||
Net income for 2011 increased $8.8 million, or 4.2%. The increase was primarily the result of an $18.3 million increase in net interest income, a $16.2 million decrease in the provision for loan losses and an $8.0 million increase in non-interest income partly offset by a $22.6 million increase in non-interest expense and an $11.1 million increase in income tax expense. Net income for 2010 increased $29.7 million, or 16.6%. The increase was primarily the result of a $26.8 million increase in net interest income and a $21.8 million decrease in the provision for loan losses partly offset by an $11.7 million decrease in non-interest income, a $3.9 million increase in income tax expense and a $3.3 million increase in non-interest expense.
Details of the changes in the various components of net income are further discussed below.
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Net Interest Income
Net interest income is the difference between interest income on earning assets, such as loans and securities, and interest expense on liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest income is the Corporation’s largest source of revenue, representing 66.7% of total revenue during 2011. Net interest margin is the ratio of taxable-equivalent net interest income to average earning assets for the period. The level of interest rates and the volume and mix of earning assets and interest-bearing liabilities impact net interest income and net interest margin.
The Federal Reserve Board influences the general market rates of interest, including the deposit and loan rates offered by many financial institutions. The Corporation’s loan portfolio is significantly affected by changes in the prime interest rate. The prime interest rate, which is the rate offered on loans to borrowers with strong credit, remained at 3.25% during 2011, 2010 and 2009. The Corporation’s loan portfolio is also impacted, to a lesser extent, by changes in the London Interbank Offered Rate (LIBOR). At December 31, 2011, the one-month and three-month U.S. dollar LIBOR rates were 0.30% and 0.58%, respectively, while at December 31, 2010, the one-month and three-month U.S. dollar LIBOR rates were 0.26% and 0.30%, respectively. The intended federal funds rate, which is the cost of immediately available overnight funds, remained at zero to 0.25% during 2011, 2010 and 2009.
The Corporation’s balance sheet has historically been asset sensitive, meaning that earning assets generally reprice more quickly than interest-bearing liabilities. Therefore, the Corporation’s net interest margin was likely to increase in sustained periods of rising interest rates and decrease in sustained periods of declining interest rates. During the fourth quarter of 2007, in an effort to make the Corporation’s balance sheet less sensitive to changes in interest rates, the Corporation entered into various interest rate swaps which effectively converted certain variable-rate loans into fixed-rate instruments for a period of time. During the fourth quarter of 2008, the Corporation also entered into an interest rate swap which effectively converted variable-rate debt into fixed-rate debt for a period of time. As a result of these actions, the Corporation’s balance sheet was more interest-rate neutral and changes in interest rates had a less significant impact on the Corporation’s net interest margin than would have otherwise been the case. During the fourth quarter of 2009, a portion of the interest rate swaps on variable-rate loans were terminated, while the remaining interest rate swaps on variable-rate loans were terminated during the fourth quarter of 2010. These actions increased the asset sensitivity of the Corporation’s balance sheet. The deferred accumulated after-tax gain applicable to the settled interest rate contracts included in accumulated other comprehensive income totaled $68.5 million at December 31, 2011. The deferred gain will be reclassified into earnings through October 2014 when the formerly hedged transactions impact future earnings. See Note 15 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to these interest rate swaps.
The Corporation is primarily funded by core deposits, with non-interest-bearing demand deposits historically being a significant source of funds. This lower-cost funding base is expected to have a positive impact on the Corporation’s net interest income and net interest margin in a rising interest rate environment. As stated previously in the section captioned “Supervision and Regulation” included in Item 1. Business, elsewhere in this report, the Dodd-Frank Act repealed the federal prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. Although the ultimate impact of this legislation on the Corporation has not yet been determined, the Corporation may begin to incur interest costs associated with demand deposits in the future as market conditions warrant. See Item 7A. Quantitative and Qualitative Disclosures About Market Risk elsewhere in this report for information about the expected impact of this legislation on the Corporation’s sensitivity to interest rates. Further analysis of the components of the Corporation’s net interest margin is presented below.
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The following table presents the changes in taxable-equivalent net interest income and identifies the changes due to differences in the average volume of earning assets and interest-bearing liabilities and the changes due to changes in the average interest rate on those assets and liabilities. The changes in net interest income due to changes in both average volume and average interest rate have been allocated to the average volume change or the average interest rate change in proportion to the absolute amounts of the change in each. The Corporation’s consolidated average balance sheets along with an analysis of taxable-equivalent net interest income are presented on pages 144 and 145 of this report.
| 2011 vs. 2010 |
2010 vs. 2009 |
|||||||||||||||||||||||
| Increase (Decrease) Due to Change in |
Increase (Decrease) Due to Change in |
|||||||||||||||||||||||
| Rate | Volume | Total | Rate | Volume | Total | |||||||||||||||||||
| Interest-bearing deposits |
$ | - | $ | 1,456 | $ | 1,456 | $ | (87 | ) | $ | 2,827 | $ | 2,740 | |||||||||||
| Federal funds sold and resell agreements |
11 | (24 | ) | (13 | ) | 6 | (139 | ) | (133 | ) | ||||||||||||||
| Securities: |
||||||||||||||||||||||||
| Taxable |
(19,601 | ) | 25,271 | 5,670 | (21,804 | ) | 18,122 | (3,682 | ) | |||||||||||||||
| Tax-exempt |
(1,296 | ) | 18,607 | 17,311 | (1,550 | ) | 31,031 | 29,481 | ||||||||||||||||
| Loans, net of unearned discounts |
(7,188 | ) | (4,128 | ) | (11,316 | ) | 5,055 | (27,335 | ) | (22,280 | ) | |||||||||||||
| Total earning assets |
(28,074 | ) | 41,182 | 13,108 | (18,380 | ) | 24,506 | 6,126 | ||||||||||||||||
| Savings and interest checking |
(1,258 | ) | 307 | (951 | ) | (366 | ) | 417 | 51 | |||||||||||||||
| Money market deposit accounts |
(4,517 | ) | 1,056 | (3,461 | ) | (11,704 | ) | 4,787 | (6,917 | ) | ||||||||||||||
| Time accounts |
(2,428 | ) | (741 | ) | (3,169 | ) | (13,597 | ) | (4,978 | ) | (18,575 | ) | ||||||||||||
| Public funds |
(168 | ) | (45 | ) | (213 | ) | (795 | ) | 194 | (601 | ) | |||||||||||||
| Federal funds purchased and repurchase agreements |
(219 | ) | 94 | (125 | ) | (415 | ) | (200 | ) | (615 | ) | |||||||||||||
| Junior subordinated deferrable interest debentures |
142 | (341 | ) | (199 | ) | 80 | (329 | ) | (249 | ) | ||||||||||||||
| Subordinated notes payable and other notes |
(342 | ) | (4,011 | ) | (4,353 | ) | - | - | - | |||||||||||||||
| Federal Home Loan Bank advances |
(13 | ) | (155 | ) | (168 | ) | 3,116 | (8,687 | ) | (5,571 | ) | |||||||||||||
| Total interest-bearing liabilities |
(8,803 | ) | (3,836 | ) | (12,639 | ) | (23,681 | ) | (8,796 | ) | (32,477 | ) | ||||||||||||
| Net change |
$ | (19,271 | ) | $ | 45,018 | $ | 25,747 | $ | 5,301 | $ | 33,302 | $ | 38,603 | |||||||||||
Taxable-equivalent net interest income for 2011 increased $25.7 million, or 4.2%, compared to 2010. The increase primarily resulted from an increase in the average volume of interest-earning assets partly offset by a decrease in the net interest margin. The average volume of interest-earning assets for 2011 increased $1.4 billion, or 9.4%, compared to 2010. The net interest margin decreased 20 basis points from 4.08% during 2010 to 3.88% during 2011. The decrease in the net interest margin was partly due to a 31 basis point decrease in the average yield on interest earning assets from 4.44% during 2010 to 4.13% during 2011 while the average cost of funds only decreased 15 basis points from 0.55% during 2010 to 0.40% during 2011. The negative effect of the decrease in the average yield on interest-earning assets on taxable-equivalent net interest income exceeded the positive effect of the decrease in the average cost of funds. The decrease in the average yield on interest-earning assets was partly due to an increase in the relative proportion of average interest-earning assets invested in lower-yielding interest-bearing deposits during 2011 compared to 2010 while the relative proportion of average interest-earning assets invested in higher-yielding loans decreased. The average yield on interest-earning assets was also negatively impacted by a decrease in the average yield on securities, as further discussed below. The average yield on interest-earning assets is primarily impacted by changes in market interest rates as well as changes in the volume and relative mix of interest-earning assets. As stated above, market interest rates decreased to historically low levels during 2008 and have remained at those levels through 2011. The effect of lower average market interest rates during the reported periods on the average yield on average interest-earning assets was partly limited by the aforementioned interest rate swaps on variable-rate loans.
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Taxable-equivalent net interest income for 2010 increased $38.6 million, or 6.7%, compared to 2009. The increase primarily resulted from an increase in the average volume of interest-earning assets. Additionally, taxable-equivalent net interest income was positively impacted as the decrease in the average cost of funds was proportionally larger than the decrease in the average yield on interest-earning assets. The average volume of interest-earning assets for 2010 increased $1.5 billion, or 11.1%, compared to 2009. The net interest margin decreased 15 basis points from 4.23% in 2009 to 4.08% in 2010. The decrease in the net interest margin was partly due to an increase in the relative proportion of interest-earning assets invested in lower-yielding interest-bearing deposits during 2010 compared to 2009 while the relative proportion of average interest-earning assets invested in higher-yielding loans decreased. The average cost of funds decreased 37 basis points from 0.92% in 2009 to 0.55% in 2010 while the average yield on interest-earning assets decreased 42 basis points from 4.86% in 2009 to 4.44% in 2010.
The average volume of loans during 2011 decreased $82.2 million, or 1.0%, in 2011 compared to 2010 and decreased $527.4 million, or 6.1%, in 2010 compared to 2009. Loans made up approximately 48.0% of average interest-earning assets during 2011 compared to 53.0% during 2010 and 62.7% in 2009. The average yield on loans was 5.02% during 2011 compared to 5.11% during 2010 and 5.05% during 2009. Loans generally have significantly higher yields compared to securities, interest-bearing deposits and federal funds sold and resell agreements and, as such, have a more positive effect on the net interest margin.
The average volume of securities increased $998.6 million in 2011 compared to 2010 and increased $950.9 million in 2010 compared to 2009. Securities made up approximately 37.0% of average interest-earning assets in 2011 compared to 34.0% in 2010 and 30.9% in 2009. The average yield on securities was 4.57% in 2011 compared to 5.02% in 2010 and 5.45% in 2009. The decrease in the average yield on securities was partly due to a decrease in the yield on taxable securities as proceeds from principal repayments were reinvested at lower market rates. The relative proportion of higher-yielding, tax-exempt municipal securities to total average securities was 35.2% in 2011 compared to 37.0% in 2010 and 34.0% in 2009. The average yield on taxable securities was 3.27% in 2011 compared to 3.84% in 2010 and 4.58% in 2009, while the average taxable-equivalent yield on tax-exempt securities was 6.97% in 2011 compared to 7.04% in 2010 and 7.15% in 2009.
Average federal funds sold, resell agreements and interest-bearing deposits during 2011 increased $519.2 million, or 26.0%, compared to 2010 and increased $1.1 billion, or 124.5%, compared to 2009. Federal funds sold, resell agreements and interest-bearing deposits made up approximately 15.0% of average interest-earning assets in 2011 compared to approximately 13.0% in 2010 and 6.4% in 2009. The combined weighted-average yield on federal funds sold, resell agreements and interest-bearing deposits was 0.26% in 2011 compared to 0.25% in 2010 and 0.27% in 2009. The increase in federal funds sold, resell agreements and interest-bearing deposits compared to prior years was primarily due to significant deposit growth, as further discussed below.
Average deposits increased $1.2 billion, or 8.4%, in 2011 compared to 2010 and $1.6 billion, or 13.1%, in 2010 compared to 2009. Average interest-bearing deposits increased $459.8 million in 2011 compared to 2010 and $862.7 million in 2010 compared to 2009, while average non-interest-bearing deposits increased $715.2 million in 2011 compared to 2010 and $765.3 million in 2010 compared to 2009. The ratio of average interest-bearing deposits to total average deposits was 62.3% in 2011 compared to 64.2% in 2010 and 65.7% in 2009. The average cost of interest-bearing deposits and total deposits was 0.23% and 0.15% in 2011 compared to 0.33% and 0.21% in 2010 and 0.69% and 0.45% in 2009. The decrease in the average cost of interest-bearing deposits during the comparable periods was primarily the result of decreases in interest rates offered on certain deposit products due to decreases in average market interest rates and decreases in renewal interest rates on maturing certificates of deposit given the current low interest rate environment. Additionally, the relative proportion of higher-cost certificates of deposit to total average interest-bearing deposits decreased to 11.9% in 2011 from 13.9% in 2010 and 19.7% in 2009.
The Corporation’s net interest spread, which represents the difference between the average rate earned on earning assets and the average rate paid on interest-bearing liabilities, was 3.73% in 2011 compared to 3.89% in
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2010 and 3.94% in 2009. The net interest spread, as well as the net interest margin, will be impacted by future changes in short-term and long-term interest rate levels, as well as the impact from the competitive environment. A discussion of the effects of changing interest rates on net interest income is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk included elsewhere in this report.
The Corporation’s hedging policies permit the use of various derivative financial instruments, including interest rate swaps, swaptions, caps and floors, to manage exposure to changes in interest rates. Details of the Corporation’s derivatives and hedging activities are set forth in Note 15 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report. Information regarding the impact of fluctuations in interest rates on the Corporation’s derivative financial instruments is set forth in Item 7A. Quantitative and Qualitative Disclosures About Market Risk included elsewhere in this report.
Provision for Loan Losses
The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level which, in management’s best estimate, is necessary to absorb probable losses within the existing loan portfolio. The provision for loan losses totaled $27.4 million in 2011 compared to $43.6 million in 2010 and $65.4 million in 2009. See the section captioned “Allowance for Loan Losses” elsewhere in this discussion for further analysis of the provision for loan losses.
Non-Interest Income
The components of non-interest income were as follows:
| 2011 | 2010 | 2009 | ||||||||||
| Trust fees |
$ | 73,233 | $ | 68,428 | $ | 67,268 | ||||||
| Service charges on deposit accounts |
94,367 | 98,796 | 102,474 | |||||||||
| Insurance commissions and fees |
35,421 | 34,015 | 33,096 | |||||||||
| Other charges, commissions and fees |
34,005 | 30,452 | 27,699 | |||||||||
| Net gain (loss) on securities transactions |
6,414 | 6 | (1,260 | ) | ||||||||
| Other |
46,562 | 50,336 | 64,429 | |||||||||
| Total |
$ | 290,002 | $ | 282,033 | $ | 293,706 | ||||||
Total non-interest income for 2011 increased $8.0 million, or 2.8%, compared to 2010 while total non-interest income for 2010 decreased $11.7 million, or 4.0%, compared to 2009. Changes in the various components of non-interest income are discussed in more detail below.
Trust Fees. Trust fee income for 2011 increased $4.8 million, or 7.0%, compared to 2010 while trust fee income for 2010 increased $1.2 million, or 1.7%, compared to 2009. Investment fees are the most significant component of trust fees, making up approximately 75% of total trust fees in both 2011 and 2010, and approximately 74% of total trust fees in 2009. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees.
The increase in trust fee income during 2011 compared to 2010 was primarily the result of an increase in investment fees (up $3.8 million), securities lending income (up $445 thousand), custody fees (up $289 thousand), real estate fees (up $165 thousand) and estate fees (up $156 thousand). The increase in investment fees was primarily due to the general appreciation in the market values of assets in trust accounts on which these fees are generally based. Equity valuations during 2011 were higher on average compared to 2010.
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The increase in trust fee income during 2010 compared to 2009 was primarily the result of increases in investment fees (up $1.6 million) and real estate fees (up $414 thousand) partly offset by decreases in financial consulting fees (down $560 thousand) and securities lending income (down $429 thousand). The increase in investment fees was primarily due to the general appreciation in the market values of assets in trust accounts on which these fees are generally based. Equity valuations during 2010 were higher on average compared to 2009, recovering somewhat from the market correction in equity valuations which began in the latter part of 2008 and reached its lowest levels during the first quarter of 2009. The decrease in securities lending income during 2010 was primarily related to a decrease in transaction spreads.
At December 31, 2011, trust assets, including both managed assets and custody assets, were primarily composed of fixed income securities (42.7% of trust assets), equity securities (40.9% of trust assets) and cash equivalents (10.7% of trust assets). The estimated fair value of trust assets was $25.2 billion (including managed assets of $10.3 billion and custody assets of $14.9 billion) at December 31, 2011 compared to $24.9 billion (including managed assets of $9.9 billion and custody assets of $15.0 billion) at December 31, 2010 and $22.7 billion (including managed assets of $10.4 billion and custody assets of $12.3 billion) at December 31, 2009.
Service Charges on Deposit Accounts. Service charges on deposit accounts for 2011 decreased $4.4 million, or 4.5%, compared to 2010. The decrease during 2011 was primarily due to decreases in overdraft/insufficient funds charges on both consumer and commercial accounts (down $4.1 million), decreases in service charges on commercial accounts (down $487 thousand) and decreases in service charges on consumer accounts (down $321 thousand) partly offset by an increase in point of sale income (up $569 thousand). The decrease in overdraft/insufficient funds charges on consumer accounts during 2011 was partly related to a new rule issued by the Federal Reserve that became effective in the third quarter of 2010, as further discussed below. The decrease in service charges on commercial accounts during 2011 was partly related to decreases in service volumes for billable services. The increase in point of sale income from PIN-based debit card transactions during 2011 was related to an increase in the volume of transactions as well as a higher interchange pricing structure during the first nine months of 2011. Effective October 1, 2011, the interchange pricing structure was significantly decreased as a result of a new rule issued by the Federal Reserve as further discussed below.
Service charges on deposit accounts for 2010 decreased $3.7 million, or 3.6%, compared to 2009. The decrease in service charges on deposit accounts was due to a decrease in service charges on commercial accounts (down $3.1 million) and overdraft/insufficient funds charges on consumer accounts (down $2.3 million). These decreases were partly offset by an increase in point of sale income from PIN-based debit card transactions (up $1.9 million). The decrease in service charges on commercial accounts during 2010 was primarily related to a decrease in billable services. The decrease in overdraft/insufficient funds charges on consumer accounts during 2010 was partly related to a new rule issued by the Federal Reserve Board that became effective in the third quarter of 2010, as further discussed below. The increase in point of sale income from PIN-based debit card transactions during 2010 was partly related to an increase in the interchange pricing structure and, to a lesser extent, an increase in the volume of transactions.
Overdraft/insufficient funds charges totaled $34.9 million during 2011 compared to $39.0 million during 2010 and $41.1 million in 2009. Overdraft/insufficient funds charges included $27.7 million, $30.4 million and $32.6 million related to consumer accounts during 2011, 2010 and 2009, respectively, and $7.2 million, $8.6 million and $8.5 million related to commercial accounts during 2011, 2010 and 2009, respectively. Overdraft/insufficient funds charges were partly impacted by changes in policies and a new rule issued by the Federal Reserve that became effective in the third quarter of 2010. The new rule prohibits financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumer’s choices.
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The Corporation had point of sale income from PIN-based debit card transactions totaling $6.8 million, $6.2 million and $4.3 million during 2011, 2010 and 2009, respectively. As stated previously in the section captioned “Supervision and Regulation” included in Item 1. Business, elsewhere in this report, the Dodd-Frank Act amended the EFTA which, among other things, gave the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers, such as Frost Bank. In June 2011, the Federal Reserve issued a final rule that, among other things, established standards for determining whether an interchange fee received or charged by an issuer with respect to an electronic debit transaction is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. These new standards took effect on October 1, 2011 and apply to issuers, such as the Corporation, that, together with their affiliates, have assets of $10 billion or more. Under the rule, the maximum permissible interchange fee for an electronic debit transaction will be the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. The Federal Reserve also issued an interim final rule that allows for an upward adjustment of no more than 1 cent to an issuer’s debit card interchange fee if the issuer develops and implements policies and procedures reasonably designed to achieve the fraud-prevention standards set out in the interim final rule. The fraud-prevention adjustment was effective on October 1, 2011, concurrent with the debit card interchange fee limits. The Corporation currently expects that future revenues from debit card interchange transactions will likely be approximately one half of levels prior to October 1, 2011. Point of sale income from PIN-based debit card transactions totaled $1.3 million during the fourth quarter of 2011 compared to $1.9 million during the third quarter of 2011 as the impact of the new rules was partly mitigated by an increase in transaction volumes during the fourth quarter. Also see the discussion regarding income from Visa check card usage below under “Other Non-Interest Income.”
Insurance Commissions and Fees. Insurance commissions and fees for 2011 increased $1.4 million, or 4.1%, compared to 2010. The increase was related to an increase in commission income (up $1.4 million). The increase in commission income was partly related to the acquisition of Clark Benefit Group in the second quarter of 2011 as well as normal variation in the timing of renewals and market demand for insurance products. Insurance commissions and fees for 2010 increased $919 thousand, or 2.8%, compared to 2009. The increase was related to an increase in commission income (up $945 thousand).
Insurance commissions and fees include contingent commissions which totaled $3.8 million for each of 2011, 2010 and 2009. Contingent commissions primarily consist of amounts received from various property and casualty insurance carriers. The carriers use several non-client specific factors to determine the amount of the contingency payments. Such factors include the aggregate loss performance of insurance policies previously placed and the volume of business, among other things. Such commissions are seasonal in nature and are mostly received during the first quarter of each year. These commissions totaled $2.2 million in 2011 $2.5 million in 2010 and $2.8 million in 2009. Contingent commissions also include amounts received from various benefit plan insurance companies related to the volume of business generated and/or the subsequent retention of such business. These commissions totaled $1.6 million in 2011, $1.2 million in 2010 and $972 thousand in 2009.
Other Charges, Commissions and Fees. Other charges, commissions and fees for 2011 increased $3.6 million, or 11.7%, compared to 2010. The increase was primarily related to increases in mutual fund management fees (up $1.2 million), loan processing fees (up $1.2 million), investment banking fees related to corporate advisory services (up $965 thousand), unused balance fees on loan commitments (up $700 thousand), lease processing fees (up $318 thousand) and income related to sale of annuities and mutual funds (up $167 thousand and $161 thousand, respectively).
Other charges, commissions and fees for 2010 increased $2.8 million, or 9.9%, compared to 2009. The increase in other charges, commissions and fees was primarily related to increases in commission income related to the sale of mutual funds (up $1.4 million), mutual fund management fees (up $1.2 million) and unused balance fees on loan commitments (up $711 thousand). These increases were partly offset by a decrease in commission income related to the sale of money market accounts (down $1.0 million). The increase in commission income related to the sale of mutual funds and the concurrent decrease in commission income related to the sale of
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money market accounts reflected the apparent increased willingness of customers to invest in equities as market conditions began to improve. The decrease in commission income related to the sale of money market accounts was also partly related to lower marketing fees paid by fund companies.
Net Gain/Loss on Securities Transactions. During 2011, the Corporation sold available-for-sale securities with an amortized cost totaling $5.6 billion and realized a net gain of $6.4 million on those sales. With the exception of the sales during the third quarter of 2011 discussed below, these securities were primarily purchased during 2011 and subsequently sold primarily in connection with the Corporation’s tax planning strategies related to the Texas franchise tax. The gross proceeds from the sales of these securities outside of Texas are included in total revenues/receipts from all sources reported for Texas franchise tax purposes, which results in a reduction in the overall percentage of revenues/receipts apportioned to Texas and subjected to taxation under the Texas franchise tax. During the third quarter of 2011, the Corporation sold available-for-sale securities with an amortized cost totaling $32.6 million and realized a net gain of $6.4 million on those sales. The Corporation sold certain longer-duration municipal securities. During 2010, the Corporation sold available-for-sale securities with an amortized cost totaling $10.0 billion and realized a net gain of $6 thousand on those sales. These securities were purchased during 2010 and subsequently sold in connection with the aforementioned tax planning strategy. During 2009, the Corporation sold available-for-sale securities with an amortized cost totaling $206.2 million and realized a net gain of $283 thousand on those sales. The majority of the securities sold were Freddie Mac mortgage-backed securities. During the fourth quarter of 2009, the Corporation purchased approximately $404.9 million of Freddie Mac TBA (to be announced) mortgage-backed securities. The Corporation subsequently sold these securities prior to settlement and realized a net loss of $1.5 million. The Corporation instead invested the funds in mortgage-backed securities issued by Ginnie Mae.
Other Non-Interest Income. Other non-interest income for 2011 decreased $3.8 million, or 7.5%, compared to 2010. Components of other non-interest income with significant decreases included sundry income from various miscellaneous items (down $1.7 million), income from Visa check card usage (down $1.3 million), lease rental income (down $908 thousand), income from municipal bond underwriting discounts/fees (down $729 thousand) and earnings on the cash surrender value of life insurance policies (down $472 thousand). Components of other non-interest income with significant increases included gains on the sale of assets/foreclosed assets (up $1.7 million) and mineral interest income (up $232 thousand).
Other non-interest income decreased $14.1 million, or 21.9%, for 2010 compared to 2009. The decrease was primarily related to a $17.7 million gain realized in the fourth quarter of 2009 related to the termination of interest rate swaps on certain Federal Home Loan Bank advances. See Note 15 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to the interest rate swaps. Excluding this gain from 2009, other non-interest income would have effectively increased $3.6 million for 2010. Contributing to this effective increase were increases in income from Visa check card usage (up $2.6 million), income from securities trading and customer derivative activities (up $1.5 million) and mineral interest income (up $726 thousand). Income from securities trading and customer derivative activities primarily relates to customer interest rate swap transaction fees. Mineral interest income is related to bonus, rental and shut-in payments and oil and gas royalties received from severed mineral interests on property owned by Main Plaza Corporation, a wholly owned non-banking subsidiary of the Corporation. The increases in the aforementioned items were partly offset by decreases in gains on the sale of assets/foreclosed assets (down $574 thousand), lease rental income (down $566 thousand) and earnings on the cash surrender value of life insurance policies (down $322 thousand).
The Corporation had income from Visa check card usage totaling $19.8 million, $21.1 million and $18.5 million during 2011, 2010 and 2009. As stated previously in the section captioned “Supervision and Regulation” included in Item 1. Business, elsewhere in this report, the Dodd-Frank Act amended the EFTA to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers, such as Frost Bank. As more fully discussed above relative to point of sale income from PIN-based debit card transactions under “Service Charges on Deposit
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Accounts,” in June 2011, the Federal Reserve issued new rules that significantly impacted the level of interchange fees that may be charged beginning October 1, 2011. The Corporation expects that future revenues from Visa check card usage will likely be approximately one third of levels prior to October 1, 2011, in part due to the fact that certain merchant negotiated rates are less than the maximum prescribed rate under the new rule. Income from Visa check card usage totaled $2.2 million during the fourth quarter of 2011 compared to $6.1 million during the third quarter of 2011.
Non-Interest Expense
The components of non-interest expense were as follows:
| 2011 | 2010 | 2009 | ||||||||||
| Salaries and wages |
$ | 252,028 | $ | 239,589 | $ | 230,643 | ||||||
| Employee benefits |
52,939 | 52,352 | 55,224 | |||||||||
| Net occupancy |
46,968 | 46,166 | 44,188 | |||||||||
| Furniture and equipment |
51,469 | 47,651 | 44,223 | |||||||||
| Deposit insurance |
12,714 | 20,451 | 25,812 | |||||||||
| Intangible amortization |
4,387 | 5,125 | 6,537 | |||||||||
| Other |
137,593 | 124,207 | 125,611 | |||||||||
| Total |
$ | 558,098 | $ | 535,541 | $ | 532,238 | ||||||
Total non-interest expense for 2011 increased $22.6 million, or 4.2%, compared to 2010 while total non-interest expense for 2010 increased $3.3 million, or 0.6%, compared to 2009. Changes in the various components of non-interest expense are discussed below.
Salaries and Wages. Salaries and wages for 2011 increased $12.4 million, or 5.2%, compared to 2010. The increases were primarily related to normal annual merit and market increases as well as increases in incentive compensation expense and stock-based compensation expense.
Salaries and wages for 2010 increased $8.9 million, or 3.9%, compared to 2009. The increase was primarily related to increases in incentive compensation expense (up $6.1 million), normal annual merit increases and an increase in stock-based compensation expense partly offset by a decrease in headcount, a decrease in overtime expense and an increase in cost deferrals related to lending activity. During 2009, the level of incentive compensation was below targeted levels as financial performance for the Corporation was below budget.
Employee Benefits. Employee benefits expense for 2011 increased $587 thousand, or 1.1%, compared to 2010. The increase was primarily related to increases in expenses related to payroll taxes (up $595 thousand), medical insurance expense (up $501 thousand) and the Corporation’s 401(k) and profit sharing plans (up $197 thousand).
Employee benefits expense for 2010 decreased $2.9 million, or 5.2%, compared to 2009. The decrease was primarily related to decreases in expenses related to the Corporation’s defined benefit retirement plan (down $3.4 million) and expenses related to the Corporation’s 401(k) and profit sharing plans (down $195 thousand). These decreases were partly offset by increases in medical insurance expense (up $529 thousand) and payroll taxes (up $256 thousand).
The Corporation’s defined benefit retirement and restoration plans were frozen effective as of December 31, 2001 and were replaced by the profit sharing plan. Management believes these actions help reduce the volatility in retirement plan expense. However, the Corporation still has funding obligations related to the defined benefit and restoration plans and could recognize retirement expense related to these plans in future years, which would be dependent on the return earned on plan assets, the level of interest rates and employee turnover. The Corporation recognized a net benefit related to the defined benefit retirement and restoration plans of $412 thousand in 2011 compared to a net benefit of $369 thousand in 2010 and a net expense of $3.1 million in
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2009. Future benefits/expense related to these plans is dependent upon a variety of factors, including the actual return on plan assets. The decrease in expense related to the Corporation’s defined benefit retirement plan during 2010 compared to 2009 was partly related to a higher than expected return on plan assets during 2009.
For additional information related to the Corporation’s employee benefit plans, see Note 11 - Employee Benefit Plans in the accompanying notes to consolidated financial statements included elsewhere in this report.
Net Occupancy. Net occupancy expense for 2011 increased $802 thousand, or 1.7%, compared to 2010. The increase was primarily related to increases in service contracts expense (up $480 thousand), repairs expense (up $394 thousand), a decrease in parking garage income (down $161 thousand) and a decrease in rental income (down $153 thousand). Offsetting these items were decreases in property tax expense (down $247 thousand) and utilities expense (down $138 thousand).
Net occupancy expense for 2010 increased $2.0 million, or 4.5%, compared to 2009. The increase was primarily related to increases in building depreciation (up $1.4 million), service contracts expense (up $606 thousand), repairs expense (up $411 thousand), building maintenance (up $410 thousand) and property taxes (up $291 thousand). Offsetting these increases were decreases in lease expense (down $458 thousand) and depreciation on leasehold improvements (down $341 thousand). The increases in building depreciation and property taxes were partly related to a new technology operations center placed into service during the first quarter of 2010. The decrease in depreciation on leasehold improvements during 2010 resulted as certain leasehold improvements were fully depreciated in 2009.
Furniture and Equipment. Furniture and equipment expense for 2011 increased $3.8 million, or 8.0%, compared to 2010. The increase was primarily related to increases in software maintenance (up $2.6 million) and software amortization (up $1.2 million) partly offset by a decrease in depreciation on furniture and fixtures (down $404 thousand). The increase in software amortization and maintenance was primarily related to new applications placed into service in 2010.
Furniture and equipment expense for 2010 increased $3.4 million, or 7.8%, compared to 2009. The increase was primarily related to increases in software amortization (up $2.0 million), equipment rental (up $1.4 million) and software maintenance (up $696 thousand) partly offset by a decrease in furniture and fixtures depreciation (down $539 thousand). The increases in software amortization and maintenance were primarily related to new applications placed into service in 2010 and 2009. The increase in equipment rental during 2010 was related to new equipment leases associated with the aforementioned new technology operations center.
Deposit Insurance. Deposit insurance expense totaled $12.7 million in 2011 compared to $20.5 million in 2010 and $25.8 million in 2009. The decrease in deposit insurance expense in 2011 was primarily related to a change in the deposit insurance assessment base and a change in the method by which the assessment rate is determined for large financial institutions. Details of these changes are further discussed below. The decreases were also partly related to the Corporation opting out of the Transaction Account Guarantee (“TAG”) component of the Temporary Liquidity Guarantee Program (“TLGP”) effective July 1, 2010. As further discussed below, deposit insurance expense during 2009 included $7.3 million related to a one-time special assessment in the second quarter. Excluding the impact of the special assessment, deposit insurance expense increased $2.0 million during 2010 compared to 2009. The effective increase was primarily related to deposit growth. Average deposits during 2010 totaled $14.0 billion compared to $12.4 billion during 2009. Deposit insurance expense during 2010 was partly reduced as a result of the Corporation opting out of the TAG component of the TLGP effective July 1, 2010.
In May 2009, the FDIC issued a final rule which levied a special assessment applicable to all insured depository institutions totaling 5 basis points of each institution’s total assets less Tier 1 capital as of June 30, 2009, not to exceed 10 basis points of domestic deposits. The special assessment was part of the FDIC’s efforts to rebuild the Deposit Insurance Fund (“DIF”). Deposit insurance expense during 2009 included $7.3 million recognized in the second quarter related to the special assessment.
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In November 2009, the FDIC issued a rule that required all insured depository institutions, with limited exceptions, to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. In December 2009, the Corporation paid $64.5 million in prepaid risk-based assessments, which included $4.0 million related to the fourth quarter of 2009 that would have otherwise been payable in the first quarter of 2010. This amount is included in deposit insurance expense for 2009. The pre-paid deposit insurance included in accrued interest receivable and other assets in the accompanying consolidated balance sheets as of December 31, 2011 and 2010 totaled $32.2 million and $43.6 million, respectively.
In October 2010, the FDIC adopted a new DIF restoration plan to ensure that the fund reserve ratio reaches 1.35% by September 30, 2020, as required by the Dodd-Frank Act. At least semi-annually, the FDIC will update its loss and income projections for the fund and, if needed, will increase or decrease assessment rates, following notice-and-comment rulemaking if required.
In November 2010, the FDIC issued a final rule to implement provisions of the Dodd-Frank Act that provide for temporary unlimited coverage for non-interest-bearing transaction accounts. The separate coverage for non-interest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012.
On April 1, 2011, the deposit insurance assessment base changed from total domestic deposits to average total assets minus average tangible equity, pursuant to a rule issued by the FDIC as required by the Dodd-Frank Act. Additionally, the deposit insurance assessment system was revised to create a two scorecard system for large institutions, one for most large institutions, including Frost Bank, that have more than $10 billion in assets and another for “highly complex” institutions that have over $50 billion in assets and are fully owned by a parent with over $500 billion in assets. Each scorecard has a performance score and a loss-severity score that are combined to produce a total score, which is then translated into an initial assessment rate. In calculating these scores, the FDIC utilizes a bank’s capital level and supervisory ratings (its “CAMELS ratings”), certain financial measures to assess an institution’s ability to withstand asset-related stress and funding-related stress. The use of risk categories and long-term debt issuer ratings was eliminated. The FDIC has the ability to make discretionary adjustments to the total score, up or down, by a maximum of 15 points, based upon significant risk factors that are not adequately captured in the scorecard. The total score is constrained to be between 30 and 90 and translates to an initial base assessment rate on a non-linear, sharply-increasing scale.
For most large institutions, including Frost Bank, the initial base assessment rate ranges from 5 to 35 basis points on an annualized basis (basis points representing cents per $100). After the effect of potential base-rate adjustments, the total base assessment rate could range from 2.5 to 45 basis points on an annualized basis. The potential adjustments to an institution’s initial base assessment rate include (i) a potential decrease of up to 5 basis points for certain long-term unsecured debt (“unsecured debt adjustment”) and (ii) (except for well-capitalized institutions with a CAMELS rating of 1 or 2) a potential increase of up to 10 basis points for brokered deposits in excess of 10% of domestic deposits (“brokered deposit adjustment”). As the deposit insurance fund (“DIF”) reserve ratio grows, the rate schedule will be adjusted downward. Additionally, the rule includes a new adjustment for depository institution debt whereby an institution will pay an additional premium equal to 50 basis points on every dollar (above 3% of an institution’s Tier 1 capital) of long-term, unsecured debt held that was issued by another insured depository institution (excluding debt guaranteed under the TLGP).
Intangible Amortization. Intangible amortization is primarily related to core deposit intangibles and, to a lesser extent, intangibles related to customer relationships and non-compete agreements. Intangible amortization totaled $4.4 million in 2011 compared to $5.1 million in 2010 and $6.5 million in 2009. The decrease in amortization expense during the comparable years was primarily the result of the completion of amortization of certain intangible assets, as well as a reduction in the annual amortization rate of certain intangible assets as the Corporation uses an accelerated amortization approach which results in higher amortization rates during the earlier years of the useful lives of intangible assets. The decreases in amortization were partly offset by the
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additional amortization related to intangible assets recorded in connection with acquisitions during 2009 and 2011. See Note 5 - Goodwill and Other Intangible Assets in the accompanying notes to consolidated financial statements included elsewhere in this report.
Other Non-Interest Expense. Other non-interest expense for 2011 increased $13.4 million, or 10.8%, compared to 2010. Components of other non-interest expense with significant increases during 2011 included advertising/promotions expense (up $7.5 million), donation expense (up $2.2 million), web-site maintenance and enhancement expense (up $2.1 million), Visa check card expense (up $1.2 million), travel expense (up $896 thousand), sub-advisor investment management fees related to Frost Investment Advisors, LLC, (up $808 thousand) and losses on the sale/write-down of assets (up $747 thousand). The increase in advertising/promotions expense is primarily related to a new, expanded marketing campaign that began during the first quarter of 2011. The increases in the aforementioned items were partly offset by decreases in losses on the sale/write-down of foreclosed assets (down $1.2 million), amortization of net deferred costs related to loan commitments (down $1.2 million), professional service expense (down $990 thousand), property taxes on foreclosed assets (down $955 thousand) and Federal Reserve service charges (down $536 thousand).
Other non-interest expense for 2010 decreased $1.4 million, or 1.1%, compared to 2009. Components of other non-interest expense with significant decreases included armored motor services expense (down $2.4 million), Federal Reserve service charges (down $1.4 million), amortization of net deferred costs related to loan commitments (down $1.2 million), outside computer services expense (down $1.1 million), depreciation expense related to leased properties (down $864 thousand) and supplies expense (down $822 thousand). Additionally, other non-interest expense in 2009 included $1.4 million related to a prepayment penalty on the early repayment of certain Federal Home Loan Bank advances further discussed in Note 7 - Borrowed Funds. Components of other non-interest expense with significant increases included losses on the sale/write-down of foreclosed assets (up $2.4 million), sundry expense from miscellaneous items (up $1.5 million), Visa check card expense (up $1.0 million), messenger services expense (up $1.2 million) and sub-advisor investment management fees related to Frost Investment Advisors, LLC (up $1.2 million). The implementation of remote check image capture at the Corporation’s branches has reduced the need for armored motor services. The Corporation now utilizes more cost effective messenger services. The increase in losses on the sale/write-down of assets during 2010 was partly due to the write-down of certain bank-owned properties.
Results of Segment Operations
The Corporation’s operations are managed along two operating segments: Banking and Frost Wealth Advisors (formerly the Financial Management Group or “FMG”). A description of each business and the methodologies used to measure financial performance is described in Note 17 - Operating Segments in the accompanying notes to consolidated financial statements included elsewhere in this report. Net income (loss) by operating segment is presented below:
| 2011 | 2010 | 2009 | ||||||||||
| Banking |
$ | 216,419 | $ | 210,351 | $ | 179,404 | ||||||
| Frost Wealth Advisors |
9,050 | 7,624 | 8,642 | |||||||||
| Non-Banks |
(7,934 | ) | (9,211 | ) | (9,012 | ) | ||||||
| Consolidated net income |
$ | 217,535 | $ | 208,764 | $ | 179,034 | ||||||
Banking
Net income for 2011 increased $6.1 million, or 2.9%, compared to 2010. The increase was primarily the result of an $18.1 million increase in net interest income, a $16.2 million decrease in the provision for loan losses and a $2.1 million increase in non-interest income partly offset by a $19.7 million increase in non-interest expense and a $10.6 million increase in income tax expense. Net income for 2010 increased $30.9 million, or 17.2%,
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compared to 2009. The increase was primarily the result of a $29.6 million increase in net interest income and a $21.8 million decrease in the provision for loan losses partly offset by a $14.4 million decrease in non-interest income, a $3.9 million increase in income tax expense and a $2.2 million increase in non-interest expense.
Net interest income for 2011 increased $18.1 million, or 3.2%, compared to 2010 while net interest income for 2010 increased $29.6 million, or 5.5%, compared to 2009. The increases primarily resulted from increases in the average volume of interest-earning assets partly offset by decreases in the net interest margin. See the analysis of net interest income included in the section captioned “Net Interest Income” included elsewhere in this discussion.
The provision for loan losses for 2011 totaled $27.5 million compared to $43.6 million in 2010 and $65.4 million in 2009. See the analysis of the provision for loan losses included in the section captioned “Allowance for Loan Losses” included elsewhere in this discussion.
Non-interest income for 2011 increased $2.1 million, or 1.1%, compared to 2010. The increase was primarily due to increases in the net gain on sale of securities, other charges, commissions and fees and insurance commissions and fees partly offset by a decrease in service charges on deposit accounts and other non-interest income. The increase in the net gain on sale of securities was primarily related to the sale of $32.6 million of certain longer-duration securities during the third quarter of 2011 on which the Banking segment realized a $6.4 million gain. The increase in other charges commissions and fees was primarily related to increases in loan and lease processing fees, investment banking fees related to corporate advisory services and unused balance fees on loan commitments. The decrease in service charges on deposit accounts was primarily related to decreases in overdraft/insufficient funds charges and service charges on both consumer and commercial accounts partly offset by an increase in point of sale income from PIN-based debit card transactions. The decrease in other non-interest income was primarily related to decreases in sundry income from various miscellaneous items, income from Visa check card usage, lease rental income, income from municipal bond underwriting discounts/fees and earnings on cash surrender value of life insurance policies. See the analysis of these categories of non-interest income included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
Non-interest income for 2010 decreased $14.4 million, or 6.9%, compared to 2009. The decrease was primarily due to decreases in other non-interest income and service charges on deposits partly offset by increases in other charges, commissions and fees and insurance commissions as well as the impact of net securities gains/losses realized during the comparable years. The decrease in other non-interest income was primarily related to a $17.7 million gain realized in the fourth quarter of 2009 related to the termination of interest rate swaps on certain Federal Home Loan Bank advances. See Note 15 - Derivative Financial Instruments in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to the interest rate swaps. Excluding the gain from 2009, other non-interest income would have effectively increased $3.6 million, in part due to increases in income from Visa check card usage and income from securities trading and customer derivative activities, primarily interest rate swap transaction fees. The decrease in service charges on deposit accounts was partly related to commercial accounts due, in part, to a decrease in service volumes for billable services. The decrease in service charges on deposit accounts was also partly related to a decrease in overdraft/insufficient funds charges on consumer accounts due, in part, to a new rule issued by the Federal Reserve Board which impacted such fees beginning in the third quarter of 2010. The increase in other charges, commissions and fees was primarily related to increases in unused balance fees on loan commitments, fees on letters of credit and fees related to accounts receivable factoring. See further analysis of these categories of non-interest income included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
Non-interest expense for 2011 increased $19.7 million, or 4.4%, compared to 2010. The increase was primarily due to an increase in other non-interest expense, salaries and wages and furniture and equipment expense partly offset by decreases in deposit insurance expense and intangible amortization. The increase in other non-interest expense was partly related to an increase in advertising/promotions expense, among other things. The increases in salaries and wages were primarily related to normal annual merit and market increases as
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well as increases in incentive compensation expense and stock-based compensation expense. The increase in furniture and equipment expense was due to increases in software maintenance and software amortization. The decrease in deposit insurance was primarily related to a change in the deposit insurance assessment base and a change in the method by which the assessment rate is determined for large financial institutions. The decrease was also partly related to the Corporation opting out of the Transaction Account Guarantee component of the Temporary Liquidity Guarantee Program effective July 1, 2010. See the analysis of these items included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.
Non-interest expense for 2010 increased $2.2 million, or 0.5%, compared to 2009. The increase was primarily related to increases in salaries and wages, furniture and equipment expense and occupancy expense partly offset by decreases in deposit insurance expense, employee benefits expense, other non-interest expense and intangible amortization. The increase in salaries and wages was mostly related to increases in incentive compensation, normal annual merit increases and stock-based compensation expense partly offset by a decrease in headcount, a decrease in overtime expense and an increase in cost deferrals related to lending activity. The increase in furniture and equipment expense was primarily related to increases in software amortization and maintenance related to new applications and equipment rental expense related to new equipment leases associated with a new technology operations center. The increase in occupancy expense was primarily related to increases in building depreciation and property taxes, which were partly related to the aforementioned new technology operations center as well as increases in service contracts, repairs expense and building maintenance. The decrease in deposit insurance expense during 2010 resulted as 2009 included $7.3 million related to a one-time special assessment. The decreases in employee benefits expense were primarily due to decreases in expenses related to the Corporation’s defined benefit retirement plan and expenses related to the Corporation’s 401(k) and profit sharing plans partly offset by increases in medical insurance expense and payroll taxes. The decrease in intangible amortization expense was primarily the result of the completion of amortization of certain intangible assets, as well as a reduction in the annual amortization rate of certain intangible assets. See further analysis of these categories of non-interest expense included in the section captioned “Non-Interest Expense” included elsewhere in this discussion.
Income tax expense for 2011 increased $10.6 million, or 17.4%, compared to 2010. The increase was partly related to the correction, during the third quarter of 2011, of an under-accrual of taxes that resulted from incorrectly deducting premium amortization on municipal securities for federal income tax purposes since 2008. See the analysis of these items included in the section captioned “Income Taxes” included elsewhere in this discussion.
Frost Insurance Agency, which is included in the Banking operating segment, had gross commission revenues of $36.0 million during 2011 compared to $34.6 million in 2010 and $33.6 million in 2009. Insurance commission revenues increased $1.4 million, or 4.1%, during 2011 compared to 2010 and increased $964 thousand, or 2.9%, during 2010 compared to 2009. The increases during both 2011 and 2010 were primarily related to higher commission income. See the analysis of insurance commissions and fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
Frost Wealth Advisors
Net income for 2011 increased $1.4 million, or 18.7%, compared to 2010. The increase was primarily due to a $5.9 million increase in non-interest income partly offset by a $3.8 million increase in non-interest expense and a $772 thousand increase in income tax expense. Net income for 2010 decreased $1.0 million, or 11.8%, compared to 2009. The decrease was primarily due to a $3.0 million decrease in net interest income, a $624 thousand increase in non-interest expense partly offset by a $2.1 million increase in non-interest income and a $553 thousand decrease in income tax expense.
Net interest income for 2011 increased $52 thousand, or 0.8%, compared to 2010. The increase was due to an increase in the average volume of funds provided due to an increase in the average volume of Frost Wealth
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Advisor’s repurchase agreements partly offset by a decrease in the funds transfer price received for funds provided to the Corporation. Net interest income decreased $3.0 million, or 32.6%, in 2010 compared to 2009. The decrease was due to a decrease in the average volume of funds provided due to a decrease in the average volume of Frost Wealth Advisor’s repurchase agreements which resulted from lower interest rates offered combined with a decrease in the funds transfer price received for providing those funds due to the lower interest rate environment.
Non-interest income for 2011 increased $5.9 million, or 6.9%, compared to 2010. The increase was primarily due to increases in trust fees (up $5.0 million) and other charges, commissions and fees (up $1.3 million) partly offset by a decrease in other non-interest income (down $402 thousand). Non-interest income for 2010 increased $2.1 million, or 2.5%, compared to 2009. The increase was primarily due to increases in other charges, commissions and fees (up $1.5 million) and trust fees (up $1.3 million).
Trust fee income is the most significant income component for Frost Wealth Advisors. Investment fees are the most significant component of trust fees, making up approximately 75% of total trust fees in both 2011 and 2010 and approximately 74% of total trust fees in 2009. Investment and other custodial account fees are generally based on the market value of assets within a trust account. Volatility in the equity and bond markets impacts the market value of trust assets and the related investment fees. The increase in trust fee income during 2011 compared to 2010 was primarily the result of an increase in investment fees, securities lending income, custody fees, real estate fees and estate fees. The increase in trust fee income during 2010 compared to 2009 was primarily the result of increases in investment fees and real estate fees partly offset by decreases in financial consulting fees and securities lending income. See the analysis of trust fees included in the section captioned “Non-Interest Income” included elsewhere in this discussion.
The increase in other charges, commissions and fees during 2011 compared to 2010 was primarily due to increases in mutual fund management fees, income related to the sale of annuities and mutual funds and brokerage commissions partly offset by a decrease in commission income related to the sale of money market accounts. The increase in other charges, commissions and fees during 2010 compared to 2009 was primarily due to increases in commission income related to the sale of mutual funds and mutual fund management fees partly offset by a decrease in commission income related to the sale of money market accounts. The increases in commission income related to the sale of mutual funds and the concurrent decreases in commission income related to the sale of money market accounts during the comparable years are reflective of the apparent increased willingness of customers to invest in equities as market conditions have improved. The decreases in commission income related to the sale of money market accounts is also partly related to lower marketing fees paid by fund companies.
Non-interest expense for 2011 increased $3.8 million, or 4.7%, compared to 2010. The increase was primarily due to increases in salaries and wages (up $1.7 million) and other non-interest expense (up $2.3 million). The increases in salaries and wages was primarily related to normal annual merit and market increases and an increase in stock-based compensation expense. The increase in other non-interest expense was partly related to increases in sub-advisor investment management fees related to Frost Investment Advisors, LLC, and increases in various overhead cost allocations, among other things, partly offset by decreases in sundry losses from various miscellaneous items.
Non-interest expense for 2010 increased $624 thousand, or 0.8%, compared to 2009. The increase was primarily due to an increase in other non-interest expense (up $989 thousand) partly offset by a decrease in salaries and wages (down $370 thousand). The increase in other non-interest expense was primarily due to increases in sub-advisor investment management fees related to Frost Investment Advisors, LLC and sundry expense from miscellaneous items, among other things, partly offset by a decrease in outside computer services expense. The decrease in salaries and wages was primarily related to a decrease in incentive compensation as well as a decrease in stock-based compensation expense resulting from the forfeiture of certain awards.
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Non-Banks
The net loss for the Non-Banks operating segment for 2011 decreased $1.3 million compared to 2010. The decrease was primarily due to a $933 thousand decrease in non-interest expense, a $204 thousand increase in income tax benefit and a $192 thousand decrease in net interest expense partly offset by a $52 thousand decrease in non-interest income. The decrease in non-interest expense was primarily related to decreases in professional services expense and property taxes partly offset by an increase in directors fees.
The net loss for the Non-Banks operating segment for 2010 did not significantly fluctuate compared to 2009 as increases in legal and professional services expense, travel expense, property tax expense and income tax expense were mostly offset by an increase in mineral interest income and a decrease in interest expense. Mineral interest income is related to bonus, rental and shut-in payments and oil and gas royalties received from severed mineral interests on property owned by Main Plaza Corporation. The decrease in interest expense resulted from the redemption of $12.4 million of floating rate junior subordinated deferrable interest debentures during the third quarter of 2010. See Note 7 – Borrowed Funds in the accompanying notes to consolidated financial statements included elsewhere in this report for additional information related to this redemption.
Income Taxes
The Corporation recognized income tax expense of $68.7 million, for an effective tax rate of 24.0%, in 2011 compared to $57.6 million, for an effective rate of 21.6%, in 2010, and $53.7 million, for an effective tax rate of 23.1% in 2009. The effective income tax rates differed from the U.S. statutory rate of 35% during the comparable periods primarily due to the effect of tax-exempt income from loans, securities and life insurance policies. The increase in the effective tax rate for 2011 compared to 2010 was primarily due to the correction, during the third quarter of 2011, of an under-accrual of taxes that resulted from incorrectly deducting premium amortization on municipal securities for federal income tax purposes since 2008. As a result, the Corporation recognized additional income tax expense totaling $4.1 million, which included interest, related to the 2010, 2009 and 2008 tax years. Excluding the effect of the correction related to prior year amounts, the Corporation’s effective tax rate would have been 22.6% for 2011. The decrease in the effective tax rate during 2010 compared to 2009 was primarily the result of an increase in holdings of tax-exempt municipal securities.
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Sources and Uses of Funds
The following table illustrates, during the years presented, the mix of the Corporation’s funding sources and the assets in which those funds are invested as a percentage of the Corporation’s average total assets for the period indicated. Average assets totaled $18.6 billion in 2011 compared to $17.2 billion in 2010 and $15.7 billion in 2009.
| 2011 | 2010 | 2009 | ||||||||||
| Sources of Funds: |
||||||||||||
| Deposits: |
||||||||||||
| Non-interest-bearing |
30.9 | % | 29.2 | % | 27.1 | % | ||||||
| Interest-bearing |
51.1 | 52.5 | 52.0 | |||||||||
| Federal funds purchased and repurchase agreements |
3.2 | 2.8 | 3.9 | |||||||||
| Long-term debt and other borrowings |
1.7 | 2.2 | 3.7 | |||||||||
| Other non-interest-bearing liabilities |
1.4 | 1.5 | 1.7 | |||||||||
| Equity capital |
11.7 | 11.8 | 11.6 | |||||||||
| Total |
100.0 | % | 100.0 | % | 100.0 | % | ||||||
| Uses of Funds: |
||||||||||||
| Loans |
43.3 | % | 47.3 | % | 55.1 | % | ||||||
| Securities |
33.5 | 30.3 | 27.1 | |||||||||
| Federal funds sold, resell agreements and interest-bearing deposits |
13.5 | 11.6 | 5.7 | |||||||||
| Other non-interest-earning assets |
9.7 | 10.8 | 12.1 | |||||||||
| Total |
100.0 | % | 100.0 | % | 100.0 | % | ||||||
Deposits continue to be the Corporation’s primary source of funding. Average deposits increased $1.2 billion, or 8.4% in 2011 compared to 2010 and $1.6 billion, or 13.1% in 2010 compared to 2009. Non-interest-bearing deposits remain a significant source of funding, which has been a key factor in maintaining the Corporation’s relatively low cost of funds. Non-interest-bearing deposits totaled 37.7% of total average deposits in 2011, 35.8% in 2010 and 34.3% in 2009. As stated previously in the section captioned “Supervision and Regulation” included in Item 1. Business, elsewhere in this report, the Dodd-Frank Act repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts beginning July 21, 2011. Although the ultimate impact of this legislation on the Corporation has not yet been determined, the Corporation may begin to incur interest costs associated with demand deposits in the future as market conditions warrant, in which case, the relative proportion of non-interest-bearing deposits to total deposits would be expected to decrease.
The Corporation primarily invests funds in loans and securities. Loans continue to be the largest component of the Corporation’s mix of invested assets despite decreasing balances in recent years. Average loans decreased $82.2 million, or 1.0% in 2011 compared to 2010 and $527.4 million, or 6.1%, in 2010 compared to 2009. Average securities increased $998.6 million, or 19.2% in 2011 compared to 2010 and $950.9 million, or 22.3%, in 2010 compared to 2009. Average federal funds sold, resell agreements and interest-bearing deposits increased $519.2 million in 2011 compared to 2010 and $1.1 billion in 2010 compared to 2009. The increases in average securities and average federal funds sold, resell agreements and other interest-bearing deposits during the comparable years were primarily funded by deposit growth.
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Loans
Year-end loans were as follows:
| 2011 | Percentage of Total |
2010 | 2009 | 2008 | 2007 | |||||||||||||||||||
| Commercial and industrial: |
||||||||||||||||||||||||
| Commercial |
$ | 3,553,989 | 44.5 | % | $ | 3,479,349 | $ | 3,577,758 | $ | 3,950,648 | $ | 3,472,759 | ||||||||||||
| Leases |
193,412 | 2.4 | 186,443 | 197,605 | 205,290 | 184,140 | ||||||||||||||||||
| Asset-based |
169,466 | 2.1 | 122,866 | 117,213 | 85,865 | 32,963 | ||||||||||||||||||
| Total commercial and industrial |
3,916,867 | 49.0 | 3,788,658 | 3,892,576 | 4,241,803 | 3,689,862 | ||||||||||||||||||
| Commercial real estate: |
||||||||||||||||||||||||
| Commercial mortgages |
2,383,479 | 29.8 | 2,374,542 | 2,327,471 | 2,250,442 | 1,982,786 | ||||||||||||||||||
| Construction |
434,870 | 5.5 | 593,273 | 659,459 | 755,704 | 560,176 | ||||||||||||||||||
| Land |
202,478 | 2.5 | 234,952 | 259,200 | 346,591 | 397,319 | ||||||||||||||||||
| Total commercial real estate |
3,020,827 | 37.8 | 3,202,767 | 3,246,130 | 3,352,737 | 2,940,281 | ||||||||||||||||||
| Consumer real estate: |
||||||||||||||||||||||||
| Home equity loans |
282,244 | 3.5 | 275,806 | 289,535 | 320,220 | 282,947 | ||||||||||||||||||
| Home equity lines of credit |
191,960 | 2.4 | 186,465 | 166,441 | 122,608 | 86,873 | ||||||||||||||||||
| 1-4 family residential mortgages |
45,943 | 0.6 | 57,877 | 66,351 | 79,446 | 98,077 | ||||||||||||||||||
| Construction |
17,544 | 0.2 | 23,565 | 30,325 | 55,947 | 61,595 | ||||||||||||||||||
| Other |
225,118 | 2.8 | 254,551 | 275,780 | 266,862 | 220,897 | ||||||||||||||||||
| Total consumer real estate |
762,809 | 9.5 | 798,264 | 828,432 | 845,083 | 750,389 | ||||||||||||||||||
| Total real estate |
3,783,636 | 47.3 | 4,001,031 | 4,074,562 | 4,197,820 | 3,690,670 | ||||||||||||||||||
| Consumer and other: |
||||||||||||||||||||||||
| Consumer installment |
301,518 | 3.8 | 319,384 | 346,255 | 349,641 | 325,351 | ||||||||||||||||||
| Student loans held for sale |
- | - | - | 24,201 | 28,889 | 62,861 | ||||||||||||||||||
| Other |
11,018 | 0.1 | 28,234 | 52,406 | 53,662 | 29,891 | ||||||||||||||||||
| Total consumer and other |
312,536 | 3.9 | 347,618 | 422,862 | 432,192 | 418,103 | ||||||||||||||||||
| Unearned discounts |
(17,910 | ) | (0.2 | ) | (20,287 | ) | (22,220 | ) | (27,733 | ) | (29,273 | ) | ||||||||||||
| Total |
$ | 7,995,129 | 100.0 | % | $ | 8,117,020 | $ | 8,367,780 | $ | 8,844,082 | $ | 7,769,362 | ||||||||||||
Overview. Year-end total loans decreased $121.9 million, or 1.5%, during 2011 compared to 2010. The Corporation stopped originating 1-4 family residential mortgage loans in 2000, and as such, this portfolio is excluded when analyzing the growth of the loan portfolio. Student loans are similarly excluded because the Corporation primarily originated these loans for resale. Accordingly, student loans were classified as held for sale. During 2008, the Corporation elected to discontinue the origination of student loans for resale, aside from previously outstanding commitments. All remaining student loans were sold during the second quarter of 2010. Excluding 1-4 family residential mortgages and student loans, year-end loans decreased $110.0 million, or 1.4% during 2011 compared to 2010, decreased $218.1 million, or 2.6%, during 2010 compared to 2009, decreased $458.5 million, or 5.3%, during 2009 compared to 2008 and increased $1.1 billion, or 14.8% during 2008 compared to 2007.
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The majority of the Corporation’s loan portfolio is comprised of commercial and industrial loans and real estate loans. Commercial and industrial loans made up 49.0% and 46.7% of total loans at December 31, 2011 and 2010 while real estate loans made up 47.3% and 49.3% of total loans at December 31, 2011 and 2010. Real estate loans include both commercial and consumer balances.
Loan Origination/Risk Management. The Corporation has certain lending policies and procedures in place that are designed to maximize loan income within an acceptable level of risk. Management reviews and approves these policies and procedures on a regular basis. A reporting system supplements the review process by providing management with frequent reports related to loan production, loan quality, concentrations of credit, loan delinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions. See Note 3 – Loans in the accompanying notes to consolidated financial statements included elsewhere in this report for further details of the Corporation’s policies and procedures related to loan origination and risk management.
Commercial and Industrial Loans. Commercial and industrial loans increased $128.2 million, or 3.4%, from $3.8 billion at December 31, 2010 to $3.9 billion at December 31, 2011. The Corporation’s commercial and industrial loans are a diverse group of loans to small, medium and large businesses. The purpose of these loans varies from supporting seasonal working capital needs to term financing of equipment. While some short-term loans may be made on an unsecured basis, most are secured by the assets being financed with collateral margins that are consistent with the Corporation’s loan policy guidelines. The commercial and industrial loan portfolio also includes the commercial lease and asset-based lending portfolios as well as purchased shared national credits (“SNCs”), which are discussed in more detail below.
Industry Concentrations. As of December 31, 2011 and 2010, other than energy loans, there were no concentrations of loans within any single industry in excess of 10% of total loans, as segregated by Standard Industrial Classification code (“SIC code”). The SIC code is a federally designed standard industrial numbering system used by the Corporation to categorize loans by the borrower’s type of business. The following table summarizes the industry concentrations of the Corporation’s loan portfolio, as segregated by SIC code. Industry concentrations are stated as a percentage of year-end total loans as of December 31, 2011 and 2010:
| 2011 | 2010 | |||||||
| Industry concentrations: |
||||||||
| Energy |
10.9 | % | 9.9 | % | ||||
| Medical services |
6.8 | 6.5 | ||||||
| Public finance |
5.5 | 4.8 | ||||||
| Services |
3.0 | 3.3 | ||||||
| General and specific trade contractors |
3.0 | 3.0 | ||||||
| Manufacturing, other |
2.8 | 2.9 | ||||||
| Religion |
2.8 | 2.7 | ||||||
| Insurance |
2.4 | 2.6 | ||||||
| Legal services |
2.2 | 2.0 | ||||||
| Restaurants |
1.7 | 1.9 | ||||||
| Building construction |
1.3 | 2.8 | ||||||
| All other (35 categories in 2011 and 2010) |
57.6 | 57.6 | ||||||
| Total loans |
100.0 | % | 100.0 | % | ||||
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The Corporation’s largest concentration in any single industry is in energy. Year-end energy loans were as follows:
| 2011 | 2010 | |||||||
| Energy loans: |
||||||||
| Production |
$ | 683,795 | $ | 603,887 | ||||
| Service |
126,496 | 155,362 | ||||||
| Manufacturing |
40,265 | 23,459 | ||||||
| Traders |
16,768 | 20,793 | ||||||
| Refining |
3,262 | 3,387 | ||||||
| Total energy loans |
$ | 870,586 | $ | 806,888 | ||||
Large Credit Relationships. The market areas served by the Corporation include three of the top ten most populated cities in the United States. These market areas are also home to a significant number of Fortune 500 companies. As a result, the Corporation originates and maintains large credit relationships with numerous commercial customers in the ordinary course of business. The Corporation considers large credit relationships to be those with commitments equal to or in excess of $10.0 million, excluding treasury management lines exposure, prior to any portion being sold. Large relationships also include loan participations purchased if the credit relationship with the agent is equal to or in excess of $10.0 million. In addition to the Corporation’s normal policies and procedures related to the origination of large credits, the Corporation’s Central Credit Committee (CCC) must approve all new and renewed credit facilities which are part of large credit relationships. The CCC meets regularly and reviews large credit relationship activity and discusses the current pipeline, among other things. The following table provides additional information on the Corporation’s large credit relationships outstanding at year-end.
| 2011 |
2010 |
|||||||||||||||||||||||
| Number
of Relationships |
Period-End Balances |
Number
of Relationships |
Period-End Balances |
|||||||||||||||||||||
| Committed |
Outstanding |
Committed |
Outstanding |
|||||||||||||||||||||
| Large credit relationships: |
||||||||||||||||||||||||
| $20.0 million and greater |
137 | $ | 4,625,356 | $ | 2,132,286 | 127 | $ | 4,168,836 | $ | 2,100,807 | ||||||||||||||
| $10.0 million to $19.9 million |
140 | 1,960,852 | 1,127,865 | 133 | 1,829,472 | 1,173,454 | ||||||||||||||||||
The average commitment per large credit relationship in excess of $20.0 million totaled $33.8 million at December 31, 2011 and $32.8 million at December 31, 2010. The average outstanding balance per large credit relationship with a commitment in excess of $20.0 million totaled $15.6 million at December 31, 2011 and $16.5 million at December 31, 2010. The average commitment per large credit relationship between $10.0 million and $19.9 million totaled $14.0 million at December 31, 2011 and $13.8 million at December 31, 2010. The average outstanding balance per large credit relationship with a commitment between $10 million and $19.9 million totaled $8.1 million at December 31, 2011 and $8.8 million at December 31, 2010.
Purchased Shared National Credits. Purchased SNCs are participations purchased from upstream financial organizations and tend to be larger in size than the Corporation’s originated portfolio. The Corporation’s purchased SNC portfolio totaled $537.4 million at December 31, 2011 increasing $77.4 million, or 16.8%, from $460.0 million at December 31, 2010. At December 31, 2011, 60.6% of outstanding purchased SNCs was related to the energy industry. The remaining purchased SNCs were diversified throughout various other industries, with no other single industry exceeding 10% of the total purchased SNC portfolio. Additionally, almost all of the outstanding balance of purchased SNCs was included in the commercial and industrial portfolio, with the remainder included in the real estate categories. SNC participations are originated in the normal course of business to meet the needs of the Corporation’s customers. As a matter of policy, the Corporation generally only participates in SNCs for companies headquartered in or which have significant operations within the
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Corporation’s market areas. In addition, the Corporation must have direct access to the company’s management, an existing banking relationship or the expectation of broadening the relationship with other banking products and services within the following 12 to 24 months. SNCs are reviewed at least quarterly for credit quality and business development successes. The following table provides additional information about certain credits within the Corporation’s purchased SNCs portfolio as of year-end.
| 2011 |
2010 |
|||||||||||||||||||||||
| Number
of Relationships |
Period-End Balances |
Number
of Relationships |
Period-End Balances |
|||||||||||||||||||||
| Committed |
Outstanding |
Committed |
Outstanding |
|||||||||||||||||||||
| Purchased shared national credits: |
||||||||||||||||||||||||
| $20.0 million and greater |
36 | $ | 1,024,373 | $ | 382,356 | 30 | $ | 788,980 | $ | 312,349 | ||||||||||||||
| $10.0 million to $19.9 million |
16 | 224,141 | 132,163 | 16 | 250,181 | 122,613 | ||||||||||||||||||
Real Estate Loans. Real estate loans totaled $3.8 billion at December 31, 2011 decreasing $217.4 million, or 5.4%, compared to $4.0 billion at December 31, 2010. Commercial real estate loans totaled $3.0 billion, or 79.8% of total real estate loans, at December 31, 2011 and $3.2 billion, or 80.0% of total real estate loans, at December 31, 2010. The majority of this portfolio consists of commercial real estate mortgages, which includes both permanent and intermediate term loans. The Corporation’s primary focus for the commercial real estate portfolio has been growth in loans secured by owner-occupied properties. These loans are viewed primarily as cash flow loans and secondarily as loans secured by real estate. Consequently, these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as that of a real estate loan.
The following tables summarize the Corporation’s commercial real estate loan portfolio, as segregated by (i) the type of property securing the credit and (ii) the geographic region in which the loans were originated. Property type concentrations are stated as a percentage of year-end total commercial real estate loans as of December 31, 2011 and 2010:
| 2011 | 2010 | |||||||
| Property type: |
||||||||
| Office building |
17.4 | % | 16.5 | % | ||||
| Office/warehouse |
15.8 | 16.7 | ||||||
| Medical offices and services |
9.7 | 8.4 | ||||||
| Non-farm/non-residential |
7.8 | 7.1 | ||||||
| Religious |
7.3 | 6.6 | ||||||
| Retail |
4.9 | 6.2 | ||||||
| Multifamily |
4.0 | 4.2 | ||||||
| 1-4 family |
3.8 | 4.6 | ||||||
| All other |
29.3 | 29.7 | ||||||
| Total commercial real estate loans |
100.0 | % | 100.0 | % | ||||
| Geographic region: |
||||||||
| Fort Worth |
25.8 | % | 27.1 | % | ||||
| San Antonio |
23.9 | 23.7 | ||||||
| Houston |
19.9 | 20.3 | ||||||
| Austin |
10.9 | 10.3 | ||||||
| Dallas |
8.3 | 8.0 | ||||||
| Rio Grande Valley |
6.5 | 5.5 | ||||||
| Corpus Christi |
4.7 | 5.1 | ||||||
| Total commercial real estate loans |
100.0 | % | 100.0 | % | ||||
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Consumer Loans. The consumer loan portfolio, including all consumer real estate, totaled $1.1 billion at both December 31, 2011 and 2010. As the following table illustrates as of year-end, the consumer loan portfolio has three distinct segments, including consumer real estate (excluding 1-4 family residential mortgages), consumer installment and 1-4 family residential mortgages.
| 2011 | 2010 | |||||||
| Consumer real estate: |
||||||||
| Home equity loans |
$ | 282,244 | $ | 275,806 | ||||
| Home equity lines of credit |
191,960 | 186,465 | ||||||
| Construction |
17,544 | 23,565 | ||||||
| Other |
225,118 | 254,551 | ||||||
| Total consumer real estate |
716,866 | 740,387 | ||||||
| Consumer installment |
301,518 | 319,384 | ||||||
| 1-4 family residential mortgages |
45,943 | 57,877 | ||||||
| Total consumer loans |
$ | 1,064,327 | $ | 1,117,648 | ||||
Consumer real estate loans, excluding 1-4 family residential mortgages, decreased $23.5 million, or 3.2%, from December 31, 2010. Combined, home equity loans and lines of credit made up 66.1% and 62.4% of the consumer real estate loan total at December 31, 2011 and 2010. The Corporation offers home equity loans up to 80% of the estimated value of the personal residence of the borrower, less the value of existing mortgages and home improvement loans.
The consumer installment loan portfolio primarily consists of automobile loans, unsecured revolving credit products, personal loans secured by cash and cash equivalents, and other similar types of credit facilities.
As previously stated, the Corporation discontinued the origination of student loans for resale, aside from previously outstanding commitments, during 2008 and sold all remaining student loans during 2010. Student loans were primarily originated for resale on the secondary market and classified as “held for sale” though included in total loans in the consolidated balance sheet. Student loans were generally sold on a non-recourse basis after the deferment period ended; however, from time to time, the Corporation sold such loans prior to the end of the deferment period. The Corporation sold approximately $23.5 million of student loans during 2010 and $4.6 million during 2009.
In general, the Corporation no longer originates 1-4 family mortgage loans; however, from time to time, the Corporation may invest in such loans to meet the needs of its customers.
Foreign Loans. The Corporation makes U.S. dollar-denominated loans and commitments to borrowers in Mexico. The outstanding balance of these loans and the unfunded amounts available under these commitments were not significant at December 31, 2011 or 2010.
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Maturities and Sensitivities of Loans to Changes in Interest Rates. The following table presents the maturity distribution of the Corporation’s loans, excluding 1-4 family residential real estate loans and unearned discounts, at December 31, 2011. The table also presents the portion of loans that have fixed interest rates or variable interest rates that fluctuate over the life of the loans in accordance with changes in an interest rate index such as the prime rate or LIBOR.
| Due in One Year or Less |
After One, but Within Five Years |
After Five Years |
Total | |||||||||||||
| Commercial and industrial |
$ | 1,886,994 | $ | 1,649,588 | $ | 380,285 | $ | 3,916,867 | ||||||||
| Real estate construction |
141,055 | 211,627 | 99,732 | 452,414 | ||||||||||||
| Commercial real estate and land |
399,099 | 1,195,147 | 991,711 | 2,585,957 | ||||||||||||
| Consumer and other |
175,221 | 199,654 | 636,983 | 1,011,858 | ||||||||||||
| Total |
$ | 2,602,369 | $ | 3,256,016 | $ | 2,108,711 | $ | 7,967,096 | ||||||||
| Loans with fixed interest rates |
$ | 833,296 | $ | 1,005,231 | $ | 1,222,336 | $ | 3,060,863 | ||||||||
| Loans with floating interest rates |
1,769,073 | 2,250,785 | 886,375 | 4,906,233 | ||||||||||||
| Total |
$ | 2,602,369 | $ | 3,256,016 | $ | 2,108,711 | $ | 7,967,096 | ||||||||
The Corporation generally structures commercial loans with shorter-term maturities in order to match the Corporation’s funding sources and to enable the Corporation to effectively manage the loan portfolio by providing the flexibility to respond to liquidity needs, changes in interest rates and changes in underwriting standards and loan structures, among other things. Due to the shorter-term nature of such loans, from time to time and in the ordinary course of business, the Corporation will renew/extend maturing lines of credit or refinance existing loans at their maturity dates. These renewals, extensions and refinancings are made in the ordinary course of business for customers that meet the Corporation’s normal level of credit standards. Such borrowers typically request renewals to support their on-going working capital needs to finance their operations. Such borrowers are not experiencing financial difficulties and generally could obtain similar financing from another financial institution. In connection with each renewal, extension or refinancing, the Corporation may require a principal reduction, adjust the rate of interest and/or modify the structure and other terms to reflect the current market pricing/structuring for such loans or to maintain competitiveness with other financial institutions. In such cases, the Corporation does not generally grant concessions, and, except for those reported in Note 3 – Loans, any such renewals, extensions or refinancings that occurred during the reported periods were not deemed to be troubled debt restructurings pursuant to applicable accounting guidance. During 2011, renewals, extensions and refinancings of commercial and industrial loans totaled approximately $1.6 billion while renewals, extensions and refinancings of commercial real estate and construction loans totaled approximately $603.4 million. Due to the shorter-term structuring of the Corporation’s loan portfolio, some loans may renew multiple times in a given year as a result of general customer practice and need. Loans exceeding $1.0 million undergo a complete underwriting process at each renewal.
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Non-Performing Assets and Potential Problem Loans
Non-Performing Assets. Year-end non-performing assets and accruing past due loans were as follows:
| 2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
| Non-accrual loans: |
||||||||||||||||||||
| Commercial and industrial |
$ | 43,874 | $ | 60,408 | $ | 82,219 | $ | 27,123 | $ | 11,445 | ||||||||||
| Real estate |
49,736 | 76,270 | 63,926 | 36,764 | 12,026 | |||||||||||||||
| Consumer and other |
728 | 462 | 722 | 1,287 | 972 | |||||||||||||||
| Total non-accrual loans |
94,338 | 137,140 | 146,867 | 65,174 | 24,443 | |||||||||||||||
| Restructured loans |
- | - | - | - | - | |||||||||||||||
| Foreclosed assets: |
||||||||||||||||||||
| Real estate |
26,608 | 27,339 | 33,305 | 12,312 | 4,596 | |||||||||||||||
| Other |
- | 471 | 7 | 554 | 810 | |||||||||||||||
| Total foreclosed assets |
26,608 | 27,810 | 33,312 | 12,866 | 5,406 | |||||||||||||||
| Total non-performing assets |
$ | 120,946 | $ | 164,950 | $ | 180,179 | $ | 78,040 | $ | 29,849 | ||||||||||
| Ratio of non-performing assets to: |
||||||||||||||||||||
| Total loans and foreclosed assets |
1.51 | % | 2.03 | % | 2.14 | % | 0.88 | % | 0.38 | % | ||||||||||
| Total assets |
0.60 | 0.94 | 1.11 | 0.52 | 0.22 | |||||||||||||||
| Accruing past due loans: |
||||||||||||||||||||
| 30 to 89 days past due |
$ | 42,463 | $ | 55,045 | $ | 90,173 | $ | 102,053 | $ | 45,290 | ||||||||||
| 90 or more days past due |
17,417 | 26,922 | 23,911 | 19,751 | 14,347 | |||||||||||||||
| Total accruing past due loans |
$ | 59,880 | $ | 81,967 | $ | 114,084 | $ | 121,804 | $ | 59,637 | ||||||||||
| Ratio of accruing past due loans to total loans: |
||||||||||||||||||||
| 30 to 89 days past due |
0.53 | % | 0.68 | % | 1.08 | % | 1.16 | % | 0.58 | % | ||||||||||
| 90 or more days past due |
0.22 | 0.33 | 0.28 | 0.22 | 0.19 | |||||||||||||||
| Total accruing past due loans |
0.75 | % | 1.01 | % | 1.36 | % | 1.38 | % | 0.77 | % | ||||||||||
Non-performing assets include non-accrual loans and foreclosed assets. Non-performing assets at December 31, 2011 decreased $44.0 million from December 31, 2010. While down significantly in 2011, in general, the level of non-performing assets in recent years is reflective of the weaker economic conditions which began in the latter part of 2008. Non-accrual commercial and industrial loans included two credit relationships in excess of $5 million totaling $17.3 million at December 31, 2011 and three credit relationships in excess of $5 million totaling $25.8 million at December 31, 2010. Non-accrual real estate loans primarily consist of land development, 1-4 family residential construction credit relationships and loans secured by office buildings and religious facilities. Non-accrual commercial real estate loans included one credit relationship in excess of $5 million totaling $5.8 million at December 31, 2011 and one credit relationship in excess of $5 million totaling $6.4 million at December 31, 2010.
Non-performing assets at December 31, 2010 decreased $15.2 million from December 31, 2009. Non-accrual commercial loans included three credit relationships in excess of $5 million totaling $25.8 million at December 31, 2010 and three credit relationships in excess of $5 million totaling $37.6 million at December 31, 2009. Non-accrual commercial and commercial real estate loans also included $6.5 million and $16.3 million in loans to certain Mexican borrowers at December 31, 2010 and December 31, 2009, respectively, primarily related to deterioration in the U.S. dollar exchange rate of the Mexican peso. Non-performing assets at December 31, 2009 increased $102.1 million from December 31, 2008. The increase in non-accrual commercial loans was partly related to the addition of two credit relationships with an aggregate total of $31.4 million. Non-accrual commercial and commercial real estate loans at December 31, 2009 also included the
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aforementioned $16.3 million in loans to certain Mexican borrowers. The increase in non-accrual real estate loans was primarily related to land development and 1-4 family residential construction credit relationships. Non-performing assets at December 31, 2008 increased $48.2 million from December 31, 2007. The increase in non-performing assets was primarily related to land development and 1-4 family residential construction credit relationships. The increase was reflective of the deterioration of economic conditions during 2008, as well as overall growth in the loan portfolio.
Generally, loans are placed on non-accrual status if principal or interest payments become 90 days past due and/or management deems the collectibility of the principal and/or interest to be in question, as well as when required by regulatory requirements. Once interest accruals are discontinued, accrued but uncollected interest is charged to current year operations. Subsequent receipts on non-accrual loans are recorded as a reduction of principal, and interest income is recorded only after principal recovery is reasonably assured. Classification of a loan as non-accrual does not preclude the ultimate collection of loan principal or interest.
Foreclosed assets represent property acquired as the result of borrower defaults on loans. Foreclosed assets are recorded at estimated fair value, less estimated selling costs, at the time of foreclosure. Write-downs occurring at foreclosure are charged against the allowance for loan losses. Subsequent to foreclosure, the fair value of property held is monitored/evaluated by a third-party service and reviewed with management on a quarterly basis. Write-downs are provided for subsequent declines in value and are included in other non-interest expense along with other expenses related to maintaining the properties. During 2011 and 2010, foreclosed assets, particularly among certain classes of property (primarily land), experienced significant deterioration in fair values as a result of the prevailing weaker economic conditions. Write-downs of foreclosed assets totaled $2.8 million and $2.3 million, during 2011 and 2010, respectively. During 2011, the Corporation recognized write-downs on 29 different properties/relationships with the average write-down totaling $96 thousand and the largest individual write-down totaling $689 thousand. The weighted-average percentage write-down was 30.3%. The weighted-average number of days these properties were held as foreclosed assets prior to write-down was 276 days. During 2010, the Corporation recognized write-downs on 60 different properties/relationships with the average write-down totaling $38 thousand and the largest individual write-down totaling $220 thousand. The weighted-average percentage write-down was 22.5%. The weighted-average number of days these properties were held as foreclosed assets prior to write-down was 336 days. There were no significant concentrations of any properties, to which the aforementioned write-downs relate, in any single geographic region.
Potential problem loans consist of loans that are performing in accordance with contractual terms but for which management has concerns about the ability of an obligor to continue to comply with repayment terms because of the obligor’s potential operating or financial difficulties. Management monitors these loans closely and reviews their performance on a regular basis. At December 31, 2011 and 2010, the Corporation had $42.6 million and $33.8 million in loans of this type which are not included in either of the non-accrual or 90 days past due loan categories. At December 31, 2011, potential problem loans consisted of seven credit relationships. Of the total outstanding balance at December 31, 2011, 66.2% related to two customers in the construction industry and 14.3% related to two customers in manufacturing. Weakness in these companies’ operating performance has caused the Corporation to heighten the attention given to these credits.
Allowance For Loan Losses
The allowance for loan losses is a reserve established through a provision for loan losses charged to expense, which represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The Corporation’s allowance for loan loss methodology includes allowance allocations calculated in accordance with ASC Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific
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loss allocations, with adjustments for current events and conditions. The Corporation’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, classified and criticized loans and net charge-offs or recoveries, among other factors. The provision for loan losses also reflects the totality of actions taken on all loans for a particular period. In other words, the amount of the provision reflects not only the necessary increases in the allowance for loan losses related to newly identified criticized loans, but it also reflects actions taken related to other loans including, among other things, any necessary increases or decreases in required allowances for specific loans or loan pools. See Note 3 - Loans in the accompanying notes to consolidated financial statements included elsewhere in this report for further details regarding the Corporation’s methodology for estimating the appropriate level of the allowance for loan losses.
The table below provides an allocation of the year-end allowance for loan losses by loan type; however, allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories:
| 2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||||||||||||||||||||||
| Allowance Loan |
Percentage of Loans in each Category to Total Loans |
Allowance Loan |
Percentage of Loans in each Category to Total Loans |
Allowance for Loan Losses |
Percentage of Loans in each Category to Total Loans |
Allowance Loan |
Percentage of Loans in each Category to Total Loans |
Allowance Loan |
Percentage of Loans in each Category to Total Loans |
|||||||||||||||||||||||||||||||
| Commercial and industrial |
$ | 42,774 | 49.0 | % | $ | 57,789 | 46.7 | % | $ | 57,394 | 46.5 | % | $ | 51,534 | 48.0 | % | $ | 50,245 | 47.1 | % | ||||||||||||||||||||
| Commercial real estate |
20,912 | 37.8 | 28,534 | 39.5 | 28,514 | 38.8 | 25,928 | 37.9 | 19,215 | 37.8 | ||||||||||||||||||||||||||||||
| Consumer real estate |
3,540 | 9.5 | 3,223 | 9.8 | 2,560 | 9.9 | 3,217 | 9.6 | 1,585 | 9.7 | ||||||||||||||||||||||||||||||
| Consumer and other |
12,635 | 3.7 | 11,974 | 4.0 | 16,929 | 4.8 | 18,846 | 4.5 | 13,426 | 5.4 | ||||||||||||||||||||||||||||||
| Unallocated |
30,286 | - | 24,796 | - | 19,912 | - | 10,719 | - | 7,868 | - | ||||||||||||||||||||||||||||||
| Total |
$ | 110,147 | 100 | % | $ | 126,316 | 100.0 | % | $ | 125,309 | 100.0 | % | $ | 110,244 | 100.0 | % | $ | 92,339 | 100.0 | % | ||||||||||||||||||||
As of December 31, 2011, the reserve allocated to commercial and industrial loans decreased $15.0 million compared to December 31, 2010. The decrease was related to decreases in the level of classified loans and allocations for specific loans. Classified commercial and industrial loans (loans having a risk grade of 11, 12 or 13) totaled $139.2 million at December 31, 2011 compared to $198.3 million at December 31, 2010. Specific allocations of the allowance for loan losses related to commercial and industrial loans totaled $2.7 million at December 31, 2011 compared to $9.1 million at December 31, 2010. The decrease was also partly due to a decrease in the historical loss allocation factor applied to non-classified commercial and industrial loans. The base historical loss allocation for each category of loans is the product of the volume of loans within each level of risk classification and the historical loss allocation factor for that particular level of risk classification, adjusted, as necessary to reflect the impact of current conditions. The base historical loss allocation is then adjusted upwards utilizing an environmental adjustment factor that is based upon a more qualitative analysis of risk. See Note 3 - Loans in the accompanying notes to consolidated financial statements for information regarding the various risks that may be considered in the determination of the environmental adjustment factor. Prior to the first quarter of 2011, the base historical loss allocation factors for non-classified loans determined based upon actual historical loss experience were adjusted upwards given the continued higher levels of charge-offs relative to historical average and the prevailing uncertain economic conditions. During the first quarter of 2011, the amounts of these upward adjustments were partly reduced in light of the decreasing trend in classified loans and an improvement in the outlook related to credit quality. The impact of these reductions was partly offset by the effect of a new allocation for distressed industries and an increase in the environmental adjustment factor. As more fully discussed in Note 3 - Loans in the accompanying notes to consolidated financial statements, the distressed industries allocation was added to the Corporation’s methodology for the determination of reserves allocated to specific loan portfolio segments in 2011. The distressed industries allocation related to commercial and industrial loans totaled $4.1 million at December 31, 2011. The environmental adjustment factor resulted in additional general valuation allowances for commercial and industrial loans totaling $5.6 million at December 31, 2011 and $4.4 million at December 31, 2010.
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As of December 31, 2011, the reserve allocated to commercial real estate loans decreased $7.6 million compared to December 31, 2010. The decrease was primarily related to decreases in the level of classified loans and allocations for specific loans. Classified commercial real estate loans totaled $180.0 million at December 31, 2011 compared to $213.6 million at December 31, 2010. Specific allocations of the allowance for loan losses related to commercial real estate loans totaled $1.1 million at December 31, 2011 compared to $4.4 million at December 31, 2010. The decrease was also partly due to a decrease in the historical loss allocation factor applied to non-classified commercial real estate loans, as discussed above with regards to commercial and industrial loans. The impact of these reductions was partly offset by the effect of a new allocation for distressed industries and an increase in the environmental adjustment factor. The distressed industries allocation related to commercial real estate loans totaled $922 thousand at December 31, 2011. The environmental adjustment factor resulted in additional general valuation allowances for commercial real estate loans totaling $3.7 million at December 31, 2011 and $3.0 million at December 31, 2010.
The reserve allocated to consumer real estate loans at December 31, 2011 increased $317 thousand compared to December 31, 2010, while the reserve allocated to consumer and other loans at December 31, 2011 increased $661 thousand compared to December 31, 2010. The increases in the reserves allocated to consumer real estate loans and consumer and other loans were primarily related to increases in the historical loss allocation factors applied to these loan segments and an increase in the environmental adjustment factor, partly offset by the effect of a decrease in the volume of loans in each of these segments.
The unallocated portion of the allowance for loan losses represents general valuation allowances that are not allocated to specific loan portfolio segments. See Note 3 - Loans in the accompanying notes to consolidated financial statements for information regarding the components of the unallocated portion of the allowance. The unallocated portion of the allowance for loan losses at December 31, 2011 increased $5.5 million compared to December 31, 2010. This fluctuation was primarily due to an increase in the allocation for excessive industry concentrations which totaled $7.0 million at December 31, 2011 compared to $1.7 million at December 31, 2010. The increase was primarily related to new industry concentrations that were not considered to be excessive industry concentrations in 2010. In addition, during 2011, the Corporation refined its methodology for the determination of general valuation allowances to (i) provide additional allocations for loans that did not undergo a separate, independent concurrence review during the underwriting process (generally those loans under $1.0 million at origination), (ii) reduce the minimum balance/commitment threshold for which allocations are made for highly leveraged credit relationships that exceed specified risk grades, (iii) lower the maximum risk grade thresholds for highly leveraged credit relationships, and (iv) include a reduction factor for recoveries of prior charge-offs to compensate for the fact that historical loss allocations are based upon gross charge-offs rather than net. The net effect of these changes to the Corporation’s methodology for the determination of general valuation allowances did not significantly impact the level of the unallocated portion of the allowance for loan losses at December 31, 2011 compared to December 31, 2010.
During 2010, the reserve allocated to commercial and industrial loans and commercial and consumer real estate loans did not significantly fluctuate compared to 2009 as the effect of a slight decrease in the level of classified loans as well as decreases in the overall volume of commercial and industrial loans and real estate loans was offset by the effect of increases in the historical loss allocation factors applied to both classified and non-classified loans. The historical loss allocation factors for non-classified loans determined based upon actual historical experience were adjusted upwards given the continued higher levels of net charge-offs relative to historical average and the continued uncertain economic conditions. Specific valuation allowances related to commercial and industrial loans decreased approximately $2.8 million in 2010 compared to 2009 while specific valuation allowances related to real estate loans increased $2.8 million in 2010 compared to 2009. The decrease in the reserve allocated to consumer and other loans during 2010 compared to 2009 was primarily related to a decrease in the volume of such loans. Despite improving economic conditions relative to 2009, the increase in the unallocated portion of the allowance for loan losses during 2010 compared to 2009 was reflective of continued economic uncertainty resulting from weakness in certain business sectors (including contractors, builders, commercial real estate, manufacturing and healthcare), high unemployment and relatively low
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consumer spending activity. The Corporation primarily monitors communications and statistical data from the Federal Reserve and other agencies of the U.S. government in assessing the status of these factors. By the end of 2010, management believed that the improving trends seen in certain components of the Texas Leading Index, as well as in the national economy as a whole, were primarily driven by government stimulus programs, the extension of tax cuts and the monetary policy of the Federal Reserve with regards to quantitative easing. Such measures were expected to act as a catalyst for long-term growth; however, while short-term improvements were seen, management believes that these measures did not lead to private-sector employment growth and increased consumer spending levels as they were expected.
During 2009, the reserve allocated to commercial and industrial loans and commercial real estate loans increased $5.9 million and $2.6 million, respectively, compared to 2008 primarily due to an increase in the historical loss allocation factors applied to non-classified loans. The historical loss allocation factors for non-classified loans determined based upon actual historical experience were adjusted upwards in 2009 given the significant increase in net charge-offs relative to historical average and the continued uncertain economic conditions. Specific valuation allowances related to commercial and industrial loans increased approximately $4.8 million in 2009 compared to 2008 while specific valuation allowances related to real estate loans decreased $461 thousand in 2009 compared to 2008. The $9.2 million increase in the unallocated portion of the allowance for loan losses during 2009 compared to 2008 was reflective of continued recessionary economic conditions which began in 2008.
During 2008, the reserve allocated to all categories of loans increased compared to 2007 primarily due to increases in the level of classified loans which impacted the level of allocations required based upon historical loss experience combined with overall growth in loans. Specific valuation allowances also increased in 2008. Specific valuation allowances related to commercial and industrial loans and real estate loans increased approximately $4.1 million and $2.0 million in 2008 compared to 2007, respectively. The increase in the reserve allocated to commercial and industrial loans due to the increase in classified loans and specific valuation allowances was mostly offset by a decrease in general valuation allowances related to large balance and highly leveraged credit relationships that exceed specified risk grades. The increase in the reserve allocated to real estate loans due to the increase in classified loans and specific valuation allowances was partly offset by a decrease in general valuation allowances previously allocated to compensate for concentration risk related to certain higher-risk categories of real estate loans. The increase in the unallocated portion of the allowance for loan losses during 2008 compared to 2007 was reflective of the deterioration of economic conditions during 2008.
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Activity in the allowance for loan losses is presented in the following table.
| 2011 | 2010 | 2009 | 2008 | 2007 | ||||||||||||||||
| Balance of allowance for loan losses at beginning of year |
$ | 126,316 | $ | 125,309 | $ | 110,244 | $ | 92,339 | $ | 96,085 | ||||||||||
| Provision for loan losses |
27,445 | 43,611 | 65,392 | 37,823 | 14,660 | |||||||||||||||
| Charge-offs: |
||||||||||||||||||||
| Commercial and industrial |
(33,678 | ) | (31,324 | ) | (35,432 | ) | (13,910 | ) | (7,541 | ) | ||||||||||
| Real estate |
(13,565 | ) | (10,206 | ) | (12,132 | ) | (6,855 | ) | (9,309 | ) | ||||||||||
| Consumer and other |
(9,442 | ) | (11,893 | ) | (12,047 | ) | (8,422 | ) | (8,309 | ) | ||||||||||
| Total charge-offs |
(56,685 | ) | (53,423 | ) | (59,611 | ) | (29,187 | ) | (25,159 | ) | ||||||||||
| Recoveries: |
||||||||||||||||||||
| Commercial and industrial |
4,526 | 2,794 | 2,525 | 3,285 | 2,125 | |||||||||||||||
| Real estate |
1,838 | 1,603 | 497 | 1,101 | 331 | |||||||||||||||
| Consumer and other |
6,707 | 6,422 | 6,262 | 4,883 | 4,297 | |||||||||||||||
| Total recoveries |
13,071 | 10,819 | 9,284 | 9,269 | 6,753 | |||||||||||||||
| Net charge-offs |
(43,614 | ) | (42,604 | ) | (50,327 | ) | (19,918 | ) | (18,406 | ) | ||||||||||
| Balance at end of year |
$ | 110,147 | $ | 126,316 | $ | 125,309 | $ | 110,244 | $ | 92,339 | ||||||||||
| Net charge-offs as a percentage of average loans |
0.54 | % | 0.52 | % | 0.58 | % | 0.24 | % | 0.25 | % | ||||||||||
| Allowance for loan losses as a percentage of year-end loans |
1.38 | 1.56 | 1.50 | 1.25 | 1.19 | |||||||||||||||
| Allowance for loan losses as a percentage of year-end non-accrual loans |
116.76 | 92.11 | 85.32 | 169.15 | 377.77 | |||||||||||||||
| Average loans outstanding during the year |
$ | 8,042,968 | $ | 8,125,150 | $ | 8,652,563 | $ | 8,314,265 | $ | 7,464,140 | ||||||||||
| Loans outstanding at year-end |
7,995,129 | 8,117,020 | 8,367,780 | 8,844,082 | 7,769,362 | |||||||||||||||
| Non-accrual loans outstanding at year-end |
94,338 | 137,140 | 146,867 | 65,174 | 24,443 | |||||||||||||||
As stated above, the provision for loan losses reflects loan quality trends, including the level of net charge-offs or recoveries, among other factors. The provision for loan losses decreased $16.2 million in 2011 to $27.4 million compared to $43.6 million in 2010 and decreased $21.8 million in 2010 compared to $65.4 million in 2009. The level of the provision for loan losses during 2011 is reflective of the decreasing trend in classified loans. The decrease in the provision for loan losses during 2010 is reflective of a decrease in the level of net charge-offs compared to 2009 as well as decreases in the level of classified loans and overall loan volumes. The increase in the provision for loan losses during 2009 compared to 2008 was partly due to higher levels of net charge-offs and an increase in classified loans related to the weaker economic conditions. The weak economic conditions particularly affected the performance of many of the Corporation’s land development and 1-4 family residential construction credit relationships. The increase in 2008 compared to 2007 was partly due to a provision totaling approximately $10 million for probable loan losses related to Hurricane Ike which impacted the Corporation’s Houston and Galveston market areas during the third quarter of 2008. In determining the amount of the provision, the Corporation identified customers that were likely impacted by the hurricane based on their geographic location. The Corporation adjusted risk grades for loans to these customers based on estimated loan payment abilities and loss of collateral value. Furthermore, the Corporation increased the historical loss allocation factors for all lower-risk, “pass” loans to customers within the areas directly impacted by Hurricane Ike and the greater Houston/Galveston market area as a whole. The increase in the provision for loan losses was also partly due to an increase in classified loans and the overall growth in loans, which increased $1.1 billion, or 13.8%, during 2008 compared to 2007.
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Net charge-offs for 2011 increased $1.0 million compared to 2010 while net charge-offs in 2010 decreased $7.7 million compared to 2009 and net charge-offs during 2009 increased $30.4 million compared to 2008. The ratio of the allowance for loan losses to total loans decreased 18 basis points from 1.56% at December 31, 2010 to 1.38% at December 31, 2011. As a percentage of average loans, net charge-offs increased 2 basis points in 2011 compared to 2010, decreased 6 basis points in 2010 compared to 2009 and increased 34 basis points in 2009 compared to 2008. The level of net charge-offs in 2011 was partly related to the charge-off of several large credit relationships during the third quarter of 2011. Aside from these charge-offs, the overall trend in net charge-offs during 2011 reflects the continued improvement in the level of classified loans. The Corporation expects the level of net charge-offs to continue to trend downward as the overall credit quality of the loan portfolio continues to improve. The decrease in charge-offs in 2010 is reflective of a stabilization of the trend of increasing classified loans experienced through-out 2009 and early 2010 as well as the Corporation’s ability to manage the overall credit quality of the loan portfolio. The increase in net charge-offs in 2009 is related to the deterioration of economic conditions which began in 2008.
The ratio of the allowance for loan losses to total loans decreased 18 basis points from 1.56% at December 31, 2010 to 1.38% at December 31, 2011, which is reflective of continued improvement in the level of classified loans. Management believes the recorded amount of the allowance for loan losses is appropriate based upon management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. Should any of the factors considered by management in evaluating the appropriate level of the allowance for loan losses change, the Corporation’s estimate of probable loan losses could also change, which could affect the level of future provisions for loan losses.
Securities
Year-end securities were as follows:
| 2011 | 2010 | 2009 | ||||||||||||||||||||||
| Amount | Percentage of Total |
Amount | Percentage of Total |
Amount | Percentage of Total |
|||||||||||||||||||
| Held to maturity: |
||||||||||||||||||||||||
| U.S. Treasury | ||||||||||||||||||||||||